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Link to previous chapter

Chapter 14 developed a
simplified valuation model
based on forecasting
operating acti vities.
This chapter
Thi s chapter develops
simple valuation models
based on forecasts of
operating activities
solely from information
in the financial
Link to next chapter
Chapter 16 develops
valuations based on
information both within
and outside the financial
Link to Web page
Learn more about simple
forecasting and valuation-
check out the text' s
Web site at
Anchoring on the
Financial Statements:
Simple Forecasting
and Simple Valuation
zy :J}
What forecasts
can be made on
the basis of
current financial
What valuations
can be made on
the basis of
current financial
How can a
growth forecast
be combined
with information
in the current
statements to
provide a
va luation?
In valuation, analysts aim for simplicity. They strip away features of the business that are
not involved in value generation. And if some features are relatively important and others
are of minor importance, analysts concentrate their efforts on those that are important. And
they look for useful approximations that give a quick benchmark valuation before proceed-
ing to a more complete, but more complex, valuati on. In thi s spirit, the last chapter stripped
away the forecasting of financing activities to simplify valuation.
Simplicity comes not only from fewer factors to forecast , but also from using less
information to make forecasts . A potentially large amount of information- from strategic
planning, marketing research, the analysis of production costs, and an assessment of the
viability of R&D, to name a few- is involved in forecasting. If we can limit ourselves to a
small set of information that captures much of the broader information, yet still obtain rea-
sonable value approximations, we are parsimonious in our endeavor.
This chapter develops simple valuati ons as a prelude to the next chapter, which utilizes
the full set of information for forecasting. The focus is on the (limited) information in the
financial statements. In many cases- particularly for relatively mature firms- the financial
statements aggregate considerable information and can be a reasonable indicator of the
future. For example, core profit margins and asset turnovers in current statements are often
Chapter 15 Anchoring on the Financial Statemenrs: Simple Forecasting and Simple Valuation 481
After reading this chapter you should understand:
How simple forecasts yield simple but insightful
How simple forecasts are developed from the current
financial statements.
How sales forecasts combine with financial statement
information to provide si mple forecasts.
When simple forecasts and simple valuations work as
reasonable approximations.
How simple forecasting works as an analysis tool in
sensitivity analysis.
How simple valuation models work in reverse
engineering mode to challenge the market price.
How simple valuation models enhance screening analysis.
After reading this chapter you should be able to:
Develop simple forecasts from financial statements.
Integrate sales forecasts into a simple forecast.
Calculate simple valuations from simple forecasts.
Calculate enterprise price-to-book ratios and price-
earnings ratios from simple forecasts.
Use simple forecasting in sensitivity analysis.
Use simple valuation models in reverse engineering to
challenge market speculation.
Use simple valuation models to screen stocks.
good indicators of future margins and turnovers. The chapter asks the question: What
forecasts and valuations can be made solely from information in the financial statements?
In this chapter you will understand that historical financial statements are not "backward
looking" but very much forward looking. (You will also get a sense of the limits of the in-
formation provided by financial statements.) With this in mind, the financial statement
analysis of Part Two of the book- with its emphasis on core operating income as a basis for
forecasting- is set up to elicit the information in the financial statements for forecasting. It
is now that you will strike pay dirt from the thorough reformulation and analysis of finan-
cial statements.
The focus of financial statement information has particular importance in fundamental
analysis. The fundamental analyst, you'll remember, follows the rule of not mixing what he
knows with speculation. Forecasting involves considerable speculation- particularly when
forecasting the "long term" (for a continuing value calculation, for example). Financial
statement information is what we know about the present and the past (subject, of course,
to the quality of the accounting). By isolating this more reliable information, we ensure we
do not contaminate it with more speculative, softer information.
We saw in Chapter 7 that the separation of hard financial statement information from
speculation was the key to challenging the market price. We saw that speculation revolves
around growth so we were careful to separate value implied by the financial statements
from value based on speculation about long-run growth. By anchoring to the financial
statements, we were able to identify the market's speculative growth forecast , which could
then be challenged. This chapter simply goes further by developing forecasts from the
financial statements and understanding the value they imply in order to strengthen our chal-
lenge to the market price.
482 Part Three Forecasringand Valuation Analysis
Simple forecasts are developed from the financial statement analysis of Part Two of the
book. That analysis identified value drivers and established the current state of those dri-
vers; forecasting asks how the future will be di fferent from the present. But the present is
an i.ndicator of the future and thus provides a benchmark forecast we can enhance with in-
formation outside the financial statements. That information is likely to be more specula-
tive, so the financial statement information also serves to di scipline our forecasting: If we
forecast that the future will be different from the present, we must have very good reasons.
Simple forecasts ground our speculative forecasting on "what we know" from the financial
Simple forecasts are converted to a valuation via the following "simple" version of the
residual operating income model of the last chapter:
E =CSE + Re0I 1
V 0 o p -g
That is, a simple valuation is based on forecasting resi dual operati.ng income for the for-
ward year and applying a growth rate to that forecast. Both the forward-year forecast and
the growth rate come from the financial statements. There are variants to this model. One
might feel confident in forecasting two years ahead and applying a growth rate at that point
(as we did in challenging the market price in Chapter 7). And of course we could also apply
the abnormal earnings growth model (applied to the operations) , which we will do later in
the chapter.
Forward residual operating income is
ReOI1 = 011 -(PF - l )NOAo
Current net operating assets, NOAo, is avail able in the reformulated balance sheet, but we
also require a forecast of forward operating income, Oi i, and a forecast of the growth rate, g.
In a simple valuation, these are elicited from the financial statements. We will show how,
but first an introduction.
Introducing PPE, Inc.
We will illustrate the analysis with two firms. One is PPE, Inc. , a firm so called because
it has just one asset, property, plant, and equipment. This is a dummy firm, so simple that
one can see the picture clearly. The other firm is our compani on example throughout the
book, ike, Inc. We will work with PPE, Inc. , both in thi s chapter and in the next, where
we will add information outside the financial statements to compl ete a fully fledged
The reformulated financial statements for PPE, Inc., are shown below. Our interest is in
the balance sheet and income statement, but the cash flow statement is also supplied. That
statement can be derived from the income statement. Make sure you can do this.
balance sheet reports 7 .7 of debt and the income statement shows that thi s debt incurs in-
terest expense at 4 percent.
