ACCT6101 – Session #1: Introduction to Valuation
PART 1 – Background
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ACCT7106 – Session #12: Forecasting & Valuation (cont)
overarching objective:
to conduct the fundamental valuation exercise for the purpose of estimating the ‘intrinsic value’ of a firm’s common shares
requires an understanding of the firm’s ‘value drivers’
need to accumulate a ‘tool kit’ as the basis for developing the pro forma Financial Statements (as an integrated system!)
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STEP 1
Understanding the past
Information collection
Understanding the business
Accounting analysis
Financial ratio analysis
Cash flow analysis
STEP 2
Forecasting the future
Structured forecasting
Income Statement forecasts
Balance sheet forecasts
Cash flow forecasts
STEP 3
Valuation
Cost of capital
Valuation models – AE, FCF, D
Valuation ratios
Complications
Negative values
Value creation and destruction
Figure 1.1 Lundholm & Sloan, Framework for Equity Valuation
Sessions #3 #10
Sessions #10 #11
Sessions #1 #3; #11, #12
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beginning stock
Beginning Balance Sheet
Cash
+ Other assets
= Total Assets
– Liabilities
= Shareholders’ Equity (BVt-1)
Statement of Changes in S/E
Cash from operations
+ Net Income & OCI
= Net Change in S/E
Cash Flow Statement
Cash from operations
+ Cash from investing
+ Cash from financing
= Net change in cash
Income Statement
Revenue
– Expenses
= Net Income (NPAT)
Ending Balance Sheet
Cash
+ Other assets
= Total Assets
– Liabilities
= Shareholders’ Equity (BVt)
flows
ending stock
‘articulation’ Financial Statements constitute an ‘integrated system’
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Forecasting & Valuation
Objective of the forecasting exercise
to develop objective and realistic expectations of future value-relevant payoffs
unbiased predictions (neither optimistic nor pessimistic sensitivity analysis)
pro forma F/S should be comprehensive need to consider each item, not just assume items will grow at a constant rate with sales
need to make consistent assumptions and maintain the relation between items in the pro forma F/S (i.e., the F/S represent an integrated system)
use external information to ensure that assumptions are realistic
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Key Steps:
Sales forecast
external environment & macroeconomic forecasts
Industry dynamics & forecasted changes
firm-specific characteristics
Forecast of ‘Core Operating Income from Sales’
forecast asset turnover and calculate NOA implied by forecasted sales and ATO
revise sales forecast (if necessary) in recognition of ‘asset constraints’ and iterate
forecast gross profit margin
forecast core operating expenses (e.g., SG&A, depreciation, advertising, R&D)
forecast the tax rate applicable to ‘core operating income from sales’
Forecasts of ‘Core Other Operating Income’ and ‘Unusual Operating Income’
Calculation of ‘Operating Income (OI) after tax
Forecast OA and OL to obtain (confirm) NOA
Calculate RNOA, FCF, ReOI and value the firm (FCF and AE valuation models; WACC)
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Key Steps (cont)
Forecast of Comprehensive Income (CI)
forecast of financial leverage (FLEV) and determination of NFO
forecast of net borrowing cost (NBC) and determination of NFE
calculation of comprehensive income (CI)
Forecast of Shareholders’ Equity = NOA – NFO
Forecast of Dividends = CI – S/E NCC
Forecast of Residual Income
determination of ‘cost of equity capital’ (ke)
calculation of abnormal earnings (residual income) = CI – ke * BVt-1
Selection and justification of terminal growth rate, g
Valuation based on Abnormal Earnings (Residual Income) valuation model
Discounted Dividend (DDM) valuation model
Conduct ‘sensitivity analyses’
Re: Coles Summary of significant assumptions
Sales growth 2.5% 2.0% 2.25% 2.25% 2.0%
Terminal growth rate (g) of 3%
ATO constant @ 3.00 (had increased from 2.914 to 3.065) if higher ROCE
