Financial Statement Analysis • Industry Analysis and Competitive Strategy • Accounting Analysis • Financial Analysis • Prospective Analysis • Forecasting • Valuation
Forecasting: Summary • Forecasting involves all prior steps in the framework • Comprehensive, iterative approach • Start with sales, determine operating costs • Are balance sheet changes required? • How will they be financed? • Use I/S and B/S to forecast SCF • Forecast of SCF may lead to changes in asset levels (depreciation should be reexamined), and debt levels (interest expense and income should be reexamined) • Always a good idea to conduct ratio and sensitivity analyses on the forecasted numbers
Prospective Analysis - Valuation Estimate the “value” of the firm. Why? • Security analysis: buy or sell? • Merger and Acquisition: how much to pay? • Initial Public Offering (IPO) • Sale of a business • Strategic planning: how firm value will affected?
Valuation Models • Discounted models • Based on cash flows: • Dividends • Free cash flow • Based on accounting: • Abnormal earnings • Price Multiples Models • Price to earnings • Price to book • Price to sales
Cash Flow-Based or Accounting-Based Accounting-Based, criticism: • Cannot “spend” earnings • Subject to accounting assumptions and estimations • Accounting manipulation
Discounted Model • Classical “Dividend Capitalization Model” • Value of a firm’s equity equals the present value of its expected future dividends • No growth: DIV/r • Constant growth: Div/(r-g) • Value of a firm equals cash flows to the providers of capital • Shareholders • Discounted by cost of equity capital • Leads to value of equity • Shareholders and creditors • Discounted by weighted average cost of capital (WACC) • Leads to value of firm: debt plus equity
Equity Alone or Whole Firm? • Analysts are interested in equity value • Equity Alone • Assets value • Equity value = Assets value – Value of debt • Theoretically, both approached should give the same equity value • Not really…
Discounted Dividends Model • Equity Value = Present value of expected future dividends • Three factors to determine: • Expected dividends • Terminal value or liquidating dividends • Could assume equilibrium • Discount rate
Discounted Dividends Model • No growth: • Equity value = dividend/re • With growth: • Equity value = dividend/(re – g) • Note: Liquidating dividend • DIVn = DIVn-1 x (1+g)/(r-g)
Discounted Cash Flows Model: Major Steps • Forecast “free cash flows “ available to debt and equity holders for 5 to 10 years • Forecast free cash flows for the terminal year • Discount the free cash flows using the WACC
Free Cash Flows - Review • The amount of cash that the owners of a business (shareholders) can consume without reducing the value of the business • Free cash flows can be used to pay • Creditors: interest or principal (reducing debt) • Shareholders: dividends, shares buyback • The more free cash flows a company has, the higher its firm value
Free Cash Flows Whole Firm (“Unleveraged Free Cash Flows”): • If from F/S • EBIT = Sales – COGS – SG&A - Tax on EBIT (= tax as reported + tax savings on int. +/- deferred tax assets/liabilities + Depreciation +/- Investment in working capital • Capital expenditure - Required cash balance Equity Alone (“Leveraged Free Cash Flows”): • The above; - Net interest +/- Cash Flows For Changes in S-T or L-T Borrowing • Capital expenditures - Required cash balance
Free Cash Flows: Gap, 1991 EBIT = Sales $2,519 - COGS 1,499 – SG&A 576 – Depreciation 70 = $374 Tax on EBIT = Tax $140.9 + Tax savings on interest 3.5*38% + DTA 9 (Note C) = $151 EBILAT = $374 – 151 = $224 (rounding error) OCF before investment in working capital = EBILAT $224 + depreciation 70 = $294 OCF before capital expenditure = OCF b/f investment in working capital $294 + net changes in CL and non-cash CA 2 = $295 (rounding error) Free cash flow = OCF b/f capital expenditure $295 – ICF 246 = $49
Select A Forecast Horizon • Short (e.g. 3 to 5 years) • More accurate prediction on cash flows • Rely heavily on the terminal value • Not proper for fast growing companies • Long (e.g. 10 to 15 years) • Less dependent on the terminal value • Less accurate prediction on cash flows Equilibrium? No growth in future cash flows or growth at a stable rate
Terminal Value • Forecast horizon: 1992 to 2002 • Terminal year: 2003 • Terminal value = (Value at t-1 * (1+r)) (r-g) • That is, assume perpetuity • E.g. terminal value = Free cash flow for 2002 $530 x (1+3%) (14%-3%) = $4,693 • These need to be discounted back to the time of the valuation
Terminal Value: Based on Multiple • Note: could apply a multiple to the terminal year free cash flow to arrive at the remaining free cash flow • Because, multiple is the reciprocal of the discount rate • Key is to apply a multiple that makes sense in light of competitive equilibrium assumption • generally a multiple of 7 to 10 will work • higher multiples implicitly imply growth opportunities
