ACCT6101 Session #1: Introduction to Valuation
PART 1 Background
1
ACCT7106 Session #11: Forecasting & Valuation
overarching objective:
to conduct the fundamental valuation exercise for the purpose of estimating the intrinsic value of a firms common shares
requires an understanding of the firms value drivers
need to accumulate a tool kit as the basis for developing the pro forma Financial Statements
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2
projected over the forecast horizon
core inputs into the valuation modelxg
Balance Sheet (B/S)
Income Statement (I/S)
Statement of Cash Flows (SCF)
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3
STEP 1
Understanding the past
Information collection
Understanding the business
Accounting analysis
Financial ratio analysis
Cash flow analysis
STEP 2
Forecasting the future
Structured forecasting
Income Statement forecasts
Balance sheet forecasts
Cash flow forecasts
STEP 3
Valuation
Cost of capital
Valuation models AE, FCF, D
Valuation ratios
Complications
Negative values
Value creation and destruction
Figure 1.1Lundholm & Sloan, Framework for Equity Valuation
Sessions #3 #10
Sessions #10 #11
Sessions #1 #3; #11 #13
4
beginning stock
Beginning Balance Sheet
Cash
+ Other assets
= Total Assets
Liabilities
= Shareholders Equity (BVt-1)
Statement of Changes in S/E
Cash from operations
+ Net Income & OCI
= Net Change in S/E
Cash Flow Statement
Cash from operations
+ Cash from investing
+ Cash from financing
= Net change in cash
Income Statement
Revenue
Expenses
= Net Income (NPAT)
Ending Balance Sheet
Cash
+ Other assets
= Total Assets
Liabilities
= Shareholders Equity (BVt)
flows
ending stock
articulationFinancial Statements constitute an integrated system
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Forecasting & Valuation
Objective of the forecasting exercise
to develop objective and realistic expectations of future value-relevant payoffs
How?
develop pro forma F/S containing unbiased predictions of the firms future operating, investing, and financing activitiesshould be neither conservative nor optimistic
pro forma F/S should be comprehensiveneed to consider the growth rate for each item, not just assume items will grow at a constant rate with sales
need to make consistent assumptions and maintain the relation between items in the pro forma F/S (i.e., the F/S represent an integrated system, both reported and pro forma)
use external information to ensure that assumptions are realistic
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Steps comprising the Forecasting Exercise
Income Statement:
Step 1:Forecast Sales
Step 2:Forecast Core OI from Sales (before tax)
Step 3:Forecast Core Other OI (before tax)
Step 4:Calculate OI (before tax)
Step 5:Forecast Income Tax Expense attributable to OI
Step 6:Calculate OI (after tax)
Balance Sheet:
Step 7:Forecast OA and OL to obtain a forecast of NOA
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Unlevered Valuationvaluing the firm
Step 8:Calculate RNOA, FCF and residual operating income (ReOI)
Step 9:Estimate the DCF and ReOI models with assumed terminal growth rate and firms weighted average cost of capital (WACC ) overall value of the firm
Step 10:Forecast Leverage and NFE (after tax)
Step 11:Calculate CI = OI (after tax) NFE (after tax) & CSE = NOA NFO
Step 12: Forecast Dividends (div = CI S/E NCC)
Levered Valuation valuing common equity (value of common shares)
Step 13:Calculate RI (residual income or abnormal earnings)
Step 14:Estimate the DDM and RI models with assumed terminal growth rate (g) and cost of equity capital (k) value of the firm to the common shareholder
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PART 2 Foundation for Forecasting
central focus estimation of intrinsic value
selected approach to valuation fundamental analysis
core valuation model residual income (abnormal earnings) based on the reformulated F/S
+
where nowresidual earnings = (ROCE cost of equity capitalBVt-1)
= (ROCEt COEC)BVt-1(dividing both terms by S/E and then multiplying by S/E)
value driven by growth in abnormal earnings = AEt AEt-1
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residual earnings =(ROCEt COEC)BVt-1
support growth in abnormal earnings arises from
growth in ROCE (i.e., profitability)
growth in S/E
