ACCT6101 Session #1: Introduction to Valuation
PART 1 Background
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ACCT7106 Session #10: Ratio Analysis; Forecasting
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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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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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
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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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What the reformulation process is NOT
it does not involve adjusting or altering the reported numbers
it does not involve creating new numbers or erasing numbers
clearly, material errors (whether unintentional or intentional = EM) need to be corrected e.g., restatement of F/S required by the relevant regulatory authority (ASIC, SEC, ) but this is not a part of the actual reformulation process
What the reformulation process IS
it takes the reported accounting numbers as given (subject to adjustment for errors)
it then reclassifies or reorders the various reported accounts to put them into a structure that (hopefully) makes them more informative, and thereby facilitates better forecasts
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Key Stepseparate operating items/activities from financing items/activities
Why? companies generate value from their operations, not their financial activities
Summary new (reformulated) accounting relations:
Balance Sheet: NOA = NFO + S/E
Income Statement: CI = OI + NFE(recall: NFE are negative)
Cash Flow Statement: FCF = C + I = F + E
Equity Statement: Change in S/E = CI + E
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Balance Sheet
operating assets (OA) financial assets (FA)
operating liabilities (OL) financial obligations (FO)
Net Operating Assets (NOA)Net Financial Obligations (NFO)
S/E = NOA NFO
Income Statement
Comprehensive Income (CI)=Operating Income (OI)Net Financial Expenses (NFE)
core operating income from sales
core other operating income
unusual operating income
operating OCI
core NFE
financial OCI
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Core Operating Income from Sales (before tax)
Core Other Operating Income (before tax)
Unusual Operating Income (before tax)
Core Net Financial Expenses (before tax)
Profit Before Tax (PBT)
Tax Expense
Net Profit After Tax (NPAT)
Other Comprehensive Income
operating OCI (after tax)
financing OCI (after tax)
Comprehensive Income
Tax Allocation:
1st tax shield from Net Financial Expenses
2ndtax on Unusual Operating Income
3rdtax on Core Other Operating Income
4thtax on Core Operating Income from Sales
Operating Income (OI)
Core Operating Income from Sales (after tax)
Core Other Operating Income (after tax)
Unusual Operating Income (after tax)
Operating OCI (after tax)
Total Operating Income
Net Financial Expenses (NFE)
Core net financing expense (after tax)
Financing OCI (after tax)
Total Net Financial Expense
Comprehensive Income
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Reformulated Statement of Cash Flows
Adjusted Cash flow from operationsC
Adjusted Cash investment in operating assets I
Free Cash Flow (FCF)C + I
Equity financing flows
dividends & share repurchasesXX
share issuances(XX)E
Debt financing flows
net purchase of financial assets(XX)
interest on financial assets (after tax)XX
net issue of debtXX
interest on debt (after tax)(XX)F
Total Financing cash flowsE + F
Uses of FCF in financing activities
Generation of FCF from operating activities
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Reformulated Statement of Changes in Shareholders Equity
Beginning Book Value of Common Equity BVt-1
+ Net effect of Transactions with Common Shareholders
+ capital contributions (share issues)
share repurchases
cash dividends to common shareholders
= Net cash contributions
+ Effect of operations and non-equity financing
+ Net Income (from the I/S)
+ Other Comprehensive Income (OCI)
preferred share dividends
= Comprehensive income available to common shareholders
Ending Book Value of Common Equity BVt
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PART 2 Profitability and Leverage (using the Reformulated F/S)
levered viewfrom the perspective of the common shareholderROCE
ROCE (return on common equity) ==
