BKAF3073 Chapter 10

The Role of Financial Information in Valuation, Cash Flow Analysis, and

Credit Risk Assessment

Learning objectives1. The basic steps in corporate valuation.

2. What free cash flows are and how they are used to value a company.

3. How accounting earnings are used in valuation.

4. Why current earnings are considered more useful than current cash flows for assessing future cash flows.

5. How and why the permanent, transitory, and valuation-irrelevant components of earnings affect price-earnings multiples.

Learning objectives:

6. What factors influence earnings quality.

7. How the abnormal earnings valuation approach is used in practice.

8. How stock prices respond to “good news” and “bad news” about earnings.

9. The importance of cash flow analysis and credit risk assessment in lending decisions.

10. How to forecast a company’s financial statements.

Corporate valuation:Overview

Step 1:

Step 2:

Step 3:

Forecast future amounts of the financial attribute that ultimatelydetermines how much a company is worth.

Determine the risk or uncertainty associated with the forecastedfuture amounts.

Determine the discounted present value of the expected futureamounts using a discount rate that reflects the risk from Step 2.

There are three steps involved in valuing a company:

• Free cash flows• Accounting earnings• Balance sheet book values

Corporate valuation:Discounted free cash flow approach

This approach says the value per share (P0) of a company’s common stock is given by:

• CFt is the future free cash flow (per share) available to common equity holders at period t.

• r is the discount rate appropriate for the risk and uncertainty of the forecasted free cash flows.

• is the discount factor for forecasted cash flows in period t.

• E0 is investors’ expectations (at time 0) about future free cash flows.

tr )1(1

Corporate valuation:DCF illustration

Estimated DCF value per share

Goodwill impairment and DCF valuation

Corning goes on to say:

• The impairment charge would have been $225 higher if the discount rate was 12.5%.• No impairment charge would have been made if the discount rate was only 11.0%.

Earnings or cash flow?• The traditional approach to stock

valuation relies on forecasted free cash flows.

• Why then do many analysts and investors pay such close attention to accrual earnings?

• According to the FASB, it’s because accrual earnings is more helpful in forecasting a company’s future cash flows (SFAC No. 1).

The role of earnings in valuation• Accrual earnings takes a long-

horizon view that smoothes out the “lumpiness” in year-to-year cash flows.

• Research evidence shows that:

1. Current earnings are a better forecast of future cash flows than are current cash flows.

2. Stock returns correlate better with accrual earnings than with realized operating cash flows.

Linkage between stock price and accrual earnings

The role of earnings in valuation:Zero growth example

• To appreciate the link between earnings and future cash flows, let’s take another look at the free cash flow valuation model:

Current earnings ( ) is assumed to be a good forecast of future free cash flow0X

Price earning ratio (P/E) or earnings multiple

Estimated share price

The zero growth assumption means that expected future earnings, and thus expected future free cash flows, form a perpetuity so that:

or

Earnings and stock prices:Evidence on value relevance

• If investors use accrual earnings to price stocks, then earnings differences across firms should explain differences in stock prices.

• The test:

30.0%

8.18$9.54

2R

XP ii

Stock price

Earnings per share

Stock price at $0 EPS

Earnings multiple (should be statistically positive)

2002 P/E relationship for 40 restaurant companies

Earnings and stock prices:Sources of variation in P/E multiples

• Why doesn’t current earnings explain 100% of the variation in stock price?

• Stock prices (and thus P/E multiples) are also influenced by:

1. Risk2. Growth opportunities3. The mix of earnings components

30.0%

8.18$9.54

2R

XP ii

2002 P/E relationship for 40 restaurant companiesPermanent

Transitory

Valuationirrelevant

Sustained over time

One time event

No future cash flow impact

Earnings and stock prices:Earnings components illustration

• Stock prices reflect information about the components of earnings.

e.g. income from continuing operations

e.g. loss from discontinued operations

e.g. cumulative effect of changes in accounting methods

Earnings and stock prices:Earnings components and P/E

Differences in earnings components mix produces differences in P/E

Earnings and stock prices:Earnings quality

• The notion of earnings quality is multifaceted, and there is no consensus on how best to measure it.