Gross profit margin @ 0.26 (had increased from 0.234 to 0.250)
Administrative expenses assumed to decline from 0.21 to 0.208 (had been 0.215 and 0.212)
Financing costs assumed growth in PPE of 1.5%, NBC up 0.6%
OR
Unchanged capital structure (FLEV)
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2021 E 2022 E 2023 E 2024 E 2025 E
Revenues 38,343 39,110 39,990 40,890 41,708
Core OI from Sales (after tax) 1,342 1,382 1,427 1,473 1,518
% 2.98% 3.26% 3.22% 3.06%
Total OI (after tax) 1,692 1,732 1,777 1,823 1,868
% 2.36% 2.60% 2.59% 2.47%
NOA 12,782 13,038 13,331 13,631 13,904
RNOA 0.1324 0.1328 0.1333 0.1337 0.1344
%RNOA 0.0269 0.0004 0.0005 0.0004 0.0007
FCF 1,115 1,476 1,484 1,523 1,595
%FCF 0.0500 0.0446 0.005 2.63% 4.73%
ReOI (k = 6.25%) (to firm) 929 933 962 990 1,016
%ReOI 0.43% 3.11% 2.91% 2.63%
‘unlevered valuation’ overall value of the firm
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Abnormal Earnings (Residual Income) valuation model
+
= 12,205 + + + + +
= $40,015 million
FCF valuation model
= + + + +
= $43,298 million
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2021 E 2022 E 2023 E 2024 E 2025 E
Revenues 38,343 39,110 39,990 40,890 41,708
Gross Margin (0.26) 9,969 10,169 10,397 10,631 10,844
Administrative Expense (8,052) (8,194) (8,358) (8,526) (8,675)
Tax Expense (30%) (575) (593) (612) (632) (651)
Core OI from Sales (after tax) 1,342 1,382 1,427 1,473 1,518
Core Other OI 500@ (1 – 0.3) 350 350 350 350 350
Unusual Items 0 0 0 0 0
Total OI (after tax) 1,692 1,732 1,777 1,823 1,868
Core NFE (NFO 1.5%) (389) (395) (401) (407) (413)
Comprehensive Income 1,303 1,337 1,376 1,416 1,455
** assumes OCI = 0
‘levered valuation’ value to common shareholder
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2021 E 2022 E 2023 E 2024 E 2025 E
Revenues 38,343 39,110 39,990 40,890 41,708
Comprehensive Income 1,303 1,337 1,376 1,416 1,455
%CI 2.61% 2.92% 2.91% 2.75%
NOA 12,782 13,038 13,331 13,631 13,904
NFO ( 1.5%) 9,734 9880 10,028 10,179 10,331
S/E 3,048 3,158 3,303 3,452 3,573
%S/E 3.61% 4.59% 4.51% 3.51%
Dividends 870 1,227 1,231 1,267 1,334
%Div 3.26% 2.92% 5.29%
ReCI (k = 7.4%) (to S/E) 1,109 1,111 1,142 1,172 1,200
%ReOI 0.20% 2.79% 2.63% 2.39%
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Abnormal Earnings (Residual Income) valuation model
+
= 2,615 + + + + +
= $26,905.0 million (** all calculations carried through using an Excel spreadsheet)
DDM valuation model
= + + + +
= $26,625.3 million
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PART 2 – Sensitivity Analyses: 1st stage = one item at a time, leaving all else as forecasted
AE Valuation DDM Valuation
‘as forecasted’ 26,905.0 26,625.3
Terminal growth rate = 2.5% (instead of 3%)
Terminal growth rate = 2.0% 24,814.3
23,110.7 24,929.4
22,402.3
Sales growth = constant 2%
Sales growth = constant 1.75% 26,802.3
26,477.6 26,499.9
27,260.7
ATO = 3.1 (instead of 3.0)
ATO = 2.9 27,536.5
26,230.2 27,180.5
26,030.8
Gross Margin = 0.25 (instead of 0.26) 20,989.8 20,708.9
Admin Exp = 0.215 (instead of 0.210 0.208) 25,841.0 25,560.2
Net borrowing cost = 5.0% (instead of 4.0%)
Net borrowing cost = 3.0% 24,806.7
29,003.7 24,525.8
28,722.8
FLEV = 3.67 (instead of NFO @ 1.5%) *** 27,184.5 27,683.0
Discount rate = 8.5% (instead of 7.4%) 25,794.4 25,394.9
**
**
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*** re: leverage (FLEV) and net borrowing cost (NBC)
as calculated in Session #10 from Coles reformulated F/S (Slides #44 – 47):
2020: NOA = 12,205 NFO = 9,590 S/E = 2,615 NFE = 322
FLEV = 3.6673 NBC = 0.0336 PM = 0.0344 ATO = 3.065
For primary valuation analyses, assumed: NFO growth of 1.5% (driven by PPE) and NBC = 4%
NOA 12,782 13,038 13,331 13,631 13,904
NFO (@ 1.5%) 9,734 9,880 10,028 10,179 10,331
S/E = NOA – NFO 3,048 3,158 3,303 3,452 3,573
Core NFE 389 395 401 407 413
Comprehensive Income 1,303 1,337 1,376 1,416 1,455
ReCI (k = 7.4%) 1,109 1,111 1,142 1,172 1,200
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re: leverage (FLEV) and net borrowing cost (NBC)
what if alternatively assumed FLEV constant at 3.67 and NBC = 4%
