ACCT6101 – Session #1: Introduction to Valuation
PART 1 – Background
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ACCT7106 – Session #10: Ratio Analysis; Forecasting
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
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projected over the forecast horizon
core inputs into the valuation model x g
Balance Sheet (B/S)
Income Statement (I/S)
Statement of Cash Flows (SCF)
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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 – #13
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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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What the reformulation process is NOT
it does not involve adjusting or altering the reported numbers
it does not involve creating new numbers or erasing numbers
clearly, material errors (whether unintentional or intentional = EM) need to be corrected e.g., restatement of F/S required by the relevant regulatory authority (ASIC, SEC, …) – but this is not a part of the actual reformulation process
What the reformulation process IS
it takes the reported accounting numbers as given (subject to adjustment for errors)
it then reclassifies or reorders the various reported accounts to put them into a structure that (hopefully) makes them more informative, and thereby facilitates better forecasts
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Key Step separate operating items/activities from financing items/activities
Why? companies generate value from their operations, not their financial activities
Summary – ‘new’ (reformulated) accounting relations:
Balance Sheet: NOA = NFO + S/E
Income Statement: CI = OI + NFE (recall: NFE are negative)
Cash Flow Statement: FCF = C + I = F + E
Equity Statement: Change in S/E = CI + E
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Balance Sheet
operating assets (OA) – financial assets (FA)
– operating liabilities (OL) financial obligations (FO)
Net Operating Assets (NOA) Net Financial Obligations (NFO)
S/E = NOA – NFO
Income Statement
Comprehensive Income (CI) = Operating Income (OI) – Net Financial Expenses (NFE)
core operating income from sales
core other operating income
unusual operating income
operating OCI
core NFE
financial OCI
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Core Operating Income from Sales (before tax)
Core Other Operating Income (before tax)
Unusual Operating Income (before tax)
Core Net Financial Expenses (before tax)
Profit Before Tax (PBT)
Tax Expense
Net Profit After Tax (NPAT)
Other Comprehensive Income
operating OCI (after tax)
financing OCI (after tax)
Comprehensive Income
Tax Allocation:
1st tax shield from Net Financial Expenses
2nd tax on Unusual Operating Income
3rd tax on Core Other Operating Income
4th tax on Core Operating Income from Sales
Operating Income (OI)
Core Operating Income from Sales (after tax)
Core Other Operating Income (after tax)
Unusual Operating Income (after tax)
Operating OCI (after tax)
Total Operating Income
Net Financial Expenses (NFE)
Core net financing expense (after tax)
Financing OCI (after tax)
Total Net Financial Expense
Comprehensive Income
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Reformulated Statement of Cash Flows
Adjusted Cash flow from operations C
Adjusted Cash investment in operating assets I
Free Cash Flow (FCF) C + I
Equity financing flows
dividends & share repurchases XX
share issuances (XX) E
Debt financing flows
net purchase of financial assets (XX)
interest on financial assets (after tax) XX
net issue of debt XX
interest on debt (after tax) (XX) F
Total Financing cash flows E + F
‘Uses’ of FCF in financing activities
Generation of FCF from operating activities
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Reformulated Statement of Changes in Shareholders’ Equity
Beginning Book Value of Common Equity BVt-1
+ Net effect of Transactions with Common Shareholders
+ capital contributions (share issues)
– share repurchases
– cash dividends to common shareholders
= Net cash contributions
+ Effect of operations and non-equity financing
+ Net Income (from the I/S)
+ Other Comprehensive Income (OCI)
– preferred share dividends
= Comprehensive income available to common shareholders
Ending Book Value of Common Equity BVt
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PART 2 – Profitability and Leverage (using the Reformulated F/S)
levered view from the perspective of the common shareholder ROCE
