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Solutions Ch 6-17

For
FINANCIAL STATEMENT ANALYSIS AND SECURITY VALUATION

Stephen H. Penman

Fifth Edition

CHAPTER SIX

Accrual Accounting and Valuation: Pricing Earnings


Concept Questions

C6.1. Analysts typically forecast eps growth without consideration for how earnings are
affected by payout. That is, they forecast ex-dividend growth, not cum-dividend growth.
Investors value ex-dividend earnings growth, but they also value additional earnings to be earned
from the reinvestment of dividends.

C6.2. The historical 8.5% growth rate that is often quoted is the ex-dividend growth rate. It
ignores the fact that earnings were also earned by investors from reinvesting dividends (in the
S&P 500 stocks, for example) that were typically 40% of earnings. The cum-dividend rate is
about 13%. See Box 6.1.

C6.3. This formula capitalizes earnings at the ex-dividend earnings growth rate, g. This ignores
growth that comes from reinvesting dividends. Further, if earnings are expected to grow at a rate
equal to the required return, r, then the growth should not be valued , and forward earnings
should be capitalized at the rate, r, not r g. Only growth in excess on the required rate should be
recognized.
The formula also has mathematical problems. If g = r, then the denominator is zero and
the value is infinite. If g is greater than r (which is necessary for growth to have value), the
denominator is negative.

C6.4. The trailing P/E is normal: 1.12/0.12 = 9.33. The forward P/E is also normal: 1/0.12 =
8.33. (The forecasted growth rate must be the cum-dividend growth rate.)

C6.5. The difference is that, for the trailing P/E, one more years of earnings are involved (the
current year). The trailing P/E can be interpreted as paying for the value of forward earnings (at
the multiple for forward earnings) plus a dollar for every dollar of current earnings.

C6.6. Cum-dividend earnings growth incorporates earnings that are earned from the
reinvestment of dividends, and investors value those earnings. Ex-dividend growth rates are
affected by dividends: dividends reduce assets which then earn lower earnings. As cum-dividend
growth rates reflect the earnings from dividends, they are not affected by dividends. Cumdividend growth rates are effectively the rates that firms would have if they did not pay
dividends.

C6.7. Correct. See the Dell example at the beginning of this chapter and Box 6.3.

C6.8. Incorrect. As the normal (forward) P/E ratio is the inverse of the required return and the
required return for a bond is (usually) lower than that for a stock, the normal P/E ratio for a bond
is greater than that for a stock. But P/E also values abnormal earnings growth. A bond cannot
deliver abnormal earnings growth, so the P/E ratio for a growth stock might well be greater than
that for a bond.

C6.9. Yes, she could. If one expects no abnormal earnings growth (AEG), the earnings yield on
a stock should be greater than the bond yield because a stock is riskier and thus has a higher
required return: the normal forward E/P (no AEG) = the required return, and the required return
is higher for a stock than a bond. Of course, stocks can deliver earnings growth (whereas a bond
cannot), so a stock with a high earnings yield (a low P/E of 1/0.12 = 8.33 here) could be
underpriced if the analyst forecasts abnormal earnings growth. But the comparison to a bond E/P
does not get a handle on this.

C6.10. A PEG ratio is the ratio of the P/E to one-year-ahead expected earnings growth in
percentage terms. As the P/E anticipates earnings growth, the PEG ratio should be 1.0 if the
market is anticipating growth appropriately. However, more than one year of growth is involved
in assessing P/E ratios (and there are other clumsy aspects to itsee text), so the measure should
only be used as a first-pass check on the P/E ratio.

C6.11. Intrinsic P/E ratios are determined by the cost of capital and earnings growth
expectations. So P/E ratios might have been low in the 1970s because the market did not see
much earnings growth in the future for the typical firm, and saw considerable growth in the
1960s and 1990s. Or the cost of capital increased in the 1970s (and fell in the 1960s and 1990s).
The interest rate is one component of the cost of capital, and interest rates were higher in the
1970s (particularly the late 1970s) than in the 1960s and 1990s.

The traded P/E ratios may also reflect market inefficiency: the market might have priced
earnings too low in the 1970s and too high in the 1960s and 1990s. That turned out to be the

case (after the fact) in the 1960s and 1970s (as P/E ratios and prices fell after the 1960s but
increased after the 1970s).

C6.12. Earnings-to-price ratios -- the inverse of price/earnings ratios -- are driven by three
things:
(1)

The required equity return

(2)

Expected growth

(3)

Market inefficiency in pricing the required return and expected growth.

The argument assumes that factors (2) and (3) do not explain the change in the earningsto-price ratio. Were growth expectations higher in the 1990s than in the 1970s? Were S&P 500
stocks overpriced?

C6.13. The trailing P/E, based on current earnings, is affected by transitory (one-time) earnings.
The forward P/E based on next years' forecasted earnings is less likely to be so affected, and so is
a better base for growth. (But the analyst does have to forecast next year's earnings in this case).

C6.14. Yes; eps growth can be increased with investment, but the investment may earn only the
required return, and thus not add value. A firm can also increase its expected earnings growth
through accounting methods, but not add value.

Exercises
Drill Exercises
E6.1 Forecasting Earnings Growth and Abnormal Earnings Growth
The calculations are as follows:

Dps
Eps
Dps reinvested at 10%
Cum-div earnings
Normal earnings
AEG

2011

2012

2013

0.25
3.00

0.25
3.60
0.025
3.625
3.300
0.325

0.30
4.10 (1)
0.025
4.125 (2)
3.960
0.165

20.0%
20.83%

13.89%
14.58%

(a)
Ex-div growth rate (from line 1)
Cum-div growth rate (from line 2)
- 3.625/3.00 for 2010
- 4.125/3.60 for 2011

(b) AEG is in pro forma above


(c) Normal forward P/E = 1/0.10 = 10.
(d) As AEG is forecasted to be greater than zero, then one would expect the forward P/E to
be greater than 10. Equivalently, as the cum-dividend earnings growth rate is expected to
be greater than the required return of 10%, the P/E should be greater than the normal P/E

E6.2 P/E Ratios for a Savings Account


a. If earnings are $10, the value of the account at the beginning of the year must
have been $250. That is, $250 earning at 4% yields $10 in earnings. The value of
the account at the end of the year is given by the stocks and flows equation:
Value at end = Value at beginning + Earnings Dividends
= $250 + 10 3 = $257
b.

Trailing P/E = (Price + div)/Earnings


= (257 + 3)/10
= 26
(This is the normal P/E for a 4% required return.)
Forward earnings = $257 0.04 = $10.28

Forward P/E = 257/10.28


= 25
(This is the normal forward P/E for a required return of 4%.)

E6.3. Valuation from Forecasting Abnormal Earnings Growth


This exercise complements Exercise 5.3 in Chapter 5, using the same forecasts. The question
asks you to convert a pro forma to a valuation using abnormal earnings growth methods. First
complete the pro forma by forecasting cum-dividend earnings and normal earnings. Then
calculate abnormal earnings growth and value the firm.

2013E

2014E

2015E

2016

2017

Earnings
388.0
Dividends
115.0
Reinvested dividends
Cum-div earnings
Normal earnings
Abnormal earn growth

570.0
160.0
11.5
581.5
426.8
154.7

599.0
349.0
16.0
615.0
627.0
-12.0

629.0
367.0
34.9
663.9
658.9
5.0

660.45
385.40
36.70
697.15
691.90
5.25

Growth rates:
Earnings growth
Cum-div earn growth (AEG)
Growth in AEG

46.91%
49.87%

5.09%
7.89%

5.00%
10.83%

Discount rate
PV of AEG

1.100
140.64

1.210
-9.92

5.00%
10.83%
5.0%

Note that the AEG for 2014 and 2015 are discounted back to the end of 2013.
a. Forecasted abnormal earnings growth (AEG) is given in the pro forma above.
AEG is the difference between cum-dividend earnings and normal earnings. So, for 2014,
AEG = 581.5 426.8 = 154.7.
Cum-dividend earnings is earnings plus prior years dividend reinvested at the
required rate of return. So, for 2014,
Cum-dividend earnings = 570.0 + (115 10%) = 581.5
7

Normal earnings is prior years earnings growing at the required rate. So, for 2014,
Normal earnings = 388 1.10 = 426.8
Abnormal earnings growth can also be calculated as
AEG = (cum-div growth rate required rate) prior years earnings
So, for 2014,
AEG = (0.4987 0.10) 388 = 154.7
b. The growth rates are given in the pro forma.
c. The growth rate of AEG after 2015 is 5%. Assuming this rate will continue into the
future, the valuation runs as follows:
Forward earnings, 2013
Total present value of AEG for 2014-2015
(140.64 9.92 = 130.72)
5
= 100.00
Continuing value (CV), 2015 =
1.10 1.05

Present value of CV =

100.0
1.210

388.00
130.72

82.64
601.36

Capitalization rate
Value of the equity =

0.10
601.36
0.10

Value per share on 1,380 million shares

6,013.6
4.36

This is a Case 2 valuation. If you worked exercise E5.3 using residual earnings methods,
compare you value calculation with the one here.
d. The forward P/E = 6,013.6/388 =15.5. The normal P/E is 1/0.10 = 10.

E6.4. Abnormal Earnings Growth Valuation and Target Prices

This exercise complements Exercise 5.4 in Chapter 5, using the same forecasts.
Develop the pro forma to forecast abnormal earnings growth (AEG) as follows:

Eps
Dps
Reinvested dividends (12%)
Cum-dividend earnings
Normal earnings (12%)

2013

2014

2015

2016

2017

3.90
1.00

3.70
1.00
0.12
3.82
4.368

3.31
1.00
0.12
3.43
4.144

3.59
1.00
0.12
3.71
3.707

3.90
1.00
0.12
4.02
4.021

-0.548

-0.714

0.003

-0.001

Abnormal earnings growth


(a) See bottom line of pro forma for answer.

(b) As AEG is forecasted to be zero after 2015, the valuation is based on forecasted AEG up
to 2015:

E
=
V2012

1
0.548 0.714
3.90 +
+

0.12
1.12
1.2544

= $23.68
Note that this is the same value as obtained using residual earnings methods in
Exercise 5.4.
(c) The expected trailing P/E for 2017 must be normal if abnormal earnings growth is
expected to continue to be zero after 2017. The normal trailing P/E for a required return
of 12% is 1.12/0.12 = 9.33.
(d) With a normal trailing P/E of 9.33,
V2017 + d 2017
= 9.33
Eps 2017

So, V + d = $3.90 x 9.33


9

= $36.387
As the dividend is expected to be $1.00, the 2017 value (ex-dividend) is $35.387.

E6.5. Dividend Displacement and Value

(a)

Firm B will have higher earnings in 2014 because it will pay no dividend

in 2013. Put another way, firm As 2014 earnings will be displaced by its 2013 dividend:
Dividend in 2013 for Firm A

= 0.6 16.60 = 9.96

Reduced 2014 earnings for Firm A

= 9.96 11% = 1.10

These reduced earnings are the earnings that could have been earned if the
dividend had not been paid but invested in the firm at 11%.
Therefore, Bs earnings (without the displacement) = 17.80 + 1.10
= 18.90
(Assumes retained earnings are invested at the cost of capital.)
(b)

Anticipated future dividends dont affect current price (unless payment reduces
investment in value-generating projects). Firm As shareholders expect to earn
the earnings of Firm Bs shareholders by reinvesting the dividend at the cost of
capital. So, cum-dividend earnings are the same for both firms, and thus so is
their value.

E6.6. Normal P/E Ratios

The normal trailing P/E ratio is

1 + required equity return


required equity return

The normal forward P/E is the trailing P/E 1.0


The schedule for the trailing P/E is as follows. Subtract 1.0 to get the forward P/E.
8%

13.50

9%

12.11

10%

11.00

11%

10.09

12%

9.33

13%

8.69

14%

8.14

15%

7.67

16%

7.25

11

Applications
E6.7. Calculating Cum-dividend Earnings Growth Rates: Nike

The pro forma is as follows:


2009

2010

Eps

3.90

4.45

Dps
Reinvestment of 2009 dividend at 10%

0.92
0.092

Cum-dividend eps

4.542

Cum-dividend eps growth rate (4.542/3.90 1)


Ex-dividend eps growth rate (4.45/3.90 - 1)

16.46%
14.10%

E6.8. Calculating Cum-dividend Earnings: General Mills

Earnings on prior
years reinvested
dividends
EPS

2006
2007
2008
2009
2010

2007
2008
2009
2010

Cumdividend
EPS

DPS

1.53
1.65
1.93
1.96
2.32

0.67
0.72
0.78
0.86
0.96

Cum-div EPS

Normal
earnings

1.7036
1.9876
2.0224
2.3888

1.6524
1.7820
2.0844
2.1168

0.0536
0.0576
0.0624
0.0688

1.7036
1.9876
2.0224
2.3888

Abnormal
Earnings
Growth
(AEG)
0.0512
0.2056
-0.0620
0.2720

Normal earnings is prior years earnings multiplied by 1.08.


E6.9. Residual Earnings and Abnormal Earnings Growth: IBM

The pro forma for the forecast is as follows:


2010 2011 2012 2013 2014 2015
Eps
13.22 14.61 16.22 18.00 19.98
Dps
3.00 3.30 3.66 4.07 4.51
Bps
18.77 28.99 40.30 52.86 66.79 82.26
Reinvested dividends at 10%
Cum-dividend earnings
Normal earnings

0.300 0.330 0.366 0.407


14.910 16.550 18.366 20.387
14.542 16.071 17.842 19.800

Abnormal earnings growth

0.368 0.479 0.524 0.587

Residual earnings

11.343 11.711 12.190 12.714 13.301

Change in residual earnings

0.368 0.479 0.524 0.587

The answers to parts a, b and c of the question are in the last three lines of the pro forma.

13

E6.10. A Normal P/E for General Electric?

a.

Forward P/E = $26.75/ $2.21


= 12.10

b. Earnings forecast for 2009


2008 dividend reinvested: $1.24 x .09
Cum-dividend earnings for 2009
AEG (2009)

$2.30
0.1116
$2.4116

= 2.4116 (1.09 2.21)


= 0.0027 or 0.27 cents per share

This is close to zero, indicating that the forward P/E should be normal. Put another
way, the cum-dividend earnings growth for 2009 = 2.4116/2.21 1 = 9.1% which
is close to the required return; thus the P/E should be normal.

E6.11. Challenging the Level of the S&P 500 with Analysts Forecasts

The required return = risk free rate + risk premium


= 5% + 5%
= 10%
To develop the pro forma for the implied growth rate, first apply the forward P/E ratio to get an
earnings forecast for 2006, then convert the PEG ratio to an earnings forecast for 2007:
Forward P/E = Price/Earnings2006
Treat the 1271 as dollars to get earnings in dollars:
$1,271/Earnings2006 = 15
Thus Earnings2006 = $84.73
PEG =

Forward P / E
= 1.47
Growth Rate for 2007

Thus, for a forward P/E of 15, the 2007 growth rate for 2007 earnings is 10.2%.

Thus, 2007 earnings forecasted is $84.73 1.102 = $93.37


a. The pro forma to calculate abnormal earnings growth (AEG) is as follows:

Earnings
Dividends (payout = 27%)
Reinvested dividends (at 10%)
Cum-dividend earnings
Normal earnings ($84.73 x 1.10)
AEG

2003

2004

84.73
22.88

93.37
2.288
95.658
93.203
2.455

b. If cum-dividend earnings are expected to grow at the required rate of return, 10%, after 2006,
the P/E should be normal:
P/E =

1
= 10
0.10

At this P/E, the index should be $84.73 10 = 847.3


The normal P/E is appropriate if (cum-dividend) earnings are expected to grow at a rate equal to
the required return, 10%. The P/E based on analysts forecast (15) is higher than this because the
market sees earnings growing at a higher rate. Is this assessment reasonable?
c. Applying the abnormal earnings growth (AEG) pricing model with the long-term growth rate
for AEG of 4%:
V =

1
2.455
84.73 +

0.10
1.10 1.04

= 1256
d. The S&P 500 index is appropriately priced (approximately) at 1271. This will not always be
the case. The estimated level can different from the actual level for a number of reasons:
1. Analysts forecasts are too optimistic relative to how the rest of the market sees it.
2. The market agrees with analysts forecasts for 2006 and 2007, but sees the long-term
growth rate at less than 4%.
3. The market requires a higher or lower required return than 10%.
4. The market is mispriced.

15

With respect to point 1, sell-side analysts forecasts are often overly optimistic, particularly twoyear ahead forecasts on which the AEG is calculated.
This exercise is dangerous when both the market and analysts are too optimistic (as in the
bubble). Then you have to challenge the price with your own forecasts.
E6.12. Valuation of Microsoft Corporation

The Pro Forma


Eps forecasted
Dps
Dps reinvested at 9%
Cum-dividend earnings
Normal earnings: 2.60 1.09
AEG

2011
2.60
0.40

2012
2.77

0.036
2.806
2.834
-0.028

a. Normal forward P/E = 1/0.09 = 11.11


Traded forward P/E = $24.30/$2.60 = 9.346
b.
Valuation with no growth:
V2010 =

1
- 0.028
2.60 +

0.09
1.09

= $28.60

Intrinsic P/E = $28.60/$2.60 =11.00


c.
The value without growth is higher than the market price. So, if you saw some
abnormal earnings growth ahead, the stock is definitely underpriced.

E6.13. Using Earnings Growth Forecasts to Challenge a Stock Price: Toro Company

a. With a required return of 10%, the value from capitalizing forward earnings is
Value2002 = $5.30/0.10 = $53

With a view to part d of the question, forward earnings explain most of the current market price
of $55. If one can forecast growth after the forward year, one would be willing to pay more that
$53.

b. First forecast the ex-dividend earnings based of analysts growth rate of 12%. Then add the
earnings from reinvesting dividends at 10%.

2003

2004

2005 2006 2007 2008

Eps growing at 12%

5.30

5.936

6.648 7.446 8.340 9.340

Dividends

0.53

0.594

0.665 0.745 0.834 0.934

Dividends reinvested at 10%

0.053

0.059 0.067 0.075 0.083

Cum-dividend earnings

5.989

6.707 7.513 8.415 9.423

c. Abnormal earnings growth (AEG) is cum-dividend earnings minus normal growth earnings.
Normal earnings is earnings growing at the required return of 10%:
Cum-dividend earnings

5.989

6.707 7.513 8.415 9.423

Normal earnings

5.830

6.530 7.313 8.191 9.174

Abnormal earnings growth (AEG)

0.159

0.177 0.200 0.224 0.249

d. With abnormal earnings growth forecasted after the forward year, the stock should be worth
more than capitalized forward earnings of $53, the approximate market price. (One would have
to examine the integrity of the analysts forecasts, however.)
The growth rate forecast for AEG for 2005-2008 is 12% (allow for rounding error in
calculating this growth rate from the AEG numbers above). This cannot be sustained if the

17

required return is 10%, but there is plenty of short-term growth to justify a price above $55. (Of
course, one can call the analysts forecasts into question.)

E6.14. Abnormal Earnings Growth and Accounting Methods

The revised pro forma is as follows:


2013E

2014E

2015E

2016E

2017E

Earnings
502.0
Dividends
115.0
Reinvested dividends
Cum-div earnings
Normal earnings
Abnormal earn growth

570.0
160.0
11.5
581.5
552.2
29.3

599.0
349.0
16.0
615.0
627.0
-12.0

629.0
367.0
34.9
663.9
658.9
5.0

660.45
385.40
36.70
697.15
691.90
5.25

Growth rates:
Earnings growth
Cum-div earn growth (AEG)
Growth in AEG

13.55%
15.84%

5.09%
7.89%

5.00%
10.83%

Discount rate
PV of AEG

1.100
26.64

1.210
-9.92

5.0%
10.83%
5.0%

(a) Forecasted earnings for 2013 increase by $114 million, to $502 million, because of the
lower cost of good sold. (This assumes that the write-down has no effect on forecasted
revenues on which forecasts for other years are based: it is often the case the an inventory
write-down means that the firm will have more trouble selling its inventory.)
(b) The valuation based on the revised pro forma is:
Forward earnings, 2013
Total present value of AEG for 2014-2015
(26.64 9.92 = 16.72)
5
Continuing value (CV), 2015 =
= 100.00
1.10 1.05
Present value of CV =

100.0
1.210

502.00
16.72

82.64

601.36
Capitalization rate
Value of the equity =

0.10
601.36
0.10

6,013.6

Value per share on 1,380 million shares

4.36

The valuation is the same at that in Exercise 6.3.


(c) As the additional earnings of $114 million in 2013 will incur a tax of $39.9 million, they
will be lower by that amount, that is $462.1 million. However, the lower earnings provide
a lower base for calculating AEG for 2014, so AEG in 2014 is higher than that in the pro
forma in (a). The net effect is to leave the valuation unchanged. (This assumes forecasts
for other years are already after tax.)

E6.15. Is a Normal Forward P/E Ratio Appropriate? Maytag Corporation

a. Normal forward P/E for a 10% cost of capital = 1/0.10 = 10.0.


Actual traded forward P/E = $28.80/$2.94 = 9.80.
The firm was trading below a normal P/E, so the market was forecasting
negative abnormal earnings growth after 2003.
b. A five-year pro forma with a 3.1% eps growth rate after 2004 and forecasted dps that
maintains the payout ratio in 2003:

19

c.
2003

2004

2005

2006

2007

Eps

2.94

3.03

3.12

3.22

3.32

Dps

0.72

0.74

0.76

0.79

0.81

Dps reinvested at 10%

0.072 0.074 0.076 0.079

Cum-dividend earnings

3.102 3.194 3.296 3.399

Normal earnings at 10%

3.234 3.333 3.432 3.542

Abnormal earnings growth -0.132 -0.139 -0.136 -0.143


An AEG valuation based on just these five years of forecasts is:
E
=
V2002

1
0.132 0.139 0.136 0.143
2.94 +
+
+
+

0.10
1.10
1.21
1.331
1.4641

= $25.07
So, even if abnormal earnings growth were expected to recover to zero after
2007, the current price of $28.80 is too high.

CHAPTER SEVEN
Valuation and Active Investing
Concept Questions
C7.1. The measure of the required return from the CAPM is imprecise. It involves an estimate of

a beta and the market risk premium. Betas are estimated with standard errors of about 0.25, so if
one estimated a beta of 1.2, say, it could actually be 0.95 or 1.45 with reasonable probability.
And the market risk premium is a big guess. See the appendix to Chapter 3. Fundamental
investors do not like to put speculation into a valuation, and the CAPM required return is
speculative.

C7.2. Inputs into a valuation more can be quite uncertain, particularly the long-term growth rate.

One can get any valuation by playing with mirrors: choosing a desired growth rate to support the
valuation one is looking for. Investment bankers do it when they use a valuation model to justify
a valuation they seek for a stock offering.

C7.3. Investing is not a game against nature means that there is not a true intrinsic value to be

discovered (as if it existed in nature). So the onus is not on the investor to come up with an
intrinsic value. All the investor has to do is assess if the current market price is a reasonable one.
That price is set by other investors, based on their analysis, beliefs, fashions, and fads. The
question is: Are the forecasts in the market price justified? The game is against other investors
who set the price, not against nature.

21

C7.4. Growth rates (in a continuing value calculation, for example), are highly speculative.

Putting speculation about the growth rate into a valuation is dangerous. Always make sure that
what goes into a valuation is based on solid analysis: Separate what you know from speculation.

C7.5. Growth refers to outcomes in the long-term, and the long-term is uncertain. Growth can be

competed away so that, unless the firm has protectionhas build a moat around its castleits
expected growth may not materialize. Buying growth is thus risky.

C7.6. In the long run, the growth rate for residual earnings cannot be higher than the required

return otherwise the firm would have infinite value. If one thinks of the typical required return of
10%, then a 16% current growth rate must be lower in the future. Basic competitive economics
tells us that firms cannot maintain superior growth in the long-term. The best guess at the longrun growth rate is the historical GDP growth rate of about 4%.

C7.7. See the answer to C7.6. Exceptional growth is usually maintained only in the short-term.

Eventually growth gets competed away, so that all firms look like the average firm in the
economy in the long-run.

C7.8. The degree of competition and the ability of the firm to protect itself from

competitionwith a brand, with proprietary technology, by adaptive behavior and innovation,


for example. The period over which growth reverts to the average is sometimes referred to as the
competitive advantage period and the speed of reversion to the average as the fade rate.

C7.9. Yes, growth is risky, so a high P/E stock with a lot of growth built into its price is risky.

And, yes, P/E ratios are positively correlated with beta. Here are the average betas for 10
portfolios formed from a ranking on E/P (the inverse of P/E) for U.S. stocks from 1963-2006.
You can see that betas are higher for low E/P (high P/E) stocks. Note also that the returns from
buying stocks are lower for the E/P (high P/E) stocks: Buying growth is risky.

E/P
Portfolio
1
(Low)
2
3
4
5
6
7
8
9
10
(High)

E/P
(%)

Beta

Annual
Returns
(%)

-32.5
-3.3
2.0
4.5
6.1
7.4
8.6
10.0
11.8

1.38
1.32
1.28
1.22
1.14
1.06
1.01
0.97
0.96

16.0
10.3
11.4
12.8
14.8
15.2
17.9
18.1
20.8

16.3

0.99

25.3

C7.10. The market is seeing some growth in this stock. The value the market is given to growth

in $16.34 - $12.92 = $3.42 per share.

C7.11. The market sees negative growth in the future.

23

Exercises
Drill Exercises
E7.1. Reverse Engineering Growth Rates
a. The pro forma:
2012

EPS
BPS (for a P/B of 2.0)
Residual earnings (10%)

2013

2.60
13.00
1.30

Set up the reverse engineering problem:


Price = $26 = $13.00 +

1.30
1.10 - g

The solution for g = 1.0 (a growth rate of 0%). The market is giving this firm a no-growth
valuation.
b. The proforma:

2012

EPS
BPS
Residual earnings (9%)

4.11
27.40

Set up the reverse engineering problem:


Price = $54 = $27.40 +

1.644
1.09 - g

The solution for g = 1.0282 (a growth rate of 2.82%).


E7.2. Reverse Engineering Expected Returns

a. Use the weighted average expected return formula:


Book value = $13.00 (for a P/B of 2.0)
B/P = 0.5
Forwards ROCE = 2.60/13.00 = 20.0%

2013

1.644

With no growth, the weighted average expected return is


ER = B/P ROCE1
= 0.5 20%
= 10%
(You can also see this from the answer in part (a) of E7.1: the market price with a 10%
required return is a no-growth valuation, so a price with no growth yields 10%.
b. The weighted-average return formula now includes growth:
B/P = 27.40/54.00 = 0.507
ROCE1 = 4.11/27.40 = 15.0%
ER = [B/P ROCE1] + [(1 B/P) (g-1)]
= [0.507 15.0%] + [0.493 4%]
= 9.577%
E7.3. Reverse Engineering Earnings Forecasts

The pro forma:


2012

EPS
DPS
BPS
Residual earnings (9%)

239.0

2013

33.46
0.0
272.46
11.95

a. Set up the reverse engineering problem:


Price = 2.6 $239.0 = $621.4 million
Price = $621.4 = $239.0 +

11.95
1.09 - g

The solution for g = 1.0588 (a growth rate of 5.88%).