FLEV = = 3.67 NFO = 3.67 * S/E
S/E = NOA – NFO S/E = NOA – 3.67 * S/E S/E = NOA 4.67
ATO = 3.0 = sales NOA NOA = sales 3 S/E = sales (3 * 4.67)
NFO = NOA – S/E = – = 0.26196 * sales
NOA 12,782 13,038 13,331 13,631 13,904
NFO (based on FLEV = 3.67) 10,004 10,245 10,476 10,712 10,926
S/E = NOA – NFO 2,738 2,793 2,855 2,919 2,978
Core NFE 402 410 419 428 437
Comprehensive Income 1,290 1,323 1,359 1,396 1,431
ReCI (k = 7.4%) 1,097 1,120 1,152 1,184 1,215
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NOA 12,782 13,038 13,331 13,631 13,904
NFO (@ 1.5%) 9,734 9,880 10,028 10,179 10,331
S/E = NOA – NFO 3,048 3,158 3,303 3,452 3,573
Core NFE 389 395 401 407 413
Comprehensive Income 1,303 1,337 1,376 1,416 1,455
ReCI (k = 7.4%) 1,109 1,111 1,142 1,172 1,200
NOA 12,782 13,038 13,331 13,631 13,904
NFO (based on FLEV = 3.67) 10,004 10,245 10,476 10,712 10,926
S/E = NOA – NFO 2,738 2,793 2,855 2,919 2,978
Core NFE 402 410 419 428 437
Comprehensive Income 1,290 1,323 1,359 1,396 1,431
ReCI (k = 7.4%) 1,097 1,120 1,152 1,184 1,215
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Sensitivity Analyses – terminal growth rate gross margin (appear to be the greatest sensitivities)
Terminal Growth Rate
1.5% 2.0% 2.5% 3.0%
0.265 24,019.6
23,151.4 25,606.6
24,898.3 27,517.5
27,001.6 29,862.7
29,583.0
0.260 21,695.8
20,827.7 23,110.7
22,402.3 24,814.3
24,298.4 26,905.0
26,625.3
Gross Margin 0.255 19,372.1
18,503.9 20,614.7
19,906.4 22,111.0
21,595.1 23,947.3
23,667.6
0.250 17,048.3
16,180.2 18,118.8
17,410.5 19,407.8
18,891.8 20,989.6
20,709.9
0.245 14,724.6
13,856.4 15,622.9
14,914.5 16,704.5
16,188.6 18,031.9
17,752.2
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PART 3 – Alternative Approach to Valuation: Use of ‘Heuristics’
‘multiplier approach’
Implementation of the formal AE valuation model (and also the DDM and FCF models) is a relatively involved and complex process
The alternative, both less rigorous and less demanding, is to focus on multipliers such as the P/E or M/B ratios.
In general terms, the “multiplier approach” can be represented as:
P0 = x M
where M is the multiplier and x is the valuation basis (e.g., earnings, book value)
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The two most commonly cited multipliers are:
Market-to-Book (M/B) ratio (price-to-book ratio)
Price-Earnings (P/E) ratio
The P/E ratio is clearly a flows-based (income statement) measure whereas the M/B ratio is a stock-based (balance sheet) measure.
Of these, the P/E ratio typically receives the greater attention
Coles (price $18) Woolworths (price $40)
Market-to-Book (M/B) = = 9.18 = = 5.70
Price-Earnings (P/E) = 24.56
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Market-to-Book (M/B) ratio (price-to-book ratio)
Abnormal Earnings Valuation Model
(CI – k * BVt-1) = (CI – k * BVt-1) = ( – k) = (ROCE – k)
=
+
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=
Profitability
Growth
Market-to-Book ratio driven by combined effects of
profitability
growth in book value
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>
since from the AE valuation model +
>
> does not required ‘abnormal earnings growth’ (AEG), although it does not preclude it either
where AEG AEt > AEt-1
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PART 4 – Heuristics (cont)
Price-Earnings (P/E) ratio (price-to-book ratio)
initially assume the firm’s earnings are expected to remain constant in perpetuity
P0 = = or P0 = E0
alternatively, assume that the earnings will grow at a constant rate, g
P0 = = E0 =
reveals immediately that in these two ‘simplistic worlds’, the P/E ratio is related to
risk as reflected in the firm’s cost of equity capital (k)
growth in future earnings (g)
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However, these two factors (risk and growth) have been found by empirical studies to explain only slightly more than 50% of the difference in P/E ratios across firms.
in the empirical domain, other factors clearly influence the magnitude of the P/E ratio.