ROCE (return on common equity) = =
return to common shareholder (i.e., return after satisfying debt)
unlevered view from the perspective of the firm RNOA
RNOA (return on net operating assets) =
return to the firm (i.e., return on the net assets provided by both debt and equity)
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Notes:
while calculations are frequently based on average figures, the ratios can also be based on year-end or beginning-of-year figures depending upon circumstance
e.g., Coles was owned by Wesfarmers up until 2019 – there are no F/S prior to 2019 and hence 2019 ratios could only be based on year-end figures
with the adoption of AASB16 (leases) in 2020, many of the figures in Coles F/S are non-comparable between 2019 and 2020
since ROCE captures the ‘levered view’ whereas RNOA presents the ‘unlevered view’, ‘loosely’ the distinction between ROCE and RNOA is the treatment of financing
the link between ROCE and RNOA relates to how the firm is financed
(equally, the link between ROOA and RNOA relates to operating leverage)
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from Session #2, slides 39 – 42
business risk “The equity risk that comes from the nature of the firm’s operating activities”
in essence, the volatility or variability of the firm’s operating income
further, leverage (both operating and financial) magnify business risk
why? leverage serves to magnify profits in ‘good’ times and
leverage serves to magnify losses in ‘bad’ times
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financial leverage use of debt financing with fixed ‘interest’ payments
ROCE = RNOA + FLEV x ( RNOA – NBC)
operating liability leverage use of operating liabilities (OL) to finance OA
RNOA = ROOA + OLLEV x (ROOA – STBC)
operating spread
financial leverage
operating liability leverage
OL spread
leverage, both financial (FLEV) and operating liability (OLLEV), magnifies profit (& loss) available to the common shareholder
ROOA RNOA ROCE
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Example #9-1 profitable firm
Net operating assets (NOA) 28,000
Net financial obligations (NFO) 15,000
Shareholders’ Equity (S/E) 13,000
Operating income (OI) 2,000
Net Financial Expense (NFE) (500)
Comprehensive Income (CI) 1,500
RNOA = 0.0714
FLEV = 1.1538
NBC = 0.0333
ROCE = RNOA + FLEV x ( RNOA – NBC)
= 0.0714 + 1.1538(0.0714 – 0.0333) = 0.1154
ROCE = = = 0.1154 Example #9-2 loss firm
Net operating assets (NOA) 28,000
Net financial obligations (NFO) 15,000
Shareholders’ Equity (S/E) 13,000
Operating income (OI) (1,000)
Net Financial Expense (NFE) (500)
Comprehensive Income (CI) (1,500)
RNOA = 0.0357
FLEV = 1.1538
NBC = 0.0333
ROCE = RNOA + FLEV x ( RNOA – NBC)
= 0.0357 + 1.1538(0.0357 – 0.0333) = 0.1153
ROCE = = = 0.1154
financial leverage (FLEV)
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Example #9-6 profitable firm
OA = 40,000 OL = 12,000 NOA = 28,000
FA = 2,000 FO = 17,000 NFO = 15,000
Shareholders’ Equity (S/E) 13,000
Operating income (OI) 2,000
Net Financial Expense (NFE) (500)
Comprehensive Income (CI) 1,500
OLLEV =
assume STBC = 0.07(1 – 0.3) = 0.049
implicit interest on OL = 12,000 * 0.049 = 588
ROOA = 0.0647
RNOA = ROOA + OOLEV(ROOA – STBC)
= 0.0647 + 0.4286(0.0647 – 0.049) = 0.0714
RNOA = 0.0714 Example #9-7 loss firm
OA = 40,000 OL = 12,000 NOA = 28,000
FA = 2,000 FO = 17,000 NFO = 15,000
Shareholders’ Equity (S/E) 13,000
Operating income (OI) (1,000)
Net Financial Expense (NFE) (500)
Comprehensive Income (CI) (1,500)
OLLEV =
assume STBC = 0.07(1 – 0.3) = 0.049
implicit interest on OL = 12,000 * 0.049 = 588
ROOA =
RNOA = ROOA + OOLEV(ROOA – STBC)
= + 0.4286( – 0.049) =
RNOA = 0.0357
operating liability leverage (OLLEV)
Summing Financial Leverage and Operating Liability Leverage Effects on ROCE
ROCE = ROOA + (RNOA – ROOA) + (ROCE – RNOA)
Return
With no leverage
Effect of
Operating Liabilities
Effect of
Financing Liabilities
profitable firm (examples #9-1 & #9-6)
0.1154 = 0.0647 + (0.0714 – 0.0647) + (0.1154 – 0.0714)
loss firm (examples #9-2 & #9-7)
-0.1154 = -0.0103 + (-0.0357 – 0.0103) + (-0.1154 – 0.0357)
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clear benefits to the use of leverage for a profitable firm
Why then don’t firms use more leverage, both operating and financial?
by definition, leverage increases business risk by introducing fixed costs that must be satisfied irrespective of the firm’s circumstances (profit or loss)
with more debt, the cost of debt and the cost of equity both increase (NFE )
???