return to common shareholder (i.e., return after satisfying debt)
unlevered viewfrom the perspective of the firmRNOA
RNOA (return on net operating assets) =
return to the firm (i.e., return on the net assets provided by both debt and equity)
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Notes:
while calculations are frequently based on average figures, the ratios can also be based on year-end or beginning-of-year figures depending upon circumstance
e.g.,Coles was owned by Wesfarmers up until 2019 there are no F/S prior to 2019 and hence 2019 ratios could only be based on year-end figures
with the adoption of AASB16 (leases) in 2020, many of the figures in Coles F/S are non-comparable between 2019 and 2020
since ROCE captures the levered view whereas RNOA presents the unlevered view, loosely the distinction between ROCE and RNOA is the treatment of financing
the link between ROCE and RNOA relates to how the firm is financed
(equally, the link between ROOA and RNOA relates to operating leverage)
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from Session #2, slides 39 42
business riskThe equity risk that comes from the nature of the firms operating activities
in essence, the volatility or variability of the firms operating income
further, leverage (both operating and financial) magnify business risk
why?leverage serves to magnify profits in good timesand
leverage serves to magnify losses in bad times
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financial leverageuse of debt financing with fixed interest payments
ROCE = RNOA + FLEV x ( RNOA NBC)
operating liability leverageuse of operating liabilities (OL) to finance OA
RNOA = ROOA + OLLEV x (ROOA STBC)
operating spread
financial leverage
operating liability leverage
OL spread
leverage, both financial (FLEV) and operating liability (OLLEV), magnifies profit (& loss) available to the common shareholder
ROOARNOAROCE
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Example #9-1 profitable firm
Net operating assets (NOA)28,000
Net financial obligations (NFO)15,000
Shareholders Equity (S/E)13,000
Operating income (OI) 2,000
Net Financial Expense (NFE) (500)
Comprehensive Income (CI) 1,500
RNOA=0.0714
FLEV =1.1538
NBC = 0.0333
ROCE = RNOA + FLEV x ( RNOA NBC)
= 0.0714 + 1.1538(0.0714 0.0333) = 0.1154
ROCE===0.1154Example #9-2 loss firm
Net operating assets (NOA)28,000
Net financial obligations (NFO)15,000
Shareholders Equity (S/E)13,000
Operating income (OI)(1,000)
Net Financial Expense (NFE) (500)
Comprehensive Income (CI)(1,500)
RNOA=0.0357
FLEV =1.1538
NBC = 0.0333
ROCE = RNOA + FLEV x ( RNOA NBC)
= 0.0357 + 1.1538(0.0357 0.0333) = 0.1153
ROCE===0.1154
financial leverage (FLEV)
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Example #9-6 profitable firm
OA = 40,000OL = 12,000NOA =28,000
FA = 2,000FO = 17,000NFO = 15,000
Shareholders Equity (S/E)13,000
Operating income (OI) 2,000
Net Financial Expense (NFE)(500)
Comprehensive Income (CI)1,500
OLLEV =
assume STBC = 0.07(1 0.3) = 0.049
implicit interest on OL = 12,000 * 0.049 = 588
ROOA =0.0647
RNOA = ROOA + OOLEV(ROOA STBC)
= 0.0647 + 0.4286(0.0647 0.049) = 0.0714
RNOA=0.0714Example #9-7 loss firm
OA = 40,000OL = 12,000NOA =28,000
FA = 2,000FO = 17,000NFO = 15,000
Shareholders Equity (S/E)13,000
Operating income (OI)(1,000)
Net Financial Expense (NFE) (500)
Comprehensive Income (CI)(1,500)
OLLEV =
assume STBC = 0.07(1 0.3) = 0.049
implicit interest on OL = 12,000 * 0.049 = 588
ROOA =
RNOA = ROOA + OOLEV(ROOA STBC)
=+ 0.4286( 0.049) =
RNOA=0.0357
operating liability leverage (OLLEV)
Summing Financial Leverage and Operating Liability Leverage Effects on ROCE
ROCE= ROOA + (RNOA ROOA) + (ROCE RNOA)
Return
With no leverage
Effect of
Operating Liabilities
Effect of
Financing Liabilities
profitable firm (examples #9-1 & #9-6)
0.1154 = 0.0647+(0.0714 0.0647) + (0.1154 0.0714)
loss firm (examples #9-2 & #9-7)
-0.1154=-0.0103+ (-0.0357 0.0103) +(-0.1154 0.0357)
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clear benefits to the use of leverage for a profitable firm
Why then dont firms use more leverage, both operating and financial?
by definition, leverage increases business risk by introducing fixed costs that must be satisfied irrespective of the firms circumstances (profit or loss)
with more debt, the cost of debt and the cost of equity both increase (NFE )
???