Free cash flow= 01 - n NOA = 9.8 - 4.5 = 5.3. Net dividends can be deduced from the change in
shareholders' equi ty using the clean-surplus relation: d =Earnings - n CSE = 5.3. Note that, as there is no
fi nanci ng cash flow but an increase in indebtedness in the balance sheet, the debt must be deep discount
(zero-coupon) debt (or t he interest was not paid).
Chapter 15 Anchoring on the Financial Statements: Simple Forecasting and Simple Valuation 483
Bal ance Sheet, December 31, Year O
Assets YearO Year Liab i liti es and Equity
Property, plant, and equipment Long-term debt (NFO)
(at cost less accumulated Common shareholders'
depreciation) 74.4 69.9 equi ty (CSE)
Net operating asset s (NOA) 74.4 69.9
Income St at ement, Year O
Operating income
Sales of products
Cost of goods sold (incl uding depreciat io n of 21 4)
Other operating expenses
Net f inancial expense: 0.04 x 7.4
St at ement of Cash Flows, Year O
Cash flow from operations
Operating income
Cash flow in investing activi t ies
Investment in PPE (21.4 + 4 5)
Free cash flow
Cash flow in financing activities
Net dividends paid
Year 0
(114 6)
(0 5)
(25 9)
These statements supply the numbers for forecasting. Current CSE
is 66.7 and current
is 74.4. These are the balance sheet numbers to anchor on for a levered and unlevered
(enterpri se) valuation. Core operating income is identified: With no unusual items, core op-
erating income is 9.8 and core RNOA = 9.8/69.9 = 14.02 percent. (We use beginning-of year
NOA for simplicity.) PPE, Inc. has a requi red return for operations of 10 percent, so the
current core ReOI
= 9.8 - (0.10 x 69.9) = 2.81.
The No-Growth Forecast and Valuation
A no-growth forecast predicts that the forward ReOI will be the same as current core
= ReOI
= 2.8 1. Thus the no-growth equity valuation (with no growth appli ed
to the forward year forecast) is
E _ + 2.8 1 _
- 94. 8
(1 5.1 )
The value of the operating activities, enterprise value, is
2.8 1
Vo = 74.4 + O. IO = 102. 5
484 Part Three Forecasting and Valuation Analysis
The difference in the two valuations is, of course, the amount of the debt on the balance
sheet, 7.7. The levered P/B is 1.42 and the unlevered (enterprise) P/B is l.38.
The no-growth forecast implies a particular forecast of forward operating income. You
might think that a no-growth forecast would predict year-ahead operating income to be the
same as current core operating income, 9.8. But that would be too simple: The firm has
added assets over the year and these will earn more income. The no-growth forecast is
That is, forward operating income is forecasted as current operating income plus further
income from assets added in the current year (6.NOA) and earning at the required return.
For PPE, 01
= 9.8 + (0.10 x 4.5) = 10.25. (It should be clear that, ifthe added assets earn
only at the required return, then forward residual income will be the same as currently.)
The no-growth enterprise value is also forward operating income capitalized:
NOA= --2!1_ = 10.25 = J 02 5
Vo PF- I 0.10 .
The forward enterprise P/E = I 02.5/ 10.25 = l 0, which is the normal PIE for a required re-
turn of 10 percent. This is an abnormal operating income growth (AOIG) valuation with no
growth. It is equivalent to the residual income valuation above of course: Constant residual
income implies no abnormal income growth.
Box 15.1 develops a no-growth forecast and valuation for Nike. The no-growth value is
$50.69 per share. Nike traded at $74 at the time, so the market is building in growth. It is
the market 's growth valuation that we wish to challenge, so let 's turn to the growth valua-
tion indicated by the financial statements. But note the no-growth value puts a floor on the
valuation: Nike is worth at least $50. 19. How much extra do you want to pay for growth?
The Growth Forecast and Valuation
The no-growth forecast sees additions to net assets earning only at the required return: In-
creased investment adds no value. This is a conservative forecast , and one should always
respect a conservative forecast. Indeed, it was the no-growth valuation that we anchored on
in challenging the market price in Chapter 7, albeit with two years of forward earnings. But
the financial statements may tell us that assets are currently earning an R OA different
from the required return. Indeed, core RNOA for PPE, Inc., is 14.02 percent, higher than
the required return. So an alternative forecast predicts that all NOA
(including the new
additions) wi ll earn at this core profitability:
OJ 1 = NOAo x Core R OAo
For PPE, 01
= 74.4 x 14.02% = 10.43. Accordingly forward ReOI
= I 0.43 - (0.10 x 74.4) =
2.99. Relative to current Re01
of 2.81, we have growth. The growth rate is 6.44 percent.
Where does this growth come from? ReOI is driven by RNOA and the amount of net op-
erating assets: ReOI
- (PF - I)] x NOAo. With RNOA
forecasted to be the
same as in the current year, growth comes from the growth in net operating assets. This is
easy to see:
G h
. R OI [RNOA1 - (PF - l)]NOAo
rowt rate 111 e 1 =
[RNOAo - (PF - l)]NOA_1
Required return for operations
Core operating income
Net operating assets
Core residual operating income
No-growth forecast of operating income
No-growth forecast of ReOI
No-growth forecast of AOIG (change in ReOI)
Value of Common Equity
E =CSE + ReOl 201 1 = 9 884+ 1,333
010 2010
0.091 ' 0.091
Value per share on 484 million shares
ReOI Valuation of Operations
~ ~
A = v ~
= 24, 532- 4,370
ReOI 1333
VNOA =NOA + --
=5 514 +-'-
0.091 ' 0.091
AOIG Valuation of Operations
V NOA = 012011 = 1, 835
0.091 0.091
2010: 1,911 - (O 091 x 6,346)
2011: 1,91 1 + (0.091 x-832)
2011: 1,835- (0.091 x5, 514)
Nike traded at $74 per share when f iscal year 2010 results were reported.