additional factors often advanced as potentially influencing the P/E ratio include earnings persistence and choice of accounting policy
re: risk
in equilibrium, investors will impose a greater risk premium on firms they perceive to have greater business risk.
as such, ke will be higher for firms with greater risk and the P/E ratio (related to 1/ ke) will be lower, all else held equal.
re: growth
as is also clear from the theoretical models above, firms with greater earnings growth will have higher P/E ratios, all else held equal, because market price will reflect the anticipated higher future earnings.
note, however, the market only prices anticipated permanent growth
re: earnings persistence
a firm’s P/E ratio will deviate from its the theoretical model if current period earnings are a poor predictor of expected future (permanent) earnings e.g., if the current period earnings include either an extraordinary gain or an extraordinary loss.
these transitory components should lead to only a temporary change in the P/E ratio.
alternatively, a permanent change in earnings should not significantly affect the P/E ratio because both the earnings figure and the market price will be affected in the same direction
re: accounting policy choice
when otherwise identical firms select different accounting policies for cosmetic reasons alone, these differences will be reflected in P/E ratios e.g., a firm selecting a more conservative accounting policy (accelerated depreciation) will report lower earnings than a firm using less conservative policies (straight-line depreciation).
if the market assesses the only difference between the two firms to be their choice of accounting policies, the firm selecting the more conservative policies will have the higher P/E ratio (since the market prices will be the same)
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Application of the multiplier approach:
Valuation developed through ‘fundamental analysis’ and implemented through the ‘abnormal earnings’, ‘DDM, and ‘FCF’ valuation models requires detailed, multi-year forecasts
An alternative approach is to base valuation on multipliers such as the P/E and M/B ratios
Such an approach simply requires the investor (analyst) to estimate the appropriate value for the selected multiplier and for the estimation base (earnings or book value)
Perhaps the greatest advantage of using the “multiplier approach” to valuation is that the P/E and M/B ratios of comparable firms can be used as the basis of the valuation
Having selected the appropriate comparable firm, the investor (analyst) implicitly assumes that the pricing of the comparable is applicable to the firm of interest
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Unfortunately, application of pricing multiples is not as simple as it might seem. Reasons for the difficulty include:
the need to identify an appropriate comparable(s)
the question of whether valuation should be based on actual figures (past performance) or forecasted figures (expected future performance)
the need to understand why multiples vary across firms, and of the determinants of the multiples, in order to make adjustments, if deemed appropriate
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re: choice of comparable firms
empirical research suggests that industry membership is the best basis for selecting comparable firms
one reason advanced as to why industry membership provides the most effective comparisons is that firms in the same industry usually experience similar profitability, face similar risks, and grow at similar rates
one problem however, is that many large firms operate within many different industry segments
one way of dealing with this problem is to use industry average multiples. Another is to search for the firm within the industry that is most similar
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re: forecasts versus realized
market prices reflect future expected performance by definition.
use of historical data in the denominator of a price multiple is justified only if history is viewed as a reasonable indicator of the future (trailing P/E)
if a reliable forecast is available, it would generally be preferred as the basis for a multiple (forward P/E)
trailing P/E multiples can be distorted by transitory gains or losses or other unusual performance.
forward multiples (based on forecasts) can also be distorted but are less likely to include one-time gains/losses
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re: adjustments
P/E and M/B ratios can vary substantially across apparently similar firms for a number of reasons e.g.,
P/E ratios can vary because of differences in risk, expected future (abnormal) earnings, and accounting policy choice
M/B ratios can vary because of differences in future ROEs, growth in book value, and risk
the differences that exist across firms, even apparently closely related firms, render pricing based on multiples an inherently crude technique.
the investor (analyst) can attempt to mitigate the effect of the differences either through using industry averages or by attempting to make “informed” adjustments
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PART 5 – Heuristics (cont)
Finally, returning to the key issue of ‘growth’, as discussed it is ‘growth in residual income (abnormal earnings) that matters for valuation.
where abnormal earnings growth (AEGt)= AEt – AEt-1
Note – growing earnings is not enough; it must be growth in abnormal earnings!
To illustrate:
consider a firm with S/E of $100 million that current earns $12 million per year, pays dividends of $12 million per year, and has a COEC of 10%
suppose it raises additional equity capital of $20m and invests it in a project that produces $1.5m earnings per year and then increases it dividend to $13.5 million
What will happen to earnings and the value of the firm after the issuance?
