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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 Profitability Chapter 11

  3. We began by identifying a role for the residual income model in valuation Recall: We identified the central role of ROCE in valuation Since: We reformatted the Income Statement to draw attention to the components of Comprehensive Income (the numerator) We reformatted the Balance Sheet to draw attention to the components of CSE (the denominator) We recognized that the component of earnings which adds value is OI and the assets used to generate that value are NOA The focus now is on the driversof operating income

  4. The Focus: Accounting-Based Valuation • The task is to determine premiums over book value (or equivalently, the P/B ratio) • What will future ROCE (residual earnings) be? • Point of departure: Current ROCE and growth • How will future ROCE and growth be different from current ROCE?

  5. An analyst’s competitive advantage lies in one or more of these steps Steps in Fundamental Analysis 1. Specify the future payoffs to be forecasted 2. Identify information that forecasts payoffs Within financial statements Outside of financial statements 3. Prepare forecasts (pro forma analysis) 4. Determine the cost of capital 5. Infer price from pro forma analysis: combine pro forma with cost of capital

  6. Forecasting and the Analysis of Current Profitability 1. Future ROCE (residual earnings) is the forecast target 2. Establish the present: Analysis of profitability Determine the current profitability (ROCE) and the factors that influence the profitability 3. Determine transition from present to future: Projecting future profitability Determine factors that influence future profitability and describe how the future will be different from the present These correspond to steps 2 and 3 of fundamental analysis The reformulation of the balance sheet and income statement has put them into a form to carry out step 2 and to use them to forecast the future in step 3

  7. 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

  8. Cutting to the Core: ROCE Drivers ROCE is decomposed into drivers over three levels of analysis: • Effects of Leverage • Analysis of Operating Profitability • Analysis of Net Borrowing Costs

  9. Chapter 11 Page 339 Box 11.1 First-Level Breakdown: Analysis of Effects of Financial Leverage (FLEV) So, ROCE is a weighted return to operating activities and financing activities: or, RNOA = OI (After tax) / NOA (Return on Net Operating Assets) FLEV = NFO / CSE (Financial Leverage) NBC = NFE (after tax) / NFO (Net Borrowing Cost) SPREAD = RNOA – NBC (Operating Spread) Spread

  10. Chapter 11 Page 340 Figure 11.2 How Financial Leverage Explains the Difference Between ROCE and RNOA

  11. Chapter 11 Page 341 Box 11.2 Financial Leverage:General Mills, Inc.   General Mills, a large manufacturer of packaged foods, has had considerable stock repurchases over the years. At the end of fiscal 1998 common shareholder equity was only $190.2 million on net operating assets of $2.251 billion. Its financial leverage was a huge 5.745, based on average balance sheet amounts. The firm’s ROCE for 1998 was 121.6%. Further analysis reveals that this very high number is driven by the high leverage: ROCE = RNOA + [FLEV x (RNOA NBC)] 121.6% = 21.6% + [5.745 x (21.6% 4.2%)] ROCE can exaggerate underlying operational profitability: RNOA is 21.6% but the high financial leverage, combined with a SPREAD over a borrowing cost of 4.2%, yields a much higher ROCE. Beware of firms boasting high ROCE: is it driven by financial leverage? A What-If Question: What if the RNOA at General Mills fell to 3%? What would be the effect on ROCE? The answer is that the ROCE would fall to -3.9%: -3.9% = 3.0% + [5.745 x (3.0% 4.2%)] The unfavorable leverage would produce a negative ROCE on a positive RNOA.

  12. Chapter 11 Page 342 Box 11.3 Financial Leverage: Microsoft, Corp. Microsoft Corp has been very profitable. For fiscal 1998 the firm reported an ROCE of 36.3% on average common equity of $13.702 billion. But Microsoft had no financing debt other than $980 million of convertible preferred stock. And it had considerable financial assets of $11.447 billion from cash generated from its operations. The return on average net financial assets was 8.0% (a significant portion from unrealized gains on financial assets). The reported ROCE masks the profitability of operations: The RNOA of 179.4% is weighted down by return on financing activities in the overall ROCE. A What-If Question: Microsoft has regular stock repurchases. In fiscal 1998 the company used $2.796 billion of its financial assets to repurchase stock. What would the ROCE have been had it not undertaken the stock repurchase? The answer: With $2.796 billion more in average financial assets and common equity, the NFA to CSE ratio would have been 0.863 rather than 0.835, and the ROCE would have been: 31.5% = 179.4% [0.863 x (179.4%  8.0%)] Stock repurchases (and dividends) increase ROCE.