However, if we forecast RNOA
= RNOAo, the growth rate becomes
. NO Ao
Growth rate m Re0I
= ---
$1,911 million
$6,346 million
$5,514 million
$1,333 million
$1,835 million
$1,333 million
$24,532 million
$20, 162 million
$20, 162 million
$20, 162 million
That is, the forecasted growth in ReOI for the next year is given by the current growth of
NOA. The growth forecast is given by growth in the balance sheet, and that is 74.4/69.9 =
1.0644, or 6.44 percent.
Now suppose we apply this forecast to all future periods. That is, we predict that RNOA will
be the same as current core RNOA indefinitely but NOA investments will continue to grow at
the current rate. ln this case, ReOl will also grow indefinitely at this rate. Capitalizing the fore-
cast ofReOI for Year 1 as a perpetuity with growth, we have the simple valuation with growth:
Vt = CSEo + [Core RNOAo - (p F - l)]NOAo
PF -g
The growth rate is the forecasted growth in ReOI from Year l on, but in this case it is the
forecasted growth in NOA at the current rate, NOA
/NOA-1- For PPE, Tnc., current core
RNOA is 14.02 percent, and the current NOA grew at 1.0644 from the previous year.
So, the value of the equity is
E =
66 7
(0.1402 - 0. 10) X 74.4 =ISO
Vo . + 1.10- 1.0644 .
The numerator here is ReOI
= 2.99.
488 Part Three Forecasting and Valuation Analysis
The valuations above are based solely on information in financial statements. This infor-
mation is (presumably) reliable information- though we will challenge this presumption
with the accounting quality analysis in Chapter 18- but it is limited information. One must
have perspective. These are simple valuations and for some firms can be simple-minded. They
are relevant only for relatively mature firms where the past is a reasonable indication of the
future. Simple valuations will not work for a start-up firm with little income (even losses) and
most of its prospects based on speculation. Indeed a speculative firm is defined as one where
the financial statements provide little valuation to anchor on.
To these benchmark valuations, the analyst may add information about how the future
might be different from the present. Here are two examples of adjustments to simple forecasts.
Weighed-Average Forecasts of Growth
If current core RNOA is higher than the required return, the no-growth forecast is a con-
servative forecast because it predicts that additions to NOA will earn only at the required
return rather than at the current RNOA. The growth forecast, on the other hand, can be op-
timistic: It predicts that NOA will earn at the current RNOA and that current RNOA and
growth in NOA will continue indefinitely into the future. History tells us that high prof-
itability tends to decline: Competition erodes profitability, so RNOA fades over time. Can
Nike maintain a core RNOA of30. l percent in the future? Similarly, high asset growth can-
not be maintained indefinitely. The question is one of durable competitive advantage, of
course, and Nike has indeed shown that its profitability is durable.
The issue of the duration of competitive advantage comes to the fore when we look at
full-information forecasting in the next chapter. But the fact that history tells us that prof-
itability tends to decline over time can be built into our simple forecasts and valuations;
after all , it is part of "what we know."
With the expectation that growth in the long run will be at the GDP growth rate, high
growth rates in residual operating income might be weighted down to the GDP growth rate
of 4 percent:
Weighted-average growth rate for ReOl = (0.7 X Current growth in ReOI) (15.4)
+ (0.3 x 4%)
Weighting the 4.6 percent financial statement growth rate we used in the growth valuation
of Nike in Box 15.2 with 4 percent GDP growth yields a weighted-average growth rate of
4.42 percent. This produces a valuati on of$7 l .54 per share. For Nike, the adjustment makes
little difference because our growth rate is close to the GDP rate. But, for a firm with ex-
ceptionally high ReOI growth, the adjustment matters.
Simple Valuations with Short-Term
and Long-Term Growth Rates
The idea that growth rates decline over the long tenn can also be accommodated with the ab-
normal operating income growth (AOIG) model. Stating the model in multiplier form:
VoNOA =011 x-l-[G2 -Giang] (15.5)
PF - I PF - Giang
Thi s analysis can be enhanced by forecasting a gradual decay in the growth rate to the GDP growth rate in
the long run. See S. Penman, Accounting for Value (New York: Columbia University Press, 2011 ), Chapter 3.
In early fiscal year 2011 , analysts fol lowing Nike were fore-
casting EPS of $4.39 for 2011 and $4.64 for 2012, up from
$3.93 in 2010. Adjusting for expected net interest income
these forecasts translated into operating income forecasts of
$2,033 million and $2, 140 million. With an expectation of net
operating assets in the 2011 balance sheet of $5,768 million,
a two-year pro forma is developed as follows:
For the val uation: G
= 1 . 132
Giang= 1 .04 (the GDP growth rate)
PF = 1.091
The value of the operations is:
V"oA =2,033x-1- [ 1.132- 1.04]=40301
0.091 1.091 -1.04 '
Operating income
Net operating assets
Free cash flow (OI - ~ N O A
Reinvested free cash flow
(at 9.1%)
Cum-dividend operating
Cum-dividend operating
2010 2011 2012
$ 2,033 $ 2,140
$5,514 5,768
= v ~ ~ ~ + NFA = 40,301 + 4,370 = $44,671 million
Value per share on 484 million shares is $92.30.
income growth rate: 2,302/2,033
The market price was $74 at the time. We would conclude
that either t he market price is too low, analysts' forecasts are
too optimistic, or the long-term growth rate is too high. The an-
alysts' forecasts here are considerably higher than the operating
income forecasts from the financial statements. Are analysts
using information outside the financial statements or are they
too optimistic?
is a forecast of forward operating income that is multiplied by a multiplier that incor-
porates two growth rates. G
is ( 1 plus) the growth rate forecasted for cum-dividend
operating income two years ahead, and G iang is the growth rate for the long term usuall y set
to the GDP growt h rate.
The model implies a gradual (geometric) decay of the growth rate
over time from the short-term to the long-term rate. Note that we are anchoring on short-
term forecasts and a GDP growth rate, both of which we might be relatively confident
about. For the model to work, the short-term rate must be hi gher than the long-term rate
(whi ch it usually is). Box 15.3 applies thi s two-stage model to Nike.