beginning with ROCE (profitability) i.e., ROCE=
informed by the financial leverage equation and the DuPont System i.e.,
ROCE = RNOA + FLEV x ( RNOA NBC)= {profit marginasset turnover} + {FLEVspread}
drivers
operating profit margin
asset turnover
leverage
spread
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further, in terms of the income measures
Comprehensive Income (CI) = Operating Income (OI) Net Financing Expenses (NFE)
where further
core operating income from sales
OI =+ core other operating income
+ unusual operating income
sustainable (core) earning earnings that can repeat in the future and grow
form the basis for growth
transitory earnings (unusual items) earnings based on temporary factors
have no bearing on future earnings or earnings growth
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central focus on sustainable (core) earning as the basis for growth
core operating income & core net borrowing costs
need to identify items that will have no bearing on the future so that they can be removed and the focus returned to the core items
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Identifying sustainable earnings: Items to consider
Deferred revenue timing of recognition can be manipulatedand hence apparent growth may not be sustainable
Restructuring charges, asset impairments & special charges typically unusual but effects can be ongoing (e.g., impairments lower future expenses, needing adjustment)
R&D reductions increase current income but impact future earnings
Advertising reductions increase current income but impact future earnings
Pension expense each of the components represents an opportunity for manipulation, especially expected returns which are not really a part of core earnings
Changes in estimates poor estimates will be adjusted in future earnings
Realised gains & losses timing and details
Unrealised gain & losses on equity investments timing and details; transitory
Unrealised gains & losses from applying fair value accounting typically transitory
Income taxes one-time items; special incentives
Other income confirm whether it includes interest income
Deferred Revenue: Microsoft
firms may defer revenue into a cookie jar and then dip into the cookie jar later, often to smooth earnings
2010 2009 2008
Unearned revenue$29,374 $24,409$24,532
Recognition ofunearned revenue(28,813)(25,426) (21,944)
Merger & Restructuring Charges: IBM
Does this provide the scope for false earning growth in the future?
note: core OI from sales
Year
1991
1992
1993
1994
1995
1996
1997
1998Restructuring Charges ($B)
3.7
11.6
8.9
(2.8)
(2.1)
(1.5)
(0.5)
(0.4)
Does this provide the scope for false earning growth in the future?
note: unusual items
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R&D Expenditures: Merck & Co
Is the drop temporary?
Will it affect future sales?
note: core OI from sales
Advertising Expenditures: Coca-Cola
Will the increase in R&D result in future sales?
note: core OI from sales
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Pension Costs: IBM
Net pension expense comprised of 6 components
notes:
net pension expense can be negative due to higher expected return on plan assets need to consider the assumed rate of return; core other OI, not core OI from sales
evaluate gains on pension fund assets
Gains & losses on sale of shares
gains often recorded to operating income but Statement of Cash Flows reveals true nature (unusual item)
timing e.g., realise winners; hold loosers
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PART 3 Growth in Residual Income (Abnormal Earnings)
residual earnings =(ROCEt cost of equity capital)BVt-1
support growth in abnormal earnings arises from
growth in ROCE (i.e., profitability)
growth in S/E
growth in ROCE
ROCE== {profit marginasset turnover} + {FLEVspread}
NOA
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RNOA==
=
=
where Core Sales Profit Margin=
profit margin unaffected by Other Income or Unusual Items
captures the firms ability to generate profits from sales
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RNOA =
= (core sales PM) @ previous ATO + ATO @ new core sales PM
To illustrate
General Mills
RNOAProfit MarginAsset Turnover
201010.1%7.95%1.27
20094.1%3.41%1.19
6.0% 4.54% 0.08
Can we gain any deeper insights that might assist with forecasting?
