Business & Finance Case Study: Comparing Companies Assignment
Serenity3203
Chapter7-TheRoleofFinancialInformationinValuationandCreditRiskAssessment.pptxThe Role of Financial Information in Valuation and Credit Risk Assessment
Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 7
© 2021 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill.
© McGraw Hill
1
Learning Objectives After studying this chapter, you will understand:
The basic steps in business valuation using free cash flows and abnormal earnings.
Why current earnings are considered more useful than current cash flows for assessing future cash flows.
The expanding use of fair value measurements in financial statements.
What factors contribute to variation in price-earnings multiples.
The notion of earnings quality and what factors influence the quality of earnings.
How stock returns relate to “good news” and “bad news” about earnings surprises.
The importance of credit risk assessment in lending decisions, and how credit ratings are determined.
How to forecast a company’s financial statements.
7-‹#›
© McGraw Hill
Business Valuation
There are three steps involved in valuing a company:
Step 1: Forecast future amounts of some financial attribute that ultimately determines how much a company is worth.
Step 2: Determine the risk or uncertainty associated with the forecasted future amounts.
Step 3: Determine the discounted present value of the expected future amounts using a discount rate that reflects the risk or uncertainty from Step 2.
Financial attribute:
Free cash flows.
Accounting earnings.
Balance sheet book values.
7-‹#›
© McGraw Hill
Free Cash Flow Model
This model calculates today’s estimate of the combined value (Vo) of a company’s stock and debt as follows:
CFt is the future free cash flow (per share) available to common equity holders at period t.
r is the discount rate (referred to as the weighted-average cost of capital), which is adjusted to reflect the uncertainty or riskiness of the expected cash flow stream.
is the discount factor for forecasted cash flows in period t.
E0 is investors’ current assessment (at time = 0) of the company’s future business activities.
7-‹#›
© McGraw Hill
Illustration of Discounted Free Cash Flow Approach to Valuation 1
Judy Choi is thinking about starting a truck rental business. She plans to buy four trucks now (the beginning of 20X1) and to add a fifth truck at the end of 20X2. Each truck will cost $20,000. Judy has carefully evaluated the local market for rental trucks and believes that each truck will generate $5,000 of net operating cash flows each year. At the end of 20X5, she believes the trucks can be sold for $30,000 in total. How much is the business worth?
EXHIBIT 7.1 Illustration of the Discounted Free Cash Flow Approach to Valuation
Step 1: Forecast expected future free cash flows
| 20X1 | 20X2 | 20X3 | 20X4 | 20X5 | |
| Net cash flows from operations | $20,000 | $20,000 | $25,000 | $25,000 | $25,000 |
| Cash flow from selling all trucks | 30,000 | ||||
| Capital expenditure at the end of 20X2 | (20,000) | ||||
| Future free cash flows | 20,000 | 0 | 25,000 | 25,000 | 55,000 |
7-‹#›
© McGraw Hill
Illustration of Discounted Free Cash Flow Approach to Valuation 2
Step 2: Determine the discount rate (10%)
Step 3: Determine the discounted present value of future free cash flows
| 20X1 | 20X2 | 20X3 | 20X4 | 20X5 | |
| Future free cash flows | 20,000 | 0 | 25,000 | 25,000 | 55,000 |
| × Present value factor | 0.90909 | 0.82645 | 0.75131 | 0.68301 | 0.62092 |
| Present values | $ 18,182 | $ 0 | $18,783 | $ 17,075 | $ 34,151 |
| Total present value of future free cash flows | $88,191 |
| Cost to launch business | (80,000) |
| Net present value of business opportunity | $ 8,191 |
7-‹#›
© McGraw Hill
Simplification of Business Valuation Model: Zero Growth Perpetuity
To apply the discounted free cash flow valuation model represented in equation 7.1 to a going concern, we need to estimate free cash flows for every future period forever.
In practice, some simplifying assumptions are made to facilitate the valuation process.
For a mature firm with a stable cash flow pattern, we can assume the current level of free cash flows (FCF0) will continue unchanged forever—a zero-growth perpetuity.
