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Financial Statement Analysis Evaluation of current and past financial conditions Estimated predictions about future financial conditions and performance Reasons for Analysis Investment decisions* Credit decisions* Performance* Valuation (investment)

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evaluation of current and past financial conditions
Evaluation of currentand pastfinancial conditions
  • Estimated predictions about
  • future financial conditions
  • and performance
reasons for analysis
Reasons for Analysis
  • Investment decisions*
  • Credit decisions*
  • Performance*
  • Valuation (investment)
  • Legal liability amount (credit & perf.)
  • Going concern decisions (credit & perf.)
  • Unreasonable returns (performance)
fsa steps
FSA Steps
  • Identify the economic characteristics
  • Identify the corporate strategies
  • Understand the financial statements
  • Assess the profitability and risk
  • Value the particular firm
tools for economic analysis
Tools for Economic Analysis
  • Porter’s Five Forces
  • Economic Attributes Framework
porter s five forces
Porter’s Five Forces
  • Buyer Power- (price sensitivity)
  • Supplier Power
  • Rivalry among Firms
  • Threat of New Entrants
  • Threat of Substitutes
economic attributes framework
Economic Attributes Framework
  • Demand
    • price sensitivity
    • demand growth
    • cyclical demand
    • seasonal demand
  • Supply
    • number of suppliers
    • barriers to entry
  • Manufacturing
    • capital intensity
    • process complexity
  • Marketing
    • marketing channel--corporate or consumer
    • demand pull or demand creation
  • Financing
    • Nature of assets
    • Asset risk
    • Source of cash flow--internal or external
strategic analysis framework
Strategic Analysis Framework
  • Nature of product or service
  • Degree of Integration
  • Degree of Geographical Diversification
  • Degree of Industry Diversification
financial statements
Financial Statements
  • Balance Sheet
  • Income Statement
  • Statement of Cash Flows
  • Footnotes
  • Auditors Report
  • Management Discussion and Analysis
income statement classification
Income Statement Classification
  • Operating income
  • Other income and expense
  • Income from continuing operations
  • Income, gains & losses from discontinued operations
  • Extraordinary gains and losses
  • Changes in accounting principles
comprehensive income
Comprehensive Income
  • Net income plus or minus the changes in shareholders’ equity from other than net income or transactions with owners.
  • (we will look at this later)
other f s considerations
Other F/S Considerations
  • Quality of Earnings
  • Statement of Cash Flows
  • Auditors Report
tools of profit and risk analysis
Tools of Profit and Risk Analysis
  • Common Size Financial Statements
  • Percentage Change Statements
  • Comparative Analysis
  • Critical Financial Ratios
risks of comparative analysis
Risks of Comparative Analysis
  • Timing
  • GAAP Application
  • Degree of Conservatism-management’s attitude
  • Size
  • Geographic Diversification
critical financial ratios
Critical Financial Ratios
  • Profitability Ratios
    • EPS
    • ROCE
  • Risk Ratios
    • Current ratio
    • CFO/Avg. Current Liabilities
    • Debt/Equity
valuation
Valuation
  • Price-Earnings Ratio
  • Market value to Book value Ratio
role of fsa in capital markets
Role of FSA in Capital Markets
  • One View: FSA has no impact
  • The Other View
    • FSA is a catalyst
    • FSA identifies individual opportunities
    • Equity markets are not perfectly eff.
    • FSA cleanses F/S biases
    • FSA has unique purpose itself- (go back to the reasons for analysis)
sources of information
Sources of Information
  • Annual Report
  • Form 10-K
  • Form 10-Q
  • Form 8-K
  • Prospectus
  • Form 20-F (foreign entity 10-K)
statement of cash flows chapter 3
Statement of Cash Flows-chapter 3
  • FASB 95--1987
  • Components
    • Operating cash: Operations and working capital
    • Investing cash: Non-current assets and investments
    • Financing cash: L/T debt, equity and dividends
businesses are like fruit trees
Businesses are like Fruit Trees

