1、Equity Analysis and Valuation12CHAPTERMcGraw-Hill/Irwin 2004 The McGraw-Hill Companies,Inc.,All Rights Reserved.Earnings PersistenceEarnings PersistenceRecasting and Adjusting Earnings persistence is a key to effective equity analysis and valuation Analyzing earnings persistence is a main analysis o
2、bjective Attributes of earnings persistence include:StabilityPredictabilityVariabilityTrendEarnings managementAccounting methodsEarnings PersistenceEarnings PersistenceRecasting and AdjustingTwo common methods to help assess earnings persistence:Recasting of income statement Adjusting of income stat
3、ementEarnings PersistenceEarnings PersistenceRecasting and AdjustingInformation for Recasting and Adjusting Income statement,including its subdivisions:Income from continuing operationsIncome from discontinued operationsExtraordinary gains and lossesCumulative effect of changes in accounting princip
4、les Other financial statements and notes Management commentary in financial statements Managements Discussion and Analysis Other:product mix changes,technological innovations,work stoppages,and raw material constraintsEarnings PersistenceEarnings PersistenceRecasting and AdjustingObjectives of Recas
5、ting1.Recast earnings and earnings components so that stable,normal and continuing elements comprising earnings are distinguished and separately analyzed from random,erratic,unusual and nonrecurring elements2.Recast elements included in current earnings that should more properly be included in the o
6、perating results of one or more prior periodsRecasting and adjusting earnings also aids in determining earning powerGeneral Recasting Procedures Income statements of several years(typically at least five)are recast Recast earnings components to yield meaningful classifications and a relevant format
7、for analysis Components can be rearranged,subdivided,and tax effected Total recasted components must reconcile to reported net incomeEarnings PersistenceEarnings PersistenceRecasting and AdjustingSpecific Recasting Procedures Discretionary expenses are segregated Distinct components are segregated(s
8、uch as equity in income of unconsolidated subsidiaries)and often reported net of tax When components of continuing income are separately reclassified,their pre-tax amounts along with their tax effectsmust be removed Income tax disclosures enable one to separate factors that either reduce or increase
9、 taxes such as:Deductionstax credits,capital gains rates,tax-free income,lower foreign tax rates Additionsadditional foreign taxes,non-tax-deductible expenses,and state and local taxes(net of federal tax benefit)Earnings PersistenceEarnings PersistenceRecasting and AdjustingRecasting and Adjusting-I
10、llustrationEarning PersistenceEarning PersistenceCampbell Soup CompanyRecast Income Statements($mil.)ItemYear 11Year 10Year 9Year 8Year 7Year 613Net sales$6,204.1$6,205.8$5,672.1$4,868.9$4,490.4$4,286.819Interest income 26.0 17.6 38.3 33.2 29.5 27.4Total revenue$6,230.1$6,223.4$5,710.4$4,902.1$4,519
11、.9$4,314.2Costs and expenses:Cost of products sold(see Note 1 below)$3,727.1$3,893.5$3,651.8$3,077.8$2,897.8$2,820.5 Marketing and selling expenses(see Note 2 below)760.8760.1605.9514.2422.7363.0145 Advertising(see Note 2 below)195.4220.4212.9219.1203.5181.4144 Repairs and maintenance(see Note 1 bel
12、ow)173.9180.6173.9155.6148.8144.016 Administrative expenses306.7290.7252.1232.6213.9195.917 Research and development expenses56.353.747.746.944.842.2102 Stock pricerelated incentive programs(see Note 3 below)15.4(0.1)17.4(2.7)8.520 Foreign exchange adjustment0.83.319.316.64.80.7104 Other,net(see Not
13、e 3 below)(3.3)(2.0)(1.4)(4.7)(0.4)(9.0)162A Depreciation(see Note 1 below)194.5184.1175.9162.0139.0120.8103 Amortization of intangible and other assets(see Note 3 below)14.116.816.48.95.66.018 Interest expense116.2111.694.153.951.756.0 Total costs and expenses$5,557.9$5,712.7$5,266.0$4,480.2$4,132.
