Equity Analysis and Valuation

CHAPTER 11
 Analysis Objective
• Analyze earnings persistence, its determinant, and its relevance for
earnings forecasting.
• Explain recasting and adjusting of earnings and earnings components for
analysis.
• Describe equity valuation and its relevance for financial analysis
• Analyze earning power and its usefulness for forecasting and valuation.
• Explain earnings forecasting, its mechanics, and its effectiveness in
assessing company performance.
• Analyze interim reports and consider their value in monitoring and
revising earnings estimates
 Equity Analysis and Valuation

Earnings Persistence: Earnings- Based Valuation Earning Power and

Forecasting
Recasting and adjusting Stock Prices and
Earning Power
Determinants of accounting data
Earning forecasting
persistence Valuation multiples
Monitoring and revising
Measuring persistence  
 Earnings Persistence
• Earnings persistence is broadly defined :
– Stability
– Predictability
– Variability
– Trend
– Earnings management
• Two common methods to help assess earnings persistence:
– Recasting of income statement
– Adjusting of income statement
 Earnings Persistence
Recasting and Adjusting
• Recasting aims to identify element included in current earnings that
should more properly in the operating result of one or more prior
periods
• Recasting and adjusting of earnings requires reliable and relevant
information
 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
• Recasting and adjusting earnings aids in determining the earning
power.
 Earnings Persistence
Recasting and Adjusting
• 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.
– 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.
 Earnings Persistence
Recasting Earnings and Earnings Components
 Earnings Persistence
Recasting Earnings and Earnings Components
 Earnings Persistence
Adjusting Earnings and Earnings Components

• Uses data from recast income statements and other available information to assign
earnings components to the periods in which they most properly belong.
• Specific (Typical) Adjusting Procedures
– Assign extraordinary and unusual items (net of tax) to applicable years
– Tax benefit of operating loss carryforwards 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
 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.
Earnings Persistence
 Earnings Persistence
Determinants of Earnings Persistence

• Earnings persistence determined by many factors including:

– Earnings Management
– Variability
– Earnings trends
– Management Incentives
• Assess earnings persistence over both the business cycle and the long run
• Earnings trends can be assessed by:
– Statistical methods
– Trend statements
• Uses earnings numbers taken from the recasting and adjusting procedures
 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
• 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
 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
 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
• 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
 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
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)

Key Question: Does the potential manipulation of

accounting data influence the accuracy of accounting-
based estimates, or forecasts, of company value?
 Earnings Based Equity Valuation
Fundamental Valuation Multiples

• Price-to-Book (PB) Ratio

Market Value of Equity
Book Value of Equity
• Price-to-Book (PB) expressed in accounting data

Vt   ROCEt 1 k     ROCEt  2 k  BVt 1    ROCEt  3 k  BVt  2 

1      ...
BVt   1  k     1 k  2
BV t    1 k  3
BV t 

Note:
 ROCE and growth in book value increase  PB increases
 Cost (risk) of equity capital increases  PB decreases
 Present value of future abnormal earnings is positive (negative)  PB is greater
(less) than 1.0
 Earnings Based Equity Valuation
Fundamental Valuation Multiples
• Price-to-Earnings (PE) Ratio
Market Value of Equity
Net Income
• PE ratio can be written as a function of short-term (STG) and long-term growth (LTG) of earning
per share (eps) as follows:

Where k is the cost of equity capital, STG (LTG) is the expected short-term (long-term) %
change in eps relative to expected “normal” growth (STG>LTG and LTG>k)
Note:
The PE ratio is inversely related to k
The PE ratio is positively related to the expected growth in eps relative to normal growth.
 Earnings Based Equity Valuation
Fundamental Valuation Multiples

• PEG ratio
• If LTG=0 (long-term growth in eps relative to “normal” growth is
expected to remain constant)

This yields the popular PEG ratio.

Example: If PE=20 and k=10%,
proponents of this screening device
recommend stock purchase (sale) if the
expected eps growth is greater (less)
than 20%.
 Earnings Based Equity Valuation
Illustration of Earnings-Based Valuation

Christy
ChristyCo.
Co.book
bookvalue
valueof
ofequity
equityat
atJanuary
January1,1,Year
Year1,1,isis$50,000
$50,000
Christy
Christyhas
hasaa15%
15%cost
costof
ofequity
equitycapital
capital(k)
(k)
Forecasts of Christy’s accounting data follow:
Forecasts of Christy’s accounting data follow:

Year
Year11 Year
Year22 Year
Year33 Year
Year44 Year
Year55
Sales
Sales $$ 100,000
100,000 $$ 113,000
113,000 $$ 127,690
127,690 $$ 144,290
144,290 $144,290
$144,290
Operating
Operatingexpenses
expenses 77,500
77,500 90,000
90,000 103,500
103,500 118,000
118,000
119,040
119,040
Depreciation
Depreciation 10,000
10,000 11,300
11,300 12,770
12,770 14,430
14,430 14,430
14,430
Net income
Net income $ $ 12,500
12,500 $ $ 11,700
11,700 $$ 11,420
11,420 $$ 11,860
11,860 $$ 10,820
10,820
Dividends
Dividends 6,000
6,000 4,355
4,355 3,120
3,120 11,860
11,860 10,820
10,820
Year
Year66and
andbeyond
beyond==Both
Bothaccounting
accountingdata
dataand
anddividends
dividendsapproximate
approximateYear
Year55levels
levels
 Earnings Based Equity Valuation
Illustration of Earnings-Based Valuation

Christy’s
Christy’s forecasted
forecasted book
book value
value at
at January
January 1,
1, Year
Year 11 isis $58,594—computed
$58,594—computed
as:
as:

This
This implies
implies Christy
Christy stock
stock should
should sell
sell at
at aa PB
PB ratio
ratio of
of 1.17
1.17 ($58,594/$50,000)
($58,594/$50,000)
at
atJanuary
January1,1,Year
Year11
 Earnings Based Equity Valuation
Illustration of Earnings-Based Valuation

• Three additional observations:

– Expected ROCE = 15% (Christy’s cost of capital) for Year 5 and beyond. Since ROCE equals the
cost of capital for Year 5 and beyond, these years’ results do not change the value of Christy
(i.e. abnormal earnings equal zero for those years). Anticipated effects of competition are
implicit in future profitability estimates.
– Since PE ratios are based on both current and future earnings, a PE ratio for Christy as of
January 1, Year 1, cannot be calculated since prior years’ data are unavailable. PE ratio at
January 1, Year 2 is computed as:
 Earnings Based Equity Valuation
Illustration of Earnings-Based Valuation

• Valuation estimates assume dividend payments occur at the end of

each year. A more realistic assumption is that, on average, these cash
outflows occur midway through the year. To adjust valuation
estimates for mid-year discounting, multiply the PV of future
abnormal earnings by (1 + k/2). For Christy Company the adjusted
valuation estimate equals $59,239. This is computed as $50,000 + (1 +
[.15/2]) x $8,594.
 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
• 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
 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.
Earning Power and Forecasting for
Valuation
 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:
 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
 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
• 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
 Earning Power and Forecasting for
Valuation
Interim Reports for Monitoring and Revising Earnings Estimates

• 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