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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 reserved.
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Part III

Forecasting and Valuation Analysis

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Layout of Part III


Chapter 13
Valuing operations separate from financing Analyzing price-to-book ratios

Part III Page 414

Chapter 14
Creating simple forecasts

Chapter 16
Analyzing price-to-earnings ratios

Chapter 15
Creating pro-forma financial statements to get forecasts for valuation

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


Chapter 13

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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

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The Accrual Accounting Valuation Model


T

Chapter 13 Page 418

T V0E = CSE0 + E t earn t ( E 1) CSE t 1 + CVT E 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
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The First Three Steps of Fundamental Analysis


1. 2. 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
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3.

The RE Forecast is a Forecast of Earnings Against a Benchmark

Chapter 13 Page 418

R E 1 = earn 1 ( E 1 )CSE
(1) (1) (2) (2)

Forecast of comprehensive earnings for next year Benchmark forecast of comprehensive earnings: CSE will earn at the cost of capital

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Chapter 13 Page 419

The Perfect Balance Sheet


MS, Inc. Balance Sheet, December 31, Year 0 Assets Year 0 Marketable equity securities (at market) 23.4 Prior Year 20.3 Long-term debt (NFO) Common shareholders equity (CSE) NOA 23.4 20.3 Equities Year 0 7.7 Prior Year 7.0

15.7 23.4

13.3 20.3

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MS, Inc. Income Statement, Year 0 Operating income Dividends from equity securities Unrealized gains from equity securities Interest expense: 0.10 x 7.0 Net income

The Perfect Balance Sheet (cont.)

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
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Forecasting from a Perfect Balance Sheet

Chapter 13 Page 420

e a r n1 = ( E 1) CSE 0 = 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 0E = CSE 0
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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

Chapter 13 Page 421 Box 13.1

V0E V = CSE0 =1 CSE0


E 0

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The Imperfect Balance Sheet


P P E , Inc. B a la nc e S he e t, D e c e m b e r 3 1 Y e a r 0 A s s e ts Y ear 0 P r op e r ty , p la n t & e q uip m e nt (a t c os t le s s a c c um d e p r e c ) 7 4 .4 P r ior Y ear 6 9 .9 L on g -te r m d e b t (N F O ) C om m on s ha r e h old e r s e q uity (C S E ) NOA 7 4 .4 6 9 .9 E q uitie s Y ear 0 7 .7 6 6 .7 7 4 .4

Chapter 13 Page 422 Exhibit 13.1

P r ior Y ear 7 .0 6 2 .9 6 9 .9

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P P E , Inc. I n c o m e S ta te m e n t, Y e a r 0 O p e r a t i n g in c o m e S a le s o f p r o d u c t s C o s t o f g o o d s s o ld ( in c l u d e d d e p . o f 2 1 .4 ) O t h e r o p e r a t in g e x p e n s e s 1 2 4 .9 (1 1 4 .6 ) 1 0 .3 ( 0 .5 ) 9 .8 ( 0 .7 ) 9 .1 P P E , Inc. S t a t e m e n t o f C a s h F lo w s , y e a r 0 C a s h f l o w f r o m o p e r a t io n s O p e r a t in g i n c o m e D e p r e c ia t i o n C a s h f l o w f r o m in v e s t in g a c t iv it ie s I n v e s t m e n t s in P P E ( 2 1 . 4 + 4 . 5 ) F r e e c a s h f lo w s F in a n c i n g f lo w s D iv id e n d s p a i d
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Chapter 13 Page 422 Ex. 13.1 & 13.2

The Imperfect Balance Sheet (cont.)

I n t e r e s t e x p e n s e : 0 .1 0 x 7 . 0 N e t in c o m e

9 .8 2 1 .4 3 1 .2 2 5 .9 5 .3 5 .3
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Chapter 13 Page 423

A Modification of the RE Model

RE Model:
V 0E = CSE 0 + PV of RE

Some assets and liabilities have zero expected RE because they are measured at market value Modified Model:
V0E = CSE 0 + PV of RE of net assets not at market val ue

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Residual Earnings Components

Chapter 13 Page 424 Table 13.1

Net Income Component Operating Income (OI) Net Financial Expense (NFE) Earnings (earn)

Book Value Component Net Operating Assets (NOA) Net Financial Obligations (NFO) Common Stockholders Equity (CSE)

Residual Earnings Component ReOI=OIt (F 1) NOAt-1 ReNFE=NFEt (D 1) NFOt-1 RE=earnt (E 1) CSEt-1

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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
V 0E = NOA +

(OI
t =1 t F

( F 1 ) NOA

t 1

) NFO
(2)

The Residual Operating Income Model: (1) Value of the firm (value of the operations) (2) Value of the net debt

(1)

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The Residual Earnings Model


V0E = +

CSE 0

t =1

t E

(earn

( E 1) CSE t 1 )

= NOA 0 NFO 0 + E t t =1

[OI
(

NFE t

( E 1) NOA t 1 NFO t 1

)] )

= NOA 0 NFO 0 + F t OI t ( F 1) NOA t 1 Dt NFE t ( D 1) NFO t 1 t =1 t =1

V0E = NOA 0 NFO 0 + F t OI t ( F 1) NOA t 1 t =1

The Residual Operating Earnings Model


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Nike 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 2,659 228 2,431 2,431