in reality, it is highly unlikely that one element can be changed without affecting other elements within the system
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ROCE=RNOA +FLEV {RNOA NBC}first-level break down of ROCE
given RNOA == profit marginasset turnover
ROCE = {profit marginasset turnover} + {FLEVspread}second-level break down of ROCE
notion of DuPont analysis decomposition of operating profitability
operations
financing
PART 3 DuPont System & Reported vs Reformulated
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The standard presentation of the DuPont System based on reported accounting numbers is:
ROE = ROA leveragewhereROA = profit margin asset turnover
** when employed outside the DuPont system, ROA is more typically measured as:
based on the firms profit after tax (available to all forms of resource providers i.e., debt and equity)
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Notes for the DuPont System based on AASB / IFRS financial statements:
the system is based on NPAT as opposed to Comprehensive Income (CI)
both operating and financial income are included in income figure (NPAT)
total assets includes both operating and financial assets
but for example, we know that returns on operating assets are quite different from those on financial assets
In contrast, the DuPont System based on the reformulated statements is as follows:
ROCE = RNOA + leverage {RNOA NBC}
leverage {RNOA NBC}
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under both sets of presentations (reported F/S & reformulated F/S)
return to the common shareholderreturn to the firm, adjusted for leverage
return to the firm:RNOA versus ROA
expect ROA to be lower than RNOA (1963 2010: median RNOA = 10.5%, median ROA = 7.1%)
ROA includes financial assets (FA) which earn a lower rate of return
operating liability leverage (OLLEV) is reflected in RNOA but not in ROA
leverage: versus
expect D/E to be higher than FLEV (1963 2010: median D/E = 1.22, median FLEV = 0.43)
D/E includes operating liabilities which create operating liability leverage (OLLEV) and financial liabilities which create financial leverage (FLEV)
D/E excludes/ignores financial assets as an offset to financial liabilities
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return to the firm:RNOA versus ROA
PenmanTable 12.1
the biggest differences between RNOA and ROA are for firms with the biggest investment in FA and the highest OLLEV
e.g., Microsoft
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DuPont System
second level
Penman Figure 12.3Profit Margin and Asset Turnover Combinations by Industry, 1963-2000
Note a given RNOA (e.g., 14%) can be achieved from various combinations of PM and ATO
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PenmanTable 12.2
median values for ratios underlying profitability by Industry, 1963-2000
median ROCE = 12.2%
median RNOA = 10.3%
pipelines vs food stores
both have RNOA = 12%
Pipelines low ATO, high PM
Food stores high ATO, low PM
pipelines have higher FLEV
higher ROCE
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PenmanE12.7
Using average B/S amounts, calculate
RNOA and NBC
FLEV
Show that the financing leverage equation explaining ROCE holds
Calculate profit margin and asset turnover (ATO) for 2007
Show RNOA = PMATO
Calculate the gross margin ratio, the operating profit margin ratio, and the operating profit margin from sales ratio
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RNOA=0.2672
NBC = 0.0392
FLEV = 0.1848
ROCE = RNOA + FLEV x ( RNOA NBC) = 0.2672 + 0.1848(0.2672 0.0392) = 0.3093
ROCE===0.3094
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RNOA=0.2672
ATO =
operating profit margin == 0.2121
RNOA = PM x ATO = 0.2121 x 1.2599 = 0.2672
gross profit margin == 0.6394
operating profit margin from sales == 0.1890
operating profit margin == 0.2121
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ROCE=RNOA +FLEV {RNOA NBC}
where
RNOA = profit marginasset turnover
both profit margin and asset turnover can be broken down further into their underlying components to gain deeper insights into the drivers of profitability
PART 4 Deeper Insights into Profitability
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disaggregation of profit margin
OI = {sales COGS}
[administrative expenses + other operating expenses + depreciation expense]
+ other operating income + unusual operating income
tax expense
profit margin
++
Note there is no right or wrong level of disaggregation it could, for example, also be done by product and/or line of business and/or further disaggregation of Other and Unusual OI whatever provides the greatest insights into the drivers of profitability
gross margin
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disaggregation of total asset turnover
NOA = {operating cash + receivables + inventory + property & plant}
[accounts payable + accrued liabilities]
asset turnover =
+ ++
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DuPont System second level
third level
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PenmanTable 12.3
Second and third level breakdown
Nike & General Mills, 2009 2010
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second levelRNOA = profit marginasset turnover
profit marginATO 30.62328.40810.0964.058
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third levelprofit margin
Actual net (rounding!)9.6 97.93.3
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third level
asset turnover
Actual net (rounding!) 0.3130.3170.7850.841
Inverse = ATO3.195 3.1551.274 1.189
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Summary:
Nike
General Mills
for both firms, increase in RNOA largely through an increased profit margin
RNOAProfit MarginAsset Turnover
201030.6%9.54%3.21
200928.4%8.99%3.16
2.2% 0.55% 0.05
RNOAProfit MarginAsset Turnover
201010.1%7.95%1.27
20094.1%3.41%1.19
6.0% 4.54% 0.08
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Further applications / insights illustrated
If Nike could increase it Accounts Receivable turnover from 6.85 to General Mills level of 15.15 while maintaining the current level of sales and all else remaining unchanged, how would its RNOA change?