Discounting the Expected Free Cash Flow • We’ve estimated free cash flows for the forecasted years and the present value (at the end of the terminal year) of the future free cash flows • Discount them back to today • use (1 + WACC)-n to estimate flows occurring at end of year
Estimating Costs of Capital • Debt • current market rates for company’s debt • net of tax • Equity • Capital Asset Pricing Model (CAPM) • rf: interest rate on risk-free securities • 90-day treasury bill: 5.8%; 1-year treasury bill: 6% • Market beta: the correlation between individual stock returns and market returns • rM: return on market portfolio • rM – rF is the “risk premium”, about 7.6% in the long-run; but some argue that it is dropping in recent years • Could adjust for size; the larger, the less riskier
Cost of Capital - Gap • From the bottom of page 12-24 • Beta is 1.3; risk-free rate is 6.3% • Long-term risk premium is 7.6% • “current” market value is $55 per share x 142,139,577,000 shares = $7,817,676 • Largest firm size decile (Table 12-10 on page 12-15) • Deserve a size adjustment, e.g. 0.9% • Cost of capital = 6.3% + 1.3x7.6% - 0.9% = 15.28%
Determining WACC • Cost of capital is cost of equity and cost of debt, weighted by the relative market value • Market value of debt: • from notes; if not, book value • Market value of equity: • price per share x outstanding shares • Question: How could we know the market value of equity??? We are trying to find it!! • Solution: use target or the ideal debt-to-equity combination
Gap’s WACC • Debt • Interest rate 8.9% • Net of tax = 8.9% x (1-38% tax rate) = 5.5% • Equity • rE = 15% • Assume 19% debt and 81% equity • WACC = 0.19 x 5.5% + .81 x 15% = 13%
GAP: Market Value • 1/31/92: $53.25 • During 1992: high $59; low $20 • Our estimate: • About $17 based on DCF • Why the big difference? • positive news since year end? • higher growth rates • longer time until competitive equilibrium and growth slow down • overvalued?
Sensitivity Analysis • Try • Higher growth rate • Lower cost of capital • Longer forecast horizon • To figure out what does the market have in mind • 20% constant growth rate?
Subsequent Development • Earnings growth at The Gap cooled down during 1992 • New entrants mimicking The Gap look • Some products of Gap did not work • Price of Gap fell throughout the first half of 1992, dropping to around $30 • Let us try the accounting-based valuation model
Why Accounting-Based Valuation? • In the long run, net income equals leveraged cash flows • Accounting accruals do not matter • Research show that accrual-based earnings reflect changes in economic values more accurately than do cash flows
Accounting-Based Valuation Model • “Clean Surplus”: All transactions affecting SE except capital transactions flow through income statement • BV1 = BV0 + NI – DIV • Or, DIV = NI + BV0 – BV1 • Dividend Discount Model: • No growth, Constant cost of equity, 2-period model
DAE Model If t , then equity value is “Normal Earnings” = re x BVt-1 “Abnormal Earnings” = NIt - re x BVt-1 Note: Think about ROE and ROE decomposition Therefore, equity value is:
DAE Model • Equity value is current book value plus sum of discounted future abnormal earnings • If a firm can earn only a “normal” return on book value, then equity value is its current book value • The firm is worth more/less if its NI or return on BV is above/below “normal”
Estimating Terminal Value • The terminal value problem we encountered with DCF is here, too! • Procedure • determine abnormal earnings in post terminal year • discount them in perpetuity: AET (r-g) • r is cost of equity capital • g is expected growth rate • Or,
Estimating Terminal Value • At the terminal year, the terminal value represents an estimate of the difference between the market value and the book value of equity in that year • We could use the projected market-to-book multiple and the forecasted BV instead • Need a “normal” multiple • Average market-to-book ratios in U.S.: 1.6
Terminal Value and DAE • In DCF we noted that a large part of equity value lies in the terminal value • If we forecast AE to where only normal returns are earned, terminal value will be zero • All future AE will be zero • The PV of the normal earnings is embedded in current book value and growth in BV over the forecast horizon
Role of Accounting Method Choice • The DAE valuation is based on accounting numbers, not cash flows • Does accounting method affect valuation? • Note that accounting choices affect both earnings and book value • Consider two examples: • Conservative accounting • Aggressive accounting
Conservative Accounting • Assume all R&D is written off (recorded as an expense) as incurred (the alternative is to capitalize and amortize, e.g. next year) • Assume $1,000 is written off in year 1, ROE is 10% • What happens to future “abnormal earnings”?
