Anchoring on the Financial

Statements: Simple Forecasting and

Simple Valuation
Chapter 15
Stephen H. Penman
What You Will Learn from this Chapter
• How simple forecasts yield simple but insightful valuations

• How forecasts are developed from the current financial

statements

• How sales forecasts are combine with financial statement

information to provide simple forecasts

• When simple forecasts and simple valuations work as

reasonable approximations

• How simple forecasting works as an analysis tool in sensitivity

analysis

• How simple valuation models work in reverse engineering mode

to challenge the market price

• How simple valuation models enhance screening analysis

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 The Big Picture for this Chapter
In valuation, analyst aim for simplicity by strip away features
of the business that are not involved in value generation.

Concentrate on those important.

Fact that Finacial Statements are not backward looking but

very much forward looking.

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 The Big Picture for this Chapter
The tenet: Anchor valuation on what you know rather
than speculation

The financial statements, appropriately formulated and

analyzed, are “what we know”

Therefore, anchor a valuation on what you see in the

financial statements before adding speculation

 Value implied by  Value from 

Value =  
financial statements
+ speculation 

This Chapter Next Chapter

“Simple Valuation” “Full pro forma
valuations”

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 A Simple Valuation Model

We can get the ingredients from the financial

statements:

 Date 0 items are in the financial statements

 Date 1 items can be forecasted from the
financial statements
 Growth, g, can be forecasted from the
financial statements

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 PPE, Inc.: The Financial Statements

Required return for operations = 10%

Required return for debt = 4%

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 The No-growth Forecast
Earnings Forecast of Earnings Forecast of Residual Earnings Forecast of Abnormal
Component Component for the Component Earnings Growth

Operating OI1  Core OI 0   ρ F  1 ΔNOA0 ReOI1 = ReOI0 AOIG = 0

Earnings Earn 1  Earn 0   ρ E  1 ΔCSE 0 RE1 = RE0 AEG = 0

PPE Inc.

Pro Forma Income Statement, Year 1

Operating income: 9.8 + (0.10 x 4.5) 10.25

Interest expense: 7.7 × 0.04 0.308

Earnings 9.942

ReOI0 = (9.8 – (0.10 × 69.9) = 2.81

ReOI1 = 10.25 – (0.10 × 74.4) = 2.81

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The No-growth ReOI Valuation

Core ReOI 0
V0NOA
 NOA 0 
ρF 1

For PPE Inc.,

2.81
V0NOA  74.4 
0.10
 102.5

V0E  V0NOA  V0NFO

 102.5 - 7.7
 94.8

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 The No-growth AOIG Valuation

V0 NOA
 OI1
ρ F 1

Constant ReOI implies AOIG = 0

Zero AOIG implies a normal enterprise P/E ratio

For PPE Inc.
10.25
V0 NOA

0.10

 102.5

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No-growth Valuation: Nike, Inc.

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 The Growth Forecast
Earnings Forecast of Earnings Forecast of Residual Earnings
Component Component

Operating OI1  Core RNOA 0 x NOA0  RNOA 1   ρ F  1  NOA 0   Core RNOA 0   ρ F  1  NOA 0

Earnings Earn 1  ROCE 0 x CSE0  ROCE 1   ρ E  1  CSE 0   ROCE 0   ρ E  1  CSE 0

For PPE, Inc. the current core RNOA = 9.8/69.9 = 14.02%

PPE Inc.

Pro Forma Income Statement, Year 1

Operating income: 0.1402 x 74.4 10.431

Interest expense: 7.7 x 0.04 0.308

Earnings 10.123

ReOI1 = 10.431 – (0.10 × 74.4) = 2.991

= (0.1402 – 0.10) × 74.4 = 2.991

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 The Forecasted Growth Rate
[RNOA1   ρ F  1 ] NOA 0
Growth Rate in ReOI1 
[RNOA 0   ρ F  1 ] NOA 1

If RNOA1 = RNOA0
NOA 0
Growth Rate in ReOI1 
NOA 1

For PPE:
g = 74.4/69.9 = 1.0644

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The Growth Valuation
ReOI1
V0NOA  NOA 0 
ρ-g