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Current Revised
Earnings = 12 Earnings = 12 + 1.5 = 13.5
BV = 100 BV = 120
AE = 12 – 0.10(100) = 2 AE = 13.5 -0.10(120) = 1.5
V = 100 + V = 120 +
The firm’s earnings have grown but its abnormal earnings have not – the new investment does not promise a return equal to COEC
‘value added’ has been reduced 100 120 versus 120 135
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note: normal forward P/E = but the trailing P/E =
why? the trailing P/E is taken one year earlier and has one extra year of return i.e.,
trailing P/E = = assumes that dividends are reinvested to earn k
Ultimately, the ‘abnormal earnings valuation model’ can be recast in terms of ‘abnormal earnings growth’
V0 =
and
P/E = –
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P/E = –
Abnormal earnings growth (AEG)
Dividend payout ratio
Price-Earnings ratio driven by combined effects of
abnormal earnings growth
dividend payout ratio
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Returning to the Market-to-Book (M/B) ratio
from the Abnormal Earnings valuation model +
M/B > 1 AE > 0
Alternatively, for the Price-Earnings (P/E) ratio
trailing P/E = if P/E > trailing P/E AEG > 0
M/B > 0 AE > 0
P/E > normal P/E AEG > 0 i.e., AEt > AEt-1
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Interpretations include –
high (above normal) PB and PE:
future abnormal earnings are expected to be positive and increase
i.e., AE > 0 and AEG > 0
high PB and low PE (below normal):
future abnormal earnings are expected to be positive but decrease
i.e., AE > 0 but AEG < 0 (AEt < AEt-1)
‘confusion’ surrounding M/B as an indication of a ‘growth stock’ ……… BUT ……..
M/B relates to whether AE is positive or not
P/E relates to whether AE are growing (i.e., AEt > AEt-1 AEG > 0)
our interest is in ‘abnormal earnings growth’, not just ‘earnings growth’ !
M/B is not an indication of AEG growth ! (even though high M/B firms are often labelled as ‘growth stocks’)
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PART 6 – Additional Worked Examples
E14.1 E14.4 E14.5 E14.7
E16.1 E16.10 E16.11
Nike 2005 – 2009 illustration of the ‘forecasting & valuation’ process
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ke = 12% kdebt = 10% WACC = 11%
ReOI = 1,400 – 0.11 * 10,000 = 300
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2011: ReOI = 2,300 – 0.10 * 18,500 = 450
2012: ReOI = 2,700 – 0.10 * 20,000 = 700
growth in ReOI = 250 55.56% (250 / 450)
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Rf = 4.3% mkt price of risk = 5.0% beta = 1.3 ke = 0.043 + 1.3(0.05) = 0.108
NBC = 7.5% 0.075 (1 – 0.36) = 4.8% after tax
Vequity = 40.70 * 58 = 2,360.6 VNFO = 1,750 Vfirm = 2,360.6 + 1,750 = 4110.6
WACC = = 0.0825 8.25%
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2013 2014 2015 2016
ReOI = OI – k*NOAt-1 72.365 77.431 82.855 88.648
%ReOI 7.0% 7.0% 7.0%
assume terminal growth rate = 7%
Vfirm = 1,135 + 2,334.29 = 3,469.29 based on the ‘abnormal earnings’ valuation model
Vequity = Vfirm – NFO = 3,469.29 – 720 = 2,749.29
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OI = 0.05(1,276) = 63.8 NOA = 1,276 / 2.2 = 580
a) ReOI = 63.8 – (0.09*580) = 63.8 – 52.2 = 11.6
b) ReOI = 0.045(1,276) – (0.09*580) = 57.42 – 52.2 = 5.22 ReOI 6.38
c) ReOI = 0 = 0.05(1,276) – (0.09*NOA) NOA = 708.889 ATO = 1,276 / 708.889 = 1.8
ATO < 1.8 (if ATO < 1.8 NOA > 708.889)
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2010: OI profit margin = 1,805 / 14,797 = 0.12198 ATO = 14,797 / 11,461 = 1.29107
given “core profit margins and asset turnovers will be the same as 2010”
PART 7 – Additional Worked Examples (cont)
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2010 2011E 2012E 2013E 2014E
Sales growth (%) 7% 7% 6% 6%
Sales 14,797 15,832.79 16,941.09 17,957.55 19,035.00
NOA @ ATO = 1.29107 11,461 12,263.31 13,121.74 13,909.04 14,743.59
OI @ PM = 0.12198 1,805 1,931.28 2,066.47 2,190.46 2,321.89
ReOI = OI – 0.08*NOA 1,014.40 1,085.41 1,140.72 1,209.17
11,461 + + + +
= $38,233.245
NFO = 11,461 – 5,403 = 6,058 38,233.245 – 6,058 = 32,175.245
= 32,175.245 / 656.5 = $49.01 per share
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2008: NOA = 5,806 S/E = 7,797 NFA = 7,797 – 5,806 = 1,991
given kfirm = 8.6% terminal growth rate (g) = 4%
ATO = 18,627 / 5,806 = 3.2 assume 2009 ATO = 3.3
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2010 2009E 2010E 2011E 2012E
Sales growth (%) 10% 9% 8% 7%
Sales 18,627 20,489.70 22,333,77 24,120.47 25,808.91
ATO assumed 3.3 3.4 3.5 3.6
NOA @ ATO 5,806 6,209.00 6,568.76 6,891.56 7,169.14
Core profit margin 9.0% 8.5% 8.0% 7.5%
OI @ PM 1,844.07 1,898.37 1,929.64 1,935.67
ReOI = OI – 0.086*NOA 1,344.76 1,364.40 1,364.72 1,342.99
Notes: OI consistently increasing will it continue to grow?
