THE ROLE OF FINANCIAL INFORMATION IN VALUATION, CASH FLOW ANALYSIS, AND CREDIT RISK ASSESSMENT

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CHAPTER 6
FINANCIAL REPORTING ANALYSIS BY REVSINE
COLLINS JOHNSON 2nd Edition

• THE ROLE OF FINANCIAL INFORMATION IN
  VALUATION,CASH FLOW ANALYSIS, AND CREDIT RISK
  ASSESSMENT

Adopted from Slides Authored by Brian Leventhal
University of Illinois at Chicago
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I. Corporate Valuation 

• A. Corporate valuation involves estimating the
  worth or the intrinsic value of a
• - company,
• - one of its operating units
• ownership shares.

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I. Corporate Valuation 

• B. Equity investors, lenders, and analysts often
  use fundamental analysis to estimate the value of
  a company.
• This valuation approach uses basic accounting
  measures or fundamentals to assess the
  amount, timing, and uncertainty of a firms
  future operating cash flows or
  earnings.

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I. Corporate Valuation 

• 1.Fundamental analysis is the focus
  of this chapter.

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I. Corporate Valuation 

• 2. Valuation involves three basic steps
• a. Forecasting future values of some financial
  attributes
  
• -distributable or free cash flows,
  -accounting earnings,
  -balance sheet book
  values

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I. Corporate Valuation 

• 2. Valuation involves three basic steps
• b. Determining the risk
  or uncertainty
  associated with the
  attributes forecasted
  future value.

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I. Corporate Valuation 
2. Valuation involves three basic steps

• c. Determining the discounted present value of
  the expected future values of the value-relevant
  attribute,
• where the discount rate reflects the risk or
  uncertainty inherent in the value attribute of
  interest.

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I. Corporate Valuation 

• 3. Cash flow assessment is critical to credit
  risk analysis
• since estimates of future cash flows can be
  compared to debt-service requirements.

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I. Corporate Valuation 

• C. Technical analysis, on the other
  hand, focuses on business cycles
  and the
  past price record
  of a firm.

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II. The Discounted Free Cash Flow
Approach

• A. The distributableor freecash flow valuation
  model combines the elements in the
  three steps listed above to express current stock
  price as the
• Discounted present value
  of expected
  future distributable
  cash flows.

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II. The Discounted Free Cash Flow
Approach

• B. Free cash flow

Operating Cash Flows (before interest) -
Cash outlays for replacement of Operating
Capacity (PPE) FREE CASH FLOW
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II. The Discounted Free Cash Flow
Approach
B. Free cash flow
Operating Cash Flows (before interest) -
Cash outlays for replacement of Operating
Capacity (PPE) FREE CASH FLOW

• 1. It is the amount available to finance planned
  expansion of operating capacity, to reduce debt,
  to pay dividends, or to
  repurchase stock.

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II. The Discounted Free Cash Flow
Approach
B. Free cash flow
Operating Cash Flows (before interest) -
Cash outlays for replacement of Operating
Capacity (PPE) FREE CASH FLOW

• 2. This is an appropriate measure for valuing the
  company as a whole and without regard to its
  capital structure.

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II. The Discounted Free Cash Flow
Approach

• C. Free cash flow available to common
  shareholders
• is an appropriate measure for valuing just the
  companys common stock.

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II. The Discounted Free Cash Flow
Approach

• C. Free cash flow available to
• common shareholders

• Operating Cash Flows (before interest)
• - Cash outlays for replacement of Operating
  Capacity (PPE)
• FREE CASH FLOW
• - Cash Interest Payments
• - Debt Repayments
• - Preferred Dividends
• Free cash flow available to
  common shareholders

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II. The Discounted Free Cash Flow
Approach
C. Free cash flow available to common
shareholders
Price of Stock
Expected free cash flow Each period
Discount factor each period
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II. The Discounted Free Cash Flow
Approach
C. Free cash flow available to common
shareholders
Expected free cash flow In each year set equal to
the free cash flow realized in year 0
Eq. 6.2
Discount factor each period
Simplifying assumptions may include
Zero Growth perpetuities
(for mature firms)
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II. The Discounted Free Cash Flow
Approach
C. Free cash flow available to common
shareholders
Expected free cash flow Each period
Discount factor each period
The discount rate is adjusted to reflect the
uncertainty or riskiness of the cash flow stream.
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II. The Discounted Free Cash Flow
Approach
C. Free cash flow available to common
shareholders
Equation says that todays market value of each
common share depends on investors current
expectations about the future economic prospects
of the firm as measured be free cash flows.
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II. The Discounted Free Cash Flow
Approach
D. The role of earnings in valuation
1. If investors are interested in a companys
future cash flows, what role does earnings have
in valuation?

• The role of accounting earnings information is
  indirect
• Accounting Earnings are only useful because they
  help generate improved forecast of future cash
  flows!