  13. Chapter 11 Page 342 The Effects of Operating Liability Leverage (OLLEV) Operating liabilities lever the Return on Net Operating Assets What would be the operating profitability without operating liabilities? where Implicit Interest on Operating Liabilities = Short-term Borrowing Rate x Operating Liabilities The Effect of OLLEV: where RNOA = ROOA + (OLLEV x OLSPREAD)

  14. Chapter 11 Page 344 Box 11.4 Operating Liability Leverage: General Mills, Inc.   General Mills had average net operating assets of $2.310 billion during fiscal 1998 of which $1.159 billion were in operating liabilities other than deferred taxes and pension liabilities. Thus its operating liability leverage ratio was 0.50. Its borrowing rate on its short-term notes payable was 5.4%, or 3.4% after tax. It reported operating income of $499.6 million, but applying the after-tax short-term borrowing rate to operating liabilities other than deferred tax and pension liabilities, this operating income includes implicit after-tax interest charges of $39.4 million. So, The effect of operating liability leverage is favorable: A What-If Question: What-if suppliers were to charge the short-term borrowing rate of 5.4% explicitly for the credit in accounts payable. What would be the effect on ROCE? The answer: Probably no effect. The interest would be an additional expense. But, to stay competitive, the supplier would have to reduce prices of goods sold to the firm by a corresponding amount so that the total price charged (in implicit plus explicit interest) remains the same. But supplier markets may not work as efficiently as this supposes, so firms can exploit operating liability leverage.

  15. Chapter 11 Page 343 Return on Net Operating Assets and Return on Assets Problems with ROA: • Financial assets in denominator • Financial income in numerator • Operating liabilities not in denominator • Net income is not comprehensive income Median ROA is 7.0% Median RNOA is 10.3%

  16. Chapter 11 Page 345 Table 11.1 RNOA and ROA forSelected Firms, 1996

  17. Chapter 11 Page 346 FLEV and Debt-to-Equity Ratios Problems with Debt-to-Equity ratio: • Excludes financial assets (which effectively decrease debt) • Includes operating liabilities Median Debt-to-Equity is 1.17 Median FLEV is 0.40

  18. Reformulated Financial Statements: Nike, Inc. Reformulated Statements of Stockholders’ Equity Chapter 11 Page 349 Exhibit 11.1

  19. Reformulated Financial Statements: Nike, Inc. Reformulated Balance Sheets Chapter 11 Page 349 Exhibit 11.1 1 Cash and cash equivalents are split between operating cash and cash investments. 2 Some accounts payable are interest bearing but this cannot be discovered. 3 Other liabilities are primarily long-term deferred endorsement payments for promotions. 4 Notes payable are interest bearing. 5 Preferred stock is less than $0.5 million.

  20. Reformulated Financial Statements: Nike, Inc. Reformulated Income Statements Chapter 11 Page 350 Exhibit 11.1 1 Broken out from selling and administrative expenses in published income statement. 2 Included in “other expense” in income statement. The nonrecurring changes in 1995 and 1994 relate to shutdown of certain facilities. 3 Marginal tax rate was 38.5%, 38.5% and 39.1% in 1996, 1995 and 1994, respectively.

  21. Reformulated Financial Statements: Reebok International, Ltd. Reformulated Statements of Stockholders’ Equity Chapter 11 Page 351 Exhibit 11.2

  22. Reformulated Financial Statements: Reebok International, Ltd. Reformulated Balance Sheets Chapter 11 Page 351 Exhibit 11.2 1 Cash and cash equivalents divided between operating cash and cash investments. 2 Excludes dividends payable which is included in stockholders’ equity.

  23. Reformulated Financial Statements: Reebok International, Ltd. Reformulated Income Statements Chapter 11 Page 352 Exhibit 11.2 1 Broken out from selling and administrative expenses in published income statement. 2 The change in 1995 is due to consolidation and streamlining of facilities and to the sale of the Avia subsidiary. 3 Marginal tax rate was 35.4%, 36.2% and 36.9% for 1996, 1995 and 1994, respectively.

  24. First Level Breakdown of ROCE: Nike, Inc. and Reebok Int’l, Ltd.

  25. 1996 1995 1994 Operating Income Revenues $6,471 $4,761 $3,790 Cost of sales 3,907 2,865 2,301 Gross margin 2,564 1,896 1,489 Operating expenses Administrative expenses $977 $730 $614 Advertising 643 495 373 Amortization of intangibles 22 1,642 13 1,238 8 995 Operating income from sales (before tax) 922 658 494 Taxes Tax as reported 346 250 192 Tax on other operating income - 4 3 Tax on financial items 9 355 (1) 253 (2) 193 Operating income from sales 567 405 301 Other operating income (expense) Nonrecurring change - (11) (7) Tax on other items - 4 3 - (7) (4) Currency translations (18) (18) 16 9 (7) (11) Operating income 549 414 290 Financing Expense (Income) Interest expense 39 24 15 Interest income (16) 23 (27) (3) (19) (4) Tax effect (9) 1 2 Net financing expense (income) 14 (2) (2) Comprehensive income to Common 535 416 292 Nike’s 1996 Reformulated Income Statements Chapter 11 Page 350 Exhibit 11.1 ROCEt = earnt / average CSEt = 535 / average CSEt or ROCEt = (OIt - NFEt) / average (NOAt - NFOt) = ( 549 - 14 ) / average (NOAt - NFOt)

