Financial Statement Analysis and Security Valuation Stephen H. Penman

1. Financial Statement Analysisand Security ValuationStephen H. Penman Prepared by Peter D. Easton and Gregory A. Sommers Fisher College of Business The Ohio State University With contributions by Stephen H. Penman – Columbia University Luis Palencia – University of Navarra, IESE Business School

2. Simple Forecasting and Simple Valuation Chapter 14

3. Chapter 14 Page 455 What you will learn in this chapter • How simple forecasts can be made from financial statements • How simple forecasts give simple valuations • When simple forecasts and simple valuations work as reasonable approximations • How simple forecasting works as a tool in sensitivity analysis • How simple valuation models work in reverse engineering • How sensitivity analysis is done

4. Chapter 14 Page 456 Review: The Perfect Balance Sheet With a perfect balance sheet, expected residual earnings are zero MS, Inc. Balance Sheet, December 31, Year 0 AssetsEquities Prior Prior Year 0YearYear 0Year Marketable equity securities (at market) 23.4 20.3 Long-term debt (NFO) 7.7 7.0 Common shareholders’ equity (CSE) 15.7 13.3 NOA 23.4 20.3 23.4 20.3

5. Chapter 13 Page 424 Table 13.1 Residual Earnings Components

6. Chapter 14 Pages 456-457 Table 14.1 Simple Forecasts: Forecasting from Book Values (SF1) Earnings Component Forecasts of Earnings Components Forecasts of Residual Earnings Components Operating Financing Comprehensive MS, Inc. Pro Forma Income Statement, Year 1 Operating income: .1134 x 23.4 2.654 Interest expense: .10 x 7.7 (.770) Net income: .12 x 15.7 1.884

7. Chapter 14 Page 457 SF1 Valuation

8. Chapter 1 Page 459 Exhibit 14.1 Review: The Imperfect Balance Sheet

9. Chapter 14 Page 458 Table 14.2 Simple Forecasts: Forecasting from Earnings and Book Values (SF2) Earnings Component Forecasts of Earnings Components Forecasts of Residual Earnings Components Operating Financing Net PPE, Inc. Pro Forma Income Statement, Year 1 Operating income: 9.8 + (.1134 x 4.5) 10.310 Interest expense: 0.7 + (.10 x 0.7) (.770) Net income: 9.1 + (? x 3.8) 9.540

10. Chapter 14 Pages 459-460 SF2 Valuation

11. Chapter 14 Page 461 Box 14.1 SF2 Valuation: Nike Nike, Inc. Required return for operations 11.0% Core operating income, – 1996 $567 million Net operating assets  1995 $2,208 million  1996 $2,659 million Core residual operating income – 1996: 567  (0.110 x 2,208) $324.1 million SF2 forecast of operating income – 1997: 567 + (0.110 x 451) $616.6 million SF2 forecast of ReOI – 1997 $324.1 million Value of common equity $5,377 million Value per share on 143.629 million shares $37.44 Value of operations $5,605 million $5,605 million $5,605 million Nike traded at $104 per share at the end of fiscal year, 1996.

12. Chapter 14 Page 461 Box 14.1 SF2 Valuation: Reebok Reebok International Ltd. Required return for operations 10.1% Core operating income, – 1996 $174 million Net operating assets  1995 $1,220 million  1996 $1,135 million Core residual operating income – 1996: 174  (0.101 x 1220) $50.8 million SF2 forecast of operating income – 1997: 174 + (0.101 x[- 85]) $165.4 million SF2 forecast of ReOI – 1997 $50.8 million Value of common equity $918 million   Value of minority interest (at 14 times 1996 MI earnings) $210 million   Value of common equity $708 million   Value per share on 55.840 million shares $12.68 Value of operations   $1,638 million $1,638 million $1,638 million Reebok traded at $43 per share at the end of fiscal year, 1996.

