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Chapter 12

Chapter 12. The Analysis of Growth and Sustainable Earnings. The Analysis of Growth and Sustainable Earnings. LINKS. Link to Previous Chapter. Chapter 11 laid out the. analysis of profitability. This Chapter.

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Chapter 12

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  1. Chapter 12 The Analysis of Growth and Sustainable Earnings

  2. The Analysis of Growth and Sustainable Earnings LINKS Link to Previous Chapter Chapter 11 laid out the analysis of profitability This Chapter How is the analysis of growth incorporated in the evaluation of the P/E and P/B ratios? What is “growth” in a valuation context? What is a growth company? How is How are This chapter analyzes growth growth in sustainable investment earnings analyzed ? identified ? Link to Next Chapter Part III of the book applies the analysis of profitability and growth to forecasting and valuation Link to Web Page Explore the web page

  3. What you will learn from this Chapter • Why the analysis of growth is important for valuation • Why growth analysis focuses on residual earnings growth • and abnormal earnings growth rather than earnings growth • What a growth firm is • What sustainable earnings are and how to identify them • What transitory earnings are • What “quality of earnings” means • How firms can generate unsustainable earnings • How operating leverage affects earnings as sales change • How changes in ROCE can be created by borrowing • What drives growth in the common shareholders’ equity

  4. What Is Growth and How Is It Valued? • Growth in sales? • Growth is assets? • Growth in equity? • Growth in earnings? • Does a high P/E ratio indicate a growth company? • Does a high P/B ratio indicate a growth company?

  5. Remember the Caveat (Chapters 5 and 6) Firms can grow earnings, but not create value • Earnings growth generated by investment • Earnings growth generated by the accounting Value-added growth: Think of growth in residual earnings and abnormal earnings growth A reminder: abnormal earnings growth (AEG) is equal to growth in residual earnings (ΔRE)

  6. A Growth Company: General Electric, Corp.

  7. Is Nike a Growth Firm?

  8. A No-Growth Firm: Reebok

  9. A Cyclical Firm: American Airlines

  10. Change in residual earnings Change due to change in ROCEover the cost of capital Change dueto change in common equity = + Analyzing Growth in Residual Earnings • Changes in residual earnings are driven by: • Changes in ROCE • Changes in required return • Changes in investment A reminder: ΔRE=AEG, so this calculation also gives AEG

  11. Analysis of Growth in Residual Earnings and AEG: Nike, Inc. [Assumes no change in required equity return]

  12. Analysis of Growth in Residual Earnings and AEG: Reebok

  13. Analyzing Change in ROCE: The Scheme

  14. Analysis of Changes in ROCE • Analyze Changes in Profitability of Operations • Analyze the Effects of Changes in Financing (1) (2)

  15. Explaining the Changes in Operational Profitability Explaining RNOA • Distinguish core and transitory components Core OI is persistent income from core business UI is unusual items that are non-recurring, sometimes called transitory or non- persistent items. All items are after tax

  16. Explaining Changes in Operational Profitability (cont’d.) • Distinguish margin and turnover drivers of core income where,

  17. Explaining Changes in Operational Profitability (cont’d.) • Explain changes in profit margins and asset turnoversExplain changes in Core PM by looking at profit margin drivers • GM (by segment) • Selling Expenses / Sales • Administrative Expenses / Sales • R&D / SalesPay particular attention to GM: per unit sales prices, production costs… Explain changes in ATO by looking at turnovers • Accounts receivables turnover • Inventory turnover • PPE turnover • Accounts payable turnover • Operating liability turnover Also • Look at operating asset composition ratios • Look at operating liabilities composition ratios • Look at OLLEV

  18. Reformulating Income Statements to Identify Core and Unusual Items Reformulated Operating Income Statement: Core and Unusual Items

  19. Reformulation to Identify Core Income: Nike

  20. Reformulation to Identify Core Income: Reebok

  21. Comprehensive Tax Allocation

  22. Change in RNOA Change in core sales profit margin at previous asset turnover level Change due to change in asset turnover Change due to change in other core income Change due to change in unusual items = + + + Explaining Changes in Operational Profitability: the Calculations The change in RNOA is explained as: (i) Effect due to change in Profit Margin (ii) Effect due to change in Asset Turnover (iii) Effect due to Unusual Items this period Note: (i) is usually more important that (ii)

  23. Changes in Operational Profitability: Nike and Reebok Nike, Inc. Reebok Int’l, Ltd.

  24. Identifying Sustainable Earnings: Items to Consider • Restructuring charges, asset impairments, special charges • Research and development • Advertising and promotion • Pension expense • Changes in estimates • Realized gains and losses: Cherry Picking • Unrealized gains and losses • Income taxes • “Other” income

  25. Watch for Bleed Back of Restructuring and Merger Charges Did IBM create earnings with restructuring charges? ($billions)