Year 1: earnings and thus abnormal earnings are $1,000 lower Ending BV is $1,000 lower Year 2: abnormal earnings is $100 higher due to lower opening BV Abnormal earnings is $1,000 higher due to lower expense Present Value -$909 (Year 1) +$909 (Year 2) Net Impact: $0 Conservative Accounting
Aggressive Accounting • Assume firm capitalizes all R&D as incurred (the alternative is to write it off as incurred) • Assume $1,000 is capitalized in year 1 and expensed in year 2 • What happens to future “abnormal earnings”?
Year 1: earnings and thus abnormal earnings are $1,000 higher Ending BV is $1,000 higher Year 2: abnormal earnings is $100 lower due to higher opening BV Abnormal earnings is $1,000 lower due to lower expense Present Value +$909 (Year 1) -$909 (Year 2) Net Impact: $0 Aggressive Accounting
So, Is Accounting Irrelevant? • Accounting choices may influence the analyst’s perception of the firm and thus the forecasts of abnormal earnings • “Functional Fixation” phenomenon • Management may be revealing new information about the results of past actions or expected results of future actions • write-offs and capitalization • Accounting choice affects the fraction of value reflected over short horizons versus terminal value
PHB, page 11-8 The abnormal earnings approach, then, recognizes that current book value and earnings over the forecast horizon already reflect many of the cash flows expected to arrive after the forecast horizon. … The DCF approach … “unravels” all of the accruals, spreads the resulting cash flows over longer horizons, and then reconstructs its own “accruals” in the form of discounted expectations of future cash flows. The essential difference between the two approaches is that abnormal earnings valuation recognizes that the accrual process may already have performed a portion of the valuation task, whereas the DCF approach ultimately moves back to the primitive cash flows underlying the accruals.
DCF vs. DAE • Note that they are actually based on the same underlying discounted dividend model • In principle the two methods should arrive at the same value, but • They focus on different issues • E.g. using DAE will force analysts to focus on I/S, B/S, ROE; this may cause the analyst to arrive at different forecasts • Amount of analysis structure is much more for DAE • Importance of terminal value analysis is more for DCF • relation to price multiples
Why bother? easy and quick reality check private companies with no market values Examples Price to earnings Price to Sales Price to Book Price to Cash Flow Valuation Based on Multiples
Price to Book Ratio • If we divide the DAE formula by BV0: • Vt is estimated value of equity at time t • bVt is book value at time t • re is cost of equity capital • gt+n is growth in BV in year t+n, e.g., (BV2-BV1)/BV1
Price-to-Book Ratio: Interpretation • We can interpret price-to-book value ratio as a function of • Future abnormal earnings • how much greater or smaller than normal will ROE be? • note that we can decompose the ROE as in Financial Analysis • Growth in BV • how fast will the investment base (BV) grow? • will ROE continue to be other than normal as BV grows? • Cost of equity capital
Price-to-Earnings Ratio Therefore; P/E is affected by the factors that affect P/G: abnormal earnings; risk; growth But, P/E is also affected by the current ROE P/E is more volatile than P/B If ROE is zero or negative, P/E is not defined
Price-to-Earnings Ratio • If Price = Book Value • P/E is the reciprocal of cost of equity capital • 6 to 10 is normal range—current market is way above • Technology sector: negative earnings
Combining PE and PB P/E Recovering but not going to be a star Rising Stars P/B Dogs Falling Stars
Selecting Comparable Firms • Who are the competitors • Dow Jones Interactive • J.C. Penny, Lands’ End, Nordstrom, The Limited • Selection criteria • Similar operating and financial characteristics • Same industry • Question: multi-business companies?
Business Analysis and Valuation- Applications • Equity Securities Analysis • Credit Analysis and Distress Prediction • Mergers and Acquisitions
Equity Securities Analysis • Evaluate a firm and its prospects to makes a risk-justified return • Who engage in securities analysis? • Security analysts • buy-side • sell-side • Investment bankers • Individual investors
Security Analysis and Market Efficiency • Efficient Markets Hypothesis • Security prices reflect all publicly available information fully and immediately upon its release • All securities are priced “right” • Return are associated with risk that cannot be diversified away • If market is efficient, who then will engage in equity security analysis?