Financial Statement Analysis and Security Valuation

3. What you will learn from this Chapter Why the analysis of growth is important for valuation Why growth analysis focuses on residual earnings growth and abnormal earnings growth rather than earnings growth Why abnormal earnings growth is equal to growth in residual earnings What a growth firm is What transitory earnings are What “quality of earnings” means How operating leverage affects earnings as sales change How changes in ROCE can be created by borrowing What are the drivers of growth in the common shareholders’ investment

4. What Is Growth and How Is It Valued? Growth in sales? Growth in earnings? Growth is assets? Growth in equity? Does a high P/E ratio indicate a growth company? Does a high P/B ratio indicate a growth company? Think of growth in residual earnings and abnormal earnings growth  A reminder: abnormal earnings growth (AEG) is equal to growth in residual earnings (?RE)

5. A Growth Company: General Electric, Corp.

6. Is Nike a Growth Firm?

7. A Cyclical Firm: American Airlines

8. Analyzing Growth in Residual Earnings Changes in residual earnings are driven by: Changes in ROCE Changes in required return Changes in investment

9. Analysis of Growth in Residual Earnings and AEG:Nike, Inc.

10. Analysis of Growth in Residual Earnings and AEG:Reebok

11. Analyzing Change in ROCE: The Scheme

12. Analysis of Changes in ROCE Analyze Changes in Profitability of Operations Analyze the Effects of Changes in Financing

13. Explaining the Changes in Operational Profitability Explaining ?RNOA Distinguish core and transitory components Core OI is persistent income from core business UI is unusual items that are non-recurring, sometimes called transitory items. All items are after tax

14. Explaining Changes in Operational Profitability (cont’d.) Distinguish margin and turnover drivers of core profits where,

15. Explaining Changes in Operational Profitability (cont’d.) The change in RNOA is explained as:

16. Changes in Operational Profitability: Nike and Reebok

17. Explaining Changes in Operational Profitability (cont’d.) Explain changes in profit margins and asset turnoversExplain (i) by looking at profit margin drivers GM (by segment) Selling Expenses / Sales Administrative Expenses / Sales R&D / Sales Pay particular attention to GM: per unit sales prices, production costs… Explain (ii) by looking at turnovers Accounts receivables turnover Inventory turnover PPE turnover Accounts payable turnover Operating liability turnover Also Look at operating asset composition ratios Look at operating liabilities composition ratios Look at OLLEV

18. Reformulating Income Statements to Identify Core and Unusual Items

19. To Analyze Sustainable Earnings, Analyze R&D

20. To Analyze Sustainable Earnings, Analyze Marketing Expenditures

21. To Analyze Sustainable Earnings, Analyze Pension Costs Components of Pension Expense: Service Cost Interest Cost Expected Return on Plan Assets Amortization of Prior Service Cost Amortization of Transaction Asset or Liability (before 2000) Changes in Actuarial Estimates (accrual gains and losses)

22. Watch for the Expected Rate of Return on Pension Plan Assets In the 1980s, firms were using expected rates of return of about 7% In the 1990s, firms were using expected rates of returns of 10-10½% Applying a high rate of return to bubble asset prices produces bubble earnings Pricing on the basis of bubble prices perpetuates the bubble The Pension Pyramid Scheme

23. Watch for Gains of Pension Fund Assets General Electric’s expected return on plan assets was $3,024 million in 1998 (22.4% earnings before tax) against a service cost of $625 million. Its net pension expense was a gain of $1,016 million. IBM reported an expected return on plan assets of $6,264 million in 2001 (56.0% of operating income before tax).

24. Watch Gains and Losses on Sales of Shares Intel In its report for its third quarter for 1999, Intel reported net income of $1,458 million, with no indication of unusual items. Its cash flow statement, however, reported $556 million in gains on sales of investments, along with a $161 million loss on retirements of plant, as add backs to net income to calculate cash from operations. Delta Air Lines Delta reported operating income (before tax) of $350 million for its September quarter in 1999. However, notes to the report indicated that these earnings included pre-tax gains of $252 million from selling its interest in Singapore Airlines and Priceline.com. IBM IBM reported before-tax operating income of $4,085 for its June, 1999 quarter. However, footnotes revealed that this income included a $3,430 million gain from the sale of IBM's Global Network to AT&T. This gain reduced selling, general and administrative expenses in the income statement!

