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. The Quality of Forecasted Accounting Chapter 19

3. Chapter 19 Page 645 What You Will Learn in This Chapter • How forecast quality improves with the length of the forecast horizon  • What accounting principles are important in determining forecast quality • How the realization principle helps and hinders valuation • How violations of the matching principle affect forecast quality • How growth forecasts affect the quality of forecasted residual earnings • How cash flow forecasts and earnings forecasts compare as to their quality for valuation

4. Chapter 19 Page 647 Figure 19.1 Summary of ForecastQuality Analysis

5. Chapter 19 Page 648 Table 19-1 Starbucks Corporation: Summary of Residual Operating Income Drivers Starbucks Corporation 1993 1994 1995 1996 1997 Sales 176,541 284,923 465,213 696,481 966,946 Operating income 7,253 15,051 24,406 31,081 53,252 As a % of sales: Gross margin 54.4 55.3 54.6 51.8 55.3 Store operating expenses 32.1 32.7 32.0 30.3 32.0 Other operating expenses 3.0 3.1 3.0 2.8 2.9 Depreciation & amortization 3.8 4.4 4.8 5.2 5.4 General & admin expenses 8.4 7.0 6.2 5.3 5.9 Taxes on core income 2.8 2.9 3.4 3.7 3.5 Core profit margin 4.4 5.3 5.2 4.5 5.6 ATO 1.89 2.00 1.74 1.84 1.95 Core RNOA (%) 8.3 10.6 9.0 8.3 10.9 Net operating assets 93,589 191,416 342,648 412,958 578,237 Growth in NOA (%) - 104.5 80.5 20.6 40.0 Growth in sales (%) - 61.4 63.3 49.7 38.8 Starbucks traded at an unlevered P/B of 6.4 in 1997 but core RNOA was only 10.9%. Is there something wrong with the accounting?

6. Chapter 19 Pages 649-651 RNOA Forecast Quality:Sales Forecast Quality andthe Realization Principle The Realization Principle can defer value recognition • The quality of forecasted growth rates • Is the forecasted growth rate for the near-term indicative of the long-term growth rate? • Assets held for resale • Are there assets whose earnings are not reported? • Equity Investments • Less than 20% equity holdings and market-to-market accounting • Hidden assets • Brand assets • Knowledge assets • Real options (opportunities) • Long-term contracting • Percentage-of-completion vs completed contract accounting

7. Chapter 19 Pages 652-653 RNOA Forecast Quality:Profit Margin Quality and the Matching of Expenses to Revenues • Research and Development • Advertising and Promotion • Start-up costs • Strategic Losses • Amortization Note: These issues are not a problem if there is no growth or if constant growth is forecasted in the future: see Chapter 17.

8. Chapter 19 Pages 655-656 RNOA Forecast Quality: Compensation Expense Stock compensation expense is omitted from financial statements. The analyst who forecasts income without compensation expense will overvalue the firm • Methods to incorporate compensation from stock options: • Extrapolate expenses from past exercising of options. • Forecast future prices at exercise dates from current prices. • Calculate the current market price minus exercise price for all options currently outstanding and in the money – a liability calculation. • Forecast future prices from an initial calculated value. • Make a normal RNOA calculation.

9. Chapter 19 Page 655 Table 19-2 Starbucks Corporation:Adjustments to operating incomefor stock issue to employees Adjustments to Operating Income for Stock Issues to Employees Employee Stock Option Plan (ESOP) Shares issued 1,407 774 946 1,177 1,382 Weighted-average share price 20.38 25.16 16.44 23.87 34.81 Weighted-average exercise price 8.59 9.25 3.34 6.78 9.92 Loss (before tax) 16,591 12,311 12,390 20,128 34,409 Tax benefit 5,243 3,719 4,754 6,808 9,626 Implicit wages expense (after tax) 11,348 8,592 7,636 13,320 24,783 Employee Stock Purchase Plan (ESPP) Proceed of share issues 263 1,735 2,313 Implicit wages expense 46 306 408 Total implicit wages expense 11,348 8,592 7,782 13,626 25,191 Restated comprehensive operating income (4,095) 6,459 16,624 17,455 28,061 Restated RNOA (%) -4.7 4.5 6.2 4.6 5.7

10. Chapter 19 Pages 656 Growth Affects the Qualityof RNOA forecasts • Conservative accounting with growth depresses RNOA. This is OK if growth is permanent. • But a change in growth will change the forecasted RNOA. • See Table 17.5 in Chapter 17.

11. Diagnostics for Steady-State RNOA • Revenues: Sales/NOA • Expenses: Expenses/Sales

12. Chapter 19 Pages 657 The Quality of Cash Flow Forecasts • Free cash flow accounting is an extreme form of mismatching. With high growth, free cash flow can be very low, or even negative: • Accrual accounting helps to give a better quality forecast: • See Chapters 4 and 5.

13. Chapter 19 Page 657 Table 19-3 Starbucks Corporation:Free Cash Flows 1994-1997 19931994199519961997 Operating income 15,051 24,406 31,081 53,252 Net operating assets 93,589 191,416 342,648 412,958 578,237 Free cash flow (CI) ----- (82,776) (126,826) (39,229) (112,027)

14. Chapter 19 Page 658 Table 19-4 ROCE, P/B and P/E byLevel of Levered FCF FCF Group FCF/Price ROCE P/B P/E 1 87.1% 4.7% .78 17.4 2 23.4 9.2 .91 10.3 3 10.8 12.1 1.10 9.6 4 6.3 13.7 1.32 10.4 5 2.2 14.6 1.55 11.6 6 -1.4 13.2 1.58 13.0 7 -6.1 12.6 1.49 12.8 8 -13.4 11.6 1.36 12.5 9 -25.9 9.9 1.14 12.2 10 -78.8 4.2 .94 22.7