in reality, it is highly unlikely that one element can be changed without affecting other elements within the system
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ROCE = RNOA + FLEV {RNOA NBC} ‘first-level’ break down of ROCE
given RNOA = = profit margin asset turnover
ROCE = {profit margin asset turnover} + {FLEV spread} ‘second-level’ break down of ROCE
notion of ‘DuPont’ analysis decomposition of operating profitability
operations
financing
PART 3 – ‘DuPont System’ & Reported vs Reformulated
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The standard presentation of the ‘DuPont System’ based on reported accounting numbers is:
ROE = ROA leverage where ROA = profit margin asset turnover
** when employed ‘outside’ the DuPont system, ROA is more typically measured as:
based on the firm’s profit after tax (available to all forms of resource providers i.e., debt and equity)
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Notes for the ‘DuPont System’ based on AASB / IFRS financial statements:
the system is based on NPAT as opposed to Comprehensive Income (CI)
both operating and financial income are included in income figure (NPAT)
total assets includes both operating and financial assets
but … for example, we ‘know’ that returns on operating assets are quite different from those on financial assets
In contrast, the ‘DuPont System’ based on the reformulated statements is as follows:
ROCE = RNOA + leverage {RNOA – NBC}
leverage {RNOA – NBC}
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under both sets of presentations (reported F/S & reformulated F/S)
return to the common shareholder return to the firm, adjusted for leverage
return to the firm: RNOA versus ROA
expect ROA to be lower than RNOA (1963 – 2010: median RNOA = 10.5%, median ROA = 7.1%)
ROA includes financial assets (FA) which earn a lower rate of return
operating liability leverage (OLLEV) is reflected in RNOA but not in ROA
leverage: versus
expect D/E to be higher than FLEV (1963 – 2010: median D/E = 1.22, median FLEV = 0.43)
D/E includes operating liabilities which create operating liability leverage (OLLEV) and financial liabilities which create financial leverage (FLEV)
D/E excludes/ignores financial assets as an offset to financial liabilities
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return to the firm: RNOA versus ROA
Penman Table 12.1
the biggest differences between RNOA and ROA are for firms with the biggest investment in FA and the highest OLLEV
e.g., Microsoft
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DuPont System
‘second level’
Penman Figure 12.3 Profit Margin and Asset Turnover Combinations by Industry, 1963-2000
Note – a given RNOA (e.g., 14%) can be achieved from various combinations of PM and ATO
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Penman Table 12.2
median values for ratios underlying profitability by Industry, 1963-2000
median ROCE = 12.2%
median RNOA = 10.3%
‘pipelines’ vs ‘food stores’
both have RNOA = 12%
Pipelines low ATO, high PM
Food stores high ATO, low PM
pipelines have higher FLEV
higher ROCE
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Penman E12.7
Using average B/S amounts, calculate
RNOA and NBC
FLEV
Show that the financing leverage equation explaining ROCE holds
Calculate profit margin and asset turnover (ATO) for 2007
Show RNOA = PM ATO
Calculate the gross margin ratio, the operating profit margin ratio, and the operating profit margin from sales ratio
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RNOA = 0.2672
NBC = 0.0392
FLEV = 0.1848
ROCE = RNOA + FLEV x ( RNOA – NBC) = 0.2672 + 0.1848(0.2672 – 0.0392) = 0.3093
ROCE = = = 0.3094
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RNOA = 0.2672
ATO =
operating profit margin = = 0.2121
RNOA = PM x ATO = 0.2121 x 1.2599 = 0.2672
gross profit margin = = 0.6394
operating profit margin from sales = = 0.1890
operating profit margin = = 0.2121
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ROCE = RNOA + FLEV {RNOA NBC}
where
RNOA = profit margin asset turnover
both profit margin and asset turnover can be broken down further into their underlying components to gain deeper insights into the ‘drivers’ of profitability
PART 4 – Deeper Insights into Profitability
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disaggregation of ‘profit margin’
OI = {sales – COGS}
– [administrative expenses + other operating expenses + depreciation expense]
+ other operating income + unusual operating income
– tax expense
profit margin
– – – + + –
Note – there is no ‘right’ or ‘wrong’ level of disaggregation – it could, for example, also be done by ‘product’ and/or ‘line of business’ and/or further disaggregation of Other and Unusual OI …… whatever provides the greatest insights into the drivers of profitability
gross margin
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disaggregation of ‘total asset turnover’
NOA = {operating cash + receivables + inventory + property & plant}
– [accounts payable + accrued liabilities]
asset turnover =
+ + + – –
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DuPont System ‘second level’
third level’
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Penman Table 12.3
Second and third level breakdown
Nike & General Mills, 2009 – 2010
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second level RNOA = profit margin asset turnover
profit margin ATO 30.623 28.408 10.096 4.058
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third level profit margin
Actual net (rounding!) 9.6 9 7.9 3.3
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third level
asset turnover
Actual net (rounding!) 0.313 0.317 0.785 0.841
Inverse = ATO 3.195 3.155 1.274 1.189
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Summary:
Nike
General Mills
for both firms, increase in RNOA largely through an increased profit margin
RNOA Profit Margin Asset Turnover
2010 30.6% 9.54% 3.21
2009 28.4% 8.99% 3.16
2.2% 0.55% 0.05
RNOA Profit Margin Asset Turnover
2010 10.1% 7.95% 1.27
2009 4.1% 3.41% 1.19
6.0% 4.54% 0.08
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Further applications / insights illustrated
If Nike could increase it Accounts Receivable turnover from 6.85 to General Mill’s level of 15.15 while maintaining the current level of sales and all else remaining unchanged, how would its RNOA change?
2010: = 0.146 A/R turnover = 6.85 =
new: A/R turnover = 15.15 = 0.066
based on figures provided = 0.311 ATO = 3.21
revised 0.311 – (0.146 – 0.066) = 0.231 ATO = 4.33
RNOA = 0.954 41.3% (up from 30.6%)
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If Nike could increase it Accounts Receivable turnover form 6.85 to General Mill’s level of 15.15 while maintaining the current level of sales and all else remaining unchanged, how would its RNOA change?