2010: = 0.146A/R turnover = 6.85 =
new:A/R turnover = 15.15 = 0.066
based on figures provided = 0.311ATO = 3.21
revised 0.311 (0.146 0.066) = 0.231 ATO = 4.33
RNOA =0.954 41.3%(up from 30.6%)
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If Nike could increase it Accounts Receivable turnover form 6.85 to General Mills level of 15.15 while maintaining the current level of sales and all else remaining unchanged, how would its RNOA change?
RNOA =0.954 41.3%(up from 30.6%)
feasible / realistic ?
current collection period = 365/6.85 = 53.3 daysrevised = 365 / 15.15 = 24.1 days
more stringent credit terms
would expectsales orsales discounts (& gross margin )
bad debt expense A/R A/R turnover
unlikely that A/R turnover can be changed in isolation
(and if feasible, why hasnt the change already been made?)
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2.If Nikes gross margin ratio dropped from 46.3% to 44.9% because of increased production costs, what would happen to its RNOA given a tax rate of 36.3%?
Gross Margin1.4% pre-tax(1 0.363) = 0.89% post tax
Profit Margin 0.89%
RNOA = 0.893.16 = 2.8RNOA 2.8%
again, is it likely that only one account is affected in isolation?
Increased production costsaccounts payable ??
inventory ??
ultimately sales price and sales ??
???
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PART 5 Coles
2020 ratios based on reformulated F/S and year-end B/S figures (given AASB 16)
1st step(slides #45 #47)
financial leverage equation ROCE = RNOA + FLEV x ( RNOA NBC)
DuPont SystemRNOA = PMATO
operating liability leverage equation RNOA = ROOA + OLLEV x ( ROOASTBC)
2nd step profit margin drivers(slide #48)
3rd step asset turnover drivers(slide #49)
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Coles Reformulated Income Statement2020
Sales Revenue37,408
Cost of sales(28,043)
Gross Margin9,365
Administrative expenses(8,122)
Core Income from Sales (before tax)1,243
Tax expense(318.2)
Core Income from Sales (after tax)924.8
Core Other Operating Income (after tax) (376 + 108 6 143.4)334.6
Core Unusual Operating Income (after tax) (41 12.3)28.7
Operating Income after Tax1,288.1
Financing costs
Core NFE (after tax)310.1
Financing OCI (after tax) 12(322.1)
Total Comprehensive Income966
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Coles Reformulated B/S2020
Operating Assets
cash & cash equivalents187
receivables434
inventories2,166
assets held for resale75
other assets190
property, plant & equipment4,127
right-of-use assets7,660
intangible assets1,597
deferred tax assets849
equity accounted investments217
Total Operating Assets (OA)17,502
Operating Liabilities
trade payables3,737
provisions1,333
other227
Total Operating Liabilities (OL)5,297
Net Operating Assets (NOA)12,205
2020
Financial Assets
financial cash805
income tax receivable42
Total Financial Assets (FA)847
Financial Obligations
interest-bearing liabilities1,354
provisions
lease liabilities9,083
Total Financial Obligations (FO)10,437
Net Financial Obligations (NFO)9,590
Shareholders Equity
contributed equity1,611
reserves43
retained earnings961
Total Equity2,615
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RNOA=0.1055
NBC = 0.0336
FLEV = 3.6673
ROCE = RNOA + FLEV x ( RNOA NBC) = 0.1055 + 3.6673(0.1055 0.0336) = 0.3694
ROCE===0.3694
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RNOA=0.1055
ATO = 0650
operating profit margin == 0.0344
RNOA=PMxATO=0.0344×3.0650=0.1054
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OLLEV =0.4340
assume after-tax STBC = 0.025
Implicit interest on OL = 5,297 @ 0.025 = 132.425
ROOA =0.0812
RNOA = ROOA + OLLEV x ( ROOASTBC) = 0.0812 + 0.4340 (0.0812 0.025) = 0.1056
RNOA=0.1055
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Profit Margin Drivers% of sales
Sales Revenue37,4081.0000
Cost of sales(28,043)(0.7497)
Gross Margin9,3650.2503
Administrative expenses(8,122)(0.2171)
Core Income from Sales (before tax)1,2430.0332
Tax expense(318.2)(0.0085)
Core Income from Sales (after tax)924.80.0247
Core Other Operating Income (after tax)334.60.0089
Core Unusual Operating Income (after tax)28.70.0008
Operating Income after Tax1,288.10.0344
Financing costs
Core NFE (after tax)310.1(0.0083)
Financing OCI (after tax) 12(322.1)(0.0003)
Total Comprehensive Income9660.0258