if trends continue into 2013 i.e., sales growth = 6% & PM = 7.0% OI = 1,915.02
ReOI initially increases and then starts to decrease (i.e., AEG < 0) why?
2011 – 2012: growth in OI = 0.31% growth in NOA = 4.0%
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5,806 + + + +
= $32,060.9514
NFA = 7,797 – 5,806 = 1,991
32,060.9514 + 1,991 = $34,051.9514
34,051.9514 / 491.1 = $65.28 per share
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Comprehensive Illustration: Nike
After reformulating Nike’s financial statements for 2004, an analyst prepares a series of forecast in order to value Nike’s shares.
With a thorough knowledge of the business, its customers and the outlook for athletic and fashion footwear, the analyst first prepares a sales forecast.
Then, understanding the production process and the components of cost of good sold, they forecast Nike’s gross profit margin
Adding forecasts of expense ratios – particularly the all-important driver, the advertising-to-sales ratio – they finalise their pro forma income statements with a forecast of operating income.
Finally, the forecasted balance sheet models accounts receivable, inventory, PPE, and other net operating assets based on their assessment of turnover ratios for these items.
From this process, the analyst arrives at the following forecasts:
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Income statement forecasts:
Sales for 2005 will be $13,500 million, followed by $14,600 for 2006. For 2007-2009, sales are expected to grow at a rate of 9 percent per year.
The gross margin of 42.9 percent in 2004 is expected to increase to 44.5% in 2005 and 2006 with the benefits of off-shore manufacturing, but then to decline to 42% in 2007 and subsequently to 41% as labor costs increase and more costly, high-end shoes are brought to market.
Advertising, standing at 11.25% of sales in 2004, will increase to 11.6% of sales to maintain the ambitious sales growth. The recruitment of visible sports stars to promote the brand will also add to advertising costs.
Other before-tax expenses are expected to be 19.6% of sales, the same level as in 2004.
The effective tax rate on operating income will be 34.6%.
No unusual items are expected or their expected value is zero.
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Balance sheet forecasts:
To maintain sales, the carrying value of inventory will be 12.38 cents per dollar of sales (an inventory turnover ratio of 8.08).
Receivables will be 16.5 cents per dollar of sales (a turnover ratio of 6.06)
PPE will fall to 12.8 cents per dollar of sales in 2005 and 2006, from the 13.1 cents in 2004, because of more sales from existing plant. However, with new production facilities coming on line, at higher construction costs, to support sales growth, PPE will increase to 13.9 cents on a dollar of sales (a turnover ratio of 7.19).
Holdings of other net operating assets, dominated by OL, will be – 6.0% of sales.