RNOA = 0.954 41.3% (up from 30.6%)
feasible / realistic ?
current collection period = 365/6.85 = 53.3 days revised = 365 / 15.15 = 24.1 days
more stringent credit terms
would expect sales or sales discounts (& gross margin )
bad debt expense A/R A/R turnover
unlikely that A/R turnover can be changed in isolation
(and if feasible, why hasn’t the change already been made?)
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2. If Nike’s gross margin ratio dropped from 46.3% to 44.9% because of increased production costs, what would happen to its RNOA given a tax rate of 36.3%?
Gross Margin 1.4% pre-tax (1 – 0.363) = 0.89% post tax
Profit Margin 0.89%
RNOA = –0.89 3.16 = –2.8 RNOA 2.8%
again, is it likely that only one account is affected in isolation?
Increased production costs accounts payable ??
inventory ??
ultimately sales price and sales ??
???
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PART 5 – Coles
2020 ratios based on reformulated F/S and year-end B/S figures (given AASB 16)
1st step (slides #45 – #47)
financial leverage equation ROCE = RNOA + FLEV x ( RNOA – NBC)
DuPont System RNOA = PM ATO
operating liability leverage equation RNOA = ROOA + OLLEV x ( ROOA STBC)
2nd step – profit margin drivers (slide #48)
3rd step – asset turnover drivers (slide #49)
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Coles Reformulated Income Statement 2020
Sales Revenue 37,408
Cost of sales (28,043)
Gross Margin 9,365
Administrative expenses (8,122)
Core Income from Sales (before tax) 1,243
Tax expense (318.2)
Core Income from Sales (after tax) 924.8
Core Other Operating Income (after tax) (376 + 108 – 6 – 143.4) 334.6
Core Unusual Operating Income (after tax) (41 – 12.3) 28.7
Operating Income after Tax 1,288.1
Financing costs
Core NFE (after tax) 310.1
Financing OCI (after tax) 12 (322.1)
Total Comprehensive Income 966
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Coles Reformulated B/S 2020
Operating Assets
cash & cash equivalents 187
receivables 434
inventories 2,166
assets held for resale 75
other assets 190
property, plant & equipment 4,127
right-of-use assets 7,660
intangible assets 1,597
deferred tax assets 849
equity accounted investments 217
Total Operating Assets (OA) 17,502
Operating Liabilities
trade payables 3,737
provisions 1,333
other 227
Total Operating Liabilities (OL) 5,297
Net Operating Assets (NOA) 12,205
2020
Financial Assets
financial cash 805
income tax receivable 42
Total Financial Assets (FA) 847
Financial Obligations
interest-bearing liabilities 1,354
provisions —
lease liabilities 9,083
Total Financial Obligations (FO) 10,437
Net Financial Obligations (NFO) 9,590
Shareholders’ Equity
contributed equity 1,611
reserves 43
retained earnings 961
Total Equity 2,615
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RNOA = 0.1055
NBC = 0.0336
FLEV = 3.6673
ROCE = RNOA + FLEV x ( RNOA – NBC) = 0.1055 + 3.6673(0.1055 – 0.0336) = 0.3694
ROCE = = = 0.3694
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RNOA = 0.1055
ATO = 0650
operating profit margin = = 0.0344
RNOA = PM x ATO = 0.0344 x 3.0650 = 0.1054
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OLLEV = 0.4340
assume after-tax STBC = 0.025
Implicit interest on OL = 5,297 @ 0.025 = 132.425
ROOA = 0.0812
RNOA = ROOA + OLLEV x ( ROOA STBC) = 0.0812 + 0.4340 (0.0812 – 0.025) = 0.1056
RNOA = 0.1055
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Profit Margin Drivers % of sales
Sales Revenue 37,408 1.0000
Cost of sales (28,043) (0.7497)
Gross Margin 9,365 0.2503
Administrative expenses (8,122) (0.2171)
Core Income from Sales (before tax) 1,243 0.0332
Tax expense (318.2) (0.0085)
Core Income from Sales (after tax) 924.8 0.0247
Core Other Operating Income (after tax) 334.6 0.0089
Core Unusual Operating Income (after tax) 28.7 0.0008
Operating Income after Tax 1,288.1 0.0344
Financing costs
Core NFE (after tax) 310.1 (0.0083)
Financing OCI (after tax) 12 (322.1) (0.0003)
Total Comprehensive Income 966 0.0258
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Asset Turnover Drivers turnover = sales / item inverse = item / sales
Operating Assets
cash & cash equivalents 187 200.043 0.0050
receivables 434 86.194 0.0116
inventories 2,166 17.271 0.0579
assets held for resale 75 498.773 0.0020
other assets 190 196.884 0.0051
property, plant & equipment 4,127 9.064 0.1103
right-of-use assets 7,660 4.884 0.2048
intangible assets 1,597 23.424 0.0427
deferred tax assets 849 44.061 0.0227
equity accounted investments 217 172.387 0.0058
Total Operating Assets (OA) 17,502 2.137 0.4679
Operating Liabilities
trade payables 3,737 10.010 0.0999
provisions 1,333 28.063 0.0356
other 227 164.793 0.0061
Total Operating Liabilities (OL) 5,297 7.062 0.1416
Net Operating Assets (NOA) 12,205 3.065 0.3263
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Aside: Microsoft Corporation, 2003
NOA 12,829 OI 6,277
NFA 36,906 NFI 1,548
S/E 49,735 CI 7,825
RNOA = 0.4893
FLEV = –0.7421 RNFA = 0.0419
ROCE = = = 0.1573
ROCE = RNOA + FLEV x ( RNOA – NBC) = 0.4893 – 0.7421(0.4893 – 0.0419) = 0.1573
Why is ROCE < RNOA
NOA earn 48.93%
NFA earn 4.19%
investments in NFA reduces the shareholders’ rate of return
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What if Microsoft paid a special dividend of $33 billion (as it did in 2004) by selling financial assets?
