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1、Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 1Financial Valuation and Financial Valuation and StrategyStrategyEquity Analysis and ValuationLecture 11Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 2Topics for Lecture 11Topics for Lecture 11uUnderstand earnings pers

2、istence and earnings poweruDetermine company values using earnings forecastinguUnderstand how to adjust financial statementsuDistinguish between different earnings componentsDiscipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 3Earnings PersistenceEarnings PersistenceRecasting and Adjusti

3、ng Earnings persistence is a key to effective equity analysis and valuation Analyzing earnings persistence is a main analysis objective Attributes of earnings persistence include:StabilityPredictabilityVariabilityTrendEarnings managementAccounting methodsAnalyzeDiscipline of Finance SILC ProgramSubj

4、ect 25050 Lecture 11Slide 4Earnings PersistenceEarnings PersistenceRecasting and AdjustingTwo common methods to help assess earnings persistence: Recasting of income statement Adjusting of income statementDiscipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 5Earnings PersistenceEarnings P

5、ersistenceRecasting and AdjustingInformation for Recasting and Adjusting Income statement, including its subdivisions:Income from continuing operationsIncome from discontinued operationsExtraordinary gains and lossesCumulative effect of changes in accounting principles Other financial statements and

6、 notes Management commentary in financial statements Managements Discussion and Analysis Other: product mix changes, technological innovations, work stoppages, and raw material constraintsDiscipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 6Earnings PersistenceEarnings PersistenceRecasti

7、ng and AdjustingObjectives of Recasting1. Recast earnings and earnings components so that stable, normal and continuing elements comprising earnings are distinguished and separately analyzed from random, erratic, unusual and nonrecurring elements2. Recast elements included in current earnings that s

8、hould more properly be included in the operating results of one or more prior periodsRecasting and adjusting earnings also aids in determining earning powerA fun potential final exam questionA fun potential final exam questionuIn analyzing a retail company in Shanghai, you are asked to determine the

9、 normal earnings to use in a valuation. You discover that the retail company had its main store near the Expo site. The earnings were: 2009 25M 2010 65M 2011 35M 2012 40MuWhat is your estimate for normal earnings in 2013?School of Finance and Economics SILC ProgramSubject 25050 Lecture 11Slide 7Disc

10、ipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 7Change earnings trend identificationChange earnings trend identificationuWhat if the earnings were: 2009 25M 2010 65M 2011 35M 2012 25MuWhat is your estimate for normal earnings in 2013?Discipline of Finance SILC ProgramSubject 25050 Lectu

11、re 11Slide 8Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 9General Recasting Procedures Income statements of several years (typically at least five) are recast Recast earnings components to yield meaningful classifications and a relevant format for analysis Components can be rearra

12、nged, subdivided, and tax effected Total recasted components must reconcile to reported net incomeEarnings PersistenceEarnings PersistenceRecasting and AdjustingDiscipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 10Specific Recasting Procedures Discretionary expenses are segregated Disti

13、nct components are segregated (such as equity in income of unconsolidated subsidiaries) and often reported net of tax When components of continuing income are separately reclassified, their pre-tax amounts along with their tax effectsmust be removed Income tax disclosures enable one to separate fact

14、ors that either reduce or increase taxes such as: Deductionstax credits, capital gains rates, tax-free income, lower foreign tax rates Additionsadditional foreign taxes, non-tax-deductible expenses, and state and local taxes (net of federal tax benefit)Earnings PersistenceEarnings PersistenceRecasti

15、ng and AdjustingAnother FUN final exam questionAnother FUN final exam questionuIs aircraft maintenance a discretionary expense when you are analyzing an airline such as Qantas airlines?uYES and NOuYes sometimes airlines treat it as discretionary when they are having financial difficultyuNo it should

16、 be done all the timeuCONCLUSION it SHOULD be non-discretionary!School of Finance and Economics SILC ProgramSubject 25050 Lecture 11Slide 11Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 11What to look for in recast statementsWhat to look for in recast statementsuYou need to find IN

17、COME FROM CONTINUING OPERATIONSAnd then reconcile to the net income as reporteduIn the following example, examine the advertising amount per year and identify any important issues that you can seeDiscipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 12Discipline of Finance SILC ProgramSubj

18、ect 25050 Lecture 11Slide 13Recasting and Adjusting - IllustrationEarning PersistenceEarning PersistenceCampbell Soup CompanyRecast Income Statements ($ mil.) ItemYear 11Year 10Year 9Year 8Year 7Year 613Net sales$ 6,204.1$ 6,205.8$ 5,672.1$ 4,868.9$ 4,490.4$ 4,286.819Interest income 26.0 17.6 38.3 3

