Penman - Financial Statement Analysis and Secur

Contents
Contento; xvii
Valuation Models for Terminal Investments 90

Valuation ModelsforGoing-Concern
Investments 92
Criteria for a Practical Valuation Model 92
What Generates ifllue? 93
Valuation Models andAssetPricing Models 97
List of Cases xxiii

List of Accounting Clinics xxiv
Chapter1
Introduction to Investing and Valuation 2
Investment Styles andFundamental Analysis 3
Bubble, Bubble 6
How Bubbles Work 7
Analysts During the Bubble 8
Fundamental Analysis Anchors Investors 8
TheSetting: Investors, Firms, Securities, and

Capital Markets 8
TheBusiness ofAnalysis: TheProfessional
Analyst 12
Investing in Firms: TheOutside Analyst 12
Investing within Firms: TheInside Analyst 13
The Analysis ofBusiness 14

Strategy andValuation 14
Mastering (heDetails 15
TheKeyQuestion: Sustainability a/Competitive
Advantage 17
Financial Statements: The Lenson the
Business 17
Choosing a Valuation Technology
[7
Guiding Principles 18
Anchoring Palue in theFinancial Statements 20
How to UseThisBook 21
An Outline of theBook 21
TheWeb Connection 22
Key Concepts 22
A Continuing Case: Kimberly-Clark Corporation 23
Concept Questions 27
Exercises 29
Minicase 31
Chapter2
Introductionto the Financial
Statements 32
TheAnalyst's Checklist 33
TheForm of theFinancial Statements 33
TheBalance Sheet 34
TheIncome Statement 34
xvl
TheCash Flow Statement 38

The Statement ofStockholders .Equiry 39
The Footnotes andSupplementary Information
to Financial Statements 40
TheArticulation a/the Financial Statements:
How the Statements Tell a Story 40
Measurement in theFinancial Statements 41

ThePrice-to-Book Ratio 42
Measurement in theBalance Sheet 44
Measurement in theIncome Statement 44
ThePrice-Earnings Ratio 49
TheReliability Criterion: Doni Mix
What You Know withSpeculation 49
Tension inAccounting 51
Summary 52
KeyConcepts 53
TheAnalyst's Toolkit 54
A Continuing Case: Kimbeny-Ctark Corporation 55
Exercises 61
Minicase 66
PART ONE
FINANCIAL STATEMENTS
AND VALUATION 72
Chapter3
HowFinancialStatements Are
Used inValnation 74
Multiple Analysis 76
TheMethod o/Comparables 76
Screening onMultiples 79
Asset-Based Valuation 82
Fundamental Analysis 84
TheProcess ofFundamental Analysis 85
Financial Statement Analysis, ProFonna
Analysis, andFundamental Analysis 86
TheArchitecture of Fundamental Analysis:

TheValuation Model 88
Terminal Investments and Going-Concern
Investments 89
Summary 97
Key Concepts 98
AContinuing Case: Kimberly-Clark
Corporation 100
Exercises 101
Minicases 105
Appendix TheRequired Return andAssetPricing
Models 110
Chapter4
CashAccounting, AccrualAccounting, and
Disconnted Cash Flow Vaination 114
TheDividend Discount Model 116
TheDiscounted Cash Flow Model 118
Free Cash Flowand Value Added 121
Simple Valuation Models 123

TheStatement of Cash Flows 124
TheCash FlowStatement underIFRS 126
Forecasting Free Cash Flows 127
Cash Flow, Earnings, andAccrual Accounting
128
Earnings andCash Flows 128

Accruals, Investments, andtheBalance
Sheet 132
Summary 135
Key Concepts 136
AContinuing Case: Kimberly-ClarkCorporation 137
Exercises 139
Minicases 144
Chapter5
AccrualAccounting and Valuation:
PricingBookValues 148
TheConcept Behind thePrice-to-Book Ratio 149
Beware of Paying Too Much for Earnings 150
Prototype Valuations
150
Valuing a Project 150

Valuing a Savings Account 151
TheNormal Price-to-Book Ratio 152
A Model forAnchoring Value on BookValue 153

Residual Earnings Drivers and value
Creation 156
A Simple Demonstration anda Simple
valuation Model 158
Applying the Model to Equities 160

TheForecast Horizon andthe Continuing Value
Calculation 161
Target Prices 164
Converting Analysts'Forecasts
to a Valuation 165
Applying theModel to Projects and

Strategies 166
Features of theResidual Earnings
Model 168
BookValue Captures Value andResidual
Earnings Captures Value Addedto
BookValue 169
Protectionfrom Paying Too Much for Earnings
Generated byInvestment 170
Protectionfrom Paying Too Much for Earnings
Created by theAccounting 171
Capturing Value Nolan theBalance SheetforAllAccounting Methods 172
Residual EarningsAre NotAffected by
Dividends, Share Issues, orShare
Repurchases 172
What theResidual Earnings Model Misses 173
Reverse Engineering theModel forActive

Investing 173
Reverse Engineering theS&P500 176
Using Analysts'Forecasts in Reverse
Engineering 176
Implied Earnings Forecasts andEarnings
Growth Rates 177
Separating Speculation from What We Know: Value

Building Blocks 177
TheWeb Connection ISO
Summary 180
KeyConcepts 18i
AContinuing Case: KimberlyClark Corporation IS2
Concept Questions IS3
Exercises 183
Minicases 189
Content;
xvlii COnlcr.:.>
Chapter 6
AccrualAccounting andValuation: Pricing
Earnings 192
TheConcept Behind the Price-Earnings Ratio
193
Beware ofPaying Too Much for Earnings

Growth 194
From Price-to-Beck: Valuation to PIE
Valuation 194
Prototype Valuation 195

TheNormal Forward PIERatio 197
TheNormal Trailing PIERatio 198
A poorPIEModel 199
A Model forAnchoring Value on Earnings 199

Measuring Abnormal Earnings Growth 201
A Simple Demonstration and a Simple
Valuation Model 202
Anchoring Valuation on Current Earnings 203
Applying theModel to Equities 204

Converting Analysts'Forecasts to
a Valuation 205
Features oftheAbnormal Earnings Growth Model 206

BuyEarnings 207
Abnormal Earnings Growth Valuation and
Residual Earnings Valuation 207
Abnormal Earnings Growth Is NotAffected by
Dividends, Share Issues, or Share
Repurchases 209
Accounting Methods andValuation 209
Reverse Engineering theModel for

Active Investing 211
Reverse Engineering theS&P500 212
Using Analysts'Forecasts in Reverse
Engineering 212
Implied Earnings Forecasts andEarning
Growth Rates 213
Separating Speculation fromWhatWe Know: Value

Building Blocks 213
PIE Screening 214
Screening on Earnings Yield 214
Screening on PEGRatios 216
Summary 217
KeyConcepts 218
Exercises 220
Minicases 226
Handling DilutedEarnings per Share 270

Share Transactions in Inefficien1r,.Markets 272
PART TWO
THEA..'lALYSIS OF FINANCIAL
STATEMENTS 230
Chapter 7
Viewing the Bnsiness Throngh the Financial
Statements 232
Business Activities: TheCash Flows 234
TheReformulated Cash FlowStatement 238
TheReformulated Balance Sheet 239
TheEyeof the Shareholder 274

Accounting Quality Watch 275
Summary 276
KeyConcepts 276
Exercises 279
Minicase 285
Business Activities: AllStocks andFlows 240

The Reformulated IncomeStatemenl 241
Accounting Relations thatGovern Reformulated

Statements 241
TheSources of Free Cash Flowand
theDisposition ofFree Cash Flow 242
TheDrivers of Dividends 242
TheDrivers a/Net Operating AssetsandNet
Indebtedness 243
Tying It Together forShareholders:

WhatGenerates Value? 244
Stocks andFlows Ratios: Business Profitability 246
Summary 248
Key Concepts 249
AContinuing Case: Kimberly-Clark Corporation 250
Exercises 252
Chapter 8
TheAnalysis of the Statement of
Shareholders' Eqnity 256
Reformulating theStatement of Owners' Equity 257
Introducing Hike 258
Refonnulation Procedures 258
Dirty-Surplus Accounting 262

Comprehensive Income Reporting WIder
GMP andlFRS 263
u.s.
Ratio Analysis 264

Payout andRetention Ratios 264
Shareholder Profitability 265
Growth Ratios 265
Hidden DirtySurplus 266

IssueofShares in Operations 266
Issuea/Sharesin Financing Activities 270
Chapter 9
The Analysis of the BalanceSheetand
IncomeStatement 290
Reformulation of theBalance Sheet 291
Issuesin Refonnulating Balance Sheets 292
Strategic Balance Sheets 299
Reformulation of the Income Statement 301

Tax Allocation 302
Issues in Reformulating Income Statements 306
Value AddedtoStrategic Balance Sheets 309
Comparative Analysis of theBalance Sheet

and Income Statement 312
Common-Size Analysis 312
TrendAnalysis 314
Ratio Analysis 316

Summary 318
KeyConcepts 320
AContinuing Case: Kimberly-Clark
Corporation 322
Exercises 323
Minicases 332
Chapter 10
TheAnalysis oftheCashFlowStatement 340
TheCalculation of FreeCashFlow 341
GAAP Statement of CashFlows andReformulated
CashFlow Statements 343
Reclassifying Cash Transactions 344
Tying It Together 349
Cash Flow from Operations 350
xix
Summary 353
KeyConcepts 354
A Continuing Case: Kimberly-ClarkCorporation 354
Exercises 355
Minicase 360
Chapter 11
TheAnalysis of Profitability 362
TheAnalysis ofRetum on Common Equity 363
First-Level Breakdown: Distinguishing Financing
andOperating Activities andtheEffect of
Leverage 364
Financial Leverage 364
Operating Liability Leverage 366
Summing Financial Leverage andOperating
Liability Leverage Effects on Shareholder
Profitability 368
Return on NetOperating AssetsandReturn
onAssets 369
Financial Leverage andDebt-to-Equity
Ratios 371
Second-Level Breakdown: Drivers

of Operating Profitability 371
Third-Level Breakdown 374
Profit Margin Drivers 374
Turnover Drivers 374
Borrowing CostDrivers 377

Summary 379
KeyConcepts 379
A Continuing Case: Kimbeny-Ctark Corporation 380
Exercises 382
Minicase 390
Chapter 12
The Analysis of Growthand Snslainable
Earnings 392
WhatIs Growth? 393
Cutting to the Core: Sustainable Earnings 394
CoreOperating Income 395
Issuesin Identifying Core Operating
Income 398
xx
Ccnrcncs xxi
COnfCTI(S
Core Operating Profitability

Core Borrowing Cost 407
405
Analysis of Growth 407

Growth Through Profitobdity 407
Operating Leverage 409
Analysis of Changes inFinancing 410
Analysis of Growth in Sharehoiders'Equity 411
Growth, Sustainable Earnings, and theEvaluation

of P'B Ratios and PIE Ratios 412
How Price-to-Book Ratios andTrailing PIE
Ratios Articulate 412
Trailing Price-Earnings Ratios andGrowth 415
Trailing Price-Earnings Ratios and Transitory
Earnings 416
PIE Ratios andtheAnalysis of Sustoinoaie
Earnings 417
Summary 418
Key Concepts 419
Exercises 422
Minicases 428
PART THREE
FORECASTING AND VALUATION
ANALYSIS 438
Chapter13
The Value of Operatiousaud the Evaluatiou
of Enterprise Price-to-Book Ratios and
Price-Earnings Ratios 440
A Modification to Residual Earnings Forecasting:
Residua! Operating Income 442
TheDrivers of Residual Operating Income 445
A Modification to Abnormal Earnings Growth

Forecasting: Abnormal Growth inOperating
Income 447
Abnormal Growlh in Operating Income andthe
"Dividend "fromOperating Activities 447
TheCostof Capital and Valuation 449

The Cost of Capitalfor Operations 450
The Cost of Capitalfor Debt 451
Operating Risk, Financing Risk, andthe
Cost of Equity Capital 452
Financing RiskandReturn andtheValuation

of Equity 453
Leverage andResidual Earnings Valuation 453
Exercises 510
Minicases 516
Leverage andAbnormal Earnings Growrh

Valuation 455
Leverage Creates Earnings Growth 460
Debt and Taxes 463
Mark-to-Market Accounting: A Tool for Incorporating

theCostof StockOptions in Valuation 464
Enterprise Multiples 466
Elite/prise Price-to-Book Ratios 467
Enterprise Price-Earnings Ratios 468
Summary 472
Key Concepts 473
Exercises 477
Minicase 483
Chapter14
Anchoring on theFinancial Statements:
SimpleForecastiug aud Simple
Valuation 486

Financial Statement Analysis: Focusing theLens
on the Business 524
1.Focus onResidual Operating Income andIts
Drivers 524
2, Focus onChange 525
3, Focus on Key Drivers 531
4. Focus on Choices versus Conditions 534
Full-Information Forecasting andPro Forma

Analysis 535
A Forecasting Template 538
Features of'Accounting-Based Valuation 543
Value Generated in ShareTransactions 545
Mergers andAcquisitions 545
Share Repurchases andBuyouts 546
Financial Statement Indicators andRed Flags 547

Business Strategy Analysis andPro Forma
Analysis 547

Simple Forecasts andSimple Valuations
from Financial Statements 488
Forecostingfrom BookValues:
SFl Forecasts 488
Forecaslingfrom Earnings andBookValues:
SF2 Forecasts 490
Forecastingfrom Accounting Rates of Return:
SF3 Forecasts 493
Simple Forecasting: Adding Information to Financial

Statement Information 498
Weighed-Average Forecasts afProfitability
andGrowth 499
Growth inSalesasa Simple Forecast
of Growlh 499
Unarticulated Strategy 549

Scenario Analysis 550

Summary 550
Key Concepts 551
Exercises 554
Minicases 561
PART FOUR
ACCOUNTING ANALYSIS
ANDVALUATION 568
TheApplicability of Simple Valuations 500

Simple Valuations withShort-Term
andLong-Term Growth Rates 503
Simple Valuation as anAnalysis Tool 503
Chapter 16
Creating Accounting Value and
Economic Valne 570
Reverse Engineering 503

Enhanced StockScreening 505
Sensitivity Analysis 505
Summary 506
Key Concepts 508
AContinuing Case: Kimberly-Clark Corporation
Chapter15
Full-Information Forecasting, Valuation, and
Busiuess StrategyAnalysis 522

Value Creation andtheCreation ofResiduai
Earnings 571
Accounting Methods, Price-to-Book Ratios,
Price-Earnings Ratios, and theValuation
of Going Concerns 574
508
Accounting Methods with a Constant Level

ofInvestment 574
Accounting Methods with a Changing Level

of Investment 577
AnException: LIFOAccounting 581
Hidden Reserves and theCreation
ofEarnings 582
Conservative andLiberal Accounting
in Practice 586
UFO versus FIFO 587
Research andDevelopment in
thePharmaceuticals Industry 588
Expensing Goodwill andResearch
andDevelopment Expenditures 589
LiberalAccounting: Breweries andHotels 590
Profitability in the 1990s 590
Economic-value-Added Measures 591
Accounting Methods and the Forecast

Horizon 591
The Quality of Cash Accounting andDiscounted
Cash FlowAnalysis 592
Summary 594
KeyConcepts 595
ConceptQuestions 596
Exercises 596
Minicase 601
Chapter 17
Aualysis of the Qualityof Fiuaneial
Statements 606
'What IsAccounting Quality? 607
Accounting Quality Watch 608
FiveQuestions About Accounting Quality 609
CuttingThrough theAccounting:
Detecting Income Shifting 610
Separating What We Knowfrom
Speculation 613
Prelude to a Quality Analysis 614
Quality Diagnostics 616
Diagnostics to Detect Manipulated Sales 619
Diagnostics toDetect Manipulation of Core
Expenses 621
Diagnostics toDetect Manipulation of Unusual
Items 627
Detecting Transaction Manipulation 629

Core Revenue Timing 629
Core Revenue Structuring 629
Core Expense Timing 630
Releasing Hidden Reserves 630
xxii Contents
OtherCore Income Timing 631

Unusual Income Timing 631
Organizational Manipulation: Off-BalanceSheetOperations 631
Justifiable Manipulation? 632

Disclosure Quality 632
Quality Scoring 633
Abnormal Returns to Quality Analysis 635
Summary 636
KeyConcepts 636
Exercises 639
Minicases 648
PART FIVE
THE ANALYSIS OF RISK
AND RETURN 656
Chapter18
The Analysisof Equity Risk and Return 658
TheRequired Return andtheExpected Return 659
TheNature of Risk 660
TheDistribution of Returns 660
Diversification andRisk 664
AssetPricing Models 665
Fundamental Risk 667

Return on Common Equity Risk 669
Growth Risk 670
Value-at-Risk Profiling 670

Adaptation Options andGrowth
Options 675
Strategy andRisk 676
Discountingfor Risk 676
Fundamental Betas 677

PriceRisk 678
Market Inefficiency Risk 678
Liquidity Risk 681
Inferring Expected Returns from Market Prices 681

Finessing theRequired Return Problem 683
Evaluating Implied Expected Returns with
value-at-Risk: Profiles 683
Enhanced Screening andPairs Trading 683
Relative Value Analysis: Evaluating Firms within

RiskClasses 683
Conservative and Optimistic Forecasting
andtheMargin ofSafety 685
Beware of PayingforRiskyGrowth 686
Expected Returns in Uncertain Times 686
Summary 687
KeyConcepts 687
Exercises 689
Chapter 19
The Analysis of Credit Risk
and Return 696
The Suppliers of Credit 697
Financial Statement Analysis forCredit
Evaluation 698
Reformulated Financial Statements 698
Short-Term Liquidity Ratios 700
Long-Term Solvency Ratios 702
Operating Ratios 703
Forecasting andCredit Analysis 703

Prelude to Forecasting: TheInterpretive
Background 703
Ratio Analysis and Credit-Scoring 704
Full-Information Forecasting 708
Required Return, Expected Return, andActive
DebtInvesting 711
Liquidity Planning andFinancial

Strategy 712
Summary 713
Key Concepts 713
Exercises 715
Minicase 719
List of Cases
Critiqueofan EquityAnalysis:America Online Inc. 31
Reviewing theFinancial Statements of Nike, Inc. 66
AnArbitrage Opportunity? Cordant Technologies and
Howmet International J05
Nifty Stocks? Returns to Stock Screening 106
Attempting Asset-Based Valuations: Weyerhaeuser
Company 107
Discounted Cash FlowValuation: Coca-Cola Company
andHome Depot, Inc. 144
Forecasting from Traded Price-to-Book Ratios:
Cisco Systems, Inc. 189
Analysts' Forecasts andValuation: PepsiCo and
Coca-Cola 190
Kimberly-Clark: BuyIta Paper? 190
Forecasting from Traded Price-Earnings Ratios:
Cisco Systems, Inc. 226
Analysts' Forecasts andValuation: PepsiCo and
Coca-Cola 227
Reverse Engineering Google: How DoI Understand
theMarket's Expectations? 227
Analysis of theEquity Statement, Hidden Losses,
andOff-Balance-Sheet Liabilities: Microsoft
Corporation 285
Financial Statement Analysis: Procter &
Gamble I 332
Understanding the Business Through Reformulated
Financial Statements: Chubb Corporation 336
Analysis of CashFlows: Dell, Inc. 360

Gamble 11 390
Gamble 1Il 428
A Question of Growth: Microsoft Corporation 429
Analysis of Sustainable Growth: International Business
Machines 432
Valuing theOperations andtheInvestments of a
Property andCasualty Insurer: Chubb
Corporation 483
Simple Forecasting andValuation: Procter &
Gamble IV 516
Simple Valuation andReverse Engineering forCisco
Systems, Inc. 516
FullForecasting andValuation: Procter &
GambleV 561
A Comprehensive Valuation to Challenge theStock
Price of Dell,Inc. 561
TheBattle for Maytag: An Analysis of a
Takeover 565
Advertising, Low Quality Accounting, andValuation:
E*Trade 601
A Quality Analysis: Xerox Corporation 648
A Quality Analysis: Lucent Technologies 652
Analysis of Default Risk: Fruitof theLoom 719
Appendix
A Snmmary of Formulas
723
Index 740
xxiii
Chapter 1 Introduction!O Inue.Hing andVallUltion 3
ction to
'~'tj;~nd Valuation
LINKS
Thlschapter
Thischapter introduces
investing and the role
of fundamental
What is therole
of the
professional
analyst?
analysis in investing.
Howare
business analysis
and financial
statement
analysis
connected?
INVESTMENT STYLES AND FUNDAMENTAL ANALYSIS
.Liak to nextchapter
Chapter2 introduces the
financial statements that
areusedin fundamental
analysis.
the primary information thatfirms publish aboutthemselves, and

of financial statements. Firms seekcapita! frominvestors
anhptePare fin~ciaj:statements to help investors decide whether toinvestInvestors expect
the firm to add value to theirinvestment-s-to return morethanwasinvested-and read financial statements toevaluate thefinn's ability todoso.Financial statements arealso used
forother purposes. Governments usethem in social andeconomic policy-making. Regulators suchas the antitrust authorities, financial market regulators, and bankinspectors use
themto control business activity. Employees usethem in wage negotiations. Seniormanagersuse them to evaluate subordinates. Courts, and the expert witnesses who testify in
court, usefinancial statements to assess damages in litigation.
Each type of user needs to understand financial statements. Each needs to know the
statements' deficiencies, what theyreveal, andwhat theydon'treveal. Financialstatement
analysisis themethod bywhich users extract information to answer theirquestions about
the finn.
This bookpresents the principles of financial statement analysis, witha focus on the
investor. Many types of investment are entertained. Buying a firm's equity-its common
stock-is one, and the book has a particular focus on the shareholder and prospective
shareholder. Buying a firm's debt-its bonds-is another. The shareholder is concerned
withprofitability, thebondholder withdefault, andfinancial statement analysis aidsinevaluating both. Banks making loans to firms are investors, and they are concerned with
default. Firms themselves arealsoinvestors when theyconsider strategies to acquire other
jllV:~t?~:artf __,_,,_
pnk"to'Webpage
Go to the book'sWebsite
for thischapterat
http://www.rnhhe.coml
penman4e.lt explains
howto find yourway
around thesite andgives
you moreof the Ilavorof
usingfinancial statement
analysis in investing.
firms, go intoa newlineof business, spinoffa division orrestructure, or indeed acquire or

disinvest inanassetofanyform. In allcases financial statements mustbeanalyzed tomake
a sound decision.
In market economies, mostfirms are organized to make money (or"create value") for
theirowners. Sofinancial statements areprepared primarily with shareholders' investment
in mind: Thestatements are formally presented toshareholders at annual meetings andthe
mainnumbers they report are earnings (for the owners) in the income statement and the
book value of owners' equity in the balance sheet But much of the financial statement
analysis for investors is relevant to otherparties. The shareholder is concerned withprofitability. Butgovernmental regulators, suppliers, the firms' competitors, andemployees are
concerned with profitability also. Shareholders and bondholders are concerned with the
riskiness of the business, but so are suppliers and employees. And securities litigation,
which involves expert witnesses, usually dealswithcompensation for lossof profits-or
lossof value-to investors. Thus muchof the financial statement analysis in this bookis
relevant to theseusersaswell.
Investors typically invest in a fum bybuying equity shares or the firm's debt. Theirprimaryconcern is the amount to pay-the value of theshares or thedebt. Theanalysis of information that focuses on valuation is calledvaluation analysis, fundamental analysis,
or,when securities likestocks andbonds are involved, security analysis. Thisbookdevelops theprinciples of fundamental analysis. Andit shows howfinancial statement analysis
is usedin fundamental analysis.
In thischapter weset thestage.
<__.users
Millions of shares of business firms aretraded every dayonthe world's stockmarkets. The
investors who buy and sell these shares ask themselves: Am I trading at the rightprice?
Whataretheshares really worth? Theyattempt toanswer these questions while a discordant
background chorus-the printed press, "talking heads" on television financial networks,
and Internet cbatrooms-c-voices opinions about whatthe priceshould be.Theyturnto investment advisers who provide an almost endless stream of information andrecommendationsto sort out.Theyhearclaims thatsomeshares are overpriced, some underpriced, and
they hear theories that stock markets can be caught up in the fads and fashions-even
mania-that aresaidto drive sharepricesaway fromtheirappropriate values.
In theabsence of anyclearindication of whatstocksareworth, investors copeindifferent ways. Some-intuitive investors-rely on their own instincts. They go on hunches.
Some-ccalled passive investors-throw up their hands and trust in "market efficiency."
Theyassume thatthemarket priceis a fairpricefor therisktaken, thatmarket forces have
driven thepriceto theappropriate point
These investment styles are simple anddon't require mucheffort. Butbothtypes of investors run risksbeyond thoseinherent in the firms they buy:Paying too much or selling
for too little damages investment returns. Theintuitive investor hastheproblem of the intuitive bridge builder: One may be pleased with one's intuition but, before building gets
underway, it might payto checkthatintuition against the calculations prescribed bymodem engineering. Not doing so mightleadto disaster. The passive investor is in danger if
stocks aremispriced. It is tempting to trust, as a matter of faith, thatthemarket is efficient,
andmuch economic theory says it should be. But it is goodpractice to check. Bothtypes
of investors runtheriskof trading withsomeone who has"donehishomework," someone
whohasanalyzed theinformation thoroughly.
4 Chapter 1 Introduction to lrwe5cng and Valuation
Passive Investing, Active Investing, and Risk
1.1
Consider the following:

Dell, Inc., the leading manufacturer ofpersonal computers, reported earnings for fiscal year
2000 of $1.7 billion on sales of $25.3 billion. At the time, the total market value of Dell's
shares was $146.4 billion, over three times thecombined market value forGeneral Motors
Corporation and Ford Motor Company, thelarge U.S. automobile manufacturers with combined sales of$3135billion and combined eamings of$13.144 billion. Dell's shares tradedat
anearnings multiple of87.9-its price-earnings (PIE) ratio-compared with a PIE of8.5for
General Motors and5.0for Ford.
General Motors and Ford have had their problems. Dell has been a very successful
operation with innovative production, "direct marketing," and a made-to-order inventory
system. The intuitive investor mightidentify Dell as a goodcompany and feel confident
about buying it. But at 88 timesearnings? The PIE ratio for the Standard & Poor'sIndex
(S&P 500)stocksat the time was 33 (very highcompared to thehistorical average of 16),
andmicrocomputer stocksas a wholetradedat 40 timesearnings. Topay88timesearnings
seems expensive. The intuitive investor should recognize that good companies mightbe
overpriced, good companies but bad buys. He might be advisedto check the price with
some analysis. The passive investor believes that both companies are appropriately priced
and ignores the PIE ratios. But with such an extraordinary PIE, she mightbe advised to
checkber beliefs. She is at riskof paying too much. As it turnedout,Dell'sper-share stock
price declined from $58 in 2000 to $29 in 2003, a loss of 50 percent. By 2008, Dell was
tradingat $20per share.
The risk of incurring such a losscan be reduced by thoroughly examining information
about firms and reaching conclusions aboutthe underlying valuethat the information implies.Thisis fundamental analysis and the investor whoreliesOn fundamental analysis is a
fundamental investor. Fundamental investors ask:Is a PIE of88 forDelltooexpensive?To
answer, they makea calculation of what PIE is reasonable given the available information
aboutDell.Theyask:Whatmultiple ofearnings is Dellreallyworth? Theyalsoaskwhether
the PIEratiosforGeneral Motors andFordaretoo low. Should theysellDellandbuyFord?
Fundamental investors distinguish price from value. Thecreedtheyfollow is "priceis what
youpay, butvalueis whatyouget." They"inspectthe goods" as a buyerdoeswithanypurchase.Of course, in one sensepriceis value, for it is the valuethatothertraders put on the
shares. You couldwellbe cynical about financial analysis and accept priceas value. Butthe
fundamental analyst seesprice as the costof the investment, notitsvalue. OscarWilde's observation is to the point: "Cynics know thecostof everything, andthevalueof nothing."
"What youget" from the investment is future payoffs, so the fundamental investor evaluateslikelypayoffs to ascertain whether theaskingpriceisa reasonable one.Thedefensive
investor doesthis as a matterof prudence, to avoid trading at the wrongprice.The active
investor uses fundamental analysis to discover mispriced stocks that might earn exceptionalratesof return.Box1.1contrasts passive andactiveinvestors in moretechnical terms
usedby investment advisers.
Fundamental investors speakof discovering intrinsic values, warranted values, or fimdamental values. Intrinsic value is theworthof an investment thatisjustified by the information aboutits payoffs. But this term should not be takento imply precision. Unlike bridge
engineering, fundamental analysis does not take away all uncertainty. It offers principles
which, followed faithfully, reduce uncertainty. Theanalysis in thisbookdevelops theseprinciplesin a deliberate, systematic wayso investors havethe security thattheirinvestment decisionsare sound, intelligent ones. The analysis highlights howerrorscan be madeby following simplistic approaches, andhowvaluecanbe lostby ignoring basicprinciples.
Investors buy gambles. They buy a chance to earn a high

return against the chance of losing their investment. Passive
and active investors differ in their approaches to handling
this risk.
Passive investors see risk inbusiness operations delivering
less value than expected. They understand that there is a
chance thatfirms' sales will beless than anticipated, that profitsfrom sales will notmaterialize. But passive investors trust
thatthis fundamental risk isefficiently priced inthemarket.
The passive investor realizes, however, that risk can be
reduced bydiversification andthatthemarket will notreward
risk that can be eliminated through diversification. So she
holds a diversified portfolio of investments to deal with risk.
But, once diversified, the passive investor believes thatsheis
price-protected, with higher risk investments efficiently priced
to yield higher expected returns. All shedesires from an anaIyst is information about the level of risk she is taking on,
sometimes referred to asbeta risk. She buys betas,andquantitative analysts supply these risk measures using models like
the capital asset pricing model ((APM) and variantsso-called beta technologies. No doubt you have been exposed
to these models infinance courses.
Active fundamental investors see another source of risk,
the risk of paying too much (or selling fortoo little). That is,
they are concerned thatsecurities are not efficiently priced.
They See price risk in addition to the inherent fundamental
risk in business operations. Sothey carry out an analysis to
challenge themarket price. Like those who supply betas, they
design technologies to dothis, sometimes referred to as alpha
technologies to differentiate them from betatechnologies. It
is these technologies with which this book is concerned.
Active fundamental investors see a reward in this endeavor,
for they seethe possibility of identifying stocks thatcan earn
abnormal rerums-chiqner expected returns than those implied by betarisk. Indeed, the trade term forthese abnormal
returns isalphas(in contrast to betas), and alpha technologies arebrought to bear to predict alphas.
Indexinvesting is an extreme form of passive investing.
The index investor buys the market portfolio of stocks or a
portfolio like the S&P 500 Index, which closefy resembles the
market. The market portfolio provides the ultimate diversification, sothe investor does noteven have to know the beta.
The investor does not have to think about anything, and
transaction costs are low. However, the index investor is in
danger of paying too much. Consider the returns (including
dividends) for the S&P 500for the years 1998-2008 here,
along with the PIE ratios for the index at December 31 of
each year. The index investor didvery well inthe bull market
of the 19905, with the returns for 1998 and 1999 following
a string of high annual returns. Her subsequent experience

was a little painful, for the average annual return on the
5&P 500 over theyears 2000-2005 was ~ 1 percent andmore
negative through 2008. Compare this with theannual return
on intermediate-term government bonds of 6 percent.
However, the index investor rides out the market, inthe belief thatstocks are "forthe long run"; the historical average
annual return to stocks has been 12.3 percent. compared
with 6 percent for corporate bonds, and 3.5 percent for
Treasury bills.
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
S&P 500 Returns
S&P 500 PIE Ratio
28.6%
21.0
-9.1
-11.9
-22.1
28.7
10.9
32.6
30.5
26.4
49
15.8
5.5
-38.5
46.5
31.9
22.8
20.7
17.9
17.4
19.8
16.6
The fundamental investor recognizes these statistical

averages butappreciates that these returns are not guaranteed. He also notes another statistic: The historical average
PIE ratio for the S&P 500 is 16. PIE ratios over 30 suggest
thatstocks aretoo expensive. However, the fundamental investor then begins an investigation as to whether times have
changed, whether higher PIE ratios arenow justified. Further,
rather than holding all of the stocks inthe index, he differentiates between those stocks he feels are undervalued in
the market, those he thinks areefficiently priced, and those
he thinks areovervalued. The indexer's action is HOLD; the
active investor expands his action alternatives to BUY, HOlD,
orSELL
it iseasy, with hindsight. to saythatselling stocks at the
endof 1999 would have been a good idea. The appropriate
question is whether an analysis in 1999 would have indicated so in advance. The passive investor is skeptical. She
points to the fact that active investment funds typically do
not perform much better than the S&P 500 Index, net of
costs of running the funds. The fundamentalist replies: If no
one does fundamental research, how can the market become efficient?
Chapter 1 Introduc!ion to Inv,ting "ndValuation 7
6 Chapter 1 Inrrcducncn to Investing and ValUlllion
Information is goldto the investor, so much ofthe bookexplains howthe analyst identifies the appropriate information andorganizes it in a wayto indicate intrinsic value. Organizing theaccounting information-s-financial statement analysis-is ofparticular importance. The analyst does not wantto be overwhelmed by the huge amount of information
available on firmsand so looks for efficient ways of organizing the information, of reducing it to manageable proportions. He desires simple, straightforward schemes but is wary
ofad hocschemes thatare toosimple. A simple (andpopular) scheme says"buyfirmswith
lowPIEratiosandsellfirms withhighPIEratios" forpricerelative to earnings is supposed
to tellus howcheapor expensive thoseearnings are.Selling Dell,witha highPIEin 2000,
would haveworked. Butbuying General Motors orFord, withlowPIEratiosof8.5 and5.0,
respectively, would not; General Motors' stockdeclined from $80per sharein 2000to $4
in 2008, and Ford's declined from $29 to $3 overthe same period. The thorough analyst
understands that usingjust one pieceof information-c-eamings here-runs the danger of
paying too much; otherimportant information is involved in determining whether a low
PIE ratio is justified or, indeed, represents an overpricing rather than an underpricing.
Rather than comparing priceto earnings, he compares priceto value implied by the completeset of information.
Traders insecurities are not alonein valuing investments. Within firms, managers daily
make investment decisions. They too must ask whether the value of the investment is
greaterthan its cost.And they too, as we willsee, must forecast payoffs to ascertain this
value.
BUBBLE, BUBBLE
Muchis at stake in valuing securities correctly. Trillions of dollars were invested in stock
markets around the worldin the 1990s. By the end of the decade, nearly 50 percent of
adults in the United States held equity shares, either directly or through retirement
accounts. In the United Kingdom, thisfigure was25 percent, in Germany, 15percent, and
in France, 13percent. Thesenumbers wereup considerably from 10 years earlier. Stock
markets inAsiaandthePacific alsobecame veryactive. Firmsin Europe andAsiathatonce
wentto banksfor capital began raising funds through public stockmarkets. An equityculture was emerging where firms tradedmoreand morewith individual equity investors or
their intermediaries. Unfortunately, the growing equity culture was not matched with a
growing understanding of howto value stocks. Trillions of dollars werelostasa stockmarketbubble burstandinvestors foundtheirsavings shrunksignificantly.
The experience repeated that of a decade earlier in Japan. On December 29, 1989, the
Nikkei 225 Indexof Japanese stockssoared to a high of38,957, a 238percent gain overa
five-year period. Twelve yearslaterin 2001, the Nikkei 225 fellbelow 10,000 for a lossof
over75 percent fromthe 1989 high.By2005, the index hadrecovered to only11,800. The
stockpricesof the 1980s werea bubble, andthe bubble burst. Therepercussions in Japan
werelong-term. Someclaimthat equityinvesting is rewarded in the longrun,butthe long
run was a long timerunning. On March 10,2000, the NASDAQ Composite Indexin the
United Statespeakedat 5,060, up 574percent from thebeginning of 1995. By mid~2002,
the indexwas below1,400, down75 percent from the high,and wasstill onlyat 1,500 in
2008.The S&P500 Index was down45 percent andtheLondon FTSE 100andthe Eurotop 300had lostmorethan40 percent. Again, a bubble hadburst, leaving investors to wonderhow longthe longrun would be. Weare reminded that the Dow Index didnot recover
its 1929 euphoric level until1954. During the 1970s, afterthebullmarket ofthelate 1960s,
the Dow stocks returned only 4.8 percent over 10 years and ended the decade down
13.5 percent fromtheir 1960s high.
InJanuary2000, priorto thebursting ofthebubble, AlanGreenspan, chairman ofthe U.S.
Federal Reserve Bank, expressed concern. He asked whether the boom would be remembered as "oneof themany euphoric speculative bubbles thathave dotted human history." In
1999 hesaid, "History tensus thatsharpreversals inconfidence happen abruptly, mostoften
withlittleadvance notice... What isso intriguing is thatthistypeofbehavior hascharacterized human interaction with little appreciable difference over the generations. Whether
Dutch tulip bulbsorRussian equities, themarket pricepatterns remain muchthesame."
Indeed, while theusual reference to bubbles istoDutch tulip bulbs in theseventeenth century orto theSouthSeasBubble in theeighteenth century, there hasbeenmore recent experience. In 1972, thepricing of thetechnology stocks of theday-Burroughs, Digital Equip.
ment, Polaroid, IBM, Xerox, Eastman Kodak-looked likea bubble waiting to burst. These
stocks were partof the"NiftyFifty" stocks, deemed a "mustbuy," thatincluded Coca-Cola,
Johnson & Johnson, andMcDonald's Corporation. Theaverage PIEratio forthe Nifty Fifty
was37 in 1972, nothing likethe PIE of over300 forthe NASDAQ 100stocks in 2000, but
considerably above thehistorical average to thatpointof 13.Thebubble didburst. The S&P
500 PIE ratiodeclined from 18.3 in 1972 to 7.7by 1974. TheIT 3D-share index in London
(prior to thedays of theFTSE 100) dropped from 543 in May 1972 to 146 inJanuary 1975.
Stockmarket bubbles damage economies. People form unreasonable expectations of
likely returns and so makemisguided consumption and investment decisions. Mispriced
stocksattractcapital to the wrong businesses. Entrepreneurs with poor business models
raisecashtoo easily, deflecting it from firms that can add value for society. Investors borrow to buy paper rather than real productive assets. Debt burdens become intolerable.
Banks that feedthe borrowing run intotrouble. Retirement savings are lostanda pension
crisis develops. And, while we have learned something of macroeconomic management
sincethen, theeuphoria of thelate 1920s andthesubsequent depression ofthe 1930s teach
us thatsystematic failure is possible. Indeed, thatwasthe fearin the market crash of2008.
Bubble, bubble, toil andtrouble.
How Bubbles Work

Bubbles worklikea chainletter. You may have joined a chainletteras a teenager for fun
(andnot muchconsequence), or as an adulttryingto get enough signatures to lobby for a
goodcause(hopefully withconsequence). Oneletterwriterwrites to a number of people,
instructing eachtosendtheletteron toa number ofotherpeople withthesameinstruction.
Letters proliferate, butultimately thescheme collapses. If the letterinvolves money-s-each
person in thechainispaidbythosejoiningthechain-e-the scheme issometimes referred to
as a Ponsi scheme or a pyramid scheme. A few thatareearlyin thechain make considerable
money, butmostparticipants areleftwithnothing.
In a bubble, investors behave as if theyarejoininga chainletter. Theyadopt speculative
beliefs thatarethenfedon tootherpeople,facilitated in recentyears bytalking heads in the
media, bloggers, andindeed byanalysts andpoorfinancial reporting. Eachperson believes
thathe willbenefit from more peoplejoiningthechain,bytheirbuying thestockandpushingthepriceup.A bubble forms, onlyto burstasthespeculative beliefs arenotfulfilled.
The popular investing stylecalled momentum investing has features of a chain letter.
Advocates of momentum investing advisebuying stocksthathave goneup, the ideabeing
thatthosestockshave momentum to continue goingup more. Whatgoesupmustkeepon
goingup. Indeed, thishappens when speculation feeds onitselfasthechainletterispassed
along.
8 Chapter 1
introductionto Inl'l'5ting anJ Vaiw'I!ioll
Bubbles canworkin reverse: Ratherthanpricesbecoming overinflated, theybecome too

depressed. Duringthe mid-1970s, in a periodof general pessimism amidoil priceshocks,
the S&P 500 PIE ratio fell below7 and its price-to-book ratio fell below 1. At the time of
writing(December 2008),duringa severe creditcrisisfollowing the crashof a real estate
bubble, equity prices fell significantly. Premium Wall Street investment banks like Bear
Steams,MerrillLynch, andLehmanBrothers disappeared. TheU.S. government baitedout
Fannie MaeandFreddie Mac,the mortgage companies, and orchestrated a hugebailoutof
toxicassetshelp by financial institutions. As a consequence, investors feared a prolonged
depressed market. (With youin real time,whatsubsequently happened?)
Analysts During the Bubble

As the renowned fundamental investor Warren Buffettobserved, the boom in technology
and Internetstocksof the late 1990s was a chain letter, and investment bankers were the
"eager postmen." He mightwell haveaddedsell-side analysts (who recommend stocksto
retail investors), someof whomworked withtheir investment banking colleagues to push
stocks at high pricesto investors. Duringthe bubble, analysts were recommending buy,
buy,buy. In the year2000,only2 percent of sell-side analysts'stockrecommendations in
the UnitedStatesweresells. Onlyafter the NASDAQ indexdropped 50 percent did analystsbeginto issue sell recommendations. This is not very helpful. One would thinkthat,
with sucha dropin price, recommendations would tend to change fromsell to buy rather
than the otherwayaround.
Tobe fairto analysts, it is difficult to goagainstthe tideof speculation. An analystmight
understand thata stockis overvalued, butovervalued stockscan gohigher, fedalongby the
speculation of the moment. The natureof a bubble is forpricesto keep rising. So, making
a sell callmaybe foolish in the shortrun.Analysts are afraidto buckthe trend. If theyturn
out to be wrong when the herd is right, they look bad. If they and the herd are wrong
together, theyare not penalized as much. But thereare big benefits forthe staranalystwho
makesthe correctcall whenthe herdis wrong.
The issuecallsintoquestion whatanalysts do.Do theywriteequity research reportsthat
develop a valuation for a company, or do theyspeculate on wherethe stockprice will go
based on crowd behavior? They might do either or both. However, they should always
justify their positionwith good thinking. Unfortunately, during the 1990s bubble, many
analysts promoted poorthinking. Theyfed the speculation. See Box 1.2.
Fundamental Analysis Anchors Investors

Fundamental analysis cuts throughthe poor thinking (likethat in Box 1.2)that promotes
the chain letter. Fundamental analysis challenges speculative beliefs and the prices they
ferment, anchoring the investor against the tide of fad and fashion. Speculation promotes
momentum in stockprices,but fundamental analysts see gravity at work. Prices, theyinsist,
must gravitate to fundamentals, and the investor anchored to fundamentals has the best
prospectfor the longrun.See Box 1.3.
THE SETTING: INVESTORS, FIRMS,

SECURITIES, AND CAPITAL MARKETS
To value businessinvestments we need to have a good understanding of howa business
works, how it adds value, and how it returns value to investors. Webegin here to build
a picture of the firm and its investors-sketchy at first-to be filled out as the book
proceeds.
Suspect Analysis During the Bubble

When speculative fever ishigh, analysts aretempted to abandon good thinking and promote speculative thinking. They
may be compromised because their firms make money from
brokerage commissions, so they want analysts to promote
stock buying. Their investment banking arm may reward analysts for recommending stocks oftheir corporate clients. Analysts may be reluctant to make sell recommendations on the
firms they cover, infear of being cutofffrom further information from those firms. Or, more likely, they may simply get
caught upinthespeculative fever ofthe moment.
There was no shortage ofspeculative analysis during the
1990's bubble, particularly in the coverage of technology,
Internet, andtelecommunication stocks. Here aresome examples. Understand thefallacy ineach point.
Profits were dismissed as unimportant. Most Internet
stocks reported losses, but analysts insisted at the time
that this did not matter. What was important, they said,
was the business model. Well, both areimportant. Afirm
has to make profits and, even though it may have losses
currently, there must be reasonable scenarios for earning
profits. See Box 1.3. As itturned out,the losses reported
for dot.com firms during thebubble were a good indicator
of outcomes. Many of these firms did notsurvive.
Commentators insisted that traditional financial analysis
was no longer relevant. The "new economy" demands
new ways of thinking, they said. They offered no persuasive newthinking, butdiscarded the old.
Analysts appealed to vague terms like "new technology,"
"Web real estate," customer share of mind," "network
effects," and indeed, "new economy" to recommend
stocks. Pseudoscience labels; sound science produces
good analysis, notjust labels.
Analysts claimed thatthe firms' value was in "intangible
assets" (and so claimed that the firm must be worth a
lot!), butthey didn't indicate how onetests for the value
ofthe intangible assets. One even sawanalysts calculating
the value of intangible assets as the difference between
bubble prices and tangible assets on the balance sheet.
Beware of analysts recommending firms because they
have "knowledge capital." Knowledge isvalue inthis information age, butknowledge must produce goods and
services, the goods and services must produce sales, and
the sales must produce profits. And knowledge assets
1.2 ~
must be paid for. Inventors and engineers must be paid.

Will there be good profits after paying for knowledge?
Analysts relied heavily on nonfinancial metres like page
views, usage metres. customer reach, andcapacity utilization. These metres may give some indication ofprofitability butthey don'tguarantee it The onus ison theanalyst
to show how these indicators translate into future profits.
Analysts moved from focusing on PIE ratios and earnings
growth to focusing on price-to-sales (PIS) ratios andsales
growth. Sales growth is important, but sales ultimately
must produce profits. With analysts' focus on price-tosales ratios, firms began to manufacture sales through accounting practices like grossing upcommissions andbarter
transactions inadvertising.
Analysts' forecasts ofgrowth rates were high compared to
pasthistory. Analysts consistently maintained thatcompanies could maintain exceptional revenue and earnings
growth rates for a long time. Analysts' "long-term growth
rates" (lor 3-5 years in the future) aretypically toooptimistic inboom times. History says thatgrowth rates usually
decline toward average rates quite quickly.
Rough indicators ofmispricinq were ignored without justification. APIE of33 for theS&P 500 attheheight ofthebubble is
awaving red flag. APlEoI87.9forDell.lnc., flashes awarning.
One should have good reasons for buying atthese multiples.
Historical perspective was ignored. Cisco Systems, with a
market value ofhalf a trillion dollars, traded at a PIE of 135
in 1999. There has never been a company with a large
market value that has traded with a PIE over 100.
Simple calculations didn't addup. Atonepoint in1999, an
online discount airline ticket seller traded at a market value
greater than thetotal for all lf.S. airlines. Internet companies
traded ata market value, in total, ofover $ i trillion, buthad
total revenues of only $30billion, giving them anaverage
price-to-sales ratio of33.This looks high against thehistorical average PIS ratio ofjust1.All themore sowhen onerecognizes that these firms were reporting losses totaling $9
billion. For $1 trillion, an investor could have purchased
quite a number ofestablished firms with significant profits.
Analysts did notexamine thequality ofearnings thatfirms
were reporting. The emphasis wasonfirms reporting earnings thatbettered analysts' forecasts, notonthequality of
the accounting thatwent into those earnings.
When individuals or institutions invest in firms, theygiveup cashin hope ofa higherretum of cash in the future. The investment givesthema claim on the firm for a return. This
claim is formalized ina contract, which may notbe tradable (likemostpartnership interests
and bankloanagreements), or in a security. which can be traded in security markets (like
stocks and bonds).
Challenging Price
1.3
i
From 1996 to 2000, the prices of Internet stocks soared to
such a degree that commentators referred to the phenomenon as speculative mania. The stock price of Amazon.com,
theleading Internet bookretailer, rose from $20inJune 1998
to $200 by January 1999 (adjusted for stock splits), at the
same time it was reporting losses. Yahoo! 's stock rose from
$25 to $225 over the same period, giving it a PIE ratio of
1,406 anda price-sales ratioof 199. Shares in America Online
(AOL), another Internet portal, rose from $20in June 1998to
$150 by April 1999 (before its acquisition of Time Warner),
giving it a PIE ratio of 649, aprice-sales ratioof 46,and amar-
ketcapitalization of 2Yz times thatof General Motors.

To investigate whether these prices represent value or
speculative mania, the fundamental investor asks what are
reasonable expectations for these firms. AOL was reporting
annual sales revenue of $3.1 billion at the time, 80 percent
from the subscriptions of 18 million members, and the remainder from online advertising and Internet commerce. The
fundamental investor might ask: What anticipated sales
growth over the next 10years isrequired to justify a price of
46 times sales? Well, ifAOLwere to maintain its 1998 profit
margin of 8V2 percent of sales, he might calculate thatAOL

needs $291 billion insales in 10 years, or a 9,387 percent increase over current sales, about 57 percent peryear. (You wi!!
seehow to make these calculations later)
Perspective might tell him this forecast isa ~igh number.
Among the largest U.S. firms instock market value, 'General
Motors had 1998sales of $1S4 billion, General Electric's 1998
sales were $100 billion, and Microsoft's were $16 billion.
wal-Mart. thelargest u.s. retailer, had 1998 sales of $138 billion and experienced sales growth of 17 percent peryear in
the 1990s. He might then take a defensive position and not
hold AOl stock. Orhemight takeanactive position andsell it
short. Orhe might come to the conclusion that AOt's future
prospects justify thecurrent price of itsshares.
The thorough fundamental investor would notbesatisfied
byassuming that AOL would maintain its profit margin at the
1998 level. He would forecast future profit margins as well.
He would investigate alternative strategic scenarios andanticipate the payoffs from the scenarios. And he would ask
whether a reasonable scenario could bedeveloped thatwould
justify thecurrent market price.
Corporate claims vary from simple "plain vanilla" types such as equity and debt to
more complicated contingent claims. Contingent claims such as convertible bonds, options, and warrantsare derivative claims whose payoffs are based on the price of firms'
stocks or bonds, usually stocks. Despitetheir contractual complexity, contingentclaims
are relatively easy to value: Once the valueof the stocksor bondsis determined, standard
option-pricing techniques can be used to get the derivative price. The techniques follow
the principlesof financial engineering (whichwillnot concernus in thisbook).Equityand
debt claimsare morebasic:Theirvalueis "fundamental" to valuingthe contingentclaims.
Their pricing is guided by principlesof fundamental analysis (on which we very much
focus in this book).
The equity is the most important corporate claim,and the value of the equity is a particularfocusfor financial analysis. It is the primaryclaim,so muchso that common stock
is sometimes referredto as the fundamental, security. The equityis theowners'claimon the
business, often referred to as owners' equity or shareholders' equity. Thisclaimis the residual claimon the valueof the fum after otherclaimants havebeensatisfied. It is, by far, the
most difficult claim to value and it is the valuation of this claim, equity valuation, with
whichwewill bepreoccupied. Butwealsowiltbe concerned withdebtclaims. Debtclaims
are relatively simpleclaimsfor returnof interestandprincipal. So they are relatively simple to value.
Figure 1.1 depicts the debtholders and shareholders and the cash flows between them
andthe finn. We ignorethe holdersof contingent claimshereto keepit simple. Debthclders
(bondholders, banks,andothercreditors) makeloansto the finn in exchange fora claimfor
a payoff in the form of interest payments and loan repayments, as shown. Shareholders
contribute cash in exchange for equityshares that entitle them to a payoffin the form of
dividends or cash from share repurchases. The amountof the payoff, lessthe amountpaid
for the claim,is calledthe return.
10
Chapter 1
Introduction 10 Im'.osrillg and Valuation 11
FIGURE 1.1 TheFirm,Its Claimants, andtheCapital Market

The Capital Market:
Trading value
Cashfrom loans
Operating
activities
investing
activities
Financing
activities
"
<
UI
The Investors:
The claimantson value
The Firm:
The valuegenerator
Interest and
Joan repayments
"
'>
DebthoJders
" Cashfrom
saleofdebt
Secondary
Debtholders
1
Cashfrom
shareissues
Shareholders
Dividends andcashfrom' \
sharerepurchases
Cashfrom
,saleofshares
Secondary
Shareholders
Whena firmsells debtor equityclaimsit tradesin the capital market. The capitalmarketcan be a formal, organized stockexchange wherepublic, "listed"firmstrade;an informalmarketinvolving intermediaries such as venture capitalists, privateequityfirms, banks,
andinvestment brokers; or a simpleprocessof raisingcapital from family and friends.
Holders of claimsalsomaysellclaimsinthecapital marketif theywishto liquidate their
investment. Theysell to secondary investors andreceive cash,as indicated by thearrowsin
thediagram, in exchange forsurrendering theirclaimsto thenewinvestors. Soyousee from
the diagramthat the payoffs to claimants (indicated by the arrowsflowing to them)come
bothfrom the firmandfromsalesof theirclaimsin the capital market. Forshareholders, the
payoffs are in the form of dividends from the firm and proceeds from the sale of shares,
eithertothefirmina sharerepurchase (wherethe firm buysbackshares)or 10 otherinvestors
in thestockmarket. Debtholders receive interest andasettlement payment, eitherbythefum
redeeming the debtbeforeor at maturity or by sellingthe debtin thebondmarket.
Thevalueof a claimtradedin the capitalmarketis basedon the anticipated payoffs that
thefinn willultimately payon theclaim.Sothediagramdescribes the firm as the value generator. Debtholders wantenoughvaluegenerated to recoverinterestand principal. Shareholders get the residual valueafter the returnto the bondholders. To the extenttheirgoals
are financial ones,shareholders wantto maximize the valuegenerated by the firm. Indeed,
as owners theyhavethe authority, in most cases,to hire andfiremanagement to ensurethat
management strivesto increase firmvalueand the valueof their residual claim.
It is always thecasethatthe valueof the claimson a firm mustaddup to the value of the
firm:
Value of the firm = Value of debt + Value of equity
(1.1)
Thisjust statesthat thetotal valuethat a firm generates mustbe divided among thevarious
claimsto thatvalueGust thetwobasicclaimsaregivenhere).So,in valuation, wecan think
of valuing the firmanddividing the firm'svalueamongclaimants, or wecan thinkof valuingthe claims,the sumofwhichis thevalueof the finn.The valueof the firm issometimes
referred to as the valueof the enterprise or enterprise value.
We will havemuchmoreto sayaboutvaluegeneration in a business. Tostart,thediagram
shows the firm involved in three activities: financing activities, investing activities, and
operating activities. Specifics vary, but thesethreeactivities are generic to all businesses.
12 Chapter 1 Inrrcdncrion rc Im'esting andValuation
Financingactivities arcthetransactions withclaimants thatwehave just talked about

raising cashforthebusiness in exchange forequity anddebtclaims andreturning cash
to claimants. These activities are investing activities for the claimants but financing
activities forthefirm.
Investing activities usethecashraised from financing activities and generated in operations to acquire assets to be employed in operations. These assets may be physical
assets, like inventories, plant, andequipment, or knowledge andintellectual assets, like
technology andknow-how
Operating activities utilize theassets inwhich thefirm hasinvested toproduce andsell
products. Operating activities combine assets withlaborandmaterials to produce productsandservices, sellthemto customers, andcollect cashfrom customers. If successful,theoperations generate enough cash to reinvest in assets or return to claimants.
Understanding these activities is fundamental to understanding the value generation in a
business. Thepicture is verymuch incomplete here, so these activities aredrawn as opaque
windows in the diagram. As thebookproceeds, wewillopenthese windows to learnmore
about how the firm generates value forits investors.
THE BUSINESS OF ANALYSIS: THE PROFESSIONAL ANALYST

Many investors find that choosing and managing investments is not their forte, so they
tum to professional financial analysts. In anyfield, the professional is someone who
has the specialized technology to get a task done. Indeedprofessionals presentthemselvesas arbiters of good technology, and a profession is judgedby its ability to successfully solvethe problem at hand.The professional continually asks:Whatare good
techniques, whatare poor ones? The professional, like any otherproducer, sells products to his customers, the investors. As a competitor withothers, the professional asks:
How can I enhance the technology to get an edge over my competition? Whatdoes a
goodvaluation product look like? What's the best way to go aboutanalyzing information on firms? Howcan I do financial statement analysis mostefficiently? Whatmethods add valuefor myclient? Understanding whata goodfundamental analysis technologylooks likeis at the heartof this book.
Astypes of investments vary, so dothetypes ofprofessionals who serve investors. Each
needs to tailoranalysis to theclient's need.
Investing in Firms: The OutsideAnalyst

Many professionals areoutside thebusiness, looking in,andwereferto themas outside analysts. Security analysts, investment consultants, money managers, and stockbrokers advise clients on buying andselling corporate securities. Investment bankers andbusiness
brokers advise clients onacquiring andselling businesses. Accountants andassessors value
firms for tax andestate purposes. Andanyoneof these might serve as anexpert witness in
litigation involving valuation issues.
Justas therearetwomain types of business claims, there are two main types of outside
analysts. Credit analysts, such as those at bond rating agencies (Standard & Poor's,
Moody's Investors Service, andFitchRatings forexample) or bank loanofficers, evaluate
theriskiness-s-and thusthe value-ofbusiness debt. Butprimeamong business analysts is
the equityanalyst. Buy-side analysts perform equity research formoney managers, mutual
funds and, increasingly, hedge funds. Sell-side analysts provide theresearch to support retailinvestors through theirbrokers. Theequity analyst typically prepares anequity research
report. The analyst's mainconcern: How do I produce an equity research report that is
Chapter 1 Introduction roInv1'.lting and Valuation 13
credible andpersuasive andgives myclientconfidence in investing? Many research reports

failthistest. Theytypically closewitha prominent buy, hold, orsellrecommendation. They
present graphs, numbers, andverbiage aboutthebusiness butit is notalways clearhow the
recommendation follows from theanalysis, or indeed whether it isjustified. View the material in thisbookas a guide to preparing an accomplished equity research report.
Investing within Firms: The Inside Analyst

Inside thefirm, business managers invest moneys contributed tothefirm inbusiness assets.
Business investment begins withan idea, a "strategy." These strategies may involve developing new products, exploring new markets, adopting a new production technology, or
beginning an entirely new line of business. Strategy may call for acquiring another firm,
merging with other firms, or entering into alliances. To evaluate their ideas, business
managers, likeoutside investors, needto analyze thevalue thattheirideas might generate.
Suchanevaluation is called strategyanalysis.
Business managers mayhave good intuition andmay feel confident thattheir ideas are
good ones. But they canbe overconfident, toopersuaded by theirown ideas. They, likethe
outside intuitive investor, need to submit their intuition to analysis. Andtheir fiduciary relationship to claimants requires thatthey focus on shareholder value. They must value their
ideas: Isthestrategy likely toaddvalue? Theinsider's view onanalysis should benodifferent from thatof the outsider. Theoutside investor mustbe persuaded to buy shares at the
market price and, to decide, looks to analysis. What value is likely to be added over the
price? Theinside investor mustbepersuaded to buyanidea or a strategy at what it will cost
to implement and, todecide, looks toanalysis. What value islikely tobeadded over thecost?
Business strategists develop appealing ideasandeachyearnewstrategy paradigms are
offered in business schools and inthefinancial press. Recent examples arethe"centerless
corporation" and the"knowledge corporation," bothof which require investment in reorganization and intellectual capital. The ideas mustbe tested. Building conglomerates was
popular in the 1960s and 1970s, but mostwere notsuccessful. Downsizing wasa popular
idea of the 1990s, but downsizing may reduce revenues as well as costs. Outsourcing
followed. Like all strategies, these ideasmustbesubjected to analysis.
Valuation analysis notonlyhelps withthegolno-go decision onwhether tocommit toan
investment, butit alsohelps intheplanning andexecution ofthe investment. Strategic ideas
sometimes canbevague; submitting the ideas to formal analysis forces theplanner tothink.
concretely aboutideas andto develop thespecifics; it turns ideasintoconcrete, dollar numbers. Andit forces theplanner to examine alternative ways of doing things. Strategies are
revised in response to the numbers untila final, bestplanemerges. A goodstrategy is the
result of bothgoodideas andgood analysis. Investing andmanaging with valuation analysis is called value-based management.
Thechieffinancial officer (CFO) typically coordinates analysis formanagement, and it
is her responsibility to institutionalize the bestanalysis. She and her corporate analysts
evaluate broadstrategies andspecific proposals to acquire firms, spinoffbusinesses, restructure operations, launch new products, and the like. Managers sometimes complain
about "bean counters" being toonarrowly focused onthenumbers, stifling innovation. Yet
"manage bythe numbers" theymust. Theonus is ontheCFO to adopt ananalysis thatnot
only avoids the criticism but actively promotes innovation and the testing of innovative
ideas, withtheassurance thatgoodideasthataddvalue willberecognized.
Inside andoutside analysts differ inonerespect: Inside analysts have farmore informationto work with. Outside analysts receive thepublished financial statements along with
much supplementary information, but they aretypically notprivy to "inside information."
Because you, as students, arenotprivy to inside information either, thefinancial statement
14 Chapter 1 Inrroducrion (0 InllCsling 11M VoJuarion

analysis in this bookis moreorientedto the outsideanalyst. Mostof the applications are to
U.S.financial statements, but the focusis not on U.S.accounting practices. Ratherit is on
how accounting information-be it accounting practices of the UnitedStatesor anyother
country-can best be handledin valuation analysis. Statements of other countries as wen
as the UnitedStatescan be reformulated and modified according to universal principles to
makethem moreamenable to analysis. And impediments to good analysis due to accounting principles or disclosure deficiencies will be identified. So we develop a critique of
financial statements as they are currently prepared.
THE ANALYSIS OF BUSINESS

Thetechniques to be developed in thisbook are for both insideandoutsideinvestors. Both
investin business operations. The outside investor talks of buyinga stock, but buying a
stock is not buyinga piece of paper;it is buyinga pieceof a business. An old adagesays,
"One does not buy a stock, one buysa business." And it goes on: "If you are goingto buy
a business, knowthe business."
An accomplished analystmustknowthe businessshe is covering. An analystseekingto
valuea telecommunications firm mustunderstand thatindustryandthe finn's positionin it.
Shemustknowthe firm'sstrategy to buildnetworks, to adaptto technological change, and
to meetthe challenges of itscompetitors. She mustknowtheproducts. Shemust anticipate
consumer demand.. She must knowwhetherthere is excesscapacity in the industry. She
mustunderstand the evolving technology path, bowvoice,data, andmultimedia mightbe
delivered in the future. Sbemustunderstand government regulations. The businesscontext
gives meaningto information, The significance of high labor costs of, say, 70 percent of
sales is much greaterfor a firmwith lowlabor inputandhigh capitalinput than for a consulting firm with a large labor input.To understand whethera PIE ratio of 87.9 for Dell,
Inc., is too high,the analystmustunderstand the computer business, theprospects forsales
growth, and the profitmarginson different computerproducts. Sometypes of firms work
on lowprofit margins (profits relativeto sales),whileothersworkon high profitmargins,
and it might be ridiculous to expecta low-margin firm to improve its profit margin substantially. Normal inventory levelsdifferbetweenretailers and wholesalers, and between
manufacturers andretailers. Depreciation chargesshouldbe high if a firmis in an industry
withrapidly changingtechnology or excesscapacity.
Analysts specialize by industry sectorsimply because knowing thenatureof thebusiness is
a necessary condition for analyzing a business. Forexample, equityresearch reports areusuallyprefaced bya discussion oftheindustry andfinancial statement analysis usually compares
measures likeprofitmargins andinventory ratiosto normal benchmarks for the industry.
Understanding businessis of coursethe subjectof a wholebusiness schoolcurriculum,
to be filledout by yearsof experience. The morethorough that knowledge, the moreconfident one is in business valuation. One treads cautiously when investing in firms about
which one knows little. Do too many investors (and indeedmoneymanagers) buy stocks
insteadof businesses?
Strategy and Valuation

Thereare many details of a business withwhichthe analyst mustbe familiar. To focushis
thinking he first identifies the businessmodel-sometimes also referred to as the business
concept or the business strategy. Whatis the firmaimingto do?Howdoes it seeitselfto be
generating value? And whatarethe consequences of the strategy? Thesequestions are often
answered in terms of how the finn represents itself to its customers. Home Depot, the
Anticipating Strategy: AOL Time Warner

Managers offirms usevaluation analysis to evaluate whether
their strategies create value forshareholders. But shareholders
andother potential investors also must familiarize themselves
with firms' strategies. And they should askwhat alternative
strategies firms might pursue, forthe value of firms isdifferent under different strategies.
Consider America Online discussed in Box 1.3. In early
1999, AOl wasan Internet portal whose revenues came from
subscriptions, advertising, and e-comrnerce. Then, in early
2000, AOL announced itsmerger with Time Warner, thelarge
media company that owned CNN, Turner Broadcasting Systems, publications like Time magazine, Warner Brothers film
and recording studios, cable systems, andmany otherassets
with valuable brand names. This acquisition wasthe first big
merger of a newInternet company with an old-style media
company, bringing distribution andcontent together.
Clearly AOl wasa company in rapid evolution, changing
from a portal firm to a content firm ina short space of time.
AOl's management would need to understand the value of
Time Warner to ensure that they were notoverpaying forits
shares. Theywould need to understand thevalue ofAOl's own
shares to ensure that, inoffering shares to make acquisitions,
1.4
they were not issuing shares that were undervalued in the

market. And they would need to understand any velue-aooec
synergies thatwould come from combining thefirms.
But outside analysts also benefit from understanding how
AOl is likely to evolve. An analyst valuing AOL as a standalone portal firm inearly 1999 would have arrived at a differentvaluation from onewho hadanticipated AOL's acquisition
strategy. And an analyst surprised bythe Time Warner acquisition would revise his valuation after recognizing theimplications ofthestrategy it revealed.
Strategies are adaptive to changing conditions. so valuations must be revised as strategies change. In mid2002. AOl
Time Warner's stock price wasdown 65percent from its level
at thetime ofthemerger, and$54 billion ofgoodwill from the
acquisition had to bewritten offthebalance sheet (the largest
write-off ever). Commentators insisted thattheexpected benefits from themerger hadnotbeen realized. The CEO position
at AOl Time Warner passed from Gerald Levin, who engineered the AOL merger, to Richard Parsons, with the challenge to modify the strategy. Would AOl be spun offfrom
Time Warner? Anticipating thatstrategy was the first stepin
valuing AOL Time Warner at thatpoint intime.
warehouse retailer of home-improvement products, follows the concept of providing highquality materials fordo-it-yourselfers at discount prices, but withtraining and advice. As a
consequence, thecombination of discount prices withadded customer servicing costsimplies
thatthefirm mustbeveryefficient in itspurchasing, warehousing, andinventory control. The
Gap,Inc.,aimstopresent dress-down clothing as fashion items at reasonable pricesinattractivestores, a different concept from warehouse retailing. As a consequence, it mustmanage
image through advertising and be creative in fashion design while at the sametimekeeping
production costslow. With considerable retail space,both firms require highturnover in that
space.Both have run intodeclining fortunes, forcing an evaluation of theirstrategies.
For the inside investor, the business strategy is the outcome of valuation analysis: A
strategy is chosenafter determining whetherit willadd value. for the outside investor, the
business strategy is the starting point for analysis, for firms can be valued only undera
specified strategy. But the outside investor also should be aware of alternative strategies
thathavethepotential forenhancing value.Sometakeovers occurbecause outsideinvestors
believe that more value can be created with new ideas and with new management.
Strategies are ever evolving, so the analyst must be attuned to the way firms adapt to
change. Indeed, a smart analyst anticipates changes in strategy and the value they might
createor destroy. SeeBox 1.4.
Mastering the Details

Oncethe business is clearlyin mind, theanalyst turns to masterthe details. Thereare many
detailsof the business to discover, but you can thinkof themunderfive categories.
1. Know the firm's products.
a. Types of products.
b. Consumer demand for the products.
15
16 Chapter 1 Introduction 10 Intle5ting QM Valua.riort
c. Priceelasticity of demand for theproducts. Doesthefinn have pricing power?

d. Substitutes for each product. Is the product differentiated? On price? On quality?
e. Brandname association withproducts.
f. Patentprotection for products.
2. Know thetechnology required to bringproducts to market.
a. Production process.
b. Marketing process.
c. Distribution channels.
d. Supplier network andhow thesupply chainoperates.
e. Coststructure.
f Economies of scale.
3. Know the fum'sknowledge base.
Q. Direction andpaceof technological change andthe finn'sgrasp of it.
b. Research anddevelopment program.
c. Tie-in to information networks.
d. Ability to innovate in product development.
e. Ability to innovate in production technology.
f Economies fromlearning.
4. Know the competitiveness of theindustry.
a. Concentration inthe industry, the number of firms, andtheirsizes.
b. Barriers to entry in the industry and the likelihood of new entrants and substitute
products. Is therebrand protection? Arecustomer switching costs large?
c. The firm's position in the industry. Is it a first mover or a follower in the industry?
Doesit have a costadvantage?
d. Competitiveness of suppliers. Do suppliers have market power? Do labor unions
have power?
e. Capacity in theindustry. Is thereexcess capacity or undercapacity?
f. Relationships andalliances withotherfirms.
5. Know themanagement.
a. What is management's trackrecord?
b. Is management entrepreneurial?
c. Does management focus on shareholders? Do members of management have a
record of serving theirowninterests? Are they empire builders?
d. Do stock compensation plans serve shareholders' interests or managements'
interests?
e. Whatarethedetails oftheethical charter underwhich the firm operates, anddomanagers havea propensity to violate it?
f What is thestrength of corporate governance mechanisms?
6. Know the political, legal, regulatory, andethical environment.
a. Thefinn'spolitical influence.
b. Legal constraints on the firm, including antitrust law, consumer law, laborlaw, and
environmental law.
c. Regulatory constraints onthe firm, including product andprice regulations.
d. Taxation ofthe business.
These features aresometimes referred to asthe economicfactors thatdrive thebusiness.
You have studied many of these factors, andmore, in courses onbusiness economics, strategy, marketing, andproduction.
Chapter 1 ImToductiort to Investing and Va!!Ul!ion 17
The Key Question: Sustainability of Competitive Advantage

Armed with an understanding of a finn's strategy anda mastery of the details, the analyst
focuses on thekeyquestion: How durable is thefirm scompetitive advantage?
Microeconomics tells us thatcompetition drives away abnormal returns, so thata firm
ultimately earnsa return equal to therequired return forthe riskassumed. With few exceptions, the forces of competition are at play, and the critical question is how long those
forces taketo playout.Thekeyto adding value is to design a business where abnormal returns endure for as long as possible. Finnsattempt to counter the forces of competition to
gaincompetitive advantage. The moreenduring the competitive advantage, the more the
firms generate value.
The business strategy andall of the economic factors listedultimately bearupon competitive advantage. Innovative strategies are adopted to "get ahead of the competition."
Products are designed to allure customers from thecompetition. Brands are builtto maintain enduring customer loyalty. Patent protection is sought. Innovative production technologies are adopted for costadvantage. And, yes,politicians are lobbied to protect firms
from competition. Theinside analyst designs strategies tomaintain competitive advantage.
Theoutside analyst understands those strategies andstrives to answer thequestion as tothe
durability ofthe firm's competitive advantage.
Financial Statements:The Lens on the Business

Understanding economic factors is a prerequisite to forecasting. But we needa way of
translating thesefactors intomeasures thatleadtoa valuation. We mustrecognize thefirm's
product, the competition in the industry, the firm's ability to develop product innovations,
andsoon,butwealsomustinterpret thisknowledge ina waythatleadstoa valuation. Economic factors are often expressed in qualitative termsthataresuggestive butdonotimmediately translate intoconcrete dollarnumbers. We might recognize thata finnhas"market
power," butwhat numbers would support thisattribution? We might recognize thata firm is
"underthethreatof competition," buthowwould thisshow up inthe numbers?
Financial statements report the numbers. Financial statements translate economic factors into accounting numbers like assets, sales, margins, cash flows, and earnings, and
therefore we analyze the business by analyzing financial statements. We understand the
effects of market power from accounting numbers. We evaluate the durability of competitiveadvantage fromsequences of accounting numbers. Financial statement analysis organizes the financial statements ina waythathighlights these features of a business.
Financial statements are the lens on the business. However, financial statements often
produce a blurred picture. Financial statement analysis focuses thelenstoproduce a clearer
picture. Where accounting measurement is defective, analysis corrects. Andwhere thepictureinfinancial statements is incomplete, theanalyst supplements thefinancial statements
withotherinformation. To do so, the analyst mustknow whatthe financial statements say
and what they do notsay. He must havea senseof good accounting andbad accounting.
Thisbook develops thatfacility, beginning in the nextchapter, where financial statements
are introduced. With this facility and a goodknowledge of the business, the analyst proceeds to value the business through the lensof the financial statements.
CHOOSING A VALUATION TECHNOLOGY

Theanalyst musthavea good understanding of thebusiness. Hemustunderstand thefirm's
competitive advantage. He must understand how the financial statements measure the
success of the business. But, with all this understanding, he must then have a way of
Valuation Technologies
The following valuation methods arecovered in thisbook.
All involve financial statement numbers in some way. Each
method must beevaluated on its costs andbenefits.
METHODS THATDO NOT

INVOlVE FORECASTiNG
The Method of Comparables (Chapter3)
This method valves stocks onthebasis of price multiples (stock
price divided byearnings, bookvalue, sales, andotherfinancial
statement numbers) that are observed for similar firms.
1.5
METHODS THATINVOLVE FORECASTiNG
Dividend Discounting: Forecasting

Dividends (Chapter4)
Value iscalculated asthe present value ofexpected dividends.
Discounted CashFlow Analysis: Forecasting Free
CashFlows (Chapter4)
Value iscalculated asthe present value of expected free cash
flows.
Residual Earnings Analysis: Forecasting Earnings

and Book Values (Chapter5)
This method identifies underpriced and overpriced stocks on Value is calculated as book value plus the present value of
the basis of their relative multiples. A stock screener buys expected residual earnings.
firms with relative low price-earnings (PIE} ratios, for example,
and sells stocks withhighPIE ratios. Orhe mayscreen stocks Earnings Growth Analysis: Forecasting Earnings and
into buys and sells by screening on price-to-book, price-to- Earnings Growth(Chapter6)
Value is calculated as capitalized earnings plus the present
sales, andother multiples.
value of expected abnormal earnings growth.
Asset-Based Valuation (Chapter3)
Asset-based valuation values equities by adding up the estimated fair values of the assets of a firm and subtracting the
value oftheliabilities.
Multiple Screening {Chapter 3}
converting that understanding into a valuation of the firm. A valuation technology allows
the analyst to make that conversion. However. the analyst must choose an appropriate
technology.
Box 1.5lists valuation technologies that are commonly used in practice. Some havethe
advantage of being simple, and simplicity is a virtue. But techniques can be too simple,
ignoring important elements. Some techniques are dangerous. containing pitfalls for the
unwary. The analyst chooses a technology with costs and benefits in mind. weighing
simplicityagainstthe costsof ignoring complexities.
This book covers the techniques in Box 1.5. highlighting their advantages and disadvantages. However, by far the mostattentionwill be givento those techniques that attempt
to calculatefundamental valuefrom forecasts, for valueis basedon the expectedpayoffs to
investing. Forthese methods, the analyst must identify what is to be forecasted. Doesthe
analyst forecast dividends (and thus use dividend discount methods)? Does the analyst
forecast cash flows (and thus use discounted cash flow methods)? Earnings? Book value
and earnings? To make the choicethe analyst must understand the advantages and disadvantages of each and thenadopta technology thatprovides the mostsecurityto theinvestor.
Guiding Principles
Years of investing experiencehaveproduced a set of principles that fundamental analysts
ding to. Box 1.6lists a numberof tenets that will be adheredto as we develop valuation
technologies throughout the book.The first six havebeen invoked already in this chapter.
Those numbered 7, 8, and 9 bearon the all-important taskof handlingthe information from
whichwe infer value.
All of the valuation methods in Box 1.5 involve financial statementinformation, but in
different ways. Too-simple techniques ignore information, and point 7 in Box 1.6 warns
18
Tenets of Sound Fundamental Analysis

As weproceed through the book, wewill appeal to a number
of guiding principles. Here is some of the wisdom, distilled
from practice offundamental analysis over the years:
1.
2.
3.
4.
1.6
365 is high by any standard, so the fundamentalist questions whether the market is forecasting too much earnings
growth. Point 10 warns usagainst getting too excited-ctco
specclatve--ebout future growth. Fundamentalists seespeculation about growth as one of the prime reasons for the
overpricing of stocks and the emergence of price bubbles. A
valuation method needs to build inprotection against paying
too much for growth. Asound valuation method challenges
the market's speculation aboutgrowth.
One does notbuy a stock, onebuys a business.

When buying a business, know the business.
Value depends onthe business model, thestrategy.
Good firms canbe badbuys.
5. Price iswhatyou pay, value iswhatyou get.
6. Part ofthe risk in investing istherisk ofpaying toomuch
When Cakulating Value to ChallengePrice.
fora stock.
Bewareof Using Price in the Calculation
7. Ignore information at your peril.
Price iswhatyou payandvalue iswhatyou get.SoPoint 11
8. Don't mix whatyou know with speculation.
warns against referring to the market price when you arecal9. Anchor a valuation on what you know rather than culating value. Ifyou doso,you aredearly being circular and
speculation.
have ruined theability ofyour analysis to challenge prices. Yet
10. Beware of paying too much forgrowth.
analysts allow prices to enterinsubtle ways. An analyst who
11. When calculating value to challenge price, beware of increases her earnings forecast because stock prices have
increased-cand then applies a valuation multiple to those
using price inthecalculation.
earnings-commits
that error. That is so easy to do when
12. Stick to your beliefs and be patient; prices gravitate to
there isexcitement abouta stock, forthere isa temptation to
fundamentals, butthatcantakesome time.
justify the price. But theanalyst may bejoining a chain letter.
Wehave referenced the first six points already inthis chapter. Apple provides another example.
Points 7, 8, and 9 arediscussed inthe adjoining text and will
With the launch of Phone, an analyst published an earnbeinvoked asweorganize information in later chapters. Points ings forecast for Apple of $6.95 for 2009, considerably
10 and 11 are illustrated below. Point 12 warns against the higher than the average for other analysts. This is fair
"quick buck." Fundamental investing is not for daytraders. enough, iftheanalyst canjustify the number. But the analyst
also published a 2009 price target of $250 pershare and,acAPPLE COMPUTER
cordingly, issued a buy recommendation. To get this number,
After thelaunch of irhone on the heels ofitsproduct hitwith
the analyst multiplied his 2009 earnings-per-share estimate
Pod, Apple Computer's shares traded at $190 each in midbyApple's current PIE of 36.5. You see the problem. The an2008. Analysts had a consensus earnings estimate of $5.20 per
alyst ispricing earnings onthe basis ofthe market's pricing of
share for its2008 fiscal year and $6.06 for 2009. Analysts often
earnings, butifthat pricing isincorrect heisbuilding mispricrefer to theforward PIE ratio, thatis, price relative to oneyear
ing into the calculation. He used price to challenge price
ahead (forward) earnings. With a stock price of $190 upfrom
rather than value to challenge price. And he compounded
$60 two years before, Apple's forward PIE was36.5, compared
the speculation in a high forecast with speculation in the
with 155 forthe S&P sao. Apple returned to the "hotstock"
market price. Ifa PIE of 36.5 represents a mispricing, heconstatus it enjoyed at the dawn of the personal computer age.
tributed to the perpetuation of the mispricing. No wonder
Bewareof PayingTooMuchfor Growth
bubbles form. The fundamentalist takes care to apply methA PIE ratio indicates the market's expectation of future earn- odsthat establish the intrinsic PIE ratio without reference to
ings growth (aswewi!1 seeexplicitly inlater chapters). A PIE of market prices.
that the investor ignoresinformation at her peril;she puts herselfin dangerof tradingwith
someone who knows more than she. Multiple screeningmethods, for example, use only
one or two bits of information, so they can get you into trouble, as we observedwith the
temptingly low multiplesfor General Motorsand Ford. Rarelycan an analystavoidforecasting the future, and forecasting requires more information. So Box 1.5 divides techniques into those that require forecasting and those that do not. Forecasting uses the full
range ofinfonnation available, but it also requires the appropriate organization of informationintoa form that facilitates forecasting.
19
20 Chapter 1 Introduction roInwsting andValuation
Chapter 1 InlrOOUl:tion 10 lnwstingllnd Valuation 21
Thetrouble withforecasting is thatit dealswiththe future, and the future is inherently

speculative. Thefundamental analyst is wary of speculation so, to exercise duecare,heinvokes points 8 and 9 in Box 1.6. In organizing the information, the analyst follows the
maxim: Don'tmixwhatyou know with speculation. To cut across speculation, he distinguishes information that is concrete from information that is more speculative. Accordinglyhetakes carenottocontaminate relatively hardinformation withsoftinformation that
leads to speculation. He views notions like intangible assets, knowledge capital, newtechnology, and Web real estate thatwere invoked during the bubble (Box 1.2)as dangerous.
Buthe alsois careful in handling financial information. Heseescurrent salesas relatively
hardinformation, forcustomers have beenwon, buthe seesinformation indicating thatthe
firmmight win morecustomers in the future as more speculative. He doesnot ignorethe
more speculative information, but hetreats it differently. Current salesareweighed differently thanforecasts of long-run growth ratesin sales. Hetreats information thatis usedto
forecast oneor twoyearsahead in a different lightthaninformation thatis usedto forecast
the distant future. And he is considerably moreuncomfortable withstockvaluations that
aredependent on forecasting thelongrun;he seessucha stockas a speculative stock.
Anchoring Value in the Financial Statements

Tenet 9 in Box1.6embellishes Tenet 8: Anchor a valuation on what you know rather than
speculation. Muchof what weknow about firms is found in thefinancial statements, so the
maxim might read: Anchor a valuation on thefinancial statements. Financial statements
contain information of varying quality andtheaccounting is sometimes suspect, buttheinformation they contain is relatively hardinformation. Financial statements arebasedonaccounting principles that largely exclude speculative information. They are audited. So,
while the analyst always teststhe quality of theinformation in thefinancial statements and
organizes thatinformation basedon its perceived quality, financial statements are a good
placeto startwhen valuating firms.
Financial statements report two summary numbers, bookvalue of equityandearnings.
The bookvalueof equity is the "bottom line"number inthe balance sheet; earnings is the
"bottom line" number in the income statement. The last two methods in Box 1.5 anchor
value onthesesummary numbers. Thefonn of the valuation is as follows:
Value = Anchor + Extra value
Thatis,theanalyst takesaparticular measure inthefinancial statements as a concrete starting pointand thengoesabout calculating "extravalue" not captured by thismeasure. The
anchormight be thebookvalue of shareholders' equity, so that
Value = Bookvalue + Extra value
Herebookvalue is the starting point, butthe analyst realizes that bookvalue is an incompletemeasure of value, so he calculates extra value. In doing so,he calculates the intrinsic
price-to-bock ratio, the multiple of book value that the equity is worth. Valuation then
comes down to the method of calculating value thatis not inbookvalue.
Alternatively, the anchor might be earnings, so that
Value = Earnings
+ Extra value
In this case, earnings is the starting point and the extra value yields the intrinsic price-
earnings ratio, the multiple of earnings that theequityis worth. In both cases, the analyst
startswitha hardnumber (inthefinancial statements) andaddsan analysis of morespeculative information.
To discipline thatspeculation, he carries out a financial statement analysis thatdistinguishes relatively hardinformation about the extra value from thatwhich is relatively soft.
Thatbeingso, he is secure in his valuation and is protected against the winds of speculation.Thesubsequent chapters in thisbook develop thesethemes.
HOWTO USE THIS BOOK
;-'-
The bestway to tackle thisbookis to seeit as an exercise in building a valuation technology. Think of yourselfas an investor who wants to have the bestmethods to protect and
enhance yourinvestments. Or thinkof yourself as oneof theprofessionals we have talked
about, an investment analyst or CFO. Thiswillgiveyoufocus. If youthink in terms of an
outside analyst, askyourself: How would I buildthebestvaluation product formyclients?
How would I prepare a credible equity research report? If youthinkin termsof an inside
analyst, askyourself: How would I write a strategy document or an investment appraisal?
You want an analysis that will be practical, but you want one that is also conceptually
sound. Andyouwant an analysis thatis understandable andeasyto use.
Thisfocus willmake youdemand a lotof thebook, andof yourself. It willhelp youdevelop yourcritique of investment products thatare beingoffered by vendors. It willhelp
youdevelop yourcritique of the accounting in published financial statements. And, yes,it
willalsohelpyoucritique the book!
Therearethreeingredients to a goodtechnology: goodthinking, goodapplication, and
good balance between costandbenefit. Usethebookto develop good thinking about businesses andtheir valuation: The book takes painsto layout the concepts clearly. Usethe
bookto translate concepts intomethods that work in practice: The book builds a practical
technique, block-by-block, from the concepts. Muchof the analysis can be built into a
spreadsheet program, and you might buildthis spreadsheet as yougo, a product to carry
overtoyourprofessional life.You willfind theBYOAP (Build Your OwnAnalysis Product)
feature on theWeb pageto be indispensable for this.Usethebookto get a sense of costbenefit tradeoffs. When is moredetail worth it? What do I loseby cutting comers? What
"bellsandwhistles" areworth adding?
Thetextis self-contained. Butyouwill alsofind thebook's Web page to bea worthwhile
companion. It goesintomore"real-lite" situations, gives youmoredatato workwith, and
opensup the broader literature. It also has numerous links to information, the basicraw
materials ofanalysis. Please visittheWeb siteat www.mhhe.comJpenman4e.
Learning comes from reinforcing concepts byapplication. Exercises aregiven at theend
of eachchapter along with larger casesat the end of eachsection. Theyare written with
learning in mind, to make a point, not solely as tests. More applications are on the Web
page.Work through as many of theseas youcan.You will see how the analysis comes to
lifeas yougo "hands on."
An Outline of the Book

This chapter hasintroduced youto fundamental investing andhasprovided a flavor of the
fundamental analysis thatsupports theinvesting. Financial statements feature prominently
in analysis, so the introduction is completed in Chapter 2, where the financial statements
are introduced. There youwill understand why an analyst might anchor a valuation in the
financial statements. The remainder of thebookis thenpresented in five parts.
Good practice is builton goodthinking. PartOne(Chapters 3-{i) Jays outthatthinking.
Part Oneevaluates eachof the methods presented in Box 1.5and laysout how financial
statement information is incorporated ineach. By theendofPartOneyouwillhave agood
22
Chapter 1 Inlroduc[ion 10 Im'ming endValuation 23
Chapter 1 In!roollrlion to Im:esring and Valmuion

senseof whatgoodanalysis is and whatpooranalysis is, andyouwill have selected a valuation technology withsomeconfidence. The remainder of the bookinvolves the applicationof the technology to goodpractice.
PartTwo (Chapters 7-12) dealswith the analysis of information. It shows howto understand the business through the lensof the financial statements. It also shows how to
carryout financial statement analysis witha view to forecasting payoffs.
PartThree(Chapters 13-15) involves forecasting. It laysout the practical steps for developing forecasts from theinformation analyzed in PartTwo. And it demonstrates howto
convert thoseforecasts intoa valuation.
Part Four(Chapters 16--17) dealswithaccounting issues. A discussion of accounting is
intertwined withthedevelopment of fundamental analysis throughout thebook, beginning
in Chapter 2. PartFourpullstheaccounting analysis together so thatyouhave a soundunderstanding of howaccounting works in valuation. And, to thefinancial statement analysis
of theearlierparts,it addsan accounting quality analysis.
PartFive(Chapters 18 and 19) discusses howto bringfundamental analysis to theevaluation of risk,boththe riskof equities andtheriskof corporate debt.
Find thefollowing on the Web page supplement for this

chapter:
A guide to thebook's Web site.
More on investment styles and the styles that equity
funds commit to intheir marketing.
More on the history of investing and the returns to
different investments.
Key Concepts
More onstock market bubbles.

More onanalysts during thebubble.
A further introduction to valuation methods.
The Readers' corner provides a guide tofurther reading.
Web Exercises hasadditional exercises, along with solutions for you to work.
activeinvestorsbuyor sell investments

afteran examination of whether they
are mispriced, inorderto earn
exceptional ratesof return. Compare
withpassiveinvestors and defensive
investors. 4
alpha is an abnormal returnoverthe
expected returnfor the investment risk
taken, 5
beta is a measure of riskas prescribed
bythe capital assetpricingmodel
(CAPM). 5
businessmodelis the concept or strategy
underwhicha firm operates to add value
from sellingproducts or services to
customers. 14
claim is an enforceable contract for returns

from an investment. 9
competitive advantageis theabilityto
earn abnormal returns byresisting the
forces of competition. 17
defensive investors buyor sell investments
afteran examination of whether theyare
mispriced, in orderto avoidtrading at the
wrong price, 4
enterprisevalueis thevalue ofthebusiness
(thefinn),incontrast tothevalue of the
various claims on the finn. 11
financial analyst is a professional who
evaluates aspects of investing; particular
typesare equityanalysts, creditanalysts,
strategy analysts, riskanalysts, and bank:
loanofficers. 12
financial statement analysisis a set of

methods forextracting information from
financial statements. 2
financing activitiesof a finn are the
transactions between a firm andits
claimants thatinvolve cashinvestments in
thefinn byclaimants andcashreturnsto
claimants by the finn. 12
forces ofcompetitionare thechallenges of
others, in the pursuit of profit, to erodea
firm's competitive advantage. The forces
of competition tendto drive away
abnormal returns. 17
fundamental analysis(or valuation
analysis) is a set of methods for
determining the value of an
investment. 3
fundamentalinvestors buyinvestments
onlyafterthoroughly examining
information aboutfirms andreaching
conclusions abouttheunderlying value
thattheinformation implies. 4
fundamental risk is thechance of losing
valuebecause of theoutcome of business
activities. Compare withprice risk. 5
indexinvesting involves buying and
(passively) holding a market index of
stocks. 5
intrinsic value is what an investment is
worth based on forecasted payoffs from
theinvestment. Payoffs areforecasted
withinformation so intrinsic valueis
sometimes saidto be thevaluejustified
bytheinformation. 4
intuitiveinvestors tradestocksbasedon
theirintuition, without submitting that
intuition to analysis. 3
investing activitiesof a firm involve the
acquisition anddisposal of assetsused in
operations. 12
momentuminvesting follows therule:

Stocks whose pricehasgoneupwillgo
up further. 7
operating activitiesof thefinn involve
usingassets (acquired in investing
activities) to produce andsellproducts in
markets. 12
passive investors buyinvestments without
an examination of whether theyare
mispriced. Compare with active
investors. 3
payoffis value received from an
investment. J0
price risk is the chance oflosing value
from buying or selling investments
at pricesthatdifferfrom intrinsic
value. 5
return to an investment is thepayoffto the
investment lessthe amount paidfor the
investment. 10
security analysis is a set of methods for
determining thevalue of an investment
when securities likestocks andbondsare
involved. 3
strategy analysisinvolves articulating
business ideas anddiscovering the
value thatmightbe generated bythe
ideas. 13
value-based managementinvolves
making business plansbymaximizing
the likely value to be generated bythe
business, and monitoring and rewarding
business performance withmeasures of
valueadded. 13
value of the equity is thevalue of the
payoffs a firm is expected to yieldfor its
shareholders (itsowners). 10
value of the firm (or enterprise value)is
thevalue of thepayoffs a firm is expected
to yieldfor all its claimants. 11
, .'
i
~.
i! .
r
A Continuing Case: Kimberly-Clark Corporation
A Self-StudyExercise
AttheendofChapters 1-15, theprinciples andtechniques of thechapter willbeapplied to
Kimberly-Clark Corporation, theconsumer products company thatmanufactures and marketsa widerangeof healthand hygiene products. By following one company throughout
24
Chapter 1
Chapter 1
lnlnxlclion10Investing and Volllo[ion
the book,you willobservehowa comprehensive financial statement analysis andvaluation

is developed. By engaging in the case-by carryingout the tasks it asks you to--you will
takeon the roleofan activeanalyst and, by the end of the book,willhavethe complete in~
gredients for an equityresearch reporton the company. Everydetailof the analysis cannot
be applied to one company, of course, but you will see many of theprinciples in the text
cometo lifewithKimberly-Clark.
As you follow Kimberly-Clark, you will be guided to sources for the inputs into
youranalysis. You will be asked, with guidance, to performcertaintasks.Aftercompleting the tasks, you can check the solutionon the Web site for the chapterto see how well
you havedone.
Chapter I is merelyan introduction to the book.But a number of principles havebeen
laid down. First and foremost is the requirement that, before you engage in valuing a
company, you must understand the business the company is in. So your firstengagement
with Kimberly-Clark here leadsyou to sources that explain Kimberly-Clark's business
model.
Knowing What Analysts Are Saying

Before beginning your own analysis, understand what "the Street" (in the U.S.) or "the
City"(intheUK)issaying. Startwitha finance Web site.TheseWeb sitesoftenhave a summary of analysts' opinions and their earnings and revenue forecasts, like the one in
Exhibit 1.1 from Yahoo! Finance (at http://finance.vahoo.comO. Does your library subscribeto services that provide recent analysts' research reports likeThomson One,Multex,
or S&P Market Insight? A number of brokerages allow youto sign up for fred trials for
theirservices.
A warning goes along with peeking at analysts' reports before you start your own
research: Beware of joining thespeculative crowd. Analysts sometimes herdtogether, and
there is considerable reward to an independent analysis that uncovers something the herd
doesnot see.
Hereare some questions you shouldconsider as you go through the various sources.
A. Whatis Kimberly-Clark's core business?
B. Whatis Kimberly-Clark's strategy for the future?
C. HowdoesKimberly-Clark intend to grow? Doesit growthrough acquisitions?
D. Whatis Kimberly-Clark's competitive environment? Whoare its main competitors?
E. Whatare the main risks facing the firm?
F. Exhibit 1.1 givesan intraday pricechartfor March24,2005. Find a pricechartforprior
periods (onYahcol, for example) and calculate the returns that shareholders earnedon
thestockoverthe 2004calendar year.
G. Summarize anddiscussthe mainfeatures of the analysts' reports in Exhibit 1.1.
H. Overall, do analysts (covered in Exhibit 1.1)think KMB shares are reasonably priced,
cheap, or expensive?
I. How has KMB's stock price fared since March 24, 2005, the date of the report in
Exhibit l.I?
KNOWING THE BUSINESS: KIMBERLY-CLARK

CORPORATION (TICKER KMB)
You have possibly sniffled into a Kleenex tissue. At a younger age you may haveused a
Huggies diaper(ornappy). Addto thesebrands the familiar names of Scott(papertowels),
Scottex, Cottonelle, Viva, Kotex, and WypAll, you get a good idea of what Ki'vfB does.
Hereis a summary statement:
Kimberly-Clark Corporation manufactures and markets a range of health and hygiene products. The Company isorganized into three global business segments. The Persona! Care segment manufactures and markets disposable diapers, training and youth pants and swim pants,
and feminine and incontinence care products. The Consumer Tissue segment manufactures
and markets facial and bathroom tissue, paper towels, wet wipes, andnapkins for household
use. The Business-to-Business segment manufactures and markets facial and bathroom tissue,
paper towels, healthcare products such assurgical gowns, drapes, infection control products,
sterilization wraps, disposable face masks andexam gloves. aswell aspremium business, correspondence and specialty papers.
This, of course, is a cursorystatement. The dedicated analyst tries to find out muchmore
aboutthe details. Where doeshe look?
Sources of Business Information

First and foremost is the firm's statement of its business. For this, go to its Webpage, at
www.kimberly-clark.com paying particular attention to its most recentannual reportto
shareholders and to the firm's most recent lO-K filing with the Securities and Exchange
Commission, at www.sec.gov/edgar.shtrnl.
Of course, youcanalsoGoogle. Go to www.google comandenterthe company's name.
Looknot only for information on the company but also on the consumer paperproducts
industry. You will get to various financial information portals-like Google Finance and
Yahoo! Finance-and to newsreports on the company. Lookfor company reports, particularly from financial analysts. Look for consumer and marketing analysis. Now is a good
timeto explore the linksto research resources onthe book's Web site. Muchinformation on
the Internetis behindpasswords, for subscribers only. Timeto headto your library and its
electronic resources. Doesyourlibrary havecompany research andindustry research available?Lookfor consumer paperproducts. Doesyourlibrary linkyouto articlesin the businessand financial press?Canyoulinkto tradepublications?
]n1rOOU{!iOl1lO I1west;ng ond Vulilmion 25
EXHIBIT 1.1
Analysts'
Recommendations
and Estimates for
Kimberly-Clark
Corporation from
Yahoo! Finance Web
Page on March 24,
2005.
Kimberly Clark CP (NYSE:KMB) Delayed quote data
Last Trade:
Trade Time:
Change:
Prev Close:
Open:
Bid:
Ask:
ly Target Est:
Day's Range:
64.81
Mar 24
.1.0.53 (0.81%)
55.34
64.81-65.55
58.74-69.00
1.096.600
52wk Range:
Volume:
55.55
N/A
N/A
72.06
Avg Vol (3m):
1,442,363
Market Cap:
PIE (ttm):
EP$ (ttm):
Div & Yield:
31.20B
18.13
357
1.80 (2.78%)
Th<: head.r Ziveslno;IOX( "Ii

alcloseoftmdingon March 24.
Ino slock pric<> movements du,.
ing lh. o<ly. ~nd b:lSic summary
inrormation. TheAn:lyslOpin
ionsummarizcs=lysts' buy.
hold. orsenrttOmmcndations.
longwithrevisions bysele<:!ed
firms. TheA""lyslEstt""'te;
summarize an:t1y,ts' cOmenSIIS

forcc= for""ming;.=roles.
and e.uningsgrowlhr:Jles, Wilh
C<lm!"ri'ons 10 the ;od"'lry.
seclor. "nd the S&? 500firms
K..\1B 24-Mar3:59pm
~ ~; ; : :;: : : : : : -: : : : : : : :
64.8
lOam
12pm
2pm
4pm
(Continuedi
26
Chapter 1 InlToduClion!o Im\'::lring andVa/llarion 27
Chapter 1 Introduction (0InlXSting andVa/allrion
AnalystOpinion
EXHIBIT 1.1
(Continued)
Earnings Est
Commendation Summary*
Mean Recommendation (this week);
Mean Recommendation (last week);
Change:
Personal Goods Industry Mean:
S&P 500 Mean:
Avg. Estimate
No. of Analysts
Low Estimate
High Estimate
Year Ago Sales
Sales Growth (year/est)
2.6
2.5
0.1
2.44
2.52
Current Qtr
Mar-OS
NextQtr
CurrentYear
Dec-OS
NextYear
Dec-06
J.9IB
4
3.B9B
3.92B
3.808
2.9%
J.90B
4
3.89B
3.91B
3.78B
3.3%
15.77B
9
15.34B
16.20B
NlA
16.35B
7
16.11B
16.68B
15.77B
3.7%
Jun~OS
NfA
'(Slrong Buy) 1.C-HI{Strong Soil)
Mar-C4
Jun-04
Sep-04
Dec-04
EP5 Est
EPS Actual
Difference
Surprise %
0.91
0.91
0.00
0.0%
0.B9
0.90
0.Q1
1.1%
0.90
0.89
-0.01
-1.1%
0.90
0.91
0.01
1.1%
EPS Trends
CurrentQtr
Mar-OS
Next Qtr
Jun-OS
CurrentYear
Dec-OS
NextYear
Dec-06
0.93
0.93
0.93
0.94
0.94
0.95
0.95
0.95
0.96
0.96
3.B1
3.B1
3.B2
3.81
3.81
4.14
4.14
4.15
4.16
4.i6
Current Qtr
Mar-OS
Next Qtr
Jun-05
Current Year
Dec-OS
NextYear
Dec-06
Earnings History
Price TargetSummary
Mean Target:
Median Target:
High Target
Low Target:
No. of Brokers:
72.06
73.50
80.00
59.00
8
Current Estimate
7 Days Ago
30 Days Ago
60 Days Ago
90 Days Ago
Upgradesand Downgrades History

Date
Research Firm
Action
From
15-Feb-05
3-Feb-04
8-0d-03
12-5ep-03
4-Apr-03
11-Dec-02
11-Dec-02
19-Jul-02
24-Apr-02
28-Feb-02
Smith Barney Citigroup

Deutsche Securities
C5FB
Morgan Stanley
Fahnestock
Salomon Smth Brny
Bane of America Sec
Bane of America Sec
Goldman Sachs
Downgrade
Initiated
Initiated
Initiated
Initiated
Upgrade
Downgrade
Upgrade
Upgrade
Initiated
Buy
ABN AMRO
To
Hold
Buy
Outperform
Equal-weight
EPS Revisions
Buy
In-line
Buy
Mkt Perform
Mkt Perform
Outperform
Mkt Perform
8uy
Mkt Outperform
Buy
Recommendation Trends
Strong Buy
Buy
Hold
Sell
Strong Sell
Current Month
Last Month
TwoMonths Ago
Three Months Ago
2
5
4
3
5
4
1
Up Last 7 Days
Up last 30 Days
Down Last 30 Days
Down last 90 Days
0
1
0
0
Growth Est
KMB
Industry
Sector
S&P 500
Current Qtr.
Next Qtr.
This Year
Next Year
Past 5 Years (perannum)
Next5 Years (per annum)
Price/Earnings (aI/g. for
comparison categories)
PEG Ratio (avg. for
comparison categories)
2.2%
5.6%
5.5%
8.7%
2.0%
8.0%
9.4%
8.6%
11.7%
11.8%
NlA
NlA
NlA
NlA
7.8%
11.5%
10.5%
10.6%
17.0
2.12
0
0
0
1
0
0
0
1
0
0
0
1
NfA
N/A
NfA
11.15%
NfA
10.51%
19.27
NfA
15.BO
1.73
NfA
1.50
Analyst Estimates
Earnings Est
Current Qtr
Mar-OS
Avg. Estimate
No. of Analysts
Low Estimate
High Estimate
Year Ago EPS
Next Earnings Date: 25-Apr-05
0.93
11
0.93
0.94
0.91
Next Qtr
Jun-05
CurrentYear
0.95
10
0.92
0.97
0.90
3.81
12
3.71
Dec~05
3.85
3.61
NextYear
Oec~06
4.14
12
4.0B
4.24
3.B1
Concept
Questions
CI.I. Whatis the difference between fundamental riskand pricerisk?

Cl.2. Whatis the difference between an alphatechnology and a beta technology?
CIJ. Critique the following statement: Holdstocksforthe longrun,forinthe longrun,the
returnto stocksis always higherthanbondreturns.
CIA. 'What is the difference between a passive investor and an active investor?
Chapter 1 Introduction toIntle5ring ondVail/arion 29
28 Chapter 1 fnlrtxf\l((ion 10 Jm:~5(ing and Vail/arion
C1.5. In the late 1990s, PIE ratioswerehighby historical standards. The PIE ratio for the
S&P 500stockswasas highas 33 in 1999. In the 1970s it was 8. Whatdo youthink
would be a "normal"PIE ratio-s-that is, where multiples higherthannormal couldbe
called"high" and multiples less than normal could be called "low"? Hint: The PIE
ratio is the inverse of the EIP ratio,sometimes called the earnings yield. Compare
this yieldwithnormal return for stocks of about 10percent.
Cl.6. Should a shareholder be indifferent between sellingher shares on the open market
and sellingthemto the finn in a stockrepurchase?
C1.7. Some commentators argue that stock prices"follow a random walk." By this they
meanthatchanges in stockpricesinthe future are notpredictable, so no onecanearn
an abnormal retum. Would stockpricesfollow a random walkif all investors were
fundamental investors who use all available information to pricestocksand agreed
on the implications of that information?
C1.8. Consider the case where all investors are passive investors: Theybuy index funds.
What is your prediction about how stock prices will behave overtime? Will they
follow a random walk? Hint: Priceswould notincorporate any information.
Cl.9. Figure 1.2plots a price-to-value ratio (PIV) for the Dow Jones Industrial Average
(DJIA) from 1979 to 1999. A PN ratiois a metricthatcompares themarketprice(P)
to anestimate of intrinsic value(V). Theintrinsic valueinthe figure isbasedon techniques that will be discussed in this book. But how it is calculated is not important
for the following questions:
a. Up to 1996, the PN ratio fluctuated around 1.0. What do you make of this
pattern?
b. Ifyou hadpurchased the Dow 30 stocks eachtimethe PN ratiofellbelow 0.8and
hadsoldthemeachtimethe p/V ratioroseabove1.2,wouldyourinvestment strategy haveperformed well?
c. Whatinterpretation do you put on the continuing upward movement of the PN
ratioafter 1995?
FIGURE 1.2
Price-to-Value Ratio
(PlY)forthe DJIA at
Monthly Intervals. V
isan Estimate ofthe

Intrinsic Value of
theDow.
2 - -- -~ ------ - - - -- - - - - - - ---- - -- - - --- ~ ---- -- - -- - ---- - --- --- - --- --- --1.8
1.4
1.2
S""r<~: Fromlhe Web po~e

,,[the Parke,C<'1te" Cornell
Univc:osity. The&",pll i. an
upd~\e of
one reported in
cte.r Mycrs.andB.
S,,,.,minolo,n. "WhOll.lhe
Intrin$ie Voluo "floO Dow?"
jo"",al oJAmmcc.OotO~f
------------
1.6
0.8
0.6
1999,pp.169J-174I.The
0.4
P;>;'~cr Conto,Website isat

h1tp:!fparkertonlerjohn,on.
0.2
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Drill Exercises
E1.1.
Calculating Enterprise Value (Easy)

Thesharesof a finntradeon thestockmarket at a totalof$1.2 billionanditsdebt trades at
$600million. Whatis the valueof the finn (its enterprise value)?
E1.2.
Calculating Value per Share (Easy)

An analyst estimates that the enterprise value of a firm is $2.7 billion. The firm has
$900million of debt outstanding. If thereare 900 million shares outstanding. 'What is the
analyst's estimated value per share?
E1.3.
Buyor Sell? (Easy)

A finn reportsbookvalueof shareholders' equityof $850 million with25 million shares
outstanding. Thoseshares tradeat $45eachinthestockmarket. An analyst values theequity
byfollowing the scheme: Value = Bookvalue + Extravalue. Shecalculates extravalueof
$675million. Shouldsheissuea buyor a sell recommendation to herclients?
Applications
E1.4.
Finding Information on the Internet: Dell, Inc.