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from Penman Exhibit 13.2 re: General Mills
20102009
Core Operating Revenues14,79714,691
Core Operating Income from Sales (after tax) 1,435 1,174
Core Other Operating Income (after tax) 370 352
Unusual Items (after tax)(628)(1,025)
Operating Income (after tax) 1,177 501
Net Financing Expenses (after tax) (251)(239)
Noncontrolling Interest (5)(9)
Comprehensive Income 921253
Core sales PM = 1.71% 0.0970 0.0799
also given = 2.85%
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RNOA = (1.71%1.19) + (0.089.70%)+0.33%+2.85%
= {2.04% + 0.78%}+0.33%+2.85%
2.82% increase related to core income from sales
increase in RNOA due to0.33% increase related to other core income (outside of sales)
2.85% increase related to unusual (one-time) items
for General Mills, slightly less then of the increase in RNOA is related to core operating income from sales (2.82% out of 6%)
(core sales PM)
ATO
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critical drivers ofgrowth (increases) in ROCE
core sales PM; asset turnover; financial leverage (FLEV); and spread (i.e., NBC)
for core sales PM:
changes in the core sales PM are determined by how costs change as sales change
notions of variable & fixed costs
Operating leverage (OLEV) the extent to which the firms operating costs are fixed
OLEV = % core OI = % core salesOLEV
** operating leverage should not be confused with operating liability leverage (OLLEV) that appears in the operating leverage equation relating ROOA to RNOA
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re: growth in S/E
S/E = NOA NFO
where NOA = salesrecall:ATO =
S/E = (sales NFO
drivers of the change (growth) in S/E
growth in sales
change in NOA (through sales & ATO)
change in FLEV (amount of net debt used to finance the change in NOA, as opposed to equity)
CSE = NOA NFO
NOA
NFO
Sales
Changes in Sales for
Business Segments
Or Product Lines
Changes in Individual
Asset Turnovers
Changes in NFO
Components
NOA = Sales
Change in S/E
=
Change due to change in sales at previous level of asset turnover
Change in financial leverage
Change due to change in asset turnover
+
+
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In summary
what is a growth firma firm that can increase its residual earnings
a growth firm features:
sustainable, growing sales
high or increasing core profit margins
high or improving asset turnovers
note:sustaining high core profit margins indicates the presence of competitive advantage
without a durable competitive advantage, the firms residual earnings (abnormal earnings) will ultimately decline
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PART 4 Valuation Exercise applied to Coles
caveats !!!
largely an art rather than a science
involves considerable interpretation and use of judgement (subjective)
you would each most likely arrive at slightly different interpretations and thereby different estimates that the ones I am about to propose
this doesnt make any particular set of estimates either more correct or more incorrect; just different!
(although clearly some estimates appear more plausible than others, at least on the surface, until explained or justified)
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PART 4 Step 1:Forecast Sales
sales drive the system !!
a consideration of historical sales growth rates can be a starting point BUT . need to develop a thorough understanding of the business and its environment to make meaningful sales forecasts
the firms business strategy
the market for the firms products
the firms marketing plan
how the broader economic factors and the industry dynamics affect the business
constraints regression to mean; sustainable growth rate; plausible terminal growth rate
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re: Coles***IBISWorldhttps://my.ibisworld.com/au/en/industry/g4111
Industry Outlook
Price competition in the Supermarkets and Grocery Stores industry is forecast to remain strong over the next five years.
Profit
Industry profitability is projected to increase over the next five years, despite weak household incomes and high unemployment.
Competition
Internal industry competition is forecast to remain high over the next five years
Investing in technology
Major supermarkets will likely become more innovative and use new technologies to attract customers to increase their market share over the next five years.