Fruit = Operating Activities

Trunk & Branches = Investing Activities

Roots = Financing Activities

net income vs cash flow indirect method
Net Income vs. Cash FlowIndirect Method
  • Net Income
  • +/- Non-cash Items
  • +/- Changes in Operating Working Capital
  • = Cash Flow from Operations
indirect vs direct method
Indirect vs. Direct Method
  • FASB prefers the direct method
  • FASB requires net income to cash from operations reconciliation
  • Components:
    • Cash from customers
    • Cash from dividends
    • Cash from interest income
    • Other operating cash receipts
    • Cash paid to suppliers
    • Cash paid to employees
    • Cash paid for taxes
    • Cash paid for interest
    • Other operating cash payments
profitability analysis chapter 4 5
Profitability Analysischapter 4 & 5
  • Rate of Return on Assets--ROA
    • Measures success in using assets to generate earnings (excluding financing)
  • Disaggregated ROA
    • ROA = Profit Margin X Asset Turnover
    • Line by line P & L Analysis
    • A/R, Inventory & F/A turnover
roa summary
ROA Summary
  • Level 1: ROA as a whole
  • Level 2: Disaggregate ROA
  • Level 3a: Margin analysis in detail
  • Level 3b: Disaggregate turnover
  • Level 4: ROA, margin & turnover by geographic segment
roce return on common shareholders equity
ROCE--Return on Common Shareholders’ Equity
  • Return after O-I-F activities
  • ROA and ROCE
    • ROCE > ROA when ROA exceeds the cost of creditor and pref. Shareholder capital
disaggregated roce
Disaggregated ROCE
  • ROCE = ROA X CEL X CSL
  • Common Earnings Leverage = op. Income available to common s/h
  • Cap. Structure Leverage = multiplier effect of other capital sources
risk analysis
Risk Analysis
  • Types of risk
    • International
    • Domestic
    • Industry
    • Firm-specific
  • Our focus will be on the financial aspects of risk
relationship to o i f
Relationship to O-I-F
  • S/T liquidity…O…working capital
  • L/T liquidity…I…plant capacity
  • L/T liquidity…F…debt svc. rqmts
s t liquidity
S/T Liquidity
  • Current ratio
  • Quick ratio
  • Ops. Cash flow to C/L
  • W/C Activity ratios:
    • A/R turnover
    • Inventory turnover
    • A/P turnover
l t liquidity
L/T Liquidity
  • L/T Debt Ratio
  • Debt/Equity Ratio
  • Liabilities/Assets Ratio
  • Interest coverage…fixed charges coverage
  • OCF to Total Liabilities
  • OCF to Capital Expenditures
comparative analyses
Comparative Analyses
  • Time series analysis (same company)
    • Changes in customers, product or geography
    • Major M&A activity
    • Accounting changes
  • Cross-sectional analysis (industry)
    • Industry definitions
    • Metric calculations
industry ratio sources
Industry Ratio Sources
  • Robt. Morris Associates, Annual Statement Studies
  • Dun & Bradstreet, Industry Norms and Key Financial Ratios
stickney s comparability risks in additon to wfo s
Stickney’s Comparability Risks…in additon to WFO’s
  • Earnings not reflective of actual economic value added
  • F/S restatement
  • F/S classification
  • Time variations in excess of 3 mos.
  • Global accounting factors
quality of earnings issues chapter 6
Quality of Earnings Issues-Chapter 6
  • Non-recurring items…sustainability
  • Earnings measurement
  • Earnings management
  • Essentially we are trying to determine if what is reported is going to recur in the future.
sustainability issues
Sustainability Issues
  • Discontinued operations
  • Extraordinary gains and losses
  • Changes in accounting principles
  • Impairment of long-lived assets
  • Restructuring charges
  • Changes in estimates
  • Peripheral gains and losses
  • Mgt. analysis including the MD&A
restructuring difficulties
Restructuring Difficulties
  • Conservative vs. aggressive accounting practices
  • Periodic charges vs. one time event
  • “Taking a bath”
analyst s role
Analyst’s Role
  • Is restructuring adequate
  • Wall street point of view
  • Significant judgement required
earnings management
Earnings Management
  • Reasons it occurs:
    • Incentive compensation factor
    • Job security
    • Smoothing reduces erratic performance which lowers perceived risk
    • Gov’t anti-trust avoidance
  • Reasons against:
    • Can’t do it forever
    • Capital market penalties for excess
methods of management
Methods of Management
  • GAAP choices
  • Management judgement and estimates
  • Timing of transactions
restated f s
Restated F/S
  • Discontinued operations
  • Pooling of interests-(new guidelines)