General Motors, and Ford(Easy)
Thischapter compared Dell,Inc.,and General Motors Corp., andFordMotor Co.Go to the
Internetandfindsources thatwillhelp research thesefirms. One sitetostartwithisYahoo!
Finance: htfp:llfinance.yahoo.com. Another isGoogle Finance: htfp:llfinance.google.coml
finance. Lookat the book's Web pagefor linksto furthersources.
E1.5.
Enterprise Market Value: General Mills and Hewlett-Packard (Medium)

a. General Mills, Inc.,the largemanufacturer of packaged foods, reported the following in
its annual reportforthe yearendingMay25, 2008(in millions):
Short-term borrowing
Long-term debt
Stockholders' equity
--------------------------------------- -
The exercises at the end of eachchapterare divided into DrillExercises and Applications.
Drill exercises test youon the basics,with simplenumerical examples. Application exercises apply the principles and techniques of the chapterto real companies. Drillexercises
are important in making sure you havethe understanding to proceedto morerealistic settings.Thedegreeof difficulty-ceasy, medium, or hard-is indicated for all exercises.
Exercises
$ 442.0
4.348.7
6,215.8
The short-term borrowing and long-term debt are carried on the balance sheet at
approximately their market value. The firm's 337.5 million shares traded at $62 per
share when the annual report was released. From these numbers, calculate General
Mills'senterprise marketvalue(themarketvalueof the firm).
b. Hewlett-Packard, the computer equipment manufacturer and systems consultant, had
2,473million sharesoutstanding in May2008,trading at $47 per share. Its mostrecent
quarterly reportlistedthe following (in millions):
a-:
Investments ininterest-bearing debt

securities anddeposits
Short-term borrowings
Long-term debt
$ 11,513
711
7,688
38.153
Chapter 1 InITodllction to jll\le5!ing and Val'wlion 31
30 Chapter 1 Introduction tofnve.sting and Valuation
Calculate the enterprise market valueof Hewlett-Packard. The question requires you
to consider the treatment of the interest-bearing debt investments. Are they part of the
enterprise?
E1.6. Identifying Operating, Investing, andFinancing Transactions:

Microsoft (Easy)
Microsoft Corp.reported the following in its annual reportto the Securities and Exchange
Corrunission for fiscal year 2004.Classify eachitem as involving an operating, investing,
or financing activity. Amounts are in millions.
a. Cornmon stockdividends
b. General and administrative expenses
c. Salesand marketing expenses

d. Common stock issues
e. Common stockrepurchases
f. Salesrevenue
g. Research and development expenditures
h. Income taxes
i. Additions to property and equipment
J. Accounts receivable
s 1,729
4,997
8,309
2,748
3,383
36,835
7,779
4,028
i,109
5,890
Real World Connection

Exercises E4.14, E6.13, E7.7,E8.1O, EIO.ii, El7.iO,andEi9.4 aisodeaiwithMicrosoft,
as do Minicascs M8.l and MI2.2.
Minicase
M1.1
Critique of an Equity Analysis:

America Online Inc.
Theso-called Internet Bubble gripped stockmarkets in 1998, 1999, and2000, as discussed in
thechapter. Internet stocks tradedat multiples ofearnings andsalesrarely seenin stock markets. Start-ups, somewithnotmuchmorethananidea, launched initial public offerings (IPOs)
thatsoldforveryhighprices(andmadetheirfounders andemployees with stockoptions very
rich). Established firms, like Disney, considered launching spinoffs with"dot.com" in their
names, just to receive thehighermultiple thatthemarket was giving tosimilar firms.
Commentators argued overwhetherthe highvaluations were justified. Many concluded
the phenomenon wasjust speculative mania. Theymaintained thatthepotential profits that
otherswere forecasting would be competed away by the low barriers to entry. But others
maintained that the ability to establish and protect recognized brand names-c-like AOL,
Netscape, Amazon, Yahoo!, and eBay-would support highprofits. And, theyargued, consumerswould migrate to thesesites from moreconventional formsof commerce.
America Online (AOL) was a particular focus in the discussion. Oneof the mostwellestablished Internetportals, AOLwasactually reporting profits, in contrast to many Internet
firms that were reporting losses. AOL operated two worldwide Internet services, America
Online andCompuServe. It soldadvertising ande-commerce services on theWeb and, with
its acquisition of Netscape,had enhanced its Internet technology services. SeeBox 1.3.
For the fiscal year ending June 30, !999, America Online reported total revenue of
$4.78billion, of which $3.32billionwas from the subscriptions of 19.6million AOL and
CompuServe subscribers, $1.00billionfromadvertising and e-commerce, andthe remainder from network services through its Netscape Enterprises Group. It also reported net
income of$762 million, or SO.73 per share.
AOLtradedat $105pershare on this reportand, with1.10billionshares outstanding, a
market capitalization of its equityof$115.50 billion. Themultiple of revenues of24.2 was
similarto the multiple of earnings for moreseasoned firms at the time,so relatively, it was
veryhigh.ACL's PIE ratio was 144.
In anarticle ontheop-ed pageof TheWall StreetJournal onApril26, 1999, David D.Alger
of FredAlger Management, a NewYork-based investment finn,argued thatAOesstock price
wasjustified. He made thefollowing revenue forecasts for2004, five years later(in billions):
Subscriptions from 39million subscribers
Advertising and otherrevenues
Total revenue
$12.500
3.500
16.000
Profits margin on sales, after tax
26%
To answer parts (A)and (8), forecast earnings for 2004.
A.IfACes forecasted price-earnings (PIE) ratiofor2004wasat the current levelof thatfor

a seasoned firm,24, whatwould AOes shares be worthin 1999? AOL is notexpected to
paydividends. Hint: The currentpriceshouldbe the presentvalueof thepriceexpected
in the future.
B. Algermadehis case by insisting that AOL couldmaintain a high PIE ratio of about50
in 2004.What PIE ratiowould be necessary in 2004tojustifya per-share priceof$105
in 1999? If the PIE were to be 50 in 2004,would AOL be a goodbuy?
C. Whatis missing from theseevaluations? Do you see a problem withAlger's analysis?
Chapter 2 Introduction ro!he Financial StlItemcms 33
After reading this chapter you should understand:

The broad picture of the firm that is painted by the
financial statements.
The component parts ofeach financial statement.
How components of the financial statements fit
together (or "artculate'').
The accounting relations that govern the financial
statements.
The stocks and flows equation that dictates how
shareholders' equity isupdated.
The concept ofcomprehensive income.
The concept ofdirty surplus accounting.
The accounting principles thatdictate how thebalance
sheetis measured.
How price-to-book ratios are affected by accounting
principles.
The accounting principles thatdictate how earnings are
measured.
How price-earnings ratios are affected by accounting
principles.
The difference between market value added and
earnings.
Why fundamental analysts want accountants to
enforce the reliability criterion.
How financial statements anchor investors.
ction to the
,alStatements
The firstchapterintroduced
activeinvesting basedon
fundamental analysis and
explained howfinancial
statements provide a lens
on thebusiness tohelp
carryout theanalysis.
This chapter
Thischaptergivesyoua
basicunderstanding of
thefinancial
statements witha view
to using them as an
,.::>::',:';t'y::L:;
,,~~,i':
~'~OOL;+;,;;,\JtiZ;
C;,k to p,rt I
The fourchapters in
Part One ofthe book show

how financial statements
are business
utilized invaluing
firms.
Link to Web page.

TheWebpagesupplement
forhischaptershowsyou
how to findfinancial
statements andgoes into
moredetailaboutthe
statements.
How arethe
How are book
How do
financial
statements
organized?
value and
earnings
measured?
accoursing rules
L __
affectprice--
to-book ratios
andpriceearnings ratios?
':Dl!',~!~~~1~\ ".
FirJ.apHi~r~~t~w~pt5' contain information that helps the analyst infer fundamental value.
The'~natYstm~'st appreciate what thesestatements are saying andwhattheyare not saying.
Shemust knew where to go in the financial statements to find relevant information. She
mustunderstand thedeficiencies of thestatements, where theyfailto provide the necessary
information for valuation. Thischapter introduces the financial statements.
You probably havesome familiarity withfinancial statements, perhaps at the technical
levelof howthey are prepared. Thisknowledge will help you here.However, our focus is
not on the detailed accounting rules,buton the broadprinciples behind thestatements that
determine howtheyareusedin analysis. Thecoverage is skeletal, to befilled outas thebook
proceeds (andwewillcomebackto a moredetailed accounting analysis in PartFour).
Financial statements are the lenson a business. Theydrawa pictureof the business that
is brought into focus with financial statement analysis. The analystmust understand how
the pictureis drawn and howshe mightthensharpenit with analysis. Two features of the
statements need to be appreciated: form and content. Form describes how the financial
statements are organized. Financial statement analysis is an organized way of extracting
information from financial statements, but to organize financial statement analysis, one
mustfirstunderstand howthe financial statements themselves are organized. The form of
the financial statements sketches thepicture. Contentfillsout theform, it colorsthe sketch.
Content describes how line itemssuchas earnings, assets, and liabilities, dictated by form,
are measured, thusquantifying the message. Thischapterlaysout the formof the financial
statements and thenexplains the accounting principles that dictate themeasurement.
After reading this chapter you should beable to:

Explain shareholders' equity in terms of assets and
liabilities.
Explain the change in shareholders' equity using the
equity statement.
Explain the change in shareholders' equity using the
income statement.
Explain the change in cosh using the cash flow
statement.
Calculate comprehensive income.
Calculate netpayout.
Generate thefinancial statements for asavings account.
Describe, for a particular firm, the picture that is
painted by thefinancial statements.
Calculate a premium over book value.
Identify items inthebalance sheet thataremeasured at
fair value.
Calculate market value added (the stock return).
Recount the history of price-to-book ratios andpriceeamlnos ratios over the past 40years.
Financial statements are reported to shareholders. All innslistedfor public trading in

the United Statesmustalso filean annual lu-K reportand a quarterly IO-Q report withthe
Securities and Exchange Commission (SEC). These reports are available online through
the SEC's EDGARdatabase at www.sec.gov/edgar.shtml. You shouldfamiliarize yourself
withthissource.
THE FORM OF THE FINANCIAL STATEMENTS

The form of the financial statements is the way in which the statements, and their
component parts, relate to eachother. Fonn is given bya set of accounting relations that
express the various components of financial statements in terms of other components.
Understanding theserelations is important because, as you will see in laterchapters, they
structure the way in which we do fundamental analysis. Indeed,manyof theserelations
specify howyou develop a spreadsheet program to valuefirms andtheirequity.
34
Chapter 2 Introdllction!O the Financial Slalementl
Chapter 2 Introdllction 10 the Financia! Swtementl 35
Finns arerequired to publishthreeprimary financial statements in the United States,the

balance sheet, the income statement, and the cash flow statement. In addition they must
reporta statement reconciling beginning and ending shareholders' equity for the reporting
period, This is usually done in a fourthstatement, the statement of shareholders' equity,
but the information is sometimes given in footnotes, Other countries have similar
requirements. The International Accounting Standards Board(lASB), which is developing
financial reporting standards with broad, international application, requires the three
primary statements plus an explanation of changes in shareholders' equity. The Web page
givesexamples of financial statements for a number of countries.
Exhibit 2.1 presents the four financial statements for the fiscal yearending February 1,
2008,for Dell,Inc.,thepersonal computer manufacturer whosePIE ratiowequestioned in
Chapter 1.WewillspendsometimewithDellin thisbook,so taketimehereto understand
its financial statements. As the statements are the lenson the business, youmightalsotake
timeto understand Dell'sbusiness. Lookat the Business and RiskFactors Sections of the
firm's IO-K.
The Balance Sheet

The balancesheet-Dell's Consolidated Statement of Financial Position in the exhibitlistsassets, liabilities, andstockholders' (shareholders') equity. Assets are investments that
are expected to generate payoffs. Liabilities are claims to the payoffs by claimants other
than owners. Stockholders' equity is the claim by the owners. So the balance sheet is a
statement of the finn's investments (from its investing activities) and the claims to the
payoffs from those investments. Both assets and liabilities are divided into current and
long-term categories, where "current" means that the assets will generate cash within a
year, or thatcashwillbe usedto settleliability claims withina year.
The three parts of the balance sheet are tied together in the following accounting
relation:
Shareholders' equity = Assets - Liabilities
(2.1)
This equation (sometimes referred to as the accounting equation or balance sheet

equation) saysthatshareholders' equityis always equalto the difference between the assets
and liabilities (referred to as net assets). That is,shareholders' equityis the residual claim
on the assetsaftersubtracting liabilityclaims. From an equityvaluation pointof view, the
shareholders' equity is the main summary number on the balance sheet. It's the accountants' attempt to measure the equity claim. In Dell's case, the shareholders' equity of
$3,735 million in 2008is represented by 19line items, 12assetstotaling to $27,561 millionand seven liabilities totaling $23,732 million, alongwith a classof redeemable stock
of$94million. Thistotal0[S3,735million is alsoexplained in theshareholders' equityby
common stock issued of S1O,589 million less stock repurchases (in treasury stock), of
$25,037 million, retained earnings of S18, 199million, and "other"itemsof $(16)million.
The Income Statement

The income statement-Dell's Consolidated Statement of Income in the exhibit-reports
how shareholders' equity increased or decreased as a result of business activities. The
"bottom line"measure ofvalue addedto shareholders' equity is netincome, alsoreferredto
as earnings or netprofit. The income statement displays the.sources of net income, broadly
classified as revenue(value coming in from selling products) andexpenses (value goingout
in earning revenue). Theaccounting relation thatdetermines net income is
Net income = Revenues - Expenses
(2.2)
EXHIBIT2.1
TheFinancial
Statements forDell,
Inc.,forFiscal Year
Ending February 1,
2008.
Four statements are

published: the
balance sheet, the
income statement,
thecash flow
statement, and the
statement of
stockholders' equity.
DEl~
INC-
Consolidated Statement of Financial Position (in millions)

February 1, 2008
February 2, 2007
ASSETS
Current assets:
Cash and cash equivalents
Short-term investments
Accounts receivable, netofallowance
Financing receivables, netofallowance
Inventories, net ofallowance
Other
Total current assets
Property, plant, and equipment, netofdepreciation
Investments
long-term financing receivables, netofallowance
Goodwill
Intangible assets, netofamortization
Other noncurrent assets
Total assets
7,764
9,546
208
752
5,961
4,622
1,530
1,732
1,180
660
~
19,939
2,409
19,880
2,668
1,560
2,147
407
323
1,648
780
110
45
~
$ 27,561
~
$ 25,635
lIABILITlES AND EQUITY
Current liabilities:
Accounts payable
Accrued and other
Short-term deferred service revenue
Total current liabilities
long-term debt
long-tenn deferred service revenue
Other noncurrent liabilities
Total liabilities
Commitments and contingencies
Redeemable common stock and capital in excess
of$.01 parvalue; shares issued and outstanding: 4 and 5,
respectively
Stockholders' equity:
Preferred stock and capital in excess of $.01 parvalue;
shares issued and outstanding: none
Common stock and capital inexcess of $.01 parvalue; shares
authorized: 7,000;shares issued: 3,320and 3,307, respectively; shares outstanding: 2,060 and 2,226, respectively
Treasury stock atcost: 785 and 606 shares, respectively
Retained earnings
Accumulated other comprehensive loss
Total stockholders' equity
Total liabilities and stockholders' equity
225
188
11,492
10,430
4,323
2,486
18,526
362
2,774
5,141
~
17,791
569
2,189
647
23,732
21,196
94
111
10,589
1O,i07
(25,037)
(21,033)
18,199
-..il.!
~
$ 27,561
15,282
~
~
$ 25,635
36 Chapter 2 Imnxluction 10 the Financial S(.(l1emenl.\
Chapter 2 lntrodllcrion lO (h~ Fli'landa! Sla(Cm~nt> 37
EXHIBIT 2.1 Financial Statements for Dell (continued)
EXHIBIT 2.1 Financial Statements for Dell (continued)
Consolidated Statement of Income(in millions)
ConsolidatedStatement of CashFlows(in millions)
Fiscal Year Ended

Net revenue
Costof net revenue
Gross margin
Operating expenses
Seiling, general, and administrative
In-process research and development
Research, development. and engineering
Totaloperating expenses
Operating income
Investment and otherincome, net
Incomebefore income taxes
Income tax provision
Net income
Earningsper commonshare
Basic
Diluted
Weighted-average sharesoutstanding
Basic
Diluted
Fiscal Year Ended
February 1, 2008
February 2, 2007
February 3, 2006
561,133
49,462
557,420
47,904
$55,788
45,897
7,538
83
610
5,948
5,051
498
6,446
458
5,509
4,382
226
4,608
3,440
387
3,827
880
$ 2947
3,070
275
3,345
762
5 2583
L..l1l
$ 1.31
1.15
$ 1.14
$ 1.50
$ 1.47
2,223
2,247
2,255
2,271
2,403
2,449
~
S 3602
Dell's revenue for2008wasinnetrevenue from sales of computer products of$61,133 million. Netrevenue issalesafterdeducting estimates forsales returns. From thisnetrevenue,
Dellsubtracts operating expenses incurred in earning therevenue to yield$3,440 million
of operating income, the income earned from selling its products. Dell holdssubstantial
short-term andlong-term interest-bearing securities, listed as "investments" onthebalance
sheet, and the "investment income" from these investments, net of interest expense on
long-term debtand income from "other" activities, is listed below operating income, but
before income taxes. Finally, taxes are subtracted to yieldnet income of $2,967 million.
Theincome statement groups likeexpenses incategories to report a number of componentsof net income. Typical groupings in U.S. statements yieldthe following sequential
components:
Netrevenue - Costof goods sold~ Gross margin
(2.2a)
Gross margin - Operating expenses = Earnings before interest andtaxes (ebit)
Earnings before interest andtaxes <Interest expense + Interest income> Income before taxes
Income before taxes - Income taxes ~ Income aftertaxes (and before extraordinary items)
Income before extraordinary items + Extraordinary items ~ Netincome
Netincome - Preferred dividends> Netincome available to common
Most of these subtotals appear on De11S income statement. (Dell reported no extraordinary items.) Names of line items can differ among companies. Gross margin is also
referred to as gross profit and operating income before tax is sometimes referred to as
Cashflows from operating activities:

Netincome
Adjustments to reconcile net income to net cash
provided byoperating activities
Depredation andamortization
Stock-based compensation
In-process research and development charges
Excess taxbenefits from stock-based compensation
Tax benefits from employee stockplans
Effects of exchange ratechangeson monetary assets
and liabilities denominated inforeign currencies
Other
Changes in:
Operating working capital
NonCurrent assets and liabilities
Net cash provided by operating activities
Cashflows from investing activities
Investments
Purchases
Maturities and sales
Capital expenditures
Acquisition of business, net of cashreceived
Proceeds from saleof building
Net cash (used in) provided by investing activities
Cashflows form financing activities
Repurchase of common stock
Issuance of common stockunderemployee plans
(Repayment) issuance of commercial paper. net
Repayments of borrowings
Proceeds from borrowings
Other
Net cash used in financing activities
Effect of exchange rate changes on cashand cash
equivalents
Net(decrease) increase incashand cash equivalents
Cash and cashequivalents at beginning of year
Cash and Cash equivalents at end of year
February 1, 2008
February 2, 2007
February 3, 2006
S 2,947
$ 2,583
$ 3,602
607
329
83
(12)
471
368
394
17
(3D)
224
30
133
(519)
351
3,949
(2,394)
3,679
(831)
(2,217)
(1.763)
(4,004)
136
12
(100)
(165)
66
~)
(4,120)
-----.ill
(1,732)
9,546
$ 7,764
37
61
397
132
3,969
(3)
157
(53)
413
4,751
(8,343)
10,320
(896)
(113)
40
1,003
(6,796)
11,692
(747)
(3,026)
314
80
100
(63)
52
(8)
(2,551)
(7,249)
1,051
71
2,492
7,054
$ 9,546
4,149
(81)
55
~
(6,252)
-ill)
2,575
4,479
$ 7,054
earnings b~fore interest andtaxes (ebit), forexample. Items included incertain categories
can also differ. Interest income is sometimes given as a separate category from interest
e~p.ense. Although necessary to calculate net income to common shareholders, preferred
dividends are ill thestatement of shareholders' equity.
38
Chapter 2 )ntrooucnOn W Ihe Financial Srarements
Chapter 2 Jnrroduaion ro [he FiMr:ciol SW!Cmefll.l 39

Investin~ cas~ flows are cash spent on purchasing assets less cash received from selling
assets. Fmancmg cashflows arethecashtransactions withdebtandequity claimants thatare
~lso depicted in Fi~ 1.1.The Sum of the cashflows from the threeactivities explains the
increase or decrease m the finn'scash(at thebottomof thestatement):
EXHIBIT 2.1 Financial Statements for Dell(concluded)

ConsolidatedStatement of Stockholders' Equity {inmillions)
Common Stock
Accumulated
andCapital in
Excess of Par Value
Issued Shares
Amount
Balances at
February2, 2007
Netincome
3,307
$10,107
Treasury Stock
Amount
Shares
606
$(21,033)
Impact of adoption of
SFA$ 155
Change in net unrealized
gainon investments,
Retained
Other
Comprehensive
Earnings
Income
Total
$15,282
2,947
$(28)
$4,328
2,947
29
(23)
56
56
17
17
(38)
~)
net of taxes
Foreign currency translation
adjustments
Change in netunrealized
loss on derivative lnstruments, net of taxes
Totalcomprehensive income
Impact ofadoption of FIN 48
Stock issuances under
employee plans
Repurchases
expense under SFAS 123(R)
Tax benefit from employee
stock plans
Balance at
February 1, 2008
(3)
13
(59)
153
153
179
3,320
2,988
(62)
(4,004)
(4,004)
329
329
$10,589
785
'HlS,037)
$18,199
$(16)
$3,735
Net income isgivenon a dollarbasisandon a per-share basis.Earnings pershare (EPS)

is always earnings (afterpreferred dividends) forthe common shareholder (called ordinary
shareholders in the UnitedKingdom and othercountries), so the numerator is net income
available to common. Basic earnings pershare ($1.33 forDell in 2008)isnet income available to common shareholders divided by the weighted-average of common shares outstanding during the year; a weighted average is used to accommodate changes in shares
outstanding fromshareissuesand repurchases. Diluted earnings pershare ($1.31 for DeB)
is basedon totalcommon sharesthat would be outstanding if holders of contingent claims
on shares(likeconvertible bondsand stockoptions) were to exercise theiroptions andhold
common shares.
The Cash Flow Statement

The cash flow statement-s-Dell's Consolidated Statement of Cash Flows in the exhibitdescribes howthe finn generated and usedcashduring the period. Cashflows are divided
into three types in the statement: cash flows from operating activities, cash flows from
investing activities, and cash flows from financing activities. Recall that this is cashgenerated from the three activities of the fum depicted in Figure l.l in Chapter 1. Cash from
operations is cash generated from selling products, net of cash used up in doing so.
Cashfrom operations + Cashfrom investment

+ Cashfrom financing = Change in cash
(2.3)
. ~el1 generated $3,949 million in cashfrom operations in fiscal 2008, spenta netSI,763
million a? investments, and disbursed a net $4,120 million to claimants, leaving a net
decrease m cas~ of $1,934 million. The line items in Dell's statement give the specific
sources of cash In eachcategory. Some,of course, involve cash outflows ratherthan cash
inflows, and outflows are in parentheses. Delltrades aroundthe worldandso holds cashin
different ~urrencies. Thusthe changein cashin u.s. dollarequivalents isalsoexplained by
a ch~g~ III exchange rates overthe year:The U.S. dollarequivalent of cash in othercurrencres Increased by $152 million over the year, so the overall decrease in cash (in U.S.
dollars) was $1,782million.
The Statement of Stockholders' Equity

The statement of shareholders' equity-c-Dells Consolidated Statement of Stockholders'
Eq~ity in the eXhi?i~-starts with beginning-of-period equity and endswithend-of-period
equity, thus explaining howthe equity changed overthe period. Forpurposes of analysis
the change in equityis bestexplained as follows:
'
Ending equity= Beginning equity + Comprehensive income
- Netpayoutto shareholders
(2.4)
This is referr~d to as the stocks andflows equation for equity because it explains how
sto~ks of equl~ (at the beginning and end of the period) changed with flows of equity
during the period Owners' equity increases from value added in business activities
(comprehensive income) and decreases if thereis a net payout to owners. DellS reported
comprehensive mcome for 2008was$2,988million. Net payout is amounts paidto shareholders lessamounts received from share issues. As cashcan be paid out in dividends or
share :epurchas.es, net ?~yout is stock repurchases plus dividends minus proceeds from
share Issues. Withno dividend, theseitems net to a net payout for Del!ofS3,85l million
(a sharerepurchase of$4,004 million net of a shareissueof$153 million).
U~fortunately, ~ statement doesnot quite reconcile beginning and ending equity as
equation 2.4prescribes. You seeotheritemsin Dell'sequity statement. Asit turnsout these
are misclassiftcations due to bad accounting prescribed by accounting rules.We will deal
withthisissuewhenweanalyze the equitystatement in depth in Chapter 8You'll notice that comprehensive income includes net income of $2,947 million reported in the in~ome statem:nt?lus some additional income reported in the equitystatement ~e practJ.~ ofreportI~g mcome in the equitystatement is known as dirty surplus
accounting,for It doesnot givea cleanincome number in the income statement. Thetotal
of dirtysurplusincome items($41 millionfor Dell)is calledothercomprehensive income
and the.totalof net in~ome (in the income statement) andothercomprehensive income (in
the equity statement) IS comprehensive income:
Comprehensive income = Netincome + Othercomprehensive income
(2.5)
A fewfirms reportothercomprehensive income below net income in the income statement

and somereportit in a separate "OtherComprehensive Income Statement."
40 Chapter 2 IIl!nxlllC!ion
to
rhe Firu:mcial $wtcmcnt.l
The Footnotes and Supplementary Information

to Financial Statements
Dell is a reasonably simpleoperation in one lineof business-c-it manufactures and sells
desktop and notebook computers, workstations, and network servers, alongwithsoftware
and supportprograms-and its financial statements are also quitesimple. However, much
more information embellishes thesestatements in the footnotes. The notesare an integral
part of the statements, and the statements can be interpreted onlywitha thorough reading
of the notes.
If yougo to the lO-K on theSEC'sWeb site(through the book's Web page)youwillsee
that the footnotes are supplemented witha background discussion of the firm-s-its strategy,
areaof operations, product portfolio, product development, marketing, manufacturing, and
orderbacklog. Thereisa discussion of regulations applying to the finn anda review offactorsaffecting the company's business and itsprospects. Details of executive compensation
also are given. This material, alongwith the more forma! "Management's Discussion and
Analysis" required in the 10-K, is an aid to knowing the business but is byno means complete. The industry analystshouldknow considerably more about the computer industry
beforeattempting to research Dell.
The Articulation of the Financial Statements:

How the Statements Tell a Story
The balancesheet is sometimes referred to as a "stock" statement because the balances it
reports are stocks of valueat a point in time.(The word "stock" here shouldnot be confused with stocksas in "stocksand shares" or "stocks"used in the United Kingdom and
elsewhere to meaninventory} The income statement andthecashflow statement are"flow"
statements because they measure flows-or changes-s-in stocks between two points in
time.The income statement reports partof the change in owners'equityand the cashflow
statement reportsthechangein cash.
The so-called articulation of the income statement, cash flow statement, and balance
sheet-c-or thearticulation of stocks andflows-is depicted in Figure 2.1.Articulation is the
wayin whichthe statements fittogether, theirrelationship to eachother. Thearticulation of
the income statement and balance sheet is through the statement of shareholders' equity
and is described by the stocksand flows relation (equation 2.4). Balance sheetsgive the
stock of owners'equityat a point in time.The statement of shareholders' equityexplains
the changes in owners'equity(theflows) between twobalance sheetdates,andthe income
statement, corrected for othercomprehensive income in the equitystatement, explains the
change in owners'equitythat comes from adding valuein operations. The balancesheet
alsogives thestockof cashat a pointin time,andthe cashflow statementexplains howthat
stock changed overa period. Indeed the cash flow relation (equation 2.3) is a stocksand
flows equation for cash.
Muchdetail buriedinthefinancial statements willbe revealed bythe financial statement
analysis later in the book. But by recognizing the articulation of the financial statements,
the reader of the statements understands the overall story that they tell. That story is in
terms of stocks and flows: The statements track changes in stocks of cash and owners'
equity(net assets). Dell beganits 2008fiscal yearwith $9,546 million in cashand ended
the year with$7,764million in cash.The cashflow statement reveals that the $1,782 million decrease came from a cash inflow of $3,949million in operations, less cashspent in
investing of $1,763 million, net cash paid out to claimants of $4,120 million, and an
increase in the U.S. dollar equivalent of cash held abroad of $152 million. But the main
focus of the statements is on the change in the owners' equity during the year. Dell's
Chapter 2 intToo"etion
FIGURE 2.1
The Articulation
of the Financial
Statements.
The stock ofcash in
thebalance sheet
increases from cash
flows that aredetailed
inthecash flow
statement. The stock
ofequity value in the
balance sheet increases
from net income that is
detailed intheincome
statement and from
other comprehensive
income and from net
investments byowners
that aredetailed in
thestatement of
shareholders' equity.
Beginning Stocks
c==~> Flows [I===~>
to
,heFinancial Stmeme,u; 41
Ending Stocks
Cash FlowStatement
Cash from operations
Cashfrom investing
Cashfrom financing
Jt Netchangein cashr-.
.Beginning Balancesheey'
0/
C~h
~ ~nding BalanceSheet
Statementof
Shareholders'Equity
Cash
+ Otherassets
+ Otherassets
Total assets
- Liabilities
Owners'equity
Investment and
disinvestment by owners
-0.
Netincome andother
earnings
Netchange!n
equny
Total assets
- Liabllilies
<: ~~
\--
Owners' equity
owner~~
IncomeStatement
Revenues
Expenses
Net income
owners' e~~ity ?e~rease~ from $~,~~8 million to $3,735 million overthe year byearning
$2,988 million m Its busmess actrvmes and payingout a net $3,851 million to its owners
~lus thoseo.ther itemsin theequitystatement). The income statement indicates thatthe net
income portion of the increase in equity from business activities ($2,947 million) came
from revenue from selling products and financing revenue of $61 133 million less
~xpenses incurred in generating the revenue of$57,693 million, plus in~estment and'other
mcome of $387million, less taxesof $880 million.
AndsoDell began its fiscaJ 2009yearwiththestocks inplacein the2008 balance sheet to
accumulate m~re cashandwealth fo.r shareholders. Fundamental analysis involves forecasting
thataccumulation. Asweproceed withtheanalysis in subsequent chapters wewill seehow the
accounting relations we havelaidoutare important in developing forecasting tools. SeeBox
2.1fora summary. Besureyouhave Figure 2.1 firmly inmind. Understand how thestatements
fit together; Understan~ how fin~ncial reporting tracks the evolution of shareholders' equity,
updatm~ ~~cks of equrty valuem the balance sheetwithvalue added in earnings from businessacuvrtres. Andunderstand theaccounting equations thatgovern eachstatement.
MEASUREMENT IN THE FINANCIAL STATEMENTS

To recap, the balancesheet reportsthe stock of shareholder valuein the firm and the incomestatement reportsthe flow, or change, in shareholder valueovera period. Using the
language of valuation, the balance sheetgivesthe shareholders' net worth and the income
statement gives the valueaddedto theirnet worthfromrunning the business. However, we
A Summary of Accounting Relations
Chapter 2 Introdllction to the Finoncio! Senemenn 43
2.1
How Parts of the Financial Statements FitTogether
FIGURE 2.2
Percentiles of Priceto-BookRatios for All
U.S. Listed Firms,
1963-2003.
PIB ratioswere
relatively low inthe
CashFlow Statement (and the Articulation of the

Balance Sheet and CashFlowStatement)
The Balance Sheet

Assets
-~
::: Shareholders' equity
Cash flow from operations

+ Cash flow frominvesting
+ Cash flowfromfinancing
= Change in cash
The IncomeStatement
Net revenue
1970s and high inthe

1960sand 1990s. The
medianis typically
above1.0.
Statement of Shareholders' Equity

(andthe Articulation of the Balance Sheet
and Income Statement)
Dividends
Net income
+ Share
- ,Cost of goods sold

= Gross margin
- Ooeration exoenses
= Operating income before taxes (eM)

- Interest expense
= Income before taxes

- Incometaxes
= Income after taxandbefore extraordinary items

+ Extraordinary items
= Netincome
.g
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o
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a price greater than bookvalue couldrecord thepremium paidas anasset, purchased goodwill, onthe balance sheet; without a purchase of the firm, thepremium is unrecorded.
Premiums are calculated for the total equity or on a per-share basis. When Dell published its fiscal 2008 report, the market value for its2,060 million outstanding shares was
$41,200 million, or $20 per share. With a bookvalue of $3,735 million, the market premium was $37,465 million: Themarket saw$37,465 million of shareholder value thatwas
not on the balance sheet. And it saw $37,465 million of net assets that were not on the
balance sheet.With 2,060million shares outstanding, the bookvalue per share(epS) was
$1.81 andthemarket premium was$18.19 pershare.
The ratio of market price to book value is theprice-to-book: ratio or themarket-to-book
ratio, andtheratio of intrinsic value to bookvalue is theintrinsic price-to-book ratio. Dell's
price-to-book ratio (P/B) in 2008 was 11.0. Investors talkof buying a firm fora number-oftimes bookvalue, referring tothePIB ratio. Themarket PIB ratio isthemultiple ofbook value
at thecurrent market price. Theintrinsic PIB ratio is themultiple of book value thattheequity is worth. We will spend considerable timeestimating intrinsic price-to-book ratios inthis
book, andwewill beasking if those intrinsic ratios indicate thatthemarket PIB is mispriced
In asking suchquestions, it is important to have a senseof history so thatanycalculationcanbejudgedagainst what wasnormal inthepast.The history provides a benchmark
forouranalysis. It was said,forexample, that PIB ratios in the 1990s were-high relative to
historical averages, indicating that the stock market was overvalued. Figure 2.2 tracks
selected percentiles of theprice-to-book ratiofor al! U.S. listedfirms from 1963 to 2003.
Median PIB ratios (the50thpercentile) forthese firms were indeed highinthe 1990s-Qver
2.Q--.--relative to the 1970s. 1 Buttheywere around 2.0inthe 1960s. The 1970s experienced
exceptionally lowPIB ratios, withmedians below 1.0insomeyears.
The Price-to-Book Ratio

Thebalance sheetequation (2.1)corresponds tothevalue equation (1.1) thatweintroduced
in the lastchapter. Thevalue equation canbe written as
Value of equity = Value of thefirm - Value of debt
repllrchases
Beginning equity + Othercomprehensive "" Total payout
income
+ Cornprebensbe-e"" Comprehensive
- Share jssues
must be careful withwords for, while financial reporting conveys these ideas conceptually,
the reality can be quite different. Value and value added have to be measured, and measurement inthe balance sheetand income statement is lessthan perfect.
{2.G}
The value of the finn is the value of thefirm's assets andits investments, andthe value of
thedebtis the value of the liability claims, Soyousee thatthevalue equation andthebalancesheetequation areof thesamefonnbutdiffer in how theassets, liabilities, andequity
are measured. Themeasure of stockholders' equity onthe balance sheet,thebookvalue of
equity, typically doesnot givethe intrinsic value of what the equity is worth. Correspondingly, thenetassets arenotmeasured at theirvalues. If they were, there would beno analysis to do! It is because theaccountant does. not,or cannot, calculate the intrinsic value that
fundamental analysis is required.
The difference between the intrinsic value of equity and its book value is called the
intrinsic premium:
Intrinsic premium = Intrinsic value of equity - Bookvalue of equity
and the difference between the market price of equity and its book value is called the
market premium:
The median PIB forall firms during the 1990swasconsiderably lower than that forthe Dow Jones
Industrial Average stocks (consisting of 30 farge firms) and the S&P 500stocks. The PIB forthe S&P 500
index increased from about2.5 in 1990to over5.0 by2000, thendecreased to 2.0 by2008.The PIB
ratio wasunder1.0inthe 19705. The stocks intheseindexes tend to be larger thanthe median stocks
but. because theycontain a significant portion of the totalvalue of the market. theyarerepresentative of
the broadmarket.
1
Market premium = Market price of equity ~ Bookvalue of equity

If these premiums are negative, they are called discounts (from book value). Premiums
sometimes arereferred to as unrecorded goodwill because someone purchasing the firm at
42
Source: Sb.nd:;,d & Poor's

CompuSlOl' dOl'.
income
.<-_i~n~cp~m~e:====",-- _ Net payout
- Netpayoutto I(
shareholders
= Ending equity
- Preferred dividends
= Netincome available to common
.-.. -plO .. ~_p25 __ Median - __ p75 ...... p90
il'
I
44 Chapter 2 IntTodllction to the Financial Srcremcnrs
Measurement in the Balance Sheet under GAAP
2.2
What causes thevariation inratios? Is it duetomispricing inthestockmarket oris it due
to the way accountants calculate book values? The low PIB ratios in the 19705 certainly
preceded a longbullmarket. Could thisbullmarket have beenforecast in 1974byananalysis of intrinsic PIB ratios? Were market PIB ratios in 1974 too low? Would an analysis of
intrinsic PIB ratiosin the 1990s find that they were too high? Dell's PIB of 11.0 in 2008
looks highrelative to historical averages. Was it too high? The fundamental analyst sees
herselfas providing answers to thesequestions. Sheestimates the intrinsic value of equity
thatis notrecorded on thebalance sheet.
You can viewPIBratios for other firms through the linkson the Web page.You also
canfind firms withparticular levels of PIB ratiosusinga stockscreener fromJinks on the
Web site.
Measurement in the Balance Sheet

Toevaluate the price-to-book ratio, theanalyst mustunderstand how bookvalues aremeasured, forthat measurement determines theprice-to-book ratio.
Thevalue of someassets andliabilities areeasyto measure, andtheaccountant doesso.
Heapplies mark-to-market accounting, thusrecording theseitems onthebalance sheets,
at fair value (in accounting terms). These items do not contribute to the premium over
bookvalue. But, for many items, the accountant does not, or cannot, mark to market. He
applies historical cost accounting. Box2.2gives the US. GAAP measurement rulesfor
itemscommonly found on balance sheets, with those carried at fair value and historical
costindicated. International accounting standards broadly follow similar rules.
Afterreviewing Box2.2, consider Dell'sbalance sheet. It lists investments of $7,764
million in cashandcashequivalents measured at theirfairvalue. Dell's short-term investments ($208 minion) and long-term investments ($1,560 million) are mainly in interestbearing debtsecurities. A market value is usually available forthesesecurities, so theycan
be marked fa market, as indeed they are on Dell's balance sheet.Dell's accounts payable
($11,492 million) is close to market value and, while the long-term debt($362 million) is
not marked to market, its book value approximates market value unless interest rates
change significantly. So, these items do not contribute to the price premium overbook
value. Net accounts receivable ($5,961 million), financing receivables (l,732),accrued expenses ($4,323 minion), and the"otherliabilities" ($2,070 million) involve estimates, but
if thesearemadein an unbiased way, theseitems, too,areat fair value.
ThusDell'slarge market premium of$37,465 million overthe bookvalue of itsequity
arises largely from tangible assets, recorded at (depreciated) historical cost,andunrecorded
assets. The latterare likely to be quitesignificant Dell's value, it is claimed, comes not so
much fromtangible assets, butfrom itsinnovative "direct-to-customer" process, itssupply
chain, andits brandname. None oftheseassets areonitsbalance sheet. Normight wewant
them to be. Identifying them and measuring their value is a very difficult task, and we
would probably endup with verydoubtful, speculative numbers.
Measurement in the Income Statement

Shareholder value added is the change in shareholders' wealth during a period. This
comes fromtwosources: (l) the increase in thevalue of theirequity and(2)anydividends
theyreceive:
Value added = Ending value - Beginning value + Dividend
(2.l)
In terms of market prices,

Market value added = Ending price- Beginning price+ Dividend
(2.8)
Generally Accepted Accounting Principles (GAAP) in the

United States prescribe the following rules for measuring
assets andliabilities inthebalance sheet. Items whose carrying
values aretypically close to fair value are indicated, but note
any exceptions mentioned. Accounting Clinics, introduced
later inthis chapter. take you into the detail forsome items.
ASSETS
Cash and CashEquivalents (Fair Value)
Cash and cash equivalents (deposits of less than gOday
maturity) are recorded as the amount of cash held which
equals their fair value.
Short-Term Investmentsand Marketable
Securities (Fair Value)
Short-term investments-in interest-bearing deposits, shortterm paper, andshares held fortrading intheshort-term-are
carried at "fair" market value. An exception is a long-term
security held to maturity that is reclassified to short-term
because it isdueto mature. See long-term securities below.
Also seeAccounting Clinic III.
Receivables (Quasi Fair Value)
Receivables are recorded at the expected amount of cash to
be Collected (that is, the nominal claim less a discount for
amounts notexpected to bereceived because of baddebts or
sales returns). If the estimate of this discount is unbiased
receivables arecarried attheir fair value. Ifbiased, the carryin~
amount may notbefair value.
earnings. In the u.S; assets are never revalued upward to

market value.
Recorded IntangibleAssets (Amortized

Historical Cost)
Intangible assets that are recorded on the balance sheetpurchased copyrights. patents, and other legal rights-are
recorded athistorical cost andthen either amortized over thelife
of the right or impaired iffair value falls below carrying value.
Goodwill (Historical Cost)
Goodwill isthe difference between the purchase price of an
acquired firm andthe fair value of net assets acquired. Since
FASB Statement No. 142 in 2001, goodwill iscarried at cost
and not amortized, but is impaired bya write-off if its fair
value isdeemed to have declined below cost.
Other IntangibleAssets (Not Recorded)

Assets such as brand assets, knowledge assets developed
from research anddevelopment, andassets arising from marketing andsupplier relationships arenot recorded at all.
Long-Term Debt Securities (Some at Fair Value)
Some investments in bonds andother debtinstruments are
marked to market, as prescribed by FASB Statement No. 115.
For marking to market, theseinvestments areclassified into
three types:
1. Investments heldfor active trading. These investments are
recorded at fair market value andtheunrealized gains and

losses from marking them to market arerecorded in the
income statement, along with interest.
2. Investments availabfe for sale (investments not held for
active trading but which may be sold before maturity).
These investments arealso recorded at fair market value,
but the unrealized gains and losses are reported outside
the income statement as part of other comprehensive
income (usually inthe equity statement), while interest is
reported intheincome statement.
3. Investments held to maturity (investments where the intent isto hold them until maturity). These investments are
recorded at historical cost. with no unrealized gains or
losses recognized. butwith interest reported in theincome
statement. Fair market values for these investments are
given inthefootnotes.
Inventories (Lower of Cost or Market Value)

Inventories arerecorded atthehistorical cost ofacquiring them.
However. thecarrying value of inventories iswritten down to
market value ifmarket value isless than historical cost, under
the"lower ofcost ormarket" rule. Historicalcost isdetermined
under anassumption about theflow of inventory. Under firstin-first-out (FIFO), thecost ofmore recent inventory goes tothe
inventory number inthebalance sheet, andthecostofolder inventory goes to cost of goods sold inthe income statement.
Under last-in-first-out (LIFO). the balance sheet includes the
older costs and cost of goods sold includes the mare recent
costs. Accordingly. intimes ofrising inventory prices, thecarrying value ofinventory inthebalance sheet islower under UFO
than FIFO, butcostof goods sold ishigher (and income lower).
All else being equal. prke-to-book ratios are thus higher for
UFO firms than forFIFO firms.
Accounting Clinic III gives thedetails.
long-Term Tangible Assets (Depreciated
Historical Cost)
EquityInvestments (Some at Fair Value)

Equity investments areclassified into three types:
Property and plant and equipment arerecorded at historical 1. Investments involving less than 20 percent ownership
cost (the amount that the firm paid for the assets), less
of another corporation. These equity investments are
accumulated depreciation. If fair market value is less than
classified aseither "held foractive trading." "available for
amortized historical cost, these assets are impaired (written
sale." or "held to maturity." with thesame accounting for
down to fair value). with the impairment loss as a charge to
debtinvestments inthese categories.
45
2, Investments involving 20percent to 50percent ownership

of another corporation, The equities are recorded using
the "equity method." Under the equity method, the
investment isrecorded at cost. butthe balance sheetcarrying value issubsequently increased bytheshare ofearnings reported bythe subsidiary corporation and reduced
by dividends paid by the subsidiary and write-efts of
goodwill acquired on purchase. The share of subsidiaries'
earnings (less anywrite-off of goodwin) isreported inthe
income statement.
3. Investments involving greater than 50 percent ownership
of another corporation. The financial statements of the
parent and subsidiary corporation are consolidated, after
elimination of intercompany transactions. with a deduction forminority interests inthe netassets (in the balance
sheet) and netincome (in the income statement).
Accounting Clinics !IIandVgive thedetails.
LIABIlITIES
Short-Term Payables(Fair Value)
Payables-such as accounts payable, interest payable. and
taxes payable-c-are measured at the contractual amount of
cash to satisfy the obligations. Because theseobligations are
short-term, the contractual amount isclose to its discounted
present value, sotheamount oftheseliabilities on the balance
sheetapproximates market value.
liabilities changes as interest rates change, but the liabilities

arenotmarked to market However, inperiods when interest
rates change little, the carrying value of liabilities is typically
close to market value. FASB Statement No. 107requires that
the fair market value of liabilities be reported in footnotes,
and thedebtfootnote typically compares market values with
car!)ling values.
Accrued and EstimatedLiabilities (Quasi Fair Value)

Some liabilities arising in operations-c-indudirq pension
liabilities, accrued liabilities, warranty liabilities, unearned
(deferred) revenue, and estimated restructuring liabilitieshave to be estimated. Ifthe estimates are unbiased present
values of expected cash to be paid out on the obligation,
these liabilities reflect their value. If biased, these liabilities
contribute toa premium over book value. They aresometimes
called quasi-marked-to-market liabilities, emphasizing that
estimation isinvolved (and canbesuspect).
Commitments and Contingencies
(Many Not Recorded)
Ifa liability iscontingent upon some event, itisrecorded onthe

balance sheetonly iftwocriteria (from FASB Statement No.5)
aresatisfied: (1) thecontingent event is"probable," and(2) the
amount oflikely loss can be "reasonably" estimated. Examples
include potential losses from lawsuits, product warranties, debt
guarantees, andrecourse onassignment ofreceivables ordebt
wren a liability does notsatisfy thetwocriteria, itmust bedisclosed infootnotes ifit is"reasonably possible." Firms (like Dell)
Borrowings (Approximate Fair Value)
Obligations arising from borrowirq-csbort-term debt, long- often indicate such a possibility byan entry inthebalance sheet
termbonds, lease obligations, andbank loans-are recorded with a zero amount andthen cover thematter inthefootnotes.
at the present value of the contractual amount, so they are Understatement of contingent liabilities in the balance sheet
at market value when initially recorded. The value of these reduces the premium over book value.
If the market is pricing the intrinsic value correctly, market value added is, of course,
(intrinsic)value added.The change in value in the marketis the stock return. The stock
return for a period, t, is
(2.Ba)
where PI - Pt - I is the change in price (the capital gain portionof the return) and d, is the
dividendpart of the return.
The accounting measure of valueadded--eamings-does notusually equal valueaddedin
thestockmarket. Thereason, again, involves therulesforrecognizing valueadded. Thoserules
are summarized in Box2.3.Thetwodriving principles are the revenuerecognition principle
and the matching principle. Accounting recognizes that firms add value by selling products
and services to customers. Unless a finn wins customers, it doesnot "make money." So accounting value is addedonlywhen a firmmakes a saleto a customer: Revenue is booked. The
accountant thenturnsto thetaskof calculating the net value added, matching the expenses incurred in gainingrevenue against the revenue. Accordingly, the difference between revenue
and matched expenses is the measure of valueaddedfromtrading withcustomers.
46
The accounting measure of value added, earnings, is determined by rules formeasuring revenues and expenses.
revenue recognition and matching principles, but violations

also are admitted (indeed, required) under GAAP. In these
cases, the difference between value added and accounting
REVENUES: THE REVENUE RECOGNITION
value added isexplained. notonly incases where the revenue
PRINCIPLE
recognition and matching principles have beenfollowed, but
Value isadded by businesses from a process-avalue creation
further by the violation of these principles. Here are some
chain-that begins with strategy and product ideas, andthen
examples ofgood andpoor matching.
continues with the research anddevelopment of those ideas,
the building of factories and distribution channels to deliver Examples of Sound MatchingPrescribed by GAAP
the product, the persuading of customers to buy thefinished
Recording cost of goods sold as the cost of producing
product, and finally the collection of cash from customers.
goods for which sales have been made and,correspondPotentially, value could berecognized gradually, asthe process
ingly, placing thecostof goods produced, but notsold, in
proceeds. However, accounting typically recognizes value
inventory in the balance sheet, to be matched against
added at one point inthe process. The two broad principles
future revenues when they aresold.
forrevenue recognition are:
Recording expenditure on plant as an asset and then allo1. The earnings process issubstantially accomplished.
eating the costof the asset to the income statement (as
2. Receipt ofcash isreasonably certain.
depredation expense) over thelife oftheasset. In this way,
income isnot affected when the investment ismade, but
In mostcases, these two criteria are deemed to be satisfied
only as revenues from the plant are recognized. Accordwhen the product or service has been delivered to the cusingly, income is revenue matched with the plant costs intomer and a receivable hasbeen established as a legal claim
curred to earnthe revenue.
against the customer. The revenue recognized at thatpoint is
Recording the costof employee pensions as expenses in
the amount of thesale, discounted to net revenue based on
the period inwhich theemployees provide service to proan assessment of the probability of not receiving cash (the
ducerevenues, rather than inthe future when pensions
receivable isalso discounted to a netreceivable).
are paid (and employees are not producing, but retired).
In a fewcases, revenue isrecognized during production,
but before final sale-in long-term construction projects,
for example-and sometimes revenue is not recognized Examples of Poor MatchingPrescribed by GAAP
until cash is collected-as in some retail installment sales
Expensing research and development (R&D) expenditures
where there is considerable doubt that the customer will
in the income statement when incurred, rather than
pay. Gains from securities aresometimes recognized prior to
recording them as an asset (an investment) inthe balance
sheet. Ifthe expenditures were recorded as an asset, their
sale-in the form of "unrealized" gains and losses-if the
securities aretrading securities or areavailable forsale. (See
costwould be matched (through amortization) against the
Box 2.2.)
future revenues thatthe R&D generates.
Expensing film production costs as incurred, rather than
EXPENSES: THE MATCHING PRINCIPLE
matching them against revenues earned after the film is
Expenses are recognized in the income statement by their
released.
association with the revenues for which they have been
incurred. This matching of revenues and expenses yields an Examples of Poor Matching by Firms
earnings number thatisnetvalue added from revenues.
Underestimating baddebtsfrom sales sothatincome from
Matching isdone by direct association ofexpenses with revsales isoverstated.
enues orbyassociation with periods inwhich revenue isrecogEstimating long useful lives forplant sothatdepreciation is
nized. Cost ofgoods sold, forexample, isrecognized bydirectly
understated.
matching thecost ofitems sold with the revenue from thesale
ofthose items, toyield gross margin. Interest expenses, in conOverestimating a restructuring charge. The overestimate
trast, arematched to theperiod inwhich thedebtprovides the
has the consequence of recording current period's infinancing oftheoperations thatproduce revenue.
come as less than itwould be with an unbiased estimate
Revenue recognition andexpense matching areviolated in
while recording future income as higher thanit would be
practice, reducing thequality ofearnings asa measure ofvalue
because expenses (like depreciation) have already been
added from customers. Firms themselves may violate the
written off.
47
Chapter 2 Imro:!Iu:llon 10 the Financial Srcremenc 49

FIGURE 2.3
THE WORLDCOM CON
for example, referred to earnings before amortization and
In June 2002, WorldCom, the second largest U.S. lonq- interest (yes, oterestl) in press releases; its GAAP numbers
distance telephone carrier through its Mel unit, confessed to (after amortization andinterest) were actually losses.
The most prevalent proforma number is ebttda, earnings
overstating income by $3.8 billion over 2001-2002, one of
the largest accounting frauds ever. The overstatement was before interest taxes, depreciation, and amortization. This
due to a mismatch of revenues with access fees paid to local number omits taxes and interest and also depreciation and
telephone companies. These fees are necessary to conned amortization. Analysts argue that it is a better number belong-distance calls through local networks to customers; thus cause depreciation and amortization are not cash costs, so
they are a cost of earning current revenue. The WorldCom ebitda isemphasized in telecom andmedia companies whose
(FO,however, capitalized thesecosts asassets inthe balance large capital investments result inlarge depreciation charges.
sheet, with the idea of amortizing them against future rev- However, while theanalyst might bewary ofmismeasurement
enue. This treatment served to inflate income by $3.8 billion ofdepreciation, depreciation isa real cost, just like wages exandallowed WorldCom to avoid reporting losses. WorldCom pense. Plants rust. Telecom networks become obsolescent.
shares hadtraded at a high of $64pershare during the tele- Telecoms canoverinvest innetworks, producing overcapacity.
com bubble, butthey fell below $1 inJune 2002, andthe firm Depreciation expense recognizes these costs.
Reliance on ebidta encourages firms to substitute capital
subsequently filed forbankruptcy.
for labor and, indeed, to invest in overcapacity because the
PRO FORMA EARNINGS OFTEN
cost ofovercapacity doesnotaffect ebitda. Ebitda canbeused
INVOLVE MISMATCHING
to deceive. The WorldCom con wasa scam to inflate ebitda
During the stock market bubble, corporations often encour- Expensing access charges as operating COs'lS reduces ebitda.
aged investors to evaluate them on "pro forma" earnings However, by capitalizing the charges, WorldCom not only
numbers that differed from GAAP earnings. Analysts and in- increased current ebitda, but also be increased future ebitda
vestment bankers also promoted these numbers. Most pro astheamortization ofcapitatzed operating costs areclassified
forma numbers involve mismatching, usually omitting ex- as depreciation or amortization; thus the charges are not
penses, Indeed they are sometimes referred to as "ebs" (in reflected inebitda in any period. GroWing ebitda would imcontrast to eps): Everything but the Bad Stuff. Amazon.com, press theunwary investor andperpetuate thetelecom bubble.
The matching principle, however, is violated in practice,introducing accounting quality

problems and, as we will see, difficulties for valuation. Firms and analysts can mislead
investors by referring to pro forma earnings numbers that fail to match expenses with
revenues. See Box2.3.
Value addedin the stock market,whilepresumably recognizing valueaddedfromselling productsduringthe period, is speculative value.The marketnot only pricesthe earningsfrom currentoperations, but it alsoanticipates salesand earnings to be madein future
operations. A firm mayannounce a newproduct line.In response, investors revaluethe firm
in the marketbasedon speculation aboutfuture sales andearnings from theproduct. A finn
may announce new strategies, new investment plans, and management changes, and the
marketpricesthe anticipated profits fromthesechanges. But none of them affects current
earnings. The accountant says: Let's waitand see if theseactions win customers; let's not
bookrevenues untilwe havea sale. Investors say:Let'spricethe anticipated valuethat will
be booked in future revenues.
Thusaccounting recognition of valuetypically Jagsintrinsic value. Accordingly, fundamental analysis involves anticipation, thatis, forecasting valueaddedthathas not beenrecognized in the financial statements but will be recognized in futurefinancial statements as
48
1--"-P10 __ ~_p25
Percentiles of PriceEarningsRatiosfor
AllU.S. ListedFirms,
1963-2003.
PIE ratios were

relatively low in the
1970s andhigh in the
1960s and 1990s.
Themedian is
typically above 10.0.
(Thefigure covers
firms with positive
earnings only.)
_Median -_-p75 .... p90
~/
,,
,,
...
"
";
I... y
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'.
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,
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~ 40 +--+-+----;:---------,"'--+-_~-
'e
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~ 30 +--I-r--+-------f"-';--!--~~.:-----___;-_!_"'!.,
.\ , ,,
,
c,
"
SOUltt:Stand,rd& I'oor's
Compus:at" data.
,
M
-o
,,,
~
-c
r-.
~
S S
-o
r-.
S S
e-
e-
~
~
00
c-:
g 00
S S
, I I ,
:;; :li
S S
"
0
0' g
sales are made. In so doing, fundamental analysis estimates value added that is missing
from the financial statements. This leadsus to the price-earnings ratio.
The Price-Earnings Ratio

The price-earnings ratio (pIE)compares currentpricewith earnings. Interpret the PIE ratio
as follows. Price,the numerator, is the market's anticipation of value to be added from sales
in the future, that is, future earnings. The denominator is currentearnings, value addedfrom
Current sales. So the PIE ratiocompares forecasted future earnings to current earnings. Ifone
expects considerably morefuture earnings thancurrentearnings, the PIE ratioshould behigh,
andif oneexpects lower future earnings thancurrentearnings, thePIEratioshould be low. To
be moreconcise, the PIEratioreflects anticipated earnings growth. Accordingly, fundamental analysis evaluates expected earnings growth to estimate intrinsic PIE ratios. Intrinsic PIE
ratios arethencompared to market PIE ratios to testthe market's anticipations.
With Dell trading at $20 per share in 2008, its PIEratio on 2008 earnings per shareof
$1.33 was 15.0. Thisis considerably lower thanthe PIEof87.9 in 2000that was queried in
Chapter 1. As in 2000, the analyst's task is to assess whether forecasts of future earnings
justifythismultiple. It is nowtoolow?As withthe PIB ratio, she hasthehistory of PIE ratios
inmindandusestheseas benchmarks. Figure 2.3tracksselected percentiles of PIEratios for
U.S. firms. Like PIB ratios, PIE ratioswerelowin the 1970s, withmedians lessthan 10. But
the 1990s sawconsiderably higher PIEratios, withmedians of20 andabove. 2
The Reliability Criterion: Don't Mix

What You Know with Speculation
Wehaveseenthat the balancesheet omitsvalueand the incomestatement does not recognize all the valuethat is addedin the stock market. Is therejustification for theseseeming
deficiencies? Accountants justify their rules by whatis calledthe reliability criterion.
2PIE ratios for theS&P 500 and theDow index were ontheorder of7to 10in themid1970s and well
over 20inthe1990s. By 2000, the PIE fortheS&P 500 reached 33.It stood at 16.6 in 2008. The average
PIE ratio forthe S&P 500 over thelast 50years has been 16.2.
50 Chapter Z
Introduction w (he
Financial Statemen!5
Thereliability criterion demands thatassetsandliabilities berecognized onlyif theycan

be measured withreasonable precision and supported by objective evidence, freeof opinion and bias. So the reliability criterion rules out recognizing Dell's direct-to-customer
marketing asset, its brand name, and its supplychain on its balance sheet. Estimates of
these assetsare deemed too subjective, too open to manipulation. Indeed, mostintangible
assetsare omitted fromthe balance sheet.Knowledge assetsdeveloped from research and
development (R&D) are usually omitted. Onlyassetsthat the finn haspurchased-csuch as
inventories, plant, R&D acquired by purchasing a patent, and acquired goodwill-c-are
recorded, for then there is an objective market transaction to justify the measurement.
Contingent liabilities, forwhichtheoutcome isnot probable or which cannotbe reasonably
estimated, also are not recorded.
The reliability criterion alsogoverns the income statement. Indeed, the revenue recognition principle (see Box 2.3) invokes the reliability criterion: Revenues are recorded only
when there is reliable evidence of a customer buyingthe product. So accountants do not
book revenue based on speculation that the firm may get customers in the future-only
whentheyactually do.
The reliability criterion suits the fundamental analystwell. Stockprices are based on
speculation aboutfirms' abilityto makesales in the future and to generate earnings from
thosesales. Theroleof fundamental analysis is to challenge thatspeculation in orderto test
whether stocksare appropriately priced. So fundamental analysts havea maxim: Don'tmix
whatyou knowwith whatyou don't know. So,youaccountants, don't mixspeculation with
knowledge. Sales made in the current period, and the earnings derived from them after
matching expenses, are something that weknow withsomereliability (unlessthe accounting is suspect). Don't contaminate that knowledge by mixing it with speculation in the
income statement, for the analyst wantsto use that knowledge to testspeculation. Further,
don't mix hard assets in the balancesheet with speculative estimates about the valueof
unobserved intangible assets. Leave speculation to the analyst. See Box2.4The practice of omitting or understating assetson the balance sheetis calledconservative accounting. Conservative accounting says: Let's be conservative in valuing assets;
let'snot speculate aboutthe valueof assets. So, if thereis uncertainty aboutthe valueof an
asset,don't book the asset at all. In practicing conservative accounting, accountants write
down assets, but they will not write up assets. You understand, then, why price-to-book
ratiosare typically greaterthan L
Accounting Clinic
BASIC ACCOUNTING PRINCIPLES
This chapter has provided an overview of the principles of
accounting. Much detail lurks behind the broad principles.
Not all will be required of a competent analyst but,aswe
proceed with thefundamental analysis thatis anchored in
the financial statements, accounting issues will arise.
Those issues will be addressed in the text but, in many
cases, thedetail istoomuch to cover. So, on issues important to the equity analyst, you will be introduced to an
Accounting diniconthe book's Web site. The purpose of
"C
these clinics isto help remedy your scant knowledge of
accounting, or to provide a review of material you have
covered in accounting courses. You might also want to
refer to the texts you have used in previous accounting
courses, to refresh your memory
Accounting Clinic Iexpands onthebasic principles of
accounting measurement thatarelaid out inthis chapter.
The book's Web site can befound atwww.mhhe.com/
penman4e
Did Financial Statements Anchor Investors

During the Stock Market Bubble?
During the stock market bubble of 1998-2000, financial reporting came into question. Commentators claimed thatthe
traditional financial reporting model, developed during the Industrial Age. was nolonger relevant for the Information Age.
Claims were made that "earnirqs nolonger matter. n Balance
sheets were said to be useless because, in the neweconomy. n value comes from knowledge assets andother intangibles that are omitted from balance sheets. To justify lofty
price-earnings ratios, technology analysts referred to metrics
such asclicks andpage views rather than earnings. "Value reporting" that relies on soft information outside thefinancial
statements became the vogue. Was this bubble froth or are
these claims justified?
Speculative beliefs feed price bubbles. Speculation overlooks hard information andoveremphasizes soft information.
The role of financial statements isto anchor the investor on
the rising tide of speculation with hard information. As we
proceed through thebook wewill learn how to anchor anelysis inthefinancial statements. Consider thefollowing:
n
Losses reported by neweconomy firms during the bubble

turned out to be a good predictor: Most of these firms
failed. Earnings did matter.
For firms thatdid survive, the earnings they reported during the bubble were a much better predictor of subsequent earnings than the speculative forecasts of analysts
pushing the stocks.
2.4
Most oftheintangible assets imagined byspeculative analysts vaporized.

The much-criticized balance sheets also provided good
forecasts. The ratio ofdebtassumed inpursuit of intangible assets (by telecoms, for example) was large relative to
tangible assets on the balance sheet, and that ratio predicted demise.
Financial reporting wasrightly criticized after the bubble
burst, exposing the poor financial reporting practices of
Enron andArthur Andersen, Xerox, Owest. andWorldCom,
to mention a few. But the critique was one of accounting
that allowed speculation to enterthe financial statements
(and in some cases the deviance of compromised management, directors, and auditors). The statements did not
anchor investors.
Good accounting serves asa check on speculation. Good
accounting challenges the pyramid scheme that bubbles perpetuate. Bad accounting perpetuates pyramid schemes. Bad
accounting creates false earnings momentum thatfeeds price
momentum. GMp, unfortunately, does have features that
can be used to perpetuate bubbles. The fundamental analyst
isaware of these features and brings her quality-of-earnings
analysis to bear onthe problem. We also will beaware, aswe
proceed through the book, culminating in the accounting
quality analysis ofChapter 17.
Tension in Accounting
Tomeasure valueaddedfromsalestocustomers, accountants match expenses withrevenues.
The reliability criterion demands that revenues not be recognized until a customer is won.
But the reliability criterion also comes into play in matching expenses, and this creates
tension.
According to the reliability criterion, investment in assetswith uncertain valuecannot
be booked on the balance sheet. So GAAP requires that investments in R&D assets and
brand assets(developed through advertising) be expensed immediately in the income statementrather then booked to the balance sheet.The result is a mismatch: Current revenues
are charged with the investments to produce future revenues, and future revenues are not
charged withthe (amortized) costof earningthoserevenues. Thereisa tension between the
matching principle and the reliability criterion and, in the case of R&D and advertising,
GAAP comes down on theside of mismatching.
The reliability criterion is not absolute, however. Matching requires estimates, and the
reliability criterion allows estimates when they can be "reasonably" made. To calculate
earnings, accountants expense the estimated costof notreceiving cashfrom the sales,that
is, the costof bad debts. The estimateof this cost is subjective and can be biased, but the
51
Chapter 2 lllnoducrion 10lhe FinancialStatemCllu 53
customers). Aswellas tracking owners'equity, the financial statements alsotrackchanges

in a firm's cash positionthrough the cashflow statement, where the changein cashis explainedbycash generated in operations, cashspent on investments, and cash paidout in
financing activities.
Accounting standards inthe United States are issued bythe
Financial Accounting Standards Board (FASB), subject to oversight by the Securities and Exchange Commission (SEC) and
ultimately theUnited States Congress. Separately, the International Accounting Standards Board (lASB), based in London,
has promulgated a set of standards known as International
Financial Reporting Standards (IFRS). Partly because of conscious harmonization ofactivities between theFASB andIASB,
these standards arequite similar to those inthe United States,
though details vary. In 2005, the European Union required
listed companies in Europe to conform to IFRS, and many
countries are adopting these international standards or are
likely to doso.
In August 2008, the SEC proposed that the United States
move to international accounting standards andinvited public
comment on the proposal. The SEC also outlined a road map
for doing so. The road map targets mandatory adopting of
IFRS by 2014 but allows certain qualifying U.S. firms (up to
110of the larger firms) to use IFRS asearly as 2009. The SEC
laid down certain milestones that would have to be reached

for the2014 objective to bemet: (1) continued improvements
inIFRS accounting standards, (2) independent funding set up
for the lASS, (3) the ability for XBRl (Extensible Business
Reporting language) to accept IFRS data, and (4) sufficient
progress in IFRS education and training inthe United States.
Stay tuned.
The desire for uniform standards across the world is
understandable. Some, however, fearthatgiving a monopoly
to onestandard setting agency isdangerous. Better, they say,
to have competing standards thatthe market can select from,
sothatbetter standards rise to thetop. Those advocating convergence say thatmight lead to a race to thebottom
As said, IFRS andU.S. GAAP arequite similar. Throughout
this book, we will highlight differences between the two
when they areimportant for the analysis at hand. Details of
other differences are on Web Supplement for each chapter.
For the moment, goto the Web Supplement for this chapter
for an introduction to IFRS.
Find the following on the Web page supplement for this

chapter:
Directions on how to find your way around the SEC's
EDGAR database.
Summary of the filings thatfirms must make with the
SEC.
Directions to online services for recovering financial

statement information.
XBRL (eXtensible Business Reporting Language) is
coming to SEC filings. The Web page takes a Jook.
Thesefeatures of the financial statements are expressed in a set of accounting relations

thatdefine thestructureofthe statements. Commit theseto memory, fortheywill comeinto
playas weorganize the financial statements intospreadsheets foranalysis. Indeed, theywill
become rules that have to be obeyedas we develop forecasted financial statements for
valuation.
Accountants calculatethe (book) value of equity, but the analyst is interested in the
(intrinsic) value of the equity. This chapter outlined the rules that determine the book
value of equity in the balancesheet.The chapter also outlined the rules that determine
valueadded-cearnings-c-in the income statement. Theserulesleadto differences inprices
and book values, so understanding them gives you an understanding of price-to-book
ratios.Therulesalso explain whyvalueaddedin the stockpriceis not recognized immediately in earnings, so you also havean understanding of the PIE ratio.That understanding will be enhanced as we establish the technology for determining intrinsic PIB and
PIE ratios.
estimate is allowed. To match depreciation of plant with the revenues that the plant produces, the accountant mustestimate the useful life overwhich depreciation is calculated,
and that estimate is subjective. Estimates can be abused, so the tension in accounting becomes one of making the appropriate matching but possibly admitting biased estimates.
Auditors and corporate directors are,of course, a checkon abuses if theypursue theirjob,
in an unbiased way, as fiduciaries for shareholders.
The analyst is aware of these tensions. He adapts to the mismatching introduced by
the reliability criterion and conservative accounting. And he develops diagnostics to
assess poor quality earnings that are biased by estimates. The quality of earnings is an
important issue in equity analysis and is an issue we will visit again and again as the
bookproceeds.
Financial statements in the United States are currently prepared according to U.S.
Generally Accepted Accounting Principles. But changes are in the wind. Go to Box 2.5
beforeclosingthis chapter.
Summary
52
Financial statements articulatein a waythat tells a story. Fromthe shareholder's point of

view, the book value of equity in the balancesheet is the "bottom line" to the financial
statements. The accounting system tracks shareholders' equity over time. Each period,
equity is updated by recognizing value added from business activities-ecomprehensive
income-s-and valuepaid out in netdividends. Thestatement of shareholders' equitysummarizes the tracking. The income statement(alongwith"othercomprehensive income" in
the equity statement) gives the details of value added to the business by matching revenues (value received from customers) with expenses (value given up in servicing
An introduction to JFRS.
Links to FASB andIASB documents.
Elaboration on how accounting relations help in building analysis tools.
More on historical PlB andPIE ratios.
The Readers' Corner provides a guide to further
reading.
Web Exercises have additional exercises, along with
solutions, foryou towork.
Key Concepts
accountingrelation is an equation that

expresses components of financial
statements in termsof other
components. 33
articulation of the financial statements
is the waytheyrelateto each
other. 40
asset is an investment that is expected to

producefuture payoffs. 34
capital gainis theamount by which the
priceof an investment changes. 46
comprehensive incomeis total income
reported (intheincome statement and
elsewhere in the financial statements). 39
al
"'&!~
~
54 Chapter 2
InITod~crion
''''l,i
1>{w.;;'
rc {h~ Financial S!a!em~m$
conservativeaccounting is the practice of