14、2$3,930.023Earnings before equity in earnings of affiliates&min.interests$672.2$510.7$444.4$421.9$387.7$384.224Equity in earnings of affiliates2.413.510.46.315.14.325Minority interests(7.2)(5.7)(5.3)(6.3)(4.7)(3.9)26Income before taxes$667.4$518.5$449.5$421.9$398.1$384.6Income taxes at statutory rat
15、e*(226.9)(176.3)(152.8)(143.5)(179.1)(176.9)Income from continuing operations$440.5$342.2$296.7$278.4$219.0$207.7135State taxes(net of federal tax benefit)(20.0)(6.6)(3.8)(11.8)(8.6)(8.0)Investment tax credit4.411.6137Nondeductible amortization of intangibles(4.0)(1.6)(1.2)(2.6)(1.4)138Foreign earni
16、ngs not taxed or taxed at other than statutory rate2.0(2.2)(0.2)3.211.115.2139Other:Tax effects(17.0)(2.2)(0.1)(3.7)7.5(4.7)Alaska Native Corporation transaction4.522Divestitures,restructuring and unusual charges(339.1)(343.0)(40.6)Tax effect of divest.,restructuring&unusual charges(Note 4)13.964.71
17、3.9(Continued on next page)Recasting and Adjusting-IllustrationEarning PersistenceEarning PersistenceCampbell Soup CompanyRecast Income Statements($mil.)ItemYear 11Year 10Year 9Year 8Year 7Year 6Gain on sale of businesses in(Yr 8)and sub.in Yr 73.19.7Loss on sale of exercise equipment subsidiary,net
18、 of tax(1.7)LIFO liquidation gain(see Note 1 below)1.72.81.4Income before cumulative effect of accounting change$401.5$4.4$13.1$241.6$247.3$223.2153ACumulative effect of accounting change for income taxes 32.528Net income as reported$401.5$4.4$13.1$274.1$247.3$223.214(Note 1)Cost of products sold$4,
19、095.5$4,258.2$4,001.6$3,392.8$3,180.5$3,082.8144Less:Repair and maintenance expenses(173.9)(180.6)(173.9)(155.6)(148.8)(144.0)162ALess:Depreciation(a)(194.5)(184.1)(175.9)(162.0)(139.0)(120.0)153APlus:LIFO liquidation gain(b)2.65.12.6$3,727.1$3,893.5$3,651.8$3,077.8$2,897.8$2,821.415(Note 2)Marketin
20、g and selling expenses$956.2$980.5$818.8$733.3$626.2$544.4145Less:Advertising(195.4)(20.4)(212.9)(219.1)(203.5)(181.4)$760.8$960.1$605.9$514.2$422.7$363.021(Note 3)Other expenses(income)$26.2$14.7$32.4$(3.2)$(9.5)$5.5102Less:Stock pricerelated incentive programs(15.4)0.1(17.4)2.7(8.5)103Less:Amortiz
21、ation of intangible and other assets(14.1)(16.8)(16.4)(8.9)(5.6)(6.0)Less:Gain on sale of businesses(Yr 8)and sub.(Yr 7)4.7 14.7104Other,net$(3.3)$(2.0)$(1.4)$(4.7)$(0.4)$(9.0)(Note 4)Tax effect of divest,restruc.,&unusual charges$115.3(c)$116.6(d)$13.9136Nondeductible divestitures,restructuring,and
22、 unusual charges(101.4)(e)(51.9)(f)$13.9$64.7$13.9 *Statutory federal tax rate is 34%in Year 8 through Year 11,45%in Year 7,and 46%in Year 6.This amount is not disclosed for Year 6.(a)We assume most depreciation is included in cost of products sold.(b)LIFO liquidation gain before tax.For example,for
23、 Year 8 this is$2.58 million,computed as$1.7/(1 0.34).(c)$339.1 22 0.34=$115.3.(d)$343.0 22 0.34=$116.6(e)$179.4 26 0.565 136=$101.4.(f)$106.5 26 0.487 136=$51.9.Earnings PersistenceEarnings PersistenceRecasting and Adjusting-IllustrationObjective of AdjustingAssign earnings components to periods wh
24、ere they most properly belongNote:Uses data from recast income statements and any other relevant informationGeneral Adjusting ProceduresAll earnings components must be consideredWhen a component is excluded from the period when reported,then1.Shift it(net of tax)to the operating results of one or mo
25、re prior periods,or2.Spread(average)it over earnings for the period under analysisNote:Only spread items over prior earnings when they cannot be identified with specific periodsEarnings PersistenceEarnings PersistenceRecasting and AdjustingSpecific(Typical)Adjusting Procedures Assign extraordinary a