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II. The Discounted Free Cash Flow
Approach
D. The role of earnings in valuation
1. If investors are interested in a companys
future cash flows, what role does earnings have
in valuation?

1. The FASB asserts the current accounting earnings
   provide a better measure of long-run
   expected operating performance than do current
   cash flows.

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II. The Discounted Free Cash Flow
Approach
D. The role of earnings in valuation
1. If investors are interested in a companys
future cash flows, what role does earnings have
in valuation?

• Recall the Canterbury Publishing Ex.
• Cash Flows are Lumpy, but accrual accounting
  earnings measurement takes a long-horizon
  perspective that smoothes out the lumpiness in
  year-to-year cash flows.

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II. The Discounted Free Cash Flow
Approach
D. The role of earnings in valuation
1. If investors are interested in a companys
future cash flows, what role does earnings have
in valuation?

• Research finds that current accounting earnings
  are a better predictor of future cash flows than
  are current cash flows!
• Stock returns correlate better with accrual
  accounting earnings than with realized operating
  cash flows.

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II. The Discounted Free Cash Flow
Approach

• 2. Through the use of accruals and deferrals,
  accrual accounting produces an earnings number
  that smoothes out the unevenness or lumpiness
  in year-to-year cash flows,
• and it provides an estimate of sustainable
  annualized long-run future free cash flows.

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III. Sources of Variation in P/E Multiples

• A. Risk Differences

• 1. Firms with the same level
  of current and future earnings can
  sell for different prices
  because of differences in
  risk or uncertainty associated
  with those earnings.

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III. Sources of Variation in P/E Multiples
A. Risk Differences

• 2. Riskier firms have higher discount rates that
  lead to lower prices.

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III. Sources of Variation in P/E Multiples

• B. Growth opportunities

• 1. The market values of a firms growth
  opportunities
• is the possibility of earnings from reinvesting
  current earnings in projects that will earn a
  rate of return in excess of the cost of equity
  capital (i.e., the
  discount rate).

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III. Sources of Variation in P/E Multiples
B. Growth opportunities

• 2. The net present value of growth opportunities
  (NPVGO) from the reinvestment of current earnings
  adds a positive increment to a firms
  average P/E
  multiples.

Present value of earnings from assets in place
NPV of future growth opportunities
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III. Sources of Variation in P/E Multiples
B. Growth opportunities

• 4. The growth rate in earnings depends on
• a. The portion of earnings reinvested each
  period, called the retention ratio.
• b. The rate of return on new investment.

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III. Sources of Variation in P/E Multiples

• C. Permanent, transitory, and valuation-irrelevant
  components of earnings

Equation 6.7
Pi a ? (Xi) ei
End of Period Stock Price
1. If investors view firms current earnings
levels to persist in perpetuity, then the slope
coefficient (?) in equation (6.7) should equal
the average earnings multiple . (P0/X0)
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III. Sources of Variation in P/E Multiples
C. Permanent, transitory, and valuation-irrelevant
components of earnings
Equation 6.7
Pi a ? (Xi) ei
End of Period Stock Price

• 2. For many firms, the earnings multiple falls
  well below this theoretical value,
• In part, because of distinctly different earnings
  components, each subject to different earnings
  capitalization rates.

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III. Sources of Variation in P/E Multiples
Equation 6.7
Pi a ? (Xi) ei
End of Period Stock Price

• 2. For many firms, the earnings multiple falls
  well below this theoretical value.

a. A permanent earnings component is value
relevant and expected to persist into the future.
i. In theory, the multiple for permanent earnings
component should approach 1/r.
ii. Income from continuing operations (exclusive
of special or nonrecurring items) is a recurring,
sustainable component of a companys profit
performance.
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III. Sources of Variation in P/E Multiples
Equation 6.7
Pi a ? (Xi) ei
End of Period Stock Price
2. For many firms, the earnings multiple falls
well below this theoretical value.
b. A transitory earnings component is
value-relevant, but is not expected to persist
into the future.
i. The multiple for transitory earnings component
should approach 1.0.
ii. Income (loss) from discontinued operations
and extraordinary gains and losses are
nonrecurring items that are viewed as transitory
components of earnings.
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III. Sources of Variation in P/E Multiples
Equation 6.7
Pi a ? (Xi) ei
End of Period Stock Price
2. For many firms, the earnings multiple falls
well below this theoretical value.
c. A value-irrelevant is unrelated to future free
cash flows and is not relevant to assessing
current share price.
i. Such value-irrelevant earnings components
should carry a multiple of zero.
ii. A change in accounting principles, which
gives rise to a cumulative effect adjustment to
income has no future cash flow consequences and
is viewed as value-irrelevant.
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III. Sources of Variation in P/E Multiples
Equation 6.7
Pi a ? (Xi) ei
End of Period Stock Price
C. Permanent, transitory, and valuation-irrelevant
components of earnings
3. The capital market does not react naively to
earnings, but instead, it appears to distinguish
among permanent, transitory, and value-irrelevant
earnings components.
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III. Sources of Variation in P/E Multiples

• D. The concept of earnings quality

1. Quality of earnings measures how much the
profits companies publicly report diverge from
their true operating earnings.
a. Low quality means the bottom line is padded
with paper gains.
b. A decline in quality means companies reported
earnings are less sustainable than they appear.
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III. Sources of Variation in P/E Multiples
D. The concept of earnings quality

• 2. Earnings quality is multifaceted and there is
  no consensus on how to measure it.

