SCH-MGMT 697 - Financial Statement Analysis Notes for second ...
SCH-MGMT 697 - Financial Statement Analysis
Notes for second day of class
June 3, 2004
Course project — handout. Due Monday morning, 9:00.
On course website: Penman’s BYOAP, Penman’s chapter notes for all chapters (link:
How do financial statements reflect business activity — especially the sorts of business
activities that we care about in valuation?
Explain the models on p . 222-3 (Slides 1-2) and note the cash conservation equation: C – I = d + F;
that is, if free cash flow is positive, the excess is used to pay down debt (F), invest in financial
assets (F), or distributed to shareholders (d). If there is a shortfall (negative free cash flow),
then the firm must borrow additional funds (F), issue more stock (d), or sell financial assets (F).
Go through the reformulated statements of cash flows (slide 3) and balance sheet (slide 4).
Then add the customers and suppliers to the model (slide 5) to introduce the income statement
(slide 6) and the whole picture (slide 7 and 8).
CSE, NOA, and NFO each has both a driver and a dividend. The drivers are earnings,
operating income, and free cash flow received and financial expense, respectively. The
dividends are net dividends (to shareholders), free cash flow (to financing activities), and
dividends, respectively. It is clear from this perspective that free cash flow is irrelevant, as it
drops out of the analysis. It is profits from operating activities and (possibly) financing activities that
drive shareholder value.
Remember that earnings must be comprehensive income, and we must have clean surplus for
all of these relations to hold.
Look at the relations at the bottom of slide 5. Explain these relations. Equations 7.2 - 7.6b (pp.
228-230) summarize the accounting relations that govern the reformulated financial statements.
What is clear from these reformulated financial statements is that the GAAP financial
statements may not be very well organized for our purposes because they mix up operating
and investing and financing activities. Plus, they do not net things that we want to see netted,
such as net operating assets and net financial obligations. As noted previously, the cash flow
statement is an excellent example of where the problems lie.
Financial statement reformulations
Note that to do these reformulations well, you need to read carefully through the financial
statements, including the notes. The main statements often are over-condensed, and there are
important details to be retrieved from the notes. For examples: interest capitalized should be
part of financing, but the other costs invested in a self-constructed asset are properly
considered part of operating assets. Unfortunately, it’s all lumped together and depreciated to
the income statement — ideally, you would separate the interest portion of the depreciation
and reclassify it to financing income.
Start with the statement of stockholders’ equity. What do we want out of that statement?
(1) net dividends (cash dividends, plus stock repurchases, less capital contributions)
(2) comprehensive income, less preferred dividends (comprehensive income available to
Reformulate the statement of stockholders’ equity (slides 9-10) and see also pages 243-247 with
detailed descriptions of steps 1-3. Use the VF Corporation reformulation (slides 12-13) as an
illustration of how to fix the stockholders’ equity section to move items into various
components of the income statement and out of equity.
Stock option accounting and its issues
Discuss the issue of hidden dirty surplus and especially the accounting for stock options (pp.
252-258, and slides 14-15). Use the Reebok example (slides 16-19 and Box 8.3 (p. 254)) to
illustrate the stock option compensation computations. Also note that at the end of 1996,
Reebok has 9,915,706 options outstanding, and the slide 16 reports that the average value of
these options is $10.76. The product of these two, $107 million, is called the option overhang, and
it is a contingent liability to issue shares at below market prices. This has to be considered
when doing the final valuation.
Balance sheet and income statement reformulations — NOTE: USE THE BYOAP SPREADSHEET
TO ILLUSTRATE THIS INSTEAD OF THE STUFF BELOW.
Reformulate the income statement and balance sheet (see slide 20 for the template and slide 21
for issues for the balance sheet; see slide 25 for the template for the income statement)
What do we want out of the balance sheet?
(1) Net operating assets
(2) Net financial obligations
See slides 22-24 for Nike’s GAAP and reformulated balance sheets. Notes: 1-split cash and cash
equivalents; 2- some AP are interest-bearing, but there wasn’t enough info to do the split; 3-
other liabilities are primarily long-term deferred endorsement payments; 4- notes payable are
interest-bearing and thus classified as financing; 5-preferred stock is less than 0.5 million.
For the income statement, what are we trying to find?
(1) core net operating income
(2) other net operating income
(3) unusual items
(4) net financial expense
Note that income tax expense needs to be properly allocated to each category in the income
statement (see slide 25). Basically, take reported tax expense from the income statement, then
compute net interest expense, multiply by the tax rate, and that is the amount of tax benefit that
is incorrectly included in operating income, so that needs to be added to reported tax expense
for the operating income. The same amount then reduces net financial expenses.
Show Nike GAAP and reformulated income statements (slides 27-28).
Note that cash flow is not the main focus of this valuation framework, so the statement of cash
flows is of less direct relevance. However, it can be useful as a source of information about
earnings quality (to be discussed later).
Financial Statement Analysis with Reformulated Financial Statements
Comparative analysis (Nike versus Reebok — see slides 29-32). The purpose here is to get a
sense of the ‘normal’ relations among the reformulated financial statement items. Here is
where you really learn a lot about the company.
Compute ratios (see slides 33-38 for the list and details).