19、3.2 29.5 27.4Total revenue$ 6,230.1$ 6,223.4$ 5,710.4$ 4,902.1$ 4,519.9$ 4,314.2Costs and expenses:Cost of products sold (see Note 1 below)$ 3,727.1$ 3,893.5$ 3,651.8$ 3,077.8$ 2,897.8$ 2,820.5 Marketing and selling expenses (see Note 2 below)760.8760.1605.9514.2422.7363.0145 Advertising (see Note 2

20、 below)195.4220.4212.9219.1203.5181.4144 Repairs and maintenance (see Note 1 below)173.9180.6173.9155.6148.8144.016 Administrative expenses306.7290.7252.1232.6213.9195.917 Research and development expenses56.353.747.746.944.842.2102 Stock price-related incentive programs (see Note 3 below)15.4(0.1)1

21、7.4(2.7)8.520 Foreign exchange adjustment0.83.319.316.64.80.7104 Other, net (see Note 3 below)(3.3)(2.0)(1.4)(4.7)(0.4)(9.0)162A Depreciation (see Note 1 below)194.5184.1175.9162.0139.0120.8103 Amortization of intangible and other assets (see Note 3 below)14.116.816.48.95.66.018 Interest expense116.

22、2111.694.153.951.756.0 Total costs and expenses$ 5,557.9$ 5,712.7$ 5,266.0$ 4,480.2$ 4,132.2$ 3,930.023Earnings before equity in earnings of affiliates & min. interests$672.2$510.7$444.4$421.9$387.7$384.224Equity in earnings of affiliates2.413.510.46.315.14.325Minority interests(7.2)(5.7)(5.3)(6

23、.3)(4.7)(3.9)26Income before taxes$667.4$518.5$449.5$421.9$398.1$384.6Income taxes at statutory rate*(226.9) (176.3) (152.8) (143.5) (179.1) (176.9)Income from continuing operations$440.5$342.2$296.7$278.4$219.0$207.7135State taxes (net of federal tax benefit)(20.0)(6.6)(3.8)(11.8)(8.6)(8.0)Investme

24、nt tax credit4.411.6137Nondeductible amortization of intangibles(4.0)(1.6)(1.2)(2.6)(1.4)138Foreign earnings not taxed or taxed at other than statutory rate2.0(2.2)(0.2)3.211.115.2139Other: Tax effects(17.0)(2.2)(0.1)(3.7)7.5(4.7)Alaska Native Corporation transaction4.522Divestitures, restructuring

25、and unusual charges(339.1)(343.0)(40.6)Tax effect of divest., restructuring & unusual charges (Note 4)13.964.713.9(Continued on next page)Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 14Recasting and Adjusting - IllustrationEarning PersistenceEarning PersistenceCampbell Soup Co

26、mpanyRecast Income Statements ($ mil.) ItemYear 11Year 10Year 9Year 8Year 7Year 6Gain on sale of businesses in (Yr 8) and sub. in Yr 73.19.7Loss on sale of exercise equipment subsidiary, net of tax (1.7)LIFO liquidation gain (see Note 1 below)1.72.81.4Income before cumulative effect of accounting ch

27、ange$ 401.5$4.4$13.1$241.6$247.3$223.2153ACumulative effect of accounting change for income taxes 32.528Net income as reported$ 401.5$ 4.4$ 13.1$ 274.1$ 247.3$223.214(Note 1) Cost of products sold$ 4,095.5$ 4,258.2$ 4,001.6$ 3,392.8$ 3,180.5$ 3,082.8144Less: Repair and maintenance expenses(173.9)(18

28、0.6)(173.9)(155.6)(148.8)(144.0)162ALess: Depreciation(a)(194.5)(184.1)(175.9)(162.0)(139.0)(120.0)153APlus: LIFO liquidation gain(b) 2.65.12.6$ 3,727.1$ 3,893.5$ 3,651.8$ 3,077.8$ 2,897.8$ 2,821.415(Note 2) Marketing and selling expenses$956.2$980.5$818.8$733.3$626.2$544.4145Less: Advertising (195.