recording relatively lowvaluesfor net
,~.i~
I", ,"",)
;ill1L~.
~~;t
assets onthebalance sheets, oromitting
~~~\
~J;:li.l
assetsaltogether. 50
dirty surplus accounting booksincome
in the equitystatement ratherthanthe
income statement. 39
expenseis valuegiven up in earning
revenue that is recognized in the financial
statements. 34
fair value is the termthataccountants use
for the valueof an asset or liability. Fair
valueis market value, or an estimate of
marketvaluewhen a liquid market does
not exist. 44
flows in financial statements are changes in
stocksbetween two pointsin time.
Compare withstocks. 40
historical cost accounting records assets
and liabilities at their historical cost,
then(in mostcases)amortizes the
cost overperiodsto the income
statement. 44
intangible asset is an assetwithout
physical form. 45
liability is a claimon payoffs fromthe firm
otherthan by the owners. 34
mark-to-market accountingrecords
assetsandliabilities at theirmarket
value. 44
market value added is the amountby
which shareholder wealth increases in the
11
~'liJ
JTh!i~;.t!
~>~
~~'f'
,~1~
&1i::tt,
~&'i'
i;~~
~';'.~;;:;i
[t~~
~f~:~v";
Chapter 2 Introduction!O theFinancial Statemems 55

market, plusanydividend received. It is
equalto the stock return. 46
matching principle is the accounting
principle by which expenses are matched
withthe revenues forwhichtheyare
incurred. 46
net payout is cashdistributed to
shareholders. 39
reliabilitycriterion isthe accounting
principle that requires assets, liabilities,
revenues, andexpenses to be booked
onlyif theycanbe measured with
reasonable precision basedon objective
evidence. 49
revenueis valuereceived from customers
that is recognized in the financial
statements. 34
revenue recognition principleisthe
accounting principle bywhich revenues are
recognized intheincome statement. 46
shareholder value added is the (intrinsic)
valueaddedto shareholders' wealth
duringa period. 44
stock return is the return to holding a
share,and it is equalto the capital gain
plus dividend. 46
stockholders' equity is the claimon
payoffs by the owners (thestockholders)
of the firm. 34
stocks in the financial statements are
balances at a pointin time.Compare with
flows. 40
Analysis Tools
Page
Accounting relations
Balance sheetequation (2.1) 34
Income statement
equation (2.2)
34
Income statement component
equations (2.2a)
36
Cash flow statement
equation (2.3)
39
Stocks and flows
equation (2.4)
39
Comprehensive income
calculation (25)
39
Value equation (2.6)
42
Value addedforshareholders
equation (2.7)
44
Market value addedequation
(2.8)
44
Stock return equation (2.8a) 46
KeyMeasures
Page Acronyms to Remember
Diluted earnings pershare

Earnings
Earnings before interest and
taxes (ebit)
Earnings before interest taxes,
depreciation, and
amortization (ebitda)
Expense
Fair value
Gross margin
liabilities
Market value added
Netassets
Netincome (ornet profit)
Netpayout
Operating income
Premium (ordiscount) over
book value
Price/earnings ratio (PIE)
Price-to-book ratio (PIB)
Revenue
Shareholder value added
Stock return
38
34
37
48
34
45
36
34
45
34
34
39
36
GAAP Generally Accepted

Accounting Principles
IASB International Accounting
Standards Board
IfRS International Reporting
Standards
NYSE New York Stock Exchange
PIB price-to-book ratio
PIE price-earnings ratio
R&D research and development
SEC Securities and Exchange
Commission
42
49
43
34
44
46

A Self-8tudy Exercise
r~~l
mOf'{g
ik<';(16~
Analysis Tools
Financial statements
Balance sheet
Income statement
Cash flow statement
Statement ofshareholders'
equity
Financial statement
footnotes
Management's discussion
and analysis
Page
34
34
38
39
40
40
Key Measures
Assets
Basic earnings pershare (eps)
Book value of equity
Book value pershare (bps)
Capital gain
Cash flow
From operations
From investing activities
From financing activities
34
38
42
43
46
39
39
39
39
BPS book value pershare

DPS dividends pershare
ebit earnings before interest and
taxes
ebitda earnings before interest
taxes, depreciation, and
amortization
EPS earnings pershare
FASB Financial Accounting
Standards Board
In the Continuing Casefor Chapter 1, you gained someappreciation of Kimberly-Clark's

business, examined its recentstockpricehistory, anddiscovered whatanalysts were saying
aboutthestock.It's nowtimeto tum to the financial statements, for it is onthosestatements
that a valuation is anchored. We will go into KMB's financial statements in considerable
depthas the book proceeds. For now you need to familiarize yourselfwith the layout of
the statements and appreciate theirmain features. Exhibit 2.2 presents the firm's 2004annualfinancial statements, alongwithcomparative numbers fromprioryears. Asweproceed
withthe firmthrough the book,we will be referring to moredetail in the financial reports,
so you mightdownload the fu112004 lO-K from the SECEDGAR Web site. If, for some
reason, you havedifficulty downloading the IO~K, it is on the Web pagefor Chapter 7 on
the book's Web siteat wwvv.mhhe.com/penman4e.
Chapter 2 ImrodllC!lon rotheFinancial Sultements 57
56 Chapter 2 /mTooucdon 10rhc Financial Sw!em~ms
EXHIBIT 2.2
FinancialStatements
for Kimberly-Clark
Corporationfor Year
Ending December3l,
2004
ConsolidatedIncomeStatement
EXHIBIT 2.2
KIMBERLY-CLARK CORPORATION AND SUBSIDIARIES

ConsolidatedBalance Sheet
(Continued)
YearEnded December31
December 31
2004
2003
Assets
594.0
2,038.3
1,670.9
278.2
290.6
1,955.1
1,563.4
281.4
~
4,961.9
7,990.5
~
4,438.1
Property, plant, and equipmentnet

Investments inequitycompanies
Goodwill
Other assets
444.4
2,702.9
~
$17,018.0
8,263.4
427.7
2,649.1
1,001.6
$16,779.9
494.5
2,005.9
1,430.1
191.3
205.9
4,327.7
7,619.4
571.2
2,254.9
~
$15,639.6
liabilities and Stockholders'Equity

Current liabiiities
Debtpayable within one year
Trade accounts payable
Other pevebles
Accrued expenses
Accrued income taxes
Dividends payable
Totalcurrent liabilities
Long-term debt
Noncurrent employee benefit and otherobligations
Deferred income taxes
Minority owners interests insubsidiaries
Preferred securities of subsidiary
Stockholders'equity
Preferred stock-ere parvahe-euthoreec
20.0 million shares, noneissued
Common stock~$1.25 parvalue-authorized
1.2billion shares; issued 568.6million shares at
December 31, 2004and 2003
Additional paid-in capital
Common stock heldintreasury, at cost-85.7
million and 67.0 million shares at
December 31, 2004and 2003
Accumulated othercomprehensive income (loss)
Retained earnings
Unearned compensation on restricted stock
Totalstockholders' equity
1,214.7
983.2
265.5
1,431.6
448.0
194.2
4,537.2
2,298.0
1,621.7
8403
368.4
722.9
710.8
348.6
(5,047.5)
864.3
857.9
283.5
1,374.7
367.2
171.1
3,918.7
2,733.7
1,614.4
880.5
2983
567.9
710.8
406.9
(3,818.1)
S 1,086.6
844.5
277.5
1,325.2
4043
~
4,092.1
2,844.0
1,390.0
854.2
255.5
553.5
710.8
419.0
(3,350.6)
2002
(Millions of dollars, except pershare amounts)
2002
(Millions of dollars)
Currentassets
Cashand cashequivalents
Accounts receivable, net
Inventories
Othercurrent assets
Totalcurrent assets
2003
2004
Netsales
Costof products sold
Grossprofit
$15,083.2
10,014.7
5,068.5
Marketing, research, and general expenses

Other (income) expense, net
Operating profit
(158.4)
(105.5)
Nonoperatingexpense
Interest income
Interest expense
Income before incometaxes, equity
interests, discontinuedoperations
and cumulativeeffect of accounting
change
$14,026.3
9,231.9
4,794.4
$13,231.5
8,537.7
4,693.8
2,510.9
2,3503
~
2,506.4
2,251.8
73.7
2,3683
17.9
18.0
15.7
~)
~}
~)
2,203.4
2,0763
(483.9)
124.8
(484,1)
107.0
(629.9)
1133
(73.9)
(55.6)
(58.1)
1,770.4
29.8
1,643.6
50.6
1,627.4
58.6
1,80o.z
1,694.2
1,686.0
Provision forincome taxes

Share of net lncome of equity
companies
Minority owners share of
subsidiaries net income
Income from continuingoperations
Income from discontinued operations,
net of income taxes
Income before cumulative effectof
accounting change
Cumulative effectof accounting
change, net of income taxes
Net income
Pershare basis
Basic
Continuing operations
Discontinued operations
Cumulative effect of accounting change
Net income
Diluted
Continuing cceretons
Cumulative effect of eccountoqchange
Netincome
2,331.6
2,202.1
(11.4)
$ 1,800.2
$ 1,694.2
$ 1,674.6
3.58
3.24
3.15
.06
.10
.11
--..ill)
3.64
3.34
3.24
3.55
3.23
3.13
.06
.10
.11
(.02)
3.61
3.33
3.22
(Continued)
(1,226.0)
11,865.9
(223)
6,629.5
$17,018.0
(1,565.4)
11,059.2
(2,157.7)
10,054.0
(27.1)
~)
5,6503
6,766.3
$16,779.9
$15,639.6
58 Chapter2 introduction 10 lhe FiJ1~l1lciQ1 Swrcments
EXHIBIT 2.2
Consolidated Cash Flow Statement
EXHIBIT 2.2
(Concluded)
(Continued)
YearEnded December31
2004
2003
2002
g
00.
Continuing operations:
Operatingactivities
Income from continuing operations
Depreciation andamortization
Deferred income tax(benefit) provision
Net losses on assetdispositions
Equity companies earnings inexcess of
dividends paid
Minority owners share ofsubsidiaries netincome
Decrease (increase) inoperating working capital
Postretirement benefits
Other
Cash provided byoperations
Investingactivities
Capital spending
Acquisitions of businesses, netofcash acquired
Investments inmarketable securities
Proceeds from sales of investments
Net increase intime deposits
Proceeds from dispositions of property
Other
Cash used forinvesting
Financing activities
Cash dividends paid
Net decrease inshort-term debt
Proceeds from issuance oflone-term debt
Repayments of long-term debt
Proceeds from preferred securities ofsubsidiary
Proceeds from exercise ofstock options
Acquisitions of common stock forthe treasury
Other
Cash used forfinancing
$1,770.4
$1,643.6
800.3
745.3
$1.627.4
704.4
(19.4)
(50.8)
189.0
45.5
(30.1)
35.0
(9.6)
37.7
(8.2)
73.9
55.5
133.0
118.2
(59.9)
58.1
(197.8)
(54.4)
-22
2,726.2
(535.0)
(872.9)
(258.5)
(861.3)
(410.8)
110.8)
(9.0)
38.0
(22.9)
29.4
(149.0)
44.9
(36.9)
7.6
4.8
~)
(1.260.1)
(1,2873)
(671.9)
~
(495.4)
(767.9)
(54.7)
(424.2)
(612.7)
(423.9)
38.7
(199.0)
540.8
(481.6)
823.1
(154.6)
(1.598.0)
31.0
(546.7)
68.9
(680.7)
(2.174.9)
(1,570.9)
~)
(1,014.8)
125.0
290.0
Cashprovidedby (usedfor) continuingoperations

Discontinued operations:
Cash provided bydiscontinued operations
Cash payment from Neenah Paper. Inc.
Cash provided bydiscontinued operations
I~I
49.4
2,341.5
(11.5)
30.7
Effect ofexchange ratechanges on cash andcash

equivalents
Increase{decrease) incash and cashequivalents

Cash andcash equivalents, beginning of year
Cash andcash equivalents, endof year
~
2552.2
(118.5)
4.1
18.6
14.7
60.0
(260.2)
54.1
30.0
56.3
75.9
243.4
56.3
303.4
290.6
(203.9)
494.5
I~I
I~I
I!I
I~I
I~I
213.4
594.0
$ 290.5
130.0
364.5
$ 494.5
59
Chapter 2 Inrroduc(ioll W lheFinancial S[(l!~m~nr5
60 Chapter 2 IlHrodllCuon EO [h~ FinMcial Sralel1l~l1ts
C2.12. Why is the matching principle important?
THE FORM AND CONTENT OF KIMBERLY-CLARK'S

FINANCIAL STATEMENTS
Go through the firm's fourstatements andshow thateachof the accounting relations in this
chapter-2.1 to 2.5-are obeyed in 2004. Be sure to identify comprehensive income and
net payout to shareholders. Satisfy yourselfthat the cash flow statement reconciles to the
opening and closingcash balances, as in Figure 2.1,and howthe income statement reconciles to the shareholders' equitystatement, as also shown in Figure 2.1. Canyou "tell the
story"of whatthe financial statements, as a whole, are depicting?
Lookat Kimberley-Clark's balance sheetandtickoffthoseassetsand liabilities thatyou
think are reported close to their fair value. On what basis are the remaining items measured?Fromyour investigation of the firmin the Chapter I case,whatassetsdo you conjectureare missing fromthebalance sheet?Whatitemsinthe income statement involve the
mostmismatching of revenues to expenses?
C2.13. Whydo fundamental analysts want accountants to follow the reliability criterion
when preparing financial reports?
Exercises
Drill Exercises
E2.1.
Concept
Questions
C2.1. Changes in shareholders' equityare determined by totalearnings minusnet payout

to shareholders, butthe change in shareholders' equityis not equal to net income
(in the income statement) minus netpayout to shareholders. Why?
C2.2. Dividends are the onlywayto paycashout to shareholders. True or False?
C2.3. Explain the difference between net income and net income available to conunon.
Which definition of income is usedin earnings-per-share calculations?
C2.4. Whymighta firm tradeat a price-to-book ratio(PIB) greaterthan l.0?
C2.5. Explain why firms havedifferent price-earnings (PIE) ratios.
C2.6. Explain the difference between accounting valueadded(earnings) andshareholder

valueadded.
C2.7. Givesome examples in which there is poor matching of revenues and expenses.
C2.8. Price-to-book ratiosare determined by howaccountants measure bookvalues. Can
you think of accounting reasons for why price-to-book ratios were high in the
1990s? Whatotherfactors mightexplain the highPIB ratios?
C2.9. Why are dividends notan expense in the income statement?
C2.10. Why is depreciation of plantand equipment an expense in the income statement?
C2.1 L Is amortization of a patentrightan appropriate expense in measuring valueadded
in operations?
Applying Accounting Relations: Balance Sheet, Income Statement,
and EquityStatement (Easy)

The following questions pertain to the samefirm.
a. The balancesheetreports$400 million in total assetsand $250 million in shareholders' equityat the end of a fiscal period. Whatare the firm's liabilities?
b. The income statement reports$30 million in net income and $175 million in total
expenses for the period. Whatare the finn's revenues?
c. Theshareholders' equity statement hasa beginning balance fortheperiodof$230million and the firm had a net payout to shareholders of$12 million. Whatis the finn's
comprehensive income forthe year? Howmuchincome is reported in the equitystate.
mentratherthan the income statement?
d. Therewere no share issuesor stock repurchases duringthe year. How much did the
firm pay in dividends?
MARKET VALUES AND MARKET MULTIPLES

You sawin the Chapter I casethat KMB traded at $64.81 in March2005,justafterits2004
annual report waspublished. Using this number and othersfrom the statements, calculate
the total marketvalueof the equity. Forthis you will needto identify shares outstanding;
remember thatsharesoutstanding are notthesameas shares issued. Calculate thepremium
or discount at which KMB trades relative to bookvalue. Also calculate the price-to-book
ratio (PIS) and the price-earnings ratio (PIE). Can you provide some explanation for the
size of theseratios?
Usingthe valueequation (2.6)andinformation inthefinancial statements, make thebest
calculation you can for the valueof the finn (enterprise value). K:\1B traded at $62 per
share 12months priorto March 2005 andpaida dividend of$1.60 pershareoverthe year.
Whatwasthe rateof returnon the stockfor theyear?
61
E2.2.
Applying Accounting Relations: Cash Flow Statement (Easy)

A firmreported $ J30 million increase in cashovera year. It also reported $400million in
cashflow fromoperations, and a net$75 million paidout to claimants in financing activities.Howmuchdid the finn invest in operations?
E2.3.
The Financial Statements for a Bank Savings Account (Medium)

You received the following statement for 2009 for your savings account at a bank. Cash
balances in the account earn interest at a 5 percentrate perannum.
Balance, January 1, 2009
Earnings at an interest rateof 5% p.a
Withdrawals
Balance, December 31, 2009
$100
-.)
100
This statement is effectively a statement of owner's equity for the account. It shows
your starting balance, adds your earnings for the year, and subtracts your dividend (the
withdrawal), to yielda closingbalance.
a. Prepare an income statement, balancesheet,and cashflow statement for this account
for 2009.
b. Ratherthan withdrawing $5 fromthe account, suppose youleftit in theaccount. What
would yourfinancial statements for 2009then looklike?
c. If, before the end of the year, youinstructed yourbankto invest theearnings of$5 in a
mutual fund(andtherewereno withdrawals), whatwould the final financial statements
looklike?
E2.4. Preparing an Income Statement andStatement
of Shareholders' Equity (Medium)

From thefollowing information forthe year2009,prepare an income statement anda statementof shareholders' equity, underGAAP rules, fora company withshareholders' equity
at thebeginning of2009 of $3,270million. Amounts are in millions.
62 Chapter 2 lmroducdon to {h~ FilUlnciaJ Statements
Sales
Common dividends paid
Selling expenses
Research and development costs
Cost ofgoods sold
Share issues
Unrealized gain on securities available for sale
Income taxes
Chapter 2 introouclion to theFinoncia! Sratcment; 63
$4.458
140
1,230
450
3,348
680
76
(200)
Applications
E2.8,
Alsocalculate comprehensive income andnetpayout. Income taxes arenegative. How can

thisbe?
E2.5.
Classifying Accounting Items (Easy)

Indicate where in the financial statements thefollowing appear underGAAP:
a. Investment in a certificate of deposit maturing in 120 days.
b. Expenses for baddebts.
c. Allowances for baddebts.
d. Research anddevelopment expenditures.
e. A restructuring charge.
f. A lease of anassetforitsentire productive life.
g. Unrealized gainon shares held for trading purposes.
h. Unrealized gainon shares available forsale.
i. Unearned revenue.
j. Preferred stockissued.
k. Preferred dividends paid.
1. Stock option compensation expense.
E2.6.
E2,9.
Using Accounting Relations: General Mills. Inc. (Medium)

Thefollowing numbers appeared in theannual report of General Mills, Inc., theconsumer
foods manufacturer, for the fiscal yearending May 2008 (in millions of dollars):
Fiscal 2008
Total assets
Total revenues
Common share issues
Common dividends
Common stock repurchases
19,042
6,216
13,652
1,133
530
1,385
Fiscal 2007
18,184
5,319
12,442
504
505
1,385
Violationsof the Matching Principle (Easy)

Thefirm hasno preferred stock.
Generally accepted accounting principles (GAAP) notionally follow the matching principle. However, there are exceptions. Explain why the following accounting rules, required
underGAAP, violate thematching principle.
a. Expenditures onresearch anddevelopment intonewdrugs areexpensed inthe income
statement as theyareincurred.
b. Advertising andpromotion costsfora newproduct are expensed as incurred.
c. Film production costsareexpensed priorto therelease of films to theaters.
E2.7.
Finding Financial Statement Information on the Internet (Easy)

TheSecurities andExchange Commission (SEC) maintains theEDGAR database of company filings withthe commission. Explore theSEC'SEDGAR site:
htlp:l!www.sec.gov/edgar.shtml.
Lookat the"Descriptions of SECForms" pageto familiarize yourself withthetypes of filingsthatfirms make. Thenclickon"Search for Company Filings" for the filings of firms
youareinterested in. Forms IO-K (annual reports) and 10-Q (quarterly reports) will be of
primary interest.
Accessing the database directly on the SECsite gives you the full textof each filing.
A number of services deliver the material in small, digestible pieces so you don't have
to scroll through the entire filing in search of a particular item. These services also formatthe filing in a form thatcanbe downloaded intoa spreadsheet program. Access these
sitesthrough linksonthe book's Web page.
Forfiscal 2008, calculate

a. Total liabilities at yearend.
b. Comprehensive income for theyear.
Real WorldConnection
SeeExercises E1.5, E2.9,E3.9,E4.9, E6.8,EIO.9, EI3.5,E14.8, and E15.10 forthematerial on General Mills.
Using Accounting Relationsto Check Errors (Hard)

A chiefexecutive reported thefollowing numbers forfiscal year2009 to anannual meeting
of shareholders (in millions):
Revenues
Total expenses, including taxes
Other comprehensive income
Total assets, end ofyear
Total liabilities, end ofyear
Dividends toshareholders
Share issues
Share repurchases
Shareholders' equity, beginning ofyear
s 2,300
1,750
(90)
4,340
1,380
4D0
900
150
19,140
Show thatat leastoneof these numbers must bewrong because it doesnotobeyaccounting

relations.
E2.10.
Using Accounting Relations: Genentech Inc. (Medium)

Consider the following excerpts from Genentech's 2004 income statement and cashflow
statement. From the2004income statement (in millions):
Revenues
Costs and expenses
Cost ofsales
Research and development
Marketing, general, and administrative
Collaboration profit sharing
Special charges
Other expense-net interest income
Income before tax
Income tax
Net income
$ 672.5
947.5
1,088.1
593.6
182.7
(82.6)
1,219.4
434.6
784.8
Chapter 2 IntrOOllcriolllQ (he Financial SWtcmCIlt5 65
64 Chapter 2 lmrooucrioll to (h~ Financial SratCmc,lt5
From the 2004 cashflow statement (inthousands);
Exercise 14.12 andMinicases 5.l, 6.1,and 14.2 dealwith Cisco Systems.
Cash flows from operating activities

Net income
Adjustments to reconcile netincome to netcash provided byoperating activities:
Depreciation and amortization
Deferred revenue
litigation-related and other long-term liabilities
Tax benefit from employee stock options
Gain on sales of securities available forsale and other
Loss on sales of securities available for sale
Write-down of securities available for sale
Loss on fixed asset dispositions
Changes in assets and liabilities:
Receivables and other current assets
Inventories
Investments in trading securities
Accounts payable and other current liabilities
Net cash providedby operatingactivities
E2,12,
784,816
Find the Missing Numbers in Financial Statements: General Motors

Corporation (Medium)
353,221
(73,585)
(14,927)
General Motors ended its 2007 year with shareholders' equity of -$37,094 million at
December 31 (yes, negative equity'). Six months later, at June 30, 2008, it reported
-$56,990 million in equity afterpaying a dividend of$283 million to shareholders. There
were no othertransactions withshareholders.
34,722
329,470
(13,577)
a. What wascomprehensive income forthe six months?

b. Theincome statement reported a lossof S18,722million forthesix months. What was
"othercomprehensive income"?
c. Total expense andotherlosses in the income statement, including taxes, were $60,895
million. What wasrevenue for thesix months?
d. Thefirm reported S148,883 million of total assetsat theendof 2007 andS136,046 at
June30, 2008. Whatwere total liabilities at thesetwodates?
e. How cana finn have negative equity?
1,839
12,340
5,115
(362,740)
(120,703)
(75,695)

Exercises 4.10and5.16alsocover General Motors.
335,542
$1,195,838
E2.13.
Mismatching at WoridCom (Hard)

DUring the four fiscal quarters of2001 andthefirstquarter of2002,WorldCom incorrectly
capitalized access charges to local networks as assets (as explained in Box 2.3). The
amount of costs capitalized were as follows:
Current assets
Total assets
Long-term liabilities
First quarter, 2001

Second quarter, 2001
Third quarter, 2001
Fourth quarter, 2001
First quarter, 2002
$3,422.8
9,403.4
1,377.9
Suppose WoridCom amortized these capitalized costs straight-line over five years
(20 quarters). Calculate the amount of the overstatement of income before tax foreachof
the five quarters.
6,782.2
d. Calculate the long-term assets andshort-term liabilities that were reported.

Thefollowing were alsoreported in the2004statements (in millions):
2004
Cash used in investing activities (inthecash flowstatement)

Cash and cash equivalents (inthebalance sheet)
$451.6
270.1
E2,14.
2003
$1,398.4
372.2
e. Calculate cashflows from financing activities reported for2004.
E2.11.
$780 million
$605 million
$760 million
$920 million
$790 million
Find the Missing Numbers in the Equity Statement: Cisco Systems, Inc. (Easy)
Attheendof its2007 fiscal year, Cisco Systems, Inc., theproducer ofrouters andother hardware and software for the telecommunications industry, reported shareholders' equity of
$31,931 million. Attheendof thefirst nine months of fiscal 2008, the firm reported $32,304
million in equity along with$6,526 million of comprehensive income fortheperiod.
a. What wasthenet transactions withshareholders inthe firstninemonths of2008?
b. Cisco paidno dividends and shareissues amounted to $2,869 million. Whatwasthe
amount of shares repurchased during the firstnine months of2008?
Calculating Stock Returns: Nlke, Inc. (Easy)

The shares of Nike, Inc.,tradedat $55 pershareat the beginning of fiscal year2008 and
closed at $67pershareat the endof theyear. Nikepaida dividend of 87.5centspershare
during theyear. What was thereturn to holding Nike's shares during 2008?

Nikeis covered extensively in thisbook, bothin textmaterial andexercises. Seeexercises
6.7,8.13, 13.17, 13.18, 15.11, 15.13, 18.5, and 19.4 andminicase 2.1in thischapter.
66 Chapter 2 InrrodtlC!ion to !h~ Financiol Sr.o.temcn1S
Minicase
Chapter 2 /nrrod"crioll co fhe Finonciol Swtements 67
F. Explain the difference between basicearnings per shareanddiluted earnings pershare.

G. Explain why some inventory costsare in cost of goodssold and someare in inventory
on the balance sheet.
M2.1
Reviewing the Financial Statements
H. Nike spent $2,308 million on advertising andpromotion during 2008. Where is this cost
of Nike, Inc.
Nike, Inc., is a leading manufacturer andmarketer ofsportandfashion footwear. Incorporated
in 1968 andheadquartered in Beaverton, Oregon, itsbrand name hasbecome almost universal, delivering salesof over$18.5 billion by 2008 andmaking it the largest sellerof athletic
footwear andapparel in theworld, withoperations in 180countries. Nike's top-selling product
categories arerunning, basketball, andcross-training shoes, butitalsomarkets shoesdesigned
fortennis, golf,soccer, baseball, football, bicycling, volleyball, wrestling, cheerleading, skateboarding, hiking, andoutdoor activity. Many of itsproducts aresoldas leisurewear.
In the 1990sNike wasa hot stock,trading at a PIE ratioof35 and a PIB ratioof5.1 in
mid-1999. By2008,its PIE ratiohad fallen to 16and its PIB ratioto 3.8, butits stockprice
actually increased duringthe bursting of the bubble, from$20 in 2000to $40 in 2004.
We will spend considerable time in the book analyzing and valuing Nike. The Build
Your Own AnalysisProduct (BYOAP) on the Web site tracks Nike from 1996to 2006.
The 2008 financial statements (and comparative 2007 and 2006 statements) that follow
introduce youto the firm. You alsocanfindthesefinancial statements in Nike'slO-K report
for 2008on the SEC'sEDGAR Web site, whichis accessible through the address given in
Exercise 2.8, or through linkson the book's Web site. Browse the entire 10-Kas an example of whata typical lO-K looks like. Look at the footnotes referred to in the statements
below. Read the management's discussion of the business and get a sense of the business
model. Lookalso at the firm's Web site at www.nike.com.
Examine the financial statements inExhibit 2.3andusethemto testyourbasicknowledge
of accounting. The questions thatfollow will helpyoufocus On thepertinent features.
A. Usingthe numbers in the financial statements, showthatthe following accounting relations holdin Nike's2008statements:
Shareholders' equity'" Assets - Liabilities
Net income> Revenue - Expenses
Cashfromoperations + Cashfrominvestment + Cashfromfinancing + Effect
of exchange rate> Change in cashandcashequivalents
B. What are the components of other comprehensive income for 2008? Show that the
following accounting relation holds:
Comprehensive income> Net income + Othercomprehensive income

C. Calculate the net payout to shareholders in 2008 from the Statement of Shareholders'
Equity.
D. Explain howrevenue is recognized.
E. Calculate the following for 2008: gross margin, effective tax rate, ebit, ebitda, and the
salesgrowth rate.
included in the financial statements? Does this treatment satisfy the matching principle?
1. Accounts receivable for 2008 of $2,795 million is net of $78.4 million (reported in
footnotes). Howis this calculation made?
1. Whyare deferred income taxesbothan assetand a liability?
K. Whatis "goodwill" and howis it accounted for?Whydid it change in 2008but not in
20077
L. Why are commitments and contingencies listedon thebalance sheet, yet the amount is
zero?
M. Explain whythereis a difference between net income andcashprovided by operations.
;}
N. Whatitemsin Nike'sbalancesheetwould yousay were closeto fairmarket value?

o. Nike'sshares tradedat $62 afterthe 2008 report wasfiled. Calculate the PIE ratioand
the PIB ratio at this price. Howdo theseratios compare with historical PIE and PIB
ratios in Figures 2.2 and2.3?
't
FOllow Nike through Chapters 5-15 and on the BYOAP feature on thebook's Web site.See
also Exercises 2.14, 6.7, 8.13, 13.17, 13.18, 15.11, 15.13, 18.5,and 19.4.
EXHIBIT 2.3
FinancialStatements
for Nike,Inc. forYear
EndingMay 3112008
NIKE, INC.
Consolidated Statementsof Income
Year Ended May31
2008
2007
2006
(in millions, except per-share data)
Revenues
$18,627.0
Costofsales
10,239.6
Gross margin
8,387.4
Seiling andadministrative expense
5,953.7
Interest income, net(Notes 1,6, and 7)
77.1
Other (expense) income, net(Notes 15 and 16)
(7.91
Income beforeincometaxes
2,502.9
Income taxes (Note 8)
619.5
Net income
$ 1 883.4
Basic earnings percommon share (Notes 1 and 11)
$
3.80
Diluted earnings percommon share (Notes 1 and 11) $
3.74
Dividends declared percommon share
s 0.875
$16.325.9
9,165.4
7,160.5
5,028.7
67.2
$14.954.9
8,367.9
6,587.0
0.9
2,199.9
~
2,141.6
~
$ 1,491.5
~
$ 1 392.0
4,477.8
36.8
2.93
2.64
0.59
(Con/iT/ued)
68 Chapter 2 lmrodllCrion 10 rho; Financial Sw(cmcn[>
EXHIBIT 2.3
(Continued)
Chapter2 Jncroduction 10 the Financial SI(l(~IllClll, 69

ConsolidatedBalance Sheets
May 31
2008
EXHIBIT 2.3
(Continued)
2006
2007
(in millions)
2008
S 2,133.9
642.2
2,7953
2,438.4
227.2
6023
8,839.3
1,891.1
743.1
448.8
520.4
$12,442.7
$ 1,856.7
9903
2,494.7
2,121.9
219.7
393.2
8,076.5
1,678.3
409.9
130.8
392.8
$10,688.3
Cashprovided (used) by operations:

Netincome
Income charges not affecting cash:
Depreciation
Stock-based compensation (Notes 1 and 10)
Gain on divestitures (Note 15)
Amortization and other
Income taxbenefit from exercise of stock options
Changes incertain working capital components
and otherassetsand liabilities excluding the
impact of acquisition and divestitures:
Increase in accounts receivable
Increase in inventories
Increase in prepaid expenses and other
current assets
Increase inaccounts peyabe, accrued liabilities
and income taxespayable
Cashprovided by operations
954.2
1,348.8
2,395.9
2,076.7
203.3
380.1
7,359.0
1,657.7
405.5
130.8
~
9,869.6
Liabilities and Shareholders'Equity

Current portion of long-term debt (Note 7)
Notes payable (Note 6)
Accounts payable (Note 6)
Accrued liabilities (Notes 5 and 16)
Income taxespayable
6.3
177.7
1,287.6
1,761.9
88.0
3,321.5
long-term debt (Note 7)

441.1
Deferred income taxesand otherliabilities (Note 8)
854.5
Commitments and contingencies (Notes 14 and 16)
Redeemable preferred slack(Note 9)
0.3
Shareholders' equity:
Common slackat statedvalue (Note 10):
Class A coovetole-es.s and 117.6shares
outstanding
0.1
Class 8-3943 and 384.1 shares outstanding
2.7
Capital in excess of statedvalue
2,497.8
Accumulated othercomprehensive income (Note 13)
251.4
Retained earnin9s
5,073.3
Totalshareholders' equity
7,8253
Totalliabilitiesand shareholders' equity
$12,442.7
2007
2006
(in millions)
Assets
Currentassets:
Cashand equivalents
Inventories (Note 2)
Deferred income taxes (Note 8)
Prepaid expenses and othercurrent assets
Property, plant, and equipment, net (Note 3)
Identifiable intangible assets, net (Note 4)
Goodwill (Note 4)
Deferred income taxes and otherassets(Note 8)
Totalassets
ConsolidatedStatements of Cash Flows

YearEnded May31
30.5
100.8
1,040.3
1,303.4
109.0
2,584.0
255.3
43.4
952.2
1,286.9
85.5
2,623.3
409.9
668.7
410.7
550.1
0.3
0.3
0.1
0.1
2.7
1,960.0
177.4
4,885.2
1,451.4
117.6
4,713.4
7,025.4
$10,688.3
6,285.2
9869.6
2.7
Cashprovided (used) by investing activities:

Purchases of short-term investments
Maturit;'es of short-term investments
Additions to property, plant, and equipment
Disposals of property, plant, and equipment
Increase inotherassets, net of otherliabilities
Acquisition of subsidiary, net of cashacquired
(Note 15)
Proceeds from divestitures (Note 15)
Cash(used) provided by investing activities
Cashprovided(used) by financingactivities:
Proceeds from issuance of long-term debt
Reductions inlong-term debt including current
portion
Increase (decrease) in notespayable
Proceeds from exercise of stock options and other
stock issuances
Excess taxbenefits from share-based payment
arrangements
Dividends-<:ommon and preferred
cash used by financing activities
Effect of exchange ratechanges
Netincreased (decrease) in cashand equivalents
Cashand equivalents, beginning of year
Cashand equivalents, end of year
Supplemental disclosure of cashflow information:
Cashpaidduring the yearfor:
Interest, net of capitalized interest
income taxes
Dividends declared and not paid
S 1,883.4
S 1,491.5
s 1,392.0
303.6
269.7
34.1
147.7
282.0
(300.6)
141.0
(60.6)
17.9
05
(26.0)
11.8
(2.9)
54.2
(118.3)
(249.8)
(39.6)
(495)
(85.1)
(200.3)
(11.2)
(60.8)
(37.2)
330.9
1,936.3
85.1
1,878.7
~
1,667.9
(1,865.6)
2,246.0
(449.2)
(2,133.8)
2,516.2
1.9
28.3
(43)
(2,619.7)
1,709.8
(333.7)
1.6
(34.5)
(21.8)
(313.5)
(571.1)
246.0
~)
(1,276.5)
41.8
(35.2)
63.7
(255.7)
52.6
(6.0)
(18.2)
343.3
322.9
225.3
63.0
(1,248.0)
(412.9)
(1,226.1)
55.8
(985.2)
(343.7)
---.i111l
(DlTS)
(761.1)
(290.9)
(850.9)
277.2
1,856.7
$ 2,133.9
42.4
902.5
954.2
$ 1,856.7
(433.9)
1,388.1
$ 954.2
44.1
717.5
112.9
60.0
601.1
92,9
54.2
752.5
79.4
---.liZ
(Continued)
EXHIBIT 2.3
(Concluded)
Consolidated Statements of Shareholders' Equity

(in millions, except per share data)
Common Stock
Class A
Class B
Balance at May 31, 2007
Stock options exercised
Conversion to Class 8 common stock
Shares
Amount
Shares
Amount
Capital in
Excess of
Stated Value
117.6
$0.1
384.1
$2,7
$1,960.0
--
--9.1
..
Accumulated
Other
Comprehensive
Income (loss)
Retained
Earnings
Total
$177.4
$4,885.2
$7,025.4
372.2
372.2
20,8
(20.8)
Repurchase of Class B common stock
(12.3)
(20.6)
Dividends on common stock ($0.875 per share)
Issuance of shares to employees
1.0
Stock-based compensation (Notes 1 and 10):

Forfeiture of shares from employees
39.2
141.0
(1.1)
1,883.4
Other comprehensive income:

Foreign currency translation and
other (net of tax expense of $101.6)
Realized foreign currency
translation gain due to
divestiture (Note 15)
Net loss on cash flow hedges (net
of tax benefit of $67.7)
Net loss on net investment hedges
(net of tax benefit of $25.1)
Reclassification to net income of
previously deferred losses related to
hedge derivatives (net of tax benefit of $49.6)
96.8
--
1Q:.!
-394.3
-$2.7.
--$2.497.8
1,883.4
211.9
(46.3)
(46.3)
(175.8)
(175.8)
(43.5)
(43.5)
..J...27.7
---
----.!lU
74.0
1,883.4
1,957.4
(15.6)
--
(3.4)
211.9
Adoption of FIN 48 (Notes 1 and 8)
(432.8)
141.0
Comprehensive income (Note 13):

Net income
Adoption of EITF06-2 Sabbaticals (net

of tax benefit of $6.2) (Note 1)
(1,248.0)
(432.8)
39.2
(2.3)
(0.1)
(1,235.7)
--'$251.4
(15.6)
(10.1)
(10.1)
$$,073.3
E.825.3
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. , . 7",:""'"' .
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Chapter 3 How Finaru:ial StatementS AreUsed in Va]:um"on 75
Link to previouschapters
Chapter I introduced
fundamental analysis
andChapter 2 introduced
thefinancial statements.
,.
'i1"
. This chapter
Thischaptershowshow
fundamental analysis and
valuation arccarriedout
andhowthefinancial
statements are utilized in
theprocess. It laysout a
five-step approach to
fundamental analysis that
involves theanalysis and
forecasting of financial
statements. Simpler
schemes involving financial
statements are also
presented.
Link to next chapter
Chapter 4 dealswith
valuation basedon
forecasting cashflows.
Link to Web page

i
offers further treatment of
ccmparables analysis and
screening analysis, as
wellas anextended
discussion of valuation
technique, andasset
pricing. It alsolinksyou
to fundamental
research engines.
Whatis
themethod
of
comparables?
Whatis
asset-based
valuation?
Howare
fundamental
screens used
in
investing?
-<.-
'-;~::;-~;<
~'::\:-:'k::
':
.......
.-y
.:,~_."
--
Howis
fundamental
analysis
carriedout?
Howdoes
fundamental
analysis
utilizethe
financial
statements?
Howis a
valuation
model
constructed?
'Ibis chaPt~.r_e~P'i~Wt~6w financial statements are usedin valuing firms. It is an important

chapter, forit setsthestagefordeveloping practical valuation analysis in Chapters 4, 5,and6.
Indeed, the material in thesecondhalfof thechapter provides a roadmapformuchof what
follows in the rest of the book.As you proceed through the book, you will find yourself
looking back to this material to maintain yourbearings.
In introducing valuation in Chapter 1,wesaidthatthe analyst's first orderof business is
to choose a technology to workwith.You willnot be ableto committo a technology until
the end of Chapter 6, but this chapter raises the issues involved in makingthat choice. It
lays out the architecture of a competent valuation technology. Here you will develop an
appreciation of what a goodtechnology looks like,and you will begin to understand the
pitfalls that awaitthose usingmisguided methods. You alsowill understand whatfeatures
of firms are relevant to theirvaluation, how these features are identified by a competent
valuation method, and how theyare recognized in financial statements.
In valuation, as with most technologies, there is always a tradeoff between simple
approaches thatignoresomepertinent features and moreelaborate techniques thataccommodate complexities. In thisbookwewillalways bepushing forthesimpleapproaches, but
simpleapproaches that do notsubstantially sacrifice the quality of the product. Simple approaches arecheap-they avoid someanalysis work-but theycanbe toocheap, leading to
errors. In adopting a simpleapproach, we wantto be sure we knowwhat we are missing
relative to a full-fledged analysis. So this chapterbeginswith simple schemes that use
financial statements and progresses to more formal valuation methods. At all points, the
tradeoffs are indicated.
What a valuation technology looks like.

What a valuation model isandhow it differs from an
asset pricing model.
How a valuation model provides the architecture for
fundamental analysis.
The practical steps involved in fundamental analysis.
How the financial statements are involved in fundamental analysis.
How oneconverts a forecast to a valuation.
The difference between valuing terminal investments
and going concern investments {like business firms}.
What business activities generate value.
The dividend irrelevance concept.
Why financing transactions do not generate value,
except inparticular circumstances.
Why the focus ofvalue creation is ontheinvesting and
operating activities ofa firm.
How the method of comparables works (ordoes not
work).
How asset-based valuation works (or does notwork).
How multiple screening strategies work (or do not
work).
How fundamental analysis differs from screening.
What isinvolved incontrarian investing.

Carry outa multiple comparison analysis.
Develop a simple or multiple screen using a stock
screener;
Calculate anarray. of price multiples for a firm.
Calculate unlevered price multiples.
Calculate trailing andforward PIE ratios.
Calculate a dividend-adjusted PIE ratio.
Apply asset-based valuation techniques.
Calculate thebreakup value ofa firm.
Value a bond.
Value a project.
Calculate thevalue added from project selection.
Show that a bond purchased at a price to yield its
required return generates novalue.
Calculate the loss to existing shareholders from issuing
shares at less than market value.
Generate "homemade dividends."
Simplevaluations use a limitedamount of information. Thechapterbeginswithmultiple analysis that uses just a few numbers in the financial statements-sales, earnings, or
book values, for example-and applies pricing multiples to these numbers. Asset-based
valuation techniques are then introduced. These techniques attempt to value equities by
summing themarket valueofthe firms'assets, netofliabilities.We willsee thatasset-based
valuation, though seemingly simple, is a doubtful exercise for mostfirms.
Simple methods run the risk of ignoring relevant information. A full-fledged fundamental analysis identifies all the relevant information and extracts the implications of that
information for valuing the finn. The chapterconcludes with a broad outline of fundamental analysis technologies that accomplish this. It leads you through the five steps
involved and shows how financial statements arc incorporated in the process. It stresses
the importance of adopting a valuation modelthat capturesvaluecreatedin the firmand
showshow that valuation modelprovides the architecture for fundamental analysis. The
chapter distinguishes valuation models for terminal investments from those for goingconcerninvestments (likebusiness firms), and it showshowvaluing goingconcernsraises
particularproblems.
j.
76 Part One Fi:Ulr0.d Srcremenrs and Vaiua!lon
Chapter 3 How Finandal StllremrnlS Are Used in Valuation 77
While TheAnalyst's Checklist forChapter 3 indicates thatthere ismuch youwill beable

to do afterreading thischapter, theprimary goalof the chapter is toprovoke yourthinking
as to what a good valuation technology looks like. With thatthinking, youwillbeprepared
to adoptsucha technology in thenextfew chapters.
TABLE 3.1
Pricing Multiples for
Comparable Firms
toDen, Inc.
Sales
Hewlett-Packard Co.
IenovoGroup Ltd.
Dell, Inc.
MULTIPLE ANALYSIS
An acceptable valuation technique musthave benefits thatoutweigh thecostofusingit, and
its cost-benefit tradeoff mustcompare favorably withalternative techniques. A full-fledged
fundamental analysis comes at somecostbecause it requires theanalyst to consider a large
amount of information, whichinvolves considerable effort. We willdevelop ways of doing
this as efficiently as possible but, before proceeding, we should consider shortcuts that
avoid thosecosts. Whatis lostbytaking an easierroute? Whatis gained bytaking themore
difficult path?Multiple analysis is cheap because it usesminimal information.
A multiple is simplythe ratioof the stockpriceto a particular number in the financial
statements. The most common ratios multiply the important summary numbers in the
statements-c-eamings, bookvalues, sales,andcashflows-hence theprice-earnings ratio
(pIE), the price-to-book ratio (PIB), theprice-to-sales ratio (PIS), andtheratio of'price-tocash flow fromoperations (P/CFO). By usingone pieceof information in the statements,
thesemultiples aresurelyparsimonious in usingfinancial statement information. Onedoes
not have to know muchaccounting to calculate theseratios.
Two techniques employ these multiples and variants on them; they are the method of
comparables andmultiple screening.
The Method of Comparables

The method of comparables or multiple comparison analysis-sometimes referred to as
"comps"-works as follows:
1. Identify comparable firms thathave operations similar to thoseof thetarget firm whose
valueis in question.
2. Identify measures for the comparable firms in their financial statements---eamings,
book value, sales,cash flow-and calculate multiples of thosemeasures at which the
firms trade.
3. Applyan average or median of thesemultiples to the corresponding measures for the
targetfirm to get that firm's value.
Wewill attemptto valueDell,Inc.,in August2008 usingthe method of comparables.
Table3.1 lists the most recent annual sales, earnings, and the book value of equityfor
Dell(fromthe 2008financial statements in Chapter 2) and two firms thatproduce similar
personal computer products, Hewlett-Packard Company, whichabsorbed Compaq Cornputer, and Lenovo Group, the Hong kong-listed firm that manufactures Thinkl'ad and
IdeaPad laptops alongwithdesktop computers and workstations. Theprice-to-sales (PIS),
price-to-earnings (PIE), and price-to-book (PIB) ratiosfor HP and Lenovo are basedon
theirmarketvalues in August 2008. Dell is valuedby applying the average of multiples
for the comparison firms to Dell sales,earnings, and book values, as seen in Table 3.2.
The threemultiples givethree different valuations for Dell,a bit awkward. So the valuations are averaged to givea marketvalueof$51,206 million on 2,060million shares, or
$24.86per share.The earnings multiple gives the highestvaluation of $39.77 per share
while the book value multiple goes the lowest valuation of 7.80 per share. Dell was
Doll~r
TABLE 3.2
Applying
Comparable Firms'
Multiples toDell, Inc.
Earnings
$84,229
14,590
61,133
Book
Value
Market
Value
$7,264 $38,526 $115,700

161
1,134
6,381
2,947
3,735
?
PIS
PIE
PIS
1.37 15.9 3.0

0.44 39.6 5.6
?
?
nombe"are inmillions.
AverageMultiple for
Comparables
Sales
Earnings
Book value
0.91
27.8
43
Dell's
Number
Dell's
Valuation
$61.133
2,947
3,735
$55,631
81,927
16.061
51,206
Average valuation
DoII~ numbers an:in millions.
Dcll~
"runl valuation on August28,2008, w:lS SSO,83Q.
trading at $25per sharein August 2008. Onthe basisof the average valuation, our analysis says"hold."1
Thesecalculations arecertainly minimal. Butthevaluation hasprobably leftyoua little
uneasy. Although Dell's inferred price is similar to its market price,this is nota valuation
thatmakes onefeelsecure.
Multiple comparison analysis is easy, butit's cheap in morethanonesense of theword.
Indeed, there's a real fallacy here. If we havethe pricesof the camps, we can calculate a
value for Dell.But if we wantto get a valuefor Hewlett-Packard (say), would we use the
calculated value of$24.86 per sharefor Dell? Thiswould be circular because Dell's price
is basedon Hewlett-Packard's price. The analysis is notanchored insomething fundamental that tellsus aboutvalue independently of market prices. It assumes that the market is
efficient in setting pricesfor thecomparab1es. Butifthisis thecase,whydoubt thatthe$25
market pricefor Dell is also efficient and go through the exercise? If the comps are mispriced, then the exercise is also doubtful. In short, the method fails the fundamentalist's
tenet(in Box 1.6inChapter I): 'When calculating value to challenge price,beware ofusing
price in the calculation. Indeed, the method can bedangerous. See Box3.1.
This methodis usedextensively and thereare situations in whichit is justified. If the
targetfirmis a private or thinlytraded fum with no reliabletradedprice,we mightget a
quick feel for the valueof its equity from the comparables, but only if their stocksare
efficiently priced.Wemightalsobe interested in theprice at whicha stockshouldtrade,
whether thatprice is efficient or not. Investment bankers floating initialpublic offerings
(IPOs) use the method of comparables to estimate the price at whichthe marketmight
valuethe issue. (Theymight use prices in past comparable IPO transactions ratherthan
comparable pricesat the moment.) If the market is mispricing the comps, they estimate
it will misprice the IPOalso.In litigation for lossof value(in shareholder classactionor
1Ina variation of the calculations (to usemoreup-to-date information), multiple analysis sometimes uses
last-twelve-months (LTM) accounting numbers:
LTM == Number for priorfiscal year + Current yeer-tc-date number - Year-to-date number for prioryear
The year-to-date numbers andthe sum of quarterly numbers reported to date.
LEVERAGE ADJUSTMENTS
Periodically, initial public offerings forparticular types offirms
become "hot." The 1990s bull market saw hot issues for
theme restaurants, technology and computer stocks, brand
fashion houses, business services, andInternet stocks. In a hot
IPQ market, firms sell for high multiples, encouraging comparable firms to go public also. Investment bankers justify the
price of an offering on the basis of multiples received in an
earlier offering. If they raise the multiples a little, to get the
IPO business, a pyramid scheme can develop, with offering
prices based on increasing comparable prices without reference to fundamental value.
In 1995 and 1996, teleservicnq firms-firms supplying
telemarketing and customer service-were offered to the
market. In anticipation ofotherfirms outsourcing these functions to the new firms, investors paid high prices inthe IPOs.
The pyramiding occurred. lehman Brothers co-managed one
of the initial offers but lost out to other investment banks

in handling later !POs. Quoted in The Waf! Street Journal on
September 15, 1998, Jeffrey Kessler of Lehman Brothers said,
"Every time we came out with whatwethought wasa reasonable valuation for a new IPQ in this area, the winning
bidder hadvaluations thatwere way higher, We were outbid
[by other investment banks] by, insome cases, over five multiple points, and we scratched our heads and said this was
cra"l:f,"
Indeed, the stock prices of teleservicirq firms dropped

dramatically afterthe IPQ boom. Apyramiding IPQ market is
another stock price bubble. Pricing IPQs on the basis of the
speculative price multiples of comparable firms perpetuates
thebubble. Beware ofprices estimated from comparables, for
you may join a chain letter (apyramid scheme) that leads you
to pay too much fora stock.
minority interest suits, for example), the question often asked is what price the stock
wouldhavebeen had certain events occurred, not what it's really worth,
Conceptual problems aside, the method of comparables also has problems in
implementation:
Identifying compswiththe sameoperating characteristics is difficult. FirmsaretypicaJ1y
matched by industry, product, size,growth, andsomemeasure of risk,butnotwofirms are
exactly alike. Onemightarguethat Hewlett-Packard, with its printerbusiness, is not the
sametypeof firm as Dell.Lenovo is a Chinese company, tradedon a different exchange.
Campsareusually competitors inthesameindustry thatmight dominate (orbedominated
by) thetargetfirmand thusnot comparable. Increasing the number of campsmightaverage outerrors,but the morecampsthereare,the lesshomogeneous theyare likely to be.
Different multiples givedifferent valuations, Applying a camp's PIB ratio to the target's
book value yields a different price from applying the camp's PIE ratio to the target's
earnings, as wejust sawwithDell.Which priceshould weuse? In theexample, wesimply took an arithmetic average, but it is not clearthatthis is correct.
Negative denominators can occur. Whenthe comphasa loss,the PIE has littlemeaning.
The methodof comparables leaves too muchroom for "playingwith mirrors." Thereis
too muchfreedom for the analyst to obtaina valuation thathe, or his client,desires. This is
not good if our aim is to challenge speculation.
Othermultiplesareusedin comparison analysis. Someadjustfordifferences in leverage
between firmsand someadjustfor differences in accounting principle. See Box3.2.
In carrying out multiple' analysis the analyst should havea feel for whattypicalmultiples look like,as a benchmark. Table3.3 listspercentiles fora numberof ratiosforall U.S.
listedfirmsfor theyears 1963-2003. You cansee from the tablethatthe median PIB (at the
50th percentile) is 1.7, the mediantrailing PIE is 15.2, and the medianunlevered price-tosales (PIS) ratio is 0.9. Furtherback in time (in the 1970s), multiples were lower, On the
other hand, multiples in the 1990swereconsiderably higherthan historical ratios. You will
findmoredetail on historical multiples on the book'sWeb page.
78
Some multiples are affected by leverage-the amount of

debtfinancing a firm hasrelative to equity financing. So, to
control for differences in leverage between the target firm
and comparison firms, these multiples are "unlevered." Typical
unlevered measures are
price/sales ratio
Market value ofequity +Net debt

Sales
Unlevered
Market value ofequity +Net debt
price/ebit
eM
unlevered
where ebit= earnings before interest andtaxes (earnings plus

interest andtax. expenses), Net debtis total debtobligations
less any interest-bearing securities (negative debt) that the
firm may hold asassets. Typically thebook value of netdebtis
anapproxmaticn of itsmarket value. The numerator inthese
ratios isthemarket value ofthefirm, sometimes referred to as
the unlevered va!ue or enterprise value, Unlevered ratios are
sometimes referred to as enterprise multiples. Price-to-sales
andprke-to-ebit ratios should becalculated asunleveled ratios
because leverage doesnot produce sales or earnings before
interest andtaxes.
The primary enterprise multiple isthat for the enterprise
itself-theenterprise price-to-book ratio;
expense). Sometimes, ebitda is referred to as "cash flow"

(from operations) but, aswewill seeinChapter 4, itisonly an
approximation ofcash flow.
Earnings canbeaffected byone-time events thatareparticular to one firm. So multiples areadjusted to remove the
effects oftheseevents onearnings:
Price/earnings
before unusual items
Market value of equity

Earnings before unusual items
VARIATIONS OFTHE PIE RATIO

The PIE ratio compares the stock price to annual earnings.
Variations are
Price pershare
Most recent annual earnings
Price pershare
Rolling PIE
Sum of EPS formost recent four quarters
Price pershare
Forward or
leading PIE Forecast of next year's EPS
Trailing PIE
The rolling PIE issometimes indicated asPIE{ttm), where ttmis

"total twelve months" to date.
The forward PIE, usually calculated with analysts' foreMarketvalueofequity + Netdebt
casts,
modifies thetrailing PIE foranticipated earnings growth
EnterprisePIB
Book valueof equity +Net debt
inthecoming year.
Price inthe numerator ofthe trailing PIE isaffected bydivThe denominator here isthebook value oftheenterprise, that idends: Dividends reduce share prices because value istaken
is, thenetassets employed by the enterprise.
out of the firm. But earnings in the denominator are not affected by dividends. SoPIE ratios candiffer because ofdifferACCOUNTING ADJUSTMENTS
ing dividend payouts. To correct forthis difference, trailing PIE
As their denominators areaccounting numbers, multiples are ratios arecalculated as
often adjusted foraspects oftheaccounting thatmay differ between firms. Depredation and amortization methods candiffer
Dividend-adjusted PIE = Price persha~~ Annual DPS
andsome analysts feel thatdepredation andamortization are
notwell measured in income statements. A ratio that adjusts
where DPS isdividends pershare. The numerator isthecumforboth leverage andtheaccounting forthese expenses is
dividend price, the price before the dividend is paid; the
Unlevered price/ebitda _ Market value O~:~Uity+ Net debt price afterthe dividend ispaid istheex-dividend price.
e It a
The Web page gives some examples of multiple
calculations.
where ebitda = earnings before interest, taxes, depreciation,
and amortization Iebit plus depreciation and amortization
Screening on Multiples
The method of comparables takesthe viewthat similarfirmsshouldhavesimilarmultiples.
One would expectthis to be the case if marketpriceswereefficient. Investors who doubt
that the market prices fundamentals correctly, however, construe multiples a little differently: If firms tradeat different multiples, they maybe mispriced. Thusstocksare screened
for buyingandsellingon the basisof their relative multiples,
79
Periodically, initial public offerings forparticular types offirms

become "hot." The 1990s bull market saw hot issues for
theme restaurants, technology and computer stocks, brand
fashion houses, business services, andInternet stocks. In a hot
IPO market, firms sell for high multiples, encouraging comparable firms to go public also. Investment bankers justify the
price of an offering on the basis of multiples received inan
earlier offering. If they raise the multiples a little, to get the
IPO business, a pyramid scheme can develop, with offering
prices based on increasing comparable prices without reference to fundamental value.
in 1995 and 1996, teleservicing firms-firms supplying
telemarketing and customer service-were offered to the
market. In anticipation of other firms outsourcing these functions to the newfirms, investors paid high prices inthe IPOs.
The pyramiding occurred. lehman Brothers co-managed one
of the initial offers but lost out to other investment banks

inhandling later IPOs. Quoted in The Wa!! Street Joumal on
September 15,1998, Jeffrey Kessler of lehman Brothers said,
"Every time we came out with what we thought was a reasonable valuation for a new IPO in this area, the winning
bidder hadvaluations thatwere way higher. We were outbid
lby other investment banks] by, insome cases, over five multiple points, and we scratched our heads and said this was
crazy."
Indeed, the stock prices of teleservicing firms dropped
dramatically after the IPO boom. Apyramiding IPO market is
another stock price bubble. Pricing IPOs on the basis of the
speculative price multiples of comparable firms perpetuates
thebubble. Beware ofprices estimated from ccmparables, for
you may join a chain letter {a pyramid scheme) thatleads you
to pay toomuch for a stock.
minority interest suits, for example), the question often asked is what price the stock
would havebeen had certaineventsoccurred, not whatit's reallyworth.
Conceptual problems aside, the method of comparables also has problems in
implementation:
identifying cornps withthesameoperating characteristics is difficult. Finnsaretypically
matched by industry, product, size,growth, andsomemeasure of risk,butnotwofirms are
exactly alike.Onemightargue thatHewlett-Packard, withitsprinterbusiness, is notthe
sametypeof firm as Dell. Lenovo is a Chinese company, traded on a different exchange.
Comps areusually competitors inthesameindustry thatmightdominate (orbedominated
by)thetargetfirm andthusnotcomparable. Increasing the number of campsmightaverageout errors, butthe morecampsthereare,the lesshomogeneous theyare likely to be.
Different multiples givedifferent valuations. Applying a camp's PIB ratioto the target's
book value yields a different price from applying the camp's PIE ratio to the target's
earnings, as wejust saw withDell.Which priceshould weuse?In the example, wesimplytookan arithmetic average, but it is not clearthat this is correct.
Negative denominators can occur. When thecomphasa loss,the PIEhaslittlemeaning.
The method of comparables leaves too much room for"playing withmirrors." Thereis
too much freedom forthe analyst to obtain a valuation thathe, or his client, desires. Thisis
notgoodif our aim is to challenge speculation.
Othermultiples areusedin comparison analysis. Someadjustfor differences in leverage
between firms and someadjustfor differences in accounting principle. See Box3.2.
In carryingout multiple analysis the analyst should havea feel for what typical multipleslook like,as a benchmark. Table 3.3 listspercentiles fora number of ratios for all U.S.
listedfirms for theyears 1963~2001 You cansee from thetablethatthe median PlB (at the
50th percentile) is 1.7, the median trailing PIE is J 5.2,and the median unlevered price-tosales (PIS) ratio is 0.9. Further back in time (in the 1970s), multiples were lower. On the
otherhand, multiples in the 1990s were considerably higherthan historical ratios. You will
find moredetailon historical multiples on the book's Web page.
78
LEVERAGE ADJUSTMENTS
Some multiples are affected by leverage-the amount of
debt financing a firm has relative to equity financing. So, to
control for differences in leverage between the target firm
andcomparison firms, these multiples are "unlevered. " Typical
unlevered measures are
uolevered
Market value ofequity + Net debt
price/sales renc "
Sales
Unlevered
price/ebit
Market value ofequity + Net debt

ebit
where ebit"" earnings before interest andtaxes (earnings plus

interest andtaxexpenses). Net debt is total debtobligations
less any interest-bearing securities (negative debt) that the
firm may hold asassets. Typically thebook value of netdebtis
anapproximation of itsmarket value. The numerator inthese
ratios isthemarket value ofthefirm, sometimes referred to as
the unlevered value or enterprise varue. Unlevered ratios are
sometimes referred to as enterprise multiples. Price-to-sales
andprice-to-ebit ratios should becalculated asunleveled ratios
because leverage does not produce sales or earnings before
interest andtaxes.
The primary enterprise multiple is that for the enterprise
itself-theenterprise price-to-book ratio:
expense). Sometlmes. ebitda is referred to as "cash flow"

(from operations) but, aswewill seeinChapter 4,itis only an
approximation ofcash flow.
Earnings can beaffected by one-time events thatareparticular to one firm. Somultiples are adjusted to remove the
effects ofthese events onearnings:
Price/earnings
Market value ofequity
before unusual items " Earnings before unusual items
VARIATIONS OF THE PIE RATIO

The PIE ratio compares the stock price to annual earnings.
venations are
Trailing PIE '"
Price pershare
Most recent annual earnings
Rolling P/E'"
Price pershare
Sum of EPS for most recent four quarters
Forward or
Price pershare
leading PIE "" Forecast of next year's EPS
The rolling PIE is sometimes indicated asPIE{ttm), where ttmis

"total twelve months" to date.
The forward PIE, usually calculated with analysts' forecasts, modifies thetrailing PIE for anticipated earnings growth
"M""c;k",'
t"va,,lu"'C;0;Cf,,,q,,u,,ity,-+,,,,N';::t:;d';::b,,t
Enterpnse p,m
IU ""
Bookvalueofequity + Netdebt
in thecoming year.
Price inthe numerator ofthetrailing PIE isaffected bydivThe denominator here isthebook value oftheenterprise, that idends: Dividends reduce share prices because value istaken
is, the netassets employed bythe enterprise.
outof the firm. But earnings inthe denominator arenotatfected bydividends. So PIE ratios can differ because ofdifferACCOUNTING ADJUSTMENTS
ing dividend payouts. To correct for this difference, trailing PIE
Astheir denominators areaccounting numbers, multiples are ratios arecalculated as
often adjusted for aspects oftheaccounting thatmay differ between firms. Depreciation andamortization methods can differ
Price pershare + Annual DPS
DividencJ:..adjusted PIE
andsome analysts feel thatdepreciation andamortization are
EPI
notwell measured in income statements. Aratio thatadjusts
where DP5 isdividends pershare. The numerator is thecumfor both leverage andtheaccounting for these expenses is
dividend price, the price before the dividend is paid; the
Market value of equity + Net debt price after the dividend ispaid is the ex-dividend price.
Unlevered price/ebitda
ebitda
The Web page gives some examples of multiple
where ebitda "" earnings before interest, taxes, depreciation, calculations.
and amortization (ebit plus depreciation and amortization
<
Screening on Multiples
Themethod of comparables takes the view thatsimilarfirms shouldhavesimilarmultiples.
One would expectthis to be the case if market priceswere efficient. Investors who doubt
that the market pricesfundamentals correctly, however, construe multiples a little differently: If firms tradeat different multiples, they may be rnispriced. Thusstocks are screened
forbuying and sellingon the basisof their relative multiples.
79
80 Part One FinancialStatements a.nd Valuation
TABLE 3.3 Percentilesof CommonPrice Multiples,1963-2003,for U.S.Listed Firms

Multiple
Enterprise Trailing
Percentile PIB
PIS
PIE
Unlevered
Forward
PIE
PIS
PIS
95
7.9
12.7
Negative
earnings
49.2
8.9
8.1
75
50
25
.5
2.9
2.7
1.5
1.0
0.6
23.5
15.2
10.3
5.9
19.1
13.1
9.2
5.6
1.7
0.8
0.3
0.1
2.0
0.9
0.5
0.2
1.7
1.0
0.5
Unlevered Unlevered
P/CFO .: P/e~itda
P/ebit
Negative
Negative
30.1
cash flow
ebit
18.8
9.9
5.6
2.3
10.6
7.0
4.8
2.5
15.3
9.9
6:6
J.3
Notes:(FO isash fiGW fromoperations. FiI'llU wifunegative denomio,lors"'" ma1ed"<highmultiple firms. Thus firm; ;71 lhe upperpercentiles of PIE,P/CFO, andP/"oit
",-"thoS" wilh negative mnings (losses),cash/lows,Orebi~ os ;ndi<::lled.
Sou",e:C.kul:!te<! fromS:andarrl &
IIBIEIS database.
Poor~
COMPUSTAT data. fo<w.ll'd PIE141;0< "'" bosod on eons,nsus:m.lys!':'ooe.ye,"a!',.'deamingsfo",=, onThomson Finmcial
Here is how screening works in itssimplest form:

I. Identify a multiple on which to screenstocks.
2. Rank stockson that multiple, fromhighest to lowest.
3. Buystockswiththe lowest multiples and (short) sell stockswith the highestmultiples.
Buyinglowmultiples andsellinghighmultiples isseenas buyingstocksthatare cheapand

selling those that are expensive. Screening on multiples is referred to as fundamental
screening because multiples pricefundamental features of the firm. Box3.3contrasts fundamental screening with technical screening.
Screening on multiples presumes thatstocks whosepricesare highrelative to a particular fundamental are overpriced, and stockswhose pricesare low relative to a fundamental
are underpriced. Stockswithhigh multiples are sometimes referredto as glamour stocks
for,it isclaimed,investors viewthemas glamorous orfashionable and,tooenthusiastically,
driveup theirpricesrelative to fundamentals. Highmultiples are alsocalledgrowthstocks
because investors see themas having a lotof growth potential. In contrast, stocks withlow
multiples are sometimes called contrarian stocks for they are stocksthat havebeen ignoredby the fashion herd.Contrarian investors run againstthe herd,so theybuyunglamarcus low multiple stocks and sell glamour stocks. Low multiple stocks are also called
value stocks because theirvalueis deemed to be highrelative to theirprice.
Fundamental screening is a cheapfundamental analysis. You acceptthe denominator of
the screenas an indicatorof intrinsic valueand acceptthe spreadbetween price and this
number as an indicator of mispricing. It useslittleinformation, which is an advantage. It's
quick-stop shopping for bargains. It may be cost effective if a full-blown fundamental
analysis is tooexpensive, but it canleadyouastray if thatonenumberisnot a goodindicator of intrinsic value. For this reason, some screeners combine strategies to exploit more
information: Buy firms withboth low PIE and low PIB (two-stop shopping), or buy small
firms withlow PIB and priorpricedeclines {three-stop shopping), for example.
Table 3.4 reports annual returns from investing in five portfolios of stocks selected by
screening on PIE and PIB ratios. The investment strategy conjectures that the marketoverpricesfirms withhigh PIE and PIB multiples (glamour stocks or growth stocks) andunderpricesfirms withlowmultiples (value stocks or contrarian stocks). This is a strategy trolled
many timesby value-glamour investors andcontrarian investors. Clearly, bothPrEand PIB
rankreturns in Table 3.4and the differences in returns between portfolio 1 (high multiples)
andportfolio 5 (lowmultiples) indicate thatone-stop shopping fromscreening solelyonPrE
or PIB would havepaidoff.Two-stop shopping usingboththePrEscreenandthe PIB screen
would haveimproved the returns: Fora given PIE, ranking on PIB addsfurther returns.
Insider-rrading screens: Mimic thetrading ofinsiders (who

must file derails oftheir trades with theSecurities and
Exchange Commission). The rationale: Insiders have inside
information that they use in trading.
TECHNICAL SCREENS
Technical screens identify investment strategies from indicators thatrelate to trading. Some common ones are:
Price screens: Buy stocks whose prices have dropped a lot
relative to themarket (sometimes called "losers") and sell
stocks whose prices have increased a lot(sometimes called
"winners"). The rationale: large price movements can be
deviations from fundamentals that will reverse.
Small-storks screens: Buy stocks with a low market value {price
per share times shares outstanding). The rationale: History has
shown that small stocks typically earn higher returns.
Neglected-stock screens: Buy stocks that are not followed
by many analysts. The rationale: These stocks are underpriced
because theinvestor "herd" which follows fashions has
deemed them uninteresting.
Seasonal screens: Buy stocks at acertain time ofyear, for
example, in early January. The rationale: History shows that
stock returns tend to behigher atthese times.
Momentum screens: Buy stocks that have had increases in
stock prices. The rationale: The price increase has momentum
and will continue.
FUNDAMENTAL SCREENS
Fundamental screens compare price to a particular number in
firms' financial statements. Typical fundamental screens are:
Prke-to-eamings (PIE) screens: Buy firms with low PIE ratios
and sell firms with high PIE ratios. See Box 3.2 for alternative
measures.
Price-to--book value (PIB) screens:
sell firms with high PIB.
Buy firms with low PIB and
Price-to-cash flow(PICFO) screens: Buy low price relative to

cash flow from operations, sell high P/GO.
Price-to-dividend (Pld) screens: Buy low Pld, sell high Pld.
The Web page for this chapter discusses these screens in

more detail anddirects you to screening engines.
TABLE 3.4 Returns to Screening onPrice-to-Earnings (PIE)and Priced-to-Book (PIB), 1963-2006.

Annual returns from screening on trailing PIE alone,PIB alone, andtrailing PIE and PIB together. Thescreening strategy ranks
firms on thescreen eachyearandassigns firms tofive portfolios based on theranking. For thescreen usingbothPIE andPIB, firms
areassigned to five portfolios eachyearfrom a ranking on PIE and then, within eachPIE portfolio, assigned 10 five portfolios based
ona ranking on PIB. Reported returns areaverages from implementing thescreening strategies eachyearfrom 1963 to2006.
Screening on PIE and PIB Alone

Average
PIE Portfolio
PIE
5 (lowPIE)
7.1
10.8
14.7
4
3
2
1 (high PIE)
Annual
Return
23.2%
18.1
14.9
12.1
13.5
31.3
tosses-
PI'
Average
Portfolio
5 (low PIB)
PI'
0.61
1.08
1.47
2.17
4.55
4
3
2
1{high PIB)
Annual
Return
24.3%
18.4
15.4
12.6
9.3
Screening on Both PIE and PIB

PIE Portfolio
PI'
portfolio
1 (High)
2
3
4
5(Low)
1 (High)
4.3%
8.8
14.4
15.5
26.4
10.9%
9.1
8.5
13.4
14.2%
13.0
12.1
14.7
20.2
17.1%
6.0
17.0
8.0
22.6
20.1
5 (low)
19.7%
22.1
21.6
24.3
30.0
Firmsin lnislo\s p"'llfolio Mvelin a""rageElFof-18.4 pe,cen!.Earnings ate beforee:\lraordinary 3Jldspoci<ll ilellll
Somce:Eorningsand bookvalueore rrom SI3J\Mrd& Poor's COMPusrATd.t<!, Anou"1 slock relurnsare "kuT'tcd from Ihcmonthly leiurns file oflhe CenlerforR''''''''h
in5urily P,k.. (CRSP)al 'he Uni,ersityofChic,goBOOlh SchoolofBIlS;n.,..
81
82 Part One Financial StatementS andValuation
But danger lurks! Thereis no guarantee thatthesereturns, documented afterthefactfrom

history, willreplicate in the future; weare notsure whether investors would have expected
these returns in advance or whether the strategy just "got lucky" in thisperiod. By buying
firms with lowmultiples youcould alsobetaking onrisk:The returns in Table 3.4could reward for risk, with low multiple firms being veryrisky and highmultiple firms havinglow
risk. Indeed, thestrategy in thetable, though successful on average, has beenknown to tum
against theinvestor at times, with highPIE rather than lowPIE yielding higher returns. That
could beuncomfortable, particularly if onehada shortposition in high PIE stocks. The PIE
ratiois theinverse ofthe EIP ratio, referred toastheearnings yield. Justasbonds withhigher
riskhavehigheryields, so mightit be withstocks.
Thereis an additional caveat in running theseinvestment strategies: Theyuseverylittle
information-only twopiecesof financial statement information in the two-stop shopping
case-and ignoring information has costs.The fundamentalist's tenet(in Box 1.6in Chapter I) is violated: Ignoreinformation at yourperil.The price-to-sales ratio is particularly
dangerous. See Box3.4. By relying on littleinformation, the traderis in danger of trading
withsomeone whoknows morethanhe,someone who'sdoneherhomework onthe payoffs
a stockis likely to yield.A low PIE couldbe lowfor verygoodreasons. Indeed, a low PIE
stock could be overpriced and a high PIE stockcould be underpriced. In such cases,the
tradermightget caughtin the wrongposition. Remember the Dell,Inc.,General Motors,
and Fordexample in Chapter 1. SellingDell with a high PIE of 87.9 in 2000wouldhave
been a good idea, but buyingGM or Fordwith low PIE ratiosof 8.5 and 5.0 wouldnot
GM'sandFord's stockpricesdeclined dramatically insubsequent years. By2008,GM'sper
sharepricehad dropped from$80 tojust $4. Fordhad dropped from$29 to $4.50.
The solution to the information problem is to build in a model of anticipations that
incorporates all the information about payoffs. This is the subjectof formal fundamental
analysis, whichproduces the intrinsic value. And, aftera discussion of asset-based valuation,it is the subjectthat webeginto develop in this chapter.
ASSET-BASED VALUATION
Asset-based valuation estimates a firm's valueby identifying andsumming the valueof its
assets. The valueof the equityis then calculated by deducting the valueof debt: Value of
the equity= Value of the firm- Value of the debt.It looksalluringly simple: Identify the
assets,get a valuation for each,addthemup, and deductthe valueof debt.
A firm's balancesheetaddsupassets and liabilities, andstockholders' equity equalstotal
assetsminus totalliabilities, as wesawin Chapter 2.Thatchapter explained thatsomeassets
and liabilities aremarked to market. Debtand equity investments are carried at "fair" market value(ifpart of a trading portfolio or if theyare "available forsale"). Liabilities are typicallycarried closeto marketvalue on balance sheets and, in any case, market values of
manyliabilities canbe discovered in financial statement footnotes. Cashandreceivables are
closeto theirvalue(though netreceivables involve estimates thatmaybe suspect). However,
thebulkof assets thatgenerate valuearerecorded at amortized historical cost,which usually
doesnot reflect the valueof thepayoffs expected from them.(Refer backto Box2.2.)
Further, theremay be so-called intangible assets-such as brandassets, knowledge assets,and managerial assets-missing fromthebalance sheetbecause accountants findtheir
valuestoo hard to measure underthe GAAP "reliability" criterion. Accountants givethese
assetsa value of zero. In Dell's case, this is probably the majorsource of the difference
between marketvalueand bookvalue. The firm has a brandnamethat maybe worthmore
thanits tangible assetscombined. It haswhatis hailed as a uniquebuilt-to-order production
technology. It has marketing networks and distribution channels that generate value. But
noneof these assetsare on the balance sheet.
The Perils of Ignoring Information:

The Price-to-Sales Ratio and Price-to-Ebitda
PRICE-TO-SALES
During theInternet bubble, theprice-to-sales ratio (PIS) was a
common metric onwhich to evaluate stocks. Table 3.3reports
thatthe median historical PIS ratio is 0.9, but in the period
1997-2000, it was not unusual for new technology firms to
trade at over 20 times sales. Why did Internet analysts focus
ontheprice-to-sales ratio? Why were IPOs priced onthebasis
of comparable PIS ratios? Well, most of these firms were reporting losses, sothe PIE ratio did notwork for comparable
analysis. But shifting to a PIS ratio carries danger.
3.4
sales" must be understood inevaluating the PIS ratio, otherwise you are ignoring information at your peril. But, with an
appreciation of the profit margin, you arereally getting back
to the PIE ratio, the first component of the PIS calculation
here; theformula says thatthe PIS ratio is really an undoing of
the PIE ratio by ignoring EIS. Analysts sometime interpret the
PIS ratio as indicating expected growth insales. But growth in
earnings (from sales) is what isimportant, andthus thefocus
should be earnings growth andthe PIE ratio.
PRICE-TO-EBITDA
Price/ebitda is a popular multiple for both multiple ccmparisons andscreening. Ebitda isearnings before interest, taxes,
depreciation, andamortization. Some analysts remove depreciation (of plant andequipment) andamortization (of intangible assets like copyrights andpatents) from earnings because
they arenot "cash costs." However, while theanalyst must be
concerned about how depreciation ismeasured, depreciation
isa rea! economic cost. Plants must be paid for, andthey wear
out and become obsolescent. They must be replaced, ultimately with cash expenditures. Pricing a firm without considering plant, copyright, andpatent expenses pretends onecan
P P E
-",-xrun a business without these expenses. Just as price/sales
5 E 5
omits consideration of expenses, so does pricelebitda. look
Here EfS istheprofit margin ratio, thatis, thefraction ofeach back at thediscussion ofWorJdCom inBox 2.3 toseehow the
dollar ofsales that ends upin earnings. This "profitability of ratio can lead usastray.
Whatdeterminesthe price-to-sales ratio?
Buying astock onthebasis ofits PIE ratio makes sense, because

afirm is worth more themore itislikely to grow earnings. Buying onthebasis ofitsprice-to-book ratio (PIB) also makes sense
because book value isnetassets, and onecanthink of buying
theassets of a business. But with sales wehave to becareful.
Sales are necessary to add value, butnotsufficient. Sales can
generate losses (that lose value), soa consideration of the PIS
ratio must bemade with some anticipation oftheearnings that
sales might generate. If currentsaes are earning losses, beware.
To appreciate a PIS ratio, understand that
Asset-based valuation attempts to redothe balance sheetby (I) getting current market
values forassets and liabilities listed on the balance sheetand(2) identifying omitted assets
andassigning a market valueto them. Is thisa cheap wayoutof the valuation problem? The
accounting profession hasessentially given up on thisideaandplacedit in the"toodifficult"
basket. Accountants point out that asset valuation presents some very difficult problems:
Assets listedon the balance sheetmaynot be tradedoften,so market values may not be
readily available.
Market values, if available, mightnot be efficient measures of intrinsic value if markets
forthe assetsare imperfect.
Market values, ifavailable, may notrepresent thevalueinthe particular useto which the
asset is put in the firm. One mightestablish eitherthe currentreplacement pricefor an
asset or its current selling price (its liquidation value), but neither of these may be
indicative of its valuein a particular goingconcern. A building used in computer manufacturing may nothavethesame valuewhen usedfor warehousing groceries.
Theomitted assetsmustbe identified fortheirmarket value to bedetermined. What is the
brand-name asset?The knowledge asset?Whatare the omitted assetson Dell'sbalance
sheet? Theverytenn "intangible asset"indicates a difficulty in measuring value. Those
who estimate the value of brand assetsand knowledge assetshavea difficult task. Accountants listintangible assetson the balance sheetonlywhen theyhave beenpurchased
in the market, because onlythenis an objective market valuation available.
83
Chapter 3 HowFinancial SlatemenlS Are Used in Valuation 85
<:':':'::~se~~~i~~:<~a'I:J~fii:~';'iS":U~~d'
to determine the breakup
:'valuebfa'firm~Whil{understanding thevalue of the firm as

.: a gOing p:incern; the investor must always ask whether the
assets areworth.rnore as a going concern or broken up. If
.their breakup value isgreater, thefirm should be liquidated.
Some of the large takeoyer and restructuring activity of the
late :1980s came about When takeover specialists sawthat a
takeover target'sassets were worth more broken upthan asa
, ' . '::;:'>'''''''''L;<:::,:::;:':'::'3:?~':S:~':;
whole. This assessment requires a dis~ove~.~(t~~ liq~:idat.iO~.::,:value (selling prices) of assets.

,':',"':,";"., :::" _
Fundamental analysis estimates value'from utjJizing'asse~:
ina going-concern business. Acomparison ofthis yal,ue witp. '
breakup value recognizes the maxim that "Value depends on
the business strategy." Proceeding as a going concern isjust
onestrategy forusing assets, selling them isanother, andthe
value ofthetwostrategies must becompared.
'<,>:.,:' .
Even if individual assets canbevalued, thesumof themarket values of allidentified assetsmaynot (andprobably willnot)be equal to the value of theassets in total. Assets
areusedjointly. Indeed, entrepreneurs create firms to combine assets in a unique w~y:o
generate value. The value of the "synergy" asset is elusive. Determining the intrinsic
value of thefinn-the value of theassets combined-is thevaluation issue.
Asset-based valuations arefeasible ina few instances. Forexample, wemight value an
investment fund thatinvests only in traded stocks by adding up themarket values of those
stocks. Butevenin thiscase,the firm may be worth more thanthisbalance sheetvalue if
oneof itsassets isthefund's ability toeamsuperior investment returns. Andthemarket valuesofthe fund's stocks may notbeefficient ones-which willbethecaseif thefund managers canpickmispriced stocks. Asset-based analysis is sometimes applied when a fum's
mainassetis a natural resource-an oil field, a mineral deposit, or timberlands, forexampIe. Indeed these firms are sometimes called asset-based companies. Proven reserves (of
oilor minerals) orboardfeet(oftimber) areestimated andpriced outat thecurrent market
pricefor the resource, witha discount for estimated extraction costs. See Box3.5 for an
application of asset-based valuation.
Asset-based valuation is nota cheap way to value firms. In fact, it'stypically so difficult
thatit becomes veryexpensive. Thisis whyaccountants dodge it.Thedifficulty highlights
the needfor fundamental analysis. Theproblem of valuing firms is really a problem of the
imperfect balance sheet. Fundamental analysis involves forecasting payoffs to getan intrinsicvalue thatcorrects forthemissing value inthebalance sheet. Coca-Cola hasa large brand
asset thatis notonthebalance sheet. Therefore, ittrades ata highpremium over bookvalue.
Butwewillsee in this book thatthepremium canbeestimated withfundamental analysis.
FUNDAMENTAL ANALYSIS
Themethod of cornparables, screening analysis, andasset-based valuation have onefeature
incommon: Theydonotinvolve forecasting. Butthevalue ofa share ina fumisbased onthe
future payoffs thatit is expected to deliver, so onecannot avoid forecasting payoffs if oneis
to do a thorough job in valuing shares. Payoffs areforecasted from information, so onecannotavoid analyzing information. Fundamental analysis is the method of analyzing information, forecasting payoffs from thatinformation, andarriving at a valuation based onthose
forecasts. Because they avoid forecasting, the method of comperables, screening analysis,
andasset-based valuation uselittle information. Thatmakes these methods simple, butthis
simplicity comes at thecostof ignoring information. Rather than a PIE, PIB, orPIS ratio, the
84
thorough investor screens stocks on a PN (price-to-value) ratio. Accordingly,

sherequires a technology to estimate V. Screening onPIE, PIB, or PIS poses the
right question: Are earnings, book values, or sales cheap or expensive? Butone
buys value, notjustoneaspect ofthatvalue.
FIGURE 3.1
TheProcess ofFundamental
Analysis
Knowing thebusiness
The products
The knowledge base
Thecompetition
Theregulatory constraints
The management
Strategy
Analyzing information
'In financial statements
Outside of financial
statements
Developing forecasts
Specifying payoffs
Forecasting payoffs
Converting forecasts
to a valuation
The Process of Fundamental Analysis

Figure 3.1outlines theprocess offundamental analysis thatproduces anestimate
ofthevalue. In thelaststep in thediagram, Step 5, thisvalue is compared with
thepriceof investing. Thisstepis theinvestment decision. Fortheinvestor outsideofthefum,theprice ofinvesting isthemarket price ofthestock tobetraded.
Ifthevaluation isgreater than themarket price, theanalysis says buy; ifless, sell.
Ifthewarranted value equals themarket price, theanalyst concludes thatthemarketin theparticular investment isefficient. In theanalysts' jargon thisis a hold.
Forthe investor inside thefum, theprice ofinvesting isthecostoftheinvestment.
If thecalculated value of a strategy or investment proposal is greater than the
cost, value is added. The analyst says (in the parlance of project evaluation)
accept thestrategy ortheproposal ifit is greater thanthecost, ifless,reject.
Steps 1-4 in thediagram show how to get thevaluation forthisinvestment
decision. Thevalue ofaninvestment isbased onthepayoffs it is likely toyield,
so forecasting payoffs (inStep3) is at theheartof fundamental analysis. Forecasts cannot be made without identifying andanalyzing the information that
indicates those payoffs, so information analysis (inStep2) precedes forecasting.Andinformation cannot be interpreted unless oneknows thebusiness and
thestrategy the firm hasadopted to produce payoffs (Step 1).
1. Knowing thebusiness. Chapter I stressed thatunderstanding thebusiness is

a prerequisite to valuing the business. An important element is the finn's
strategy to add value. The analyst outside thefinn values a given strategy,
following the steps in the diagram, and adjusts the valuation as the finn
Trading on thevaluation "5
modifies its strategy. The analyst inside the firm is, of course, involved in
Outside investor
theformulation of strategy, sosheproceeds through thesteps to testforthe
Compare valuewith
value that alternative strategies might add. So yousee a feedback loop in
priceto buy,sell, or
haid
Figure 3.1: Once a strategy hasbeen selected, thatstrategy becomes theone
under which thebusiness is valued as a going concern.
Insideinvestor
Compare valuewith
2. Analyzing information. With a background knowledge of thebusiness, the
costto accept or
valuation of a particular strategy begins withan analysis of information
reject strategy
about thebusiness. The information comes in many forms andfrom many
sources. Typically, a vastamount of information mustbe dealt with, from
"bard" dollar numbers inthefinancial statements like sales, cashflows, and
earnings, to "soft"qualitative information on consumer tastes, technological change, and the quality of management. Efficiency is needed in organizing this information for forecasting. Relevant information needs to be
distinguished from the irrelevant, and financial statements needto be dissected to extract information forforecasting.
3. Developingforecasts. Developing forecasts thusbastwosteps, as indicated in Step 3 in
Figure 3.1.First, specify howpayoffs aremeasured. Then, forecast thespecified payoffs.
Thefirst stepis a nontrivial one,asthevalidity of a valuation willalways depend onhow
payoffs are measured. Doesoneforecast cashflows, earnings, bookvalues, dividends,
ebit, or return-on-equity? Oneseesan of these numbers in analysts' research reports.
Thisis a critical design issuethatbasto be settled before wecanproceed.
86 PartOne Financial. Stmemems and Valua,ion
4. Converting thejorecast to a valuation. Operations payoff overmanyyears, so typically

forecasts are made for a stream of future payoffs. Tocomplete theanalysis, thestreamof
expected payoffs hasto be reduced to onenumber, thevaluation. Sincepayoffs are in the
future and investors prefervaluenow ratherthanin the future, expected payoffs mustbe
discounted for the timevalueof money. Payoffs areuncertain; thereis a chance theywill
prove considerably worse or betterthan expected. So, as investors typically preferless
riskyexpected payoffs to moreriskyones,expected payoffs alsomust be discounted for
risk.Therefore, the final step involves combining a stream of expected payoffs intoone
number in a waythatadjusts themforthe timevalueof money and for risk.SeeBox3.6.
5. The investment decision: Trading on thevaluation. Theoutsideinvestor decides to trade

securities by comparing their estimated value to their price.The insideinvestor compares the estimated valueof an investment to its cost. In both cases, the comparison
yields the value added by the investment. So, ratherthancomparing priceto one piece
ofinformation, as in a simple multiple, priceis compared to a valuenumber that incorporates all the information used in forecasting. That is, the fundamental analyst screens
stocks on their PN ratios-price-to-value ratios-rather thanon a PIEor PIB ratio.
An analystcan specialize in anyone of thesestepsor a combination of them.The ana-
lystneedsto get a sense of wherein the process his comparative advantage lies, where he
cangetan edgeonhis competition. Whenbuyingadvicefromananalyst, the investor needs
to knowjust what the analyst's particular skill is. Is it in knowing a great deal aboutthe
business (Step1)7Is it in discovering and analyzing information (Step2)7Is it in developing goodforecasts fromthe information (Step3)7Is it in inferring valuefromthe forecasts
(Step 4)7 Or is it in the function of developing trading strategies from the analysis while
minimizing trading costs(Step5)7Ananalyst mightbea verygoodearnings forecaster, for
example, but mightnot be goodat indicating the valueimplied by the forecast.
Financial Statement Analysis, Pro Forma Analysis,

and Fundamental Analysis
Financial statements are usually thought of as a place to findinformation aboutfirms, and
indeedwe haveseenthemas suchin the"analyzing information" step above. Butfinancial
statements playanotherimportant role in fundamental analysis.
We haverecognized thatforecasting payoffs to investments is at the heart offundamental analysis. Futureearnings are the payoffs thatanalysts forecast, and futureearnings will
be reported in future income statements. Cash flows might also be forecasted, and cash
flows will be reported in future cashflow statements. So financial statements are not only
information to help in forecasting; theyare also whatis to be forecast. Figure 3.2 givesa
pictureof howfinancial statements are usedin valuation.
Alongwithearningsandcashflows, the financial statements reportmanylineitemsthat
explain howfirms produce earnings and cash flows. The income statement reportssales,
the costs of production, and other expenses necessary to make the sales.The cash flow
statement gives thesourcesof the cashflows. Thebalance sheetliststhe assetsemployed to
generate earnings and cash. Financial statements, in thejargonof valuation analysis, give
the "drivers" of earnings and cash flows. So they provide a wayof thinking abouthowto
buildup a forecast, a framework for forecasting. If wethinkof the line items in the financial statements-sales, expenses, assetsemployed-we will understand the valuegeneration.Andif we forecastthe complete, detailed statements, we willforecast the factors that
driveearnings and cash flows, and so construct forecasts.
Forecasting futurefinancial statements is calledpro forma analysisbecause it involves
preparing pro forma financial statements for the future. A pro formastatement is one that
Having forecasted payoffs, the investor asks: How much

should I pay for theexpected payoffs? Inanswering thisquestion,he understands thathe must cover hiscosts. Hehas two
costs in making the investment. First, heloses interest on the
money invested (heloses the "timevalue of money") and, second, hetakes onrisk (thecost of possibly losing some or allof
hisinvestment). These two costs determine hiscostof capital,
sometimes referred to as hisrequired return, sometimes as
thenormal return:
Required return = Risk-free interest return + Premium for risk
So, if onecan earn 5 percent on a risk-free investment (like a
U.S. government obligation or a government-guaranteed
savings account) but requires 10 percent to invest in a firm,
oneisrequiring a 5 percent risk premium. The value received
frommaking aninvestment must compensate theinvestor for
bothriskandthetimevalue of money. Therefore, in converting forecasted payoffs to a valuation, the payoffs must be
adjusted for the required return. There are two ways of doing
thisin a valuation model.
formula foroneperiod. Because theformula involves discounting to present value. therequired return issometimes referred
to asthediscountrate.Note thatthehigher thediscount rate,
thelowerthediscounted value ofthepayoff. Thatis, thehigher
the cost is in terms of lostinterest and risk, the loweris the
amount theinvestor should pay fora dollar of payoff.
2. CAPITALIZING RETURNS
Expected returns (rather thantotalpayoffs) are capitalized rather
than discounted. Capitalization divides the return forecast by
therequired return, rather than 1plus therequired return:
Value
Expected return
Required return
For a savings account, the return is the earnings on the

account rather than the total cash payoff at the end of the
holding period. For a $100savings account, expected earnings for oneyear (at 5 percent) is$5,andtherequired return
is5 percent. So,
1. DISCOUNTING PAYOFFS
Value can be determined by discounting expected payoffs at
1 plusthe required return. So, thevalue of an expected cash
payoff oneperiod inthefutureis
Value=~
Value = Present value of expected cash flow
The earnings are capitalized at 0.05 rather than 1,05, for 5

cents isthe(opportunity) cost of a dollar of earnings lostfrom
not investing in a similar account. Inthiscontext, the required
return is referred to asthe capitalization rate. Note that,as
with discounting, the higher the required return, the lower
thecapitalized value.
Wewill see when payoffs are to be discounted andwhen
theyare to becapitalized, but note for the moment that total
cash payoffs arediscounted while earnings are capitalized. The
savings account examples here are forpayoffs over oneperiod,
butdiscounting andcapitalization apply to a stream of payoffs
over anumber of periods inmuch thesame way, aswewillsee.
Expected cash flow oneyear ahead

1+ Required return
An investment in a(government-guaranteed) savings account
is risk free, so the required return is the risk-free rate, say
5 percent. The account will also earn at a 5 percent rate. So,
for an investment of $100 in a savings account that earns
5 percent peryear andisto be heldforoneyear, theexpected
payoff oneyear ahead is$1 OS, andthevalue atthebeginning
of theyear is
Value = $105
1.05
= $100
which, of course, iswhatthesavings account isworth. The expected cash flow of $105 isdiscounted by 1.0+ 0.05= 1.05.
The amount 1.05is thecost of each dollar of investment because it is the(opportunity) cost of not investing a dollar in a
similar account (withthesame risk) at 5 percent. You will recognize the mechanics here as the standard present value
0.05
= $100
THE REQUIRED RETURN

Clearly, oneneeds a measure of the required return to complete a valuation. While the required return for a savings
account isstraightforward, calculating therequired return for
equities is nontrivial. Discounting or capitalizing expected
payoffs isa mechanical exercise that can be left to a spreadsheet program once the required return is known. The substantive aspect of Step 4 is the measurement of the required
return. For that we need a beta technology. The appendix to
thischapter deals with the estimation of the required return.
57
'.<
i
:\
88
Part One
Chapter 3 How Financial Starcmenrs AreUsed in Valuation 89
Financial Staremcnll 'mdValuation
FIGURE 3.2
HowFinancial
Statements are Used
in Valuation.
Theanalyst forecasts
future financial
statements and
converts forecasts in
thefuturefinancial
statements to a
valuation. Current
financial statements
arc usedas
information for
forecasting.
"fade rates," "franchise factors," and "competitive advantage periods," for example. Are
thesemarketing gimmicks? Towhatextent, andhow, dothesefactors actually createvalue?
Howdoes one choosebetween the different models? Theseare questions that a potential
clientmustask.Andthe vendor of the valuation model musthavea satisfying answer. The
valuation model is at the heart of equity research, and the analyst must have a valuation
model thatsurvives scrutiny.
Current Financial
Statements
r---}
Forecasts
Financial
Statements
Year I
I
~
Valuation
of
Equity
<
Terminal Investments and Going-Concern Investments
~:
Financial
Statements
Year 3
Other
Information
tH
:~
Financial
Statements
Year2
100 o
Convert forecasts toa valuation
will be reported if expectations aremet. Forecasting isat theheart of fundamental analysis

andproforma analysis is at theheartof forecasting. Accordingly, fundamental analysis is
a matter ofdeveloping proforma (future) financial statements andconverting these proformas into a valuation. This perspective also directs the analysis of current financial statements. Currentfinancial statements are information for forecasting, so they are analyzed
withthe purpose of forecasting futurefinancial statements.
To start you thinking aboutan appropriate valuation model, refer to Figure 3.3. Suppose
youmakean investment nowwiththe intention of sellingit at sometimein thefuture. Your
payofffromthe investment willcomefrom thetotalcashit yields, and thisarises fromtwo
FIGURE 3.3
Periodic Payoffs to
Invesung.
)I' Investment horizon: T
The first investment
isfor a terminal
investment; thesecond
isfor a going-concern
investment ina stock.
T-I
+---+-+----t-------+-+
o
Theinvestments are
madeat time zero and
held for T periods
,-----
Ic';-,I ~
when they terminate
orareliquidated.
THE ARCHITECTURE OF FUNDAMENTAL ANALYSIS:

THE VALUATION MODEL
Fo. a terminal investment:

10 Initialinvestment
----'
Cashflows
Terminal flows
For a going-concern investmentin equity:
As Figure3.1 illustrates, fundamental analysis isa process that transforms yourknowledge

of the business (Step1) intoa valuation andtrading strategy (Step5). Steps2, 3, and 4 accomplish the transformation. Thesethreestepsare guided by the valuation modeladopted
by the analyst. Forecasting in Step3 is at the heartof analysis, andthe analyst cannotbegin
the analysis without specifying what's to be forecast. The valuation model specifies the
payoffs and, accordingly, directs Step 3-the forecasting step--of fundamental analysis.
But it also directs Step 2-infonnation analysis-because the relevant information for
forecasting canbe identified onlyafterdefining whatis to be forecast. And, it tellsthe analysthowto do Step4---converting forecasts to a valuation. So the valuation modelprovides
the architecture for valuation, anda goodor poorvaluation technology rideson the particularvaluation model adopted.
Good practice comes from good thinking. Valuation models embedthe concepts regardinghowfirms generate value. Firmsarecomplex organizations and inferring the value
theygenerate fromtheirmanyactivities requires someorderly thinking. Valuation models
supply that thinking. A valuation model is a tool for understanding the business and its
strategy. Withthat understanding, the model is usedto translate knowledge of the business
intoa valuation of the business.
Investment bankers and equityresearch groups typically havea common discipline, an
in-house approach to valuation, that articulates theirvaluation model. An investment consultant's valuation modelis oftenat thecenterof itsmarketing. Manymodels are beingpromoted. At onetimediscounted cashflow (DCF) models weretherage.Butnowmanymodels focus on "economic profit"and refer to particular economic factors-"value drivers,"
Po Initialprice
Investment horizon
)I' whenstockissold
T-I
+-+-+--+------+-+
o
G;]
'-----~------'
Dividends
PT+dr
" ' Sellingpriceat T+

dividend
Forterminal investment.
10", Amount invested at timezero
CF'" Cashflowreceived fromthe investment
Forinvestment in equity,
PQ", Pricepaidfortheshareat timezero
d '" Dividend received whileholding thestock
PT", Pricereceived fromsellingtheshareat lime T
Chapter 3 HowFinancial Sralcments AreU.led ill Valllalion 91
90 Part One Financid SWlcment.l and Vdllation
sources: the cashthat the investment pays while youare holding it and the cashyouget
from selling it.Thesepayoffs aredepicted fortwotypes of investments on the time linein
Figure 3.3.This linestartsat thetimethe investment is made (time zero)andcovers I'periods, where T is referred to as theinvestment horizon. Investors typically think in terms
of annual returns, so thinkof theperiods in thefigure as years.
Thefirst investment in the figure is an investment fora fixed term, a terminal Investment.A bondis an example. It pays a cashflow (CF) in the form of coupon interest each
yearanda terminal cashflow at maturity. Investment ina single asset-a rental building, for
example-is another. It pays offperiodic casbflows (inrents) anda final cashflow when the
assetisscrapped. Thesecond investment in thefigure differs from a bondora single assetin
thatit doesn't terminate. This is a feature of investment in an equity shareof a finn. Finns
areusually considered tobegoing concerns, thatis,togoonindefinitely. There is noterminal date and no liquidating payoff thatcanbe forecast However, aninvestor mayterminate
her investment at some time T in the future by selling the share. This leaves her withthe
problem of forecasting her terminal payoff. Foraninvestment inequity, Po is thepricepaid
for the share and d 1, d2, d), ... , d r are the dividends paid each year by the firm. The
dividends are the periodic cashflow payoffs likethe coupon on a bond. Pt is theterminal
payoff, theprice from selling the share. We consider bothterminal investments andgoingconcern investments inthisbook, butwefocus ongoing-concern equity investments.
Following the mechanics for valuing the savings account in Box3.6,we know that the
payoffs forthetwotypes of investments must beconverted to a valuation with therequired
return. In this book, wewillrepresent 1 + the required return (usedin discounting) by the
symbol p. So,if therequired return is 5 percent (asforthesavings account), p = I + 0.05 =
1.05. When wetalkof therequired return, wewindenote it as p - 1,so therequired return
for the savings account is 1.05 - l.0 = 0.05. You may be used to using a symbol
(r, say) for the required return and using I + r as a discount rate. So P is equivalent to
1-:- r andP - 1 to r. You willseethatourconvention makes for simpler formulas.
A percentage rate is frequently referred to as the required return. Strictly speaking, one
means the required rateof return.
FIGURE 3.4
Cash Flows fora
$1,000, Five*Year,
10Percent p-eCoupon Bond anda
Five-Year Investment
Project.
Inboth cases a cash
investment ismade at
time 0 and cash flows
are received over five
subsequent years. The
investments terminate
atthe end ofYear 5.
Periodic cash coupon
$100
$100
$100
$100
$100
Cash at redemption
$1.000
Purchase price (1,080)

I
Time, t
$460
$460
$380
For a project:
Periodic cash flow
$430
$250
Salvagevalue
$120
Initial investment ($1,200)

I
TIme, r
analysts who value debtusually specify different ratesfordifferent future periods, thatis,
they give the discount rate a term structure. We will use a constant rate here to keep it
simple. Saythisis 8 percent perannum. Then
VI! = $100 + ~ + $100 + ~ + $1,100

o 1.08 (1.08)' (1.08)3 (1.08)' (1.08)'
= $1 07985
'
Thisis the amount you would payfor the bond if it were correctly priced, as indicated
bythecashoutflow at time0 in thefigure.
Thisof course is thestandard present value formula. It is oftenapplied forproject evaluation inside thefirm, thatis, formaking decisions about whether to invest in projects such
as newfactories or newequipment. Figure 3.4alsodepicts expected cashflow payoffs for
a project that requires an outlay of $1,200 at time 0 and runsfor five years. The present
value formula canagain be applied:
Valuation Models for Terminal Investments

The standard bond valuation formula is an example of a valuation modeL The top of
Figure 3.4depicts thecashpayoffs fora five-year, $1,000 bond withan annual coupon rate
of 10percent. Thelayout follows the timeline in Figure 3.3.The bondvaluation formula
expresses theintrinsic value of thebondat investment datezero,as
Forabond:
Value of a project = Present value of expected cashflows

.j'
(3.2)
vt = CF + CF2 + CF) + CF4 + CFs

j
Value ofa bond = Present value of expected cashflows
Vf = CF +
PD
j
CF2
Pb
+ CF) +
CF4
+ CFs
pb
Ph
pb
(3.1)
The PD hereis the required return on the bondplus 1.TheD indicates the valuation is
fordebt(as a bondis commonly identified). Thismodel statesthatfuture cashflows (CF)
from the bondareto be forecasted and discounted at the required payoffrateon thedebt,
PD. Specifying what's to be forecasted in Step3 is not difficult here-just referto thecash
flow payoffs as specified in thebondagreement. Theformula dictates how theseare combined withthe required return (Step 4): Cash flows foreachperiod t are weighted by the
inverse of the discount rate, l/pb, to discount them to a "present value."
The onlyreal issuein getting a bond value is calculating the discount rate.This is the
rateof return that the lender requires, sometimes called the cost of capital for debt. This
rateis the yieldon a bond withidentical features that the lender could buy. Fixed-income
Pp
p~
p~
p~
p~
wherePindicates thisis fora project and Pp is therequired payoffperdollarinvested inthe

project, which reflects its risk.The required rateof return fora project is sometimes called
a hurdle rate. If thisis 12percent(pp= 1.12), thevalue ofthe investment is $1,530. (Make
sure youcancalculate this.) This formula is a project valuation model. It directs that we
should forecast cashflows from theproject in Step3 andcombine theforecasts withtherequired payoff according tothepresent value formula in Step4.Aswithbonds, determining
the cost of capital for the project is an issue. But a project's future cashflows are not as
transparent as those for bonds, so we mustalso analyze information to forecast them. So
Step2, information analysis, comes intoplay. Thevaluation model directs what todoin the
information analysis: Discover information thatforecasts future cashflows.
A firm aimsto create value for shareholders. The forecasted payoffs in Figure 3.4 are
illustrations oftwoinvestments thata firm could make withshareholders' money. Consider
thebond. If themarket ispricing thebondcorrectly, it will setthepriceofthis bondtoyield
Chapter 3 HowFinancialSWle1nen!S AreU.\cd in ValMlion 93
92 Part One FiMndal SWlemcnls zmd Valll,l('Oll
8 percent Thus, if the firm buys the bond, it will pay$1,079.85. What is the anticipated
value created bythatinvestment? It'sthepresent value of thepayoffminus thecost.Thisis
the /let present value afthe investment, the NPV, discovered in Step5. Forthebondpriced
at $1,079.85, thisis zero,so the investment is referred to as a zero-NPV investment. Equivalently, it is saidthatthe bondinvestment doesnot create value, orthereisno value added.
You get whatyoupayforbecause it generates payoffs thathave thesame(present) valueas
thecost. Ofcourse, if the manager thinks thatthemarket is mispricing thebond-because
it hascalculated thediscount rateincorrectly-then he maybuyor sell thebondandcreate
value. This is whatbond traders do:Theyexploit arbitrage opportunities from whatthey
perceive as mispricing of bonds.
Most businesses invest in assets and projects like the one at the bottom of Figure 3.4.
This is an example of a positive-NP V investment, one that adds valuebecause the value
exceeds thecost.In appraising the investment, themanager would conclude thatthe anticipated netpresent value was$1,530 - Sl,200:::: $330,so adopting theproject creates value.
Valuation Models for Going-Concern Investments

The valuation of terminal investments likea bondor a project is a relatively easytask. But
firms are goingconcerns, and so are the strategies their managers embark upon. Firms
invest in projects buttheyperpetually roll projects overintonewprojects. Equity valuation
andstrategy analysis thatinvolve ongoing operations presenttwoadditional complications.
First, as goingconcerns continue (forever?), payoffs have to be forecast for a very long
(infinite?) timehorizon. This raises practical issues. Second, the attribute to be forecasted
to capture value addedis notas apparent as thatfor a singleterminal investment. Identifying it requires a good understanding of where in the business value is generated. Wedeal
with thesetwoissues in turn.
Criteria for a Practical Valuation Model

Wewanta valuation model to capture value generated withinthe tL.'111, to be sure.But we
also wantit to be practical. Wedon't wanta fancy valuation model that is cumbersome to
applyin practice. The following aresomeconsiderations.
1. Finite forecast horizons. Going concerns areexpected to goonforever butthe ideathat
we have to forecast "to infinity" for goingconcerns is not a practical one.The further
into the future we haveto forecast, the more uncertain we will be aboutour forecast
Indeed, in practice analysts issueforecasts forjust a few yearsahead, or theysummarize
the long term with long-term growth rates. Weprefera valuation method for whicha
finite-horizon forecast(fora setnumber ofyears, for 1,5, or 10years, say)doesthejob.
This dictates the specification of the forecast targetin Step3; it mustbe such thatforecastingthe payoffoverrelatively short horizons is equivalent to forecasting perpetual
payoffs for goingconcerns. And theshorter thehorizon, thebetter.
2. Validation. Whatever we forecast must be observable after the fact. That is, whenthe
feature that'sbeen forecasted actually occurs, we can see it. Wedon't wantto forecast
vague notions such as "economic profit," "technological advantage," "competitive
advantage," or "growth opportunities." These maybe important to building a forecast
but,as a practical matter, wewanttoforecast something thatcanbeaudited andreported
in firms' future financial statements. The ability to validate a forecast requires us to be
concrete. So, if "growth opportunities" create value, we wantto identify themin terms
of a feature thatwillshowupinfinancial statements. The insistence on validation makes
the method credible: An analyst's earnings forecast canbe validated in financial reports
after the factto confirm that the forecast wasa good(or poor)one.From the investor's
pointof view, the ability to ascertain product quality is important. He'swaryof stock
tipsthatuse vaguecriteria. He demands concreteness.
3. Parsimony. We want to forecast something for which the information-gathering and
analysis task in Step 2 is relatively straightforward. The fewer pieces of information
required, themoreparsimonious is thevaluation. We wantparsimony. If wecould identify one or two pieces of information as being particularly important-because they
summarize a lotof information aboutthepayoff-that would be ideal. Andifthat information is in the financial statements thatare readyat hand, all thebetter.
What Generates Value?

Firms are engaged in the three activities we outlined in Chapter I: financing activities,
investing activities, andoperating activities. Look at Figure 1.1 in Chapter 1again. Which
of these activities addsvalue?
The economist's answer states that it is the investing and operating activities that add
value. Financing activities, the transactions that raise moneys from investors and return
cashto them, are of course necessary to run a business. But the standard position among
financial economists is that financing activities do not generate value. However, thereare
someexceptions. Weconsider transactions withshareholders anddebtholders in turn.
EquityFinancing Activities
Share Issues in Efficient Markets. A firm with 120million shares outstanding issues
10million additional shares at themarket priceof$42 pershare. Whathappens to theprice
pershare? Well, nothing. Thefinn's market value priortotheoffering was120million x $42::::
$5,040 million. Theoffering increases itsmarket value by 10million x $42:::: $420 million,
that is, to $5,460 million. With now 130 million shares outstanding, thepriceper shareis
still$42.The value of a shareholder's claimis unchanged. The total investment in thefirm
increases butnovalue isadded to investment. Thisobservation tellsusthatweshould always
consider shareholder value ona per-share basis. Value creation is a matter of increasing the
per-share value of theequity, notthetotalvalue. Andmanagers shouldnotaimat increasing
thesizeof the firm if it doesnotadd to per-share value.
Suppose thesamefinn wereto issue 10million shares butat $32a shareratherthanthe
market price of $42. This issue increases the market value of the finn by 10 million x
$32:::: $320million, that is, to $5,360 million. But theper-share priceon the 130million
shares afterthe issueis $41.23. Hasthis transaction affected shareholder value? Well, yes.
Shareholders have lost 77 cents per share. Their equityhas been diluted: The per-share
value hasdeclined.
Thesetwoscenarios illustrate a standard principle: Issuing sharesat market valuedoes
not affectshareholders' wealth but issuing them at less than market value erodes their
wealth. In valuation we might ignore share issues at market value but we cannot ignore
issues at lessthan market value. The latteroccurs, for example, whenshares areissuedto
executives andemployees understockcompensation plans. If we ignore these transactions
wewillmisssomevalue thatis lost.
The effect of issuing shares at market value is different from the effect of announcing
thata shareissuewillbe made. Sometimes the announcement, in advance of theissue, carriesinformation aboutthevalue of the firm, aboutits investment prospects, forexampleand so the market price changes. But this effect-sometimes referred to as a signaling
effect~is generated bynewinformation, notbythe issue itself.
Share Issues in Inefficient Markets. The standard view of the effects of financing
assumes that the market price of shares reflects their value, that is, the share market is
Chapter 3 How Financial Stoumems ATe Used in Valuation 95
In takeovers, acquiring firms often offer shares oftheir firm in

exchange for shares of the firm they are buying. Questions
always arise asto whether particular mergers or acquisitions
are value-adding transactions: lf the shares in the transactions areefficiently priced, the acquirer pays fair value and
expects toearn just a normal rate ofreturn ontheacquisition.
An acquirer adds value inanacquisition in three ways:
1. Identifying targets whose shares are undervalued in the
market relative to their fundamental value.
2. Identifying targets whose operations, combined with
those oftheacquirer, will addvalue.
3. Identifying thattheacquirer's own shares areovervalued in
themarket.
Under the first strategy, the acquirer behaves like any
active investor and looks for undervalued assets.
The second strategy looks for so-called synergies from the
two combined companies. Cost savings--economies ofscale-were said to be the motivation for many bank mergers inthe
1990s. Economies from marketing a broad range offinancial
services under one roof was said tobeoneofthemotivations for
the merger ofbanks, brokerages, and insurance firms, like the
merger ofTravelers Ute, Salomon Smith Barney, andCitibank

into Citigroup in1999. And theannouncement ofthemerger of
America Online and Time Warner combined the content ofa
media company with anInternet portal tothatcontent.
Under thethird strategy, the acquirer recognizes that he
has "currency" in the form of overvalued stock andso can
buy assets cheaply. In the AOl and Time Warner merger,
AOL's shares were trading at 190times earnings and35times
sales, very high multiples by historical standards. Was AOl
using overvalued currency to acquire Time Warner? Indeed,
in the agreement to acquire Time Warner, AOL offered its
shares at an (unusual} discount of 25 percent of market
value, inadmission that itsshares might have been overvalued. Even at this price, AOl shareholders did well. Although
the merger was a failure operationally, AOl shareholders
benefitted enormously by using their overpriced shares; they
bought Time Warner assets cheaply.
Before going into a transaction, both theacquirer and the
target need to understand thevalue from combining operations. But they also need to understand thevalue of both the
scquirers shares and the target's shares and how they compare to market values. They thenunderstand value given up
and value received.
efficient. If so, value received is value surrendered, on bothsidesof the transaction. But if
sharesare mispriced, one partycan loseat theexpense of theother. If management knows
thatthesharesof theirfirm areovervalued in themarket, theymight choose to issueshares.
The new shareholder pays the market price but receives less in value. The existing
shareholders receive morevalue thanthe valuesurrendered, so theygain.Forthis reason
announcements of shareofferings aresometimes greeted as badnewsinformation, andthe
sharepricedrops. Thiswealth transfer can onlyhappen in an inefficient market or a market
where the manager knows more aboutthefirm's prospects thanthemarket. Buyerbeware!
Understand thevalue of thesharesbefore participating in a shareissue. SeeBox3.7.
ShareRepurchases. Share repurchases areshare issues in reverse. Soshare repurchases at

market pricedo notaffect per-share value andsharerepurchases at more thanmarket value
(should theyoccur) do.But,like share issues, management canmake sharerepurchases when
theyseethatthesharepriceisbelow intrinsic value. In thiscase,shareholders whooffertheir
shares lose; those thatdon't, gain. Forthis reason, announcements of sharerepurchases are
sometimes seenas signals that thestockis underpriced, increasing shareprice. In thiscase,
sellerbeware.
Dividends. Dividends arepart of thereturn toequity investment so it istempting to think.
thattheyarevalueforshareholders. Indeed, fundamental analysts oncebelieved thathigher
payout meanthigher value. Butmodern finance theory seesit differently. Dividends arenot
whattheyappearto be.
If a firm paysa dollarofdividends, theshareholders geta dollar. Butthereisa dollarless
in the firm, so the value of the firm dropsby a dollar. Shareholders receive the dollarof
94
dividends, but theycan sell the sharefor a dollarless.The dividend payment makes them
no betteroff;it doesnot create value. In otherwords, theinvestor's cum-dividend payoffis
not affected. The returnto the shareholder is madeup of a dividend anda capital gain.A
dividend adds to the returnbut the capital gain is reduced by the amount of the dividend,
leaving thereturnunaffected.
You might have heard these arguments referred to asthe dividendirrelevance concept,
or as theM&M dividend proposition afterthetwoprofessors whoadvanced thearguments,
Merton Miller and Franco Modigliani. Some investors might prefer dividends to capital
gains because theyneedthe cash. But theycan sell someof theirshares to convert capital
gains into dividends. Otherinvestors mightpreferno dividends; theycan achieve this by
buying thestockwiththe cashfrom dividends. This ability to make what arecalled homemade dividendsmeans that investors do not care if theirreturncomes from dividends or
capital gains. Andifits shareholders wantdividends, thefirm alsocancreate dividends withoutaffecting thefirm's investments, byborrowing against thesecurity intheinvestments and
usingtheproceeds to paydividends. Of course, if a firm forgoes value-creating projects to
pay dividends, it will destroy value. But, given a ready availability of financing, sensible
management will borrow or issue sharesto pay the dividends rather than affecting good
investments.
Homemade dividends and borrowing do involve sometransaction costs,but these are
usuaily considered smallenough to ignore, given the imprecision we typically have incalculating value. Ifmakinghomemade dividends is difficult because of illiquidity in themarket for the shares(of a nontraded firm, for example), lack of dividends mightreduce the
value of an investment to a shareholder whodesires dividends. The value effectis referred
to as the liquidity discount (to the valueof an equivalent liquid investment). That same
shareholder will not demand a liquidity discount, however, if he can generate cash by
borrowing againstthe security of his shares. Just as a firm can borrow to paydividends
(andnotaffectthevalue of investments), so shareholders canborrow to generate dividends
(andnotaffectthevalue of shares).
Like shareissues and sharerepurchases, dividend announcements might convey information thataffects stockprices. Dividend increases areoftengreeted asgoodnews, an indicatorthatthe finn willearnmore inthefuture, andcutsindividends areoften greeted asbad
news. Theseinformation effects--called dividend signaling effects-occur when dividends
areannounced. The dividend irrelevance notion says thatthe dividends themselves willnot
affect (cum-dividend) shareholder value(when thestockgoesex-dividend).
Somearguethatdividends mightlosevalue forshareholders if theyaretaxedat a higher
rate thancapital gains. This is of no consequence to tax-exempt investors, but the taxable
investor mightincurmoretaxes with dividends, and so would preferto get returns in the
form of capital gains. Accordingly, thetaxable investor would paylessfora sharethatpays
dividends to yieldthesamereturnfora similar sharethatreturns onlycapital gains. Others
argue, however, that investors can shielddividends from taxes with careful tax planning.
And some also argue that market prices cannot be lower for dividend-paying stocks
because tax-exempt investors (suchas the largeretirement funds and not-for-profit endowments) dominate themarket. A lower price thatyields thesameafter-tax returntoa taxable
investor as thereturnwithout dividends would provide an arbitrage opportunity to thetaxexempt investor, andexploitation ofthisopportunity would drive thepriceto yieldthesame
returnas a stockwithno dividends. Thus dividends have no effect on prices or values. Go