25

b. Reverse engineer the residual earnings calculation:


Earnings2014 = (Book value2013 0.09) + RE2014
RE2014 = RE2013 RE growth rate
= $11.95 1.0588
= $12.653
Earnings2014 = (Book value2013 0.09) + RE2014
= $(272.46 0.09) + 12.653
= $37.17

E7.4. Expected Returns for Different Growth Rates

Apply the weighted-average expected return formula to elicit the expected return in the market
price:
ER = [B/P ROCE1] + [(1 B/P) (g-1)]
B/P =1/2.2 = 0.455
ROCE1 = 15.0%
Thus,
ER = [0.455 15.0%] + [0.545 (g-1)]
Here is the ER for different growth rates:
Growth Rate
ER
3%
8.46%
4%
9.01%
6%
10.10%
E7.5. Reverse Engineering with the Abnormal Earnings Growth Model
The pro forma:
0

EPS
DPS
Cum-dividend earnings
Normal earnings (2.11 1.09)
Abnormal earnings growth

2.11
0.0

2.67
0.00
2.67
2.30
0.37

a. Set up the reverse engineering problem using the AEG model of Chapter 6:

Price = $105.69 =

1
0.37
2.11 +

0.09
1.09 g

The solution for g = 1.04 (a growth rate of 4.0%)


b. Reverse engineer the AEG formula (with no dividends)
Thus,

AEG3 = Earnings3 (1.09 Earnings2)


Earnings3 = (Earnings2 1.09) + AEG 3
AEG3

= AEG2 Growth rate


= 0.37 1.04
= 0.384
Earnings3 = $(2.67 1.09) + 0.3848
= $3.295
Applications
E7.6. Reverse Engineering Growth Rates: Dell, Inc.

To answer this question, you have to specify your required return: a 10% rate is used here.
The pro forma is as follows:
2008

EPS
DPS
BPS
RE (10%)

2009
1.47
0.00
3.283
1.289

1.813

The growth rate is calculated by reverse engineering:


P2008 = $20.50 = 1.813 +

1.289 1.442
1.442 g
+
+
1.10
1.21 1.21(1.10 g )

The solution for g = 1.025 (or a 2.5% growth rate).


The solution is the same with the following calculation:

27

2010
1.77
0.00
5.053
1.442

P2008 = $20.50 = 1.813 +

1.289
1.442
+
1.10 1.10 (1.10 g )

E7.7. Building Blocks for a Valuation: General Electric

To answer this question, you have to specify your required return: a 10% rate is used here.
a. Here is the pro forma using a required return of 10%.
2004

EPS
DPS (dividend payout 50%)
BPS
RE (10%)

2005
1.71
0.86
11.32
0.663

10.47

2006
1.96
0.98
12.30
0.828

The value is calculated as follows, with a 4% growth rate in the continuing value:

$28.38 = $10.47 +

0.663
1
0.828
+

1.10 1.10 1.10 1.04

= $23.62
b. The first building block is the book value

$10.47

The second component is the addition to book value if there is no growth, and is
calculated as:

$11.12 =

0.663
1 0.828
+
1.10 1.10 0.10

8.13

The third (growth) component plugs to


the market price

17.40

Market price

36.00

The three components are diagramed as follows:

Book
Value

Value from
Short-term
Forecasts

Value from
Growth

c. Reverse engineer the model:


$36.00 = $10.47 +

0.663
1
0.828
+

1.10 1.10 1.10 g

The solution is g = 1.0698, or approximately a 7% growth rate.

E7.8. The S&P 500 During Boom and Bust

a. At the end of 2008:


Residual earnings, 2009 = 73 (0.09 451)
= 32.41
The reverse engineering problem:
Price = 903 = 451 +

32.41
1.09 g

29

The solution to g = 1.0183, or a growth rate of 1.83%. This is considerably lower than the
average implied growth rate of 4.2% for the S&P 500 in Figure 7.1.
b. At the end of 1999:
Residual earnings, 2000 = 50.1 (0.09 294)
= 23.64
The reverse engineering problem:
Price = 1469 = 294 +

23.64
1.09 g

The solution to g = 1.0699, or a growth rate of 6.99%. High!

E7.9. The Markets Forecast of Nikes Growth Rate

The pro forma:


2010

EPS
DPS
BPS
RE (9%)

20.15

2011
4.29
1.16
23.28
2.477

2012
4.78
1.29
26.77
2.685

The dividend for 2012 is forecasted to be at the same payout ratio as in 2011: 0.270 4.78 =
1.29.
a. The growth rate is calculated by reverse engineering:
P2010 = $74 = 20.15 +

2.477
2.685
+
1.09 1.09 (1.09 g )

The solution for g = 1.0422 (or a 4.22% growth rate).


b. Reverse engineer the residual earnings calculation:
RE2013 = RE2012 Growth rate
= 2.685 1.0422
= 2.798
Earnings2013 = (Book value2012 0.09) + RE2013
= $(26.77 0.09) + 2.798
= $5.207

RE2014= RE2013 Growth rate


= 2.798 1.0422
= 2.916
BPS2013 = 26.77 + 5.201 1.406
= 30.571

(dividend is at the payout ratio of 27%)

Earnings2014 = (Book value2013 0.09) + RE2014


= $(30.571 0.09) + 2.916
= $5.667

E7.10. The Expected Return from Buying Novartis

Apply the weighted-average return formula:


B/P =1/2.1 = 0.476
ER = [B/P ROCE1] + [(1 B/P) (g-1)]
= [0.476 19.0%] + [0.524 4%]
= 11.14%

E7.11. The Expected Return to Buying a Google Share

a. Price = $535
Book value = $143.92
B/P = 143.92/535 = 0.269
ROCE1 = 33.94/143.92 = 23.58%

The weighted-average return formula:

Similarly, the ER for a growth rate of 5% = 10.00%, and ER for a 6% growth rate =
10.73%.

31

b. This is somewhat difficult. For this question, one has to apply the B/P ratio at the end of
2011and the ROCE for 2012:
Book value2011 = 177.86
Price2011 = Price2010 1.10 = 535 1.10 = 588.50
B/P (2011) = 0.302
ROCE2012 = 39.55/177.86 = 22.24%

(from Exhibit 7.1)

The price at the end of 2011 is the current price growing at the required return of 10% in
the exhibit. Note that one can solve the problem only by putting in a required return (that
was not necessary in part a), but the estimate (just for one year) will not affect the
calculation much.
ER = [B/P (2011) ROCE2012] + [(1 B/P) (g-1)]
= [0.302 22.24%] + [0.698 4%]
= 9.51%
Similarly, the ER for a growth rate of 5% = 10.21%, and ER for a 6% growth rate =
10.91%.
E7.12 Growth for a Hot Stock: Netflix

The pro forma:


2010

EPS
DPS
BPS
RE (11%)

5.50

2011
3.71
0.00
9.21
3.105

2012
4.84

3.827

a. First get the no-growth valuation:

Value = $5.50 +

3.105
3.827
+
1.11 1.11 0.11

= $39.64
Value is growth = Market valuation No-growth value
= $157 39.64
= $117.36

b. Reverse engineer:
Price = $157 = $5.50 +

3.105
3.827
+
1.11 1.11 (1.11 g )

The solution for g = 1.0868, a 8.68% growth rate. This is very high! Think of a GDP
growth rate of about 4% as normal.
E7.13. Sellers Wants to Buy

a. The Pro forma:


2006

EPS
DPS
BPS

12.67

Residual earnings (10%)

2007
2.98
0.60
15.05

2008
3.26
0.70
17.61

1.713

1.755

The current book value per share = Book value/Shares outstanding


= $26,909/2,124
= $12.67
Reverse engineer Sellers price:
$50 = 12.67 +

1.713
1.755
+
1.10
1.10 x (1.10 - g)

g = 1.0555 (a 5.55 % growth rate)


A.

Getting to EPS growth rates for 2009 and 2010:

RE growing at 5.55%
Prior BPS
Prior BPS x 0.10
EPS (1) + (2)
EPSgrowth rate
DPS (at 2008 payout ratio)
BPS
Prior BPS x 0.10
EPS (1) + (3)
EPS growth rate

2009
1.852
17.61
1.761
3.613

2010
1.955

(1)
(2)

10.83%
%

0.776
20.447
2.045
4.00
10.71%
%
33

(3)

E7.14. Reverse Engineering Growth Forecasts for the S&P 500 Index

(a)
With a P/B ratio is 2.5, investors are paying $2.50 for every dollar of book value in the S&P 500
companies. With an ROCE of 18%, the current residual earnings on a dollar of book value is:
RE0 = (0.18 0.10) 1.0
= 0.08
That is, 8 cents per dollar of book value. The value of an asset (with a constant growth rate is
mind) is calculated as:

V0 = B0 +

RE0 g
g

(One always capitalizes the one-year-ahead amount, which is the current residual earnings, RE0,
growing one year at 10%.) So, for every dollar of book value worth $2.50,
2.50 = 1.0 +

0.08 g
1.10 g

Solving for g,
g = 1.044 (a 4.4% growth rate)
A good benchmark growth rate for the market as a whole is the GDP growth rate. This has
historically been an average of about 4.0%. So, if history is an indication of the future, a 4.4 %
implied growth rate suggests that the S&P 500 stocks, as a portfolio, are a little overpriced.
What does a growth rate of 4.4% for residual earnings mean? If the S&P 500 firms can
maintain an ROCE of 18%, then investment in net assets must grow by 4.4%.
Alternatively, if ROCE were to improve, a growth in residual earnings of 4.4% can be
maintained with a lower growth rate. Is a 4.4% growth rate for residual earnings

reasonable? What is the prospect for ROCE for the market as a whole? Is the market
appropriately priced?
(Analysis in Part II of the book will help answer these questions.)

(b)
See the last paragraph. With a constant ROCE, the growth in residual earnings is
determined by the growth in net assets (book value). Remember, residual earnings is
driven by two factors:
1. Profitability of net assets: ROCE
2. Growth in net assets

E7.15. The Expected Return for the S&P 500

a.

Book value on January 1, 2008 = 1,468 / 2.6


= 564.62
B/P = 564.62/1468 = 1/2.6 = 0.385
Forward ROCE for 2008

= 72.56 / 564.62
= 12.85%

b. The reverse engineering problem:

1,468 = 564.62 +

72.56 (? 564.62)
? 1.04

? = 1.07403, or a 7.403% expected return


The following formula solves for the expected return:

B
B

? = ROCE1 + 1 ( g 1)
P
P

35

= [0.385 12.85%] + [(1 0.385) 4%]


= 7.41%
c. Required return = 4% + 5% = 9%
Do not buy, for the expected return is less than the required return.
d. Although the level of the index is not given, one can still work the problem based on the
price-to-book of 5.4. For every $1 of book, the price is 5.4, so the reverse engineering
problem can be set up as:

5.4 = 1 +

(0.23 ?) 1
? 0.04

($1 of book value)

? = 7.52%
The weighted average expected return formula solves for the expected return:
Expected return =

B0
B
ROCE1 + (1 0 )( g 1)
P0
P0

= (0.185 0.23) + (0.815 4%)


= 4.255% + 3.26%
= 7.52%
If the required return is 9%, this expected return indicates that the S&P 500 stocks are
overvalued. All the more so when one appreciates that a 23% ROCE used as an input is quite
a bit above the historical ROCE of 17-18%. A 23% ROCE means a high residual earnings
base to apply a 4% growth rate to. If one entered a 17% ROCE, then the expected return
would be lower, at 6.41%. (Correspondingly, the forward ROCE for 2008 in part (a) is lower
than the historical average, and a higher return that the 7.41% there would be expected with a
higher forward ROCE.)

E7.16. Inferring Implied EPS Growth Rates: Kimberly-Clark Corporation

Price, March 2005

$64.81

a.

Trailing P/E =

64.81 + 1.60
= 18.24
3.64

Forward P/E =

64.81
= 17.01
3.81

Normal trailing P/E =

1.089
= 12.24
0.089

Normal forward P/E =

1
= 11.24
0.089

b.

Calculate AEG for 2006:


2004

2005

2006

Eps

3.64

3.81

4.14

Dps

1.60

1.80

1.96

Dividends reinvested at 8.9%

0.1602

Cum-dividend earnings

4.3002

Normal eps (3.81 x 1.089)

4.1491

Abnormal earnings growth (AEG)


0.1511

37

P = 64.81 =

1
0.1511
3.81 +

0.089
1.089 - g

g = 1.012 (1.2% growth rate )


c.
2005

2006

2007

2008

2009

3.81
1.80

4.14
1.96

2.14

2.33

2.54

2.77

0.1529

0.1547

0.1566

0.1585

(0.1744)

(0.1905)

(0.2074)

(0.2261)

Normal earnings

4.5085

4.8863

5.2822

5.6970

Eps

4.4870

4.8505

5.2314

5.6294

8.38%

8.10%

7.85%

7.61%

Eps
Dps

AEG
0.1511
(growing at 1.2%)
Reinvested dividends

2010

(at 8.9%)

Eps growth rate

8.66%

Note: Normal earnings are the earnings in the prior year growing at 8.9%. So, for 2008, normal
earnings = $4.487 x 1.089 = 4.8863.

d.

The market was pricing approximately the same growth rates as forecasted by analysts. Put
another way, the market was pricing KMB based on consensus analysts forecasts.
e.

Yes, as analysts were forecasting the same growth rates as those implied in the market price, they
are saying that the market price is reasonable. The 2.6 ratinga HOLDhas integrity.

CHAPTER EIGHT
Viewing the Business through the Financial Statements
Concept Questions
C8.1

Free cash flow is a cash dividend from the operating activities to the financing activities;

that is, it is the net cash payoff from operations that is distributed in the financing activities. The
operations generate free cash flow which is then distributed to investors, namely to the
shareholders in net dividends with the remainder going to the net debtholders: C I = d + F. To
see the point more clearly, C I = d in the case where there is no net debtthat is, free cash flow
is the dividend to shareholders. With net debt, this dividend is dividend between the shareholders
and the debtholders.
C8.2

Refer to the cash conservation equation: C I d = F. The firm must pass out the excess

of free cash flow after dividends to net debtholders, by buying down to its own financial
obligations or by buying others debt as a financial asset.

C8.3

The firm borrows: C - I = d + F. So, if C - I = 0, then the firm borrows to pay the

dividend such that d + F = 0.

C8.4

An operating asset is used to produce goods or services to sell to customers in operations.

A financing asset is used for storing excess cash to be reinvested in operations, pay off debt, or
pay dividends.

39

C8.5

An operating liability is an obligation incurred in producing goods and services for

customers. A financial liability is an obligation incurred in raising cash to finance operations.

C8.6

True. From the reformulated balance sheets and income statement,

C-I = OI - NOA. So, with operating income identified in a reformulated income statement and
successive net operating assets identified in a reformulated balance sheet, free cash flow drops
out. See Box 8.3.

C8.7

Operations drive free cash flow. Specifically, value is added in operations through

operating earnings, and free cash flow is the residual after some of this value is added to net
operating assets: C I = OI - NOA.

C8.8

Free cash flow can be paid out as dividends, but dividends are the residual of free cash

flow after servicing the interest and principal claims of debt (or investing in net financial assets):
d = C I NFE + NFO.

C8.9

Net operating assets are increased by earnings from operations and reduced by free cash

flow: NOA = OI (C I). Expanding, net operating assets are increased by operating income
(operating revenues less operating expenses), reduced by cash flow from operations, and
increased by cash investment: NOA = OI C + I.

C8.10 Net financial obligations are increased by the obligation to pay interest, and by dividends,

and are reduced by free cash flow: NFO = NFE (C I) + d.

C8.11 True. Free cash flow is a dividend from the net operating assets to the net financial

obligations. So, as CSE = NOA - NFO, free cash flow does not affect CSE.
C8.12. Profitable companies have investment opportunities. New investments expenditures can

be higher than cash from operations, producing negative free cash flow. Starbucks in Chapter 4
is another example.
Exercises
Drill Exercises
E8.1. Applying the Cash Conservation Equation (Easy)

a. Apply the cash conservation:


CI=d+F
$143 = $49 + ?
? = $94 million
b. Net dividend (d) = $162 + 53 = $215
Debt financing flows (F) = -$86
Now apply the cash conservation equation:
CI=d+F
= $215 + (-86)
= $129 million
C8.2. A Question for the Treasurer

The correct answer is b. By the cash conservation equation, any free cash flow left over after
paying net dividends can only be used to pay net interest or to buy down net debt (either by
buying back the firms own debt or buying others debt as a financial asset).
C8.3. What Were the Payments to Shareholders?

a. d = C I NFE + NFO
= 410 340
= 70
Also,
41

d=CI=F
= 410 340
= 70

b. d = Cash dividends + Share repurchases Share issues


70 =
?
+
0
- 50
? = 120

E8.4. Applying the Treasurers Rule

a. The treasurers rule:


C I i d = Cash applied to debt trading
$2,348 23 (14 + 54) = $2,365 million
After paying interest and receiving $40 million (14 54) from the negative net dividend,
there was $2,365 of cash left over from the free cash flow. The treasurer used it to buy
debt, either by buying back the firms own debt or investing in debt assets.
b. From the treasurers rule,
C I i = d + cash from trading in debt
-$1,857 32 = d + cash from trading in debt
= ($1,050 + stock repurchases share issues) + cash from trading
in debt
(The dividend is $1.25 per share 840 million shares = $1,050 million)
The cash shortfall after paying the dividend is $1,857 + 32 + 1,050 = $2,939
million. The treasurer meets this shortfall by selling debt either issuing the
firms own debt or selling debt assets (financial assets) that the firm holds or
by issuing shares.

E8.5. Balance Sheet and Income Statement Relations

a. Net financial assets = Financial assets - Financial obligations


= $432 - $1,891
= -$1,459 million
That is, the firm has net financial obligation (negative NFA)
Net operating assets = Common equity + Net financial obligations

= $597 + 1,459
= $2,056 million
b. Operating income (after tax) = Comprehensive income + NFE (after tax)
= $108 + 47
= $155 million

E8.6. Using Accounting Relations

The reformulated balance sheet:


Net Operating Assets

Net Financial Obligations and Equity

Operating assets
Operating liabilities

2012
205.3
40.6

2011
189.9 Financial liabilities
34.2 Financial assets
NFO
CSE
155.7

NOA

164.7

(a) Dividends

= Net income CSE

(Clean-surplus equation)

= 1.9
(These are net dividends)
(b) C I

= OI NOA
= 21.7 9.0
= 12.7

(c) RNOAt

= OIt / (NOAt + NOAt-1)


= 21.7/160.2
= 13.55%

(d) NBC

2012
120.4
45.7
74.7
90.0
164.7

= Net interest/ (NFOt + NFOt-1)


= 7.1/76.55
= 9.27%
43

2011
120.4
42.0
78.4
77.3
155.7

E8.7. Using Accounting Relations

(a)
Income Statement:
Start with the income statement where the answers are more obvious:
A = $9,162
B = 8,312
C=

94

(Comprehensive income = operating revenues operating expenses net financial expenses)


Balance sheet:
D = 4,457
E = 34,262
F = 34,262
G = 7,194
H = 18,544
Before going to the cash flow statement, reformulate the balance sheet into net operating
assets (NOA) and net financial obligations (NFO):

Operating assets
Operating liabilities

Jun-12

Dec-12

28,631
7,194

30,024
8,747

Financial obligations
Financial assets
Net financial obligations
Common equity

Net operating assets


Cash Flow Statement:

21,437

21,277

Free cash flow:

J = 690

[C - I = OI - NOA]

Cash investment:

I = (106)
(a liquidation)

[I = C - (C - I)]

Jun-12

Dec-12

7,424
4,457
2,967

6,971
4,238
2,733

18,470
21,437

18,544
21,277

Total financing flows:

M = 690

[C - I = d + F]

Net dividends:

K = 865

[Net dividends = Earnings - CSE]

Payments on net debt:

L = (175)
[F = d + F - d]
(more net debt issued)

(b)
Operating accruals can be calculated in two ways:
1.

2.

(c)

NFO

Operating accruals

Operating accruals

Operating income Cash from operations

850 584

266

NOA Investment

160 (-106)

266

NFE (C - I) + d

59 690 + 865

234

45

E8.8. Inferences Using Accounting Relations

(a)
This firm has no financial assets or financial obligations so CSE = NOA and total
earnings = OI. Also the dividend equals free cash flow (C - I = d).

Price
CSE (apply P/B ratio to price)
Free cash flow
Dividend (d = C - I)
Price + dividend
Return (246.4 224)
Rate of return

2009

2008

224
140

238
119
8.4
8.4
246.4
22.4
10%

(b)
There are three ways of getting the earnings:
1.

2.

3.

Stock return - premium

22.4 (119 - 84)

(12.6)

C - I + NOA

8.4 + (119 140)

(12.6)

(Earnings

OI as there are no financial items)

Earnings

CSE + dividend

-21 + 8.4

(12.6)

Earnings

OI

(a loss)

Applications
E8.9. Applying the Treasurers Rule: Microsoft Corporation
a.

The treasurer would run through the following calculation to find the cash surplus or deficit:
Cash flow from operations
Cash investment
Free cash flow
Interest receipts
$702 million
Taxes
253
Cash available to shareholders
Net payout to shareholders:
Stock repurchase
Dividends
Share issued

23.4 billion
3.2
20.2
0.449
20.649

40.0 billion
4.7
(2.5)
42.200

Cash surplus

(21.551)

As the surplus is actually a cash shortfall, the treasurer must sell debt. He or she does so by
selling part of the $23.7 billion in financial assets on hand.
b.

In the treasurers plan, $4.2 billion would be added to cash investments:


Cash flow from operations
Cash investment (3.2 + 4.2)
Free cash flow
Interest receipts
$702 million
Taxes
253
Cash available to shareholders
Net payout to shareholders:
Stock repurchase
Dividends
Share issued

23.4 billion
7.4
16.0
0.449
16.449

40.0 billion
4.7
(2.5)
42.200

Cash surplus

(25.751)

Now the treasurer must liquidate more of the $23.7 billion in financial assets on hand.
47

c.

With almost all of its financial assets of $23.7 billion distributed, under these scenarios,
Microsoft might need cash for further stock repurchases, dividends, or investments in operations.
E8.10. Accounting Relations for Kimberly-Clark Corporation
a. Reformulate the balance sheet:
2007

Operating assets
Operating liabilities
Net operating assets (NOA)
Financial obligations
Financial assets

2008

$18,057.0
6,011.8
12,045.2
$6,496.4
382.7

Common equity

6,113.7

$4,395.4
270.8

$ 5,931.5

$16,796.2
5,927.2
10,869.0

(i)

4,124.6

(ii)

$ 6,744.4

(iii)

b. Free cash flow = Operating income Change in net operating assets


= $2,740.1 (12,045.2 10,869.0)
= $1,563.9
c. NOA (end) = NOA (beginning) + Operating income Free cash flow
$12,045.2 = $10,869.0 + 2,740.1 1,563.9
d. CSE (end) = CSE (beginning) + Comprehensive income Net payout
Comprehensive income = Operating income Net financial expense
$2,593.0 = $2,740.1 147.1
$5,931.5 = 6,744.4 + 2593.0 Net payout
Thus, net payout = $3,405.9

CHAPTER NINE
The Analysis of the Statement of Shareholders Equity

Concept Questions
C9.1. Because the accounting is not clean in reporting additions to surplus. Surplus is

an old-fashioned word meaning shareholders equity the surplus of assets over liabilities. An
effect on equity from operations that creates additional surplus -- bypasses the income
statement (which is supposed to give the results of operations), and thus is dirty. Clean-surplus
accounting books all income in the income statement.
C9.2. If a valuation is made on the basis of income that is missing some element (of the value

added in operations), the valuation is wrong. For example, if sales or depreciation expense were
put in the equity statement rather than the income statement, we would see the income statement
as missing something that is value-relevant.

C9.3. Currency translation gains and losses are real. If a U.S. firm holds net assets in another

country and the dollar equivalent of those asset falls, the shareholder has lost value.
Many of the net assets behind the Nikes shareholders equity are in countries other than the U.S.
If the value of the dollar were to fall against those currencies, the firm would have more dollar
value to repatriate to ultimately pay dividends to shareholders. Nikes 2010 equity statement (in
Exhibit 9.1) reports a currency translation loss of $159.2million. This means that the dollar value

49

of net assets in other countries in which the shareholders are investing dropped by $159.2
million over 2010. The shareholders lost in dollar terms.

C9.4. Existing shareholders lose when shares are issued to new shareholders at less than the

market price. They give up a share worth the market price, but receive in return a cancellation of
a liability valued at its book value. The new shareholders buying into the firm through the
conversion gain: they receive shares worth more than they paid for the bonds. The accounting
treatment (the market value method) that records the issue of the shares in the conversion at
market value, along with a loss on conversion, reflects the effect on existing shareholders
wealth.
C9.5. The firm is substituting stock compensation for cash compensation but, while recording

the reduced cash compensation (and so increasing reported profits), the firm is not recording the
full cost of the stock compensation. One would have to calculate the equivalent cash
compensation cost of the stock option compensation to see if the compensation was attractive to
shareholders. (One would also have to consider the incentive effects of stock optionsthe
benefits as well as the costs). Watch for a fake increase in profit margins when a firm substitutes
stock option compensation for cash compensation.
C9.6.

(a)Yes. Issuing shares at less than the market price dilutes the per-share value of the existing
shares. See Chapter 3 and the exercise for Chapter 3 for more.
(b)No. Repurchasing shares at market value has no effect on the per-share value of existing
shares. See Chapter 3, text and exercises. The number of shares is reduced and EPS might thus

increase (depending on the numerator effect), and this might look like reverse dilution. But the
value per share does not change. (Chapter 14 deals with the effect of share repurchases on EPS.)
(c)If Microsoft felt its shares were overvalued in the market it would feel they are too expensive.
In this case, repurchasing would dilute the value of each share, as the price is not indicative of
value. Buying overpriced shares is never a good idea.

C9.7. No. The tax benefit arises only because the firm pays wages (in the form of options) that

the tax authorities allow for as tax deduction. The net benefit (to the shareholder) is the tax
benefit less the value given up to employees in stock compensation. This net amount must
always be negative, as the tax is the tax rate applied to the difference between the market and
issue value of the shares, the value given up by the shareholders.
If there is any benefit to shareholders, it must be from the incentive effects of the stock
options. That is, the revenues that employees generated are in excess of the value given to them
(net of taxes) for their work.

C9.8. The scheme effectively recognizes the difference between the market price and the

exercise price of options exercised as an expense, and so recognizes the compensation expense at
exercise date. The net cash paid by the firm is equivalent to paying the compensation as cash
wages to employees. But why use cash? The expense could be recognized in the books with
accrual accounting without paying out cash.
The only fault with the recognition of the expense is that it is recognized at exercise date
rather than matched to revenue over a service period during which the employees worked for the
compensation.
51

C9.9. Microsoft might think its own shares are overvalued in the market. So it uses them as

currency to get a cheap buy. Buy when price is less than value.

