Forecasting Part I

1. ForecastingPart I Free Cash Flow and Residual earnings Capitalization Modeling of Equity Value Simple Forecasting

2. The Goal of Forecasting • To support the valuation of equity shares by producing an estimate of what expected free cash flows and/or residual earnings will be going forward.

3. Free cash flows = Cash from operations – capital expenditures needed to maintain operational capacity. • Residual earnings = Operating income less a capital charge for equity capital. • Both of these metrics, or their derivatives, will become key inputs in the two kinds of valuation models we use.

4. “Free” Cash Flows • The idea behind the concept of “free cash flows” is that firms must re-invest back into the business. Equity shareholders have access only to the residual cash that remains after this investment is made. • This is very related to the simple idea of cash dividends, where firms pay out all available free cash.

5. Residual Earnings • The idea of residual earnings has become an important tool in Business Valuation using Financial Statement data. • The idea of residual earnings derives from the notion that stocks (balance sheet numbers) and flows (income statement numbers) are really two forms of the same thing. • Because of this they are interchangeable.

6. Residual Earnings • The magic that makes balance sheet and income statement data interchangeable is the discount rate. Discount rates are a function of a number of factors, including uncertainty, inflation, opportunity cost, etc. • The discount rate converts future cash flows (flows) to a present value (stocks). • So stock information can be stated as a flow, and flow data can be stated as a value, or “stock”.

7. A simple example • Assume company X has an expected earnings stream, X, of $100 per year into perpetuity. • The appropriate discount rate, r, for this earnings stream is 10%. • The present value, PV, of this earnings stream is PV = X/r = 100/.10 = $ 1,000. • This is an example of converting a flow ($100) into a stock ($1,000).

8. A simple example (Cont.) • Now, assume the equity invested in a given firm is $ 1,000. The discount rate is 10%. • For now, assume there is no debt. • The flow represented by the equity is $100 ($1000 x .10). This is an example of a stock being transformed into a representative flow.

9. A simple Example (Cont.) • If the firm earns $ 100, there will be no residual earnings. It has earned exactly what was expected. • If the firm earns $ 110, the residual earnings is $10. It has earned $10 over and above the cost of equity capital. In this case, the flow is worth $ 1,100 (110/.10).

10. Many things can increase earnings and residual earnings, but not all of these things result in more wealth for shareholders. Examples include: new investment at the required rate of return, the taking on of debt, and changes in accounting methods. • Residual operating earnings, however, does, in many cases, drive equity value.* *with the exception of certain accounting effects, but valuation models correct for this.

11. Forecasting and Residual Earnings • The forecast task can thus be conceptualized around the idea of predicting residual earnings. • This approach allows us to understand how balance sheet and income statement data can be used together to value equity shares. • A key question: What is the pattern of residual earnings going forward?

12. What drives residual earnings? • The degree to which the balance sheet is well specified. • RNOA • New investment to the extent that it earns more than the required rate of return. • Leverage when the rate of return on investment exceeds the cost of borrowing, however • Leverage does not normally drive equity value. For that reason, in the following examples, we focus on residual operating earnings

13. The Pattern of Residual Operating Earnings • Four forecast possibilities • SF1: Zero residual operating earnings • SF2: A constant level of residual operating earnings • SF3: A constantly growing level of residual operating earnings. • FF: A level and/or growth rate of residual operating earnings that will be unrelated to past results.

14. The Perfect Balance Sheet Equity cost of capital = 12% Debt cost of capital = 10%

15. A note on nomenclature • 1+Discount rate on debt = • 1+Discount rate on equity = • 1+ Discount rate for the firm’s business operation =

16. Simple Forecasts: Forecasting from Book Values (SF1) The required return for operations weights the equity cost of capital (12%) and the cost of debt (10%) by their respective values given in the fair value balance sheet: Required return for operations

17. SF1 Valuation

18. In Summary- SF1 • Presumes that balance sheet is perfectly specified as to value. • Presumes that the firm will earn exactly its rate of return on all assets. • Presumes a continuous and stable earnings stream.

19. The Imperfect Balance Sheet

20. The Income Statement

21. The Cash Flow Statement

22. Simple Forecasts: Forecasting from Earnings and Book Values (SF2)

23. SF2 ReOI Valuation

24. SF2 Valuation: Nike

25. Summary-SF2 Forecasts • Presumes the existence of residual earnings that will remain constant. • Thus presumes that all new investment by the firm will return only the required rate of return expected by the market for this type of business operation.

26. Simple Forecasts: Forecasting from Current Accounting Rates of Return (SF3) For PPE, Inc. the current RNOA, NBC and ROCE (with beginning of year amounts in the denominator) are 14.02%, 10.00% and 14.02% respectively

27. SF3 ReOI Valuation (with Constant RNOA) • If RNOA1 = RNOA0 If RNOA is constant for all future periods, (g is growth rate in NOA; RNOA0 is Core RNOA0)

28. SF3 Valuation of PPE Inc V = 69.9 + (.1402-.1134)x 69.9 / (.1134-.0644) = $ 108.06

29. SF3 Valuation: Nike

30. Summary-SF3 forecasts • Presumes that all new investment will earn as much as all prior investment. • Thus presumes that the firm’s RNOA will remain constant. • Thus presumes that residual operating income will grow at a systematic and constant rate. • What will drive this change is the change in the level of new investment.

31. Simple Forecasts of Growth in NOA If ATO is constant, Forecast growth in NOA with forecasted sales growth rate

32. A Simple Valuation with ReOI Growth: Coca Cola

33. A Simple Valuation with ReOI Growth: Coca Cola If required return for operations is 10%:

34. Price-to-Book Ratios and ROCE, 1968 - 1985

35. 0.25 0.2 0.15 0.1 0.05 ReOI 0 0 1 2 3 4 5 4 -0.05 3 2 -0.1 1 0 -0.15 -0.2 -0.25 Year Ahead Residual Operating Income Patterns: 1965 - 1996

36. 40% 35% 30% 25% 20% RNOA 15% 10% 5% 0 - 5% - 10% I I I I I I 0 1 2 3 4 5 Year Ahead RNOA Patterns, 1965 - 1996

37. Growth in NOA Patterns, 1965 – 1996 60% 50% 40% 30% Growth in NOA 20% 10% 0 - 10% - 20% I I I I I I 0 1 2 3 4 5 Year Ahead

38. 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

39. 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

40. In Summary • Forecasting is an art. • The simpler the better, all else equal. • Its sometimes good to begin with simple forecasting, e.g., SF1, SF2 and SF3 modeling. • All forecasting involves assumptions. • Much of the price can often be explained with simple forecasting methods. • Full information forecasting attempts to address what cannot be explained or assumed via simple forecast relationships.