13. Chapter 14 Pages 462-463 Table 14.3 Simple Forecasts: Forecasting from Current Accounting rates of Return (SF3) Earnings Component Forecasts of Earnings Components Forecasts of Residual Earnings Components Operating Financing Net For PPE, Inc. the current RNOA, NBC and ROCE (with beginning of year amounts in the denominator) are 14.02%, 10.00% and 14.47% respectively PPE, Inc. Pro Forma Income Statement, Year 1 Operating income: .1402 x 74.4 10.431 Interest expense: .10 x 7.7 .770 Earnings: ? x 66.7 9.661

14. Chapter 14 Page 463 SF3 Forecasting:An Adjustment for Leverage For PPE, Inc.,

15. Chapter 14 Pages 463-464 Valuation with Constant RNOA If RNOA1 = RNOA0 If RNOA is constant for all periods,

16. Chapter 14 Page 466 Box 14.2 SF3 Valuation: Nike Nike, Inc. Cost of capital for operations 11% Core RNOA, 1996 (on average NOA) 23.3% Forecasted growth rate for net operating assets 7% Net operating assets 1996 $2,659 million   SF3 forecast of operating income 1997: 2,659 x 23.3% $619.5 million SF3 forecast of ReOI 1997 $327.1 million Value of common equity $10,607 million Value per share on 143.629 million shares $73.85 Value of operations $10,835 million $10,835 million $10,835 million

17. Chapter 14 Page 466 Box 14.2 SF3 Valuation: Reebok Reebok International Ltd. Required return for operations 10.1% Core RNOA, 1996 (on average NOA) 14.8% Forecasted growth rate for net operating assets 7.0% Net operating assets 1996 $1,135 million SF3 forecast of operating income 1997: 1,135 x 14.8% $168.0 million SF3 forecast of ReOI 1997 $53.4 million Value of common equity $2,136 million Value of minority interest (at 14 times 1996 MI earnings) 210 million $1,926 million Value per share on 55.840 million shares $34.49 Value of operations $2,856 million $2,856 million $2,856 million

18. Chapter 14 Page 465 Table 14.4 Simple Forecasts and Simple Valuations

19. SF2: Simple Valuation: PPE, Inc. SF1: SF3:

20. Chapter 14 Page 467 Simple Forecasts ofGrowth in NOA If ATO is constant, Forecast growth in NOA with forecasted sales growth rate

21. Price-to-Book Ratios & ROCE 1968-85 ROCE ROCE P/B Group (%) 1 43.3 3.43 2 28.7 2.57 3 23.8 2.20 4 21.0 1.89 5 19.1 1.65 6 17.7 1.45 7 16.5 1.36 8 15.4 1.25 9 14.4 1.16 10 13.5 1.10 11 12.6 1.06 12 11.7 1.00 13 10.6 .97 14 9.5 .91 15 8.3 .84 16 6.8 .80 17 4.9 .78 18 2.2 .75 19 -3.2 .74 20 -22.5 1.01 Based on all NYSE, AMEX and NASDAQ firms. The grouping is done each year; the numbers reported are averages from the analysis for all years. Chapter 14 Page 469 Table 14.5

22. Chapter 14 Page 470 Figure 14.1 Unlevered P/B on RNOA

23. Chapter 14 Page 471 Figure 14.2(a) Residual Operating Income Patterns: 1965-96

24. Chapter 14 Page 471 Figure 14.2(b) Return on Net Operating Assets Patterns: 1965-96

25. Chapter 14 Page 471 Figure 14.2(c) Growth in Net Operating Assets Patterns: 1965-96

26. Chapter 14 Page 473 Simple Forecasting as an Analytical Device: Sensitivity Analysis “As If” Questions • Effect of changes in RNOA on forecasts and values • Effect of changes in PM and ATO • Effect of changes in investment (growth in NOA) • Effect of leverage on forecasts of net income

27. Chapter 14 Page 474 The Valuation Grid: Nike What values are implied by different combinations of RNOA and growth in NOA?

28. Chapter 14 Page 474 Market Forecast Pairs: Nike What combination of RNOA and growth in NOA justify the market price? Market Forecast Pairs Nike, Inc., 1996 Price = $104 __________________________________ RNOA Growth in NOA __________________________________ 15% 10.15% 16 9.94 17 9.72 18 9.51 19 9.30 20 9.09 21 8.87 22 8.66 23 8.45 24 8.24 25 8.02 26 7.81 27 7.60 28 7.39 29 7.17 30 6.96