Chapter 15 (1571.0K)


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Chapter 15 (1571.0K)

  1. 1. Chapter 15 Full-Information Forecasting, Valuation, and Business Strategy Analysis
  2. 2. Full-Information Forecasting, Valuation, and Business Strategy Analysis Chapter 14 developed simple forecasting schemes based solely on information in financial statements Link to Previous Chapter This chapter uses the financial statement analysis of Chapter 11 and 12 to develop a scheme for full- information forecasting This chapter shows how information outside the financial statements is utilized to make forecasts that improve upon the simple forecasts in Chapter 14 This Chapter Chapter 16 begins an investigation of accounting issues that arise from forecasting and valuation Link to Next Chapter Develop forecasting and valuation spreadsheets with BYOAP Link to Web Page How is knowledge of the business applied to forecasting ? How is financial statement analysis utilized in forecasting ? How are proforma future financial statements prepared ? How is pro forma analysis used in strategy decisions ? Chapters 11 and 12 laid out the analysis of financial statements that uncovers drivers of profitability and growth. Link to Chapter 10
  3. 3. What you will learn from this chapter <ul><li>What types of economic factors have to be considered for forecasting </li></ul><ul><li>How financial statement drivers translate economic factors into valuation </li></ul><ul><li>How particular drivers typically change over time </li></ul><ul><li>How to do pro forma analysis </li></ul><ul><li>The 15 steps involved in forecasting residual operating income and abnormal operating income growth </li></ul><ul><li>How to convert pro forma financial statements to a valuation </li></ul><ul><li>How pro forma analysis is used as a tool in strategy analysis </li></ul><ul><li>The difference between dollar forecasting and per-share forecasting </li></ul><ul><li>How mergers and acquisitions are evaluated </li></ul>
  4. 4. A Reminder: The Steps of Fundamental Analysis
  5. 5. Review of Chapter 1 Knowing the Business: Know the Firm’s Products <ul><li>Type of products </li></ul><ul><li>Consumer demand for the product </li></ul><ul><li>Price elasticity of demand for the product </li></ul><ul><li>Substitutes for the product. Is it differentiated? On price? On quality? </li></ul><ul><li>Brand name association of the product </li></ul><ul><li>Patent protection for the product </li></ul>
  6. 6. Knowing the Business: Know the Technology <ul><li>Production process </li></ul><ul><li>Marketing process </li></ul><ul><li>Distribution channels </li></ul><ul><li>Supplier network </li></ul><ul><li>Cost structure </li></ul><ul><li>Economies of scale </li></ul>
  7. 7. Knowing the Business: Know Industry Competition <ul><li>Concentration in the industry, the number of firms and their sizes </li></ul><ul><li>Barriers to entry in the industry and the likelihood of new entrants and substitute products </li></ul><ul><li>The firm’s position in the industry. Is it the first mover or a follower in the industry? Does it have a cost advantage? </li></ul><ul><li>Competitiveness of suppliers. Do suppliers have market power? Do labor unions have power? </li></ul><ul><li>Capacity in the industry? Is there excess capacity or under capacity? </li></ul><ul><li>Relationships and alliances with other firms </li></ul>
  8. 8. Knowing the Business: Know the Political, Legal and Regulatory Environment <ul><li>The firm’s political influence </li></ul><ul><li>Legal constraints on the firm including antitrust law, consumer law, labor law and environmental law </li></ul><ul><li>Regulatory constraints on the firm including product and price regulations </li></ul><ul><li>Taxation of the business </li></ul>
  9. 9. Financial Statement Analysis: The Lens on the Business Economic Factors The Filter of Financial Statement Analysis Economic Factors Interpreted as ReOI Drivers
  10. 10. Four Points of Focus <ul><li>1. Focus on Residual Operating Income and its Drivers </li></ul><ul><li>2. Focus on Change </li></ul><ul><li>3. Focus on Key Drivers </li></ul><ul><li>4. Focus on Choice versus Conditions </li></ul>
  11. 11. Focus on Residual Operating Income (ReOI) <ul><li>Two drivers: </li></ul><ul><li>1. </li></ul><ul><li>2. </li></ul><ul><li>The two drivers can be captured in one expression for ReOI: </li></ul><ul><li>To add ReOI (and AOIG and value): grow sales and increase Core Sales PM relative to Turnover Efficiency Ratio </li></ul>