  • Accounting principle changes
  • Big issue here is the difficulty of calculating prior years’ impact if information is not presented.
global considerations
Global Considerations
  • Use SEC Form 20-F
    • Discloses equity and net income reconciliation between local GAAP and US GAAP
  • Evaluate environmental, customs and strategic implications as well as GAAP
chp 6 examples
Chp. 6 Examples
  • Ex. #1: Halliburton-discontinued segment
  • Ex. #2: Fountain Pwerboats – extraordinary item
  • Ex. #3: Tenneco Automotive – changes in acctg. Princ.
  • Ex. #4: Brunswick- effect of actg. Changes
  • Ex. #5: Ford-cumulative effect acctg changes
  • Ex. #6: PepsiCo-other comprehensive loss
  • Ex. #7: Cisco-other items
  • Ex. #8: PepsiCo-asset impairment
  • Ex. #9: JDS Uniphase- asset impairment
  • Ex. #10: JDS Uniphase -restructuring
  • Ex. #11: Brunswick-unusual charges
  • Ex. #12: PepsiCo-merger related costs
chp 6 examples cont
Chp. 6 Examples, cont.
  • Ex. #13: DriveTime-change in actg estimate
  • Ex. #14: Hersey-change in actg estimate
  • Ex. #15: Delta Air Lines- other gains and losses
  • Ex. #16: PepsiCo-other gains and losses
  • Ex. #17: PepsiCo-other gains and losses
  • Ex. #18: General Mills –restated statements
  • Ex. #19: Account classification differences
  • Ex. #20: Ericsson-worldwide reporting
extended profitability use for chapter 4 5
Extended Profitability-(use for chapter 4 & 5)
  • ROA=PM x AT
  • ROA increases as Risk increases
  • ROA increases as OL increases
  • Sales cyclicality increases risk
  • Offset with higher AT
  • ROA varies with life cycle
economic aspects
Economic Aspects
  • Monopoly…high PM; low AT
  • Pure Competition…low PM; high AT
  • Oligopoly…mixture of the two
roce considerations
ROCE Considerations
  • ROCE tends to follow ROA
  • Two theories
    • Random walk…high stays high; low stays low
    • Equilibrium…revision to average ROCE
  • Penman’s findings
    • Random walk valid 1-6years
    • Equilibrium thereafter takes hold
  • Capital structure not changed for ROCE improvement
extended risk
Extended Risk
  • Financial Distress
    • Credit risk
    • Bankruptcy risk
  • Financial Distress Spectrum
    • Payment omission
    • Default
    • Bankruptcy
    • Liquidation
credit risk c s
Credit Risk C’s
  • Circumstances
  • Cash flows (Capability to repay)
  • Collateral
  • Capacity for debt
  • Contingencies
  • Character of management
  • Conditions
bankruptcy
Bankruptcy
  • Process
    • Chapter XI…liquidation
    • Chapter VII…reorganization
  • Predictive Models
    • Beaver…univariate
      • Net income before amort. etc./total liab.
    • Altman’s Z…see pages 631-633
      • Multivariate
multivariate criticisms
Multivariate Criticisms
  • Relevant ratios might be missing
  • Subjective evaluation
  • Model based on available info; lack of info might bias model
  • MDA assumes normal distribution of ratios
  • MDA requires similar relationship of variables for bankrupt and non-bankrupt firms
other issues in bankruptcy models
Other Issues in Bankruptcy Models
  • Population does not include equal # of bankrupt and non-bank. Firms
  • Excludes size and industry factors
  • Accrual vs. cash flow variables
  • Models remain unchanged over time
general summary of factors
General Summary of Factors
  • Investment Factors
    • Liquidity lowers risk
    • AT lowers risk
  • Financing Factors
    • Lower debt levels lowers risk
    • S/T debt increases risk over L/T debt
  • Operating Factors
    • Profitability lowers risk
    • Operational consistency lowers risk
    • Small size, rapid growth and audit exceptions increase risk
market risk
Market Risk
  • Drivers
    • Political
    • Personnel
    • Product
  • Market risk drives market return
  • CAPM measures market risk
    • Market risk beta is driven by…
      • Operating leverage
      • Financial leverage
      • Sales variability
pro forma financials chapter 10
Pro-forma Financials-Chapter 10
  • Sales revenue (revenue growth)
  • Operating expenses
  • Asset requirements (asset turnover)
  • Debt and equity requirements
  • Cost of financing-(interest etc.)
  • Statement of cash flows
  • Balance sheet
pro forma approaches exhibit 10 1
Pro Forma ApproachesExhibit 10.1
  • Follow the 6 step plan page 742
  • FSAP has a Forecast pro forma template
  • % analysis can be used to project income statement and balance sheet
  • Individual items
    • Turnover ratios as a benchmark
key assumptions and caveats
