Financial

Financial Statement
Statement Analysis
Analysis
and
and Security
Security Valuation
Valuation
Stephen
Stephen H.
H. Penman
Penman

Prepared by
Peter D. Easton and Gregory A. Sommers
Fisher College of Business
The Ohio State University
With contributions by
Stephen H. Penman Columbia University
Luis Palencia University of Navarra, IESE Business School
McGraw-

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14-1

Simple Forecasting and

Simple Valuation
Chapter 14

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What you will learn in this chapter

Chapter 14
Page 455

How simple forecasts can be made from financial

statements
How simple forecasts give simple valuations
When simple forecasts and simple valuations work as
reasonable approximations
How simple forecasting works as a tool in sensitivity
analysis
How simple valuation models work in reverse engineering
How sensitivity analysis is done

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Chapter 14
Page 456

Review: The Perfect Balance Sheet

MS, Inc.
Balance Sheet, December 31, Year 0
Assets

Equities

Marketable equity
securities (at market)

NOA

Year 0

Prior
Year

23.4

20.3

23.4

Year 0

Prior
Year

Long-term debt (NFO)

7.7

7.0

Common shareholders
equity (CSE)

15.7

13.3

23.4

20.3

20.3

With a perfect balance sheet, expected residual

earnings are zero
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Residual Earnings Components

Chapter 13
Page 424
Table 13.1

Net Income Component

Book Value Component

Residual Earnings Component

Operating Income (OI)

Net Operating Assets (NOA)

ReOI=OIt (F 1) NOAt-1

Net Financial Expense (NFE)

Net Financial Obligations (NFO)

ReNFE=NFEt (D 1) NFOt-1

Earnings (earn)

Common Stockholders Equity (CSE)

RE=earnt (E 1) CSEt-1

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Simple Forecasts: Forecasting from

Book Values (SF1)

Chapter 14
Pages 456-457
Table 14.1

Earnings
Component

Forecasts of
Earnings Components

Forecasts of Residual
Earnings Components

Operating

O I1 ( F 1) NOA0

O I1 ( F 1) NOA0 0

Financing

N F E1 ( D 1) NFO0

N F E1 ( D 1) NFO0 0

Comprehensive

e a r n1 ( E 1)CSE0

e a r n1 ( E 1)CSE0 0

MS, Inc.
Pro Forma Income Statement, Year 1
Operating income:
Interest expense:
Net income:
McGraw-

.1134 x 23.4
.10 x 7.7
.12 x 15.7

2.654
(.770)
1.884

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SF1 Valuation

Chapter 14
Page 457

V CSE0
E
0

NOA
0

McGraw-

NOA0

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Review: The Imperfect Balance Sheet

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Chapter 1
Page 459
Exhibit 14.1

14-8

Simple Forecasts: Forecasting from

Earnings and Book Values (SF2)

Chapter 14
Page 458
Table 14.2

Earnings
Component

Forecasts of
Earnings Components

Forecasts of Residual
Earnings Components

Operating

O I1 OI 0 ( F 1)NOA0

O I1 ( F 1) NOA0 OI 0 ( F 1) NOA1

Financing

N F E1 NFE0 ( D 1)NFO0 N F E1 ( D 1) NFO0 NFE0 ( D 1) NFO1

Net

e a r n1 earn0 ( E 1)CSE0 e a r n1 ( E 1)CSE0 earn0 ( E 1)CSE1

PPE, Inc.
Pro Forma Income Statement, Year 1
Operating income:
Interest expense:
Net income:
McGraw-

9.8 + (.1134 x 4.5)

0.7 + (.10 x 0.7)
9.1 + (? x 3.8)

The McGraw-Hill Companies, Inc., 2001 All

10.310
(.770)
9.540
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SF2 Valuation

Chapter 14
Pages 459-460

Re OI 0
V CSE0
F 1
E
0

NOA
0

O I1 F 1 NOA0
NOA0
F 1

O I1 F 1 NOA0
NOA0

F 1
F 1
O I1

F 1
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Chapter 14
Page 461
Box 14.1

SF2 Valuation: Nike

Nike, Inc.
Required return for operations
Core operating income,
Net operating assets
Core residual operating income

1996
1995
1996
1996: 567 (0.110 x 2,208)

11.0%
$567 million
$2,208 million
$2,659 million
$324.1 million

SF2 forecast of operating income

SF2 forecast of ReOI

1997: 567 + (0.110 x 451)

1997

$616.6 million
$324.1 million

Value of common equity

E
V1996
CSE 1996

Re OI 1996
324.1
2,431
0.11
0.11

Value per share on 143.629 million shares

$5,377 million
$37.44

Value of operations
NOA
E
V1996
V1996
NFO1996 5,377 228

NOA
V1996
NOA 1996

NOA
V1996

Re OI 1996
324.1
2,659
0.11
0.11

OI 1997 616.6

0.11
0.11

$5,605 million
$5,605 million
$5,605 million

Nike traded at $104 per share at the end of fiscal year, 1996.