NOA 12,829
NFA 3,906
S/E 16,735
new FLEV = –0.233
ROCE = 0.4893% – 0.233(0.4893 – 0.0419) = 0.3849
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PART 6 – Forecasting & Valuation
Objective of the forecasting exercise
to develop objective and realistic expectations of future value-relevant payoffs
How to achieve this?
develop pro forma F/S containing unbiased predictions of the firm’s future operating, investing, and financing activities should be neither conservative nor optimistic
pro forma F/S should be comprehensive need to consider the growth rate for 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, both reported and pro forma)
use external information to ensure that assumptions are realistic
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Steps comprising the Forecasting Exercise
Income Statement:
Step 1: Forecast Sales
Step 2: Forecast Core OI from Sales (before tax)
Step 3: Forecast Core Other OI (before tax)
Step 4: Calculate OI (before tax)
Step 5: Forecast Income Tax Expense attributable to OI
Step 6: Calculate OI (after tax)
Balance Sheet:
Step 7: Forecast OA and OL to obtain a forecast of NOA
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Unlevered Valuation valuing the firm
Step 8: Calculate RNOA, FCF and residual operating income (ReOI)
Step 9: Estimate the DCF and ReOI models with assumed terminal growth rate and firm’s weighted average cost of capital (WACC ) overall value of the firm
Step 10: Forecast Leverage and NFE (after tax)
Step 11: Calculate CI = OI (after tax) – NFE (after tax) & CSE = NOA – NFO
Step 12: Forecast Dividends (div = CI – S/E NCC)
Levered Valuation valuing common equity (value of common shares)
Step 13: Calculate RI (residual income or abnormal earnings)
Step 14: Estimate the DDM and RI models with assumed terminal growth rate (g) and cost of equity capital (k) value of the firm to the common shareholder
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Implementing the forecasting steps
be aware that the steps are integrated and interdependent
the amounts in each of the pro forma F/S need to agree with each other – be aware of the interrelations between the financial statements
need some flexible accounts that expand or decrease in response to changes in activities; working through the pro forma F/S results in a circularity which in turn may result in the need for more than one iteration of the accounts
quality of forecast financial information is a direct function of the quality of forecast assumptions
sensitivity analysis should be conducted on the pro forma statements
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Step 1: Forecast Sales
sales ‘drive’ the system !!
the sales forecast is the starting point and typically requires the greatest attention during the forecasting process
a consideration of historical sales growth rates can be a starting point BUT …. need to develop a thorough understanding of the business and its environment to make meaningful sales forecasts
the firm’s business strategy
the market for the firm’s products
the firm’s marketing plan
how the broader economic factors and the industry dynamics affect the business
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1. the firm’s business strategy e.g.,
what lines of business is the firm likely to be in?
is the firm likely to develop new products?
what stage in their ‘lifecycle’ are the firm’s products at?
what is the firm’s acquisition and takeover strategy?
2. the market for the firm’s products e.g.,
is consumer behaviour likely to change, and if so how?
what is the ‘elasticity of demand’ for the firm’s products?
are new products likely to emerge that could displace the firm’s current product line?
are substitute products a material threat?
3. The firm’s marketing plan e.g.,
is the market for the firm’s products expanding, or are new markets opening up?
what is the firm’s pricing strategy (cost leadership; differentiation; focus)?
what is the firm’s advertising strategy?
does the firm have, or can it develop and maintain brand names (or other intangibles)?