• Most observers agree that earnings are high quality when they are sustainable over time.

• Unsustainable earnings might arise from:– Debt retirement– Corporate restructurings– Temporary reductions in advertising or R&D spending– Certain accounting methods used for routine, on-going transactions– Inherent subjectivity of accounting estimates.

• Research evidence shows that earnings quality matters to investors.

Abnormal earnings• What matters most to investors is:

1. The amount of money they turn over to management.

2. The profit management is able to earn on that money.

• Abnormal earnings is:

CapitalrEarningsAE

What management does

with the moneyExpected

return

What investors entrust to management

b) Management does worse than expected:

$200$150

Capitalr Earnings

- $50 of

abnormal earnings

a) Management does better than expected:

$200$300

Capitalr Earnings

+ $100 of abnormal earnings

Suppose investors contribute $2000 of capital, and expect to earn a 10% rate of return.

Corporate valuation:Abnormal earnings valuation approach

What shareholders have invested in the firm

Expectations operator Cost of equity capital

What management accomplished What shareholders expected

Abnormal earnings:Price premium and discount

[1] $20 $15 $5

$5 premium

Investors willingly pay a premium over BV for companies that earn positive AE

[2] $10 $15 - $5

$5 discount

Firms that earn negative AE sell at discount to BV

Abnormal earnings valuation:Illustration

Abnormal earnings valuation:Illustration

The same answer we got with the DCF approach

Abnormal earnings and ROE• ROE combines information about

earnings and equity book value:

• Companies with ROEs that consistently exceed the industry average have shares that sell for a premium relative to book value.

18.4%2R

ROE=Earnings

Equity book value

Relationship between ROE performance and market-to-book (M/B) ratios for 40 restaurant companies

Regression Result:

M/B = 1.09 + 0.09 ROE

Abnormal earnings approach:Summary

• A company’s future earnings are determined by:

1. the resources (net assets) available to management;

2. the rate of return (profitability) earned on those net assets.

• If a firm can earn a return above its cost of capital, then it will generate positive abnormal earnings.

• Firms that earn less than their cost of capital generate negative abnormal earnings.

• Firms expected to generate positive abnormal earnings sell at a premium to equity book value.

• Those expected to generate negative abnormal earnings sell at a discount to equity book value.

• The abnormal earnings valuation model makes explicit the role of:

1. Income statement and balance sheet information;

2. Cost of capital

Earning surprises:Share price response to earnings information

• Here’s an expression that describes how stock prices change in response to earnings information:

• If GM’s quarterly earnings announcement just confirms investors’ expectations, there is no surprise and no change in expected future earnings, so GM’s share price is also unchanged.

GM’s earnings announcement could inform investors about current or future earnings

Earnings surprises:Typical behavior of stock returns

Stock returns and quarterly earnings “surprises”

Valuing a business opportunity:The BookWorm store

Valuing a business opportunity:Free cash flow approach

What the business is worth

Valuing a business opportunity:Abnormal earnings approach

The same as our previous FCF estimate

Cash flow analysis and credit risk:Traditional lending products

Short-termLoans

Long-termLoans

RevolvingLoans

Public Debt

• Seasonal lines of credit• Special purpose loans (temporary needs)• Secured or unsecured

• Mature in more than 1 year• Purchase fixed assets, another company, refinance debt ,etc.• Often secured

• Like a seasonal credit line• Interest rate usually “floats”

• Bonds, debentures, notes• Sinking fund and call

provisions• Covenants

Credit analysis:Evaluating the borrower’s ability to repay

Understandthe business

Step 1: • Business model and strategy• Key risks and successful

factors• Industry competition

Evaluateaccounting quality

Step 2: • Spot potential distortions• Adjust reported numbers as

needed

Evaluate current profitability and health

Step 3: • Examine ratios and trends• Look for changes in profitability, financial conditions, or industry position.

