Financial Statement Analysis and Security Valuation Stephen H. Penman

McGraw-Hill/Irwin

© The McGraw-Hill Companies, Inc., 2001 All rights reserved.

14-1

Financial Statement Analysisand Security Valuation

Stephen H. Penman

Financial Statement Analysisand Security Valuation

Stephen H. Penman

Prepared by

Peter D. Easton and Gregory A. SommersFisher College of Business

The Ohio State University

With contributions by

Stephen H. Penman – Columbia University

Luis Palencia – University of Navarra, IESE Business School

McGraw-Hill/Irwin


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Simple Forecasting andSimple Valuation

Chapter 14

McGraw-Hill/Irwin


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What you will learn in this chapter

• How simple forecasts can be made from financial statements

• How simple forecasts give simple valuations

• When simple forecasts and simple valuations work as reasonable approximations

• How simple forecasting works as a tool in sensitivity analysis

• How simple valuation models work in reverse engineering

• How sensitivity analysis is done

Chapter 14 Page 455

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Review: The Perfect Balance Sheet

Chapter 14 Page 456

MS, Inc.Balance Sheet, December 31, Year 0

Assets EquitiesPrior Prior

Year 0 Year Year 0 YearMarketable equity securities (at market) 23.4 20.3 Long-term debt (NFO) 7.7 7.0

Common shareholders’ equity (CSE) 15.7 13.3

NOA 23.4 20.3 23.4 20.3

With a perfect balance sheet, expected residual earnings are zero

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Residual Earnings Components

Net Income Component Book Value Component Residual Earnings Component

Operating Income (OI) Net Financial Expense (NFE)

Net Operating Assets (NOA) Net Financial Obligations (NFO)

ReOI=OIt – (F – 1) NOAt-1

ReNFE=NFEt – (D – 1) NFOt-1

Earnings (earn) Common Stockholders’ Equity (CSE) RE=earnt – (E – 1) CSEt-1

Chapter 13 Page 424

Table 13.1

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Simple Forecasts: Forecasting from Book Values (SF1)

Chapter 14 Pages 456-457

Table 14.1

MS, Inc. Pro Forma Income Statement, Year 1

Operating income: .1134 x 23.4 2.654Interest expense: .10 x 7.7 (.770)Net income: .12 x 15.7 1.884

EarningsComponent

Forecasts ofEarnings Components

Forecasts of Residual Earnings Components

Operating

Financing

Comprehensive

01 )1( NOAIO F

01 )1( NFOEFN D

01 )1( CSEnrae E 0)1( 01 CSEnrae E

0)1( 01 NFOEFN D

0)1( 01 NOAIO F

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SF1 ValuationChapter 14

Page 457

00 NOAV NOA

00 CSEV E

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Review: The Imperfect Balance Sheet

Chapter 1 Page 459

Exhibit 14.1

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

Chapter 14 Page 458

Table 14.2

EarningsComponent



Operating

Financing

Net

PPE, Inc.Pro Forma Income Statement, Year 1

Operating income: 9.8 + (.1134 x 4.5) 10.310Interest expense: 0.7 + (.10 x 0.7) (.770)

Net income: 9.1 + (? x 3.8) 9.540

001 )1( NOAOIIO F

001 )1( NFONFEEFN D

001 )1( CSEearnnrae E 1001 )1()1( CSEearnCSEnrae EE

1001 )1()1( NFONFENFOEFN DD

1001 )1()1( NOAOINOAIO FF

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SF2 ValuationChapter 14

Pages 459-460

1

1

1

1

1

1

1

010

0100

F

F

F

F

F

FNOA

IO

NOAIONOA

NOAIONOAV

1

Re 000

F

E OICSEV

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SF2 Valuation: NikeChapter 14

Page 461Box 14.1

Nike, Inc.

Required return for operations 11.0%Core operating income, – 1996 $567 millionNet operating assets 1995 $2,208 million

1996 $2,659 millionCore residual operating income – 1996: 567 (0.110 x 2,208) $324.1 million

SF2 forecast of operating income – 1997: 567 + (0.110 x 451) $616.6 millionSF2 forecast of ReOI – 1997 $324.1 million

Value of common equity

$5,377 million

Value per share on 143.629 million shares $37.44

Value of operations

$5,605 million

$5,605 million

$5,605 million

Nike traded at $104 per share at the end of fiscal year, 1996.

