CHAPTER 6

1. FINANCIAL REPORTING & ANALYSIS BY REVSINE – COLLINS – JOHNSON 2nd Edition CHAPTER 6 THE ROLE OF FINANCIAL INFORMATION IN VALUATION,CASH FLOW ANALYSIS, AND CREDIT RISK ASSESSMENT Slides Authored by Brian Leventhal University of Illinois at Chicago

2. I. Corporate Valuation A. Corporate valuation involves estimating the worth or the intrinsic value of a - company, - one of its operating units ownership shares.

3. I. Corporate Valuation • B. Equityinvestors, lenders, and analysts often use fundamental analysis to estimate the value of a company. • This valuation approach uses basic accounting measures or fundamentals to assess the amount, timing, and uncertainty of a firm’s future operating cash flows or earnings.

4. 1.Fundamental analysis is the focus of this chapter. I. Corporate Valuation

5. 2. Valuation involves three basic steps: a. Forecastingfuture values of some financial attributes : -distributable or free cash flows, -accounting earnings, -balance sheet book values I. Corporate Valuation

6. 2. Valuation involves three basic steps: b. Determining the risk or uncertaintyassociated with the attribute’sforecasted future value. I. Corporate Valuation

7. c. Determining the discounted present value of the expected future values of the value-relevant attribute, where the discount rate reflects the risk or uncertainty inherent in the value attribute of interest. I. Corporate Valuation 2. Valuation involves three basic steps:

8. 3. Cash flow assessment is critical to credit risk analysis since estimates of future cashflows can be compared to debt-service requirements. I. Corporate Valuation

9. C. Technical analysis, on the other hand, focuses on business cycles and the past price record of a firm. I. Corporate Valuation

10. II. The Discounted Free Cash Flow Approach • A. The distributable—or free—cash flow valuation modelcombines the elements in the three steps listed above to express current stock price as the: • Discounted present valueofexpected future distributable cash flows.

11. II. The Discounted Free Cash Flow Approach B. Free cash flow: Operating Cash Flows (before interest) - Cash outlays for replacement of Operating Capacity (PPE) FREE CASH FLOW

12. 1. It is the amount available to finance planned expansion of operating capacity, to reduce debt, to pay dividends, or to repurchase stock. II. The Discounted Free Cash Flow Approach B. Free cash flow: Operating Cash Flows (before interest) - Cash outlays for replacement of Operating Capacity (PPE) FREE CASH FLOW

13. 2. This is an appropriate measure for valuing the company as a whole and without regard to its capital structure. II. The Discounted Free Cash Flow Approach B. Free cash flow: Operating Cash Flows (before interest) - Cash outlays for replacement of Operating Capacity (PPE) FREE CASH FLOW

14. C. Free cash flowavailable to common shareholders is an appropriate measure for valuingjust the company’s common stock. II. The Discounted Free Cash Flow Approach

15. C. Free cash flowavailable to common shareholders: II. The Discounted Free Cash Flow Approach • Operating Cash Flows (before interest) • - Cash outlays for replacement of Operating Capacity (PPE) • FREE CASH FLOW • - Cash Interest Payments • - Debt Repayments • - Preferred Dividends • Free cash flow available tocommon shareholders

16. P0 = E0(CF1) + E0(CF2) + E0(CF3) + Continuing to Infinity (1+r)t (1+r)t (1+r)t II. The Discounted Free Cash Flow Approach C. Free cash flowavailable to common shareholders: Price of Stock Expected free cash flow Each period Discount factor each period

17. P0 = (CF0) + (CF0) + (CF0) + Continuing to Infinity (1+r)t (1+r)t (1+r)t II. The Discounted Free Cash Flow Approach C. Free cash flowavailable to common shareholders: Expected free cash flow In each year set equal to the free cash flow realized in year 0 Eq. 6.2 Discount factor each period Simplifying assumptions may include: Zero Growth perpetuities(for mature firms)

18. P0 = E0(CF1) + E0(CF2) + E0(CF3) + Continuing to Infinity (1+r)t (1+r)t (1+r)t II. The Discounted Free Cash Flow Approach C. Free cash flowavailable to common shareholders: Expected free cash flow Each period Discount factor each period The discount rate is adjusted to reflect the uncertainty or riskiness of the cash flow stream.

19. P0 = E0(CF1) + E0(CF2) + E0(CF3) + Continuing to Infinity (1+r)t (1+r)t (1+r)t II. The Discounted Free Cash Flow Approach C. Free cash flowavailable to common shareholders: Equation says that today’s market value of each common sharedepends on investors’ current expectations about thefuture economic prospects of the firm as measured be free cash flows.