Prepare “pro forma”cash flow forecasts

Step 4: • Develop financial statement forecasts• Assess financial flexibility

Due diligenceStep 5: • Kick the tires

Comprehensive risk assessment

Step 6: • Likely impact on ability to pay• Assess loss if borrower defaults• Set loan terms

Credit analysis:G.T. Wilson’s credit risk

• A bank client for over 40 years.• Owns 850 retail furniture stores throughout the U.S.• Recent shift in business strategy:

– Higher quality furniture, consumer electronics, and home entertainment systems.

– Credit card system to help customers pay for purchases.– Urban shopping mall locations rather than downtown stores.

• Bank now has a $50 million secured construction loan and a $200 million revolving credit line with Wilson.

• What do the company’s financial statements tell us about its credit risk?

Credit analysis:Interpretation of cash flow components

.

.

. Negative free cash flow

Increased borrowing

Continued dividend payment

Credit analysis:Selected financial statistics

Declining margin

Customers take longer to pay, but reserve is smaller

Larger debt burden

Credit analysis:G.T. Wilson recommendation

• Wilson is a serious credit risk: – Extensive reliance on short-term debt financing.– Inability to generate positive cash flows from

operations.• The company may be forced into bankruptcy unless:

– Other external financing sources can be found.– Operating cash flows can be turned positive.

• Update: Bankruptcy was declared shortly after these financials were released.

Summary• This chapter provides a framework for understanding equity

valuation and credit analysis.

• The framework illustrates how accounting numbers are used in valuation, cash flow analysis, and credit risk assessment.

• You have also seen how financial reports help investors and lenders assess the “amounts, timing, and uncertainty of prospective net cash flows”.

• Knowing what numbers are used, why they are used, and how they are used is crucial to understanding the decision-usefulness of accounting information.

Appendix A:Abnormal earnings valuation

1. Obtain analysts’ EPS forecasts for the next five years.

2. Combine those forecasts with projected dividends to forecast common equity book value over the horizon.

3. Compute yearly abnormal earnings from analysts’ EPS forecasts.

4. Forecast the terminal year abnormal earnings flow.

5. Add the current book value and the present value of forecasted abnormal earnings to arrive at an intrinsic value estimate of the company’s share price.

Appendix A:Krispy Kreme Doughnuts forecasts

Analysts’ growth estimate

Analysts’ EPS forecasts

Another forecast

Appendix A:Krispy Kreme Doughnuts abnormal earnings

Appendix A:Krispy Kreme Doughnuts valuation

Abnormal earnings for 2008Long-term growth rate

Abnormal earnings

$1.54x 1.03

$1.59

Perpetual factor x 12.50

$19.88Discount factor x 0.59345

$11.79

Appendix B:Steps in financial statement forecasting

1. Project sales revenue for each period in the horizon.

2. Forecast operating expenses like COGS (but not depreciation, interest, or taxes) using expense margins.

3. Forecast balance sheet operating assets and liabilities needed to support the projected operations in 1 and 2 using turnover ratios.

4. Forecast depreciation expense and the income tax rate.

5. Forecast financial structure, dividend policy, and interest expense.

6. Derive projected cash flow statements from the forecasted income statements and balance sheets.

Appendix B:Financial statement forecast illustration

Step 1: Project sales revenue

Sales $24,000 $25,200 $27,720 $31,878

$25,200 x 1.10 =

Growth forecast


Step 2 : Forecast operating expensesMargin forecast

Cost of goods sold 15,760 16,380 18,018 20,721

$27,200 x 0.65 =

Forecasted sales


Step 3 : Forecast balance sheet

Accounts receivable 2,120 2,016 2,218 2,550

$27,200 x 0.08 =

Forecasted sales

forecast

operating assets and liabilities


Step 4: Forecast depreciation expenseMargin forecast

Property, plant & equipment( gross) 18,018

1,171

18,018 x 0.065 =

Depreciation expense

From step 3


Step 5: Forecast financial structure, dividend policy and

DebtCurrent portion

Long-term debt

Interest expense

219

1,975

307

14% interest rate

$14,629 x 15% =

2,194

10% of debt

interest expense

Appendix B:Forecasted income statement

Appendix B:Forecasted balance sheet assets

Appendix B:Forecasted balance sheet liabilities & equity

Appendix B:Forecasted cash flow statements

From income statement

From balance sheet change

Forecast

End of the Chapter