Growth in Sales as a Simple Forecast of Growth
The growth models in equations 15.2, 15.2a, and 15.2b forecast growth based on past
growth in net operating assets. But another method can be used: A simple forecast of NOA
growth can be made from forecasted sales growth. Net operating assets are driven by sales
and the asset turnover: NOA= Sales x 1/ ATO. Thus if ATO is expected to be constant in the
future, forecasting growth in sales is the same as forecasting growth in NOA. A sales fore-
cast, you' ll agree, is much easier to think about than an NOA forecast. And ATO typically
does not change much. If so, set the growth rate equal to the sales growth rate.
Recogni ze that RNOA =Profit margin x ATO. So if we forecast a constant ATO, we fore-
cast a constant RNOA if we also forecast constant margins. You see, then, that the simple
growth valuation is likel y to work best for finns that have fairly constant profit margins and
turnovers and steady sales growth. Many retai lers have thi s feature: Their current RNOA along
with a sales growth forecast often give a good approximation. Look also at the valuation for the
Coca-Cola Company in Box 15.4. On the other hand, firms that are changing their type of busi-
ness (and thus their sales growth rates, profit margins, and asset turnovers) are not good candi-
dates for a si mple growth valuation. More analysis (as in the next chapter) is required.
The two-stage growth model was developed by Ohlson and Juettner-Nauroth. See J. Ohlson and
B. Juettner-Nauroth, "Expected EPS and EPS Growth as Determinants of Value," Review of Accounting
Studies, July-September 2005, pp. 347-364.
Challenging Stock Prices with a Simple Valuation:
The Coca ... Cola Company 15.4
The 2,318 million outstanding shares of the Coca-Cola Com-
pany traded at $60 each when its 2007 financial statements
were issued. Analysis of those and earlier financial statements
establishes the following history (dollar numbers are in
millions) :

~ ~ ~ =
+ ( 0.269 - 0.09) x 26,858
Net debt
$160,402 million
$155,258 million
$66.98 Value per share on 2,318 million shares
2007 2006 2005 2004 2003 2002
Core profit 20.7% 20.4% 21.4% 22.4% 21 .3% 22.1%
The $66.98 valuation suggests that the market price is a little
low, though this i s just a simple valuation. Observe how far we
get with just a few ingredients once financial statements have
been reformulat ed and analyzed to highlight the relevant
value drivers. And observe that an historical sales growth rate
is an input when asset turnovers are fairly stable, as they often
are. Given the stability of the ATO, the analysts asks whether
profit margins an d sales growth in the future wi ll be different
from the past.
Asset turnover 1.30 1.32 1.36 1.32 1.32 1.35
Core RNOA 26.9% 26.9% 29.1 % 29.6% 28.1% 29.8%
Net operating assets $26,858
Net financial obligations 5,144
Common equity $21,714
Coke's core profit margin has declined somewhat over the
years, but its asset turnover is very stable. That means that net
operating assets grow at the same rate as sales. The average
annual sales growth rate over the five years up to 2007 was
5.4 percent (ignoring growth from acquisitions in 2007), and
this rate is in line with the rate analysts were forecasting for
the future. Using this growth rate for the NOA growth rate
along with 2007 core RNOA, Coke's value is calculated as
follows with a 9 percent required return:
You see how simple valuations can be used to challenge a
stock price. But there is another lesson here. Coke has a big
brand-name asset that is not in the balance sheet. Some claim
that because accountants do not record brand assets, it is diffi-
cult to value such firms. Not so. Valuation involves both the bal-
ance sheet and the income statement, and we see here that a
valuation with both is indeed plausible. The simple valuation
might be too simple, but you can see that modifying it with a
more intelligent forecast of future RNOA and growth will give
an intelligent valuation even with a deficient balance sheet.
Information in Analysts' Forecasts
Analysts are supposedly industry experts, so the consensus analyst forecast is one point of
reference to check on simple forecasts. Any difference could be attributed to the additional
information that analysts have relative to the financial statements. But there is one problem:
considerable research has shown that forecasts based on financial statement analysis are
often better predictors than analysts' forecasts. (The Web page for this chapter provides
details.) Analysts tend to be too optimistic in good times- particularly dming bubbles-
and too pessimistic in bad times. Warren Buffett said that the 1990s stock market bubble
was a chain letter and investment bankers were the postmen, but he could also have in-
cluded analysts who hyped stocks. Analysts' forecasts may contain additional information
over the financial statements, but they are also speculative. Two-year ahead forecasts are
particularly suspect, as are their intermediate-term EPS growth rates. The Nike valuation in
Box 15.3, based on analysts' forecasts, produced a price of$92.30, well above the $74 mar-
ket price at the time and well above our simple forecasts. One might see the simple fore-
casts as a check on analysts: Why are their forecasts so different from what we see in the fi-
nancial statements? Do their research reports, with its firm and industry analysis, point to
solid reasons for the difference? Or are the forecasts speculations that feed speculation in
the market price? The financial statements are used to challenge the market price, but they
can also be used to challenge your analyst.
Chapter 15 Anchoring on the Financial Stateme nts: Simple Forecasting and Simple Valuation 491
Simple models provide a rough valuation, but they come to their fore as analysis tools.
Sensitivity Analysis
For the simple growth valuation of Nike, we set core RNOA equal to the 2010 number of
30.1 percent and the growth rate at the historical rate for net operating assets of 4.6 percent.
But the simple valuation formulas allow us to enter any values. Accordingly we can enter-
tain what the valuation might be under different scenarios for future profitability and
Setting different values for these features is cal led sensitivity analysis. This tests how a
valuation changes as inputs to a model change, how the valuation is sensitive to alternative
forecasts of the future. The simple valuation model gives the form in which to conduct sen-
sitivity analysis.