26、nd unusual items(net of tax)to applicable years Tax benefit of carryforwards normally moved to the loss year Costs or benefits from lawsuit settlements moved to relevant prior years Gains and losses from disposals of discontinued operations usually relate to operating results of several prior years
27、Changes in accounting principles or estimates yield adjustments to all years under analysis to a comparable basisredistribute“cumulative effect”to the relevant prior years Normally include items that increase or decrease equityEarnings PersistenceEarnings PersistenceRecasting and AdjustingEarnings P
28、ersistenceEarnings PersistenceRecasting and AdjustingCampbell Soup CompanyAdjusted Income Statements($mil.)Year 11Year 10Year 9Year 8Year 7Year 6TotalNet income as reported$401.5$4.4$13.1$274.1$247.3$223.2$1,163.6Divestitures,restructuring&unusual charges 339.1343.040.6Tax effect of divestitures,res
29、tructuring,etc.(13.9)(64.7)(13.9)Gain on sale of businesses(Yr 8)and sale of subsidiary(Yr 7),net of tax(3.1)(9.7)Loss on sale of exercise equipment subsidiary1.7ANC transaction(4.5)LIFO liquidation gain(1.7)(2.8)(1.4)Cumulative effect of change in acctg for taxes(32.5)Adjusted net income$401.5$329.
30、6$291.4$263.5$232.0$221.8Total net income for the period$1,739.8Average earnings for the period$289.97Earnings PersistenceEarnings PersistenceDeterminants of PersistenceEarnings persistence determined by many factors including:Earnings variabilityEarnings trendEarnings stabilityEarnings predictabili
31、tyEarnings ManagementManagement IncentivesNote:Assess earnings persistence over both the business cycle and the long termEarnings PersistenceEarnings PersistenceMeasuring PersistenceEarnings variability can be measured:1.Standard variability measures2.Average earnings-typically using 5 to 10 years o
32、f data3.Minimum earnings-typically selected from the most recent business cycle,reflecting a worst-case scenarioEarnings PersistenceEarnings PersistenceMeasuring PersistenceEarnings Trend can be measured:1.Statistical methods2.Trend statements(such as Index numbers)Earnings PersistenceEarnings Persi
33、stenceMeasuring PersistenceEarnings Management is reflected as follows:Changes in accounting methods or assumptions Offsetting extraordinary/unusual gains and losses Big baths Write-downs Timing revenue and expense recognition Aggressive accounting applicationsEarnings PersistenceEarnings Persistenc
34、eMeasuring PersistenceManagement Incentives affecting persistence include:Personal objectives and interests Companies in distress Prosperous companiespreserving hard earned reputations Compensation plans Accounting-based incentives and constraints Analysts targetsEarnings PersistenceEarnings Persist
35、enceMeasuring PersistenceEarnings persistence ofcomponents depends on key attributesRecurring vs Non-recurringOperating vs Non-operatingKey application of theseattributes is the reporting ofExtraordinary vs Non-extraordinaryEarnings PersistenceEarnings PersistenceMeasuring PersistenceAnalyzing and I
36、nterpreting Extraordinary Items1.Determine whether an item is extraordinary(less persistent)or not2.Assessing whether an item is unusual,non-operating,or non-recurring 3.Determine adjustmentsnecessary given assessment of persistenceThree broad categories:1.Nonrecurring operating gains and losses-Usu
37、ally include in current operatingincome2.Recurring non-operating gains and losses-Consider inclusion in current operating earnings3.Nonrecurring non-operating gains and losses-Omitted from operating earnings of a single yearEarning PersistenceEarning PersistenceMeasuring PersistenceEquity value(Vt)B
38、ook value(BVt)Residual Income(RIt=Net income k*BVt-1)Cost of equity capital(k)Earning-Based ValuationEarning-Based ValuationStock Prices and Accounting DataEarning-Based ValuationEarning-Based ValuationValuation MultiplesPrice-to-Book(PB)equity of value Bookequity of valueMarket Earning-Based Valuat