Reebok 1,135 720 415 34 381

Residual Earnings Forecast Components

648 (8) 656

143 (29) (15) 187

Chapter 13 Page 425 Box 13.2


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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)
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0
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Continuing Values for the Residual Operating Income Model

Chapter 13 Page 426 Box 13.3

Case 1:

CV

= 0 Re OI T +1 F 1
Re OI T +1 F g

Case 2:

CV T =

Case 3:

CV T =

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Reebok Intl. 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

Chapter 13 Page 427 Table 13.2

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 3,071.9

253 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. The McGraw-Hill Companies, Inc., 2001 All rights reserved.
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The Drivers of Residual Operating Income The Drivers of RE:

Chapter 13 Page 428

RE t = earn t ( E 1)CSE t 1 = [ROCE t ( E 1)]CSE t 1


The Drivers of ReOI:
Re OI t = OI t ( F 1) NOA t 1 = [RNOA t ( F 1)] NOA t 1 (1)
(1) RNOA (2) NOA put in place to earn at RNOA
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(2)

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 For MS, Inc.: F
= V 0E V 0 NOA E + V 0D V 0 NOA D

15 .7 7 .7 11 .34 % = 12 % + 10 % 23 .4 23 .4
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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

Chapter 13 Page 430

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The Cost of Equity Capital


The cost of capital for equity is really derived from the cost of capital for operations (not vice versa) V NOA VD E = 0 E F 0E D V0 V0 or
E = F +

Chapter 13 Page 431

V 0D ( F D )(Compare to the ROCE formula) V 0E

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
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Cost of Operating Capital: Nike and Reebok


Cost of equity using CAPM:
Nike: Reebok: 5.4% + .95 x 6% = 11.1% 5.4% + 1.10 x 6% = 12.0% Nike 14,950 228 15,178 Reebok 2,352 720 3,072

Chapter 13 Page 431 Box 13.5

Market values at 1996 year end:


Market value of equity Net financial obligations (assumed at market) Market value of net operating assets

Cost of capital for operations (WACC):


228 14 ,950 Nike : 3.5% = 11.0% 11.1% + 15,178 15,178 720 2 ,352 Reebok : 4.0% = 10.1% 12.0% + 3,072 3,072
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Required Return and Accounting Return on Equity


Required Return on Equity:
E = F +
V 0D ( F D ) V 0E

Chapter 13 Page 432

Accounting Return on Equity:


ROCE = RNOA + NFO (RNOA NBC CSE book leverage

market leverage

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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--- 120 120--- Earnings 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

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Leverage and Valuation


RE Valuation of the Same Firm Cost of equity capital = 9.0% + Net operating assets Net financial obligations Common shareholders equity Earnings ROCE Residual earnings, RE (0.10) PV of RE Value of common equity Value per share (on 600 shares)

Chapter 13 Page 434 Table 13.3

300 x [9 .0 % 5 .0 % ] = 10 .0 % 1,200

0 1,300 300 1,000

120 12% 20 200 1,200 2.00

120 12% 20

120--- 12%-- 20---

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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
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Chapter 13 Page 434 Table 13.3

135 35 100 16.7% 25

135--- 35--- 100--- 16.7% 25---

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Levered and Unlevered P/B Ratio


Levered P/B = V0E CSE 0

Chapter 13 Page 438

Unlevered
Levered P/B =

V 0NOA P/B = NOA 0


V0NOA 1 NOA 0

V0NOA V0NFO V NOA = 0 + FLEV NOA NFO NOA 0

[FLEV is the leverage ratio, NFO/CSE]

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Le ve re d P/B vs . Financial Le ve rage


7.0
VNOA/NOA = 3

Levered P/B (V / CSE)

Levered P/B vs. Financial Leverage

6.0
VNOA/NOA = 2.5

5.0

4.0

VNOA/NOA = 2

3.0
VNOA/NOA = 1.5

2.0

1.0

VNOA/NOA = 1

0.0 0.0 -1.0 0.3 0.5 0.8 1.0 1.3 1.5 1.8 2.0 2.3
VNOA/NOA = 0.5

Chapter 13 Page 439 Figure 13.1a


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Lev erag e (NFO/CSE)

V E CSE

V NOA NOA

+ FLEV

V NOA NOA

1
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Le ve re d vs. Unle ve re d P/B


3.0

2.5

FLEV = 1.5 FLEV = 1.0

Levered P/B (V /CSE)

Levered vs. Unlevered P/B

2.0

FLEV = 0.75

1.5

FLEV = 0.5 FLEV = 0.25

1.0

FLEV = 0

0.5

0.0 0.0 -0.5 0.5 1.0 1.5 2.0

-1.0

Chapter 13 Page 440 Figure 13.1b


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-1.5 Un lev ered P/B (V


E NOA NOA
NOA

/NOA )

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Median Levered and Unlevered P/B Ratios, 1963-96 for NYSE & AMEX Firms

Chapter 13 Page 441 Figure 13.2

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The Leverage Effects


Levered Measure
ROCE

Chapter 13 Page 441 Table 13.4

Concept
Profitability

Unlevered Measure
RNOA

Relationship
ROCE=RNOA+FLEV[RNOA-NBC]

Cost of Capital

E = F +

V 0D [ F D V 0E

P/B Ratio

V0E / CSE 0 V0NOA / NOA0

V 0E V NOA NFO 0 V 0NOA = 0 + 1 CSE 0 NOA 0 CSE 0 NOA 0

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