Sensitivity analysis involves varying forecasts of RNOA and growth and observing
the effect on the valuation. How does Nike's valuation in Box 15.2 change if we forecast
that future RNOA will be 25.0 percent rather than 30.1 percent? Or if we forecast growth
to be 3 percent rather than 4.6 percent? Indeed, we can construct a valuation grid that
gives per-share values for different combined forecast s of the two drivers:
Valuation Grid for Nike, Inc., 2010. Required Return for Operations: 9.1 Percent

25% 30% 33% 36%
0% 40.33 46.59 50.34 54.10
3% 50.12 59.46 65 06 70.66
4% 55.94 67.11 73.82 80.51
5% 64.60 78.50 86.83 95. 17
6% 78.85 97.23 108.25 119.28
The valuation grid can be three-dimensional to incorporate different estimates of the
required return. The two-dimensional grid here gives price per share, calculated for differ-
ent combinations ofRNOA and growth in NOA. If asset turnovers are forecasted to be con-
stant, growth in NOA is replaced by sales growth.
As well as answering "what-if" questions, the grid expresses our uncertainty. We might
be unsure about Nike's profitability in the future, so the grid displays the value of uncertain
outcomes: What could the value drop to, or increase to, under reasonable scenarios?
The valuation grid also indicates what combinations ofRNOA and growth in NOA jus-
tify the current price. A $74 price can be legitimized by forecasting RNOA of 30 percent
with a growth rate of about 4.6 percent or, alternatively, an RNOA of 25 percent and a
growth rate of 5 .5 percent. If we rule out a growth rate of 5 .5 percent as too high, we must
demand that Nike maintain an RNOA higher than 25 percent to justify its $74 price.
Reverse Engineering to Challenge the Market Price
Chapter 7 applied valuation models to challenge the market price. The technique was that
of reverse engineering. One version reverse engineers a valuation model to identify the
growth expectations implicit in the market price. Another version calculates the expected
return to buying at the market price.
The simple valuation model can be reverse engineered to infer
the forecast of growth in the market price. The simple enter-
prise valuation model is:
Net operating ass e ts (NOA
Forward residual i n come (Re01
Required return f o r operations
= $5,514 million
= $1, 158 million
= 9 .1 percent
ReOl 1
VNOA = NOA + ---
0 o PF- 9
The reverse engi n eering model is:
Setting the value at Nike's enterprise market value and inserting
the NOA and growth forecast for Re01
, one can calculate g:
1, 158
$3 1 ,446 = $5,514 + ---
1.091 -g
Enterprise market price
= Equity market price
- Net financial assets
= (484 million shares x
$74)- $4,370 million
= $31,446 million
The solution for g is 1.046, that is, a 4.6 percent growth rate.
The market is for e casting the same growth rate as the simple
growth valuation . This residual operating income growth rate
can be converted to an operating income growth rate follow-
ing the procedures in Chapter 7.
It should be clear that one can reverse engineer from a simple valuation model: Given
current price, current book value, and simple forecasts for the near term, what is the
growth that the market is forecasting? The only difference is that we are now working
with unlevered, enterprise valuation models rather than the levered versions in Chapter 7.
That makes sense for a growth forecast because it is growth from operations that gener-
ates value.
We will return to active, reverse engineering i n Chapter 19. For the moment, you can
ask the question: What is the growth rate we must see to justify the market price? After
reviewing our financial statement analysis, you can then ask: Is that rate reasonable?
Box 15.5 does so for Nike.
This chapter shows how simple forecasts can be developed from current and past finan-
cial statements utilizing financial statement analysis of Part Two of the book. With core
profitability identified, forecasts can be developed as if that core profitability is
sustainable. Add to core profitability a measure of growth, and the analyst has a simple
forecast. The simple forecasts yield simple valuations that give the analyst a first, quick-cut
feel for the valuation and quick enterprise P/B and P/E ratios.
The analyst who ignores information is at peril. The simple valuations will not work
well when information outside the financial statements indicates that future profitability
and growth will be different from current profitability and growth. The analyst calculates
the simple valuations as starting points but then turns to full-information forecasting (as in
the next chapter).
Notwithstanding, the simple valuations are an analysis tool to examine how valuations
are sensitive to different scenarios for future profitability and growth-for asking "what-
if" questions. And they lend themselves to reverse engineering to uncover the forecasts of
profitability and growth that are implicit in the market price. But, most importantly, simple
valuations serve as an anchor as the analyst engages in speculation about the future. A val-
uation that differs from a simple valuation must be justified with sound reasoning as to why
the future will be different from the past.
Chapter 15 Anchoring on the Financial Statements: Simple Forecasting and Simple Valuation 493
- . -
. . . .
Find the following on the Web page for this chapter: More coverage of sensitivity analysis.
More demonstrations of simple forecasts.
More applications of two-stage growth forecasting.
More on weighted-average forecasts and durable com-
petitive advantage.
More on anchoring long-term growth on the GDP
growth rate.
More on analysts' forecasts.
Key Concepts sensitivity analysis tests how value
changes with different forecasts of the
future or with different measures of
the required return. 491
The Analyst's Toolkit
Analysis Tools Page Key Measures
Simple forecasting 482
No-growth forecasting 483
Growth forecasting 484
Core residual operating
simple forecasts involve forecasting from
information in the current financial
statements. 482
simple valuations are valuations
calculated from simple forecasts. 482
Acronyms to Remember
AOIG abnormal growth in
operating income
Simple no-growth valuation Growth rate for cum-di vidend
CSE common shareholders'
(equation 1 5 1) 483
Simple growth valuation
(equation 15.2) 485
Enterprise P/B multiplier
(equation 15.2b) 486
Enterprise P/E multiplier
(equation 15.3) 486
Weighted-average forecasts 488
Combining sales forecasts
with simple forecasts 489
Two-stage growth forecasting
(equation 15.5) 489
Valuation grid 491
operating income (G) 489
Growth rate in net operating
assets 485
Growth forecast of ReOI 484
No-growth forecast of ReOI 483
G (1 plus) growth rate in cum-
dividend operating
NOA net operating assets
01 operating income
ReOl residual operating
RNOA return on net operating
494 Part Three Forecasting and Valuation Analysis
A Continuing Case: Kimberly-Clark Corporation
A Self-Study Exercise
You finally have arrived at the point to value Kim berly-Clark's shares. In this chapter, you
will carry out a simple valuation, limiting your inp uts to those from the financial statements
that you have diligently been analyzing. Then, in t he next chapter, you will carry out a full
pro forma analysis and valuation.