This means the expected free cash flows in each future period will equal the known current period cash flow so that equation becomes:
7-‹#›
© McGraw Hill
Simplification of Business Valuation Model: Constant Perpetuity
The present value of the same dollar cash flow each period over an infinite horizon—called a constant perpetuity—simplifies the business valuation model to:
(7.3)
Assume a company is currently generating an annual free cash flow of $5 million that is expected to continue indefinitely and the weighted-average cost of capital is 10%.
The estimate of intrinsic value is $5 million / 0.10 = $50 million.
7-‹#›
© McGraw Hill
Simplification of Business Valuation Model: Flows to Equity Model
Under the flows to equity model, the forecasted cash flow stream to be discounted is after subtracting flows to debtholders and preferred shareholders.
The flows to equity valuation model can be written using CF instead of FCF and the cost of equity rather than the weighted-average cost of capital.
If the expected flows to equity constitute a perpetuity, the value of equity (EQ0) simplifies to a form similar to:
(7.4)
7-‹#›
© McGraw Hill
The Role of Earnings in Valuation
If investors are interested in knowing a company’s future cash flows, why do they care about current earnings?
Figure 7.1 LINKAGE BETWEEN STOCK PRICE AND ACCRUAL EARNINGS
Current earnings provide a better measure of long-run expected operating performance than do current cash flows.
Empirical research shows:
Current earnings are a better forecast of future cash flows than are current cash flows.
Stock returns correlate better with accrual earnings than with realized operating cash flows.
7-‹#›
© McGraw Hill
Abnormal Earnings Approach to Valuation
Investors willingly pay a premium only for those firms that earn more than the cost of capital—meaning firms that produce positive abnormal earnings.
For firms whose earnings are “ordinary” or “normal,” investors are willing to pay only an amount equal to the underlying book value of net assets.
Firms that earn less than the cost of capital—that is, that produce negative abnormal earnings—sell at a discount to book value.
This relationship among share prices, book value, and abnormal earnings performance is expressed as:
7-‹#›
© McGraw Hill
Abnormal Earnings Approach to Valuation Example
Suppose investors contribute $2,000 of capital expecting a 10% rate of return.
a) Management does better than expected:
b) Management does worse than expected:
7-‹#›
© McGraw Hill
Corporate valuation: Abnormal earnings valuation approach
Access the text alternative for slide images.
© McGraw Hill
Abnormal Earnings: Price Premium and Discount
7-‹#›
© McGraw Hill
Abnormal Earnings Valuation Illustration: Background Information
Recall:
Judy Choi is thinking about starting a truck rental business. She plans to buy four trucks now (the beginning of 20X1) and to add a fifth truck at the end of 20X2. Each truck will cost $20,000. Judy has carefully evaluated the local market for rental trucks and believes that each truck will generate $5,000 of net operating cash flows each year. At the end of 20X5, she believes the trucks can be sold for $30,000 in total. How much is the business worth?
Additional information:
Choi will finance the business entirely with equity by putting $80,000 cash into the business.
The company will pay out all excess cash as dividends each year. The cash needed to buy the last truck in 20X2 will come from operating cash flows that year. No new investment will be required.
Truck depreciation is $3,043.48 per truck per year, which results in the trucks having a book value of $30,000, the expected salvage value, at the end of 20X5.
7-‹#›
© McGraw Hill
Abnormal Earnings Valuation Illustration: Step 1
Step 1 shows the computations of forecasted net income, dividends paid (assuming no net change in cash), and book value of equity.
EXHIBIT 7.2 Illustration of the Abnormal Earnings Approach to Valuation
Step 1: Forecast earnings and equity book value
Notes
Equity book value:
Increases by net income for the year.
Decreases when dividends are paid to shareholders.
Choi’s company does not pay a dividend in Year 2 because the entire $20,000 of operating cash flows generated that year is needed to buy the fifth truck.
Access the text alternative for slide images.
7-‹#›
© McGraw Hill
Abnormal Earnings Valuation Illustration: Steps 2 and 3
Step 2: Forecast future abnormal earnings
Step 2: Each year the beginning book value of equity is multiplied by the 10% rate of return required by investors to arrive at required or “normal” earnings.
Step 3: Determine the present value of expected future abnormal earnings
Step 3: The present value of expected future abnormal earnings over the life of the business is calculated.