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SF2 Valuation: Reebok

Chapter 14
Page 461
Box 14.1

Reebok International Ltd.

Required return for operations
Core operating income,
Net operating assets
Core residual operating income

1996
1995
1996
1996: 174 (0.101 x 1220)

10.1%
$174 million
$1,220 million
$1,135 million
$50.8 million

SF2 forecast of operating income

SF2 forecast of ReOI

1997: 174 + (0.101 x[- 85])

1997

$165.4 million
$50.8 million

Value of common equity

E
V1996
before minority interest MI CSE 1996 MI 1996

415

Re OI 1966
0.101

50.8
0.101

Value of minority interest (at 14 times 1996 MI earnings)

Value of common equity
Value per share on 55.840 million shares

$918 million
$210 million
$708 million
$12.68

Value of operations
NOA
E
V1996
V1996
before MI NFO1996 918 720

NOA
V1996
NOA 1996

NOA
V1996

Re OI 1996
50.8
1,135
0.101
0.101

OI 1997
165.4

0.101
0.101

$1,638 million
$1,638 million
$1,638 million

Reebok traded at $43 per share at the end of fiscal year, 1996.

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Simple Forecasts: Forecasting from Current

Accounting rates of Return (SF3)
Earnings
Component
Operating

Financing

Forecasts of
Earnings Components

O I1 RNOA0 NOA0

Chapter 14
Pages 462-463
Table 14.3

Forecasts of Residual
Earnings Components

R NO A (
1

NB C (

N F E1 NBC0 NFO0

1) NOA0 RNOA0 ( F 1) NOA0

1) NFO0 NBC0 ( D 1) NFO0

e a r n1 ROCE0 CSE0 R O C E1 ( E 1) CSE0 ROCE0 ( E 1)CSE0

Net

For PPE, Inc. the current RNOA, NBC and ROCE (with beginning of year
amounts in the denominator) are 14.02%, 10.00% and 14.47% respectively

PPE, Inc.
Pro Forma Income Statement, Year 1
Operating income:
Interest expense:
Earnings:
McGraw-

.1402 x 74.4
.10 x 7.7
? x 66.7

10.431
.770
9.661

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SF3 Forecasting:
An Adjustment for Leverage

Chapter 14
Page 463

NFO0 end
Adjusted ROCE 0 RNOA0
RNOA0 NBC 0
CSE 0 end

For PPE, Inc.,

7.7
Adjusted ROCE0 .1402
.1402 .10 .1448
66.7

earn1 .1448 66.7 9.661

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Valuation with Constant RNOA

Chapter 14
Pages 463-464

[ RNOA1 F 1 ]NOA0
Growth Rate in ReOI1
[ RNOA0 F 1 ] NOA1

If RNOA1 = RNOA0
Growth Rate in ReOI1

NOA 0
NOA 1

If RNOA is constant for all periods,

V CSE0
E
0

RNOA0 F 1 NOA0

V0NOA NOA0

F g NOA

RNOA0 F 1 NOA0
F g NOA

RNOA0 g NOA 1
NOA0
F g NOA
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Chapter 14
Page 466
Box 14.2

SF3 Valuation: Nike

Nike, Inc.
Cost of capital for operations
Core RNOA, 1996 (on average NOA)
Forecasted growth rate for net operating assets
Net operating assets
1996
SF3 forecast of operating income 1997: 2,659 x 23.3%
SF3 forecast of ReOI
1997

11%
23.3%
7%
$2,659 million
$619.5 million
$327.1 million

Value of common equity

E
V1996
CSE 1996

Re OI 1997
327.1
2,431
1.11 1.07
0.04

Value per share on 143.629 million shares

$10,607 million
$73.85

Value of operations
NOA
E
V1996
V1996
NFO1996 10,607 228

NOA
V1996
NOA1996

RNOA1996 0.11 NOA1996

1.11 1.07
0.233 0.11 g 1
2,659
0.04

NOA
V1996
NOA1996

$10,835 million

RNOA1996 g 1

1.11 1.07
0.233 0.07
2,659
0.04

McGraw-

$10,835 million

$10,835 million

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Chapter 14
Page 466
Box 14.2

SF3 Valuation: Reebok

Reebok International Ltd.
Required return for operations
Core RNOA, 1996 (on average NOA)
Forecasted growth rate for net operating assets
Net operating assets
1996
SF3 forecast of operating income 1997: 1,135 x 14.8%
SF3 forecast of ReOI
1997