to a corporate finance text for the subtleties of this reasoning. Empirical research on the
issue hasproduced conflicting findings.
In this bookweaccept thepresumption that"dividends don't matter" andcalculate values accordingly. The investor whoexpects to paymore taxes ondividends mustreduce the
Chapter 3 HowFinancial Swcernentl Are Usedin ValU/lrian 97
96 Part One Financ'.a.I SlaremcnlS andValuation
Valuation models aredeveloped withtheunderstanding thatit is theoperations, andthe

investment in those operations, thatgenerate value. So valuation models value operations,
ignoring value thatmight becreated from share issues andshare repurchases. Accordingly,
the valuation indicates whether the stock market is mispricing the equity, so that the
investor understands whether share issues andshare repurchases aremade atfairvalue-cor
whether the finn has the opportunity to create value for shareholders by issuing shares
(inan acquisition, for example).
before-tax values thatwe calculate in this book by the present value of any forecasts of
taxes on dividends. (Shealsomight consider buying a stockwithsimilar features thatdoes
notpaydividends.) Theadjusted valuation involves tax planning because thisinvestor must
consider how taxes ondividends canbe avoided or deferred byholding highdividend yield
stocks in retirement funds andemployee savings plans (forexample). Similarly, the valuationsheremight be adjusted forliquidity discounts.
DebtFinancing Activities
Valuation Models and AssetPricing Models
Thebondin Figure 3.4 thatyields 8 percent perannum has a market value of $1,079.85.
We saw that at this pricethe bondis a zero-Nl'V investment; it doesn't add value. Most
firms accept debt markets as being efficient andissueandbuybonds andother debtinsrruments at theirmarket value, so donotaddvalue (over therequired return fortheirrisk). The
exceptions arc financial firms like banks, which can buydebt(lend) at a higher ratethan
theycan sell it (borrow). Theyaddvalue as financial intermediaries in thecapital market.
And, as wesaw, firms inthebusiness ofbondarbitrage might addvalue if theydetectmispricing of bonds.
In debtfinancing activities, firms selldebtto raise money. Theyare notin the business
of bondarbitrage, so theyaccept the market priceas fair value andsellat thatprice. The
transaction thusdoes notaddvalue. The firm gets what itpaysfor. If it issues bonds, it gets
cashat exactly the present value of what it expects to payback. If it borrows from a bank,
itgetstheamount ofcashequal tothepresent value, atthe interest rate, oftheprincipal plus
interest it hasto paybackin thefuture. In thejargonof modern finance, debt financing is
irrelevantto the value of thefum. It is simply a transaction at fairvalue to bringmoneys
intothe firm foroperations.
Some argue that because interest on debt is deductible against income in assessing
corporate taxes, issuing debtgains a tax advantage thatshareholders cannot get in paying
personal taxes. Thus it generates value for theshareholder. Thisis controversial and you
should go to corporate finance texts fora discussion. If oneaccepts thistaxargument, one
canaddthevalue of the tax benefit in valuing the finn.
Investing and OperatingActivities

Value generation in a business is ascribed to many factors-know-how, proprietary technology, goodmanagement, brandrecognition, brilliant marketing strategy, and so on. At
the root of these factors is good ideas. Good entrepreneurs build goodbusinesses anda
goodentrepreneur is someone withgood ideas. Butideasare vague, as arethefactors just
mentioned, and it is difficult to see the value of ideas without being more concrete. The
value of ideas is ascertained from what firms do,andwhatfirms do is engage in investing
andoperating activities.
Investing activities use the moneys contributed to the fum in financing transactions to
invest in the assets necessary to conduct the business envisioned by ideas. Theproject in
Figure 3.4is a simple example. It adds value. Value is anticipatory; it is based on expected
future payoffs from investing. Butthere has to be follow-through, andoperating activities
are the follow-through. Operating activities utilize the investments to produce goods or
services for sale,andit is these sales thatrealize thevalue anticipated in investing. Simply,
a finn cannot generate value without finding customers foritsproducts, andtheamount of
value received is theamount of value those customers are willing to surrender. Netvalue
added in operations is thevalue received from customers lessthevalue surrendered bythe
fum in getting products to customers. So investments generate value, but the anticipated
value is determined by forecasting the success of the investment in generating value in
operations.
You have beenintroduced to assetpricing models in finance courses andare probably familiar withthemostcommon model, the capital assetpricing model (CAPM). Besurenot
to confuse a valuation model withan asset pricing model.
The name "asset pricing model" suggests that the model will give you the price or
value of an asset Butit is a misnomer. Asset pricing models yieldtherequired return (the
cost of capital), not the value of an asset. The capital assetpricing model, for example,
specifies therequired return forholding a share ofa firm as therisk-free return plusa risk
premium, determined bytheequity betaforthe firm. An assetpricing model isa betatechnology. Valuation models, on theotherhand, do yieldthe value of an asset. As thisvalue
canbe compared withprice, a valuation model is analpha technology Asset pricing models arepertinent to valuing anasset, of course, forwehave seenthatconverting a forecast
to a valuation usinga valuation model (in Step 4) requires specification of the required
return. Valuation models show how, giving a required return from an asset pricing model,
theassetpricing is completed.
In thisbook, we donot spend much timeon the technology involved in measuring the
required return. You should be familiar withthe techniques-c-students sometimes referto
themas "betabashing't-c-from yourcorporate finance courses. Theappendix to this chaptergives a briefoverview of assetpricing models andprovides some caveats to using these
models forthemeasurement of therequired return.
Summary
Thischapter hasgiven youa roadmapforcarrying outfundamental analysis. Indeed, Figure3.1laysouta roadmapforthe restof thebook. It lays outthefive steps of fundamentalanalysis, steps thatconvert your knowledge of a business andits strategy to a valuation
of thatbusiness. At thecoreof theprocess is theanalysis of information (Step 2), making
forecasts from that information (Step 3), and converting those forecasts to a valuation
(Step4).
A valuation model provides the architecture for fundamental analysis. A valuation
model is a toolfor thinking about value creation in a business andtranslating thatthinking
into a value. The chapter introduced youto valuation models for bonds andprojects and
showed thatvaluation ofgoing concerns is inherently more difficult thanvaluation ofthese
terminal investments. We concluded thata valuation model mustfocus ontheaspects ofthe
finn that generate value, the investing and operating activities, so setting the stage for
thedevelopment of appropriate valuation models in thefollowing chapters.
Having gained an understanding of fundamental analysis-at leastin outline-s-you can
appreciate the limitations of "cheap" methods that use limited information. The chapter
outlined three such methods: the method of comparables, screening analysis, andassetbased valuation. You should understand the mechanics of these methods butalsobeaware
of thepitfalls in applying them.
How arefinancial statements usedin valuation? You don't have a complete answer to
thisquestion yet, for that is the subject of the whole book. But you do have an outline.
98 Part One Financial $1Q(emenu and Valuation

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Chapter 3 Hew Financial SUUcmCI1!S AreUsed ill Valua!iOl1 99

screening, it is a stockwith a high
multiple that is contrasted witha value
stock witha lowmultiple. 80
homemadedividendsare dividends a
shareholder creates forhimselfbyselling
someof his shares, thussubstituting
dividends for capitalgains 95
investmenthorizon is the period for which
an investment is likely to be held. 90
liquidity discount is a reduction in the
valueof an investment due to difficulty
in converting valuein the investment
into cash. 95
parsimony (in valuation) is the abilityto
valuea firm froma reduced amount of
information. 93
pro forma analysisis the preparation of
forecasted financial statements for future
years. 86
risk premium is the expected returnon an
investment overthe risk-free return. 87
<
l'~li:e)Web C?ntiection
Find thefollowing on the Web page supplement for this
chapter:
More onthecalculation of multiples.
More on the method of comparables and price
bubbles.
A discussion of arbitrage.
Unks to screening engines.

A formal analysis of required returns, abnormal returns,
alphas, and betas.

Buying firms with market values less than book value.
The Reviewers' corner guides you to further reading.
Minimal financial statement information is used in the method of comparables and in

screening strategies. Balance sheet information is used in asset-based valuation; indeed,
asset-based valuation is a matterof marking to marketthe assetsand liabilities of a fum.
But financial statements reallycome into play in full fundamental analysis. Not only are
currentandpast financial statements analyzed as partof the information for forecasting (in
Step 2), but also forecasting (in Step3) is a matterof preparing pro formafinancial statements for the future. That is, financial statements are information, but they also must be
forecasted. (Figure 3.2 gives the picture.) So you see that financial statements are very
much involved in fundamental analysis; indeedpreparing pro forma financial statements
for the future, and analyzing currentfinancial statements to forecast thosestatements, is
verymuchwhatfundamental analysis is all about.
Analysis Tools
Key Concepts
breakup value is the amount a firm is

worthif its assets(net ofliabilities)are
soldoff. 84
contrarian stock isa stockthatis out-offavor andtrades at lowmultiples
(viewed bycontrarian investors as
undervalued). 80
cost of capital is the opportunity costof
havingmoneytied up in an investment.
Alsoreferred to as the normal return,
the required return, or,whencalculating
values; as the discount rate or
capitalization rate. 87
cum-dividend price is the priceinclusive
of the dividend received whileholding
the investment. Compare with
ex-dividendprice, which isprice
without the dividend. 79
debt financingirrelevancemeansthat
the valueof a firm is not affected by
debtfinancing activities, thatis, by
issuingdebt. 96
dividend irrelevancemeansthat paying

dividends doesnot generate valuefor
shareholders. 95
finite-horizon forecastingrefersto
forecasting for a fixed (finite) number
of years. 92
forecasthorizon is a point in the future
up to whichforecasts are made. 92
fundamental analysisis the method of
analyzing information, forecasting payoffs
fromthatinformation, andarriving at a
valuation basedon thoseforecasts. 84
glamour stock is a stockthatis
fashionable and tradesat highmultiples
(viewed by contrarian investorsas
overvalued). Sometimes referredto as a
growthstock. 80
going-concern investmentis one which
is expected to continue indefinitely.
Compare withterminal investment 90
growthstock is a term withmany
meanings but, in the context of multiple
.,..
Method of comparables
Screening analysis:
Technical screening
Fundamental screening
Glamour screening
Contrarian screening
Value screening
Momentum screening
Asset-based valuation
Breakup valuation
Converting a forecast to a
valuation:
Discounting payoffs
Capitalizing returns
Five-step fundamental analysis
Valuation models:
Bond valuation model
equation (3.1)
Project valuation model
equation (3.2)
Page
76
80
80
80
80
80
80
81
82
84
KeyMeasures
Adjusted multiples
Capitalization rate
Cost of capital
Cum-dividend price
Dividend-adjusted PIE
Discount rate
ebit
ebitda
Ex-dividend price
Hurdle rate
PIE
86
87
87
85
90
91
Trailing PIE
Rolling PIE
Leading (fof'Nard) PIE
Enterprise PIB
Price-to-book (PIB)
Price-to-cash flow (P/CFO)
Price-to-dividend (Pld)
Price-to-sales (PIS)
Required return
Risk-free return
Risk premium
Terminal payoff
Unlevered multiples
Price-to-sales (PIS)
Price-to-eblt
Price-to-ebitda
terminal investmentis an investment that

terminatesat a point of time in the
future. Compare with going-concern
investment. 90
unlevered measures aremeasures that are
notaffected by how a finn isfinanced. 79
valuationmodelis thearchitecture for
fundamental analysis thatdirects what is to
be forecast as a payoff, whatinformation
is relevant forforecasting, andhow
forecasts are converted to a valuation. 88
value added (or valuecreated or value
generated) isthe valuefrom anticipated
payoffs to an investment (fundamental
value) in excessof valuegiven up in
makingthe investment (thecostof the
investment). 86
value stock is a stockthattradesat low
multiples (viewed by value investors as
undervalued). Compare withgrowth
stock. 80

79
87
87
79
79
87
79
79
79
91
76
79
79
79
79
76
76
81
83
87
87
87
90
79
79
79
79
CAPM capital asset pricing model

CF cash flow
CFO cash flow from operations
DPS dividends pershare
ebt earnings before interest and
taxes
ebitda earnings before interest.
amortization
EPS earnings pershare EJP
earnings yield
GAAP generally accepted
accounting principles
IPO initial public offering
NPV netpresent value
P/CFO price-to-cash flow ratio
PIE price-to-earnings ratio
P/d price-to-dividends ratio
PIS price-to-sales ratio
PN price-to-value ratio
Ir
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100 Part One FillQadaJ Seremenc and VaIw:uion
Chapter 3 HOll! Financial Sta(c'11Ientl Are Used inValilluion 101
Concept
Questions
C3.1. Whatexplains differences between firms'price-to-sales ratios?

C3.2. It is common to compare firmson theirprice-to-ebit ratios. Whatare the merits of
usingthismeasure? Whatare the problems withit? Hint: ebitleaves something out.
C3.3. It isalsocommon to compare firms on theirprice-to-ebitda ratios. What arethemer.
its of usingthismeasure? Whatare thedangers? Hint: ebitdaleaves something out.
C3.4. Whydo trailing PIE ratios vary withdividend payout?
A Seif-Study Exercise
In the Continuing CaseforKimberly-Clark in Chapter 2, yougainedsome familiarity with
the financial statements for 2004 and calculated the two basic ratios, the price-to-book
(PIB) andprice-earnings (PIE) ratios, Afterthischapteryoucancalculate manymoreratios
at the March2005price of $64.81. Go ahead. You'll nowmodify your calculation of the
trailing PIE in the Chapter 2 case to accommodate the 2004 dividend of $1.60 per share.
Calculate the enterprise price-to-book ratioand other unlevered ratios. Withanalysts'consensusforecasts in theYahoo! reportforthe firm in Chapter 1,you willalsobe ableto calculatethe forward PIE.
C15. Ifa firm has a PIEratio of 12and a profit margin on sales of 6 percent, what is its
price-to-sales (PIS) ratiolikelyto be?
C3.6. If a firm is expected to havea profit margin of 8 percent but trades at a price-tosalesratio of 25,whatinferences would youmake?
C17. What do traders mean when they refer to stocksas "glamourstocks"and "value
stocks?"
COMPARABLES
C3.8. Why would youexpectasset-based valuation to be moredifficult to apply to a technologyfirm, likeDen, Inc.,thanto a forest products company, likeWeyerhaeuser?
C3.9. Theyieldon a bondis independent of the coupon rate.Is this true?
C3.10. It issometimes saidthatfirms preferto makestockrepurchases ratherthanpaydividends because stockrepurchases yielda highereps. Do they?
Who are Kimberly-Clark's comparable firms? Here are the major finns that sell similar
consumer products, alongwith theirstockpricesat the endof March2005.
The Procter & Gamble Company (PG)
Georgia-Pacific Corporation (GP)
Playtex Products Inc. (PYX)
$54
35
9
You can get descriptions of these firms from their lO-K filings, the Yahoo! finance Web
page, or otherfinancial Web pages suchas www.hoovers.com. Lookat thesedescriptions
and askwhichof thesefirms wouldbestserveas comparables. Canyouget goodmatches?
Withthe firms' stockpricesand accounting information in their SECfilings, you can calculatecomparison multiples. Whatdothesemultiples imply Kl0l3's priceshouldbe? How
confident are you in yourconclusion?
Usingthe multiples as screens, do you think that KMB's multiples are typically higher
or lower than the comps? If so would yourecommend takinga buy or sellpositionon the
basisoftbe difference?
ASSET-BASED VALUATION
Do youthinkthatasset-based valuation willwork for Kl\1B?
SOME QUESTIONS TO CONSIDER

Looking back to the firm's financial statements in Exhibit 2.2 in Chapter 2, identifythe
amountofsharesrepurchased during2004. Whateffectdoyou think theserepurchases had
on the stockprice?
Identify the amount of dividends paidduring2004.Would thesedividends haveresulted
in an increase in the stockprice,or a decrease?
Kimberly-Clark hadan equitybetaof 0.88in March2005.The 1O-year U.S. government
bondrate was 4.5 percent. If the market risk premium is 5%, what is the requi.red equity
return indicated by the capitalassetpricingmodel(CAPM)? What would be the required
return if the market risk premium is 6 percent? In Chapter 2, you calculated the prior
12-month stockreturnfor KMB. Would yousay thatinvestors covered theircost of capital
duringthat year?
C3.11. Your answer to concept question C3.10 shouldhavebeen:Yes. Ifshare repurchases

increase epsmorethandividends, do sharerepurchases alsocreatemorevaluethan
dividends?
C3.12. Shoulda finn thatpayshigherdividends have a highersharevalue?
Exercises
Drill Exercises
E3.1.
Calculating a Price from Comparables (Easy)

A fum trading witha totalequitymarketvalueof$100 million reported earnings of$5 millionand bookvalueof $50 million. This finn is usedas a comparable to pricean IPQ finn
with earnings per shareof $2.50and book valueper shareof $30 per share. Neitherfirm
paysdividends. Whatper-share IPQpricedoesthe comparable firmimply?
E3.2. StockPrices and Share Repurchases (Easy)

A finn with IOO million shares outstanding repurchased lO million shares at the market
priceof $20 per share. What is the total marketvalueof the equityafterthe repurchase?
Whatis the per-share valueafterthe repurchase?
E3.3.
Unlevered (Enterprise) Multiples (Easy)

A finn reported $250 million in total assets and $140 in debt. It had no interest-bearing
securities amongits assets. In the income statement it reported $560 million in sales. The
firm's 80 million shares tradedat $7 each.Calculate
a. Theprice-to-book ratio(PIB)
b. Theunlevered price-to-sales ratio (PIS)
c. The enterprise price-to-book ratio
E3.4.
Identifying Firms with Similar Multiples(Easy)

Finda screening engine on the Web, entera multiple youare interested in, and get a list of
firms thathavethatmultiple of a particular size.Choose a particular industry andseehow the
various multiples-PIE, price-to-book, price-to-sales-differamong fums in the industry.
Screening enginescan be found at the following site (among others):
screener.finance.vahoo.com/newscreener.html
102 Part
One Financial Swtemcnrs and VallWtiOll
E3.5.
Chapter 3 HowFiMncial Swtemen(J: AreUsed in Valuation
Valuing Bonds (Easy)
E3.9.
a. Afirm issues azero-coupon bondwith afacevalue of$I,OOO, maturing infive years. Bonds
withsimilar riskare currently yielding 5 percent peryear. Whatisthevalue of thebond?
b. A firm issuesa bond with a face valueof $1,000 and a coupon rate of 5 percentper
year, maturing in five years. Bondswith similarrisk are currently yielding 5 percent
peryear. Whatis the valueof the bond?
c. A firm issuesthe samebondas in part(b) butwithan annual coupon rateof 4 percent
per year. Whatis the valueof the bond?
E3.6.
E3.10.
Applications
E3.11.
E3.7. The Method of Comparables: Dell, Inc. (Easy)

Here are some accounting numbers and market values (in millions) for Hewlett-Packard
and Gateway for 2002.These twocomputer manufactures are considered to be comparables for Dell,Inc.
Hewlett-Packard Co.
Gateway, Inc.
$45,226
6.080
$624
(1,290)
Book
Value
Market
Value
$13.953
1,565
$32.963
1.944
a. Calculate price-to-sales, price-earnings (P/E), and price-to-book (PIB) ratios for

Hewlett-Packard and Gateway.
b. Dell reported the following number forfiscal year2002:
willpay no dividends?
b. At what pricedo youexpectWeyerhaeuser to sell at the end of J997 if it doespay the
dividends?
E3.12.
~"
<

A Stab at Valuation Using Multiples: Biotech Firms (Easy)
The following tablegivesaccounting datafromthe 1994 annualreportsof six biotechnologyfirms. The market valueof the equity of five of thefirms is alsogiven. All numbers are
in millions of dollars. Fromthesenumbers, estimate a valuefor Genentech, Inc. Genentech
had a bookvalueof$l ,349million in 1994.
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Company
Amgen
Biogen
Chiton
Genetics Institute
Immunex
Genentech
Market Value
of Equity
$8.096.71
1,379.00
2,233.60
925.00
588.53
Price/Book
5.6
3.6
4.6
2.5
4.5
Revenue
R&D
$1,571.0
152.0
413.0
138.0
$307.0
101.0
158.0
109.0
151.0
81.0
3143
795.4
Net Income
$406.0
15.0
28.0
-7.0
-34.0
124.4
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Valuation of Bonds and the Accounting for Bonds, Borrowing Costs,

and Bond Revaluations (Hard)
OnJanuary 1,2008,DebtorCorporation issued10,000 five-year bondswitha facevalueof
$1,000 and an annual coupon of 4 percent. Bondsof similarrisk were yielding 8 percent
p.a. in the marketat the time.
a. Whatdid the:firm receive foreachbond issued?
b. At the end of2008, the marketwasstill yielding 8 percenton the bonds.
1. Whatwasthe firm's borrowing cost beforetaxfor 2008?
2. Howmuchinterest expense wasreported in the income statement for2008?
c. At theend of 2009,the yieldon the bondshaddropped to 6 percent.
1. Whatwasthe finn's borrowing costbefore taxfor 2009?
2. Howmuchinterest expense was reported in the income statement for 2009?
d. Creditor Corporation purchased 2,000 of the bonds in the issue. FASB Statement
No. 115requires firms to markthesefinancial investments to market
I. Whatwerethe bondscarriedat on the balance sheetat the end of2009?
2. What wasinterestincome in the income statement for 2009?
See exercises E3.14,E5.J I, E8.12,EI3.16, and E19.4 andMinicases MIO.1 andM15.2.
B.B.
a. At whatprice do you expect Weyerhaeuser tosell at the end of 1997if you forecast it
,~
Apply multiples for Hewlett-Packard and Gateway to price Dell's2,602millionoutstanding shares. Whatdifficulties did youencounter?
Forecasting Prices in an Efficient Market:

Weyerhaeuser Company(Medium)
Weyerhaeuser, the forest products producer, tradedat $42 at the beginning of J996. Beta
services typically place its betaat 1.0with a market risk premium of 6 percent. The riskfree rate at the end of 1995 was 5.5 percent. The firm was expected to pay dividends of
$1.60 per share in 1996and I997. Use the CAPM to calculate the required return, then
answer the following.
$31,168 million
$ i ,246 million
$ 4,694 million
Sales
Earnings
Book value
MeasuringValueAdded (Medium)
a. Buying a stock. A finn is expected to pay an annual dividend of $2 per shareforever.
Investors require a return of 12 percent per year to compensate for the risk of not
receiving the expected dividends. The firm's shares trade for $19 each. Whatis the
valueaddedby buying a shareat $19?
b. An investment within afirm. Thegeneralmanager of a soccerclub is considering paying$2.5million per yearfor fiveyearsfor a "star" player, alongwitha $2 million upfront signing bonus. He expects the player to enhance gate receipts and television
advertising revenues by $3.5million per yearwithno addedcosts.The clubrequires a
9 percent returnon its investments. What would be the valueadded from the acquisition of theplayer?
In the year2008,a realestateanalyst forecasts thata rental apartment building willgenerate $5.3 million each year in rents over the five years 2009-20ll Cash expenses are
expected to be $4.2 million a year. At the endof five years, the building is expected to sell
for $I2 million. Realestateinvestors expect a 12percent return ontheirinvestments. Apply
present valuediscounting techniques to value the building.
Earnings
Pricing Multiples: General Mills, Inc. (Medium)

General Mills, the consumer foods company, traded at 1.6 times sales in 2008. It was
reporting a net profit margin on its sales of9.5 percent. Whatwasits PIE ratio?
Applying Present Value Calculations to Value a Building (Easy)
Sales
103
E3.13.
Share Issuesand Market Prices: IsValueGenerated or Lost

by Share Issues?(Medium)
a. XYZCorporation had158million shares outstanding onJanuary 1,2009. OnFebruary 2,
2009, it issued an additional 30 million shares to the market at the market price
of $55 per share.Whatwasthe effectof this share issueon the price pershareof the
firm?
104 Part One Financial Star~mcn(s and Valuation
b. OnFebruary 28,2009,directors of thesameXYZCorporation exercised stockoptions to

acquire 12million shares at an exercise priceof$30 pershare. Priorto this transaction
the stocktraded at $62 pershare. Whatwastheeffect of the shareissueto the directors
on theper-share valueof the fum?
E3.14.
Stock Repurchases and Value: Dell, Inc. (Easy)

During fiscal year 2008, Dell repurchased 179 million shares on the market for $4,004
million. Therewere 2,239million shares outstanding priorto the repurchase. Whatwasthe
effectof the repurchases on the per-share priceof Dell'sstock?
E3.15.
Dividends, StockReturns, and Expected Payoffs:

Weyerhaeuser Company(Medium)
Weyerhaeuser, the forest products producer, tradedat $42 atthe beginning of 1996. Its cost
of equity capital, calculated withthe CAPM, is 11.5 percent. It is expected to paydividends
ofSl.60 per share in 1996and 1997. Straightforward calculations (as in Exercise E3.ll)
giveit an expected priceat the eod of 1997 of $48.83 pershare.
Suppose the company had announced that, instead of paying a cash dividend, it would
makesharerepurchases in 1996 and 1997 equalto the amount of the totalannual dividend.
It had 198million shares outstanding at the end of 1995. What nowwouldyou expect the
per-share priceto be at the endof J997?

See Exercise E3.11 and Minicase M3.3 for related material on Weyerhaeuser.
E3.16.
Betas,the Market Risk Premium, and the EquityCostof Capital:

Sun Microsystems (Medium)
A risk analyst gives Sun Microsystems, the networking computer firm, a CAPMequity
betaof 1.38. The risk-free rateis 4.0percent.
a. Prepare a tablewiththe costof capital that youwould calculate for the equitywiththe
following estimates of the market riskpremium:
4.5%
6.0%
7.5%
9.0%
b. Otheranalysts disagree on the beta,withestimates ranging from 1.25to 1.55. Prepare
a tablethat givesthe cost of capital for eachestimate of the marketrisk premium and
beta estimates of 1.25 and 1.55.
c. In earlyJuly2008, analysts were forecasting earnings of $0.54per sharefor the fiscal
yearendingJune30, 2009. TheywereaJso forecasting a PIE ratiofor the fum of20 in
June2009.Thecompany paysno dividends. Calculate the currentvalueof the stockin
July 2008for this PIE forecast usingthe lowest and highest cost of capitalestimates
frompart b.
E3.17.
Implying the Market Risk Premium:

Procter & Gamble(Easy)
Analysts giveProcter & Gamble, the consumer products finn, an equitybeta of 0.65.The
risk-free rate is 4.0 percent. An analyst calculates an equity cost of capitalfor the firm of
7.9 percent usingthe capitalasset pricingmodel (CAPM). 'What marketrisk premium is
sheassuming?

See Minicases M9.l, Mll.1, M12.l, M14.l, MI5.!.
Chapter 3 How Financial SUl~menrs AreU,cdin Valuation 105
Minicases
M3.1
An Arbitrage Opportunity? Cordant

Technologies and Howmet International
Cordant Technologies, based in Salt Lake City, manufactures rocketmotors, "fasteners"
(bolts), and turbine engine components for the aerospace industry. For the first half of
J999, its sales were $1.28 billion,up 7 percenton the sameperiodfor the previous year.
Net income was $85.7 million,or $2.34 per share, up 16 percent. Cordant's gas turbine
business was growing, but production cuts and inventory buildup at Boeing forecast a
slowdown in the firm's revenues from otheraerospace products. Otherdata on the finn are
as follows:
Rolling 12~month eps to June 30,1999
Book value pershare, June 30,1999
Rolling 12-month sales pershare to
June 30, 1999
Profit margin
Price pershare, September 30,1999
Market capitalization of equity
$4.11
$7.76
$67.20
7.4%
$32
$1.17 billion
Analysts were forecasting earnings of $4.00pershare forthe full 1999yearand $4.28for

2000.
Cordant's financial statements consolidate an 85 percent interest in Howmet International, anothermanufacturer of turbine enginecomponents. HO\VIDet reported net income
of$65.3 million for the firsthalf of 1999, up 33 percent, on salesof$742.4 million. Other
dataon Howmet are:
Rolling 12-month eps to June 30, 1999
Book value pershare, June 30,1999
Rolling 12-month sales pershare to
June 30,1999
Profit margin
Price pershare, September 30,1999
Market capitalization of equity
$1.21
$4.25
$14.28
8.7%
$14
$1.40 billion
Analysts were forecasting earnings of$1.24 for 1999and $1.36for2000.

Both firms werecategorized by someanalysts at the timeas "neglected" or "ignored"
stocks. Theirclaimwasthatthe marketwasirrational notonlyin overpricing the newtechnologystocks,but also in underpricing the old, "blue-collar" industrial stocks. Forreference, firms like Micosoft, Dell, Yahoo!, and AOL traded at multiples of over 50 times
earnings at the time,whereas aerospace firms tradedat 11 times earnings.
Calculate price multiples for Cordant and Howrnet. Do you see an arbitrage opportunity?Whattrading strategy do you recommend to exploitthe opportunity? Would youcall
it a riskless arbitrage opportunity?
106 Part One Fina<'lcial Srczemencs andValuation
Chapter 3 How Financial Stato:mcnI.l AreUsed inYaluaEion 107
M3.2
M3.3
Nifty Stocks? Returns to Stock Screening
Attempting Asset-Based Valuations:

Weyerhaeuser Company
In the early 1970s a widelypublicized list of the "Nifty Fifty" stockswas drawnup. This
list,whichincluded Avon Products, Polaroid, Coca-Cola, McDonald's, WaltDisney, American Express, and Xerox, was toutedas a set of "good buys."Most of the firms tradedat
highmultiples. Their PIE ratioswere as highas 70 to 90, withan average of 42, whilethe
S&P 500 traded at a multiple of 19 times earnings. Burton Crane, a New York Times
reporter, wrote the famous words at the time: "Xerox'smultiple not only discounts the
future but thehereafter as well,"
Unfortunately, many of those Nifty Fiftystocks lost considerable valuein the subsequent 1970s bearmarket. Avon's stockfe1180 percent,as did Polaroid's. Coca-Cola, IBM,
and Xerox felldramatically.
Themultiples of theNiftyFiftyin 1972beara strongresemblance to thoseof the "nifty"
technology stocksof the late 1990s, and indeedto thoseof mature "quality" firms such as
Coca-Cola, General Electric, Pfizer, Merck, andWattDisney (allof which werein the originalNiftyFiftyof 1972). Morgan Stanley published a newset of NiftyFiftystocksin 1995
that included these stocks. Here are some of the firms with high earnings multiples in
September 1999, withtheirper-share pricesat thatdate:
Microsoft (MSFT)
Dell Computer (DEll)
lucentTechnologies (LU)
America Online (AOl)
Analog Devices (AD!)
Mattei (MAn
CBS Corp. (CBS)
Cisco Systems ((SeO)

Home Depot (HD)
Motorola (MOT)
Charles Schwab (SCH)
Time Warner (TVYX)
PIE
Price per Share ($)
64
70
75
168
65
90
72
72
110
51
95
56
185
Centex (OX)
Seagate Technology (SEG)
U.S. Airways (U)
64
104
56
21
46
68
69
87
34
61
PIE
Price per Share ($)
7
2
7
3
28
32
30
26
20
10
Conseco (CNC)
Hilton Hotels (HTl)
Timberlands andwood products

Pulp, paper, and packaging
Real estate
Corporate operations
44
Track the return to these stocks from October 1999. You mightuse a price chart that
tracksstocksplits(for example, BigChartsat http://www.bigcharts.com).
Howhavethese nifty stocks fared?
Here are someless nifty stocksat the time, all of whichwere in theS&P500.They have
low PIE ratios.
In Industries (ITT)
Weyerhaeuser Company grows, harvests, and processes timberand develops residential

real estate. Incorporated in Washington State, the company has four business segments:
timberlands; woodproducts; pulp,paper,and packaging; and realestate.
The company manages 5.3 million acres of commercial forestland, 5.1 million of them
company-owned, with 3.3million acres in thesouthern United Statesand 2 million acres in
the Pacific Northwest. The standing timber inventory on these lands was approximately
9.4 million cunitsas of early 1999(a cunit is 100cubicfeetof solid wood).
The wood products division of Weyerhaeuser is the world's largest producer of
commercial-grade softwood timber and also produces coated groundwood and coated
freesheet. Weyerhaeuser's pulp, paper,and packaging division is the world's largestproducerof pulp and a leadingproducerof corrugatedcontainers. The realestateoperations
involve homebuilding.
Segments contributed to total revenues and totaloperating income in 1998 as follows:
Howhavethesestocksfared?
(Note: This case waswrittenin October 1999, without any ideaof the outcome.)
.'11
Percentof Revenue
Percentof Operating Income
47.5%
40.1
11.1
74.1%
18.2
10.9
(3.2)
1.3
Exhibit 3.1 presentsWeyerhaeuser's 1998 income statement and balance sheet. The
notesreferto footnotes to the financial statements thatcan be found on theSEC'sEDGAR
Web site.
A. Listthe assets and liabilities on the balance sheetthat you think are probably close to
market value.
Si
B. Consider assigning a marketvalueto the assetsand liabilities you have not put on the
list.Use the following information.

Analysts estimate thatthe timberlands in theSouthare worth$1,000 peracreand those
in the Pacific Northwest $2,000 per acre.Valuers estimate the replacement costof plants
usedin producing pulp, paper, and packaging to be $12,500 million and thoseproducing
wood products to be $2,100million.
Market values are notavailable for the homesbeingbuilt or for the landheldforbuilding homes, but firms withsimilaroperations sellat seven timespretax. earnings.
C. Prepare a balancesheetthat purports to givethe valueof the equity. Whatdo youestimateto be the intrinsic premium?
D.What reservations do you have about the process? What other approaches do you
recommend?
For reference, Weyerhaeuser's shares traded at $54 in March 1999, when its annual
reportwasreleased.

SeeExercise E3.11 andE3.15 inthis chapterformorecoverage ofWeyerhaeuser Company.
108 Part One Financial Sw(~mellts andValuarion
EXHIBIT3.1
Chapter 3 Holl.' Financial SWfcmenl.l AreU5ed in Vduarion 109
EXHIBIT 3.2
WEYERHAEUSER CO.
ConsolidatedIncome Statement
(dollaramounts in millions except per-sharefigures)
Netsales and revenues:
Weyerhaeuser
Real estateand related assets
Total netsales and revenues
1998
1997
s 9,574
$10,117
1,093
11,210
~
10,766
Costsand expenses:
Weyerhaeuser:
Costs of products sold
Depreciation, amortization, and feestumpage
Selling, general, and administrative expenses
Research and development expenses
Taxes otherthan payroll and income taxes
Charge forclosure ordisposition offacilities (Note 15)
7,468
611
649
57
130
71
42
9,028
Charge for year2000remediation
Real estateand related assets:

Costs and operating expenses
Selling, general, andadministrative expenses
Taxes other than payroll and income taxes

Total costs and expenses
Operating income
Interest expense and other:

Weyerhaeuser:
Interest expense incurred
less interest capitalized
Equity in income (loss) of affiliates (Note 3)
Otherincome (expense), net (Note 4)
Interest expense incurred
less interest capitalized
Equity in income ofjointventures and limited partnerships {Note 3}
Otherincome, net (Note 4)
Net earnings
Percommon share(Note 2)
Basic net earnings
Diluted net earnings
Dividends paid
7,866
616
646
56
142
89
1
9,416
ASsets
Weyerhaeuser
Current assets:
Cashandshort-term investments (Note 1)
Receivables, less allowances $5 and $6
Prepaid expense
Property and equipment (Note 8)
Construction in progress
Timber andtimberlands at cost, less feestumpage charged
to disposals
uwestments inand advances to equity affiliates (Note 3)
Otherassets anddeferred charges
1,016
5
53
8
1,082
10,110
~
10,441
656
769
264
7
271
15
(7)
(10)
Liabilitiesand Shareholders' Interest
909
12
96
8
))
14
110
69
14
23
70
463
169
539
197
61
December 27,
1998

Cash and short-term investments, including restricted deposits
ofS16in1997
Receivables, less discounts and allowances of $6 and $6
Mortgage-related financial instruments, less discounts and allowances
of $9 and $27(Notes 1 and 13)
Real estateinprocess of development and forsale(Note 9)
land being processed fordevelopment
Investments inand advances to jointventures and limited partnerships,
less reserves of $4 and $6 (Note 3)
Otherassets
28
15
Earningsbefore incometaxes
ConsoldiatedBalanceSheet
(dollaramounts in millions)
(Continued)
294
$ 1.48
$ 1.47
$ 1.60
342
$ 1.72
$ 1.72
$ 1.60
(Continued)
Total assets
Weyerhaeuser
Notes payable
Current maturities of long-term debt
Accounts payable (Note 1)
Accrued liabilities (Note 10)
long-term debt(Notes 12and 13)
Deferred income taxes (Note 5)
Deferred pension, other postretirement benefits, and other
liabilities (Note 6)
Minority interest insubsidiaries
Commitments and contingencies (Note 14)
28
886
962
294
2,170
6,692
315
1,013
December 28,
1997
100
913
983
298
2,294
6,991
354
996
482
249
~
10,934
22
81
119
62
173
584
854
120
593
845
116
135
1,900
$12,834
193
2,004
$13,075
25
17
694
88
699
707
1,499
3,397
1,404
488
11,071
~
1,384
3,483
1,418
498
121
Chapter 3 How Financia.! StatementS AreUsed in Valuation 111
110 Part One Financia.l Starements and Valuation

December 27,
1998
EXHIBIT 3.2
(Concluded)
Liabilities and Shareholders' Interest (continued)
Notes payable and commercial paper(Note 11)
long-term debt(Notes 12 and 13)
Otherliabilities
Commitments and contingencies (Note 14)
'totalliabilities
Shareholders' interest (Note 16):
Common shares; authorized 400,000,000 shares, issued
206,072,890 shares, $1.25parvalue
Other capital
Retained earnings
Cumulative othercomprehensive expense
Treasury common shares, at cost:7,063,917 and 6,586,939
Totalshareholders' interest
Tota! liabilitiesand shareholders' interest
December 28,
1997
564
228
701
1,032
255
262
-.22.Q
8,308
1,522
8,426
258
258
416
407
4,372
4,397
(208)
(123)
~
4,526
$12,834
~
4,649
$13,075
The Required Return and Asset

Pricing Models
Thechapter hasintroduced the required return foran investment, otherwise known as the
normal return or thecostof capital and,in thecontext of project selection, thehurdle rate.
Therequired return is theamount thatan investor requires to compensate herforthetime
value ofmoney tiedupintheinvestment andfortaking on riskintheinvestment. These are
hercosts of taking on the investment, thusthe name, costof capital. In effect, thecostof
capital is the opportunity costof forgoing an alternative investment withthesame risk. To
addvalue, an investment mustearnmore thanthecostofcapital, sotherequired return features invaluation: In converting forecasted payoffs to a valuation, the payoffs mustbe discounted forthecostof capital. (See Box3.6again.)
Considerable time is spent in corporate finance courses estimating thecostof capital,
The techniques afe called beta technologies. This appendix gives an overview. Chapter 18 comes backto thetopicwith a discussion ofhow fundamental analysis helps in the
assessment of the required return.
MEASURING THE REQUIRED RETURN:

BETA TECHNOLOGIES
When you invest, youbuy a gamble. Different investments will yield different expected
payoffs, buttheexpected payoff is only onefeature of the gamble. You arebuying a range
of possible outcomes with different probabilities for each, and you must be concerned
aboutthe chance of getting payoffs different from those expected. Most people are risk
averse (thatis, particularly concerned about the downside), so they want to be rewarded
witha higher return fortaking on risk. Theywant to earnat leastthe risk-free return that
onewould geton a US. government bond, say, buttheyalsowant a premium foranyrisk
thattheytakeon.
An asset-pricing model supplies the technology to calculate required returns. These
models have one insight in common: Themarket will notpricean investment to compensate for riskthat canbe diversified away in a portfolio. Theyalsohave a common form.
They characterize required returns as determined by the risk-free return plus a risk
premium:
Required return>Risk-free return + Risk premium
Theriskpremium is given by (1) expected returns overthe risk-free return on riskfactors
to which the investor mustbe exposed because theycan'tbe diversified away, and(2)sensitivities of the returns on a particular investment to these factors, known as betas. Multiplying components (1) and (2)together gives theeffectof an exposure to a particular risk
factor on the riskpremium, andthe totalriskpremium is thesumof theeffects of all risk
factors.
Thewell-known capital assetpricingmodel (CAPM) identifies the market return (the
return on all investment assets) as the(only) riskfactor. Box3.8outlines theCAPM. This
model determines thenormal return foranequity investment astherisk-free rateplusa risk
premium, which is the expected return on the whole market over the risk-free ratemultipliedby thesensitivity of theinvestment's return to themarket return, itsbeta. Therisk-free
rateis readily measured by theyieldon a U.S. government bondthatcovers the duration of
theinvestment, so theCAPM leaves theanalyst withthe taskofmeasuring themarket risk
premium anda stock's beta.
Alternatively, multifactor pricing models insist that additional factors are involved in
determining the riskpremium. The box reviews thesemodels. These models expand the
taskto identifying the relevant riskfactors andestimating betas foreachfactor. Thearbitrage pricing theory (APT) is behind thesemultifactor models. It characterizes investment
returns asbeing sensitive to a number of economywide influences thatcannot bediversified
away, but is silent as to whatthese might be and indeed as to thenumbers of factors. One
mightbe theCAPM market factor, andthe enhancement in practice comes from identifyingtheotherfactors. Somethathave beensuggested areshocks resulting from changes in
industrial activity, the inflation rate, thespread between shortand long-term interest rates,
andthespread between low-andhigh-risk corporate bonds.' Firmsizeandbook-to-market
ratio are among othercharacteristics thathave beennominated as indicating firms' exposuresto risk factors.' But these areconjectures.
Playing with Mirrors?

Clearly, thisis a tricky business. Notonlymusttheelusive riskfactors beidentified, butthe
unobservable riskpremiums associated withthem alsomustbe measured, along withthe
beta sensitivities. With these problems it's tempting to play with mirrors, but coming
up witha solidproduct that gives an edgeoverthe competition is a challenge. Even the
one-factor CAPM is demanding. Betas have to be estimated andthere aremany commercialservices thatsellbetas, eachclaiming itsbetas arebetter thanthose of thecompetition.
1 See, forexample, N-F. Chen, R. Roll, and S.A.Ross, "Economic Forces and the Stock Market" Journal
of Business, July 1986, pp.383-403,
Z SeeE. E Perna and K. R. French, "TheCross-Section of Expected Stock Returns," Journal of Finance,
June1992, pp. 427-465.
Chapter 3 How Financial Statement; Are Used in Valllltiorl 113
THE CAPITAL ASSET PRICING MODEL
The risk premium for
bu~ng CiScowas8opercenJ~a~;up'
of 5.0percent forthe risk inth,e marke!. as_:a wh?le:pi,u~, an: ,:

extra 3.0percent forrisk ~igher thenthatforthe mar~?L_;:,:_,::':-'
for aperiod isdetermined by
The CAPM isbased ontheidea that?necandiversi~ av.t.ay::..
a considerable amount of risk byholding the marketportfoli() {-.'
Required return (i) = Risk-free return
ofall investment assets. Sothe ~nly risk th?taninvestotneeds
+ [Beta (i) x Market risk premium)
to take on-and the only risk that will be rewardedinthe"
market-is therisk thatonecannot avoid, the riskin thenia,t~
The market risk premium is the expected return from holding
ketas a whole. The normal return foran investment isthus
all risky assets over thatfrom a risk-free asset. The portfolio of
determined by the risk premium tor the market: and'theall risky assets (stocks, bonds, real estate, human capital, and
investment's sensitivity to market risk.
" .' "', ' _" _.':'
many more) is sometimes called "the market porttolio" or
The required return given bythe CAPM isbased on two'.
"themarket." So
expectations, expected sensitivities to the market and the
expected market risk premium. Expectations are difficult to
Market risk premium =Expected return on the market
estimate. This isthechallenge for a beta technology.
The CAPM states thatthe required return for an investment i
- Risk-free return
MULTIFACTOR PRICING MODELS
.....
......
The market issaid tobea risk factor. Arisk factor lssqm.e~ing

that affects the returns on all investments o comeonso it',
how theprice of theinvestment will move as the price of the produces risk that cannot be diversified away. Therr;ari<etis:
the only risk factor inthe CAPM because the mod,el Says that
market moves. Itisdefined as
risk produced byother factors can be diversified away." Beta
analysts suggest, however, thatthere areother risks, inaddi-,
Setae;) Covariance (return oni, return onthemarket)
tion to.market risk, that cannot be negated. So they bua~
Variance (return onthemarket)
multifactor models to capture the risk fr~r11 additional factpi:s~:>
The beta for aninvestment measures the expected sensitivity

of its return to the return on the market. That is, it measures
The covariance measures the sensitivity but, as it isstandardized by thevariance ofthemarket, itis scaled sothatthe marketasawhole hasa betaof 1.0. Abeta greater than 1 means
the price of the investment is expected to move up more
than the market when the market goes up and drop more
when the market declines.
The risk premium forthe investment isits beta multiplied
by the market risk premium. in 2008, the riskfree rate (on
to-year U.S. Treasury notes) was about 4.0percent. Commercial services thatpublish betaestimates were giving Cisco Systems a beta ofabout 1.6. So, ifthe market risk premium was
5 percent, then the required return for Cisco given by the
CAPM was 12.0 percent:
12.0% = 4.0% + (1.6 x 5.0%)
Required return (i) ='Risk~free return ~ [Betal :(h~'Risk"

premium forfactor tl + Iaetaz (i)
x Risk premium for factor 2j
.;: ... + IBetak(i) x Risk premium for
factor kj
.
The risk premium for each ,ofthe k factors is the, expeCie?
return identified with thefactor over the risk-free return. The
market isusually considered to be risk factor' 1,'so,the beta
analyst needs to deal with the measurement probemsin the
CAPM. But the analyst must alsoidentify the edditiobalfac-'.
tors, calculate their expected risk premiums, andcalculate-the
factor betas that measure the sensitivities of given 'i[lvest.ment to thefactors. Such a task, if indeed possible, isbeyond
thescope ofthisbook..
Nooneknows thetruebeta andinevitably betasaremeasured witherror. Butevenif weget

a goodmeasure of beta,there is the moredifficult problem of determining the marketrisk
premium. We used 5 percentfor the marketrisk premium in calculating Cisco System's
equitycost of capitalin Box 3.8.But estimates rangefrom 3 percent to 9.2percent in texts
and research papers. Withthisdegree of uncertainty, estimates of required returnsarelikely
to be highly unreliable. An 8percentmarketriskpremium would yielda required returnfor
Cisco of 16.8percent. A 4 percent marketrisk premium would yielda required returnof
10.4percent. We mightwellbe cynical abouttheabilityto getprecisemeasures of required
returnswiththesemethods.
112
Indeed, thereis a caseto be made that usingthesebetatechnologies isjust playing with

mirrors. If Cisco's costof capitalcan rangefrom 10.4 percentto 16.8 percentdepending on
the choiceof a number for the marketriskpremium, we cannotbe verysecurein our estimate. Disappointingly, despite a huge effort to build an empirically valid asset pricing
model, research in finance hasnot delivered a reliable technology. In short,wereallydon't
knowwhatthe costof capital for mostfirms is.
If youhave confidence in the beta technologies you have acquired in finance courses,
youmaywishto apply themin valuation. In this book,we willbe sensitive to the imprecision that is introduced because of uncertainty aboutthe cost of capital. Analysis is about
reducing uncertainty. Forecasting payoffs is the firstorderof business in reducing our W1~
certainty aboutthe worthof an investment, so ourenergies in thisbookare devoted to that
aspectof fundamental analysis ratherthanthe measurement of thecost of capital. Wewill,
however, find ways to deal with our uncertainty about the cost of capital. Indeed, Chapter 18bringsfundamental analysis to the taskof estimating the costof capitalandoutlines
strategies for finessing the imprecision in measuring thecost of capitalin equity investing.
You maywish tojump to that chapter, to get a flavor of the approach and how it relates to
standard betatechnologies.
Chapter 4 Cll$h Accounring, Acmml Accounring, and Duccumed Cash Flow ValllGcion 115
Afterreading thischapter you should understand:
~punting,
\\t.
..C.
y.
Chapter 3 outlined the

process of fundamental
analysis anddepicted
valuation asa matterof
forecasting future
Thischapterintroduces
dividend discounting and
discounted cashflow
valuation, methods that
involve forecasting
future cashflow
statements. Thechapter
alsoshowshowcash
flowsreported in thecash
flowstatement differ
fromaccrual earnings
in theincome statement
andhowignoring accruals
indiscounted cashflow
valuation cancause
problems.
':'- ~iIlk'i6'~#p~(
Chapters 5 and6 lay
outvaluation methods
that forecast income
statements andbalance
sheets.
provides further
explanation andadditional
examples of discounted
cashflowanalysis, cash
accounting, andaccrual
accounting.
v,
ounting
ted Cash
what is the
difference
between
cash
accounting
andaccrual
accounting?
Whattype
of accounting
bestcaptures
valueadded
inoperations:
cash
accounting
0''''"'"
accounting?
<,:'.'
h"'vi"USC~~'Pt~;:i:scribed
Howthe dividend discount model works (or does not

work).
Calculate thevalue of aperpetuity.
What a constant growth model is.
Apply the discounted cash flow model.
What ismeant bycash flowfromoperations.
Make a simple valuation from free cash flows.
Whatismeant bycash used in investing activities.
Calculate cash flow from operations froma cash flow

statement.
What ismeant byfree cash flow.
fundamental analysis as a matter of forecasting future

financial statemertts, witha focus on those features in the statements thathaveto do with
investing and operating activities. Wbich of the fourfinancial statements should be forecasted andwhatfeatures of thesestatements involve the investing andoperating activities?
This chapter examines valuation technologies basedon forecasting cash flows in the
cash flow statement. First we deal with valuations based on forecasting cash flows to
shareholdersc-dividends-eknown as dividend discount analysis. Second, wedealwithvaluations basedon forecasting cashflow from operations and cashinvestment. Forecasting
cashflow fromoperations and cashinvestment anddiscounting them to a present value is
called discounted cash flow analysis. Bothtechniques prove to be unsatisfactory, for the
simple reason thatcashflows donot capture value added ina business.
As a student in an introductory financial accounting course, youwere no doubtintroduced to the difference between cash accounting and accrualaccounting. The cashflow
statement tracks operating and investment activities with cash accounting. Accordingly,
discounted cash flow analysis is a cashaccounting approach to valuation. Income statements and balance sheets, on the otherhand, are prepared according to the principles of
accrual accounting. Thischapter explains the difference between cashaccounting andaccrual accounting and so sets the stage for valuation techniques in the nexttwochapters
Afterreading thischapter youshould be able to:
Howdividends andfree cash flow are related.
Calculate thevalue of a perpetuity with growth.
Howdiscounted cash flowvaluation works.
Calculate cash used in investing from a cash flow

statement.
Whata "simple valuation" is.
Calculate freecash flow.
Problems that arise in applying cash flowvaluation.
Calculate after-tax net interest payments.
Whyfree cash flow maynot measure value added in

operations.
Calculate levered and unlevered cash flow from

operations.
Whyfree cash flow isa liquidation concept.
Calculate totalaccruals from a cash flow statement.
How discounted cash flow valuation involves cash

accounting for operating activities.
Calculate revenue from cash receipts and revenue

accruals.
Why "cash flow from operations" reported in u.S.

financial statements does not measure operating cash
flowscorrectly.
Calculate expenses from cash payments and expense

accruals.
Why"cash flow in investing activities" reported in u.S.

financial statements does not measure cash investment
in operations correctly.
Explain thedifference between earnings andcash from

operations.
Explain the difference between earnings andfree cash
flow.
How accrual accounting for operations differs from

cash accounting for operations.
The difference between earnings and cash flow from
operations.
The difference between earnings and free cash
flow.
How accruals and the accounting for investment
affect the balance sheet as well as the income
statement.
Why analysts forecast earnings rather than cash
flows.
that involve forecasting accrual accounting income statements and balance sheets rather
than the cashflow statement. Afterexplaining how accrual accounting works and how it
differs from cashaccounting, the chapter askswhy those differences are relevant in valuationIn the spiritof choosing the besttechnology, weask twoquestions. What problems
arise when we forecast cash flows? Can accrual accounting help in remedying those
problems?
116
PartOne Financial Sw(emen{S and Valualion
THE DIVIDEND DISCOUNT MODEL

Manyinvestment texts focus on the dividend discount model in theirfundamental analysis
chapter. At firstsight,the modelisveryappealing. Dividends are thecashflows thatshareholders getfromthe finn, the distributions toshareholders thatarereported inthe cashflow
statement. In valuing bondswe forecast the cashflows fromthe bond, so, in valuing stocks,
whynot forecast the cashflows fromstocks?
The dividend discount model values the equity byforecasting future dividends:
Value of equity = Present valueof expected dividends
dl
dz
d;
PE
pi pl pi
(4.1)
d4
vt=-+-+-+-+
(Theellipsisin the formula indicates that dividends mustbe forecast indefinitely intothe
future, for years 5, 6, and so on.) The dividend discount modelinstructs us to forecast dividendsand to convert the forecasts to a valueby discounting them at oneplus the equity
cost of capital, PE. Onemightforecast varying discount rates for future periods but forthe
moment we wit! treat the discount rate as a constant. The dividend discount model is a
straight application of thebondvaluation modelto equity. Thatmodelworks fora terminal
investment. Willit workfora going-concern investment underthe practical criteriawelaid
down at the end of the lastchapter?
Well, goingconcerns are expected to payout dividends for many(infinite") periods in
the future. Clearly, forecasting for infinite periods is a problem. Howwould weproceed by
forecasting for a finite period, say 10years? Lookagainat the payoffs foran equityinvestmentin Figure 3J in the lastchapter. Fora finite horizon forecast of Tyears,we mightbe
ableto predictthe dividends toYear T but weare leftwith a problem: Thepayofffor Tyears
includes the terminal price,Pt, as wellas the dividends, so we alsoneedto forecast Pr, the
priceat whichwe mightset! at the forecast horizon. Forecasting just the dividends would
be likeforecasting the coupon payments on a bondandforgetting the bondrepayment. This
lastcomponent, theterminal payoff, isalsocalledtheterminal value.Sowehavetheproblemof calculating a terminal valuesuchthat
Valueof equity= Present valueof expected dividends to time T
+ Presentvalueof expected terminal valueat T
vt = ~+
PE
(4.2)
Pk Pk
You cansee that thismodelis technically correct, for it is simply thepresent valueof all
the payoffs from the investment that are laidout in Figure3.3.The problem is that one of
thosepayoffs is thepricethatthe sharewillbe worthTyears ahead, Pro Thisis awkward., to
saythe least:The valueof the shareat timezerois detennined by its expected value in the
future, but it is the valuewe are tryingto assess. Tobreakthe circularity, wemustinvestigatefundamentals thatdetermine value.
A methodoftensuggested is to assume that the dividend at the forecast horizon will be
the sameforever afterward. Thus
vt = .!!l+ !!!- + !!l +

p p~ p}
f~ture,
(4.3)
return adjusted for thegrowth rate:
Its present value can be captured ina simple cakula-
non. Two examples area perpetuity andperpetual growth a'

'
a constant rate.
Vl-- -dlPc -g
THE VALUE OF A PERPETUITY

A perpetuity is a constant stream that continues without
end. ~e amount each period is sometimes referred to asan
annuity, soa perpetuity isan annuity thatcontinues forever.
To value thatstream, onejustcapitalizes theconstant amount
expected. If ~e d.ividend expected next year, d1 isexpected to
bea perpetcny tnevalue of thedividend stream is
required return). So, if a $1 dividend expected next year is
\1 _
1
" -Pc--1
-
Here. 9 is one plus the growth rate (and ps isone plus the
expected to 9.row at 5% peryear in perpetuity, the value of
stream, with a required return of 10% is $20 Not th t
In both th: case o~ a perpetuity anda perp~tuity ~ith 9~owtah:
thevalu~ [S est~bhshed at thebeginning oftheyear when the
perpe~ulty ~egms. Sofor a perpetuity beginning inyear 1, the
value IS at time O. For a perpetuity beginning at time T + 1 in
models 4.3 and 4.4, the value of tbe perpetuity isa' time T
(and sothatvalue isdiscounted at prt : notp"'1
'
c:
~he
So, i!a dividend of $1 isexpected each year forever andthe CONSTANT GROWTH MODELS
re~UI:ed return is 10% peryear, then the value ofthe perpe- The calculation for theperpetuity with growth issom ti
terred t
e imes retUity IS $10.
..
0 as a constant growth valuation model. Sothemod I
wltn growth above is referred to as the constant gmmh div~
THE VALUE OF A PERPETUITY WITH GROWTH
dend.model (and sometimes as the Gordon growth model
If anamount IS forecasted togrow ata constant rate, itsvalue after Its exponen~). It is a simple model, butapplicable only if
can becalculated bycapitalizing the amount at the required constant growth IS expected.
The terminal valuehere (in the bracketed term) is th

.
bycapitalizing the forecasted dividend t T + 1 h
e value oj a perpenaty: calculated
then discounted to present value.
a
at t e costof capital. Thisterminal valueis
This perpetuity assumption is a boldone We are u .
will maintain a constant payout'. If there IS
""Iess thang full
essmg. How do we know the firm
t f
.
expect dividends to grow as the retaimed f unds earn rnorepayou
i th 0f earnmgs.
.. one would
accommodated in a terminal valuecalcuIatiIon that
i
In
e
rm.This
Idea can be
at incorporates growth:
vt =: ~+
PE
r
dz +~+ ... + d + Pr
pi pl
If anam.ount is forecasted to evolve ina predictable way inthe
d~ +~+ ...
PE
pi
+p~ +[~J/
dr
Pc-g
Pc
(4.4)
where g is I plusa forecasted growth rate I The te .

.
petuity with growth If the consta t
wth
rm.'nal value here IS the value oj a per_
E
n growt starts rn the fist
. d, h
"
"
collapsestoVo=dlf(PE~g) which'.
r peno t e entire senes
See Box4.1.
, I S somenmes referred 10 as the constantgrowth model.
Whatwould wedo, however, fora firm thatmi ht b
very long time in the future? For a finn th h g e e.xpected ~o have zeropayout fora
maintained? Whatif payout come" t kat as exceptionally high payout that can't be
s m s oc repurchases (that t . 1I d '
holdervalue) ratherthandividends?
yprca y on t affect shareThe truth of the matter is that divid d
much. Somefirms paya lotof divid~ I en :ayout overthe fores~eable future doesn'tmean
nds. 01 ersnone. A firm that IS veryprofitable andworth
1 The capitalization rate in thedenomin t
. value can beexpressed as(PE - 1) - (g - 1).
which
is thesame asPc _ g.
a or0f thetermmal
117
Chapter4 Cash Accounting, Acmwl Accounting, and Discounted Cash Flow ValllCloon 119
Forecast horizons: Typically

ADVANTAGES
periods.
Easy concept: Dividends are what shareholders get, so
forecast them.
WHEN ITWORKS BEST
Predictability: Dividends are usually fairly stable in the When payout ispermanently tied thevalueqeneratlonin short run sodividends areeastto forecast the firm. For example, when a firm has a fixed payout ratio; .
to
(intheshortrun).
(dividendy'earnings}.
DISADVANTAGES
Relevance:
Dividend payout isnot related to value, at
least in the short run; dividend forecasts
ignore the capital gain component of
payoffs.
FIGURE 4.1
Cash Flows from All
Projects fora Going
Concern.
Freecashflowis cash
flowfromoperations
that results from

investments minus
cash used to make
investments.
c,
Cash flows from

operations (inflows)
Cash investment
(outflows)
Free cash flow
Time,I
2
a lotcanhavezeropayout anda fum thatismarginally profitable canhave highpayout, atleast

intheshortrun.Dividends usually arenotnecessarily tiedtovalue creation. Indeed, fumscan
borrow to paydividends, andthishasnothing to dowiththeirinvesting andoperating activitieswhere value iscreated. Dividends aredistributions ofvalue, notthecreation ofvalue.
These observations justrestate what wecovered inthelastchapter: Dividends arenotrelevant to value. Tobepractical wehave toforecast overfinite horizons. Todoso,the dividend
discount model (equation 4.2)requires ustoforecast dividends uptoa forecast horizon plus
theterminal price. Butpayoffs (dividends plusthe terminal price) areinsensitive to thedividend component Ifyouexpect a stock topayyoumoredividends, itwillpayoffa lower terminal price; if thefinnpays outcash, theprice willdropbythisamount toreflect thatvalue
hasleftthefinn.Any change in dividends willbeexactly offset bya price change suchthat,
inpresent value terms, theneteffect iszero. Inotherwords, paying dividends is a zero-NPV
activity. That's dividend irrelevance! Dividends do not create value. If dividends are irrelevant, we are left withthe task of forecasting the terminal price, butit is pricethat we are
after. Box4.2sununarizes theadvantages anddisadvantages ofthedividend discount model.
Thisleaves us withtheso-called dividendconundrum:Equity value is basedonfuture
dividends, but forecasting dividends over a finite horizon doesnot give an indication of
value. The dividend discount model fails the firstcriterion for a practical analysis established in the lastchapter. We haveto forecast something elsethatis tiedto the value ereation. Themodel fails the second criterion-validation-also. Dividends canbe observed
afterthefact, so a dividend forecast canbevalidated foritsaccuracy. Buta change in a dividend froma forecast maynot be related to valueat all,just a change in payout policy, so
ex-post dividends cannot validate a valuation.
Thefailure ofthe dividend discount model isremedied bylooking inside the firm to the
features thatdo createvalue-the investing andoperating activities. Discounted cashflow
analysis doesjust that.
THE DISCOUNTED CASH FLOW MODEL

We sawin Chapter 1thatthevalue of the fum (enterprise value) is equal to thevalueof the
debtplus the value of the equity: V~ = vg + vg. The value of thefirm is the value of its
investing and operating activities, and this value is divided among the claimants-the
debtholders and shareholders. One cancalculate the value of the equity directly by forecasting cashflowing to equityholders, as withthe dividend discount model. But onecan
118
c,
alsovalue the equity by forecasting the cashflowing from thefirm's investing andoperatingactivities (thevalue ofthe firm), andthendeduct thevalue of thedebt. Discounted cash
flow analysis, byforecasting operating andinvesting cashflows, values thefirm's operating
andinvesting activities.
Investing andoperating activities aregenerally referred tosimply as operating activities,
with investing in operations implicit. Accordingly, the valueof the operations is usedto
mean thevalue of theinvesting andoperating activities of the finn,andtheterms, value of
theoperations, valueof thefirm, and enterprise value arethesamething.
We sawin Chapter 3 thatwecanvaluea project by forecasting itscashflows. Thisis a
standard approach inproject evaluation. The firm isjust a lot of projects combined; to discover thevalue of thefirm, wecancalculate thepresent value of expected cashflows from
allthe projects in the finn'soperations. Thetotalcashflow fromallprojects is referred to
as the cash flowfromoperations. Going concerns invest in newprojects as oldonesterminate. Investments require cashoutlays, called capital expenditures or cash investment (in
operations).
Figure 4.1 depicts the cashflow from operations, C, and the cashoutflows for investments, It, forfive years fora goingconcern. Aftera cashinvestment is made in a particular
year(Year 2, say), cashflow fromoperations in subsequent years(Year 3 andbeyond) will
include the cashinflow from that project until it terminates. In anyparticular year, operations yielda netcashflow, thedifference between thecashflow from operations (from previous investments) andcashoutlays fornewinvestment, C; -L. Thisis called freecashflow
because it isthepartofthecashfromoperations thatis"free"afterthe firm reinvests innew
assets.'
Ifweforecast freecashflows, wecanvalue thefirm's operations byapplying thepresent

value formula:
Value of the fum = Present valueof expected freecashflows
(4.5)
v[= C]-I] + C2-h + C)-I> + C4 - I4 + Cs-Is + ...

PF
p}
p],
p}
P~
2Be warned that youwill encounter a multitude of "cash flow" definitions inpractice: operating cash
flow, freecash flow, financing cash flow, and even ebitda (used to approximate "cash flow" from
operations). You needto understand whatismeantwhenthe words cash flow arebeing used.
Chapter 4 Cash Accounting, Accnd Accounting, and Discounl~d Cash Flow ValHD.1ion 121
120 PartOne Financial SEat~merll.l (ind VallUltion

This isa valuation model forthefirm, referred to asthe discounted cashflow (DCF) model.
Thediscount ratehereis onethat is appropriate for theriskiness of thecashflows from all
projects. It is calledthe costof capitaljorthefinn or the costof capitaljor operations.'
The equityclaimants have to sharethepayoffs from the firm's operations with the debt
claimants, so the value for the common equity is the value of the firm minus the value of
thenetdebt: = Vb - vf. Netdebt is thedebtthefirm holdsas liabilities lessanydebtinvestments that the firm holdsas assets. As wesaw in Chapter 2, debtis typically reported
on thebalance sheetat closeto market value so onecan usually subtract thebookvalue of
thenetdebt. Inanycase,themarket value of thedebtis reported, in mostcases, in thefootnotesto the financial statements. When valuing the common equity, boththe debtandthe
preferred equityaresubtracted from the value of thefirm; from the common shareholder's
pointof view, preferred equityis really debt.
You should have noticed something: This model, like the dividend discount model,
requires forecasting overan infinite horizon. If weare to forecast for a finite horizon, we
will have to add valueat thehorizon for thevalue of free cashflows afterthehorizon. This
valueis calledthecontinuingvalue.Fora forecast ofcashflows for Tperiods, thevalue of
equitywillbe
EXHIBIT 4.1
Discounted Cash
Flow Valuation for
TheCoca-Cola
Company
(Inmillions ofdollars
except share and pershare numbers.}
Required return for the
finn is9%.
vt
vt = _C_,-_II + _C_,_-_1_, + _C_,_-_1_3 + .. + Cr - Ir + CVr _ v,D

PF
p~
p].
pF
p~
CT+! -IT+!
PF -I
(4.7)
Or, if weforecast freecashflow growing at a constant rateafterthe horizon, then

CV =
T
,Cr +1 -IT+I
PF - g
(4.8)
whereg is 1 plusthe forecasted rateof growth in freecashflow. Lookagain at Box4.1.

Exhibit 4.1 reports actual cashflows generated byThe Coca-Cola Company from 2000
to 2004. Suppose that the actual cash flows werethoseyouhad forecasted-with perfect
foresight-at the endof 1999 whenCoke's shares traded at $57.The exhibit demonstrates
howyoumighthave converted these cashflows to a valuation. Following model 4.6, free
cash flows to 2004 are discounted to present value at the required return of 9%. Then
the present value of a continuing value is added to complete the valuation of the firm
(enterprise value). The continuing value is that for a perpetuity with growth at 5%,as in
3 Chapter
a~

Cash investments
Free cash flow
Discount rate(1.09)1
Present value offree cash flows
Total present value to 2004
Continuing value (CVJ*
Present value of CV
Enterprise value
Book value of netdebt
Value ofequity (11;999)
Shares outstanding
Value pershare
2000
2001
2002
2003
3.657
947
2,710
4.097
1.187
2,910
4)36
1,167
3,569
5,457
906
4,551
5.929
618
1.2950 1.4116
2,449 2,756 3.224
1.5386
1.09 1.1881
2,486
2004
5,311
3,452
14,367
139,414
90,611
104,978
4,435
100.543
2,472
140.67
,+
cv'= 51~~1:I~O~
'=
139,414
139,414
Present valucofCV~ ~
90.611
(4.6)
The continuing value is not the sameas the terminal value. The terminal valueis the
valueweexpectthe firm to be worthat T, theterminal payoffto sellingthe finn at T. The
continuing value is the valueomittedby the calculation when we forecast only up to T
ratherthan"to infinity." Thecontinuing value is thedevice bywhichwereduce an infinitehorizon forecasting problem to a finite-horizon one, so our first criterion for practical
analysis is reallya question of whether a continuing value can be calculated withina reasonable forecast period. Howdo wecalculate the continuing valueso that it captures all
the cash flows expected after T? Well, we can proceed in the samewayas with the divi~
denddiscount model if weforecast that the free cashflows after Twill be a constant perpetuity. In this casewe capitalize the perpetuity:
CVT
&
1999
13covers the cost ofcapital for operations and how itrelates to the cost ofcapital for equity.
In corporate finance courses, the cost ofcapital for the firm is often called the weightedaverage cost of
capital ryJACC).
EXHIBIT 4.2
AFirmwith Negative
Free Cash Flows:
General Electric
Company
(In millions ofdollars,
except per share
amounrs.}

Cash investments
Free cash flow
Earnings
Earnings pershare (EPS)
Dividends pershare(DP5)
2000
2001
2002
2003
2004
30,009
37,699
(7,690)
39,398
34,848
61,227
(26,379)
14.118
1.42
0.73
36,102
36,484
38,414
(1,930)
16,593
1.60
0.82
12,735
1.29
0.57
40,308
(910)
13.684
1.38
0.66
21,843
14,259
15.002
1.50
0.77
calculation 4.8:Freecashflows areexpected to growat 5%peryearafter2004indefinitely.

The bookvalue of net debt is subtracted from enterprise value to yield equity value of
$100,543 million, or $40.67 pershare. Thevalueto priceratiois $40.67/$57:::: 0.71.
Hereare the stepsto follow for a DCF valuation:
1. Forecast free cashflows to a horizon.
2. Discount the free cashflows to present value.
3. Calculate a continuing value at the horizon withan estimated growth rate.
4. Discount the continuing value to the present.
5. Add 2 and 4.
6. Subtract net debt.
Free Cash Flow and Value Added

Onecanconclude thatCokeisworth $40.67 persharebecause it cangenerate considerable
cashflows. Butnowlookat Exhibit 4.2 where cashflows aregiven forGeneral Electric for
thesamefive years. GEearnedoneof the highest stockreturns of an u.s. companies from
1993-2004, yet its freecashflows are negative for all yearsexcept 2003.
Suppose youwerethinking of buying GE in 1999. Suppose alsothat,againwithperfect
foresight, youknewthenwhatGE'scashflows weregoingto be andhadsoughtto apply a
DCFvaluation. Well, the free cashflows are negative in all but one yearand theirpresent
value is negative! The last cash flow in 2004 is also negative, so it can't be capitalized to
Chapter 4 CashAccotlfuing. Accrual ACCOllllong, andDiscOimfed Cash Flow Valuocion 123
Valuation is a matter of disciplining speculation about the

future. In choosing a valuation technology, twoofthefundamentalist's tenets come into play: Don'r mix what youknow
with speculation and Anchor a valuation on what you know
rather than onspeculation. Amethod thatputs less weight on
speculation isto bepreferred, and methods thatadmit speculation areto beshunned. We know more about the present
and thenear future than about thelong run, somethods that
give weight to what we observe at present and what we
forecast forthenear future arepreferred to those thatrely on
speculation about the long run. To slightly misapply Keynes's
famous saying, inthelong run weareall dead. This consideration isbehind thecriterion thata good valuation technology
isonethatyields a valuation with finite-horizon forecasts. and
theshorter the horizon the better. Going concerns continue
into the long run, of course, so some speculation about the
long run isinevitable. But, ifa valuation rides onspeculation
about thelong run-about which weknow little--we have a
speculative. uncertain valuation indeed.
Discounted cash flow valuation lends itself tospeculation.
The General Electric case inExhibit 4.2isa good example. An
analyst trying to value thefirm ini999may have a reasonably
good feel for likely free cash flows inthe near future, 2000
and 2001, but thatwould do her little good. Indeed, ifshe

forecast the cash flows over the five years, 2000-2004 with
some confidence, thatwould dolittle good. These cash flows
are negative, so she isforced to forecast (speculate!) about
free cash flows that may turn positive many years in the
future. In 20iD, 2015, 2020? These cash flows are hard to
predict; they are very uncertain. In the long run we are all
dead. Abanker oranalyst trying to justify a valuation might
like themethod, ofcourse, foritistolerant to plugging inany
numbers, buta serious fundamental analyst does notwant to
becaught with such speculation.
Speculation about thelong run is contained inthecontinuing value calculation. So another way ofinvoking ourprinciples is to say that a valuation is less satisfactory the more
weight it places on thecontinuing value calculation. You can
seewith GE that, because cash flows upto2004 arenegative,
a continuing value calculation drawn at the end of 2004
would be more than 100% of the valuation. A valuation
weighted toward forecasts for thenear term-veers 2000 to
2002, say-is preferable, forwe are more certain about the
near term than thelong run. But GE's near term cash flows do
notlend themselves toa valuation.
yielda continuing value. Andif, in 2004, youhad looked backon the free cashflows GE
had produced, you surely would not have concluded that they indicate the value added to
the stockprice.
Why does DCF valuation not work in somecases? The short answer is that free cash
flow doesnot measure value added from operations overa period. Cashflow from operations is value flowing intothe fum from sellingproducts but it is reduced by cash investment. Ifa finn invests morecashinoperations thanit takes in from operations, its freecash
flow is negative. And even if investment is zero NPV or adds value, free cash flow is
reduced, and so is its present value. Investment is treated as a "bad" ratherthana "good."
Of course, the return to investments will comelater in cashflow from operations, but the
more investing the finn doesfor a longer periodin the future, the longer the forecasting
horizon has to be to capture these cashinflows. GEhas continually found newinvestment
opportunities so its investment hasbeengreaterthanits cashinflow. Many growth firms-c.
that generate a lot of value-s-have negative free cashflows. The exercises andcasesat the
endofthechaptergiveexamples of twootherverysuccessful firms-c-Wal-Mart andHome
Depot-with negative free cashflows.
Freecashflow is not really a concept aboutadding value in operations. It confuses investments (andthe valuetheycreate) with thepayoffs from investments, so it is partlyan
investment or a liquidation concept. A firm decreases its freecashflow byinvesting andincreases it by liquidating or reducing its investments. But a firm is worthmore if it invests
profitably, not less. If an analyst forecasts low or negative free cash flow for the nextfew
years, would we take thisas a lackof success in operations? GE's positive free cash flow
in 2003 mighthavebeenseen as bad news because it resulted mostly from a decrease in
122
investment. Indeed, Coke'sincreasing cash flows in 2003 and 2004 in Exhibit 4.1 result
partly from a decrease in investment. Decreasing investment means lower future cash
flows, calling intoquestion the5%growth usedin Coke's continuing valuecalculation. Exercise4.7 rolls Cokeforward to 2006-2007 whereyou see similar difficulties emerging.
Free cash flow would be a measure of value from operations if cash receipts were
matched in thesameperiodwiththecashinvestments thatgenerated them. Thenwewould
have value received less valuesurrendered to gain it. But in DCFanalysis, cashreceipts
from investments are recognized in periods afterthe investment is made, and thiscanforce
us to forecast overlonghorizons to capture value. DCFanalysis violates thematching principle(seeBox2.3 in Chapter 2).
A solution to the OEproblem is to have a very long forecast horizon. But thisoffends
the first criterion of practical analysis thatweestablished inChapter 3. See Box4.3.
Another practical problem is that free cash flows are not whatprofessionals forecast.
Analysts usually forecast earnings, not free cashflow, probably because earnings, notfree
cashflow, area measure of success in operations. Toconvert an analyst's forecast to a valuation usingDCFanalysis, wehave to convert theearnings forecast to a freecashforecast.
Thiscanbedonebysubtracting accrued components from earnings butnotwithout further
analysis. Box4.4 summarizes the advantages anddisadvantages of DCFanalysis.
SIMPLE VALUATION MODELS

Box4.3 identified thecontinuing value component as themostspeculative part of a valuation.To applythe fundamentalist's tenet, Don'tmix what you know with speculation, he
mightset a forecast horizon on the basisof forecasts about which he is relatively sure~
whathe knows-and use a continuing value calculation at the end of the forecast period
to summarize his speculation. So, if a Cokeanalyst felt he couldforecast cash flows in
Exhibit a.I for2000-2004 withsomeprecision, he might workwith. a five-year forecasting
horizon and thenaddspeculation aboutthelongtermin thecontinuing value. Hehas then
effectively separated whathe knows from speculation.
Inpractice, oneusually doesnotfeelcomfortable witha forecast forfive years. Analysts
typically provide pointestimates (of earnings) for onlytwoyearsahead, and their"longtermgrowth rates"aftertwoyearsare notoriously bad.A simple valuation model forecasts
for shorter periods. The most simple model forecasts for just one period and then adds
speculation with a growth rate. For the dividend discount model in Box 4.1, the Gordon
growth model is a simple model. ForDCFvaluation, a simple model is
v ::: _'C_-1_
I -
PE - g
Netdebt
(4.9)
Applying themodel to Coke's2000freecashflow withthe samegrowth rateof 5%,as in

Exhibit 4.1.
v'
1m
= $63 315 =
'
2,710
1.09 - 1.05
$4,435
This valuation, in millions, is considerably less than the $100,543 million calculated in
Exhibit 4.1.Butit serves as a benchmark in theanalyst's thinking to checkhisspeculation:
HowsureamI aboutthehighergrowth in theforecasts for years after2000in Exhibit 4.1?
Can I justifymyforecasts and thehighervaluation withsound analysis?
Chapter4 Cash Accounting, Accrual Accounting, andDi.lcounred Cash Flow Valuation 125
ADVANTAGES
Easy concept: Cash flows are "real" and easy to think
about: they are notaffected by accounting
Familiarity:
Forecast horizons:
Typically, longforecast horizons are
required to recognize cash inflows
from investments, particularly when
rules.
investments aregrowing. Continu-
Cash flow valuation is a straightforward
ingvalues have a highweightinthe

valuation.
Analysts forecast eamings, not free
cash flow; adjusting earnings forecaststo free cashflow forecasts requires further forecastoq ofaccruals.
application
of familiar present value
techniques.
DiSADVANTAGES
Suspect
Free cash flow does not measure value
concept:
added in the shortrun;value gained is not
matched with value given up.
Notaligned with
whatpeople
forecast:
WHEN iT WORKS BEST
When the investment patternproduces positive constantfree

cash flow or free cash flow growing at a constant rate;
a "cashcow" business.
DCF applies whenequityinvestments are terminal or the
Free cash flow is partly a liquidation con- investor needs to "cashout," as inleverage buyout situations
cept;firms increase free cashflow bycut- and private equity investments: wherethe ability to generate
ting back on investments.
cashis lrroortant.
Free cash flow fails to recognize value

generated thatdoes notinvolve cash flows.
Investment istreated asa loss ofvalue.
THE STATEMENT OF CASH FLOWS

Cash flows are reported in the statement of cashflows, so forecasting cashflows amounts
to preparing pro forma cashflow statements for the future. But the cash flows in a U.S.
statement (prepared following GAAP) are not quite what we want for DCF analysis.
Exhibit 4.3 gives "cash flows from operating activities" and "cash flows from investing
activities" from the statement of cashflows forDell, Inc., forfiscal year2008. The extract
is from Dell's fullcashflow statement, provided inExhibit 2.1in Chapter 2. Dellreported
2008 cashflow from operations of$3,949million andcashusedininvesting of$I,763 million,so itsfreecashflow appears to bethedifference, $2,186 million.
Cash flow from operations iscalculated inthestatement asnetincome less items in income
thatdo notinvolve cashflows. (These noncash items aretheaccruals, to be discussed laterin
thechapter.) Butnetincome includes interest payments, which arenotpartof operations but
rather financing activities. Interest payments arecash flows todebtholders outoftbecashgenerated byoperations. They arefinancing flows. Firms arerequired to report theamount of interest paidas supplementary information to thecashflow statement; DeU reported $54 millionin2008 (seeExhibit 4.3). Netincome also includes income (usually interest) earned on
excess cashthatistemporarily invested ininterest-bearing deposits andmarketable securities
like bonds. These investments arenotinvestments inoperations. Rather, they areinvestments
to storeexcess cashuntil it canbe invested inoperations later, or topayoffdebtorpaydividends later. Dell had over $9 billion of interest-bearing securities on its 2008 balance sheet
(in Chapter 2).Thesupplementary information inExhibit 4.3reports $387 million of investment income onthese securities. This interest income from theinvestments was notcashgenerated byoperations.
The difference between interest payments and interest receipts is called net interest
payments. In the United States, net interest payments are included in cash flow from
124
EXHIBIT 4.3
Operating and
DEll, Inc.
Partial Consolidated Statementof Cash Flows
(inmillions of dollars)
Investing Portionof
the 2008 Cash Flow
Fiscal Year Ended
Statement forDell,
Inc.
February1,
2008
Cash flowsfromoperatingactivities
Net income
Adjustments to reconcile netincome to netcash
provided byoperating activities
In-process research anddevelopment charges
Tax benefits from employee stock plans
Effects ofexchange rate changes on monetary assets
andliabilities denominated inforeign currencies
Other
Changes in
Operating working capita!
Noncurrent assets andliabilities
Netcashprovided by operatingactivities
February3,
2006
s2,947
s 2,583
$ 3,602
607
329
83
471
368
394
17
(12)
(80)
224
(3)
30
133
61
(519)
397
(53)
351
132
413
3,949
3,969
4,751
cash flowsfrominvesting activities

Investments
(2,394)
Purchases
3,679
Maturities andsales
(831)
Acquisition of business, netofcash received
(2,217)
Proceeds from sale of building
Netcesb(usedin)provided by investing activities (1,763)
Supplemental information
Interest paid
Investment income, primarily interest
February 2,
2007
54
387
37
157
(8,343)
(6.796)
10,320
11,692
(896)
(118)
40
(1.003)
(747)
(4,149)
57
275
39
226
5<>=: Don,Inc.,lQ-K filing, 2008.
operations," SO theymust beaddedbackto the reported freecashflows fromoperations to

gettheactual cashthatoperations generated. However, interest receipts aretaxable and interest payments aredeductions forassessing taxable income, so netinterest payments must
be adjusted for the taxpayments theyattractor save. Thenet effect of interest andtaxes is
after-tax net interest payments, calculated as net interest payments x (1 - tax rate). Cash
flow from operations is
Cashflow fromoperations = Reported cashflow from operations
+ After-tax net interest payments
(4.10)
International accounting standards permit firms to classify netinterest payments either aspartof
operations or asa financing cash flow.
DELL, INC., 2008

A COMMON APPROXIMATION
DELL. Inc" 2008
(in millions of dollars)

Reported cashflow from operations
Interest payments
Interest income"
Netinterest payments
Taxes (35%)t
Net interest payments aftertax(65%)
Reported cashused in investing activities
Purchases of interest-bearing securities
Sales of interest-bearing securities
Cash investment inoperations
Free cashflow
FROM THE CASH FLOW STATEMENT
(in million of dollars)
(216)
3,733
Earnings
Accrual adjustment
levered cashflows from operations
Interest payments
Interest receipts
Net interest payments
Tax at 35%
Free cash flow
1,763
2,394
(3,679)
'lnlo=1 payment'3~ givenassupplcmcmol OOlJ 10tn. ;(:Il."",nl orcoshflows, but interest receiplS lISoolly ;"c nol.Int.'o<lincome (fromthe inco"'"'t:llemcnt)is u<cd
instead; this inc:lod"S ,..",:11, bot i;lISuolly closeto toe Cl;h interesl received,
'D<II', 't:llulory 13~ rJlc(for fedcr:l13nd ,t"tc laX.,.) ;,3S paceOI.a, indicated in Ih. fina""i,l,i:ltemenl Iocrnctcs.
The first part of Box 4.5 calculates Dell's cash flow from operations from its reported
number. Formany firms, interest payments are greaterthaninterest receipts (unlikehere),
so cashflow from operations is usually larger than the reported number.
The U.S. statement of cashflows has a section headed "cashflow from investing activities." Butthe investments thereinclude the"investments" of excesscashin interest-bearing
securities. Theseare not investments in Dell's computer operations, so
Cashinvestment in operations = Reported cashflow from investing
(4.11)
- Net investment in interest-bearing securities
Net investment is investments minusliquidations (purchases minus sales)of investments.
Dell's revised cash investment in operations is given in Box4.5, along with its free cash
flow. Theadjusted investment in operations is nowequal to the sumof capital expenditures
and costsof acquisitions.
Cashflow fromoperations issometimes referred to as theunlevered cash jfowfromoperalions butthe"unlevered" is redundant. The reported cashflow from operations is sometimes
called the levered cashflowfrom operations because it includes the interest from leverage
through debtfinancing. Butlevered cashflow is nota useful measure. Dividends arethecash
flows toshareholders andthese arecalculated afterservicing notjust interest buttherepayment
of principal to debtholders also.
The Cash FlowStatement under IFRS

Thecashflow statement under IFRSis similar to the U.S. statement, witha few exceptions:
I. Firms can classify dividends paidand received as eitheroperating or financing activity.
[f a finn chooses to classify dividends paid as an operating activity, the analyst must
transfer it to the financing section: Dividends paidare a distribution of cashfromoperations to shareholders, not cash used up in operations. But dividends received are
126
3,949
54
(387)
(333)
117
2,947
1,002
3,949
54
(387)
(333)
117
Earnings before interest andtaxes (ebit)

Taxes on ebit(at 35%)
+ Depreciation and amortization
+ Change inoperating working capital
-.ill2)
3,733
3,048
685

- Cash investments:
Acquisitions
Free cashflow
3,440
1,204
2,236
607
519
-831
2,217
1,126
3,362
3,048
314
Owlge inoperatingworking atpilal is Ihe cb30ge in current:tS5C1s min,.,Cu:'",ot !i.roilitics 2ftereliminating cashandcashcquM:lcnts, shorttcml investments andshorltcrm
borrowings. anddeferred lues. The number on Ibecash flowstatemcntis usedbore.
Asthesecond method isonly anapproximation, thetwomethods differ. Accrual items inDell's cash
flow statement other than depreciation andamortization andchange inoperating working capital
have been ignored intheapproximation. Note thatisIt common to deduct only capital expenditures
(Cap-Ex) as investments, butonemust ensure thatthe number includes all investment expenditures
such asacquisitions.
appropriately operating itemsif theyare dividends from investing in otherbusinesses as

part of the business plan.
2. Firmscanclassifyinterest paidand received as eitheroperating or financing activity. If
classified as an operating activity, the analyst mustadjustcash fromoperations for the
net interest (aftertax),as in the United States(equation 4.10),
3. Taxes paid are in cash from operations (as in the United States), unless they can be
specifically identifiable witha financing or investing activity.
Purchases andsalesof interest-bearing securities areclassified as cashinvesting activities, as
intheUnited States, sothesameadjustment tocashinvestment must bemade (equation 4.ll).
Forecasting Free Cash Flows

ForDCFanalysis we need forecasts of freecash flow that willbe reported in the cashflow
statement in the future. However, developing suchforecasts without first forecasting sales
andearnings is difficultTheseare accrual numbers, so forecasts of freecashflow are made
by converting earnings forecasts intoforecasts of cashflows from operations, thendeductinganticipated investment in operations. Thedifference between earnings (netincome) and
cash from operations is due to income statement accruals, the noncash items in net
income, and these accruals are indicated by the difference between net income and cash
from operations in the cash flow statement. The accruals in Dell's 2008 statement total
$1,002 million. Deducting theseaccruals fromnet income-and making the adjustment for
after-tax interest-produces cashflow from operations. Box4.6shows youhowto convert
127
Chapter4 Cosh Acwunling, Accrual Accounting, and Distounud Cosh Flow Valuation 129
128 PartOne Finarll;ilI1Srote!l1ent.<; and Valuation
Dell's earnings to cash flow from operations and, witha deduction for newinvestments in
operations, to free cashflow.
Forecasting future accruals is notall thateasy. People resortto shortcuts by forecasting
earnings before interest and taxes (ebit),deducting taxes that applyto ebit, then making
the accrual adjustment by adding back depreciation and amortization (in the cash flow
statement) plusthe change in working capital itemsinvolved in operations. Thisis onlyan
approximation, andsomewhat cumbersome. Wewillshowa muchmoredirectandquicker
wayto do this in Chapter 10 after handling balance sheets and income statements in our
finanical statement analysis in Cbapter 9. The common method that starts with ebit is
demonstrated for Dellin Box4.6.
We must ask whether the exercise of converting earnings forecasts to cash flows is a
useful one,particularly if weend upwith thenegative free cashflows wesawfor General
Electric in Exhibit 4.2. Canwe valuea firm from earnings forecasts ratherthan cashflow
forecasts andsaveourselves theworkin making theconversion? Theanswer is yes. Indeed
wewillnowshowthattaking theaccruals outofearnings canactually introduce morecomplications to the valuation taskandproduce a more speculative valuation.
CASH FLOW, EARNINGS, AND ACCRUAL ACCOUNTING

Analysts forecast earnings ratherthan cash flows. And the stockmarket appears to value
firms on thebasisof expected earnings: A firm's failure to meetanalysts' earnings forecasts
typically resultsin a dropinshareprice,whilebeating earnings expectations usually results
in an increased shareprice.
Thereare goodreasons to forecast earnings ratherthanfree cashflows if wehavevaluationin mind. The difference between earnings andcashflow fromoperations is the accrualso Wenow showhowaccruals in principle capture value added in operations that cash
flows do not.And wealsoshowhowaccrual accounting treatsinvestment differently from
cashaccounting to remedy the problems we have just seen in forecasting free cashflows.
Earnings and Cash Flows

Exhibit 4.4 gives the statement of income for Dell,Inc., for fiscal 2008along with prior
years'comparative statements. Theincome statement recognizes valueinflows from selling
products in revenues andreduces revenues by thevalue outflows in expenses to yielda net
number, netincome, as wesawin Chapter 2.
Thereare threethings youshould noticeaboutincome statements:
1. Dividends do not appear in the statement. Dividends are a distribution of value, not a
partof thevaluegeneration. So theydo notdetermine themeasure of value added, earnings.Dividends do reduce shareholders' value in the firm, however; appropriately, they
reduce thebookvalue of equityin thebalance sheet. Accountants get thisright.
2. Investment is not subtracted in theincome statement, so thevalue-added earnings number is not affected by investment, unlike freecashflow. (An exception is investment in
research and development, so the value-added measure may be distorted in this case.)
3. There is a matching of valueinflows (revenues) to value outflows (expenses). Accountantsfollow thematching principle,whichsaysthatexpenses shouldbe recorded in the
sameperiodthattherevenues theygenerate arerecognized, aswesawin Chapter 2.Value
surrendered is matched withvaluegainedto get netvalueaddedfrom selling goods or
services. Thus, for example, onlythoseinventory coststhat applyto goodssoldduring
a period are recognized as valuegiven up in cost of sales (and the remaining costsvalue not yet givenup-are recorded as inventories in thebalancesheet); anda costto
EXHIBIT 4.4
Income Statements
for Dell, Inc.
DEll,lnc.
Consolidated Statementsof Income
(amountsin millions)
Fiscal YearEnded
Net revenue
Cost of netrevenue
Gross margin
Operatingexpenses
Selling, genera! andadministrative
In-process research anddevelopment
Research, development. andengineering
Total operating expenses
Operating income
Investment andotherincome, net
Income before incometaxes
Income taxprovision
Net income
February 1,
February 2,
2008
2007
2006
$61,133
$57,420
$55,788
49,462
47,904
45,897
11,671
9,891
7,538
5,948
5,051
83
610
February 3,
498
458
6,446
5,509
3,440
3,070
4.382
387
275
226
3,827
3,345
4,608
-.l.1
1.006
$ 2,947
$ 2,583
$ 3,602
soUn:e: Dell,I~o., IO_K filing,200g.
pay pensions to employees arising from their service during the current period is
reported as an expense in generating revenue for theperiodeventhoughthe cashflow
(during the employees' retirement) may be many years later (and a corresponding
pension liability is recorded in the balance sheet). Dell reported 2008 revenues of
$61,133 million from the sale of computers and related products. Against this, it
matched $49,462 million forthecostof theproducts soldandanother $8,231 million in
operating expenses, to report$3,440 million as operating income before taxes-cvalue
received lessvaluegivenup in operations.
Cashflow from operations addsvalueandis incorporated in the revenue andexpenses.
But to effectthe matching of revenues andexpenses, the accountant modifies cashflows
from operations withthe accruals.Accruals are measures of noncash value flows.
Accruals
Theseareof twotypes, revenue accruals and expense accruals.
Revenues are recorded whenvalue is received from sales of products. To measure this
value inflow, revenue accruals recognize value increases thatarenotcashflows andsubtract
cashinflows thatarenotvalue increases. Themostcommon revenue accruals arereceivables:
A saleon credit is considered an increase in value eventhough cashhas notbeenreceived.
Correspondingly, cashreceived inadvance of a saleisnotincluded in revenue because value
is not deemed to have been added: The recognition of value is deferred (as deferred or
unearned revenue) until such time as the goods are shipped and the sale is completed.
Revenue fora period is calculated as
Revenue = Cashreceipts from sales+ Newsalesoncredit- Cashreceived forprevious
periods' sales- Estimated salesreturns- Deferred revenue for cashreceived
in advance of sale+ Revenue previously deferred to thecurrentperiod
130 Part One Financial StatemOl<S and VailWOon

You willnoticein thiscalculation thatestimated returns of goods anddeferred revenue are
accruals. Theyare amounts that arejudgednot to add value. Revenue, after these adjustments, is sometimes called netrevenue.
Expense accruals recognize valuegiven up in generating r~venue that is not a cashflow
and adjust cash outflows that are not value given up. Cash payments are modified by
accruals as follows:
Expense = Cashpaidfor expenses +Amounts incurred in generating revenues butnot
yetpaid- Cashpaid forgenerating revenues in future periods + Amounts
paid in the pastfor generating revenues in thecurrentperiod
Pension expense is an example of an expense incurred in generating revenue that will
notbe paiduntil later. Wages payable is another example. A prepaid wagefor work in the
future is an example of cashpaid for expenses in advance. Depreciation arisesfrom cash
flows in the past for investments in plant. Plants wearout. Depreciation is that part of the
costof theinvestment that is deemed to be usedup in producing therevenue of thecurrent
period. Dell'sexpenses havecashandaccrual components. Income tax expense, forexampIe,includes taxes duefortheperiodbutnotpaidandcostofgoods soldexcludes cashpaid
for production of computers thathavenotyetbeensaid.
Total accruals for a periodare reported as the difference between net income andcash
flow from operations in the statement of cashflows. Reported cashflows fromoperations
areafter interest, so
Earnings = Levered cashflow from operations + Accruals
Earnings = (C-1) + Accruals
(4.12)
This is another accounting relation to be addedto those discussed in Chapter 2. See

Box4.7. Weuse C to indicate (unlevered) cash flow from operations, as before, and i to
indicate after-tax net interest payments, so C - i is levered cashflow fromoperations. We
see in Exhibit 4.3 thatDell had$1,002 million in accruals in 2008. Thatis, $1,002 million
less valuewas deemedto have been added in earnings of $2,947 million than in levered
cash flows fromoperations of $3,949 million.
Accruals change the timing for recognizing valuein thefinancial statements from when
cashflows occur. Recognizing areceivable asrevenue orrecognizing anincrease inapension
obligation as expense recognizes value aheadof the future cashflow; recognizing deferred
revenue or depreciation recognizes value laterthancashflow. In allcases, the concept is to
matchvalue inflows andoutflows to geta measure of value added in selling products in the
marketTiming isimportant toour firstcriterion forpractical valuation analysis, a reasonably
shortforecast horizon. You readily seehowrecognizing a pension expense 30 years before
thecashflow atretirement is goingto shorten the forecast horizon. Wewill nowseehowdeferring recognition untilaftera cashflow alsowillshorten theforecast horizon.
. Cash flow from operations

_ Net interest payments (after tax)
Add these accounting relations to those inChapter 2

(Box 2.1). They aretools for analysis.
+~
Earninos
Free cash flow

- Net interest payments (after tax)
+ Accruals
+ . Investments
Earnings
Accrual accounting addsbackinvestment to free cashflow. Because it places investment

in the balance sheetas assets, it does not affectincome. Thenit recognizes decreases in
those assets in subsequent periods in the form of depreciation accruals (andothcramcrtizations) as assets losevalue in generating revenue. Look at Box4.7 again.
Toappreciate thefull details ofhow accrual accounting works, youmustgrasp agooddeal
of detail. Herewe have seen onlya broad outline of how the accounting works to measure
value flows. Thiswinbe embellished later-particularlyin PartFour of the book-but now
would be a good timeto review a financial accounting textandgo to Accounting Clinic II.
The outline of earnings measurement here nominally describes how the accounting
works andourexpression forearnings above looks likea goodway tomeasure value added.
Butthereis noguarantee tbat a particular set of accounting rules-U.S. GAAP or international accounting standards, for example-achieves the ideal. Yes, depreciation nominally
matches value lostto value gained, butwhether thisis achieved depends on howthedepreciationis actually measured. This is true for all accruals. Cashflows are objective, but the
accruals depend on accounting rules, and theserulesmaynotbe goodones. Indeed, in the
caseof depreciation, firms can choose fromdifferent methods. Many accruals involve estimates, whichoffera potential for error. Accruals canbe manipulated to somedegree. And
you see in Dell's income statement that R&D expenditures are expensed in the income
statement eventhough they are investments. These observations suggest that the valueadded measure, netincome, maybe mismeasured, so a valuation technique based on forecasting earnings mustaccommodate thismismeasurement. Indeed, one rationale for DCF
analysis is thattheaccounting is so suspect thatone mustsubtract or"backout"theaccruals from income statements to get to the"realcashflows." Wehave seenin thischapterthat
Accounting Clinic
r n:~
% ",;; ,:.
Investments
Theperformance measure in DCFanalysis is freecashflow, notcashflow fromoperations.
Freecashflow is cashgenerated from operations aftercashinvestments, C- I, andwesaw
that investments are troublesome in the DCF calculation because they are treated as
decreases in value. But investments are madeto generate value; theylose valueonlylater
as the assetsare used up in operations. The valuelost in operations occurs after the cash
flow. The earnings calculation recognizes this:
Earnings = Freecashflow - Net cashinterest + Investments + Accruals (4.13)
Earnings = (C- I) - i + I + Accruals
HOW ACCRUAL ACCOUNTING WORKS

Accounting Clinic II, on the book's Web site, lays out in
more detail how accrual accounting works and contrasts
accrual accounting with (ash accounting. After going
through this clinic you will understand how and when revenues ate recorded andwhy cash received from customers
is not the same as revenues recorded under accrual
accounting. You also will understand how accrual
accounting records expenses. You will see how the

matching principle-etc measure value added-ahat was
introduced in Chapter 2 is applied through the rules of
accrual accounting. You also will recognize those cases
where GMP violates the principle of good matching.
And you will appreciate how accrual accounting affects
not only the income statement but also the balance
sheet.
131
Chapter 4 <Ash Accounting, Accruol Accounting, am!DimlUnled Cosh Flow Valuation 133
132 Part One Financial Sw:mems and Voluation
this induces problems, however. We will come backto the quality of accrual accounting
throughout thebook.
Accruals, Investments, and the Balance Sheet

Exhibit 4.5 is Dell's 2008 comparative balance sheet. The investments (which are not
placed in the income statement) are there-inventories, land, buildings, equipment, and
intangible assets. Butthestatement alsohasaccruals. Shareholders' equity is assets minus
liabilities, so onecannot affect theshareholders' equity through earnings without affecting
assets andliabilities also. Thecashflow component of earnings affects cashon thebalance
sheetandthe accrual component affects otherbalance sheetitems. Thatis why some accrualadjustments in thestatement of cashflows are expressed as changes in balance sheet
items. Credit sales, recognized as a revenue accrual on Dell's income statement, produce
receivables on Dell's balance sheet andestimates of baddebts andsales returns reduce net
receivables. Inventories arecosts incurred ahead of matching against revenue inthefuture.
Dell'sproperty, plant,and equipment are investments whose costs will laterbe matched
against revenues astheassets areused up in producing those revenues. Ontheliability side,
Dell's accrued liabilities and payables are accruals, Accrued marketing and promotion
costs, forexample, arecosts incurred in generating revenue butnotyetpaidfor.
Indeed aU balance sheetitems, apartfrom cash, investments thatabsorb excess cash, and
debtandequity financing items, result from either investment or accruals. To modify free
cash flow according to the accounting relation (equation 4,13), investments andaccruals
are put in the balance sheet. Andin some cases, balance sheet items involve bothinvestmentandaccruals, Netproperty, plant, andequipment inDell's balance sheetis investment
reduced by accumulated accruals fordepreciation, forexample.
Figure 4.2 depicts how cashflows andaccruals affect the income statement andbalance
sheet This figure is an embellishment of Figure 2.1 in Chapter 2. Net cashflow from all
activities updates cashonthebalance sheet, as in Figure 2.1_ Itscomponent cashflows from
operating, investing, and financing activities update other aspects of the balance sheet:
Equity financing cash flows update shareholders' equity (through thestatement of shareholders' equity), debtfinancing cash flows update liabilities, andcashinvestments update as~
setsotherthancashin the balance sheet. Andcashflow from operations update shareholders' equity as a component of earnings. Butjust as cashflow from operations updates both
shareholders' equity andcash, so accruals update bothshareholders' equity (asa component
of earnings) andassets andliabilities otherthan cash. Box4.8gives some examples of specific accruals andhow theyaffect boththeincome statement andthebalance sheet.
The accruals in the balance sheettakeon a meaning of theirown, either as assets or
liabilities. Anasset is something thatwillgenerate future benefits. Accounts receivable are
assets because theyare cashto be received from customers in the future. Inventories are
assets because they can generate sales and ultimately cashin the future. A liability is an
obligation to give up value in thefuture, Accrued compensation, for example, is a liability
to paywages; a pension liability, an obligation to paypension benefits. Andaccruals that
reduce investments arereductions of assets. Property, plant, andequipment areassets from
investment butsubtracting accumulated depreciation recognizes thatsome of theability to
generate future cashhas beengiven up in earning revenues to date. So net assets (assets
minus liabilities) are anticipated value that comes from investment but also anticipated
value thatis recognized by accruals,
The net assets give the bookvalue of shareholders' equity, $3,735 million for Dell in
2008. We observed in Chapter 2 that these net assets are typically not measured at the
(intrinsic) value of the equity. We now see why. The cash, debt investments, and debt
liabilities are oftencloseto theirappropriate values. Buttheassets andliabilities thatarea
EXHIBIT 4.5
Balance Sheets for

Dell, Inc.
DEll, Inc,
Consolidated Statement of Financial Position
Fiscal Year Ended
February1, 2008
Assets
Currentassets
Cash andcash equivalents
Accounts receivable, net of allowance
Financing receivables, net of allowance
Inventories, net of allowance
Other
Totalcurrent assets
Property, plant, andequipment, net of depreciation
Investments
long-term financing receivables, net of allowance
Goodwill
!ntangible assets, net of amortization
Other noncurrent assets
Totalassets
liabilitiesand Equity
Currentliabilities
Short-term borrowinqs
Accounts payable
Accrued andother
Short-term deferred service revenue
Long-term debt
Long-term deferred service revenue
Totalliabilities
Commitments andcontingencies
Redeemable common stock andcapital in excess of $.01 parvalue;
shares issued andoutstanding: 4 and 5, respectively
Preferred stock andcapital inexcess of $.01 parvalue:
shares issued andoutstanding: none
Common stock and capital inexcess of $.01 parvalue;
shares authorized 7,000; shares issued: 3,320and3,307,
respectively; shares outstanding: 2,060and 2,226, respectively
Treasury stock at cost: 785and606shares, respeCiively
Retained earnings
Accumulated othercomprehensive loss
Totalstockholders'equity
Totalliabilities and stockholders'equity
February 2, 2007
7,764
208
5,961
1,732
1,180
3,035
19,880
2,668
1,560
407
1,648
780
9,546
752
4,622
1,530
660
2,829
19,939
2,409
2,147
323
110
45
~
$, 27,561
~
$ 25,635
225
11,492
4,323
2,486
18,526
2,774
2,070
23,732
188
10,430
5,141
2,032
17,791
569
2,189
647
21,196
94
111
10,589
(25,037)
18,199
10,107
(21,033)
15,282
--.Jlf;1
~I
3,735
$ 27,561
$ 25,635
362
4,328
134 Part
Accrual Accounting: Examples
One Financial Stmcmen~ and VallllHion
FIGURE 4.2
The Articulationof
the Financial
Statementsthrough
the Recording of
Cash Flows and
Accrualsbetween
Time 0 andTime 1
Beginning Stocks
c::==~>
====>
Flows [I
EndingStocks
Here aresome examples of accrual accounting andtheway itaffects the income statement andthebalance sheet:
Cash"F1ow
-Statemant-c-Year L.' .
EndingBalance
Sheet-Year 0
Cosho
+ Other assets o
Total assetso
- LiabililleSo
Owner'sequityo
4.8
Accrual Item
Effect on
IncomeStatement
Effect on
Balance Sheet
Booking a sale before cash isreceived

Booking rent expense before paying cash
Paying rent inadvance
Booking wages expense before paying cash
Booking thecost of pensions
Paying wages inadvance
Purchasing inventories
Selling inventories
Purchasing plant andequipment
Increase in revenue
Increase inrentexpense
No effect
Increase inwages expense
Increase pension wages expense
No effect
No effect
Increase incost of goods sold
No effect
Recognizing depreciation ofplant

Recognizing interest duebutnotpaid
Recognizing taxes due to the government
Recognizing taxes thatultimately will
bepaid on reported income butwhich
arenotyetdueto thegovernment
Increase indepreciation expense

Increase interest expense
Increase intaxexpense
Increase taxexpense
Increase inaccounts receivable

Increase inrent payable
Increase inprepaid expenses
Increase inwages payable
Increase pension liability
Increase inprepaid expenses
Increase ininventories
Decrease in inventories
Increase inproperty, plant, and
equipment (PPE)
Decrease inPPE
Increase interest payable
Increase intaxes payable
Increase deferred taxes
IncomeStatement- .
Year!
Summary
Cashfrom operations
+Accruals
Netincome
(1)Netcashflowsfrom allactivities increases cashin thebalance sheet.

(2) Cash from operations plusaccruals increases netincome andshareholders equity.
(3) Cash investments increase otherassets.
(4) Cashfrom debtfinancing increases liabilities.
(5) Cash from equityfinancing increases shareholders' equity.
(6) Accruals increase net income, shareholders' equity, assets, andliabilities.
resultof accrual accounting are measured at the amount of cashinvestment in the assets
(referred to as historical cost) plus the accruals made to effect matching in the income
statement. Historical cost accountingrefers to the practice of recording investments at
theircashcostandthenadding accruals. Historical costis notthevalue of an investment;
it's the cost incurred to generate value. Accruals are value added (orlost)overcashfrom
operations from selling products. But theyare accounting measures of value added that
maynot be perfect. And, more important, they are onlyvalue thathas beenadded to operations to date. Thevalue of investments is basedon value to be added in operations in the
future. Thuswe expect the value of equityto be different from its bookvalue. We expect
shares to be worth a premium or discount over bookvalue. GAM historical costaccounting,through impairment rules,requires assets to be written down iftheirvalue isjudgedto
be below theirbookvaluebutdoesnotpermit mostbusiness assets to be written up above
historical cost. We therefore expect premiums typically to be positive, which, of course,
they are.
A valuation model isa tool forthinking about thevalue creation ina business and translating
thatthinking intoa valuation. Thischapter introduced thedividend discount model andthe
discounted cash flow model. These models forecast cashflows. Thedividend discount model
focuses on thecashflow distributions to shareholders (dividends); thediscounted cashflow
model focuses on theinvesting andoperating activities ofthefirm, where value isgenerated.
Thechapter demonstrated, however, thatdividends andcashflows from investing andoperating activities, summarized infreecashflow, aredoubtful measures ofvalue added. Indeed,
as a value-added measure, free cashflow is perverse. Firms reduce freecashflows byinvesting, whereas investment ismade togenerate value. Thus veryprofitable firms with investment
opportunities, likeGeneral Electric, generate negative free cash flow. Finns increase free cash
flow by liquidating investments. So wepreferred to call free cash flow a liquidation concept
rather than a value-added concept and, indoing, socalled intoquestion theidea offorecasting
free cashflows tovalue firms. We recognized, ofcourse, thatforecasting free cashflows forthe
long runcaptures value. Butthatgoesagainst ourcriterion of working with relatively short
forecast horizons andavoiding speculative valuations with large continuing values. Forecastingwhere GEwill bein2030 isnotaneasytask. Buttheproblem isprimarily a conceptual one
aswell asa practical one: Freecashflow is nota measure ofvalue added.
How might wedealwith theproblems of cashflow valuation? Thechapter outlined the
principles of accrual accounting that determine earnings (in the income statement) and
book values (in the balance sheet). It showed that accrual accounting measures earnings
in a way that, in principle at least, corrects for deficiencies in free cashflow as a measure
of value added. Under accrual accounting, investments arenotdeducted from revenues (as
with freecashflow), but rather theyare put inthe balance sheet as an asset, to bematched
as expenses against revenues at the appropriate time. Additionally, accrual accounting recognizes accruals-noncash value-as part of value added. Accordingly, accrual accountingproduces a number, earnings, thatmeasures thevalue received from customers lessthe
value given up inwinning therevenues, thatis, value added in operations.
135
136 Part One FilUlnda/ Sralemems and ValualiDll
Find the following on the Web page supplement for this

chapter:
Further examples of discounted cash flow valuation.
Further discussion of the problems with DCF valuation.
Further demonstration of the difference between cash
andaccrual accounting.
Chapter 4 Cash ACCOlmring. A"nwr ACCDlIlllillg. am! Discollmcd GltSh Flow Va/Italian 137
Adiscussion ofthe question: Is cash king?

Adiscussion of the statement: Cash valuation models
and accrual valuation models must yield the same
valuation.
The cash flow statement under IFRS.
Analysis Tools
Dividend discount model

(equations 4.1 and 4.2)
116
Dividend growth model
(equation 4.4 and Box 4.1) 117
Discounted cashflow model
(equations 4.5, 4.6)
119
Six stepsfor DCF valuation
121
Simple valuation
(equation 4.9)
123
equation (4.10)
125
equation (4.11)
126
Accounting relations equations
Earninqs (C- i) +
Accruals (4.12)
130
Earnings == (C- f) - i
+ I + Accruals (4.13)
130
Analysts forecast earnings ratherthancashflows, and-c-as wenowsee-s-for verygood

reasons. The next twochapters develop valuation methods basedon forecasts of earnings
andbookvalues. Thatis, theyarebasedon forecasted income statements andbalance sheets
ratherthanforecasted cash flow statements. We willsee that thesemethods typically yield
valuations with less reliance on long-term continuing values. The investor is thus more
assured, for he or she isputtingmoreweight on"whatweknow" ratherthanspeculation.
There is one further subtle point to be gleaned from this chapter. A valuation model
provides the architecture forvaluation. A valuation model specifies whataspect of the firm's
activities is to be forecasted, and we haveconcluded that it is the investing and operating
activities. Buta valuation modelalsospecifies howthoseactivities areto be measured. This
chapterinvestigated cashaccounting for investing and operating activities, butit alsoraised
thepossibility of using accrual accounting (which wewilldo inthe nexttwochapters). Here
is the subtlepoint:A valuation model notonlytellsyouhowto thinkaboutthe valuegenerationin the future, but it alsotellsyouhowto account forthe valuegeneration. A valuation
modelis really a modelofproformaaccountingfor thefuture. Should youaccount for the
future in terms of dividends? Should youaccount for the future in termsof cashflows? Or
shouldyou use accrual accounting forthe future? You see, then,that accounting and valuationare verymuchalike. Valuation is a matter of accounting for value.
Accordingly one can think of goodaccounting and bad accounting for valuation. This
chapterhas suggested thataccrual accounting mightbe betterthancashaccounting. But is
accrual accounting as specified by U.S. GAAP (or u.K. accounting, German accounting,
Japanese accounting, or international accounting standards) goodaccounting forvaluation?
Wemustproceed with a critical eyetoward accounting prescribed by regulators.
accrual is a noncash valueflow recorded

in the financial statements. Seealso
income statement accrual and balance
sheet accrual. 127
annuitythe annual amount inaconstant
stream ofpayoffs. 117
continuingvalueis thevaluecalculated at a
forecast horizon thatcaptures value added
afterthe horizon. 120
dividendconundrum reters to the following
puzzle: The value of a share isbasedon
expected dividends butforecasting
dividends (overfinite horizons) doesnot
yield thevalueof the share. 118
historical cost accountingmeasures

investments at theircashcostandadjusts
the cost withaccruals. 134
matching principle is the accounting
principle that recognizes expenses when
the revenue forwhichtheyare incurred
is recognized. 128
perpetuity is a periodic payoffthat
continues without end. 117
terminal value is whatan investment
is expected to be worthin the future
when it terminates or when it maybe
liquidated. 116
KeyMeasures
Accruals
After-tax net interest payments
Cash flow ininvesting activities
Continuing value
Discounted cashflow
Free cash flow
Free cash flow growth rate
levered cashflow from
operations
Netdebt
(Unlevered) cashflow from
operations
Value of a perpetuity
Value of a perpetuity
with growth

127
125
119
119
120
118
119
120
126
119
C cashflow from operations

CV continuing value
OCf discounted (ashflow
ebitda earnings before interest.
amortization
cash flow forinvestments in
operations
NPV net present value
PPE property, plant, and
equipment
126
117
117

A Self-Study Exercise
THE CASH FLOW STATEMENT
-;~
Key Concepts
Page
You examined Kimberly-Clark's cash flow statement in the continuing case for
Chapter 2. Nowgo backto thatstatement(in Exhibit2.2) and recalculate "cash provided
by operations" for 2002-2004 on an unlevered basis.The firm's combined federal and
state tax rate is 35.6%. Also recalculate cashused for investing appropriately to identify
actual investment in operations. Finally, calculatefree cash flow for each year. The following, supplied in footnote 17 (Supplemental Data) in the 10-K, will help you with
thesecalculations:
YearEndedDecember 31
Other CashFlowData
Interest paid
Income taxes paid
Interest Expense
Gross interest cast
Capitalized interest on major construction projects
Interest expense
2004
2003
2002
$175.3
368.7
$178.1
410.4
$183.3
621.4
$169.0
$180.3
(12.5)
$167.8
..J1..U
~)
$162.5
$192.9
$181.9
Chapter4 Cash Accoumillg. Accrnel Accoun(ing, <llld DiscOllmed Cash Flow Valualion 139
138
Part One
Financial $t<l(rol~ms
and Valua(ion
Drill Exercises
Exercises
Cash Flows and Accruals
E4.1.
A Discounted Cash FlowValuation (Easy)
Identify the amount of accruals that are reported in the cash flow statement. Then reconcile your calculations of free cash flow for 2002-2004 to net income,following the
accounting relation 4.13. Look at the accrualitems in the cash flow statementfor 2004
and identifywhichassets these affect on the balancesheet. Whichitemson the balance
sheet are affected by the items listed in the investment section of the cash flow
statement?
At the end of 2009,you forecast the following cashflows (in millions) for a firm withnet
debtof$759 million;
Discounted Cash Flow Valuation
You forecast thatfreecashflow willgrowat a rateof4%peryearafter2012. Usea required

return of 10% in answering the following questions.
