11-1

Equity Analysis and Valuation

11
CHAPTER
 11-2

Earnings Persistence
• Earnings persistence is a continuity and durability of
the current earnings.
• It’s a key to effective equity analysis and valuation.
• Analyzing earnings persistence is a main analysis
objective.
• Attributes of earnings persistence include:
– Stability
– Predictability
– Variability
– Trend
– Earnings management Analyze
– Accounting methods
 11-3

Earnings Persistence
Recasting and Adjusting
• Two common methods to help assess earnings
persistence:
– Recasting of income statement
– Adjusting of income statement
• Recasting and adjusting earnings
aids in determining the earning power.
 11-4

Earnings Persistence
Recasting and Adjusting
• Information for Recasting and Adjusting
– Income statement, including its subdivisions:
• Income from continuing operations
• Income from discontinued operations
• Extraordinary gains and losses
• Cumulative effect of changes in accounting principles
– Other financial statements and notes
– Management’s Discussion and Analysis
– Others: product-mix changes, technological innovations, work
stoppages, and raw material constraints
 11-5

Earnings Persistence
Recasting Earnings and Earnings Components
• Aims at rearranging earnings components to provide a
meaningful classification and relevant format for analysis.
– Components can be rearranged, subdivided, or tax effected, but
the total must reconcile to net income of each period.
– Discretionary expenses, components like equity in income (loss)
of unconsolidated subsidiaries or affiliates should be segregated.
– Components reported pretax must be removed along with their
tax effects if reclassified apart from income from continuing
operations.
 11-6

Earnings Persistence
Recasting Earnings and Earnings Components
– Income tax disclosures enable one to separate
factors that either reduce or increase taxes such as:
• Deductions—tax credits, capital gains rates, tax-free income,
lower foreign tax rates
• Additions—additional foreign taxes, nontax-deductible
expenses, and state and local taxes (net of federal tax
benefit)
– Immaterial items can be considered in a lump sum
labeled other.
 11-7

Earnings Persistence
Adjusting Earnings and Earnings Components
• “Adjusting” aims to assign earnings components
to the periods in which they best belong.
• Uses data from recast income statements and
other available information.
 11-8

Earnings Persistence
Adjusting Earnings and Earnings Components
• Specific (Typical) Adjusting Procedures
– Assign extraordinary and unusual items (net of tax) to applicable
years.
– Tax benefit of operating loss carry forwards normally moved to
the loss year.
– Costs or benefits from lawsuit settlements moved to relevant
prior years.
– Gains and losses from disposals of discontinued operations can
relate to one or more prior years.
– Changes in accounting principles or estimates yield adjustments
to all years under analysis to a comparable basis—redistribute
“cumulative effect” to the relevant prior years.
– Normally include items that increase or decrease equity.
 11-9

Earnings Persistence
Adjusting Earnings and Earnings Components
• Specific (Typical) Adjusting Procedures
– If a component should be excluded from the period it is
reported:
• Shift it (net of tax) to the operating results of one or more prior
periods or
• Spread (average) it over earnings for the period under analysis.
– Spread the component over prior periods’ earnings only
when it cannot be identified with a specific period.
– While spreading helps in determining earning power, it is
not helpful in determining earnings trends.
– Moving gains/ losses to other periods does not remedy the
misstatements of prior years’ results.
 11-10

Earnings Persistence
Determinants of Earnings Persistence

• Earnings persistence determined by many factors

including:
– Earnings trends
– Variability
– Earnings Management
– Management Incentives

• Note: assess earnings persistence

over both the business cycle and the long run.
 11-11

Earnings Persistence
Determinants of Earnings Persistence

• Earnings trends can be assessed by:

– Statistical methods
– Trend statements
• Uses earnings numbers taken from the recasting
and adjusting procedures
 11-12

Earnings Persistence
Determinants of Earnings Persistence

• Earnings management
– Changes in accounting methods or assumptions
– Offsetting extraordinary or unusual gains and losses
– Big baths
– Write-downs
– Timing revenue and
expense recognition
 11-13

Earnings Persistence
Determinants of Earnings Persistence

• Management incentives affecting persistence

include:
– Personal objectives and interests
– Companies in distress
– Prosperous companies—preserving hard-earned
reputations
– Compensation plans
– Accounting-based incentives and constraints
– Analysts’ targets
 11-14

Earnings Persistence
Persistent and Transitory Items in Earnings
• Recasting and adjusting earnings for equity valuation
rely on separating stable, persistent earnings
components from random, transitory components.
– Assessing persistence is important in determining earning
power.
– Earnings forecasting also relies on persistence.
• A crucial part is to assess the persistence of the gain and
loss components of earnings.
 11-15