Show BYOAP as an example of what you would do once you’ve got the reformulated financial
Note that the purpose here is that we are trying to get a handle on the flows within a company
so that we can better think about the drivers of value: ROCE and growth in BV. The
reformulations, comparative analyses, and ratio analysis facilitate this process. Coming up is
some technology to apply these efficiently to the job of analysis, then forecasting, then
See slide 39 to sum up and set the stage.
Profitability Analysis and Growth Analysis
The first task is to get a firm grasp on what is going on at present for the firm. Once this is
done in a disciplined way, we are then in a better position to forecast how things will or will
Remember that we’re using the residual earnings valuation model, which says that value is a
function of current book value and expected future residual earnings. So to do an effective
valuation, we need high-quality forecasts of future residual earnings.
Figure 11.1 outlines the entire process for the analysis of profitability (slides 40-44)
Discussion of leverage (financial leverage and operating liability leverage) and its effects on
ROCE — see especially slide 43 and 44.
What’s wrong with ROA? Why does it have to be RNOA? (Slide 45)
What’s wrong with Debt-equity ratios? Why does it have to be FLEV? (Slide 46)
See level 1 analysis comparisons between Nike and Reebok based on reformulated financial
statements (slide 47) and then second and third level breakdowns also (slides 48-52).
Net borrowing costs (a component of SPREAD) can also be broken down in a similar fashion to
identify its drivers (slide 53). Because we are going to ignore the financing activities in later
analyses, I won’t pay much attention to it here.
This seems a bit overwhelming — so many ratios and mnemonics and relationships to
remember. But focus on the fact that these relationships are uncovering the sources of residual
earnings. They also give the analyst the ability to ask useful ‘what-if’ questions that will guide
forecasting. For example, “What if Nike increased its receivable turnover from 5.4 to Reebok’s
6.5 in 1996? How would RNOA change?” By running the numbers, you can see that this
would lead to an increase in RNOA from 22.6% up to 24.6% (assuming all else is equal, of
course). This sort of thinking is exactly what the analyst does when they attempt to make
forecasts of the future.
AT THIS POINT, GO BACK TO THE NIKE EXAMPLE IN BYOAP.
Growth and Sustainability of Earnings
To get from the present to forecasts of the future, we have to have a sense of what is causing
changes. Understanding which components of the level of and change in profitability of
operations are permanent and which are transitory is very important. We can decompose the
change into core and transitory items (slides 54-57). Slide 58 shows how to organize the
income statement to identify separately the core operating income from sales (after tax), core
other operating income (after tax), and unusual items. Slides 59 and 60 discuss games played
with pension plans. Slides 61 and 62 discuss other miscellaneous transitory earnings issues,
and slide 63 has a checklist.
At this point, we are now ready to use what we have learned through financial statement
analysis to make forecasts and compute estimated values.
This next section argues for ignoring financing activities under the assumption that they are
typically executed at market prices. So the focus moves to residual operating income rather
than residual earnings. See slide 64. Another way to put it is that if some of the assets and
liabilities are recorded at market in the books, there are no residual earnings from such items
(earnings - (D-1)BV = 0, because when properly measured, the BV of these items earns exactly
what it should earn). This leads us to the valuation equation shown in slide 64, which is
basically a residual income valuation model where we focus only on operating income.
Imagine that all of the assets and liabilities of the company were measured at market value.
Then the value of the equity would just be equal to book value (no residual earnings at all).
Now suppose that there’s just one asset measured at market value; that asset would generate
no residual earnings. So it’s just a short stretch to imagine that if all financial assets and
liabilities were measured at market value, there would be no residual earnings from any of
them, and thus their inclusion in book value is sufficient, and thus all we need to focus on is
residual earnings from the net operating assets.
The drivers of ReOI are RNOA and the assets in place (NOA) to generate RNOA. See slide 66.
COST OF CAPITAL CONSIDERATIONS
We now need to have a cost of capital for operations, however. The idea here is that A = L +
OE, so cost of capital for the assets (or firm) is the weighted-average cost of capital of the debt
and equity. Remember that you have to use after-tax cost of debt. And we use the CAPM-
indicated cost of capital for the equity capital measure — RF + $(market risk premium).
Conceptually, Penman argues that really the operations cost of capital determines the cost of
equity, not the other way around. That is, the cost of equity capital is based upon (1)
operational risk; and (2) financing risk, such that we really would ideally measure operational
risk, then add a premium for leverage and the spread. The problem, of course, is that we do
not have a technology for measuring operating risk (other than what is provided in Chapter
Next, Penman makes the point that leverage causes increases in residual income (but not
increases in value). Leverage also creates earnings growth, but again, not change in value. See
slide 67 for 3 caveats: Investment, accounting methods, and leverage all create earnings
growth, but not necessarily value-relevant earnings growth.
Full-Information Forecasting, Valuation, and Business Strategy Analysis
See slides 68-70 for discussion of the big-picture strategy for valuation. Focus on ReOI
(equation 15.1, p. 513) shows its main components; focus on what the typical patterns are for
the relevant drivers (Sales, core sales PM, ATO, other OI, etc.). Do key drivers grow or fade?
Slide 71 illustrates factors that influence how a given firm’s driver patterns will possibly differ
from other firms.
Slide 72 shows a set of key drivers for various industries.
Next, we forecast the full set of ReOI drivers and a full set of pro forma financial statements.
For example, in Penman’s PPE illustration, he forecasts just three things: sales growth, core PM,
and ATO. These are sufficient to value the firm.
The steps to valuation and forecasting are summarized in slides 73-77.