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Industry Life Cycle
The life cycle stage of this industry is Growth
LIFE CYCLE REASONS
The industry is growing slightly faster than the overall economy
Fierce competition is restricting the entry of new players, but established players are expanding store networks
Technological change in the industry is moderate and increasing
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Industry Performance Data Historical & Prospective
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2011201220132014201520162017201820192020
Revenues54,505.755,492.258,921.761,155.060,868.458,276.055,669.056,726.059,984.063,675.0
ave = 1.82%1.81%6.18%3.79%-0.47%-4.26%-4.47%1.90%5.74%6.15%
EBIT3,329.903,919.603,733.703,783.103,748.402,564.002,326.002,548.002,724.003,219.00
ave = 0.79%17.71%-4.74%1.32%-0.92%-31.60%-9.28%9.54%6.91%18.17%
CFO2,991.102,873.802,719.903,472.703,345.102,358.003,122.002,930.002,948.004,561.00
ave = 7.42%-3.92%-5.36%27.68%-3.67%-29.51%32.40%-6.15%0.61%54.72%
Op Margin7.708.708.007.808.006.206.006.406.608.90
NPAT (%)4.004.904.004.004.004.702.502.802.902.50
dividends1.221.261.331.371.390.770.841.031.020.94
Payout ratio69.0056.0070.0070.0071.0036.0076.0084.0077.0074.00
Woolworths
Industry
2011201220132014201520162017201820192020
ave = 3.14%2.89%4.68%3.97%5.87%3.99%-0.88%1.08%1.15%5.48%
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YearRevenue
(%) IVA
(%) Establishments
(%) Enterprises
(%) Employment
(%) Exports
(%) Imports
(%) Wages
(%) Domestic
Demand
(%)
2020210.51 -0.11 -0.84 -0.55 -1.12 N/A N/A -0.67 N/A
2021222.64 2.64 0.13 -0.60 -0.01 N/A N/A 1.50 N/A
2022231.76 3.00 -0.37 -1.40 0.01 N/A N/A 1.12 N/A
2023242.31 2.30 0.09 -0.82 -0.26 N/A N/A 1.08 N/A
2024252.37 2.37 0.41 -0.72 -0.15 N/A N/A 1.25 N/A
2025261.49 1.50 0.98 1.23 0.01 N/A N/A 1.40 N/A
Industry Performance Data Outlook(from IBISWorld)
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caveats moving from industry forecasts to firm-level forecasts
historical industry patterns can be a good starting point, especially if the future is likely to be similar to the past however, also need to recognise broad indicators to the contrary
govt or trade statistics that forecast change in global economy, or the specific industry
forecasts of a recession or slowdown in GDP
shifts in industry-wide demand with changing demographics and/ consumer tastes
need to have a knowledge of industry trends and of the susceptibility of the industry to macroeconomic changes
need to tailor the industry projections to fit with the specific firm features
firms have idiosyncratic features that yield drivers that are predictably different from industry patterns
need to consider how the firms future drivers may or will be different from the typical pattern in the industry (arguably the main factor relates to competition and the firms reaction to it)
focus on the drivers that are key to understanding the firms profitability
start with industry drivers (e.g., Table 16.3)and then
adjust for firm-specific features
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Sales forecasts Coles
2019 A2020 A2021 E2022 E2023 E2024 E2025 E
Revenues38,17637,40838,34339,11039,99040,89041,708
-2.01%2.50%2.00%2.25%2.25%2.00%
Based on the macroeconomic outlook, the industry outlook, and Coles historical performance and prospects to exploit growth opportunities:
growth rates in core sales revenue will range between 2.0% and 2.5% over the next 5 years, with the pattern largely following predicted industry growth pattern
ultimately Coles sales growth will stabilise at 3% (terminal growth rate)
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Step 1:Forecast Sales
Step 2:Forecast Core OI from Sales (before tax)
next steps:
2aforecast ATO and calculate NOA implied by sales forecasts and forecasted ATO
2brevise sales forecasts (if necessary) in recognition of asset constraints
Explain changes in ATO by looking at individual asset turnovers
A/R; inventory; property, plant & equipment
A/P; operating liability turnover
Also consider
operating asset composition ratios
operating liabilities composition ratios
OLLEV
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ATO forecast Coles
2020ATO = 3.065
2019 ATO = 38,176/13,102 = 2.914 (based on the adjusted 2019 NOA)
is there any reason to believe that the ATO might or could change?