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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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Aside:Microsoft Corporation, 2003
NOA12,829OI6,277
NFA36,906NFI1,548
S/E49,735CI7,825
RNOA=0.4893
FLEV = 0.7421RNFA = 0.0419
ROCE=== 0.1573
ROCE = RNOA + FLEV x ( RNOA NBC) = 0.4893 0.7421(0.4893 0.0419) = 0.1573
Why is ROCE < RNOANOA earn 48.93%NFA earn 4.19% investments in NFA reduces the shareholders rate of return52What if Microsoft paid a special dividend of $33 billion (as it did in 2004) by selling financial assets?NOA12,829NFA3,906S/E16,735new FLEV = 0.233ROCE = 0.4893% 0.233(0.4893 0.0419) = 0.384953PART 6 Forecasting & ValuationObjective of the forecasting exerciseto develop objective and realistic expectations of future value-relevant payoffsHow to achieve this?develop pro forma F/S containing unbiased predictions of the firms future operating, investing, and financing activitiesshould be neither conservative nor optimisticpro 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 salesneed 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 realistic54Steps comprising the Forecasting ExerciseIncome Statement:Step 1:Forecast SalesStep 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 OIStep 6:Calculate OI (after tax)Balance Sheet:Step 7:Forecast OA and OL to obtain a forecast of NOA55Unlevered Valuationvaluing the firmStep 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 firmStep 10:Forecast Leverage and NFE (after tax)Step 11:Calculate CI = OI (after tax) NFE (after tax) & CSE = NOA NFOStep 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 shareholder56Implementing the forecasting stepsbe aware that the steps are integrated and interdependentthe amounts in each of the pro forma F/S need to agree with each other be aware of the interrelations between the financial statementsneed some flexible accounts that expand or decrease in response to changes in activities; working through the pro forma F/S results in a circularity which in turn may result in the need for more than one iteration of the accountsquality of forecast financial information is a direct function of the quality of forecast assumptionssensitivity analysis should be conducted on the pro forma statements57Step 1:Forecast Salessales drive the system !!the sales forecast is the starting point and typically requires the greatest attention during the forecasting processa 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 forecaststhe firms business strategythe market for the firms productsthe firms marketing planhow the broader economic factors and the industry dynamics affect the business581. the firms business strategy e.g., what lines of business is the firm likely to be in?is the firm likely to develop new products?what stage in their lifecycle are the firms products at?what is the firms acquisition and takeover strategy?2. the market for the firms products e.g., is consumer behaviour likely to change, and if so how?what is the elasticity of demand for the firms products?are new products likely to emerge that could displace the firms current product line?are substitute products a material threat?3. The firms marketing plan e.g., is the market for the firms products expanding, or are new markets opening up?what is the firms pricing strategy (cost leadership; differentiation; focus)?what is the firms advertising strategy?does the firm have, or can it develop and maintain brand names (or other intangibles)?59macroeconomic factorshistorical values & patternsfuture valuesindustry dynamicsunderstand the relationsforecast industry salesFirm Salesforecast firm salesunderstand the relations & the competitive environment(unpredictable series based on past data)Business strategy** forecasted sales **60end productforecast of future salesconsiderations / constraints include regression to mean phenomenonappropriate forecast horizonappropriate terminal growth ratesustainable growth rate61regression to mean phenomenoncompany performance tends to be mean-revertingcompanies with above average performance tend to experience a decline in profitability/growthcompanies with below average performance tend to experience an improvementmean-reversion suggests that most companies eventually reach a steady state where their