Proceed to a simple valuation, using the required return for operations you have previously cal-
culated. Limit yourself solely to information you ha ve discovered in current and past financial
statements. Calculate enterprise price-to-book and enterprise PIE ratios from the information.
What does that info1mation imply the stock price s h ould be at the end of2010? Remember to
deduct the option overhang you calculated in the Continuing Case for Chapter 14. How does
your valuation compare with the market price (in M arch 2011) of $65 .24 per share?
The market price embeds expectations of future growth. Assuming Kimberly-Clark can
maintain future operating profitability at the level of current core RNOA, what growth rate
in residual operating income is the market proj e cting for the future? Would you say this
forecast is reasonable, given the history? What t o ols might you use to get better insights?
Now staii to experiment. What scenarios wou ld justify the market price? Do you see
these as reasonable scenarios? Do you see scena rios that would suggest that the stock is
underpriced or overpriced? Are these speculations consistent with what you know from the
financial statement history?
C 15.1. A valuation that simply capitalizes a forecast of operating income for the next year
implicitly assumes that residual operating income will continue as a perpetuity. Is
this correct?
Cl5.2. An analyst forecasts that next year's core operating income for a firm will be the
same as the current year's core operating income. Under what conditions is this a
good forecast?
Cl5.3. When is the forecasted growth rate in residual operating income the same as the
forecasted growth rate in sales?
Cl 5.4. Would you call a firm that is expected to have ahigh sales growth rate agrowth firm?
C 15 .5. The higher the anticipated return on net operating assets (RNOA) relative to the an-
ticipated growth in net operating assets, the higher will be the unlevered price-
to-book ratio. Is this correct?
Cl5.6. What is the effect of increasing the asset turnover (ATO) on enterprise price-to-
book, holding all else constant?
Exercises Drill Exercises
E15.1. A No-growth Forecast and a Simple Valuation (Easy)
An analyst calculates residual operating income of$35.7 million from financial statements
for 2012, using a required return for operations of 10 percent. She also forecasts residual
operating income at the same level for 2013 and years after on net operating assets of
$1,257 million at the end of2012.
Chapter 15 Anchoring on the Financial Stateme nts: Simple Forecasting and Simple Valuation 495
a. What is the analyst's forecast of operating income for 2013?
b. What is the value of the operations based on these forecasts?
c. What is the forward enterprise PIE ratio implied by the forecasts?
E1S.2. A Simple Growth Forecast and a Simple Valuation (Easy)
An analyst prepares the following reformulated balance sheet (in millions):
2012 2011
Net operating assets
Net financial obligations
Common shareholders' equity
Core operating income (after tax) for 2012 was $990 million. The required return for oper-
ations is 9 percent. For ease, use beginning-of-year balance sheet numbers where pertinent
in calculations.
a. What was the core return on net operating assets for 2012?
b. Prepare a growth forecast of operating income and residual operating income for 2013
based on this financial statement information.
c. Value the equity based on the information.
d. What is the intrinsic enterprise price-to-book ratio?
E1 S.3. Two-Stage Growth Valuation (Medium)
An analyst develops the following pro fonna at the end of2012 for a firm that uses a 9 per-
cent hurdle rate for its operations (in millions):
Operating income
Net operating assets
Net financial obligations
Common equity
$ 782
$ 868
7, 190
a. Forecast the cum-dividend operating income growth rate for 2014.
b. Using the two-stage growth model 15.5, value the equity with a long-tenn growth rate
of 4 percent.
c. What is the forward enterprise price/earnings ratio implied by the valuation?
E1S.4. Simple Valuation with Sales Growth Rates (Medium)
An analyst forecasts that the current core return on net operating assets of 15.5 percent will
continue indefinitely in the future with a 5 percent annual sales growth rate. She also
forecasts that the current asset turnover ratio of 2.2 will persist. Calculate the enterprise
price-to-book ratio ifthe required return for operations is 9.5 percent.
E1 S.S. Simple Forecasting and Valuation (Medium)
An analyst uses the following summary balance sheet to value a firm at the end of 2012
(in millions of dollars):
Net operating assets
Net financial obligations
Common shareholders' equity
2012 2011
496 Part Three Forecasting and Valuation Analysis
The analyst forecasts that the firm will earn a return on net operating assets (RNOA) of
12 percent in 2013 and a residual operating incom e of $91.4 million.
a. What is the required rate of return for operations that the analyst is using in his resid-
ual operating income forecast?
b. The analyst forecasts that the residual opera ting income in 2013 will continue as a
perpetuity. What value does this imply for the equity?
c. Calculate the forecast ofresidual earnings (on common equity) for 2013 that is implied
by these forecasts. The firm's after-tax cost of debt is 6.0 percent.
E15.6. Simple Valuation for General Mills, Inc. (Easy)
The following are from the financial statements for General Mills (in millions):
Net operating assets
Common equity
Core operating income (after tax)
2008 2007
5,31 9
There were 337.5 million shares outstanding at the end of fiscal year 2008 and they traded
at $60 each. Use a required return for operations of 8 percent in answering the following
a. What is General Mills's no-growth per-share valuation?
b. What is General Mills's per-share valuation based on growth forecasts from these
Real World Connection
See Exercises El.5, E2.9, E3.8, E4.10, E6.8, El 1.9, El3.9, El4.15, and El 6.10.
E15.7. Simple Valuation for the Coca-Cola Company (Medium)
In early 2006, the 2,369 million outstanding shares of the Coca-Cola Company traded at
$48.91 each. The price-to-book ratio was 6.3 and the forward PIE was 19.3 based on ana-
lysts' consensus EPS forecast for 2007. An analyst extracted the following numbers from
Coke's financial statements (in millions of dollars):
Sales 23, 104
Core operating income, after tax 4,944
Net operating assets (average for year) 17, 184
15, 735
a. Calculate the core operating profit margin and asset turnover for each year
2002- 2005.
b. Calculate the average sales growth rate over the years 2003- 2005.
c. The firm reported common shareholders' equity at the end of2005 of $16,945 mil-
lion, along with $1,010 billion in net financi al obligations. Using the numbers you
calculated, estimate Coke's enterprise value at the end of 2005 and also the value
per share. Use a required return for operations of 10 percent. Box 15.4 will help
Chapter 15 Anchoring on the Financial Statemen ts : Simple Forecasting and Simple Valuation 497
Real World Connection
See Exercises E4.7, E4.8, E12.7, E16.12, E17.7, and E20.4. Also see Minicases M4.1 ,
M5.2, and M6.2 for coverage of Coke.
