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Financial Statement Analysis and Security Valuation Stephen H. Penman

Financial Statement Analysis and Security Valuation Stephen 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

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Financial Statement Analysis and Security Valuation Stephen H. Penman

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  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. The Analysis of Growth and Sustainable Earnings Chapter 12

  3. Chapter 12 Page 377 What You Will Learn In This Chapter • Why the analysis of growth is important for valuation • How changes in residual earnings are driven by changes in return on common shareholders' equity (ROCE) and growth in investment • What a growth firm is • What is sustainable growth • What drives sustainable growth • What is sustainable earnings • What drives sustainable earnings • What are transitory earnings • What “quality of earnings” means • How operating leverage affects earnings as sales change • How ROCE can be created by borrowing • What are the drivers of growth in the common shareholders' investment

  4. Growing Residual Earnings Residual Earnings (RE) = (ROCE – Required Return) x CSE So, RE grows (for a given Required Return) by • Increasing profitability (ROCE) • Increasing investment if ROCE > Required Return So, analyze changes in profitability and growth in investment

  5. Chapter 11 Page 338 Figure 11.1 Level 1 Level 2 PM = OI / Sales ATO = Sales / NOA Level 3 Sales PM Other Items PM Gross Margin Ratio Expense Ratios Other OI/Sales Ratios Individual Asset andLiability Turnovers Borrowing CostDrivers Cutting to the Core:The Analysis of Profitability

  6. Chapter 12 Page 383 Figure 12.1 Level 1 Level 2 Level 3 Breaking Down Changesin Profitability

  7. STEP A Explaining RNOA 1. Distinguish core and transitory components Core OIis persistent income from core business UI is unusual items that are non recurring (transitory) Use MD & A to identify unusual items All items are after tax Chapter 12 Page 383 Time Series Analysis:Explaining the Change in Profitability

  8. Chapter 12 Page 391 Time Series Analysis:Explaining the Change in Profitability • STEP A Explaining RNOA 1. Distinguish core and transitory components 2. Distinguish margin and turnover drivers of core profits

  9. 3. Calculate changes in drivers Chapter 12 Page 392 Box 12.7 (ii) Effect due to Change in Asset Turnover (iii) Effect due to Unusual Items this Period (i) Effect due to Change in Profit Margin (What do I think is being held constant?) Time Series Analysis:Explaining the Change in Profitability Note: (i) is usually more important than (ii) As an alternative,

  10. Core RNOAt Chapter 12 Page 392 Box 12.7 Subtract and add Or Subtract and add (What do I think is being held constant?) TSA: Explaining the Change in Profitability

  11. RNOA Chapter 12 Page 392 Box 12.7 RNOA1996 RNOA1995 RNOA1996 for Nike: for Reebok:

  12. RNOA Chapter 12 Page 392 Box 12.7 for Nike: RNOA1996 RNOA1995 RNOA1996 for Reebok:

  13. RNOA Chapter 12 Page 392 Box 12.7 for Nike: RNOA1996 RNOA1995 RNOA1996 for Reebok:

  14. RNOA Chapter 12 Page 392 Box 12.7 for Nike: RNOA1996 RNOA1995 RNOA1996 for Reebok:

  15. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike:

  16. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike:

  17. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: for Reebok:

  18. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: for Reebok:

  19. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: for Reebok:

  20. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: for Reebok:

  21. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: for Reebok:

  22. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: for Reebok:

  23. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: for Reebok:

  24. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: for Reebok:

  25. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: for Reebok:

  26. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: for Reebok:

  27. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: for Reebok:

  28. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: Nike = 0.0068 for Reebok: = -0.0507

  29. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: Nike = 0.0068 + 0.0005 for Reebok: = -0.0507 + -0.0001

  30. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: Nike = 0.0068 + 0.0005 + -0.0124 for Reebok: = -0.0507 + -0.0001 + 0.0237

  31. Components of RNOA Chapter 12 Page 392 Box 12.7 for Nike: Nike = 0.0068 + 0.0005 + -0.0124 = - 0.005 for Reebok: = -0.0507 + -0.0001 + 0.0237 = - 0.028

  32. STEP B Explaining ROCE 1. Explain change in spread: Spread = RNOA - NBC Distinguish core and unusual borrowing cost Core financing expenses Change in interest rates (risk free and risk premium) Change in tax rates (and shield) Substitution of preferred for debt financing Unusual financing expenses Tax effect from unusually high or low taxes (operating losses) Interest income from tax refunds of prior years Gains and losses on financial items Chapter 12 Page 395 Box 12.8 (i) Effect of change in operating profitability (ii) Effect of change in spread (iii) Effect of change in leverage TSA: Explaining the Change in Profitability

  33. STEP B Explaining ROCE 1. Explain change in spread: Spread = RNOA - NBC Distinguish core and unusual borrowing cost 2. Explain changes in financial leverage Explain change in NFO/CSE Look at financial obligation composition ratios Chapter 12 Page 395 Box 12.8 (i) Effect of change in operating profitability (ii) Effect of change in spread (iii) Effect of change in leverage TSA: Explaining the Change in Profitability

  34. Components of ROCE Chapter 12 Page 395 Box 12.8 for Nike: for Reebok:

  35. Chapter 12 Page 397 Figure 11.2 The Analysis of Changes in Common Stockholders’ Equity Changes in sales for business segments or product lines Changes in individual asset turnovers Changes in NFO components

  36. Components of ROCE Chapter 12 Page 398 Box 12.10 for Nike: for Reebok:

  37. Preparing Financial Statementsfor Forecasting 1. Identify dirty surplus and calculate ROCE from statement of shareholders’ equity 2. Reformulate balance sheet 3. Reformulate income statement 4. Decompose ROCE 5. Analyze DROCE 6. Analyze DCSE Now you are ready to forecast future ROCE, and apply the residual income model

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