  26. Analyze R&D THE ANALYSIS OF R&D: MERCK & CO.

  27. Analyze Marketing Expenditures The Analysis of Advertising Costs: Coca-Cola

  28. Analyze Pension Costs Components of Pension Expense: • Service Cost • Interest Cost • Expected Return on Plan Assets • Amortization of Prior Service Cost • Amortization of Transaction Asset or Liability • Changes in Actuarial Estimates (accrual gains and losses)

  29. Watch for the Expected Rate of Return on Pension Plan Assets • In the 1980s, firms were using expected • rates of return of about 7% • In the 1990s, firms were using expected rates of • returns of 10-10½% • Applying a high rate of return to bubble asset • prices produces bubble earnings • Pricing on the basis of bubble prices perpetuates • the bubble • The Pension Pyramid Scheme

  30. Watch for Gains of Pension Fund Assets • General Electric’s expected return on plan assets was $4,327 million in 2001 (22.0% of earnings before tax) against a service cost of $884 million. Its net pension expense was a gain of $2,095 million. • IBM reported an expected return on plan assets of $6,264 million in 2001 (56.0% of operating income before tax).

  31. Watch Gains and Losses on Sales of Shares

  32. Watch for Changes in Estimates • Bad debt allowances • Deferred revenue • Warranty allowances • Residual values for leases Beware of Cookie Jar Accounting

  33. Watch Income Taxes • One-time or expiring credits • Changes in valuation allowances for deferred tax assets Effective tax rates tend to move towards the statutory rate overtime

  34. Analyzing Operating Leverage Operating Leverage is the proportion of total costs that are fixed versus variable The first component here is called the contribution margin ratio This ratio measures the change in income from a change in one dollar of sales

  35. Operating Leverage Measures Operating Leverage is sometimes calculated as the ratio of fixed costs to variable costs Another measure is: Applying this measure to core operations:

  36. Effect of Financing Analysis of Effect of Changes in Financing Change in ROCE = Change in RNOA + Change due to change in spread at previous level of financial leverage + Change due to change in financial leverage (i) Effect of change in operating profitability (ii) Effect of change in spread (iii) Effect of change in leverage

  37. Effect of Changes in Financing: Reebok Stock Repurchase In 1996, Reebok borrowed $600 million to repurchase stock If financial leverage had been maintained at 1995 level, Explaining ΔROCE

  38. Explaining Changes in the SPREAD SPREAD = RNOA – NBC RNOA has been explained Explain Change in 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

  39. A Rough Approximation • Some observations • The change in leverage effect (iii) is generally minor • The change in borrowing costs is generally small (then, Spread is largely determined by RNOA) • The RNOA effect (i) is generally the largest • So, if FLEV and NBC are small, a useful approximation is

  40. Breakdown of Growth in Equity Investment  CSE  NOA  NFO  Sales Changes in Sales for Business Segments Or Product Lines Changes in Individual Asset Turnovers Changes in NFO Components

  41. Analysis of Growth in Equity Investment These components of growth in equity investment: • Growth in sales • Change in net operating assets that support each dollar of sales • Change in the amount of net debt that is used to finance the change in net operating assets rather than equity

  42. = + + Change in Common Equity Change due to change in sales at previous level of asset turnover Change due to change in asset turnover Change in financial leverage Nike Reebok Analysis of Growth in Common Equity: Nike and Reebok

  43. Preparing Financial Statements for Forecasting • Identify dirty surplus and calculate ROCE from statement of shareholders’ equity • Reformulate balance sheet • Reformulate income statement • Decompose ROCE: Profitability Analysis • Analyze ROCE: Sustainability of Earnings • Analyze Growth Now you are ready to forecast future ROCE and growth and carry out valuations

  44. Using Growth Analysis to Understand P/B and P/E Ratios • How does P/B relate to growth? • How does P/E relate to growth? • How does P/E relate to transitory earnings?

  45. A reminder: The Benchmark Case of Normal P/B and Normal P/E

  46. A Normal P/E: Whirlpool Corporation Valuation: (approx) (approx) These are normal P/E for a 10% cost of capital

  47. P/E Ratios Different from Normal • If earnings are expected to grow faster than the cost of capital (cum-dividend), P/E > Normal • If earnings are expected to grow slower than the cost of capital (cum-dividend), P/E < Normal OR • If AEG is forecasted to be positive, P/E > Normal • If AEG is forecasted to be negative, P/E < Normal OR • If RE is forecasted to increase, P/E > Normal • If RE is forecasted to decrease, P/E <Normal

  48. The P/E Ratio and the P/B Ratio • P/B indicates expected growth in book value • P/E indicates expected growth in earnings OR • P/B indicates future RE • P/E indicates future changes in RE from current RE

  49. How do P/E and P/B Articulate? P/B High Low High 23,146 10,848 P/E Low 10,849 23,147 Joint Values of P/E and P/B Ratios; 1963-2001

  50. Median P/B for E/P Portfolios: 1968-85

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