which accounts are sufficiently material to influence the ATO, and can they be changed?see the third level break down of ROCE (next slide)
material accounts:inventory; property, plant & equipment; intangible assets
accounts payable; provisions
examine related NOTES to the F/S to understand the roles of each account and the likelihood that they can be changed
is the level of NOA implied by the estimated ATO and the sales forecasts supportable?
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Asset Turnover Driversturnover = sales / item inverse = item / sales
Operating Assets
cash & cash equivalents187200.0430.0050
receivables43486.1940.0116
inventories2,16617.2710.0579
assets held for resale75498.7730.0020
other assets190196.8840.0051
property, plant & equipment4,1279.0640.1103
right-of-use assets7,6604.8840.2048
intangible assets1,59723.4240.0427
deferred tax assets84944.0610.0227
equity accounted investments217172.3870.0058
Total Operating Assets (OA)17,5022.1370.4679
Operating Liabilities
trade payables3,73710.0100.0999
provisions1,33328.0630.0356
other227164.7930.0061
Total Operating Liabilities (OL)5,2977.0620.1416
Net Operating Assets (NOA)12,2053.0650.3263
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2019 A2020 A2021 E2022 E2023 E2024 E2025 E
Revenues38,17637,40838,34339,11039,99040,89041,708
NOA = sales / ATO of 313,10212,20512,78113,03713,33013,63013,903
% NOA4.72%2.00%2.25%2.25%2.25%
2020ATO = 3.065
2019 ATO = 38,176/13,102 = 2.914 (based on the adjusted 2019 NOA)
is there any reason to believe that the ATO might or could change?
not obvious that any of the material accounts can or will change
set ATO = 3.00
(also sensitivity under the assumption that ATO could increase slightly over time)
is the level of NOA implied by the estimated ATO and the sales forecasts supportable? YESsustainable growth rate for 2020g* = 3.4%
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2cgross profit margin = (core sales revenue COGS) / sales
2020(37,408 28,043) / 37,408 = 0.2504
2019 (38,176 29,253) / 38,176 = 0.2337
slight improvement but is there any reason to believe that it could improve further?
no NOTE to help understand
Woolworths gross profit margins:2020 0.29162019 0.2908
(but no reason to believe that the 2 companies aggregate expenses the same way e.g., branch and admin expenses)
set gross profit margin at 0.260(and conduct sensitivity between 0.25 and 0.275)
2021 E2022 E2023 E2024 E2025 E
Revenues38,34339,11039,99040,89041,708
Gross Margin(@ 0.260)9,96910,16910,39710,63110,844
2 factors
price
cost
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2dcore operating expensesadministrative expenses
2020:(8,081 41) / 37,408 = 0.21492019:(8,031 + 42) / 38,176 = 0.2115
administrative expense ratio up slightly when sales down
consistent with a fixed cost component
2021 E2022 E2023 E2024 E2025 E
Revenues38,34339,11039,99040,89041,708
Administrative Expense (%)0.2100.20950.2090.20850.208
= Admin Expense(8,052)(8,194)(8,358)(8,526)(8,675)
assume a modest decline over the 5-year horizon 6 from 0.21 to 0.208 as sales increase, and then stabilise at 0.208
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2ftax expense
current effective tax rate on PBT (i.e., after int)2020:25.85% 2019:23.65%
assume 30% tax rate on core OI
2gother operating revenue; equity accounted investments
no NOTE to explain; assume constant at 2020 level of $500 million
2hunusual OI
given definition as non-recurring, assume 0
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2021 E2022 E2023 E2024 E2025 E
Revenues38,34339,11039,99040,89041,708
Gross Margin (0.26)9,96910,16910,39710,63110,844
Administrative Expense(8,052)(8,194)(8,358)(8,526)(8,675)