sales growth, RNOA, and other performance measures flatten out62why does mean reversion happen? The answer can see seen through the lens of Porters five forces coupled with opportunity threat of new entrants: competitors enter markets that are profitable and exit markets that are unprofitablepower of suppliers: suppliers might consolidate or find new markets for their products, and so become more powerfulthreat of substitutes: high profits encourage the invention of substitute products (e.g., Skype versus long-distance telephone calls)companies tend to run out of growth opportunities as they mature e.g., Walmart636465662) appropriate forecast horizonusual approach – sales are forecasted for a finite period at which point a steady state growth rate is establishedthe question that arises is around how long the forecast horizon beusually forecast out as many years as the estimates are reliable stop once the point where cant estimate better than assuming stable growth is reachedthe forecast horizon is also the period during which the firm has a competitive advantagei.e., the period over which the abnormal returns are positive.stable growth achieved when:constant sales growth ratemargins constant this means that expenses grow at the same constant rate as salesturnover ratios constantfinancial leverage ratios constantPART 7 Forecasting (cont)67business/industry life cycle will likely impact on forecast horizon.mature industry shorter forecast horizon since growth more likely to be stablehigh growth firms forecast horizon likely to be longer as less likely that the above factors will be constantsales growth affected by industry wide growth as well as firms growth in market share; also affected by macroeconomic factorsprofit margin results from the firms competitive advantageturnover tend to be fairly stable over time; rapidly growing firms may have increasing turnover ratios due to economies of scale. leverage unlikely to influence forecast horizonideally, would like to make year-by-year forecasts until the company reaches a steady state, at which point the companys sales growth rate should approximate the terminal growth rate (g) however, there is also the question of practicality68To illustrate the importance of forecasting to the point of steady state, consider the following forecasted data for a hypothetical company Year 0Year 1Year 2Year 3Year 4Year 5Sales1,0001,3001,6252,035.52,420.32,774.4 % Sales30.00%27.08%23.21%18.91%14.63%OI600.0764.4951.91,149.51,339.41,504.7 margin60.00%58.80%57.62%56.47%55.34%54.24%NOA400.0520.0660.8814.2968.11,109.8 % NOA30.00%27.08%23.21%18.91%14.63%ReOI724.4899.91,083.41,258.01,407.9 % ReOI24.23%20.38%16.12%11.91%FCF644.4811.1996.11,185.51,363.1 % FCF25.88%22.80%19.02%14.98%69Assume that a sensible terminal growth rate for both ReOI and FCF is 3%, and the companys WACC is 10%Implications of using a 5-year forecast horizongrowth in ReOI drops abruptly from 11.91% in year 5 to 3% in year 6growth in FCF drops abruptly from 14.98% in year 5 to 3% in year 6using the FCF valuation model, V = $16,114.2using the ReOI valuation model, V = $17,212.8the undesirable outcome of different valuation estimates70Alternatively, if the forecast horizon is extended to the point where sales, OI, and NOA are growing at (approximately) the terminal growth rate here for illustrative purposes, 10 yearsYear 0Year 1Year 2Year 3Year 4Year 5Year 6Year 7Year 8Year 9Year 10Sales1,0001,3001,6252,035.52,420.32,774.43,072.83,303.63,468.23,577.13,684.4 % Sales30.00%27.08%23.21%18.91%14.63%10.75%7.51%4.98%3.14%3.00%OI600.0764.4951.91,149.51,339.41,504.71,633.21,720.71,770.31,789.41,842.2 margin60.00%58.80%57.62%56.47%55.34%54.24%53.15%52.09%51.05%50.02%50.00%NOA400.0520.0660.8814.2968.11,109.81,229.11,321.41,387.31,430.81,473.8 % NOA30.00%27.08%23.21%18.91%14.63%10.75%7.51%4.98%3.14%3.00%ReOI724.4899.91,083.41,258.01,407.91,522.21,597.81,638.21,650.71,699.1 % ReOI24.23%20.38%16.12%11.91%8.12%4.97%2.53%0.76%2.93%FCF644.4811.1996.11,185.51,363.11,513.81,628.41,704.51,745.91,799.3 % FCF25.88%22.80%19.02%14.98%11.06%7.57%4.67%2.43%3.06%by year 10, growth rates in sales, OI, and NOA (and thereby ReOI and FCF) have systematically converged to the terminal growth ratethe valuation estimate is the same based on both models ($17,787.3)the