25. Watch for Bleed Backs of Restructuring and Merger Changes

26. Miscellaneous Check List Changes in estimates Bad debt allowances Deferred revenue and cookie jar accounts Warranty allowances Residual values for leases Income Taxes One-time or expiring credits Valuation allowances for deferred tax assets Investigate “other income”

27. Analyzing Operating Leverage Operating Leverage is the proportion of total costs that are fixed versus variable

28. Operating Leverage Measures Operating Leverage is sometimes calculated as the ratio of fixed costs to variable costs Another measure is: Applying this measure to core operations:

29. Analysis of Effect of Changes in Financing

30. Effect of Changes in Financing: Nike and Reebok

31. Explaining Changes in the SPREAD SPREAD = RNOA – NBC ?RNOA has been explained Explain Change in NBC: Distinguish core and unusual borrowing cost Core financing expenses Change in interest rates (risk free and risk premium) Change in tax rates (and shield) Substitution of preferred for debt financing Unusual financing expenses Tax effect from unusually high or low taxes (operating losses) Interest income from tax refunds of prior years Gains and losses on financial items

32. A Rough Approximation Some observations The change in leverage effect (iii) is generally minor The change in borrowing costs is generally small (then, ?Spread is largely determined by ?RNOA) The RNOA effect (i) is generally the largest So, if ?FLEV and ?NBC are small, a useful approximation is

33. Breakdown of Growth in Equity Investment

34. Analysis of Growth in Equity Investment These components of growth in equity investment: Growth in sales Change in net operating assets that support each dollar of sales Change in the amount of net debt that is used to finance the change in net operating assets rather than equity

35. Analysis of Growth in Common Equity: Nike and Reebok

36. Preparing Financial Statements for Forecasting Identify dirty surplus and calculate ROCE from statement of shareholders’ equity Reformulate balance sheet Reformulate income statement Decompose ROCE: Profitability Analysis Analyze ?ROCE: Sustainability of Earnings Analyze Growth Now you are ready to forecast future ROCE and growth and carry out valuations

37. Using Growth Analysis to Understand P/B and P/E Ratios How does P/B relate to growth? How does P/E relate to growth? How does P/E relate to transitory earnings?

38. A reminder: The Benchmark Case of Normal P/B and Normal P/E

39. A Normal P/E: Whirlpool Corporation Valuation: (approx) (approx) Normal P/E for a 10% cost of capital

40. Forecasted RE and Earnings for a Normal P/E: Whirlpool Corporation For Whirlpool, RE is forecasted to be constant and cum-dividend earnings also expected to grow at the cost of capital, so Abnormal Earnings Growth (AEG) is expected to be zero.

41. P/E Ratios Different from Normal If earnings are expected to grow faster than the cost of capital (cum-dividend), P/E > Normal If earnings are expected to grow slower than the cost of capital (cum-dividend), P/E < Normal OR If AEG is forecasted to be positive, P/E > Normal If AEG is forecasted to be negative, P/E < Normal OR If RE is forecasted to increase, P/E > Normal If RE is forecasted to decrease, P/E <Normal

42. The P/E Ratio and the P/B Ratio P/B indicates expected growth in book value P/E indicates expected growth in earnings OR P/B indicates future RE P/E indicates future changes in RE from current RE

43. How do P/E and P/B Articulate?

44. Median P/B for E/P Portfolios: 1968-85

45. Median E/P for P/B Portfolios: 1968-85

46. Fill Out the Cells(this is not TIC-TAC-TOE)

47. The Solution

49. What is a Growth Stock? P/E indicates growth in RE but this could be from a very low base: Firms in cell C can be high P/E firms Trailing P/E reflects growth and transitory earnings. If earnings are temporarily low, P/E will be high The Molodovsky Effect: Cells B and H are pure Molodovsky effects Cells A, C, G and I are mixed growth and Molodovsky effects

50. Additional Presentation for Nike and Reebok

73. The Analysis of Changes in Common Stockholders’ Equity

75. Additional Tables and Graphs on P/E and P/B ratios Source: Penman S, 1996, “The Articulation of Price-Earnings Ratios and Market-to-Book Ratios and the Evaluation of Growth”

77. For firms around the median E/P, earnings per share grew at an average rate slightly higher than the historical average cost of equity (10-12%). High E/P (low P/E) indicate lower future earnings changes relative to median in the central portfolios. Low E/P (high P/E) indicate higher future earnings changes relative to median.

78. Table 1 –Changes in EPS (Cum Dividend)

79. Table 1 –Changes in EPS (Cum Dividend)

81. Table 2 –Residual Income

84. Median Observed E/P Ratios for Portfolios Formed on P/B (Panel B): 1968-85

86. Table 4 – Panel A (Residual Income)

88. Table 4 – Panel B (Residual Income)

90. Table 4 – Panel C (Residual Income)

91. P/E, P/B and Growth Textbook models, based on Gordon [1962], characterize P/E as projecting earnings growth. This description reconciles the "Molodovsky effect" with the growth explanation for P/E. The pure Molodovsky effect applies in cases B and H where P/E is determined by transitory current earnings and gives no differential indication of future profitability P/E never indicates future profitability unconditionally; only by conditioning on current ROE can one draw inferences about future profitability from a P/E ratio.

93. P/E is not a good indicator of future profitability. It is the transitory property in earnings and ROE that the constant growth models do not capture.

94. P/E, P/B and ROE P/B is assessed by forecasting future ROE, not current ROE. P/E is determined by comparing forecasted future ROE with current ROE.

96. Table 6