Equity Analysis and Valuation

Analyze
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 Earnings Persistence
• Earnings persistence is a key to effective equity
analysis and valuation
• Analyzing earnings persistence is a main
analysis objective
• Attributes of earnings persistence include:
– Stability
– Predictability
– Variability
– Trend
– Earnings management
– Accounting methods Analyze
 Earnings Persistence
Recasting and Adjusting

• Two common methods to help assess earnings

persistence:
– Recasting of income statement
– Adjusting of income statement
• Recasting and adjusting earnings
aids in determining the earning power.
Earnings Persistence
 Earnings Persistence
Determinants of Earnings Persistence

• Earnings persistence determined by many factors

including:
– Earnings trends
– Variability
– Earnings Management
– Management Incentives

• Note: assess earnings persistence

over both the business cycle and the long run.
 Earnings Persistence
Determinants of Earnings Persistence
• Earnings trends can be assessed by:
– Statistical methods
– Trend statements  Uses earnings numbers taken from the recasting and
adjusting procedures
• Earnings management
– Changes in accounting methods or assumptions
– Offsetting extraordinary or unusual gains and losses
– Big baths
– Write-downs
– Timing revenue and expense recognition
• 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
 Earnings Persistence
Persistent and Transitory Items in Earnings

• Recasting and adjusting earnings for equity valuation rely on

separating stable, persistent earnings components from random,
transitory components.
• A crucial part is to assess the persistence of the gain and loss
components of earnings.
• Purpose of analyzing and interpreting extraordinary items:
– Determine whether an item is transitory.
• Assessing whether an item is unusual, nonoperating, or
nonrecurring.
– Determine adjustments that are necessary given assessment of
persistence.
 Earnings Persistence
Analyzing and Interpreting Transitory Items
• Determining persistence (transitory nature) of items:
– Nonrecurring operating gains and losses
• Usually included in current operating income
– Nonrecurring non-operating gains and losses
• Omitted from operating earnings of a single year
• Part of the long-term performance of a company
• Adjustments to Extraordinary Items Reflecting Persistence:
– Effects of transitory items on company resources.
• Effects of recorded transitory items and the likelihood of future
events causing transitory items.
– Effect of transitory items on evaluation of management.
Earnings Based Equity Valuation
Relation between Stock Prices and Accounting Data

• Equity value (Vt)

• Book value (BVt)
• Residual Income, RIt = (NIt – k * BVt-1)
• Cost of equity capital (k)

Key Question: Does the potential manipulation of

accounting data influence the accuracy of accounting-
based estimates, or forecasts, of company value?
 Earning Power and Forecasting for Valuation
Earning Power
• Earning power is the earnings level expected to persist
into the foreseeable future
– Accounting-based valuation models capitalize earning power
– Many financial analyses directed at determining earning power
• Measurement of Earning Power reflects:
– Earnings and all its components
– Stability and persistence of earnings
and its components
– Sustainable trends in earnings and its
components
 Earnings Based Equity Valuation
Fundamental Valuation Multiples

• Price-to-Book (PB) Ratio

Market Value of Equity
Book Value of Equity

• Price-to-Earnings (PE) Ratio

Market Value of Equity
Net Income
 Earnings Based Equity Valuation
Fundamental Valuation Multiples

• Earnings per share (basic & dilutive)

• Dividend per share (dividends / numbers of
shares outstanding)
• Dividend yield (annual cash dividends per
share / market price per share)
• Dividend Payout (dividends / earnings
available to common stock)