 74.4  2.991
1.10 - 1.0644

 158.41

V0E  V0NOA  NFO

 158.41  7.7

 150.71

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The Growth Valuation Restated

Core RNOA 0  (g  1)
V0NOA  NOA 0 x
ρF  g

The NOA multiplier

(Enterprise P/B ratio)

For PPE Inc., g = 1.0644 (6.44% growth)

For PPE Inc., g = 1.0644 (6.44% growth)

0.1402  0.0644
V0NOA  74.4 x
1.10  1.0644
Enterprise P/B = 2.13
 158.41

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The AOIG Growth Valuation
1  G 2  ρF 
V0NOA  OI1  1  
ρF 1  ρF  g 

Forward
Enterprise P/E

G2 = Cum-dividend growth rate, two years ahead

For PPE Inc.

G 2  11.667 10.431  1.1185 (11.85% growth)

1  1.1185  1.10 
V0NOA  10.431 x 1
0.10  1.10  1.0644 


Forward
 158.41 Enterprise
P/E =15.20

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Growth Valuation: Nike, Inc.

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Simple Forecasts and Simple Valuations

V0E  CSE 0 V0NOA  NOA 0

Core ReOI 0 Core ReOI 0 OI 1

V0E  CSE0  V0NOA  NOA0  
F 1 F 1 F 1

V0E  CSE0 
 Core RNOA   
0 F
 1  NOA0
V0NOA  NOA 0 
 Core RNOA 0
  ρ F  1  NOA 0
F  g ρF  g
Core RNOA 0   g  1
 NOA 0 
ρF  g

1  G 2  ρF 
 OI1  1  
ρF 1  ρF  g 

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 Weighted-Average Forecasts of Growth
Weighted-average forecast of growth in ReOI:

Forecasted growth rate for ReOI =

(0.70 × Current growth rate for ReOI) + (0.30 × 4%)

where 4% is the historical GDP growth rate

________________________________________________________________
For Nike Inc.,

Forecasted NOA growth rate = (0.70 × 4.6%) + (0.30 × 4.0%)

= 4.42%

This implies a value for Nike of $71.54 per share)

_________________________________________________________________________________
_

Recognize an historical fact:

Growth rates trend towards the average growth rate for the economy
 RNOA tends to decline over time
 Investment tends to slow down over time

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Sales Growth Can Replace NOA Growth
1
NOA  Sales 
ATO

If ATO is constant,

1
Growth in NOA  Growth in Sales 
ATO

Forecast growth in NOA with forecasted sales growth rate

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A Simple Valuation Based on Core RNOA and Sales Growth:
Coca Cola

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A Simple Valuation Based on Core RNOA and Sales
Growth: Coca Cola
Average sales growth rate, 2002-2007 = 5.4%

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 Simple Valuation:
Reverse Engineering the Enterprise P/B for Nike Inc.

Nike share price = $74

Shares outstanding = 484 million
Market price of equity= $35,816
Net financial assets = 4,370
Enterprise market value $31,446

NOA2010 = $5,514
Core RNOA2010 = 30.1%

ReOI 2011  (0.301  0.091)  5,514  $1,158

1,158
Enterprise price  31,446  5,514 
1.091 - g

0.301 - (g - 1)
 5,514 x
1.091 - g

g  1.046 (a 4.6% growth rate)

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 Enhanced Stock Screening

Rather than screen on P/E or P/B, screen as follows:

1. Unlever: Use enterprise multiples (and get rid of leverage

effects on the ratios)

2. Reverse engineer to the expected return or the implied growth

rate

3. Screen on expected returns or implied growth rates

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 Simple Forecasting as an Analytical Device:
Sensitivity Analysis

“As If” Questions

• Effect of changes in RNOA on forecasts and values

• Effect of changes in PM and ATO

• Effect of changes in sales growth and in NOA

• Effect of leverage on forecasts of net income

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 The Valuation Grid: Nike, Inc.

What values are implied by different combinations of RNOA and growth in

NOA?

A Valuation Grid for Nike, 2010:

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