This is the same estimate (within rounding) that was developed using the free cash flow approach
7-‹#›
© McGraw Hill
Abnormal Earnings Approach to Valuation: Recap
A company’s future earnings are determined by the:
Resources (net assets) available to management
Rate of return (profitability) earned on those net assets
If a firm can earn a return above its cost of capital:
It will generate positive abnormal earnings
Its stock will sell at a premium relative to book value.
If a firm earns a return on assets below its cost of capital:
It will generate negative abnormal earnings
Its stock will sell at a discount relative to book value.
A key feature of this valuation approach is that it explicitly takes into account a cost for the capital (net assets) provided by the owners of the business.
Value is added only if the earnings generated from those net assets exceed the equity cost of capital benchmark.
7-‹#›
© McGraw Hill
Fair Value Accounting
For decades, GAAP balance sheet carrying amounts were based primarily on historical cost––what had been paid for a particular asset.
Over the last 25 years, more and more fair value measurements have been introduced.
In 2006, the FASB issued SFAS No. 157, “Fair Value Measurements,” to increase consistency and comparability in the way fair values are determined for financial reporting purposes.
ASC Topic 820 defines fair value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
This means that, for accounting purposes, fair value is an exit price, not an entry price.
7-‹#›
© McGraw Hill
GAAP Hierarchy of Approaches to Be Used in Measuring Fair Values
GAAP provides a hierarchy of approaches to be used in measuring fair values that has three levels of fair value estimates.
Firms must use the highest level estimate possible when determining a fair value.
| Level 1 Estimate | Uses quoted prices from active markets for identical assets or liabilities to determine fair value. |
| Level 2 Estimate | Uses observable inputs other than Level 1 quoted prices. |
| Level 3 Estimate | Uses a valuation model, together with unobservable inputs such as management’s estimates of expected future cash flows or abnormal earnings. |
Firms must disclose at each reporting date:
The hierarchy level at which the fair values were determined.
Transfers between levels.
A reconciliation of beginning Level 3 inputs to ending inputs.
The amount of unrealized fair value gains or losses that are included in earnings for the period, among other related disclosures.
7-‹#›
© McGraw Hill
Global Vantage Point
In 2011, the International Accounting Standards Board (IASB) and FASB concluded a joint convergence project on fair value measurement and disclosure.
The aim was to ensure that U.S. GAAP and IFRS reflect a shared view about fundamental principles such as what fair value means and how best to measure it.
The IASB issued IFRS 13 “Fair Value Measurement.”
It fundamentally agrees with U.S. GAAP on the definition of fair value as an exit price, the three-level measurement hierarchy, and most disclosure requirements.
As part of the convergence project, FASB revised ASC 820-10 to bring U.S. fair value disclosure rules more in line with IFRS.
7-‹#›
© McGraw Hill
Research on Earnings and Equity Valuation
If investors view accounting earnings as an important piece of information for assessing firm value, then earnings differences across firms should help explain differences in firms’ stock prices.
Dots that are above the regression line denote firms that seem to be “overvalued” by investors—P/E is too high—whereas seemingly “undervalued” firms fall below the line.
Figure 7.3 STOCK PRICE AND ACTUAL EPS FOR 48 RESTAURANT COMPANIES
7-‹#›
© McGraw Hill
Y/E Stock Prices and Analysts’ Forecasts of Next Year’s EPS
Can professional stock analysts use expected future earnings (rather than current earnings) to predict year-end stock prices?
Figure 7.4 STOCK PRICE AND FORECASTED EPS FOR 43 RESTAURANT COMPANIES
Although using expected future earnings do not explain all of the variation in
share price, it explains 74.4% (the regression
) of that variation.
Historical earnings only explained 61.7% of the variation (shown on the previous slide).
7-‹#›
© McGraw Hill
Sources of Variation in P/E Multiples
Stock prices (and thus P/E multiples) are influenced by:
Risk differences
Growth opportunities
Components of earnings:
Permanent
Expected to persist into the future and, so, valuation relevant.
Transitory
Valuation relevant but is not expected to persist into the future.