  12. 12. Focus on Change <ul><li>Establish Typical Driver Pattern for Industry </li></ul><ul><li>Modify Typical Driver Pattern for Forecasted Changes for the Industry and the Economy </li></ul><ul><li>Discover How a Firm’s Driver Pattern will be Different from the Typical Pattern </li></ul><ul><li>Remember </li></ul>
  13. 13. Driver Patterns: Core RNOA <ul><li>(All NYSE and AMEX firms, 1965 – 96) </li></ul><ul><li>The rate of convergence towards common </li></ul><ul><li>level is referred to as the Fade Rate </li></ul><ul><li>What economic factors drive fade rates? </li></ul>Core RNOA Year Ahead
  14. 14. Driver Patterns: Core Other Income/NOA Core Other Income / NOA Year Ahead
  15. 15. Driver Patterns: Unusual Items/NOA Unusual Items / NOA Year Ahead
  16. 16. Driver Change Patterns: Sales Growth Rates Sales Growth Rate Year Ahead
  17. 17. Driver Change Patterns: Change in Core Sales PM Year Ahead Change in Core Sales PM
  18. 18. Driver Change Patterns: Change in ATO Year Ahead Change in ATO
  19. 19. Forecasting How a Firm’s Drivers will be Different from the Typical Pattern <ul><li>The tension between the forces of competition and the firm’s responses to those forces: challenge and counter challenge </li></ul><ul><li>Firms challenge other firms: </li></ul><ul><ul><li>Product price reduction </li></ul></ul><ul><ul><li>Product innovation </li></ul></ul><ul><ul><li>Lower production costs </li></ul></ul><ul><ul><li>Imitation of successful firms </li></ul></ul><ul><ul><li>Entering industries where firms are earning abnormal profits </li></ul></ul><ul><li>Firms counter challenge: </li></ul><ul><ul><li>Brand creation </li></ul></ul><ul><ul><li>Patent protection </li></ul></ul><ul><ul><li>Managing consumer expectations </li></ul></ul><ul><ul><li>Alliances and agreements with competitors, suppliers and firms with related technology </li></ul></ul><ul><ul><li>Exploiting first-mover advantages </li></ul></ul><ul><ul><li>Mergers </li></ul></ul><ul><ul><li>Creating superior production and marketing technologies </li></ul></ul><ul><ul><li>Creating economies of scale that are difficult to replicate </li></ul></ul><ul><ul><li>Creating a technological standard that consumers and other firms must tie into </li></ul></ul><ul><ul><li>Government protection </li></ul></ul>
  20. 20. Focus on Key Drivers <ul><li>Some firms have one or two drivers that are key to driving ReOI. Analysts focus on these key drivers </li></ul>
  21. 21. Driver History for a Brand Name Company: Coca-Cola <ul><li>Coke targets “economic profit” (similar to ReOI) to create shareholder value. It reported the following in its 10-K: </li></ul><ul><li>This is a Growth Pattern, not a Fade Pattern </li></ul><ul><li>Forces of competition create fade patterns </li></ul><ul><li>Challenges to competition create growth patterns </li></ul>
  22. 22. Full Information Forecasting <ul><li>Forecast all economic factors and the full set of ReOI drivers </li></ul><ul><li>Express forecasts in a set of pro forma financial statements </li></ul><ul><li>An Example with PPE Inc. follows </li></ul>
  23. 23. PPE Inc.: The Initializing Balance Sheet, Year 0
  24. 24. The Initializing Income Statement and Cash Flow Statement
  25. 25. Forecasting for PPE Inc. <ul><li>The forecasts: </li></ul><ul><li>Sales are forecasted to grow at 5% </li></ul><ul><li>Forecasted Core PM is 7.85% </li></ul><ul><li>Forecasted ATO is 1.762 </li></ul><ul><li>(1/ATO = 56.75 cents for each dollar of sales) </li></ul><ul><li>With these three items we can value the firm. </li></ul><ul><li>Cost of capital for operations = 11.34% </li></ul><ul><li>Cost of capital for debt = 10.00% </li></ul>
  26. 26. PPE Inc.: The Pro Forma for Operating Activities
  27. 27. A Short-Cut Calculation of ReOI <ul><li>For PPE Inc., Year 3 </li></ul>
  28. 28. A Short-Cut Calculation of AOIG <ul><li>Abnormal OI Growth </li></ul><ul><li>For PPP Inc., Year 3: </li></ul>
  29. 29. PPE Inc.: The ReOI Valuation from the Pro Forma <ul><li>Features of the pro forma: </li></ul><ul><li>1 . Future RNOA is the same as currently </li></ul><ul><ul><ul><li>Core PM the same </li></ul></ul></ul><ul><ul><ul><li>ATO the same </li></ul></ul></ul><ul><li>2. Growth rate is constant </li></ul>($0.96 per share on 100 million shares)
  30. 30. PPE Inc. The AOIG Valuation from the Pro Forma
  31. 31. PPE Inc. The Free Cash Flow Valuation from the Pro Forma
  32. 32. Filling out the Pro Forma Financial Statements <ul><li>Dividend forecast: Payout will be 40% of Earnings </li></ul><ul><li>Borrowing cost forecast: Same as present (10%) </li></ul>
  33. 33. Full-Information Forecasting: Nike
  34. 34. Full-Information Forecasting: Nike (Cont.)
