Valuation and Forecasting

1. Valuation and Forecasting

2. Introduction • Valuation models: • Asset-based valuation models • Discounted cash flow models • The abnormal earnings or Edwards-Bell-Ohlson (EBO) model

3. Asset-Based Valuation Models • Asset-based models assign a value to the firm by aggregating the current market value of its individual component assets and liabilities • Discrepancy between market price and book value

4. Asset-Based Valuation Models • Book value: measurement issues • Used book value is an “index” against which to compare the stock price • Assumption: historical cost-based book value reflects the minimum value of the firm • Book value is also a function of management’s financial reporting choices

5. Asset-Based Valuation Models • Stability and growth of book value: • Earnings retention • Effect of new equity financing • Effect of acquisitions • Effect of changing exchange rates • Effect of financial reporting choices and accounting changes • Restructuring provisions and write-offs

6. Discounted Cash Flow Valuation Models • 3 alternative cash flow measures: • Dividends • Accounting earnings • Free cash flows (cash available to debt and equityholders after investment)

7. The Abnormal Earnings or EBO Model • A model based on book values and abnormal earnings

8. Terminal Value • In DCF models: terminal value frequently constitute 60 to 70% of total value • All parameters must be estimated and those that are most difficult to estimate play a large role in valuation • In EBO model: the book value approximates 75% of firm value • Book value is given and does not have to be estimated • Forecasting is simpler for EBO model

9. Forecasting Models and Time Series Properties of Earnings • Permanent versus transitory components: • When using time series of a firm’s earnings, it is important to separate the permanent and transitory components

10. Earnings Persistence • A good financial analysis identifies components in earnings that exhibit stability and predictability  persistent components • Analysis must be alert to earnings management and income smoothing

11. Earnings Persistence Recasting and Adjusting • Two common methods to help assess earnings persistence: •  Recasting of income statement •  Adjusting of income statement

12. Earnings Persistence Recasting and Adjusting Information for Recasting and Adjusting  Income statement, including its subdivisions: Income from continuing operations Income from discontinued operations Extraordinary gains and losses Cumulative effect of changes in accounting principles  Other financial statements and notes  Management’s Discussion and Analysis  Other relevant information

13. Earnings Persistence Recasting and Adjusting Objectives of Recasting Recast earnings and earnings components so that stable, normal and continuing elements comprising earnings are distinguished and separately analyzed from random, erratic, unusual and nonrecurring elements Recasting and adjusting earnings also aids in determining earning power

14. Earnings Persistence Recasting and Adjusting Objective of Adjusting Assign earnings components to periods where they most properly belong Note: Uses data from recast income statements and any other relevant information

15. Earnings Persistence Measuring Persistence Earnings Trend can be measured: 1. Statistical methods 2. Trend statements

16. Earnings Persistence Measuring Persistence • Some forms of Earnings Management: • Changes in accounting methods or assumptions • Offsetting extraordinary / unusual gains and losses • Big baths • Write-downs • Timing revenue and expense recognition

17. Earnings Persistence Measuring Persistence • 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

18. Earnings Persistence Measuring Persistence • Analyzing and Interpreting Extraordinary Items • 1. Determine whether an item is extraordinary (less persistent) or not • 2. Assessing whether an item is unusual, non-operating, or non-recurring • 3. Determine adjustments • necessary given • assessment of persistence

19. Earning Power and Forecasting Earning Power Factors in selecting a time horizon for measuring earning power One-year period is often too short to reliably measure earning power Many investing and financing activities are long term Better to measure earning power by using average (or cumulative) earnings over several years An extended period is less subject to distortions, irregularities, and other transitory effects Preferred time horizon in measuring earning power is typically 5 to 10 years

20. Earning Power and Forecasting Earning Forecasting • Factors Impacting Earnings Forecasts • Current and past evidence • Continuity and momentum of company performance • Industry prospects • Management • Economic and competitive factors

21. The Projection Process Projected Income Statement • Steps: • Project sales • Project cost of goods sold and gross profit margins using historical averages as a percent of sales • Project SG&A expenses using historical averages as a percent of sales • Project depreciation expense as an historical average percentage of beginning-of-year depreciable assets • Project interest expense as a percent of beginning-of-year interest-bearing debt using existing rates if fixed and projected rates if variable • 6) Project tax expense as an average of historical tax expense to pre-tax income

22. The Projection Process Projected Balance Sheet • Steps: • Project current assets other than cash, using projected sales or cost of goods sold and appropriate turnover ratios • Project PP&E increases with capital expenditures estimate derived from historical trends or information obtained in the MD&A section of the annual report • Project current liabilities other than debt, using projected sales or cost of goods sold and appropriate turnover ratios • Obtain current maturities of long-term debt from the long-term debt footnote. • Assume other short-term indebtedness is unchanged from prior year balance unless they have exhibited noticeable trends. • Assume initial long-term debt balance is equal to the prior period long-term debt less current maturities from 4) above. • Assume other long-term obligations are equal to the prior year’s balance unless they have exhibited noticeable trends. • Assume initial estimate of common stock is equal to the prior year’s balance • Assume retained earnings are equal to the prior year’s balance plus (minus) net profit (loss) and less expected dividends. • Assume other equity accounts are equal to the prior year’s balance unless they have exhibited noticeable trends.

23. The Projection Process Projected Balance Sheet • Cash balance: • 1) Amount needed to balance total liabilities and equity • If the estimated cash balance is much higher: a) invest excess in marketable securities or b) reduce long-term debt and/or equity proportionately • If the level of cash is too low, additional long-term debt and/or common stock can be increased

24. The Projection Process Sensitivity Analysis • - Vary projection assumptions (e.g., sales growth, expense percentages, turnover rate) to find those with the greatest effect on projected profits and cash flows • - Examine the influential variables closely • - Prepare expected, optimistic, and pessimistic scenarios to develop a range of possible outcomes