Value Irrelevant (Noise)
Unrelated to future free cash flows or future earnings; not pertinent to assessing current share price.
7-‹#›
© McGraw Hill
Earnings and stock prices: Earnings components and P/E
EXHIBIT 7.3 Applying P/E Multiples to Earnings Components
| Firm A | Firm B | |
| EPS as reported | $10 | $10 |
| Analyst’s EPS decomposition: | ||
| Permanent component | 60% of $10 = $6 | 50% of $10 = $5 |
| Transitory component | 30% of $10 = $3 | 20% of $10 = $2 |
| Value-irrelevant component | 10% of $10 = $1 | 30% of $10 = $3 |
| Earnings multiple applied to each earnings component at cost of capital of r = 10% | ||
| Permanent component | 10 × $6 = $60 | 10 × $5 = $50 |
| Transitory component | 1 × $3 = $3 | 1 × $2 = $2 |
| Value-irrelevant component | 0 × $1 = $0 | 0 × $3 = $0 |
| Implied share price | $63 | $52 |
| Implied total earnings multiple (share price/EPS as reported) | 6.3 | 5.2 |
Differences in earnings components mix produces differences in P/E
7-‹#›
© McGraw Hill
The Concept of Earnings Quality
Investors recognize differences in the quality of reported earnings numbers and consider these differences when assessing the implications of earnings reports for share prices.
Earnings are considered to be high quality when they are sustainable.
Earnings that are generated from repeat customers and from high-quality products that enjoy steady consumer demand would be considered high quality.
Earnings that result from cutting back on discretionary expenditures are considered to be unsustainable.
These expenditures are critical to creating future demand for the firm’s products, creating new products, and developing competent management.
Examples:
Gains or losses from debt retirement.
Asset write-offs from corporate restructuring and plant closings.
Profit increases traceable to temporary reductions in discretionary expenditures for advertising, research and development, or employee training.
7-‹#›
© McGraw Hill
Earnings Surprises
Figure 7.5 STOCK RETURNS AND QUARTERLY EARNINGS “SURPRISES”
Reported earnings are viewed as a good news earnings surprise because they exceed market expectations.
Reported earnings contain no news because they correspond to market expectations.
Reported earnings are viewed as a bad news earnings surprise because they fall below market expectations.
7-‹#›
© McGraw Hill
Credit Risk Assessment: 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; 2 to 5 years most common.
Used to finance purchase of fixed assets, the acquisition of another company, refinancing existing long-term debt, or permanent working capital needs.
Frequently secured.
Revolving Loans
Variation on a seasonal credit line.
Interest rate usually changes (or “floats”).
Commercial Paper
Short-term notes sold directly to investors.
Usually mature in 270 days or less.
Interest rate is fixed.
Public Debt
Bonds, debentures, notes.
Sinking fund and call provisions.
Covenants.
7-‹#›
© McGraw Hill
Credit Analysis: Evaluating the Borrower’s Ability to Repay Loan
Step 1:
Understand the business and industry
Business model and strategy.
Key risks and success factors.
Industry competition.
Step 2:
Evaluate quality of earnings
Spot potential distortions.
Adjust reported numbers as needed.
Step 3:
Evaluate profit performance and balance sheet strength
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.
Step 5:
Perform due diligence evaluation
“Kick the tires.”
Step 6:
Perform comprehensive risk assessment
Likely impact on ability to pay.
Assess loss if borrower defaults.
Set loan terms.
7-‹#›
© McGraw Hill
Credit Rating Agencies
Investors’ beliefs about borrower credit risk influence the price paid – and thus the amount borrowed
The riskier the borrower
The less investors are willing to pay for the security
The higher the credit rating
The lower the default risk
Credit independent agencies assess and grade the creditworthiness of entities that sell debt to investors.
Credit ratings are letter-based grades (for example, A A A) that express the rating agency’s opinion about:
Default risk or the borrower’s capacity.
Willingness to meet its financial commitments on time and in accordance with the terms of the debt security.
7-‹#›
© McGraw Hill
Credit Ratings Process
The ratings process involves more than just a detailed examination of financial statements, notes, and ratios.
Each rating agency has teams of analysts who grill corporate executives about operating and financial plans, management policies, risk tolerance, and the firm’s competitiveness within the industry.