E15.8. Reverse Engineering for Starbucks Corporation (Medium)
In January 2008, the 738.3 million outstanding shares of Starbucks Corporation traded at
$20 each. Analysts' consensus earning-per-share estimates of $1.03 for the fiscal year end-
ing September 30, 2008, gave the firm a forward PIE of 19.4. The firm reported earnings
per share for 2007 of $0.90, up from $0.74 a year earlier.
The following information was garnered from the firm's financial statements (in
2007 2006
Core operating income (after tax)
Net operating assets
Net financial obligations
Common equity
2, 178
a. From these statements, calculate the following for 2007 (with beginning-of-period
balance sheet numbers in denominators where applicable):
( 1) Core operating profit margin
(2) Core return on net operating assets (core RNOA)
(3) Asset turnover
( 4) Growth rate for net operating assets
b. Using these numbers and a required return of9 percent, forecast residual operating in-
come (ReOI) for fiscal year 2008.
c. What is the stock market's implied rate of growth for residual operating income after
Real World Connection
Exercises on Starbucks are E9.8, El0.10, El2.9, and El3.8.
E15.9. A Simple Valuation and Reverse Engineering: IBM (Medium)
The following are key numbers from IBM's financial statements for 2004.
Net operating assets, end of year
Net financial obligations, end of year
Common equity, end of year
Common shares outstanding, end of year
Core return on net operating assets
Sales growth rate
$ 42, 104 million
12,357 million
29,747 million
1,645.6 million
IBM's shares traded at $95 when 2004 results were announced. Use a required return for
operations of 12.3 percent to answer the following questions:
a. Forecast operating income and residual operating income for 2005 if IBM maintains
the same core RNOA as in 2004.
498 Part Three Forecasting and Valuation Analysis
b. Calculate the per-share value of the equity ir IBM were to maintain this profitability in
the future and if residual earnings were to grow at the 2004 sales growth rate. Also
calculate the implied forward enterprise P/E ratio and the enterprise P/B ratio.
c. What growth rate in residual operating incorne would justify the current stock price if
you were sure that 12.3 percent was a reasonable required return?
Real World Connection
Exercises E6.9 and El4.14 deal with IBM, as does Minicase M13.3.
E15.10. Buffett's Acquisition of Burlington Northern Santa Fe (Medium)
In 2009, Warren Buffett announced that Berkshire Hathaway would acquire all of the
341 million outstanding shares of Burlington Nor thern Santa Fe (BNSF) railroad for $100
per share, a large premium from the current price. BNSF reported shareholders' equity of
$12,798 million in its most recent annual report, with $9,135 million in net financial oblig-
ations that Buffett would assume. The corresponding numbers for the prior year were
$1 1, 131 million and $9, 155 million. The income tatement reported $14,016 million in rev-
enue for the year that translated into $2, 113 million in after-tax core operating income.
a. On the basis of the current numbers, do you think the $100 per share bid can be justi-
fied? What growth rate is implied in the price? (Experiment with "reasonable" esti-
mates ofBuffett's required return.)
b. What might Buffett see to justify paying $100 per share? (Think: ATO).
E15.11. Comparing Simple Forecasts with Analysts' Forecasts: Home Depot, Inc.
Home Depot, the warehouse retailer, traded at $42 per share when its 2005 financial state-
ments were published. Analysts were forecasting $2.59 earnings per share for 2006 and
$2. 93 for 2007. There were 2, 185 million shares outstanding at the time. Below are income
statements for fiscal years 2003- 2005, along with information extracted from balance
sheets. Home Depot's combined federal and stat e statutory tax rate is 37.7 percent.
Develop forecasts of earnings for 2006 and 2007 from the financial statements. How
close are your forecasts to the analysts' forecasts?
Consolidated Statements of Earnings
(In millions except per-share numbers)
Fiscal Year Ended
January 30, February 1,
2005 2004
Net sales $73,094 $64,816
Cost of merchandise sold 48,664 44,236
Gross profit 24,430 20,580
Operating expenses:
Selling and store operating 15, 105 12,588
General and administrative 1,399 1, 146
Total operating expenses 16,504 13,734
Operating income 7,926 6,846
Interest income (expense):
Interest and investment income 56 59
Interest expense (70) (62)
Interest, net (14) (3)
February 2,
Chapter 15 Anchoring on the Financial Statemen ts: Simple Forecasting and Simple Valuation 499
Earnings before provi sion for income taxes
Provi sion for income taxes
Net earnings
Weighted-average common shares
Basic earnings per share
Diluted weighted-average common shares
Diluted earnings per share
From the balance sheet (in millions):
Net operating assets
Net financial assets
Common equity
24, 158
$ 3,664
$ 1.57
E15.12. Valuation Grid and Reverse Engineering for Home Depot, Inc. (Medium)
a. Using the information in Exercise 15 .11, calculate the implied growth rate in residual
operating income that is implicit in the market price of $42 per share.
b. If you forecast that the growth rate in residual earnings after fiscal year 2006 will be the
GDP growth rate of 4 percent, what is the expected return to buying the stock at $42?
c. Prepare a valuation grid showing what the stock is worth for alternative forecasts of
return on net operating assets and growth in net operating assets.
Real World Connection
Home Depot is also discussed in E 15 .11 .
500 Part Three Forecasting and Valuation Analysis
Mini cases M15.1
Simple Forecasting and Valuation:
Procter & Gamble V
This case continues the financial statement analysis of Procter & Gamble Co. begun in
Minicase 10.l and developed further in Minica es 11.1, 12.1 , and 13.1. This fifth install-
ment focuses on forecasting and valuation, with further development in Minicase 16.1 in
the next chapter.