Key Assumptions and Caveats
  • Annual revenue growth rate
  • Expense relationships
  • Levels of investment
    • Working capital
    • Fixed Assets
  • Financing mix
  • 4-5 year range
  • Consistency
  • GIGO (garbage in garbage out)
pro forma methodology
Pro-forma Methodology
  • Chapter 10 provides you with a format for building the excel worksheet and integrating it with the FSAP template
rev recognition options chapter 7
Rev. Recognition OptionsChapter 7
  • Period of production
  • Completion of production
  • Time of sale
  • During collection period
  • Upon cash receipt
earnings management59
Earnings Management
  • Increases as cash flow period grows
  • Increases as options for estimation grows
criteria for recognition
Criteria for Recognition
  • Work is completed
  • Measurable amount
  • Costs are identifiable
  • Collection is reasonably assured
earnings sustainability risk
Earnings Sustainability Risk
  • Uncollectible A/R
  • High volume of returned goods
  • Unrecorded warranties
l t contractors
L/T Contractors
  • Multiple accounting periods
  • Price established in advance of work
  • Periodic payments
  • Percentage of completion
    • IRS approach
  • Completed contract
criteria for exp recognition
Criteria for Exp. Recognition
  • Matched with revenue
  • Consumption of service or benefit
rev recog when cash is uncertain
Rev. Recog. When Cash is Uncertain
  • Installment method
  • Cost-recovery-first method
disclosure
Disclosure
  • Accounting policies footnote
inventory cost flow assumptions
Inventory Cost Flow Assumptions
  • Weighted average
  • FIFO-first in; first out
  • LIFO-last in; first out
lifo liquidation
LIFO Liquidation
  • Sales greater than production
  • Cash flow increases due to reduced purchases
  • Cash flow decreases due to higher income taxes
lifo characteristics
LIFO Characteristics
  • Rapid price increases
  • Provides better income smoothing in light of inventory change variability
  • Tax savings
  • Industry specific
  • Larger firm size
other lifo factors
Other LIFO Factors
  • GAAP disclosure: LIFO reserve
  • Stock reaction is inconclusive
analytical considerations
Analytical Considerations
  • Cost flow assumption
  • Price variation & inventory turnover
  • LIFO liquidation impact
  • Inventory obsolescence
  • Inventory financing
lifo fifo adj
LIFO - FIFO Adj.
  • Inventory value
  • Working capital changes
  • Income statement changes
  • SCF changes
fixed assets key issues
Fixed Assets--Key Issues
  • B/S Amount
  • Useful lives
  • Depreciation method
  • Recoverability
  • Maintenance & repair expense
  • Overall issue: undervaluation potential
f a earnings sustainability
F/A--Earnings Sustainability
  • B/S amount vs. replacement cost
  • Choice of depr. Lives (instant profit)
  • Choice of depr. method
intangibles general
Intangibles--General
  • Expense cost of development
  • Recognize as asset purchased intangibles
  • Amortize up to 40 years
  • Caution surrounding “in process R&D”
s w development costs
S/W Development Costs
  • Expense through “tech. feasibility”
  • Capitalize, thereafter
  • Amortize over useful life
goodwill
Goodwill
  • Results from acquisitions
    • Treat according to GAAP
    • Eliminate from B/S
intangibles earnings sustainability
Intangibles--Earnings Sustainability
  • Generally expense
  • The above is a questionable approach
  • Needed-ways to value intangibles
liability recognition chapter 8
Liability RecognitionChapter 8
  • Probable future sacrifice
  • Little or no discretion to avoid
  • Event has occurred
no liability if
No Liability, If...
  • Mutually unexecuted contracts
  • Certain contingencies
    • Not probable
    • Not measurable
controversial liability issues
Controversial Liability Issues
  • Hybrid securities
  • Sale of A/R w/recourse
  • Product financing arrangements
  • R&D financing arrangements
  • Take or pay contracts
  • Derivative instruments
liability valuation
Liability Valuation
  • PV of future cash flows > 1 year
  • Cost of future deliverables
  • Cash advance value
leases
Leases
  • Operating lease
    • Expense
  • Capital lease
    • Capitalize w/liability
    • SFAS 13
      • Title transfer
      • Bargain purchase option
      • 75% of life rule
      • 90% of cost rule
    • Slightly different tax rules
  • May want to restate all as capital
retirement benefits
Retirement Benefits
  • Pensions (FASB 87 & 132)
  • Post-retirement Health Benefits (FASB 106 & 132)
pensions
Pension Fund Assets