Exercises
Drill Exercises
E9.1. Some Basic Calculations

a. Common equity = total equity preferred equity


= $237 - 32 = $205 million
b. Net dividend = Dividends + share repurchases share issues
= $36 + 45 230 = -$149 million
(There was a net payment into the firm from shareholders.)
Comprehensive Earnings

= CSE (end) CSE (beginning) + net dividend


= $1,292 1,081 - 149
= $62 million

This applies the stocks and flow equation underlying the reformulated equity statement. See
equation 2.4 in Chapter 2.
c. The difference of $25 million is other comprehensive income (dirty-surplus
income) reported in the equity statement.

E9.2. Calculating ROCE from the Statement of Shareholders Equity

. Comprehensive Earnings = CSE (end) CSE (beginning) + net dividend


= 226.2 174.8 26.1
= 25.3
This applies the stocks and flow equation underlying the reformulated equity statement. The net
dividend is negative, that is share issues are in excess on cash paid out in dividends and share
repurchases.
ROCE = Comprehensive earnings / beginning CSE
= 25.3 / 174.8
= 14.47%

[Beginning CSE is used in the denominator because the share issue was at the end of the year. If
the share issue was half way through the year, use average CSE in the denominator]
E9.3. A Simple Reformulation of the Equity Statement

Beginning balance (1,206 200)


Net transactions with shareholders:

$1,006

Share issues
Dividends

$45
(94)

Comprehensive income to common:


Net income
Currency translation loss
Unrealized gain on debt securities
Preferred dividends

(49)

$241
(11)
24
(15)

Ending balance (1396 200)

239
$1,196

Preferred stock has been subtracted from beginning and ending balances (to make it a statement
of common shareholders equity).

E9.4. Using Accounting Relations that Govern the Equity Statement

a.

Balance, December 31, 2011 = $4,500 - 2,100 = $2,400 million


Balance, December 31, 2012 = $5,580 2,100 = $3,480 million
These numbers supply the missing balances in the statement. Given these
balances, the only missing item is net income. This must be $1,083 million.

b.

The reformulated statement is as follows:


Balance, December 31, 2011
Net transactions with shareholders:
Issue of common stock
Common dividend

$2,400
$155
(132)

Comprehensive income:
Net income
Unrealized gain on securities

$1,083
13
53

23

Translation loss
Preferred dividends

(9)
(30)

$1,057

Balance, December 31, 2012

$3,480

Comprehensive income is $1,057 million.


E9.5. Calculating the Loss to Shareholders from the Exercise of Stock Options

Market price of shares issued in exercise 305 $35


Exercise price
305 $20
Loss on exercise before tax
Tax benefit (at 36%)
Loss after tax

$10,675
6,100
$ 4,575
1,647
$ 2,928

E9.6. Reformulating an Equity Statement with Employee Stock Options

Before the reformulation, calculate the loss on exercise of stock options:


12
= 34
0.35
Tax Benefit (35%)
12
Loss on exercise =

Compensation, after tax

22

The loss is obtained from the tax benefit, reported in the equity statement. The 34 (rounded) is
the amount that draws a tax benefit at a 35% tax rate: Method 1 in the text. The after-tax loss, 22,
goes into comprehensive income.
The reformulation:
Balance, end of 2011

1,430

Net transactions with shareholders:


Share issues from options (810 + 34)
Stock repurchases
Dividends

844
(720)
(180)

(56)

Comprehensive income:
Net income
Unrealized gain on debt investments
Loss on exercise of employee options

468
50
(22)

496

Balance, end of 2012

1,870

Applications
E9.7. A Simple Reformulation: J.C. Penney Company

This reformulation is pretty straightforward. The main issue is taking out the preferred stock to
convert the statement to a statement of common shareholders equity: Take out preferred stock
from beginning and ending balances and omit preferred stock transactions (other than the
preferred dividend)
Balance, January 29, 2000 ($7,228 446)

$6,782

Transactions with shareholders:


Common stock issued
Common dividends (249 24)

$ 28
(225)

(197)

Comprehensive income (to common):


Net income
Unrealized change in investments
Currency translation loss
Other comprehensive income
Preferred dividends

(705)
2
(14)
16
(24)

(725)

Balance, January 27, 2001 ($6,259 399)

$5,860

E9.8. Reformulation of an Equity Statement and Accounting for the Exercise of


Stock Options: Starbucks Corporation

a.
Reformulated Statement of Shareholders Equity
(in millions)
Balance, October 1, 2006
$ 2,228.5

Net payout to shareholders:


Stock repurchase

1,012.8
55

Sale of common stock


Issue of shares for employee stock option
Comprehensive Income:
Net income from income statement
Unrealized loss on financial assets
Currency translation gains

(46.8)
(225.2)

(740.8)

672.6
(20.4)
37.7

689.9

Balance, September 30, 2007

$2,177.6

Note: The closing balance excludes $106.4 million for Stock-based compensation expense
which is a liability rather than equity. (It is added to operating liabilities in the reformulated
balance sheet).

b.

Tax benefit from exercise of options in equity statement = $95.276 million


Tax rate = 38.4%
Loss from exercise, before tax (Method 1 in the text)
95.276
0.384
Tax benefit
Loss from exercise of options, after tax

$248.115
95.276
$152.839

C.

Market price per share


Weighted average exercise price
In-the-money amount

28.57
20.60
7.97

Number of options expected to be exercised

63,681,867

Option overhang (7.97 x 63,681.9 million)


Tax benefit (at 38.4%)
Option overhang after tax (a liability)

$507,544
194,897
$312,647

This is a floor estimate; it is only the in-the-money value of the options (it excludes option
value).
Note that the appropriate options number is the number that are expected to be exercised. As
options cannot be exercised until they vest (after a service period), the appropriate number is the

number expected to vest (some employees are expected to leave before vesting). Here the
number of options actually exercisable at the end of 2007 is 40,438,082. With a lower exercise
price of $14.65, one calculates an option overhang of $562.898 which could be recognized as the
overhang.

E9.9. Loss on the Conversion of Preferred Common Stock: Microsoft Corporation

In 1999, Microsofts shares traded at an average price of $88.


With 14.901 million common shares issued -- 1.1273 shares for every one of the 12.5 million
preferred shares -- common stock worth $1,240 million was issued. As the carrying value of the
preferred stock was $990 million, the loss in conversion was $260 million:
Market value of common shares issued: 14.901 $88
Carrying value of the preferred stock
Loss on conversion

= $1,240
980
$ 260

E9.10. Conversion of Stock Warrants: Warren Buffett and Goldman Sachs

The loss to shareholders is the difference between the market price of the shares and the issue
price:
Market price of shares issued on exercise of warrants:
43.5 million x $136

$5,916.0 million

43.5 million x $115

$5,002.5

43.5 million x $(136-115)

$ 913.5 million

Exercise price:

Loss:

The loss is not tax deductible.


57

E9.11. Reformulation of an Equity Statement with Hidden Losses: Dell, Inc.

a.
Loss on stock option exercise

260
0.35

743

Tax effect

260
483

b.
Reformulated Equity Statement:
Balance, February 1, 2002

4,694

Net transaction with shareholders:


Share issue, at market value (418 + 483)
Share repurchase, at market value
(2,290 890)
Comprehensive income:
CI reported
Loss on share repurchase

901
(1,400)

(499)

(890)

1,161

2,051

Balance, January 31, 2003

5,356

The loss on the stock repurchase occurred because shares were repurchased at $45.80 when the
shares traded at $28. The $45.80 repurchase price is the total amount paid, $2,290 million,
divided by 50 million shares repurchased. The repurchase at such a high price was a result of a
share repurchase agreement that gave the counter party the right to sell shares to Dell at $28. See
Box 9.3 in the chapter. The loss is calculated as follows:
Market value of shares repurchased
Amount paid on repurchase
Lost on repurchase

28 x 50 million shares =

1,400
2,290
890

The loss on exercise of options has not been included in comprehensive income because of the
potential double counting problem.

E9.12. Ratio Analysis for the Equity Statement: Nike

Follow the ratio analysis in the chapter. Work from the reformulated equity statement in Exhibit
9.2. The following summary starts with the profitability ratio (ROCE).

Profitability:
ROCE

1,810.4
9,349.5

19.36%

(Average CSE is used in the denominator. In ROCE calculated on beginning ROCE =


20.54%. As earnings are earned over the whole year, we usually use average book value
for the year in the calculation.)

Payout:
Dividend payout

Total payout

1,259.8
1,810.4

Dividends-to-book value

Retention ratio

505.5
1,810.4

27.9%

69.6%

505.5
= 4.9%
9,884.4 + 505.5

1,810.4 505.5
= 72.1%
1,810.4
1,259.8
= 11.3%
9,884.4 + 1,259.8

Total payout-to-book value

Net investment rate

(740.5)
8,814.5

= -8.4%

Growth rate in CSE

1,069.9
8,814.5

= 12.1%

Growth:

Nike added book value from business activities by 19.36% of book value, as indicated by the
ROCE. Nike disinvested with cash dividends and share repurchases paid to shareholders in
excess of share issues.
59

E9.13. Losses from Put Options: Household International

This exercise illustrates the trouble that a firm can get into with put contracts on its own shares,
and how GAAP failed to signal the trouble. (GAAP has since been modified: see the Postscript
at the end of the exercise.)
How share repurchase agreements work

Share repurchase agreements and similar instruments like put options and put warrants --- are
agreements to purchase stock at a prespecified price, with settlement in cash or a net share
transaction for equivalent value. The agreements are written with private investors or banks who
pay a premium for the option right. Firms write put contracts in this case forward share
purchase agreements presumably because they think their shares are undervalued; they do not
expect the option to be exercised. Or, if a share repurchase program is in place, they may be
hedging against increases in the repurchase price. But there may be more sinister motives, as we
will see.
GAAP accounting
When a firm is issuing stock for an average of $21.72 per share and using the cash to
repurchase stock at $53.88, one can easily see that it is losing value and endangering its liquidity
and credit status. But GAAP at that time treated the transactions as if they were plain vanilla
share issues and repurchases at market price, with no recognition of the losses. Further, in the
case where settlement can be in shares, as here, no liability is recorded when these contracts are
entered into; rather the proceeds from the option premium paid by the counterparties are treated
as part of equity. So the firm treats a liability for current shareholders to potentially give up value
(and equity) as part of their equity. (A liability is recorded at the amount of the premium if

settlement is required in cash, that is, if the firm is required to repurchase shares for cash rather
than settling up in shares.)
If the option is not exercised (because the market price of the shares is above the strike
price), the firm pockets the premium paid for option and thus makes a gain for shareholders.
GAAP does not report a gain, however; rather the amount of the premium remains as part of
issued capital, or is transferred to equity if it had been carried as a liability. With Household
Internationals agreements, the counterparty is required to deliver value, in the form of shares,
for the difference between exercise price and market price, augmenting the gain. If the option is
exercised against the firm (because the market price is less than the strike price), the share
repurchase is recorded but no loss is recognized. But there is indeed a loss because the firm
repurchases shares at more than the market price.
a. Exercise of options. During the current quarter, Household International repurchased 2.1
million shares at $55.68 under the agreements. The share issue (yielding $400 million from 18.7
million shares) was at $21.39 per share. Taking this $21.39 as the market price at the time of the
repurchase, the loss per share (gross of the premium received for the contracts) was $34.29 per
share (55.68 21.39), for a total of $72.009 million. See Box 9.3. In journal entry form, the
appropriate accounting is (in millions of dollars):
Loss on stock repurchase
Common Stock

Dr. 72.009
Cr. 72.009

The $72.009 million credit to equity is the value of the stock net issued to settle. If settlement
were in cash, shares would be repurchased at market value (2.1 x $21.39 = $44.919 million),
with the difference between the share value and cash paid (2.1 x $55.68 = 116.928) recorded as
the loss.
61

b. Options overhang. In addition, a liability exists at September 2002 for outstanding agreements.
One could apply option pricing methods to measure this liability, although this would be
complex here because of the varying triggers, the limits on shares to be delivered under the
contracts, and the feature that the firm receives shares if the stock price goes above the forward
price. One can get a feel for the magnitude, however, by comparing the weighted-average strike
price for the 4.9 million options outstanding to the closing market price at September 30, 2003:
Market price 4.9 x $28.31
Exercise price 4.9 x $52.99

$138,719
259,651

Liability

$120,932

(Losses are not tax deductible, so there is no tax benefit to net out here.) This valuation of the
liability excludes the further option value and does not build in the effects of restrictions in the
agreements. The footnote does give some further information on the value of the liability
because it indicates that 4.2 million shares will have to be issued to settle outstanding contracts at
the current market price of the shares. At $28.31 per share, this is $118.902 million. But there are
scenarios under the agreements, depending on the price of the shares, where more shares would
have to issued, up to a maximum of 29.8 million shares.
Share repurchase agreements and put options have a sharp barb for shareholders. When
the share price goes down, they of course lose. But if, in addition, the firm has these agreements,
the shareholder gets hit twice; the loss is levered. Yet GAAP (at that time) did not account for
the loss.
The counterparties here were banks. So you could see the premium received as a loan
from the bank to be paid back in stock, with the expected interest being any difference between
market and strike price. However, this loan was not recorded as such, but rather as equity, so

enhancing capital ratios and improving book leverage. Effectively, the transactions took loans off
balance sheet. Put it down as another structured finance deal to move debt off the balance sheet.
c. Here is how Floyd Norris described it in an article in The New York Times, November 8, 2002,
page C1:
Here's how it worked. Household, following the strategy recommended by Wall Street,
decided in 1999 that it would embark on a big share-buyback program. It figured the stock was
cheap. There was, however, a limitation on how many shares Household could buy. It had
promised investors that it would maintain certain capital ratios, which required that it limit
leverage. If it spent all that money, capital ratios would fall too low.
It could have just waited to buy back the stock until it could afford to do so, but
Household had a better idea. It signed contracts with banks in which it promised to buy the
shares within a year, for the market price when it signed the contract plus a little interest to cover
the cost of the bank's buying the stock immediately. In reality, that amounted to a loan from the
bank. But that is not the way that Household accounted for it. It structured the contracts so that it
had a right to pay off the loan by issuing new stock, even though that was not what it intended to
do. By doing that, it was able to pretend that the shares it had agreed to buy were still
outstanding, and to keep its capital ratios up. All that was in accord with some easily abused
accounting rules.

Postscript: In early 2003 the FASB began deliberations on dealing with the accounting issues
posed by forward purchase agreements, put warrants, and put options. As a result, FASB
Statement No. 150 was issued, requiring a liability to be recognized.

63

CHAPTER TEN
The Analysis of the Balance Sheet and Income Statement
Concept Questions
C10.1. Without the reformulation, operating profitability is confused with financing profitability,

and the return on financial assets (and borrowing cost for financial obligations) is typically
different from operating profitability. Operations add value whereas financing typically does
not, so financing activities need to be separated out to uncover the operating profitability.

C10.2.

(a)

operating

(b)

operating

(c)

operating

(d)

financing

(e)

financing

(f)

financing

(g)

operating (these are investments in the operations of another company)

(h)

operating

(i)

operating

(j)

operating

(a)

operating

(b)

operating

(c)

financing

(d)

operating

(e)

financing

(f)

financing if interest is at market rates.

C10.3.

C10.4. Not correct. In a sense, minority interest (noncontrolling interest) is an obligation for

common shareholders to give the minority in a subsidiary a share of profits. But it is not, like
debt, an obligation that is satisfied by free cash flow from operations. Rather, it is equity that
shares in a portion of profits after net financing costs. In a reformulated balance sheet, put it on a
line between net financial obligations and common shareholders equity.
C10.5. Interest is deductible for taxes so issuing debt shields the firm from taxes.
C10.6 A firm losses the tax benefit of debt when it cannot reduce taxable income with interest

on debt. This can happen if a firm has losses in operations (and thus has no income to reduce
with the interest deduction). In the U. S. this situation is unlikely because firms can carry losses
forward or backward against future or past income.

C10.7. The operating profit margin is the profitability of sales, the percentage of a dollar of sales

that ends up in operating income after operating expenses.

65

C10.8. A negatively levered firm has more financial assets than financial obligations, that is, it

has negative net debt.

Exercises
Drill Exercises
E10.1. Basic Calculations

a. Reformulated balance sheet


Operating assets
$547
Operating liabilities 132

Financial obligations
Financial assets
Net financial obligations
Common shareholders equity

Net operating assets $415


Operating liabilities = $322 190 = $132 million.
b. Reformulated income statement
Revenue
Cost of goods sold
Gross margin
Operating expenses
Operating income
Net financing expense:
Interest expense
Interest income
Earnings

$4,356
3,487
869
428
441
$132
56

76
$ 365

E10.2. Tax Allocation

Net interest after tax = $140 x 0.65 = $91 million


Operating income after tax = Net income + net interest after tax
= $818 + $91
= $909 million
(This is the bottom-up method on Box 10.3)

67

$190
145
45
370
$415

E10.3. Effective Tax Rates

Income before tax = $100 10 = $90 million


Effective tax rate on income before tax = $25/$90 = 27.78%
Operating income
Tax on operating income:
Tax reported
Tax benefit on interest ($10 0.35)
Operating income after tax

$100.0
$25.0
3.5

28.5
71.5

Effective tax rate on operating income = $28.5/$100 = 28.5%

E10.4. Tax Allocation: Top-Down and Bottom-Up Methods

Top-down method:
Revenue
Cost of goods sold
Operating expenses
Operating income before tax
Tax expense:
Tax reported
$181
Tax on interest expense
50
Operating income after tax
Net interest:
Interest expense
Tax benefit at 37%
Earnings

135
50

$6,450
3,870
2,580
1,843
737
231
506

85
421

Bottom-down method:
Earnings
Net interest:
Interest expense
Tax benefit at 37%
Operating income after tax

$421
135
50

85
$506

E10.5 Reformulation of a Balance Sheet and Income Statement

Balance sheet:
Operating cash
Accounts receivable
Inventory
PPE
Operating assets
Operating liabilities:
Accounts payable
Accrued expenses
Deferred taxes
Net operating assets

$ 23
1,827
2,876
3,567
8,293
$1,245
1,549
712

Net financial obligations:


Cash equivalents
Long-term debt
Preferred stock
Common shareholders equity

3,506
4,787
$( 435)
3,678
432

3,675
$1,112

Income statement:
Revenue
Operating expenses
Operating income before tax
Tax expense:
Tax reported
$295
Tax on interest expense
80
Operating income after tax
Net financial expense:
Interest expense
Tax benefit at 36%
Preferred dividends
Net income to common

221
80
141
26

69

$7,493
6,321
1,172
375
797

167
$630

E10.6. Reformulation of a Balance Sheet, Income Statement, and Statement of


Shareholders Equity

a. Reformulated balance sheet


Operating cash
Accounts receivable
Inventory
PPE
Operating assets
Operating liabilities:
Accounts payable
Accrued expenses
Net operating assets

$ 60
940
910
2,840
4,750
$1,200
390

Net financial obligations:


Short-term investments
Long-term debt
Common shareholders equity

1,590
3,160
$( 550)
1,840
1,290
$1,870

Reformulated equity statement:


Balance, end of 2011
Net transactions with shareholders:
Share issues
$ 822
Share repurchases
(720)
Common dividend
(180)
Comprehensive income:
Net income
$ 468
Unrealized gain on debt investments 50
Balance, end of 2012

$1,430

78)

518
$1,870

b. Reformulated statement of comprehensive income


Revenue
Operating expenses, including taxes
Operating income after tax

$3,726
3,204
522

Net financing expense:


Interest expense
$
Interest income
Net interest
Tax at 35%
Net interest after tax
Unrealized gain on debt investments
Comprehensive income

98
15
83
29
54
50

4
$ 518

After calculating the net financial expense, the bottom-up method is used to get operating
income after tax. That is, net interest expense is calculated first (= $4 million). Then, as
comprehensive income is $518 million, operating income must be 518 + 4 = 522. The
number for operating expense (3,204) is then a plug to get back to the $3,726 million revenue
number. Bottom up.

E10.7. Testing Relationships in Reformulated Income Statements

The solution has to be worked in the following order:


A

= Operating revenues operating expenses


= 5,523 4,550
= 973

= Interest expense after tax/ (1 tax rate)


= 42/0.65
= 64.6

= E 42
= 22.6

= 610 + 42
= 652

= F
71

= 22.6
B

= ACD
= 973 22.6 652
= 298.4

Effective tax rate on operating income


= Tax on operating income/ Operating income before tax
= (B + C)/A
= 33.0%

Applications
E10.8. Price of Cash and Price of the Operations: Realnetworks, Inc.

a.
Total price of equity = $3.96 142.562 million shares = $564.5 million
Book value of shareholders equity =
876.0 million
Price/book = 564.5/876 = 0.64
b.
NOA = CSE NFA
= 876 454
= 422 million
c.
Price of operations = Price of equity Price of net financial assets
As the price of net financial assets are close to their market value,
Price of operations = 564.5 454
= 110.5 million

E10.9. Analysis of an Income Statement: Pepsico Inc.

a. The reformulation:
Net Sales
Operating expenses
Operating income from sales (before tax)
Tax reported
Tax benefit of debt
Tax oon other operating income
Operating income from sales (after tax)
Other operating income
Gain on asset sales
Restructuring charge
Tax on other operating iincome, 36.1
Operating income (after tax)

Net financial expense:


Interest expense
Interst income

20,367
17,484
2,883
1,606
88
(367)

1,083
65
1,018
367

363
118
245
88

Tax on net i interest (36.1%)


Net Income

1,327
1,556

651
2,207

157
2,050

1,327
= 46.0%
2,883
You might ask why the tax rate is so high: Pepsico had a special 10.6 percent extra tax
charge on its bottling operations in 1999.
c.

Effective tax rate on operating from sales =

73

E10.10. Coffee Time: A Reformulation for Starbucks Corporation

a.
Reformulated Statement of Shareholders Equity
(in millions)

Balance, October 1, 2006

$ 2,228.5

Net payout to shareholders:


Stock repurchase
1,012.8
Sale of common stock
(46.8)
Issue of shares for employee stock options (225.2)
Comprehensive Income:
Net income from income statement
Unrealized loss on financial assets
Currency translation gains
Balance, September 30, 2007

672.6
(20.4)
37.7

(740.8)

689.9
$2,177.6

Note: The closing balance excludes $106.4 million for Stock-based compensation expense
which is a liability rather than equity. (It is added to operating liabilities in the reformulated
balance sheet).
b.

Reformulated Comprehensive Income Statement, 2007


(in millions)
Net revenues
$ 9,411.5
Cost of sales and occupancy costs
3,999.1
Store opening expenses
3,215.9
Other operating expenses
294.1
Depreciation and amortization
467.2
General and administrative expenses
489.2
Operating income from sales (before tax)
946.0
Tax reported
$ 383.7
Tax benefit of net interest
5.6
Tax on other operating income
(6.6)
382.7
Operating income from sales (after tax)

563.3

Other operating income, before-tax item


Gain on asset sales
Other operating charges

Tax at (38.4%)
Operating income, after tax-items
Income from equity investees
Currency translation gains

26.0
(8.9)
17.1
6.6
10.5
108.0
37.7

156.2
719.5

Operating income (after tax)


Net financing expenses
Interest expense
Interest income
Net interest expense
Realized gain on financial assets

Tax (at 38.4%)


Unrealized loss on financial assets

38.2
(19.7)
18.5
(3.8)
14.7
5.6
9.1
20.4

29.5
689.9

Comprehensive income

Note: Interest income and interest expense are given in the notes to the financial statements in
the exercise. That note also identifies the other operating income here.
Reformulated Balance Sheets
(in millions)

Operating Assets
Cash and cash equivalents
Short-term investmentstrading securities
Accounts receivable, net
Inventories
Prepaid expenses and other current assets
Deferred income taxes, net
Equity and other investments
Property, plant and equipment, net
Other assets
75

2007

2006

40.0
73.6
287.9
691.7
148.8
129.5
258.8
2,890.4
219.4

40.0
53.5
224.3
636.2
126.9
88.8
219.1
2,287.9
186.9

Other intangible assets


Goodwill

42.0
215.6

37.9
161.5

Total operating assets

4,997.7

4,063.0

Operating liabilities
Accounts payable
Accrued compensation and related costs
Accrued occupancy costs
Accrued taxes
Other accrued expenses
Deferred revenue
Other long-term liabilities
Total operating liabilities

390.8
332.3
74.6
92.5
257.4
296.9
460.5
1,905.0

340.9
288.9
54.9
94.0
224.2
231.9
262.9
1,497.7

Net operating assets

3,092.7

2,565.3

Net financial obligations


Short-term borrowing
Current maturities of long-term debt
Long-term debt
Cash equivalents (281.3-40.0 in 2008)
Short-term investments (available for sale)
Long-term investments (available for sale)
Net financial obligations

710.2
0.8
550.1
(241.3)
(83.8)
(21.0)
915.0

700.0
0.8
2.0
(272.6)
(87.5)
(5.8)
336.9

Common shareholders equity

2,177.6

2,228.5

Notes:
1. Short-term investment (trading securities) is operating assets connected to employees.
2. Stock-based compensation, excluded from the equity statement, has been added to
other liabilities.
c.
ROCE = 689.9 / 2,228.5 = 30.96%
RNOA = 719.5 / 2,565.3 = 28.05%
NBC = 29.5 / 336.9 = 8.76%

E10.11. A Bite of the Apple: Apple Inc.

a. The reformulated statements:


Reformulated Balance Sheet
March 26, 2011
Operating Assets:
Cash (0.25 % of Sales)
Accounts receivables
Inventories
Deferred tax assets
Vendor receivables
Property, plant and equipment
Goodwill
Acquired intangibles

62
5,798
930
1,683
5,297
6,241
741
507

Other assets (current and noncurrent)


Operating Liabilities:
Accounts payable
Accrued expenses
Deferred revenue current
Deferred revenue noncurrent
Other liabilities
Net Operating Assets

7,940
29,199
13,714
7,022
3,591
1,230
7,870

Financial Assets:
Cash equivalents (15,978-62)
Short-term marketable securities

33,427
(4,228)

15,916
13,256

Long-term marketable securities

36,533

65,705
61,477

Common shareholders equity

77

Reformulated Income Statement


Three months Ended
March 26, 2011

Net sales
Cost of sales
Gross margin
Operating expenses:
Research and development
Selling, general and administrative
Total operating expenses
Operating income
Tax reported
Tax on financial income
Operating income after tax
Financing income
Tax @37%
Net Income

$ 24,667
14,449
10,218
581
1,763
2,344
7,874
1,913
10
26
10

1,903
5,971
16
5,987

b. The cash (financial assets) balance is $65.705 billion. Firms hold cash for future
investment and to protect against bad times, but if they see no need there, they pay it out
to shareholders in dividends or stock repurchases. Investors at the time queried why
Apple was holding so much cash (financial assets). Did they have big investment
plans? Why dont they pay it out to shareholders? An answer came in March, 2012 when
the cash balance had reached almost $100 billion. Apple announced that they would be
paying a dividend and buying back about $10 billion of their stock.
Note: U.S. firms (like Apple) will hold cash in overseas subsidiaries because they incur
taxes if they repatriate it back to the U.S. If the cash cannot be invested overseas, this
explains some of the cash balanceavoidance of taxes.
c. If Apple borrowed, what would it do with the cash? It has a large amount of cash for any
investment needs and pays no dividends. It also has continual large free cash flow. Apple
could only invest the cash in financial assets (which it does not need!). You see this from
the cash conservations equation: C I = d + F. If the firm is not paying dividends (d = 0)
and free cash flow is positive, then there is no need to borrow.

d. Apple is like the Dell example in this chapter: an excess of operating liabilities over
operating assets. It manages its business to keep the investment in operating assets low
while maintaining high operating liabilitieshigh accounts payable to suppliers and
deferred revenues from customers. Essentially, the suppliers and customers are helping to
finance the operations (via operating credit), thus reducing the need for shareholders to
finance the business. Indeed, they do this to such an extent as to give shareholders a
negative investment in the business.
We use a 9% required return for the calculation of residual income from operations:
ReOIt = OIt (Required return NOAt-1)
= $5,971 (0.09 -4,228)
= $6,351.5 million
The residual income is greater than operating income, reflecting the value of having
negative investment in the NOA: Shareholders can effectively invest the free float of
$4,228 million at 9 %.
(Note on the residual income calculation: Strictly, ReOI should be calculated on the
beginning-of-period NOA, that is, at December 31, 2010. That is not available in the
question, so the ending NOA is used.)