29、4) (20.4) (212.9) (219.1) (203.5) (181.4)$ 760.8$ 960.1$ 605.9$ 514.2$ 422.7$ 363.021(Note 3) Other expenses (income)$26.2$14.7$32.4$(3.2) $(9.5) $5.5102Less: Stock pricerelated incentive programs(15.4)0.1(17.4)2.7(8.5)103Less: Amortization of intangible and other assets(14.1)(16.8)(16.4)(8.9)(5.6)(

30、6.0)Less: Gain on sale of businesses (Yr 8) and sub. (Yr 7) 4.7 14.7104Other, net$ (3.3) $ (2.0) $ (1.4) $ (4.7) $ (0.4) $ (9.0)(Note 4) Tax effect of divest, restruc., & unusual charges $115.3(c)$116.6(d)$13.9136Nondeductible divestitures, restructuring, and unusual charges (101.4)(e)(51.9)(f)

31、$ 13.9$ 64.7$ 13.9 *Statutory federal tax rate is 34% in Year 8 through Year 11, 45% in Year 7, and 46% in Year 6.This amount is not disclosed for Year 6.(a)We assume most depreciation is included in cost of products sold.(b)LIFO liquidation gain before tax. For example, for Year 8 this is $2.58 mil

32、lion, computed as $1.7/(1 0.34).(c)$339.1 22 0.34 = $115.3.(d)$343.0 22 0.34 = $116.6(e)$179.4 26 0.565 136 = $101.4.(f)$106.5 26 0.487 136 = $51.9.Typical QuestionTypical QuestionuHow has advertising varied over the years? How might this affect future profitability?uIn year ten, advertising was dro

33、pped to only $20M instead of being around $200MuThis may reduce future salesuIt may have been a short term attempt to improve profitabilityDiscipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 15Yet ANOTHER FUN exam questionYet ANOTHER FUN exam questionuYou notice an extraordinary charge f

34、or environmental clean up costs for a retail gasoline company that has sold a station and been required to clean up the soil around the gas tanks once the tanks were removed to sell the property. Do you include this cost in the future income?School of Finance and Economics SILC ProgramSubject 25050

35、Lecture 11Slide 16Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 16Yet ANOTHER FUN exam questionYet ANOTHER FUN exam questionu You notice an extraordinary charge for environmental clean up costs for a retail gasoline company that has sold a station and been required to clean up the

36、soil around the gas tanks once the tanks were removed to sell the property. Do you include this cost in the future income?uYES AND NOuYES you may have to reduce the value of the real estateuNO you do not explicitly include the clean up costs that year since it was extraordinary.uCONCLUSION it will r

37、educe the value of the company but not on a yearly basis.School of Finance and Economics SILC ProgramSubject 25050 Lecture 11Slide 17Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 17Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 18Earnings PersistenceEarnings Persis

38、tenceDeterminants of PersistenceEarnings persistence determined by many factors including:Earnings variabilityEarnings trendEarnings stabilityEarnings predictabilityEarnings managementManagement IncentivesNote: Assess earnings persistence over both the business cycle and the long termDiscipline of F

39、inance SILC ProgramSubject 25050 Lecture 11Slide 19Earnings PersistenceEarnings PersistenceMeasuring PersistenceEarnings variability can be measured:1.Standard variability measures2. Average earnings-typically using 5 to 10 years of data3.Minimum earnings-typically selected from the most recent busi

40、ness cycle, reflecting a worst-case scenarioYet ANOTHER FUN exam questionYet ANOTHER FUN exam questionuA management led buyout of a company will prefer to buy the company at the top or bottom of a business cycle?School of Finance and Economics SILC ProgramSubject 25050 Lecture 11Slide 20Discipline o

41、f Finance SILC ProgramSubject 25050 Lecture 11Slide 20Typical QuestionTypical QuestionuEarnings for NNN Corporation have been approximately $550M for each of the last 5 years, but if you go back 6 years the earnings were only $200M. What should you report as earnings persistence?uUsing rules like “t

42、he last 5 year average” may miss an important difference that occurs due to the business cycle. uIn the case of NNN Corporation, you may want to report $550M as the average in the last 5 year (bull market) and report that earnings could be much lower if there is a bear market. They to understanding

43、what earnings to use, is to try to figure out whywhy the earnings were only $200M 6 years ago.Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 21Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 22How can you recognizeHow can you recognizeEarnings Management?Earnings Man

44、agement is reflected as follows: Changes in accounting methods or assumptions Offsetting extraordinary/unusual gains and losses Big baths Write-downs Timing revenue and expense recognition Aggressive accounting applicationsDiscipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 23Earnings Pe

