FINANCIAL STATEMENT ANALYSIS

AND VALUATION (ACFI810)

Week 8 – Forecasting and Valuation Analysis
What You Will Learn from this Lecture

 How, for an asset at fair market value on the balance sheet, expected residual income in the future must be
zero
 How a valuation based on forecasting residual income from operations differs from a residual earnings (RE)
valuation based on forecasting full comprehensive income
 Why forecasted residual income (or expense) on financial assets and liabilities is typically zero
 How return on net operating assets and growth in net operating assets are the two drivers of residual
operating income
 How a valuation based on forecasting abnormal operating income growth differs from an abnormal earnings
growth (AEG) valuation
 How the required return for operations and the required return for equity are related
 How financial leverage affects ROCE, earnings growth, and the required return for equity
 How financial leverage affects a valuation
 Why earnings growth that is created by leverage should not be valued
 The effects of stock repurchases on value
 The difference between enterprise (unlevered) price multiples and levered multiples

14-2
The Big Picture for this Chapter
1. Net financial obligations are close to their value on
the balance
sheet.

2. Financing activities do not add value (usually)

So, valuation focuses on the valuation of operating activities:

Enterprise Valuation

The metrics:
• Residual operating income
• Abnormal operating income growth

14-3
A Reminder:
The Residual Earnings Valuation Model

RE1 RE 2 RE T CVT
V0E = CSE 0 + + 2 + .... T + T
ρE ρE ρE ρE

The valuation of equity

• Forecast future residual income (RE)

• Calculate a continuing value
• Take present values and add to current book
value

Review Chapter 5

14-4
Market Value Balance Sheets and Expected Residual
Earnings If the balance sheet is at market value, then

• Book value is expected to earn at the required

return

• Residual earnings is expected to be zero

V0 = CSE0 implies forecasted RE = 0

Forecasted RE = 0 implies V0 = CSE0

14-5
A Modification of the RE Model
• RE Model:

V0E = CSE 0 + PV of RE

Some assets and liabilities have zero expected RE because they are measured at
market value

• Modified Model:

V0E = CSE0 + PV of residual earnings from

net assets not at market value
Earnings Components and
Corresponding Residual Earnings Measures
Net Income Component Book Value Component Residual Earnings Measure

Operating Income (OI) Net Operating Assets (NOA) OIt – (F – 1) NOAt-1 (ReOI)

Net Financial Expense (NFE) Net Financial Obligations (NFO) NFEt – (D – 1) NFOt-1(ReNFE)

Earnings Common Stockholders’ Equity (CSE) Earnt – (E – 1) CSEt-1 (RE)

Focus on:

Residual Operating Income (ReOI)

= OIt − (ρ F −1) NOAt −1
The Value of the NFO and the Value of the NOA
• NFO are usually at market value on the balance sheet (or close
to it). So residual earnings from NFO are expected to be zero:

V0NFO = NFO0 (usually)

• NOA are not usually at market value in the balance sheet

ReOI1 ReOI 2 ReOI T CVT

V0NOA = NOA0 + + + ... + + T
ρF 2
ρF T
ρF ρF
CVT = 0 Case 1

Re OI T +1
CVT = Case 2
F − 1
Re OI T +1
CVT = Case 3
F − g
The Value of the Common Equity
V0E = V0NOA − V0NFO
V0NOA
  V0NFO
ReOI ReOI CV 
V0E = NOA0 + 1
+ ... T T + TT − NFO0
ρF ρF ρF

ReOI1 ReOI T CVT

V0E = CSE 0 + + ... + + T
 ρF T
ρF ρF
NOA0 − NFO0

14-9
Residual Operating Income Valuation: Nike, Inc.
The Drivers of Residual Operating Income
• The Drivers of RE:

RE t = Earnt − (E − 1) CSE t −1 = ROCEt − (E − 1)CSE t −1

(1) (2)

• The Drivers of ReOI:

ReOI t = OI t − (F − 1) NOA t −1 = RNOA t − (F − 1) NOA t −1

(1) (2)
(1) RNOA

(2) NOA put in place to earn at RNOA

14-11
A Reminder: The Abnormal Earnings Growth Model for Valuing Equity
V0E = capitalized [forward earnings + present value of abnormal earnings growth]

1  AEG 2 AEG 3 AEG 4 

= Earn1 + + + + ....
ρ E − 1  ρE 2
ρE 3
ρE 

Abnormal earnings growth t (AEG) = cum-dividend earnings t − normal earnings t

= earnings t + (ρ E − 1)d t −1  − ρ E earnings t −1

= G t − ρ E  x earnings t −1
A Modification to the AEG Model
V0E = Capitalized [forward operating income + present value
of abnormal operating income growth] – net financial obligations

1  AOIG 2 AOIG 3 AOIG 4 

V0E =  1
OI + + + + ... − NFO0
ρ F − 1  ρF 2
ρF 3
ρF 

Abnormal operating income growtht (AOIG)

= cum-dividend operating income – normal operating income

= [operating incomet + (ρF – 1)FCFt-1] - ρF operating incomet-1

= [Gt – ρF] x operating incomet-1

where Gt is now growth rate is “cum-dividend” operating income

The “dividend” from the operating activities is free cash flow

Abnormal OI Growth Valuation: Nike
An Equivalent Form: Easy Method
Just as AEG = RE, so AOIG = ReOI

So,
1  ReOI2 ReOI3 ReOI4 
V0E = OI + + + + ... − NFO0
ρF − 1  ρF ρF ρF
1

2 3

In the ReOI pro forma, just add an extra line for ReOI

See how this works for Nike :

AOIG (2012) = 22 = ReOI (2012) - ReOI (2011) = 1,470 - 1,448 = 22
The Cost of Capital for Operations
• 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
V0E V0D
F = F E + F D
V0 V0
• It is also called the weighted average cost of capital
because
The Effective Cost of Capital for Debt is After Tax
AfterTax Cost of Debt (ρD ) = Nominal Cost of Debt ×(1-t)

t is the marginal income tax rate

The WACC Calculation: Some Examples

Risk free rate = 3.6%

Market risk premium = 5%
The Cost of Equity Capital
• The cost of capital for equity is really derived from the cost of capital
for operations (not vice versa)
V0F V0D
E = E F − E D
V0 V0
or
V0D
E = F + E (F − D )
V0

• Equity risk has two components

1. Operating risk
2. Financing risk
• Leverage
• Spread

So, for General Mills, the equity cost of capital is

 5,813 
5.15% +  (5.15% - 3.3%)  = 5.6%
 29,447 
Financing Risk and Return and Value of Equity
• Required Return on Equity:

V0D
E = F + E
(F − D )
V
 0
market
leverage

• Accounting return on equity

NFO
ROCE = RNOA + (RNOA − NBC)
CSE

book
leverage

Leverage increases both accounting return (if SPREAD is positive) and required
return

What is the net effect of leverage on the present value of RE (and value)?

Financing irrelevance: None

The Effect of Change in Leverage on Equity Value: RE
Valuation
ReOI Valuation of a Firm with 9% cost of capital for operations and 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 .05) 15 15 15 ---→
Earnings 120 120 120 ---→

Residual operating income, ReOI (.09) 18 18 18 ---→

PV of ReOI  
18 200
 .09 

Value of common equity 1,200

Value per share (on 600 shares) 2.00

Leverage Demonstration in RE Valuation (cont.)
C. RE Valuation for the Same Firm after Debt for Equity Swap

x 9% − 5% = 12.5%

700
Cost of equity capital = 9% +
800
0 1 2 3
Net operating assets 1,300
Net financial obligations 700
Common shareholders’ equity 600