Suppose you were valuing KMB at the end of 200I and that you received the free cash
flows that youjust calculated as forecasts for2002-2004. Attempt to value the equitywith
a DCFvaluation. Identify aspects of the valuation aboutwhichyouare particularly uncertain. Kimberly-Clark had 521 million sharesoutstanding at the end of 2001 and had net
debtof$3,798 million.
Forthesecalculations, use a required return for the firmof 8.5%. Kimberly-Clark has a
betaof about0.8for itsbusiness risk,so itsrequired returnis quitelowundera CAPMcalculation. Withthe lu-yearU.S. treasury noterateof4.5% at the timeand a riskpremium of
5%, the CAPM gives you a 8.5% required return for operations. (Confirm that you can
make this calculation.)
Supposenowthatyouwishto valuetheequity at the end of2004, butyou haveno forecastsfor2005andonward. Construct a simplemodel basedon capitalizing 2004cashflows
for doingthis.You willhaveto estimate a growth rateand might do so by reference to the
cashflows or anyotherdatafor 2002-2004. Do youthinkthat the 2004freecashflow is a
goodbase on which to establish a DCF valuation?

Cash investment
2010
2011
2012
$1.450
$1.576
1.124
$1,718
1,020
1.200
a. Calculate the firm's enterprise valueat the end of2009.

b. Calculate the valueofthe equity at the end of2009.
E4.2.
A SimpleDCF Valuation(Easy)
At the end of2009, youforecast thata firm'sfreecashflow for2010willbe $430 million.
If youforecast thatfreecashflow willgrowat 5%peryearthereafter, whatisthe enterprise
value? Usea required returnof 10%.
E4.3.
Valuationwith NegativeFree Cash Flows (Medium)

At the end of 2008, you forecast the following cash flows for a firm for 2009-2012
(in millions of dollars):

Cash investments
2009
2010
730
673
1,023
932
2011
2012
1,234
1.352
1,592
1,745
E4.4.
Concept
Questions
C4.1. Investors receive dividends as payoffs for investing in equity shares. Thus the
value of a shareshould be calculated by discounting expected dividends. True or
false?
C4.2. Some analysts trumpet the saying "Cash is King." They mean that cash is the
primaryfundamental that the equityanalyst shouldfocuson. Is cashking?
C4.3. Shoulda firmthathas higherfree cashflows havea highervalue?
C4.4. After years of negative free cash flow, General Electric reported a positive
free cash flow of $7,386 million in 2003. Look back at GE's cash flows displayed in Exhibit 4.2. Would you interpret the 2003 free cash flow as good
news?
C4.5. Whichof the following two measures gives a betterindication of the valueadded
from selling inventory; (a) cash received from customers minus cash paid for
inventory, or (b) accrual revenue minuscostof goodssold?Why?
C4.6. Whatexplains the difference between cashflow from operations andearnings?
C4.7. Whatexplains the difference between freecashflow and earnings?
C4.8. Whyis an investment in a Tbill notan investment in operations?
C4.9. Explainthe difference between levered cashflow and unlevered cashflow.
C4.10. Why must the interest component of cash flow or earnings be calculated on an
after-tax basis?
Net income
Accruals innet income
Cash ininvesting activities:
Purchase of property andplant
Purchase ofshort-term investments
Sale of short-term investments
$2,198
3.072
5.270
$2.203
4.761
(5471
6,417
The firm madeinterestpayments of$I,342 million and received $876in interest receipts
fromT-bills thatit held.Thetax rateis 35 percent.
Calculate freecashflow.
Applications
E4.S.
Calculating Cash Flow from Operations and Cash Investment

for Coca-Cola (Easy)
The Coca-Cola Company reported "Net cash provided by operating activities" of $7,150
million in its 2007 cash flow statement. It also reported interest paid of $405 million and
interest income of $236 million. Cokehas a 36% tax rate.What was the company's cash
flow fromoperations for 200n
Chapter 4 Cash Acwuming. AccrunJ Accmmring, and DiscoulHed Cash flowValuation 141
140 PartOne Financial Seuemenu and Valuation
Coca-Cola Company alsoreported "Netcashusedin investing activities" of$6,719million in its 2007 cash flow statement. As part of this number, it reported "Purchases of
investments" (ininterest-bearing securities) of$99 million and"Proceeds from disposal of
investments" of $448million. Whatcashdid it spendon investments in operations? What
wasCoca-Cola's freecashflow for20077
E4.6.
IdentifyingAccruals for Coca-Cole (Easy)

The Coca-Cola Company reported "Net cash provided by operating activities" of $7,150
million in its 2007cash flow statement. Cokealso reported $5,981 million in net income
for theperiod. Howmuchof net income wasin the form of accruals?
E4.7.
Converting Forecastsof FreeCash Flowto a Valuation:

Coca-Cola Company(Medium)
Afterreviewing the discounted cashflow valuation of Coca-Cola in Exhibit 4.1, consider
thefree cashflows belowthatwere reported byCokefor2004-2007. Theyarebasedon the
actual reported cash flows but areadjusted for interest andinvestments in interest-bearing
securities {inmillions of dollars}.
Cash flow fromoperations

Cash investments
Free cash flow
2004
2005
2006
2007
$5,929
618
16,421
$5,969
17,258
1,496
2,258
3,711
7,068
5.311
4,925
190
a. Freecashflow generated in 2004.

b. The accrual component of2004 netincome.
Follow the Continuing Casefor Kimberly-Clark. See also Exercises E6.14, E7.8, ElO.1O,
andE11.6andMinicase M5J.
E4,9, A Discounted Cash FlowValuation: General Mills, Inc. (Medium)
At thebeginning of its fiscal year2006, an analyst made the following forecast for General
Mills, Inc.,theconsumer foods company, for 2006-2009 (in millions of dollars):

Cash investment in operations
2006
2007
2008
2009
12,014
300
$2,057
380
12,095
442
12,107
470
General Millsreported $6,192 million in short-term andlong-term debtat theendof 2005

butvery littlein interest-bearing debtassets. Usea required rerumof9% to calculate both
the enterprise valueandequity valuefor General Mills at thebeginning of2006 undertwo
forecasts for long-run cashflows:
a. Freecashflow willremain at 2009levels after2009.
b. Freecashflow willgrowat 3 percent peryearafter2009.
Pretend thatyouaresittingatthebeginning of2004,tryingto value Coke,giventhese numbersas forecasts. What difficulties would you encounter in trying to valuethe firm at the
beginning of2004?Whatdoyoumake of thedeclining freecashflows overthefouryears?
General Mills had 369 million sharesoutstanding at the end of 2005, trading at $47 per
share. Calculate value pershareand a value-to-price ratiounderbothscenarios.
SeeExercises E1.5, E2.9, E3.9,E6.8,EIO.9, E13.15, EI4.8, andEI5.10.
Othermateria! on Coca-Cola can be found in Exhibit 4.1 andMinicase M4.1 in thischapter, Minicase M5.2in Chapter 5, Minicase M6.2in Chapter 6, andExercises E11.7,E12.7,
EI4.9, EI5.l2, EI6.7, andEI9.4.
E4.8.
The fum has a combined federal andstatetax rateof35.6 percent. Calculate:
Cash Flowand Earnings: Kimberly-Clark Corporation (Easy)

Kimberly-Clark Corporation (KMB) manufactures and markets consumer paperproducts
underbrand names that include Kleenex, Scott, Cottonnelle, Viva, Kotex, andWypAll. For
fiscal year2004, the firm reported thefollowing numbers (in millions):
Netincome (in income statement)
Cash flow from operations (in cash flow statement)
Interest paid(in footnote to cash flow statement)
Interest income (from income statement)
11,800.2
2,969.6
175.3
17.9
Thecash investment section ofthe2004 cashstatement was reported asfollows (inmillions):

InvestingActivities:
Capital spending
Investments in marketable debtsecurities
Proceeds from sales of investments in marketable debt securities
Net increase in time deposits
Proceeds from disposition of property
Otheroperating investments
Cash used for investing activities
1(535.0)
(11.5)
38.0
(22.91
30.7
5.3
$(495.4)
E4,10. FreeCash Flowfor General Motors (Medium)

Forthefirstninemonths of2005, General Motors Corporation reported thefollowing in its
cashflow statement. GMruns an automobile operation supported by a financing arm, and
bothactivities are reflected in thesestatements.
CondensedConsolidated Statements
of CashFlows (unaudited)
Nine Months Ended

September 30
2005
2004
(dollars inmillions)

Cash flows from investing activities:
Expenditures forproperty
Investments in marketable seccntes-ecculslucns
Investments in marketable securities-liquidations
Net originations and purchases of mortgage servicing rights
Increase in finance receivables
Proceeds from sales of finance receivables
Operating leases-acquisitions
Operating leases-liquidations
Investments incompanies, netof cash acquired
Other
Net cash (used in) investingactivities
3,676
$12,108
(5,048)
(14,473)
(4,762)
16,091
10.095
(1,151)
11,089)
(9,503)
(15,843)
27.802
(12,372)
5,029
(31,731)
16,811
1,367
(1,643)
(85)
808
(179)
$(24,209)
(10,522)
5,831
142 Part One Financial Statements and VahlO.Mn

Chapter 4 Cash Accounnng, Accrual Acco:<ming, and Discollllled Cash Flow Vahuuion 143
Netinterest paidduring the2005 periodwas$4,059 million, compared with$3,010 million
in thecorresponding 2004 period. General Motors' taxrateis 36%.
An analyst made a calculation of free cash flow from these numbers as follows
(inmillions):
- - - - - - -2005
- - -2004
Free cash flow
$3,676
(179)
$3,497

SeeMinicase M5.2 inChapter 5, Minicase 6.2inChapter 6,andExercise E9.8 inChapter 9
formore on PepsiCo.
E4.13.
E4.14.
E4.11.
1988 1989 1990 1991
Cash from operations 536

Cash investments
627
Free cash flow
~)
Net income
628
EP5
0.28
828
968
894
541
74
287
837 1,076
0.37 0.48
1992
1993
1994
1995
1996
1,422 1,553 1,540 2,573 3,410 2,993

1,526 2,150 3,506 4,486 3,792 3,332
(382) (339)
~) (597) (1,966) (1,913)
1,291 1,608 1,995 2,333 2,681 2,740
0.57 0.70
0.87
1.02
1.17 1.19
Thecashflows areunievered cashflows.

a. Why would sucha profitable firm have suchnegative freecashflows?
b. Whatexplains the difference between Wal-Mart's cashflows andearnings?
c. Isthisa good firm to apply discounted cashflow analysis to?
E4.12 Accruals and Investmentsfor PepsiCo (Easy)

PepsiCo, the beverage andfoodconglomerate, reported net income of $4,212 million for
2004 and $5,054 million in (levered) cash flow from operations. How much of the net
income reported was accruals?
PepsiCo reported thefollowing in the investment section of its cashflow statement for
2004:
Capital spending
Sales of property, plant, andequipment
Acquisitions andinvestments inaffiliates
Divestitures
Short-term investments, by maturity:
More thanthree months purchases
More thanthree months maturities
Three months or less, net
Net cash used forinvesting activities
How much didPepsiCo invest in operations during 20041
(1,387)
38
(64)
52
(44)
38
(963)
(2,330)
Accrual Accounting Relations (Medium)

a. A firm reported $405 million in revenue andanincrease innetreceivables of$32 million. What wasthecashgenerated by the revenues?
b. A firm reported wages expense of$335 million andcashpaidforwages of$290 million. What wasthechange inwages payable fortheperiod?
c. A firm reported netproperty, plant, andequipment (PPE) of$873 million at thebeginningof the yearand$923 million at theendof the year. Depreciation on thePPEwas
$131 million fortheyear. There were no disposals of PPE. How much new investment
inPPEwasthereduring theyear?
$12,108
(24,209)
$(12,101)
An Examination of Revenues: Microsoft (Medium)

Microsoft Corp. reported $36.835 billion in revenues for fiscal year 2004. Accounts
receivable, netof allowances, increased from $5.196 billion in 2003 to $5.890 billion.
Microsoft has been criticized for underreporting revenue. Revenue from software
licensed to computer manufacturers is not recognized in the income statement until the
manufacturer sellsthecomputers. Other revenues arerecognized over contract periods with
customers. As a result, Microsoft reported a liability, unearned revenue, of $6.514 billion
in 2004, down from $7.225 billion in 2003.
What wasthecashgenerated from revenues in 2004?

SeeExercises E1.6, E6.13, E7.7, E8.10, E1O.lI,EI7.1O, andE19.4, and Minicases M8.1,
andM12.2 forrelated material on Microsoft.
Chapter 4 Cash Accounring, Accnu:l Acco:mling, andDisCOunted Cd Flow Vall/alion 145
144 Part One Fina.l1cia! Seuemenn aM Va!uarion
Minicases
If you usedthese cashflows for yourforecasts, whatdifficulties would you encounter in

tryingto value theCoca-Cola Company at thebeginning of2004?What doyoumake ofthe
declining freecashflows overthe fouryears?
M4.1
Discounted Cash Flow Valuation: Coca-Cola

Company and Home Depot Inc.
TheCoca-Cola Company andHome Depot have beenveryprofitable companies, typically
trading athighmultiples ofearnings, bookvalues, andsales. Thiscaseasksyoutovalue the
two companies using discounted cash flow analysis, and to appreciate the difficulties
involved. Exhibit 4.1 in the text provide a guide. Butalso keep in mind the lesson from
Exhibit 4.2.
Coca-Cola, established in thenineteenth century, isa manufacturer anddistributor ofnonalcoholic beverages, syrups, andjuices under recognized brand names. It operates in nearly
200countries around theworld. Atthebeginning of 1999, Coke traded at$67pershare, with
a PIE of 47,a price-to-book ratio of19.7,anda price-to-sales ratio of8.8 on annual salesof
$18.8 billion. With 2,465 million shares outstanding, themarket capitalization of the equity
was $165.2 billion, putting it among thetop20U.S. firms inmarket capitalization.
Home Depot is a newer company, butit basexpanded rapidly, building outlets forhome
improvement and gardening products throughout the United States, Canada, Mexico, and
Argentina. Bythe endof itsfiscal year ending January 1999, Home Depotoperated nearly
900stores as wellas a number of design centers, adding storesat a rateof about250a year
to become thesecondbiggest retailer in the United States afterWal-Mart. It traded at $83
pershareinJanuary 1999, with a PIE ratio53,a price-to-book ratioof 10.7,anda price-tosalesratioof 4.1 on annual salesof $30.2 billion. With 1,475 million shares outstanding,
the market capitalization of the equity was $122.4 billion, putting it also among the top
20U.S. firms in market capitalization.
Exhibits 4.6 and 4.7 provide partial statements of cash flow for Coca-Cola and Home
Depot forthreeyears, 1999~2001, along withSome additional information (Home Depot's
fiscal year, likemostretailers, ends inJanuary).
Suppose thatyouwere observing thesefirms' stock prices at thebeginning of 1999 and
were trying to evaluate whether 10 buytheshares. Suppose, further, thatyouhadtheactual
cashflow statements forthenext three years (asgiven in theexhibits), soyouknew forsure
whatthe cashflows were going to be.
A. Calculate freecashflows for the twocompanies forthe three years using the informationgiven in thestatements below.
B. Attempt to value the shares of Coca-Cola and Home Depot at the beginning of 1999.
Usea costof capital of 9 percent for bothfirms.

See Minicases M5.2 and M6.2 on Coca-Cola. Exercises E4.5, E4.6, E4.7, Ell.7, EI2.7,
EI4.9, E15.12, E16.7, and E19.4 deal with Coca-Cola, and Exercises E5.12, E9.1O,
Ell.lO, EI2.9, andEI4.IJ deal with Home Depot
EXHIBIT 4,6
Operating and
Investing Cash Flows

as Reported for the
THE COCA-COLA COMPANY ANO SUBSIDIARIES

ConsolidatedStatements of CashFlows
(lnmillions}
Coca-ColaCompany,
1999-2001.
Year EndedDecember 31,
Operating Activities
Netincome
Equity income or loss, netof dividends
Foreign currency adjustments
Gains on issuances of stock byequity investees
Gains on sales of assets, including bottling interests
Other operating charges
Other items
Netchangeinoperating assets andliabilities
Net cash providedby operating activities
InvestingActivities
Acquisitions andinvestments, principally trademarks
and bottling companies
Purchases of investments andotherassets
Proceeds from disposals of investments andotherassets
Purchases of property. plant. and equipment
Proceeds from disposals of property. plant, andequipment
Other investing activities
Netcash used in investingactivities
As you have only three years of forecasts to deal with, your valuations will be only
approximations. List the problems you run into and discuss the uncertainties you have
about the valuations. Forwhich finn doyoufeelmostinsecure in yourvaluation?
Now skipforward to the beginning of 2004. Below are the free cashflows reported by
Coke for 2004-2007 (in millions of dollars). Theyare based on the actual reported cash
flows butare adjusted forinterest andinvestments ininterest-bearing securities.
Cashflowfromoperations
Cashinvestments
Free cashflow
2004
2005
2006
2007
\5,929
\6,421
1,495
$4,925
$5,969
$7,258
7.068
$ 190
~
$5.311
2,258
$3,711
Other information:
Interest paid
Interest income
Borrowings at the endof 1998:
Investment indebtsecurities at the
end of 1998:
Statutory taxrete:
2001
2000
1999
$3.969
$2,177
77J
3
380
196
$2,431
792
97
803
56
(54)
(60)
(91)
(85)
34
(462)
(127)
916
119
(852)
292
(41)
(49)
799
119
(557)
4,110
3,585
3,883
(651)
(456)
455
(769)
91
141
(397)
190
(733)
45
138
(1,876)
(518)
176
(1,069)
45
(179)
(1,188)
(1.165)
(3.421)
304
315
458
345
160
$4,990 million
$3,563 million
36%
(SOB)
199
146 Part One FiMncial SWt<mtellts and Vailltltian
EXHIBIT 4.7
Operatingand
Investing Cash Flows
as Reportedby Home
HOME DEPOT INC.

ConsolidatedStatements of Cash Flows
(amounts in millions)
Depot, Inc.,
Fiscal YearEnded
2000-2002.
Cash Flowsfrom Operations;

Net earnings
Seccncletonof netearnings to netcash provided by
operations
Depredation andamortization
Increase in receivables, net
Increase in merchandise inventories
Increase inaccounts payable andaccrued liabilities
Increase inincome taxes payable
Other
February 3,
January 28,
January 30,
2002
2001
2000
$3,044
52,581
764
(i19)
(166)
2,078
Net cash provided by operations

CashFlowsfrom Investing Activities:
Capital expenditures, netof $5, $16, and $37 of noncash
capital expenditures infiscal 2002, 2001, and 2000,
respectively
Payments for business acquired, net
Proceeds from saleof business, net
Proceeds from sales of property andequipment
Purchases ofinvestments
Proceeds from saleof investments
Other
601
(46)
463
(85)
(1,075)
(1,142)
820
272
90
754
151
30
5,963
2,996
2,446
(3,393)
(3,558)
(2,581)
(190)
(26)
(101)
64
126
(85)
25
(13)
87
(32)
30
(25)
(2,622)
(3,466)
(3,530)
Other information:
Interest paid, netofinterest capitalized
Interest income
Borrowings at the endoffiscal 1999:
Investment indebtsecurities at the
endof fiscal 1999:
Statutory taxrate:
18
53
$1,580million
16
47
$81 million
93
(23)
95
(39)
30
(32)
Net cash used in investing activities
39%
$2,320
26
37
Chapter 5 Acmw! AccOlmting and Vall/llrion: Pricing Book Values 149

What "residual earnings" is.
How forecasting residual earnings gives the premium
over book value andthe PIB ratio.
How residual earnings aredriven byreturn oncommon
equity (ROCE) andgrolNth inbook value.
The difference between a Case 1, 2, and 3 valuation.
How the residual earnings model captures value added
ina strategy.
The advantages and disadvantages of using the residual earnings model and how it contrasts to dividend
discounting anddiscounted cash flow analysis.
How residual earnings valuation protects the investor
from paying toomuch forearnings added by investment.
How residual earnings valuation protects the investor
from paying for earnings thatarecreated byaccounting methods.
How residual earnings valuation follows the dictum of
separating "what weknow" from speculation.
How the residual earnings model isapplied in reverse
engineering.
How the residual earnings model can be used to understand the market's earnings expectations.
Chapter 4 showed how

accrual accounting modifies
cashaccounting to produce
a balance sheetthatreports
However, Chapter 2
alsoexplained thatthe
bookvaluein the
balance sheetdoesnot
measure thevalueof
shareholders' equity,
so firms typically trade
at price-to-book ratios
different from l.0.
This chapter
Thischaptershowshowto
estimate thevalueomitted
fromthebalance sheetand
thushowto estimate
intrinsic price-to-bock
ratios.
Howis a firm
valued by
forecasting
income
statements
andbalance
sheets?
Howare
strategies
evaluated?
Howdocs
theanalyst
inferthe
market's
forecast
of
futureearnings?
Link to nextchapter
Chapter 6 complements
thischapter. While
Chapter 5 showshowto
pricethebookvalueof
equity, the"boucmline"
of thebalance sheet,
Chapter 6 showshowto
priceearnings, the
"bottom line"of the
income statement.
Link to Webpage
Goto theWebpage
supplement formore
applications of the
techniques Inthischapter.
Finns typically trade at a price that differs from book value. Chapter2 explained why:
While some assets and liabilities are markedto market in the balance sheet, othersare
recorded at historical cost, and yet others are excluded from the balancesheet. Consequently, the analystis left with the task of estimating the value that is omittedfrom the
balancesheet.The analystobserves the bookvalueof shareholders' equityand thenasks
howmuchvaluemustbe addedto markthe bookvalueto intrinsic value: Whatis the premium over book valueat which a shareshouldtrade? Chapter3 showed that asset-based
valuation methods typically do notwork. How, then,doesthe analystproceed?
Thischapterlaysouta valuation model forcalculating the premium and intrinsic value.
It also models strategy analysis as well as providing directions for analyzing firms to
discover the sources of value creation. And, for the active investor, it provides tools to
challenge the marketprice.

Calculate residual earnings.
Calculate the value of equities and strategies from
forecasts ofearnings andbook value.
Calculate anintrinsic price-to-book ratio.
Calculate value added ina strategy.
Calculate continuing values.
Calculate target prices.
Convert ananalyst's earnings forecast into a valuation.
Calculate an implied growth rate in residual earnings
from themarket price ofa stock.
Break down a valuation into itsbuilding blocks.
Reverse engineer the residual earnings model to infer
the market's earnings forecasts.
Identify thespeculative component ofa valuation.
Apply tools to challenge the market price.
THE CONCEPT BEHIND THE PRICE-TO-BOOK RATIO

Bookvalue represents shareholders' investment in thefirm. Bookvalueis alsoassetsminus
liabilities, that is, net assets. But, as Chapter 2 explained, book value typically does not
measure the value of the shareholders' investment. The value of the shareholders'
investment-and thevalueof the net assets-is basedon howmuchthe investment (netassets) is expected to earn in the future. Therein liesthe conceptof the PIBratio: Bookvalue
is worthmoreor less, depending upon the future earnings that the net assetsare likelyto
generate. Accordingly, the intrinsic PIB ratiois determined by the expected returnon book
value.
Thisconceptfitswithourideathatshareholders buyearnings. Price,in the numerator of
the PIB ratio, is basedon the expectedfuture earnings that investors are buying. So, the
higher the expected earnings relative to book value, the higherthe PIB ratio. The rateof
return on bookvalue-sometimes referred to as the profitability-is thus a measure that
features strongly in the determination ofPIB ratios.
This chaptersupplies the forma! valuation model to implement this concept of the PIB
ratio,as well as the mechanics to applythe model faithfully. The formality is important, for
formality forces one to be careful. In evaluating PIB ratios,one must proceed formally
because one canpaytoomuchfor earnings ifone is not careful.
Chapter 5 ACCnla1 Acco~~nting andVall/arion: Pricing Book ValU~5 151

150 Part One Fina.ndal Slatemcnt; IM'1d Va1ualiD;;
Bewareof Paying Too Much for Earnings

A basic precept of investing is that investments add value only if they earn above their
required return. Firmsmayinvest heavily-in an acquisition spree,for exampl~but that
investment, whileproducing more earnings, addsvalueonly if it delivers earnings above
the required returnon the investment. If a finn paysfair valuefor an acquisition or other
investments, it mayearnonlythe required return, andthus notaddvalue. Indeed, a fum can
increase earnings through investments evenif those investments yieldlessthan therequired
return (and thus lose value). This maxim refines the PIB concept: The PIB ratio prices
expected returnon bookvalue,but it does not pricea return that is equalto the required
returnon bookvalue.
Theanalysis in thischapteris designed to prevent youfrommaking themistake of paying too muchfor earnings. As you apply the model and methods in this chapter, you will
see that PIBratiosincrease onlyif earnings yielda return thatis greaterthan the required
return on book value. Indeed, with the tools in this chapter, you can assess whether the
marketis overpaying (or underpaying) forearnings andso detectcaseswherethe PIB ratio
is too highor toolow. You willbe ableto identify thespeculative component of the market
pricethat youcan challenge to makethis assessment.
PROTOTYPE VALUATIONS
Fundamental analysis anchors valuation in thefinancial statements. Bookvalueprovides an
anchor. The investor anchors his valuation withthe valuethat is recognized in the balance
sheet-the bookvalue-and thenproceeds to assessvaluethatis not recognized-the premiumoverbookvalue:
Value e Bookvalue+ Premium
Two prototypes introduce youto themethods.
Valuing a Project
Suppose a fum invested 400 in a projectthat is expected to generate revenue of $440 a
year later. Thinkof it as buyinginventory and sellingit a yearlater. Aftersubtracting the
$400 cost of the inventory from the revenue, earnings are expected to be 40, yielding a
rateof returnof 10 percent on the investment. The required rateof returnfor the projectis
10 percent Following historical cost accounting, the asset (inventory) would be recorded
on thebalancesheetat 400.Howmuchvaluedoesthisprojectaddto thebookvalue? The
answer, of course, is zero because the asset is expected to earn a rateof return equalto its
costof capital. Andthe projectwouldbe worth its bookvalue.
A measure thatcaptures the valueaddedto bookvalueis residual earnings Or residual
income.Forthe oneperiodfor thisproject(where the investment is at time0),
Residual earnings] ::: Earnings] ~ (Required returnx Investments)
Forearnings of $40,residual earnings is calculated as
Residual eamingse $40- (0.10x $400):::SO
Iftheproject were to generate revenues ofS448andsoearn$48,a rateof return of 12percent
onthe investment of$400,residua! earnings would be calculated as
Residual eamingse $48- (0.10x S400)::: S8
The required dollar earnings for this project is 0.10 x $400::: $40. Residual earnings is
the earnings in excess of theserequired dollar earnings. If the projectearns $40,residual
earnings is zero; if the project earns $48, residual earnings is $8. Residual earnings is
sometimes referredto as abnormal earnings or excess profit.
A model that measures value added from forecasts of residual earnings is called the
residual earnings model:
Value> Bookvalue+ Presentvalueof expected residual earnings
The one-period projectwithan expected rateof return of 10 percent earnsa residual eamingsof zero.So the valueof the projectis
$0
Value =$400 + -
J.IO
=$400
This project is worth its historical cost recorded on the balance sheet; there is no value
added. If the project were expected to earn at a 12 percent rate, that is, earn residual
earnings of $8,
$8
Value = $400 +-
J.IO
= $407.27
In thiscasetheproject isworth more than itshistorical-cost bookvalue because it isanticipated

to generate positive residual earnings; there is value added, a premium overbook value.
Theresidual earnings valuefora terminal project isalways thesameas thatcalculated with
discounted cashflow methods. Forthe project yielding $448in sales, the DCFvaluation is:
$448
Value (DeF) = = $407.27

1.10
Valuing a Savings Account

Howmuchis a simplesavings account worth? Well, surelyit is worth its bookvalue-the
balance on the bank statement-because that is the amount you would get out of the accountif you cashed it in.The bookvalueis the liquidation value. But it is also the goingCOncern valueof the account.
Exhibit 5.1 lays out forecasts of book values, earnings, dividends (withdrawals), and
free cash flows for 2009~2013 for a $100 investment in a savings account at the end of
2008,undertwoscenarios. In the first scenario, earnings arepaidouteachyearsothatbook
valuedoesnot change. The required return for thissavings account is 5 percent-that is,
theopportunity costof therateavailable at anotherbankacross thestreetinan account with
thesamerisk.So, forecasted residual earnings foreachyearis $5 - (0.05x $100)::: $0.As
thisassetis expected toyieldnoresidualearnings, itsvalueis equal to its bookvaluc, $100.
In the secondscenario in Exhibit 5.1, no withdrawals are taken fromthe account. As a
result, both earnings and book values grow as earnings are reinvested in the bookvalues
to earnwithinthe account (numbers are rounded to twodecimal places). Butresidual earningsis still zero for eachyear.For2009,residual earnings is $5 - (0.05x $100)::: $0; for
2010, residual earnings is $5.25 - (0.05 x $105) ::: SO; for 20J1, residual earnings is
S5.5125 - (0.05x $110.25) = SO, andso on. In an years, the rateof return onbookvalueis
equalto the required return. As expected residual earnings are zero,the valueof this asset
at the end of2008 is itsbookvalue, $100.
Note that in Scenario I, forecasted dividends and free cash flows are $5 eachyear. In
Scenario 2, where cash is reinvested in the account, forecasted dividends and free cash
flows are zero.Yet the two scenarios havethesamevalue.
152 Part One FiMrlcial S!llIcments andValuation

EXHIBIT 5.1
Forecasts for a
Savings Accountwith
$100Invested at the
End on008, Earning
5% per Year.
Chapter 5
Forecast Year
2008
2009
2010
2011
2012
2013
AC(T~a! Accounting and Val!tation:
Pricing Book Vahle; 153
Therequired rerum is sometimes referred to as the normal return forthe level of riskin
the investment. Accordingly, as an investment with a PIB of 1.0 earns a normal return,a
PIB of 1.0 is sometimes referredto as a normal PIB ratio.
Scenario 1: Earnings withdrawn each year(fuffpayout)

Earnings
Dividends
Book value
$100
Residual earnings
Free cash flows
$ 5
5
100
$ 5
5
100
$ 5
5
100
0
5
0
5
0
5
$ 5.25
0
110.25
$ 5.51
0
115.76
0
0
0
0
5
5
100
5
5
100
0
5
0
5
5.79
0
121.55
$ 6.08
0
127.63
0
0
0
0
Scenario 2: No withdrawals (zero payout)

Earnings
Dividends
Book value
Residual earnings
Free cash flows
s5
$100
0
105
0
0
These examples from thesavings account bring outsome important principles thatalso
apply to the valuation of equities:
L An asset is worth a premium or discount to its book value only if the book value is
expected toearn nonzero residual earnings.
2. Residual earnings techniques recognize thatearnings growth doesnot add valueif that
growth comes from investments earning the required return. In the second scenario,
there is more earnings growth than in the first scenario, but that growth comes from
reinvesting earnings in book values to earn at the required return of 5 percent. After
charging earnings forthe required returnon the investment, thereis no addition to residual earnings, eventhough thereis growth in earnings. Accordingly, the valueof the asset
is the sameforthe case withno earnings growth.
3. Eventhough an asset does not pay dividends, it can be valued fromits bookvalueand
earnings forecasts. Forecasting zerodividends in thesecond scenario will notwork, but
wehavebeenable to valueit from earnings andbookvalues.
4. The valuation of the savings account does not depend on dividend payout. The two
scenarios have different expected dividends, but thesamevalue: The valuation basedon
bookvaluesand earnings is insensitive to payout. This is desirable if, indeed, dividends
are irrelevant to value,as discussed in Chapter 3.
5. The valuation of the savings account is unrelated to freecashflows. The twoscenarios
have different free cash flows but the same value. Even though the account for
Scenario 2 cannot be valued by forecasting free cash flows over fiveyears-they are
zero--it can be valued from its bookvalue.
The Normal Price-to-Book Ratio

Thevalueof thesavings account is equalto its bookvalue. That is, the price-to-book ratio
is equalto 1.0.A PIB ratioof 1.0is an important benchmark case, for it is the case where
the balance sheetprovides the complete valuation. It is alsothe case where the forecasted
returnonbookvalueis equalto therequired rateof return,andforecasted residual earnings
is zero-c-as withboththe savings account and the projectearninga 10 percentreturn.
A MODEL FOR ANCHORING VALUE ON BOOK VALUE

The prototypes showus how to valueassets by anchoring on their book value and then
adding extra value by forecasting future residual earnings. The anchoring principle is
clear:
Anchoring principle: If one forecasts that an asset will earn a return on itsbookvalue equal
to its required return, it mustbe worth itsbookvalue.
Correspondingly, if oneforecasts thatan assetwillearna returnon bookvaluegreaterthan

its required return-positive residual earnings-it must be worthmore than book value;
there is extravalueto be added. The valuation modelthat captures the extravaluefor the
equityfor a going-concern is
E
RE\ RE2 REJ
Value ofcommon equity (flo)::::: Bo +-+-'-+-j+...
PE
PE
PE
(5.1)
whereRE is residual earnings for equity:

Residual eamingse Comprehensive earnings - (Required returnfor equity
x Beginning-of-period bookvalue)
RE/=Earn,-(PE-l)B1_1
Bo is the currentbook valueof equityon the balance sheet,and the residual earnings for
eachperiod in the futureis the comprehensive earnings available to common equity for the
period less a charge against the earnings for the book value of common equity at the
beginning of theperiod, Bt _ 1, earningat the required return,pc-I. Thisrequired returnfor
equityis alsocalledthe equitycostof capital,
Wesaw in Chapter 2 that Dell, Inc.,reported $2,988mil1ion of comprehensive income
in 2008on bookvalue(assetsminusliabilities) at the beginning of the yearof$4,328 million.If Dell'sshareholders requirea 10percentreturn,then its 2002residual earnings was
$2,988- (0.10x 4,328) = $2,555.2 million. Delladded$2,555.2 million in earnings overa
10 percent returnon the shareholders' investment in bookvalue.
Wecalculate the valueof equitybyadding the present valueof forecasted residual earningsto the currentbookvaluein thebalancesheet.Theforecasted residual earnings are discounted to presentvalueat I plus the equitycost of capital, PE. Wecalculate the intrinsic
premium overbookvalue, ~ - Bo, as the present valueof forecasted residual income. This
premium is the missing value in the balance sheet. The intrinsic price-to-book ratio is
VijiBo. This makessense:Ifwe expecta firm to earn income forshareholders overthat requiredon the bookvalueof equity (a positive RE), its equitywill be worthmorethan its
book valueand should sell at a premium. And the higher the earnings relative to book
value, the higherwillbe the premium.
Table 5.1shows thatpremiums (or PIB ratios) forecast subsequent residual earnings. This
tablegroups allNYSEandAMEXfirms intoone of 20 groups basedon their PIB ratio. The
first group (Levell) includes the firms with the highest 5 percent of rIB ratios, while the
154 Part One FilUln,1al $t(l(el7lems and ValUlition
TABLE 5.1
Price-to-Book Ratios
and Subsequent
ResidualEarnings,
1965--1995.
High-PIB fums yield
highresidua! earnings,
onaverage, and
tow-PfB firms yield
lowresidual earnings.
Residual earnings for
PIB ratioscloseto La
(inLevels 14and15)
arecloseto zero.
Sou",.: Coml'3ny: Sland.,d &
Poor"5 Compusl3t"" d.1ta.
Residual Earnings Each Yearafter P!SGroupsAre Formed (Year 0)

PIS level
PIS
1 (high)
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20 (low)
6.68
3.98
3.10
2.59
2.26
2.01
1.81
1.65
1.51
1.39
1.30
1.21
1.12
1.05
0.97
0.89
0.80
0.70
0.58
0.42
0.181
0.134
0.109
0.090
0.076
0.066
0.057
0.042
0.043
0.031
0.024
0.026
0.016
0.009
0.006
-0.007
-0.017
-0.031
-0.052
-0.090
0.230
0.155
0.113
0.089
0.077
0.067
0.048
0.039
0.034
0.031
0.026
0.028
0.021
0.008
0.005
-0.011
-0.018
0.030
-0.054
-0.075
0.223
0.144
0.106
0.077
0.069
0.059
0.043
0.029
0.031
0.028
0.023
0.023
0.012
0.009
0.011
-0.004
-0.004
-0.030
-0.039
-0.066
0.221
0.154
0.101
0.093
0.068
0.057
0.052
0.039
0.038
0.036
0.035
0.036
0.031
0.026
0.018
0.008
0.006
-0.010
-0.015
-0.037
0.226
0.154
0.120
0.100
0.079
0.076
0.052
0.050
0.046
0.047
0.036
0.039
0.039
0.034
0.031
0.029
0.023
0.015
-0.003
-0.020
0.236
0.139
0.096
0.099
0.071
0.073
0.057
0.044
0.031
0.028
0.030
0.038
0.026
0.032
0.017
0.015
0.008
-0.001
-0.008
-0.039
bottom group (Level 20)includes those with the lowest 5 percentThemedian PIB forLevell
is 6.68, while thatfor Level 20 is 0.42,as indicated in the PIB column of thetable. Thetable
givesthe median RE for eachlevel forthe yearthat firms are grouped (Year 0) and for the
subsequent five years. The RE is standardized by bookvalue in Year O. You can see that the
REentries inYears I to 5 arerelated to the PIB ratios inYear 0: High~PIB firms payhighRE,
onaverage, while 10w~P/B firms paylowRE. Levels 14and15have PIB closeto 1.0inYear 0
(a zero premium) and, correspondingly, their RE payoffs are close to zero. Price-to-book
ratios higher than 1.0yieldpositive REand lowPIB ratios yieldnegative RE. In short, the
datafor actual firms behave just as themodel says.'
The forecasting to infinity that is required for the going-concern model(5.1) is a cballenge. The criteriafor a practical valuation technique presented in Chapter3 require finite
forecast horizons. If, as we forecasted further intothe future, the presentvalues of the RE
were to become very small, we could stop forecasting RE at some point. But if not, a
finite-horizon forecasting model wouldbe needed for goingconcerns. Forthe mathematically inclined, Box 5.1 formally develops a model for forecasts over finite horizons and
shows that it captures the returns to investing in stocks. For a forecast over a r-penod
horizon,
(5.2)
1 The same required return forequity of 10percent isused forailfirms in the table. But using a CAPM
cost of capital (and thus adjusting firms' required returns fortheir betas) gives similar patterns.
Wesaw in Chapter 3 that value isdetermined bydiscounting

expected payoffs to present value. For an equity investment,
thepayoffs are thestream of dividends plustheprice at which
the investment isliquidated. The dividend discount model in
Chapter 4 applies thisnotion quiteliterally:
Value of equity = Present value of expected dividends to
time T+ Present value of expected
terminal value at T
d1 = Earn, - (81 - 801. by the stocks and flows accounting

relation. So, substituting for dividends in thepayoff,
P:
Eaml-(B,-Bo)+P,
p,
= Bo+Eam,+P\-B1
We saw, however, that this model is not very practical. The

residual earnings model isa practical model thatpreserves the
concept that value isbased on expected dividends (including
the liquidating price). Howdo we get from the dividend discounting to theresidual earnings model?
Payoffs come over many periods but, to start simply, let's
deal first with the one-period payoff to equity. The efficient
equity price is the present value of the payoff that comes in
theform of a dividend and a terminal price, So Po = (dJ + P1)JPE,
where Po is thecurrent price, PJ is the price oneyear ahead,
d1 isthe dividend payoff oneyear ahead, andPE is 1 plusthe
required rate of return on equity. The expected dividend
component of the payoff isequal to forecasted comprehensive earnings minus the forecast change in book value;
P,
p.
= 8 + Earn\-(p,-l)Bo + P,-B1
PI
P,
The amount forecasted in thesecond term, Earn, - (PE - 1)80,

isthe residua! earnings for equity for thecoming year.
The model says thatwegettheefficient price byforecasting
nextyear's residual income and thepremium at theendof the
year. taking theirpresent value, andadding the current book
value in the balance sheet. We can extend the formula to
longer forecast horizons by substituting comprehensive earnings andbook values for dividends ineach future period. For a
forecast for T periods,
r.:e,
RE, RE, RE]

RE r
Po""Bo+- +""l"" +3 +''' +r +- ,PE P, Pf
Pf
Po
Efficient prices are equal to intrinsic values, sowe can express

the model with intrinsic values rather thanefficient prices. See
model 5.2in thetext.
vf-
where
Bris the forecast of the intrinsic premium at the forecast horizon. So thismodel
saysthat for forecasting 1,2,5, or 10yearsahead, weneed three things (in addition to the
equitycostof capital) to valuethe equity:
I. The currentbookvalue.
2. Forecasts of residual earnings to a chosen forecast horizon.
3. The forecasted premium at the horizon.
The equity cost of capitalis givenby a beta technology such as the capitalasset pricing
model(CAPM). Combining these threecomponents of the valuewiththe cost of capital
according to the residual earnings formula accomplishes Step 4 of the fundamental
analysis. Currentbookvalueis of coursein the currentbalancesheet,leaving us withthe
task of forecasting residual earningsand the horizon premium. We also need to choosea
forecast horizon. The horizon premium-s-the stock's expected value relative to book
value T periods from now-c-appears to be a particularchallenge. Indeed, the model appears circular: To determine the current premium, we need to calculate a premium expected in the future. The calculation of this premium is the problem of a continuing
value at the horizon. The section in this chapter titled Applying the Model to Equities
deals with this problem.
155
156
PartOne
Financial Sw(cmerH$ and Vai1la(ion
The residual earnings model always yields the same value that we would get from
forecasting dividends overan infinite forecasting horizon. This is important to appreciate,
so that you can feel secureabout the valuation, becauseshare value is basedon the dividends that the share is ultimately expected to pay. Box 5.1 derives the residual earnings
model merely by substituting earnings and book values for dividends. That substitution
means that we are really forecasting dividends; however, Vie get an appreciation of the
ultimate dividends that a firm will pay using forecasts of earnings and book values over
forecast horizons that are typically shorter than those required for dividend discounting
methods. The savings account example makes this abundantly clear. In a zero-payout
case where dividends mightnot be paid out for 50 years (say),we wouldhaveto forecast
dividends very far into the future. But using a residual earnings method, the valuation is
immediate-it is givenby the current bookvalue.
Residual Earnings Drivers and Value Creation

Residual earnings is the return on common equity, expressed as a dollar excess return
ratherthan a ratio. Foreveryearningsperiod I, wecan restateresidual earnings as
Residual earnings = (ROCE- Required returnon equity)
x Bookvalueof commonequity
Earn, - (PE -I)BH
(5.3)
[ROCE, - (PE -l)JB'-1

(I)
(2)
where ROCEt = Eam/Bt _ 1 is the rate of return on common equity. Box 5.2 takes you
throughthe calculation of ROCE. Thus residual earningscompares ROCE to the required
return, PE - I, and expresses the difference as a dollar amountby multiplying it by the
beginning-of-period book value. Dell's (comprehensive) ROCEfor 2008 was 69.04 percent (fromBox 5.2). Ifits requiredreturnon equity(the equitycostof capital)was 10percent, then its residual earningswas (0.6904 - 0.10) x $4,328 = $2,555.2 million, which is
the same number as we got before (adjusted for rounding error). If ROCE equals the
requiredreturn, RE will be zero. If we forecast that the finn will earn an ROCEequal to
its cost of capita! indefinitely in the future, intrinsicprice will be equal to book value. If
we forecastthat ROCEwill be greaterthan the cost of capital, the equity shouldsell at a
premium.If we forecast that ROCEwill be Jess than the cost of capital,the equityshould
sell at a discount.
RE is determined by two components, (1) and (2) in expression 5.3.The first is ROCE
and the second is the amount of the book value of the equity investment (assets minus
liabilities, or net assets) that are put in place in each period.These two components are
calledresidual earnings drivers. Finns increase their valueoverbookvalueby increasing
their ROCEabove the cost of capital. But they further increasetheir valueby growth in
book value (net assets) that will earn at this ROCE. For a givenROCE (greaterthan the
cost of capital), a firm will add more valuewith more investments earningat that ROCE.
Indeed these two drivers are sometimes referred to as value drivers. Determining the
premium or discount at whicha share shouldsell involves forecasting these two drivers.
Figure5.1 depicts howforecasts of thetwodrivers, alongwiththecurrentbookvalue,yield
current value.Muchof our analysis to uncover the valuein a firm will involve uncovering
the features of the business that determine thesedrivers. You also see howthis model can
be a strategy analysis tool:Increase valuebyadoptingstrategies thatincrease ROCEabove
the requiredreturn and growbook values (net assets) that can earn at an ROCE above the
required return.
Return on common equity, ROCE, iscomprehensive earnings

to common earned during a period relative to the book value
of netassets put In place at the beginning ofthe period. For
period 1,
not matter much. But forlonger periods, like a full fiscal year,
it might. SoROCE fora year isoften calculated as
ROCE
EO
1
Comprehensive earningsl
)f (81 + 80)
ROCEI = Comprehensive earnings to commonl

Book value(l
The denominator isthe average of beginning andending

book value fortheyear. This calculation isapproximate. More
Comprehensive earnings to common areafterpreferred divi- strictly, the denominator should be a weighted average of
dends andthebook value is(of course} thebook value ofcom- book values during the year. Significant errors will occur only
mon shareholders' equity. Sometimes this measure isreferred if there are large share issues or stock repurchases near the
to asreturn onequity (ROE}, butwewill use ROCE to beclear beginning or endofa year.
The calculation canbedoneon a per-share basis:
thatitisthereturn to common shareholders whose shares we
are pricing. The ROCE isalso referred to as a book rate of retum or an accounting rote of retum to distinguish itfrom the
ROCE EO~
1
BPS(l
rate of return earned inthe market from holding the shares.
Comprehensive income forDell, Inc., for2008 was$2,988
million, andthebook value ofcommon shareholders' equity at
the beginning of the year was $4,328 million. SoDell's ROCE
for2008 was $2,988/$4,328 = 69.04%. This isvery high. But
of course, most of Dell's assets-customer relationship, brand,
supply chain-are notonits balance sheet, buttheearnings from
those assets are coming through comprehensive income. The
high ROCE explains why Dell traded atsuch a high P/B of11.0.
Earnings are earned throughout the period and will
change with changes in book values through share issues,
stock repurchases, ordividends. But book value ismeasured at
a point In time. For short periods, like a fiscal quarter, thisdoes
(with EPS based oncomprehensive income). BPS isbook value

of common equity divided by shares outstanding (and shares
outstanding isissued shares minus shares intreasury). The EPS
areweighted down forshare issues and repurchases during
theyear bytheweighted-average calculation. So this calculation keeps the numerator anddenominator onthesame pershare basis.
The three calculations typically give different answers but
the difference is usually small. It is, however, dangerous to
compare ROCE over time with calculations based on pershare amounts because share issues and repurchases affect
EPS andBPS differently. SeeChapter 13.
Below are selected firms ranked by their PIB ratios at the end of their2003 fiscal years,
alongwiththe ROCE theyearned in 2004 andtheirbookvalue growth rates for2004.
TheGap, Inc.
General Electric Co.
Verizon Communications, Inc.
Citigroup, Inc.
Home Depot, Inc.
Genera! Motors Corp.
Federated Department Stores
PIS in 2003
ROCE in 2004
4.23
28.1%
4.16
22.3%
23.4%
17.4%
3.32
2.79
2.62
1.19
0.92
19-2%
11.1%
12.0%
Growth Rate for

Book Value in 2004
30.7%
39.3%
12.2%
11.5%
13.2%
9.7%
3.1%
You can see that PIB is related to subsequent ROCE and growth in book value. General
Motors andFederated Department Storeshavea PIB closeto 1.0 andcorrespondingly earned
an ROCE of ! 1-12 percent, roughly considered typical for a required return on equity. The
2004residual earnings for thesefirms wereroughly zero,appropriate fora normal PIB ratio
157
Chapter 5 An:ruol Accounting and Vall/Ilrion: Pricing Book Values 159

158 Part One Finaru::ial S!alements andValuation
FIGURE 5.1 TheDrivers ofResidual Earnings andtheCalculation oftheValue ofEquity

Residual earnings isdriven byreturn oncommon equity (ROCE) and thebook value ofinvestments putinplace. Valuation
involves forecasting future RQCE andthegrowth inthebook values ofnetassets, discounting theresidua! income that they
produce topresent value, and adding thecurrent book value.
FIGURE 5.2
Price-toBook Ratios
forS&P 500 Firms
andSubsequent
Return on Common
ROCEon P/B Ratio
L:~
0.8
Equity(RaCE).
The figure plots RQCE

0.6
R
in2002 onprice-to8
0.4
book ratios (PIB) atthe
w
end of2001. The line
c 0.2
through thedots isthe 0~
regression line for the
0
relationship between
-0.2
RaCEandP/R RaCE
ispositively related to
-0.4
PIE.
"
'.
.'
12
14
.~
10
; ..,
-0.6
Souroc SWldud & Pool'S

COMPUSTA~ data.
.,
Price-to-book ratio(2001)
Futurebookvalues are forecasted usingthe stocksand flows equation of Chapter 2:

Ending bookvalue = Beginning bookvalue + Comprehensive income - Netdividend
No shareissues or repurchases are expected for this finn, so the dividend forecasted equals
thenetdividend. Theexpected bookvalue at the endof Year 1, in millions, is $103 = S100 +
12.36 - 9.36, and so for subsequent years. Residual earnings forYear 1 is $12.36 - (0.10 x
100) = $2.36 million, and so for subsequent years. You can see that forecasted residual
earnings is growing at a 3 percent rateperyearafterYear 1,so a simple valuation capitalizes
the residual earnings forecasted forYear 1as a perpetuity withgrowth:
Vl=Bo+~
PE - g
of 1.0. Theotherfirms haveconsiderably higherPIB and, correspondingly, higherRQCE and

growth rate in bookvalue. Notice alsothat,while somefinns hada lower ROCE thananother
fum witha higherPIB onthe list, theformer hadhigher growth in bookvalue to compensate.
Compare General Electric andVerizon, forexample.
A few firms do not givethe full story, of course, so lookat Figure 5.2.Thisfigure plots
2002 RaCE for the S&P 500 firms on their PIB at the end of 2001. The regression line
through the plots shows that PIB forecasts subsequent RaCE. The plot is typical of most
years. Of course, manyfirms do not fall on the regression lineand it is thetaskof financial
analysis to explain why. Is it growth in bookvalue, the second driver?
For a historical picture of RaCE and bookvalue growth, Figure 5.3 plotspercentiles of
RaCE overtheyears 1963-2003 fortheS&P500 firms. Themedian RaCE overall years is
13.7 percent, but there is considerable variation. Accordingly, therehas been considerable
variation in PIB ratios, as indicated in Figure 2.2 in Chapter 2. The median RaCE for all
NYSEandAMEXlistedstocks since1963 was 12.5 percent. Theaverage RaCE fortheS&P
500overthe30 yearsto 2009 (based on a market-value weighting of stocks in the index) has
been18percent.
A Simple Demonstration and a Simple Valuation Model

Exhibit 5.2presents forecasts of comprehensive earnings anddividends overfive years for a
finn with $100 million in bookvalueattheendofthecurrent year, Year O. Therequired equity
return is 10percent andwemustvalue the equity at timeO.
FIGURE 5.3
Percentiles ofROCE
forS&P 501) Firms,
0.5
1....-piO
. .t-p25
....... Median
- ...._ p75
,90
0.4
1963-2003.
The median ROCE

over allyears is
0.3
13.7 percent.
So=: Standard &!'ooI's

COMPUSTA"J'l' &13.
e,
0.2
.:L
~
~
0.1
0
..... .
"
,: \.
.........
,.'
+-....
e ".............. ~-..., ..............- ....'::1.-
'+-
~~-.t~_
,
....... 11.'oi:'
,k....
~ . . . . . .""
,-L . . . . . . .
. ............'1.'"' ................ -....1!! \...-.-....-,{
'
lI:
......
'--
\
.' ' . "-
'.
..
,".,
'l
40.........
,
"
, ,
I ,, ,,
,?
k'
-'
.'
.....
~yr\
(
,,
',l ~''''.''
,
..
"
-0.1
'
,
-0.2
/'
160 Part One Financial Statements andValuation
Chapter5 Ac=J Accounting andValualian: Pricing Book Values 161
EXHIBIT 5.2
Forecasts for a
Forecast Year
Simple Firm
In millions of dollars.
Required return is
10%.
Earnings
Dividends
Book value
RE (10% charge)
RE growth rate
12.00
9.09
100.00
12.36
9.36
103.00
2.36
12.73
9.64
106.09
2.43
13.11
9.93
109.27
2.50
13.51
10.23
112.55
2.58
13.91
10.53
115.93
2.66
3%
3%
3%
3%
Withg e 1.03 and PE:::: 1.10, thevaluation is
Vl : : $100+
$2.36 _ $133.71 million

1.10-1.03
The intrinsic price-to-book ratio (pIE) is $133.71/S100 :::: 1.34. This is a simple valuation
model ofthetypeintroduced in Chapter 4: Growth at a constant ratebegins aftertheforward
year. The forecast horizon is veryshort, just oneyearahead.
The RE model gives thesamevaluation thatwould resultfrom forecasting dividends indefinitely intothefuture. Thatis,if wethink of equity valueasbasedonthedividends thata
fum is ultimately expected to pay(in the verylongrun), theRE model gives us thisvalue.
Indeed, theexample hasbeenconstructed to demonstrate thispoint. Dividends areexpected
to growat 3 percent peryear in thisexample, so
9.36
1.10-1.03
133.71 million
This is a stylizedcase in which the dividend discount model works because the payout is
tied directly to earnings with a fixed payout ratio,andgrowth in dividends is the sameas
growth in residual earnings. As wesawin Chapter 4, thisis notusually thecase, asthesavings account with zero payout makes abundantly clear. However, the accrual accounting
model supplies an answer.
APPLYING THE MODEL TO EQUITIES

Hereare thestepsto follow for a residual earnings valuation:
1. Identify thebookvaluein the mostrecentbalance sheet.
2. Forecast earnings anddividends up to a forecast horizon.
3. Forecast future bookvalues fromcurrentbookvalues andyourforecasts of earnings and
dividends.
4. Calculate future residual earnings fromtheforecasts of earnings andbookvalues.
5. Discount the residual earnings to presentvalue.
6. Calculate a continuing valueat the forecast horizon.
7. Discount the continuing valueto presentvalue.
8. Add I, 5, and7.
Residual earnings can be calculated by themethod in equation 5.3,andFigure 5.1 depicts
theprocess withthat calculation.
Case I applies thesestepsto Flanigan's Enterprises, Inc.,a firm operating chainrestaurants and beverage stores. The firsttwolines givethefirm's basicearnings per share(BPS)
and dividends per share (DPS) for 2000 through 2003. Let's play the same game as in
Chapter 4 andpretend thatweareforecasting at the endof 1999 butknow forsurewhat the
SUbsequent earnings anddividends are goingto be. From forecasts of EPS and DPS wecan
compute successive book values pershare (BPS) by adding EPS to beginning-of-period BPS
andsubtracting DPS. Thisjust applies thestocks andflows accounting relation. SotheforecastofBPSfortheendof2001, forexample, is 4.76,as shown below thevaluation.
With a forecast ofEPSandBPSwecanforecast RE. TheCAPM costofcapital is9 percent,
so RE for2001 is 0.80- (0.09 x 4.20) = 0.422 or,calculating it from theforecasts ofROCE
andbookvalue, REis (0.1905 - 0.09) x 4.20:::: 0.422, asalsoshown below thevaluation?
Nowsuppose wewishedto valuethis firm at theendof 1999. Wewould takethepresent
value ofthe RE forecasts (thediscount factors are 1.09'),sumthem, andaddthesumto the
1999 bookvalue of$3.58per share. Thisgives us a valuation of$4.53pershare,as shown.
The calculated premium overbookvalueis 4.53- 3.58 = 0.95. Is our valuation correct?
Well, it wouldbe if we forecasted RE after2003 to be zero. You see the RE are declining
overtheyears toward zero.Although the bookvaluedriver ofRE is increasing, theROCE
driver is declining, and in 2003it is 9.0 percent, equal to the cost of capital. It looks as if
RE from 2003 andonward might be zero. If so, we have completed the valuation. We can
write it as
RE
RE
RE
PE
PE
PE
V:=BO+_1+~+----f
Casel
(5.4)
where, in this case,Year 0 is 1999 andYear T (three years ahead) is 2002.

Compare thiscalculation withmode15.2. The continuing premium is missing hereand
thismakes sense: IfRE afterthe forecast horizon is forecasted to be zero, thentheforecast
of thepremium at thatpointmustbe zero. Wehaveforecasted ri- Br = O.
TheForecast Horizon and the Continuing Value Calculation

Welabelthiscaseof a forecast of a zero premium at thehorizon as Case 1. Howtypical is
it? Well, let's return to General Electric (GE), the firm for which discounted cash flow
analysis failed in Chapter 4. Case2 displays thesamefive yearsasearlier, butnowtheEPS,
DPS, andBPSaregiven. Againpretending theseactual numbers arenumbers forecasted in
1999, forecasted REandROCE have been calculated We charge OEa 10percent cost for
usingequitycapital. The sumof thepresentvalues of the REup to 2004(3.27per share),
addedto the 1999 bookvalueof 4.32per share,yielda valuation of7.59 pershare.Butthis
is notcorrect because GEis earning a positive REin 2004andisprobably expected to earn
more in years after. GE has a declining ROCE driver, but its growth in book value more
thanoffsets thisto maintain its RE. The valuation of? .59pershareis missing thecontinuingvalue, the continuing premium in model 5.2.
Thecontinuing valueisthevalue ofresidual earnings beyond thehorizon. Lookat the seriesofRE forecasts for GE. You canseethatRE is fairly constant. Suppose weforecast that
REbeyond 2004is goingto be thesameas the0.882 in 2004: Thesubsequent REwillbea
perpetuity. The value of the perpetuity is the capitalized amount of the perpetuity:
0.882/0.10 = 8.82, as shown below thevaluation. Andas lhisis thevalue of expected REs
2In this andotherexamples wewill usethe approximate CAPM costofcapital. We will also assume that
the costofcapital isthesame forallfuture periods. This maynotbe realistic forthe equity costof capital
because itchanges with leverage, aswewill see. But wewill also see(in Chapter B) howvaluations can
be made with an accommodation forleverage.
Chapter5 AccrualAccounling andValuation' Pricing Book Value.! 163
162 Part One Financia! Sr.atements andValuation
CASE 1
Flanigan'sEnterprtses,Inc.
Required rateofretum
is 9 percent. In this
case, residual earnings
isexpected to bezero
after 2003.
after2004, it is also thevalue oftheexpected premium at theendof2004. Sowecanreplace

model 5.2with
Forecast Year
EPS
DPS
BPS
1999
2000
2001
2002
2003
0.80
0.24
4.76
0.71
3.58
0.73
0.11
4.20
5.22
0.47
0.27
5.42
20.4%
0.408
1.09
0.374
19.0%
14.9%
0.282
1.295
0.217
9.0%
0.000
1.412
0.000
ROCE
RE (9% charge)
Discount rate (1.09~
Present value of RE
Total present value of RE to 2003

Value per share
0.422
1.188
0.355
0.25
0.9S
4.53
How the forecasts are developed (for2001):
Forecasting BookValueper Share (BPS)
Forecasting Residual Earnings
Beginning BPS (a)
4.20
Forecasted EP$ (b)
0.80
Forecasted DPS
(0.24)
Ending BPS
4.76
Forecasted ROCE (bla)

Costof equity capital
19.05%
-9.00
Excess ROCE (c)

RE (ox c)
10.05%
0.422
Alternatively,
RE = 0.80 - (0.09 x 4.20)
0.422
Case2
where, in GE's case, T is five years ahead. So the 1999 valuation is 13.07 = 4.32 t 3.27t
8.82/1.6105. Thecalculated premium is 13.07 ~4.32 =8.75.TheREforecasts for2005 and
beyond supply the continuing value (CV) at the end of 2004 and this is the expected
premium in 2004: vf- B5 = 8.82.
We referto thecase of constant REaftertheforecast horizon as Case 2. Cases 1 and2
cover many of thecases youwillrunintoin practice.aYou might expect Case 1to be typical:A finn might earn a positive REfora while (ROCE greater thanthecostofcapital), but
eventually competition willdrive itsprofitability down so its ROCE will equal thecostof
capital. HighROCE dodecline, as illustrated by bothFlanigan's Enterprises andGE, butit
is more common forROCE andREto level offat a positive amount. Ifso, Case 2 applies.
Note that we are ableto value General Electric, eventhough its free cash flows are
negative. Byapplying accrual accounting, wehave dealtwiththeproblem thathaunted us
in Chapter 4. Exercise E5.13100ks at GEin 2004.
Case 3 is demonstrated with Dell, Inc., forthe fiscal years 2000 to 2005. After2002,
Dell's residua! earnings aregrowing, dueto fairly constant ROCE butgrowing bookvalues.
It is probably unreasonable to expect RE to beconstant or zero after2005. If the growth is
forecast to continue at a constant rate, thecontinuing value calculation can be modified:
RE'+_3..L
RE ... +__
RET+[RE
V.E=B t _RE' +__
-----ZL ) /pT
o
CASE 2
GeneralElectricCo.
Required rateof return
is 10percent.In this
case,residual earnings
is expected to be
constant, butnonzero,
after2004.
ROCE
RE (10% charge)
Discount rate (1.1 O~
Present value of RE
Continuing value (CV)
Present value of CV
Value pershare
2000
2001
2002
2003
2004
4.32
1.29
0.57
5.04
1.38
0.66
5.76
1.42
0.73
6.45
1.50
0.77
7.18
1.60
0.82
7.96
29.9%
0.858
27.4%
0.876
1.210
0.724
24.7%
0.844
1.331
0.634
23.3%
0.855
1.464
0.584
22.3%
0.882
1.100
PE
p~
P~'
p~
PE _ g
Case3
(5.6)
1.75+ 8.50 = 12.31.
1999
0.780
wheregis 1plustherate of'growth." Dell's RE growth ratein2005 is about 6.5percent (g =

1.065). If thisratewere expected to continue after2005, theforecasted REfor2006 would
be 0.605 x 1.065 = 0.644. Sothe continuing value is 14.32, and itspresent value at theend
of2000is 8.50, as indicated in thecasestudy. Thevalue at theendof2000 is vg = 2.06t
Forecast Year
EP5
DPS
BPS
(5.5)
1.611
0.548
3.27
8.82
Thislooks likea lowvaluation, forDelltraded at $58in 2000, asweobserved in Chapter I. We challenged theprice(andthe PIE ratioof'S? .9)at thattimeaslooking a littlehigh.
The $12.31 valuation, basedon whathappened to Dellfrom 2001 to 2005, doesnot look
unreasonable. Delltraded at $22 in 2006. Buying thestockat $12.31 in 2000would have
given youan 11 percent return onyourinvestment, therequired return usedin thecalculationhere. Exercise E5,11 looks at Dellin 2008.
Case 3, along with Cases I and 2, completes the set of cases we are likely to meet in
practice.' The long-term level ofRE and its growth rate are sometimes referred to as the
steady-state condition for the firm. The growth rate distinguishes Case 3 from Case 2
because Case 2 isjustthecaseofno growth (g= 1.0). Forthesake ofourexamples, wehave
extrapolated growth rates. The forecast growth rate up to the horizon gives information
The continuing value:

3 Forecasts of RE canbe negative and sofirms cantradeat a discount. Negative RE also canbe perpetual
but, more likely, it recovers to zeroora positive amount.
CV= 0.882 =882

0.10
.
Present value of continuing value "" 1~6~~5
Note: A11~ forrounding tmm.
growth ratehasto be less thanthe costofcapital orthe terminal value calculation "blows up. ~ It is
unreasonable to expect a firm's RE to growat a rategreater thanthe costofcapital indefinitely (andso
have an infinite price).
s Growth could be negative at a horizon (9 -c 1). This is typically a case ofa positive RE declining to zero.
4 The
"" 5-48
II
II
;
164 Part One Finandol Statements andVduarion
Chapter 5 Accrual Accounting and. Valuation: Pricing Book Values 165
CASE 3
Dell, Inc.
Required rateofreturn
is 11 percent. In this
case, residual earnings

is expected to growat
a 6.5 percentrateafter
2005.
Forecast Year
2000
2001
2002
2003
2004
2005
1.06
0.84
0.0
1.90
0.48
0.0
3.38
0.81
0.0
4.10
1.03
0.0
5.23
1.18
0.0
6.41
40.8%
0.613
1.110
0.553
16.6%
0.161
1.231
0.131
24.3%
0.448
1.368
0.318
24.5%
0.568
1.518
0.374
22.6%
0.605
1.685
0.359
EP5
DPS
BPS
ROCE
RE (11 % charge)
Discount rate o.ut)
Present value of RE
Continuing value (CY)
1.75
14.31
Present value of CV
Value pershare
The continuing value:
Cv 0.605 x 1.065 14.31
- 1.11 1.065
..
I
14.31 850
I
Present vaueor
continuing vaue= 1.685:= .
Note:Allow forrounding errors.
aboutthe long-term growth rate but it is unwise to extrapolate a rate in practice. It is even
worse to asswne a rate.Ratherwe shouldaskwhatthe information tellsus that the growth
rate will be.Thevaluation canbe quite sensitive to thisgrowth rate. If, forexample, wehad
specified a growth rateof 5 percentforDell, the continuing valuewould have been (0.60~ x
1.05)10.06:= 10.59, andthevaluation would have been10.09 ratherthan 12.31. Thefinancial
analysis of PartsTwo andThreeof thebookis designed to uncover thegrowth rate.
.
Noteonefurther point Wehaveproceeded as if weknow therequired return. In fact,this
is an element of uncertainty that wehavebuiltintothe valuation. Evenif webelieve in the
capital asset pricingmodel (CAPM), estimates of the required returnare.stillspeculative
(seethe appendix to Chapter 3).Wewillreturn to this issueat the endof this chapter; at the
moment we can turn onlyonedialat a time.
TargetPrices
Alongwith earnings forecasts and recommendations to buy,hold,or sell a stock, ana~ysts
also provide their clients with target prices. Target prices are forecasts of future pnces.
Residual earnings analysis readilysupplies thesetargetprices.
The continuing valueis theterminal premium,thatis, the expected difference between
thevalueand bookvalueat the forecast horizon. So targetpriceis bookvalueplus the continuingvaJue:Vf:= Br + eV r. So for Cases1,2, and 3, the targetpricesare:
Flanigan's Enterprises: Target price, Vf003 := B zDo3 := $5.41
Case 1
GeneralElectric: Target price, VfOO4 =B2OO4 + CV2004:= $7.96+ 8.82
Case 2
= $16.78
Dell,Inc.:Targetprice, vloos:= B 2005 + CV200S

=$6.41
+ 14.32=$20.73
Case 3
As these target pricesare those at which the investment might be sold at a future point
in time, they are terminal values (introduced in Chapter 3). Note, again, the difference
between a continuing valueanda terminal value.
There is one qualification to the designation of these forecasts as targetprices.The
calculations are expected values, not necessarily expectedprices.Theyare targetprices
if the analystexpectsprices to "gravitateto fundamentals" in the future. But, if the analyst expects prices to deviate from fundamental value-because of speculative fever
sweeping the market,for example-she may forecast a target price that differsfrom her
targetvalue.
Thisconsideration underscores an important pointin applying fundamental analysis to
stockvaluation. Whilean analyst mightconclude thata stockis currently undervalued, she
mightissue a buy recommendation in anticipation of the pricereverting to the target value
in the future. But a stockmighttake a longtimeto adjustto fundamental value. Indeed, in
theshortrun,it mightdeviate further away from its value. When Dell'sshares were trading
at $38in 1998, theylooked expensive bythecalculations wehavegonethrough here. AIl analystmighthaveconcluded thattheywereoverpriced andrecommended selling. Thatwould
havebeen a mistake in the short run for, as the bubble in technology stocks overtook the
market, Dell'sstockpriceincreased to$58byearly2000. Ofcourse, thebubble burst.A fundamental investor witha long-run perspective would have avoided the bursting of the bubble:By 2006, Dell was trading at $22. Fundamental tenet number 12 (in Chapter 1) says:
Sticktoyour beliefsandbepatient;pricesgravitate tofundamentals, butthatcantakesome
time.
The targetvaluescomputed here supplythe missing ingredient for dividend discount
analysis. Weobserved in Chapter 4 thatone candiscount dividends forecasted up to a forecast horizon, but the valuation is incomplete without a forecast of the terminal value. The
targetvalues above supply the terminal values. So theycomplete the dividend valuation.
But note we have adopted accrual accounting techniques to do so for, unlikedividends,
accrual accounting earnings and book values are related to the valuecreation. The Web
pagesupplement to this chapter elaborates.
Converting Analysts' Forecasts to a Valuation

Analysts typically forecast earnings for one or two years ahead and then forecast
intermediate-term growth ratesfor subsequent years, usually threeto five years. The forecastsfor oneand twoyearsaheadare somewhat reliable (butbuyerbewarel); however, analysts'intermediate-term forecasts are oftennotmuchmorethana guess.Inanycase,given
the forecasts, the investor asks: Howcan the forecasts be converted to a valuation?
Table 5.2 gives consensus analysts' forecasts for Nike, Inc., made after fiscal 2008
financial statements werepublished. A consensus forecast is an average of forecasts made
by sell-side analysts covering the stock.The forecasts for 2009-2010are point estimates,
and those for 2011-2013 are those implied by the analysts' five-year intermediate-term
EPSgrowth rateof 13percent peryear.Analysts typically do notforecast dividends, so one
usually assumes thatthe currentpayoutratio-DPSIEPS-will be maintained in the future.
Nikepaid$0.88persharein dividends during2008on EPSof$3.80, so itspayout ratiowas
23 percent. You cansee fromthe tablethat Nike'sresidual earnings, calculated fromtheanalysts'forecasts, are growing. Analysts do not forecast earnings for the verylongrun, but
if wewere to forecast thatREafter2009wereto growat a long-term rateequalto the typical rate of growth in Gross Domestic Product (GDP) of 4 percent, we would establish a
continuing value of $58.24, as indicated in the table. The value implied by the analysts'
forecasts is$62.56pershare.At the time,Nike'ssharestradedat $60eacb.So,onthesecalculations, Nikeis reasonably priced.
166 Part One Financial Statements and Valuation
TABLE 5.2 Converting Analysts'Forecasts to a Valuation: Nike,Inc.(NKE)

Analysts forecast EPS two years ahead ($3.90 for2009 and$4.45 for2010) andalsogivea fiveyearEPS growth rateof 13 percent. Forecasts for2011-2013 apply thisconsensus EPS growth rate
to the2010 estimate. Dividends pershare (DPS)aresetat the2008 payout rateof23 percent of
earnings. Required rateof return is 10percent. Years labeled A areactual numbers, years labeled E
are expectednumben.
EPS
DPS
BPS
ROCE
RE (10% charge)
Discount rate(1.1 O)t
Present value of RE
Total PV to 2013
Present value of CV
Value pershare
2008A
2009E
2010E
3.80
0.88
15.93
3.90
0.90
18.93
4.45
1.02
22.36
5.03
1.16
26.23
5.68
1.31
30.60
6.42
1.48
35.54
245%
2.307
1.100
2.097
23.5%
2.557
1.210
2.113
225%
2.794
1.331
2.099
21.7%
3.057
1.464
2.0BB
21.0%
3.360
1.611
2.0B6
2011E
2012E
3.360x 1.04
1.10-1.04
book value? Well, if the return that investors require to buy

the initial share issue isalso 9 percent-12 percent, thefirms
would be expected to generate Zero residual earnings from
theirbook values, andsoshould bepriced at book value.
John Hancock's initialpublic offering was on January 27,
2000, when it became John Hancock Financial Services, Inc.
The firm's ROCE was 12 percent. It issued 331.7 million
shares, 229.7 million to policyholders. These shares traded
at $171. per share, a little above book value of $15 per
share.
10.48
5B.24
36.15
62.56
Thecontinuing value based on GDP growthrate:
CV
A number of large insurance companies, including John

Hancock Mutual Life Insurance andMetropolitan Ufe Insurance, have converted from mutual companies owned bypolicyholders to companies owned byshareholders. The process of
"demutcalizstion" involves issuing shares to policyholders
and newinvestors in aninitial public offering.
When' these two firms demutualized, analysts conjectured
that they would be priced at bookvalue. They were earning
9 percent-tz percent return on equity and analysts did not
expect this rate of return to improve. Why might they trade at
20UE
5B.24
NOI~: Allow f<lrro""ding~mlrs.
In converting theanalyst's forecast to a valuation, wehaverunintosomedifficulties. So

thevaluation is tentative. Analysts' forecasts areusually onlyforthe immediate future. We
haveno idea of their forecasts for the long run (after2013 here), so we are left withthe
problem of supplying a continuing value at theirforecast horizon. ForNike, weapplied the
GDP growth rate.While thisis a reasonable benchmark, is it reasonable forNike? Wewill
comebackto thisissue at the endof thechapter. Now lookat Box5.3.
::;!
f
Thevalue of theproject is its bookvalue plus thepresent value of expected residual incomecalculated from the forecasts of net income andbookvalues. Thisvalue of$I,530 is
thesame as thediscounted cashflow valuation in Chapter 3.Theforecasts ofRE have captured thevalue added overthe costof the investment: Thepresent value of theforecasts of
REof$330 equals the NPV wecalculated inChapter 3.
Strategy involves a seriesof ongoing investments. Table 5.4evaluates a strategy which
(to keep it simple) requires investing $1,200 in the same project as before but in each
year indefinitely. The revenues are thosefrom all overlapping projects in existence in a
given year: The revenue inYear 1is $430fromtheproject beguninYear 0, therevenue in
Year 2 of $890is the secondyear's revenue ($460) from the project begun inYear 0 plus
the firstyear's revenue from theprojectbeguninYear I ($430), and so on. Depreciation
is thesameas before ($216 per yearfora project), so totaldepreciation is $216times the
number of projects operating at a time. By the fifth year intothe strategy thereare five
projects operating each year with a steadystreamof $1,980 in revenues and $1,080 in
depreciation. Book value at all points is accumulated net investment less accumulated
depreciation.
APPLYING THE MODEl TO PROJECTS AND STRATEGIES

TheRE method alsocanbe usedto value projects within the firm. At thebeginning of the
chapter wedemonstrated thisfora simple one-period project. Multipericd project evaluation
is typically done using NPV analysis (ofcashflows), as fortheproject inFigure 3.4inChapter3 thatrequired aninvestment ofS1,200. Table 5.3accounts forthatproject using accrual
accounting. The revenue is from the cashinflow butdepreciation has beendeducted to get
thenetincome from theprojectThedepreciation iscalculated using thestraight-line method,
thatis, by spreading costlessestimated salvage value (thedepreciation base) overthe five
years. Thebookvalue oftheproject eachyear is itsoriginal costminus accumulated depreciation. Andthisbookvalue follows thestocks andflows equation, similar to equities:
Bookvalue, = Bookva1uel_1 + Income.>- Cashflow,
Sothebookvalue inYear 1 is $1,200 + 214- 430 = $984, and so forsubsequent years. At
the end ofYear 5, thebookvalue is zeroas the assets in theproject aresoldfor estimated
salvage value. Thisis standard accrual accounting.
TABLE 5.3 Project Evaluation: Residual EarningsApproach

Hurdle rate: 12%.
Forecast Year
o
Revenues
Depreciation
Project income
Book value
Book rateof return
Residua! project income (0.12)
Discount rate(1.12 1}
PV of RE
Total PV of RE
Value of project
$430
216
$460
$460
$380
$250
-.lli
-.lli
-.lli
-.!M
-.lli
2i4
$1,200
330
$1,530
9B4
17.8%
70
1.120
62.5
244
768
24.8%
126
1.254
100.5
244
552
31.8%
152
1.405
10B.2
336
29.7%
98
1.574
62.3
0
10.1%
(6)
1.762
(3.4)
Value added = $330
167
168
Part One Financial Statements andValuation
TABLE 5.4 Strategy Evaluation

Hurdle rate: 12%.
ADVANTAGES
Focus onvalue drivers:
Forecast Year
6 ...
Residual Earnings Approach

$1,350
$1,730
$1,980
$1,980.
Revenues
$430
$890
1,080
1,080
Depreciation
..1!.
432
~
~
Strategy income
702
900.
.....1..B
458
~
~
Book value
$1,200 2,184
3,504
3,840
3,840
3,840.
2,952
Book rateof return
23.8%
24.7%
23.4%
17.8%
21.0%
23.4%
347.8
Residual strategy income (0.12)
439.2
70.0
195.9
4455
439.2.
249.3
PV of RE
625
156.2
2475
283.0
Tota! PV of RE
999
Continuing value'
3,660
PVorCV
Valueadded: $3,076
Value of strategy
Discounted Cash FlowApproach

Cash inflow
Investment
Free cashflow
PV of FeF
TotalPV of FCF
Continuing valuePVofCV
Value of strategy
$890
$430
$(1,200) (1,200) (1,200)
(310)
(1,200) (770)
-(687.5) (247.2)
20
$1,350
(1,200)
----;so
106.8
$1,730
(1,200)
530
336.7
$2,100
0,200)
900
$2,100.
(1,200) ..
900.
Focuses on profitability of investment and growth in investment, which drive value; directs strategic thinking to these drivers.
Incorporates thefinancial statements: Incorporates thevalue already recognized inthebalance sheet (the book value); forecasts
theincome statement and balance sheet rather than thecash flow statement
Uses accrual accounting:
Uses the properties of accrual accounting that recognize value added ahead of cash
flows, matches value added to value given up, and treats investment asanasset rather
than a loss ofvalue.
Forecast horizon:
Forecast horizons (an beshorter than forDCF analysis andmore value istypically recognized intheimmediate future. Forecasts uptothehorizon give anindication ofprofitability andgrowth for a continuing value calculation.
Versatility:
Can beused with a wide variety ofaccounting principles (Chapter 16).
Aligned with what people forecast:
Analysts forecast earnings (from which forecasts of residual earnings can becalculated).
Protection:
Protects from paying toomuch for growth.
DISADVANTAGES
Accounting complexity:
Suspect accounting:
Requires anunderstanding of how accrual accounting works.

Relies on accounting numbers, which canbe suspect (must be applied along with an
accounting quality analysis; Chapter 1h
510.7
7,500
Netpresent value: $3,076
'cv~ 439.210.12 ~.s3.6611.

'CV B90010.12 ~S7jOO
You see from thecalculations thatthestrategy adds$3,076 ofvalue totheinitial investment
of $1,200 if the required return is 12 percent, and this valueadded is the present valueof
expected residual income from theprojectYou alsoseefromthesecond panel thatthisvalue
added equals theNPVof thestrategy calculated using discounted cashflow analysis.
Many of the strategic planning products marketed by consulting firms-with such
namesas economic profitmodels, economic value-added models, valuedrivermodels, and
shareholder value-added models-are variations on the residual earnings model. Toguide
strategy analysis, they focus on the two drivers of residual income and of value added:
return on investment and growth in investment. They direct management to maximize
returnon investment and to growinvestments thatcan earna rateof returngreaterthanthe
required return. Thesevalue-added measures areused, in turn,to evaluate andreward management on thesuccess of theirstrategies.
FEATURES OF THE RESIDUAL EARNINGS MODEL

Box5.4liststhe advantages and disadvantages ofthe residual earnings approach. Compare
it to summaries for the dividend discount and discounted cash flow (DCF) models in
Chapter 4. Someof the features listedwillbe discussed in moredetaillaterin the book(as
indicated). Someare discussed below.
Book Value Captures Value and Residual Earnings

Captures Value Added to Book Value
The residual earnings approach employs the properties of accrual accounting that (typically) bring value recognition forward in time. More value is recognized earlierwithin a
forecasting period, and lessvalueis recognized in a continuing valueaboutwhich weusuallyhave greateruncertainty.
Residual earnings valuation recognizes the value in the current book value on the
balancesheet,for a start; in addition,value is usually recognized in RE forecasts earlier
than for free cash flow forecasts. You can see this by comparing the value captured in
forecasts for one and two years ahead with the two methods in the strategy example we
just wentthrough: Freecash flowsforecasts are negative forYears I and 2 but RE forecastsare positive. Scenario 2 for the savingsaccount,earlier in the chapter,provides an
extreme example: Forecasted free cash flows are zero, yet a savings account can be
valued immediately from the current book value, without forecasting at all. The comparisonof the General Electricvaluationhere with the attemptto apply DCF valuation
to its negative free cash flows in Chapter4 drives the point home. With negative free
cash flows overthe forecast horizon, the continuing value must be more than 100percent of the valuation. In the Case 2 example here it is 42 percent. In short, RE valuation
honors the fundamentalist's dictum to put less weight on speculation (abouta continuing value).
Nevertheless, forecast horizons for DCF analysis and RE analysis are often the same.
You see thisinTable 5.4where both methods forecast steady state(for thecontinuing value
calculation) at Year 5. We layout the conditions where both methods give thesamevalue
forthesameforecasting horizon on the Web pagesupplement for Chapter 16.
169
170
Part One Financial Swrements andValua(ion
Chapter 5 Accrual Accounting andValuation; Pricing Book Va!:le5 171
Protection from Paying Too Much for Earnings Generated

by Investment
The stockmarketis oftenexcitedbyearnings growth, andit rewards earnings growthwith
a higher price. Analysts tend to advocate growth firms. Momentum investors push up
stockpricesof growthfirms, anticipating evenmoregrowth. However, growth in earnings
does not necessarily imply higher value. Firms can grow earnings simply by investing
more.If those investments fail to earn a returnabove the required return,they will grow
earnings but theywin not growvalue.So,growthcomeswith a caveat An investor should
not payfor earnings growththatdoes not add value.
A case in pointis a finn thatgrows earnings dramatically through acquisitions. Themarket oftensees acquisitive firms as growth firms and givesthemhigh PIE multiples. But, if
an acquirerpaysfair valuefor an acquisition, it maynotadd valueto the investment: Even
though the acquisition addsa lot of earnings, the investment just earnsthe required return.
Or Worse, shouldan acquirer overpay for the acquisition-as is oftenthe casewithempire
builders-he mayactually destroy valuewhile adding earnings growth.
During the 1990s, a number of firms wenton acquisition sprees. Someacquisitions were
for strategic reasons, while othersappeared to be growth for growth's sake. Tyco International a firm with$8 471 million in assets in 1996, grew to become a conglomerate with
sr I1,287 millionin ~ets by 2001. Its businesses included electronic components, undersea cables, medical supplies, fire suppression equipment, security systems, andflow control
products, and it also ran a financing arm. It became a darling of the market, with its stock
price increasing fromSIOper share in 1996to S60 in 2001. In 2002,muchof its market
valueevaporated, withthe pricefalling to $8, as the valueof the acquisitions-and the accounting employed in reporting earnings from theacquisitions-c-came intoquestion. WorldComgrewfroma smallMississippi firmto the number twotelecommunications firm in the
United States,acquiring (among others) MCL Its stockpriceroseto over$60,but by 2002,
dueto an accounting scandal, it wastrading at 25centspershareand ultimately wentbankrupt BothTyco and WorldCom wereled by aggressive empire builders (who subsequently
resigned under doubtful circumstances), both borrowed heavily to makeacquisitions, and
both ultimately ran into difficulties in servicing that debt. General Electric, on the other
hand, made manyacquisitions that significantly addedvalue.
The residual earnings model has a built-in safeguard againstpaying too muchfor earningsgrowth: Value is addedonlyif the investment earnsoverand above its required return.
Lookat Exhibit5.3.This is the same example as in Exhibit5.2 exceptthat, in additionto
paying a dividend of$9.36 million, the finn issuessharesin Year I for S50million, giving
EXHIBIT 5.3 Forecasts fora Simple Firmwith Added Investment

Inmillions ofdollars. This isthesame firm asthat inExhibit 5.2except thefirm isexpected to
make a share issue of$50 inYear 1,tobeinvested inassets earnings 10percent peryear. Required
return is 10percent peryear.
ForecastYear
0
Earnings
Netdividends
Book value
RE (10%charge)
RE grovvth rate
12.00
9.09
100.00
12.36
(40.64)
153.00
1.36
17.73
9.64
161.09
1.43
18.61
9.93
169.77
1.50
19.56
10.23
179.10
2.58
20.57
10.53
189.14
1.66
3%
3%
3%
3%
EXHIBIT 5.4 Forecasts fora Simple Firmwith an Inventory Write-down

Inmillions ofdollars. This isthe same example as inExhibit LZ, except the firm has written down
inventory inYear 0 by$8million, reducing cost ofgoods sold inYear J by$8million. Required
return is 10percent peryear.
Forecast Year
0
Earnings
Dividends
Book value
RE (10%charge)
RE gro'N1:h rate
4.00
9.09
92.00
10.36
9.36
103.00
11.16
11.73
9.64
106.09
2.43
13.11
9.93
109.17
1.50
13.51
1023
111.55
2.58
13.91
10.53
115.93
1.66
3%
3%
3%
it a net dividend in Year 1 of -$40.64 million. Book value at the end of Year I is thus
$153.00 million. The investment, earningat a to percent rate,is expected to contribute $5
additional earnings in Year 2, and earnings forYears 3 to 5 also increase. Yet forecasted
residual earnings are unchanged. Andthe calculated valueis thesameas before:
Va' = $100 +
$1.36
1.l0 -l.03
$1J3.71 million.
Although the investment produces moreearnings, it does notaddvalue.
Protection from Paying Too Much for Earnings Created

by the Accounting
Accrual accounting canbe usedto createearnings. Byrecognizing lowerearnings currently,
a firm can shift earnings to the future. An unwary investor, forecasting higherearnings,
might think that the finn is worth more. But earnings created by the accounting cannot
createvalue.
Exhibit 5.4 illustrates this, again with the same finn as in Exhibit5.2. At the end of
Year 0, the management writesdowninventory-in accordance with the lower of cost or
marketrule-by $8 million. Accordingly, Year 0 earnings and bookvaluesare $8 million
lower. Inventory (onthe balance sheet)becomes future cost of goodssold.If the inventory
writtendown is to be soldinYear I, cost of goodssold forYear I will be $8 miIlion lower,
and (withno changein revenues) earnings are expected to be $8 higher. You can see, by
comparing the S20.36 million forecast for Year I with the previous $12.36million, that
future earnings havebeencreated. A perceptive analyst will increase his earnings forecast
appropriately. But this is not earnings we shouldpayfor.
Residual earnings forYear 1is now$20.36- (0.10x 9200) = Sl l.Irimillion, while that
for subsequent yearsis unaffected (andgrowing at a 3 percent rate).The valuation is
1 6
V/=$92+ 1.1
1.l0
+[
1.43 !1.l0]=$133.71rniliiOn
l.1O - l.03
The valuation is unchanged from before. The accounting has created earnings, but not
value, and the residual earnings valuation has protected us from payingtoo muchfor the
earnings created. Howdoesthe built-in safeguard work? Well, onecanonlygenerate future
earnings by reducing current book values-that is how accounting works. Provided we
172
Chapter 5 Accrual Accounting andVahration: Pricing Book VaI'lCS 173
Part One Financial Suuemerm and Vallra!ion

carry the lower bookvalue($92 million here instead of$IOO million) alongin the valuation with the higher future earnings, we are protected: The higher earnings are exactly
offsetby the lower bookvalue.
Inventory write-downs arejust one wayof shifting income to the future. Othersinclude
write-downs and impairments of plant assets (that reduce future depreciation charges),
restructuring charges of whole businesses, and deferment of revenue recognition. Wewill
embellish moreas we introduce accounting issuesas the text proceeds.
Capturing Value Noton the Balance Sheetfor All Accounting Methods

Residual earnings valuation corrects for the valuethat accountants do not include on the
balancesheet Chapter 2 showed howaccounting rulesformeasuring assetsand liabilities
typically yield a bookvalue thatdiffers fromvalue,usually lower. Chapter 3 showed that
asset-based valuation techniques are verydoubtful forcorrecting bookvalues, exceptperhapsfornaturalresource companies. Residual earnings valuation solves theproblem of the
imperfect balancesheet,adding a premium by forecasting the earnings that the bookvalues willproduce.
Accordingly, residual earnings valuation applies for all accounting methods forthe balancesheet.UnderGAAP, firmsare required to expense R&D expenditures ratherthanbook
themonthe balance sheetas assets. Investment in brands through advertising andpromotion
expenditures mustalso be expensed, so the brandasset is missing fromthe balance sheet.
But wesawthat, although Dellhassignificant amounts of these"intangible assets"missing
fromthe balance sheet,theshares can be valued witha Case3 valuation. With no R&D or
brandasset,subsequent amortization of the assetcostis zero,so future earnings are higher.
Combined witha charge on thelower bookvalues in theresidual earnings calculation, residual earnings are higher. Thesehigherresidual earnings compensate for the lower bookvalues,to produce a valuation thatcorrects the lowbookvalue. Dell's2001 residual earnings of
0.613 per shareand ROCE of 40.8 percentin the Case 3 demonstration reflect strong eamings. Butthesemeasures alsoreflect thatearnings arecoming fromlowbookvalues because
R&D, brand, and the otherintangible assets-cwhich generate the earnings-are not on the
balance sheet.This makes sense: If assetsare missing from the balance sheet, the PIB ratio
shouldbe higher, and a higherPIE meansthat residual earnings are expected to be higher.
A methodbasedon accounting numbers mightbe seenassuspect. Forthisreason, some
advocate discounted cashflow analysis, forcashflows are "real"and cannotbe affected by
accounting methods. However, youcan see,bothin the discussion hereand in the example
in Exhibit5.4, that residual earnings valuation adjusts forthe accounting, and so works for
all accounting methods. This,too, makessense,for valueis basedon the economics of the
business, not On the accounting methods it uses.There are some subtleties-the forecast
horizon can be affected by the accounting methods used--but thesesubtleties are left for
laterchapters.
Residual Earnings Are NotAffected by Dividends,

Share Issues, or ShareRepurchases
In Chapter 3 we saw that share issues, share repurchases, and dividends typically do net
createvalueif stockmarkets areefficient. But,as residual earnings is basedonbookvalues
and thesetransactions with shareholders affectbookvalues, won't residual earnings (and
thusthe valuation) be affected byexpected dividends, shareissues, and sharerepurchases?
The answer is no. Thesetransactions affectboth earnings and book values in the residual
earnings calculation suchthattheireffectcancels to leaveresidual earnings unaffected. Go
to the Web supplement for this chapterfor a demonstration.
What the Residual Earnings Model Misses

The residual earnings model captures the anticipated valueto be generated within thebusinessby applying shareholders' investment to earnprofits fromselling products andservices
to customers. Wehaverecognized, however, thatshareholders canalsomake money ifshares
are issuedat a pricegreaterthantheirfairvalue. Thiscanhappen if the market priceis inefficient or if management (whoactson shareholders' behalf)hasmoreinformation about the
valueof the firmthanthebuyers of theshareissue. Gainsalsocanbe made (bysomeof the
shareholders) from stockrepurchases: If shares are repurchased at a pricethat is lessthan
fairvalue, theshareholders whoparticipate in the repurchase losevalueto thosewhochose
not to participate. In short,owners makemoney fromselling or buying the firm at a price
thatis different from fairvalue.
The residual earnings modelcalculates (appropriately) thatthereis novalueaddedfrom
an anticipated share issueor repurchase at fair value. However, this is not so if the share
issue or repurchase is at a price that is different from fair value: The gain or loss to the
existing shareholders is notcaptured by themodel. Thismightbe thecasewhen a firm uses
overpriced shares to acquire another firmby issuing sharesratherthanpaying cash.Wewill
see how to correct for this deficiency when we apply the model in all its dimensions in
Chapter 15.
REVERSE ENGINEERING THE MODEL FOR ACTIVE INVESTING

As we saw in Chapter 3, active investors use fundamental screens. One of thosescreens
takespositions in stocks based on the PIB ratio. The PIB ratio is supposed to identify mispricingin the market: Buy low-PIE stocks, sell high~P?3 stocks. We suggested.in Cha~ter:
thatthissimplescreencouldget youintotrouble: A high PIB, for example, might be jusnfied because considerable valueis omittedin the balance sheet(andhigh RE are forecast
for the future). This omitted valuemightevenbe underpriced. Theresidual income valuation calculates the intrinsic P!B ratio and so indicates whether a high or low PIB is really
due to mispricing. The appropriate screenis the VIP ratio,where V is the calculated value.
Buy if VIPis greaterthan 1.0and sell ifV/P is lower. SeeBox5.5.
Theresidual earnings modelisa formula, andonemustbe careful inapplying formulas:
It is easyto plug in any inputto get anyvalue(garbage in, garbage out).Indeed, formulas
can be usedtojustifyanyvaluation one desires (ina courtcase,for instance, or the caseof
an investment bankertryingto justify a highprice for a stockissue). Benjamin Graham,
the father of fundamental analysis, warned investors manyyearsago:
Theconcept of future prospects and particularly of continued growth in the future invites the
application of formulas outof higher mathematics toestablish the present value of thefavored
issue. Butthe combination of precise formulas withhighly imprecise assumptions can be used
to establish, orrather justify, practically anyvalueone wishes, however high, for a really out-
standing issue."
Graham wasparticularly concerned withthe growthrate (vcontinued growth") andweunderstand thatthe long-term growth ratein the continuing valueis indeedthe mostspeculative part of a valuation. By choosing a speculative growth rate and plugging it into the
model, we can build speculation into the valuation. We can develop false confidence.
Remember ourdictumfromChapter 1: Beware ofpayingtoomuch for growth.
Howmightwehandlethe modelto avoidthis?Wecouldusethe historical average GDP
growth rate-something wecananchoron fromhistory-which appears to workwellwhen
6B.Graham, The Intelligent Investor. 4th rev. ed.(NewYork: Harper andRow. 1973). pp.315-316.
Chapter 5 Accrual Aceolln~'ng and Valuation: Pricing Book Value> 175
above 1.o-indicating prices aretooJow-it tends to revert t6'

1.0asprices adjust to fundamentals. When VIP isbelow 1.~
indicating prices aretoo high-it tends to revert back to 1.0.'
Ofcourse, it could be that deviations from 1.0aredueto' '
poor valuation model rather than mispricinq, so we would
have to beconfident of ourmodel and the numbers that g~
into the model before claiming that a VIP different from:
1.0indicates mispricing. The pattern could also bedueto dis:"
count rates changing as market-wide risk changes, so one
does have to be careful. We have used a risk premium of
5 percent at all points intime incalculating Vhere. But inbad'
times, like the 1970s, investors might require a higher risk pre-"
mium, pushing prices down. In good times, like the 19905,:
the risk premium declines, so prices rise. This isthe "efficient
The required return, P, is set at the risk-free rate (on u.s. markets" interpretation ofthe graph.
..;
government 10-year obligations) for each year plus a 5 perVIP ratios should becalculated for individual firms with the'
cent risk premium. This valuation isonly approximate as the valuation tailored to each firm, butmedian VIP ratios-cor viP.
continuing value and the required return will be different for ratios for representative portfolios like the S&P 500 or Dow
different firms.
stocks-can give a sense of mispridng in the market
Even though the valuation is approximate, you can see whole. Refer back to a similar graph for the Dow
that VIP ratio oscillates around 1.0. When the VIP ratio is Figure 1.2inChapter 1.
Value-to-price ratios compare calculated value to the current

market price. If a VIP ratio ismore than 1.0, a buy recommendation isimplied. If theVIP ratio isless than 1.0, a sell recommendation isimplied.
The graph below tracks median VIP ratios forall U.5.listed
firms from 1975 to 2001. Value is estimated using analysts'
consensus forecasts for two years ahead, converting them
into a residual earnings forecast (as inTable 5.2), andthen applying a GOP growth rate of 4 percent forgrowth in residual
earnings thereafter. That is,
year-ahead residual earnings of$2.36 million. Accordingly, youmightsetup the following

problem and solvefor g:
Po = $133.71 million = $100 + $2.36 million.

J.l0- g
Po is the tradedprice of the equity, not necessarily its value (V). Witha priceof$133.71
million, g = 1.03. You haveconverted the market priceintoa forecast: Themarket's implied
residual earnings growth rate is 3 percent. You havedoneso by reverse engineering the
residual earnings model, a processsometimes referredto as inverting the model. Rather
thanforecasting g and converting thatforecast to a valuation, you have converted the market's valuation intoa forecast of g.
Suppose now thatthe equitywastrading at $147.2 million. Wewould thencalculate g :::
1.05. You havereverse engineered the residual earnings model to conclude thatthe market
is forecasting a residual earnings growthrateof 5 percentper year. If, as a resultof your
analysis of the firm, youconclude thatthe growth ratecanbe no higherthan3 percent, you
would conclude thatthe $147.2valuation is too high:At this pricethestockis too expensive.Butyoumightalsoturnthe analysis on yourself: Is theresomething the market knows
that I don't know?
The reverse engineering canbe doneanother way. Suppose you were very fum in your
beliefthatthe residual earnings growthratecanbe no higherthan3 percent. Thenyoucan
set up the following problem and solvefor p:
2.5ll __ Median VfPRatioI
Po = $147.2 million = $100 + RE!O

P -1. 3
I
.3 1.5
+-+"---------------------
Residual earnings oneyearahead, REb isbased on theexpected return, sosetREI::: $12.36[(p-1) x IOO.O]. Thereverse-engineered amount forpis 1.0936; thatis,the market is forecastinga 9.36 percentrate of returnfrom buyingthis stock.This is the market's implied
expected return. Note, importantly, that it is not the required return, but rather the expectedreturnto buyingthe stockat the currentmarketprice.So it is attractive foractiveinvesting. If yourequire 10percentto compensate youforrisk,youwould saythestockis too
expensive. The formula forreverse engineering the expected return is:
Earn,
Po
P~-
s,
p-l=-+--(g-l)
i
~
~
SO\J~ce:
i
~
~
i
~
r-.
~
i
M
00
i
~
00
,, i
00
,,
i
~
00
;;
~
i
M
~
,,
i
~
~
e-,
c,
i
~
~
(5.7)
<5
0
N
srcesarefrom Standsrd & Pccx~ (OMPUSTAf'l. Analysts' earningslOl'eca>ts arefrom Thomson Financial V8/EIS data.
whichis thesameas
Eo
looking at the market as a whole in Box5.5. But stocks presumably will havedifferent expectedgrowth rates.We usedthe GDPgrowth rateforNikeinTable 5.2,butNikemightbe
able to generate a highergrowth ratethan the average, as leastfor a number of years.
Reverse engineering is a wayof dealing withthe problem, andit lendsitselfto activeinvestment strategies. Consider the simpleexample in Exhibit 5.2. Suppose that the equity
for this firm were trading at $133.71 million and you forecast earnings one-year aheadof
$12.36 million, as in the exhibit. With a 10 percentrequired return, that forecast implies
(EO))
p-l=-ROCE,+ 1-- (g-1
Po
174
Po
Po
(5.7a)
The second formula says that the expected return is a weighted average of the forward
ROCE and the expected growthrate, where the weights (that sum to 1) are given by the
market's book-to-price ratio.
Rather than screening stocks on the too-simple PIB ratio, the active investor might
screenstockson theirimplied expectedreturns: Buystockswithhighexpected returnsand
sell thosewith lowexpected returns.This requires someanalysis, of course, for we must
havesomesenseof the growthrate. PartTwo of the bookbuilds the analysis. Differences
in expected returns are explained by differences in risk as wellas mispricing, so one must
conduct thesescreens withina givenriskclass. Chapter 18elaborates.
176 Part One Financial Suuements andValuation
Chapter 5 AcmwlAccollnting andVaIll<ltiQll: Pricing Book Va!llC5 177
Reverse Engineering the S&P 500

Attheendof2007,theS&P500index stood at 1468, which priced theportfolio ofthe500
stocks in the index at 2.6 times bookvalue. A bookvalue multiple implies a certain RE
forecast, so we can ask: Whatfuture RE is the market implicitly forecasting to pricethe
S&P500at 2.6times bookvalue? TheS&Pfirms earned an ROCE of 17percent in 2007.
TheS&Pportfolio is representative of the market as a whole, so has a betaof l.0. Thus,
witha risk-free rateof 4.0percent at thetimeandanequity riskpremium of5 percent, the
CAPM required return is 9.0percent. Thefollowing RE formula is reversed engineered to
calculate the implicit REgrowth rate;
~007 ::= ~007 +
RE 2007 X
p-g
RE2QQ7 X g is simply theforecast ofRE for2008. Thepriceat theend0[2007 is based on

expected RE for 2008 capitalized as a perpetuity withgrowth, and 2008 REis forecasted
by growing REfor 2007 for oneperiod. With a PIB of2.6, every dollar of bookvalue is
priced at 2.6 dollars, so a dollar on bookvalue is priced as follows;
$2.6=$1.0+ (0.17-0.09)xg
1.09- g
RE for 2007on Sl of bookvalueis (ROCE- Requiredreturn) x Sl = (0.17- 0.09)= SO.08,
as in the numerator. Thesolution for g is 1.038, or a 3.8percent perpetual growth ratefor

residual earnings. We couldtestthesensitivity of thiscalculation to different costof capital estimates, butwe could alsoask:Is it reasonable to expect a growth rateof3.8 percent
fortheS&PSOD? Firstwewould askwhether thebase2007ROCE is a highor low year. In
fact, the average has been about 18 percent since 1980. Next we would ask what is the
expected growth from this base? If we concluded that the long-term growth ratewill approximate the average historical GDP growth rate of 4 percent, we might conclude that
3.8percent isjust aboutright: TheS&P500is appropriately priced.
As shown withthe simplevaluation andequation 5.7,we canreverse engineer to the
expected returnratherthan to the growth rate. You can easily see that if youhave firm
convictions thatthe growth ratefor thecorporate sectormustbe the GDP growth rate of
4 percentfortheeconomy as a whole, thentheexpected return fortheS&P500attheend
of2007 is about9 percent (theexactnumber is 9.2percent). If yourequire a 9 percent return to invest in stocks, then you would say that the market as a whole is reasonably
priced. You would be comfortable in buying an index fund. But should you infer an
expected return of less than 9 percent, you mightchoose not to buy an index fund, or
move out of your fund into an asset deemed more reasonably priced. Look at ExerciseE15.5.
Using Analysts' Forecasts in Reverse Engineering

In Table 5.2 we converted analysts' consensus EPS forecasts for Nike into a valuation.
We can turn the exercise around and convert Nike's market priceof $60 into a forecast.
Analysts' three-to-five year growth rates are notoriously speculative so, for thisexercise,
weanchor on theirone-andtwo-year ahead forecasts. The 2009 and2010 consensus EPS
forecasts for Nike, made at the beginning of the 2009fiscal year, were $3.90 and$4.45.
The corresponding residual earnings, calculated in Table 5.2, were $2.307 and $2.557.
Asthebookvalue per share at theend of2008 is $15.93, thereverse engineering problem

runs as follows for therequired return of 10percent:
2.557x g
P.
'00'
=$60=SI5.93+ 2.307+2.557 + 1.10-g

1.10
1.21
1.21
(1)
(2)
(3)
Thesolution forg is 1.045 or a4.5percent growth rate. Given theanalysts' two years offorecasts, themarket is forecasting growth in residual earnings of4.5percent peryear after 2010,
perpetually. Thisa little higher than theGDP growth rate, butonemight expect this ofNike.
The diligent analyst asks: Whatgrowth rate do I see for Nike? If she concludes that
Nike can deliver a growth ratehigherthanthe market's forecast of 4.5 percent, shewould
also conclude that Nike is underpriced at $60. Rather thanchallenging price, she challenges themarket's implied forecast of growth. PartTwo of thebookbrings analysis to the
issueof challenging the market's implied growth rate.
Implied Earnings Forecasts and Earnings Growth Rates

Residual earnings growth rates are a little difficult to interpret But an implied residual
earnings growth ratecanbe converted intoan earnings growth rate. Based onthe implied
growth rate of 4.5 percent, Nike's 2011 residual earnings are forecasted to be 2010 RE
growing at 4.5 percent: $2.557 x 1.045 = $2.672. As bookvalue at the end of 2010 is
forecasted to be $22.36 (inTable 5.2),earnings forecasted for 2011 are ($22.36 x 0.10) +
2.672::= 4.91. This is the 2011 EPS that yields RE for 2011 of $2.672. The formula to
convert a residual earnings forecast to anearnings forecast is:
Earnings forecast, ::= (Book valuec,x Required return) + Residual earnings,
(5.8)
Thisformula reverse engineers theresidual earnings calculation.

Implied earnings forecasts can, in turn, be converted intoearnings growth rates. As
Nike's implied EPS forecast for 2011 is $4.91 and the 2010forecast is $4.45, the forecasted EPS growth rate for 2011 is $4.91/4.45 ::= 10.34 percent, and so for subsequent
years. Figure 5.4 plots analysts' growth rate for 2010from their forecasts for 2009 and
2010 ($4.45/$3.90::= 14.1 percent), followed by the implied EPS growth rates for each
subsequent year, 2011 to 2016forthecasewhere thecurrent payout ratioof23 percent is
preserved. You can see that the constant RE growth rate translates into a declining EPS
growth rate. If you forecast thatgrowth rateswillbe lower thanthe growth rates plotted
here, youwould sell thestock, as indicated bythe"sell"region in thefigure. If youforecastthatgrowth rateswillbehigherthanthe plotted market's growth rates, youwould be
in the"buy"region.
SEPARATING SPECULATION FROM WHAT WE KNOW:

VALUE BUILDING BLOCKS
Thefundamentalist understands whatpart of a valuation is based on solidinformation and
what partisspeculative-andso obeys hisdictum to distinguish what beknows from specillation. Thereverse engineering ofNike's $60price above labels threecomponents of the
valuation (with the numbers under the calculation). Figure 5.5 shows how these components buildthevaluation.
Thefirst, theS15.93 in bookvalue, isknown forsure, andsofirmly anchors thevaluation.
Beware of Paying for Risky Growth
178 PartOne FilUlncia! Seneneus and Valuation
FIGURE 5.4 Plotting the Market's Implied EPS Growth Rates: Nike, Inc.
Themarket's implied forecast ofEPSgrowth rates, obtained byreverse engineering, areplotted for
2010-2016. Thegrowth rate for2010 isanalysts' two-year-ahead growth rate from their EPS
estimates for2010 and2009. Growth rates forecasted above theline imply buying the stock.
Growth rates forecasted below theline imply sell.
14.50%
14.00%
14.1%
13.50%
13.00%
12.50%
~ 12.00%
'"
iC
BUY
11.50%
[1.00%
10.50%
LO.34%
SEll.
10.15%
10.03%
1O.OO%[=-=:~=:==:===~==~'
9.50%
2010
2011
2012
9.90%
9.79%
9.69%
2014
2015
2016
2013
The second is based on forecasts for two years ahead. These are typically made with
some confidence, but with less assurance than the book valuecomponentThe valuefrom
theseforecasts is the presentvalueof the one-year-ahead residua! earningsplus that from
two-year-ahead residual earningscapitalized as a perpetuity. ForNike,
2.557)
Value from secondcomponent = - 1 ( 2.307+- = $25.34
1.10
0.10
FIGURE 5.5 BuildingBlocks of a Residual EarningsValuation: Nike, Inc.

Thethree building blocks distinguish components ofa valuation about which theanalyst is
reasonably sure from more speculative components: (1)book value, known forsure; (2)value from
near-term forecasts (fortwo years' ahead), usually made with some confidence; and(3)value from
long-term growth forecasts, themost speculative partofthevaluation.
$60
-----------------:J--------Current market value
When it comes to valuing the future, the residual earnings

model tells us to make forecasts for the short term, add a
long-term growth rate, and insert a required return that reflects risk. Each element carries uncertainty. Ifweare reasonably confident about our short-term forecasts, the reverse
engineering analysis shows thatwe canestimate the implied
growth rate if we are also reasonably confident about the
required return. Alternatively, ifwe are reasonably confident
with a growth forecast, we can reverse engineer to the
expected return to buying a stock at the market price.
You can see,however, thatwehave onetoomany dials to
turn here: We may notbesure ofeither therequired return or
the growth rate. We may be more sure of the latter oncewe
have done more analysis (in Part Two of the book), but that
opens an intriguing question. We may forecast growth, but
growth can be risky, requiring a higher return; growth
andthe required return are related. This isquite reasonable:
Following the law of a risk-return tradeoff, if one expects
more earnings {growth), one might betaking onmore risk. Indeed, insetting up the building block diagram inFigure 5.5,
we recognized that the third, speculative component of the
valuation is the most uncertain and that component is of
course based onthe anticipated growth rate. The higher that
component isin the valuation, the higher might be our required return. Indeed, research shows thatbetas arerelated to
thesize ofthis component.
So, incarrying outa valuation, beware: Do notthink ofthe
required return and the growth rate as independent inputs.
Rather, think of adjusting the required return upward if
you seemore growth. Ifreverse engineering to the expected
return fora given growth rate, require a higher cutoff to acceptthe expected return ifa lotofgroVl'th isinvolved.
Consider the short-form residual earnings model we applied inchallenging theS&P 500.
5.6
2009 of$1.67. After applying therequired return of9 percent

we used forthe S&P 500, the EPS forecast implies a residual
earnings forecast for 2009 of $1.145. Suppose we forecast
that Cisco can maintain a growth rateof 6 percent (not unreasonable fora firm like this at the edge of its qame). Then
the short-form model says thatCisco isworth
P.
100')
=$5.83+~=$44.00
1.09-1.06
Cisco traded at $23.BO at the time. What could be wrong?

Well, themarket could be underpricing thestock, butitcould
also bethattherequired return istoolow forthehigh growth:
Growth is risky andthe required return should reflect this. If
we set the required return at 11 percent, thevalue becomes
$26.40.
Clearly we will get a better fix on this once we have
analyzed growth (in Part Two) andthe risk of gro\Nth (Chapter 1B). But you may have noticed something here. The difference between the Cisco growth rate of 6 percent and the
GOP growth rate of 4 percent thatwe used forthe S&P 500
earlier is2 percent. Adding this to therequired return forthe
S&P 500 (themarket as a whole) to yield a required return of
11 percent, wegeta more reasonable price. We could follow
the rule: An extra 1percent inthegrowth ratemeans anextra
1 percent required return, so that Pt and 9 inthe denominator of the short-form model cancel. This means that growth
adds novalue, justrisk, with no effect ofvalue.
This would be a conservative valuation, of course, for
firms presumably can add value from growth over the required return. The calculation follows the(too-conservative)
mantra of the traditional fundamentalist of not paying for
growth at all. But it does have thefeature ofcreating a margin of safety that those fundamentalists built into their valuations. And a margin of safety issurely desirable ifgrowth is
f>B+~
o
0
p,_g
risky.
After analyzing growth wewill return, inChapters 14and
Cisco Systems had a book value pershare of $5.83 at theend 18,to incorporating risky growth inactive investing.
of fiscal year 200B, andanalysts were forecasting an EPS for
$18.73
$41.27
,o
$25.34
~
$15.93
(I)
(2)
(3)
Book value
Value from
short-term
forecasts
Value from
long-term
forecasts
You can see that the secondcomponent forecasts no growthin residual earnings after two
years. The third component adds value for growth. The long-term growth rate is usually
fairly uncertain, so thiscomponent of the valuation is the mostspeculative, As the first two
blocks for Nikeaddto $41.27,the amountof valueassigned to the thirdblockby a market
price of $60 is $18.73. If the analyst is assured of her two-year-ahead forecasts, she now
understands howmuchof the current price is basedon speculation aboutgrowth overthe
longterm.
Whatdoes the building blockdiagramtell us? Importantly, it separates the speculative
component of price in block 3 from the blocks I and 2 components about which we are
179
180 Part One
Financial Swremen(,\ anl1'Valuation
;,%.::,~r~-"'''~':",;,::? '.f::'-'~~ 0~~~,_;%?",~
,i"' ':"'-.~.' ',-, '.', " ','
~itlte'Web
CorinectiOD._
, ,,; .' ,.",.
1<:r,;.{~;-
Chapter 5
-~;'.
'
Find thefollowing ontheWeb page for this chapter:

Further applications ofresidual earnings valuation.
A spreadsheet program to help you develop residual
earnings pro formes.
Further discussion of thefeatures of residual earnings
valuation.
A demonstration of how residual earnings areinsensitive to dividends, share issues, and share repurchases.
>,"':.-r\',.
.-.
Payattention to thereverse engineering of theresidual earnings model in the lastpartof

thechapter. With a view to active investing, wewillapply themodel inthisway, with refinements, laterinthebook. Butfirst wemust getintofinancial statement analysis (inPart Two of
thebook) sowecanmore effectively challenge theprecosts implied bythemarket price.
Ademonstration of how residual earnings techniques

solve theproblems with dividend discounting.
Directions to finding analysts' forecasts on the Web.
Further examples ofreverse engineering.
The Readers' Corner takes you to papers that cover
residual earnings valuation.
Key Concepts
more certain; following the fundamentalist dictum, it separates "whatwe know" (or feel
comfortable with)fromspeculation. Theanalyst not onlyunderstands where the mostuncertainty in thevaluation lies,butalsoidentifies the speculative component 3 thathastobe
challenged to justify the current market price. He or she then brings soundanalysis to
challenge the speculative EPSgrowth ratesunderlying the thirdcomponent (like those in
Figure 5.4.).Thisanalysis is in Part Two of thebook.
Before closing the chapter, go to Box 5.6. It underscores the warning of paying too
muchfor growth.
Summary
This chapter has outlined an accrual accounting valuation model that can be applied to
equities, projects, andstrategies. Themodel utilizes information from thebalance sheetand
calculates the difference between balance sheetvalue andintrinsic value from forecasts of
earnings andbookvalues thatwillbereported in future forecasted income statements and
balance sheets.
Theconcept of residual earnings is central inthe model. Residual earnings measures the
earnings in excess of those required if thebookvalue were toearnat therequired rateofretum. Several properties of residual earnings havebeenidentified in this chapter. Residual
earnings treats investment as part of bookvalue, so thatan investment thatis forecast to
earn at the required rate of returngenerates zeroresidual earnings andhas no effect on a
value calculated. Residual earnings is not affected by dividends, or by share issues and
sharerepurchases at fair value, so using the residual income model yields valuations that
are notsensitive to these(value-irrelevant) transactions withshareholders. Thecalculation
of residual earnings usesaccrual accounting, which captures added value overcashflows.
Residual earnings valuation accommodates different ways of doing accrual accounting.
Andresidual earnings valuation protects usfrom paying toomuchforearnings growth generatedby investment and earnings created byaccounting methods.
Above all, theresidual earnings model provides a way of thinking abouta business and
aboutthevalue generation inthebusiness, Tovalue abusiness, itdirects usto forecast profitability of investment and growth in investment, forthesetwofactors drive residual earnings. Andit directs management toaddvalue to a business by increasing residual earnings,
which, in tum, requires increasing RaCE andgrowing investment. Theanalyst alsounderstands thebusiness fromthemodel andalsodevelops important tools tochallenge themarketprice.
Accrual AccOlmling andValum;on: Pricing [look Valuel 181
horizonpremium is thedifference
between value andbook value expected at
a forecast horizon. 155
impliedearningsforecastis a forecast of
earnings thatis implicit in themarket
price. 177
impliedexpected return is the expected
rateof return implicit in buying at the
current market price. 175
impliedresidualearningsgrowthrate is
theperpetual growth in residual earnings
thatis implied bythecurrent market
price. 175
normal price-to-book ratio applies when
priceis equal to book value, thatis, the
P/B ratiois LOO 153
residual earningsis comprehensive
earnings lessa charge against bookvalue
for required earnings. Alsoreferred to as
Analys!s Tools
Residual earnings equity
valuation
Case 1 (5.4)
Case 2 (5.5)
Case 3 (5.6)
Target price calculation
Converting ananalyst's
forecast to a valuation
Residual earnings project
valuation
Residual earnings strategy
valuation
Reverse engineering the
residual earnings model
-aor implied growth rates
-for expected returns
Value-to-price ratios
Valuation building blocks
Page Key Measures

153
161
163
163
164
165
167
168
173
175
175
174
177

Case 1
Case 2
Case 3
Implied growth rate
Implied expected return
Growth inbook value
Pricebook ratio (P/B)
Return on common equity
gesdual earnings (RE)
Target prices
Case 1
Case 2
Case 3
Value-to-price ratio
residualincome, abnormal earnings,or

excess profit. 150
residualearnings driver is a measure that
determines residual earnings; thetwo
primary drivers are rate of return on
commonequity (ROCE) andgrowth
in book value. 153
residualearnings model is a model that
measures value added tobookvalue from
forecasts of residual earnings. 151
steady-state condition is a permanent
condition in forecast amounts that
determines a continuing value. 163
target price is a price expected in the
future 164
terminal premiumor horizonpremium
is thepremium at a forecast horizon (and
is equalto the continuing valuefor the
residual earnings valuation), 164

161
163
163
175
175
156
153
157
150
164
164
164
167
174
AMEX American Stock Exchange

BPS book value pershare
CAPM capital asset pricing model
CV continuing value
OPS dividends pershare
GOP gross domestic product
NYSE New York Stock Exchange
RE residual earnings
ROCE return oncommon equity
182 Part One
Fin(1l1cial SEalemelle; andVa!tw.cion
Chapter 5 Accnw.1 Accaunn'ng andValuation: Pncing Book Values 183
Concept
Questions
C5.1. Information indicates thata firm willearna return oncommon equity above itscost
of equity capital in all years in the future, but its shares trade below bookvalue.
Those shares mustbe mispriced. Trueor false?
C5.2. Jetform Corporation traded at a price-to-book ratioof 1.01 in May 1999.1ts most
recently reported ROCE was 10.1 percent, andit is deemed to have a required equity returnof 10percent. What is yourbestguess as to the ROCE expected forthe
next fiscal year?
A Self-Stlldy Exercise
CONVERTING ANALYSTS' FORECASTS

TO A VALUATION
C5.3. Telesoft Corp.traded at a price-to-book ratioof 0.98 inMay1999 afterreporting an

RaCE of 52.2 percent. Does the market regard this ROCE as normal, unusually
high, or unusually low?
C5.4. A sharetradesat a price-to-book ratioof 0.7.An analyst whoforecasts an ROCE
of 12 percent each year in the future, and sets the required equity return at
10 percent, recommends a hold position. Does his recommendation agree with
his forecast?
C5.5. A firm cannot maintain an ROCE lessthantherequired return andstay in business
indefinitely. Trueor false?
C5.6. Look attheCase 3 valuation ofDell, Inc., inthechapter. Why areresidual earnings increasing after2002, even though return oncommon equity (RaCE)isfairly constant?
C5.7. An advocate ofdiscounted cashflow analysis says, "Residua! earnings valuation does
notwork well forcompanies likeCoca-Cola, Cisco Systems, or Merck, which have
substantial assets, like brands, R&D assets, and entrepreneurial know-how off the
books. A lowbookvalue mustgive youa low valuation." Trueor false?
C5.8. When an analyst forecasts earnings, it mustbe comprehensive earnings. Why?
C5.9. Comment On the following: "ABC Company is generating negative free cashflow
andis likelyto do so for the foreseeable future. Anyone willing to paymore than
book value needs theirheadread."
Exhibit 1.1 in the Chapter 1 introduction to Kimberly-Clark gives consensus analysts'

forecasts madeinMarch 2005 when thestockprice stoodat $64.81 pershare. These forecasts are in the form of point estimates for 2005 and 2006 and an estimated five-year
growth rate.Find theseforecasts in the exhibit. An annual dividend of $1.80 persharewas
indicated for2005 at thetime, witha 9 percent annual dividend growth ratethereafter. With
bookvalue information from thefinancial statements in Exhibit 2.2inChapter 2, calculate
thefirm's traded PIBratio in March 2005.
With a five-year growth rate, you can forecast analysts' EPS estimates for the years
2005-2009. Do this and, from theseforecasts, layout a corresponding return on common
equity (ROCE) andresidual earnings. You willneedthebookvalue pershare at the endof
2004; you can calculate this from the balance sheet given in the Kimberly-Clark case
in Chapter 2. For the residua! earnings calculations, use a required return for equity of
8.9 percent.