Tax Expense (30%)(575)(593)(612)(632)(651)
Core OI from Sales (after tax)1,3421,3821,4271,4731,518
Core Other OI 500@ (1 0.3)350350350350350
Unusual Items 00000
Total OI (after tax)1,6921,7321,7771,8231,868
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Step 1:Forecast Sales
Steps 2 6:Forecast components of OI after tax
Step 7:Forecast OA and OL to obtain NOA
** given the previous arguments surrounding the stability of asset turnover (ATO) and the inability to alter the material accounts, will assume that the turnovers for the OA and OL items remain unchanged
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Asset Turnover DriversCurrent turnoverAssumed turnover20212022202320242025
(38,343)(39,110)(39,990)(40,890)(41,708)
Operating Assets
cash & cash equivalents200.043200192196200204209
receivables86.19486446455465475485
inventories17.27117.252,2232,2672,3182,3702,418
assets held for resale498.7735007778808283
other assets196.884200192196200204209
property, plant & equipment9.06494,2604,3464,4434,5434,634
right-of-use assets4.8844.758,0728,2348,4198,6088,781
intangible assets23.424231,6671,7001,7391,7781,813
deferred tax assets44.06144871889909929948
equity accounted investments172.387175219223229234238
Total Operating Assets (OA)2.1372.10518,21918,58319,00119,42919,818
Operating Liabilities
trade payables10.010103,8343,9113,9994,0894,171
provisions28.063281,3691,3971,4281,4601,490
other164.793165232237242248253
Total Operating Liabilities (OL)7.0627.0535,4365,5455,6705,7985,914
Net Operating Assets (NOA)3.0653.00012,78213,03813,33113,63113,904
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Step 1:Forecast Sales
Steps 2 4:Forecast components of OI after tax
Step 5:Forecast NOA
Step 8:Calculate RNOA, FCF, and ReOI
RNOA=FCF = OI NOA
ReOI (to firm) = OIt kF*NOAt-1
WACC =(NBC) +(kE) =(3.36%) +(7.40%) = 6.25%
Session #3
Session #10
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2021 E2022 E2023 E2024 E2025 E
Revenues38,34339,11039,99040,89041,708
Core OI from Sales (after tax)1,3421,3821,4271,4731,518
%2.98%3.26%3.22%3.06%
Total OI (after tax)1,6921,7321,7771,8231,868
%2.36%2.60%2.59%2.47%
NOA12,78213,03813,33113,63113,904
RNOA0.13240.13280.13330.13370.1344
%RNOA0.02690.00040.00050.00040.0007
FCF1,1151,4761,4841,5231,595
%FCF0.05000.04460.0052.63%4.73%
ReOI(k = 6.25%) (to firm)9299339629901,016
%ReOI0.43%3.11%2.91%2.63%
Step 9: unlevered valuation overall value of the firm
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Illustrative Calculations
Free Cash Flow (FCF) = OI NOA
2021:1,692 (12,782 12,205) = 1,115
2022:1,732 (13,038 12,782) = 1,476
2023:1,777 (13,331 13,038) = 1,484
2024:1,823 (13,631 13,331) = 1,523
2025:1,868 (13,904 13,631) = 1,595
Residual Income (ReOI) = OI ke* NOAt-1
2021:1,692 0.0625 * 12,205 =929
2022:1,732 0.0625 * 13,038 =933
2023:1,777 0.0625 * 13,331 =962
2024:1,823 0.0625 * 13,631 =990
2025:1,868 0.0625 * 13,904 = 1,016
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Abnormal Earnings (Residual Income) valuation model
+
= 12,205 +++++
= $40,015 million
FCF valuation model
=++++
= $43,298 million
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Step 10leverage (FLEV) and financing costs (NFE)
interest expense on long-term debt and lease liabilities
2020:FLEV =3.6673
2020:NFE = 322
assume property, plant & equipment (both purchased & leased) grow at 1.5%
assume capital structure remains largely unchanged FLEV = 3.67
assume interest rates 0.5-0.6%current NBC = 3.36% NBC = 4%
2020 A2021 E2022 E2023 E2024 E2025 E
NFO (@ 1.5%)9,5909,734988010,02810,17910,331
NFE (after tax)322389394401407413
what happens to FLEV when S/E is calculated
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2021 E2022 E2023 E2024 E2025 E