11.0

1.324431,2

11.0

OIReCSEV 1996

1996E

1996

228377,5NFOVV 1996E

1996NOA

1996

11.0

1.324659,2

11.0

OIReNOAV 1996

1996NOA

1996

11.0

6.616

11.0

OIV

1997NOA1996

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Reebok International Ltd.

Required return for operations 10.1%Core operating income, – 1996 $174 millionNet operating assets 1995 $1,220 million

1996 $1,135 millionCore residual operating income – 1996: 174 (0.101 x 1220) $50.8 million

SF2 forecast of operating income – 1997: 174 + (0.101 x[- 85]) $165.4 millionSF2 forecast of ReOI – 1997 $50.8 million


$918 million Value of minority interest (at 14 times 1996 MI earnings) $210 million Value of common equity $708 million Value per share on 55.840 million shares $12.68

Value of operations

$1,638 million

$1,638 million

$1,638 million

Reebok traded at $43 per share at the end of fiscal year, 1996.

SF2 Valuation: ReebokChapter 14

Page 461Box 14.1

101.0

8.50415

101.0

OIReMICSEMIinterest minority beforeV 1966

19961996E

1996

720918199619961996 NFOMIbeforeVV ENOA

101.0

8.50135,1

101.0

OIReNOAV 1996

1996NOA

1996

101.0

4.165

101.0

OIV

1997NOA1996

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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 14.47% respectively

Chapter 14 Pages 462-463

Table 14.3

EarningsComponent



Operating

Financing

Net

001 NOARNOAIO

001 NFONBCEFN

001 CSEROCEnrae 0001 )1()1( CSEROCECSEECOR EE

0001 )1()1( NFONBCNFOCBN DD

0001 )1()1( NOARNOANOAAONR FF

PPE, Inc.Pro Forma Income Statement, Year 1

Operating income: .1402 x 74.4 10.431Interest expense: .10 x 7.7 .770Earnings: ? x 66.7 9.661

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SF3 Forecasting:An Adjustment for Leverage

For PPE, Inc.,

00

0

000 endCSE

end NBCRNOA

NFORNOAROCEAdjusted

1448.10.1402.66.7

7.71402. 0

ROCEAdjusted

661.97.661448.1 earn

Chapter 14Page 463

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If RNOA is constant for all periods,

Valuation with Constant RNOA

If RNOA1 = RNOA0

10

011

]1[

]1[ReOI

NOARNOA

NOARNOAinRateGrowth

F

F

1

01

NOANOA

ReOI in Rate Growth

NOA

F

FE

gρ

NOAρRNOACSEV

0000

1

NOA

F

NOA

NOAF

FNOA

g

gRNOANOA

g

NOARNOANOAV

1

1

00

0000

Chapter 14Pages 463-464

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SF3 Valuation: NikeChapter 14

Page 466Box 14.2

Nike, Inc.

Cost of capital for operations 11%Core RNOA, 1996 (on average NOA) 23.3%Forecasted growth rate for net operating assets 7%Net operating assets 1996 $2,659 million

SF3 forecast of operating income 1997: 2,659 x 23.3% $619.5 millionSF3 forecast of ReOI 1997 $327.1 million


$10,607 million Value per share on 143.629 million shares $73.85

Value of operations

$10,835 million

$10,835 million

$10,835 million

04.0

1.327431,2

07.111.1

OIReCSEV

1997

1996E

1996

228607,10NFOVV 1996E

1996NOA

1996

04.0

111.0233.0659,2

07.111.1

NOA11.0RNOANOAV 19961996

19961996

g

NOA

04.0

07.0233.0659,2

07.111.1

1RNOANOAV 1996

1996NOA

1996

g

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Reebok International Ltd.