  26. 1996 1995 1994 Net Operating Assets: Operating assets: Cash $ 27 $ 20 $ 15 Account receivable, net 1,346 1,053 704 Inventories 931 630 470 Prepaid expenses 94 74 40 Property, plant & equipment 643 555 406 Goodwill $328 $330 $182 Trademarks & other intangibles 210 209 12 Accumulated amortization (63) 475 (43) 496 (31) 163 Deferred income taxes & other assets 200 119 72 3,716 2,947 1,870 Operating liabilities: Accounts payable (455) (298) (211) Accrued liabilities (480) (345) (182) Income taxes payable (79) (36) (38) Deferred income taxes (2) (18) (18) Other liabilities (41) (1,057) (42) (739) (40) (489) 2,659 2,208 1,381 Net Financial Obligations: Cash equivalents (235) (196) (503) Current portion of long-term debt 7 32 4 Notes payable 446 397 127 Long-term debt 10 228 11 244 12 (360) Common Stockholders' Equity 2,431 1,964 1,741 Nike’s 1996 Reformulated Balance Sheets ROCEt = earnt / average CSEt = 535 / [( 2,431 + 1,964 ) / 2] = 24.3% Chapter 11 Page 349 Exhibit 11.1 or ROCEt = (OIt - NFEt) / average (NOAt - NFOt) = (549 - 14) / [( 2,659 + 2,208 ) / 2 - ( 228+ 244 ) / 2] = 24.3%

  27. Chapter 11 Page 352 Table 11.2 First Level Breakdown: Reebok

  28. Chapter 11 Page 352 Table 11.2 First Level Breakdown: Reebok

  29. Chapter 11 Page 352 Table 11.2 First Level Breakdown: Reebok

  30. Chapter 11 Page 353 Box 11.7 First Level Breakdown: Reebok What about Minority Interests?

  31. Cutting to the Core: ROCE Drivers Chapter 11 Page 339 Shorthand notation for average CSE NBCt RNOAt FLEVt • First Level Breakdown: Distinguish operating and financial profitability and the effects of leverage

  32. Breaking Down ROCE Drivers Chapter 11 Pages 352-353 Table 11.2 for Nike:

  33. Breaking Down ROCE Drivers Chapter 11 Pages 352-353 Table 11.2 for Nike:

  34. Breaking Down ROCE Drivers Chapter 11 Pages 352-353 Table 11.2 for Nike:

  35. Breaking Down ROCE Drivers Chapter 11 Pages 352-353 Table 11.2 for Nike:

  36. Breaking Down ROCE Drivers Chapter 11 Pages 352-353 Table 11.2 for Nike:

  37. Breaking Down ROCE Drivers Chapter 11 Pages 352-353 Table 11.2 for Nike:

  38. Breaking Down ROCE Drivers Chapter 11 Pages 352-353 Table 11.2 for Nike:

  39. Breaking Down ROCE Drivers Chapter 11 Pages 352-353 Table 11.2 for Nike:

  40. Breaking Down ROCE Drivers Chapter 11 Pages 352-353 Table 11.2 for Nike: for Reebok:

  41. Chapter 11 Page 354 • (3) Financial Leverage: • Amount of leverage • Spread (1) Profit margin (PM): The profitability of each dollar of sales (2) Asset Turnover (ATO): The ability to generate sales for a given asset base. Cutting to the Core:Drivers of Operating Profitability • Second Level Breakdown:

  42. Chapter 11 Page 355 Figure 11.3 1 2 3 4 5 6 7 Asset Turnover Profit Margin and Asset Turnover Combinations for 238 Industries, 1963-96

  43. Typical Levels for ROCE, FLEV, OLLEV, RNOA, PM and ATO Chapter 11 Page 356 Table 11.3 Source: Standard & Poor’s COMPUSTAT®

  44. Breaking Down ROCE Drivers Chapter 11 Page 359 Table 11.4 for Nike:

  45. Breaking Down ROCE Drivers Chapter 11 Page 359 Table 11.4 for Nike:

  46. Breaking Down ROCE Drivers Chapter 11 Page 359 Table 11.4 for Nike:

  47. Breaking Down ROCE Drivers Chapter 11 Page 359 Table 11.4 for Nike:

  48. Breaking Down ROCE Drivers Chapter 11 Page 359 Table 11.4 for Nike: for Reebok:

  49. Chapter 11 Page 357 Profit Margin Drivers Asset Turnover Drivers Third Level Breakdown

  50. Third level breakdown: Chapter 11 Page 357 by product or line of business benefit or expense? Cutting to the Core :Profit Margin Drivers

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