Earnings Persistence
Analyzing and Interpreting Transitory Items
• Purpose of analyzing and interpreting extraordinary
items:
– Determine whether an item is transitory.
• Assessing whether an item is unusual, nonoperating, or
nonrecurring.
– Determine adjustments that are necessary given
assessment of persistence.
 11-16

Earnings Persistence
Analyzing and Interpreting Transitory Items

• Determining persistence
(transitory nature) of items:
– Nonrecurring operating gains and losses
• Usually included in current operating income
– Nonrecurring non-operating gains and losses
• Omitted from operating earnings of a single year
• Part of the long-term performance of a company
 11-17

Earnings Persistence
Analyzing and Interpreting Transitory Items
• Adjustments to Extraordinary Items Reflecting
Persistence:
– Effects of transitory items on company resources.
• Effects of recorded transitory items and the likelihood of future
events causing transitory items.
– Effect of transitory items on evaluation of management.
 11-18

Earnings Based Equity Valuation

Relation between Stock Prices and Accounting Data

• Equity value (Vt)

• Book value (BVt)
• Residual Income, RIt = (NIt – k * BVt-1)
• Cost of equity capital (k)
 11-19

Fundamental Valuation Multiples

• Price-to-Book (PB) Ratio

Market Value of Equity
Book Value of Equity

• Price-to-Earnings (PE) Ratio

Market Value of Equity

Net Income
 11-20

Earning Power and Forecasting for Valuation

Earning Power
• Earning power is the earnings level expected to persist
into the foreseeable future.
– Accounting-based valuation models capitalize earning power.
– Many financial analyses directed at determining earning power.
• Measurement of Earning Power reflects:
– Earnings and all its components
– Stability and persistence of earnings
and its components
– Sustainable trends in earnings and its
components
 11-21

Earning Power and Forecasting for Valuation

Earning Power
• Factors in selecting a time horizon for measuring earning
power:
– One-year is often too short to reliably measure earning power.
– Many investing and financing activities are long term.
– Better to measure earning power by using average (or cumulative)
earnings over several years.
– An extended period is less subject to distortions, irregularities, and
other transitory effects.
– Preferred time horizon in measuring earning
power is typically 4 to 7 years.
 11-22

Earning Power and Forecasting for Valuation

Earning Power
• Adjusting Earnings per Share
– Earning power is measured using all earnings components.
– The issue is to what year we assign these items when computing
earning power.

Our earnings analysis might be limited to a short time

horizon. We adjust short time series of earnings for
items that better relate to other periods. If this is done
on a per share basis, every item must be adjusted for
its tax effect using the company’s effective tax rate
unless the applicable tax rate is specified. All items
must also be divided by the number of shares used in
computing EPS.
 11-23

Earning Power and Forecasting for Valuation

Earnings Forecasting
• Done by analyzing earnings components and considering all
available information, both quantitative and qualitative.
– Forecasting benefits from disaggregation.
– Disaggregation involves using data by product lines or segments
• Especially useful when segments differ by risk, profitability, or growth.
– Difference between forecasting and extrapolation.
Divisional earnings for TechCom, Inc., reveal how different divisional
performance can be masked by aggregate results:
 11-24

Earning Power and Forecasting for Valuation

Earnings Forecasting
• Elements Impacting Earnings Forecasts
– Current and past evidence
– Forecast’s reasonableness.
– Continuity and momentum of company performance
– Industry prospects
– Company's financial condition
– Management
• Management quality—resourcefulness
• Asset management—operating skills
– Economic and competitive factors
– Key Indicators such as capital expenditures, order backlogs,
and demand trends
 11-25

Earning Power and Forecasting for Valuation

Interim Reports for Monitoring and Revising Earnings Estimates

• Limitations in interim reporting related to difficulties in

assigning earnings components to periods of under one
year in length:
– Period-end accounting adjustments
– Seasonality in business activities
– Integral reporting method
– SEC interim reporting requirements
– Analysis implications of interim Reports
 11-26

Earning Power and Forecasting for Valuation

Interim Reports for Monitoring and Revising Earnings Estimates

• Available Interim Reports
– Quarterly reports (Form 10-Q)
– Reports on current developments (Form 8-K)
– Disclosure of separate fourth-quarter results
– Details of year-end adjustments
• Interim reports filed with the SEC such as:
– Comparative interim and year-to-date income statement
– Comparative balance sheets
– Year-to-date statement of cash flows
– Pro forma information on business combinations
– Disclosure of accounting changes
– Management’s narrative analysis of operating results
– Reports of a change in auditor