valuation estimate is higher than based on only 5 years of forecasts missed value by not forecasting long enough71 In the ideal, it is desirable to forecast on a year-by-year basis until the steady state growth rate has been reached … BUT … again there is the mitigating factor of practicalityfinally and to re-iterate, both macroeconomic factors and industry dynamics have an important role in the process of forecasting salesIndustry growthkey determinant in forecast horizonattempt to identify variables that predict industry salesindustry data needs to be predictableneed strong links to the firms salesfactors include demographic trends, nominal GDP growth, competition, market share Competitive advantageoften a factor that is over-estimatedrare to have indefinitely sustainable competitive advantage (monopoly)723) appropriate terminal growth ratesales growth terminal growth rate cannot exceed long-run expected economy-wide growth rate (e.g., nominal GDP growth)if terminal growth rate > economy-wide growth rate, company will outgrow economy
if the terminal growth rate < economy-wide growth rate, company will shrink often safe to assume that the company will continue to grow at the long-term economy-wide growth rate (but not always)need to justify assumed gguidelines for margins, turnover, and leverage are not as obvious however, their relations with ROCE provides a useful basis for assumptions remember, ROCE is mean reverting (as is RNOA); thus, it is reasonable to assume that ROCE will move towards the cost of equity capital over timeif a firm is operating in a long-run competitive equilibrium and there is a relatively close link between ROCE and economic rate of return, the terminal ROCE growth rate should equal the cost of equity capital734) sustainable growth rate, g*the sustainable growth rate indicates the maximum rate at which a firm can grow without additional external financing, given its current level of profitability and dividend policyg* = ROCE x earnings retention rate= {(profit margin x asset turnover) + FLEV (RNOA NBC)}x earnings retention ratethe rate at which the firm can safely grow without changing any of these factorsi.e.,if the firm wishes to grow at a rate exceeding g* then it must either turn to external financial markets for additional support, or generate/retain more internally (improved profit margin, improved asset turnover, and/or reduce payout ratio)74HOWEVER- the profit margin may be relatively inflexible- dividend policy is typically viewed as stickymay only have asset turnover and leverage (use of additional debt or equity financing) as the available ways in which to support growth in excess of g*Thus, if a firms forecasted sales growth rate exceeds its sustainable growth rate (g*), it is useful to try and understand how the additional growth will be financedone possibility is through increased future profitability; however, if the increased profitability is not achieved, the growth plans may be curtailedalternatively, the additional growth may be financed externally through new debt and/or equity; this also introduces uncertainty because advance planning is required and capital markets must be receptive to the firms growth plansa final option is for the firm to cut is dividend payout ratio; however, given that average dividend payout ratios are close to zero for growth firms, this final option is often not available75g* = {(profit margin x asset turnover) + FLEV (RNOA NBC)}x earnings retention rateNote, the sustainable growth rate also provides a crude starting point for a growth estimate i.e., assuming the firm pays out the same proportion of profits each year, dividends and earnings will both grow by the following rate (all else held equal including feasibility):g = RRxROCEwhere RR = retention rate and ROE = return on equityBased on the reformulated F/S, the most common measure for the payout ratio is:comprehensive dividend payout ratio = E = net transactions with shareholders (see reformulated Statement of Cash Flows or Statement of Changes in Shareholders EquityCI = comprehensive incomenote requires CI > 0 (a profitable firm)
76
Coles 2020sales37,408dividends873
OI1,288.1repurchases 17
CI966share-based exp(13)
NOA12,205E877
RNOA=0.1055ROCE===0.3694
ATO = 0650operating PM == 0.0344