Operating income 135 135 135 ---→

Net Financial expense (700 x .05) 35 35 35 ---→
Earnings 100 100 100 ---→

ROCE 16.7% 16.7% 16.7%

Residual earnings, RE (.125) 25 25 25 ---→

PV of RE 
25  200

 .125 

Value of common equity 800

Value per share (on 400 shares) 2.00

P/B = 1.33

Value per share is not affected but P/B increases

Effect of a Stock Repurchase and Debt Issue: Reebok
August, 1996: repurchase of 16.7 million common shares at $36 per share; $601.2 million
borrowed to finance the repurchase

Actual 1996 Balance Sheet “As If” 1996 Balance Sheet

with Stock Repurchase without Stock Repurchase
Net operating assets 1,135 1,135
Net financial obligations 720 119
Total equity 415 1,016
Minority interest 34 34
Common stockholders’ equity 381 982

Financial leverage (FLEV) 1.73 0.12

(continued)
Effect of a Stock Repurchase and Debt Issue: Reebok (cont.)
Pro Forma 1997 “As If” Pro Forma 1997
Income Statement Income Statement
with Stock Repurchase without Stock Repurchase
Operating income 187 187
Net financial expense (4% of NFO) (29) (5)
Minority interest in earning (15) (15)
Earnings forecast 143 167

Shares outstanding (millions) 55.840 72.540

Forecasted eps 2.56 2.30

Forecasts for 1997 − RNOA 16.5% 16.5%

− SPREAD 12.5% 12.5%
− ROCE 37.5% 17.0%

Note the effect on ROCE

Reebok Stock Repurchase
Valuation with “As If” Valuation
Stock Repurchase without Stock Repurchase
Value of NOA 3,472 3,472
Book value of NFO 720 119
Value of equity 2,752 3,353
Value of minority interest 210 210
Value of common equity 2,549 3,143

Value per share 45.52 43.33

If the 16.7 million shares had been repurchased at $43.42 rather than $36, the
comparison is
Valuation with Valuation without
Repurchase at $43.42 per share Repurchase

Value of NOA 3,472 3,472

Book value of NFO 843 119
Value of equity 2,629 3,353
Value of minority interest 210 210
Value of common equity 2,419 3,143

Value per share 43.33 43.33

The Effect of Change in Leverage on Equity Value: AEG
valuation
0 1 2 3

AOIG Valuation of a Firm with 9% Cost of Capital for Operations and 5% After-Tax Cost of Debt

Operating income 135 135 135 →

Net financial expense (300 x 0.05) 15 15 15 →
Earnings 120 120 120 →
Eps (on 600 million shares) 0.20 0.20 0.20 →

Free cash flow (C – I = OI -  NOA) 135 135 135 →

Reinvested free cash flow (at 9%) 12 12 12 →
Cum-dividend operating income 147 147 →
Normal operating income (at 9%) 147 147 →
Abnormal operating income growth (AOIG) 0 0→

Value of operations ( 135

) 1,500
0.09
Net financial obligations 300
Value of equity 1,200

Value per share (on 600 million shares) 2.00

2.00
Forward P/E = = 10
0.20
Leverage Demonstration in AEG Valuation (cont.)
0 1 2 3

AEG Valuation of the Same Firm

 300 
Cost of equity capital = 9.0% +  x(9% − 5%) = 10.0%
1,200 
Operating income 135 135 135 →
Net financial expense (300 x 0.05) 15 15 15 →
Earnings 120 120 120 →
Eps (on 600 million shares) 0.20 0.20 0.20 →

Dividend (d = Earn -  CSE) 120 120 120 →

Reinvested dividends (at 10%) 12 12 12 →
Cum-dividend earnings 132 132 132 →
Normal earnings (at 10%) 132 132 132 →
Abnormal earning growth (AEG) 0 0→
1,200
Value of Equity ( )
120
0.10
Value per share (on 600 million shares) 2.00
2.00
Forward P/E= = 10
0.20
Effect of a Change in Leverage (Cont.)
AEG Valuation of the Same Firm after Debt-for-Equity Swap
 700 
Cost of equity capital = 9% +  x(9% − 5%) = 12.5%
 800 