Required return for operations 10.1%Core RNOA, 1996 (on average NOA) 14.8%Forecasted growth rate for net operating assets 7.0%Net operating assets 1996 $1,135 millionSF3 forecast of operating income 1997: 1,135 x 14.8% $168.0 millionSF3 forecast of ReOI 1997 $53.4 million


$2,136 million

Value of minority interest (at 14 times 1996 MI earnings) 210 million$1,926 million

Value per share on 55.840 million shares $34.49

Value of operations

$2,856 million

$2,856 million

$2,856 million

SF3 Valuation: ReebokChapter 14

Page 466Box 14.2

720136,2NFOMIbeforeVV 1996E

1996NOA

1996

031.0

135,1101.0148.0135,1VNOA

1996

031.0

07.0148.0135,1VNOA

1996

07.1101.1

IOeRMICSEMIinterest minority beforeV 1996

19961996E

1996

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Simple Forecasts and Simple Valuations

00 CSEV E

1

Re 000

F

E OICSEV

NOA

F

FE

g

NOARNOACSEV

0000

1

00 NOAV NOA

1

1

Re

1

000

F

F

NOA

OI

OINOAV

NOA

F

NOA

NOAF

FNOA

g

gRNOANOA

g

NOARNOANOAV

1

1

00

0000

Chapter 14 Page 465

Table 14.4

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Simple Valuation: PPE, Inc.

SF2:

7.660 EV

22.831134.

873.17.660 EV

39.1070644.11134.1

994.17.660

EV

0644.1NOAgSF3:

SF1:

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Simple Forecasts ofGrowth in NOA

If ATO is constant,

Forecast growth in NOA with forecasted sales growth rate

NOA SalesATO

1

Growth in NOA Growth in SalesATO

1

Chapter 14 Page 467

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Price-to-Book Ratios &

ROCE 1968-85

Chapter 14 Page 469

Table 14.5

ROCE ROCE P/BGroup (%)

1 43.3 3.43 2 28.7 2.57 3 23.8 2.20 4 21.0 1.89 5 19.1 1.65 6 17.7 1.45 7 16.5 1.36 8 15.4 1.25 9 14.4 1.16 10 13.5 1.10 11 12.6 1.06 12 11.7 1.00 13 10.6 .97 14 9.5 .91 15 8.3 .84 16 6.8 .80 17 4.9 .78 18 2.2 .75 19 -3.2 .74 20 -22.5 1.01Based on all NYSE, AMEX and NASDAQ firms. The grouping is done each

year; the numbers reported are averages from the analysis for all years.

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Unlevered P/B on RNOAChapter 14

Page 470Figure 14.1

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Residual Operating Income Patterns: 1965-96

-0.25

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

0 1 2 3 4 5

Year Relative To Current Year

Res

idua

l Ope

ratin

g In

com

e (R

eOI)

I I I I I I

Chapter 14 Page 471

Figure 14.2(a)

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Return on Net Operating Assets Patterns: 1965-96

Chapter 14 Page 471

Figure 14.2(b)

-10%

-5%

0

5%

10%

15%

20%

25%

30%

35%

40%

0 1 2 3 4 5


I I I I I I

Ret

urn

on N

et O

pera

ting

Ass

ets

(RN

OA

)

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Growth in Net Operating Assets Patterns: 1965-96

Chapter 14 Page 471

Figure 14.2(c)

-20%

-10%

0

10%

20%

30%

40%

50%

60%

0 1 2 3 4 5


I I I I I I

Gro

wth

in N

et

Op

era

ting

Ass

ets

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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

Chapter 14 Page 473

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The Valuation Grid: Nike

What values are implied by different combinations of RNOA and growth in NOA?

Valuation Grid for Nike, Inc., 1996 Required return for operations: 11%

RNOA Growth In NOA

15%

20%

23.3%

25%

0%

4%

7%

8.39%

9%

23.66

27.50

35.44

45.30

53.95

32.07

40.73

58.58

80.76

110.23

37.63

49.46

73.85

104.00

130.78

40.49

53.95

81.72

116.23

146.52

104.00000

Chapter 14 Page 474

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Market Forecast Pairs: Nike

Market Forecast PairsNike, 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

What combination of RNOA and growth in NOA justify the market price?

Chapter 14 Page 474

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Financial Statement Analysis and Security Valuation Stephen H. Penman