They also conduct a thorough review of business fundamentals.
Credit risk can be adversely affected:
By organizational considerations can also adversely affect credit risk.
When firms are deemed to be aggressive in their application of accounting standards.
When their financial statements lack transparency to business fundamentals.
7-‹#›
© McGraw Hill
Standard & Poor’s Credit Ratings
EXHIBIT 7.4 Standard & Poor’s Credit Ratings
Note: Historical default rates are 15-year cumulative default rates by issuers rated by Standard & Poor's during 19 81-2014 based on the rating they were initially assigned.
Source: McGraw-Hill Financial. "Investor Fact Book 2015."
7-‹#›
© McGraw Hill
Financial Ratios and Debt Ratings 1
Credit analysts use financial ratios to measure:
Profitability (return on capital).
The extent to which operating earnings exceed interest costs (EBIT interest coverage and EBITDA interest coverage).
Financial structure (Total debt/ Capital).
Cash flow capacity (Funds from operations/Total debt, Free operating cash flow/ Total debt, and Total debt/EBITDA).
Each ratio’s median value for U.S. corporate borrowers in each rating level is used for comparison.
7-‹#›
© McGraw Hill
Financial Ratios and Debt Ratings 2
EXHIBIT 7.5 Standard & Poor’s Key Financial Ratios and Ratings of Corporate Debt
Three-Year Medians
| AAA | AA | A | BBB | BB | B | CCC | |
| EBIT interest coverage | 23.8 | 13.6 | 6.9 | 4.2 | 2.3 | 0.9 | 0.4 |
| EBITDA interest coverage | 25.3 | 17.1 | 9.4 | 5.9 | 3.1 | 1.6 | 0.9 |
| FFO/Total debt (%) | 167.8 | 77.5 | 43.2 | 34.6 | 20.0 | 10.1 | 2.9 |
| Free operating cash flow/Total debt (%) | 104.1 | 41.1 | 25.4 | 16.9 | 7.9 | 2.6 | (0.9) |
| Total debt/EBITDA | 0.2 | 1.1 | 1.7 | 2.4 | 3.8 | 5.6 | 7.4 |
| Return on capital (%) | 35.1 | 26.9 | 16.8 | 13.4 | 10.3 | 6.7 | 2.3 |
| Total debt/Capital (%) | 6.2 | 34.8 | 39.8 | 45.6 | 57.2 | 74.2 | 101.2 |
7-‹#›
© McGraw Hill
Summary
The objective of financial reporting is to provide information to existing and potential investors and creditors. This chapter provides a framework for understanding how financial reporting meets this important objective.
We show how accounting numbers are used in business valuation and credit risk assessment, and then illustrate in Appendix A what it means to assess the amounts, timing, and uncertainty of prospective net cash inflows of a business.
A critical part of understanding the decision-usefulness of accounting information is understanding which accounting numbers are used, why they are used, and how they are used when making investment and credit decisions.
Knowing how earnings, book values, and cash flows are used in investment and credit decisions will help you to evaluate alternative accounting measures—not only those recognized directly in the financial statements but also those disclosed in the financial statement notes.
7-‹#›
© McGraw Hill
Appendix A: Discounted Cash Flow and Abnormal Earnings Valuation Applications
The appendix illustrates how the discounted free cash flow and abnormal earnings valuation methods are used to value a business opportunity and to determine the value of a company’s common stock.
Background information:
Allen Ford rejected the idea of opening his own independent coffee shop.
He considered affiliating with a national or regional company.
After investigating several possibilities, he settled on By the Cup, an expanding regional chain of franchised coffee shops.
The appendix then illustrates how to determine the value of the company’s common stock.
7-‹#›
© McGraw Hill
Appendix A: Valuation of Expected Future Free Cash Flows
EXHIBIT 7.6 By the Cup Franchise
Valuation of Expected Future Free Cash Flows
7-‹#›
© McGraw Hill
Appendix A: Valuation of Expected Abnormal Earnings
EXHIBIT 7.7 By the Cup Franchise
Valuation of Expected Abnormal Earnings
7-‹#›
© McGraw Hill
Appendix A: The Kroger Co. Illustration 1
The five steps to deriving a share price estimate using analysts’ earnings forecasts and the abnormal earnings valuation model are:
Obtain analysts EPS forecasts for some finite horizon.