Nowgoaheadandvalue KJAB's shares from thisproforma. Assume a long-term growth
rate in residual earnings afterthefive-year forecast period of 4 percent, roughly equaltothe
average GDPgrowth rate. What is your intrinsic price-to-book ratio? What is your ViP
ratio? Whatreservations did youdevelop as youwentaboutthis task? Would youissuea
buy, hold, or sellrecommendation?
Reverse Engineering
Working only from the analysts' forecasts for 2005 and 2006, find the market's implied
growth rateforresidual earnings after2006. Whataretheearnings pershare andEPSgrowth
rates that the market is forecasting for the years 2007-201O? You might plot those
growth rates,justas inFigure 5.4.
Exercises
Drill Exercises
E5.1.
UnderstandingYour Uncertainty
Assemble a building blockdiagram likethatin Figure 5.5. What partof thevaluation are
youmostuncertain about?
WhydoesKimberly-Clark trade atsucha highprice-to-book ratio? Why is itsRaCE so
high, given its required equity return is only8.9percent?
EP5
DPS
Using Spreadsheet Tools

As you proceed through the book, youwillsee that mostof the analysis canbe builtinto
a spreadsheet program. The BYOAP feature on the Web site shows you howto do this,
but you mightwait until Chapter 7 to get into this. At this point, experiment with the
spreadsheet tool for residua! earnings valuation on the Web page supplement for this
chapter. Insertyourforecasts intothe spreadsheet thereand specify growth ratesand the
required return. By changing forecasts, growth rates, and the required returns, you can
seehowsensitive the valuation is to the uncertainty aboutthesefeatures. If youarehandy
with spreadsheets, you might try to build an engine that does the reverse engineering
also.
Forecasting Return on Common Equityand Residual Earnings(Easy)

Thefollowing areearnings anddividend forecasts made at theendof 2009 fora finn with
$20.00 bookvalue percommon shareat thattime. The fum hasa required equity return of
10 percent peryear.
2010
2011
2012
3.00
0.25
3.60
0.25
4.10
0.30
a. Forecast return of common equity (ROCE) and residual earnings for each year,
201~2012.
b. Based on yourforecasts, doyouthinkthis firm is worth moreor lessthan book value?

Why?
E5.2.
ROCE and Valuation(Easy)

Thefollowing are ROCE forecasts made fora firm at theendof2009.
Return of common equity(ROC E)
2010
2011
2012
12.0%
12.0%
12.0%
184 Part One Fir:o.nda! $Eo.lemeJlts o.nd Vo.Iualion
Chapter 5 Accruo.l Accounting o.nd VQluation: Pricing Book Vo.ltU.l 185
ROCE is expected to continue at thesamelevel after2012. Thefirm reported bookvalue of

common equityof$3.2 billion at the end of2009, with500million shares outstanding. If
the required equity return is 12percent, what is theper-share value of these shares?
ES.3.
a. What is thevalue added tothe firm from this investment?

b. Forecast free cashflow for each yearof the project. What is the net present value of
cashflows for theproject?
A Residual EarningsValuation (Easy)

Ananalyst presents youwiththe following pro forma (in millions of dollars) thatgives her
forecast of earnings anddividends for2010-2014. Sheasksyouto value the 1,380 million
shares outstanding at the endof 2009, when common shareholders' equity stood at $4,310
million. Usea required return forequityof 10 percent in yourcalculations.
Earnings
Dividends
2010E
2011E
2012E
20BE
2014E
388.0
115.0
570.0
160.0
599.0
349.0
629.0
367.0
660.4
385.4
a. Forecast bookvalue, return on common equity (ROCE), andresidual earnings foreach

ofthe years2010-2014.
b. Forecast growth ratesfor bookvalueandgrowth in residual earnings for each of the
years2011-2014.
c. Calculate the per-share value of the equity from thisproforma. Would youcallthis a
Case1,2, or 3 valuation?
d. What is thepremium overbookvalue given byyourcalculation? What is thePIBratio?
E5.4.
years. Therequired returnforthistypeofproject is 12percent; thefinndepreciates thecost

of assets straight-line overthelifeof theinvestment.
ES.7.
projects are expected to generate a 15 percentrate of returnon its beginning-of-period

bookvalueeachyearfor fiveyears. The required return forthistypeof project is 12percent; the firm depreciates the cost of assetsstraight-line overthe life of the investment.
a. What is the value of the finn underthis investment strategy? Would you referto this
valuation as a Case1, 2, or 3 valuation?
b. What is thevalue added to the initial investment of$150 million?
c. Why is thevalue added greater than 15percent of me initial $150 million investment?
ES.8.
Residual Earnings Valuation and TargetPrices (Medium)
2010E
2011E
2012E
201JE
3.90
3.70
1.00
J.J1
3.59
3.90
1.00
1.00
1.00
1.00
a. Forecast earnings from thisproject fortheyear.

b. Forecast the rate of return on the bookvalue of this investment and also the residual
earnings.
c. Value theinvestment.
2014E
E5.9.
E5.5.
Residual EarningsValuation and Return on Common Equity(Medium)
Reverse Engineering (Easy)

A share traded at $26 at the end of 2009 with a price-to-book ratio of 2.0.Analysts are
forecasting earnings per share of$2.60 for2010. The required equity return is 10percent.
What is growth inresidual earnings thatthemarket expects beyond 201 O?
The firm hasan equity costof capital of 12percent per annum.

a. Calculate the residual earnings thatareforecast foreachyear, 2010 to 2014.
b. What is the per-share value of the equity at the end of 2009 based on me residua!
income valuation model?
c. What is the forecasted per-share value ofthe equity at theendof theyear2014?
d. What is the expected premium in 2014?
Creating Earnings and Valuing CreatedEarnings (Medium)

Theprototype one-period project at thebeginning of thechapter wasbooked at itshistorical
costof$400. Suppose, instead, thattheaccountant wrote down theinvestment to$360 onthe
balance sheet at the beginning of the period. See the investment as consisting of 5360 of
plant(booked to thebalance sheet) and$40advertising (which cannot bebooked to thebalance sheet underGAAP)_ Revenues of $440are expected from theproject andtherequired
return is 10percent.
The following forecasts of earnings per share (EPS) and dividend per share (DPS) were
made at the endof 2009 fora firm witha bookvalue pershareof $22.00:
EPS
DPS
Using Accountjnq-Based Techniques to MeasureValue Added

for a Going Concern (Medium)
A newfirm announces thatit will invest $150millionin projects eachyear forever. All
Applications
E5.10.
Residual Earnings Valuation: Black Hills Corp(Easy)

Black HillsCorporation is a diversified energy corporation anda public utility holding company. Thefollowing gives thefirm's earnings pershare anddividends pershare fortheyears
2000-2004.
A firm witha bookvalue of$15.60pershareand 100percent dividend payout is expected

tohavea returnon common equity of 15percent peryearindefinitely in thefuture. Its cost
of equity capital is 10percent.
a. Calculate theintrinsic price-to-book ratio.
b. Suppose this finn announced thatit wasreducing its payout to 50 percent of earnings
in thefuture. How would thisaffectyourcalculation of theprice-to-book ratio?
E5.6.
Using Accounting-Based Techniques to MeasureValue Added

for a Project(Medium)
A firm announces thatit willinvest $150million in a project thatis expected to generate a
15percent rateof return on its beginning-of-period bookvalue eachyearforthe nextfive
1999
EPS
DPS
BPS
2000
2001
2002
2003
2004
2.39
1.06
3.45
1.12
2.28
2.00
1.22
1.71
1.24
1.16
9.96
Suppose these numbers were given toyouattheendof 1999, asforecasts, when thebook value
pershare was $9.96, as indicated. Usea required return of 11percent forcalculations below.
a. Calculate residual earnings and return of common equity (ROCE) for each year,
2000-2004.
186 Part One Financial Statements andValuacion
Chapter 5 Accrual ACCOllJlring and Va!l<llIion: Pricir.g Book Values 187
b. Value the firm at the end of 1999 under the assumption that the ROCE in 2004 will
continue at thesamelevel subsequently. Would youcalltills a Case1,Case 2, or Case 3
valuation?
c. Based onyouranalysis, give a target price at theendof2004.
E5.11.
d. What arethe forecasts of earnings growth rates for2007 and2008 thatare implied by
theS36 market price? Assume thatthefinn's dividend payout ratio of 50percent will be
maintained after2006.
Exercises E6.10, andElO.8 alsodealwithGeneral Electric.
Valuing Dell,lnc. (Easy)

In September 2008 theshares of Dell, Inc., thecomputer maker, traded at $20.50 each. Analysts were forecasting earnings pershare ofS1.47forfiscal year2009 and$1.77 for2010.
Refer toDell's balance sheet inExhibit 2.1inChapter 2 tocalculate itsbookvalue at theend
of thefiscal yearending February 1, 2008. Dellpays nodividends. Usea required return of
! 0 percent to answer the following questions:
E5.14.
a. Calculate theper-share value of Dell in 2008 based onthe analysts' forecasts, with an
additional forecast thatresidual earnings will grow at theanticipated GDP growth rate
of 4 percent per yearafter2010.
-b, Given the analysts' forecasts, what wasthe market's forecast of the residual earnings
growth rateafter201O?
Exercises E3.7, E3.14, E8.12, E13.16, andE19.4 dealwith Dell, as do Minicases MIO.1
a. Calculate the residual earnings growth rate that the market is forecasting for these
stocks.
b. Suppose youforecast thata return on common equity of 18percent willbe sustained in
the future. What is the growth in the net assets that you would then forecast at the
current level of the index?
E5.15.
andMlS.2.
E5.12.
a. Whatis theforecast of returnon common equity (RaCE) fortheindex for2008?

b. If you expect residual earnings growth for the corporate sectorto equal the GDP
growth rate of 4 percentfor the economy as a whole, whatis the implied expected
return to buying theS&P500at 1468?
c. Therisk-free rateatthe timewas 4 percent. If yourequire a riskpremium of5 percent
to buyequities, would you havebought an index fund thattracks the S&P 500 index?
d. In 1999, the price-to-book ratio for the S&P 500 was much higher, at 5.4.Trailing
ROCE was 23percent.With thesameGDP growth rateforgrowth inresidual earnings,
calculate the implied expected return to buying the sap 500 at that point in time.
Would youhave purchased a market index fund thattracks theS&P500index?
E5.16.

SeeExercises E9.10, E1UO, E12.9, andE14.13 onHome Depot, andMinicases 4.1.
ES.13.
Building Blocks for a Valuation: General Electric Co. (Medium)

General Electric Co. reported a per-share book value of $10.47 in its balance sheet on
December 31, 2004. In early 2005,analysts were forecasting consensus earnings pershare
Valuing Dividends or Return on Equity: General Motors Corp (Easy)

In April 2005, General Motors traded at $28 per share on book value of S49 per share.
Analysts were estimating that GM would earn 69 cents per share for the year ending
December 2005. The fum waspaying anannual dividend at thetimeof$2.00pershare.
a. Calculate theprice-to-book ratio(PIB) andthereturn on common equity (ROCE) that

analysts were forecasting for2005.
h. Is the PIB ratio justified by the forecasted ROCE?
c. An analyst trumpeted the high dividend yield as a reason to buy thestock. (Dividend
yieldis dividend/price.) "Adividend yield of over7 percent is toojuicyto passup,"he
claimed. Would yourather focus on theRaCE or on thedividend yield?
ofSUI for2005 and$1.96 for2006.

a. Calculate thevalue pershare in early 2005 witha forecast thatresidual earnings will grow
at a long-term growth rateof 4 percent, the average GDP growth rate,after2006.
b. General Electric traded at$36pershare in early 2005. Construct abuilding block diagram,
likethatin Figure 5.5, displaying thecomponents ofthis$36price thatareattributable to
bookvalue, short-term earnings expectations, and speculation about long-term growth.
c. What istheforecast oftheresidual earnings growth rateafter2006thatisimplied bythe
$36market price?
The ExpectedReturn for the S&P 500(Medium)

On January 1, 2008, the S&P 500 index stood at 1468 with a price-to-book ratio of 2.6.
Expected earnings fortheindex forcalendar year 2008 were 7256.These earnings estimates,
compiled from analysts' consensus earnings forecasts forthe 500 stocks in the index, arein
thesamedollar units asthe index.
Sellers Wants to Buy (Medium)

Mark Sellers, a hedge fund manager withSellers Capital in Chicago, wrotea piece in the
Financial Times on September 9, 2006, arguing that Home Depot, the warehouse retailer,
wasworth S50per share. Home Depot traded at $34per share at the time. Analysts were
forecasting a consensus S2.98 earnings persharefor fiscal year2007and$3.26for2008.
A forward dividend ofSO.60per share was indicated for2007 and$0.70for2008, with the
dividend payout ratio maintained at the 2008 level in subsequent years. Home Depot reported a book value of $26,909 million for fiscal yearending January 2006, with2,124
shares outstanding.
Usea required returnof 10 percent peryear in answering the following questions:
a. Given the analysts' forecasts, what is the growth ratefor residual earnings after2008
thatis implied byMr. Sellers's S50valuation?
b. What are the earnings-per-share growth ratesfor 2009 and 2010that are implied by
Mr. Sellers's $50valuation?
Reverse Engineering GrowthForecasts for the S&P 500 Index (Medium)

With theS&P price index at 1270 inearly 2006, theS&P 500stocks traded at 2.5times book
value. On most recent (2005) annual earnings, the stocks in the index earned a weighted
average return ontheircommon equity of 18percent. Usea required equity return of 10percentfor this''market portfolio."

Exercises E2.12 and4.10alsodealwithGeneral Motors.
ES.17.
Residual Earnings Valuation andAccounting Methods (Hard)

Referbacktothevaluation in Exercise 5.3.In thatproforma, ananalyst forecast $388millionof earnings for2010on a bookvalue at the end of2009 0[$4,310 million, thatis, a
188 Part One financial Senemenu andValuation
returnon common equityof 9 percent. The forecasts weremade at the end of 2009 based
on preliminary reports from the fum.
Whenthe final reportwaspublished, however, the analyst discovered thatthe finn had
decided to write-down its inventory at the end of 2009 by $114 million (following the
lower-of-cost-or-market rule). As this was inventory that the analyst forecasted would be
soldin 2010(andthusthe impairment affects cost of goods soldfor thatyear), the analyst
revised her earnings forecast for2010. Forquestions (a) and(b),ignore anyeffectof taxes.
a. Whatis the revised earnings forecast for20I0 as a resultof theinventory impairment
assuming no change in the sales forecast? What is the revised forecast of return on
common equity(ROCE) for 201O?
b. Show thatthe revision in the forecast of2010 earnings doesnot change the valuation
of theequity.
c. Recognize, now, thatthefirm's income tax rateis 35 percent. Doyouranswers to questions (a)and(b) change?
E5.18.
Impairment of Goodwill (Hard)

A finn madean acquisition at the end of 2008 and recorded the acquisition cost of $428
million on its balance sheetas tangible assets of$349million andgoodwill of$79 million.
The firm useda required returnof 10percent as a hurdleratewhenevaluating the acquisition anddetermined that it waspaying fairvalue.
a. Whatis theprojected residual income from the acquisition for 2009?
b. By the endof2009, thetangible assets from the acquisition hadbeendepreciated to a
book value of $30I million. Management ascertained thatthe acquisition would subsequently earn an annual returnof only9 percent on bookvalueat the end of 2009.
'What is theamount bywhichgoodwill shouldbe impaired underthe FASB and lASB
requirements for impairment?
Chapter 5 Accrual Accounring and Valuation: Pricing Book Val:us 189
Minieases
M5.1
Forecasting from Traded Price-to-Book Ratios:

Cisco Systems, Inc.
Cisco Systems, Inc. (CSeO), manufactures and sells networking and communications
equipment fortransporting data,voice, andvideoandprovides services related to thatequipment. Its products include routing and switching devices, home and office networking
equipment, Internet protocol, telephony, security, network management, and software services. The finn has grown organically but alsothrough acquisition of othernetworking and
software firms. Cisco's Web site is at wwwclsco.com.
Ciscowas a darling of the Internetboom, oneof the few firms withconcrete products.
Indeed itsproducts wereimportant to the development of theinfrastructure fortheInternet
age and the expansion in telecommunications. At onepoint,in early2000, thefirm traded
witha totalmarket capitalization of overhalfa trillion dollars, exceeding thatof Microsoft,
and its sharestraded at a PIE of over130.With thebursting of the Internet bubble andthe
overcapacity in telecommunications resulting from overinvestment bytelecommunications
firms, Cisco's growth slowed, but it certainly was a strongsurvivor. By 2004,its revenue
hadrecovered to the$22.0billion levelreported for2001.
In September 2004, just after its reports for fiscal year ended July 2004 had been
published, Cisco's6,735 million sharestradedat 521 each on bookvalue of 525,826 million. The firm pays no dividend. Analysts were forecasting consensus basicearnings per
shareof$0.89for2005and$1.02for2006.Mostanalysts hadbuyrecommendations on the
stock, somehad holds, but nonewas issuing a sell recommendation. With a betacloseto
2.0, investment analysts wereusing a 12percent required returnfor Cisco's equityat the
time.
A. Bring all thetoolsin thischaptertoan evaluation ofwhether Cisco'sprice-to-book ratio

in September 2004is appropriate. You willnotbeableto resolve theissuewithout some
detailed forecasting of Cisco's future earnings (Which you should not attempt at this
stage). Rather, using the analysts' forecasts for 2005 and 2006, quantify the earnings
forecasts for subsequent years implicit in Cisco's $21 price that couldbe challenged
with further analysis. Identify the speculative components of Cisco's price using the
building blockapproach. Figures 5.4 and5.5 should be helpful to you.
B. Analysts wereforecasting an average target priceof $24forthe endof fiscal year2005.
Is the targetpriceconsistent with a buy recommendation on the stock? Analysts were
alsoforecasting a 14.5 percent five-year growth rateforearnings. Is thebuyrecomrnendation consistent withthe forecasts thatanalysts were making?
C. If, through diligent analysis, you concluded that Cisco's long-run residual earning
growth rate can be no morethan 6 percent per year, whatis the expected rateof return
from buying Ciscoat $2l?

SeeMinicase M6.1 in Chapter 6 fora parallel investigation usingPIE ratios. Minicase M14.2
alsodealswithCisco, as well as Exercises E14.12 andE2.ll.
190 Part One Financia! Scnemenu and Valull!ion
M5.2
Analysts' Forecasts and Valuation:

PepsiCo and Coca-Cola
PepsiCo, Inc.(PEP) is a global snackandbeverage company operating in nearly 200countries. It is organized into fourdivisions: Frito-Lay NorthAmerica, PepsiCo Beverage North
America, PepsiCo International, andQuaker foods. Products include convenience snacks,
sweet andgrain-based snacks, carbonated andnoncarbonated drinks, andfoods.
On October 1,2004, PepsiCo traded at $49.80 pershare on a bookvalue at the endof
2003 of $6.98 per share. Analysts were forecasting per-share earnings of $2.31 for fiscal
yearending December 31,2004, and$2.56 forthe 2005 year. Theindicated dividend for
2004was 0.98 per share. The street was using 9 percent as a required rate of return for
PepsiCo's equity.
TheCeca-Cola Company (KO) alsooperates inover 200countries worldwide andcornpetes intensively withPepsiCo inthemarket forcarbonated andnoncarbonated beverages.
OnOctober I, Coke traded at$40.70 pershare ona bookvalue pershare of$5.77atthe
end of 2003. Analysts were forecasting $1.99 in earnings per share for fiscal yearending
December 31,2004, and$2.10 for2005. Theindicated dividend pershare was SI.00. The
equity is considered to have thesamerequired return as PepsiCo.
A.Forboth PepsiCo andCoke, calculate theearnings per share that the market was implicitly forecasting for2006, 2007, and2008.
B. Analysts were forecasting a five-year annual growth rateinearnings persbare of II percent for PepsiCo and8 percent for Coke. Compare these growth rates with those that
were implied bythe market prices forthefirm's shares at thetime.
C. Why dothese firms have suchhighPIB ratios? Why aretheirrates ofreturn on common
equity (ROCE) so high?
Foryourcalculations, assume thatthepayout ratio indicated for2004 willbemaintained in
thefuture.
Chapter 5 Acl.TlUl! Acco~ming and Vabauon: Pricing Book Values 191
company" claimed a portfolio manager. In 2007, Kimberly-Clark (KMB) grew sales by

9 percent, compared withjust over 5 percent the year before. Even though it absorbed
increased raw material costs without increasing prices, the firm grew operating profit by
24.5 percent. Analysts expected thatthe finn would be ableto passthose costs on to customers in 2008 and 2009, further accelerating earnings growth. Benefits from the finn's
Competitive Improvement Initiative andStrategic CostReduction Plan, both begun in2005
to streamline marketing, manufacturing, andadministrative operations, were evident, andits
research and development operation was producing new products like GoodNites Sleep
Boxers andSleepShorts disposable training pants.
TheBarron s article concluded, "Kimberly shares area lotlikeKleenex: Every investor
should tuck some in a pocket." Thiscaseaskswhether youagree.
At the time, theconsensus analysts' estimate of earnings per share forthe yearending
December 31,2008, was $4.54 and$4.96 for 2009, up from the$4.13 earnings per share
reported for2007. Attheendof 2007, thefinn alsoreported bookvalue of$5,224million
on 420.9 million outstanding shares. Morningstar, a provider of financial information and
mutual fund rankings, wasforecasting a dividend of $2.32 pershare for2008.
A. Calculate the forward PIE and price-to-book (PIB) at which Kimberley-Clark was
trading.
B. Using theanalysts' forecasts, value KMB withanadditional forecast thatresidual earningswillgrow at theGDP growth rateof 4 percent peryearafter2009. Usea required
return of9 percent.
C. Thedividend payout ratio for2008is expected tobemaintained in2009. Based onyour
calculations, whattarget pricewould youforecast fortheendof2009?
D.Consumers require tissues, paper towels, and diapers in good times and bad, so
Kimberly-Clark hasa fairly lowequity betais0.6.Thus, a 9 percent required return may
be a bithigh. If theequity riskpremium forthe market as a whole is 5 percent andthe
risk-free rate is 5 percent, show that the required return from the capital asset pricing
model (CAPM) for a betaof 0.6is 8 percent. Whatwould your valuation ofK.MB beif
the required return were 8 percent? Also test the sensitivity of your valuations to a
required return of 10percent.
E. At a price of $63.20, what is the market's implied forecast of the residual earnings
growth rate after 2009 for a 9 percent required return? What is its forecast of the
earnings-per-share growth ratefor201 O?
SeeMinicase M6.2 in Chapter 6 fora parallel investigation using PIE ratios. SeealsoMinicaseM4.1 in Chapter 4 fordiscounted cash flow analysis applied to Coca-Cola. Exercises
E4.5, E4.6, E4.7. EI1.7,E12.7, EI4.9,E15.12, E16.7, andE19.4 alsodeal with Coca-Cola,
andExercises E4.l2 andE9.8 deal withPepsiCo.
F. Doyouagree withtheconclusion in theBarron s article? What aspect of your calculations areyoumostuncomfortable with?
M5.3
The Continuing Case at the end of each chapter covers Kimberly-Clark. Also see
Exercises E4.8, E6.l4, E7.8, EIO.lO, and El1.l6.
Kimberly-Clark: Buy Its Paper?

In anarticle inBarron sonApril2l, 2008, a commentator remarked, "Asoneof theworld's
largest makers of bathroom tissue andbaby diapers, Kimberly-Clark knows a thing or two
about bottoms. Lately, however, shares of the venerable household-products company,
whose Kleenex brand is virtually synonymous withtissue, look to be neara bottom of anotherSort."
WithShares trading at $63.20, down to a nearlow from a 52~week highof$72.79,the
trailing PIE of 15 was low by historical standards. "This is as cheap as it gets for this
Chapter 6 Accrun.1 Accounring and Valuation: Pricing Earnings 193
UNKS
Chapter 5 showedhowto
pricebookvalues in the
balance sheetand
calculate intrinsic
price-to-book ratios.
This chapter
Thischaptershowshow
topriceearnings in the
income statement and
calculate intrinsic
price-earnings ratio.

Chapter 7 begins the
financial statement
analysis thatis necessary
tocarryout the
price-to-book and
price-earnings
valuations discussed in
Chapters 5 and6.
Link to Webpage
hasmoreapplications
of the techniques
in thischapter.
Howis a firm
valued from
forecasts of
earnings
growth? When
shouldan
investor not
payfor
growth?
Howdo
valuation
methods
protect the
investor
from paying
toomuch
forearnings
growth?
Howdoesthe
analyst
inferthe
market's
forecast of
earnings
growth?
The lastchaptershowed howto anchor valuations on thebookvalue,thebottomlineof the

balance sheet.This chapter shows howto anchorvaluations on earnings, the bottomlineof
the income statement. By anchoring on bookvalue, the analyst develops the price-to-book
ratio (PIB). By anchoring on earnings, the analyst develops the price-earnings ratio (pIE).
So, whilethe last chapter askedhow muchone shouldpay per dollarof book value, this
chapter asks how muchoneshouldpayper dollarof earnings.
What a Pitratio means.

What "abnormal earnings growth" is.
How forecasting abnormal earnings growth yields the
intrinsic PIE ratio.
What ismeant bya normal PIE ratio.
The difference between ex-dividend earnings growth
andcum-dividend earnings growth.
The difference between a Case 1 andCase 2 abnormal
earnings growth valuation.
How both abnormal earnings growth valuation and
residual earnings valuation putless weight on a Speculative, long-term continuing value.
The advantages anddisadvantages of using an abnormal earnings growth valuation andhow the valuation
compares with residual earnings valuation.
How abnormal earnings growth valuation protects the
investor from paying toomuch for earnings growth.
How abnormal earnings growth valuation protects the
investor from paying for earnings that are created by
accounting methods.
How to use the abnormal earnings growth model in
reverse engineering.
What a PEG ratio is.

Calculate cum-dividend earnings.
Calculate abnormal earnings growth.
Calculate thevalue ofequities from forecasts ofearnings
anddividends.
Calculate intrinsic forward PIE andtrailing PIE ratios.
Calculate continuing values for the abnormal earnings
growth model.
Convert an analyst~ EPS forecast to a valuation.
Identify thespeculative component ofa valuation.
Calculate implied earnings growth forecasts from the
market price ofa stock.
Calculate the expected return from buying a stock at
thecurrent market price.
Evaluate a PEG ratio.
Apply tools thatchallenge themarket price.
THE CONCEPT BEHIND THE PRICE-EARNINGS RATIO

PIB ratios differfrom 1.0because accountants do not measure the full valueof the equity
in the balance sheet. However, the missing valueis ultimately realized in the future earnings thatassetsproduce, and theseearnings can be forecasted: A price-to-book ratiois determined byexpected earnings thathavenotyet beenbooked to bookvalue, andthe higher
the future earnings relative to bookvalue, the higherthe PIB ratio.
A parallel idea lies behindthe PIE ratio.As share pricesanticipate future earnings, the
PIEratiocompares the valueof expected future earnings (in thenumerator) to currentearnings (inthe denominator). Just as the PIB ratiois basedon expected earnings thathavenot
yetbeenbooked to bookvalue,the PIE ratioisbasedon expected earnings thathavenotyet
been recognized in currentearnings. So PIE ratiosare high when one forecasts considerablyhigherfuture earnings thancurrentearnings, and PIE ratiosare lowwhenfuture earnings are forecasted to be lowerthancurrentearnings. In short,the PIEratiopricesearnings
growth.
This chapter supplies the formal valuation modelto implement this conceptof the PIE
ratio rigorously, as wellas the mechanics to applythe model faithfully. The formality is
warranted, for One canpay too muchfor earnings growthif one is notcareful.
194 Part One Financial Statements andValuation
Chapter 6 Accrual Accounting andVahUlIion: Pricing Earnings 195
Bewareof Paying TooMuch for Earnings Growth

History shows thathigh PIE stocks-sa-called growth stocks-have beenrewarding investments duringbubble periods: Investors, excited aboutgrowth, pushupprices, andmomentum trading takesoverto yieldyethigher prices and yethigher PIE ratios. Buthistory also
shows that,overall, growth expectations are notrealized: HighPIE stocks have earnedlower
returns than low PIE stocks, andlower returns thanbroadindexes. Chapter 5 camewith a
warning: Beware of earnings growth, and use valuation methods that build in protection
from paying too muchforearnings growth.
This warning sets the stage for this chapter: A sound PIE valuation prices earnings
growth but doesnotpricegrowth thatdoesnotaddvalue. Thischapter not only supplies the
appropriate valuation but alsoone that typically putsless weight on speculative, long-run
continuing values. Accordingly, like residual earnings valuation, the valuation is adept at
challenging the speculation in themarket's PIE ratio.
a forecasted number (yours or an analyst's), so weare anchoring on a forecast rather than

something in the present. But the forward earnings is earnings for the currentfiscal year
(notyet ended), and we maywellhave up to three quarterly earnings already. Butwe can
anchor on the number only if we feel it is something we are fairly confident about(rather
that ?ure speculation). If not, forecast the forward earnings as equalto the trailing actual
earnings.
Thinking of growth as residual earnings growth is a bit awkward. Wewould preferto
thinkof a PIE in termsof earnings growth ratherthanresidual earnings growth. Andindeed
wecan.
PROTOTYPE VALUATION
In anchoring a valuation on earnings ratherthanbookvalues, appreciate thatearnings is a
measure of change in value-a flow ratherthana stock. Toconvert flows to stocks, simply
capitalize theflow. The stockof value implied by earnings is
From Price-to-Book Valuation to PIE Valuation

As boththe PIB ratioandthe PIE ratio are based on thesameearnings expectations, valuationmethods thatanchor onearnings mustyieldthesame valuation as methods thatanchor
on book values. Indeed, we can quickly showthisby returning to the Case 3 valuation of
Dell,Inc.,in Chapter 5. Dell's pro forma fortheresidual earnings (RE) valuation at theend
of 2000 is reproduced herewithoneextraline: the change in residual earnings forecasted
eachyear. (The2006numbers are based on residual earnings growing at 6.5percent, as in
the PIB valuation.)
Stockof value =
Thisearnings capitalization wasexplained in Box 3.6 in Chapter 3. Thewayto think about

anchoring value on earnings is as follows:
Value = Capitalized earnings + Extravaluefor forecasted earnings growth
ForecastYear
2000
EPS
DPS
BPS
2.06
RE (11 % charge)
2001
2002
2003
2004
2005
2006
0.84
0.0
2.90
0.613
0.48
0.0
3.38
0.161
-0.452
0.82
0.0
4.20
0.448
0.287
1.03
0.0
5.23
0.568
0.120
1.18
0.0
6.41
0.605
0.037
1.35
0.0
7.76
0.644
0.039
Change in RE
Rather than anchoring on bookvalue, anchor on the forward earnings of$0.84 per share.
Earnings arejust the change in bookvalue (before dividends), so correspondingly addto
thisanchorby forecasting the subsequent change in residual earnings (fiRE) as follows:
I [ EPS,+--'+-,-'+-,-'
lIRE lIRE lIRE +_,_5+
lIRE
V/=-p-l
Pt
Pt
Pt
Pt
ARE]
6
PE(P~g)
(6.1)
Withthe forecasts above, a required return of 11 percent, andan REgrowth rateof6.5 percentafter2005(as inChapter 5),the per-share value for Dellis
VE =_1_[084+ -0.452 + 0.287 + 0.120 + 0.037 +

2000
0.11'
1.11
1.11'
1.113
1.11'
0.039
]
1.11'(1.l1-1.065)
=$12.31
This is thesamevaluewe obtained in Chapter 5 (allowing for rounding error). Changes in

residual earnings are growth in residual earnings, so we are adding growth to forward
earnings. Thus we havethe intrinsic forward PIEratiothat incorporates growth expectations: vfooo = $12.31/S0.84 = 14.65. Oneaspect maygiveyoupause: Forward earnings is
Earnings
Required return
Tovalueearnings wealways startwith theanchor of capitalized earnings, and thenask

whatextravalue mustbe addedfor anticipated earnings growth.
A savings account iseasyto value, sowewillbeginwiththissimple assetasa prototype
for valuing equities. Exhibit 6.1 presents the same savings account as in Exhibit 5.1 in
EXHIBIT 6.1
Forecasts for a
Savings Account with
$100 Invested at the
End of2008,Earning
5% per Year
ForecastYear
Z008
2009
2010
Earningswithdrawn each year (fullpayout)

Earnings
5
5
Dividends
5
5
Book value
100
100
100
Residual earnings
0
0
Earnings growth rate
0
0
Cum-dividend earnings
5
5.25
growth rate
5%
Nowithdrawals (zero payout)
Earnings
5
Dividends
0
Book value
100
105
Residual earnings
0
Earnings growth rate
5
growth rate
2011
2012
2013
5
5
100
0
0
5.51
5
5
100
0
0
5.79
5
5
100
0
0
6.08
5%
5%
5%
5.25
0
110.25
0
5%
5.25
5.51
0
115.76
0
5.79
0
121.55
0
6.08
0
127.63
0
5%
5%
5%
5.51
5.79
6.08
5%
5%
5%
5%
196 Part One Financial SraCernentlllnd ValWltion
Chapter5. The account involves $100invested in 2008to eam a 5 percentrate eachyear,

from2009and thereafter. Two dividend payout scenarios are presented, fullpayoutand no
payout.
In bothcases, expected residual earnings are zero,so the assetcanbe valued at itsbook
valueof $100 in 2008using the residual earnings model. However, the asset also can be
valuedby capitalizing forward 2009earnings of $5:
Forward Earnings
.
Valueofsavmgs account e
Required return
$5
0.05
::: - : : :
$100
Thusthe savings account can be valued notonlyfrom its bookvalue, but alsoby capitalizingforward earnings.
For the savings account, thereis no extravaluefor anticipated earnings growth. However, youwillnotice that,whiletheearnings growth ratein the full-payout scenario is zero,
it is 5 percent peryearin the no-payout scenario. Yetthe valueof the account is the samein
both cases. According to our calculations, we will not pay for the 5 percentgrowth. The
growth of 5 percent comesfromreinvesting earnings, butthe reinvested earnings earnonly
the required return.The equivalent valuations for the twoaccounts demonstrate the principle that one does not pay for growththat comes from an investment that earns only the
required return,for suchan investment doesnotadd value.
A little more formalism captures this idea and protects us from paying too much for
growth. The earnings growthrates in the twoscenarios look different, but in fact theyare
not. The earnings from the full-payout account are actually understated, for the dividends
fromtheaccountcan be reinvested in an identical account to earn5percent So, forexample, the$5 withdrawn in 2009canbe reinvested to earn5 percent, or$0.25in 2010,so that
the total expected earnings for2010are $5.25, the sameas the zero-payout account. Earningsfroman assetarisefromtwosources, earnings earnedbythe assetandearnings earned
fromreinvesting dividends in another asset. So, by reinvesting dividends for all years, the
earnings in the twopayout scenarios hereare the same;in the no-payout case,earnings are
reinvested in the sameaccount-cthat is, earnings areretained-and in the full-payout case,
earnings canbe reinvested in a different account, in bothcasesearning 5 percent.
The total earnings from an investment are referredto as cum-dividendearnings, that
is, earnings withthe dividend reinvested. Earnings without the reinvestment of dividends
are calledex-dividend earnings. Value is always based on expected cum-dividend earningsand the PIE ratiois always basedon cum-dividend earnings growth, for we mustkeep
track of all sources of earnings from the investment. For2010, the earnings withreinvestment of the dividends fromthe prioryearis
Cum-dividend earnings2010 ::: Earnings2olO + (p ~ 1)dividend2oo9
wherep is (as before) 1 plus the required return. So, for the full-payout savings account,
cum-dividend earnings for 2010 are Earnings2oio + (0.05x Dividend2()()9):::: $5 + (0.05 x
55) = 55.25.
Ona cum-dividend basis,earnings growth in the twoscenarios is thesame,Spercentper
year,as you can see fromthe cum-dividend earnings line in Exhibit 6.1. However, in both
cases, the earnings growth is not growth that we will pay for. We only pay for earnings
growth that is greater than the required return. Earnings that are due to growth at the
required returnare callednormal earnings. Forany period, t
Normal eamings.> pEamingsl_l
So, for the savings account, normal earnings in 2010:::: 1.05x $5:::: $5.25,that is, the prior
year'searnings growing at 5 percent. The part of cum-dividend earnings for which wewill
P/ERA.TJ<)S A.~DEA.RNINGS GROWTH

FOR THE S&P soil
The riddle IS solved as follows. Firms in the S&P 500 pay

dividends; indeed, the historical dividend payout ratio has
The. historical average forward PIE ratio for the S&P 500 is been about 45 percent of earnings. The 8.5 percent growth
about 15 (and the average trailing PIE ratio isabout 16). The rate isan ex-dividend growth rate. The cum-dividend growth
historical average. earnings per share growth rate is about ratewith 45 percent payout isabout 13 percent. So, histori8.5 percent peryear. If the required return for stocks ingen- cally, earnings have really grown 13 percent peryear, cumeral is 10 percent, the normal forward PIE ratio IS 10. These dividend, above the assumed required return of 10 percent.
numbers present a.riddle: If the growth rate is 8.5 percent, That puts theforward PIE ratio above thenormal of 10,which
less than the required return of 10 percent, the forward PIE indeed ithas been.
should bebelow the norma! of 10, notabove itat 15.
payis the cum-dividend earnings growthoverthesenormal earnings, thatis,the abnormal

earnings growth:
Abnormal earnings growth,>Cum-dividend earnings, - Normal earnings,
:::: [Earnings, + (p - Ijdividendc.] - pEarningsl_l
Ascum-dividend earnings forthesavings account in 2010are$5.25,andas normal earnings
alsoare$5.25,abnormal earnings growth iszero.Andso foryears20II andbeyond. We win
not payforgrowthbecause, whilewe forecast growth, wedo not forecast abnormal growth.
Withthesebasicconcepts in place,we nowcan move from the simpleprototype to the
valuation of equities. Hereis a surrunary of the concepts wecarry withus:
I. An asset is worthmore than its capitalized earnings only if it can growcum-dividend
earnings at a rategreaterthanthe required return. Thisrecognizes thatonepaysonlyfor
growththataddsvalue.
2. When forecasting earnings growth, one must focus on cum-dividend growth.
Ex-dividend growthignores the valuethatcomes fromreinvesting dividends.
3. Dividend payout is irrelevant to valuation, for cum-dividend earnings growth is the
sameirrespective of dividends.
Box 6.1 solvesa riddleaboutearnings growth for the S&P500.
The Normal Forward PIE Ratio

Theforward PIE is pricerelative to the forecast of next year's earnings. For the savings
account, the forward PIE ratio in 2008is $100/$5 = 20.This is a particularly specialPIE,
referred to as the normal forward PIE:
Normal forward PIE
Required return
Thatis, the normal forward PIE isjust $1 capitalized at the required return. Forthe savings
account, the forward PIE is 1/0.05 = 20.
The normal PIEembeds a principle thatapplies to all assets, including equities. If one
forecasts no abnormal earnings growth (as withthe savings account), the forward PIEratio
mustbe l/required return. Or,putdifferently, ifoneexpects the growth ratein cum-dividend
earnings to be equalto therequired return,the forward PIEratiomustbe normal. Thatis, a
normal PIE implies thatnormal earnings growth is expected. Fora required (nonnal) return
of 10percent, the normal forward PIE is 1/0.10, or 10.Fora required return of 12percent,
197
19B Part One Financial $ulIemenlS andValuation
Chapter 6 Accrual AC(Qunnng andValuarion: PndngEarnings 199
the normal forward PIEis 1/0.12::= 8.33. If oneforecasts cum-dividend earnings to growat
a rate greatertban the required return, the PIE mustbe above normal: One pays extrafor
growth above normal. If one forecasts cum-dividend earnings to growat a rate lower than
the required return, the PIE ratiomustbe lower thannormal: Onediscounts forlow growth.
A Poor PIE Model

The following modelforvaluing equities fromforward earnings is quitecommon:
Valueof equity = Earn l
PE - g
The Normal Trailing PIE Ratio

Chapter 3 distinguished the trailing PIE-the multiple of current earnings-from the
forward PIE-the multiple of earnings forecasted one year ahead. Having calculated the
valueof thesavings account fromforecasts offorward earnings andearnings growth, calculatingthe trailing PIE is, of course, straightforward: Justdivide the calculated valueby the
earnings reported in the lastincome statement. But thereis an adjustment to make.
For the savings account in Exhibit 6.1, the trailing year is 2008, suppose that S100
were invested in the account at the beginning of 2008 to earn 5 percent.Earnings for
2008 wouldbe S5 and, if these earnings werepaid out as dividends, the value of the-account at the end of 2008would still be $100. So it wouldappearthat the trailing PIE is
$100/$5 = 20, the same as the forward PIE. However, this is incorrect. How could the
value of one more yearof earningsbe the same?Supposethe $5 earningsfor 2008 were
not paid out, so that the value in the account was $105. The PIE ratio then becomes
SI05/$5 = 21.The latteris the correcttrailing PIE.
The amountthat $1 of earnings is worth-the PIEmultiple-should notdependon dividends. The S5 of earnings for a savings account produces $105in valuefor the owner of
the account-the SIOO at the beginning of the periodthat produced the earnings, plus the
S5 of earnings. If she leaves the earnings in the account, the ownerhas $105;if she withdrawsthe earnings, she still has $105,with $100 in the account and $5 in her wallet. The
trailingPrE is 21.Thus,the trailingPIE mustalways be basedon cum-dividend prices:
Trailing PIE
Price+ Dividend
Earnings
This measure is the dividend-adjusted PIE introduced in Chapter 3. Theadjustment is necessary because dividends reduce the price (in the numerator) but do not affectearnings
(in the denominator). The adjustment is not necessary for the forward PrE because both
pricesand forward earnings are reduced by thecurrentdividend PIE ratiospublished in the
financial pressdo notmakethe adjustment for the trailing PIE. If the dividend is small,it
matters little,but for high-payout firms, published PIE ratiosdepend On dividends as well
as the abilityof the fum to growearnings.
Whereas the normal forward PIE is lfRequired return,the normal trailing PIE is
Normal trailing P/E
(l
+ Required return)
Required return
Forthesavings account, the normal trailing PrEis $1.05/$0.05 = 21 (compared with 20 for
the forward PIE). For a required return of 10 percent, the normal trailing PIE is
S1.10/S0.1O = 11 (compared with 10 for the forward PIE), and for a requiredreturn of
12percent,it is $1.121S0.12 = 9.33(compared with8.33for the forward PIE). The normal
forward PIE and the normal trailing PrE always differ by 1.0, representing one current
dollar earning at the required returnfor an extrayear.
Just as a normal forward PrE implies thatforward earnings are expected to grow, cumdividend, at the required rate of return after the forward year, so a normal trailing PIE
implies that current earnings are expected to grow, cum-dividend, at the required rate of
return after the currentyear. So the trailing PrEfor the savings aCC01.mt is 21 because the
expected cum-dividend earnings growth rateis the required rateof 5 percent.
where g is (1 plus)theforecasted earnings growth rate.(You perhaps have seenthismodel with

the letter r usedto indicate the required return rather than p.)The model looks as ifit should
value earnings growth. Theformula modifies thecapitalized earnings formula (which worked
fora savings account) forgrowth; indeed, themodel issimply the formula fora perpetuity with
growth thatwasintroduced in Chapter 3. Withthismodel, the forward PIE ratio is lI(PE- g).
Thismodel is simple, but it is wrong. First, it is applied with forecasts of ex-dividend
growth rates rather than cum-dividend growth rates. Ex-dividend growth rates ignore
growth fromreinvesting dividends. Thehigherthe dividend payout, the higherthe omitted
valuecalculated by the formula withex-dividend growth rates. Second, the formula clearly
doesnotworkwhenthe earnings growth rateis greaterthantherequired return, forthenthe
denominator is negative. Forthe savings account, the required returnis 5 percent, but the
expected cum-dividend growthrate is also5 percent, so the denominator of this formula is
zero (and the calculated valueof the savings account is infinitel). For equities, the cumdividend growth rate is often higher than the required return, resulting in a negative
denominator: This is the case for the S&P 500 in Box 6.1, for example. A growth rate
slightly lower thantherequired returnwouldhaveyoupaying a veryhighprice-and overpayingfor growth.
Thisis a poor model; it leadsyouintoerrors.The denominator problem is a mathematicalproblem, butbehindthismathematical problem lurks a conceptual problem. Weneeda
valuation model that protects us frompayingtoo muchforgrowth.
A MODEL FOR ANCHORING VALUE ON EARNINGS

The prototype valuation of the savings account gives us an anchor: capitalized forward
earnings. It also indicates the anchoring principle:
Anchoring Principle: Ifoneforecasts thatcum-dividend earnings willgrowata rateequal to
the required rateof return, the asset's value mustbe equal to itsearningscapitalized.
Correspondingly, one adds extra value to the anchorif cum-dividend earnings are forecasted to growat a rategreater than the required return: Theassetmustbe worth morethan
its earnings capitalized. Abnormal earnings growthis the metric that captures the extra
value, so the valueof the equityfor a goingconcern is
Value of equity = Capitalized forward earnings + Extravaluefor
abnormal cum-dividend earnings growth
Vl =
Earn] + _1_[ AEG2 + AEO} + AEG4 +...1
PE -1
PE -1
PE
pi
p~
]
AEG, AEG) AEG 4
= -I - [Eam,+--+--+--+.
PE-l
PE
p}
Pk
(6.2)
where AEGis abnormal (cum-dividend) earnings growth. (Theellipses indicate thatforecasts continue on intothe future, for equitiesare goingconcerns.) You see fromthe first
version of the formula herethatthe discounted valueof abnormal earnings growthsupplies
200 Part One Financial Statements a.nd Vahwlion
I,
Chapter G Accrnal Accounting andValuation: Pricing Earnings 201
FIGURE 6.1 Calculationof EquityValue UsingtheAbnormalEarningsGrowthModel

Abnormal earnings growth is thedifference between cum-dividend earnings andnormal earnings. The present valueof
abnormal earnings growth forYear 2 andbeyond is addedto forward earnings forYear 1, andthetotalis then capitalized
to calculate equity value.
Abnormal earnings growth, ""Cum-dividend earnings, - Normal earnings,
Cum-dividend earnings, "" Earnings, + (PE - 1)dividendc,
Normal earnings, '" PE Eamingsc.r
The intrinsic forward PIE is obtained by dividing the value calculated by forward
earnings: vij"lEaml. If no abnormal earnings growth is forecasted,
andthe PIE is normal:
vt
1 Forecasts
'Year 1ahead
Forward
earnings I
Earn,
,Year3 ahead
Cumdividend
earnings)
,--c,
Normal
earnings)
Cumdividend
earnings4
Normal
earnings,
=_1_
PE-l
This model is referred to as the abnormal earnings growth model, Or the OhlsonIuettner model afterits architects.'
Measuring Abnormal Earnings Growth

Abnormal
earnings
Abnormal
eamings4
As for the savings account, abnormal earnings growth (AEG) is earnings (withdividends
reinvested) in excess of earnings growing at the required return:
Abnormal earnings growth, = Cum-dividend earn[ - Normal earn,
= [Earn, + (PE- l)d,_I]- PEEamH
(6.3)
Calculations canbe madeon a per-share basisor on a totaldollarbasis.Whenworking

on a per-share basis, dividends are dividends per share; when working on a total dollar
basis,dividends are net dividends (dividends plus share repurchases minus share issues).
Here are calculations of abnormal earnings growth for 2008 for twofirms, Dell,Inc., and
Nike, Inc.Therequired returnin bothcasesis 10percent.
Dell, Inc.
+
+
Total
earnings
plus
growth
the extravalueoverthatfrom capitalized forward earnings. Thediscounting calculates the

valueat the endof Year 1 of growthfromYear 2 onward., andthe valuefrom growth is then
capitalized (toconvert the value offiowsto a stockof value). Asboththe valueofgrowth and
forward earnings arecapitalized, thesecond version ofthe formula simplifies thecalculation.
So,to valuea share, proceed through the following steps:
1. Forecast one-year-ahead earnings.

2. Forecast abnormal earnings growth (AEG) afterthe forward year(Year 1).
3. Calculate thepresentvalue(at the end ofYear 1) of expected abnormal earnings growth
after the forward year.
4. Capitalize the totalof forward earnings and the valueof abnormal earnings growth.
Figure 6.1 directs youthrough thesethreesteps.As withresidual earnings valuation, earningsmust be comprehensive earnings; otherwise, valueis lost in the calculation. Simply
stated, the model saysthat valueisbasedon futureearnings, butwithearnings fromnormal
growth subtracted.
EPS 2008
DPS 2007
Earnings on reinvested dividends
Cum-dividend earnings 2008
Normal earnings from2007:
Dell: 1.15x 1.10; Nike: 2.96x 1.10
Abnormal earnings growth (AEG) 2008
Nike.fnc.
11.33
10.00
13.80
10.71
0.00
1.33
0.071
3.871
1.265
0.065
3.256
0.615
As Dellhasno dividends, cum-dividend EPSis thesame as reported EPS ($lJ3). Nike

paid DPS of SO.71 in 2007, so cum-dividend EPSfor 2008 is the reported EPS of $3.80
plus SO.071 from reinvesting the 2007 dividend at 10percent. In bothcases, normalearn.
ingsfor 2008 is 2007 EPSgrowing at the"normal"rate of 10 percent.
Abnormal earnings growthcanbe expressed in termsof growth ratesrelative to required
returnrates:
Abnormal earnings growth, '" [G[ - pEJ x Earnings t _ 1
(6.3a)
where G1 is 1 plusthe cum-dividend earnings growth rateforthe period. Thatis,AEGis the

dollaramount by which a prioryear'searnings grow, cum-dividend, relative to the required
rate.If G, isequalto therequired rateof return,thereisno abnormal earnings growth. With
EPS of $1.33 for 2008 (andno dividends), Dell's cum-dividend earnings growth rate was
1 See J. A.Ohlsonand
B. E. Juettner-Nauroth, "Expected EPS and EPS Growthas Determinants
orValue," Revlewo( AccountIng Studies, July-September, 2005, po. 347-364.
::1
Chapter6 Acrnw1 AccOtlming and Valuarian: Pricing Earning> 203
202 Part One Financial Statements and Valuation
,\
S1.33/Ll5"" 15.65 percent (plus 1).So, with a required returnof 10percent, Dell'sAEO
for 2008was $1.15 x (0.1565 - 0.10)= $0.065 pershare,as before.
'!
A Simple Demonstration and a Simple Valuation Model

Exhibit 6.2 applies the abnormal earnings growth model to thesimple prototype fum used
in Chapter 5. This firm has a required returnof 10percent andits earnings areexpected to
growat 3 percent a year. A 3 percent growth rate looks low, but lookscan be deceiving
because the firm has a highpayout ratio(76percent of earnings).
Basedon the earnings and dividend forecasts and the future book values they imply,
residual earnings for the finn are forecasted to growat a 3 percent rate,as indicated in the
exhibit. So thefirm canbe valuedwitha Case3 residual earnings valuation bycapitalizing
Year 1 residual earnings at thisgrowth rate, as in Chapter 5:
V[f = 100 +
2.36..,:::: 133.71 million
1.10-1.0,
EXHIBIT 6.2 Forecasts for a Firm with Expected Earnings Growth of 3 Percentper Year
In millions of dollars. Required returnis 10percentper year.
Residual earnings forecasts:

Earnings
Dividends
Book value
Residual earnings (RE)
RE growth rate
12.00
9.09
100.00
12.73
9.64
106.09
1.431
13.11
9.93
109.27
1.504
13.51
10.23
112.55
2.579
3%
3%
3%
3%
11.36
9.36
0.909
12.73
9.64
0.936
13.11
9.93
0.964
13.51
10.23
13.269
13.667
14.077
13.200
0.069
13.596
0.071
14.004
0.073
14.499
14.424
0.075
13.91
10.53
1.023
14.934
14.857
0.077
10.57%
10.0%
3%
10.57%
10.0%
3%
10.57%
10.0%
3%
10.57%
10.0%
3%
10.57%
10.0%
12.36
9.36
103.00
2.360
13.91
10.54
115.92
2.656
Abnormal earnings growth forecasts:

Earnings
Dividends
Earnings on reinvested dividends
Norma! earnings
Abnormal earnings growth (AEG)
Abnormal earnings growth rate
Cum-dividend earnings growth rate
Normal earnings growth rate
11.00
9.09
0.993
The Calculations:
Earnings on reinvesteddividends refers to the prior year's dividend earning at the required return. So,
forYear 2, earnings on reinvested dividends are0.10x 9.36:= 0.936.
Cum-dividend earnings addsearnings on reinvested dividends to the ex-dividend earnings forecasted. So,
cum-dividend earnings forYear 2 are 12.73 + (0.10 x 9.36):=: 13.667.
Normal earnings isthe prior year's earnings growing at the required return. So, forYear 2, normal earnings are
11.36 x 1.10 = 13.596.
Abnormal earnings growth iscum-dividend earnings - normal earnings. So, forYear 2, AEG =" 13.667 13.596 = 0.071.
Abnormal earnings growth isalsothe prior year's earnings multiplied bythe spread between the cum-dividend
growth rateandthe required rate. So, forYear 2, AEG is(1.1057 - 1.10) x 12.36:::: 0.071.
Allowfo' rounding errors.
.
VoE :::: - I [ 12.3 6 + 0.071] :::: 133.71 million
0.10
1.10 -1.03
(Allow for rounding errors.) This is a simple valuation model where growth at a constant
rate begins after the forward year. The forward PIE ratiois 133.71/12.36"" 10.82, higher
than the normal PIE of 10. You will notice at the bottom of the exhibit that the cumdividend earnings growth rate is 10.57 percent, higherthanthe required returnof 10 percent,andaccordingly the PIE ratiois greaterthan thenormal PIE. You alsowillnoticethat
the cum-dividend earnings growth rate is considerably higher thanthe 3 percent rateforecastedfor (ex-dividend) eamings.' And you will notice that the RE model and theAEO
model give us the samevaluation.
Anchoring Valuation on Current Earnings
ForecastYear
0
The exhibit also forecasts abnormal earnings growth (AEO), in orderto apply the abnormal earnings growth model. Abnormal earnings growth eachyearis cum-dividend earningslessnormal earnings. Calculations are described at thebottom of theexhibit usingboth
the equation 6.3 and 6.3amethods. You see thatAEG is growing at 3 percent afterYear 1.
So,the AEG forYear 2 can be capitalized withthisgrowth rate:
The valuation in this example pricesforward earnings so, strictly speaking, it anchors on
forecasted earnings ratherthanthe currentearnings in the financial statements. The value
canalsobe calculated by anchoring on current(trailing) earnings: Capitalize currentearnings, and then add the value of forecasted AEG from Year 1 onward. That is, shift the
application of themodel one period backin time.So,for the example in Exhibit 6.2,
VoE + do
=133.71 + 9.09 =-UO [ 12.00 +

0.10
0.069 ]
UO - 1.03
=142.80 million
Thevalue obtained is thecum-dividend value(price plusdividend) appropriate forvaluing

current earnings. The trailing PIE is $142.80/$12.00 "" 11.90, higherthanthe normal trailing PIE of II (for a required returnof 10 percent). The $12.00 here is earnings forYear 0
andthe$0.069 is forecastedAEO forYear I, whichis expected togrowat a 3 percent rate.
The capitalization rate is 1.10/0.10, the normaltrailing PIE, ratherthan 1/0.10, thenormal
forward PIE. The formal model forthe calculation is
E
E [
AEG, AEG, AEG,
]
Vo
+do= , P
, - - Earn,+ - - + - - + - - + ...
PE-l
PE
p}
pi
(6.4)
Clearly, withnoABO afterthecurrent year, thetrailing PIE is normaL

Anchoring valuation on current earnings anchors on actual earnings in the financial
statements ratherthan a forecast of earnings. However, thereis a goodreason to apply the
model to forward earnings ratherthan currentearnings. As we wilJ see when we come to
analyze financial statements, currentearnings oftencontain nonsustainable componentsunusual events and one-time charges, for example-that do not bear on the future. By
focusing on forward earnings and using current earnings as a base for the forecast, we
2Strictly. cum-dividend earnings foranyyearaheadareearnings forthat year plus earnings from all
dividends paid andreinvested from Year 1 up to that year. So, forYear 3, cum-dividend earnings are
the $13.11 EP5 forthat year, plus the Year Zdividend invested foroneyear, plus the earnings from the
reinvested Year 1 dividend. However, as dividends earn at the required return and earnings at the
required return aresubtracted inthe AEG calculation, itmakes no difference to the valuation-andis
certainly simpler-ifwe justinclude the earnings on the prior year's dividends incum-dividend earnings.
204 Part One
Financial SEa!emems and Valuation
Anchor on What You Know and Avoid Speculation 6.2
effectively focus on the sustainable portionof currentearnings that can grow. Indeed, the
financial statement analysis of PartTwo of the bookaims to identifysustainable earnings
thatare a soundanchorfor forecasting forward earnings.
The Web page for this chapterprovides a spreadsheet to help you develop abnormal
earnings growth pro formas.
APPLYING THE MODEL TO EQUITIES

Theexample in Exhibit 6.2issimilarto our prototype savings account example, exceptthat
this firm has someabnormal earnings growthwhereas the savings account had none.The
firm is simplebecause AEGis forecasted to growat a constantrateimmediately after the
firstyearahead.Model6.2 requires infinite forecasting horizons, so, to valueequities, we
needcontinuing values to truncate the forecast horizon. In the simpleexample, this occurs
just one yearahead.
There are two typesof continuing valuecalculations. Case I applieswhenone expects
subsequent abnormal earnings growth at the forecast horizon to be zero. Case 2 applies
whenone expects moreabnormal earnings growth afterthe forecast horizon.
Case I is illustrated usingGeneral Electric Company witha required returnofl0 percent.
TheEPSandDPSnumbers inCase1areGE'sactual numbers for2000-2004, thesamenumhersusedto valueGEusingresidual earnings methods in the lastchapter. Asin thelastchapter,wetreatthenumbers asforecasts andvalueGE'sshares at theendof1999.Recall thatwe
attempted to valueGEusingdiscounted cashflow techniques in Chapter 4 butranintodifficulties. However, wefound wecouldvalueit withresidual earnings methods. TheAEGvaluation hereproduces the same$13.07 persharevalueasthe REvaluation in Chapter 5.
The Case 1 valuation is basedon a forecast thatAEGwill be zeroafter2004.Whilethe
analyst forecasts positive AEGfor2004, he notesthattheaverage AEGisclose tozeroover
2001-2004andsoforecasts zeroAEGsubsequently. ZeroAEGimplies, of course, thatcumdividend earnings are expected to growafter2004at the required rateof return.justlikethe
savings account. The totalAEGover2001-2004, discounted to the end of 2000, is SO.Ql7
pershare.Addedto forward earnings for 2000of Sl.29 yields $1.307, whichwhen capitalizedat the 10percentrate,yields thevaluation of$13.07pershare.Nowgo to Box 6.2.
CASE1
ForecastYear
General Electric
1999
C,.(GE)
Inthis case, abnormal

earnings growth is
expected tobezero
after 2004. Required
rate ofreturn is
10percent.
DP5
EP5
DPS reinvested (0.10x DPS r_ 1)

(EPS + DPS reinvested)
Normal earnings (1.10 x EPS r_ 1)
Discount rate(1.l0t )
Present value of AEG
Total PVofAEG
Total earnings to be capitalized
Capitalization rate
Value pershare (1.307)
0.10
Noto' Allow ro, rounding error.!.
2000
2001
2002
2003
2004
0.57
1.29
0.66
1.38
0.057
0.73
1.42
0.066
0.77
1.50
0.073
0.82
1.60
0.077
1.437
1.419
0.018
1.100
0.016
1.486
1.518
-0.032
1.210
-0.026
1.573
1.562
0.011
1.331
0.008
1.677
1.650
0.027
1.464
0.018
0.017
1.307
0.10
13.07
..
!'.
Fundamentalist principles (in Chapter 1)emphasize that we

should separate what we know from speculation and anchor
onwhat weknow. This isparticularly important when valuing
growth, for growth isspeculative.
!n Chapter 4, we pointed out that discounted cash flow
(DCF) analysis often putsa lotofthevalue into thecontinuing
value. This is problematic forthecontinuing value isthe most
uncertain part ofa valuation, dealing asit does with the long
term. For General Electric (GE) inChapter 4, more than 100
percent ofthevaluation isinthe continuing value. We would
much prefer a valuation method where thevalue comes from
thepresent ("what weknow") or the near-term future (what
weknow with some confidence): We suggested thatearnings
might supply some level of comfort.
Indeed, for General Electric inCase 1,thecontinuing value
at the forecast horizon, 2004, iszero, compared with more
than 100 percent in the OCF valuation. We valued GE with
five years of forecasts. We may have some uncertainty about
these forecasts-and would prefer a valuation based on one
or twoyears offorecasted earnings-but probably feel more
comfortable with this valuation than one that speculates
about a large continuing value.
The difference between DCF valuation and the valuation
here is, of course, the accounting: Cash accounting versus
accrual accounting. Accrual accounting brings the future
forward intime, leaving less value in a continuing value.
The residual earnings valuation for GE inChapter 5 also

used accrual accounting, butthe Case 2 valuation there has
a nonzero continuing value (in equation 5.5). Is it then the
case that AEG valuation gives us a more secure valuation
than an RE valuation? It does look like it, butinfact no. The
residual earnings valuation gives the same valuation as the
AEG valuation for the same forecast horizon. Forecasting
thatRE will bea constant at theforecast horizon ina Case 2
residual earnings valuation is the same as forecasting that
AEG = 0, for it isalways the case that AEG = change inRE.
By forecasting that RE will be positive but constant. we are
justforecasting that there will bevalue missing from the balance sheet. But therewill benoadded value for qrowth. See
Box 6.3.
If expected AEG = 0, then the PIE is normal, as demonstrated with the savings account. Soforecasting thatGE will
have zero AEG in2005 isequivalent to forecasting thatits PIE
will benormal. (By 2008, GE's PIE was approximately normal.
See Exercise E6.1 0.)
Proceed now to thevaluation ofDell, Inc. You will seethat
there is now a continuing value containing a qrowth speculation. In this case, we do notescape some speculation about
the long run. But weseparate thatspeculation (in thecontinuing value) from what wearemore confident about (in nearterm forecasts).
A Case 2 valuation is demonstrated using Dell, lnc., with a required rate of return of
II percent. TheEPSandDPSup to 2005are thesameas thosein Chapter 5 where wevalued the firmusingresidual earnings methods with a continuing valuebasedon a forecast
that residual earnings after2005 would growat 6.5 percent. The EPS for2006here is that
which would result from this growth rate. Dellpays no dividends, so cum-dividend earningsare the sameas earnings.
Case2 differs fromCase 1 because AEGis expected to continue to growafterthe forecast horizon, so the valuation adds a continuing valuethat incorporates this growth. With
the forecasted AEGfor 2006expected to growat a rateof 6.5 percent after 2006, the continuing valueforDellat the endof2005 is0.873pershare.Adding thepresent value of this
continuing valueat the end of 200I to the totalpresent valueof AEG up to the endof2005
($-0.062) andthe forward earnings for 2001 (50.84) yields $1354 of earnings to be capitalized, resulting in a valueofS123 I per share.
Thisis thesamevaluecalculated withresidual earnings methods in Chapter 5.Andit is
also the same as the value using forecasted changes in residual earnings in equation 6.1.
Indeed, youcan see that theAEG for Dell herealways equals the change in residual earnings given above in equation 6.1.As bothare anchored on forward earnings, the two valuationsmust be thesame.Go to Box 6.3 for a formal demonstration that t.RE :::: AEG.
Converting Analysts' Forecasts to a Valuation

In Chapter 5 we converted analysts'forecasts for Nike to a valuation usingresidual earnings methods. Herewe do the samefor Google, Inc.,the supplier of Web-based software,
205
206 Part One Fi'nancial Statemel1ts and Valll(ldon
Chapter 6 AccrudAccounting and Valuotion: Pricing Earnings 207
CASE 2
Dell, Inc.
In thiscase, abnormal
earnings areexpected
to grow ata 6.5perccnt rateafter 2005.
Required rateof return
is 11 percent.
TABLE 6.1
Forecast Year
2000
DPS
EPS
DPS reinvested (0.11 x DPS H )
Normal earnings (1.11 x EPS t_ 1)
Abnormal earnings growth
Discount rate (1.11 'l
Total PV of AEG
PVof CV
Total earnings to becapitalized
Capitalization rate
1.354)
Value pershare ( 0.11
2001
2002
2003
2004
2005
2006
0.0
0.84
0.0
0.48
0.00
0.48
0.932
-0.452
1.110
-0.408
0.0
0.82
0.00
0.82
0.533
0.287
1.232
0.233
0.0
1.03
0.00
1.03
0.910
0.120
1.368
0.088
0.0
1.18
0.00
1.18
1.143
0.037
1.518
0.025
0.0
1.35
0.00
1.349
1.310
0.039
0.84
-0.062
0.873
0.576
1.354
0.11
..
The continuing value calculation:

CV
0.0393
1.11-1.065
0.873
Present value of CV = 0.873 = 0.576

1.5181
Note:Allow forrounding emns.
particularly Web search, whose revenues come largely from online advertising. In Table
6.1, analysts'consensus EPS forecasts for 2008and2009are entered, alongwithforecasts
for 2010-2012from applying theirintermediate-term (five-year) consensus growth rate to
the 2009estimate.
The calculations in the table show that analysts are forecasting abnormal earnings
growthafterthe forward year,2008.Analysts do notprovide forecasts morethanfiveyears
ahead, so thecontinuing value here is basedon a 4 percentlong-term growthrate,the typical GDP growth rate. By doingso, we are refusing to speculate; we are relying on a historicalaverage ("whatweknow"). Thecalculated valueis $699.58 pershare.Google traded
at $520at the time, so this valueis well in excessof themarket's valuation. Whatcouldbe
'Wrong? Analysts' five-year growthratesare typically optimistic, moreso(probably) forthis
hot stock.Alternatively, the marketprice is cheap. Or, couldit be the case that the longtermgrowthrateof 4 percenthereis toooptimistic? We willreturnto theseissueswhenwe
reverse engineer the marketpriceat the end of the chapter.
FEATURES OF THE ABNORMAL EARNINGS GROWTH MODEL

Box 6.4 lists the advantages and disadvantages of the abnormal earnings growth
model. Compare it to similarsummaries for the dividend discount model (in Chapter 4),
the discounted cash flow model (in Chapter 4), and the residual earnings model (in
Chapter5).
Converting Analysts'
Forecasts to a
Valuation: Google,
10c
Analysts forecast EPS

two years ahead
(S19.61 for2008 and
$24.01 for2009) and
also give a five-year
EPS growth rate of
28 percent. Forecasts
for 2010-2012 apply
this consensus growth
rate tothe2009
estimate. Google pays
nodividends. Required
rate ofreturn is
12 percent, reflecting
Google's high beta.
2007A 200aE 2009E
2010E
J1!L 0.0
19.61 24.01
0.0
24.01
21.96
2.05
1.12
1.830
12.39
0.0
30.73
0.0
30.73
26.89
3.84
1.254
3.061
DPS
EPS
DPS reinvested (0.12 x DPSt_l)
Normal earnings (1.12 x EPS t_ l )
Discount rate (1.12f)
Total PV of AEG
PVofCV
Total earnings to becapitalized
Capitalization rate
Value pershare ( 8395)

0.12
2011E
2012E
0.0
0.0
39.34
50.35
0.0
0.0
39.34 50.35
34.42
44.06
4.92
6.29
1.405 1.574
3.502
3.996
81.77
51.95
83.95
0.12
$699.58..J

CV" 6.29x 1.04"81.77
1.12-1.04
81.77
Present value of CV=1.574 =51.95
Note:Allow forroundingorrors.
We haveemphasized that AEGvaluation, like the residual earnings valuation, protects

us from paying too much for earnings growth. In this sectionwe will discuss someother
features of the model.
Buy Earnings
The abnormal earnings growth modeladopts the perspective of "buying earnings." It embodiesthe ideathatthe valueof a fum is basedon whatit can earn. As earnings represent
value to be added from selling products and services in markets, the model anticipates
the valueto be addedfrom trading with customers, after matching revenues from those
customers withthe values given up, in expenses, to generate the revenue.
TheAEGmodel embraces the language of the analyst community. PIEratiosare more
oftenreferredto than Pro ratios. Analysts talkofearnings andearning growth, notresidual
earnings andresidual earnings growth. So,converting an analyst's forecast to a valuation is
more direct with this model than with the residual earnings model. (The language of the
(Wall) street does not recognize how dividends affect growth, however; analysts talk of
ex-dividend earnings growth rates, not cum-dividend rates.)
Abnormal Earnings Growth Valuation

and Residual Earnings Valuation
On the otherhand,the AEGmodel does not giveas much insightinto the valuecreation
as the residual earnings model.Firms investin assets and add value by employing these
ADVANTAGES
Easy to understand:
The AEG model andthe RE model look different butarereally
quite similar. Both require forecasts ofearnings and dividends,
although the RE model adds theextra mechanical stepofcalculating book value forecasts from these forecasts.
Structurally, thetwomodels aresimilar. The RE starts with
book value as an anchor and then adds value by charging
forecasted earnings by the required return applied to book
value. The AEG model starts with capitalized earnings as an
anchor and then adds value by charging forecasted (cumdividend) earnings by the required return applied to prior
earnings, rather than book value.
This structural difference isjust a different arrangement of
the inputs. A little algebra underscores the point. Abnormal
earnings growth can bewritten ina different form:
You can also see the equivalence bycomparing the AEG for
Dell intheCase 2 valuation with the changes inRE inthe Dell
valuation at thefront of this chapter.
So, forecasting that there will be no abnormal earnings
growth isthe same as forecasting that residual earnings will
notchange. Or, as abnormal earnings growth of zero means
that(cum-dividend) earnings aregrowing at therequired rate
of return, forecasting this normal growth rate isthe same as
forecasting that residual earnings will not change. Correspondingly, forecasting cum-dividend earnings growth above
normal isthesame asforecasting growth inresidual earnings.
Accordingly, onesetof forecasts gives usboth valuations, as
the Case 2 valuation for Dell and the equivalent valuation
based on changes in residual earnings at the front of this
chapter demonstrate.
AEG r "" IEarn( +(PE -l)dl_d - PEEarnl_1
The rearrangement ofthe inputs leads to thedifferent an"" Earnr- Earnr_1 -(Pf-1){Earnt_1 -dl_l)
chors anddifferent definitions ofadding value to theanchors.
Using the stocks and flows equation for accounting for the Yet the underlying concepts are similar. AEG valuation enbook value of equity (Chapter 2), 81_1"" 81_2 + Earnl~l - dl~l, forces the point that a firm cannot addvalue from growing
earnings unless it grows earnings at a rate greater than the
soEarnt_l - d l_1 "" 8:_ 1 ~ 8r_2. Tnus,
required rate of return. Only then does itincrease its PIE ratio.
AEG t "" Earnl- Earnl_1 ~(PE- 1)(81_1 ~8(_2)
But thatisthesame assaying thatthefirm must grow residual
earnings to increase itsPIB ratio. That is. added value comes
'"[Esm, - (Pc -1)8 H ] - [EarnC_1 - (Pc - 1)8c_2]
from investing to earn a return greater than the required
'" RE r - RE t_1
return, and that added value has its manifestation in both
So, abnormal earnings growth isalways equal to the change growth inresidual earnings andgrowth incum-dividend earnin residual earnings. You can see this by comparing the ings over a normal growth rate.
changes in residual earnings with the AEG for the prototype
In onesense, theAEG valuation ismore convenient for one
firm inExhibit 6.2:
does not have to worry about book values. However, the RE
model gives usmore insight into the value creation (that pro2
3
4
duces growth) so is more useful when wecome to analysis in
Residual earnings
2.360 2.431 2.504 2.579 2.656 Part Two ofthe book.
Change inresidual
earnings
0.071 0.073 0.075 0.077
Abnormal earnings
growth
0.071 0.073 0.075 0.077
assets in operations. The residual earnings(RE) mode! explicitly recognizes the investment in assets, then recognizes that valueis added only if that return is greater that the
required return.The residual earningsmodel is a better lens on the business of generating value, the cycle of investment and return on investment. Accordingly, we have not
proposed theAEG model as a modelforstrategy analysis(as we did withthe RE model),
for strategy analysis involves investment. The central question in strategy analysis is
whether the investment will add value. When we come to analysis in Part Two of the
book, we will focus on the RE model, for it provides more insightinto valuegeneration
within a business.
208
Investors think interms offuture earnings andearnings growth; investors buy earnings. Focuses
directly onthemost common mUltiple used, the PIE ratio.
Uses accrual accounting: Embeds the properties of accrual accounting bywhich revenues are matched with expenses to
measure value added from selling products.
Versatility:
Can beused under a variety ofaccounting principles (Chapter 16).
Aligned with what
Analysts forecast earnings andearnings growth.
people forecast:
Forecast horizon:
Forecast horizons are typically shorter than those for DCF analysis and more value is typically
recoqoized intheimmediate future. There isless reliance oncontinuing values.
Protection:
Protects from paying too much for growth.
DISADVANTAGES
Accounting complexity:
Concept complexity:
Requires anunderstanding of how accrual accounting works.

Requires an appreciation of the concept of cum-dividend earnings and abnormal earnings
growth.
Sensitive to the required As the value derives completely from forecasts thatare capitalized at the required return. the
return estimate:
valuation is sensitive to the estimate used for the required return. Residual earnings valuations
derive partly from book value thatdoes notinvolve a required return.
Use inanalysis:
The residual earnings model provides better insight into the analysis of value creation andthe
drivers of growth (in Part Two ofthe book).
Application to strategy: Does notgive an insight into the drivers of earnings growth. particularly balance sheet items;
therefore, it is notsuited to strategy analysis.
Suspect accounting:
Relies onearnings numbers thatcart besuspect. Should beimplemented along with anearnings
quality analysis. (Chapter 17).
Abnormal Earnings Growth Is Not Affected by Dividends,

Share Issues, or Share Repurchases
We sawin Chapter 5 that residual earnings valuation is notsensitive to expected dividend
payout or share issuesand share repurchases. This is also the case withthe AEGmodel.
With respect to dividends, you can prove this to yourselfusing the simpleexample in
Exhibit 6.2. Rather than paying a dividend, reinvest the dividends in the firm at the 10percentrate. Subsequent earnings within thefirmwill increase bythe amount ofthe reinvested
dividends. Cum-dividend earnings-the amount of earnings earned in the firm plus that
earned by reinvesting the dividends outsidethe firm-will be exactly the same as if the
shareholder reinvested the dividends in a personal account (asin the exhibit). AEG willnot
change, norwillthe valuation. (You alsosawthis with thesavings account)Thissimulates
the earnings for an investor who receives the dividend but usesthe cashto buy thestock,
which is priced to yield a 10 percent required return. He effectively undoes the dividend,
withno effect on value. The samelogic appliesif the payouts in Exhibit 6.2are from stock
repurchases ratherthandividends.
Accounting Methods and Valuation

The residual earnings model accommodates different accounting principles. As wesawin
Chapter 5, thisis because bookvalues andearnings work together. Firms may create higher
future earnings by the accounting they choose, but to do so they must writedown book
209
Chapter 6 Accrua1Accollnting tmd Valuation: Pricing Earnings 211
Exhibit 6.2 presented pro forma earnings and earnings Year 0 is

growth for valuing the equity of a prototype firm. Suppose
V,f = _'_[20.36 _ 8.729 + 0.073
I
133.71
themanager of this firm hasdecided to create more earnings
o 0.10
1.10 1.10 1.03/1.10J
for Year 1 by writing down inventory by $8 in Year O. This
accounting adjustment changes theaccounting numbers, but
This is the same as the value before the accounting
it should not affect the value. Here isthe revised pro forma:
change. While forward Year 1 earnings have increased, the
higher earnings of $20.36 mean higher normal earnings for
Creating Earningswith Accounting: Modifying
Exhibit6.2 for a Write-Down
Year 2 andconsequently lower earnings growth of -$8.729.
The neteffect is to leave thevalue unchanged.
1'"
Forecast Year
EFFECT ON PIE RATIOS

While valuations are not affected by accounting methods,
13.11 1351 13.91
PIE ratios certainly are. The forward PIE for this firm isnow
9.93 10.23 10.54
$133.71/$20.36 '" 6.57, down from 10.82. The trailing
109.27 112.55 115.92
(dividend-adjusted) PIE is now ($133.71 + $9.09}/$4.00 =
35.70, upfrom 11.90. Shifting income from current earnings
to forward earnings increases the trailing PIE; there is now
0.964 0.993 1.023
more anticipated earnings growth next year andthe PIE prices
14.077 14.499 14.934 growth. However, shifting income tothe future decreases the
forward PIE-there isnow less anticipated growth after the
14.004 14.424 14.857 forward year, andthevalue oftheearnings (inthenumerator)
does notchange.
3
4.00 20.36 12.73

Earnings
Dividends
9.09 9.36
9.64
Book value 92.00 103.00 106.09
Earnings on
reinvested
dividends
0.936
Cumdividend
earnings
13.667
Normal
earnings
22.396
Abnormal
earnings
(8.729)
growth
Abnormai
earnings
growth rate
0.073
0.075
0.077
3%
3%
EFFECT ON VALUATION
As a result of the $8 write-down, the $12 reported for Year 0
earnings is now $4 (and the book value is $92 instead of
$100). Correspondingly, Year 1 forward earnings increase by
$8 to $20.36 because cost ofgoods sold is lower by$8. Cum-
dividend earnings for Year 2 are not affected but, because

those earnings are now compared to normal earnings of
$22.396, on the high base of $20.36 for Year 1, abnormal
earnings growth fer Year 2 is(a decline of) -$8.729. Subsequent years areunaffected. The AEG valuation at the end of
A LESSON FOR THE ANALYST

There is a lesson here. The diligent analyst distinguishes
growth .that comes from accounting from growth 'thatcomes
from real business factors. If growth is induced bythe accounting, he changes the PIE ratio, buthe does notchange
thevaluation. Applying theAEG model (orindeed theresidual
earnings model) protects him from making the mistake of
pricing earnings thataredueto accounting methods.
We opened this chapter with the caveat that we do not
want to pay for growth that does not add value. We do
notwant to pay for earnings growth from added investment
thatearns only the required return. But we also do notwant
to pay for growth that is created by accounting methods.
Using the residual earnings model or the abnormal earnings
growth model protects usfrom both dangers.
values. When the higherearnings are combined withthe lower bookvalues (in a residual
earnings valuation), valueis unaffected.
TheAEG model, at first glance, looksas ifit mightnot havethis feature. A manager can
create higher future earnings by writing down book values, and the AEG model values
future earnings without carrying bookvalues as a correcting mechanism. We do not want
to pay for growth that does not add value, and accounting methods can creategrowth in
earnings that we do not want to pay for. As it happens, the AEG model, like the residual
earnings model, provides protection against paying for growth that is createdby accounting.Box 6.5explains.
210
Make sureyoureadthe sectiontitled ''A Lessonfor theAnalyst" in Box 6.5.The trailfig PIE indicates expected earnings fromsalesin the future relative to the earnings recognized from current sales. To measure the value added from sales, accounting methods
match expenses with revenues. If that matching underestimates current expenses (by
underestimating bad debts, for example), current earnings are higher. However, future
earnings are lower-c-eaminga are "borrowed fromthe future." Because morecurrentearnings are recognized and less future earnings are expected (and valueis not affected), the
trailing PIE is lower. Withlower future earnings, the forward PIE is higher. The converse is
true if a firm recognizes moreexpenses in currentearnings.
REVERSE ENGINEERING THE MODEL FOR ACTIVE INVESTING

Like the residual earnings model, the AEG model can be reverse engineered to discover
the market's expections. Consider the simple example in Exhibit 6.2, where a value
of $133.71 millionwas calculated. Suppose that the equityfor this finn were trading at
$133.71 million andyouforecast one-year-ahead earnings of$12.36million, and two-yearaheadearnings of$12.73 million. Witha 10 percentrequired return,theseforecasts imply
AEG of $0.071 for two years ahead, as in the exhibit. Reverse engineering sets up the
following problem andsolves for g:
. nIOn = - 1 [ 12.36 + -0.071

P0= $133.7l nul
- -]
0.10
LlO-g
With a valueof $133.71 million, g = L03. You have converted the marketprice into a
forecast themarket's implied abnormal earnings growth rate is 3 percent. You havedone
so by reverse engineering the AEG model. Rather than forecasting a growth rate and
converting that forecastto a valuation, you have converted the market's valuation into a
forecast of the growthrate.The simplevaluation modelserves as a tool.
Suppose now that the equity were trading at $147.2 million. We would then calculate
g = 1.07 (rounded). You havereverse engineered theresidual earnings model to conclude that
themarket isforecasting anabnormal earnings growth rateof7 percent peryear. If,asa result
ofan analysis of the firm, you conclude thatthe growth ratecanbe no higherthan3percent,
youwould conclude thatthe market priceof$147.2 million is too high: sell.But youmight
alsoturn theanalysis on yourself: Is theresomething themarket knows thatI don'tknow?
Reverse engineering can also extractthe impliedexpected return. Suppose you were
veryfirm in yourbeliefthatthe growth ratecan be no higherthan3 percent Thenyoucan
set up the following problem andsolvefor p:
Po = S147.2 million = _ 1- [12.36 + AEG2]

p-1
p-LOJ
AEG2 involves the required return for reinvesting dividends, so set AEG2 = [12.73 +
(p -1) x 9.36] - (p x 12.36). The reverse-engineered amount for p is 1.0936; that is, the
market is forecasting a 9.36percentrate of returnfrombuying this stock.This is the market'simpliedexpectedreturn. If yourequire 10percent, youwouldsaythestockistoo expensive. The formula forreverse engineering the expected returnlooksa littlecomplicated,
buttherearejust a fewnumbers to plug in:
,---Eam=--('Eam----,Eam=--~
p-I=A+ A2 +__l x
Po
Earn,
(g-l)
(6.5)
212
Part One
Financial $rawneml and Valtullion
Chapter 6 Accma1 Accounting and ValootiDn: Pridng Earning!
.1
where
A=
the time.The reverse engineering problem (with a required returnof 12 percent) runs as
.!(g
-1 + DiVl)
2
Po
follows.
Rather than screening stocks on the too-simple PIE ratio, the active investor might
screenstocks on theseimpliedexpected returns: Buystockswith highexpected returnsand
sell those with lowexpected returns. This requires some analysis, of course, for we must
haveSOme senseof the AEGgrowth rate. PartTwo of the bookbuilds the analysis.
Reverse Engineering the S&P 500

At theendof2003, theS&P500indexstoodat 1000. Thechiefeconomistofa leading Wall
Street investment bank was forecasting 2004 earnings for the S&P stocks of $53.00 and
$58.20for2005.Theseearnings estimates are in the same units as the index,so the econo-
mist's forward PIE ratio for theindex was $1,000/$53;;;;; 18.87. Thepayoutratio fortheS&P
500 was 31 percent at the time and the economist estimated a marketrisk premium of
5 percentoverthe lO-yearTreasury rateof 4 percent.
Witha beta of 1.0 for this marketportfolio, these rates imply a CAPM required return
of 9 percent.The normal forward PIE for a 9 percentrequired returnis l/0.09 =: 11.11, so
the market, with a PIE of 18.87, is expecting someabnormal earnings growth. Thepayout
ratio implies expected dividends of$53 x 0.31 = $16.43 in 2004, andwiththe reinvestment
of this dividend at the 9 percent rate, expected abnormal earnings growth for 2005 is
$1.909, as follows:
Earnings
Dividends (31 % payout)
Reinvested dividends at 9!.l/o
Normal earnings {$53 x 1.09}
213
2004
200S
$53.00
$58.20
16.43
AEG
1.479
$59.679
57.770
$ 1.909
P
2007
=$520=_I_[I9.61+~]
0.12
Ll2 _ g
The solution for g is 1.0721; that is, the market is forecasting a growth rate of (approximately) 7.2 percentafter 2009.You will remember that, using analysts' five-year growth
rateinTable 6.1,weobtained a valueof$69958 persharewithanalysts forecasting an EPS
growth rateof28 percent. Clearly the market is forecasting less growth thananalysts. Having nowunderstood the market's forecast, we can challenge the price by challenging that
forecast: Is a growth rate of7.2 percentfor Google too high?Toanswer thatquestion, we
willhaveto do somefurther analysis (in PartTwo of thebook).
Implied Earnings Forecasts and Earning Growth Rates

AEGgrowth rates are a littledifficult to conceptualize, but can be converted intoearnings
and earning growthforecasts by reverse engineering theAEGcalculation:
Earnings forecast = Normal earnings forecast + AEGforecast
- Forecast of earnings from prioryear'sdividends
(6.6)
Themarket'sAEG growthrateforGoogle is 7.2percent. So,the market is forecastingAEG

for2010 of$2.198,thatis, theAEGof$2.05 for2009growing at 7.2percent. Normal earningsfor 2010are the forecasted 2009earnings of$24.01 growing at the required return of
12percent, that is, $24.01 X 1.12 = $26.89.Asthereare no dividends, forecasted earnings
for 2010 are $26.89 + 2.198 = $29.09, and the forecasted EPS growth rate for 2010 is
S29.09/$24.01 = 21.2 percent.
Continuing the calculations forsubsequent years, onegetsthesequence oftheimplied EPS
growth ratesin Figure 6.2.If, asa result ofan analysis, youforecast growth ratesabove those
here, youare in the "buy"zone. If youforecast lower growth rates, youarein the"sell"zone.
SEPARATING SPECULATION FROM WHAT WE KNOW:

VALUE BUILDING BLOCKS
Withtheseingredients, we are readyto reverse engineer:
1.909]
hoOJ = 1,000 = - 1[53.00 +----0.09
1.09 - g
The solution for g is 1.039, that is, a 3.9 percent growthrate.This is close to the typical
GDPgrowthrate so, if we acceptthat the long-term growth rate for this marketportfolio
should be about thesameas the GDP growthrate,we wouldconclude the S&P500 stocks
werereasonably pricedat an indexlevel of 1000at the end of2003.
Using Analysts' Forecasts in Reverse Engineering

In Table 6.1 we converted analysts'consensus EPS forecasts for Google into a valuation.
Wewereunsureas to whatgrowthrate to use in the continuing value,so wejust usedthe
GDP growthrate. Reverse engineering allows us to assesswhatgrowth rate the marketis
using.As analysts'five-year growthratesare unreliable, we use onlythe forecasts for two
yearsahead in this exercise. EPSforecasts were $19.61 for 2008and $24.01 for 2009,and
the AEG for 2009, calculated in Table 6.1, is $2.05. Google's shares traded at $520 at
Just as we deconsrructed residual earnings valuation into a set of building blocks (in
Chapter 5), so canwe deconstruct abnormal earnings growth valuation. Figure6.3 depicts
thebuilding blocksthatbuildto Google's market priceof$520.
The first component is capitalized forward earnings-constituting S19.6l!0.12 =
$163.42 of Google's value. We are usually relatively sure aboutthis part of the valuation.
Thesecondcomponent is the addedvaluefromAEG for twoyearsahead, capitalized as
a perpetuity. For Google, this is the $2.05 of forecasted AEG valued as a perpetuity. This
blockadds$142.36 to Google's value,givinga totalforblocks1 and2 of$305.78.
The third component captures value from the markets speculation about long-term
growth inAEG,a component weareusually lesssureabout. Analysts' forecasts inTable 6.1
addedconsiderable valuefor this component, but we see that the market (with a price of
$520) assigns $214.22.
Whatdoesthe building blockdiagram tell us? Importantly, it separates thespeculative
component of price in block3 from the blocks 1 and 2 components aboutwhich we are
morecertain; following the fundamentalist dictum, it separates "whatwe know"(or feel
comfortable with)fromspeculation. The analyst not onlyunderstands where the most uncertainty in thevaluation lies,butalsoidentifies thespeculative component 3 thathasto be
challenged to justify the current market price. He or she then brings sound analysis to
214
Part One financial Statement> and Valuation

FIGURE 6.2 Plotting the Market's Implied EPS GrowthRates: Google, Inc.
The market's implied forecast ofEPS growth rates,obtained by reverse engineering, areplotted
for 201 0-2014. Thegrowth ratefor 2009 is analysts' two-year-ahead growth ratefromtheirEPS
estimates for 2008 and 2009. Growth ratesforecasted above the lineimply buying thestock.
Growth ratesforecasted belowtheline imply selling.
From anarticle inBarron's in1998.

Fed Chairman Alan Greenspan hasn't said much about the
stock market this year, buthis favorite valuation model isjust
about screaming a sell signal. The so-called Greenspan model
(or Fed model) was brought to our attention last summer
byEdward Yardeni, economist at Deutsche Morgan Grenfell,
who found it buried inthe back pages of a Fed report. The
model's very presence in such a report was noteworthy because the Fed officials normally don't tip their hand about
their views onthestock market. The model surfaced at a particularly interesting time: Stocks were near a high point, and
the Greenspan model indicated that the market was about
20percent higher than itshould have been.
That turned outto bea pretty good call. By October 1998,
stocks hadfallen as much as 15 percent from their summer
high point. By year-end, ofcourse, the Dow had recovered to
around 7900. butit still remained about 5 percent below its
peak for theyear.
Now thatthe Dow has climbed above 8600, Greenspan's
model is again flashing a warning signal. To be exact, the
23.00%
22.4%
='J
21.2%
BUY
221.00%
20.1%
1>=1
~
SELL
19.2%
19.00%
18.5%
17.9%
1800%
17.00%
I
20ll
I
2010
2009
I
2012
I
2013
I
2014
FIGURE 6.3 BuildingBlocksof an Abnormal Earnings GrowthValuation:Google, Inc.

The building blocksdistinguish components of a valuation aboutwhich the analyst is reasonably
surefrommorespeculative components: (I) valuefromcapitalized forward earnings, aboutwhich
one is reasonably certain; (2) valuefromcapitalizing two-year-ahead abnormal earnings growth;
and (3) valuefromforecasts oflong-term growth, themostspeculative partof thevaluation.
$520
--- --- ----- ------- - --- - - - - 1 - , - - - - - ,
$214.22
$305.;8
&
,
~
$142.36
$163.42
(I)
(2)
(3)
Bookvalues
Value from
short-term
Value from
long-term
forecasts
forecasts
overvalued.
The Fed's model arrives at its conclusions bycomparing the

yield on the 10-year Treasury note to the price-to-earnings
ratio ofthe S&P 500based onexpected operating earnings in
thecoming 12months. To putstocks and bonds onthe same
footing, the model uses the earnings yield on stocks, which
is the inverse of the (forward) PIE ratio. 50 while the yield
on the to-year Treasury is now 5.60 percent, the earnings
yield onthe 5&P 500, based ona (forward) PIE ratio of 21,is
4.75percent.
In essence, the Fed's model asks, Why would anyone buy
stocks with a 4.75 percent earnings return, when they could
geta bond with a 5.60 percent yield?
The Fed's model suggests the S&P should be trading
around 900, well under its current level of 1070.
Source: "Is Alan Addled? 'Greenspan Model' Indicates Stocks
Today Are Overvalued byAbout 18%." Barrons, March 16, 1998.
p.21.
The"Greenspan model" or the"Fed model" compares the expected earnings yield with
the IO-year Treasury yieldto assesswhether stocks are overpriced. The expected earnings
yield, measured as forward earnings/price, isjust the inverse of the forward PIEratio, so an
earnings yieldof 4.75percent(at the timeof the newspaper report) implies a forward PIE
of21.05. A Treasury yieldof 5.60percentimplies a forward PIE of 17.86. TheFedmodel
saysthatstocks are likely to be overpriced when the forward PIEfor stocks risesabove the
PIE forTreasury notes. Is this a goodscreen?
ls the Fedmodel not well calibrated? Oneexpects the forward PIEforstocks to be different fromthat for bondsbecause stocksand bondshave different riskand thusdifferent
required returns. The forward PIEof 17.86 for a bond is the normal PIE for a required
return of 5.60percent. Stocksare morerisky; if the required return is 10percent, the nor.
malPIEis 10,considerably lessthanthe PIEfora riskless government bond. However, PIE
ratios also incorporate growth, and the Fed model does notexplicitly build in growth after
the forward year. A bondhas no abnormal earnings growth (it is similarto a savings account), so the normal PIEis theappropriate PIE. Butstockswith a normal PIEof I0 could
be worth a PIEof 21 if abnormal earnings growth is anticipated after the forward year.
Without forecasts of subsequent earnings, the PIE of 21 cannotbe challenged effectively.
The Fed model asks: Why would anyone buy stocks with a 4.75 percent earnings return.
when they couldget a bondwith a 5.60percent yield? Well, they would do so if theysaw
growth thattheywere willing to pay for. An earnings yieldscreen is toosimplistic.
The two errors in applying the Fed model-ignoring differences in risk and expected
growth-work in the opposite direction. Stocks shouldhavea lower PIE because theyare
morerisky, butthey shouldhavea higher PIE if theycandeliver growth. Bydemanding that
stocks havean earnings yield no less thanthe yieldonTreasury notes, themodel is saying
thatgrowth canneverbe highenough to compensate forthe errorof treating stocks as risklesssecurities likeTreasury notes.
But we have to be careful; risk couldindeedcompensate forgrowth. We are really not
surewhat theriskpremium forstocksshouldbe,andperhaps more growth means morerisk.
Current market value)
(I)
Greenspan model now indicates that stocks are 18 percent
challenge the speculative EPS growth ratesunderlying the third component (likethose in
Figure6.2).Forthis analysis, we turnto PartTwo of the book.
PIE SCREENING
Screening on Earnings Yield
AlanGreenspan, chairman of the Federal Reserve Bankduringthe 1990s, wasknown for
his statements regarding the "irrational exuberance" of the stock market. According to
Barron s, he used an earnings yieldscreen. See Box 6.6.
215
Chapter 6 Acmwl Accounting lind Valuation: Pricing Earnings 217
The PIE in thenumerator is usually theforward PIE, but sometimes thetrailing PIEisused.
If the forward PIE is used,the appropriate measure of growth in the denominator of the
PEGratio is the forecasted one-year growthafterthe forward year, that is, growth for two
years ahead. Theratiocompares thetraded PtE,themarket's assessment ofearnings growth
after the forward year, with actual growth forecasts. Analysts' growth forecasts are typicallyused.If the ratiois lessthan 1.0,the screener concludes thatthe market is underestimating earnings growth. Ifit is greaterthan 1.0,thescreener concludes thatthe market is
toooptimistic aboutgrowth. Witha forward PIEof$520/$19.61 = 26.5in 2008 anda forecastedtwo-year-ahead growth rateof22.4 percent, Google's PEGratiowas L 18.
The benchmark PEG ratio of 1.0 is consistent with the ideas in this chapter. If the
required return fora stockis 10percent (andthustheforward PtEis 10),themarket ispricingthestockcorrectly if earnings areexpected to grow (cum-dividend) at therequired rate
of lO percent. If an analyst indeed forecasts a growth rate of 10percent afterthe forward
year, the PEGratio is 10/10 = 1.0. (Notethat the growth rate is in percentage terms.) If,
however, an analyst forecasts a growth rateof 15percent, thePEG ratiois 10/15 = 0.67and
the analyst questions whether, at a PtEof 10,the market is underpricing expected growth.
Caution iscalledforinscreening onPEGratios. First, thebenchmark of 1.0applies only
for a required return of 10 percent. If the required return is 12 percent, the normal PtE
is 8.33which, when divided by normalgrowthof 12percent, yields a benchmark PEGof
0.69. Second, standard calculations (incorrectly) use the forecasted growth rate in exdividend earnings ratherthanthe cum-dividend rate. Third, screening onjust one yearof
anticipated growth ignores information aboutsubsequent growth.
Forthisreason, somecalculations ofthePEGratiouseannualized five-year growth rates
in the denominator. In 2002,Ford MotorCompany's sharestraded at $7.20each on analysts'consensus forecast offorward EPSof$0.43,giving a PtEof 16.7.Analysts wereforecasting $0.65 in per-share earnings for two years ahead. As the firm indicated 40 cents
per-share dividends in 2002, thecum-dividend forecast for twoyears aheadwas$0.69, assuming a required returnof 10 percent, Thusthe anticipated cum-dividend growth ratefor
twoyears ahead was60.5percent, andFord's PEGratio was 16.7/60.5 = 0.28. ThisPEGratio
indicates that Ford wasunderpriced. But the two-year-ahead growth rate is probably due
to thefactthattheforward yearwasa particularly badyearforFord. Ford would notbeable
to maintain a 60 percent growth rateintothefuture (andcertainly didnot). Indeed, analysts
atthetimewereforecasting onlyan average 5 percent annual growth rateover thenextfive
years. Using thisgrowth ratein thedenominator ofthePEGratioyieldsa ratiooOJ.
est rates were relatively low inthe 19905, PIEs were relatively
high. But therelationship between PIE and interest rates isnot
strong. This isbecause expectations offuture earnings growth
are more important in determining the PIE than changes in
interest rates.
Of course we must be cautious inour interpretations because themarket may have been inefficient attimes inpricing
earnings. Were PIE ratios too low inthe 1970s? Too high in
the 1990s? Was the market underestimating future earnings
growth inthe 19705 and overestimating it inthe 1990s7
As PIE ratios involve the capitalization of earnings bythe required return, and as the required return varies as interest
rates change, PIE ratios should be lower in periods of high
interest rates andhigher intimes of low interest rates. Correspondingly, earnings yields should be higher intimes of high
interest rates and lower in times of low interest rates. The
figure beiow indicates that PIE ratios and interest rates have
moved intheopposite directions inrecent history.
When interest rates on government obligations were high
inthe late 1970s andearly 19805, PIEs were low; when inter-
Median PIE Ratiosand Interest Rates (in Pereentages) on One-YearTreasury Bills
!...._
20
Interestrate
[8
I
\.-. T17'
j"
- - PIEratio
,0
&
[0
.~
$B
;t
2
0
,--.,
/-e "
"
:'\~
..
II
'\1
r \Ji
./ 7.7
, ,I ,
\/
g [2
\ ,J \
<3 [6
[4
!I
iI'.,
sr
,i
-:.-
-.--
,,
,
",
..
..-'."
"
,;
\,
'.
I, , , , , , , , , , , , , , , , , , , , , ,e-, i , , , , , , , , , i , , ,
[
'8 G
~
~
;;;
Ii:
ro-:
g <; 8
0
0
S
S
'" '" '" '" '" '" '" '" '" '" '" '" '" '" '"
~
r-.
r-.
r-.
00
00
00
a-:
Source: PIE ratios were calculated fromStandard & Poor's COMPUSTA"f'l' data. Interest ratesarell'Or.l the Federal Reserve Statistic;
Release I.wwwfuderalrewYfl.ggY).
Summary
Wecould modify the Fedmodel forexpected growth, but if growth is risky, wewould also
have to modify the required return. High PIE stocks(with growth) tend to be high beta
stocks. Always beware of paying toomuchforriskygrowth. Return to Box5.6in Chapter 5
fora discussion of thisissue. It is one wewill returnto.
The comparison of earnings yieldstoTreasury ratesdoesremind us thatearnings yields
and PIEratiosshould change as interest rateschange. See Box6.7.
Screening on PEG Ratios

In recent years, the PEG ratio has come into prominence. The PEG (PIE~to-earnings
growth) ratiocompares the PIE ratioto a forecast of percentage earnings growth ratein the
following year:
PEG ratio
216
PIE
l-year-ahead percentage earnings growth
Thevaluation methods in thischaptercomplement thosein Chapter 5.Theyyieldintrinsic

PIEratiosrather than PIB ratios. Rather thananchoring valuation onbookvalue, themethodshereanchor valuation on earnings. However, the form of thevaluation is similar. With
PIB valuation, one addsvalueto bookvaluefor earnings in excess of normal earnings (at
therequired return) on bookvalue; withPtEvaluation, oneaddsvalueto capitalized earnings for earnings in excess of normal earnings (at the required return) on priorearnings.
Abnormal earnings growth----eamings growth in excess of normal earnings growth-is
the central concept for the valuation. This concept, in tum, requires an appreciation that,
whenthe analyst focuses on earnings growth, she must focus on cum-dividend earnings
growth because future earnings involve not onlyearnings earnedin the fum butalsoearnings from reinvesting anydividends to be received.
As with residual earnings valuation, the application of the methods in this chapter
protects the investor from paying too muchfor earnings. Thesemethods also protect the
investor frompaying for earnings created by accounting methods. And, as with residual
earnings, the abnormal earnings growth model facilitates reverse engineering: Theanalyst
can deduce earnings forecasts andexpected returns implicit instockmarket prices.
i
,i
Chapter 6 AccrlUll ACCOllnting and ValM!iOn; Pricing Eamings 219
218 Part One Finar.dai Swtemwt5l1nd Va.I"naon
;1
Find the following on the Web page forthischapter:
Further applications of abnormal earnings growth

valuation.
A spreadsheet program to helpyoudevelop abnormal
earnings growth proformes and valuations.
Key Concepts
Further examples of reverse engineering.

A further demonstration thatAEG valuation and residual earnings valuation yield thesame value.
The Readers' Corner points you to further reading.
abnormal earnings growthis earnings

implied expectedreturn is the expected
growthin excessof growthat a rateequal
rateof returnfrominvesting at the
to the required return.Compare with
currentmarket price. 211
normal earnings growth. 197
normal earnings growth is earnings
cum-dividend earningsareearnings
growth at a rateequalto the required
that include earnings on priordividends
return. 196
normal forward PIE is a price-earnings
paid.Compare with ex-dividend
earnings. 196
ratiothat is appropriate whenearnings
ex-dividend earnings areearnings without
are expected to grow(cum-dividend)
consideration to the earnings that can be
afterthe forward yearat a rate equalto
the required return; that is, normal
earnedon dividends. Compare with
cum-dividend earnings. 196
earnings growthis expected. 197
impliedabnormal earningsgrowthrate
normal trailing PIE is a price-earnings
is the growth ratefor abnormal earnings
ratiothat is appropriate when earnings
implied by thecurrent market price. 2I 1
are expected to grow(cum-dividend)
implied earnings forecast is a forecast
afterthe currentyearat a rate equalto the
that is implicitin the marketpriceof a
required return. 198
stock. 213
AnalysisTools
model (6.2)
Case 1
Case 2
Normal forward PIE
Normal trailing PIE
Abnormal earnings
growth (6.3), (6.3')
Trailing PIE model (6.4)
Converting an analyst's
forecast to a valuation
Page
199
204
206
197
198
201
203
205
Key Measures
Page
Acronyms to Remember

Continuing value
Case 1
Case 2
Earnings yield
Ex-dividend earnings
Forward PIE ratio
Implied abnormal earnings
grovvth rate
201
AEG
EPS
DPS
GOP
PEG
RE
204
206
196
214
196
201
211
abnormal earnings growth

earnings pershare
dividends pershare
gross domestic product
price-to-earnings growth
residual earnings
AnalysisTools
Reverse engineering the
abnormal earnings
valuation model
-for implicit qrowth rates
-for expected returns
Valuation building blocks
PEG ratio
Page
Key Measures
Page
211
211
211
213
Normal earnings
Normal forward PIE ratio
Normal trailing PIE ratio
Implied earnings growth rate
Implied expected returns
PEG ratio
196
197
198
Acronymsto Remember
213
211
216
216

CONVERTING ANALYSTS' FORECASTS

TO A VALUATION
In the Kimberly-Clark case for Chapter 5, you were asked to convert anaiysts' earnings
forecasts intoa valuation usingresidual earnings methods. You cannowdo thesameusing
abnormal earnings growth methods. Exhibit LI in Chapter I gives consensus analysts'
forecasts madein March2005whenthe stockpricestoodat $64.81 pershare.Theseearnings forecasts are in the form of point estimates for 2005 and 2006and an estimated fiveyeargrowth rate.KMB paidan annualdividend per shareof$I.60 in 2004 anda dividend
of$I.80 per sharewasindicated for 2005at the time.
Calculate the forward PIE ratio.Also,usinginformation in the2004financial statements
in Exhibit2.2 in Chapter 2, calculate the trailing PIE in March 2005.
With a five-year growth rate, you can forecast analysts' EPS estimates for the years
2005-2009. Do thisand,fromtheseforecasts, pro formathe corresponding abnormal earningsgrowth. Use a required returnfor equityof 8.9%for the calculations.
Nowgo aheadandvalueK1v1B's shares from thispro forma. You might adaptthe spreadsheet engine on the Web pagefor this chapter to makethisvaluation. Assume a long-term
growth rate after the five-year forecast period of 4%, roughly equal to the average GDP
growth rate.Whatisyourintrinsic forward PIE ratio? Whatisyourintrinsic trailing PIEratio?
Did youget the samevalueas in the residual earnings application in the lastchapter?
Reverse Engineering
Working onlyfromthe analysts' forecasts for 2005 and 2006,findout whatis the market's
implied rate for abnormal earnings growth after2006.Whatare the earnings pershareand
EPS growth rates that the marketis forecasting for the years2007-2010? You might plot
those growth rates,just as in Figure6.2. If you are handy with spreadsheets, you might
builda program to do this.
Understanding Your Uncertainty

Assemble a building blockdiagram like that in Figure 6.3. Whatpart of the valuation are
youmostuncertain about?
Chapter 6 Accrual AceO~lnting Qnd VQlaariQn: Pricing &1mings 221
220 Part One FinanC;QI $tlHemCIllS QrJd Vo:t!u,Qrion
Using SpreadsheetTools
As in the continuing case for Chapter5, you can experiment with spreadsheet tools that
carry out a valuation. Lookat the engineon theWeb pagesupplement forthis chapter.
EP5
DP5
C6.2. The historical earnings growth rate for the S&P 500 companies has been about
8.5 percent. Yetthe required growth rate for equity investors is considered to be
about 12 percent. Canyouexplain the inconsistency?
C6.3. The following formula is oftenused to valueshares,whereEarn, is forward earnings, r is the costof capital,and g isthe expected earnings growth rate.
E6.2.
2011
3.60
0.25
4.10
0.30
PIE Ratiosfor a SavingsAccount (Easy)

Suppose you owna savings account that earned SI0 overthe pastyear. Your only transaclion in the account has been to withdraw $3 on the lastday of this Iz-mcoth period. The
account bears an interest rateof 4 percent per year.
.
Earn,
YaIue 0 f equity = - r-g
Explain whythisformula can leadto errors.
C6.4. A firm's earnings areexpected to grow ara rateequal to therequired rateof return for
its equity, 12 percent. Whatis the trailing PIE ratio? Whatis the forward PIE ratio?
C6.5. The normal forward PIE and the normal trailing PIEalways differby 1.0.Explain
the difference.
C6.6. Explain why, for purposes of equityvaluation, earnings growth forecasts must be
for cum-dividend earnings growth, yetneithercum-dividend growthratesnor valuationare affected by expected dividends.
C6.7. Abnormal earnings growthis always equalto growthof (change in) residual eamings.Correct?
C6.8. A PIE ratiofor a bondis always less thanthatfor a stock.Correct?
C6.9. In anequityresearch report,ananalyst calculates a forward earnings yieldof 12percent. Noting that this yield is considerably higher than the 7 percentyield on a
1If-year Treasury, she headsher report witha buy recommendation. Couldshe be
makinga mistake?
C6.1O. Howdo youinterpret a PEGratio?
C6.ll. Lookat Figure2.3in Chapter 2, which tracksmedian PIEratiosfrom 1963 to 2003.
Explain why PIE ratioswerelowin the 1970s and high in the 1960s and 1990s.
C6.12 The earnings-to-price ratio for the S&P500stocksdeclined significantly from the
late 1970s to the late 1990s. As this ratio is a "return" per dollar of price, some
claimed that the decline indicated that the required returnfor equityinvesting had
declined, and theyattributed the increase in stockpricesoverthe periodto the decline in the required return. Whyis thisreasoning suspect?
C6.13. Why mightan analyst refer to a leading (forward) PIE ratio ratherthan a trailing
PIEratio?
2010
3.00
0.25
a. Forecast the ex-dividend earnings growth rateand the cum-dividend earnings growth
ratefor 2010and 2011.
b. Forecast abnormal earnings growth for 20I0 and 2011.
c. Calculate the normal forward PIEforthis finn.
d. Basedon yourforecasts, do youthinkthis finn willhave a forward PIE greaterthanits
nonna1 PIE?Why?
C6.1. Explain whyanalysts'forecasts of earnings-per-share growth typically underestimate the growththat an investor values if a firmpaysdividends.
Concept
Questions
2009
a. Whatis the valueof the account afterthe$3 withdrawal?

b. Whatis the trailingPIEand forward PIE for thisaccount?
E6.3.
Valuation FromForecastingAbnormal EarningsGrowth (Easy)

An analystpresents you with the following pro forma (in millions of dollars). The pro
formagives her forecasts of earnings and dividends for 2010-2014. She asksyouto value
the 1,380 million shares outstanding at the end of2009. Usea required return forequityof
10 percent in your calculations. (This is the samepro forma that was used for a residual
earnings valuation in Exercise E5.3.)
Earnings
Dividends
2010E
2011E
2012E
20BE
2014E
388.0
115.0
570.0
160.0
599.0
349.0
629.0
367.0
660.45
385.40
a. Forecast growth rates for earnings and cum-dividend earnings for each year,
2011-2014.
b. Forecast abnormal earnings growth foreach of theyears2011-2014.
c. Calculate the per-share valueof the equity at the end of 2009 from this pro forma.
Would youcail this a Case 1 or Case2 abnormal earnings growth valuation?
d. Whatis the forward PIEratiofor this firm? Whatis the normal forward PIE?
E6A. Abnormal EarningsGrowth Valuationand Target Prices (Medium)

The following forecasts of earnings per share (EPS) and dividend per share (DPS) were
made at the end of2009:
[P5
DPS
2010E
2011E
20UE
20BE
2014E
3.90
1.00
3.70
3.31
1.00
3.59
1.00
3.90
1.00
1.00
C6.14. Can a firmincrease its earnings growth yet notaffectthevalueof its equity?
Exercises
Drill Exercises
E6.1.
Forecasting EarningsGrowth and Abnormal Earnings Growth (Easy)

The following are earnings and dividend forecasts madeat the endof2008. The firm has a
required equityreturnof 10percentper year.
Thefirmhasan equitycostof capitalof 12percent perannum. (Thisis thesameproforma

used in the residual earnings valuation in Exercise E5.4.)
a. Calculate the abnormal earnings growththat is forecast for each year, 2011 to 2014.
b. Whatis the per-share valueof the equityat the end of 2009based on the abnormal
earnings growthvaluation model?
222 Part One
Chapter 6 Accnd AccOl<nting ond Vahwn'on; Pricing Earningl 223
Financial SraEements ane! Vall.l(lIion
The book value ofIBM's common equity at the end of2002 was$23.4billion, or $13.85
per share. Usea required returnfor equityof 12percent incalculations.
c. Whatis theexpected trailing PIE for 2014?

d. Whatis the forecasted per-share value of theequityat the endof theyear 20147
EG.s.
a. Forecast residual earnings for eachofthe years 2003-2007.

b. Forecast abnormal earnings growth foreach of theyears 2004-2007.
c. Show that abnormal earnings growth is equal to the growth in residual earnings for
everyyear.
Dividend Displacementand Value(Medium)

Two firms, A andB, which have verysimilar operations, have thesamebookvalueof 100
at theendof2009 andtheircostof capital is 11percent. Bothareforecast to have earnings
of$16.60 in 2010. FinnA, which has 60 percent dividend payout, is forecast to have earningsof$17.80 in 2011. Finn B haszeropayout.
a. Whatis yourbestestimate offirm B's earnings for 201I?
b. Would youpaymore,less,or thesamefor firm B relative to firm A in 2009?
EG.G.

Exercises EI3.14 andE14.11 dealwith IBM, as doesMinicase MI2.3.
EG.10.
Prepare a schedule that gives the normal trailing and forward PIE ratiosfor the following
levels ofthe costof equitycapital: 8, 9, 10, 11, 12, 13, 14, IS,and 16percent.
a. Whatis GE'snormal forward PIE? What wasthe PIE at which it traded?

b. The estimated abnormal earnings growth for 2009indicates thatGE'sstockshould be
tradingat abouta normal PIE. Show this.
Applications
EG.7.
Calculating Cum-Dividend EarningsGrowth Rates Nike {Easy}

In earlyfiscal year2009,analysts wereforecasting $3.90forNike'searnings per sharefor
thefiscal yearendingMay2009 and$4.45for 2010, witha dividend per shareof 92 cents
expected for 2009. Compare the cum-dividend earnings growth rate forecasted for 2010
withex-dividend earnings growth rate,usinga required rateof returnof 10percent.
EG.11.
CalculatingCum-Dividend Earnings: General Mills {Easy}

General Millsreported earnings and paiddividends from2004to 2008as follows:
Basic EPS
DPS
2004
2.82
2005
2006
2007
3.34
3.05
3.30
2008
3.86
1.10
1.24
1.34
1.44
1.57
Calculate cum-dividend earnings for General Millsfor eachyear, 2005--2008. Also calculateabnormal earnings growth foreachoftheseyears. Assume a reinvestment ratefor dividends of 10percent.

Exercises E15, E2.9, E3.9, E4.9, ElO.9, E13.15, E14.8, andE15.10 alsodeal with General
Mills.
EG.9.
ResidualEarnings and Abnormal EarningsGrowth: IBM (Medium)

Consider the following pro forma for International Business Machines (IBM) based on
analysts' forecasts in early2003.
Earnings pershare
Dividends pershare
2003E
2004E
NextThree Years
4.32
5.03
0.67
Growth at 11 %
Growth at 11 %
0.60
Plotting EarningsImplied Growth Rates for the S&P 500 (Medium)

This exercise extends thereverse engineering example for the S&P500 in thischapter. At
the endof 2003, theS&P500 index stoodat 1000. The chiefeconomist of a leading Wall
Streetinvestment bank was forecasting 2004earnings for the S&Pstocksof $53.00 and
$58.20 for 2005. Theseearnings estimates arein the sameunitsas theindex, so theeconomist's forward PIEratiofortheindexwas$1,000/$53 "" 18.87. Thepayout ratiofortheS&P
500was31percent at thetimeandtheeconomist estimated a market riskpremium of5 percentoverthe lO-yearTreasury rateof 4 percent.
Fromthetext,youwillunderstand that,given the economist's forecasts, thestockmarket was forecasting an AEG growth rate for the S&P500 of 3.9 percent after2005. What
were the (ex-dividend) earnings growth rates fortheyears2006, 2007, and2008 forecasted
by the stockmarket at the end of 2003? What were the cum-dividend earnings growth
rates? Assume thatthe 31 percent payout willbe maintained in the future.

SeeExercises E2.14, E8.iJ, EiJ.i7, EiJ.18, E15.ii, E15.iJ, E18.5 andE19.4 on Nike.
Minicase M2.1 dealswithNike.
EG.S.
A Norma! PIE for General Electric? (Easy)

In early 2008, General Electric (GE) shares were trading at $26.75 each.Analysts were
forecasting $2.21 in EPS for 2008 and$2.30for 2009. A dividend of $1.24wasindicated
for2008. Usea required returnof 9 percent for the questions below.
Normal PIE Ratios (Easy)
EG.12.
Challenging the level of the S&P 500 Index with Aoajysts' Forecasts
(Medium)
The S&P500index stoodat 1271 in early2006. Basedon analysts' consensus EPSforecastsfor calendar year2006, theforward PIE ratiofortheindex was15.0at thetime. Those
sameanalysts weregiving the S&P500 a PEGratioof 1.47, based on forecasts for 2007.
Thepayout ratioforthisportfolio ofstocks was27 percent at thetimeandinvestment banks
typically published estimates of the equity risk premium of 5 percent over the current
1O~year Treasury rateof 5 percent.
a. Calculate the abnormal earnings growth for 2007thatis implied bytheforecasts.
b. Whatshould be thelevel of the S&P500if (cum-dividend) earnings are forecasted to
growat 10percent afterthe forward year? Whyis the PIE based on analysts' forecasts
different?
c. Setting the long-term abnormal earnings growth rate equal to 4 percent (the average
growth ratefor GDP), what do analysts' forecasts say about the level of the S&P500
index?
d. Whatconclusions canyourdraw from thisanalysis?
224 Part One Financial Swt~J1l~n!S andVahlmion
E6.13. Valuation of Microsoft Corporation (Medium)

In2006,some fundamental investors believed that Microsoft, afterbeingoverpriced in the
stockmarket formany years, wasnow a firm to buy. Microsoft's shares traded at $27.20 on
September 26,2006,down from a peakof $60(split-adjusted) inJanuary 2000.
Analysts' consensus earnings-per-share forecasts for Microsoft's 2007 and 2008 fiscal
years were SI.44 and $1.67, respectively. A dividend of $0.40 persharewasindicated for
2007.
a. In orderto build in a margin of safety, fundamental investors think of value without

growth. Value a Microsoft share using abnormal earnings growth (AEO) methods
under the assumptions thatAEG will remain at the forecasted 2008 level after2008.
Use a 9 percent required return for equity investment in Microsoft. What doesyour
calculation tell youabout themarket's forecast of growth inAEGafter2008?
b. Calculate thetraded forward PtEratio forMicrosoft andalso theforward PtE implied
byyourvaluation. What is thenormal forward PIE forMicrosoft?
c. Calculate Microsoft's traded PEG ratio basedon analysts' forecasts of earnings for
fiscal years 2007 and2008.
Coverage of Microsoft continues in Exercises El.6, 4.14, 7.7, E8.10, ElO.ll, E1UO
and19.4,and in Minicases M8.! andM12.2.
E6.14. Inferring Implied EPS Growth Rates: Kimberly-Clark Corporation (Medium)
In March 2005, analysts were forecasting consensus earnings pershareforKimberly Clark
(KMB) of $3.81 for fiscal yearending December 31, 2005, and $4.14for 2006, up from
$3.64for 2004. KMB traded at $64.81 per shareat the time. The firm paida dividend of
$1.60 in 2004 anda dividend of $! .80wasindicated for 2005, withdividends growing at
9 pecent a yearfor thefive yearsthereafter. Usea required return of 8.9percent forthefollowing calculations.
a. Calculate thetrailing andforward PIE ratioat which K.MB tradedin March 2005. Also
calculate the normal trailing and forward PIE forKMB.
b. Calculate the market's implied growth rateforabnormal earnings growth (AEG) after
2006.
c. What are the earnings-per-share growth ratesthat the market wasforecasting forthe
years 2007-2010?
d. Analysts were forecasting an EPSgrowth rateof 8.0percent per yearovertheseyears.
Whatdo youconclude from the comparison of these growth rateswiththose youcalculated inpart (c) of theexercise?
e. Analyst average buy/hold/sell recommendation, on a scaleof 1 to 5 (with 5 being a
strong buy), was2.6. Is thisrating supported bytheirforecasts?
Thecontinuing caseat theendof eachchapter follows Kimberly-Clark. SeealsoExercises
4.8,E7.8,EIO.lO, and El1.l6 andMinicase 5.3.
E6.15. Using Earnings Growth Forecasts to Challenge a Stock Price:
Taro Company (Medium)
Taro Company, a lawn products maker based in Minnesota, traded at $55 per share in
October 2002. The firm hadmaintained a 20 percent annual EPSgrowth rateovertheprevious five years, andanalysts were forecasting $5.30pershare earnings forthe fiscal year
Chapter 6 Accrual Accollnling Qnd Valualion: Pricing Earnings 225
ending October 2003, with a 12 percent growth rate for the five years thereafter. Use a
required return of 10percent in answering the following questions.
a. How much is a share of Toro worth based on the forward earnings of $5.30 only
(ignoring anysubsequent earnings growth)?
b. Toro maintains a dividend payout of 10percent of earnings. Based on the forecasted
EPS growth rate of 12 percent, forecast cum-dividend earnings for the five years,
2004-2008.
c. Forecast abnormal earnings growth fortheyears 2004-2008.
d. Do yourcalculations indicate whether or notTarois appropriately priced?
E6.16. Abnormal Earnings Growth Valuation and Accounting Methods (Hard)
Referbackto thevaluation in Exercise E6.3. In thepro forma there, an analyst forecasted
earnings of$388 million for2010. Theforecast was made at theendof2009based onpreliminary reports from thefirm.
When the final report was published, however, the analyst discovered thatthe firm had
decided towritedown itsinventory at theendof2009by$114million (following thelowerof-cost-or-market rule). As thiswasinventory thattheanalyst hadforecasted would besold
in20Ia(andthustheimpairment affects costofgoods soldforthatyear), theanalyst revised
herearnings forecast for2010. Forquestions (a)and(b),ignore anyeffect of taxes.
a. Whatis therevised earnings forecast for20I0 as a result of the inventory impairment

assuming no change in salesforecasts?
b. Show that therevision in the forecast of2010 earnings doesnot change the valuation
of theequity.
c. Now assume thatthefirm's income taxrateis35percent. Doyouranswers toquestions
(a) and (b)change?
E6.17. Is a Normal Forward PIE Ratio Appropriate? Maytag Corporation (Easy)
A share of Maytag Corp., another appliance manufacturer, traded at $28.80 in January