Operating income 135 135 135 →

Net financial expense (700 x 0.05) 35 35 35 →
Earnings 100 100 100 →
Eps (on 400 million shares) 0.25 0.25 0.25 →

Dividends (d = Earn -  CSE) 100 100 100 →

Reinvested dividends (at 10%) 10 10 →
Cum-dividend earnings 110 110 →
Normal earnings 110 110 →
Abnormal earnings growth (AEG) 0 0→
800
Value of equity ( 100
)
0.125
Value per share (on 400 million shares) 2.00
2.00
Forward P/E = =8
0.25

Value per share is not affected but P/E declines

Leverage Creates Earnings
Before stock repurchase: No Leverage
Growth but not Value
0 1 2 3 4
Net operating assets 100.00 110.00 121.00 133.10 146.41
Common equity 100.00 110.00 121.00 133.10 146.41

Operating income 10.00 11.00 12.10 13.31

(equals comprehensive
income)

Eps (on 10 million 1.00 1.10 1.21 1.33

shares)
Growth in eps 10.0% 10.0% 10.0%

RNOA 10% 10% 10% 10%

ROCE 10% 10% 10% 10%
Residual operating 0 0 0 0
income
Free cash flow 0 0 0 0
Cum-div OI 11.0 12.10 13.31
Normal OI 11.0 12.10 13.31
Abnormal OI Growth 0 0 0

Value of equity 100.00

Per-share value of 10.00
equity
(10 million shares)
Forward P/E ratio 10.0
P/B ratio 1.0
Leverage Creates Earnings Growth but not Value (cont.)
After stock repurchase: Leverage introduced with 5 million shares repurchased at $2
each, financed by borrowing at 5%. (Required return for operations = 10%)
0 1 2 3 4
Net operating assets 100.00 110.00 121.00 133.10 146.41
Net financial obligations 50.00 52.50 55.12 57.88 60.77
Common equity 50.00 57.50 65.88 75.22 85.64

Operating income 10.00 11.00 12.10 13.31

Net financial expense 2.50 2.63 2.76 2.89
Comprehensive income 7.50 8.37 9.34 10.42

Eps (on 5 million shares) 1.50 1.68 1.87 2.08

Growth in eps 11.67% 11.57% 11.48%

RNOA 10% 10% 10% 10%

ROCE 15.0% 14.6% 14.2% 13.9%
Residual operating 0 0 0 0
income
Free cash flow 0 0 0 0
Cum-dividend OI 11.0 12.10 13.31
Normal OI 11.0 12.10 13.31
Abnormal OI growth 0 0 0
Value of equity 50.00
Per-share value of equity 10.00
(5 million shares)
Forward P/E ratio 6.67 Value per share is not affected but P/E declines
P/B ratio 1.00
Leverage and Earnings Growth: A Formula
Do Share Repurchases Add Value ?
Share repurchases add to EPS, but do they add value?

Consider:
Buying shares at fair market value cannot add value

See the leverage examples: Share repurchases add to ROCE and to

earnings growth but do not add to value

An exception:

Repurchase of shares at less than fair value

14-32
Why do Managers Repurchase Shares?
1. To pay out cash

2. To reverse dilutive effect of stock

options!!??

3. To increase EPS!!???

4. To actively time the market price

 IBM: Repurchases, Leverage, and EPS

International Business Machines (IBM)

2000 1999 1998 1997 1996 1995

Share repurchases, net ($ billions) 6.1 6.6 6.3 6.3 5.0 4.7
Change in net debt ($ billions) 2.4 1.2 4.4 4.6 0.8 2.3
Financial leverage (FLEV) 1.21 1.10 1.22 0.98 0.68 0.62

Earnings per share 4.35 4.58 4.25 3.38 3.09 2.56

IBM’s EPS growth has been increased by stock repurchases and financial leverage

14-34
Median Leverage, U.S. Firms: 1963-2010

14-35
The Three Caveats
• Beware of earnings growth created by investment

• Beware of earnings growth created by accounting methods

• Beware of earnings growth created by financial leverage

14-36
Marking to Market: Incorporating the Anticipated Cost of
Stock Options in Valuation (Nike)