20. II. The Discounted Free Cash Flow Approach D. The role of earnings in valuation: 1. If investors are interested in a company’s future cash flows, what role does earnings have in valuation? • The role of accounting earningsinformation is indirect— • Accounting Earnings are only useful because they help generateimproved forecast of future cash flows!

21. II. The Discounted Free Cash Flow Approach D. The role of earnings in valuation: 1. If investors are interested in a company’s future cash flows, what role does earnings have in valuation? • The FASB asserts the current accounting earnings provide a bettermeasure of long-run expected operating performance than do current cash flows.

22. II. The Discounted Free Cash Flow Approach D. The role of earnings in valuation: 1. If investors are interested in a company’s future cash flows, what role does earnings have in valuation? • Recall the Canterbury Publishing Ex. • Cash Flows are “Lumpy”, but accrual accounting earningsmeasurement takes a long-horizon perspective that smoothes out the “lumpiness” in year-to-year cash flows.

23. II. The Discounted Free Cash Flow Approach D. The role of earnings in valuation: 1. If investors are interested in a company’s future cash flows, what role does earnings have in valuation? • Research finds that current accounting earnings are a better predictor of future cash flows than are current cash flows! • Stock returnscorrelatebetter with accrual accounting earnings than with realized operating cash flows.

24. 2. Through the use of accruals and deferrals, accrual accounting produces an earnings number that smoothes out the unevenness or “lumpiness” in year-to-year cash flows, and it provides an estimate of sustainable “annualized” long-run future free cash flows. II. The Discounted Free Cash Flow Approach

25. P0 = (CF0) + (CF0) + (CF0) + Continuing to Infinity (1+r)t (1+r)t (1+r)t II. The Discounted Free Cash Flow Approach 3. Valuation model where current observed earningsreplacecurrent cash flows : X 0 X 0 X 0 Eq. 6.4

26. II. The Discounted Free Cash Flow Approach 4. So we can now express the Current Stock Price as: P0 = 1 X0 r Equation 6.6 • The left-hand side of equation (6.6) is the price-earnings (P/E) ratio, also called the earnings multiple, • which is a measure of the relation between a firm’s current earnings and its share price.

27. II. The Discounted Free Cash Flow Approach So we can now express the Current Stock Price as: P0 = 1 X0 r Equation 6.6 b. The price-earnings ratio in equation (6.6), under the assumption of zero growth, is the reciprocal of the risk-adjusted interest rate used to discount future earnings.

28. P0 = 1 (X0) = X0 r r II. The Discounted Free Cash Flow Approach E. Research on earnings and equity valuation: 1. Equation (6.5) suggests that current earnings can “explain” current value.

29. 2. It immediately follows that earnings differences across firms should help explain differences in these firm’s stock prices (i.e., earnings are value-relevant). P0 = 1 (X0) = X0 r r II. The Discounted Free Cash Flow Approach E. Research on earnings and equity valuation:

30. 3. Cross-sectional tests (i.e., test that examine the association between stock prices and earnings across many firms at a given point in time) show that earnings explain only 34.2% of the proportion of variation in stock prices of grocery companies.WHY?? P0 = 1 (X0) = X0 r r II. The Discounted Free Cash Flow Approach E. Research on earnings and equity valuation:

31. III. Sources of Variation in P/E Multiples A. Risk Differences: • 1. Firms with the same level of current and futureearnings can sell for different prices because of differences in risk or uncertainty associated with those earnings.

32. 2. Riskier firms have higherdiscount rates that lead to lower prices. III. Sources of Variation in P/E Multiples A. Risk Differences:

33. B. Growth opportunities: III. Sources of Variation in P/E Multiples • 1. The market values of a firm’s growth opportunities— • is the possibility of earnings from reinvesting current earnings in projects that will earn a rate of return in excess of the cost of equity capital (i.e., the discount rate).