2003. Analysts were forecasting earnings pershareof$2.94 for2003 and$3.03 for2004,
with dividends pershare of72 centsindicated for2003. Analysts' 3-5 yeargrowth ratefor
earnings pershareafter2004 was3.1 percent.
a. Calculate thenormal forward PIEratio forMaytag ifits equity costofcapital is 10percent. Compare thenormal PIE to the actual traded PIEat thetime.
b. Do the forecasts of earnings after2003 indicate that the tradedPIEis the appropriate
pricing for the firm's shares?
Minicase M15.3 deals with the takeover of Maytag by Whirlpool. Exercise 19.6 deals
withMaytag also.
II
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226 Part One Fin"rlCial $tuternellfS andVaJu.mion
Minicases
M6.1
Forecasting from Traded Price-Earnings

Ratios: Cisco Systems, Inc.
Cisco Systems, Inc. (CSeO), manufactures andsells networking andcommunications equipmentfor transporting data, voice, and videoand provides services related to that equipment. Its products include routing and switching devices; home and office networking
equipment; andInternet protocol, telephony, security, network management, andsoftware
services. The firm has grown organically but also through acquisition of other networking
andsoftware firms. Cisco'sWeb siteis www.clsco.com.
Ciscowasa darling of the Internet boom,one of the few firms with concrete products.
Indeed itsproducts wereimportant to thedevelopment of theinfrastructure for theInternet
age andthe expansion in telecommunications. At one point, in early2000, the firm traded
witha totalmarket capitalization of overhalfa trillion dollars, exceeding thatof Microsoft,
andits shares tradedat a PIEof over130. Withthebursting of the Internet bubble andthe
overcapacity in telecommunications resulting from overinvestment bytelecommunications
firms, Cisco's growth slowed, butit certainly wasa strongsurvivor. By2004itsrevenue had
recovered to the $22.0billionlevel reported for 2001.
In September 2004,just afterits reports for fiscal year ended July 2004hadbeenpublished, Cisco's 6,735 million shares traded at $21eachon bookvalue of$25,826billionand
a basicearnings persharefor2004of$0.64.Thefirm paysnodividend. Analysts wereforecasting consensus basic earnings per share of $0.89for 2005 and $ 1.02 for 2006. Most
analysts had buy recommendations of the stock, somehad holds, but nonewas issuing a
sellrecommendation. Witha betacloseto 2.0,investment analysts were usinga 12percent
required returnfor Cisco's equityat the time.
A. Bring all the tools in this chapter to an evaluation of whether Cisco'sforward priceearnings ratioinSeptember 2004isappropriate. You willnotbe ableto resolve theissue
without somedetailed forecasting of Cisco's future profitability (which you should not
attempt at this stage).Rather, quantify the forecasts implicit in Cisco's $21 price that
could be challenged with further analysis. Identify the speculative components of
Cisco's priceusingthebuilding block approach. Tostart,youshouldcalculate abnormal
earnings growth for2006thatis implied bythe analysts' forecasts andtakethe analysis
from there. Figures 6.2 and6.3 should be helpful to you.
B. Analysts wereforecasting an average targetpriceof $24for theendof fiscal year2005.
Is the target priceconsistent with a buy recommendation on the stock?Analysts were
also forecasting a 145 percent five-year earnings growth rate.Is the buyrecommendationconsistent withthe forecasts thatanalysts were making?

See Minicase 5.1 in Chapter 5 for a parallel investigation using PIB ratios for Cisco
Systems. Minicase M14.2 alsodealswiththevaluation of Cisco, as doesExercise E14.12.
~~;g
'!~m1i
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Chapter 6 Accnlll! Accounting a.nd VaJll<ltion: Pricing camillg5 227
M6.2
Analysts' Forecasts and Valuation:

PepsiCo and Coca-Cola
PepsiCo, Inc.(PEP), isa global snackandbeverage company operating in nearly 200countries. His organized intofourdivisions: Frito-Lay NorthAmerica, PepsiCo Beverage North
America, PepsiCo International, and Quaker foods. Products include convenience snacks,
sweetandgrain-based snacks, carbonated and noncarbonated drinks, andfoods.
On October 1, 2004, PepsiCo tradedat $49.80 per share,with a forward PIE of 21.6.
Analysts were forecasting per-share earnings of $2.31 forfiscal yearending December 31,
2004, and$2.56for 2005. The indicated dividend for 2004was 0.98per share. The street
wasusing9 percent as a required rate of returnfor PepsjCo's equity.
The Coca-Cola Company (KO) alsooperates in over200countries worldwide andcompetesintensively withPepsiCo in the market forcarbonated andnoncarbonated beverages.
On October I, Coketradedat $40.70 with a forward PIE of20.5. Analysts wereforecasting $1.99in earnings per sharefor fiscal yearending December 31,2004,and$2.10for
2005. The indicated dividend per share wasS1.00. The equityis considered to have the
samerequired returnas PepsiCo.
A.For both Pepsico and Coke, calculate the earnings per share that the market was
implicitly forecasting for2006,2007,and2008.
B. Analysts wereforecasting a five-year annual growth rateinearnings pershareof 11 percent for PepsiCo and 8 percent for Coke. Compare thesegrowth rates with thosethat
wereimplied by themarket pricesforthe firm's shares at the time.
C. If theforecast is thatbothfirmswillmaintain theirpercentage current netprofit margins
(Earnings/Sales) in the future, what is the forecast of the salesgrowth rates for 2006,
2007, and2008 thatwasimplicitin thecurrent sharepricesfor thetwofirms?
D. Calculate the PEGratio forbothof thefirms. Whatdo youmake of thisratio?
Foryourcalculations, assume thatthepayout ratioindicated for2004willbe maintained in
thefuture.

See Minicase M5.2 in Chapter 5 for a parallel investigation using PIB ratios. Also see
Minicase M4.1 in Chapter 4 for an application of discounted cash flow analysis to CocaCola. Exercises E4.5, E4.6, E4.7, EI 1.7,EI2.7, EI4.9, EI5.12, EI6.7, andE19,4 also deal
with Coca-Cola, andExercises E4.12andE9.8dealwithPepsiCo.
M6.3
Reverse Engineering Google: How Do

I Understand the Market's Expectations?
(This case covers material on Google in Chapter 6. It brings thatmaterial together in one
package andaddsrelated issues.)
228 Part One Financial Sroremel1ts andVaiu<1lion
Valuation models can be dangerous if used naively: An analyst canplug in any growth
rateor required return estimate to geta desired valuation. Indeed, a valuation model canbe
a vehicle to build speculation into the valuation: Choose a speculative growth rate-or
speculative near-term forecasts-and you will get a speculative valuation. Garbage in,
garbage out.
Remember the fundamentalist dictum: Beware of paying too much for growth. We
would like to apply valuation models in a way thatdisciplines speculation about growth.
Chapters 5 and6 have shown thatresidual earnings andabnormal growth models protect us
from paying too much forearnings growth from investment thatdoesnot addvalue. They
alsoprotect usfrom paying forearnings growth generated byaccounting methods. Butthey
cannot protect us fromourownfoolish speculation.
Benjamin Graham hit thenailon thehead:
Theconcept of future prospects and particularly of continued growth in thefuture invites the
application of formulas outof higher mathematics to establish thepresent value of the
favored issue. Butthecombination of precise formulas withhighly imprecise assumptions
canbe usedto establish, or ratherjustify, practically anyvalueonewishes. however high,for
a really outstanding Issue.'
Reverse engineering gives us a way of handling valuation models differently: Rather

than using a model to get a value, use a model to understand the forecasts implicit in the
market price. Thisfits wellwithactive investing. Investing is nota gameagainst nature, but
rather a gameagainst other investors. Forthe active investor, there is no "true" intrinsic
value to bediscovered. Rather, heor sheis playing against others; active investors "win"if
theyfind thatothers' expectations (embedded inthemarket price)arenotjustified bysound
analysis. Thus, the rightquestion is not whether a valuation model gives you the "right"
value but ratherwhether themodel canhelp youunderstand whatexpectations explain the
market price. With thisunderstanding, the investor thencompares those expectations tohis
or her own. Rather than challenging the price with a "true" intrinsic value, the active
investor challenges price by challenging others' expectations. Reverse engineering is the
vehicle.
Atthispoint, youhave notdonetheanalysis to form confident expectations, butyoucan
do the reverse engineering to understand others'expectations. Tbiscaseasksyouto doso
withGoogle, Inc., a firm forwhich themarket hashadhighexpectations.
After coming to the market at just under$100per share in a muchheralded IPO in
August 2004,Google's shares soared to over$700bythe endof 2007. The firm, with revenues tied mostly to advertising on its Web search engine andWeb application products,
heldoutthe promise of the technological frontier. It certainly delivered salesandearnings
growth, increasing salesfrom $3.2 billion in 2004 to $16.6billion in 2007, withearnings
per shareincreasing overthe same years from $2.07 to $13.53. One might be concerned
'aboutbuying such a hotstock. This caseasks you to challenge the market price in mid2008, but todo soby challenging theforecasts implicit inthe market price. Tease outthose
forecasts usingtheabnormal earnings growth valuation model.
In mid~2008, Google traded at $520. Analysts at the time were forecasting EPS of
$19.61 for 2008 and$24.01 for2009, yielding a forward PIE of26.5.Analysts' consensus
five-year EPSgrowth ratewas28percent.
A. Apply abnormal earnings growth (AEG) valuation to value Google based on these forecasts. Betashopsreport a typical betafor Google of about 2.0,so usea highrequired
returnof 12percent (against the current risk-free rateof 4 percent).
I
B. Graham,TheJnldligenlllll'CSlOr, 4th rev.ed. (NewYork; Harperand Row, 1973), pp-315-316.
Chapter 6 Accrlla! AccoHnringaM V;"llimion: Plicing Eamfngs 229
B. Analysts' intermediate-range forecasts (up to five years ahead) are notoriously opti-
mistic, especially for a "hotstock"like Google. Anchoring on onlythe 2008 and 2009
forecasts, estimate the growth ratein abnormal earnings growth (AEG) thatthemarket
is forecasting foryearsafter2009. What doesyouranswer tellyou about analysts' fiveyeargrowth rate?
C. Build a valuation building block diagram, likethatin Figure 6.3in the text, andplotthe
EPSgrowth ratesfor2010 to 2012 thatareforecasted by themarket price.
D. How would younow goabout challenging themarket price of$520? Calculate Google's
PEGratio. Doesthishelpyou?
E. Suppose youconclude thatthehighest (AEG) growth ratethatGoogle canmaintain (in

perpetuity) is 6 percent. What is theexpected return tobuying thestockat$520with this
growth rate? When might you preferto reverse engineer to the expected return rather
than thegrowth rate?
Chapter 7 Viewing theBusinmThrough theFilUlnciat SUlternentl 233
Business
Financial
Chapter I introduced
thefirm'soperating,
investing, andfinancing
activities. Chapter 2
introduced thefinancial
statements. Chapters 5
and6 outlined valuation
models thatanchoron
thosefinancial statements.
This chapter
;f{iii%d2
Thischaptershowshowthe I
threebusiness activities are I,
depicted in thefinancial
statements. It alsoshows
howthestatements are
redesigned to highlight
theseactivities andto
prepare thestatements for
applying thevaluation
models in Chapters 5 and 6.
Boware
operating and
financing
income
identified in the
income
statement?
.Linkto Webpage':
Buildyourownfinancial
analysis spreadsheet based
on thechapter.for
assistance visittheBYOAP
feature on thetext'sWeb
siteat www.mhhe.com/
penman4e

Apply the treasurer's rule.
layouttheform ofreformulated cash flow statements,
balance sheets, andincome statements.
Explain how netoperating assets change over time.
Explain how netfinancial obligations change over time.
Explain how free cash flow is generated.
Explain how free cash flow is disposed of.
Add newaccounting relations to your set of analyst's
tools.
Calculate return on net operating assets and net
borrowing cost from reformulated statements.
Wh"
measures
capturethe
operating and
financing
profitability?
Li~ to nextthreecbapters
Chapters 8, 9, and 10
reformulate thestatements
according to thedesign
developed in thischapter.
How businesses areset upto generate value.

Why reformatting financial statements is necessary for
analysis.
How operating, investing, and financing activities are
depicted inreformatted financial statements,
The four types of cash flows ina business.
How the four types of cash flows relate to each other.
How reformulated statements tietogether as a set of
stocks andflows.
What operating activities involve.
What financing activities involve.
What determines dividends.
What determines free cash flow.
How free cash flow isdisposed of.
How free cash flow isa dividend from operating activities to thefinancing activities.
How thefinancial statements areorganized to measure
value added for shareholders.
Why free cash flow does notaffect the accounting for
value added.
Everystockpurchase is in factthe purchase of a business. Andanyone whobuysa business

should know that business. This maxim, recognized in Chapter l, requires the analyst to
investigate "what makesthe business tick."Thismightbe donethrough factoryvisits and
interviews with management. But we also observe the business through financial statements. Financial statements are the lens On the business, so we need to get a feel for not
only how the business operates but also how its operations are represented in financial
statements. Thenwe willunderstand the storybehind the numbers.
This chapterbuildson the introduction to businesses in Chapter I and the introduction
to financial statements in Chapter 2. Chapter 2 showed how financial statements depict
"stocks"and "flows"and howthesearticulating stocksand flows tella story. This chapter
shows howthe threebusiness activities introduced in Chapter l-e-financing, investing, and
operating activities-are depicted through stocks andflows in thestatements. Andit shows
howthis depiction is the basisforthe analysis of thevaluegeneration in a business.
Chapter 2 introduced the financial statements in the form in which they are presented
underGAAP accounting and the disclosure rules issued by the Securities and Exchange
Commission (SEC).That form doesnot quitegive the picture we wantto draw for valuationpurposes. Toimprove our focus, wereformulate thestatements in thischapterin a way
that aligns thestatements with the business activities. Thisreformulation readies thestatements for the analysis in subsequent chapters whichuncovers the factors that determine
residual earnings and abnormal earnings growth, the primary valuation attributes in
Chapters 5 and 6.
Theemphasis in the chapteris on design. In subsequent chapters, the designtemplate is
applied to realcompanies and the analysis comesto life.
As you read the chapter, begin to think about how you might build a spreadsheet
program that inputs the financial statements in a way that readies them for analysis. In
Chapter 2 the formof the financial statements was given by a set of accounting relations.
Here,too, the formof the reformulated financial statements is given by a setof accounting
relations. Theseaccounting relations tell you howto structure a spreadsheet program that
can, with further embellishments in subsequent chapters, be used to analyze financial
statements and valuefirms. At the end of the chapteryouwill be introduced to a spreadsheetfeature On the book's Web site thatleads yOIl in this direction.
234 Part Two The Anal)'sis of Financial Seuemenn
Chapter 7 Viewing theBusiness Thro~gh the financial StalemCnlS 235
BUSINESS ACTIVITIES: THE CASH FLOWS

In Figure 1.1 in Chapter I we depicted the transactions between the firm and its shareholders and debtholders. The firm, however, was left as a black box, although we recognized that the firm is engaged in financing activities, investing activities, and operating
activities. Ouraim in thisand subsequent chaptersisto fillout thatbox. Figure 7.l begins
to buildthe picture,to be completed in Figures 7.2 and7.3. Figure7.1 is similarto Figure
1.1in Chapter I, wherecashflows to and fromdebtholders and shareholders are depicted.
The cashflows to and from the debtholders and the firm havebeen reduced to a net flow,
the netdebtfinancingflow, labeled F in the figure. Thisinvolves the net cashflow to bondholders, banks,and othercreditors, thatis, cash paidto debtholders in interestand principal repayments less cash paid into the firm from borrowing more from these creditors.
Similarly, the net dividend to shareholders (d in the figure) is cash paid in dividends and
stock repurchases lesscash contributions to the finn from shareholders. The transactions
between the twoclaimants andthe finn are the finn'sfinancing activities--debt andequity
financing-and these take place in capital markets where the firm and these claimants
trade.
Debtfinancing flows involve payments to and fromdebt issuers as well as debtholders.
A firmalways beginswith cashcontributions from shareholders. Cashis a nonproductive
assetso, until it is invested in operations, firms invest this cashin bondsor otherinterestbearing paper and deposits, referred to as financial assets or sometimes as marketable
securities. These financial assetsare purchased in the capital market from debt issuers->
governments (T-bills andbonds), banks (interest-bearing deposits), or otherfirms (corporate
FIGURE 7.1
CashFlows between
the Firmand
Claimants in the
Capital Market
Cash received from
debtholders and
shareholders is
(temporarily) invested
infinancial assets. Cash
payments todebtholders
and shareholders are
made byliquidating
financial assets (that
is,selling debt). Net
financing assets arc
debt purchased from
issuers, netofdebt
issued todebtholders.
Net financing assets
can benegative (that
is,ifdebt sold to
debtholders isgreater
than debt purchased).
The Firm
Capital Markets
F
Debtbclders
or
debtissuers
Net
financial
assets
(NFA)
Shareholders
II
FInancing Activities
Key:
TheFirm
FIGURE 7.2
Capital Markets
CashFlows to
Claimants andCash
F
Flows within theFirm
Debtholders
Cash generated from
C
or
operations isinvested
debt issuers
in netfinancial assets
(that is,it is used to
Not
Not
buy financial assets or
operating
financial
assets
assets
toreduce financial
(NOA)
(NFA)
liabilities). Cash
investment in
I
operations ismade by
Shareholders
reducing netfinancial
d
assets (that is,by
liquidating financial
assets or issuing
,
financial obligations).
1\
,
,
Financing Activities
and cash investment
may benegative (such
that,fer example, cash Key:
F:= Neteash flow to debtholders andissuers
can begenerated by
d:= Netcashflow to shareholders
liquidating an
C:=Cashflow fromoperations
1:= Cashinvestment
operating asset and
NFA=Netfinancial assets
investing theproceeds
NOA:= Netoperating assets""Operating assets- Operating liabilities
ina financial asset).
F'" Netcashflow todebthorders andissuers

d'" Netcashflow toshareholders
NFA :=Net financial assets Financial assets- Financialliabilities
bondsor commercial paper). They involve a cash payment outof the firm in exchange for
the financial assets. Likethe issueof debt,the purchase of debt is alsoa financing activity.
It is lending ratherthanborrowing, but both amountto buyingand sellingbondsor other
financial claims. A firm can be a buyerof debt(ofa debt issuer) if it hasexcesscashor can
be an issuerof debt(to a debtholder) if it needscash. In the first caseit holdsfinancial assets and interest and principal repayments flow into the firm. In the second case it has
financial obligations Or financial liabilities, and interest and principal repayments are
paid out of the finn. In the first case, the net debt financing flow, F, is cash paid to buy
bondsor paperlesscashreceived in interestand fromthe sale of the bonds. In the second
case,the net debtfinancing flow, F, is cash paid in interest and to redeembondslesscash
received in issuing (selling the firms own) bonds.
Firmsoftenissuedebtand holddebtat the sametime.Thustheyholdboth financial assets and financial obligations. The net debtholding is netfinancial assets, financial assets
minusfinancial obligations, as depicted in Figure 7.1,or,if financial obligations are greater
thanfinancial assets, netfinancial obligations. Correspondingly, thenet debtfinancing flow
is the net cashoutflow with respectto bothborrowing and lending.
Figure 7.2completes the cashflow picture. Firmstypically arenotprimarily in thebusiness of buyingbondsbut hold bondsonlytemporarily to investidle cash.They invest in
operating cssers-c-land, factories, inventories, and so on-e-that produce products for sale.
This is the fum's investing activities and the cash flows involved are cash investment or
cashflowin investment activities, labeledI in the figure. Toinvest in operating assets, firms
il, '
".11',
Ji
236 Part Two The Analysis of Financial Sw(cment.l
sell financial assetsand buy operating assets with the proceeds. The arrowsgo both ways
in the diagram because finns can also liquidate operating assets (in discontinued operations, forexample) andbuyfinancial assets withtheproceeds. Theoperating assets, set to
work, produce net cash flows (cash inflows from selling products lesscash outflows from
paying wages, rent, invoices, andso on) andthiscashflow is referred to as cash/lowfrom
operations. This cash is invested in financial assets by buyingdebt,or used to reducethe
firm '$ own debt. The circle perpetuates. Cash from operations is never "leftlying around"
but is invested in financial assets to earn interest until needed. When needed, financial
assetsare liquidated to makecash investment in operations. Notethat the term "investing
activities" meansinvestment in operating assets, notfinancial assets; indeed, investment in
operating assetsinvolves a liquidation of net financial assets.
Cash flow from operations and cash flow for investing activities were introduced in
Chapter 4. We can now state a very important accounting identity known as the cash
conservation equation or the sources and usesof cash equation. The four cash flows in
Figure7.2 always obeythe relationship
MICROSOFT CORPORATION: POSITIVE FREE CASH FLOW

In itssecond quarter for 2004, Microsoft generated $4,064 million infree cash flow andreceived $338 million ininterest, net
oftax, from short-term marketable securities itheld. Itpaid a net $2,270 million incash outto shareholders, leaving $2,132 million with which it purchased short-term interest-bearings securities.
In itssecond quarter for 2005, Microsoft generated $3,200 million infree cash flow andreceived $242 million ininterest,
netof tax, for short-term marketable securities itheld. In this quarter, the firm paid outa large special netdividend to shareholders of $33.672 million, leaving a cash short fall. Accordingly itsold $30,230 million of marketable securities to provide cash
for thedividend.
The calculations for thetreasurer's trading indebtareas follows (in millions);
2ndQuarter
Freecash flow> Net dividends to shareholders
+ Net payments to debtholders and issuers
(7.1)
C-I=d+F
Thatis, cashflow fromoperations lesscashinvestment in operations always equals the net

cashflows paidto debthclders (orissuers) andshareholders. The left-hand side, C -!, isthe
free cash flow. If operations generate morecashthan is used in investment, free cashflow
is positive. If operations produce less cash than is needed for new investment, free cash
flow is negative. A positive freecashflow is usedeitherto buy bonds(F) or pay dividends
(d). A negative freecashflow requires thata firm eitherissuebonds(negative F) or issue
shares (negative d) tosatisfythe cashshortfall. Thecashconservation equation iscalledan
identity because it's always true.Cashgenerated mustbe disposed of; the sources of cash
mustbe equalto its uses.
You seenowhowa firm mayhave financial obligations ratherthanfinancial assets(as is
oftenso),Financial obligations arejust negative financial assets. If freecashflow is negative,a finn cansellofffinancialassetsto get cash; if theseassetsare all soldand if thefirm
chooses not to reduce its net dividend, however, the firm will haveto issuedebt to get the
cash.Thus the firm becomes a net debtorrather than a creditor, a holder of net financial
obligations ratherthannet financial assets. In eithercaseitjust trades in the debtmarket. If
freecashflow is positive, the firm buysothers'bondswiththe cashor buysits ownbonds
(redeems them), holding net dividends constant. If free cash flow is negative, it sells
bonds-either its ownbondsor others'bondswhichit holds. This is debtfinancing activity,and although sometimes it's donewithbanks(where the firm mighthavea loanor an
interest-bearing deposit), youcan thinkof it as trading in bonds. In doingso, the firm will
haveto coverany net dividend it wants to pay and,of course, net cashinterest also generatesor usescash.The treasurer Srulesummarizes this:

Cash investment in operations
Free cash flow
Cash interest received (after tax)
Cash available lor shareholders
2ndQuarter
2004
2005
$4,236
$3,377
177
3,200
142
3,442
--.!..ll
4,064
338
4,402
Net dividend:
Cash dividend
Share repurchases
Share issues
Purchase (safe) offinancial assets
$1.729
730
(189)
$33,498
969
2,270
$2,132
33,672
$(30,230)
GENERAL ELECTRIC CORPORATION: NEGATIVE FREE CASH FLOW

During 2002, General Electric generated $34.8 billion incash flow from operations but made $61.2 billion further investment
inoperations, including $7.7 billion of capital expenditure on property, plantandequipment, $21.6 billion inacquisitions, and
$18.1 billion investment infinancing receivables. Accordingly, itsfree cash flow was negative to the amount of -$26.4 billion.
As it paidout $8.1 billion to shareholders, ithad to borrow $40.6 billion to cover this payout, thefree cash deficit, and $6.1 billion in interest payments ondebt.
The calculations forthetreasurer's trading indebtare asfollows (in millions):

Free cash flow
Interest paid (after tax)
Cash available toshareholders
$34.848
61,227
(26,379)
6,082
(32,461)
Netdividend:
If C ~ I ~ i > d, thenlendor buydown owndebt.

If C- 1- i < d, thenborrow or reduce lending.
Herei is the net interest cashoutflow (interest paidminusinterest received). Net interest is
after tax, as calculated in Chapter 4, because netcashpaidis afterreceiving a tax deduction
for interest. SeeBox7.1.
Cash dividend
Share repurchases
$7,157
985
Net issue ofdebt

Asthe treasurer had $57.8 billion ofdebtto repay, he issued $98.4 billion of new debt(for a netdebtissue of $40.6 billion).
237
Chapter7 Viewing the Business Through the Financial S~ternenlS 239
TheReformulated Balance Sheet
reformUl~~~d:~taie~e~r'
Thecashflows in Box 7.1 aresummarized in reformulated cashflowstatements below(inmillions). The

distinguishes cashflows associated withoperating activities fromcashflows associated with financing activities. Asfreecashflow
must be paidout eitherto shareholders or net debtholders. the statementobeysthe cashconservation equation: C-'I= d+ F.-
G,
Microsoft
Cash flow from operations (0

Cash investment (I)
Freecashflow (C-I)
Equityfinancing flows (d):
Dividends andshare repurchases
Share issues
Debtfinancing flows (F):
Net purchase offinancial assets
Interest on financial assets (after tax)
Net issue ofdebt
interest paid on debt(after tax)
Total financing flows (d + F)
1Q,2004
1Q,2005
$4,236
~
4,064
$3,377
(177)
3,200
$34,848
$2,459
(189) 2,270
(61,227)
(26,379)
$8,142
$34,467
(795) 33,672
2,132
(338)
8,142
(30,230)
(242)
$3,200
$(26,379)
The Reformulated Cash Flow Statement

Theaccountant keeps track of the cashflows in a statement of cashflows. A statement of
cashflows thatsummarizes the fourcashflows in Figure 7.2is as follows (items in parentheses arenegative amounts):
Reformulated Statementof Cash Flows

Cash investment
Free cash flow
Equity financing flows:
Dividends andshare repurchases
Share issues
Debt financing flows:
Net purchase offinancial assets
Interest onfinancial assets (after tax)
Net issue of debt
Interest on debt(after tax)
Total financing flows
Balance Sheet
Liabilities and Equity
Assets
(40,603) .
6,082
$4,064
Thecashflows inFigure 7.2areflows intoand out ofstocks ofnetassets depicted byboxes.

So a cashinvestment, forexample, is a flow thatreduces thestockof netfinancial assets and
increases thestockofoperating assets. Thebalance sheetkeeps track ofthestockoffinancial
assets andobligations, andsoreports thenetindebtedness. Thebalance sheetkeeps trackof
thestockofoperating assets aswell. Published balance sheets listassetsandliabilities, usuallyclassified intocurrent and long-term categories. Thisdivision is useful forcredit analysis(aswewill seeinChapter 19). Butforequity analysis, thepublished statements arebetter
reformulated into operating and financial assets and operating and financial liabilities.
Operating assets and liabilities aresimply the assets andliabilities usedinthe business of
selling to customers. Financing assets are assetsandliabilities usedinthe financing of the
business. Theformer areinvolved intrading withcustomers andsuppliers, thelatterintradingincapital markets.
A dummy balance sheetthatcorresponds to Figure 7.2looks likethis:
(I)
(-I
OA
Operating assets
Financial assets
fA
OA+FA
Total assets
xx
Financial Obligationsand Owners' Equity
OA
(OL)
Operating assets
Operating liabilities
d+F
Financial obligations
Financial assets
Net financial obligations
Common shareholders' equity
Net operating assets

This dummy statement is a littledifferent from the GAAP statement of cashflows introduced earlier. It corresponds to the thought process of thetreasurer or chieffinancial officerwho is considering financing needs, andwewant financial statements thatreflect management activities. Oneofourtasks when weanalyze thecashflow statement inChapter lO
will be to reformulate the statement to identify the four cashflows clearly. See Box 7.2.
238
OL+ FO+ CSE
Reformulated Balance Sheet
OperatingAssets
OL
fO
(SE
Financing items canbe assetsorobligations (liabilities), as wehave discussed. Butoperating items alsocan be positive or negative. If theyare positive, theyare calledoperating
assets (OA). If they are negative, they are called operating liabilities (OL). Accounts
receivable is an operating asset because it arises from selling products in operations.
Accounts payable is anoperating liability because it arises from buying goods andservices
in operations. So are wages payable, pension liabilities, and otheraccrued expenses. We
willdealwith theseclassifications inmoredetail when weanalyze actual balance sheets in
Chapter 9 andreformulate themalong thelinesofthisdummy statement. Fornow, note that
operating liabilities ariseas part of operations whereas financial liabilities ariseas partof
thefinancing activities to getcashto runthe operations.
To distinguish operating and financing activities, it helps to regroup these items in the
balance sheet:
d
(XX)
(XX)
XX
Common stockholders' equity
Total claims
Netoperating assets (NOA) = OA - OL

Netfinancial assets(NFA) := FA - FO
Common shareholders' equity (CSE):= NOA + NFA
fO
(flI)
NfO
---'2L....
NfO + (SE
240 Part Two TheAnaly~is ofFil1llncial Swements
Chapter 7 Viewing meBusiness Through theFinancial SWWmeJ1rs 241
Usually NFA is negative, in which case it is net financial obligations (NFO):
CSE = NOA - NFO

Thedifference between operating assetsandoperating liabilities is the netoperating assets
(NOA). Thedifference between financial assetsandfinancial obligations is the netfinancial
assets (NFA). If NFA is negative, we have net financial obligations (NFO), as in this
dummy statement. IfNFA is positive, it is placedon the left-hand side.The bookvalueof
common stockholders' equity, eSE, waspreviously indicated as B. The last twoidentities
under the statement restate the standard balance sheet equation (Assets - Liabilities =:
Owners'equity) in terms of the two net stocks for operating and financial activities. The
owners'equityis seenas an investment in net operating assetsandnet financial assets, and
the investment in net financial assetscanbe negative.
The Reformulated Income Statement
BUSINESS AaIVITIES: ALL STOCKS AND FLOWS

ThepictureinFigure7.2is notcomplete: Howdoestheincome statement fitin?Well, firms
raise cash from capitalmarkets to invest in financing assets which are then turned into
operating assets. Buttheythenuse the operating assetsin operations. Thisinvolves buying
inputs fromsuppliers (of labor, materials, and so on)and applying themwiththe net operating assets (such as factories, plant, and equipment) to produce goodsor services that
are sold to customers. Financing activities involve trading in capitalmarkets. Operating
activities involve trading withthesecustomers andsuppliers inproduct and inputmarkets.
Figure 7.3 completes the picture.
FIGURE 7.3
All Stocks andFlows
fora Firm
Netoperating assets
employed inoperations
generate operating
revenue (by selling
goods and services to
customers) andincur
operating expenses (by
buying inputs from
suppliers). D. indicates
changes.
Productand
InputMarkets
-------------,,
i
),:
The Firm
IN
OR
<, ,
I
,,, I
,,
,
,,
,,,
,,
,
11
C
I
,:
"
>
Not
operating
assets
(NOA)
OE
0;
debtissuers
>
Shareholders
r:,
,
,- ---- -- ------,
JI
Dcbtholders
Net
financial
assets
(NFA)
I
Suppliers
--,
:Q~- ~NOA =:c:--/:
Key:
F '" Net cash flowto dcbthclders and issuers
d", Net cash flowto shareholders

C'" Cash flow fromoperations
I == Cash investment
NFA'" Netfinancial assets
Reformulated Income Statement
Operating revenue
Operating expense
Operating income
Financial expense
Financial income
!..C_-:.:-lll'l:FA
+ Nfl = d
__
~"~
_ _.......J
Financing Activities
OR
(OE)
01
(NEE)
Earnings
Bothoperating income and net financialexpenseare after tax. Chapter 9 shows howto
calculate the after-tax amounts. Operating revenues and operating expenses are not cash
flows. Theyaremeasures of valuein andvalueoutas determined bythe accountant. Tocapture that value, the accountant adds accruals to the cash flows, as we saw in Chapter 4.
Similarly, interest income andinterest expense (andotherfinancingincomeandexpenses)
are not necessarily cashflows. As withoperating income, the accountant determines what
interest income and expense should be using an accrual: As cash interest on a discount
bond(forexample) doesnotrepresent the effective borrowing cost,the accountant usesthe
effective interest methodto adjustthe cashamount. The netamount of effective interest income(onfinancial assets) and effective interest expense (onfinancial obligations) is called
net financial income (NFl) or, if interest expense is greater than interest income, net
financialexpense(NFE).
ACCOUNTING RELATIONS THAT GOVERN

REFORMULATED STATEMENTS
OR-OE:o'Ol,
___
The income statement summarizes the operating activities and reports the operating income or operating loss.The operating income is combined withthe income and expense
from financing activities to give the total valueadded to the shareholder, comprehensive
income, or earnings:
Capital Markets
Customers
Trading with suppliers involves giving up resources, and this loss of value is called
operating expense(OEin the figure). Thegoodsand services purchased havevaluein that
theycan be combined with the operating assetsto yieldproducts or services. Theseproductsor services are soldto customers to obtainoperating revenue,or valuegained(OR in
the figure). The difference between operating revenue and operating expense is called
operating income: OJ = OR ~ OE. If an goeswell,operating income is positive: The firm
addsvalue. If not,operating income is negative: The firmloses value.
Figure 7.3 depicts the stocks and flows involved in the three business activities-cfinancing, investing, and operating activities. It is common, however, to referto the operatingand investment activities together as operating activities (as in the figure), because investment is a matter of buyingassets for operations. So analysts distinguish operating
activities (which include investing activities) fromfinancing activities (as in the figure).
NOA Net operating assets

OR == Operating revenue
OE:o Operating expense
OJ", Operating income
NFl", Netfinancial income
Wenowhave threereformulated statements. Just as published statements are governed by

the accounting relations laidout in Chapter 2, so the reformulated statements are alsogovernedbyaccounting relations. Thecashflow andincome statements are statements of flows
overa period-operating flows and financing flows~and the balance sheetis a statement
of the stocks-eoperating and financing stocks-c-at the end of a period. The flows duringa
periodflow intoand out of the stocks,as in the diagram, so the changes in the stocks are
explained by the flows.
'i'
Chapter 7 Viewing the Busmess Throllgh the Firumdal Statement! 243
242 Part Two Th Analysi$ o[Financial Statement!
Theflows andthe changes in stocks are linked at thebottom of Figure 7.3.These links
between stocks and flows are accounting relations. Accounting relations not only govern
theform of thestatements-howdifferent components relate to eachother-but theyalso
describe what drives, or determines, eachcomponent. Financial analysis is a question of
whatdrives financial statements, whatdrives earnings andbookvalues. So theaccounting
relations weareaboutto layout,though stated in technical terms here, willbecome analysis tools in subsequent chapters. Asweproceed, you might referto Box7.3where youcan
see theaccounting relations working forNike, Inc.
The Sources of Free Cash Flow and the Disposition

of Free Cash Flow
Free cashflow isgenerated bycash from operations netofcash investment. Butwecanalso
depict -the generation of free cashflow in terms of the accrual accounting income statements aad balance sheets. Moving from left to rightin Figure 7.3,we see howfree cash
flow is generated:
Freecashflow = Operating income - Change innetoperating assets
(7.2)
C-I=OI-ilNOA
where the Greek delta, .6., indicates changes. Operations generate operating income, and
free cashflow is thepart of thisincome remaining afterreinvesting some of it innetoperating assets. In a sense, freecashflow is a dividend from theoperations, thecasbfrom operating profits after retaining some of the profits as assets. If the investment in NOA is
greater thanoperating income, free cash flow is negative, andaninfusion of cash(a negativedividend) intotheoperations is needed.
Theright-hand sideofthe figure explains thedisposition of free cashflow:
Free cashflow:::: Change in netfinancial assets
- Netfinancial income + Netdividends
(7.3a)
Thelastpointofthisdividend generation isstated bytheaccounting relation totheright

in Figure 7.3:
Netdividends = Freecashflow + Netfinancial income
- Change in netfinancial assets
d= C- I + NFI- ilNFA
which is a reordering ofthefreecashflow relation (7.3a). Thatis,dividends arepaidoutof

free cashflow andinterest earned onfinancial assets andbyselling financial assets. If free
cashflow is insufficient to paydividends, financial assets are sold(orfinancial obligations
incurred) topaythe dividend.
If the firm is a netdebtor,
Netdividends = Free cashflow - Netfinancial expenses
+ Change in netfinancial obligations
Free cashflow = Netfinancial expenses

- Change in netfinancial obligations + Netdividends
which is a reordering of thefree cashflow relation (7.3b). Thatis,dividends are generated

from free cashflow afterservicing interest, butalsoby increasing borrowing. You seewhy
dividends might notbea goodindicator ofthevalue generation ina business (atleastinthe
shortrun): A firm canborrow to generate dividends (at leastintheshortrun).
Dividends in these relations are netdividends, so cashis paidin byshareholders if free
cashflow afternetinterest is lessthannetborrowing.
The Drivers of Net Operating Assets and Net Indebtedness

By reordering these accounting relations we explain changes in the balance sheet. From
equation 7.2,
Netoperating assets (end) = Netoperating assets (beginning)
+ Operating income - Freecashflow
(7.3b)
C-I = NFE-ilNFO + d
Thatis, free cashflow is applied to payfornet financial expenses, reduce net borrowing,
andpaynetdividends. Box7.2provided an example forGeneral Electric.
These two expressions for free cash flow will be important to cash flow analysis (in
Chapter 10).
The Drivers of Dividends

Running alltheway from leftto right inFigure 7.3,you seehow thevalue created in product and input markets and recorded in the accounting system flows through to the final
dividend to shareholders: Operations yield value (operating income) thatis invested in net
operating assets; excess (or"free") cash from operations is invested innetfinancial assets,
which yieldnetinterest income; then these financial assets are liquidated to paydividends.
If operations need cash(negative free cashflow), financial assets areliquidated orfinancial
obligations are created through borrowing. Alternatively, cashis raised from shareholders
(anegative dividend) andtemporarily invested in financial assets until needed to satisfy the
negative freecashflow. Andso theworld turns.
(7.4b)
d=C-I-NFE+ilNFO
C-I = ilNFA- Nfl +d
That is, free cash flow is used to paynet dividends, with the remainder invested in net
financial assets, along with net financial income. Box 7.1 provided an example for
Microsoft. If the fum basnetfinancial obligations,
(7.4a)
NOAr = NOAr_1 + OIr -
(7.5)
(Cr~ I r)
or
Change innetoperating assets = Operating income - Freecashflow

11N0A, = or, - (C1-II)
Operating income is value added from operations, andthatvalue increases the netoperatingassets. So,forexample, a saleoncredit increases bothoperating revenue andoperating
assets through a receivable; andpurchase of materials on credit or a deferral of compensationincreases bothoperating expense andoperating liabilities through anaccounts payable
or wages payable. (This isjust thedebits andcredits of accounting at work.) Freecashflow
reduces netoperating assets as cashis taken from operations andinvested in netfinancial
assets. Or, expressing thechange in NOA as toNOA = 01 - C + I, yousee that operating
income andcash investment increase NOA, andNOA is reduced by thecashflows from
operations thatareinvested in netfinancial assets.
Correspondingly, thechange in net financial assets is determined by the income from
netfinancial assets andfree cashflows, along withdividends:
Netfinancial assets (end) = Netfinancial assets (begin)
+ Netfinancial income
+ Free cashflow - Netdividends
NFA, = NFAH + NFlt + (Ct-It ) -dl
(7.Ga)
ii'il II
!
Chapter 7
244 Part Two TheAnal)~is of Firumdal Statements
or
FIGURE 7.4
Change in net financial assets> Net financial income + Freecashflow - Net dividends
.6.NFA/= NFlr + (Cr-It)-dt
The net financial income earned on net financial assets adds to theassets, freecashflow
increases the assets (as the cash from operations is invested in financial assets), and the
assetsare liquidated to pay net dividends. If the firmholds net financial obligations rather
thannetfinancial assets,
Net financial obligations (end)= Netfinancial obligation (begin)
+ Netfinancial expense
- Freecashflow + Netdividends
the Financial SUllements 245
The Articulation of Refonnulated Financial Statements.
This figure shows how reformulated income statements, balance sheets, and thecash flow
statements report theoperating and financing activities ofa business, and how the stocks and flows
inFigure 7.3 areidentified inthefinancial statements. Operating income increases netoperating
assets andnetfinancial expense increases netfinancial obligations. Free cash flow isa "dividend"
from theoperating activities tothefinancing activities: Free cash flow reduces netoperating assets
and also reduces netfinancial obligations. Netdividends toshareholders arepaid outofnet
financial obligations.
~---~
IncomeStatement
(7.6b)
NFO,:::: NF01_ 1 + NFE1 - (C/- I,) + d,
Viewing !he Bwinl.'5S Through
Nlr-"'Olr- NFE,
*~~
BalanceSheet
or
Change in net financial obligations>Netfinancial expense - Freecashflow
+ Netdividends
..lNFOr = NFEr - (C1- II) +d,
Thatis, interest obligations increase net indebtedness, freecashflow reduces indebtedness,

and the firmhas to borrow to finance the net dividend.
These accounting relations, remember, tell us what drives the various aspects of the
(reformulated) statements. Net operating assets are driven by operating income and
reducedby free cash flow, as in equation 7.5. Or, stateddifferently, NOAis increased by
operating revenue, reduced by operating expenses, increased by cash investment, and
reduced by cashfromoperations (which is not "left lying around" butinvested in financial
assets). The relations for net financial assets and obligations, equations 7.6a and 7.6b,
explain whatdetermines the borrowing or lending requirement andso restate thetreasurer's
rule:Theamountof newdebt to be purchased (and puton the balance sheet)is determined
by the freecashflow after interest and the net dividend.
TYING ITTOGETHER FOR SHAREHOLDERS:

WHAT GENERATES VALUE?
Figure7.4 sbows how reformulated financial statements articulate. The comparative balance sheet, at the center, reports the change in net operating assets, net financial obligations, and common shareholders' equityfor a period. Thesechanges are explained by the
incomestatement andcashflow statement. Operating income increases net operating assets
(and also increases shareholders' equity), and net financial expense increases net financial
obligations (and decreases shareholders' equity). Free cash flow decreases net operating
assetsand also decreases the net indebtedness. Dividends are paid out of the net financial
obligations-by liquidating financial assets(togetthe cash)orby issuingdebt.In short,the
financial statements track the operating and financing flows of a business and showhow
they updatethe stocks of net operating assets, net financial obligations, and (as ll.CSE:=
ll.NOA - 6.NFO) the change in shareholders' equity. The stocks and flows relations for
NOAand NFO(or NFA) are similarin form to the stocks and flows equation for common
stockholders' equityintroduced in Chapter 2:
CSEr:= CSE/_ 1 + Earnings, - Net dividends,
That is, common equity is driven by comprehensive earnings and is reduced by net
dividends. The expressions forNOAandNFO (equations 7.5 and 7.6b)alsohavea driver
anda dividend. NOA is driven by operating income andreduced bya "dividend," freecash
flow that is paid to the financing activities. Andthe net financial obligations are driven by
the free cash flow received from the operating activities alongwith the financial expense
theythemselves incur, andtheypaya dividend to the shareholders.
The aim of the accounting systemis to trackvaluecreatedfor shareholders. Thestocks
and flows equation for shareholders indeedsaysthis: Owners'equity is driven by a valueaddedmeasure, comprehensive income, and reduced by net distributions to owners. But
common equityis alsothe net total of stocksin the balance sheet,the difference between
net operating assetsandnet financial obligations:
CSEt = NOA r - NFO/
So changes in common equity are driven by the drivers that change NOA and NFO.
Figure 7.5 depicts how common shareholders' equity is generated by NOA and NFO.
Line1 explains thechangein netoperating assetsfrom the beginning ofa periodand line2
explains the change in net financial obligations. Line3 explains thechange in common equity (for the case of net financial obligations). The difference between the flows for NOA
andNFO(line1minusline2) explains the flow forcommon equity. Thechange in thecommon equity is explained by comprehensive earnings minus net dividends, but it is also
explained by the flows thatexplainthe net operating assets and net financial obligations.
You'll noticein this explanation of the changein shareholders' equity thatalthough the
freecashflow affects NOA andNFO, freecashflow drops out in the difference between the
twowhenexplaining thechange in shareholders' equity: Takeline2 from line1to getline3
246 Part Two The Anal)5i.s of Final1cial Statement5
FIGURE 7.5 Changein Common Stockholders'EquityIs Explained by Cbanges (Flows)

in NetOperatingAssets (NOA) and NetFinancialObligations (NFO).
Take line2 fromline 1and yousee that free cash flow(C -1) does notaffect thechange in
common stockholders' equity.
(l) NOA _1
OIt-(el-It)
(2)NFO _
NFEI-(et-It ) +dl
t 1
The 2008financial statements for Nike, Inc., the athletic footwear manufacturer, are given in Exhibit 2.3in Chapter 2. Reformulation of financial statements involves rearranging thestatements according to thedesign inthischapter. Wewill gointothe
detail of reformulating Nike's statements in Chapter 9, To addsome Jive numbers to the rather cryptic presentation you have
justgone through, themain summary numbers from Nike's reformulated balance sheets andincome statement are given below,
along with a demonstration of the accounting relations that tie them together.
You will see something significant. Wedonothave to develop a reformulated free cash flowstatement from theGMP cash
flow statement. It isimplied bythe balance sheet andincome statement using theaccounting relations.
(3) CSEt_ 1
'--y---'
Earnings
NIKE,INC.
Reformulated Balance Sheet
andfreecashflow dropsout.Theaccounting saysthatfreecashflow doesnot addvalue to

shareholders, Freecashflow is a driver ofmenetfinancial position, notthe operating activities, and the amount of free cashflow is irrelevant in determining the value of owners'
equity. Rather, the profits from operating activities (01) and financing activities (NFE),
which together giveearnings, increase ordecrease shareholder wealth. Freecashflow isjust
a dividend ofexcess cashfrom theoperating activities to thefinancing activities, nota measureof the value addedfromselling products. And freecashflows, just like dividends to
shareholders, have littleto dowithvalue generated.
Thismakes eminent sense. BothMicrosoft and General Electric in Boxes 7.1 and 7.2
haveaddedtremendous value forshareholders. Microsoft haslarge positive freecashflow.
General Electric haslargenegative freecashflow. Butit doesnotmatter. Accrual accountinggetsit right.
Theexplanations forthe changes in NOA, NFO, andCSEwork onlyif earnings referto
comprehensive income. Accordingly, theaccounting foroperating income andnetfinancial
expense must also be comprehensive: We must include all relevant flows in operating
income and net financial expense. And the accounting mustbe clean:We mustnot mix
financing flows withoperating flows orfinancing assets andliabilities withoperating assets
andliabilities. SeeBox 73.
Operating assets (OA)

Operating liabilities (OL)
2008
2007
9,760
3,954
7,923
2,984
5,806
4,939
Financial assets (FA)

Financial obligations (Fa)
Common shareholders equity ((SE)
Total NFO + CSf
2008
2007
2,683
692
2,765
586
(1.991)
7,797
(2,179)
7,118
5,806
4,939
Balance sheet relations:

NOA = OA- Ol = 9,760 - 3,954 = 5,806
NFO :::FO-FA
:::692-2.683 "'O.991}
CSE :::NOA-NFO",S,806+1,991:::7.797
(anetfinancial asset position)
Reformulated Income Statement 2008

Operating income (01)
Net financial income (NFl)
Comprehensive income (0)
1,883
49
1,932
Income statement relations:

(I :::01+ NFl :::.1,883 +49::: 1,932
Articulating relations between statements:

The stocks andflows equation for equity:
CSE200S '" CSE2G07 + (12008 - dacca> 7,118 + 1,932 - 1,253'" 7,797
STOCKS AND FLOWS RATIOS: BUSINESS PROFITABILITY
The free cash flow generation anddisposition equations:
The separation of operating and financing activities in the income statement identifies
profit flows from thetwoactivities. Thecorresponding stocks in thebalance sheet identify
the net assets or obligations put in placeto generate theprofit flows forthe twoactivities.
Thecomparison of the flows to the stocks yields ratios that measure profitability as a rate
ofretum:
C -I::: OI-L'l.NOA::: 1,883- 867::: 1,016

C-I :::8NFA-NFl + d:::-188 -49 + 1,253:::1,016
The stocks and flowsequation for operating activities:
NOA2008::: NOA2OO7 + 01 2008 - (C -Ihcos::: 4,939 + 1,883 - 1,016:::5.806

The stocks andflows equation for financing activities:
NFA2008 ::: NFA 2OO7 + NFI 2OO8 + (C - Ihoos - d200a ::: 2,179 + 49 + 1,016- 1,253 :::1,991
Return on net operating assets (RNOAI )

.
Return on net financial assets (RNFAt)
=:: ; ;
OIl
2 (NOA t
=::
1/
+ NOAt _ 1)
N"FI1
h (NFA[ + NFAt _ 1 )
Using the free cash flow generation and disposition equations, we have calculated free cash flow without a cash
flow statement. Bythe(ash conservation equation, the debtfinancing cash flow isF::: C-1- d, that is, for Nike, F'" 1,0161,253:::-237.
(Continued)
247
Chapter 7 Viewing me Business Through meFinancial Srmement.s 249

howto manipulate the statements to express one component in termsof others. The relations arestatedin stark,technical termshere,butthey, too,willcometo lifeas the analysis
develops. As a set, theyprovide thearchitecture fora spreadsheet program thatcanbe used
to analyze reformulated statements and valuefirms. You willfindyourselfreferring backto
themand, as you do, youwill appreciate howthe summary of the financial statements in
terms of the six relations (7.1-7.6) provides a succinct expression of the"story behind the
numbers." It is now time to visit the BuildYour Own Analysis Product (BYOAP) on the
book's Web site. Referto the Web Connection boxthat follows.
Now, having calculated all the components of the cash flow statement, the reformulated cash flow statement can be
constructed as follows:
Reformulated Cash Flow Statement, 2008
Free cash flow
Equity financing flows:
Net dividend toshareholders (d)
Debt Financing flows:
Net cash to debtholderYissuers (F)
1,253
(237)
1,016
The numbers here are summary numbers, and more detail can be added by displaying the components of these numbers.
Chapters 9 and 10 take you through it.
RNOA is sometimes calledreturn on invested capital (ROIC) or, confusingly withrespect

to OUf use of ROCE, return on capitalemployed (a different ROCE). Denominators are
calculated as the average of beginning and ending dollaramounts. If a firmhasnet interest
expense (and netfinancial obligations ratherthannet financial assets), the rateof return on
financing activities is calledthe net borrowing cost(NBC):
NB C ) =
1
Net Borrowing cost (
II
NFE,
.
h (NFO( 1"" NF0 1_ 1)
These ratios are primary ratios in the financial statement analysis we are about to
develop, for theysummarize the profitability of the twoaspects of business, the operating
activities and the financing activities, that have to be analyzed.
Summary
248
Thischapterhas laidout the bare bonesof how a business works and howbusiness activities are highlighted in reformulated financial statements. A seriesof accounting relations
describe the drivers of reformulated statements andconnectthe statements together. These
relations aresummarized in theAnalyst's Toolkit below, andyoushouldtry to commit them
to memory. More importantly, you should appreciate what they are saying. Taken as a
whole, these relations outline how valueis passed from shareholders to the firm in share
issuesand, optimistically viewed, withvalueaddedpassed backtoshareholders. Figures 7.3
and 7.4 summarize this well. Putthemfirmly in yourmindas youcontinue.
The chapter, indeed, is bare bones, andthereis muchfleshto be addedin the following
chapters. You havebeengiven the formof the reformulated statements thatdistinguish the
operating and financing activities of the firm, butthe formhas to be Wed out.The distinctionbetween thetwotypesofactivities is important for, as weobserved inChapter 3,it isthe
operating activities that are typically the source of the value generation, so it is these
operating activities-and the return on net operating assets(RNOA)-that we willbe particularly focused on as we analyze firms. Indeed, as we proceedwith financial statement
analysis, wewillworkwithreformulated statements, notthepublished GAAP statements.
The accounting relations that govern the reformulated statements are also toolsfor the
analyst. Theyexplain howto pullthestatements apartto get at thedrivers. Andtheyexplain
BUILD YOUR OWN ANALYSIS PRODUCT

(BYOAP)
The structure laid out in this chapter is a template for
developing spreadsheets for analyzing the operating and
financing activities of a firm and valUing the firm. The
various accounting relations dictate the form that the
spreadsheet must taketo have integrity, andyou will need
to refer to these relations ifyou choose to develop your
own analysis andvaluation spreadsheet product.
You will find that developing such a product will be
rewarding. Not only will you have a product thatyou can
take into your professional life (and, indeed, usefor your
personal investing). butalso theconcepts will come alive as
you go"hands-on. Itis important thatyou develop aquality product. You do notwant to lose any feature that is
important to thevaluation. Applying the framework inthis
chapter ensures that nothing is lost in your calculations.
N
Key Concepts
You are notready to develop the product yet. As the

book proceeds, you will beable to build it using thearchitecture provided in this chapter, adding more bells and
whistles as you go along. The feature Build Your Own
Analysis Product (BYOAP) on the book's Web site will
guide you inthe practicalities. Rather than a final, off-theshelf product that you can appropriate, BYOAP isa guide
to building your own analysis product, soyou learn asyou
goand gain anunderstanding oftheengineering involved.
With this understanding, you will be able to challenge the
features of off-the-shelf products andreach theconclusion
thatyours is, indeed, a product with an edge.
For the moment, goto theSYOAP feature On theWeb
site, and familiarize yourself with the layout. Nike isused
for illustration there. We will refer to 8YOAP as we proceed to develop theanalysis insubsequent chapters.
financial asset is an assetheldto store

cashtemporarily andwhichis liquidated
to Invest in operations or paydividends.
Alsocalledmarketable securities. 234
financial expenseis an expense incurred
on financialobligations. 241
financial income is earnings on financial
assets. 241
financialobligationor financialliability
is an obligation incurred to raisecashfor
operations or to pay dividends. 235
net financial expenseis the difference
between financial expenseand financial
income.If financial income is greater
thanfinancial expense, it is referred to as
net financialincome. 241
operating asset is an assetused in

operations (to generate valuefromselling
products and services). 239
operating expenseis a lossof valuefrom
selling products (in operations). 241
operating incomeis net valueaddedfrom
operations. 241
operating liability is an obligation
incurred as partof operations (togenerate
valuefrom sellingproducts and
services). 239
operating revenueis valuegained from
sellingproducts (in operations). 241
250 Part Two ThcAnalysis of Financial S!m<mC~l.,
Analysis Tools
Page
KeyMeasures
The treasurer's rule

236 Common stockholders' equity
IfC -f-i>d, then lend
(eSE)
or buydowndebt
Financial assets (FA)
IfC-f-i<d, then borrow
Financial obligations (FO)
or reduce lending
Free cashflow
Accounting relations
Netborrowing cost(NBC)
Cash conservation equation
Netfinancial assets(NFA)
C-I=d+F(7.1)
236 Netfinancial obligations (NFO)
Free cashflow sources
Net financial expense (NFE)
equation
Netfinancial income (NFl)
C-I = 01- 6NOA (7.2)
242 Netoperating assets (NOA)
Free cash flow disposition
Operating asset(OA)
equations
Operating expense (OE)
C-I::=.6.NFA-NFI+d
17.3,)
242 Operating liabilities (OL)
C-I=NfE-6NfO+d
Operating revenue (OR)
(7.3b)
242 Return on net financial assets
Dividend driver equations
(RNfA)
d=C-f+NFI-.6.NFA
Return on net operating assets
243
(7Aa)
(RNOA)
d=C-I-NFE+.6.NFO
243
(7Ab)
Chapter 7
Page
244
235
235
236
248
235
235
241
241
239
239
241
241
239
241
246
246
Thwllgh rhe Financial Srarements 251
You will be helpedby delvinginto the full lu-K reportfor 2004.Download it fromthe
SEC'sEDGAR Web site andgo through the footnotes to the financial statements. You will
be referring to thesefootnotes constantly overthe nextfewchapters, so geta senseof their
layout. The detail is not important at this stage,but do familiarize yourselfwith the broad
content. The KMBcase forChapter 2 givesdownload instructions. If, forsomereason, you
havedifficulty downloading the IO-K, it is on theWeb page for this chapteron the book's
Web site.
BYOAP Build Your Own Analysis
Product
CSE common shareholders'
equity
FA financial asset
FO financial obligation
NBC net borrowing cost
NFA net financial assets
NFE net financial expense
NFl net financial income
NFO net financial obligations
NOA net operating assets
OA operating assets
OE operating expense
01 operating income
OL operating liabilities
OR operating revenue
RNFA return on netfinancial
assets
RNOA return on net operating
assets
THE TREASURER'S RULE

Usingthe cash flow statement for 2004 in Exhibit 2.2 in Chapter2 and anyother information yougleanfromthe lO-K, layout the sequence thatconcludes with the treasurer's trading in debt,as in Box7.1.
Nowtakethis information and presentit in the formof a summary cash flow statement
(as in Box 7.2) that obeys the equation: Free cash fiow Distributions to shareholders +
Distributions to net debtholders. One question youwill haveto resolve is the treatment of
the increase in cash of $303.4 millionoverthe year.
IDENTIFYING OPERATING AalVITIES

The rationale for the reformulation on the financial statementsketched out in this chapter
is to separate operating activities from financing activities. Typically valueis generated in
operating activities-trading with customers andsuppliers-not in financing activities that
merelyinvolve passing cash to and from investors. Reformulation sets us up to examine
valueadded.You will carry out a full reformulation of Kimberly-Clark'sbalancesheetand
income statementin Chapter9. For now, go through the balancesheet and income statementin Exhibit2.2 and identify thoseitemsyouthinkare involved in operations andthose
involved in financing activities. If you are ambitious, youcan follow throughandcalculate
totalsfor net operating assets,netfinancial obligations, operating income, andnet financial
expenses, as inBox 7.3, but you bestwaituntil Chapter 9.
Netoperating assetdriver
equation
6NOA= 01- (C- 0 (7.5)
Vi~l<'ing theBIl.\inc,.
243
Netfinancial asset(or
obligation) driver equations
.6.NFA= NFl +(C
d
-n -
(7.6al
t.NFO = NFE - (C(7.6bl
n+ d
243
244

Kimberly-Clark's financial statements for 2004 are presented in Exhibit2.2 as part of the
the continuing case for Chapter2. Overthe nextthree chapters, you will be reformulating
thesestatements following the designin this chapter. Then,in Chapters I J and 12you will
be performing a full analysis of the reformulated statements in preparation for valuingthe
company in PartThree of the book.This moduleof the continuing case prepares you for
what is to come.
Concept
Questions
C7.1. Whycan freecash flow be regarded as a dividend, that is, as a distribution of value
ratherthan the valuecreated?
C7.2. A firm has positive free cash flow and a net dividend to shareholders that is less
than free cash flow. Whatmust it do with the excessof the free cash flow overthe
dividend?
C7.3. Howcan a firm pay a dividend with zerofree cash flow?
C7.4. Distinguish an operating asset froma financial asset.
C7.5. Distinguish an operating liabilityfroma financial liability.
C7.6. If an analyst has reformulated balancesheetsand income statements, she does not
needa cash flow statement to calculatefreecash flow. Trueor false?
C7.7. Whatdrivesfree cashflow?
C7.8. Whatdrivesdividends?
C7.9. Whatdrivesnet operatingassets?
C7.10. Whatdrives net financial obligations?
C7.l L Freecash flowdoes not affectcommonshareholders' equity. Trueor false?
252 Part Two The Ana!ysis of Financial Sl<lIcments
Exercises
Chapter 7 Viewing the Bllsiness Through rhe Financial StlItemcnts 2S3
Drill Exercises
E7.5.
E7.1. Applying the Cash Conservation Equation (Easy)

a. A finn generated $143 million in freecashflow and paida net dividend of $49 million
to shareholders. Howmuchwaspaidto debtholders and debt issuers?
b. A finn paid a dividend to shareholders of $162 million and repurchased stock for
$53 million. Therewerenoshareissues. The fum received netcashof$86 million from
debt financing transactions. Whatwas its freecashflow?
Using Accounting Relations (Medium)

Below are financial statements that have been reformulated using the templates in this
chapter. Someitemsare missing; theyare indicated by capital letters.
IncomeStatement
Six Months to June 30, 2009

Revenues
E7.2. Applying the Treasurer's Rule (Medium)

a. A finn generated freecash flow of $2,348 million andpaid net interest of $23 million
after tax. It paid a dividend of $14 million and issuedshares for $54 million. There
wereno sharerepurchases. Whatdid the treasurer do withthe remaining cashflow and
for howmuch?
b. A finngenerated a negative freecash flow 0[$1,857million, butthe boardof directors,
understanding that the:firm wasquite profitable, maintained the dividend of S1.25 per
share on the 840 million shares outstanding. The firm also paid $32 million in net
interest (aftertax).Whatare the responses opento the treasurer?
E7.3.
E7.4.
Balance Sheet and Income Statement Relations (Easy)

a. A firmholdingS432 million in interest-bearing financial assetsandwithfinancing debt
of $1,891 million, reported shareholders' equity of $597 million. What were its net
financial assets? Whatwereits net operating assets?
b. The same finn reported S108 million in comprehensive income and net financial
expense, after tax,of$47 million. Whatwas its after-tax operating income?
Using Accounting Relations (Medium)
Beloware a balancesheetand an income statement that havebeenreformulated according
to the templates laidout in this chapter.
Operating expenses
Cost of sales
Selling, administrative, and general expenses
Other operating expenses, including taxes
Operating income aftertax
Net financial expenses aftertax
Interest expense
Interest income
2,453
507
2,423
2,929
-!3.
850
153
_C
59
791
Balance Sheet
June 30, 2009
June
December
June
December
2009
2008
2009
2008
Operating assets 28.631

Financial assets
0
33.088
30,024
4,238
G
Financial liabilities
7,424
Common equity
18,470
33.088
8,747
6,971
H
Balance Sheet
Assets
Operating assets
Financial assets
2009
2008
2053
45.7
189.9
42.0
251.0
Shareholders' equity
231.9
2009
2008
40.6
120.4
90.0
251.0
34.2
120.4
773
231.9
Cash FlowStatement
SixMonths EndingJune 30, 2009

Cash investment
Free cash flow
Netdividends (dividends and share repurchases - share issues)
Payment to netdebtholders
584
.i.
)
-"M
IncomeStatement
2009
Operating revenues
Operating expenses
Operating income
Interest revenues
Interest expenses
a. Howmuchwaspaid out in net dividends during 20097

b. What is freecashflow for 2009?
c. What wasthe returnon net operating assetsin 2009?
d. What wasthe finns net borrowing cost?
134.5
(112.8)
21.7
2.5
a.
b.
c.
d.
Supply themissingnumbers usingthe accounting relations laidout in this chapter.

Whatwerethe totalnewoperating accruals in the first halfof 2009?
Howmuchnewnet debt wasissuedduringthis period?
Whatgenerated the net dividend in the period?
--"'i)
14.6
E7.6. Inferences Using Accounting Relations (Hard)

A firm with no financial assets or financial obligations generated free cash flow of
$8.4million in 2009.At the end of2008 it hada marketvalueof$224 million, or 1.6times
bookvalue. At the end of 2009 it had a marketvalueof $238 million, twicebook value.
a. Whatwasthe rate of returnfrom investing in thestockof this firm for2009?
b. Whatwerethe earnings for this finn for 2009?
254 Part Two The AnalY5is ofFinancial Swremcnro
Applications
E7.7.
Applying the Treasurer's Rule: Microsoft Corporation (Medium)

At the end of its June 30, 2008, fiscal year, Microsoft Corporation reported $23.7 billion
in short-term interest-bearing investments and cash equivalents. The firm had no debt
obligations. Subsequently, inSeptember ofthatyear, thefirm announced a $40billion stock
repurchase anditsintention to raise theannual dividend to 52 cents a share, from 44 cents,
or to a totalof$4.7 billion.
Cash flow from operations for fiscal year2009 was projected to be $23.4 billion, up
from $21.6 billion for2008; interest receipts were expected tobe$702 million; andthefirm
wasexpected to maintain cashinvestment at the 2008 level of $3.2 billion. Cash receipts
from the issue of shares toemployees (including tax benefits) were expected tobe $2.5 billion. Thefirm's tax rateis 36percent.
a. By applying the treasurer's rule., lay out the strategy for Microsoft's treasurer for
managing cashflows.
b. Microsoft is actively looking foracquisitions toenhance itspresence in theWeb search
and Web applications area. What would be the effect on the treasurer's plan if
Microsoft decided to make a $4.2billion cashacquisition?
c. Formany years, Microsoft has carried no debt(obligations). At the timeof the share
repurchase announcement, Microsoft alsosaidthatit hadreceived authorization from
its board of directors for debtfinancing up to $6 billion. Why would the management
seeksuchauthorization at thisstage?
Exercises dealing with Microsoft are E1.6, E4.14, E6.13, E8.l0, EIO.ll, E17.l0, and
E19.4. Also seeMinicases M8.1 andM12.2.
E7.8.
Accounting Relations for Kimberly-Clark Corporation (Medium)

Below are summary numbers from reformulated balance sheets for 2007 and 2006 for
Kimberly-Clark Corporation, the paper products company, along with numbers from the
reformulated income statement for2007 (inmillions).
Operating assets
Financial assets
Operating income (after tax)
Netfinancial expense (after tax)
2007
2006
$18,057.0
6,011.8
382.7
6,496.4
$16)96.2
5,927.2
270.8
4,395.4
2)40.1
147.1
a. Calculate thefollowing for2007 and2006:

(i) Netoperating assets.
(ii) Netfinancial obligations.
(iii) Shareholders' equity.
b. Calculate freecashflow for2007.
c. Show thattheaccounting relation for change in net operating assets (equation 7.5 in
thechapter) works forKimberly-Clark.
d. Whatwasthenetpayment to shareholders (thenetdividend) in 2007?
Follow Kimberly-Clark through thecontinuing case at the endof eachchapter. Also see
Exercises E4.8, E6.l4, EIO.lO, andEl1.l6, andMinicase M5.3.
Chapter 8 The Analysis of !he Srltemem ofShareholders' Equity 257
LINKS
I Link to previouschapter
, Equity
Chapter 7 laidouta design

forfinancial statements
thatprepares them for
analysis.
After reading this chapter you should be able to:
How statements of shareholders' equity are typically

laid out.
Why reformulation ofthestatement isnecessary.
What is reported in "other comprehensive income"
andwhere it is reported.
What "dirtysurplus" items appear inthe statement of
How stock options work to compensate employees.
How stock options and other contingent equity claims
result ina hidden expense.
How management can create value (and losses) for
shareholders with share transactions.
How accounting hides losses from share transactions.
Reformulate a statement ofshareholders' equity.

Distinguish the creation of value from the distribution
ofvalue intheequity statement.
Calculate the netpayout to shareholders.
Calculate comprehensive income and comprehensive
ROCE from theequity statement.
Calculate payout andretention ratios.
Calculate a growth rate for common shareholders'
equity and analyze its components.
Calculate the expense from exercise of stock options.
Calculate gains andlosses from putoptions.
Calculate losses from the conversion of securities into
common stock.
This chapter
Thischapterreformulates
thestatement of owners'
equityaccording to the
design inChapter 7. The
reformulation highlights
comprehensive income.
Whatis hidden
dirty-surplus
income?
REFORMULATING THE STATEMENT OF OWNERS' EQUITY

Chapter 9 continues the
reformulation withthe
balance sheetandthe
income statement.
Link to Webpage
Formoreapplications of
Chapter 8 content, visit
thetext's Websiteat
www.mhhe.coml
penmance.
and IFRS accounting sometimes confuses the financing and operating aspects of these
transactions; thatis,itconfuses themoneys raisedforfinancing withtheexpenses incurred in
operations. The analysis of the statement of shareholders' equitysorts out this accounting.
The statement of shareholders' equityis usually notconsidered the mostimportant part of

the financial statements and is oftenignoredin analysis. However, it is the first statement
that the analyst shouldexamine beforegoingon to the other statements. It is a summary
statement, tyingtogether all transactions that affectshareholders' equity. By analyzing the
statement, the analystensures that all aspects of the business thataffectshareholders' equityare included in his analysis to value the equity.
Wesaw in Part One of the book that whenaccounting income is used in valuation, it
must be comprehensive income. Otherwise valueis lostin the calculation. The accounting
relations in the last chapterholdonlyif income is comprehensive. We will use theserelationsas analysis tools in laterchapters, butthe toolswill workonlyif income is on a comprehensive basis. Unfortunately, earnings reported in most income statements in most
countries is not comprehensive, including earnings reported in statements prepared under
U.S. GAAP and international accounting standards. The analysis of thestatement of shareholders'equity makesthe correction.
Value is generated for equityholders through operations, not byequityfinancing activities.Wesaw in Cbapter 3 that share issuesand repurchases at marketvaluedo not create
value in efficient capitalmarkets. But share issues are sometimes made in exchange for
goodsandservices inoperations, mostly foremployee compensation. Unfortunately, GAAP
The statement of owners'equityprovides the reconciliation of beginning andendingowners' equityaccording to thestocksandflows equation introduced in Chapter 2: The change
in owners'equityis explained by comprehensive income for the periodplus capital contributions from share issues, lessdividends paid in cash and stockrepurchases. The GAAP
statement isoften-and unnecessarily-more complicated thanthis,however, so partof the
analysis involves simplifying it. The idealstatement for a fiscal periodhas the following
form:
Reformulated Statement of Common Shareholders' Equity
Beginning bookvalue ofcommon equity

+ Net effect oftransactions with common shareholders
+ Capital contributions (share issues)
- Share repurchases
- Dividends
Net cash contribution (negative netdividends)
+Effect ofoperations and nonequity financing
+ Net income (from income statement)
+ Other comprehensive income
- Preferred dividends
_ Comprehensive income available tocommon
Closing bookvalue ofcommon equity
258 P?rt Two The Analysis ofFinancial Statement!
Notice threethings aboutthisstatement:

1. With a view to valuing the common shareholders' equity, the reformulated statement
excludes preferred equity. Fromthecommon shareholders' pointof view, thepreferred
equityis an obligation to pay otherclaimants beforethemselves, and it is treated as a
liability. So the beginning and ending balances refer only to common shareholders'
equity.
2. The net addition to common equityfrom transactions withshareholders-the negative
net dividend-is separated from the addition to shareholders' equity that arisesfrom
business activities.
3. The total effectof operations and nonequity financing on the common shareholders is
isolated in comprehensive income. This has three components: net income reported in
the income statement, othercomprehensive income reported outside the income statement, and preferred dividends. As preferred stockis effectively debtfromthe common
shareholders' viewpoint, preferred dividends are an "expense" in calculating comprehensive income, just likeinterest expense.
Introducing Nike
The analysis of financial statements in thisand subsequent chapters will be demonstrated
with the 2008statements of Nike,Inc.,the sport and leisure footware company. You will
findit helpful to see a complete analysis of this firm. The BuildYour OwnAnalysis Product (BYOAP) feature on thebook's Web site,introduced at the endofthelastchapter, takes
the Nike analysis backto earlier years. Aftercovering the material in the bookandin that
Web module, you will have a complete analysis history for Nike for a 10-year period,
1999-2008. Take the Nile analysis in thebookandin BYOAP as a model for theanalysis
of anyfum, andusethe roadmap in BYOAP to develop spreadsheets thatdeliver a concrete
analysis andvaluation product. You canviewNike'sfull2008financial statements in MinicaseM2.1 in Chapter 2.
Weemphasized in Chapter1 thatthefirststepin analysis and valuation is "knowing the
business." Nikeis no doubtfamiliar to you: Its logois visible on theclothes andshoes that
manyof us wear, from the greatest sports stars to the smallest of kid pretenders. Box 8.1
gives somefurtherbackground on the company; however, in practice a muchdeeper understanding of a firm is required tocarryouta capable analysis. Fora start,checktheBusinessSection(Item I) of the firms IO~K reporton EDGAR.
Reformulation Procedures
Exhibit 8.1 presents the GAAP statement of shareholders' equity forNike,alongwith reformulated statements in the form of thetemplate on theprevious page.Flagsto the right
of the GAAP statement indicate whichitems are transactions with shareholders (f) and
whicharecomponents of comprehensive income (Cl).
Reformulation follows threesteps.
1. Restate beginning andending balances for theperiodfor items thatare notpart of commonshareholders' equity:
a. Preferred Stock: Preferred stock is included in shareholders' equity in the GAAP
statement, but it is a liability for the common shareholders. So reduce the balances
by the amount of preferred stock in thosebalances (and ignore any preferred stock
transactions during the period in the reformulation). An exception is mandatory
redeemablepreferred stock which, underGAAP, is notpart of equitybut ratheris
Incorporated in1968, Nike (www.nike.com)isaleadingmanufacturer and marketer ofsport and fashion footwear. The firm
is headquartered inBeaverton, Oregon.
STRATEGY
Nike aims to dominate the worldwide market for athletic
footwear and athletic footwear used for casual and leisure
dress. It attempts to accomplish this through extensive promotion, often using high-profile sports figures and endorsements ofsporting events.
The market for footwear ishighly competitive, with Puma

and Adidas being major competitors. Changes inconsumer
preferences, changes in technology, and competition areseen
asthemain risk factors.
EQUITY FINANCING
Two cesses ofcommon shares have equal shares in profits. A

total of491.1 million shares were outstanding at theendof
fiscal 2008. Nike has a continuing stock repurchase program
and pays dividends. Asmall number of redeemable preferred
shares areheld byanAsian supplier.
OPERATIONS
The company has an active stock compensation plan for
Nike's top-se'linc footwear are basketball, training, running, employees. In fiscal 2008, options on6.9million shares were
and children's shoes, but it also sells tennis, soccer, golf, granted and options on9.1 million shares were exercised at a
baseball, football, bicycling, and other footwear, as wei! as weighted-average exercise price of$33.45 pershare.
apparel, brand-name sports equipment, and accessories. It
sells its products through retail outlets in the United States SUMMARY DATA
and around theworld and through independent distributors
2008
2007
2006
and licensees. About 43 percent of Nike's sales in 2008 were
intheUnited States.
Basic earning, per share
$ 3.80
$ 2.96
$ 2.69
The firm maintains an active research and development Diluted earnings per share
3.74
2.93
2.64
effort to improve itsproducts. Most ofits manufacturing facil- Dividends per share
0.88
0.71
0.59
ities areoutside theUnited States, inAsia andSouth America. Book value per share
15.93
14.00
i2.2B
Ithas approximately 32,500 employees, butmuch oftheman- Price per share, end ofyear
57.20
55.60
40.00
ufacturing is through independent contractors.
reported on thebalance sheet in a "mezzanine" between liabilities andequity. Nike's

preferred stockis redeemable, so noadjustment is required.
b. Dividends Payable. GAAP requires dividends payable to common shareholders to be
reported asa liability. Butshareholders cannot owe dividends to themselves. Anddividends payable do notprovide debtfinancing. Common dividends payable arepart of
theequitythatthecommon shareholders have inthefirm. Soinstead ofreporting them
as liabilities, reclassify themto thebalances of shareholders' equity, as explained in
thenotesto Nike's reformulated statement in Exhibit 8.1.
c. Under FASB Statement 123R, applied forthe first time in 2007, and under thesimilar international accounting standard, IFRS 2, firms mustbookthe grant-date value
of stock options granted to employees as deferred compensation, with the conespending creditgoing to shareholders' equity ($141 million in Nike's 2008 statement). While the option grantis indeed compensation to theemployee. the creditto
shareholders' equityis clearly wrong: It looks as if an expense increased shareholders' equity in the firm. Rather, stockoptions are (contingent) liabilities to theshareholders: The shareholders are liable to loseequity-not add to theirequity-if the
options go intothe money and employees are issued shares, on exercise of the options, at lessthan market price.Wewillaccommodate this"bad"accounting later in
thischapter, butforthemoment taketheoffending $141 million out ofthestatement
and adjustthe closing balance of shareholders' equityaccordingly. See the note to
Nike's reformulated statement.
259
260
Chapter 8 The Analysis 0/tile StatemC7\t ofShareholden' Eqllir) 251
PartTwo TheATlIJ1)'s.is of Financial S=entl
Reformulated Statement of Common Equity
EXHIBIT 8.1 GAAPStatementand Reformulated Statement of Common Shareholders'Equity for Nike,Inc"

May31,2008
Thereformulated statement separates transactions withshareholders from comprehensive income. Theflags on therightof the
GAAP statementindicate transactions withshareholders (T) andcomprehensive income (Cl).
NIKE,!NC.
GAAP Statement of Shareholders' Equity

(inmillions, except pershare data)
Accumulated
CommonStock
ClassA
Balanceat May31, 2007
Shares
Amount
Shares
117.5
$0.1
384.1
Stock options exercised

Conversion to Class Bcommon
stock
Other
Comprehensive Retained
Amount Stated Value Income(Loss) Earnings
ClassB
S2.7
$1,960.0
$177.4
$4,885.2
Total
20.8
Repurchase of Class Bcommon

stock
(20.5)
(1,235.7) (l,248.0){T)
(12.3)
$372.2
35.8
0,248.0)
(412.8)
(1,252.8)
1,883.4
165.6
(91.6)
(25.7)
1,931.8
7,797.3
Note: Thebeginning b~\anec in therefOlmol,te<l Sl,temenl isc:I!""I,te<l :IS follows:

Repol1e<lo,J,,,,,::e
57,025.4
Dividends p:ty:lbie
----'ll1.
57.1183
Theendiogbalance iSC<llcul,ted as follows:
Reported b:lI=
S7.825.4
Dividend~ p;ly.lble
112.9
(141.0)
Siod-b.,.,d com~eM'ltion
$7,797.3
Dividends on common stock

($0.875per share)
(432.8)
39.2 {T}
39.2
1.0
Issuance of sharesto employees
(432.8) (T)
2. Calculate net transactions with shareholders (the net dividend). This calculation nets
Stock-based compensation:
141.0
(Notes 1 and 10):
141.0
(2.3)
(O.l)
Forfeiture of sharesfromemployees
Comprehensive income (Note 13):
Netincome
Othercomprehensive income:
Foreign currency translation and
other (net of taxexpenseof
$101.5)
Realized foreign currency
translation gaindue to
divestiture (Note 15)
Netlosson cashflowhedges
(net of tax benefitof $67.7)
Netlosson net investment
hedges(net of tax benefit
of $25.1)
Redassifkaticn to net income of
previously deferred losses
relatedto hedgederivatives
(1.1)
(3.4)(T)
1,883.4
1.883.4(0)
211.9
211.9(0)
(45.3)
(45.3)(CI)
(175.8)
(175.S) (CI)
(43.5)
(43.5)(CI)
127.7(CI)
127.7
74.0
Adoption of FIN 48 (Notes 1 and 8)
1,883.4
(15.6)
Adoption of E1TF 062 Sabbaticals

(Note1)
Balanceat May 31. 2008
$7,118.3
$7,025.4
372.2 m
372.2
9.1
(20.8)
Capital in
Excess of

Transactionswith shareholders
Stockissued for stockoptions
Stock issued to employees (net)
Stockrepurchased
Cash dividends
Netincome reported
Nettranslation gainsand losses
Net hedging gainsand losses
Prior earnings restatements
(10.1)
96.8
$0.1
394.3
$2.7
$2,497.8
$251.4
Note: Footr.o:es 10the IOK indicMe Nikeh:>d S112.9:nillionindividends P"Y"ble ,t the endof2008 :u>d $92.9mimon,t Ibeeodof2007.
1,957.4
(15.6)(O)
(10.1)(0)
$5,073.3 $7,825.3
dividends andstockrepurchases againstcashfromshareissues, as in the exhibits. Dividends must be cash dividends (calculated as follows), and not dividends declared as
dividends payable:
Cashdividends = Dividends reported + Change in dividends payable
With dividends payable of $92.9 million and $112.9 million at the end of 2007 and
2008,respectively, Nike'scashdividends paid are $432.8 + 92.9 ~ 112.9 = $412.8 million,which is the number for cashdividends in the cashflow statement.
3. Calculate comprehensive income. Comprehensive income combines net income and
otherincome reported in the equitystatement. Besides net income, the GAAP statement
for Nikereportscurrencytranslation gains and lossesand gainsand losseson hedging
instruments, You cansee in the GAAP statementthata totalis drawn forcomprehensive
income aftertheseitems.But comprehensive income also includes the twoitemsunder
thistotalfor the adjustments to prioryears' income forchanges in accounting methods:
Theseare changes to shareholders' equityfrom (measuring) business income. The income reported outside net income is referred to as other comprehensive income, so
comprehensive income is net income plus other comprehensive income. Note that all
items in othercomprehensive income are after tax.That is, theyare reported net of any
tax thattheydraw.
You willnotice in this reformulation that we have not made any use of the distinction
between statedvalue(orpar value) of shares andadditional (orexcess) paid-incapital. This
is of no importance for equityanalysis; better to know the company's telephone number
thantheparvalueof its stock.Retained earnings is a mixture ofaccumulated earnings, dividends, sharerepurchases, and stockdividends, and it doesnot bear on the analysis. Conversions of one class of common to anotherwith zeroeffect do notchangethe bookvalue
of equity (as with Nike). Nor do stock splits or stockdividends change the bookvalueof
equity; splitschangethe number of sharesbut do not change a given shareholder's claim.
262 Part Two The AMJ)'sis ofFinancial Statements
DIRTY-SURPLUS ACCOUNTING
Reporting income itemsas part of equityratherthan in an income statement is known as
dirty-surplus accounting. An equity statement that has no income otherthan net income
from theincome statement is a clean-surplusaccountingstatement. Thetermsarepejorative, and appropriately so. Under dirty-surplus accounting, the income in the income
statement is not "clean:' it is not complete. "Net" income or profit, as usedunder GAAP
andinternational accounting standards, is really a misnomer.
Table g.j Iists the dirty-surplus items youarelikely toseein theUnited States. Income
items are designated as part of operating income or financial income (expense) to categorizethemina reformulated income statement (later). Some oftheitemsyouwillrarelysee.
The three most Common are unrealized gains and losses on securities, foreign currency
translation gainsand losses, and unrealized gainsandlosses on certainderivatives.
I. Unrealized gains and losses On securities available for sale. FASB Statement No. 115
distinguishes threetypes of securities:
Trading securities
Securities available for sale
Securities heldto maturity
Trading securitiesare thoseheld in a portfolio that is actively traded. Thesesecurities
are marked to marketvalue in the balance sheet and the unrealized gains and losses
from changes in marketvalueare reported in the income statement. Securities that are
not actively traded but which might be sold before maturity are available for sale.
These also are marked to "fair" marketvaluebut the unrealized gainsand losses are
reported as part of othercomprehensive income. Securities that management intends
to hold to maturity are recorded at cost on the balancesheet, so no unrealized gains
and losses are reported. Realized gains and losses on all types of securities are
reportedin the income statement as part of net income. The rules applyto both debt
securities and equitysecurities involving less than20 percent ownership interest. Go
to Accounting ClinicIII.
2. Foreign currency translation gains and losses. The assets and liabilities of majorityowned foreign subsidiaries, measured in theforeign currency, mustbeconsolidated into
the statements of a U.S. parent in U.S. collars. If theexchange ratechanges overthereportingperiod, the value of theassetsandliabilities changes in u.s. dollars. Theresultinggainor lossis a translation gainor loss, to bedistinguished from gains andlosseson
foreign currency transactions. Mosttransaction gainsandlossesare reported as part of
net income. Translation gains and losses are part of other comprehensive income.
Translation gains and lossescan applyto both theoperating and financing assetsand
liabilities of subsidiaries, so their income can affect operating or financing income as
indicated in Table 8.1.
3. Gains and losses on derivative instruments. FASB Statement No. 133requires most
derivatives to be marked to fair valueon the balance sheet, eitheras assetsor liabilities. If the instrument hedgesan existing assetorliabilityor a firm conunitment bythe
company-s-a so-called fair value hedge-the gain or loss from marking the instrument to fair value is recorded as part of net income. (Undercertain conditions, the
gain or loss is offsetin the income statement by the gain or loss on the hedgeditem.)
If the instrument hedges the cash flow from an anticipated future transaction-a
so-called cashflow hedge-the gain or loss is recorded to the equitystatement, and
Chapter 8 Th~ AnCl/Y.lb of(he Slalemenc ofShar~ho!Jer; Eq:lilj 263
TABLE 8.1
Dirty-Surplus
Accounting: U.S.
GAAP
Alldirty-surplus
income items are
reported netof tax.
OperatingIncome Items
Changes inaccounting forcontingencies (FASB Statement No. 11)
Additional minimum pension liability (FASB Statement No. 87)
Tax benefits of loss carryforwards acquired (FASB Statement No. 109)
Tax benefits of dividends p~id to ESOPs (FASB Statement No. 109)
Unrealized gains andlosses onequity securities available forsale
(FASB Statement No. 115)
Some adjustments of deferred taxvaluation allowances (FASB Statement No. 109)
Change infunding statusof pension pians (FASB Statement No. 158)
Financing Income (or Expense) Items
Preferred dividends
Unrealized gains andJesses ondebtsecurities available forsale (FASB Statement No. 115)
Operatingor Financing Income Items
Foreign currency translation gains andlosses (FASB Statement No. 52)
Gains andlosses on derivative instruments designated as cash-flow hedges
(FASB Statement No. 133)
Restatements of prior years' income due to a change inaccounting principles (FASB
Statement No.1 54)
Balance Sheet Itemsto BeReclassified
Credits to shareholders' equity forstock compensation expense (FASB Statement No. 123R)
Dividends payable
then removed from the equity statement to net income when the hedgedtransaction
affectsearnings. 1
Comprehensive Income Reporting under u.s. GAAP and IFRS

FASB Statement No. 130requires comprehensive income to be identified in the financial
statements. It distinguishes net income from othercomprehensive income and permits the
sumof the two, comprehensive income, to be reported in oneof threeways:
I. Report comprehensive income in the statement of shareholders' equityby adding net
income to othercomprehensive income items reported in theequitystatement.
2. Addothercomprehensive income to net income in the income statement, andclosethe
total comprehensive income to shareholders' equity.
3. Present a separate statement of other comprehensive income apart from the income
statement, andcloseit to equity alongwithnet income from theincome statement.
1 SeeM. A. Trombley, Accounting for Derivatives andHedging (New York: McGraw-Hill/lrwin, 2003) for
a primer onthe accounting forderivatives. fi5 these hedging gains and losses will be matched against
realized gains andlosses on the hedged items insubsequent income statements. theyare more appropriately classified asdeferred income ordeferred charges inthe liability andasset sections ofthebalance
sheet. Weleave themintheequity statement hereto maintain thereported number forcomprehensive
income. But notethat theyrepresent income that islikely to be reversed insubsequent periods when the
corresponding gains and losses on thehedged items are recognized on termination ofthe hedge.
264 Part Two TheAna1)"lil ojFilUlncia.1 Srar.emenl.l
Chapter 8 TheAnalylis ofdle Sra.rement ofS!w.rcno1ders' Eq"ir)' 265

'~il'l
~~
Accounting Clinic
ACCOUNTING FOR MARKETABLE SECURITIES
Further detail on the accounting for securities is covered
in Accounting Clinic 1I! on the book's Website.Theclinic
covers debt securities held by firms and equity securities
representing lessthan 20 percent interest in other corporations. The accounting for equity investments of more
than 20 percent iscovered inAccounting Clinic V.
Most firms follow the first approach/ So you now observe dirty-surplus income items
added together intoa number called"othercomprehensive income" andothercomprehensiveincome andnetincome added to "totalcomprehensive income"-all within theequity
statement. This presentation facilitates the task of identifying comprehensive income.
However, it is not, in fact, comprehensive from the common shareholders' pointof view.
First, it omits preferred dividends, and, second, certain hidden items(which wewill identifytoward theend of thischapter) arenot included.
Other comprehensive income under lFRSconsists ofitems similartothose intheUnited
States, withthe addition of actuarial gainsandlosses onpension assets andassetrevaluationgainsand losses. Up to 2009, firms could electto report othercomprehensive income
ina statement of recognized income expense, outside ofboththe income statement andthe
equity statement. UnderlAS 1(Revised 2007), effective from 2009 on,thisseparate statementdisappears. Finnswillchoose to reporta single statement of comprehensive income
or twostatements, a statement of operations anda statement of comprehensive income. The
revised lAS 1 will not permit comprehensive income to be displayed in the statement of
changes in shareholders' equity (asis permitted under GAAP).
RATIO ANALYSIS
What does the reformatted statement of changes in owners' equity reveal? It gives the
growth in equity overa period. Andit distinguishes clearly between the growth in equity
fromnewinvestment or disinvestment by the owners andadditions to equity from running
the business. Accordingly, the reformulated statement distinguishes the creation of value
from thedistribution of value. Indeed, bothreturn oncommon equity(ROCE) andgrowth
in equity-the twodrivers ofresidual earnings-ean be identified inthestatement. A setof
ratios analyzes the statement to refine this information.
Payoutand Retention Ratios
total payoutis dividends plusshare repurchases. Some firms pay no dividends but have
regular stock repurchases. The total payout ratio is
.
Dividends + Stock repurchases
TotaI payout ratro Comprehensive income
calculated with totaldollaramounts rather than per-share amounts. Thedifference between
this ratio andthe dividend payout ratiogives the percentage of earnings paidout as stock
repurchases.
Note that stock dividends and stock splits are not involved. These simply change the
share units, withno effect on the claim of each shareholder. Some splitsand stock dividends involve a reclassification from retained earnings to additional paid-in capital, but
again thishasno effect on the value of claims.
Although thedividend payout ratiosuggests thatdividends are paidoutofearnings, they
arereally paidoutofbookvalue, outofassets. Soa firm canpaya dividend even ifitreports a
loss. Payout, asaproportion ofbook value, istherateofdisinvestment byshareholders:
Dividends-to-book value
Totalpayout-to-book value
Dividends
Book value of CSE + Dividends
Dividends + Stock repurchases
Bookvalue ofCSE + Dividends + Stock repurchases
Usually ending bookvalue of common shareholders' equity (CSE) is usedin the denominatorinthese calculations (although, withdividends paidoutovertheyear, average CSEis
alsoappropriate).
Retentionratios focus On earnings retained rather than earnings paidout.Thestandard
retention ratio involves only cash dividends (but Can be modified to incorporate stock
repurchases):
Comprehensive income - Dividends
.
.
Retennon rano Comprehensive income
= 1- Dividend payoutratio
Shareholder Profitability
The reformulated statement yields the comprehensive rate of return on common equity,
ROCE, theprofitability oftheowners' investment fortheperiod. ROCE isalsogrowth inequityfrom business activities. ForNike, the2008 ROCE (using average equity fortheyear) is
Thedisinvestment byshareholders isdescribed bypayout andretention ratios. Thestandard

dividend payout ratio is theproportion of income paidoutin cashdividends:
ROCE,
Comprehensive earnings
Yz (CSE, + CSEr-l)
1,931.8
25.9%
Dividends
Dividend payout = -=--~-"'=~'--
1, (7,118.3 +7,797.3)
A calculation that you commonly see compares dividends to net income rather than
comprehensive income. Thedividend payout ratio involves payout in theform of dividends;
TheROCE calculated on beginning common equity is 27.1 percent.

Notethat the income statement and balance sheetare not needed to calculate ROCE;
rather, theyprovide the detail to analyze ROCE.
2 For anexample ofthe third approach, seethe 2005 lO-K filing forMaytag Corporation, ontheSEC's
EDGAR Web site. For anexample ofthesecond approach, seeChubb Corporation inMinicase M9.Z in
Chapter 9. Also look at the Web page supplement forthischapter.
Growth Ratios
Thegrowth inshareholders' equity issimply thechange from beginning toending balances.
Growth ratios explain thisgrowth as a rateof growth.
266 Part Two TheAnalysis of Financial Smtcmenrs
The part of the growth rate resulting from transactions with shareholders is the net
investment rate:
.
Net mvestment
rate == _N~'e~t_tr~an_S7a_ti~o~ns_,~v_it_h~s~ha~r~e~ho::l:,d::ers:c
Beginning bookvalue of CSE
METHOD 2
Nike'snetinvestment ratewasa negative 17.6 percent because netcashwaspaidout;shareholders disinvested. Thepart ofthe growth ratethatcomes from business activities is given
by theROCE on beginning equity, 27.1 percent forNike. The rateof growth of owners'equity from bothsources-new shareholder financing and business activities-is the growth
rate in common stockholders' equity:
If there isnoreported tax benefit to work from, thecalculation must estimate the market price at exercise date. Nike's
average stock price during 2008 was $62.00. With 9.1 million
options exercised. thecalculation isasfollows:
-,C-,ha"ncge"i"n-,C,::SE=,
Growth rate 0 fCSE ==:::.
Beginning CSE
Estimate market value of

shares issued
9.1 x $62
Exercise (issue) price, from equity statement
(less tax benefit of.$63)
Stock option 1055, before tax
Tax benefit at 36.4%
Stock option 1055.after tax
Comprehensive income + Nettransactions withshareholders

Beginning CSE
Nike's 2008growth ratewas9.5 percent.
IfROCEis calculated withbeginning CSEin thedenominator, then
Growth rateofCSE = ROCE + Net investment rate
ForNike, the growth rate in common equityis 27.1 percent - 17.6 percent = 9.5 percent.
HIDDEN DIRTY SURPLUS

The distinction between comprehensive income and transactions withshareholders in the
reformulated statement ofowners'equity separates thecreation ofvalue from theraising of
funds and the distribution of valueto shareholders. The premise is that transactions with
shareholders do notcreatevalue. Thisisso when sharetransactions areat market value, but
when sharesare issued at lessthanmarket value, shareholders lose. Andthe losses do not
appearin GAAP financial statements.
Issue of Shares in Operations

When firms grant shares to employees at less than market price, the difference between
market priceand issuepriceis treated as (deferred) compensation to employees and ultimately amortized as an expense to the income statement. This is appropriate accounting,
for thediscount from market value is compensation to employees anda lossofshareholder
value. Morefrequently, though, shares are not granted to employees. Rather, stockoptions
are granted and shares are issued later when the options are exercised. Unfortunately,
GAAP and IFRS accounting do a poorjob of reporting the effects of stock options on
shareholder value.
Fourevents areinvolved in a stockoption award: the grantofthe option, thevesting of
the option,the exercise of the option, and the lapseof the option. At the grantdate, employees are awarded the rightto exercise at an exercise price; the vesting date is the first
date at whichtheycan exercise the option; theexercise date is the dateon which theyactuallyexercise at the exercise price; and the lapsedate is the date on which the option
lapsesshouldthe employee choosenot to exercise. Clearly the employee exercises if the
stock is "in the money" at exercise date, that is, if the market price is greaterthan the
exercise price.
If thecalloption is granted in themoney at grantdate(with theexercise pricesetat less
than the market priceat grant date), accounting treats the difference between the market
price and exercise priceas compensation. Unearned compensation is recorded and then
Stock option loss

Tax benefit at 36.4%
Stock option loss, after tax
$173.1
(63.0)
$110.1
$564.2
309.2
255.0
92.8
S162.2
This calculation is tentative. If employees exercised below the

$62 price, theexpense would be lower. Indeed. theMethod 2
number is higher than the Method 1 number.
Method 2must beused for incentive options, where the
firm does notreceive a tax benefit (nor isthe employee taxed
until theshares aresold).
amortized to the income statement overthe vesting period, as in thecaseof a stockgrantat

less than market price. However, most options are granted "at the money," with exercise
price equal tothemarket priceatgrantdate.As time elapses andthemarket priceofthestock
moves "intothemoney," noadditional compensation expense isrecorded. Further, when optionsareindeed exercised, nocompensation expense isrecorded. You seeinNike's statement
of equity thatthe amount received on exercise is recorded as issued shares, but,unlike the
stockgrants, the expense-the difference between the market price and the issue priceis notrecorded.
Theappropriate accounting isto record the issue ofsharesat market price andrecognize
the difference between the market priceand issuepriceas compensation expense. In the
absence of this accounting there is a hidden dirty-surplus expense. The expense is not
merely recorded in equity ratherthan the income statement; it is not recorded at alL But
there hasbeen a distribution ofwealth 10 employees andthatdistribution hascome attheexpense of theshareholders: Thevalue of theirsharesmustdropto reflect thedilutionof their
equity. GAAP accounting treats this transaction, which is botha financing transactionraising cash-and an operational transaction-paying employees-as if it is just a financing transaction. This hidden dirty-surplus accounting creates a hidden expense. Box 8.2
calculates Nike's lossfrom theexercise of stockoptions during 2008.
Some commentators argue that, because options are granted at the money, there is no
expense. Employees-andparticularly management, who benefit most-say thisadamantly.
Butthere isnoexpense onlyiftheoptions faiito move intothemoney. Theyalsosaythat,as
the exercise of options does not involve a cash payment by the firm, there is no expense.
However, paying employees with stock options that are exercised substitutes for paying
267
268
Chapter 8 TheAu.alysil of rhe Statemenr ofShareholders' Equiry 269
Part Two TheAnaJ)'sis of Financial Starements

themwithcash,and recording the expense is recording the cash-equivalent compensation:
The firm is effectively issuing stockto employees at market priceand givingthema cash
amount equivalent to the difference between market and exercise pricesto help payfor the
stock. From a shareholder's point of view, it makes no difference whether employees are
paid withcashor with thevalueof the sharesthatshareholders haveto giveup. Recognizingthis expense is at the heartof accrual accounting for shareholder value,for accrual accounting lookspast cashflows to valueflows; it seesan award of valuable stockforwages
as no different from cash wages. If youare hesitant in viewing stock compensation as an
expense, thinkof the casewherea firm paysforaU its operations-s-its materials, its advertising,its equipment-with stockoptions. (Indeed somesportsstars have asked to be paid
withstockoptions forpromotions') Ifthe hidden expenses were notrecognized, the income
statement would haveonlyrevenues on it andno expenses. Stockoptions produce revenues
and profits for shareholders if they present an incentive for employees and management.
But GAAP accounting does not match the cost of the options againsttheserevenues and
profits. Value addedmustbe matched withvaluelost.
With the large growthin stockcompensation in the 1990s, the hiddenexpense became
quitesignificant, particularly in the high-tech sector. The Financial Accounting Standards
Boardaddressed the issue, but in Statement No. 123R cameto an unsatisfactory conclusion.This statement requires unearned compensation to be recognized at grant date at an
amount equal to the valueof the option, priced usingoption-pricing formulas. The credit
goes to shareholders' equity, incorrectly as we haveseen with Nike.The unearned cornpensation is thenamortized to the income statement overa serviceperiod, usually thevesting period.' The international accounting standard on the issue, IFRS 2, requires similar
treatment. Thistreatment iscalledgrant dateaccounting. Butthegranting of options yields
an expense only in recognition of possible exercise. If the option lapses(because the stock
does notgo intothe money), no expense is incurred, but the accounting maintains the expense. An expense is realized onlyif the option is exercised. The difference between the
marketpriceandexercise priceat exercise date isthe lossto shareholders. Recognizing this
expense, as in Box8.2, is calledexercise dateaccounting. In 2008,Nikereported (in footnotes) $127.0 million in before-tax stock option expense using grant date accounting.
Box8.2 calculates an expense of $J73.1 million, beforetax, from the exercise of options
during2008. Nowgo to Accounting ClinicIV.
Significantly, the Internal Revenue Service recognizes thatan expense is incurred when
options areexercised andgives the finn a taxdeduction forit (ifcertainconditions are met).
The firm booksthistax benefit to equity, oftenas an addition to theproceeds fromtheshare
issue. So the $372.2 million that Nike received from the exercise of stock options (in
Exhibit 8.1)represents $309.2million received fromthe shareissueplus$63million in tax
benefits. So,the accounting recognizes the taxbenefit of theexpense, increasing equity, but
not the associated expense!
You can see that stock optionaccounting underthe presentaccounting standards is a
bit of a mess.Wecould correct the accounting by recognizing the appropriate loss from
exercise of options($173.1 million,beforetax, for Nikein Box8.2) but, as Nikehasrecognized an expense from grant-date accounting (SI27.0 million), we would be double
counting to some extent. We could unravel the GAAP accounting and apply the appropriate accounting outlined in the box introducing Accounting Clinic IV, but that is a
difficult task.
Prior to2006. noexpense was recognized atall. Rather, theexpense was reported ill footnotes.
.~ .
Accounting Clinic
balance sheet The option value at grant date is the

ACCOUNTING FOR STOCK COMPENSATION
amount recognized with grant-date accounting under
GAAP accounting for stock options intheUnited States emFAS8 Statement No. 123R. The grant-date value given
ploys grant-date accounting. The International Accounting
toemployees iscompensation, butitiscontingent upon
Standards Board {lASB} also requires grant-date accounting
the options going into the money, so it is a contingent
under IFRS2. Accounting Clinic IV leads you through grantliability to issue shares. The deferred compensation
dateaccounting.
asset issimilar to thatwhich arises from stock issues to
Accounting Clinic IV also lays out exercise-date acemployees at less than market value.
counting andtakes you through thecomplete accounting
that measures the effects of stock options on sharehold- 2. Amortize thedeferred compensation over anemployee
ers. Unearned compensation costs are recorded at grant
service period, usually thevesting period.
date, andthen recognized as expense intheincome state- 3-. Mark the contingent liability to market as options go
ment over the period when employee services aregiven.
into themoney to capture thevalue oftheoption overAccordingly, thecompensation cost is matched against the
hang, and recognize a corresponding unrealized loss
revenues that the employees produce. Subsequent to
from stock options.
grant date, further losses arerecognized asoptions gointo 4. Extinguish the liability against the share issue (at marthe money. Here are the steps to effect sound accrual
ketvalue) at exercise date. If options arenotexercised,
accounting for stock options:
extinguish the liability and recognize a windfall gain
from stock options.
1. Recognize the option value at grant dateas a contingent liability, along with a deferred (unearned) comFor more on appropriate exercise dateaccounting, go
pensation asset. The twoitems can be netted on the also to theWeb page for this chapter.
Withan eyeon the future, we canfinesse the problem. Thelossfrom exercise of options
in the currentperiodis a legitimate lossthatshouldbe reported. But when an investor buys
a stock, he is concerned about how he could lose from these instruments in the future.
Accordingly, valuation focuses on the expected lossesfrom future exercise of options. This
expected lossis referred to as the option overhang.Itcan be estimated as the lossincurred
if outstanding options were exercised at the currentmarket price.At the endof2008, Nike
had36.6million options outstanding witha weighted-average exercise priceofS40.l4. The
closingmarket pricefor its sharesat fiscal yearend was$67.20. So the optionoverhang is
estimated as follows (in millions):
Market price of shares to be issued foroptions
Exercise price
Tax benefit (at 36.4%)
Contingent liability (option overhang)
36.6 x $67.20= $2,460

36.6 x $40.14= 1,490
991
.21
630
This drag on the value of the shares amounts to S1.28 per share (with 491.1 million
shares outstanding). Note that the liabilityfor the expected loss is reduced by the expectedtax benefit on exercise. The measure of the option overhang here is a floorvaluation; it shouldalso include optionvaluefor the possibilityit mightincrease. Wereturnto
the complete treatment in Chapter 13 when we formally buildcontingent claims intoequity valuation.
Firmsuseoptions andwarrants forotheroperating expenses besidewages. SeeBox8.3.
In 2001, Reebok, Nike's rival. entered into a 10-year license But the GAAP accounting is inappropriate. The issue of a
agreement with the National Football league(NFL) giving the warrant-like the issue of a stock option-is not an issue of
company exclusive rights to design, develop, and sell NFL equity but, rather, an obligation for the shareholders to surfootwear, apparel, andaccessories inexchange forstock war- render value in the future should the warrants be exercised.
rants valued at $13.6 million. These warrants gave theNFL the From the shareholders' point of view a warrant isa (continright to purchase up to 1.6million shares of Peebok's common gent) liability, and appropriate accounting for shareholder
stock etvarous exercise prices, with anexpiration dateof2012. value requires itto be recognized assuch. Further, ifandwhen
Reebok recorded an intangible asset Cfkenses" below) the warrants are exercised, the difference between the exerandthen amortized this asset over 10years. So itsintangible cise price andthe market price of the stock at the time, over
assetfootnote for2003 reported the following (in thousands): and above the $13.6 million already recognized, is a further
loss to shareholders.
Amortizable intangible assets:
The diligent equity analyst recognizes that GAAP fails to
licenses
$13,600
track the effects of this transaction on shareholder value.
Other intangible assets
4,492
Many of the warrants have an exercise price of $27.06 per
$18,092
share. Atthe endof2004, Reebok's shares traded at $44.00,
Less accumulated amortization
3,656
so the warrants were well in the money and likely to be
$14,436
exercised. The analyst anticipates that therewill be a loss of
ncnamoruzebte intangible assets:
shareholder value when thishappens and builds thisintoher
Company tredenemes andtrademarks
valuation. This is the warrant overhang. For now, note that
a rough calculation of the warrant overhang (at the end of
2004) is the amount of value that the shareholders would
You seethat Reebok recognized the license assetandisamor- have to give up ifthe warrants wereexercised at the endof
tizing the license costalong withotheramortizable intangible 2004: The difference between the market price of the share
assets. Sothe license expense is being matched against rev- andtheexercise price at theendof 2004is$44.00 - $27.06 =
enue from NFL branded products in the income statement $16.94 perwarrant. Chapter 13 modifies thiscalculation to
over the term of the license. This is appropriate accounting. recognize that the warrants cannot be exercised in 2004, but
However, the issue ofthewarrants wasrecorded asa share rather in 2012, so option value must be added to thisrough
issue in the equity statement in 2001, as required byGAAP. calculation.
Issue of Shares in Financing Activities

Hidden lossesoccur notonly with employee stockoptions but with the exerciseof all contingent equity claims. Call and put options on the firm'sown stock, warrants, rights,convertible bonds, and convertible preferred shares are all contingent equity claims that, if
exercised, requirethe issue(or repurchase) of sharesat a pricethat is differentfrom market
value. Look at Box 8.4.
Box 8.5 coversthe accounting for convertible bondsand convertible preferredstock and
shows how GAAPand IFRS accounting do not recognizethe full cost of financing with
these instruments. The accounting is not comprehensive, even though a nominal number,
comprehensive income, is reported.
Handling Diluted Earnings per Share
In Dell's statement of shareholders' equity for the fiscal year

ending February 1, 2002, the following line item appeared
(in millions):
Repurchase ofcommon shares
Shares
Amount
68
$3,000
This line suggests a routine stock repurchase. But further

investigation reveals otherwise. Dividing the $3 billion paid
out bythe 68 million shares purchased, the average per-share
purchase price is$44.12. But Dell's shares didnottradeabove
$30 during the year, and the average price was $24. Footnotes reveal that Dell wasforced to repurchase shares at the
strike price of $44on put optionswritten to investors. In previous years, Dell had gained from theseoptions as the stock
price continued to rise during the bubble. But with the share
price falling (from a high of $58in2000) as the stock. market
bubble burst, Dell was caught as these options went under
water. Using the average price of $24for2002 asthe market
price when the shares were repurchased, the loss from the
exercise of putoptions isasfollows:
Market price for shares
repurchased
$24 x 68 million
Amount paid for shares repurchased
Loss on exercse ofputoptions
$1 632 million
(3
0001
$1,368 million
(The loss isnot taxdeductible.) This loss should be reported as

partof comprehensive income, butit was not. Onthe 2,670
million shares outstanding before the repurchase, the loss is
$0.51 per share, a significant amount compared to Dell's
reported EPS of $0.48. Dell effectively ran two types of businesses, a computer business earning $0.48 pershare in 2002
and a business of betting on itsownstock, earning a loss of
$0.51pershare.
The omission of thisloss isa concern to the investor, and
the investor must be vigilant. Shareholders lose when share
prices fal!, of course, but when the firm haswritten put options, the shareholder suffers twice; the loss from the price
decline islevered. In 2002, Electronic Data Systems Corporation (EOS) announced that the firm had some accounting
problems and that contract revenue would not be as previously expected. The stock price dropped 70 percent on the
bad news. later, the firm indicated that the drop in price
would trigger the exercise of put options. The price dropped
further.
Putoptions are sometimes referred to as put warrants.
Firms make similar commitments to buyback. stock through
forward share purchase agreements. They disclose the
existence of put options and share purchase agreements in
footnotes. In buying a stock of Dell in 2002, one must be
aware of the putoption overhang, foritmight require further
repurchases that lose value forshareholders. Atthe endoffiscal2002, Dell hasa further putoption overhang for51 million
shares to be repurchased at $45 per share. In September
2002, when the shares were trading at $25, the options were
inthe money by$20pershare, a totalof $1.020 billion, projecting a loss of $0.39 peroutstanding share. Analysts were
forecasting $0.80 EPS forfiscal 2003,but that is GAAP earnings. Expected comprehensive earnings was $0.39 less, or
$0.41 pershare.
FASB STATEMENT NO. 1S0

In 2003, the FASB issued Statement 150 to reform the
accounting for these putobligations. Firms arenowrequired
to recognize a liability, measured at fair value, whenthe contractiswritten. Subsequently, as the stock price changes, this
liability is measured at the amount of cash that would be required to settle the obligation at the reporting date.This, of
course, isthe difference between the exercise price and market price at reporting date.The revaluation of the liability is
booked to the income statement as interest cost. So, the rule
seesa putoption contract (appropriately) asa borrowing: The
firm borrows the amount that the contract isworth andthen
repays the "loan" incash or shares. The amount lost on the
contract isthe interest coston the loan. The accounting under
Statement 150effectively putsthe liability fortheoption overhang on the balance sheet and records losses, as interest,
as the option moves intothe money (and sothe shareholders
mustgive up more value). If the option doesnot go intothe
money, a gain isrecognized.
Accordingly, Statement 150 brings the hidden expense
into the income statement and also puts a hidden (offbalance-sheet) liability on the balance sheet.Note, however,
that GAAP does not apply the same treatment to call
options, (call) warrants, andotherconvertible securities. See
Box 8.3.
Firms report two earnings-per-share numbers, basic EPS and diluted EPS. Basic EPS
is simply earningsavailable to common(after preferred dividends) dividedby the number
of outstanding shares. Diluted EPS is an "as if" number that estimates what earnings
per share would be if holders of contingent equity claims like stock options, warrants,
convertibledebt, and convertible preferred shares were to exercisetheir option to convert
270
271
Convertible securities are securities, such as bonds and

preferred stock, thatcan beconverted into common shares if
conditions aremet Textbooks propose twomethods to record

the conversion of a convertible bond or a convertible preferred stock into common shares:
i_The bookvalue method records theshare issue atthebook
value of thebond or preferred stock. Common equity isincreased anddebtor preferred stock isreduced bythesame
emount. sono gain or loss isrecorded.
2. Tne market value method records the share issue at the
market value of theshares issued in theconversion. The difference between thismarket value andthe bookvalue of
the security converted isrecorded as a loss on conversion.

The book value method is almost exclusively used in
practice. It involves a hidden dirty-surplus loss. The market
value method reports the loss. It accords the treatment of
convertible securities the same treatment as nonconvertible
securities. On redemption of nonconvertib!e securities before
maturity, a loss (or gain) is recognized. The only difference
with convertible securities is that shares rather than cash
are used to retire them. In both cases there isa loss to the
existing shareholders.
Convertible bonds carry a lower interest rate than ronconvertible bonds because of the conversion option. GAAP