Combine the EPS forecasts with projected dividends to forecast common equity book value over the horizon.
Compute yearly abnormal earnings by subtracting normal earnings from analysts’ EPS forecasts.
Forecast the perpetual abnormal earnings flow that will occur beyond the explicit forecast horizon.
Add the current book value and the present value of the two abnormal earnings components to obtain an intrinsic value estimate of the company’s share price.
7-‹#›
© McGraw Hill
Appendix A: The Kroger Co. Illustration 2
EXHIBIT 7.8 The Kroger Co.
7-‹#›
© McGraw Hill
Appendix A: The Kroger Co., concluded
EXHIBIT 7.8 The Kroger Co.
7-‹#›
© McGraw Hill
Appendix B: Financial Statement Forecasts
This appendix illustrates the construction of comprehensive financial statement forecasts.
The approach uses information about the company’s complete operating, investing, and financing activities to yield a forecast of each individual financial statement item.
7-‹#›
© McGraw Hill
Appendix B: Steps for Preparing Comprehensive Financial Statement Forecasts
Preparing comprehensive financial statement forecasts involves six steps:
Forecast sales revenue for each period in the forecast horizon.
Forecast operating expenses
Forecast the level of balance sheet operating assets and liabilities needed to support the projected operations in Steps 1 and 2.
Forecast depreciation expense and tax expense each period.
Forecast the company’s financial structure and dividend policy each period. Then, project interest expense and complete the income statement.
Derive forecasted cash flow statements from the forecasted income statements and balance sheets.
7-‹#›
© McGraw Hill
Accessibility Content: Text Alternatives for Images
7-‹#›
© McGraw Hill
The Role of Earnings in Valuation – Text Alternative
Return to parent-slide containing images.
Diagram depicts how current earnings lead to forecasted future free cash flows, which leads to current stock price:
Analyst uses current earnings to forecast future cash flows.
With the forecast, analyst uses valuation model to compute per-share intrinsic value estimate from cash flow forecast, and the result is the current stock price.
7-‹#›
© McGraw Hill
Corporate valuation: Abnormal earnings valuation approach – Text Alternative 1
Return to parent-slide containing images.
Share value at Time 0 equals Book value of equity at Time 0, with the callout What shareholders have invested in the firm. This is added to expected future abnormal earnings, with callout Expectations operator. This is divided by discount factors for each future period, with callout Cost of equity capital.
7-‹#›
© McGraw Hill
Corporate valuation: Abnormal earnings valuation approach – Text Alternative 2
Return to parent-slide containing images.
Abnormal earnings sub t equals Actual earnings, with callout What management accomplished. From this is subtracted Required earnings, carrying callout What shareholders expected.
7-‹#›
© McGraw Hill
Abnormal Earnings: Price Premium and Discount – Text Alternative
Return to parent-slide containing images.
Number 1 shows share value of $20 and book value of $15, so a $5 premium. Investors willingly pay a premium over B V for companies that earn positive A E.
Number 2 shows share value of $10 and book value of $15, so a $5 discount. Firms that earn negative A E sell at discount to B V.
7-‹#›
© McGraw Hill
Abnormal Earnings Valuation Illustration: Step 1 – Text Alternative
Return to parent-slide containing images.
Data for five years, years 20X1 through 20X5, are as follows:
Operating cash flows (=earnings before depreciation), $20,000, $20,000, $25,000, $25,000, $25,000
Depreciation ($3,043.48 per truck per year), (12,174), (12,174), (15,217), (15,218), (15,217)
Net income (A), $7,826, $7,826, $9,783, $9,782, $9,783
Operating cash flows, $20,000, $20,000, $25,000, $25,000, $25,000
Capital expenditures, 0, (20,000), 0, 0, 0
Proceeds from sale of trucks, N A, N A, N A, N A, 30,000
Cash available to pay dividends, 20,000, 0, 25,000, 25,000, 55,000
Dividends, (20,000), 0, (25,000), (25,000), (55,000)
Net change in cash, $0, 0, $0, $0, $0
Beginning book value of equity, $80,000, $67,826, $75,652, $60,435, $45,217
Net income (A), 7,826, 7,826, 9,783, 9,782, 9,783
Dividends, (20,000), 0, (25,000), (25,000), (55,000)
Ending book value of equity, $67,826, $75,652, $60,435, $45,217, $0
7-‹#›
© McGraw Hill
Abnormal Earnings Valuation Illustration: Steps 2 and 3 – Text Alternative
Return to parent-slide containing images.