79

CHAPTER ELEVEN
The Analysis of the Cash Flow Statement
Concept Questions
C11.1 If the analyst uses discounted cash flow analysis, he must analyze the source of the cash

flows, in order to forecast the cash flows. If accrual accounting methods are used, cash flow
analysis is of less interest. However, the analyst might forecast cash flows for two reasons:
a. To carry out a credit analysis (like that in Chapter 20) to see if the firm can pay its debts.
If not, the firm could be transferred to the debtholders, with the shareholders losing value.
The firm is worth less to the shareholder under a liquidation scenario than under a goingconcern scenario. How likely is the former?
b. Sometimes an equity investor must ensure that cash is available in the future to settle
claims. In a leveraged buyout, where investors take on a lot of debt, they wish to
understand if the firm can generate the cash to pay own that debt. In private equity
investing, the private equity firm may look for cash to pay off investors who wish to
redeem at a certain date.

C11.2 Cash flow forecasting is necessary in the following situations:

1. For discounted cash flow valuation.


2. For forecasting liquidity, to see if debt payments can be covered by cash flow.
3. More generally for financial planning, to ensure enough cash is raised to meet debt
repayments, dividends and investment requirements. Think of the Treasurers Rule of
Chapter 9.

C11.3 Free cash flow must be paid out in dividends as there are no debt financing flows.

For a pure equity firm,


C - I = d

C11.4 Excess cash can result from operations generating cash. Yet the GAAP statement

presentation reduces net cash from operations (free cash flow) by the amount of the excess cash
that operations generate. The generation and disposition of free cash flow are confused;
investment in short-term securities is a disposition of free cash flow, not part of its generation.

C11.5 The direct method gives considerably more detail on the sources of cash from operations.

But the indirect method gives the accruals for the period.

C11.6 No. This interest is a cost of financing construction, not investment in the construction.

It should be in the financing section of the statement, not the investing section

C11.7 Because a firm increases its free cash flow by selling off (liquidating) assets (and reduces

free cash flow by acquiring assets).

C11.8 Current free cash flow is reduced by investment that generates future cash flow. So the

lower the current free cash flow (because of investment), the higher future free cash flow is
likely to be.

81

C11.9 Yes and no. Receiving cash from customers is a firms primary source of value.

Increasing cash from selling receivables is not cash from additional customers its just the
acceleration of cash that the firm would eventually get from existing customers when they pay.
But it is indeed cash from customers, so strictly is cash from operations (and should be reported
as such). Accelerated receipt of cash from receivables is an example of the dangers of looking as
cash as value added: The increased cash does not imply increased sales. (There is a question here
as to whether this is a low-cost financing method: The buyer of the receivables will charge an
implicit interest rate for the financing.)
C11.10. Very profitable firms have investment opportunities and more investment reduces free

cash flow, even enough to make it negative. See GE and Starbucks in Chapter 4.

Drill Exercises
E11.1. Classification of Cash Flows

A cash flow that affects cash flow from operation also affects free cash flow.
Cash from operations

FCF

Financing

Yes
No
Yes
Yes
No
No
Yes

No
No
No
No
Yes
Yes
No

Flows

a.
b.
c.
d.
e.
f.
g.

Yes
No
No
Yes
No
No
Yes

Interest payments affect the GAAP number for cash from operations, but not the real number.
Purchases of short-term investments affect the GAAP measure of cash investment, but not the
real investment in operations nor free cash flow.
E11.2 Calculation of Free Cash Flow from the Balance Sheet and Income Statement

First reformulate the balance sheet:


NOA
NFO
CSE

2012
3160
1290
1870

2011
2900
1470
1430

Method 1:
Free cash flow = OI - NOA
= 500 (3,160 2,900)
= 240
Method 2:
Free cash flow = NFE NFO + d
Net dividend = Comprehensive income CSE
= 376 (1,870 1,430) = -64
83

(stocks and flows equation)

So,
Free cash flow = 124 (-180) + (-64)
= 240

E11.3. Analyzing Cash Flows

a)

As there is no debt or financial assets,


CI =d
= $150,000
OR
As there is no change in shareholders equity and no financial income or
expenses,
OI = NI = d
= $150,000
So,
CI

= OI NOA
= $150,000 0
= $150,000

(There is no change in net operating assets because there is no change in


shareholders equity and no net financial obligations.)
b)

The increase in cash comes from operations, the sale of land (and
dividends decreased the cash):
Cash from operations = NI Accs. Rec. Inv. + depr. + Accs.
payable
= $150,000 40,000 100,000 + 100,000 + 25,000
= $135,000
Sale of land
Dividends
Change in cash

$400,000
$535,000
150,000
$385,000

c) No change. The investment in the short-term deposit is a financing activity, not


an investment in operations, so free cash flow is not affected. Its a disposition of
cash from operations, not generation of free cash flow.
E11.4. Free Cash Flow for a Pure Equity Firm
For a pure equity firm,

Free cash flow (C - I) = d


Net dividends (d) for the year:
Dividends paid
Shares issued

$ 8.3 million
$34.4 million
-$26.1 million

So free cash flow is -$26.1 million


Another solution
Earnings

= CSE + net dividend


= 51.4 - 26.1
= $25.3 million

C - I = OI - NOA
As, for a pure-equity firm, OI = Net earnings and NOA = CSE, then
C - I = 25.3 - 51.4
= -26.1 million

E11.5 Free Cash Flow for a Net Debtor

By Method 2 in Box 11.1,


C - I = NFE NFO + d
NFO = 37.4 54.3 = -16.9 (net debt declined)
d = 8.3 34.3 = -26.1

(negative net payout)

So, C I = 4 (-16.9) + (-26.1)


85

= -5.2

(free cash flow was negative)

OR, using Method 1,


C-I

= OI - NOA
= 29.3 - 34.5
= -5.2

where
OI
= Comprehensive income (25.3) + NFE (4.0) = 29.3
NOA = CSE - NFO
= 51.4 - 16.9 = 34.5
Comprehensive income is plugged from the equity statement.

E11.6. Applying Cash Flow Relations

(a)

NOA = OI - (C - I)
= 390 - 430
= - $40 million
(The firm reduced its investment in net operating assets.)

(b)

OI = C - I + I + operating accruals
So, operating accruals = OI - (C - I) + I
= 390 - 430 -29
= - $69 million
Or, as NOA is made up of investment and operating accruals,
Operating accruals

(c)

= NOA - I
= - 40 - 29
= - $69 million

C - I = NFE - DNFs + d
So, with a negative net dividend of $13 million

NFO = NFE + d - (C - I)

= 43 - 13 - 430
= - $400 million
(The firm reduced its NFO by $400 million by applying free cash flow and the net
dividend to reducing net debt).

E11.7. Applying Cash Flow Relations

(a)

Use the free cash flow generation equation: C - I = OI - NOA


As there was no net financial income or expense, operating income (OI) equals
the comprehensive income of $100 million. The net operating assets for 2012 and
2011 are as follows:

Operating assets
Operating liabilities
NOA

2012

2011

640
20
620

590
30
560

C - I = OI - NOA
= 100 - 60
= $ 40 million
(b)

Use the free cash flow disposition equation: C - I = NFA - NFI +d


The net dividend (d) = comprehensive income - CSE
= 100 - 160
= - $60 million (a net capital contribution)

The net financial assets for 2012 and 2011 are as follows:

Financial assets
Financial liabilities
NFA
87

2012

2011

250
170
80

110
130
(20)

C-I

= NFA - NFI + d
= 100 - 0 - 60
= $40 million

The firm invested the $40 million of free cash flow in financial assets. In
addition, it raised a net $60 million from shareholders which it also invested in
financial assets.

(c)

Net financial income or expense can be zero if financial income and financial
expense exactly offset each other. This firm moved from a net debtor to a net
creditor position in 2012 such that the weighted-average net financial income was
zero.

Applications
E11.8. Free Cash Flow and Financing Activities: General Electric Company

a. General Electric, while generating large cash flow from operations, has had a huge
investment program as it acquired new businesses, leaving it with negative free cash
flow.
b. Given that cash from operations from the businesses in place continues at, or grows from
the 2004 level, free cash flow will increase and will become positive (probably by big
amounts). Rather than borrowing or issuing shares to finance a free cash flow deficit, GE
will have cash to pay out. It can either,
1. But down its debt
2. Invest the cash flow in financial assets
3. Pay out dividends or buy back its stock.
The firm would not invest in financial assets for too long, but rather buy back debt
or pay out to shareholders. Indeed, in 2005, the firm announced a large stock
repurchase program.

E11.9. Method 1 Calculation of Free Cash Flow for General Mills, Inc,

By Method 1,
Free cash flow = OI NOA
= $1,177 (11,461 11,803)
= $1,519 million
E11.10. Free Cash Flow for Kimberly-Clark Corporation

a.
Reformulate the balance sheet:

Operating assets
Operating liabilities
Net operating assets (NOA)

2007

2008

$18,057.0
6,011.8
12,045.2

$16,796.2
5,927.2
10,869.0

89

Financial obligations
Financial assets

$6,496.4
382.7

Common equity (CSE)

6,113.7

$4,395.4
270.8

$ 5,931.5

4,124.6
$ 6,744.4

By Method 1,
Free cash flow = Operating income Change in net operating assets
= $2,740.1 (12,045.2 10,869.0)
= 1,563.9
By Method 2,
Free cash flow = Net financial expense NFO + d
= 147.1 (6,113.7 4,124.6) + 3,405.9
= 1,563.9
Net payout to shareholders (d) = Comprehensive income CSE
= (2,740.1 147.1) (-812.9)
= 3,405.9
b.
Cash flow from operations reported
Net interest payments
Tax on net interest payments
Cash flow from operation

142.4
52.1

Cash investment reported


Liquidation of short-term investments

898.0
56.0

Free cash flow

$2,429.0 million
90.3
2,519.3
954.0
$1,565.3 million

E11.11. Extracting Information from the Cash Flow Statement with a


Reformulation: Microsoft Corporation

a. Cash dividends are read off the financing sections of the cash flow statement: $33,498
million. A large dividend indeed! This dividend would also be reported in the statement
of shareholders equity.
b. Net dividend = Dividends + Stock Repurchases Stock Issues
= 33,498 + 969 795
= 33,672 million

As Microsoft has no debt, the net dividend is equal to the total of financing activities.
c. Cash flow for operations reported
Interest received
Tax on interest (at 37.5%)
Cash from operations

$3,619 million
$378
142

236
$3,383

(Note: there is no interest paid.)


d. Cash generated from investments, reported
(Positive number means cash has been generated, not used)
Net sales of short-term investments
Cash generated from investing in operations

$23,414
23,591
$ (177)

That is, $177 million was invested in operations.


e. Free cash flow = $3,383 177 = $3,206
f. The actual cash invested in operations for 2003 (after adjusting for net investment in
interest-bearing securities) was $172, almost the same as 2004. Both years numbers are
affected by the net investment in interest-bearing securities.
g. The net investment in financial assets is the net investment in short-term investments (in
part d above) plus the change in cash and cash equivalents. (As $60 million of working
cash is the same at the beginning and end of the period, the change in cash and cash
equivalents (a negative $6,639 million) is all investment in financial assets).
Investment in financial assets = -$23,591 - $6,639
= -$30,230 million
That is, Microsoft liquidated $30,230 of financial assets (to pay the large
dividend).

The Reformulated Cash Flow Statement (in millions of dollars)


Cash flow for operations reported
Interest received
Tax on interest (at 37.5%)
Cash from operations

$3,619 million
$378
142

Cash generated from investments, reported


Net sales of short-term investments
Cash generated from investing in operations
Free cash flow

236
$3,383

$23,414
23,591
(177)
$3,206

91

Cash in financing activities:


Net dividend
Sale of financial assets
Interest in financial assets, after tax

$33,672
(30,230)
( 236)
$ 3,206

CHAPTER TWELVE
The Analysis of Profitability
Concept Questions
C12.1 This question applies the financial leverage equation. The two rates of return will be the

same in either of the following conditions:


(a)

The SPREAD is zero, that is, return on net operating assets (RNOA) equals net

borrowing cost (NBC).


(b)

Financial leverage (FLEV) is zero, that is, financial assets equal financial

obligations.

C12.2 This question applies the operating liability leverage equation. The two rates of return

will be the same in either of the following conditions:


(a)

The operating liability leverage spread (OLSPREAD) is zero, that is, ROOA

equals the implicit borrowing rate for operating liabilities.


(b)

Operating liability leverage (OLEV) is zero, that is, the firm has no operating
liabilities.

C12.3 (a)

Positive

(b)

Negative

(c)

Negative

(d)

It depends on whether the operating liability leverage spread is positive or


negative

(e)

Positive

(f)

It depends on whether the operating spread is positive or negative

(g)

Positive

Note: the advertising expense ratio (advertising/sales) might be high in the current period,
producing a negative effect on ROCE. But the large amount of advertising might produce higher
future sales, so could be regarded as a positive value driver (and a positive driver of future
ROCE).

C12.4 If the assets in which the cash from issuing debt is invested earn at a rate, RNOA),

greater than the borrowing cost of the debt, ROCE increases: shareholders earn from the
SPREAD.
C12.5 If a firm can generate income using the liabilities that are higher than the implicit cost

that creditors charge for the credit, it increases its RNOA. This condition is captured by the
OLSPREAD.
C12.6 Not necessarily. If the supplier charges a higher price for the goods to compensate him

for financing the credit, buying on credit may not be favorable. The operating liability leverage
created by buying on credit will be favorable if the return earned on the inventory is greater than
the implicit cost the supplier charges for the credit.
93

C12.7 The first part of the statement is correct: A drop in the advertising expense ratio increases

current ROCE because, all else constant, it increases the profit margin. But a drop in advertising
might damage future ROCE share value because of a drop in sales that the advertising might
otherwise generate.
C12.8 Return on common equity (ROCE) is affected by leverage. If a firm borrows, pays

dividends, or makes a stock repurchase, it can increase its ROCE. But if a change in leverage
does not add value, shareholders are not better off. The firms return on operations (RNOA) is
not affected, and it is RNOA that adds value. Operating activities vs. financing activities.
Always examine increases in ROCE to see if they are due to leverage.

C12.9 If the firm loses the ability to deduct interest expense for tax purposes, it does not get the

tax benefit of debt and so increases its after-tax borrowing cost. Of course the firm also may find
that creditors will charge a higher before-tax borrowing rate if it is making losses.

C12.10 The inventory yield is a measure of the profitability of inventory, the profit from selling

inventory relative to the inventory carried. If gross profit falls or inventories increase, the ratio
will fall.

C12.11 ROA mixes operating and financial activities. Financial assets are in the denominator

and operating liabilities are missing from the denominator. Interest income is in the numerator.
This calculation yields a low profitability measure, as the return on financial assets is typically
lower than operating profitability and the effect of operating liabilities --- to lever up operating
profitability --- is not included.

C12.12 False. A firm can have a low profit margin (PM) but compensate with a high asset

turnover (ATO). Look at the plots in Figure 12.3 and also Table 12.2.

C12.13. The firm has financial assets but no financial obligations. See Box 12.3.

a. This is a case of negative leverage. By the financing leverage equation, negative leverage
yields an ROCE below RNOA provided that the RNOA is greater than the return on
financial assets.
b. The is the case where the RNOA is less than the return on financial assets
c. Apple has a very high RNOA, so it is an example of case (a).

95

Drill Exercises
E12.1. Leveraging Equations

(a)

1. By the stocks and flows equation for equity


Net dividends = earnings - CSE
= 207 300
= (93) (i.e. net capital contribution)
(This answer assumes no dirty-surplus accounting)
2011
1,900
1,000
900

NOA
NFO
CSE

2012
2,400
1,200
1,200

Average
2,150
1,100
1,050

2. ROCE = 207/1,050 = 19.71%


Operating income (OI) = Sales operating expense tax on OI
= 2,100 1,677 [106 + (0.34 x 110)]
= 279.6
3. RNOA = OI/ave. NOA = 279.6/2,150 = 13.0%
4. ROCE = [PM ATO] + [FLEV (RNOA NBC)]
PM
ATO
FLEV
NBC

So,

=
=
=
=

OI/Sales = 279.6/2,100 = 0.1331 (or 13.31%)


Sales/ave. NOA = 2,100/2,150 = 0.9767
Ave. NFO/ave. CSE = 1,100/1,050 = 1.0476
Net interest expense/ave. NFO = (110 0.66)/1,100 = 6.6%

19.71% = (0.1331 0.9767) + [1.0476 (13.0% - 6.6%)]


(b)
2011
2,000
(100)
1,900

Operating assets
Operating liabilities
NOA

2012
2,700
(300)
2,400

Average
2,350
(200)
2,150

Implicit interest on operating liabilities (OL) = 200 4.5%


=9
Return on operating assets (ROOA)

= (OI + Implicit interest)/ave. OA


= (279.6 + 9)/2,350
= 12.28%

Operating liability leverage

= OL/NOA
=

200
2,150

= 0.093
So,
13.0% = 12.28% + [0.093 (12.28% - 4.5%)]
(c)

This is the case of a net creditor firm (net financial assets).


Net dividends

= 339 700
= (361)

ROCE

= 339/3,050 = 11.11%

Operating income

= 2,100 1,677 (174 (0.34 90))


= 279.6 (as before)

RNOA

= 279.6/2,150 = 13.0% (as before)


97

Return on net financial assets (RNFA) = Net financial income/ave. FA


=

90 0.66
900

= 6.6%
FLEV = -900/3,050 = -0.295
PM and ATO are as before.
So,
11.11% = (0.1331 0.9767) [0.295 (13.0% - 6.6%)]

E12.2. First-Level Analysis of Financial Statements

(a)

First reformulate the financial statements:


Reformulated Balance Sheets

NOA
NFO
CSE

2012
1,395
300
1,095

2011
1,325
300
1,025

Average
1,360
300
1,060

Reformulated Income Statement, 2012


Sales
Operating Expenses
Tax reported
Tax on NFE
OI
Net interest
Tax on interest at 33%
NFE
Comprehensive Income

3,295
3,048
247
61
9

70
177

27
9
18
159

CSE2012 = CSE2011 + Earnings2012 Net Dividends2012


1,095 = 1,025 + 159 - 89

Stock repurchase = 89
(b)

ROCE =

159
= 15.0%
1,060

RNOA =

177
= 13.0%
1,360

FLEV =

300
= 0.283
1,060

SPREAD = RNOA NBC


NFE
18

= 13.0% - 6.0% = 7.0% NBC =


=
NFO 300

CI

= OI - NOA
= 177 70
= 107

(c)

The ROCE of 15% is above a typical cost of capital of 10% - 12%. So one might
expect the shares to trade above book value. But, to trade at three times book
value, the market has to see ROCE to be increasing in the future or investment to
be growing substantially.

E12.3. Reformulation and Analysis of Financial Statements

c. Reformulated balance sheet


2012

Operating cash
Accounts receivable
Inventory
PPE
Operating assets

2011

60
940
910
2,840
4,750

99

50
790
840
2,710
4,390

Operating liabilities:
Accounts payable
Accrued expenses
Net operating assets
Net financial obligations:
Short-term investments
Long-term debt
Common shareholders equity

$1,200
390

1,040
450

1,590
3,160

$( 550)
1,840 1,290
$1,870

( 500)
1,970

Reformulated equity statement (to identify comprehensive income):


Balance, end of 2011
Net transactions with shareholders:
Share issues
Share repurchases
Common dividend
Comprehensive income:
Net income
Unrealized gain on debt investments
Balance, end of 2012

$1,430
$ 822
(720)
(180)

$ 468
50

518
$1,870

Reformulated statement of comprehensive income


Revenue
Operating expenses, including taxes
Operating income after tax
Net financing expense:
Interest expense
$
Interest income
Net interest
Tax at 35%
Net interest after tax
Unrealized gain on debt investments
Comprehensive income

$3,726
3,204
522

98
15
83
29
54
50

78)

4
$ 518

1,490
2,900

1,470
1,430

After calculating the net financial expense, the bottom-up method is used to get operating
income after tax.
d. Free cash flow = OI NOA
= 522 (3,160 2,900)
= 262
e. Ratio analysis
Profit Margin (PM) = 522/3,726 = 14.01%
Asset turnover (ATO) = 3,726/2,900 = 1.285
RNOA
= 522/2,900 = 18%
f. Individual asset turnovers
Operating cash turnover = 3,726/5 = 74.52
Accounts receivable turnover = 3,726/790 = 4.72
Inventory turnover = 3,726/840 = 4.44
PPE turnover = 3,726/2,710 = 1.37
Accounts payable turnover = 3,726/1,040 = 3.58
Accrued expenses turnover = 3,726/450 = 8.28
1/individual turnover aggregate to 1/ATO:
1/ATO = 1/1.285 = 0.778 = 0.013 + 0.212 + 0.225 + 0.730 0.279 0.121
(allow for rounding error)
g. ROCE = 518/1,430 = 36.22%
Financial leverage (FLEV) = 1,470/1,430 = 1.028
Net borrowing cost (NBC) = 4/1,470 = 0.272%
ROCE = 36.22% = 18.0% + [1.028 (18.0% - 0.272%)]
h. NBC = 4/1,470 = 0.272% (as in part e)
If RNOA = 6% and FLEV = 0.8,
ROCE = 6.0% + [0.8 (6.0% - 0.0.272%]
= 10.58%
Note: it is more likely that NBC will be at the core borrowing rate (that excludes
The unrealized gain of debt investments): Core NBC = 54/1,470 = 3.67%.
Chapter 12 identifies core borrowing costs.
101

i. Implicit cost of operating liabilities = 1,490 0.03 = 44.7


522 + 44.7
Return on operating assets (ROOA) =
= 12.91%
4,390
Operating liability leverage (OLLEV) = 1,490/2,900 = 0.514
RNOA = 18.0% = 12.91% + [0.514 (12.91% - 3.0%)]

E12.4 Relationship Between Rates of Return and Leverage

(a)

ROCE = RNOA + [FLEV (RNOA NBC)]


13.4% = 11.2% + [FLEV (11.2% - 4.5%)]
FLEV = 0.328

(b)

RNOA = ROOA + (OLLEV OLSPREAD)


11.2% = 8.5%

+ [OLLEV (8.5% - 4.0%)]

OLLEV = 0.6
(c)

First calculate NFO and CSE using the financial leverage ratio (

the net operating assets of $405 million.

So

NFO
CSE

FLEV

NOA

= CSE + NFO

NFO
CSE

= 1 + FLEV
= 1.328

As NOA
Then CSE

= $405 million
=

$405 million
1.328

= $305 million

NFO
) applied to
CSE

and NFO

= $100 million

Now distinguish operating and financing assets and liabilities

So

OL
=
NOA

OLLEV

OL

= 0.6 $405 million

0.6

= $243 million
OA

= NOA + OL
= 405 + 243
= $648 million

Financial assets

= total assets operating assets


= 715 648
= $67 million

Financial liabilities

= NFO + financial assets


= 100 + 67
= $167 million

Reformulated Balance Sheet


Operating assets
Operating liabilities

648
243

Financial liabilities
Financial assets
Common equity

405

167
67
100
305
405

E12.5 Profit Margins, Asset Turnovers, and Return on Net Operating Assets: A What-If
Question

The effect would be (almost) zero.


Existing RNOA = PM ATO
103

= 3.8% 2.9
= 11.02%
RNOA from new product line is
RNOA = 4.8% 2.3
= 11.04%

Applications
E12.6. Profitability Measures for Kimberly-Clark Corporation

The exercise is best worked by setting up the reformulations balance sheet:

Operating assets
Operating liabilities
Net operating assets (NOA)
Financial obligations
Financial assets
Common equity (CSE)

2007

2006

$18,057.0
6,011.8
12,045.2

$16,796.2
5,927.2
10,869.0

a (1)

$6,496.4
382.7 6,113.7

$4,395.4
270.8 4,124.6

a (2)

$ 5,931.5

$ 6,744.4

a (3)

a.
The answers to question (a) are indicated beside the reformulated statement.
b.
Comprehensive income = 2,740.1 147.1 = 2,593 million
ROCE = 2,593/6,744.4 = 38.45%
RNOA 2,740.1/10,869.0 = 25.21%
FLEV = NFO/CSE = 4,124.6/6,744.4 = 0.612
NBC = 147.1/4,124.6 = 3.57%

c.
The financial leveraging equation is:
ROCE = RNOA + [FLEV (RNOA NBC)]
= 25.21% + [0.612 (25.21% - 3.57%)]
= 38.45%

d.
On sales of $18,266 million for 2007,
PM = 2,740.1/18,266
15.00%

ATO = 18,266/10,869
1.68

= 25.2%

E12.7. Analysis of Profitability: The Coca-Cola Company

Average balance sheet amounts are as follows:

Net operating assets


Net financial obligations
Common shareholders equity

2007
$26,858
5,114
$21,744

a.
RNOA = 6,121/22,905 = 26.72%
NBC = 140/3,573
= 3.95%
105

2006
$18,952
2,032
$16,920

Average
$22,905
3,573
$19,332

b.
FLEV = 3,573/19,332 = 0.185
c.
ROCE = RNOA + [FLEV (RNOA NBC)]
= 26.72% + [0.185 (26.72% - 3.95%)]
= 30.93 % = 5,981/19,332
d.
PM = 6,121/28,857 = 21.21%
ATO = 28,857/22,905 = 1.26
RNOA = 21.21% 1.26 = 26.72%

e.
Gross margin ratio = 18,451/28,857 = 63.94%
Operating profit margin from sales = 5,453/28,857 =18.90%
Operating profit margin = 6,121/28,857 = 21.21%

E12.8. A What-If Question: Grocery Retailers

Net operating assets for $120 million in sales and an ATO of 6.0 are $20 million.
An increase in sales of $15 million and an increase in inventory of $2 million would
increase the ATO to

120 + 25
= 6.59.
20 + 2

With a profit margin of 1.5%, the RNOA would be:


RNOA = 1.5% 6.59
= 9.89%
The current RNOA is:

RNOA = 1.6% 6.0


= 9.6%
So the membership program would increase RNOA slightly.