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III. Sources of Variation in P/E Multiples
D. The concept of earnings quality

• 3. Earnings are considered to be high quality
  when they are sustainable.

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III. Sources of Variation in P/E Multiples
D. The concept of earnings quality

• 3. Earnings are considered to be high quality
  when they are sustainable.

• Sustainable earnings are generated from
• repeat customers,
• high quality product that enjoys steady customer
  demand based on brand name identity, etc.

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III. Sources of Variation in P/E Multiples
D. The concept of earnings quality

• 3. Earnings are considered to be high quality
  when they are sustainable.

• Unsustainable earnings derive from
• gains and losses from debt retirement,
• write-offs of assets from corporate restructuring
  and plant closings,
• reduction in discretionary expenditures for
  advertising and research and development, etc.

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III. Sources of Variation in P/E Multiples
D. The concept of earnings quality

• 4. Earnings quality is also affected by the
• accounting methods chosen by management to
  describe routine, ongoing activities of a company
  
• and by the subjectivity of accounting
  estimates.  

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IV. The Abnormal Earnings Approach

• A. Earnings and equity book value numbers are
  direct inputs into the valuation process.

• This new approach is based the value of a company
  and its share price is driven not by the level of
  earnings themselves ..
• 
  but by the level of
  earnings relative to a fundamental economic
  benchmark the cost of
  capital,expressed
  in dollars.

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IV. The Abnormal Earnings Approach

• A. Earnings and equity book value numbers are
  direct inputs into the valuation process.

2. This benchmark reflects the level of earnings
that investors demand from a company as
compensation for the risks of the investment.
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IV. The Abnormal Earnings Approach
Expected future Abnormal Earnings
BV of equity at time 0
P0 BV0 S E0 (Abnormal Earnings)
t-1 (1 r ) t
Eq.6.11
Share Price at Time 0
Discount factors for each future period

• 3. This shows that share price is a function of
  the book value of equity plus capitalized
  expected future abnormal earnings.

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IV. The Abnormal Earnings Approach
Eq.6.11
Required Earnings
Actual Earnings
Abnormal Earnings X t (r x BV t-1)
Eq.6.12

• a. Investors pay a premium for firms that earn
  more than the cost of capitalmeaning the firms
  produce positive abnormal earnings.

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IV. The Abnormal Earnings Approach
Eq.6.11
Required Earnings
Actual Earnings
Abnormal Earnings X t (r x BV t-1)
Eq.6.12

• b. Firms whose earnings are ordinary or
  normal, where the earnings rate is equal to
  the cost of capitalinvestors are willing to pay
  an amount equal to the underlying book value of
  equity.

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IV. The Abnormal Earnings Approach
Eq.6.11
Required Earnings
Actual Earnings
Abnormal Earnings X t (r x BV t-1)
Eq.6.12

• c. Firms that earn less than the cost of
  capitalthey produce negative abnormal earnings
  have a share price below book value.

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IV. The Abnormal Earnings Approach
Eq.6.11
Required Earnings
Actual Earnings
Abnormal Earnings X t (r x BV t-1)
Eq.6.12

• d. Abnormal earnings represents any difference
  between actual earnings for the period and
  stockholders required return on invested capital
  at the beginning of the period.
  (i.e., the cost of beginning equity
  capital).

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IV. The Abnormal Earnings Approach
Eq.6.11
Eq.6.12
Abnormal Earnings X t (r x BV t-1)

• 4. Financial statements and related footnotes
  provide a wealth of information for assessing the
  relationships expressed above.

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IV. The Abnormal Earnings Approach
Eq.6.11
Eq.6.12
Abnormal Earnings X t (r x BV t-1)

• a. The balance sheet provides detailed
  information on the book value of equity
  (assets minus liabilities).

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IV. The Abnormal Earnings Approach
Eq.6.11
Eq.6.12
Abnormal Earnings X t (r x BV t-1)

• b. The income statement provides detailed
  information for assessing a firms earnings.

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IV. The Abnormal Earnings Approach
Eq.6.11
Eq.6.12
Abnormal Earnings X t (r x BV t-1)

• c. In making comparisons across firms, the
  analyst must be careful to gauge the quality and
  comparability of the accounting policies or
  methods used.
• Much of the information needed for assessing the
  quality and value-relevance of a companys
  reported accounting numbers appears in
  footnotes.