Data for five years, years 20X1 through 20X5, are as follows:
Net income (A), $7,826, $7,826, $9,783, $9,782, $9,783
Beginning book value of equity, 80,000, 67,826, 75,652, 60,435, 45,217
Cost of equity capital, 10%, 10%, 10%, 10%, 10%
Normal earnings (B), 8,000, 6,783, 7,565, 6,044, 4,522
Abnormal earnings (C) = (A) - (B), $174, $1,043, $2,218, $3,738, $5,261
Data for five years, years 20X1 through 20X5, are as follows:
Abnormal earnings (C), ($174), $1,043, $2,218, $3,738, $5,261
Present value factor, 0.90909, 0.82645, 0.75131, 0.68301, 0.62092
Present value of future abnormal earnings, ($158), $862, $1,666, $2,553, $3,267
Sum of all present values, $8,190 for year 20X1 (other years are blank)
Beginning equity book value, 80,000 for year 20X1 (other years are blank)
Value of business, $88,190 for year 20X1 (other years are blank).
The last row, Value of business and $88,190, is circled and a callout notes difference versus Exhibit 7.1 is due to rounding.
7-‹#›
© McGraw Hill
Research on Earnings and Equity Valuation – Text Alternative
Return to parent-slide containing images.
In the line graph, actual earnings per share (X) for same year as Year-end stock price is measured ($0–$4.00) are marked on the horizontal axis, and year-end stock price (P) is noted on the vertical axis. An upward-sloping line begins at (0, 9.57). Stock price is $9.57 at zero EPS. The slope of the regression line is 14.28. Most of the data points on the graph are clustered around the regression line to the left of the $2.00 EPS mark; fewer points are in the $2.00–3.00 range; and several outliers show higher stock price compared to earnings per share, and one outlier has a $3.75 EPS at a $40 stock price.
7-‹#›
© McGraw Hill
Y/E Stock Prices and Analysts’ Forecasts of Next Year’s EPS – Text Alternative
Return to parent-slide containing images.
In the line graph, forecasted earnings per share (Xi) for the next year ($0–$3.50) are marked on the horizontal axis, and year-end stock price (Pi) is noted on the vertical axis. An upward-sloping line begins at (0, 6.65). Stock price is $6.65 at zero EPS. The slope of the regression line is 14.83. Most of the data points on the graph are clustered around the regression line to the left of the $2.00 EPS mark; several data points are above and below the regression line between the $2.50 and $3.00 EPS marks.
7-‹#›
© McGraw Hill
Earnings Surprises – Text Alternative
Return to parent-slide containing images.
In the line graph, days before and days after an earnings announcement trading day are marked on the horizontal axis, and cumulative return percentage is noted on the vertical axis. Three lines, indicating good news, no news, and bad news are plotted on the graph. They all begin at the 0 percent cumulative returns at 60 days before the earnings announcement trading day.
The no news line remains within a half percentage point of 0 through the announcement day and past 60 days after the announcement day.
The bad news line begins to trend downward about 40 days before announcement; on announcement day it drops from –3 percent to below –4 percent; and it remains between –5 and –6 percent for Days 10 to 60.
The good news line begins to trend upward about 40 days before announcement; on announcement day it rises from 3 percent to about 5 percent; it reaches 6 percent by Day 30 and remains there for the next 30 days.
7-‹#›
© McGraw Hill
Standard & Poor’s Credit Ratings – Text Alternative
Return to parent-slide containing images.