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macroeconomic factors
historical values & patterns
future values
industry dynamics
understand the relations
forecast industry sales
Firm Sales
forecast firm sales
understand the relations & the competitive environment
(unpredictable series based on past data)
Business strategy
** forecasted sales **
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‘end product’ forecast of future sales
considerations / constraints include –
‘regression to mean’ phenomenon
appropriate forecast horizon
appropriate ‘terminal growth rate’
sustainable growth rate
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‘regression to mean’ phenomenon
company performance tends to be ‘mean-reverting’
companies with above average performance tend to experience a decline in profitability/growth
companies with below average performance tend to experience an improvement
mean-reversion suggests that most companies eventually reach a steady state where their sales growth, RNOA, and other performance measures ‘flatten out’
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why does mean reversion happen?
The answer can see seen through the lens of ‘Porter’s five forces’ coupled with opportunity
threat of new entrants: competitors enter markets that are profitable and exit markets that are unprofitable
power of suppliers: suppliers might consolidate or find new markets for their products, and so become more powerful
threat of substitutes: high profits encourage the invention of substitute products (e.g., Skype versus long-distance telephone calls)
companies tend to run out of growth opportunities as they mature e.g., Walmart
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2) appropriate forecast horizon
usual approach - sales are forecasted for a finite period at which point a ‘steady state growth rate’ is established
the question that arises is around how long the forecast horizon be
usually forecast out as many years as the estimates are reliable – stop once the point where can’t estimate better than assuming stable growth is reached
the forecast horizon is also the period during which the firm has a competitive advantage i.e., the period over which the abnormal returns are positive.
stable growth achieved when:
constant sales growth rate
margins constant – this means that expenses grow at the same constant rate as sales
turnover ratios constant
financial leverage ratios constant
PART 7 – Forecasting (cont)
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business/industry life cycle will likely impact on forecast horizon.
mature industry – shorter forecast horizon since growth more likely to be stable
high growth firms – forecast horizon likely to be longer as less likely that the above factors will be constant
sales growth – affected by industry wide growth as well as firm’s growth in market share; also affected by macroeconomic factors
profit margin – results from the firm’s competitive advantage
turnover – tend to be fairly stable over time; rapidly growing firms may have increasing turnover ratios due to economies of scale.
leverage – unlikely to influence forecast horizon
ideally, would like to make year-by-year forecasts until the company reaches a steady state, at which point the company’s sales growth rate should approximate the ‘terminal growth rate’ (g) – however, there is also the question of ‘practicality’
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To illustrate the importance of forecasting to the point of ‘steady state’, consider the following forecasted data for a ‘hypothetical’ company
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Sales 1,000 1,300 1,625 2,035.5 2,420.3 2,774.4
% Sales 30.00% 27.08% 23.21% 18.91% 14.63%
OI 600.0 764.4 951.9 1,149.5 1,339.4 1,504.7
margin 60.00% 58.80% 57.62% 56.47% 55.34% 54.24%
NOA 400.0 520.0 660.8 814.2 968.1 1,109.8
% NOA 30.00% 27.08% 23.21% 18.91% 14.63%
ReOI 724.4 899.9 1,083.4 1,258.0 1,407.9
% ReOI 24.23% 20.38% 16.12% 11.91%
FCF 644.4 811.1 996.1 1,185.5 1,363.1
% FCF 25.88% 22.80% 19.02% 14.98%
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Assume that a “sensible” terminal growth rate for both ReOI and FCF is 3%, and the company’s WACC is 10%
Implications of using a 5-year forecast horizon
growth in ReOI drops abruptly from 11.91% in year 5 to 3% in year 6
growth in FCF drops abruptly from 14.98% in year 5 to 3% in year 6
using the FCF valuation model, V = $16,114.2
using the ReOI valuation model, V = $17,212.8
the undesirable outcome of different valuation estimates
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Alternatively, if the forecast horizon is extended to the point where sales, OI, and NOA are growing at (approximately) the terminal growth rate – here for illustrative purposes, 10 years