  35. 35. A Forecasting Template <ul><li>Forecast sales </li></ul><ul><li>Forecast ATO and calculate NOA </li></ul><ul><ul><li>NOA=sales/ATO </li></ul></ul><ul><li>Revise sales forecast for asset constraints </li></ul><ul><li>Forecast Core PM and calculate Core OI </li></ul><ul><ul><li>Core OI = Sales x Core PM </li></ul></ul><ul><li>Forecast Other Core OI and total Core OI </li></ul><ul><ul><li>Core OI = Core OI from sales + Other Core OI </li></ul></ul><ul><li>Forecast unusual operating items </li></ul><ul><li>Calculate ReOI and AOIG </li></ul><ul><ul><li>OI t = Core OI t + UI t </li></ul></ul><ul><ul><li>ReOI t = OI t - ( ρ F -1) NOA t-1 </li></ul></ul><ul><ul><li>AOIG t= Δ ReOI t </li></ul></ul><ul><li>Calculate Free Cash Flow </li></ul>
  36. 36. A Forecasting Template (cont) <ul><li>Forecast net dividend payout </li></ul><ul><li>Calculate financial expenses (or income) </li></ul><ul><li>Calculate net financing position </li></ul><ul><li>Calculate comprehensive net income </li></ul><ul><li>Calculate common stockholders’ equity </li></ul><ul><li>Adjust the valuation for stock option overhang (Chapter 13) </li></ul><ul><li>Adjust for any value for minority interests </li></ul><ul><li>Steps 1-6 and step 9 and 10 require forecasting </li></ul><ul><li>All other steps are calculations from forecasted amounts using accounting relations </li></ul><ul><li>Only steps 1-7 are necessary for valuation (without stock options) </li></ul>
  37. 37. Forecasting ReOI and AOIG from Their Drivers (1) Sales Forecast (4) Forecast PM: Gross Margin - Expense Ratios Core OI Other OI UI OI NOA ATO (2) Forecast ATO (3) Revise Sales Forecast Apply PM: Core OI = Sales x PM (5) Forecast Other OI (6) Forecast Unusual Items Apply ATO: NOA = Sales / ATO (7) Match OI and NOA ReOI
  38. 38. Checking Pro Forma Analysis <ul><li>Make sure CSE reconciliations in Step 13 agree </li></ul><ul><li>Check common size analysis against industry norms. Are differences reasonable? </li></ul><ul><li>Watch for financial asset build up. What will the firm do with the build-up? </li></ul>
  39. 39. Features of the OI Valuation Approach <ul><li>1 .- It is efficient: forecast five factors </li></ul><ul><ul><ul><li>Sales </li></ul></ul></ul><ul><ul><ul><li>Core PM </li></ul></ul></ul><ul><ul><ul><li>ATO </li></ul></ul></ul><ul><ul><ul><li>Other Core OI </li></ul></ul></ul><ul><ul><ul><li>Unusual Items </li></ul></ul></ul><ul><li>2 .- Focuses in the part of the business that adds </li></ul><ul><li>value: the operations </li></ul><ul><li>3 .- Dividends are irrelevant </li></ul><ul><li>4 .- Financing is irrelevant </li></ul><ul><li>5 .- Zero NPV (zero ReOI) investments don’t </li></ul><ul><li>affect the valuation </li></ul><ul><li>6 .- Value-generating investments are </li></ul><ul><li>identified </li></ul><ul><li>7 .- Avoids problems of the discount rate </li></ul><ul><li>changing as leverage changes </li></ul>
  40. 40. Mergers and Acquisitions Involving Share Issues <ul><li>Mergers and Acquisitions often involve share issues </li></ul><ul><li>Residual earnings valuation cannot be done by forecasting per-share amounts if shares outstanding are likely to change </li></ul><ul><ul><li>Always carry out residual earnings valuations on a dollar basis, then divide by current shares outstanding </li></ul></ul><ul><li>Abnormal Earnings Growth (AEG) valuation can be carried out by forecasting per-share earnings and dividends </li></ul><ul><ul><li>However, must then work on a levered basis (requiring changes in the cost of equity capital) </li></ul></ul><ul><li>Best to work with operations on a dollar basis </li></ul>