Additional Information:
2004 NFO = 743
Terminal growth rate for AE g = 5%
# Common shares outstanding = 263.1 million
Pro forma Income Statements
2004A 2005E 2006E 2007E 2008E 2009E
Sales 12,253 13,500 14,600 15,914 17,346 18,907
Cost of sales (7,001) (7,492) (8,103) (9,230) (10,234) (11,155)
Gross margin 5,252 6,008 6,497 6,684 7,112 7,752
Advertising (1,378) (1,566) (1,694) (1,846) (2,012) (2,193)
Operating expenses (2,400) (2,646) (2,862) (3,119) (3,400) (3,706)
Operating income before tax 1,474 1,796 1,941 1,719 1,700 1,853
Tax at 34.6 % (513) (621) (672) (595) (588) (641)
Operating income after tax 961 1,175 1,269 1,124 1,112 1,212
Core profit margin 7.84% 8.69% 8.69% 7.06% 6.41% 6.41%
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Pro forma Balance Sheets
2004A 2005E 2006E 2007E 2008E 2009E
Accounts receivable 2,120 2,228 2,409 2,626 2,862 3,120
Inventory 1,634 1,671 1,807 1,970 2,147 2,341
PPE 1,587 1,728 1,869 2,212 2,411 2,628
Other NOA (790) (810) (876) (955) (1,041) (1,134)
Net operating assets 4,551 4,817 5,209 5,853 6,379 6,955
Asset turnover (ATO) 2.803 2.803 2.719 2.719 2.719
54
55
2004A 2005E 2006E 2007E 2008E 2009E
Operating income after tax 961 1,175 1,269 1,124 1,112 1,212
Net operating assets 4,551 4,817 5,209 5,853 6,379 6,955
ReOI = OI – 0.086*NOA 783.614 854.738 676.026 608.642 663.406
FCF = OI – NOA 909 877 480 586 636
AE valuation model
NFO = 749
Common shares = 263.1 P = 19,461.9 / 263.1 = $73.97
aside: FCF valuation model 15,077.6 has not reached ‘steady state’
require a different ‘g’ for FCF
56
overarching objective:
to conduct fundamental value for the purpose of estimating the ‘intrinsic value’ of a firm’s common shares
requires an understanding of the firm’s ‘value drivers’
need to accumulate a ‘tool kit’ as the basis for developing the pro forma Financial Statements
STEP 1
Understanding the past
Information collection
Understanding the business
Accounting analysis
Financial ratio analysis
Cash flow analysis
STEP 2
Forecasting the future
Structured forecasting
Income Statement forecasts
Balance sheet forecasts
Cash flow forecasts
STEP 3
Valuation
Cost of capital
Valuation models – AE, FCF, D
Valuation ratios
Complications
Negative values
Value creation and destruction
PART 8 – Summary
57
external environment
economic prospects
macroeconomic factors
socio-cultural forces
political / regulatory
Industry dynamics
Porter’s five forces
(suppliers, buyers, new entrants, substitutes, rivalry)
Analysis of Financial Statements
understanding current F/S
re-formulating the F/S
accounting quality
ratio analysis
analysts’ reports
management forecasts
financial press
???
Forecasts and Valuation
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A
High P/B; High P/E
B
Normal P/B; High P/E
C
Low P/B; High P/E
Nike, Inc.
The market gave Nike a P/B of 4.1
and a P/E of 21 in 2005, both high
relative to normal ratios. Current
residual earnings were $642 million
and analysts were forecasting
earnings that indicated higher residual
earnings in the future.
Westcorp
Westcorp, a financial services holding
company, reported earnings for 1998 of
0.65 per share and an ROCE of 5.4%.
Analysts in 1999 forecasted earnings of
$1.72 for 1999 and $2.00 for 2000,
which translate into an ROCE of 13.6%
and 14.1% respectively. With a
forecasted ROCE at about the
(presumed) cost of capital but increasing
from the current level this is a cell B
firm. The market gave the firm a P/B of
1.10 and a P/E of 24.
Rocky Shoes & Boots, Inc.
Like Nike, a footwear manufacturer, Rocky
Shoes reported an ROCE of 1.8% for 1998
with earnings of 0.21 per share. Analysts
forecast an ROCE of 6.2% for 1999 and
7.8% for 2000, on earnings of 0.72 and 0.95
respectively. The market gave the firm a
P/B of 0.6 and a P/E of 33, appropriate for a
firm with forecasted ROCE less than the
(presumed) cost of capital but with
increasing ROCE.
D
High P/B; Normal P/E
E
Normal P/B, Normal P/E
F
Low P/B; Normal P/E
Whirlpool Corp.
Whirlpool, with a positive but
constant RE was a cell D firm in
1994. Whirlpool was priced at 11
times earnings (cum-dividend), as we
saw, and at 1.8 times book value.
Horizon Financial Corp.
Horizon Financial Corp., a bank holding
company, reported an ROCE of 10.3%
for fiscal 1999. Analysts forecasted that
ROCE would be 10.6% for 2000 and
after, roughly at the same level. If the
equity cost of capital is 10%, this firm
should have a normal P/B and a normal
P/E. The stock traded at 11 times
earnings and 1.0 times book value.
Rainforest Cafe Inc.
In 1999, analysts covering Rainforest Cafe,
the theme restaurant (“a wild place to eat”),
forecasted earnings of $0.62 per share for
1999 and $0.71 for 2000, or an ROCE of
6.8% and 7.2%. The stock traded at a P/B
of 0.6, reflecting the low anticipated ROCE.
The ROCE for 1998 was 6.5%. With 1998
profitability similar to forecasted
profitability, the stock should sell at a
normal P/E ratio. And indeed it did: the
P/E at the time of the forecasts was 11.