payout ratio = 0.9079retention rate = (1 0.9079) = 0.0921
sustainable growth rate g* = 0.3694 x 0.0921 = 0.0340
77
Coles 2020
sustainable growth rate g* = 0.3694 x 0.0921 = 0.0340
sales201938,176
202037,408sales growth = 0.0201
actual sales growth < g*generation of surplus cash during period (from reformulated SCF, FCF = 2,185)can retain surplus cash for future investment, or return to resource providers (debt and equity)from the reformulated Statement of Cash FlowsF = (1,308)including net repayment of borrowings = 106 millionE =(877)including repurchase of shares = 17 millionfrom the reformulated Balance Sheet, financing cash increased by $56 million78overarching objective: to conduct fundamental value for the purpose of estimating the intrinsic value of a firms common sharesrequires an understanding of the firms value driversneed to accumulate a tool kit as the basis for developing the pro forma Financial StatementsSTEP 1Understanding the pastInformation collectionUnderstanding the businessAccounting analysisFinancial ratio analysisCash flow analysis STEP 2Forecasting the futureStructured forecastingIncome Statement forecastsBalance sheet forecastsCash flow forecasts STEP 3ValuationCost of capitalValuation models AE, FCF, DValuation ratiosComplicationsNegative valuesValue creation and destructionPART 8 Summary79external environment economic prospectsmacroeconomic factorssocio-cultural forcespolitical / regulatoryIndustry dynamics Porters five forces(suppliers, buyers, new entrants, substitutes, rivalry)Analysis of Financial Statements understanding current F/Sre-formulating the F/Saccounting qualityratio analysisanalysts reportsmanagement forecastsfinancial press???0V =tx( 1+ tkt)t =1 =E( tx )t(1+k)t=1n +E( nx ) (1+ g)k g1n(1+k)0V=tx(1+tkt)t=1=E(tx)t(1+k)t=1n+E(nx)(1+g)k-g1n(1+k)ROCE(%) FLEV OLLEV RNOA(%) PM(%) ATOPipelines17.1 1.093 0.154 12.0 27.8 0.40 Tobacco15.8 0.307 0.272 14.0 9.3 1.70 Restaurants15.6 0.313 0.306 14.2 5.0 2.83 Printing and publishing 14.6 0.154 0.374 13.6 6.5 2.20 Business services 14.6 0.056 0.488 13.5 5.2 2.95 Chemicals14.3 0.198 0.352 13.4 7.1 1.91 Food stores13.8 0.364 0.559 12.0 1.7 7.39 Trucking13.8 0.641 0.419 10.1 3.8 2.88 Food products13.7 0.414 0.350 12.1 4.4 2.74 Communications13.4 0.743 0.284 9.1 12.5 0.76 General stores13.2 0.389 0.457 11.3 3.5 3.55 Petroleum refining 12.6 0.359 0.487 11.2 6.0 1.96 Transportation equipment 12.5 0.369 0.422 11.2 4.5 2.47 Airlines12.4 0.841 0.516 9.0 4.3 1.99 Utilities12.4 1.434 0.272 8.2 14.5 0.59 Wholesalers, non-durable goods 12.2 0.584 0.461 10.2 2.3 3.72 Paper products11.8 0.436 0.296 10.2 5.9 1.74 Lumber11.7 0.312 0.384 10.4 4.0 2.60 Apparel11.6 0.408 0.317 10.1 4.0 2.55 Hotels11.5 1.054 0.201 8.5 8.2 1.04 Shipping11.4 0.793 0.205 9.1 12.6 0.61 Amusements and recreation 11.4 0.598 0.203 10.1 9.5 1.10 Building and construction 11.4 0.439 0.409 10.6 4.5 2.06 Wholesalers, durable goods 11.2 0.448 0.354 9.9 3.4 2.84 Textiles10.4 0.423 0.266 9.3 4.3 2.09 Primary metals9.9 0.424 0.338 9.4 5.0 1.80 Oil and gas extraction 9.1 0.395 0.263 8.3 13.0 0.57 Railroads7.3 0.556 0.362 7.1 9.7 0.78ROCE(%)ROCE(%)FLEVOLLEVRNOA(%)PM(%)ATOPipelines17.11.0930.15412.027.80.40Tobacco15.80.3070.27214.09.31.70Restaurants15.60.3130.30614.25.02.83Printing and publishing14.60.1540.37413.66.52.20Business services14.60.0560.48813.55.22.95Chemicals14.30.1980.35213.47.11.91Food stores13.80.3640.55912.01.77.39Trucking13.80.6410.41910.13.82.88Food products13.70.4140.35012.14.42.74Communications13.40.7430.2849.112.50.76General stores13.20.3890.45711.33.53.55Petroleum refining12.60.3590.48711.26.01.96Transportation equipment12.50.3690.42211.24.52.47Airlines12.40.8410.5169.04.31.99Utilities12.41.4340.2728.214.50.59Wholesalers, non-durable goods12.20.5840.46110.22.33.72Paper products11.80.4360.29610.25.91.74Lumber11.70.3120.38410.44.02.60Apparel11.60.4080.31710.14.02.55Hotels11.51.0540.2018.58.21.04Shipping11.40.7930.2059.112.60.61Amusements and recreation11.40.5980.20310.19.51.10Building and construction11.40.4390.40910.64.52.06Wholesalers, durable goods11.20.4480.3549.93.42.84Textiles10.40.4230.2669.34.32.09Primary metals9.90.4240.3389.45.01.80Oil and gas extraction9.10.3950.2638.313.00.57Railroads7.30.5560.3627.19.70.78/docProps/thumbnail.jpeg
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