Three columns, with the headings and data as follows:
Rating, Credit Quality, Historical Default Rate (%)
Investment grade
A A A, Extremely strong, 0.99%
A A, Very strong, 1.24
A, Strong, 2.45
B B B, Adequate protection, 6.27
Speculative (or “junk”) grade
B B, Less vulnerable, 17.64
B, More vulnerable, 30.81
C C C, Currently vulnerable, 54.40
C C, Highly vulnerable, 54.40
C, Currently highly vulnerable, 54.40
D, In default
7-‹#›
© McGraw Hill
Appendix A: Valuation of Expected Future Free Cash Flows – Text Alternative
Return to parent-slide containing images.
Column heads and data corresponding to those heads are as follows.
Untitled, Year 1, Year 2, Year 3, Year 4, Year 5, Year 6+
Sales, $200,000, $250,000, $300,000, $325,000, $350,000, $350,000
Royalties, (10,000), (12,500), (15,000), (16,250), (17,500), (17,500)
Depreciation, (2,500), (2,500), (2,500), (2,500), (2,500), (2,500)
Amortization, (4,200), (4,200), (4,200), (4,200), (4,200),
Other operating expenses, (170,000), (212,500), (255,000), (276,250), (297,500), (297,500)
Pre-tax income, $13,300, $18,300, $23,300, $25,800, $28,300, $32,500
Pre-tax income, $13,300, $18,300, $23,300, $25,800, $28,300, $32,500
Depreciation and amortization, 6,700, 6,700, 6,700, 6,700, 6,700, 2,500
Working capital (inventory additions), N A, (5,000), (5,000), (2,500), (2,500), 0
Capital expenditures, N A, N A, N A, N A, N A, (2,500)
Free cash flow, 20,000, 20,000, 25,000, 30,000, 32,500, 32,500
Divide by discount rate, N A, N A, N A, N A, N A, 0.16
Present value of perpetual flows as of Year 5, N A, N A, N A, N A, N A, 203,125
Present value factors, 0.86207, 0.74316, 0.64066, 0.55229, 0.47611, 0.47611
Present value, 17,241, 14,863, 16,016, 16,569, 15,474, 96,710
Total present value, $176,873, N A, N A, N A, N A, N A
7-‹#›
© McGraw Hill
Appendix A: Valuation of Expected Abnormal Earnings – Text Alternative
Return to parent-slide containing images.
Column heads and data corresponding to those heads are as follows.
Untitled, Year 1, Year 2, Year 3, Year 4, Year 5, Year 6+
Beginning book value, $100,000, $93,300, $91,600, $89,900, $85,700, $81,500
Pre-tax income, 13,300, 18,300, 23,300, 25,800, 28,300, 32,500
Dividend (= F C F), (20,000), (20,000), (25,000), (30,000), (32,500), (32,500)
Ending book value, $93,300, $91,600, $89,900, $85,700, $81,500, $81,500
Pre-tax income, $13,300, $18,300, $23,300, $25,800, $28,300, $32,500
Normal earnings, 16,000, 14,928, 14,656, 14,384, 13,712, 13,040
Abnormal earnings, (2,700), 3,372, 8,644, 11,416, 14,588, 19,460
Divide by discount rate, N A, N A, N A, N A, N A, 0.16
Present value of perpetual abnormal earnings as of Year 5, N A, N A, N A, N A, N A, 121,625
Present value factors, 0.86207, 0.74316, 0.64066, 0.55229, 0.47611, 0.47611
Present value of abnormal earnings, 2,328, 2,506, 5,538, 6,305, 6,945, 57,907
Total present value of abnormal earnings, 76,873 (in year 1 column, rest of year columns are blank)
Initial investment, 100,000 (in year 1 column, rest of year columns are blank)
Total value of investment, $176,873 (in year 1 column, rest of year columns are blank). This amount is noted as what the business is worth.
7-‹#›
© McGraw Hill
Appendix A: The Kroger Co. Illustration 2 – Text Alternative
Return to parent-slide containing images.
Actual results are shown for two years, 2016 and 2017. Forecasted results are shown for 2018 through 2022. A column for Beyond 2022 contains no data. Earnings per share for all years is shown. This is followed by equity book value at beginning of year, plus earnings per share and minus dividends, to yield equity book value at end of year and return on equity. Then calculations for abnormal earnings are shown.
7-‹#›
© McGraw Hill