Revenues38,34339,11039,99040,89041,708
Gross Margin (0.26)9,96910,16910,39710,63110,844
Administrative Expense(8,052)(8,194)(8,358)(8,526)(8,675)
Tax Expense (30%)(575)(593)(612)(632)(651)
Core OI from Sales (after tax)1,3421,3821,4271,4731,518
Core Other OI 500@ (1 0.3)350350350350350
Unusual Items 00000
Total OI (after tax)1,6921,7321,7771,8231,868
Core NFE(389)(395)(401)(407)(413)
Comprehensive Income1,3031,3371,3761,4161,455
** assumes OCI = 0
Steps 11 , 12& 13CI, S/E, dividends, ReCI
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2021 E2022 E2023 E2024 E2025 E
Revenues38,34339,11039,99040,89041,708
Comprehensive Income1,3031,3371,3761,4161,455
%CI2.61%2.92%2.91%2.75%
NOA12,78213,03813,33113,63113,904
NFO9,7349,88010,02810,17910,331
S/E = NOA NFO3,0483,1583,3033,4523,573
%S/E3.61%4.59%4.51%3.51%
Dividends8701,2271,2311,2671,336
%Div3.26%2.92%5.29%
ReCI(k = 7.4%) (to S/E)1,1091,1111,1421,1721,200
%ReOI0.20%2.79%2.63%2.39%
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Illustrative Calculations
Dividends (Div) = CI S/E NCCassume NCC = 0 (on average)
2021:1,303 (3,048 2,615) = 870
2022:1,337 (3,158 3,048) = 1,227
2023:1,376 (3,303 3,158) = 1,231
2024:1,416 (3,452 3,303) = 1,267
2025:1,455 (3,571 3,452) = 1,336
Residual Income (ReCI) = CI ke* BVt-1
2021:1,303 0.074 * 2,615 = 1,109
2022:1,337 0.074 * 3,048 = 1,111
2023:1,376 0.074 * 3,158 = 1,142
2024:1,416 0.074 * 3,303 = 1,172
2025:1,455 0.074 * 3,452 = 1,200
58
Abnormal Earnings (Residual Income) valuation model
+
= 2,615 +++++
= $26,911.5 million(** possible rounding errors if all calculations carried through an Excel spreadsheet with no rounding, this figure becomes 26,905.0)
DDM valuation model
=++++
= $26,606.7 million
context
current share price (20 January 2021) = $17.94
market capitalisation $18 * 1,334 million shares = $24,012 million
Abnormal Earnings (Residual Income) valuation model
market capitalisation = $26,911.5 million
DDM valuation model
market capitalisation = $26,606.7 million
Sensitivity assume g = 2.5% (instead of 3%)
AE $24,819.8 million
DDM $24,281.5 million
59
gap suggests not quite to steady state
increased gap perhaps a bit extra g left in DIV, or a a bit less in AE before reach steady state
Summary of significant assumptions
Sales growth2.5%2.0%2.25%2.25% 2.0%
ATO constant @ 3.00 (had increased from 2.914 to 3.065)if higher ROCE
Gross profit margin @ 0.26 (had increased from 0.234 to 0.250)
Admin expenses assumed to decline from 0.21 to 0.208 (had increased from 0.212 to 0.215)
Financing costsassumed growth in PPE of 1.5%, NBC up 0.6%
Unchanged capital structure
Terminal growth (g) = 3%
60
61
overarching objective:
to conduct fundamental value for the purpose of estimating the intrinsic value of a firms common shares
requires an understanding of the firms value drivers
need to accumulate a tool kit as the basis for developing the pro forma Financial Statements
STEP 1
Understanding the past
Information collection
Understanding the business
Accounting analysis
Financial ratio analysis
Cash flow analysis
STEP 2
Forecasting the future
Structured forecasting
Income Statement forecasts
Balance sheet forecasts
Cash flow forecasts
STEP 3
Valuation
Cost of capital
Valuation models AE, FCF, D
Valuation ratios
Complications
Negative values
Value creation and destruction
PART 5 Summary
62
external environment
economic prospects
macroeconomic factors
socio-cultural forces
political / regulatory
Industry dynamics
Porters five forces
(suppliers, buyers, new entrants, substitutes, rivalry)
Analysis of Financial Statements
understanding current F/S
re-formulating the F/S
accounting quality
ratio analysis
analysts reports
management forecasts
financial press
???
