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The Role of Financial

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

E0 is investors expectations (at time 0) about future free cash flows.

is the discount factor for forecasted cash flows in period t.

Corporate valuation:
DCF illustration

Estimated DCF
value per share

Goodwill impairment and DCF


valuation

Corning goes on to say:

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%.

Earnings or cash flow?

The traditional approach to


stock valuation relies on
forecasted free cash flows.

Why then do many analysts


and investors pay such close
attention to accrual
earnings?

According to the FASB, its


because accrual earnings is
more helpful in forecasting a
companys future cash flows
(SFAC No. 1).

The role of earnings in valuation

Linkage between stock price and accrual earnings

Accrual earnings takes a


long-horizon view that
smoothes out the
lumpiness in year-to-year
cash flows.

Research evidence shows


that:
1. Current earnings are a
better forecast of future
cash flows than are current
cash flows.
2. Stock returns correlate
better with accrual earnings
than with realized operating
cash flows.

The role of earnings in valuation:


Zero growth example
To appreciate the link between earnings and future cash flows, lets
take another look at the free cash flow valuation model:

Current earnings ( X 0 ) is assumed to be a good forecast of future free cash flow

The zero growth assumption means that expected future earnings,


and thus expected future free cash flows, form a perpetuity so that:
or

Estimated share price

Price earning ratio (P/E) or


earnings multiple

Earnings and stock


prices:
Evidence on value relevance

If investors use accrual


earnings to price stocks,
then earnings differences
across firms should explain
differences in stock prices.

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)

Earnings and stock


prices:
Sources of variation in P/E multiples

Why doesnt current


earnings explain 100% of the
variation in stock price?

Stock prices (and thus P/E


multiples) are also
influenced by:
1. Risk
2. Growth opportunities
3. The mix of earnings
components
Sustained over time
Permanent
Transitory

One time event

Valuation
irrelevant

No future cash flow impact

Pi $9.54 8.18X i
R 2 30.0%

2002 P/E relationship for 40 restaurant companies

Earnings and stock prices:


Earnings components illustration
Stock prices reflect information about the
components of earnings.
e.g. income from
continuing operations

e.g. loss from


discontinued
operations

e.g. cumulative effect


of changes in
accounting methods

Earnings and stock prices:


Earnings components and P/E

Differences in earnings components mix


produces differences in P/E

Earnings and stock prices:


Earnings quality
The notion of earnings quality is multifaceted, and there is
no consensus on how best to measure it.
Most observers agree that earnings are high quality when
they are sustainable over time.
Unsustainable earnings might arise from:

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.

Research evidence shows that earnings quality matters to


investors.

Abnormal earnings

What matters most to


investors is:

a) Management does better than


expected:

1. The amount of money they

turn over to management.


2. The profit management is
able to earn on that money.

Abnormal earnings is:


AE Earnings r Capital
What
management
does with the
money

Expected
return

+ $100 of
abnormal
earnings
$300
$200
r Capital

Earnings

b) Management does worse than


expected:

What investors
entrust to
management

Suppose investors contribute


$2000 of capital, and expect to
earn a 10% rate of return.

$200
r Capital

- $50 of
abnormal
earnings
$150
Earnings

Corporate valuation:
Abnormal earnings valuation approach

What shareholders have


invested in the firm

Expectations operator

What management
accomplished

Cost of equity capital

What shareholders expected

Abnormal earnings:
Price premium and discount

[1]

$20

$15

$5

$15

- $5

$5 premium

[2]

$10
$5 discount

Investors willingly pay a


premium over BV for
companies that earn
positive AE

Firms that earn negative


AE sell at discount to BV

Abnormal earnings
valuation:
Illustration

Abnormal earnings
valuation:
Illustration

The same answer we got


with the DCF approach

Abnormal earnings and


ROE
ROE combines information
about earnings and equity
book value:
ROE=

Earnings
Equity book value

Companies with ROEs that


consistently exceed the
industry average have
shares that sell for a
premium relative to 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:

Firms expected to generate


Summary
positive abnormal earnings

A companys future earnings


are determined by:

sell at a premium to equity


book value.

1. the resources (net assets)

available to management;
2. the rate of return
(profitability) earned on
those net assets.

If a firm can earn a return


above its cost of capital,
then it will generate positive
abnormal earnings.

Those expected to generate


negative abnormal earnings
sell at a discount to equity
book value.

The abnormal earnings


valuation model makes
explicit the role of:
1. Income statement and

Firms that earn less than


their cost of capital generate
negative abnormal earnings.

balance sheet information;


2. Cost of capital

Earning surprises:
Share price response to earnings information

Heres an expression that describes how stock prices


change in response to earnings information:

GMs earnings announcement


could inform investors about current or future earnings

If GMs quarterly earnings announcement just confirms


investors expectations, there is no surprise and no
change in expected future earnings, so GMs share price is
also unchanged.

Earnings surprises:
Typical behavior of stock returns

Stock returns and quarterly earnings surprises

Valuing a business
opportunity:
The BookWorm store

Valuing a business
opportunity:
Free cash flow approach

What the business


is worth

Valuing a business
opportunity:
Abnormal earnings approach

The same as our previous


FCF estimate

Cash flow analysis and


credit risk:
Traditional lending products
Short-term
Loans

Seasonal lines of credit


Special purpose loans (temporary needs)
Secured or unsecured

Long-term
Loans

Mature in more than 1 year


Purchase fixed assets, another company,
refinance debt ,etc.
Often secured

Revolving
Loans

Like a seasonal credit line


Interest rate usually floats

Public Debt

Bonds, debentures, notes


Sinking fund and call
provisions
Covenants

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

Examine ratios and trends


Look for changes in profitability, financial
conditions, or industry position.

Step 4:

Prepare pro forma


cash flow forecasts

Develop financial statement forecasts


Assess financial flexibility

Due diligence

Kick the tires

Comprehensive risk
assessment

Likely impact on ability to pay


Assess loss if borrower defaults
Set loan terms

Step 5:

Step 6:

Business model and strategy


Key risks and successful
factors
Industry competition
Spot potential distortions
Adjust reported numbers as
needed

Credit analysis:
G.T. Wilsons credit risk

A bank client for over 40 years.


Owns 850 retail furniture stores throughout the U.S.
Recent shift in business strategy:
Higher quality furniture, consumer electronics, and
home entertainment systems.
Credit card system to help customers pay for
purchases.
Urban shopping mall locations rather than downtown
stores.

Bank now has a $50 million secured construction loan


and a $200 million revolving credit line with Wilson.

What do the companys financial statements tell us about


its 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

Wilson is a serious credit risk:


Extensive reliance on short-term debt
financing.
Inability to generate positive cash flows
from operations.
The company may be forced into
bankruptcy unless:
Other external financing sources can be
found.
Operating cash flows can be turned
positive.

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

1. Obtain analysts EPS forecasts for the next


five years.
2. Combine those forecasts with projected
dividends to forecast common equity book
value over the horizon.
3. Compute yearly abnormal earnings from
analysts EPS forecasts.
4. Forecast the terminal year abnormal
earnings flow.
5. Add the current book value and the present
value of forecasted abnormal earnings to
arrive at an intrinsic value estimate of the

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

Abnormal earnings for 2008


$1.54
Long-term growth rate
x 1.03
Abnormal earnings
$1.59
Perpetual factor
Discount factor

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

Cost of goods sold

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

Property, plant & equipment( gross)


Depreciation expense

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

End of the Chapter