Financial statements for Procter & Gamble are presented in Exhibit 10.15 in Chapter I 0.
If you worked Mini case 10.1 , you will have reformulated the income statements and bal-
ance sheets to distinguish operating activities from financing activities. If you worked
Mi nicases M 12 .1 and 13 .1 , you wi 11 have reached an understanding of P &G's core prof-
itability and the factors that drive that profitability. If not, you should do so now.
To start, calculate residual core operating income for the years 2008 to 2010 and note
changes over time. Use a required equity return of8 percent but convert it to an unlevered
required return (for operations). In July 2010, just after the fiscal year ended, the 2,844 mil-
lion outstanding shares of P&G were trading at $62. What is the trend in residual operating
income? Does P&G appear to be a growth company? What drives the trend?
A. Develop forecasts of residual operating income for 2011 and growth thereafter based
solely on info1mation in the financial statements. Your analysis should include a no-
growth forecast, along with a forecast that includes growth. Consider a weighted-
average forecast that forecasts GDP growth in the long run. Do you think these forecasts
are applicable to P&G? Carry out a sensitivity analysis to changes in inputs by develop-
ing a valuation grid.
B. Analysts were forecasting $3.93 in earnings per share for fiscal year 2011 . How does
the analyst forecast compare with yours?
C. Calculate the (traded) enterprise price-to-book ratio and reconcile it to the levered
price-to-book ratio. Now calculate an intrinsic enterprise P/B using equation l 5.2b in
this chapter. Do you think the $62 price is reasonable?
Real World Connection
Minicases MIO. I, Ml 1.1 , M12. l , Ml3. l , and Ml6. l also cover Procter & Gamble.
Simple Valuation, Reverse Engineering, and
Sensitivity Analysis for Cisco Systems, Inc.
Cisco Systems, Inc. (CSCO) , manufactures and sells networking and communications
equipment for transporting data, voice, and video and provides services related to that
equipment. Its products include routing and switching devices; home and office network-
ing equipment; and Internet protocol, telephony, security, network management, and
software services. The firm has grown organically but also through acquisition of other
networking and software firms. Cisco's Web site is at www.cisco.com.
Chapter 15 Anchoring on rhe Financial Sraremenrs: Simple Forecasring and Simple Valuarion 501
By any stretch of the imagination, Cisco Systems (CSCO) has been a strong growth
company. A darling of the Internet boom of the late 1990s, it was one of the few technol-
ogy companies tied to the Internet and telecommunications that prospered during that era.
Its products built the infrastructure of the Internet. While most Internet and telecommuni-
cations firms struggled and failed, their supplier, Cisco, capitalized on the new technology.
At one point in 2000, its market capitalization was over half a trillion dollars, the largest
market capitalization ofany firm, ever. Its PIE was over 130. The stock price increased from
$10 in 1995 to $77 in 2000, supported by sales growth from $2.0 billion in 1995 to
$18.9 billion in 2000.
However, with the subsequent collapse of the technology bubble and the demise of
telecommunications firms such as WorldCom, Qwest, and AT&T, growth slowed consider-
ably. Sales that peaked at $22.3 billion in fiscal year 2001 dropped to $18.9 billion by 2003
and recovered to the 2001 level only in 2004. The stock price also tumbled, reaching a low
of a little over $8 in late 2002 after the firm reported a net loss for the year. The stock price
recovered to $24 by 2004.
Subsequently, Cisco's sales grew, reaching $39.5 billion by 2008. However, from 2008
to 2010, sales remained flat, standing at $40.04 billion in 2010. Profit margins also declined
and EPS in 2010 of$1.36 was little changed from the $1.35 in 2008. Rivals Motorola and
Juniper Networks were gaining ground. Cisco 's diversification, via acquisitions, into cable
set-top boxes and videoconferencing equipment was not proving successful, with cable
companies cutting back on orders for the cable boxes and customers using Skype or Google
Talk to conference for free. Cisco suffered a precipitous decline in government orders dur-
ing 2010 as state governments cut budgets.
Cisco's 5,655 million shares traded at $20 by the end of 20 I 0 and were down further to
$15 by June 2011. On the next page are summary numbers from its financial statements
for 2008 to 2010.
Prepare simple valuations based on these statements. Use a required return of9 percent
for Cisco's operations. Then introduce some scenarios for the future- speculation about
sales growth and the level of profitability, for example- to see if the current price can be
justified or whether reasonable speculation might justify an even higher price. You might
also test how your valuations are sensitive to the required return you use. Also use reverse
engineering techniques to ask the question: What growth rate is the market forecasting?
A. Would you pay $15 for a share of Cisco Systems?
B. Would you attribute the drop in stock price from 2000 to 2002 to problems in Cisco's
C. Clearly the great Cisco is now challenged. Discuss the lesson here.
D. In 2010, Cisco announced that it would pay a dividend of$0.24 per share for the first
time. Why might Cisco be doing this? What effect do you think it had on the share
E. In 2010, Cisco borrowed about $5 billion. The firm has a high level of financial
assets on its balance sheet; why would it borrow?
F. Goodwill on the 2010 balance sheet stood at $16,674 million, up from $12, 121 bil-
lion in 2007 because of acquisitions. Given that these acquisitions have not been
successful, what do you think might happen to the carrying value of the goodwill in
the future?
502 Part Three Forecasting and Valuation Analysis
Summary Reformulated ln ,come Statement s
(i n millions of dollars, except p er-share amounts)
2 010
Sales 4 0,040
Cost of sales 1 4,397
Gross Margin 25,643
Operating expenses 1 6,479
Core operating income before tax 9,164
Tax on operating income 1,557
Core operating income after tax 7,607
Net interest income after tax 160
Net income 7,767
Earnings per share $ 1.36
Summary Reformulated Balance Sheets
(in milli ons of dollars)
Net operating assets
Net financial assets
Common equity
Real World Connection
2 009
1 3,971
36, 117
- --
$ 1.05
14, 194
$ 1.35
Mini case M7 . 1 is a reverse engineering study of Cisco, and Exercises E2. l and El 9.6 also
deal with the firm.