  41. 41. Valuation with an Anticipated Acquisition: Dealing with Value Received in the Exchange Ratio
  42. 42. Financial Statement Indicators <ul><li>1 .- Current RNOA different from the past </li></ul><ul><li>2 .- Components of RNOA different from the </li></ul><ul><li>past </li></ul><ul><ul><li>Analyze the determinants of the current Δ RNOA: </li></ul></ul><ul><ul><li>Δ in Core PM is particularly important </li></ul></ul><ul><li>3 .- RNOA different from industry mean </li></ul><ul><ul><li>RNOAs tend to revert towards industry averages </li></ul></ul>
  43. 43. Financial Statement Indicators (cont) <ul><li>4 .- Components of RNOA different from industry mean </li></ul><ul><li> PM components: </li></ul><ul><ul><li>Cost of sales/Sales </li></ul></ul><ul><ul><li>Advertising/Sales </li></ul></ul><ul><ul><li>G & A expenses/Sales </li></ul></ul><ul><ul><li>R & D /Sales </li></ul></ul><ul><li>ATO components </li></ul><ul><ul><li>Inventories/Sales </li></ul></ul><ul><ul><li>Accounts receivables/Sales </li></ul></ul><ul><ul><li>Doubtful debts/Sales </li></ul></ul><ul><ul><li>PPE/Sales </li></ul></ul><ul><ul><li>… </li></ul></ul><ul><li>5 .- Changes in RNOA components different from industry </li></ul><ul><li>mean </li></ul><ul><li>6 .- Changes in capital expenditures different from a </li></ul><ul><li>industry mean </li></ul><ul><li>Combine investigation with Quality of Earnings </li></ul><ul><li>Analysis (Chapter 17). </li></ul>
  44. 44. Indicators Outside Financial Statements <ul><li>Firm specific indicators </li></ul><ul><ul><li>Non-working assets </li></ul></ul><ul><ul><li>Order backlog </li></ul></ul><ul><ul><li>Per-unit sales prices </li></ul></ul><ul><ul><li>R&D success </li></ul></ul><ul><ul><li>Firms’ investment plans </li></ul></ul><ul><ul><li>Change in labor force </li></ul></ul><ul><ul><li>Management discussion and analysis </li></ul></ul><ul><ul><li>Insider trading </li></ul></ul><ul><ul><li>Contingent liabilities (see footnotes) </li></ul></ul>
  45. 45. Red Flag Indicators <ul><li>Slow sales growth </li></ul><ul><li>Declines in order backlog </li></ul><ul><li>Increasing Accounts Receivable/Sales </li></ul><ul><li>Increasing Inventory/Sales </li></ul><ul><li>Deterioration in Gross margin/Sales </li></ul><ul><li>Increasing Selling and Administrative Expenses/ Sales </li></ul><ul><li>Low effective tax rates </li></ul><ul><li>Large non-recurring items </li></ul><ul><li>Increases in dilutive securities: executive stock options </li></ul><ul><li>Build up of financial assets </li></ul><ul><li>Go to Quality of Earnings Analysis (Chapter 17) </li></ul>
  46. 46. Business Strategy and Pro Forma Analysis <ul><li>The same apparatus serves strategy analysis </li></ul><ul><li>Five steps of fundamental analysis are the five steps of strategy analysis </li></ul><ul><li>Focus: </li></ul><ul><ul><li>maximize RNOA relative to required return </li></ul></ul><ul><ul><li>grow NOA </li></ul></ul><ul><li>Pro forma financial statement analysis articulates strategy </li></ul><ul><li>Beware of unarticulated strategy fads </li></ul>