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10
Sales 1,000 1,300 1,625 2,035.5 2,420.3 2,774.4 3,072.8 3,303.6 3,468.2 3,577.1 3,684.4
% Sales 30.00% 27.08% 23.21% 18.91% 14.63% 10.75% 7.51% 4.98% 3.14% 3.00%
OI 600.0 764.4 951.9 1,149.5 1,339.4 1,504.7 1,633.2 1,720.7 1,770.3 1,789.4 1,842.2
margin 60.00% 58.80% 57.62% 56.47% 55.34% 54.24% 53.15% 52.09% 51.05% 50.02% 50.00%
NOA 400.0 520.0 660.8 814.2 968.1 1,109.8 1,229.1 1,321.4 1,387.3 1,430.8 1,473.8
% NOA 30.00% 27.08% 23.21% 18.91% 14.63% 10.75% 7.51% 4.98% 3.14% 3.00%
ReOI 724.4 899.9 1,083.4 1,258.0 1,407.9 1,522.2 1,597.8 1,638.2 1,650.7 1,699.1
% ReOI 24.23% 20.38% 16.12% 11.91% 8.12% 4.97% 2.53% 0.76% 2.93%
FCF 644.4 811.1 996.1 1,185.5 1,363.1 1,513.8 1,628.4 1,704.5 1,745.9 1,799.3
% FCF 25.88% 22.80% 19.02% 14.98% 11.06% 7.57% 4.67% 2.43% 3.06%
by year 10, growth rates in sales, OI, and NOA (and thereby ReOI and FCF) have systematically converged to the ‘terminal growth’ rate
the valuation estimate is the same based on both models ($17,787.3)
the valuation estimate is higher than based on only 5 years of forecasts missed value by not forecasting long enough
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In the ideal, it is desirable to forecast on a year-by-year basis until the steady state growth rate has been reached ... BUT ... again there is the mitigating factor of ‘practicality’
finally and to re-iterate, both macroeconomic factors and industry dynamics have an important role in the process of forecasting sales
Industry growth
key determinant in forecast horizon
attempt to identify variables that predict industry sales
industry data needs to be predictable
need strong links to the firm’s sales
factors include demographic trends, nominal GDP growth, competition, market share
Competitive advantage
often a factor that is over-estimated
rare to have indefinitely sustainable competitive advantage (monopoly)
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3) appropriate ‘terminal growth rate’
sales growth – terminal growth rate cannot exceed long-run expected economy-wide growth rate (e.g., nominal GDP growth)
if terminal growth rate > economy-wide growth rate, company will outgrow economy
if the terminal growth rate < economy-wide growth rate, company will shrink
often safe to assume that the company will continue to grow at the long-term economy-wide growth rate (but not always) need to justify assumed g
guidelines for margins, turnover, and leverage are not as obvious – however, their relations with ROCE provides a useful basis for assumptions
remember, ROCE is mean reverting (as is RNOA); thus, it is reasonable to assume that ROCE will move towards the cost of equity capital over time
if a firm is operating in a long-run competitive equilibrium and there is a relatively close link between ROCE and economic rate of return, the terminal ROCE growth rate should equal the cost of equity capital
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4) sustainable growth rate, g*
the sustainable growth rate indicates the maximum rate at which a firm can grow without additional external financing, given its current level of profitability and dividend policy
g* = ROCE x earnings retention rate
= {(profit margin x asset turnover) + FLEV (RNOA – NBC)} x earnings retention rate
the rate at which the firm can “safely” grow without changing any of these factors
i.e., if the firm wishes to grow at a rate exceeding g* then it must either turn to external financial markets for additional support, or generate/retain more internally (improved profit margin, improved asset turnover, and/or reduce payout ratio)
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HOWEVER - the profit margin may be relatively inflexible
- dividend policy is typically viewed as “sticky”
may only have asset turnover and leverage (use of additional debt or equity financing) as the available ways in which to support growth in excess of g*
Thus, if a firm’s forecasted sales growth rate exceeds its sustainable growth rate (g*), it is useful to try and understand how the additional growth will be financed
one possibility is through increased future profitability; however, if the increased profitability is not achieved, the growth plans may be curtailed
alternatively, the additional growth may be financed externally through new debt and/or equity; this also introduces uncertainty because advance planning is required and capital markets must be receptive to the firm’s growth plans
a final option is for the firm to cut is dividend payout ratio; however, given that average dividend payout ratios are close to zero for growth firms, this final option is often not available