Assets-BOP+/- Actual Earnings+ Contributions- Payments

= Assets-EOP

Pension Fund Liab.

Liab-BOP+ Incr.- Time+ Incr.- Service+/- Actuarial G & L- Payments

= Liab-EOP

pensions
key terms
Key Terms
  • ABO - amount expected to be paid--current salaries
  • PBO - amount expected to be paid--future salaries
pension expense
Pension Expense
  • Service cost
  • Interest cost
  • Actual return on plan assets
  • Amort. of adoption cost
  • Amort. of PBO increase/decrease
  • Amort. of actuarial gains & losses
minimum liability
Minimum Liability
  • If ABO > FV of Assets, then adjust to Comprehensive Income
health care benefits
Health Care Benefits
  • No minimum liability
  • Minor measurement differences
  • Considers income tax impact
  • Sensitivity analysis
  • Note politicization on p. 410
analyst s role89
Analyst’s Role
  • Awareness of underfunding
  • Reasonableness of assumptions
  • Actual performance vs. expected performance
income taxes fasb 109
Income Taxes-FASB 109
  • Book income
  • Permanent differences
  • Temporary differences
    • Taxables
    • Deductibles
  • Taxable income
fasb 109 history
FASB 109-History
  • APB 11 - income statement focus
  • FASB 109 - B/S focus
  • FASB 109 - Allows deferred debits
implementation
Implementation
  • Determine differences
  • Eliminate permanent differences
  • Classify temporary differences
  • Assess need for valuation allowance
    • Taxables > deductibles
    • Negative factors
    • Positive factors
    • “more likely than not…”
disclosure93
Disclosure
  • Income tax expense
  • Income before taxes
  • Statutory rate reconciliation
  • Composition of deferred taxes and assets
deferred tax liability
Deferred Tax Liability
  • Is it real?
  • Consider in terms of a “going concern”
analyst s role95
Analyst’s Role
  • Effective tax rate changes
  • Changes in valuation allowance
  • Tax rate by venue
  • Normalize rate excluding one time changes
reserves
Reserves
  • Matching principle
  • Exclude expenses
  • Defer negative asset revaluation (ie FASB 115)
  • Difficult to assess & adjust
combination issues chapter 9
Combination IssuesChapter 9
  • Corporate acquisitions
  • Investments in securities
  • Foreign currency translation
  • Segment reporting
business combinations
Business Combinations
  • Purchase accounting
    • Record at FMV
    • Excess to goodwill
  • Pooling
    • Assume assets and liabilities
    • Must meet the 12 criteria for pooling
pooling criteria
Pooling Criteria
  • 2 year autonomy
  • independence
  • single transaction w/in one year
  • stock for at least 90% of stock
  • 2 year moratorium on equity interest changes
  • no reacquisition of shares for bus. Combos
  • ratio interests remain unchanged
  • no change in voting rights
  • no security issues remain outstanding
  • no reacquisition of securities
  • no special funding agreements
  • no disposal plans
investment in securities
Investment in Securities
  • Under 20%
  • 20% to 50%
  • Over 50%
under 20
Under 20%
  • Held to maturity
  • Available for sale…comprehensive inc.
  • Trading…income statement
  • Analyst issues
    • include or exclude adj. from income
20 to 50
20% to 50%
  • Equity method if influence exists
  • Analyst issues
    • relationship between income and cash
    • submerged assets
over 50
Over 50%
  • Consolidation
  • Might want to consider ROA after inclusion of unconsolidated subs.
tax consequences
Tax Consequences
  • Under 80%…interest or dividends
  • Over 80%…consolidated return
foreign currency translations
Foreign Currency Translations
  • Functional currency
    • Foreign currency
      • all-current method
      • income stmt. at the avg. rate
      • B/S at end-of-period rate
      • unrealized translation adj. in comp. income
    • U.S. currency
      • monetary method
      • avg., end of period and historical rates
fx analyst issues
FX-Analyst Issues
  • Translation adjustments in income?
  • Difficult to interpret due to limited disclosure
  • Significant international variance in practice