34. 2. The net present value of growth opportunities (NPVGO) from the reinvestment of current earningsadds a positive increment to a firm’s average P/E multiples. P0 = X0 + NPVGO r III. Sources of Variation in P/E Multiples B. Growth opportunities: Present value of earnings from assets in place NPV of future growth opportunities

35. 4. The growth rate in earnings depends on: a. The portion of earnings reinvested each period, called the retention ratio. b. The rate of return on new investment. III. Sources of Variation in P/E Multiples B. Growth opportunities:

36. C. Permanent, transitory, and valuation-irrelevant components of earnings III. Sources of Variation in P/E Multiples Equation 6.7 Pi = a +  (Xi) + ei End of Period Stock Price 1. If investors view firms’ current earnings levels to persist in perpetuity, then the slope coefficient () in equation (6.7) should equal the average earnings multiple . (P0/X0)

37. 2. For many firms, the earnings multiplefallswell below this theoretical value, In part, because of distinctlydifferent earnings components, each subject to differentearnings capitalization rates. III. Sources of Variation in P/E Multiples C. Permanent, transitory, and valuation-irrelevant components of earnings Equation 6.7 Pi = a +  (Xi) + ei End of Period Stock Price

38. 2. For many firms, the earnings multiplefallswell below this theoretical value. III. Sources of Variation in P/E Multiples Equation 6.7 Pi = a +  (Xi) + ei End of Period Stock Price a. A permanent earnings component is value relevant and expected to persist into the future. i. In theory, the multiple for permanent earnings component should approach 1/r. ii. Income from continuing operations (exclusive of special or nonrecurring items) is a recurring, sustainable component of a company’s profit performance.

39. III. Sources of Variation in P/E Multiples Restructuring charges are generally considered nonrecurring items, once a firm has recorded them it is likely that they will recordadditional restructuring charges within the next three years.

40. III. Sources of Variation in P/E Multiples Equation 6.7 Pi = a +  (Xi) + ei End of Period Stock Price 2. For many firms, the earnings multiplefallswell below this theoretical value. b. A transitory earningscomponent is value-relevant, but is not expected to persist into the future. i. The multiple for transitory earningscomponentshould approach 1.0. ii. Income (loss) from discontinued operations and extraordinary gains and losses are nonrecurring items that are viewed as transitory components of earnings.

41. III. Sources of Variation in P/E Multiples Equation 6.7 Pi = a +  (Xi) + ei End of Period Stock Price 2. For many firms, the earnings multiplefallswell below this theoretical value. c. A value-irrelevant is unrelated to future free cash flows and is not relevant to assessing current share price. i. Such value-irrelevantearnings components should carry a multiple of zero. ii. A change in accounting principles, which gives rise to a cumulative effect adjustment to income has no future cash flow consequences and is viewed as value-irrelevant.

42. III. Sources of Variation in P/E Multiples Equation 6.7 Pi = a +  (Xi) + ei End of Period Stock Price C. Permanent, transitory, and valuation-irrelevant components of earnings 3. The capital marketdoes not react naively to earnings, but instead, it appears to distinguish among permanent, transitory, and value-irrelevant earningscomponents.

43. D. The concept of earnings quality: III. Sources of Variation in P/E Multiples 1. Quality of earningsmeasureshow much the profits companies publicly report diverge from their true operating earnings. a. Low quality means the bottom line is padded with paper gains. b. A decline in quality means companies’ reported earnings are less sustainable than they appear.

44. 2. Earnings quality is multifaceted and there is no consensus on how to measure it. III. Sources of Variation in P/E Multiples D. The concept of earnings quality:

45. 3. Earnings are considered to be high quality when they are sustainable. III. Sources of Variation in P/E Multiples D. The concept of earnings quality:

46. 3. Earnings are considered to be high quality when they are sustainable. III. Sources of Variation in P/E Multiples D. The concept of earnings quality: • Sustainable earnings are generated from • repeat customers, • high quality product that enjoys steady customer demand based on brand name identity, etc.

47. 3. Earnings are considered to be high quality when they are sustainable. III. Sources of Variation in P/E Multiples D. The concept of earnings quality: • Unsustainable earnings derive from • gains and losses from debt retirement, • write-offs of assets from corporate restructuring and plant closings, • reduction in discretionary expenditures for advertising and research and development, etc.

48. 4. Earnings quality is also affected by the accounting methods chosen by management to describe routine, ongoing activities of a company and by the subjectivity of accounting estimates. III. Sources of Variation in P/E Multiples D. The concept of earnings quality:

49. IV. The Abnormal Earnings Approach A. Earnings and equity book value numbers are directinputs into the valuation process. This new approach is based the value of a company and its share price is drivennot by the level of earnings themselves ….. but by the level of earningsrelative to a fundamental economic benchmark —the cost of capital,expressed in dollars.

50. IV. The Abnormal Earnings Approach A. Earnings and equity book value numbers are directinputs into the valuation process. 2. This benchmarkreflects the level of earnings that investors demand from a company as compensation for the risks of the investment.