E12.9. Financial Statement Reformulation and Profitability Analysis for Starbucks


Corporation

a.
To prepare a reformulated income statement, first identify comprehensive income in the equity
statement. If you worked Exercise E9.9, you would have done this and produced the statement
below. If not, you just need to calculate the comprehensive income of $689.9 million in the
statement here.

Reformulated Statement of Shareholders Equity


(in millions)
Balance, October 1, 2006

$ 2,228.5

Net payout to shareholders:


Stock repurchase
Sale of common stock
Issue of shares for employee stock options
Comprehensive Income:
Net income from income statement
Unrealized loss on financial assets
Currency translation gains
Balance, September 30, 2007

1,012.8
(46.8)
(225.2)

(740.8)

672.6
(20.4)
37.7

689.9
$2,177.6

Note: The closing balance excludes $106.4 million for Stock-based compensation expense
which is a liability rather than equity. (It is added to operating liabilities in the reformulated
balance sheet).
With comprehensive income identified, reformulate the (comprehensive) income statement that
totals to comprehensive income:
107

Reformulated Comprehensive Income Statement, 2007


(in millions)
Net revenues
$ 9,411.5
Cost of sales and occupancy costs
3,999.1
Store opening expenses
3,215.9
Other operating expenses
294.1
Depreciation and amortization
467.2
General and administrative expenses
489.2
Operating income from sales (before tax)
946.0
Tax reported
$ 383.7
Tax benefit of net interest
5.6
Tax on other operating income
(6.6)
382.7
Operating income from sales (after tax)

Other operating income, before-tax item


Gain on asset sales
Other operating charges
Tax at (38.4%)

Operating income, after tax-items


Income from equity investees
Currency translation gains

563.3

26.0
(8.9)
17.1
6.6
10.5

108.0
37.7

Operating income (after tax)


Net financing expenses
Interest expense
Interest income
Net interest expense
Realized gain on financial assets
Tax (at 38.4%)
Unrealized loss on financial assets
Comprehensive income

156.2
719.5

38.2
(19.7)
18.5
(3.8)
14.7
5.6
9.1
20.4

29.5
689.9

Note: Interest income and interest expense are given in the notes to the financial statements in
the Exercise 9.9. That note also identifies the other operating income here.

The reformulated balance sheet is as follows:

Reformulated Balance Sheets


(in millions)
2007

2006

Operating Assets
Cash and cash equivalents
Short-term investmentstrading securities
Accounts receivable, net
Inventories
Prepaid expenses and other current assets
Deferred income taxes, net
Equity and other investments
Property, plant and equipment, net
Other assets
Other intangible assets
Goodwill

40.0
73.6
287.9
691.7
148.8
129.5
258.8
2,890.4
219.4
42.0
215.6

40.0
53.5
224.3
636.2
126.9
88.8
219.1
2,287.9
186.9
37.9
161.5

Total operating assets

4,997.7

4,063.0

Operating liabilities
Accounts payable
Accrued compensation and related costs
Accrued occupancy costs
Accrued taxes
Other accrued expenses
Deferred revenue
Other long-term liabilities
Total operating liabilities

390.8
332.3
74.6
92.5
257.4
296.9
460.5
1,905.0

340.9
288.9
54.9
94.0
224.2
231.9
262.9
1,497.7

Net operating assets

3,092.7

2,565.3

710.2
0.8
550.1

700.0
0.8
2.0

Net financial obligations


Short-term borrowing
Current maturities of long-term debt
Long-term debt
109

Cash equivalents (281.3-40.0 in 2008)


Short-term investments (available for sale)
Long-term investments (available for sale)
Net financial obligations
Common shareholders equity

(241.3)
(83.8)
(21.0)
915.0

(272.6)
(87.5)
(5.8)
336.9

2,177.6

2,228.5

Notes:
3. Short-term investment (trading securities) is operating assets connected to
employees.
4. Stock-based compensation, excluded from the equity statement, has been added to
other liabilities.

b.
ROCE = 689.9 / 2,228.5 = 30.96%
RNOA = 719.5 / 2,565.3 = 28.05%
NBC = 29.5 / 336.9 = 8.76%

c.

ROCE = 28.05% + [0.151 x (28.05% - 8.76%)]


= 30.96%
d.
Operating profit margin = 719.5/9,411.5 = 7.64%
Operating profit margin from sales = 563.3/9,411.5 = 5.99%
ATO = 9,411.5/2,565.3 = 3.67
e.
OLLEV = 1,497.7/2,565.3 = 0.584
f.
Implicit interest on operating liabilities = 0.036 1,497.7 = 53.92
719.5 + 53.92
= 19.04%
4,063.0
RNOA = ROOA + OLLEV (ROOA 3.6%)
= 19.04% + 0.584 (19.04% - 3.6%)

ROOA =

= 28.05%

CHAPTER THIRTEEN
The Analysis of Growth and Sustainable Earnings
Concept Questions
C13.1 A growth firm is one that is expected to grow residual earnings. As changes in residual

earnings are equal to abnormal earnings growth, a growth firm can also be defined as one
that can generate abnormal earnings growth, that is, earnings growth (cum-dividend) at a
rate greater than the required rate. As residual earnings is driven by return on common
equity (ROCE) and growth in equity, a growth firm is one that can increase ROCE and/or
grow investment that is expected to earn at an ROCE that is greater than the equity cost
of capital.

C13.2 Abnormal earnings growth is the same as growth in residual earnings, so it doesnt matter.

Abnormal growth in earnings growth above the required rate of growth is a simpler

111

concept, but residual earnings growth helps to lead the analyst into the drivers of growth
investment and the profitability of investment.

C13.3 A no-growth firm has zero or negative residual earnings growth or, equivalently, has

growth in cum-dividend earnings at a rate equal or less than the required return.

C13.4 A growth company would have the following features:

An ROCE greater than the cost of capital

Increasing residual earnings (that amounts to abnormal earnings growth) due to

Sales growth (with positive profit margins)

Increasing profit margins

Increasing asset turnover

Growing net investment producing these features

A growth company is one that is expected to have these attributes in the future. It is
possible that a firm may have had these attributes in the past but is not expected to
have them in the future. And it is possible that a firm may not have these features
currently (a start-up, for example), but is expected to have them in the future.

C13.5 The analyst is interested in the future because value is based on future earnings (or

strictly, on future residual earnings). So she analyzes current earnings for indications of
what future earnings might be. To the extent that current earnings is not sustainable (that
is, will not be a part of future earnings), the analyst wants to identify those earnings.

C13.6 Transitory earnings are aspects of current earnings that have no bearing on future

earnings. Examples are earnings from a one-time contract, a write-off on unusually large
bad debt, a write-down of obsolescent inventory, a one-time uninsured loss of property, a
restructuring charge, and profit from an asset sale or a discontinued line of business.
Note that write-offs and restructurings do have an effect on future
income in a technical, accounting sense because, if the charge is not taken now,
it will have to be taken in the future. But, provided the charge is a "fair" one
that does not over or underestimate the restructuring cost, its effect on earnings
will be completed in the current period.

C13.7 In one sense, these gains and losses are persistent because they occur every period. But a

gain or loss in the current period gives no indication of whether there will be a gain or
loss in the future. That is, the expected future gain or loss is zero, irrespective of the
current gain or loss. So these gains and losses are treated as transitory.

C13.8 Operating leverage is the proportion of fixed and variable costs in a firm's cost structure;

it is an income statement concept.


113

Operating liability leverage is the proportion of operating liabilities in net operating


assets; it is a balance sheet concept.
Both create leverage. Operating leverage levers the operating income from sales.
Operating liability leverage levers operating income from net operating assets (RNOA).

C13.9 This is correct. A higher contribution margin means lower variable costs. So more of

each dollar of sales "goes to the bottom line."

C13.10 Profit margins in retailing tend to be low because the business is very competitive. See

Table 12.2 in Chapter 12 where the median profit margin for food stores is 1.7%. If a
firm were reporting a 6.0% profit margin, we'd guess that it is temporary: Competition
will probably erode this margin.

C13.11 Common equity grows through earnings and new share issues, and declines through

stock repurchases and dividends. But more fundamental factors underlie this growth.
Equity grows because of increases in sales (revenues) that require more net operating
assets (to service the sales). The amount of net operating assets to service additional
sales depends on

1
, that is, on the NOA required for each dollar of sales. The
ATO

amount of equity growth to finance the NOA growth depends on the extent of net debt
financing used. If firms issue debt to finance the growth or liquidate financial assets, no
growth in equity occurs.

C13.12 Yes, this is correct. A trailing P/E can be high because current earnings are

temporarily low, even though expected future growth would indicate that the
P/E should otherwise be low.

C13.13 This is correct. A normal P/E implies that residual earnings are expected to

continue at the current level (and, equivalently, earnings are expected to grow,
cum-dividend, at the required rate of return). See the Whirlpool example in the
chapter.
C13.14 Yes. See the cell analysis of the chapter. A firm with a high P/E and a low P/B is

one where residual earnings are expected to increase from their current level but
are expected to be lower than zero (a cell C firm).

C13.15 Yes, correct. Temporarily high earnings are expected to decline, so should have

a low P/E ratio.

C13.16. A write-off reduces current earnings but the effect is temporary. With temporarily low

earnings (that will increase in the future), the trailing P/E must be high. This is the so-called
Molodovsky effect.

115

Drill Exercises
E13.1. Identifying Transitory Items

a. Core income
b. Transitory income: they may be repeated in the future but the current years gain is not a
good indicator of future gains and losses
c. Transitory, for the same reason as (b)
d. Transitory
e. Core income
f. Core income
g. Core income (but not income from sales)

E13.2. Forecasting from Core Income

First calculate core operating income after tax:


Sales

$496

Cost of goods sold


Selling and administrative expense
Core operating income before tax
Tax reported
Tax benefit of interest expense
Tax benefit of unusual items
Core operating income after tax

240
48

288
208

40
6.3
10.5

56.8
151.2

The best estimate of the future profit margin is the current core profit margin.
Core profit margin = 151.2/496 = 30.48%

E13.3. Analyzing a Change in Core Operating Profitability

Core RNOA = Core PM ATO


Core RNOA for 2012 = 4.7% x 2.4 = 11.28%
Core RNOA for 2011 = 5.1% x 2.5 = 12.75%
Change in Core RNOA
-1.47%
Change in Core PM -0.4% -0.1

Following Box 13.7,


Core RNOA = -1.47% = (-0.4% x 2.5) + (-0.1 x 4.7%)
=

-1.0%

- 0.47%

[Due to PM] [Due to ATO]

E13.4. Analyzing a Change in Return on Common Equity

ROCE for 2012: 15.2% = 11.28 + [0.4678 x (11.28 2.9)]


ROCE for 2011: 13.3% = 12.75 + [0.0577 x (12.75 3.2)]
117

ROCE

1.9%

RNOA

-1.47%

ROCE due to financing

3.37%

This change due to financing is due to a change in leverage and a change in SPREAD:
FLEV

0.4101

SPREAD

-1.17%

The explanation of the change in ROCE due to change in operating profitability (RNOA) is
given in Exercise E13.3. Using a similar scheme, the explanation of the change due to financing
is
ROCE due to financing = 3.37% = (-1.17% x 0.0577) + (0.4101 x 8.38%)
=

-0.07%

+ 3.44%

[Due to change in spread] [Due to change in leverage]

E13.5. Analyzing the Growth in Shareholders Equity

Change in CSE = 583


Change in sales = 5,719
Change in 1/ATO = 1/2.4 1/2.5 = 0.4167 0.4 = 0.0167
Change in NFO = 1,984
Change in CSE = 583 = (5,719 x 0.4) + (0.0167 x 16,754) 1,984
= 2287.6 + 279.8 1,984.0

Due to
Sales

Due to Due to
NOA Borrowing

E13.6. Calculating Core Profit Margin

The reformulated statement that distinguishes core and unusual items is as follows (in millions of
dollars):
Sales
Core operating expenses
Core operating income before tax
Tax as reported
Tax benefit of net debt
Tax on operations
Tax allocated to unusual items:
Core operatimg inome after tax
Unusual items
Start-up costs
Merger charge
Gain on asset disposals

667.3
580.1
(73.4 +13.8)

87.2
18.3

(0.39 20.5)

8.0
26.3
5.4

31.7
55.5

(4.3)
(13.4)
3.9
(13.8)

Tax effect (0.39)

5.4
(8.4)

Translation gain

8.9

Comprehensive operating income

0.5
56.0

Note:

1. The currency translation gain is transitory; it does not affect core


income.
2. Translation gains, like all items reported in other comprehensive
income are after-tax.
3. The gain on disposal of plant may attract a higher tax rate than 39%
due to depreciation recapture.

119

Core operating income (after tax) = 55.5


Core profit margin

Core operating income (after tax)


Sales

55.5
667.3

= 8.32%

E13.7. Explaining a Change in Profitability

Reformulate balance sheets and income statements:


Balance Sheets
2008

2009

C ash
A/R
Inventory
PPE
Accr. Liab.
A/P
D ef. T axes

NOA
100
900
2,000
8,200
(600)
(900)
(490)

S/T investm ents


Bank loan
Bonds payable
Preferred stock

Leverage (N FO /C SE)
Average leverage

NOA
100
1,000
1,900
9,000
(500)
(1,000)
(500)

(300)

9,210
C SE

NFO

4,300
1,000
5,000
4,210
9,210
1.188
1.086

2007
NFO

NOA
120
1,250
1,850
10,500
(550)
(1,100)
(600)

(300)

10,000

4,300
1,000
5,000
5,000
10,000
1.000
0.853

11,470

N FO

(330)
3,210
1,000
1,000
4,880
6,590
11,470
.741

Income Statements
2009
Sales
CGS
S&A
Core OI b/4 tax
Tax on OI
Core OI after tax
Restructuring charge
Tax Benefit
Operating income
Net Financial expenses
Net interest expenses
Tax Benefit
Gain on retirement (after tax)
Preferred divs.
NI available for common

2008
22,000

13,000
8,000

190
65

406
(138)
268
0
268
80

Tax on Core OI (2009) = 134 + 138 + 65 = 337


Tax on Core OI (2008) = 675 + 137
= 812
Net borrowing cost (NBC): Net fin. exp/average NFO
2009: 348/5,000 = 6.96%
2008: 248/4,940 = 5.02%
Return on net operating assets (RNOA): OI/average NOA
2009: 538/9,605
= 5.60%
2008: 1,838/10,735 = 17.12%
Core profit margin (PM): Core OI/Sales
2009: 663/22,000 = 3.01%
2008: 1,838/24,000 = 7.66%

121

21,000
1,000
337
663

24,000
13,100
8,250

21,350
2,650
812
1,838

(125)
538

(348)
190

405
(137)
268
100
168
80

(248)
1,590

Asset turnover (ATO):

Sales/average NOA

2009: 22,000/9,605 = 2.290


2008: 24,000/10,735 = 2.236
Unusual items to net operating assets: UI/average NOA
2009: -125/9,605
2008:
Spread:

= -1.30%
=0

RNOA - NBC

2009: -1.36%
2008: 12.10%
Explaining ROCE:
ROCE (2009) = CI avail for common/Average CSE = 190/4,605 = 4.13%
ROCE (2008)
= 1,590/5,795 = 27.44%
ROCE (2009)
= -23.31%
As ROCE = RNOA + [FLEV (RNOA - NBC)], this change in ROCE is determined by:
RNOA = -11.52%
FLEV = 1.086 0.853 = 0.233
NBC = 1.94%
Explaining the RONA component:

RNOA

= [ core profit margin turnover (2008)] + [ turnover core


profit margin (2009)] + unusual items/NOA
= [-0.0465 2.290] + [0.054 0.0766] - 0.0130
= -0.1152

In words, the decrease in ROCE is explained by an decrease in profit margin (despite a small increase in
asset turnover) that was levered up by an decrease in the spread over net borrowing costs, the effect of
which was further increase by an increase in leverage. In addition there were unusual changes in 2009
that reduced operating profitability.

Applications
E13.8. Identification of Core Operating Profit Margins for Starbucks

To reformulate the income statement to identify core income, first separate net financial income from
operating income, then separate core operating income from unusual items, then separate core operating
income from sales from other core income.
Reformulated Comprehensive Income Statement Identifying Core Operating Income, 2007
(in millions)
Net revenues
$ 9,411.5
Cost of sales and occupancy costs
3,999.1
Store opening expenses
3,215.9
Other operating expenses
294.1
Depreciation and amortization
467.2
General and administrative expenses
489.2
Operating income from sales (before tax)
946.0
Tax reported
$ 383.7
Tax benefit of net interest
5.6
382.7
Tax on other operating income
(6.6)
Core OI from sales (after tax)
Equity income from investees (after tax)
Core operating income
Unusual items, before-tax item
Gain on asset sales
Other operating charges
Tax at (38.4%)

563.3
108.0
671.3
26.0
(8.9)
17.1
6.6

Operating income, after tax-items


Currency translation gains

10.5

37.7

Operating income (after tax)

719.5

Net financing expenses


Interest expense
Interest income
Net interest expense

38.2
(19.7)
18.5
123

Realized gain on financial assets


Tax (at 38.4%)
Unrealized loss on financial assets
Comprehensive income

(3.8)
14.7
5.6
9.1
20.4

29.5
689.9

The question only asked for calculations of operating income, but the financing part of the statement is
also prepared to calculate the tax benefit ($5.6 million) from financing activities to allocate to the
operating activities. (You need only get to the $5.6 million number.) Note that taxes have also been
allocated between (taxable) unusual items and core operating income. The reformulated statement brings
in the currency gains and losses from the equity statement (which is an unusual item). Unusual items
also include items in net interest and other income that are detailed in the footnote. (Realized gains on
available-for-sale investments are gains on financial asset s, often called investments as in the
footnote.)
a. Core operating income from sales = $563.3 million
b. Other core income = $108.0 million (this is income from sales in subsidiaries but it is a
net figure, that is, sales minus expenses)
c. Core operating profit margin from sales = $563.3 million/$,=9,411.5 million = 5.99%.
d. Unusual items = $48.2 million

E13.9. Forecasting from Core Income: General Mills

a. Reformulate to cut to the core:


2008

Core OI from sales (net of restr charges)


Tax reported
Tax benefit of net interest (at 38.5%)
Tax benefit of restr charges (at 38.5%)
Core operating income from sales
Earnings from joint ventures
Core operating income

2007

2,249.0
622
162.5
8.1

792.6
1,456.4
111.0
1,567.4

2,097.0
560
164.4
15.0

739.4
1,357.6
73.0
1,430.6

Note that earnings from joint ventures is always after taxthe earnings have been
taxed in the venture.
b. Core RNOA = 1,567.4/12,572 = 12.47%
c. Core profit margin for 2008 = 1,567.4/13,652 = 11.48%
The best forecasts for 2009 are the core numbers for 2008:
Forecast of core profit margin for 2009 = 11.48%
Forecast of Core RNOA for 2009 = 12.47%
d. Because these earnings are taxed in the joint venture so are not taxed in General Mills.

125

CHAPTER FOURTEEN
The Value of Operations and the Evaluation of Enterprise Price-to-Book
Ratios and Price-Earnings Ratios
Concept Questions

C14.1 This is correct. The assets are expected to earn at their required return. Therefore

expected residual income is zero.

C14.2 The shares held may not be priced efficiently. If the fund is an actively managed fund,

the fund managers are investing in shares that they think are under-priced. So the fund
might trade at a premium.

C14.3 Residual operating income growth is driven by an increase in RNOA and in the NOA that

earn at this RNOA. Breaking it down further, ReOI growth is driven by


1.

Growth in sales (that drives growth in NOA)

2.

Increase in operating profit margins

3.

Increase in asset turnovers (so NOA increases but sales increase more that NOA)

C14.4 A financing risk premium is the additional risk that equity holders have of losing value

because the firm cannot meet obligations on its net debt. The premium will be negative if
the firm has net financial assets rather than net financial obligations.

C14.5 This statement is incorrect. The required return for equity is a weighted average of the

required return for operations and that for net financial assets. As the required return on
net financial assets is typically less than that for operations, the required return for equity
is greater than that for operations. (The relationship is reversed if the firm has net
financial obligations.)
C14.6 Earnings per share can be increased by increasing leverage. See the example in Box

14.5 in the chapter and the stock repurchase example for Reebok in Box 14.4. Although
leverage increases EPS, leverage does not increase value (apart from tax effects, if they
exist). So management can increase their bonuses without creating value for
shareholders by increasing leverage. They increase risk, but not value.
Residual operating income is a more desirable metric. It focuses on
operations (where value is created) and is not affected by financing.

C14.7 Shareholders wealth declines. A share repurchase increases ROCE so, in this case,

increases managements bonus pay. But a change in ROCE does not create value for
shareholders unless the repurchase is at a price that is less than fair value. The
shareholders are paying a bonus for nothing.

C14.8 ROCE and residual earnings are indeed affected by a change financial leverage. But,

following the argument through, the required return for equity also changes with
leverage such that the present value of forecasted residual earnings (and thus the equity
value) is unchanged.

127

C14.9

No. This statement is only correct for a firm with positive financial leverage (FLEV
greater than zero which implies financial obligations are greater than financial assets)
and unlevered price-to-book ratios greater than 1.0.See formula 14.9.

C14.10 The effect of these repurchases and borrowings was to increase earnings per share

growth and ROCE for the time that the leverage remained favorable (that is, operations
were profitable). In the downturn, leverage turned unfavorable, damaging the equity
value of highly leveraged firms.

C14.11 An increase in financial leverage increases equity risk and the required return for

equity. The levered P/E declines, provided the operating income yield is higher
than the net borrowing cost, NBC (or, equivalently, the enterprise P/E is less than
1/NBC). As the enterprise P/E also incorporates growth expectations, this means
that the P/E decreases provided that growth is not particularly high (as to swamp
the leverage effect). See formulas 14.10 and 14.12.

C14.12 He is correct with the statement that EPS will increase. But he is not correct in

saying the P/E ratios will increase. Stock repurchases increase leverage and
leverage reduces P/E ratios (typically). See the leverage example in Box 14.5
and formula 14.12.

C14.13 He is correct is saying that increased leverage will typically result in higher

ROCE. But an increase in leverage does not increase equity value. And an
increase in leverage will reduce P/E ratios (see the leverage example in Box 14.5

and formula 14.12.). It may be that there will be more share buy-backs and
dividends of firms use the borrowed funds for such purpose, but that will not add
to shareholder value.

Drill Exercises
E14.1. Residual Earnings and Residual Operating Income

Using beginning of period balance sheet amounts,


Residual earnings (RE) = 900 (0.12 5,000) = $300 million
Residual operating income (ReOI) = 1,400 (0.11 10,000) = $300
Residual financing expense (ReNFE) = 500 (0.10 5,000) = 0
E14.2. Calculating Residual Operating Income and its Drivers
2007

2008

2009

2010

187.00
1,214.45

200.09
1,299.46

214.10
1,390.42

229.08
1,487.75

RNOA (%)
Residual operating income (ReOI)

16.48
77.48

16.48
82.90

16.48
88.71

Growth rate for NOA

7.0%

Operating income (OI)


Net operating assets (NOA)

7.0%

E14.3. Calculating Abnormal Operating Income Growth

The long-hand method:


2007

Operating income (OI)


Net operating assets (NOA)
Free cash flow (C-I = OI - NOA)
Income from reinvested free cash flow (at 10.1%)
Cum-dividend OI
Normal OI
Abnormal OI Growth (AOIG)
129

2008

2009

2010

187.00 200.09
214.10
229.08
1,214.45 1299.46 1,390.42 1,487.75
107.55 115.08
123.31
131.76
10.86
11.62
12.45
210.95
225.72
241.53
220.30
235.72
205.89
5.06
5.42
5.81

7.0%

The short hand method: AOIG = ReOI, so just calculate the changes in ReOI from the ReOI
calculated in Exercise E14.2.
2008
2009
2010
Residual operating income (ReOI)
Abnormal operating income growth (AOIG)

77.48

82.90
5.42

88.71
5.81

(As there is no ReOI for 2007, the ReOI cannot be calculated for 2008)

E14.4. Residual Operating Income and Abnormal Operating Income Growth

Residual operating income


(ReOI)

2012
2,700 - (0.10 20,000)
= 700

Abnormal operating income growth


(AOIG = ReOI)

2011
2,300 (0.10 18,500)
= 450

250

E14.5. Cost of Capital Calculations

By CAPM,
Equity cost of capital = 4.3% + [1.3 5.0%] = 10.8%
Debt cost of capital = 7.5% (1- 0.36)
= 4.8%
Equity cost of capital
Cost of capital for debt
(after tax)
Market value of equity
Net financial obligations
Market value of operations

10.8%
4.8%
$2,361 million ($40.70 x 58 million)
1,750
4,111

2,361
1,750

10.8% +
4.8% = 8.25%
Cost of capital for operations (WACC) =
4,111
4,111`

E14.6. Calculating the Required Return for Equity

After-tax cost of debt = 8.0% (1 0.37) = 5.04%

Required return for equity = 10% +

2,450
(10.0% 5.04% )
8,280

= 11.47%

E14.7. Residual Operating Income Valuation

This carries Exercise E14.2 over to valuation.


2012A

Operating income (OI)


Net operating assets (NOA)
RNOA (%)
Residual operating income (ReOI)
Discount rate (1.101t )
PV of ReOI
Total PV of ReOI
Continuing value (CV)
PV of CV
Value of NOA
Book value of NFO
Value of equity

1,135

2013E

2014E

2015E

2016E

187.00
1,214.45
16.48
72.37
1.101
65.73

200.09
1,299.46
16.48
77.48
1.212
63.91

214.10
1,390.42
16.48
82.90
1.335
62.12

229.08
1,487.75
16.48
88.71
1.469
60.37

253
3061.93
2,084
3,472
720
2,752

The continuing value calculation:


CV =

PV of CV =

88.71 1.07
= 3,061.93
1.101 1.07
3,061.93
= 2,084.36
1.469

As ReOI is growing at 7% in 2015 and 2016, this is extrapolated into the future as the long-term growth
rate.
(Allow for rounding errors)

131

Residual operating income (ReOI) is OIt (F 1)NOAt-1.


So, for 2013, ReOI = 187.00 (0.101 x 1,135) = 72.37

E14.8. Abnormal Operating Income Growth Valuation

This extends Exercises E14.2 and E14.3 to valuation.