45、rsistenceEarnings PersistenceMeasuring PersistenceEarnings persistence of components depends on key attributesRecurring vs Non-recurringOperating vs Non-operatingKey application of these attributes is the reporting ofExtraordinary vs Non-extraordinaryDiscipline of Finance SILC ProgramSubject 25050 L

46、ecture 11Slide 24Earnings PersistenceEarnings PersistenceMeasuring PersistenceAnalyzing and Interpreting Extraordinary Items1. Determine whether an item is extraordinary (less persistent) or not2. Assessing whether an item is unusual, non-operating, or non-recurring 3. Determine adjustments necessar

47、y given assessment of persistenceDiscipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 25Three broad categories:1. Nonrecurring operating gains and losses-Usually include in current operatingincome2. Recurring non-operating gains and losses-Consider inclusion in current operating earnings3

48、. Nonrecurring non-operating gains and losses-Omitted from operating earnings of a single yearEarning PersistenceEarning PersistenceMeasuring Persistence* *CautionCaution* *uBe able to justify any changes to the financial statements that you make when determining the persistent earnings!Most common:

49、 REMOVAL of one time eventsuThen we use the recurring earnings in valuation models!Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 26Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 27Equity value (Vt)Book value (BVt)Residual Income (RIt = Net incomet k * BVt-1)Cost of

50、 equity capital (k)Earning-Based ValuationEarning-Based ValuationStock Prices and Accounting DataDiscipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 28Earning-Based ValuationEarning-Based ValuationValuation MultiplesPrice-to-Book (PB)equity of value Bookequity of valueMarket Discipline o

51、f Finance SILC ProgramSubject 25050 Lecture 11Slide 29Earning-Based ValuationEarning-Based ValuationValuation MultiplesPrice-to-Earnings (PE)incomeNet equity of valueMarket Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 30Earning-Based ValuationEarning-Based ValuationValuation Multi

52、plesPrice-to-Earnings (PE) expressed in accounting data Where k is the cost of equity capital, STG (LTG) is the expected short-term (long-term) % change in eps relative to expected “normal” growth (STGLTG and LTGk) The PE is inversely related to k The PE is positively related to the expected growth

53、in eps relative to normal growth. LTGkLTGSTGk1epsPttDiscipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 31If LTG=0 (long-term growth in eps relative to “normal” growth is expected to remain constant)This yields the popular PEG ratio. Example: If PE=20 and k=10%, proponents of this screen

54、ing device recommend stock purchase (sale) if the expected eps growth is greater (less) than 20%.Earning-Based ValuationEarning-Based ValuationValuation Multiples- PEG Ratio 2kSTGepsPttDiscipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 32Earning-Based ValuationEarning-Based ValuationEar

55、nings-Based Valuation-IllustrationChristy Co. book value of equity at January 1, Year 1, is $50,000Christy has a 15% cost of equity capital (k)Forecasts of Christys accounting data follow: Year 1 Year 2 Year 3 Year 4 Year 5Sales$ 100,000 $ 113,000$127,690$144,290$144,290Operating expenses77,50090,00

56、0103,500118,000119,040Depreciation10,00011,30012,77014,43014,430Net income$12,500 $11,700$ 11,420$ 11,860 $ 10,820Dividends6,0004,3553,12011,86010,820Year 6 and beyond = Both accounting data and dividends approximate Year 5 levelsDiscipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 33Earn

57、ing-Based ValuationEarning-Based ValuationEarnings-Based Valuation-IllustrationChristys forecasted book value at January 1, Year 1 is $58,594computed as:This implies Christy stock should sell at a PB ratio of 1.17 ($58,594/$50,000) at January 1, Year 1. . .015. 1451 ,72)15. 015(0.15. 1451 ,72)15. 01

58、644(0.15. 1845,63)15. 01789(0.15. 1500,56)15. 02071(0.15. 1000,50)15. 025(0.000,50594,58$5432Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 34Earning-Based ValuationEarning-Based ValuationEarnings-Based Valuation-IllustrationAn EXCEL spreadsheet illustrating the calculation of the v

59、aluation is on UTS online to help you see the calculationThe book value increases with the earnings (less dividends)The value of the company increases when earnings exceed 15% (but they have to be discounted back to todays value)Discipline of Finance SILC ProgramSubject 25050 Lecture 11Slide 35Earni

60、ng-Based ValuationEarning-Based ValuationEarnings-Based Valuation-IllustrationExpected ROCE equals 15% (Christys cost of capital) for Year 5 and beyond. Since ROCE equals the cost of capital for Year 5 and beyond, these years results do not change the value of Christy (that is, abnormal earnings equal zero for