39、ionEarning-Based ValuationValuation MultiplesPrice-to-Book(PB)expressed in accounting data NoteROCE and growth in book value increase PB increasesCost(risk)of equity capital increases PB decreasesPresent value of future abnormal earnings is positive(negative)PB is greater(less)than 1.0 .tttttttttBVB
40、VkkROCEBVBVkkROCEkkROCEBVV23312211111Earning-Based ValuationEarning-Based ValuationValuation MultiplesPrice-to-Earnings(PE)incomeNet equity of valueMarket Earning-Based ValuationEarning-Based ValuationValuation MultiplesPrice-to-Earnings(PE)expressed in accounting data Where k is the cost of equity
41、capital,STG(LTG)is the expected short-term(long-term)%change in eps relative to expected“normal”growth(STGLTG and LTGk)The PE is inversely related to k The PE is positively related to the expected growth in eps relative to normal growth.LTGkLTGSTGkepsPtt1If LTG=0(long-term growth in eps relative to“
42、normal”growth is expected to remain constant)This yields the popular PEG ratio.Example:If PE=20 and k=10%,proponents of this screening device recommend stock purchase(sale)if the expected eps growth is greater(less)than 20%.Earning-Based ValuationEarning-Based ValuationValuation Multiples-PEG Ratio
43、2kSTGepsPttEarning-Based ValuationEarning-Based ValuationEarnings-Based Valuation-IllustrationChristy Co.book value of equity at January 1,Year 1,is$50,000Christy has a 15%cost of equity capital(k)Forecasts of Christys accounting data follow:Year 1 Year 2 Year 3 Year 4 Year 5Sales$100,000$113,000$12
44、7,690$144,290$144,290Operating expenses77,50090,000103,500118,000119,040Depreciation10,00011,30012,77014,43014,430Net income$12,500$11,700$11,420$11,860$10,820Dividends6,0004,3553,12011,86010,820Year 6 and beyond=Both accounting data and dividends approximate Year 5 levelsEarning-Based ValuationEarn
45、ing-Based ValuationEarnings-Based Valuation-IllustrationChristys forecasted book value at January 1,Year 1 is$58,594computed as:This implies Christy stock should sell at a PB ratio of 1.17($58,594/$50,000)at January 1,Year 1.015.1451,72)15.015(0.15.1451,72)15.01644(0.15.1845,63)15.01789(0.15.1500,56
46、)15.02071(0.15.1000,50)15.025(0.000,50594,58$5432Earning-Based ValuationEarning-Based ValuationEarnings-Based Valuation-IllustrationTwo additional observations are important.1.Expected ROCE equals 15%(Christys cost of capital)for Year 5 and beyond.Since ROCE equals the cost of capital for Year 5 and
47、 beyond,these years results do not change the value of Christy(that is,abnormal earnings equal zero for those years).The anticipated effects of competition are implicit in estimates of future profitability.2.Valuation estimates assume dividend payments occur at the end of each year.A more realistic
48、assumption is that,on average,these cash outflows occur midway through the year.To adjust valuation estimates for mid-year discounting,multiply the present value of future abnormal earnings by(1 k/2).For Christine Company the adjusted valuation estimate equals$59,239.This is computed as$50,000 plus(
49、1 1.15/2)3$8,594.Earning Power and ForecastingEarning Power and ForecastingEarning PowerEarning power is the earnings level expected to persist into the foreseeable future Accounting-based valuation models capitalize earning power Many financial analyses directed at determining earning powerEarning
50、Power and ForecastingEarning Power and ForecastingEarning PowerMeasurement of Earning Power reflects:Earnings and all its components Stability and persistence of earnings and its components Sustainable trends in earnings and its componentsEarning Power and ForecastingEarning Power and ForecastingEar