Treat the Option Overhang as a liability and subtract from the value of equity

Outstanding options, end of 2010 36.0 million

Weighted average exercise price $46.60
Market price, end of 2010 72.38
Weighted average option value, end of 2010 41.50
Levered and Unlevered (Enterprise) P/B Ratios
V0E V0NOA
Levered P/B = Unlevered P/B =
CSE 0 NOA0

V0NOA − V0NFO
Levered P/B =
NOA − NFO

V0NOA  V0NOA 
= + FLEV  − 1
NOA0  NOA0 

FLEV is the financial leverage ratio, NFO/CSE

14-38
Levered P/B vs. Financial Leverage
Levered P/B vs. Financial Leverage

7.0

VNOA/NOA = 3

6.0
VNOA/NOA = 2.5

5.0

VNOA/NOA = 2
Levered P/B (V / CSE)

4.0
E

3.0

VNOA/NOA = 1.5

2.0

1.0 VNOA/NOA = 1

0.0
0.0 0.3 0.5 0.8 1.0 1.3 1.5 1.8 2.0 2.3
VE V NOA  V NOA 
VNOA/NOA = 0.5 = + FLEV  − 1
-1.0 CSE NOA  NOA 
Leverage (NFO/CSE)
Levered vs. Unlevered P/B
Levered vs. Unlevered P/B

3.0

FLEV = 1.5

2.5 FLEV = 1.0

FLEV = 0.75
2.0
FLEV = 0.5

1.5 FLEV = 0.25

Levered P/B (V /CSE)

FLEV = 0
1.0
E

0.5

0.0
0.0 0.5 1.0 1.5 2.0

-0.5

VE V NOA  V NOA 
-1.0
= + FLEV  NOA − 1
CSE NOA  
-1.5
Unlevered P/B (VNOA/NOA)
Median Levered and Unlevered P/B Ratios, 1963-2010
Levered and Unlevered (Enterprise) P/E Ratios
Value of Operations V0NOA
Forward enterprise P/E = =
Forward OI OI I

 V0E  V0NOA V0NOA 1 


Levered forward P/E 
 = + ELEV1  − 
 Earn1  OI1  OI1 NBC1

NFE
ELEV =
Earnings

NBC = net borrowing cost

Levered and Unlevered (Enterprise) P/E Ratios

Value of Operations+ FCF

Trailing enterprise P/E =
current OI

V0NOA + FCF0
=
OI0

 V0E + d0 
Levered trailingP/E  
 Earn0 

V0NOA + FCF0 V0NOA + FCF0 1 

= + ELEV0  − − 1
OI0  OI0 NBC0 
Levered and Unlevered
Forward E/P Ratios
Median Levered and Unlevered P/E Ratios, 1963 - 2003
The Leverage Effects
Simple Levered Unlevered
Relationship
Forecast Measure Measure

Profitability ROCE RNOA ROCE = RNOA + FLEV[RNOA − NBC]

V0D
Cost of Capital E F E = F + E F − D 
V0

V0E V0NOA NFO0  V0NOA 

P/B Ratio E
V 0 /CSE 0 V0 NOA
/NOA 0 = +  − 1
CSE 0 NOA0 CSE 0  NOA0 

V0E V0NOA VE0 V0NOA  V0NOA 1 

= + ELEV1  −
Forward P/E
OI1 Earn1 OI1  OI1 NBC1 
Earn1 

VE0 + d 0 V0NOA + FCF0  V NOA + FCF0 1 

V0E + d 0 V0NOA + FCF0 = + ELEV0  0

− − 1
Trailing P/E OI0 Earn 0 OI0  OI0 NBC0 
Earn 0
Advantages of Valuing Operations
• Financing activities can be ignored for forecasting: focus on
operations where the value is generated

• Required return does not have to be adjusted as leverage changes

• Debt and Taxes?

QUESTIONS?