10.1%
14.8%
7.0%
$1,135 million
$168.0 million
$53.4 million

Value of common equity

E
V1996
before minority interest MI CSE1996 MI1996

R e O I1996
1.101 1.07

Value of minority interest (at 14 times 1996 MI earnings)

Value per share on 55.840 million shares

$2,136 million
210 million
$1,926 million
$34.49

Value of operations
NOA
E
V1996
V1996
before MI NFO1996 2,136 720

NOA
V1996
1,135

NOA
V1996
1,135

McGraw-

0.148 0.101 1,135

0.031

0.148 0.07
0.031

$2,856 million
$2,856 million
$2,856 million

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Chapter 14
Page 465
Table 14.4

Simple Forecasts and Simple Valuations

V0E CSE0

V0NOA NOA0

Re OI 0
V CSE0
F 1

V0NOA NOA0

E
0

V0E CSE0

RNOA0 F 1 NOA0
F g NOA

Re OI 0
F 1

OI 1
F 1

V0NOA NOA0

RNOA0 F 1 NOA0
F g NOA

RNOA0 g NOA 1
NOA0
F g NOA

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Simple Valuation: PPE, Inc.

SF1:

V 66.7

SF2:

1.873
V 66.7
83.22
.1134

SF3:

E
0

E
0

NOA

1.0644

1.994
V 66.7
107.39
1.1134 1.0644
E
0

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Chapter 14
Page 467

Simple Forecasts of
Growth in NOA
1
NOA Sales
ATO

If ATO is constant,
Growth in NOA Growth in Sales

1
ATO

Forecast growth in NOA with forecasted

sales growth rate

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ROCE
Group

Price-to-Book
Ratios &
ROCE 1968-85

Chapter 14
Page 469
Table 14.5
McGraw-

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

ROCE
(%)

P/B

43.3
28.7
23.8
21.0
19.1
17.7
16.5
15.4
14.4
13.5
12.6
11.7
10.6
9.5
8.3
6.8
4.9
2.2
-3.2
-22.5

3.43
2.57
2.20
1.89
1.65
1.45
1.36
1.25
1.16
1.10
1.06
1.00
.97
.91
.84
.80
.78
.75
.74
1.01

Based on all NYSE, AMEX and NASDAQ firms. The grouping is done each
year; the numbers reported are averages from the analysis for all years.

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Unlevered P/B on RNOA

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Chapter 14
Page 470
Figure 14.1

14-22

Chapter 14
Page 471
Figure 14.2(a)

Residual Operating Income

Patterns: 1965-96

0.25

0.2

Residual Operating Income (ReOI)

0.15

0.1

0.05

-0.05

-0.1

-0.15

-0.2

-0.25

I
0

I
1

I
2

I
3

I
4

I
5

Year Relative To Current Year

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Chapter 14
Page 471
Figure 14.2(b)

Return on Net Operating Assets

Patterns: 1965-96

40%

Return on Net Operating Assets (RNOA)

35%
30%
25%
20%
15%
10%
5%
0
-5%
-10%

I
0

I
1

I
2

I
3

I
4

I
5

Year Relative To Current Year

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Growth in Net Operating Assets

Patterns: 1965-96

Chapter 14
Page 471
Figure 14.2(c)

60%

50%

Growth in Net Operating Assets

40%

30%

20%

10%

-10%

-20%

I
0

I
1

I
2

I
3

I
4

I
5

Year Relative To Current Year

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Simple Forecasting as an Analytical

Device: Sensitivity Analysis

Chapter 14
Page 473

As If Questions
Effect of changes in RNOA on forecasts and
values
Effect of changes in PM and ATO
Effect of changes in investment (growth in
NOA)
Effect of leverage on forecasts of net income

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Chapter 14
Page 474

The Valuation Grid: Nike

What values are implied by different combinations of
RNOA and growth in NOA?
Valuation Grid for Nike, Inc., 1996
Required return for operations: 11%
RNOA

15%

20%

23.3%

25%

0%

23.66

32.07

37.63

40.49

4%

27.50

40.73

49.46

53.95

7%

35.44

58.58

73.85

81.72

8.39%

45.30

80.76

116.23

9%

53.95

110.23

104.00
104.00
000
130.78

Growth
In NOA

McGraw-

146.52

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Market Forecast Pairs: Nike

Chapter 14
Page 474

What combination of RNOA and growth in NOA justify the market price?
Market Forecast Pairs
Nike, Inc., 1996
Price = $104
__________________________________
RNOA
Growth in NOA
__________________________________
15%
10.15%
16
9.94
17
9.72
18
9.51
19
9.30
20
9.09
21
8.87
22
8.66
23
8.45
24
8.24
25
8.02
26
7.81
27
7.60
28
7.39
29
7.17
30
6.96

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