Operating income (OI)


Net operating assets (NOA)

2012A

2013E

2014E

2015E

2016E

1,135

187.00
1,214.45

200.09
1,299.46

229.08
1,487.75

16.48
72.37

16.48
77.48
5.06

214.10
1,390.4of
CV2
16.48
82.90
5.42

RNOA (%)
Residual operating income (ReOI)
Abnormal operating income growth (AOIG)

In this calculation, AOIG is just the change in ReOI. One can also calculate AOIG
as follows, and proceed from there to the valuation:

2012A 2013E

Operating income (OI)


Net operating assets (NOA)
Free cash flow (C-I = OI - NOA)
Income from reinvested free cash flow (at
10.1%)
Cum-dividend OI
Normal OI
Abnormal OI Growth (AOIG)
Discount rate
PV of AOIG
Total PV of AOIG
Continuing value
PV of continuing value
Forward OI for 2013
Capitalization rate
Value of operations
Book value of NFO
Value of equity

2014E

2015E

2016E

187.00 200.09
214.10
229.08
1,135 1,214.45 1299.46 1,390.42 1,487.75
107.55 115.08
123.31
131.76
10.86
11.62
12.45
210.95
205.89
5.06
1.101
4.60

225.72
220.30
5.42
1.212
4.46

241.53
235.72
5.81
1.335
4.35

13.41
200.54

3,472
720
2,752

150.22
187.00
350.63
0.101

16.48
88.71
5.81

The continuing value calculation:

CV =

5.811.07
= 200.54
1.101 1.07

Present value of CV:


PV of CV =

200.54
= 150.22
1.335

As AOIG is growing at 7% in 2015 and 2016, this is extrapolated into the future as the long-term
growth rate. Note that ReOI is also growing at 7%: if ReOI grows at 7%, then AOIG must also
grow at 7%.
The calculations above are as follows:
Income from reinvested free cash flow is prior years free cash flow earning at the required
return of 10.1%. So, for 2014, income from reinvested free cash flow is
0.101 x 107.55 = 10.86.
Cum -dividend OI is operating income plus income from reinvesting free cash flow. So, for
2014, cum-dividend OI is 200.09 + 10.86 = 210.95.
Normal OI is prior years operating income growing at the required return. So, for 2014, normal
OI is 187.00 x 1.101 = 205.89.
Abnormal OI growth (AOIG) is cum-dividend OI minus normal OI. So, for 2014, AOIG is
210.95 205.89 = 5.06. AOIG is also given by OIt-1 (Gt - F). So, for 2014, AOIG is (1.1281
1.101) 187.00 = 5.06.

But AOIG is also always equal to the change on ReOI.

133

E14.9. Financing Leverage and Earnings Growth

The formula in Box 14.5 is:


Growth rate for earningst =
Growth rate for operating incomet + [Earnings leveraget-1 (Growth rate for operating
incomet Growth rate for net financial expenset)]
To avoid rounding error, note that the NFE for Year 2 is 52.50 0.05 = 2.625 (rather than the
rounded 2.63 number on Box 14.5). The ELEV for Year 1 = 2.50/7.50 = 0.3333
Growth rate rate2 = 10% + [0.333 (10% - 5%]
= 11.67%
E14.10. Growth, the Cost of Capital, and the Normal P/E Ratio

(a)

The repurchase was at fair value (value received was equal to value surrendered).
So there is no effect on value. More technically, the value of the equity is driven
by the value of the operations and the value of the operations did not change. The
total dollar value of the equity changed, but not the per-share value.

(b)

The $10.00 million is operating income (from operations) with no debt service.
The net financial expense increased to $2.50 million due to the new debt,
reducing earnings (to the equity) to $7.5 million.

(c)

Although forecasted earnings decreased to $7.5 million, shares outstanding


dropped from 10 million to 5 million, increasing eps: stock repurchases increase
eps (providing leverage is favorable).

(d)

The required return for the equity is given by the following calculation:
Required Equity Return =
Required Return for Operations
+ (Market Leverage Required Return Spread)
where
Value of Net Debt
Value of Equity

Market Leverage

Required Return Spread

= Required Return for Operations -

After- tax Cost of Debt


So, after the stock repurchase,
$ 50million

Required return for equity = 10% +


(10% 5% )
$50million

= 15%
(e)

The expected ROCE for Year 1 is 15%, an increase over the 10% before the
repurchase. As the required return was 15%, the expected residual earnings is zero
as must be the case for the equity is worth its book value.

(f)

The case with leverage:


The equity must be worth its book value (as expected residual operating income
for years after Year 1 is zero), and expected Year 1 book value, is $57.50 million,
or $11.50 per share.
The case with no leverage:
Again, the value of the equity must be worth its book value, $110.0 million, or
$11.00 per share.
The leverage case gives a higher expected price per share (target price) at the
end of Year 1, so it looks as if leverage has added value. But, the expected price
must be higher in the leverage case to yield a higher expected return to
compensate for the higher risk of not getting the expected price. Equity value is
always expected to grow at the required equity return (before dividends). In the
leverage case, Year 0 per-share value is $10.00 and the required return is 15%,
giving an expected Year 1 value of 11.50 ($10.00 x 1.15). In the no leverage case,
Year 0 per-share value is also $10.00, but the required return is only 10%, giving
an expected Year 1 value of $11.00 ($10.00 x 1.10). In both cases, the present
value of the expected Year 1 price is $10.00, discounting with the (leverage) risk
adjusted discount rate.
Note that the value of the equity in the leverage case is expected to grow at
14.6% in Year 2 because that is the required return for equity at the beginning of
Year 2: financial leverage has changed over Year 1, changing the required return.
Note that the ROCE for Year 2 is 14.6% also, giving expected residual earnings
of zero for Year 2. Do you see how accounting data and required returns fit
together?

135

(g)

For the leverage case:


The eps in Year 1 is expected to be $1.50 and the price-per-share is expected to be
$11.50. So the P/E is 7.67. This P/E is appropriate for a normal P/E. The
required equity return is 15%. (after the stock repurchase) and so the normal P/E
1.15
= 7.67.
is
0.15
For the no-leverage case:
Eps in Year 1 are expected to be $1.00 and the price $11.00. So the P/E is
expected to be 11.0. This is a normal P/E for a required return of 10%.
Why are the two P/Es different? Well, they are both normal P/Es, so earnings
growth is expected at a rate equal to the required return. But the required equity
return is different, and P/E ratios are based on both expected growth and the
required return.

E14.11. Levered and Unlevered P/B and P/E Ratios

Value of the equity = $233 2.9


= $675.7
Value of the operations = $675.7 + 236
= $911.7
(a)

Levered P/E

= 675.7/56 = 12.07

(b)

Enterprise P/B = 911.7/469 = 1.94

(no dividends)

Enterprise P/E = (VNOA + FCF)/ OI


What was the free cash flow? Free cash flow is equal to
C I = NFE - NFO + dividends
= 14 0 + 0
= 14
Thus,
Enterprise P/E

= (911.7 + 14)/70

(no change in NFO and no dividends)

= 13.22

You might prove that the levered and unlevered multiples reconcile according to equations 14.9,
14.10, and 14.12 in the text. (The net borrowing cost (NBC) = 14/236 = 5.93%).
E14.12. Levered and Unlevered P/E Ratios

First value the firm from forecasted residual operating income or abnormal operating income
growth:
2009A

2010E

2011E

2012E

18

18
0

18
0

Fo recasted free cash flo w :


O I-  N O A

13 5

13 5

13 5

Fo recasted d iv id end :
d= Earnings -  CSE

120

12 0

120

(a) Fo recasted v alu e o f o per at io ns


Forecasted value of eq ui ty

1 ,5 0 0
1 ,2 0 0

1,50 0
1,20 0

1 ,5 0 0
1 ,2 0 0

(b) Levered P/E ratio


U n levered P/E ratio

11 .0 0
12 .1 1

11 .0 0
12 .1 1

11.0 0
12.1 1

Residual o p er ating in co me
Ab n o rmal o p erating i ncome g ro wt h
PV o f ReO I(18 /0 .0 9)
N et op erati ng assets
V al ue o f op erati on s
N et finan cial o b lig at io ns
V al ue o f equ ity

200
1 300
1500
300
1200

The forecasted residual operating income is expected to be a perpetuity of $18 million,


and net operating assets are expected to be $1,300 always. So the value of the operations is
137

18
expected to be 1,300 +
=1,500 in all years. The "cum-dividend" value of the operations
0.09

in 2010 is expected to be 1,500 + free cash flow = 1,500 + 135 = 1,635. So the "cum-dividend"
value is growing at the required return of 9% (and so on for subsequent years).
The value of the operations can also be calculated using the abnormal earnings growth
method. As residual earnings are not forecasted to grow, abnormal operating income growth
(AOIG) is forecasted to be zero. Accordingly, the value of the operations in calculated by
capitalizing forward operating income:
V NOA = 135/0.09 = 1,500

and so for all years.


The value of the equity is (with similar reasoning) expected to remain at $1,200. The
cum-dividend equity value in 2010 is expected to be 1,200 + 120 = $1,320.
The levered and unlevered trailing P/E ratios are calculated using these cum-dividend
(dividend-adjusted) values:
Unlevered Trailing P/E

Value0 + Free Cash Flow0


Operating Income0

1,500 + 135
135

12.11

This P/E is a normal for a cost of capital for operations of 9%:


The unlevered forward P/E is:
Unlevered Forward P/E =

Value0
OI 1

1.09
= 12.11 .
0.09

1,500
135

= 11.11
This is normal for a cost of capital of 9%:

1
= 11.11. Normal unlevered P/Es are appropriate
0.09

because residual operating income is forecasted to be constant and abnormal operating income
growth is zero.
Now to the levered P/E:
Trailing Levered P/E =

Value + Dividends
Earnings

1,200 + 120
120

11.0

This is a normal P/E for a cost of capital of 10%.


Forward Levered P/E = Value/Forward earnings
= 1,200/ 120
= 10
This is a normal P/E for a cost of capital of 10%.
(c)

As earnings are expected to be constant (at $1,000 million), residual earnings (on
equity) must also be constant. So the levered P/E is a normal P/E. For a normal
P/E of 11.0, the equity cost of capital is 10%.
You can prove this with the calculation:
300

Required equity return = 9% +


(9% 5% ) = 10%
1,200

139

Applications
E14.13. The Quality of Carrying Values for Equity Investments: SunTrust Bank

Sun Trust Banks acquired the Coke shares many years earlier. The historical cost of $110
million is a poor indicator of their value. The current market value of $1,077 million is a better
quality number. But beware: was the market value an efficient price, or was Coke undervalued
or overvalued in the market? Would we accept the market value of Cokes shares during the
bubble of 1997-2000 as fair value? Coke was a hot stock then whose market price subsequently
declined.
E14.14. Enterprise Multiples for IBM Corporation

Here are the totals for IBMs balance sheet, first with book values and then with market values:
Book Value

Market Value

Net operating assets (NOA)

41,019

220,593

Net financial obligation (NFO)

17,973

17,973

Common equity (CSE)

23,046

1,228 $165 =

202,620

The amounts for NOA and the market value of NOA are obtained by adding NFO back to CSE
and the market value of equity, respectively. The book value of NFO is considered to be the
market value.
a. Levered P/B = 202,620/23,046 = 8.79
Unlevered (enterprise) P/B = 220,593/41,019 = 5.38
Leverage explains the difference according to the formula,
Levered P/B = Unlevered P/B + FLEV [Unlevered P/B 1.0]
8.79 = 5.38 + (0.780 4.38)
b. Forward levered P/E = $165/$13.22 = 12.48
To get the unlevered P/E, first calculate forward OI:
Earnings forecast for 2011: $13.22 1,228m shares
$16,234.2
Net financial expense for 2011: $17,973 3.1%
557.2

Forward operating income


$16,791.4

Forward unlevered (enterprise) P/E = $220,593/$16,791.4= 13.14.


Note that the levered P/E is lower than the unlevered P/E: leverage reduces the
P/E.
E14.15. Residual Operating Income and Enterprise Multiples: General Mills, Inc.

a. Free cash flow = OI NOA


= 1,177 (11,461 11,803)
= 1,519
b. ReOI (2008) = 1,177 (0.051 11,803)
= 575.05
c. Market value of equity = $36 656.5 shares = 23,634
Net financial obligations
5,648
Minority interest ($245 4.37)
1,071
Enterprise market value
30,353
(Minority interest is valued at book value multiplied by the P/B ratio for common equity,
4.37).
Enterprise P/B = 30,353/11,461 = 2.65
On the required return: The WACC number calculated in Box 14.2 uses a
number of inputs that give one pause (see Box 14.3):
- market values are used for the weighting, but it is market value that valuation tries
to challenge. One is building the speculation in price into the calculation.
- Market risk premiums used to get the equity required return (5% here) are just a
guess. More speculation.
- Betas are estimated with error.
- The 10-year Treasury rate was particularly low at this time. Is this rate a good
predictor of rates over the 10 yearsparticularly given the prospect of inflation
from the money printing by the Fed at the time?
Does 5.1% seem a bit low? Its only 1.5% above the risk-free rate (of 3.6% at the time). But we
really dont know the cost of capital, and using the CAPM is playing with mirrors. The investor
can, of course use his or her own hurdle rate.
141

E14.16. Calculating Residual Operating Income: Dell, Inc.

NOA, beginning of year = 13,230 20,439 = -7,209 (NOA are negative)


ReOI = OI (0.12 x NOA)
= 2,618 (0.12 x -7,209)
= 3,483
Because Dells NOA were negative, its ReOI is greater than is operating income.
Dell generated value in operations from
(1)

Operating income of $1,325 million (sales less operating expenses in trading with
customers)

(2)

A negative investment in NOA: shareholders earned 12% on operating debt in


excess of operating assets. (Operating creditors financed operating assets and
more). Dell used other peoples money. See Chapter 10 for coverage of Dell.

Further analysis of the drivers of residual operating income would involve analysis of profit
margins and asset turnovers.

E14.17. Residual Operating Income Valuation: Nike, Inc., 2004

Here are the totals for Nikes balance sheet at the end of 2004, first with book values and then
with market values:
Book Value
Net operating assets (NOA)
Net financial assets (NFA)
Common equity (CSE)

Market Value

4,551

19,444

289
4,840

289
263.1 $75

19,733

The amount for the market value of NOA is obtained by subtracting NFA from the market value
of CSE. The book value of NFO is considered to be the market value.

a. Levered P/B = 19,733/4,840 = 4.08


Unlevered (enterprise) P/B = 19,444/4,551 = 4.27
b. ReOI = 961 (0.086 4,330) = 588.6
c. RNOA = 961/4,330 = 22.19%
d. OI for 2005 = NOA at the end of 2004 Forecasted RNOA
= 4,551 0.2219
= 1,010
ReOI for 2005 = 1,010 (O.086 4,551)
= (0.2219 0.086) 4,551
= 618.6
d. If ReOI is expected to be constant for 2005 onwards, the value is

E
V2004
= CSE 2004 +

E
= 4,840+
V2004

Re OI 2005
F g

618.6
1.086 1.04

= $18,287.8 or $69.51 per share

143

E14.18. Stock Repurchases: Expedia, Inc.

a. EPS and the EPS growth rate are likely to increase. See Box 14.5.
b. Risk increases for shareholders. See the reversed WACC formula in equation 14.7: the
required return for operations does not change, but the increase in leverage increases the
required return for equity.
c. If repurchases are made at fair value, they cannot add to the per-share value. However, if
the firm pays less than fair value (buying the shares cheaply), it will add value for
shareholders (who did not sell their shares). See Box 14.6. A P/E of 26 looks high; if
Expedia is overpaying, then it is losing value for shareholders.
d. No. Management can increase EPS with a stock repurchase but not add value for
shareholders, yet get a bonus.

CHAPTER FIFTEEN
Anchoring on the Financial Statements:
Simple Forecasting and Simple Valuation
Concept Questions
C15.1 Yes, this is correct. The following two valuations are equivalent (using a 10% required

return for operations):


Value of Operations0 = NOA0 +

Value of Operations0 =

ReOI1
0.10

OI1
0.10

See the equivalence demonstrated in the No-growth Forecast and Valuation section of this
chapter. If there is no growth in residual operating, abnormal operating income growth must be
zero. And if abnormal operating income growth is zero, value is equal to forward income
capitalized.

C15.2 If current core operating income is appropriately purged of transitory items the forecast is

a good forecast if:


(1) Profitability of the net operating assets (RNOA) will be the same, and
(2) There is no growth in net operating assets.
A forecast should adjust for growth. So a sound forecast based on current operating
income (a growth forecast) is:
Core OI1, = Core OI0 + (Required return NOA)

145

C15.3 The growth rate for sales is the same as the growth rate in residual operating income

when RNOA is constant, the required return is constant, and asset turnovers are constant. (If
RNOA is constant and ATO is constant, profit margins (PM) must also be constant.)

C15.4 A firm with high expected growth in sales is probably a firm that can grow residual

earnings. But sales have to be profitable: a firm might grow sales, but with declining profit
margins and increasing asset turnovers, that is, with rising expenses per dollar of sales and
increasing investment to get a dollar of sales. A growth firm is one that can grow residual
operating income. Sales growth does not necessarily imply residual income growth.

C15.5 This statement is generally correct. See the calculation for the unlevered P/B in equation

(15.2b) in the chapter. But RNOA must be greater than the growth rate (in the numerator) for it
to be strictly correct.

C15.6 Increasing the asset turnover increases RNOA, all else held constant. So, by the

enterprise P/B formula in equation (15.2b) in the chapter, an increase in ATO increases the
multiplier.

Drill Exercises
E15.1. A No-growth Forecast and a Simple Valuation

a. ReOI2013 = OI2013 (0.10 1,257) = $35.7 million (= that in 2012)


Therefore,
OI2013 = ($1,257 0.10) + 35.7 = $161.4 million
b. With ReOI2013 forecasted to be a constant, a no-growth valuation applies:
35.7
0.10
= $1,614 million

NOA
V2012
= 1,257 +

c. Forward (enterprise) P/E =

NOA
V2012
OI 2013

= $1,614/$161.4
= 10.0
Constant ReOI (and a no-growth valuation) implies a normal P/E ratio for a 10% required return)
E15.2. A Simple Growth Forecast and a Simple Valuation

a. Core RNOA2012 = 990/9,400 = 10.53%.


b. Simple growth forecast of OI for 2013 = NOA2012 Core RNOA2012
= 9,682 0.1053
= $1,019.5 million
c. Growth rate for NOA in 2012 = 9,682/9400 = 1.03 (3%)
ReOI2013 = 1,019.5 (0.09 9,682) = 148.12
A simple growth valuation applies the NOA growth rate from the financial statements:
E
V2012
= 7, 695 +

148.12
1.09 1.03

= $10,163.7 million

147

d. Enterprise value = Value of equity + NFO


= 10,153.7 + 1,987
= 12,140.7
Enterprise P/B = 12,140.7/9,682
= 1.25
Also,
Enterprise P/B =

RNOA2012 ( g 1)
F g

0.1053 0.03
1.09 1.03

= 1.25
(allow for some rounding error)

E15.3. Two-Stage Growth Valuation

a. Free cash flow for 2013 = OI NOA


= 782 (6,848 6,400)
= 334
Reinvested FCF for 2014 =334 0.09 = 30.06
OI for 2011
= 868.00
Cum-dividend OI for 2014
898.06
Cum-div OI growth rate for 2014 = 898.06/782 = 1.1484 (14.84%)

b. V0NOA = OI 1

1 G2 Glong

F 1 F Glong

= 782

1 1.1484 1.04
0.09 1.09 1.04

= $18,837.5 million
Value of equity = Enterprise value NFO
= 18,837.5 756
= $18,081.5 million

c. Forward enterprise P/B = 18,837.5/782 = 24.09


(This is equal to the term that multiplies the forward earnings of 782 in Part b)

E15.4. Simple Valuation with Sales Growth Rates

If RNOA is constant and ATO is also constant, the growth rate for ReOI is given by the sales
growth rate. So,
RNOA ( g 1)
V0NOA = NOA

F g

Hence, the enterprise P/B ratio =

0.155 1.05
1.095 1.05

= 2.33

E.15.5 Simple Forecasting and Valuation

(a)

Residual operating income (ReOI) is


91.4 = (12% - required return) 4,572
So required return = 10%

(b)

Value of equity = CSE +

Re OI2013
0.10

= 3,329 +

91.4
0.10

= $4,243 million
Also,
Value of equity =

OI2013
- NFO
0.10

149

548.64
- 1,243
0.10

= $4,243 million

(c)

To get the residual earnings forecast, we need the required return for equity. Using the
value of the equity calculated in part (b), and the value of the net debt on the balance sheet,
we can calculate the required return using the "market leverage," as in the formula 14.7 in
Chapter 14.
Required return for equity = 10.0% +

1,243
4,243

(10.0% - 6.0%)

= 11.17%

So the comprehensive earnings forecast for 2013 is


Operating income
Net financial expense
Comprehensive

548.6

(4,572 12%)

74.6

(1,243 6%)

474.0

The residual earnings forecast is


RE

= 474.0 - (0.1117 3,329) = 102.2

Applications
E15.6. Simple Valuation for General Mills, Inc.

a. A no-growth valuation forecasts ReOI for 2009 as the same as Core ReOI for 2008.
ReOI2008 = 1,560 (0.08 12,297) = 576.2
One can also forecast the ReOI for 2009 by forecasting OI for 2009 as a no-growth
forecast:
OI2009 = OI2008 + (0.08 NOA)
= 1,560 + (0.08 550)
= 1,604
ReoI2009 = 1,604 (0.08 12,847) = 576.2
The no-growth valuation:
E
V2008
= 6,216 +

576.2
0.08

= $13,418.5 million or $39.76 per share


b. The simple growth forecast of OI for 2009 in NOA at the end of 2008 earning at the core
RNOA rate:
Core RNOA2008 = 1,560/12,297 = 12.69%
OI2009 = 12,847 0.1269 = 1,630.3
ReOI2009 = 1,630.3 (0.08 12,847) = 602.5
ReOI2009 can also be calculated by growing ReOI2008 by the NOA growth rate for 2008:
NOA growth rate for 2008 = 12,847/12,297 = 4.47%
ReOI2009 = 576.2 1.0447 = 602.5 (allow for rounding error)
The simple growth valuation applies the NOA growth rate in 2008 as ReOI growth:

151

E
V2008
= 6,216 +

602.5
1.08 1.0447

= $23,285 million or $68.99 per share


This growth valuation can also be calculated by applying the enterprise P/B multiplier
to NOA, as in model 15.2b:
Core RNOA ( g 1)
V0NOA = NOA

F g

0.1269 0.0447
V0NOA = 12,847
1.08 1.0447
= 12,847 2.329
= 29,916
NFO
VE

6,631
23,285

(NOA CSE)
or $68.99 per share

E15.7. Simple Valuation for the Coca-Cola Company

a.

Core PM (CoreOI/Sales)
ATO (Sales/NOA)*
Core RNOA (PM ATO)

2005

2004

2003

21.40%

22.40%

21.30%

1.395

1.382

1.397

29.85%

30.96%

29.76%

* On beginning-of-year NOA

b.
Sales growth rate

6.26%

Average sales growth rate

5.70%

4.24%

6.61%

2002

22.10%

c.
Enterprise value is given by the multiplier formula for a simple growth valaution:
Core RNOA ( g 1)
V0NOA = NOA

F g

NOA = $16,945 + 1,010 = $17,955


Set Core RNOA = 29.85% (as in 2005; one can also use average of 30.19% for 2003-05)
Set growth (g) = average sales growth rate
= 5.70%

(this is NOA growth rate with constant ATO)

0.2985 0.057
V0NOA = 17,955
1.10 1.057
= $100,840 million
NFO
VE

1,010
$ 99,830 or 42.14 per share on 2,369 million shares

E15.8. Reverse Engineering for Starbucks Corporation

a.
(1) Core operating PM = 671 / 9,412 = 7.13 %
(2) Core RNOA = 671/ 2,565 = 26.16 %
(3) ATO = 9,412/2,565 = 3.669
(4) NOA growth rate = 3,093/2,565 1 = 20.58%
Operating income, 2008 = NOA2007 x Core RNOA2007
= 3,092.7 x 26.17 %
= 809.4
b.
153

ReoI2008 = (0.2616 0.09) x 3,093


= 530.8
(One can also get the number by forecasting OI2008 = NOA2007 0.2616 .)
c.
Market price of equity = $20 x 738.3 million shares = 14,766
The reverse engineering problem:

14,766 = 2,178 +

530.8
1.09 g

g = 1.048 (a growth rate of 4.8 %)

Additional question: Suppose you forecast that Starbucks will grow residual operating income at
a 3.5% rate after 2008. What is your expected return from buying Starbucks business at the
current market price:
Reverse engineer the simple growth model for the expected return: Solve for ER:

RNOA ( g 1)
P0NOA = NOA

ER g

The formula is:

NOA
NOA

Expected return = NOA Forecasted RNOA + 1 NOA ( g 1)
P
P

(This is the unlevered version of the weighted-average expected return


formula in Chapter 7. It will be applied for active investing in Chapter 19.)
Enterprise price = Equity price + NFO = 14,766 + 915 = 15,681
Enterprise book/price = 3,093/15,681 = 0.197
Expected return = [0.197 26.16%] + [0.803 3.5%]
= 7.96%

E15.9. A Simple Valuation and Reverse Engineering: IBM

a. OI2005 = NOA2004 Core RNOA2004


= 42,104 0.188
= $7,915.6 million
ReOI2005 = 7,915.6 (0.123 42,104) = $2,736.8 million
0.188 0.088
E
b. V2004
- 12,357
= 42,104
1.123 1.088
= 120,298 -12,357.0
= $107,941 million or $65.59 per share on 1,645.6 million shares
Forward enterprise P/E = 120,298/7,915.6 = 15.20
Enterprise P/B ratio = 120,298/42,104 = 2.86 (the amount in the square brackets
above)
c. Market value of equity = $95 1,645.6 million shares = $156,332 million
Net financial obligations
12,357
Enterprise price
168,689 million
Reverse engineer:
Enterprise price = 42,104

0.188 ( g 1)
1.123 g

Solution: g = 1.1014 (a 10.14% growth rate)

E15.10 Buffetts Acquisition of Burlington Northern Santa Fe

Equity
NFO
Enterprise

Market Value
34,100
9,135
43,235

Book Value
2009
2008
12,798
11,131
9,135
9,155
21,933
20,286

Core RNOA = 2,113/20,286 = 10.42%


(average NOA can also be used)
Set required return = 8%
Forecast of ReOI for 2010 = (0.1042 0.08) x 21,933
= 530.8 million
155

a.

The reverse engineering problem:

Solution for g = 1.0551

(a 5.51% growth rate)

One can experiment with alternative required rates of return. Note: a higher required
return requires a higher growth rate to justify the current price.
Is the $100 per share price justified? It can be justified if core RNOA is at least 10.42%
in the future with a growth rate of 5.51% (given the required return is 8%).
One can set up a valuation grid that gives alternative combinations of RNOA, the growth
rate, and the required return that justify the price.
b. Railroads have a fixed track system that is unlikely to be extended. This mean that there
is unlikely to be much growth in NOA. So growth must come from an increase in RNOA
on the NOA represented by the track system. As RNOA = PM x ATO, this must come
from an increase in profit margins or asset turnover. As ATO is sales relative to NOA,
one would have to see higher sales on the given track system. That is, more freight
moving to railroads from road and air transportation. If, in addition, one sees an increase
in freight charges (that increases profit margins), one can forecast a yet- higher RNOA.