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g* = {(profit margin x asset turnover) + FLEV (RNOA – NBC)} x earnings retention rate
Note, the sustainable growth rate also provides a crude starting point for a growth estimate i.e., assuming the firm pays out the same proportion of profits each year, dividends and earnings will both grow by the following rate (all else held equal including feasibility):
g = RR x ROCE where RR = retention rate and ROE = return on equity
Based on the reformulated F/S, the most common measure for the payout ratio is:
comprehensive dividend payout ratio =
E = net transactions with shareholders (see reformulated Statement of Cash Flows or Statement of Changes in Shareholders’ Equity
CI = comprehensive income
note – requires CI > 0 (a profitable firm)
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Coles 2020 sales 37,408 dividends 873
OI 1,288.1 repurchases 17
CI 966 share-based exp (13)
NOA 12,205 E 877
RNOA = 0.1055 ROCE = = = 0.3694
ATO = 0650 operating PM = = 0.0344
payout ratio = 0.9079 retention rate = (1 – 0.9079) = 0.0921
sustainable growth rate g* = 0.3694 x 0.0921 = 0.0340
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Coles 2020
sustainable growth rate g* = 0.3694 x 0.0921 = 0.0340
sales 2019 38,176
2020 37,408 sales growth = 0.0201
actual sales growth < g* generation of surplus cash during period (from reformulated SCF, FCF = 2,185) can retain ‘surplus cash’ for future investment, or return to resource providers (debt and equity) from the reformulated Statement of Cash Flows F = (1,308) including net repayment of borrowings = 106 million E = (877) including repurchase of shares = 17 million from the reformulated Balance Sheet, ‘financing cash’ increased by $56 million 78 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 79 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 ??? 0V = tx ( 1+ tk t)t =1 ∞ ∑ = E( tx ) t (1+k)t=1 n ∑ + E( nx ) (1+ g) k − g 1 n (1+k) 0 V = t x ( 1+ t k t ) t=1 ¥ å = E( t x ) t (1+k) t=1 n å + E( n x ) (1+g) k-g 1 n (1+k) ROCE(%) FLEV OLLEV RNOA(%) PM(%) ATO Pipelines 17.1 1.093 0.154 12.0 27.8 0.40 Tobacco 15.8 0.307 0.272 14.0 9.3 1.70 Restaurants 15.6 0.313 0.306 14.2 5.0 2.83 Printing and publishing 14.6 0.154 0.374 13.6 6.5 2.20 Business services 14.6 0.056 0.488 13.5 5.2 2.95 Chemicals 14.3 0.198 0.352 13.4 7.1 1.91 Food stores 13.8 0.364 0.559 12.0 1.7 7.39 Trucking 13.8 0.641 0.419 10.1 3.8 2.88 Food products 13.7 0.414 0.350 12.1 4.4 2.74 Communications 13.4 0.743 0.284 9.1 12.5 0.76 General stores 13.2 0.389 0.457 11.3 3.5 3.55 Petroleum refining 12.6 0.359 0.487 11.2 6.0 1.96 Transportation equipment 12.5 0.369 0.422 11.2 4.5 2.47 Airlines 12.4 0.841 0.516 9.0 4.3 1.99 Utilities 12.4 1.434 0.272 8.2 14.5 0.59 Wholesalers, non-durable goods 12.2 0.584 0.461 10.2 2.3 3.72 Paper products 11.8 0.436 0.296 10.2 5.9 1.74 Lumber 11.7 0.312 0.384 10.4 4.0 2.60 Apparel 11.6 0.408 0.317 10.1 4.0 2.55 Hotels 11.5 1.054 0.201 8.5 8.2 1.04 Shipping 11.4 0.793 0.205 9.1 12.6 0.61 Amusements and recreation 11.4 0.598 0.203 10.1 9.5 1.10 Building and construction 11.4 0.439 0.409 10.6 4.5 2.06 Wholesalers, durable goods 11.2 0.448 0.354 9.9 3.4 2.84 Textiles 10.4 0.423 0.266 9.3 4.3 2.09 Primary metals 9.9 0.424 0.338 9.4 5.0 1.80 Oil and gas extraction 9.1 0.395 0.263 8.3 13.0 0.57 Railroads 7.3 0.556 0.362 7.1 9.7 0.78 ROCE(%) ROCE(%) FLEV OLLEV RNOA(%) PM(%) ATO Pipelines 17.1 1.093 0.154 12.0 27.8 0.40 Tobacco 15.8 0.307 0.272 14.0 9.3 1.70 Restaurants 15.6 0.313 0.306 14.2 5.0 2.83 Printing and publishing 14.6 0.154 0.374 13.6 6.5 2.20 Business services 14.6 0.056 0.488 13.5 5.2 2.95 Chemicals 14.3 0.198 0.352 13.4 7.1 1.91 Food stores 13.8 0.364 0.559 12.0 1.7 7.39 Trucking 13.8 0.641 0.419 10.1 3.8 2.88 Food products 13.7 0.414 0.350 12.1 4.4 2.74 Communications 13.4 0.743 0.284 9.1 12.5 0.76 General stores 13.2 0.389 0.457 11.3 3.5 3.55 Petroleum refining 12.6 0.359 0.487 11.2 6.0 1.96 Transportation equipment 12.5 0.369 0.422 11.2 4.5 2.47 Airlines 12.4 0.841 0.516 9.0 4.3 1.99 Utilities 12.4 1.434 0.272 8.2 14.5 0.59 Wholesalers, non-durable goods 12.2 0.584 0.461 10.2 2.3 3.72 Paper products 11.8 0.436 0.296 10.2 5.9 1.74 Lumber 11.7 0.312 0.384 10.4 4.0 2.60 Apparel 11.6 0.408 0.317 10.1 4.0 2.55 Hotels 11.5 1.054 0.201 8.5 8.2 1.04 Shipping 11.4 0.793 0.205 9.1 12.6 0.61 Amusements and recreation 11.4 0.598 0.203 10.1 9.5 1.10 Building and construction 11.4 0.439 0.409 10.6 4.5 2.06 Wholesalers, durable goods 11.2 0.448 0.354 9.9 3.4 2.84 Textiles 10.4 0.423 0.266 9.3 4.3 2.09 Primary metals 9.9 0.424 0.338 9.4 5.0 1.80 Oil and gas extraction 9.1 0.395 0.263 8.3 13.0 0.57 Railroads 7.3 0.556 0.362 7.1 9.7 0.78 /docProps/thumbnail.jpeg