G
High P/B; Low P/E
H
Normal P/B; Low P/E
I
Low P/B; Low P/E
US Airways Group
US Airways reported an ROCE of
81% in 1998. Analysts deemed 1998
to be a particularly good year and
forecast ROCE for 1999 and 2000
down to 29% and 33%. The stock
traded at 12.6 times book value,
consistent with high ROCE in the
future, but at a P/E of only 4.
America West Holdings
America West Holdings, the holding
company for America West Airlines had
an ROCE of 15.0% in 1998. Analysts
forecasted in 1999 that the ROCE would
decline to 11.7% by 2000. Th e market
gave the stock a P/B of 1.0 in 1999, in
line with the forecasted ROCE equaling
the cost of capital. But the P/E was 7,
consistent with the expected drop in the
ROCE.
UAL Corporation
United Airlines’ holding company traded at
a P/B of 0.7 in mid-1999 and a P/E of 6. It
reported an ROCE of 29.2% for 1998, but
its ROCE was expected by analysts to drop
to 10.6% (before a special gain) in 1999 and
to 9.1% in 2000.
A
High P/B; High P/E
B
Normal P/B; High P/E
C
Low P/B; High P/E
Nike, Inc.
The market gave Nike a P/B of 4.1 and a P/E of 21 in 2005, both high relative to normal ratios. Current residual earnings were $642 million and analysts were forecasting earnings that indicated higher residual earnings in the future.
Westcorp
Westcorp, a financial services holding company, reported earnings for 1998 of 0.65 per share and an ROCE of 5.4%. Analysts in 1999 forecasted earnings of $1.72 for 1999 and $2.00 for 2000, which translate into an ROCE of 13.6% and 14.1% respectively. With a forecasted ROCE at about the (presumed) cost of capital but increasing from the current level this is a cell B firm. The market gave the firm a P/B of 1.10 and a P/E of 24.
Rocky Shoes & Boots, Inc.
Like Nike, a footwear manufacturer, Rocky Shoes reported an ROCE of 1.8% for 1998 with earnings of 0.21 per share. Analysts forecast an ROCE of 6.2% for 1999 and 7.8% for 2000, on earnings of 0.72 and 0.95 respectively. The market gave the firm a P/B of 0.6 and a P/E of 33, appropriate for a firm with forecasted ROCE less than the (presumed) cost of capital but with increasing ROCE.
D
High P/B; Normal P/E
E
Normal P/B, Normal P/E
F
Low P/B; Normal P/E
Whirlpool Corp.
Whirlpool, with a positive but constant RE was a cell D firm in 1994. Whirlpool was priced at 11 times earnings (cum-dividend), as we saw, and at 1.8 times book value.
Horizon Financial Corp.
Horizon Financial Corp., a bank holding company, reported an ROCE of 10.3% for fiscal 1999. Analysts forecasted that ROCE would be 10.6% for 2000 and after, roughly at the same level. If the equity cost of capital is 10%, this firm should have a normal P/B and a normal P/E. The stock traded at 11 times earnings and 1.0 times book value.
Rainforest Cafe Inc.
In 1999, analysts covering Rainforest Cafe, the theme restaurant (“a wild place to eat”), forecasted earnings of $0.62 per share for 1999 and $0.71 for 2000, or an ROCE of 6.8% and 7.2%. The stock traded at a P/B of 0.6, reflecting the low anticipated ROCE. The ROCE for 1998 was 6.5%. With 1998 profitability similar to forecasted profitability, the stock should sell at a normal P/E ratio. And indeed it did: the P/E at the time of the forecasts was 11.
G
High P/B; Low P/E
H
Normal P/B; Low P/E
I
Low P/B; Low P/E
US Airways Group
US Airways reported an ROCE of 81% in 1998. Analysts deemed 1998 to be a particularly good year and forecast ROCE for 1999 and 2000 down to 29% and 33%. The stock traded at 12.6 times book value, consistent with high ROCE in the future, but at a P/E of only 4.
America West Holdings
America West Holdings, the holding company for America West Airlines had an ROCE of 15.0% in 1998. Analysts forecasted in 1999 that the ROCE would decline to 11.7% by 2000. The market gave the stock a P/B of 1.0 in 1999, in line with the forecasted ROCE equaling the cost of capital. But the P/E was 7, consistent with the expected drop in the ROCE.
UAL Corporation
United Airlines’ holding company traded at a P/B of 0.7 in mid-1999 and a P/E of 6. It reported an ROCE of 29.2% for 1998, but its ROCE was expected by analysts to drop to 10.6% (before a special gain) in 1999 and to 9.1% in 2000.
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