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Information in Valuation,
Cash Flow Analysis, and
Credit Risk Assessment
Learning objectives
1.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 valuationirrelevant 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 companys financial statements.
Corporate valuation:
Overview
There are
three steps
in of
valuing
a company:
Forecast
futureinvolved
amounts
the financial
attribute that
ultimately
Step 1: determines how much a company is worth.
Determine the risk or uncertainty associated with the
Step 2:
forecasted
future amounts.
Step 3: Determine the discounted present value of the expected
future
amounts using a discount rate that reflects the risk from
Free cash flows
Step 2.
Accounting earnings
Balance sheet book values
Corporate valuation:
Discounted free cash flow approach
This approach says the value per share (P0) of a companys
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.
1
(1 r ) t
Corporate valuation:
DCF illustration
Estimated DCF
value per share
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%.
The test:
Stock
price
Pi $9.54 8.18X i
R 2 30.0%
Earnings
per share
2002 P/E relationship for 40 restaurant companies
Stock
price at
$0 EPS
Earnings multiple
(should be statistically
positive)
Valuation
irrelevant
Pi $9.54 8.18X i
R 2 30.0%
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.
Abnormal earnings
Expected
return
+ $100 of
abnormal
earnings
$300
$200
r Capital
Earnings
What investors
entrust to
management
$200
r Capital
- $50 of
abnormal
earnings
$150
Earnings
Corporate valuation:
Abnormal earnings valuation approach
Expectations operator
What management
accomplished
Abnormal earnings:
Price premium and discount
[1]
$20
$15
$5
$15
- $5
$5 premium
[2]
$10
$5 discount
Abnormal earnings
valuation:
Illustration
Abnormal earnings
valuation:
Illustration
Earnings
Equity book value
Relationship between ROE performance and marketto-book (M/B) ratios for 40 restaurant companies
Regression Result:
M/B = 1.09 + 0.09 ROE
R 2 18.4%
Abnormal earnings
approach:
available to management;
2. the rate of return
(profitability) earned on
those net assets.
Earning surprises:
Share price response to earnings information
Earnings surprises:
Typical behavior of stock returns
Valuing a business
opportunity:
The BookWorm store
Valuing a business
opportunity:
Free cash flow approach
Valuing a business
opportunity:
Abnormal earnings approach
Long-term
Loans
Revolving
Loans
Public Debt
Credit analysis:
Evaluating the borrowers ability to repay
Step 1:
Understand
the business
Step 2:
Evaluate
accounting quality
Step 3:
Evaluate current
profitability and health
Step 4:
Due diligence
Comprehensive risk
assessment
Step 5:
Step 6:
Credit analysis:
G.T. Wilsons 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
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
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
x 12.50
$19.88
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
Appendix B:
Financial statement forecast illustration
Step 1: Project sales revenue
Sales
$24,000
Growth forecast
$25,200
$25,200 x 1.10 =
$27,720
$31,878
Appendix B:
Financial statement forecast illustration
Step 2 : Forecast operating expenses
Margin forecast
15,760
16,380
$27,200 x 0.65 =
Forecasted
sales
18,018
20,721
Appendix B:
Financial statement forecast illustration
Step 3 : Forecast balance sheet
operating assets and liabilities
forecast
Accounts receivable
2,120
2,016
2,218
$27,200 x 0.08 =
Forecasted sales
2,550
Appendix B:
Financial statement forecast illustration
Step 4: Forecast depreciation expense
Margin forecast
18,018
1,171
18,018 x 0.065 =
From step 3
Appendix B:
Financial statement forecast illustration
Step 5: Forecast financial structure, dividend policy and
interest expense
Debt
2,194
Current portion
Long-term debt
Interest expense
219
1,975
14%
interest rate
307
$14,629 x 15% =
10% of debt
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