E15.11. Comparing Simple Forecasts with Analysts Forecasts: Home Depot Inc.

A summary of the reformulated balance sheets is given in the exercise, but the income statement
has to be reformulated to identify core operating income:

Reformulated Income Statements, Fiscal Year Ended January 30, 2003 2005
($millions)

Net sales
Cost of sales
Gross profit
Selling and store operating costs
General and administrative
Core operating income before tax
Tax as reported
Tax benefit of net debt
Core operating income after tax
Interest expense
Interest income
Net interest expense
Tax on net interest (37.7%)

2005
73,094
48,664
24,430

15,105
1,399

16,504
7,926

2,911
5

2,916
5,010

70
56
14
5

2004
64,816
44,236
20,580

12,588
1,146
2,539
1

(9)

Net income

62
59
3
1

5,001

13,734
6,846
2,540
4,306

2003
58,247
40,139
18,108

11,276
1,002
2,208
(16)

(2)
4,304

Calculate Core RNOA, NOA growth and return on net financial assets (RNFA) from the
financial statements:
Core RNOA2005 = 5,010/22,356 = 22.41% (using average NOA)
NOA Growth2005 = 323,833/20,886 = 1.1411 (a 14.11% growth rate)
RNFA2005 = 9/923 = 0.98%
(The RNFA looks a bit low; there was a considerable change in NFA over the prior and the
average of beginning and ending balances is a crude average. But financial income is a very
small component of net earnings.)

157

37
79
(42)
16

12,278
5,830
2,192
3,638

26
3,664

Here are the forecast of OI for 2006 and 2007 based on the financial statements:
2006

OI for 2006: NOA2005 Core RNOA2005


23,833 0.2241

2007

$5,341

OI for 2007: NOA2006 Core NOA2005


27,196 0.2241

$6,095

Net interest income for 2006: NFA2005 RNFA2005


325 0.0098

Net income forecast

$5,344

$6,095

EPS (on 2,185 million shares)

$2.45

$2.79

2.59

2.93

Analysts Forecasts

Note:
NOA2006 = NOA2005 NOA Growth2005 = 23833 x 1.1411 = 27,196
The net interest income for 2007 is set to zero
One could also calculated Core RNOA and NOA based on averages over 2003-2005.
The forecasts from the financial statements are a little below those for the analysts. Either
analysts have more information (outside the financial statements) or are being too optimistic. It is
always good to check an analysts against what you get from the financial statements and ask:
Why are they different?
Postscript:
One can also forecast from the financial statements by applying the 2005 sales growth rate of
12.77% and converting forecasted sales into operating income at the 2005 core PM of 6.85%. So,

2006

Sales, 2006: $73,094 1.1277

2007

$82,428

Sales, 2007: $82,429 1.1277

$92,954

Core PM, 2005

0.0685

0.0685

Operating income

$5,646

$6,367

Net income

$5,649

$6,367

EPS

$2.59

$2.91

Net interest income

These forecast s almost precisely the same as the analysts forecasts.

E15.12. Valuation Grid and Reverse Engineering for Home Depot Inc.
a. First calculate the market price of the operations, for it is this number we are challenging.

Market price of equity: $42 x 2,185 million shares


Net financial assets

$91,770 million
325

PNOA

$92,095 million

Now, with Core RNOA = 22.41%, reverse engineer to the growth rate from this market valuation
using the formula:
Core RNOA ( g 1)
V0NOA = NOA0

F g

Students have to choose a required return for the operations. The solution here uses 9%.
1.2241 g
NOA
V2005
= 92,095 = 23,833

1.09 g

Solving, g = 1.043 or a = 4.3% growth rate (approx), a little higher than the GDP growth rate.
Note: the following version of the formula can also be reversed engineered:
159

V0NOA = NOA0 +

CoreRNOA1 ( F 1) NOA0
F g

b. Now reverse the simple valuation model for the expected return:
1.2241 1.04
NOA
V2005
= 92,095 = 23,833

1.04

The solution for the expected return is 8.745%. The formula is:

NOA
NOA

Expected return = NOA Forecasted RNOA + 1 NOA ( g 1)
P
P

This is the weighted-average expected return formula of Chapter 7, but now on an unlevered
(enterprise) basis. (We will exploit this formula again when we return to active investing in
Chapter 19).
c. Using a required return of 9%, model alternative scenarios and identify those that are
consistent with the current price. For example, an RNOA of 18% with an NOA growth rate of
5% will justify the price for the operations (approximately):
0.18 0.06
NOA
V2005
= 23,833
1.09 1.06
= $95,332
Adding the NFA of $325 yield an equity value of $95,657 and a value per share of $43.78.
Clearly, there a number of combinations of RNOA and g that will yield the current market
price. A full valuation grid gives these scenarios and the analyst can ask whether these are
reasonable scenarios with some probability. The following grid gives enterprise value (in
billions of dollars) for different combinations of growth in sales and RNOA. Some cells are
filled in, but the grid in easily completed.

Valuation Grid (per share)


RNOA
Growth in
NOA

14%

16%

18%

19%

20%

22%

23%

2%
4%

39.42

5%

35.60

6%

43.78

7%

Postscript:
A grid can also be prepared for the expected return under alternative forecasts of RNOA and
growth. If the analyst has a relatively firm idea of RNOA and growth, the expected return from
investing at the market price can be estimated as in Part b of the Exercise:

NOA
NOA

Expected return = NOA Forecasted RNOA + 1 NOA ( g 1)
P
P

The grid takes the following form:


Expected Return Grid
RNOA
Growth in
NOA

14%

16%

18%

19%

20%

2%
4%
5%

8.9%

6%
7%
161

22%

23%

The 8.9% expected return for a 20% RNOA forecast and a 5% NOA growth rate is indicated
here. Fill out the expected returns for other combinations.

163

CHAPTER SIXTEEN
Full-Information Forecasting, Valuation, and Business Strategy Analysis
Concept Questions
C16.1 To forecast future financial statements, the analyst must know where the business is

going. She must also have an idea of the key drivers that will determine the future financial
statements, and these key drivers are determined by the business concept and by customers
acceptance to the concept. Valuations are made from pro forma financial statements, and pro
forma financial statements are those that the business is likely to produce in the future.

C16.2 Fade diagrams give the typical patterns (within industries) of changes in drivers over

time. The forecaster takes these patterns as a starting point and asks how the individual firm in
question might be different from the average firm.

C16.3 Competition is the primary determinant. But the ability of a firm to challenge the

competition slows the fade rate. A slow fade rate indicates durable competitive advantage.

C16.4 Pro forma financial statements have integrity if the various parts tie together according to

the accounting relations that govern the statements.

C16.5 Values are calculated from forecasts of operations, and dividends do not affect

operations. Dividends, rather, are a disposition of the free cash flow from operations.

C16.6 A red flag indicator is a feature within or outside the financial statements that indicates

deterioration in profitability in the future.

C16.7 An unarticulated strategy is a business idea that is not developed enough to quantify it

into pro forma statements. A strategy to research into a cure for cancer does not lend itself
readily to financial valuation.

C16.8 When shares are issued in a merger or acquisition, the analyst must be concerned with the

division of the value of the merged company between the shareholders of the two firms in the
merger. That division is determined by the terms under which shares are issued in the merger
(and thus how much each shareholder receives per share).

C16.9 A firm generates value for shareholders when it buys the firms shares at less than

intrinsic value. If management considers the shares to be undervalued in the market, buying
them generates value.

It is also argued that leveraged buyouts incentivize management

because they have to service the high debt load.

C16.10 The acquirers shares will decline if the market thinks the acquirer is overpaying for the

acquisition. This may be because the acquirees shares are over-priced possibly driven up by
bidding from a number of potential acquirers or because the acquirer offers unfavorable terms
(to itself) in a share exchange. The acquirers share price might also decline if the market views
the merger as one where the acquirer is using its overvalued shares to make and acquisition, and
thus views the merger announcement as a signal of that overvaluation.

165

Drill Exercises
E16.1. A One-Stop Forecast of Residual Operating Income

a.
The one-stop formula is:
Re quired return for operations

Re OI = Sales Core Sales PM


+ Core Other OI + UI
ATO

0.09

= 1,276 0.05
+0 + 0
2.2

= 11.600
Proof:
OI = 1,276 0.05 = 63.8
NOA = 1,276/2.2 = 580
ReOI = 63.8 (0.09 580) = 11.6
b.
0.09

Re OI = 1,276 0.045
+0 + 0
2.2

= 5.220
c.
The calculation in the square must be negative to yield negative ReOI. So a PM less than
4.0909% will yield negative ReOI.

E16.2. A Revised Valuation: PPE, Inc.

The revised pro forma:


Year 0

Sales (growing at 6%)


Operating income (PM = 0.07)
NOA
ReOI (10% charge)
Growth rate for ReOI

124.9
9.80
74.42

Year 1

Year 2

132.39 140.34
9.27
9.82
73.86
78.29
1.828 2.434
33.2%

Year 3

148.76
10.41
82.99
2.581
6.0%

OI = Sales 0.07
NOA = Sales one year ahead/1.9
Sales, OI, NOA, and ReOI will grow at 6% after Year 3: With constant ATO and PM, ReOI
grows at the sales growth rate.
a.
Value of Equity = 66.72 +

1.828
2.434
+
1.10 (1.10 1.06) 1.10

= 122.2
b.
Extending the pro forma:
Year 0

Sales (growing at 6%)


Operating income (PM = 0.07)
Net financial income (expense) (at 4%)
Earnings

124.9
9.80

NOA
NFA

74.42
( 7.70)

Free cash flow (OI NOA)


Dividends (40% of earnings)
Payment of debt

Year 1

Year 2

Year 3

132.39 140.34
9.27
9.82
(0.31) ( 0.07)
8.96
9.75

148.76
10.41
( 0.01)
10.40

73.86
(1.76)

78.29
(0.34)

82.99
1.20

9.83
3.58
6.25

5.39
3.90
1.49

5.71
4.16
1.55

The NFA position each year is NFAt-1 + NFEt (FCF dividend).

167

E16.3. Forecasting Free Cash Flows and Residual Operating income, and Valuing a Firm

(a)
20

Free cash flow (C I = d)


Investment (I)
Cash from operations (C)

20

20

20

20

70

75

75

75

75

80
150

89
164

94
169

95
170

95
170

As the firm is pure equity (no debt), free cash flow (C - I) is equal to dividends.

Forecast operating income and residual operating income:


2013

2014

NOA
CI
OI

39
70
109

Beginning net operating assets


ReOI (0.12)

2015

2016

2017

30
75
105

24
75
99

14
75
89

9
75
84

596

635

665

689

703

37

29

19

As the firm is a pure equity firm, net operating assets (NOA) equal common shareholders
equity (CSE) and operating income (OI) equals comprehensive income. And comprehensive
income equals CSE + dividends. As an alternative calculation, OI = C I + NOA (as above),
(b) Based on the forecasted ReOI, with zero ReOI forecasted after 2017,

Value = 596 +
= 669.5
(c)

37
1.12

29
1.12 2

19
1.12 3

6
1.12 4

Using DCF analysis, one is tempted by the following calculation:


Value =

70
75
+
/1.12
1.12 0.12

= 620.5
This value is different from that value in part (b). The 75 in free cash flow after 2009 looks
like a perpetuity, so has been capitalized as such in this valuation. But free cash flow cannot be a
perpetuity at 75. Forecasted NOA for the beginning of 2012 is 703 + 84 - 75 = 712. If the firm
were to hold net operating assets at 712 and thus earn 85.44 in operating income (at an RNOA of
12 % to yield a zero ReOI), free cash flow would be 76.44: C I = OI NOA = 85.44 (712
703) = 76.44. If the firm were to maintain a zero ReOI after 2013 and still grow net operating
assets, free cash would be lower, but would have to grow.
The point:
1. Make sure you get to steady state before calculating a continuing value.
2. DCF valuation often requires longer forecasting horizons.

E16.4. Analysis of Value Added

Pro forma and valuation under the status quo:


0

Sales
Operating income (PM = 7%)

857.0
60.0

882.7
61.8

909.2
63.6

936.5
65.6

(grows at 3%)
(grows at 3%)

Net operating assets

441

454.2

467.8

481.9

(grows at 3%)

7%
2.0
14%

7%
2.0
14%

7%
2.0
14%

7%
2.0
14%

ReOI
Value of operations under the status quo:

17.64

18.18

18.73

PM
ATO
RNOA

169

(grows at 3%)

Value of NOA = 441 +

17.64
1.10 1.03

= 693

Pro forma and valuation under the plan:

Sales
Operating income
(PM = 7%)
Net operating assets
(ATO = 1.67)
PM
ATO
RNOA

857.0

891.3

926.9

964.0

(grows at4%)

60.0

62.4

64.9

67.5

(grows at4%)

534.8

556.1

578.4

601.6

(grows at 4%)

7%
1.67
11.67%

ReOI

7%
1.67
11.67%

7%
1.67
11.67%

7%
1.67
11.67%

8.93

9.29

9.66

(grows at 4%)

Value of operations under


the plan:
Value of NOA

= 534.8 +

8.93
1.10 1.04

= 684
The plan (marginally) loses value. The additional growth (that generates additional profit margin) is
not sufficient to cover the required return on the additional investment in net operating assets.

E16.5. Evaluating a Marketing Plan

(a)
This is a simple growth valuation:
Value of operations0 = NOA0 +

Re OI1
F g

Re OI = (15% 11% ) 498


1

= 19.92
For a profit margin (PM) of 7.5% and an RNOA of 15%, the ATO must be 2.0. With a
constant ATO (implied by the constant PM and RNOA), the growth in ReOI is given by the
growth in sales. So,
Value of operations = 498 +

19.92
1.11 1.06

= $896 million
(b)
A reduction of the ATO to 1.9 would reduce forecasted profitability (RNOA) to 14.25%:
RNOA = PM ATO
= 7.5% 1.9
= 14.25%

Under the status quo, residual operating income is expected to be generated as follows:

Year
1
2
3

NOA at
beginning
498.0
527.9
559.6

Sales
996.0
1,055.8
1,119.2

PM
7.5%
7.5%
7.5%

ATO
2.0
2.0
2.0

RNOA
15%
15%
15%

ReOI
19.92
21.12
22.38

ReOI
Growth
--6%
6%

Under the marketing plan, residual operating income is expected to be generated as follows:

Year

NOA of
beginning

Sales

PM

ATO

171

RNOA

ReOI

ReOI
Growth

498.0

996.0

7.5%

2.0

14.25%

19.92

----

2
3

557.0
591.8
628.8

1,058.3
1,124.4
1,194.7

7.5%
7.5%
7.5%

1.9
1.9
1.9

14.25%
14.25%
14.25%

18.10
19.23
20.44

6.25%
6.25%
6.25%

[The plan is implemented in year 1, to take effect in year 2.]

The valuation under the plan is


Value of operations = NOA +

= 498 +

Re OI1
1.11

19.92
1.11

Re OI 2

/1.11
1.11 1.0625

18.10
/1.11

0.0475

= $859 million
The plan reduces the value calculated in part (a). The additional investment in receivables loses
value (when charged at the required return) even though it generates more value from the
additional operating income that comes from the additional sales growth.

E16.6. Forecasting and Valuation

(a) Forecast return on net operating assets (RNOA) for 2013.


RNOA = PM ATO
= 14% 1.25
= 17.5%

(b) Forecast residual operating income for 2013. Use a required return for operations of 9%.
ReOI 2013 = (0.175 - 0.09) NOA 2012
= (0.175 - 0.09) 3,160
= 268.6
(c) Value the shareholders equity at the end of the 2012 fiscal year using residual income
methods.

V E = NOA 2012 +
= 3,160 +

ReOI 2013
- NFO
F g

268.6
- 1,290
1.09 - 1.06

= 10,823
(growth in ReOI is equal to growth in sales, 6%, because ATO is constant)
(d) Forecast abnormal growth in operating income for 2014.
Method 1:

AOIG = growth in ReOI

AOIG 2014 = 268.6 x 0.06


= 16.12

Method 2:
The Pro forma:
2012
Operating income
Net Operating assests
FCF (OI - NOA)
Reinvested FCF (at 9%)

3,160.00

2013
553.00
3,349.60
363.40

2014
586.18

32.71
618.89
602.77
16.12

Normal OI (553 x 1.09)


AOIG

Note: OI and NOA both grow at 6% per year.


OI for 2013 = 3,160 0.175 = 553.

(e) Value the shareholders equity at the end of 2012 using abnormal earnings growth
methods.
E
=
V2012

AOIG 2014
1
- NFO
OI 2013 +
F - g
0.09

16.12
1
- 1,290
553 +

1.09 - 1.06
0.09
= 10,825

[OI 2013 = 3,160 x 0.175 = 553]

173

(f) After reading the stock compensation footnote for this firm, you note that there are
employee stock options on 28 million shares outstanding at the end of 2012. A modified
Black-Scholes valuation of these options is $15 each. How does this information change
your valuation?
E
V2012
before option overhang

10,825

Option overhang :
Value of outstanding options
28 million 15 = 420
Tax benefit (@35%) 147
273
Adjusted valuation
10,552
(g) Forecast (net) comprehensive income for 2013.
Forecast of operating income for 2013
Forecast of net financial expense
NFO x NBC = 1,290 x 0.056
Tax benefit (at 35%)

553
72
25

Compensation income

47
506

[NBC for 2013 is the same as for 2012: 83/1,470=5.6%]

E16.7. Valuing a Property-Casualty Insurer

a.

ReOI2012 = OI2012 (0.09 NOA2011)


= (43) (0.09 -3,300)
= 254

b.

Value of equity = Value of investments + Value of underwriting business


254 1.02
= $6,050 + (-2,850 +
1.09 1.02
= $6,050 + 851
= $6,901 million
(Investments are marked to market on the balance sheet)

E16.8. Integrity of Pro Formas

(a)
(1)

Net financial expenses are growing even though net financial obligations remain

constant.
(2)

Successive numbers for common equity are not reconciled by the stocks and flows
equation: CSE = Comprehensive income Net dividends

(3)

Free cash flow does not obey the relation, C I = OI NOA.

(4)

Successive net financial obligations do not obey the relation,


NFO = NFE (C I) + d.

In short, accounting discipline is lacking from the pro forma.


(b)
Sales are forecasted to grow at 6% per year. The forecasted asset turnovers are constant (at
2.0) and the RNOA is forecasted to be a constant 20% (on beginning NOA). So residual
operating income must be forecasted to grow at the sales growth rate of 6%.

E16.9. Comprehensive Analysis and Valuation

Part I
(a)
Loss from exercise of stock options = 12/0.35 = 34
Tax benefit
12
Compensation expense, after tax

22

(b)

175

Market price of shares repurchased


Amount paid for shares: 720/24 mill.
Loss per share
Number of shares

25
30
5
24 million

Total loss

120 million

(These losses are not tax deductible)


(c)
Comprehensive income statement
Sales
Operating expenses
OI before stock compensation
Stock compensation
Operating income
Interest expense
Interest income
Tax benefit
Unrealized gain on investments
Put option losses
Comprehensive income

3,726
(3,204)
522
(22)
500
98
(15)
83
29
54
(50)
120

124
376

(d)
2012

2011

Net operating assets


Net financial obligations

3,160
1,290

2,900
1,470

Common shareholders equity

1,870

1,430

Financial leverage (FLEV) = 1,290/1,870 = 0.690


Operating liability leverage (OLLEV) = 1,590/3,160 = 0.503

(Operating liabilities = 1,200 + 390 = 1,590)

(e)
FCF = OI NOA
= 500 (3,160 2,900)
= 240
Part II
(a)
RNOA = PM ATO
= 14% 1.25
= 17.5%
(b)
ReOI2013 = (0.175 0.09) NOA2012
= (0.175 0.09) 3,160
= 268.6
(c)
VE = NOA2012 + ReOI2013/(F g) NFO2012
= 3,160 + 268.6/(1.09 1.06) 1,290
= 10,823
(Growth rate in ReOI is the sales growth rate because ATO is constant)
(d)
Method 1:

177

OI2014
FCF2013, reinvested
Normal OI
AOIG2014

586.18
32.71
618.89
602.77
16.12

Method 2:
AOIG = growth in ReOI
AOIG2014 = 268.6 x 0.06
= 16.12
(OI and NOA both grow at 6%)
(e)
E
V2012
=

AOIG2014
1
NFO
OI 2013 +
0.09
F g

1
16.116
553 +
1,290

0.09
1.09 1.06

= 10,823
(OI2013 = 3,160 0.175 = 553)
(f)
VE before option overhang
Option overhang:
Value of outstanding options
28 mill x 15
Tax benefit (35%)

10,823
420
147

Adjusted valuation

273
10,550

(g)
Forecast of operating income for 2013
Forecasts of net financial expense:

553

NFO x NBC = 1,290 0.056


Tax benefit (at 35%)

72
25

Forecast of comprehensive income

47
506

(The NBC used is the core net borrowing cost on net debt for 2002: 83/1470 = 0.056)

Applications
E16.10. Forecasting and Valuation for General Mills, Inc.
General Mills Pro Forma

Sales
Core Operating income

2010A
14,797
1,805

2011E
15,833
1,932

2012E
16,941
2,067

2013E
17,958
2,191

Net operating assets


Net financial obligations
Common equity

11,461
6,058
5,403

13,318

14,118

14,965

1,015.1
1.08
939.9

1,001.6
1.1664
858.7

1,061.6
1.2597
842.7

Core profit margin


ATO
ReOI (8%)
Discount rate
PV of ReOI
Total PV of ReOI
Continuing value (CV)
PV of CV
NOA
Enterprise Value
Net financial obligations
Value of equity
CV =

2014E
19,035
2,322

12.20%
1.272
1,124.8
1.3605
826.8

3,468
29,245
21,496
11,461
36,425
6,058
30,367 or $46.26 per share

1,124.8 1,04
= 29,245
1.08 1.04

[Forecasts of NOA are made by applying ATO to forecasted sales one year ahead, but not in
2011, since NOA is given at the end of 2010]

179

E16.11. Pro Forma Analysis and Valuation: Nike, Inc.

Nike Pro Forma


Sales
Operating income
Net operating assets
Net financial assets
Common equity
ReOI (8.6%)
Discount rate
PV of ReOI
Total Pv of ReoI
Continuing value (CV)
PV of CV
Value of equity

2008A
18,627

2009E
20,490
1,844

2010E
22,334
1,898

2011E
24,120
1,930

5,806
1,991
7,797

6,569

6,891

7,169

1,344.7
1.086
1,238.2

1,333.1
1.1794
1,130.3

1,337.4
1.2808
1,044.2

1,319.5
1.3910
948.6

4,361
29,832
21,447
33,605

or $68.43 per share

E16.12. One-Step Residual Operating Income Calculation: Coca-Cola

a.
The one-step calculation of residual operating income is:
Required Return for Operations

ReOI = Sales PM + Other operating income


ATO

0.09

= $24,088 0.20
+ 102
1.32

= $3,277.3 million
An alternative solution:
Core OI = ($24,088 0.20) + 102 = $4,919.6
NOA

2012E
25,809
1,936

= $24,088/1.32 = 18,248.5

ReOI

= $4,919.6 (0.09 18,248.5) = 3,277.3 million

b.
0.09

ReOI = $24,088 0.20


+ 102
1.70

= $3,644.4 million

E16.13. A Valuation from Operating Income Growth Forecasts: Nike, Inc.

(a)
ReOI (8.6% charge)
Abnormal OI Growth (= ReOI)
Discount rate
PV of AOIG
Total PV to 2009
33.17
CV
1.086 1.05
PV of CV
Operating income
Capitalize at required return
Enterprise value (1,842.31/0.086)
Net financial assets
Option overhang
Value of equity

2005

2006

2007

2008

2009

2010

783.6

854.7

676.0

608.6

663.4

696.6

71.1
1.086
65.47
-99.3

-178.7
1.179
-151.57

-67.4
1.281
-52.62

54.8
1.391
39.40

33.2

921.39
662.4
1,175.0
1,738.1
0.086
20,211
289
20,500
452
20,048

Note:
AOIG is equal to the change in residual operating income (ReOI) given in Box 16.4. From 2010
onwards, ReOI is forecasted to grow at a 5% rate and thus so is AOIG, for AOIG is always the
change in ReOI. So the continuing value uses a 5% growth rate.

(b)

181

The two-stage growth model (equation15.5) incorporates short-term and longterm growth rates, G2 and Glong:
NOA
= OI 1
V2004

1 G2 Glong

F 1 F Glong

Calculating G2:
Cum-FCF OI for 2006 = normal income + abnormal income growth
= (1.086 x OI2005) + AOIG2006
= (1.086 x 1,175) + 71.1
= 1,347.15
G2

= 1,347.15/1,175 = 1.1465 (14.65%)

Set Glong = 1.05, the long-term growth rate forecasted by the analyst,
NOA
V2004
= 1,175

1 1.1465 1.05
0.086 1.086 1.05

= $36,628 million
The forward P/E is 31.17.
Why is this value greater than that in (a)? Because the two-stage growth model implies a
gradual decay in the growth rate from the 14.65 % in 2006 to the 5% in the (very) long term. So,
it does not pick up the slower AEG growth after 2006 that is apparent in the full pro forma.

E16.14. Evaluating an Acquisition: PPE Inc.

The important point in this exercise is to calculate the effect of the proposed acquisition on
the per-share value of PPE. As shareholders of the acquired firm are to share in the benefits of
the merger, the division of the value added in the merger between PPEs shareholders and those
of the acquired firm has to be calculated. The value added will depend on the value of the
merged firm. The division of the value will depend on the relative shares in the value (which
depend on the rate of exchange of shares in the acquisition).

(a)
To solve the problem proceed as follows:
1.

Calculate the value of the equity of the merged firm at the end of Year 1.

2.

Calculate the per-share value of the equity of the merged firm at Year 1.

3.

Calculate the present value (at Year 0) of the per-share value of Year 1 plus the
present value of the Year 1 dividend.

4.

Compare the Year 0 per share value with that calculated without the acquisition (from
the pro forma in the text: $1.24).
Is per-share value added?

The following calculates the value of the merged firm at the end of the year 1 and the per-share
value of the 220 shares in the new firm (steps 1 and 2):
1

RNOA

7.16%

8.46%

9.92%

21.30%

21.31%

Residual operating
income (11%)
income (11%)

(4.90)

(3.10)

(1.27)

11.59

12.30

Year

PV of ReOI to

183

Year 5
Year 5

1.63

Continuing value,
Year 5

246.0

PV of CV

162.05

Net operating
assets, end Year 1

127.50

Value of NOA,
Year 1
end Year 1

291.18

Value of NFO
Value of equity
Value per share
(220 shares)

5.71
285.47
1.298

12.30

CV = 1.11 - 1.06
Note that the ReOI is growing at 5% per year after Year 5.
(Calculations use a 11% required return for operations.)