disaggregation of info
Disaggregation of Info.
  • Disclosure of segments (mgt. Approach)
    • operating segments
    • geographic locations
    • major customers
  • 10% rule
  • Elements
    • operating income
    • sales
    • assets
why value via cash flow chapter 11
Why Value Via Cash Flow?Chapter 11
  • Cash = ultimate value
  • Cash = common denominator
economists cash flow
Economists & Cash Flow
  • Investors spend cash
  • Accrual method subject to “acctg. Tricks
  • Mgt. can manipulate earnings
valuation cash flow based
Valuation: Cash Flow Based
  • Periodic cash flows
  • Residual value
  • Approximate discount rate
    • Cost of capital
periodic cash flows
Periodic Cash Flows
  • Unleveraged
    • Excludes interest, debt & pfd. stock
    • Weighted avg. cost of capital
    • Valuation of assets
  • Leveraged
    • Includes interest, debt & pfd. Stock
    • Cost of equity capital
    • Valuation of common shareholder equity
periodic cash flows cont
Periodic Cash Flows, cont.
  • Appropriately reflect inflation
    • Nominal vs. real cash
  • Use after tax amounts
residual value
Residual Value
  • Horizon = no growth
  • (last cash flow) x (1 + growth rate) (discount rate - growth rate)
  • Consider conversion tables (Stickney-p. 766)
cost of capital
Cost of Capital
  • Debt
    • Market rate (1-tax rate)
    • Leases: use borrowing rate
  • Preferred Equity
    • Dividend rate
  • Common Equity
    • Risk free rate + ß(Mkt. Rate - RFR)
    • Betas published in S&P’s stock reports
releveraging @ new capital structure
Releveraging @ New Capital Structure
  • BL0=BU[1+(1-tax rate)(Current Debt)]Current Equity
  • Substitute BU with new capital structure
  • BL1=BU[1+(1-tax rate)(New Debt)]New Equity
capm critique
CAPM Critique
  • Unstable ß’s
  • Unstable MROR
  • Size vs. ß’s
valuation techniques
Valuation Techniques
  • Equity
    • CFU-[(interest)(1-tax rate)] Cost of equity capital
  • Debt plus equity
    • CFU ÷ Wtd. average cost of capital
  • Adjusted present value
    • CFU ÷ Unleveraged cost of equity cap.
    • [interest(tax rate)] ÷ cost of debt cap.
unleveraging
Unleveraging
  • CECU = CECL - [(current debt)(1-tax rate)(CECU-CDC)]current equity
cash flow evaluation
Cash Flow Evaluation
  • Advantages
    • Economic base
    • Rigorous methodology
  • Disadvantages
    • Residual value dominant
    • Time consuming
    • Subjective
price earnings ratio chapter 12
Price-Earnings RatioChapter 12
  • Higher risk -> lower PE
  • Theoretical model
    • P/Actual earnings = (1+g)/(r-g)
theoretical variances pe
Theoretical Variances: PE
  • Earnings persistance
    • Transitory…no change in PE
    • Permanent…change in PE
  • Accounting principles
    • Lower earnings…higher PE
trending
Trending
  • Penman found transitory earnings consistency…that is high PE caused by lower than normal earnings is counterbalanced in the following year.
  • 5-7 years reversion to mid-teens growth
pe ratio factors
PE Ratio Factors
  • Risk (cost of capital)
  • Growth
  • Earnings persistence
  • GAAP
pe analysis keys
PE Analysis Keys
  • Use a sustainable growth rate
  • Doesn’t work when g>r
  • Doesn’t work when g approximates r
  • Test reasonableness with actual PE
  • Existence of transitory earnings
  • Impact of GAAP
price to book value
Price to Book Value
  • Market rewards growth in excess of cost of capital
  • Ultimately reverts to 1.0
  • Function of
    • Profitability
    • BV growth
p bv theoretical model
P/BV-Theoretical Model
  • 1+ [(Expected ROCE-r)(BVt)/(1+r)t] … BV0
theoretical variances p bv
Theoretical Variances: P/BV
  • ROCE errors
  • Cost of capital errors
  • Growth rate errors
  • Transitory earnings
  • GAAP impact
    • lower earnings…higher P:BV
trending p bv
Trending: P/BV
  • ROCE remains consistent and reverts to 1.0 slowly.
cash flow vs earnings
Cash Flow vs. Earnings
  • Long term impact is indifferent
  • Short term impact: earnings more indicative
  • Use multiple approaches
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