0V =
tx
( 1+ tk
t)t =1
=
E( tx )
t
(1+k)t=1
n
+
E( nx ) (1+ g)
k g
1
n
(1+k)
0
V
=
t
x
(
1+
t
k
t
)
t=1
=
E(
t
x
)
t
(1+k)
t=1
n
+
E(
n
x
)
(1+g)
k-g
1
n
(1+k)
(In billions of dollars)
2010 2009 2008
Revenues35.1 31.0 31.9
Cost of goods sold12.7 11.1 11.4
Gross profit22.4 19.9 20.5
Selling, administrative and general14.0 11.7 12.1
Operating income (before tax)8.4 8.2 8.4
Advertising expenses 2.9 2.8 3.0
Advertising expenses/Sales8.3% 9.0% 9.4%
(In billions of dollars)
2010 2009 2008
Sales46.0 27.4 23.8
R&D11.0 5.8 4.8
R&D-to-Sales23.9% 21.2% 20.2%
(In millions of dollars)
(In billions of dollars)
2010
2009
2008
Revenues
35.1
31.0
31.9
Cost of goods sold
12.7
11.1
11.4
Gross profit
22.4
19.9
20.5
Selling, administrative and general
14.0
11.7
12.1
Operating income (before tax)
8.4
8.2
8.4
Advertising expenses
2.9
2.8
3.0
Advertising expenses/Sales
8.3%
9.0%
9.4%
(In millions of dollars)
(In billions of dollars)
2010
2009
2008
Sales
46.0
27.4
23.8
R&D
11.0
5.8
4.8
R&D-to-Sales
23.9%
21.2%
20.2%
_____________________________________________________________________
International Business Machines (IBM)
Components of pension expense,2001-2004
(In millions of dollars)
2004 2003 2002 2001
Service cost1,263 1,113 1,155 1,076
Interest cost4,071 3,995 3,861 3,774
Expected return on plan assets(5,987) (5,931) (6,253) (6,264)
Amortization of transition asset(82) (159) (156) (153)
Amortization of prior service
cost
66 78 89 80
Actuarial losses (gains)764 101 105 (24)
Net pension expense95(803) (1,199) (1,511)
_____________________________________________________________________
_____________________________________________________________________
International Business Machines (IBM)
Components of pension expense, 2001-2004
(In millions of dollars)
2004
2003
2002
2001
Service cost
1,263
1,113
1,155
1,076
Interest cost
4,071
3,995
3,861
3,774
Expected return on plan assets
(5,987)
(5,931)
(6,253)
(6,264)
Amortization of transition asset
(82)
(159)
(156)
(153)
Amortization of prior service cost
66
78
89
80
Actuarial losses (gains)
764
101
105
(24)
Net pension expense
95
(803)
(1,199)
(1,511)
ATO
1
D
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