The Year 0 per share value to PPEs shareholders (step 3) is


Value at Year 1

$1.298

Dividend at year 1

0.0399

Year 1 pay off

1.338

PV at Year 0 (1.11)

$1.205

Note: the dividend for Year 1 in Exhibit 16.2 is 3.99 million which is 0.0399 per share on 100
million shares.
The value of a PPE share without the acquisition is $1.24, so the proposed acquisition does not
add value.
(b)

The revised pro forma, without amortization of goodwill, excludes the amortization expense in
the income statement and maintains goodwill in the balance sheet:

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

131.15
120.86

189.00
168.87

200.34
179.00

212.36
189.74

10.29

20.13

21.34

22.62

23.97

Net operating assets


127.50
Net financial obligations 5.71
Common equity
121.79

133.17

139.18

145.55

152.30 159.46

Income Statement

Sales
Core expenses
Operating income

225.10 238.61
201.13 213.19
25.42

Balance Sheet

(c)
Calculate forecasts of residual operating income (ReOI) for the alternative pro forma and value
the operations from those forecasts.
Year 1

ReOI
ReOI growth rate

Year 2

Year 3

Year 4

6.105

6.691
9.60%

7.310
9.25%

Year 5

7.960
8.89%

Year 6

8.667
8.86%

The ReOI growth rate is declining each year, but is not in steady state. Sales and operating
income are growing at 6%, as in part (a), but the book values of NOA are not. However, the
book values will eventually converge to the 6% sales growth rate. You need a computer: Input
the pro forma into a spreadsheet and continue computations for years after Year 6:

185

Grow operating income at 6% per year

Calculate the free cash flow each year from either pro forma: FCF = OI NOA. (Free
cash flow does not change with the changed accounting, of course, so will be the same
when calculated from either pro forma.) Appreciate that free cash flow grows at a 6%
rate. So, as FCF is $18.26 for Year 6, subsequent FCF can be extrapolated at 6%.

Calculate NOA each year as NOAt = NOAt-1 + OIt - FCFt

Calculate ReOI and present value it

Add NOA at the end of Year 1 to get the value of operations at that point.

This Year 1 value is the same at that in part (a) (the accounting does not affect the value!), the
value at Year 0 is also the same.

CHAPTER SEVENTEEN
Creating Accounting Value and Economic Value
Concept Questions
C17.1 The first half of the statement is not correct. A firm can have a high RNOA because of

the accounting it uses, not because it is investing in value-added projects. But the second part of
the statement is correct. If a firm has high RNOA because of the accounting or because of
economic profitability it must trade at a premium.

C17.2 Both policies understate the book value of assets relative to alternatives, and conservative

accounting involves understatement of assets.

C17.3 Conservative accounting means that the carrying value of net assets is lower than

otherwise. So, as accounting does not affect intrinsic prices, conservative accounting yields
higher intrinsic P/B ratios. See Table 17.3 in this chapter.

C17.4 Conservative accounting produces higher return on net operating assets (RNOA) and

return on common equity (ROCE). When first implemented, it may produce lower measures (as
net assets are written off) but the write off results in higher rates of return subsequently. See
Table 17.3 in this chapter.

187

C17.5 Conservative accounting does not affect the intrinsic P/E ratio if net operating assets are

constant, for earnings are not affected by the accounting and neither is value. But if net
operating assets are increasing, earnings are lower with conservative accounting, so the P/E is
higher. And P/E ratios are lower if net operating assets are declining. See Tables 17.3 and 17.5
in this chapter.

C17.6 The concept of economic profit refers to value added by an investment over the

opportunity cost of the investment. But it cannot be observed, without measurement, and
measurement involves choices of accounting rules (which may or may not capture economic
profit).

All measures of economic profit are accounting measures.

Economic profit or

economic value added can, however, be estimated ex ante (before the fact) with residual earnings
techniques.

C17.7 Accounting policies determine residual income by changing book values. So, if book

values are added to the present value of residual earnings, the calculated value is not affected,
provided steady state residual income is forecasted.

C17.8 No, this is not always correct. If inventories are constant, income and margins will be the

same under LIFO and FIFO. If inventories decline, LIFO liquidation will yield higher income
and profit margins.

C17.9 No, this is not correct. LIFO yields lower inventory values (if inventory costs are rising)

so a higher inventory turnover.

C17.10 No. Growth in eps can be created by leverage and stock repurchases, as seen in Chapter

14. And growth can be created by conservative accounting, as seen in this chapter (in Table
17.5).

C17.11 A hidden reserve is an asset that would otherwise be on the balance sheet if it were not

for conservative accounting. It can also be created by an overstated liability. Hidden reserves
are created by reducing earnings (and so recording lower net assets). Releasing hidden reserves
refers to the practice of slowing investment that has generated the reserve (along with
conservative accounting) so as to increase income.

Hidden reserves are also released by

reducing an overstated liability. The LIFO reserve is an example of a hidden reserve (for
inventories). A decrease in the LIFO reserve is a release of the reserve (that increases income
through lower cost of goods sold).

C17.12 Steady-state is a point in the evolution of a firm (usually in the future) where residual

income subsequent to that point can be summarized by residual earnings at the point in time and
a growth rate.

C17.13 Return on common equity should be higher, on average, in the U.S. Accounting in the

U.S. is more conservative, producing higher ROCE.

189

C17.14 The return on net operating assets (RNOA) will be lower in the first year as the new

write-off of credit-card receivables hits the income statement, but thereafter the change will
increase RNOA.
C17.15

R&D expensing is cash accounting: investment is expensed immediately. Like free

cash flows, this can give low or negative income when the firm is in fact generating value
through the R&D. Accordingly, when forecasting for valuation, the forecast horizon often must
be pushed far into the future (as with cash accounting) to capture the earnings from R&D
investment. Capitalizing R&D and matching expenses for it against future revenue rectifies the
problem. (But one then has to ask about the quality of the asset and its amortization: will the
R&D really be successful?)

Drill Exercises
E17.1. A Simple Demonstration of the Effect of Accounting Methods on Value

a.
Value of investment = Present value of cash expected cash flow
=

115
1.09

= 105.50
b.
Book value of investment = $100
Earnings, Year 1

= $115 - $100

(the $100 represents the expensing of the


investment)

= $15
ReOI1 = 15 (0.09 100) = 6
Value of investment = $100 + Present value of expected ReOI
= $100 +

Re OI 1
1.09

= $100 +

6
1.09

= $105.50
c.
Book value of investment = $80
Earnings, Year 1

= $115 80
= $35
ReOI1 = 35 (0.09 80) = 27.8

191

Value of investment = $80 + Present value of expected ReOI


= $80 +

27.8
1.09

= $105.50

E17.2. Valuation of a Project under Different Accounting Methods

a.
Year 0

Cash flows
Discount rate
PV of cash flows
Total PV of cash flows

Year 1

1,540
1.09
1,412.8

Year 2

1,540
1.1881
1,296.2

2,709

b.
Year 0

Revenue
Depreciation
Earnings
Book value
RNOA
Residual earnings
Discount rate
PV of residual earning
Total PV
Value of project

2,200

509
2,709

Year 1

Year 2

1,540
1,100
440
1,100
20.0%
242
1.09
222.0

1,540
1,100
440
0
40.0%
341
1.1881
287.0

c.

Revenue
Depreciation
Earnings
Book value
RNOA
Residual earnings
Discount rate
PV of residual earning
Total PV
Value of project

Year 0

Year 1

Year 2

2,200

1,540
1,300
240
900

1,540
900
640
0
10.91%

42
1.09
38.5

71.1%
559
1.1881
470.5

509
2,709

The value of the project does not change, but the accounting numbers do. The more conservative
depreciation in Year 1 decreases earnings, RNOA, and residual earnings in that Year, but creates
earnings, RNOA, and residual earnings in Year 2.
d.
Year 0

Revenue
Depreciation
Earnings
Book value
RNOA
Residual earnings
Discount rate
PV of residual earning
Total PV
Value of project

1,500

Year 1

Year 2

1,540
750
790
750
52.67%
655
1.09
600.9

1,540
750
790
0
105.33%
722.5
1.1881
608.1

1,209
2,709

The value is unchanged, but the conservative accounting (expensing advertising), increases
subsequent earnings, RNOA, and residual earnings.
e.
For capitalizing and expensing advertising in part b, P/B = 2,709/2,200 = 1.23
For expensing advertising on part d. P/B = 2,709/1,500 = 1.81

193

Conservative accounting increases P/B ratios.


E17.3. Valuation of a Going Concern Under Different Accounting Methods

Initial investment $2,200 million


Further investment of $2,200 million each year
Sales revenue 70 percent of the investment
Accounting depreciation: straight-line over those two years
Hurdle rate = 9%
a. Price-to-book ratio = 3.80
Foreward P/E = 19.01
Year 0
Sales
From investments in Year 1
From investments in Year 2
From investments in Year 3
From investments in Year 4

Operating expenses (depreciation)


From investments in Year 1
From investments in Year 2
From investments in Year 3
From investments in Year 4
From investments in Year 5
0.0
Operating income
Net Operating Asset (NOA)
From investments in Year 1
From investments in Year 2
From investments in Year 3
From investments in Year 4
From investments in Year 5

Investment
Free cash flow
RNOA (%)
Profit margin (%)
Asset turnover

Year 1

Year 2

1540.0

1540.0
1540.0

1540.0

3080.0

1100.0

1100.0
1100.0

1100.0

2200.0

440.0

880.0

2200.0

1100.0
2200.0

1100.0
2200.0

Year 3

Year 4

1540.0
1540.0 1540.0
1540.0
3080.0 3080.0

1100.0
1100.0 1100.0
1100.0
2200.0 2200.0
880.0

880.0

2200.0

3300.0

3300.0

1100.0
2200.0 1100.0
2200.0
3300.0 3300.0

2200.0
(2,200.0)

2200.0
(660.0)

2200.0
880.0

2200.0 2200.0
880.0
880.0

20.0
28.6
0.7

26.7
28.6
0.9

26.7
28.6
0.9

26.7
28.6
0.9

Growth in NOA (%)


ReOI
Growth in ReOI (%)
Growth in cum-dividend OI (%)
AOIG (0.10)
Growth in AOIG (%)
Value of firm
Premium over book value
P/B
Trailing P/E
Forward P/E
Equity Return

8364.9
3.80
19.01

50.0
242.0
N/A

0.0
583.0
140.9
86.5
341.0
N/A

9777.8
6477.8
2.96
20.7
11.1
9%

9777.8
6477.8
2.96
12.1
11.1
9%

0.0
583.0
0.0
9.0
0.0
N/A

0.0
583.0
0.0
9.0
0.0
N/A

9777.8 9777.8
6477.8 6477.8
2.96
2.96
12.1
12.1
11.1
11.1
9%
9%

b. 20 percent of the projected investment to be expensed each year.


Price-to-book ratio = 4.75
Foreward P/E = 38.02
Year 0
Sales
From investments in Year 1
From investments in Year 2
From investments in Year 3
From investments in Year 4

Operating expenses (depreciation)


From investments in Year 1
From investments in Year 2
From investments in Year 3
From investments in Year 4
From investments in Year 5

440.0

440.0
Operating income
Net Operating Asset (NOA)
From investments in Year 1
From investments in Year 2
From investments in Year 3
From investments in Year 4
From investments in Year 5

Investment

(440.0)

1760.0

Year 1

Year 2

1540.0

1540.0
1540.0

1540.0

3080.0

880.0
440.0

880.0
880.0
440.0

1320.0

2200.0

220.0

880.0

880.0
1760.0

880.0
1760.0

Year 3

Year 4

1540.0
1540.0 1540.0
1540.0
3080.0 3080.0

880.0
880.0
440.0

880.0
880.0
440.0
2200.0 2200.0
880.0

880.0

880.0
1760.0

1760.0

2640.0

2640.0

880.0
1760.0
2640.0 2640.0

2200.0

2200.0

2200.0

2200.0 2200.0

195

Free cash flow

(2,200.0)

RNOA (%)
Profit margin (%)
Asset turnover
Growth in NOA (%)
ReOI
Growth in ReOI (%)
Growth in cum-dividend OI (%)
AOIG (0.10)
Growth in AOIG (%)
Value of firm
Premium over book value
P/B
Trailing P/E
Forward P/E
Equity Return

8364.9
4.75
38.02

(660.0)

880.0

880.0

880.0

12.5
14.3
0.9
50.0
61.6
N/A

33.3
28.6
1.2
0.0
642.4
942.9
273.0
580.8
N/A

33.3
28.6
1.2
0.0
642.4
0.0
9.0
0.0
N/A

33.3
28.6
1.2
0.0
642.4
0.0
9.0
0.0
N/A

9777.8
7137.8
3.70
41.4
11.1
9%

9777.8
7137.8
3.70
12.1
11.1
9%

9777.8 9777.8
7137.8 7137.8
3.70
3.70
12.1
12.1
11.1
11.1
9%
9%

Year 1

Year 2

Year 3

1540.0

1540.0
1617.0

c. 5% investment growth rate; no immediate expense


Price-to-book ratio = 7.31
Foreword P/E = 36.53
Year 0
Sales
From investments in Year 1
From investments in Year 2
From investments in Year 3
From investments in Year 4

Operating expenses (depreciation)


From investments in Year 1
From investments in Year 2
From investments in Year 3
From investments in Year 4
From investments in Year 5
0.0
Operating income
Net Operating Asset (NOA)
From investments in Year 1
From investments in Year 2
From investments in Year 3

1540.0

3157.0

1100.0

1100.0
1155.0

1617.0
1697.9
3314.9

1155.0
1212.8

Year 4

1697.9
1782.7
3480.6

1212.8
1273.4

1100.0

2255.0

2367.8

2486.1

440.0

902.0

947.1

994.5

2200.0

1100.0
2310.0

1155.0
2425.5

1212.8

From investments in Year 4


From investments in Year 5

Investment
Free cash flow

2546.8
2200.0

3410.0

3580.5

3759.5

1273.4
2674.1
3947.5

2200.0
(2,200.0)

2310.0
(770.0)

2425.5
731.5

2546.8
768.1

2674.1
806.5

20.0
28.6
0.7
55.0
242.0
N/A

26.5
28.6
0.9
5.0
595.1
145.9
89.3
353.1
N/A

26.5
28.6
0.9
5.0
624.9
5.0
12.3
29.8
-91.6

26.5
28.6
0.9
5.0
656.1
5.0
12.3
31.2
5.0

18287.5
14877.5
5.36
39.8
20.3
9%

19201.9
15621.4
5.36
22.1
20.3
9%

RNOA (%)
Profit margin (%)
Asset turnover
Growth in NOA (%)
ReOI
Growth in ReOI (%)
Growth in cum-dividend OI (%)
AOIG (0.10)
Growth in AOIG (%)
Value of firm
Premium over book value
P/B
Trailing P/E
Forward P/E
Equity Return

16071.1
7.31
36.53

20162.0 21170.1
16402.4 17222.6
5.36
5.36
22.1
22.1
20.3
20.3
9%
9%

c. 5% investment growth rate; 20% immediate expense

Price-to-book ratio = 9.13


Foreword P/E = 81.17
Year 0
Sales
From investments in Year 1
From investments in Year 2
From investments in Year 3
From investments in Year 4

Operating expenses (depreciation)


From investments in Year 1
From investments in Year 2
From investments in Year 3
From investments in Year 4
From investments in Year 5

440.0

440.0

Year 1

Year 2

1540.0

1540.0
1617.0

1540.0

3157.0

880.0
462.0

880.0
924.0
485.1

1342.0

197

2289.1

Year 3

1617.0
1697.9
3314.9

924.0
970.2
509.4
2403.6

Year 4

1697.9
1782.7
3480.6

970.2
1018.7
534.8
2523.7

Operating income
Net Operating Asset (NOA)
From investments in Year 1
From investments in Year 2
From investments in Year 3
From investments in Year 4
From investments in Year 5

Investment
Free cash flow

(440.0)

1760.0

880.0
1848.0

867.9

924.0
1940.4

911.3

970.2
2037.4

956.9

1760.0

2728.0

2864.4

3007.6

1018.7
2139.3
3158.0

2200.0
(2,200.0)

2310.0
(770.0)

2425.5
731.5

2546.8
768.1

2674.1
806.5

11.3
12.9
0.9
55.0
39.6
N/A

31.8
27.5
1.2
5.0
622.4
1471.7
303.3
582.8
N/A

31.8
27.5
1.2
5.0
653.5
5.0
12.6
31.1
-94.7

31.8
27.5
1.2
5.0
686.2
5.0
12.6
32.7
5.0

18287.5
15559.5
6.70
88.5
21.1
9%

19201.9
16337.5
6.70
23.0
21.1
9%

RNOA (%)
Profit margin (%)
Asset turnover
Growth in NOA (%)
ReOI
Growth in ReOI (%)
Growth in cum-dividend OI (%)
AOIG (0.10)
Growth in AOIG (%)
Value of firm
Premium over book value
P/B
Trailing P/E
Forward P/E
Equity Return

198.0

16071.1
9.13
81.17

20162.0 21170.1
17154.3 18012.1
6.70
6.70
23.0
23.0
21.1
21.1
9%
9%

Applications
E17.4. Inventory Accounting, P/B, and P/E Ratios: Ford Motor Company

(a)

The LIFO reserve is the amount by which cumulative FIFO profits would have been

greater than LIFO profits. But that difference would attract taxes, so shareholders equity would
be higher by the amount of the LIFO reserve, after tax. The LIFO reserve is the amount by which
inventories would be higher under FIFO than LIFO, but the extra taxes payable would also be
recognized, to net to the effect on shareholders equity.
1999 Shareholders Equity (FIFO) = $27.537 billion + 1.1(1 - 0.36)
= $28.241 billion
1998 Shareholders Equity (FIFO) = $23.409 billion + 1.2(1 0.36)
= $24.177 billion
(b)

FIFO Earnings

= LIFO Earnings + Change in LIFO Reserve (after tax)


= $7.237 (0.1 0.64)

= $7.173 billion
(There was a liquidation of the LIFO reserve).
1999 ROCE (FIFO)

= 7.173/24.177
= 29.67%

(c)

Market value of equity = $53 1.21 billion shares


= $64.13 billion

P/B (LIFO)

64.13
27.537
= 2.33

P/B (FIFO)

64.13
28.241

199

= 2.27
P/B (LIFO) is higher than P/B (FIFO) because book value is lower with LIFO.
(d)

P/E (LIFO)

64.13
7.237
= 8.86

P/E (FIFO)

64.13
7.173
= 8.94

(Dividends are ignored in these calculations.)


P/E (LIFO) is lower than P/E (FIFO) because earnings are higher under LIFO due to the
inventory liquidation. Typically, however, LIFO P/E ratios are higher than FIFO P/E ratios
because, with inventory growth rather than liquidation, LIFO earnings are lower than FIFO
earnings.

E17.5.

The Accounting for Research and Development and Economic Profit Measures

(a)
2008
Sales
Operating expenses (80%)
OI before R&D
R&D expense
Operating income
Net operating assets

80

RNOA
ReOI (10%)

2009

2010

2011

2012

2013

2014

160
128
32
100
(68)

320
256
64
100
(36)

480
384
96
100
(4)

640
512
128
100
28

800
640
160
100
60

800
640
160
100
60

80

80

80

80

80

80

35.0%
20

75.0%
52

75.0%
52

-85.0%
(76)

-45.0%
(44)

-5.0%
(12)

(b)
OI before R&D
Amortization
Operating income
Net operating assets
RNOA
ReOI (10%)

180

32
20
12

64
40
24

96
60
36

128
80
48

160
100
60

160
100
60

260

320

360

380

380

380

6.6%
(6)

9.2%
(2)

11.25%
4

13.3%
12

15.8%
22

15.8%
22

201

(c)

The RNOA and ReOI are different because of the treatment of R&D

expenditures. Expensing initially gives lower RNOA and ReOI, but higher RNOA and
ReOI subsequently.

(d)
RNOA2015 with expensing = 75.0%
RNOA2015 with capitalizing = 15.8%
ReOI2015 with expensing = $52 million
ReOI2015 with capitalizing = $22 million
(The firm is in steady-state.)

The forecasts differ because of the relative conservative accounting: expensing yields
higher RNOA and ReOI.

(e)

With expensing:
V0NOA = 80 +

(76) + (44)

1.10 1.10

= $334 million

(12)
1.10

20
52
4
+
/ 1.10
4
1.10 0.10

With capitalization:
V0NOA = 180 +

(6)

(2)

1.10 1.10

(4)
1.10

12
22
4
+
/ 1.10
4
1.10 0.10

= $334 million

The valuations are the same: the accounting does not matter once
steady-state is forecasted.
(f)

In both cases, the full valuation would not be captured because 2011 is

prior to steady-state.

203

E17.6. Depreciation Methods, Profitability, and Valuation


(a)

Pro forma with three-year estimated life


Revenues
Depreciation
Other Expenses (70%)
Operating Income

2009
-----

2010
250
200
175
(125)

2011
1,530
433
1,071
(26)

2012
3,540
700
2,478
362

2013
4,295
800
3,007
488

2014
4,305
900
3,014
391

2015
4,410
967
3,087
356

2016
4,500
1,000
3,150
350

2017
4,500
1,000
3,150
350

Net Operating Assets


Investment
RNOA

600
600
--

1,100
700
-20.8%

1,467
800
-2.4%

1,666
900
-24.7%

1,866
1,000
29.3%

1,967
1,000
21.0%

2,000
1,000
18.1%

2,000
1,000
17.5%

2,000
1,000
17.5%

Pro forma with five-year estimated life


Revenues
Depreciation
Other expenses (70%)
Operating income
Net operating assets
Investment
RNOA

2009
----600
600
--

2010
250
120
175
(45)
1,180
700
-7.5%

2011
1,530
260
1,071
199
1,720
800
16.9%

2012
3,540
420
2,478
642
2,200
900
37.3%

2013
4,295
600
3,007
688
2,600
1,000
31.3%

2014
4,305
800
3,014
491
2,800
1,000
18.9%

2015
4,410
880
3,087
443
2,920
1,000
15.8%

2016
4,500
940
3,150
410
2,980
1,000
14.0%

2017
4,500
980
3,150
370
3,000
1,000
12.4%

2018
4,500
1,000
3,150
350
3,000
1,000
11.7%

2019
4,500
1,000
3,150
350
3,000
1,000
11.7%

(b)
Depreciation over five years yields higher operating income in 2013: for the same
revenues and other expenses, depreciation expense is lower. And depreciation over five
years yields a higher RNOA in 2013 (31.3% compared with 29.3%). Even though net
operating assets are higher with five-year estimated lives, the numerator effect dominates
the denominator effect (prior to steady state). Note, however, that these RNOA are not a
good forecast of the relative RNOA once steady state is realized: steady-state RNOA
with three-year estimated lives is 17.5% compare to 11.7% with five-year estimated lives.

205

(c)
Three-year estimated life
2013
ReOI
PV of ReOI to 2015
150

= 1,500
0.10

PV of continuing value
Net operating assets
Value at 2013

2014
204

2015
159

2016
150

2017
150

2018
150

2019
150

2014
231

2015
163

2016
118

2017
72

2018
50

2019
50

317
1,240
1,866
3,423

Five-year estimated life


2013
ReOI (10%)
PV of ReOI to 2017
50

= 500
0.10

PV of continuing value
Net operating assets
Value at 2013

482
341
2,600
3,423

(d)
Good analysis would find that the RNOA in 2013 is not indicative of the long-run RNOA for this firm (see part (b)). But
maybe the market does not see this. If an investment banker were pricing the IPO on the basis of multiples of earnings from
comparison firms, and did not adjust for depreciation methods, she might price the earnings with five-year lives higher for the IPO.
Would the market penetrate this illusion?

(e)
In 2018, profit is the same for both depreciation methods (and so, of course, is the value of the firm). However, RNOA is
higher with three-year life depreciation. Would the market interpret this higher profitability (incorrectly) as requiring a higher price? If
the officers of the firm believed that the market could be "fooled," they might choose the three-year method to get a higher price for
the shares obtained from exercise of the options. Shareholders beware!

207

E17.7.
(a)

The Quality of Free Cash Flow and Residual Operating Income: Coca-Cola Company

Economic profit is similar to residual operating income (ReOI). To see the difference between free cash flow and ReOI, see
how they are calculated:
ReOIt = OIt (cost of capital NOAt - 1)
Free cash flowt = OI NOAt
So ReOI and free cash flow are the same if net operating assets grow at the cost of capital. In 1995, the two methods were
approximately the same and total capital grew at approximately the 9% rate used to calculate economic profit.
The growth in the two measures are compared as follows:
Growth in ReOIt =

OI t (cos t of capital NOA t 1 )


OI t 1 (cost of capital NOA t 2 )

Growth in free cash flowt =

OI t t
t 1 t 1

So the growth rates are the same if net operating assets grow at the cost of capital consistently.

208

(b)
Both methods would work with Coke.
E17.8. Research and Development Expenditures and Valuation

The pro forma for the firm is as follows:

Sales
R&D
Other expenses (80%)
Operating income
Net operating assets
ReOI (10%)
PV of RE
Total PV to Yr. 5
105
Continuing value
1.10 1.05

PV of CV
Value of firm

1,000
350
800
(150)

1,500
350
1,200
(50)

2,000
350
1,600
50

2,500
350
2,000
150

3,000
350
2,400
250

3,500
350
2,800
350

3,675
368
2,940
367

3,859
386
3,087
386

714

1,429

1,786

2,143

2,500

2,625

2,756

(121)
(110)

(93)
(77)

(29)
(22)

36
25

100
62

105

(122)
2,100
1,304
1,896

(a)
Value of the firm is $1,896 million

209

110

(b)
Earnings for years 1 to 3 are of low quality because they dont forecast long-run earnings. The low quality is due to the
expensing of R&D expenditures.

(c)

R&D-to-sales

23.3%

17.5%

14.0%

11.7%

10.0%

10.0%

10.0%

The ratio settles down to a steady-state of 10% from year 5 onwards. Prior to that the ratio is higher, indicating that the sales from
R&D have not yet been realized.

210

E17.9. The Quality of Forecasted Residual Operating Income and Free Cash Flow

(a)
The pro forma is as follows:
2012
Sales
Depreciation
Operating income
Net operating assets

400

RNOA
ReOI (10%)

2013

2014

2015

2016

2017

240
200
40

484
420
64

530
460
70

576
500
76

622
540
82

640

700

760

820

880

10%
0

10%
0

10%
0

10%
0

10%
0

Value of firm is book value = $400 (Zero ReOI is forecasted).


(b)
2013
Free cash flow:
Operating income
NOA
Free cash flow
Growth in free cash flow

2014

40
240
(200)

211

2015

2016

2017

64
60
4

70
60
10

76
60
16

82
60
22

150%

60%

38%

Free cash flow is low in years 2013 and 2014 but grows after that. However, the
growth rate in free cash flow is not constant, making the firm hard to value with a
(constant growth) continuing value. For discounted cash flow analysis, the forecast
horizon has to be extended to a point where the growth rate converges to its long-term
rate. As free cash flow forecasting requires a long forecast horizon, it can be said to be of
low quality.