accounting records only this interest expense as the financing cost, so it looks asifthefinancing ischeaper. But thefull
financing cost toshareholders includes any loss onconversion of

the bonds into common shares-andthis loss is notrecorded.
In the 1990s, financing with convertible preferred stock
became common. Only the dividends on the preferred
stock were recorded asthefinancing cost, nottheloss onconversion. Suppose a convertible preferred stock issue had no
dividend rights but, to compensate, setafavorable conversion
price to the buyer of the issue. Under GAAP accounting it
would appear thatthis financing hadnocost.
In September 2008, in themidst ofthecredit crisis onWall
Street, Goldman Sachs invited Warren Buffett, the legendary
fundamental investor, to contribute much-needed equity
capital tothefirm. Buffett seemingly gota very good deal. For
a $5 billion cash infusion, he received perpetual preferred equity shares carrying a 10percent dividend (redeemable byGoldman Sachs) plus warrants to buy 43.5million common shares
at $115 pershare (for a total ofanother $5 billion}. The $115
conversion price was setat the current share price, a threeyear low for Goldman. The stock price rose to $135 within
three days, putting Mr. Buffett's warrants well into themoney.
It remains to be seen at what price Mr. Buffett exercises.
But any difference between theexercise price andthemarket
price at that point will be a loss for shareholders. GAAP
accounting will not, however; record that loss. At a stock
price of $135 per share, the prospective loss-the warrant
overbanq-was $20 pershare, or a total of $870 million for
the 43.5 million shares.
those claimsto common shares; ratherthanshares outstanding, the denominator is shares

outstanding plusshares that would be outstanding shouldconversion takeplace. (AccountingClinicIV givesmoredetail.)
Handle the diluted EPS numberwith care. Whilediluted EPS gives an indication of
likely dilution to the common shareholders, it is not a numberto be used in valuingthe
common shareholders'equity.lt commingles the Current shareholders' claimon earnings
withthose of possiblefuture shareholders. The claimsof current and futureshareholders
are quite different. Both will share in future earnings should options be exercised, but
only current shareholders share in current earnings. Further, they share future earnings
differently. When claims are converted to common equity, the loss will fall on current
shareholders. while the Dew shareholders will gain as current shareholders effectively
sell the firm to newshareholders at less than marketprice.The twoearnings claimsmust
be differentiated and the diluted EPS does not do this. With a focus on valuingthe current outstanding shares, one must focus on basic EPS,adjustedof course for the failure
of the accounting to recordlosses(to currentshareholders) whenclaimsare converted to
common equity.
Ii
II
II
Share Transactions in Inefficient Markets

Themaxim thatshareISSUes andrepurchases atmarket valuedo notcreatevaluerecognizes
that in efficient stock markets. value received equalsvalue surrendered; bothsides of the
272
Dell, Jne., explains its put option transactions (examined in

Box 8.4) as "pert of a share-repurchase program to manage
theollution resulting from shares issued under employee stock
plans. ~ Itis common forfirms to explain share repurchases in
this way. The exercise of stock options increases shares outstanding and, as we have seen, dilutes existing shareholders'
value. Buying back shares reduces shares outstanding. But
does itreverse thedilution?
The answer is no. If shares are purchased at fair value,
there is no change inthe per-share value of the equity; the
shareholder does notget extra value to compensate for the
loss ofvalue from stock options. Maintaining constant shares
outstanding with share repurchases only gives theappearance

of reversing thedilution.
During the stock market bubble, employees exercised
options against the shareholders as prices soared. Firms then
repurchased shares "to manage dilution. ~ But purchasing
shares at bubble prices (above intrinsic value) destroys value
for shareholders. Shareholders lost twice, once with the employee options, andagain with therepurchases. Assome firms
borrowed to finance the share repurchases, they were left
with large debts thatled to significant credit problems as the
bubble burst.
transaction get whattheypaidfor. Ina sharerepurchase, forexample, thefirm gives up,and

thesellerreceives, cashequalto the valueof the stock.
Butwerecognized in Chapter 3 that if stockmarkets are inefficient, a firmcan buyback
shares at less thantheyare worth and issuesharesat morethantheyare worth. The other
side of the transaction-the shareholder whosells the sharesor the new shareholder who
buys-loses value. But the existing shareholders whodo not participate in the transaction
gain.Thesegains(or lossesif shareholders lose in the transaction) are not revealed in the
accounts.
Even if stock markets are efficient with respect to publicly available information, a
fum's management mighthave private information about the valueof their firm's shares
and issue or repurchase shares at pricesthatare different fromthosethat willprevail when
the information is subsequently made public. Such transactions also generate value for
existing shareholders. (In the United States there are legal constraints on this practice,
however.)
The active investor whoconjectures that the marketmay be inefficient at timesis wary
of share transactions with firms. As with all his trading in the stock market, he tests the
marketpriceagainstan estimate of intrinsic value. Buthe isparticularly careful in thiscase
because the firm's management mayhavea betterfeel for intrinsic valuethan he.
The active investor who understands the intrinsic value of a stock understands when
it mightbe overvalued or undervalued. Andhe understands that management mightusethe
mispricing to advantage. The management might, for example, use overvalued shares
to make acquisitions, to acquire otherfirms cheaply. Indeed thisis a reason why an investor
might buy overvalued shares; He sees that valuecan be generated by usingthe shares as
currency in an acquisition. But this is a trickybusiness: If investors force up the pricesof
shares that are already overpriced, a price bubble can result. The fundamental investor
bases his actions on a good understanding of the firm's acquisition possibilities and its
acquisition strategy.
As forthe management, theycantakeadvantage of sharemispricings to createvalue for
shareholders withsharetransactions. Theycan chooseto finance newoperations withdebt
ratherthanequity if theyfeel thestockpriceis "too low." But theyalsocan choose to exercise theirstockoptions whenthe price is high-a double whammy for shareholders. They
mightalsohave misguided ideasaboutstock issuesand repurchases. See Box8.6.
273
Chapter 8 The AlUllYlis of1M Stmement ofShareholders' Equity 275
would make a loss. When thefum forces it onthem, they alsomake a loss. Theaccounting
fails to understand the distinction between cash transactions withshareholders (to raise
cashandtopassoutunneeded cashas a matter of financing) andvalue added (orlost) from
operations that can be embedded in a share issue. It also fails to see that transactions
between claimants-convertible bondholders and conunon shareholders, for examplecaninvolve losses forthecommon shareholders.
In short,GAAP and IFRS accounting does nothonortheproperty rightsof thecommonshareholder. Thisis so despite thefactthatfinancial reports areprepared nominally
for theshareholder, company directors (including theauditcommittee) havea fiduciary
duty to the shareholders, and management and auditors formally present the financial
reports to shareholders at the annual meeting. The accounting doesnothonortheshareholders as the owners of the firm. Consequently, the equity analyst mustrepairthe accounting, as wehavedoneinthischapterandwill continue to doaswemove tovaluation
in laterchapters.
This chapterhas identified quality lapses in GAAP and IFRS accounting. Withan eyeon the shareholder, the analyst needsto
maintain a watchon the following. Theissues ariseboth in GAAP and IFRS accounting.
IIi
I
Accounting Item
Quality Problem
Dividends payable
GAAP treats dividends payable asa liability. Rather, itispartofshareholders' equity. Shareholders have
a daim to thesedividends that have been declared butnotpaid. They do notowethemto others.
Unrealized gains and losses

onsecurities
Unrealized gains and losses on available-for-sale debtandequity securities are reported as

part ofother comprehensive income intheequity statement rather thanintheincome statement Thus,
thefull performance ofaninvestment portfolio isnotreported intheincome statement. Worse, asfirms
report realized gains andtosses intheincome statement, they can"cherry pick" gains into theincome
statement (and earnings pershare) byselling securities thathave appreciated invalue while holding those
onwhich they have experienced losses andreporting those unrealized losses intheequity statement.
Translation gains andlosses
Again orloss results from holding assets and liabilities inforeign currencies whenexchange rate
change isnotrecognized in theincome statement(The effect isbooked to equity inthe equity statement, bypassing the income statement)
Preferred dividends
Preferred dividends are treatedas a distribution of equity ratherthan a costto (common)

shareholders.
Stock compensation credits

to equity
GAAP recognizes deferred compensation fromgrantof stock options as a creditto equity,

as ifshareholders' equity increases bycompensating employees. This isa liability-togive
upvalueon the exercise of options-not an increase inequity.
Grant-date stockoption
accounting
GAAP recognizes stockoptioncompensation at option grantdate. However, the expense

(to the shareholder) isincurred at exercise date asshares areissued for lessthan market price. If
grantedoptionsare not exercised, GAAP overstates wages'expense. If options are exercised,
GAAP typically understates wages'expense.
Accounting forwarrants
and options
GAAP does not reportthe loss to shareholders whenwarrants and (call and put)options
on the firm's stockareexercised and sharesare issued or repurchased at prices differing
from market price.
ACCOUNTING QUALITY WATCH

k; we proceed with
thefinancial statement analysis in Part Two ofthebook, wewill address

accounting issues asthey arise. Thetextwill provide anoutline of how therelevant accounting
works-as wedidformarketable securities andemployee stock options inthischapter-and
referyou to Accounting Clinics on the book's Web site for further elaboration-as wedid
with Accounting Clinics III andIVon marketable securities andstock compensation in this
chapter.
Oneneeds to understand how the accounting works, but onealso needs to understand
when theaccounting doesnotwork fortheequity analyst. When do accounting quality issues frustrate theanalyst? Some of these quality issues arise just because of practical difficulties in accounting measurement. Others arise because theaccounting standard setters do
notget it right, as wehave seen in this chapter. Andyetothers arise because firms usethe
license available within GAAP to manipulate theaccounting.
Box8.7starts ourAccounting QualityWatch. It liststhe accounting quality issues we
have encountered inthischapter. We willaddto thislistas we proceed so that, when wego
specifically into theanalysis of accounting quality in Chapter 17,wewillhave considerable
background.
Accounting for convertible GAAP converts theseclaims to equity at theirbookvalue. Thus, no loss is recognized
bondsand preferred stock on the conversion.
Omitted borrowing costs
As losses are not recognized on conversion of nonequity financing instruments (like convertible
bonds) intoequity, borrowing costsare understated.
:"
Omitted (off-balance-sheet) Outstanding obligations to issue shares at lessthen market price are not recognized on the
liabilities
balance sheet These include the optionoverhang from outstanding stockoptions.
THE EYE OF THE SHAREHOLDER

We have characterized thefinancial statements as a lenson thebusiness. Forequity analysis,the lens must be focused to theeye of theshareholder. GAAP andIFRS accounting is
inadequate forequity analysis because it does not have its eyeon the shareholder. It does
notaccount faithfully forthe welfare of theshareholder, andnowhere elseis thismore apparent than with theaccounting in thestatement of shareholders' equity.
GAAP and IFRS fail to seea saleof shares by current shareholders at less thanmarket
value as a loss. If theshareholders were forced to do so on their own account, they surely
274
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,'-~
-The WeliConnection- :
:>'~ -'< -
'_
>)':;:_>,,~~:c.~ :;~. ,;,_,-,~;".-
,,,,,
-i:
-,
Find the following on the Web pagefor thischapter:

Accounting for the equitystatement and comprehensiveincome underIFRS.
Further examples of reformulated statements of shareholders' equity.
Further discussion of hidden expenses.
More coverage of footnotesthat pertain to the equity
statement.
;,,,,-,,,-,~
'".
- '.
_~" .. ~,
",,_ '.
'~:
" '.
,~ ~~ :~
" : _ '-.,
~:;::~~
.:,
,':_~.
':'~':;-'~;iS:t
More on GAAP and IFRS accounting for convertible

securities.
More discussion on the appropriate accounting for
contingentclaims on equity.
Adiscussion of accelerated stock repurchase programs
(that alsoinvolve dirty-surplus accounting).
The Readers' Cornerexplores the issues raised in this
chapter.
276 Part Two TheAnalysis of Fillancial Sta.lrmenlS
Summary
Key Concepts
Chapter 8 TheAnal)'sis of the Sta.temem ofShareholders' Equity 277
Misclassifications in thefinancial statements canleadto erroneous analysis ofthe financial

statements and to erroneous valuations. Reformatting the statements classifies itemscorrectly. TheGAAP statement ofequitysometimes commingles theresults of operations with
the financing of the operations. This chapter reformulates thestatement to distinguish the
creation of valuein a finn from the distribution of valueto shareholders in net dividends.
Thereformulation identifies dirty-surplus itemsin thestatement andyields comprehensive
income and comprehensive ROCE.
Omission in the financial statements is more pernicious than misclassification, and the
chaptersensitizes the analyst to expenses (hatcan arisefromexercise of contingent claims
but whichare hidden by GAAP and IFRS accounting. Failure to recognize theseexpenses
in forecasting can leadto overvaluation of firms.
As always, a senseof perspective mustbe maintained in analyzing thestatement of eq. uity Forsomefirms withfewdirty-surplus itemsandno stockcompensation, thereis little
to be discovered. Formanyfirms therearejust twoitems-translation gainsand lossesand
unrealized gainsand losseson securities-that appear. Andformanyfirms, the amounts of
these itemsaresmall.In the UnitedStates,onecan sometimes glanceat thestatement and
dismiss the itemsas immaterial. In othercountries, the practice of dirty-surplus accounting
is quite extensive. And in the United States, the use of stock options in compensation is
widespread.
call option is a claimthatgivesthe holder

the right,butnotthe obligation, to buy
sharesat a particular price(theexercise
price). 266
clean-surplus accountingproduces a
statement ofshareholders' equitythat
containsonlynet income (closedfrom
the income statement) and transactions
with shareholders. 262
contingent equity claim is a claimthat
may be converted into common equity if
conditions aremet. Examples are call
options, put options,and convertible
securities. 270
convertiblesecuritiesare securities (such
as bondsandpreferred stock)thatcanbe
converted intocommon sharesif
conditions are met,butwhich have
additional claims also. 272
dilution (to existing shareholders) occurs
whenshares are issuedto newshareholders at lessthanmarketvaIue. 267
dirty-surplus item is an accounting item
in shareholders'equity other than
transactionswith shareholders or
incomeclosed from the income

statement. 262
forward share purchase agreement is an
agreement to buybackshares at a
specified price in the future. 271
hidden dirty-surplus expenseis an
expense thatarisesfromthe issueof
shares but is notrecognized in the
financial statements. 267
incentiveoptions are employee stock
options thatare nottaxedto the employee
on exercise andare not tax deductible for
the issuingfirm. 267
nonqualifyingoptions areemployee stock
options thatare taxable to the employee
on exercise and tax deductible to the
issuingcorporation. 267
option overhang is the valueof stock
options unexercised. 269
payout is amounts paidto shareholders.
Theterm is sometimes usedto referonly
to dividends, sometimes to dividends and
stockrepurchases. Compare with
retention. 265
put option is a claimthatgivesthe

holderthe right, but notthe obligation, to
sellsharesat a particular price(the
exercise price). 271
redeemablesecurities are securities (such
as bondsand preferred stocks) that can be
redeemed by the issuerunderspecified
conditions. 258
AnalysisTools
Page
Reformulated statements
of common shareholders'
equity
257
Analysis of dirty-surplus
accounting
262
Ratio analysis of the equity
statement
264
Payout analysis
264
Compensation expense
analysis
266
Grant-date accounting
268
Exercise-date accounting
268
Warrant accounting
270
Put option accounting
271
The book value method
272
The market value method
272
Key Measures
retentionispaying out lessthan 100 percent

ofearnings. Compare with payout. 265
tax benefit is a tax deduction or credit
given for specified transactions. 268
warrant is similarto a call option but
usually of longerduration. A put
warrant is similarto a put option. 270
Page
257
Neteffect of transactions with
shareholders (netdividend) 261
Other comprehensive income 258
Foreign currency translation
gains and losses
262
Gains and losses on
derivative instruments
262
Basic earnings pershare
270
Diluted earnings pershare 270
Hidden compensation
expense
267
Option overhang
269
lossesonwarrants
270
Gains and losses on put
options
271
losson conversion of a
convertabfe security
272
Ratios
Dividend payout
264
Total payout
265
Dividends-to-book value
265
Total payout-to-book value 265
Retention
265
New investment rate
266
Comprehensive ROCE
265
Growth rateof common
shareholders' equity
265
Tax benefit on issue of shares
inexercise of employee
stock options
267
Unrealized gains and losses on
securities available forsale 262

equity
IFRS International Financial
Reporting Standard
RaCE return on common
278 Part Two The Analysis of Financial S!mcments
Chapter 8 TheAllol)'sis of the$latemem ofShardlolders' Equi)' 279

the conversion. Which treatment best reflects the effectof the transaction on the
wealth of the existing shareholders?
C8.5. The compensation vice president of General Mills was quoted in The Wall Street
Journal onJanuary 14, 1997, as saying thatoption programs are"veryattractive for
shareholders" because theycut fixed costsandboostprofits. So, forGeneral Mills's
1996year, seUing, general, and administrative expenses, which include compensation,dropped by$222million, or 9 percent, whilepretax earnings from continuing
operations roseby$194 million, or 34 percent. At the same time,the firmwasdistributing about3 percent of its stockto employees annually.
What's wrongwiththis picture?
You are now ready to begin an analysis of Kimberly-Clark's financial statements with a
view, ultimately, of usingthe analysis to valueKMB's shares.
As always, start with the equitystatement. This is givenin Exhibit2.2 in the Continuing Case for Chapter 2. The layout is similarto the Nikestatement in this chapter. Totals
are not given,so firstconfirm that the beginning and endingbalances total to the amount
of shareholders' equity in the balancesheet.Kimberly-Clark issuesshareswhenemployees exercise stock optionsand also issuesrestricted stock to employees. The fum repurchasesstockintotreasury-with a verylargerepurchase of$1.617 billiondollarsin 2004.
(It paid a dividend $1.60 per share in 2004, as noted in an earlier installment of the
Continuing Case).
C8.6. Before it found the practice to be too expensive, Microsoft (anda number of other
firms) was in the habitof repurchasing someof the sharesthat it issued each year
as employees exercised stock options. The rationale, according to commentators,
wasto avoid the dilution fromsharesissued to employees.
a. Do shareissuesfrom the exercise of employee stockoptions causedilution?

b. Do sharerepurchases reverse dilution?
REFORMULATION
c. W'rrj would Microsoft feel that repurchasing sharesis "tooexpensive"?

C8.7. CiscoSystems, the networking equipment firm, reported a tax benefit from the exerciseofstockoptions of$537 million in its fiscal 2004shareholders' equity statement. Overthe previous years, the taxbenefits hadcut morethan25 percent off the
firm's tax bills.Commentators Saw this tax reliefas a majorsource of valueforthe
shareholders. Is this correct?
Your task is to reformulate this equitystatement for 2004along the linesof the Nikereformulation in thischapter. Gothrough andmarkofftheitemsthataretransactions withshareholders andthosethatare part ofcomprehensive income. Thenaskyourselfif thereare any
hiddendirty-surplus expenses. Thinkabout how you shouldtreat the spin-offof Neenah
Paper, Inc. You should note that dividends payable are given in the balance sheet (in the
Chapter 2 installment of the Continuing Case). Kimberly-Clark's tax rate is 35.6percent.
C8.8. In February 1999, Boots, the leading retail chemist in the United Kingdom, announced plansto reform its employee optioncompensation scheme. In the future,
it said,the firm willpurchase its ownsharesto provide shares to issuewhen options
are exercised, and it will chargethe difference between the market price and the
issuepricefor theoptions againstprofits. Thechargeforthefirstyearwasexpected
to be 63 million ($103 million). Whatdo youthinkof thisscheme?
RATIO ANALYSIS
Statein oneor twosentences whatthe reformulated statement youhavedrawn up is saying.
Then carry out a ratio analysis that embellishes the story. Why do you think this firm is
paying out so muchcash to shareholders?
BUILD YOUR OWN ANALYSIS ENGINE FOR KMB

You mightenteryourreformulated equity statement intoa spreadsheet Afteryouhavecoveredthe nextchapter, youcan addthe balance sheetandincome statement. Then,in subsequentchapters, you can use spreadsheet operations to analyze the statements and derive
valuations from that analysis. The BYOAP feature on the book's Web site will guideyou.
C8.9. In September 1999, Microsoft agreedto buyVisio Corporation for stockvaluedat

$1:26billion. Visio sellsa popularlineof technical drawing software. At the time,
MIcrosoft had $14 billionof cash on its balance sheet. Why mightMicrosoft pay
for the acquisition withits ownstockratherthanin cash?
Exercises
Drill Exercises
E8.1.
Concept
Questions
C8.1. Why is income in the equity portion of the balance sheet called "dirty-surplus"
income?
C8.2. Whycan "v-alue be lost" if an analyst works withreported net income ratherthan
comprehensive income?
C8.3. Are currency translation gains and losses real gains and losses to shareholders?
Aren'ttheyjust an accounting effectthatis necessary to consolidate financial statementspreparedin different currencies?
C8.4. In accounting fur the conversion of convertible bondsto common stock,mostfirms
recordthe issueof sharesat the amount of the bookvalueof the bonds. The issue
of the sharescould be recorded at their market value, withthe difference between
the market valueof the sbares andthe bookvalueof thebondsrecorded as a losson
Some Basic Calculations (Easy)

a. A finn listedtotal shareholders' equityon its balance sheet at $237million. Preferred
shareholders' equity was$32 million. Whatis the common Shareholders' equity?
b. From the following information, calculate the net dividend to shareholders and comprehensive income (in millions):
Common shareholders' equity, beginning of period
Common share issues
Common share repurchases
Common dividends
Common shareholders' equity, beginning of period
$1,081
230
45
36
$1,292
c. A firmreported $62million of comprehensive income in its statement ofshareholders'

equity but $87 million as net income in its income statement. What explains the
difference?
280 Part Two Tite Ana1;lsil of Financial Star~m~n!5
E8.2.
Chapter 8 The Analysis ofmcStalcmcm ofShareholders' Equity 281
$35pershare, sheexercised theoptions. Thefirm's income taxrateis36percent. What was

theafter-tax costto shareholders of remunerating thisemployee withoptions?
Calculating ROCE from the Statement of Shareholders' Equity (Easy)

From the following information, calculate thereturn on common equity fortheyear2009
(amounts in millions of dollars). Therewere nosharerepurchases.
Common stockholders' equity, December 31,2008
Dividends paid to common stockholders
Share issue on December 31,2009
Common stockholders' equity, December 31, 2009
E8.3.
E8.6.
174.8
8.3
34.4
226.2
Reformulating an Equity Statement with Employee

StockOptions (Medium)
Reformulate the following statement of shareholder's equity. The firm's tax rate is 35%.
Balance, end of fiscal year 2008
Share issues fromexercised employee stock options
Repurchase of 24million shares
Cash dividend
Tax benefit fromexercise of employee stock options
Unrealized gain on debtinvestments
Netincome
A Simple Reformulation of the Equity Statement (Easy)

From the following information, prepare a reformulated statement of common shareholders' equity for2008. Amounts are inmillions.
Balance, December 31,2007
Netincome
Foreign currency translation loss
Unrealized gain on debtsecurities held
Issue of shares
Common dividends
Preferred dividends
$1.206
241
(11)
24
45
E8.7.
(94)
(132)
(30)
155
13
(9)
a. Themarket value of the equity was$4,500 million at December 31, 2008, and$5,580
million at December 31, 2009. Atbothdates, theequity traded at a premium of$2,100
million overthebookof the common equity. What wasnetincome for2009?
b. Fill outthemissing numbers intheequity statement andreformulate it toidentify comprehensive income for thecommon shareholders for2009.
E8.5.
J. C. PENNEY COMPANY, INC., AND SUBSIDIARIES

ConsolidatedStatements of Stockholders' Equity
Using Accounting Relations that Govern the Equity

Statement (Medium)

Net income
Common dividends
Preferred dividends
Issue of common stock
Unrealized gain on securities held for sale
Foreign currency translation loss
Calculating the loss to Shareholdersfrom the Exercise of Stock

Options (Easy)
In2004, an employee wasgranted 305 options onthestockofa firm withanexercise price
of$20 per option. In 2009,aftertheoptions hadvested and when the stock wastrading at
A Simple Reformulation: J.c. Penney Company (Easy)

Reformulate the following statement of shareholders' equity statement for Ie. Penney
Company. Dividends paidconsisted of$24 million inpreferred dividends and$225 million
incommon dividends.
(15)
11.396
The following is a statement of common shareholders' equity withsome numbers missing

(in millions of dollars).
1,870
Applications
The beginning andend-of-year balances include $200million of preferred stock.
E8.4.
1,430
810
(720)
(180)
12
50
468
Common Preferred
Stock
Stock
($ in millions)
January 29, 2000

Net loss
Net unrealized change ininvestments
Currency translation adjustments
Other ccrrorebensbe income from
discontinued operations
Ictal comprehensive (Ioss)lincome
Dividends
Common stock issued
Preferred stock retired
January 27, 2001
Eg.S.
3,266
446
Reinvested
Earnings
3,590
AccumulatedOther
Comprehensive
(loss)/Income
(74)
a05)
a05)
(249)
7,228
(705)
2
(i4)
(14)
16
16
-.
28
(761)
(249)
28
(47)
$3,294
Total
Stockholders'
Equity
$399
(47)
$2,636
$(70)
$6,259
Reformulation of an Equity Statement and Accounting for the Exercise of

StockOptions:Starbucks Corporation(Hard)
Thestatement of shareholders' equity below forStarbucks Corporation, theretail coffee
vendor, is forfiscal year 2007.
282
Part Two TheAnai;;sil of financial Starcmen[S
Chapter 8 TheAnalysis of the $Wlel/lell! of$harcholders' Eqllj()' 283

Accumulated
Additional Other Additional
($ in thousands)
CommonStock
Shares
Amount
Balance, October 1, 2006 756,602,071
$756
Netearnings
Paid-In
capital
Paid-In
Capital
$39,393
Unrealized holding less,

net
Translation adjustment.
net of tax
Stock-based
compensation
expense
Exercise of stock
optons. including tax
benefit of $95,276
Sale of common stock,
indudingtax
provision of $139
Repurchase of Common
stock
Balance September 30,

200i
Other
Retained Comprehensive
Earnings lncome/(loss)
$2,151,084
672,638
Total
$37.273
$2,228,506
672,638
(20,380)
(20,38D}
37,727
37,727
689,985
106,373
12,744,226
13
1.908,407
(32,969,419)
i38,28S,285
$738
107
13.877)
(470)
~
37,196
225,246
E8.l0.
loss on the Conversion of Preferred Stock: Microsoft Corporation (Easy)

In 1996, Microsoft issued12.5 million convertible preferred shares carryinga dividend of
2.75 percent for $980 million. The shareswereconverted into common shares in Decemher 1999, witheachpreferred sharereceiving 1.1273 common shares. At the timeof conversion, Microsoft's common sharestraded at $88 each.Whatwasthe lossto shareholders
from the conversion?
E8.ll.
Conversion of Stock Warrants: Warren Buffett and Goldman Sachs (Easy)

In September 2008, in the midstof the creditcrisison Wall Street, Goldman Sachs invited
Warren Buffett, the legendary fundamental investor, to contribute much-needed equity capital to the firm. Buffett seemingly got a very good deal. Fora $5 billioncashinfusion, he
received perpetualpreferred equity shares carryinga 10 percent dividend (redeemable by
Goldman Sachs)plus warrants to buy43.5 million common sharesat $115 per share(for
a totalof another $5 billion). The$115conversion price wasset at the currentshareprice,a
three-year lowfor Goldman. If Buffet exercises the warrants whenGoldman Sachs's persharepriceis $150,whatis the lossto Goldman's shareholders?
46,828
(378,432)
(634,356)
$39,393
$2,189,366
(1,012,821)
---$54,620
$2,284,117
a. Reformulate the statement to distinguish comprehensive income from transactions

withshareholders
b. Calculate the after-tax loss to shareholders from the exercise of stockoptions during
the year.
c. Thefollowing information is provided intheequity footnote inthefirm's 10-K for2007:
Outstanding. October 1,2006

Granted
Exercised
Cancelledlforfeited
Outstanding. September 30, 200i
Exercisable, September 30, 2007
Vested and expected to vest,
September 30, 2007
1.684
Calculate comprehensive income to Intel'sshareholders for2000,beingsureto include any

hidden dirty-surplus expenses.
225,233
31.535
10,535
(3.596)
106,373
46,826
133)

Net income
Unrealized loss on available-for-sale securities
Issuance of shares through employee stock plans,
netof taxbenefit of $887 million
Conversion of subordinated notes to common stock
(market value of stock was $350 million)
Cash dividends
Issuance of shares for acquisitions
Shares
Subject to
Options
Weighted
Average
Exercise
Price
perShare
69,419,871
12,298,465
{12,744,226l
(3.458,007)
65,516,103
40.438,082
16.83
36.04
10.23
30.92
20.97
14.65
63,681,867
20.60
Weighted
Average
Remaining
Contractual
Life (Years)

SeeExercises E1.6,E4.14, E6.13,E7.7,10.11,E17.lO, andE19.4.Minicases M8.1 in this
chapter andM12.2alsodeal with Microsoft.
62
6.1
5.0
E8.l2.
Reformulation of an Equity Statement with Hidden losses: Dell, Inc. (Hard)

Thefollowing is a condensed version of the statement ofshareholders' equityforDell, Inc.,
for fiscal yearendingJanuary 31, 2003 (in millions of dollars):
6.2
At balance sheetdate in 2007, Starbucks' shares traded at $28.57each.Provide an

estimate of the optionoverhang at that date.

Material on Starbucks canbe found in Exercises E9.9,El1.9, E12.8, and El4.1O.
E8.9. Calculating Comprehensive Income to Shareholders:
Intel Corporation (Medium)
The following is adapted from the statement of shareholders' equity for IntelCorporation
for2000(in millions of dollars). Intelfaces a 38 percenttax rate.
Balance at February 1,2002

Netincome
Unrealized gain on debt investments
Unrealized loss on derivative instruments
Foreign currency translation gain
Shares issued on exercise of options,
including taxbenefits of $260
Repurchase of 50million shares
Balance of January 31,2003
4.694
2,112
16
(101)
4
1.051
418
12.190)
4,873
284 PartTwo The Anal:;;sis of Finanrial SUlWnentl
Chapter 8 TheAnal:;;5is of the SW!emem ofShareholders' Equily 285
Otherinformation:
1. Dell's tax rate is 35 percent.
2. The sharerepurchase occurred when the stocktradedat $28 pershare.

a. What wasthe lossto shareholders fromthe exercise of stockoptions?
b. Preparea reformulated statement of shareholders' equityfor 2003for Dell,Inc.The
reformulated statement shouldidentify comprehensive income and include all hidden
items.

Exercises E3.7,E3.14,E5.11, 13.16,andE19.4 alsodealwithDell. Minicases MlO.1 and
M15.2 coverDellalso.
E8.13.
Ratio Analysis for the Equity Statement: Nike (Easy)

Usingthe statement of shareholders' equityin Exhibit 8.1, carry out a ratio analysis that
highlights the information aboutNikein thatstatement.
E8.14. Losses from Put Options: Household International (Hard)

Household International (acquired by HSBC in 2003 and nowknown as HSBCFinance
Corporation) is one of the largestU.S. lenders to consumers withpoorcredithistories, carrying receivables for auto loans, Mastercard and Visa credit card debt, and a significant
amountof private noncredit card debt. In September 2002,Household issued 18.7million
. shares, raising about$400million. The issue, combined witha decision tosell $7.5billion
of receivables and deposits, wascheered by analysts concerned aboutthe subprime lender's
liquidity and creditrating.
However, closerinspection revealed thatHousehold International mighthaveto usethe
cashraisedforpurposes otherthat bolstering its reserves. While the finnissuedsharesat a
priceof$21.40 per share,aboutthe sametimeit also repurchased 2.1 million sharesat an
average price of $53.88 underforward purchase agreements whenthe market price of the
shareswas $27.
a. Whatwasthe losstoshareholders fromtherepurchase ofshares underthe forward purchaseagreements?
b. At the endof its thirdquarterfor2002,whenthestockpricestoodat $28.31, therewere
outstanding contracts to repurchase 4.9 million sharesat a weighted-average price of
$52.99per share.Makea rough calculation of the optionoverhang that shareholders
werefacing?
c. Why does issuingshares at onepriceandusingthe proceeds to repurchase shares at a
higherpricelosevaluefor shareholders?

Further Nike Exercises are in E2.l4, E6.7, Ell17, Elll8, E15.11, El8.5, and EI9.4.
Minicase 2.1 covers Nike.
Minicase
M8.1
Analysis of the Equity Statement, Hidden

Losses, and Off-Balance-Sheet Liabilities:
Microsoft Corporation
Microsoft hasundoubtedly beenthe mostsuccessful software firmever. Between 1994and
2000,the firm's revenues increased from$2.8billionto $23.0 billion, anditsearnings from
S708 million to $9.4billion. Overthe twoyear1998to 2000, itsstockpriceincreased from
$36pershareto almost S120, givingit a trailing PIE ratioof 66 anda market capitalization
at the heightof the stockmarketbubbleof overhalf a trillion dollars. By 2005,Microsoft:
wastrading at $40per share(ona pre-split basis)witha market capitalization of$275 billionanda trailing PIE ratioof25.
Microsoft's success hasbeendueto a strongproduct, market positioning, and innovative
research and marketing. In terms of the buzzwords of the time,Microsoft has significant
"knowledge capital"combined withdominant marketpositioning andnetworkexternalities.
Theseintangible assetsarenoton its balancesheet,andaccordingly theprice-to-book ratio
wasover12in2000.Yet, todevelop andmaintain theknowledge base,Microsoft hadtoattract
leading technical expertswith attractive stock optionpackages, with consequent coststo
shareholders. Unfortunately, GMP accounting didnotreportthiscostof acquiring knowledge, nor did it report significant off-balance-sheet liabilities to pay for the knowledge.
Knowledge liabilities, aswellas knowledge assets,weremissing fromthebalance sheet.
This case asks youto uncover the knowledge costsand the associated liabilities and to
deal withotherimperfections in the statement of shareholders' equity.
Microsoft's income statement for the first nine months of its June 30, 2000,fiscal year
follows, along withits statement of shareholders' equityat the end of the ninemonths and
the shareholders' equityfootnote. At the time,Microsoft's shares weretrading at $90 each.
Reformulate the equitystatement andthenanswer the questions that follow.
MICROSOFT CORPORATION
Income Statements
(in millions, except earnings per share)
(Unaudited)
Nine Months Ended
March 3t 2000
Revenue
Operatingexpenses
Cost of revenue
Research anddevelopment
Sales andmarketing
General andadministrative
Other expenses (income)
Operatingincome
investment income
Gains onsales
$17,152
2,220
2)35
2,972
825
~
8,739
SA13
2,055
~
(Continued)
286 PartTwo TheAlwl7Sis ofFinancia!Sraremenl.l
Chapter 8 TheAnalysis of theStalem.;lU ofSMrcho!ders' Eq1lil1 287

NineMonths Ended
March 31, 2000

Net income
Earnings pershare:
Basic
Diluted
10,624
3,612
$ 7,012
1.35
1.27
Stockholders' Eqoity Statement (inmillions) (Unaudited)
Nine Months Ended

March 31,2000
Common stockand paid-incapital
Balance, beginning of period
Common stock issued
Common stock repurchased
Proceeds from saleof putwarrants
Steck option income taxbenefits
Balance, end of period
Retained earnings
Balance, beginning of period
Net income
Net unrealized investment gains
Translation adjustments and other
Preferred stock dividends
Balance, endof period
Total stockholders'equity
$13,844
2,843
(l86)
472
4,002
20,975
A. Whatwasthe net cashpaid out to shareholders duringthe ninemonths?

B. WhatwasMicrosoft's comprehensive income for the ninemonths?
C. Discuss yourtreatment of the $472million from"proceeds fromsaleof put warrants."
Whywould Microsoft sell putwarrants? HowdoesGAAP account forputwarrants, put
options, and future sharepurchase agreements?
D. If the put warrants are exercised rather than allowed to lapse, how would GAAP
accounting report the transactions? How would you report the effect on shareholder
value?
E. The equity statement shows that Microsoft repurchased $4.872 billion in common
shares during the nine months. The firm had a policy of repurchasing the amount of
sharesthatwereissuedin exercise of employee stock options, to "reverse the dilution,"
as it said. Microsoft discontinued the policy in 2000, as indicated in the shareholders'
equityfootnote. Doesa repurchase reverse the dilution of shareholders' equity? Arerepurchases at thesharepricesthatprevailed in 2000advisable froma shareholder's point
of view?
F. Calculate the loss to shareholders from employees exercising stock options during the
nine months. Microsoft's combined federal and state statutory tax rate is 37.5 percent.
G.The following is the financing section of Microsoft's cash flow statement for the nine
months (in millions):
13,614
7,012
2,724
166
9,902
(13)
(4,686)
18,817
$39,792
Extract fromthe footnotes to the financial statements:
Stockholders' Equity
Duringthe first threequarters offiscal2000,the Company repurchased 54.7million shares
of Microsoft common stockin the openmarket. In January 2000,the Company armounced
the termination of its stockbuyback program.
To enhance its stock repurchase program, Microsoft sold put warrants to independent
third parties.These put warrants entitle the holders to sell shares of Microsoft common
stockto the Company on certain datesat specified prices. On March31, 2000,163million
warrants wereoutstanding with strikepricesranging from $69 to $78 per share. The put
warrants expire between June 2000 and December 2002. The outstanding put warrants
permit a net-share settlement at the Company's optionand do not result in a put warrant
liability on the balancesheet.
During1996,Microsoft issued12.5 million sharesof2.75% convertible exchangeable
principal-protected preferredstock.Net proceeds of $980 million wereused to repurchase
common shares. The Company's convertible preferred stock maturedon December 15,
1999. Eachpreferredsharewasconverted into 1.1273 common shares.
Ninemonths ending March

Financing
Common stock issued
Common stockrepurchased
Put warrant proceeds
Stock option income taxbenefits
Netcash from financing
1999
2000
$1,102
(1,527)
757
(21)
$1,750
(4,872)
472
2,238
$2,549
4,002
$1,339
(13)
Noticethatthe tax benefits fromthe exercise of stockoptions are included as financing

cashflows. Later in 2000, the Emerging Issues TaskForce of the Financial Accounting
Standards Boardrequired thesetax benefits to be reportedin the cash from operations
sectionof thestatement of cashflows. Which is the correcttreatment?
H. The income statement reportsincome taxesof$3,612 million on $10,624 million of income. Yet press reportsclaimed that Microsoft paid no taxes at the time.Can you see
why? Whatdoesthe act of paying no taxeson a largeincome tell youaboutthe quality
of Microsoft's reported income?
I. Review the shareholders' equityfootnote. Whatissuesarise in the footnote that should
be considered in valuing Microsoft's shares?
Microsoft's annual reportfor the year ending May 31, 2000, reported the following in
thestockoptionfootnote:
Stock Option Plans

Forvarious priceranges, weighted-average characteristics of outstanding stock options at
June 30,2000,wereas follows:
288 Part Two TheAnalysis of Financial Slatcmen15
Outstanding Options
Range of
Exercise Prices
$ 0.56-$ 5.97
5.98- 13.62
13.63- 29.80
29.81- 43.62
43.63- 83.28
83.29-119.13
Shares
133
104
135
96
198
166
Remaining
life (Years)
Weighted-Average
Price
21
3.0
3.7
4.5
7.3
8.6
$ 4.57
10.89
14.99
32.08
63.19
89.91
Theweighted average Black-Scholes value of options granted under thestock option plans
during 1998, 1999, and2000 was$1L81, $20.90, and$36.67, respectively. Value wasestimatedusing a weighted-average expected lifeof 5.3years in 1998, 5.0 yearsin 1999,and
6.2yearsin2000, nodividends, volatility of.32 in 1998 and1999 and.33 in2000,andriskfreeinterest rates of5.7%,4.9%,and6.2%in 1998, 1999, and2000, respectively.
What information does this footnote give you about the off-balance-sheet knowledge
liability for the optionoverhang? Canyouestimate the amount of the liability?

Minicase Ml2.l also deals with Microsoft, as do Exercises E1.6, E4.14, E6.13, E7.7,
E8.IO, EI0.11,EI7.1O, andEI9.4.
II
Chapter 9 The Anal)'sis of theBalance Sheet and Income Statement 291
After reading thischapter youshould understand:

Whythe analyst reformulates income statements and
balance sheets.
reformulated statements.
Howoperating andfinancing components of the two
statements are identified.
Allocate income taxes between operating income and

financing income (orexpense).
What assets andliabilities typically fall into operating

andfinancing categories.
Whyincome taxes are allocated to different parts of the
income statement.
Whatbalance sheet andincome statement ratios reveal.
How one learns about a firm's strategy through the
Howfirms manage" cash."
Thischaptercontinues
thereformulation and
analysis with
the balance sheetand
income statementThe
reformulation follows the
design in Chapter 7.
Chapter 10analyzes
thecashflow statemeflt,
Link
to Webpage
Moreapplications and
analysis areonthetext
WebSite at
www.mhhe.coml
penmanee.
~1?J;~'i
Howaretaxes
allocated to the
operating and
Whatratios
arecalculated
from
financing
reformulated
components of
theincome
statement?
statements?
wnardc they
mean?
ntof shareholders' equity of the last chapter yields the overall

:profita~,i4",if'comprehensive return on common shareholders' equity, which,
alongwithgt":'; drives residual earnings andvalue. Thebalance sheetandincome statementgivethe detailtodiscover the sources of profitability and growth. Thischapter takes
youthrough thereformulation of thetwostatements in preparation forthe analysis ofprofitability and growth in Chapters 11and 12.
Profitability that generates value comes from a firm's business operations, Thus the
analysis begins witha reformulation ofthestatements, following thetemplates ofChapter 7,
which distinguishes operating activities from financing activities. This reformulation enforces the rulethatonecannot value a firm without knowing thebusiness, fordistinguishing operating activities identifies thebusiness the firm is in.Anddistinguishing operating
items from financing itemsin financial statements requires understanding the roleof each
iteminthe business andhow it contributes to theprofitability of the firm. Reformulation of
the financial statements-the lens on the business-brings the business activities into
sharper focus. We understand thebusiness, thestrategy, andthevalue it generates, through
thelensof reformulated financial statements.
The mainaimof reformulating thebalance sheetandincome statements, however, is to
discover the drivers of ROCE (return on common equity) and growth in preparation for
forecasting and valuation. Thisdiscovery is made through ratioanalysis, combined as always witha goodknowledge ofthebusiness. Thischapter introduces ratioscalculated from
these statements; these ratios become part of the comprehensive analysis of profitability
andgrowth in Chapters 11and12.
Reformulate income statements and balance sheets.

Addfootnote information to reformulated statements.
Prepare a reformulated income statement on a comprehensive income basis.
How knowledge of the business is incorporated in
This chapter
Afterreading thischapter youshould beable to:
Calculate effective taxrates for operations.

Prepare and interpret a common-size. comparative
analysis.
Prepare andinterpret a trend analysis.
Calculate income statement ratios-including ranos tbat
reveal theprofitability of sales.
Calculate balance sheet ratios-inclUding financial
leverage ratios andoperating liability leverage ratios.
Calculate summery profitability ratios.
Calculate growthratios.
REFORMULATION OF THE BALANCE SHEET

Thetypical balance sheetusually divides assets and liabilities intocurrent andnoncurrent
(long-term) categories. Forassets, thisdivision is based on liquidity, andforliabilities, it is
based on maturity, with the aim of giving an indication of the firm's ability to meetcreditors'claims oncash.Theanalysis of credit riskinChapter 19willemploy thisdivision, but
in Chapter 7 weoverrode thisclassification withonethatidentifies thedifferent sources of
profitability, theoperations andthe financing activities. Todiscover a fum's ability to generateprofits, weneedto reformulate the balance sheet intooperating andfinancing assets
and liabilities. Following the template of Chapter 7, operating assets andliabilities net to
net operating assets (NOA), sometimes referred to as enterprise assets, and financing
assets andliabilities netto net financial assets(obligations).
Exhibit 9.1 Jays outa typical balance sheet.ltliststhestandard lineitems youseeinpublished statements. Balance sheets forspecific firms donotinclude allthese items, of course,
and some items are often aggregated or grouped into"other assets" or "other liabilities"
categories. In some industries youwillseespecial lineitems thatarenot listed here.
From Chapter 7 you'llremember thatoperating assets and liabilities arethose involved
inthebusiness, in selling goods and services. Financing assetsandliabilities arethose that
are involved in raising cash for operations and disbursing excess cash from operations.
Before reformulating thestatement, be sureto have an answer to the question: What business is the firm in? Forit is the answer to this question that defines the operating assets
and liabilities. Also keep in mind the parallel classification in the income statement
(discussed later): Operating assetsand liabilities generate operating income and financial
292 PartTwo The Ana!J5is Df Financia! $wremenrs
EXHIBIT 9.1
TheTypical GAAP
BalanceSheet
Assets
liabilitiesand Stockholders'Equity
Current assets:
Cash
Cash equivalents
Short-term investments (marketable securities)
Deposits andadvances
Accounts receivable (less allowances)
Short-term notesreceivable
Other receivables
Inventories
Prepaid expenses
Deferred income taxes (current portion)
long-term assets:
Noncurrent receivables
Long-term debt investments
Long-term equity investmentsless than 20% ownership
long-term equity ovestoents-.
equity method
Property, plant, and equipment
(less accumulated deoreciation)
land
Buildings
Equipment
leasedassets
leasehold improvements
Construction inprogress
Intangible assets
Patents
tkenses, franchises, andbusiness rights
Copyrights andtrademarks
Goodwill
Software development costs
Deferred taxes (noncurrent portion}
Deferred charges
Accounts payable
Accrued expenses
Deferred (unearned) revenues
Advances from customers
Warranty liabilities
Short-term notes payable
Deferred taxes (current portion)
Reformulating balance sheets involves distinguishing assets

and liabsities that are usedin business operations-where the
firm makes itsmoney-from assetsand liabilities that are used
in financing-to raise cash for operations and temporarily
store excess cashfrom operations. Afirm "makesits money"
by selling goods and servces to customers, so identifying
operating assets requires knowledge of goods and services
the firm isdelivering to customers.
Assets and liabilities withsimilar nameson balancesheets
maybe financing itemsfor one firm but operating itemsfor
another. Consider the following.
long-term liabilities:
Bank loans
Bonds payable
long-term notespayable
leaseobligations
Commitments and contingencies
Deferred taxes
Pension liabilities
Postemployment liabilities
BANKS
CAPTIVE FINANCE SUBSIDIARIES

Automobile manufacturers like General Motors and Chrysler
consolidate finance subsidiaries into their financial statements. These finance subsidiaries hold (what look like)
financial assets and liabilities. But they are used to support
customers' purchases of eutomobges, and often generous
creditterms are used in promotions as effective price reductions. The finance subsidiaries are an integral part of operations and their assets and fiabilitiE's should be classified
as such.The interest earned from the financing is operating
income.
RETAILERS WITH CREDIT FACILITIES
Banks holdmainly (whatlook like) financial assets and fman- Retailers makemoney from selling goodsbut often alsomake
oal liabilities in the form of customer deposits, bonds, and money from providing creditto customers. Accordingly, their
loans. But they make money from the spread between the interest income from creditcardsthey issue and other credit
interest they pay on their financial liabilities and the interest facilities is operating income, and the financing receivables
they earn on their financial assets. These apparent financial that generatethe income are operating assets.
assetsand liabfities are operating assets and liabilities.
Redeemable preferred stock
EXHIBIT 9.2
The Classification
ofOperating and
FinancingItems in
the BalanceSheet for
Nonfinancial Firms
Minority interest
The Reformulated Balance Sheet
Assets
Liabilities and Stockholders' Equity
Financial assets
Cash equivalents
Short-term notes receivable (?)
long-term debtinvestments
Finarlcialliabilities:
Current maturities of lone-term debt
Short-term notes payable (?)
long-term borrowing (bank loans, bonds
payable, notes payable)
Lease obligations
Preferred stock
Operating assets:
All else
Operating liabilities:
All else
Minority interest
Common equity
Preferred equity
Common equity
assetsand liabilities are those that produce financial income or incur financial expenses.
See Box9.1.
Issues in Reformulating Balance Sheets

The GAAP balancesheetfor the typical nonfinancial fum is reformulated into operating
and financial itemsas in Exhibit 9.2.Thislayout follows the template in Chapter 7. Some
issuesarise:
Cash. Working cash,or operating cash, whichis needed as a bufferto paybillsas they
falldue,is anoperating asset. Thisis non-interest bearing, inthe formof cash On handor
in a checking account. Justas thefinnneedsto invest inplantandequipment to carryout
operations, it also hasto invest in working cash.However, interest-bearing cash equivalents(investments with less than three months maturity) or cashinvested in short-term
securities are financial assets-they are investments of excess cashoverthat required to

meet liquidity demands. Typically firms lump cash and cash equivalents together, so
identifying the working cash is difficult. If the analystknows the typeof business well,
she mightimpute the required working cash(as a percentage of sales, say)but,as many
firms have cashswept dailyinto interest-bearing accounts, she would be safe in classifying all cashas a financial asset.
293
294 PartTwo TheAnal:fsis ofFinancial Statements
Short-term notes receivable. Notes can be written by customers for goodsreceived in

trade, withor without interest, and, with interest, by borrowers. If the notesare temporary investments, treatthemas financial assets. If theyare tradenotes, treatthemas Op8
crating assets. Trade notes can be treatedas financial assetsif they bearthe marketrate
of interest Thetradereceivable has beenconverted to a financial claim. But if the firm
is usingcreditto attractcustomers, treatthe notesas operating assets: The fum is effectively offering a lower interest rate insteadof a lowerprice for goodsshipped. Correspondingly, the interest income should be classified as operating income, part of the
income fromsellinggoodswithfavorable creditterms.Finance receivables (for finencing productsales)fall in the samecategory. SeeBox 9.1 again.
Debt investments. For nonfinancial firms, investments in bonds and other interestbearinginvestments are financial assets. UnderFASE Statement No. 115, both current
and noncurrent investments are marked to market (carried at market valueon the balance sheet)if theyare part of a trading portfolio or are available for sale, as we saw in
the last chapter, They are recorded at cost if the firm intends to holdthemto maturity.
(The accounting for securities is covered in Accounting ClinicIII in Chapter 8.) The
footnotes givea schedule of all securities showing theirhistorical costsand currentfair
values, along with the associated unrealized gains and losseswhich are income or expensein comprehensive income. Ifbondsarepartof a trading portfolio, the fum is probably in the business of makingmoney frombonds,so classify themas operating assets.
Banksmakemoneyon the spreadbetween borrowing and lending rates,so in theircase,
debt investments and liabilities are operating items.
Long-term equity investments. Long-term equity investments (in the shares of other
firms) are investments in the operations of othercompanies, andso theyareclassified as
operating assets. If the holding is Jess than20 percentof the sharesof the othercorporation,theyare recorded on the balance sheetat marketvalueif"available forsale"or at
cost if"held to maturity." If the holding is greaterthan20 percent and less than50 percent, they are recorded as equity investments under the equity method. The equity
methodcarriestheseinvestments at costplus accumulated shareof income of the subsidiary, lessdividends paidby the subsidiary and anywrite-offs of the goodwill onpurchase. If theholding is greaterthan50 percent, consolidation accountingcombines the
financial statements of the relatedfirms into one set of financial statements, so equity
investments do not appear on the consolidated statement. Go to Accounting ClinicV
Equity investments in subsidiaries include the parent's shareof net financial assets of
subsidiaries. Thustheyare investments in financial assetsand obligations of thesesubsidiaries as wellas theiroperating assets. Ideally we would liketo goback intothe subsidiaries'financial statements tosort outthe operating andfinancial activities and divide
the equityinvestments accordingly. Tbisis oftendifficult to do if the subsidiary is nota
public corporation, so as an expediency, treatthe entireinvestment as an investment in
an operating subsidiary.
Short-term equity investments. Short-term marketable equityinvestments canbe an exception to classifying equities as operating assets. If theyarepart of a trading portfolio,
they are operating assets. If theyare usedto temporarily mop up excess cash, they are
financial assets. Theseinvestments aremarked to market.
Short-term notes payable. Short-term notes can be written to generate cash, in which
case they are financial obligations. However, notes also can be written to satisfytrade
obligations, forthepurchase of inventory, forexample. If thesearenon-interest bearing,
or carry an interest rateless thanthe market rate for this typeof credit,classify themas
operating liabilities; if theyare interest bearing at marketrates,treat them as financial
liabilities. A notewrittento satisfy a trade obligation results from operating activities but
Chapter 9 TheAnalJlil of [he Bakmce Sheer and Income Sr.otemenr 295
Accounting Clinic
['i;.
Fin...
ACCOUNTING FOR EQUITY INVESTMENTS

AND ACCOUNTING FOR BUSINESS
COMBINATIONS
Accounting Clinic IIIcovers theaccounting for debtsecuritiesandequity securities that represent less than20 percentownership of another corporation. Accounting Clinic
V deals with equity investments of 20 percent-50 percent
ownership, where the equity method applies, andthecase
of majority control (over 50 percent ownership), where

consolidation accounting applies.
Firms acquire shares of other firms in mergers and
acquisitions. Accounting Clinic V also Covers the accounting for these business combinations, along with issues
related to recognition, amortization, and the impairment
of tlte goodwill acquired in business combinations.
if it is interest bearing at market rate, the operating liability (the accounts payable) has
effectively been converted into a financial liability (the note payable). In the United
States, GAAP requires the effective market rate of interest to be imputed On long-term
notespayable (andreceivable) so thoseitems shouldbeclassified as financialobligations.
Accrued e::pense:. Thes~ include liabilities to pay for the whole variety of operating
expenses, including rent,insurance, wages, andtaxes. Treatthemas operating liabilities.
But interest payable on financial obligations is a financing item.
Deferred revenues (Unearned revenues). These include receipts from customers that
are notyet recognized as revenue (because the firm has not performed on thesale)and
obligations to complete performance such as warranties and guarantees. Treatthemas
operating liabilities.
Leases. Leasesthatare capitalized are placedon theassetsideof thebalance sheetas a
leaseassetat the present valueof the expected payouts underthe leaseagreement. The
leaseasset is an operating asset The leaseobligation is reported underliabilities and
classified as a financial obligation in reformulated statements. Interest expense on the
leaseobligation isreported withotherinterest expenses in the income statement. Leases
that are capitalized and placedon the balance sheet are called capital leases. Capital
leasesare essentially in-substance purchases granting the finna rightto usetheassetfor
most of its useful life. Accordingly, if an asset satisfies criteria that indicate an insubstance purchase, the leaseasset is treated similarly to any otherproperty, plant,or
equipment. Andtheobligation toservicethe leaseis treated as if the firm hadpurchased
the assetand borrowed to finance the purchase: Theleaseobligation isan effective loan
to finance the purchase of theasset.Leases thataredeemed notto beeffective purchases
are calledoperating leases.They do not appearon the balance sheetbut the rentpayments are included as rentexpense in the income statement.
Deferred taxassets andliabilities. Deferred taxesarisealmostalways fromaccounting
differences in calculating the operating income component of taxable income and
reported bookincome. So treatthemas operating assetsor liabilities.
Dividends payable. These are classified as shareholders' equity, not a liability, as
explained in the lastchapter.
Preferred stock, From a common shareholders' focus, preferred stock are financial
Obligations.
"Other" items. Balance sheetstypically havea linefor"otherassets"and"other iiabilities."The detail canbe discovered fromfootnotes andsometimes from the rnanazement
discussion and analysis (MD&A). If thesesources prove fruitless, usually tbes; items
296 Part Two TheAnalyst<; of Financiol $uucmenrs
are considered operating. If any of the otherliabilities are material amounts, firms are
required to disclose them.
Minority interest. It mightbe tempting to viewminority interest in a consolidated subsidiaryas a financial obligation from the common shareholders' pointof view, an interest that hasto be satisfied. But the minority interest is not an obligation, likedebt,that
is satisfied withcashgenerated fromfreecashflow. Rather it is an equity sharing in the
results of the consolidated operations. In the reformulated statements treatit as a separate line itemthatshares withthe common equity in the operating and financing assets
and liabilities. The reformulated statement with minority interest has the following
form: NOA - NFO:: : CSE+ Minority interest
Somepeople havetrouble thinking of operating liabilities as part of operations and not
part of the financial indebtedness. Indeed, you may have seen these included in debt and
debtratiosin otherbooks. Asobligations to creditors, theyare debt,and if weweremaking
calculations to evaluate creditrisk-or the abilityto payoff debt-we would include these
in relevant ratios (as in Chapter 19).However, our purpose here is to get a senseof operatingprofitability relative to the net assetsput in place. And to the extentthat a firm has operatingliabilities, it reduces itsnet investment in operations, itsnet operating assets. Return
on net operating assets(RNOA) compares operating income to the investment in net operating assets; to the extentthat a finn can induce suppliers to givecredit, this reduces the
investment and increases the returnon net operating assets. Just as firms lever up returnon
equity through financial liabilities, so they lever up returnon operating assetswithoperatingliabilities. The following examples illustrate:
Dell,Inc. is renowned in the computer business for its made-to-order system that keeps
its investment in inventories low. Dell'sfiscal 2008 balance sheet(in Chapter 2) reports
$1,180million in inventory, only 1.9percent of sales.
However, Dell also reports $11,492million in accounts payable. Dell has managed
to get inventory suppliers to givecreditto "finance" the inventory (andothersupplies),
so, in effect, Dell bas negative investment in inventory. This generates value for shareholders as the shareholders do not need to use their funds to purchase inventories;
indeed, creditors havesupplied fundsto finance otheroperating assetsbesides inventory.
Andshareholders neednotserviceinterest on financing debt.
OracleCorporation, the largesoftware and information management firm, reports deferredrevenue of$4,754million as a liability in its 2008balancesheet Thisis cashthat
has been givento Oracleby customers in advance of receiving services from the finn.
Thiscashgenerates shareholder valuebecause it canbeusedto purchase operating assets
forwhich shareholders would otherwise haveto provide funds.
General Motors, the automobile manufacturer, has a program to pay health benefits to
employees aftertheyretire. An amountof$43.4 billionwasreported as a liability on its
2007balancesheetfor obligations underthis benefit plan.The plan pays benefits later
rather than usingcash for wages that would be higherwithout the health benefits. The
liability, likewages payable, arisesfrom operations. So doesits2007pension liabilityof
SllA billion.
Whirpool Corporation, the appliance manufacturer, included sales warranties of $226
million in itsaccrued liabilities for2007. These obligations toservice saleseffectively net
against receivables andcashfromthesales.
Exhibit 93 reproduces the published comparative balance sheets for Nike, Inc., for
2006-2008, alongwithreformulated balance sheets. Weintroduced Nikein the lastchapter
with a reformulation of its equity statement. Notice several things about the reformulated
Chapter 9 TheAnalysis of tAe Balance Sheet ond Income StaWllen! 297
EXHIBIT 9.3
NIKE.INC.
GAAPConsolidated
BalanceSheetsand
Reformulated
BalanceSheetsfor
Nike,Inc.,
2006-2008.
GAAP BalanceSheets
(inmillions)
May31
2008
The reformulated
balance sheet
reformats the GAAP
statement into net
operating assets
(operating assets
minus operating
liabilities), net
financial assets
(financial assets minus
financial obligations),
and common
(net operating assets
plusnetfinancial
assets).
Numbers in
parentheses to the right
of thereformulated
statementrefer to
points on the
reformulation made
in the text.
2007
2006
Assets
Currentassets:
Cash and equivalents
Deferred lncome taxes(Note8)
Prepaid expenses and other currentassets
Totalcurrent assets
Property, plant, and equipment, net(Note 3)
Identifiable intangible assets, net (Note 4)
Goodwill (Note 4)
$ 2,133.9
642.2
2,795.3
2,438.4
227.2
602.3
8,839.3
1,891.1
743.1
448.8
Deferred income taxesand other assets (Note 8)

Totalassets
~
$12,442.7
1,856.7
9903
2,494.7
2,121.9
219.7
~
~
1,678.3
409.9
130.8
$ 954.2
1,348.8
2,395.9
2,076.7
203.3
380.1
7,359.0
1,657.7
405.5
130.8
~
$10,688.3
~
9,869.6
30.5
100.8
1,040.3
1,303.4
liabilities and Shareholders' Equity

Currentliabilities:
Current portion of long-term debt (Note 7)
Notes payable (Note6)
Accounts payable (Note6)
Accrued liabilities (Notes 5 and 16)
Income taxespayable
Long-term debt (Note7)
Deferred income taxesand other liabilities {Note 8}
Commitments and contingencies (Notes 14and 16)
Redeemable Preferred Stock (Note 9)
Shareholders'equity:
Common stock at stated value(Note 10):
Class Aconvertible-96.8 and 117.6shares
outstanding
Ciass 6-394.3 and 384.1 shares outstandinq
Capital in excess of stated value
Accumulated other comprehensive income (Note 13)
Retained earnings
63
3,32.1.5
~
2,584.0
255.3
43.4
952.2
1,286.9
85.5
2,623.3
441.1
854.5
409.9
668.7
410.7
550.1
177.7
1,287.6
1,761.9
88.0
03
03
OJ
0.1
01
0.1
2.7
2,497.8
251.4
5,073.3
7,825.3
$12,442.7
2.7
1,960.0
177.4
4,885.2
2.7
1,451.4
117.6
4,713.4
6,285.2
9,869.6
$10,688.3
Netles n:fortonolesin Ibepubli,h.ed financial stl1emenlO. Refertothe 2003 10-Kn:l"'rt
(continued)
298 Part Two The AnalJl15 of FinancialStatement>
EXHIBIT 9.3
Chapter 9 TheAnalysis oftheBalance Shee1llnd Income Stcremene 299
(concluded)
2. Net operating assets (NOAs) is the difference between operating assets and operating
liabilities.
ReformulatedBalance Sheets (inmillions)

2008
2007
2006

Operating assets
Working cash'
Accounts receivable, less allowance for
doubtful accounts
2,7953
2,490
2,395.9
Inventories
2,438.4
2,121.9
2,076.7
93.1
Prepaid expenses and other current assets

Property, plant, andequipment, net
Goodwill
Identifiable int<lngible assets
Deferred income taxes andotherassets

Totaloperating assets
74.8
81.6
602.3
393.2
380.1
1,891.1
1,678.3
1657.7
448.8
130.8
130.8
743.1
409.9
612.5
7,922.9
405.5
747.6
9,759.7
(4)
~
7,641.4
Accounts payable-non-interest
bearing'
Accrued liabilities3
Income taxespayable
Deferred income taxesand other
liabilities
Net financial assets
Financial assets
Cash equbeems'
Totalfinancialassets
$1,221.7
1,790.0
88.0
854.5
3,954.2
5,805.5
2,040.8
642.2
2,683.0
Current portion of long-term debt
Notes payable'
Accounts payable-e-interest bearing 2
Long-term debt
Redeemable preferred stock
Totalfinancial liabilities
CommonShareholders' equity3
'3
177.7
65.9
441.1
0.3
$ 995.7
$ 882.5
1,210.5
1,207.4
109.2
85.5
668.7
2,983.9
4,939.0
1,775.1
990.3
2,765.4
879.4
1,348.8
2,228.2
30.5
100.8
255.3
(')
2,725.5
4,915.9
(ll(2)
(4)
69.7
410.7
~
~
Strategic Balance Sheets
43.4
44.'
409.9
1,991.7
7,797.3
550.1
.........JU
2,179.3
7,118.3
779.4
3. Net financial assets (NFAs) is the difference between financial assets and financial
obligations.
4. Cash and cashequivalents havebeendivided up between operating cashand financial
assets. Operating cashhas beenestimated at 1/2percent of sales.
5. Redeemable preferred stockis a financial obligation.
6. Dividends payable, reported as an accrued liability in the GAAP statement, is included
in shareholders' equity (as in the reformulated equity statement in Chapter 8). Stockbasedcompensation, included in shareholders' equity in the GAAP statement, is included in accrued liabilities (following Chapter 8).
7. Thediligent analyst reviews thenotesto the financial statements andbrings further information onto the face of the reformulated statements. Lookinto"otherassets" and
"otherliabilities" items particularly and also "accrued liabilities." If long-term investments are reported, check footnotes to see if these are equity investments (an operating
asset) or debtinvestments (a financial asset).
1,448.8
6,364.7
(5)
(1){3)
(l){')
'Co:sh ~nd =h .'loi""l"nl.'l m splitbclWl:.n opo;;,t;n!: =h:llld =h invcslm<nl.'l. Opom;n!: cashis estimated at In pclttnt of sales.
llntcrestbe.Jrin!: accounts po.y.ble are classified as fin~ncin!: oi:lig:ltions.
J Mc,ued li.bilitiesexelode dividends pay.blelh.t havebeenincluded in shareholdm't<joity andinelude stockcompensation li.bility"'movedfrom sh....holdcrs't<juity.
'NOlesp.y~bJe're interest bearing.
Someitemsmaynotlot~1 precisely cl""to roonding error.
statement (numbers below correspond to the numbers flagging items in the reformulated
statement):
1. The reformulation maintains the balance sheet equation: CSE = NOA - NFO. The
balances of COmmon shareholders' equity (CSE) agree with those in the reformulated
equity statement (in Chapter 8)
A reformulated balance sheetgives insight intohow a finn organizes its business. Indeed,
wemight referto it as a strategic balancesheet.
Nike's reformulated balance sheet tells us that Nike conducts business by investing
shareholders' equity in net operating assets with additional investment in net financial
assets. It gives the composition of both,along withchanges from the previous year. The
positive netfinancial assets reveal the firm's current financing strategy: Rather thanfinancing operations through borrowing, the firm does so through equity and indeed is a net
lender rather thanborrower. Operating assetslistthe typeof assets thatthe firm invests in
to runthebusiness, while the operating liabilities indicate how much operating creditsuppliersprovide to finance those assets. These liabilities arenot financing debt, for thcy arise
from operations andindeed mean thatNikedoesnothave to issuefinancing debtto finance
the operations. They are also financing thatshareholders do not have to provide. Indeed,
duepartlyto supplier credit, Nikehassignificant financial assets thatit canpayout in dividends or stockrepurchases to shareholders (which it subsequently did).
Exhibits 9.4 and 9.5 present strategic balance sheets for Dell,Inc., and General Mills,
Inc.The GMP balance sheetfor Dellis given in the Exhibit 2.1 in Chapter 2. Whatdo
thesestatements sayaboutthe strategies of these firms?
Dell, Inc.
Dellhasa large amount of financial assets andlittle debt. So,likeNike, it hasnetfinancial
assets rather than netfinancial obligations; thefirm generates considerable cashflow andinvests thatcashflow in interest-bearing securities. Butthestriking feature of Dell's strategic
balance sheet is the negative net operating assets: Shareholders' equity in 2008 is represented by a netinvestment in financial assets of $8.811 billion anda negative investment in
operations of -$5.076 billion. Thisis rarefora manufacturing firm. How canit be?Well, it
reflects Dell's strategy: Keep operating assets low withjust-in-time inventory, require a
credit cardbefore shipping retailcustomer sales(thus keeping accounts receivable Jow), outsource production (reducing investment in plantandequipment), require cashup front for
servicing contracts (andthusamass large deferred revenues), and, importantly, require suppliers to carryDell's payables and thus supply operating credit. Accordingly, shareholders
have a negative investment in the firm. Thatnegative investment means thatthey cantake
300 PartTwo The Analysis of Financ:01 Srcremerus
Chapter 9 The Ana!)'5is of the Balance Sheet aru:! Income Srat.emenl 301
EXHIBIT 9.4
EXHIBIT 9.5
DEll, INC.
Reformulated,
StrategicBalance
Sheetfor Dell,Inc.,
2008
2008
Operating assets
Working cash
Accounts receivables
Financing receivables
Inventories
Goodwill
Intangible assets
Other assets
Operating liabmties
Accounts payable
Accrued liabilities
Deferred service revenue
Other liabilities
Netoperating assets
Net finandal assets
Cash Equivalents
Long-term investments
2007
45
3.653
18,069
3,491
13,230
20,439
(7,209)
Accounts payable
Deferred taxliabilities
Otherliabilities
Netoperating assets
$ 937
1,483
3,164

Current portion of debt
Notes payable
long-term debt
Cashequivalents
442
2,209
4,349
23,145
(5,076)
660
2,409
110
$10,430
5,141
4,221
647
9,506
208
752
2,147
12,405
(188)
(225)
(362)
40
4,622
1,853
7,724
~)
2008
780
40
5,961
2,i39
1,i80
2,668
1,548
9,492
Short-term borrowing
long-term debt
Redeemable stock
Strategic Comparative BalanceSheet, 2008

Operating assets
Working cash
Receivables
Inventories
Prepaid expenses
Land, building, and equipment
Goodwill
Intangible assets
Deferred taxassets
Otherassets
$11,492
4,323
5,260
2,070
GENERAL MilLS, INC.
Reformulated,
StrategicBalance
Sheetfor General
Mills, Ine.,2008
Strategic ComparativeBalance Sheet. 2008

(Inmillions of dollars)
(569)
3,735
-0.J..1)
11,537
4,328
cashoutofthefirm to invest elsewhere, asthey dointheform ofstockrepurchases. In short,

the shareholders of Dellareplaying a float Thatplay addsvalue, as we willseewhen we
come to value Dell. At thispoint it is important to appreciate how thereformulated, strategicbalance sheetprovides insights intothevalue generation thatwewish toevaluate.
An insurance company works on a float to addvalue. Minicase 9.2prepares a strategic
balance sheetfor a property casualty insurer thatbecomes thestarting pointforvaluation,
General Mills, Inc.

Both Nikeand Dell have positive net financial assets (negative net financial obligations).
General Mills in Exhibit 9.5ismore typical withmore financing debtthan debtassets held.
Thusit is a netdebtor: Thefinancing strategy involves taking on leverage through borrowing.The firm has $18.431 billion in operating assets to finance, with considerable investment in land, building, and equipment and intangible assets (these are investments in
purchasing itsmany brands suchasPillsbury, Progresso, Green Giant, OldElPaso, HsagenDazs, andUncle 'Iobys). It alsohasinvested a considerable amount in acquisitions, as indicated by the$6.768 billion goodwill number. With $5.584 billion inoperating liabilities, net
operating assets stand at $12,847 billion, of which about halfis financed byborrowing and
Minorityinterest
Commonshareholders' equity
2007
50
1,082
1,367
511
3,108
6,786
3,777
50
953
1,173
444
3,014
6,835
3,694
67
1,587
17,817
~
18,431
~)
5,584
12,847
$ 778
1,433
3,309
5,520
12,297
1,734
1,254
3,218
6,389
6,458
242
6,216
(367)
5,839
6,458
1,139
5,319
halfbycommon shareholders plussmall minority equity interests in subsidiaries. Notethat

minority interest in a subsidiary is nota financing obligation butrather anequity share that
shares in thesubsidiary withthecommon shareholders atGeneral Mills.
Netfinancial assets ("cash") are alsostrategic assets. Box 9.2explains.
REFORMULATION OF THE INCOME STATEMENT

The income statement reports the profits and losses thatthe netoperating assets and net
financial assets have produced. The presentation of the GAAP statement varies, but the
typical lineitems found in the income statement are given in Exhibit 9.6.
Thereformulated statement groups these items intooperating andfinancing categories.
However, thereformulated statement is ona comprehensive basis, so italsoincludes dirtysurplus items reported within the equity statement. Exhibit 9.7 gives the layout. The two
components in thetemplate in Chapter 7-operating income andnet financial expenseare identified, with dirty-surplus income and expense associated with each included
(including hidden items discovered in the reformulation of theequity statement). Operating income is sometimes referred to as enterprise income or net operatingprofit after
Chapter 9 The AnalY5il oftheBalance Shee! and Income SUlIement 303
Financial assets (in theformof cash andcash equivalents and

short-term and long-term debt investments) are sometimes
just referred to as "cash." Having identified these financial
assets, the analyst asks: Whatdoes thefirm intend to do with
the "cash?" Asa basic rule, firms should not holdcash without purpose, but rather pass it out to shareholders: Cash isa
zero residual earnings asset (adding no value) that shareholders can justaswell holdon theirown account. Indeed, they
may have investment opportunities to use the cash. Financial
assets are held for the following (financing, investment, and
operating) purposes:
1. For payout to shareholders (in dividends and stock repurchases) in the immediate future.
2. For payment of anupcoming debtmaturity. (The payment
does not affect netfinancial sssets.)
3. For capital expenditures or acquisitions in the immediate
future.
4. As "insurance" against bad times in operations: If cash
flow turns negative, the firm has financial assets to alleviatethecash crunch.
The firstuse, payout to shareholders, isthedefault. Afterreporting considerable financial assets in its2008 balance sheet,
Nike announced a stock repurchase program aswell as an increase in dividends. Dell, with significant financial assets, has a
continuing stock repurchase program. Neither appears to have a
significant acquisition orcapital expenditure program otherthan
replacing eXisting investments, andneither has significant debt
to retire. If cash were held for investment in operations, the
analyst would bekeen to discover theinvestment strategy.
The fourth use of financial assets is often controversial.
Firms can borrow indifficulttimes if firm value isthere to back
up the loans; if the value is not there, the shareholders may
be better off with liquidation of the firm,with the cash from
financial assets paid out earlier safely in their pockets. Some
complain that financial assets cushion management rather

than shareholders. Nevertheless, borrowing in bad times is
difficult-particularly when credit contracts generally in the
economy as it didin thefinancial crisis of 2008-50 firms may
holdcash asprotection. General Motors, Ford, and Chrysler,
the U.S. automobile firms, traditionally held large amounts
of cash, andangry shareholders oftendemanded payout. The
firms always replied thatthecash was needed for a "rainy day."
indeed, General Motors held $52.6 billion in cash in2005, but
a "cash burn" subsequently ensued asthefirm reported considerable losses in itsoperations, leaving it with littlein cash in
2008butsaving it from immediate illiquidity. (Whether shareholders were better off isanother issue) If financial assets are
used inoperations in thisway, they must beclassified asoperatingassets andcharged with the required (risky) return in a
valuation: The cash isbeing putasrisk inoperations.
FINANCIAL ASSETS ASA MINIMUM

VALUATION
Benjamin Graham, in the depths of the 1930s depression, advised buying firms whose market price was lower than their
cash value (more common then than now). Having identified
netfinancial assets andnetoperating assets we can viewthe
valuation of common equity as
Value of common equity e Value of netoperating assets
+ Value of netfinancial assets
If theequity istrading at less than thevalue of thenetfinancial
assets, the market isimplicitly saying that the firm (theenterprise) has a negative value. Typically theequity isworthat least
thenetfinancial assets, socash supplies theminimum valuation'
(before adding thevalue of thebusiness). Dell traded at $10.20
inDecember 2008. With$8.811 billion of netfinancial assets on
itsstrategic balance sheet and2.060 billion shares outstanding,
theminimum per-share value is$4.28. The market was valuing
Dell's operations at $5.92.
tax (NOPAT). Within operating income, further distinctions are made. Weneed to understandthe profitability of trading withcustomers, so operating income fromsales is distinguished from operating income not coming from sales. For example, equity income in
subsidiaries, booked under the equity method, is a net number-sales minus operating
expenses in thesubsidiary-and is notgenerated bytop-line sales.Norare mergercharges
or gainsandlosseson assetsales,forexample. Finally, thereformulated statementallocates
taxesso that income in eachpart of the statement is net of taxesit attracts.
Tax Allocation
Income taxesarereported in twoways. Theincome taxexpense reported in theincome statementapplies to income above the tax line in the income statement. The firm mayalsopay
taxes on items below the tax line, including the income reported in the equity statement.
302
EXHIBIT 9.6
TheTypical GAAP
Income Statement
Net sales (sales minus allowances)

+ Other revenue (royalties, rentals. license fees)
Cost of sales
:: Gross margin
- Marketing and advertising expenses
- General expenses
- Administrative expenses
Special items and nonrecurring items
Restructuring charges
Merger expenses
Gains and losses onasset sales
Asset impairments
litigation settlements
Environmental remediation
- Research and development expense
+ Interest revenue
-Interest (expense)
Realized gains and losses onsecurities
Unrealized gains and losses ontrading securities
+ Equity share insubsidiary income
-mccmebefore tax
'" Income taxes
-Income before extraordinary items and discontinued operations
Discontinuedoperations
Extraordinary items
Gains and losses ondebt retirement
Abnormal gains and losses inoperations
- Minority interest
'" Net income orloss
However, extraordinary itemsand other items below the tax lineare reported net of tax, as
are the dirty-surplus items. Thusno tax needsto be allocated to them. Theseafter-tax items
havebeenlistedbelow the itemsto whichthe reported tax expense applies, in bothoperatingandfinancing sections in the template in Exhibit 9.7.
The twocomponents of income, operating and financing, both havetax consequences.
Only one income tax number is reported in income statements, so this number must be
allocated to the twocomponents to put both on an after-tax basis.Referred to as tax allocation, this is doneby firstcalculating the taxbenefit of deducting net interest expense on
debt for tax purposes and allocating it to operating income. The tax benefit-sometimes
referredto as the tax shield fromdebt-is calculated as
Taxbenefit = Net interest expense x Taxrate
andthe after-tax net interest expense is
After-tax net interest expense> Net interest expense x (1- Taxrate)
Finns are taxed on a schedule of tax rates,depending on the size of their income. Thetax
rate used in the calculation is the marginal tax rate, the highestrate at which income is
taxed, for interest expense reduces taxesat thisrate.Thismarginal rateis notto be confused
withthe effective tax rate, which is tax expense divided by income before taxin theincome
statement (and incorporates any tax benefits the firm generates). The effective tax rate is
304
Part Two TheAnalJsil of financial Statements
EXHIBIT 9.7
The Form of the
Reformulated
Comprehensive
Income Statement
(1) Operating items
areseparated from
financing items.
(2) Operating income
from sales isseparated
fromother operating
income. (3)Taxis
allocated to
components ofthe
statement, with no
allocation toitems
reported onan aftertax basis
Reformulated Comprehensive Income Statement

Net sales
- Exoenses togenerate sales
Operating income from sales (before tax)
- Tax onoperating income from sales
+ Tax asreported
+Tax benefit from netfinancial expenses
- Tax allocated toother operating income
Operating income from sales (after tax)
Other operating income (expense) reqUiring tax allocation
Restructuring charges and asset impairments
Merger expenses
Gains and losses onasset sales
Gains and losses onsecurity transactions
- Tax onother operating income
After-tax operating items
Equity share in subsidiary income
Operating items in extraordinary income
Dirty-surplus operating items in Table 8.1
Hidden dirty-surplus operating items
Operating income (aftertax)
- Net financial expenses aftertax
+ Interest expense
-Interest revenue
+ Realized oains and losses onfinancial assets
- Net financial expense before tax
- Tax benefit from netfinancial eXf?nses
Net financial expenses after tax
Gains and losses ondebt retirement
Dirty-surplus financial items in Table 8.1 (including preferred dividends)
Hidden dirty-surplus financing items
- Minority interest
- Comprehensive income to common
reported in footnotes, but it is not to be usedfor the tax allocation.. With littlegradation in
taxratesin theUnited States, themarginal rateis almost always themaximum statutory tax
rate for federal and statetaxes combined. Theseratesarereported in the taxfootnote or can
be inferred there.
Without the tax benefit of debt, taxes On operating income wouldbe higher, so the
amount of the benefit thatreduces the netinterest expense is allocated to operating income.
Thusthe tax on operating income is
Chapter 9 TheAnal)'5is ofUte Balance Sheer mulIncome Stlllemenl 305
Accounting Clinic
"
ACCOUNTING FOR INCOME TAXES

Income taxes are recorded by matching taxes with the
income thatdraws thetax, sotheanalyst understands the
after-tax consequences of earnings income {or losses}. As
theincome maynotbe taxed (on thefirm's taxreturn)atthe
same time as it isreported (in the income statement), this
matching leads to deferred taxliabilities anddeferred tax
assets.
VIAccounting Clinic VI takes you through the detais of

deferred taxaccounting and COvers other taxissues such
as operating loss carryforwards andvaluation allowances
against deferred tax assets. It also shows how taxes are
allocated over various components of income in reported
finandal statements.
operating loss (or NOL) for tax purposes can be carriedback and deducted from taxable
income in the previous two years or carriedforward to income for 20 future years. So a
firmlosesthe tax benefitonlyif the loss cannotbe absorbed intotaxable income overthe
carryback and carryforward periods.
Preferreddividends typically are not deductible in calculating taxes, so no benefit
arises. An exceptionis preferred dividends paid to an ESOP for whichthe tax benefit is
recognized as a dirty-surplus item and brought into the income statement. In a recent
innovation, firms issue preferredstock through a whollyownedtrust from which firms
borrowthe proceeds of the issue.In the consolidation of the trust intothe firm's accounts,
the firm gets the tax benefits of interest paid to the trust and recognizes the preferred
dividends paid by the trust.Tbis effectively gives the firm a tax benefitfor the preferred
dividends paid.
Returningto Exhibit9.7, you see that tax On financingactivitieshas been calculated
on items that attract or reducetaxes (interest),but not on items, such as preferreddividends, that do not, or on items that are reported after tax. The tax benefit fromfinancingactivitiesis then added to the reportedtax to calculatethe tax on operatingincome.
The tax on operatingincomefromsales is then reducedby the amountof tax that other
operatingincomeattracts. Accordingly, tax is allocatedwithin the statementto the inCOme it attracts, with components that reduce taxes allocated a negative tax. Box 9.3
gives a simple example and contrasts the top-down approach, outlined above, with a
bottom-up approach.
The tax allocation produces a revised effective tax rate that applies to the operations:
Taxon operating income = Taxexpense as reported + (Netinterest expense x Taxrate)

If there is net interest income (morefinancial assetsthan financial obligations), then the
financial activities attract taxratherthanreduce it, andthistax reduces the taxon operating
activities. In both cases,the idea is to calculate after-tax. operating income that is insensitive to the financing activities: Whatwould after-tax operating income be if therewere no
financing activities? Thisprovides a measure of the profitability fromoperations that takes
intoaccountthe tax consequences of conducting operations.
Theonecircumstance wherethis tax calculation is notdoneis whenthe firmcannotget
the benefit of tax deduction for interestexpense because it has losses for tax purposes.
In thiscase the marginal tax rateis zero.Butthis isnotcommonin theUnitedStates.A net
Effective tax rate for operations
TaxOn operating income

Operating income beforetax,equityincome,
and extraordinary and dirty-surplus items
Thebenefits of tax. planning (from usinginvestment tax. allowances andcredits, andlocating

operations in low-tax jurisdictions forexample) arisefromoperations. Theeffective taxrate
is a measure of thosebenefits. As income from equity in subsidiaries, extraordinary items,
anddirty-surplus itemsis reported aftertax,the denominator excludes theseincome items.
Accounting ClinicVI dealswiththe accounting for income taxes.
Before proceeding, lookat Box9.4.
"~'h~:'t~:rm' Op~(ating income isused to mean different things in

difference circumstances:
The allocation of taxes to calculate operating income aftertaxisapplied to the simple income statement on the leftusing a
top-down approach anda bottom-up approach. The firm hasa 35 percent statutory tax rate.
Revenue
Operating expenses
Interest expense
Income before tax
Income tax expense
Net income
Bottom-Up
Tax Allocation
Top-Down
Tax Allocation
GAAP
Income Statement
$4,000
(3,400)
(100)
SOD
(1SO)
S 350
Revenue
Operating expenses
Operating income before lax
Tax expense:
Tax reported
Tax benefit for interest
(S100xO.35)
Operating income after tax
$4,000
(3,400)
600"
Net income
Interest expense
Tax benefit
$350
$100
-12
--"'
$415
1. Even though GAAP does not recognize the term, firms
sometimes taga line in theirincome statement as Operating Income. However, theanalyst must becareful. Operatin'g income so reported often includes interest income on
financial assets and excludes some expenses associated
withoperations'."
2. Operating Income isused by(Wall) Street analysts to refer
to recurring income, that is, income adjusted forone-time
$150
(185)
Abnormal gains and losses in extraordinary items are, along with incomefrom discontinued operations, operatingitems, but gains and losses from debt retirement, also in
extraordinary items,are financing items.
$ 415
The top-down approach adjusts the reported taxfor that which applies to financing activities. The bottom-up approach
works upfrom the bottom line, netincome, andcalculates operating income after-tax asnetincome adjusted fortheafter-tax
financing component ofnet income.
The effective taxrateonoperating income is $185/$600 = 30.8%.Why isthis rateless thanthestatutory taxrate of 35 percent? Well, because operations generate taxbenefits. So, ifthefirm receives research anddevelopment taxcredits orcredits for
investment incertain industrial zones, it lowers itstax rate. These credits arise from operations, so theoperations areallocated
the benefit. Finandng activities draw nosuch benefit, soaretaxed at the statutory rate.
UnderGAAP, interestthat finances construction is capitalized into the cost of assetson

the balancesheet. It is treatedas a construction costjust likethe laborand materials that
go into the asset.This accounting practice confuses operating and financing activities;
laborand material costs are investments in assets,and interestcosts are costs of financing assets.The resultmay be that little interestexpenseappears in the incomestatement
for debt on the balance sheet. But it is difficult to unscramble this capitalizedinterest:
It is depreciated, along with other construction costs, throughto the income statement
and so is hardto trace.As the depreciation expensethat includes interestis an operating
expense,the practicealso distortsthe operatingprofitability.
Reformulated statementscan be preparedfor segmentsof the finn-from the detailprovided in the footnotes-to revealmore of the operations.
Issues in Reformulating Income Statements

Apart from the tax allocation, reformulating the income statement, as with the balance
sheet, is a mechanical reclassification exercise. But, as with the balancesheet, the analyst
must knowthe business. Interestincomeis usuallyearnedon financial assets,but interest
income on a finance receivable from financing customer purchases is operatingincome.
The following issuesarise in the reformulation:
Lackof disclosure is often a problem:
The share of incomeof a subsidiary may include both financing incomeand operating income,but the twocomponents are often not identifiable. As the investment in the
subsidiaryin the balance sheet is identified as an operating item, so shouldthis correspondingincomestatementitem.
Dividingcurrency translation gains and losses into financing and operatingcomponents is often difficult.
Detailingsome expenses is often frustrating. ln particular, selling, administrative,
and generalexpensesare usually a large numberwith little explanation provided in the
footnotes.
Interestincomeis oftenlumped togetherwith"otherincome"fromoperations. If this
is the case, estimateinterestincomeby applying an interestrate to the average balances
of financial assets duringthe period. If financial assets are all current assets,this rate is
the short-terminterestrate.
i
I
II
I I
306
charges such asrestructuring charges andgains from asset

sales.
3. Firms sometimes refer to operating income-orproforma
income-in their press releases as different from GAAP
income. Be particularly careful in this case. These pro
forma income numbers sometimes exclude significant
expenses.
4. Operating income isalso used intheway itisdefined inthe
chapter. As such, it also goes under the name of NOPAl,
net operatingprofitafter tax. Sometimes it isreferred to
as enterpriseincome.
Analysis of the equity statementis a prerequisite for the reformulation of the income
statement, for that reformulation identifies dirty-surplus items-including the hidden
items-that have to be brought into the incomestatement. Exhibit 9.8 gives the reformulated equitystatementfor Nike, with comprehensive income-to which the reformulated
incomestatementmust total-identified.
EXHIBIT 9.8
Reformulated
Statementof
Shareholders' Equity
for Nike, Inc.
(in millions).
Thestatement identifies
SI,931.8 million in
comprehensive income.

Transactions withshareholders
Stock issued for stock options
Stock issued to employees (net)
Stock repurchased
Cash dividends
Net income reported
Net translation gains andlosses
Net hedging gains andlosses
Prior earnings restatements
Balance at May 31,2008
$7.118.3
$ 372.2
35.8
(1,248.0)
(412.8)
(1,252.8)
1,883.4
165.6
(91.6)
--lill)
307
308 Part Two TheAnalysts of Financial Stotements
Chapter 9 TheAnalYlts of the Balance Sheet andIr.rome Statemenr 309
Exhibit 9.9gives theGAM comparative income statementforNikefor2008,alongwith

the reformulated statement. Notethe following in the reformulated statement (numbers flag
itemsin the exhibit):
1. Dirty-surplus items have been brought into the statement so the "bottom line" for
2008 is the comprehensive income calculated in Exhibit 9.8 (and so for 2007 and
2006).
2. The reformulation distinguishes operatingincome that comes from sales from operatingincomethat doesnot comefromsales.This distinctiongivesa clean measureof
the profit margin from sales and also a clean measure of the effective tax rate on
operating income. Operating income from items reported net of tax are separately
identified
3. Taxes havebeen allocated usingfederal and statestatutoryrates, 35percentforthe federal rate plus the state 1.4percentrate.The rates are ascertained fromthe tax footnote.
Nike's effective tax rate on operating income from sales for 2008 is 24.06 percent
(569.312,365.2 = 24.06%).
4. Detailon expenses has been discovered in the footnotes. However, more detailon the
largeadministrative and general expenses is not available. You will often be frustrated
by sucha lack of disclosure.
The reformulation of Nike's financial statements for prior years is continued on the
BYOAP feature on the book'sWeb site.SeeBox 9.5.
EXHIBIT 9.9
GAAPConsolidated
Statements of Ineome
and Reformulated
IncomeStatements
for Nike,Inc.,
2006-2008.
The reformulated
statement reformats
theGAAPstatement
into operating income
(operating revenue
minus operating
expense) and net
financial income
(financial income
minus financial
expense), adds dirtysurplus income items,
and makes the
appropriate tax
allocation. Numbers
to the right ofthe
reformulated statement
refer topoints onthe
reformulation inthe
text.
NIKE, INC.
GAAPIncome Statements
(inmillions, except per-share data)
Year EndedMay
2008
Revenues
Cost ofsales
Gross margin
Selling andadministrative expense
Interest income, net(Notes 1, 6, and 7)
Other (expense) income, net (Notes 15 and 16)
Net income
Basic earnings percommon share
(Notes 1 and 11)
Diluted earnings percommon share
(Notes 1 and 11)
Dividends declared percommon share
NOles refer to notes in the publilhedst>.temen~. Refer 1020081OK.
$18,627.0
10,239.6
8,387.4
5,953.7
77.1
---221
s
2,502.9
619.5
1.883.4
3.80
3.74
0.875
2007
2006
$16,325.9
9.165.4
7,160.5
5.oz8.7
67.2
0.9
2,199.9
~I
2,141.6
---
2.96
---
2.69
2.93
2.64
0.71
0.59
$ 1,491.5
$14,954.9
8,367.9
6,587.0
4,477.8
36.8
$ 1,392.0
EXHIBIT 9.9 (<ondud'd)

Reformulated Income Statements
2008
Operating revenues
Cost ofsales
Gross margin
Operating expenses
Administrative expenses
Advertising 1
Other income {expense}2
Operatingincomefromsales (beforetax)
Taxes
Taxes as reported
Tax on financial items andother
operating income (28.1 +22.1 in 2008)3
Operating incomefromsales(aftertax)
Other operating income(beforetax items)
Gains on dNestitures 2
Tax on divestiture gains3
Other operating income (after tax items)
Currency translation gains (losses}4
Hedging gains (losses)4
Effect ofaccounting changef
Operatingincome(after tax)
Financing income(expense)
Interest income!
Interest expense
Net interest income
Tax effect (at 35.4%~
Net interest expense aftertax
Preferred dividends 6
Net financing income aftertax
2007
16,325.9
9,165.4
7,160.5
3,545.4
2,3083
3,1163
1,912.4
0.9
2132.7
~)
2,355.2
619.5
150.2)
60.6
22.1
2006
18,627.0
10,239.6
8,387.4
708.4
5693
1,795.9
(24.5)
14,954.9
8,367.9
6,587.0
2,737.6 (4)
1,740.2 (4)
~I (4)
2104.8
749.6
683.9
1,448.8
~I
736.3 (3)
1,368.6 (21
38.5
(2)(3)
165.6
(91.61
84.6
(16.7)
~)
135.5
1,652.2
1,882.7
115.8
38.7
116.9
--.2:Q
~
67.2
24.5
42.7
0.0
~
1,931.8
1,694.8
77.1
28.1
49.0
42.7
87.1 (1)(2)
(38.81 (1)(2)
11.5 (1)(2)
1,428.4
87.3 (4)
--.2Q.l.
36.6
13.3 (3)
233
0.0 (11
23.3
1,451.8 (11
IBm ." outfromsellingandadministr.ltive eo;penses.
loth.:r expenses intheGMP stal=l in2008iaelu<kd gam.. fromdivestitures.

lSlatutory tax rate is 36.4%. including bothfederal md Slatetaxes. See: taxfootnote.
'These ill:tnS ee dirty-surplus income reported in the equity.tl.tement
llnim.st inromeis nettedagoiMlinteRslexpense in eeGMP ~en!.l.
61'refem:d dividends arelessthan SO.OS millionSomecolumns may 1101 adddueto rounding emll".
Value Added to Strategic Balance Sheets

A reformulated income statement identifies theearnings flowing from thestrategic balance
sheet; operating income reportsthe earningsflowing fromthe net operating assets; andnet
financing income (expense) reports the earnings flowing from the net financial assets
(obligations).
Exhibits 9.10 and 9.11 presentthe reformulated income statements for Dell, Inc., and
General Mills,Inc. Dell reports net financial income flowing fromthe large net financial
Chapter9 The Analysis of the Balance Sheel andIncome SW-tement 311
Thereformulation of Nike's 2006-2008financial statementsinthischaptercontinues an analysis ofthe firm on the Build Your
Own Analysis Product{BYOAP) featureon the book'sWeb site.By goingto thisfeature,youcantraceNike overan extended
period, giving yourself more information for a valuation in 2008. Below are some summary numbers from the reformulated
statements on B'i'OAP (inmillions of dollars).
Sales
Netfinancial obligations
Common shareholders'equity
EXHIBIT 9.10
Reformulated Income
Statement for Dell,
Inc.,for FiscalYear
2008
2007
2006
2005
2004
2003
2002
18,627
1,883
1,932
5,806
(1,992)
7,797
16,326
1,652
1,695
4,939
(2,179)
7,118
14,955
1,428
1,452
4,916
(1,499)
6,364
13)40
1,457
1,433
4)82
(939)
5,721
12,253
1,035
1,019
4,551
(289)
4,840
10,697
424
406
4,330
302
4,028
9,893
620
599
4,460
616
. 3,495
DEll. INC.
Reformulated Comparative Income Statementfor Fiscal Year 2008
(in millions ofdollars)
2008
Dell'scomprehensive
income comes from
revenues from
customers, other
operating income, and
net financing income
fromits considerable
netfinancial assets.
Eachcomponent of
the income statement
carries the appropriate
tax allocation.
310
YearEnding February 1
2008
Operatingrevenues
Cost of revenue
Gross margin
Operatingexpenses
Administrative andgeneral expenses
Advertising expenses
Operatingincome fromsales (beforetax)
Taxes
Taxes as reported
Taxes on netfinancial income
Operatingincome fromsales (aftertax)
Other operating income (allafter tax)
Foreign currency translation gain(loss)
Unrealized gain (loss) on derivatives
Other
Operatingincome (aftertax)
Financing income (expense)
Interest income
Interest expense
Net interest income
Tax effect (at 35%)
Net interest income aftertax
Unrealized gains (losses) on financial assets
Net financing income after tax
880
(135)
2007
61,133
49,462
11,671
57,420
47,904
9,516
6,595
943
693
3,440
5,112
836
498
3,070
745
2,695
17
(38)
----2")
2,618
762
(96)
666
2,404
(11)
30
23
2,446
302
27
410
23
387
135
275
96
179
31
252
56
~
2,926
---.llQ
2,656
EXHIBIT 9.11
Reformulated Income
Statement for
General Mills,Inc"
forFiscalYear 2008
General Mills's
comprehensive income
COmes from revenues
from customers and
before-tax andaftertax otheroperating
income, lessnet
interest expense on its
netfinancial
obligations.
GENERAL MillS. Inc.

Reformulated Comparative Income Statementfor Fiscal Year 1008
YearEnding May 25
2008
Operating revenues
Cost ofsales
Gross margin
Administrative andgeneral expenses
Advertising
Operating income fromsales(beforetax)
Taxes
Taxes as reported
Tax benefit on otheroperating expense
Tax benefit on net interest
Operating income fromsales(aftertax)
Other operatingIncome (before-tax items)
Restructuring andimpairment charges
Tax effect (at385%)
Otheroperating income (after-taxitems)
Earnings fromjoint ventures
Gain (loss) on hedge derivatives
Other
Netfinancing expense
Interest expense
Interest income
Net interest expense
Tax effect (at 38.5%)
Net financing expense after tax
Comprehensive income 1
2007
13,652
8,778
4,874
1,792
628
12,442
7,955
4,487
1,655
543
......1Q2
~
2,097
2,249
622
8
170
560
15
.......1QQ
1,449
21
_8
(13)
111
246
(2)
110
1,901
449
27
422
(170)
----l]2
1,358
39
15
(24)
73
194
22
~)
1,602
458
__3_1
427
~)
252
-2
1,649
1,339
IGen.",1 Millsdid1I01.sep=:'lyidentify(thep~umably small)minoriiy inlOf05t ineamings.
assetsin its strategic balance sheetwhileGeneral Millsreportsnet financial expense flowin~ fromits considerable net financial obligations. In bothcases,operating income thatperms to ~e net operating assetsis separated fromthe financing income, and thatoperating
mcome lS broken down into operating income from sales and other operating income.
Dell's otheroperating income has only after-tax items, but General Mills's statement has
tax allocated to before-tax itemswithinotheroperating income: Restructuring charges and
impairment losses are tax deductions, so reducetaxes.
Reformulated income statements and balance sheetsare designed to identify the value
added to the strategic balance sheet. The focus is on the operating activities, for that is
wherethe firm trades with customers and suppliers to add value. We calculated residual
earnings for the equity in Chapter 5, but nowwe can identify residual earnings from the
:a
312 Part Two TheAllillysis of Financial Statements
Chapter9 TheAllillY5is of meBalance Sheet andIncome SCOlemen! 313
operating component oftheshareholders' equity. Thevalue-added measure isreferred to as

residual operating income(ReOI). It is calculated as
Residual operating income, = Operating income, - (Required return X
Netoperating assetscr)
ReOI,=OI,-(p-I)NOAH
Here01 isoperating income from thereformulated income statement, andNOA isnetoperating assets atthebeginning oftheyear. Iftherequired returnforGeneral Mills is 9 percent,
residual operating income for2008 = $1,901- (0.09 x 12,297) =$794.3.3 million. Thatis,
General Millsadded $794.3 million inoperations overthe operating income required for a
normal returnonthebookvalue ofoperations.
Dell provides an illuminating case of how reformatted strategic balance sheets and
income statements identify the sources of value creation. When discussing the strategic
balance sheet,wepointed outthatDell'snegative netoperating assets mean thatitsshareholders havenegative investment in the business andthat negative investment means they
canwithdraw cashfrom thebusiness andinvest it elsewhere. Residual 2008 operating earningsforDell(with a required return of 10percent) is
ReOI'00S = $2,618 - (0.10 x -$7,209)= $3,338.9 million
Dell's residual operating income from operations is actually greater than its operating
income! Why? Well, the negative net operating assetsmeans that Delleffectively runs a
fioat that shareholders can invest elsewhere at 10percent, and this value-adding feature
is picked up in the residual operating income calculation. The reformulated statements
identify two drivers of residual operating income: Operating income from trading with
customers plusthe value of strategically structuring operations to deliver a float. In valuing Dell,we willkeepthesetwodrivers in mind: DellcangrowReO! by increasing sales
and margins to produce operating income in the income statement and also by expanding the float in its management of assets and its relationships with customers and
suppliers.
COMPARATIVE ANALYSIS OF THE BALANCE SHEET

AND INCOME STATEMENT
Tomake judgments abouta firm's performance theanalyst needs benchmarks. Benchmarks
are established by reference to otherfirms (usually in the same industry) or to the same
finn'spasthistory. Comparison to otherfirms is called cross-sectional analysis. CompariSOn to a firm's own history is called time~series analysis. Financial statements areprepared
forcross-sectional comparisons usingthe techniques of common-size analysis. Thestatements are compared overtimeusing trend analysis.
Common-Size Analysis
Common-size analysis is simply a standardization of line itemsto eliminate the effect of
size.Lineitemsareexpressed perdollarof anattribute thatreflects thescaleof operations.
However, if thatattribute is chosen carefully, and if reformulated statements are used, the
scaling will reveal pertinent features of a firm's operations. And when compared across
firms, or across time, common-size statements willidentify unusual features that require
further investigation.
EXHIBIT 9.12
Comparative
Common-Size
IncomeStatements
for Nike,Inc.,and
General Mills, Inc.,
for 2008.Dollar
amountsin millions.
Percentages are per
dollar of sales.
Common-size income
statements reveal the
profitability of sales
andtheeffect of each
expense item on the
profitability of sales.
Nike
s
Revenue
Cost ofsales
Gross margin
Operating expenses
Administrative
Advertising
Other expense
Operating income fromsales
(beforetax)
Tax on operating income from sales
Otheroperating income fromsales
(aftertax)
Other operating income
Net financing income (expense)
Comprehensive income to common
General Mills
18,627
10,2.40
8,387
100.0
3,645
2.308
~
$r
13.652
8,778
4,874
100.0
64.3
35.7
19.6
12.4
1,792
628
13.1
46
--M
...1Q2
.-J2
16.5
55.0
45.0
2.365
12.7
2,249
....l.J
21
1,796
9.6
0.5
10.1
03
10.4
1.449
452
1,901
10.6
87
1,883
49
1.932
Je?l
1,649
33
13.9
~I
12.1
Common-Size Income Statements

Exhibit 9.12placesNike's and General Mills's reformulated 2008 income statements On
a common-size basis. Revenues and expenses, alongwithnet comprehensive income, are
expressed as a percentage of the revenue.
Thecomparative common-size statements reveal twothings:
How firms dobusiness differently andthedifferent structure ofrevenues andexpenses that
result. Looking at operating expenses, thefirms have similar costcomponents, butNike
hasthelowest costofsalesperdollar of revenue (55.0 percent) andthusa higher percentagegross margin (45.0 percent). General Mills maintains the lowest administrative expenses at 13.1 percent of sales, andhaslower advertising expenses (4.6percent ofsales).
Operating profitability per dollarof sales. Aseachoperating itemis divided through by
salesrevenue, the common-size number indicates theproportion of eachdollarof sales
the itemrepresents. Thusthenumber foran operating expense is thepercentage ofsales
thatis absorbed bythe expense, andthe number foroperating income is thepercentage
of salesthatendsup in profit. The latter is particularly important:
Operating profit margin fromsales= Operating income from sales(aftertax)/Sales
Nike's profit margin from salesis 9.6percent, compared witha 10.6 percent margin for
General Mills. Ratios also can be calculated for operating income before tax and for
total operating income, asintheexhibit. Reviewing theexpense ratios, weseethatNike,
despite a higher percentage grossmargin, had a lower profit margin thanGeneral Mills
primarily because of higher administrative and advertising expenses.
Thefinal comprehensive income number, expressed as a percentage ofsales, isthe(comprehensive) netprofit margin. Thecomparison of thisnumber totheoperating profit margin
reveals how much thefirms increased or decreased theirprofits through financing activities.
Nike earned a net 10.4 centsof comprehensive income forevery dollarof sales, compared
to 12.1 centsforGeneral Mills.
314 Part Two TheAnal)'sis of Financial Sr'lICmCllD:
Chapter 9 The A11Il1)'5is of the Balance Sheet and Income $ituemem 315
EXHIBIT 9.13
Nfke
Comparative
Common-Size
BalanceSheetsfor
Nike, Inc" and
General MillsInc.,
for 2008. Dollar
amountsin millions.
Common-size balance
sheets revealthe
percentage makeup of
operatingassetsand
operatingliabilities.
Operating assets
Operating (ash
Accounts renewable
Inventories
Prepaid expenses
General Mills
IncomeStatement
93
2,795
2,438
0.9
50
0.3
28.6
25.0
1,082
1,367
7.4
5.9
602
6.2
511
2.8
1,891
19.4
3,108
16.9
Goodwill
449
46
6,786
36.8
Identifiable intangibles
743
7.6
3,777
20.5
Deferred taxesand otherassets
748
7.7
1,750
9.5
9,760
100.0
18,431
100.0
Accounts payable
1,222
Accrued liabilities
1,790
income taxes payable
88
854
3,954
5,806
Deferred taxesandother
EXHIBIT 9.14 Trend Analysisof Selected Financial Statement Items for Nike, Inc., 2004-2008.Base = 100 for 2003.
Trendanalysisrevealsthe growthor decline in financial statementitemsovertime.
30.9
453
937
16.8
3,164
56,7
1,483
5,584
12,847
26.6
100.0
Sales
Costof sales
Gross margin
Operating expenses
Operating incomefrom sales (before tax)
Operating incomefrom sales (after tax)
Operating income
Comprehensiveincometo common
2007
2006
2005
2004
174.1
162.2
191.3
186.4
205.3
236.9
152.6
145.2
163.4
155.6
185.2
191.1
389.8
417.6
139.8
132.5
150.3
138.7
182.7
180.5
337.0
357.7
128.4
120.8
139.5
129.7
166.9
167.9
338.9
353.2
114.5
110.9
119.8
116.9
128.1
126.8
244.1
251.1
10,697
6,314
4,383
3,232
1,152
115.0
137.1
1023
122.4
168.7
120,8
142.6
113.5
-479.6
158.0
108.6
119.6
99.1
112.9
151.2
92.0
118.7
110.4
-310.9
142.0
101.7
108.9
99.4
108.1
140.8
92.7
114.9
105.1
-95.4
120.1
2,084
1.515
1.521
6,241
444.2
475.9
758
424
406
BalanceSheet
2.2
21.6
100.0
Base in 2003
($ millions)
2008
Common-Size Balance Sheets

Common-size balance sheets often standardize on total assets, but a more informative
approach, usingreformulated statements, standardizes operating assetsand liabilities On
their totals. The operating section of the comparative common-size balance sheets for
the two firms is shown in Exhibit 9.13. The percentages describe the relative composition of the net assets in the operating activities. You can easily spot the differences
when thebalance sheets are in this form; compare the relative amounts of investments in
accounts receivable, inventory, property, plant, and equipment, and so on, for the two
companies.
Trend Analysis
Exhibit 9.14 presents trends forNike,Inc.,from 2004 to 2008. Thenumbers onwhich the
analysis is basedarein theBYOAP toolon the text's Web site.SeeBox9.5.Trend analysisexpresses financial statement items asan index relative to a baseyear. In Nike's case, the
index is 100 forthe baseyearof2003.
Trend analysis gives a picture ofhowfinancial statement itemshavechanged over time.
The index for net operating assets indicates whether the finn is growing investments in
operations, andat what rate,or is liquidating. Theindex forcommon stockholders' equity
tracks the growth or decline in the owners' investment. And the index. for net financial
obligations tracks the net indebtedness. Similarly, the indexes for the income statement
trackthe income and the factors thataffect it. Of particular interest are sales, operating
income, andcomprehensive income.
Thepicture drawn forNike is oneofsalesgrowth overthefive years, resulting ingrowth
in operating income from sales, after tax, of 136.9 percent andgrowth in comprehensive
income of 375.9 percent overthe five years. The indexes for specific line itemsindicate
Accounts receivable
Inventories
Property, plant. and equipment. net
Operating assets
Accounts payable
Accrued liabilities
Net financialobligations
Commonshareholders' equity
134.1
161.0
116.7
156.4
233.5
179.1
206.9
134.1
-6593
193.6
119.7
140.1
103.5
126.9
1903
121.1
156.1
114.1
-721.4
176.7
523
999
1.911
4330
302
4,028
where the growth hascomefrom, and year-to-year changes indicate the periods thathave
contributed mosttogrowth. Costofsaleshasgrown slower thansales and, correspondingly,
grossmargins have grown at a higher ratethansales. From thebalance sheettrends, weobserve that net operating assetshave grown slower than sales, indicating that,as timehas
evolved, moresaleshave beenearned foreachdollarinvested inthese assets.
Year-to-year changes in the index represent year-to-year growth rates. For example,
Nike's 2008 salesgrowth rate was {174.l - 152.6)/152.6, or 14.1 percent, compared with
the2007 growth rateof{152.6 - 139.8)/139.8, or 9.2percent. Comparisons of growth rates
raisequestions for the analyst. In 2006, salesgrew by 8.9percent, but inventories grew by
a much largeramount, 14.6percent. Why? Was the inventory buildup due to Nike having
trouble moving inventory, indicating lower demand andsalesrevenue inthefuture? Orwas
Nike building up inventory in anticipation of higher demand in the future? Why didoperating expenses growfaster thansalesrevenue in 2008? Such questions provoke theanalyst
to further investigation.
Common-size and trend analysis can be combined by preparing trendstatements on a
common-size basis. Thisfacilitates the comparison of onefinn's trends withthose of comparable firms.
PROFIT MARGIN RATIOS

Profit margins are the percentage of sales that yield profits:
Operating profit margin (PM)
01(after tax)
items' PM is0.5percent, soits total operating profit margin ."\~

10.1 percent.
15\
The bottom-line margin ratio is
Net (comprehensive)
income profit margin
Sales
This profit margin isbased on the total operating income on

the last lineof operating income before financial items. It can
bedivided into profitmargin from income generated bysales
andprofit margin from income thatdoesnotcome from sates:

Sales PM == 01 (after tax) fromsales
Sales
Nike's bottom-line margin in2008 is 10.4 percent.

EXPENSE RATIOS
Expense ratios calculate the percentage ofsales revenue that
isabsorbed byexpenses. They have theform
Sales
Ecenseratio Expense
,
Sales
Other items PM::: 01 (aftertax) fromotheritems

Sales
These two margins sum to the operating profit margin. The
most common otheriteminthe income statement istheshare
of income (or loss) of subsidiaries. This income is from sales
reported in the subsidiary, not from the reported sales in the
This ratio is calculated for each expense item in operating

income from sales so
1 - Sales PM :=; Sum of expense ratios
Expense ratios aregiven inExhibit 9.12. Cost ofsales for Nike

absorb 55.0 percent of sales. The firm's total expense ratios
the profitability of thesales inthe parent's income statement Sum to 87.3 percent before taxand 9004 percent after tax,
results in an incorrect.assessment of the profit margin on with the remaining 9.6 percent of sales providing operating
sales. Nike's sales PM ih.6 percent in Exhibit 9.12, itsother income after tax.
parents income statement Including it in the analysis of
RATIO ANALYSIS
From the reformulated statements, we can calculate the two ratios that were introduced
in Chapter 7 to summarize the profitability of the operating activities and the financing
activities: return on net operating assets (R1\lOA), which is operating income after tax
relative to net operating assets, and net borrowing cost (NBC), which is net financial
expenses after tax relative to net financial obligations. If a firm has net financing assets
(ratherthan net financing obligations), likeNike, the profitability of the financing activities
is measured by returnon net financial assets(RNFA).
For Nike, Inc., the return on net operating assetsfor2008was
RNOA
1,883
1,(5,806+4,939)
35.0%
Nike's2008net returnon net financial assets was

49
RNFA
1,(1,992+2,179)
,1
2.3%
ForGeneral Mills, the 2008RNOA was

RNOA
1,901
1,(12,847+ 12,297) "
15.1 %
'bMPOSITION RATIOS
FINANCIAL LEVERAGE
he percentages in common-size balance sheets (as in A second leverage ratio gives the relative size of netfinancial
hibit 9.13) are composition ratios:
assets orobligations. General Mills has netdebtin2008,while
Nike holds net financial assets. The differences are captured
..
.
Operating asset
byratios thatcompare totals for netoperating assets andnet
.
Perating asset ccmpcsmon reno e -Iota 1operating
assets
financing obligations to owners' equity.
These ratios are
Operating liability
Operating liability
composition ratio Total operating liabilities
Capitalization ratio::: NOAfCSE
The ratios for individual items sum to 100 percent within their
.;: category.
and
Financial leverage ratio (FLEV) '" NFO/CSE
which isnegative ifthe firm haspositive net financial assets.

':OPERATING LIABILITY LEVERAGE
Finandalleverage is thedegree towhich netoperating assets
The composition ofnetoperating assets can behighlighted by arefinanced by common equity. Itisalways thecase that
comparing operating liabilities to netoperating assets:
Capitalization ratio - Financial leverage rato e 1.0
. ..
Thus,
either measure can be used asan indication of the deOperating liability leverage (OLLEV) :::
.
gree to which net financial assets arefinanced bycommon
equity or net financial debt, but it is usual to refer to the
The operating liability leverage ratio gives an indication of financial leverage ratio. Itiscalled a leverage ratio because, as
how theinvestment innetoperating assets has been reduced we will see in Chapter 11, borrowing levers the ROCE up or
by operating liabilities. Itiscalled a leverage ratio because it down.
can lever up the return on netoperating assets (RNOA) with
General Mills had a capitalization ratio of 1.99 and a
alower denominator (as wewill seeinChapter 11). For Nike, financial leverage ratio of 0.99 in 2008. Nike's financial leverthe operating liability leverage ratio at the end of 2008 is ageratio in2008was -0.26 percent and itscapitalization ratio
68.1 percent compared to 43.5 percent for General Mills. The was 0.74 percent
operating liability composition ratios reveal which liabilities
have contributed to theoperating liability leverage.
and the net borrowing cost was

N'BC
252
=4.1%
1,(6,389 + 5,839)
Thesereturnsare, of course,aftertax (andafterthe taxbenefit of debt). Thecalculations

use theaverage of beginning and endingbalances in the denominator; theycanbe inaccurate if thereare largechanges in balancesheetitemsotherthan halfway through the year.
Net borrowing cost is particularlysensitive to the timing of largechanges in debt. Always
compare the NBCagainst the cost of debt reported in the debtfootnotes, as a check.
These profitability ratios will be analyzed in detail in Chapter 11. The common-size
analysis of the statementsyield a numberof ratiosthat will be used in thatanalysis. These
ratiosare summarized in Boxes9.6 and 9.7.
Bothprofitability and growthare relevant for forecasting residual earnings. Trend analysis that documents past growth yields a number of growth ratiosthat will be used in the
analysis of growthin Chapter 12.See Box9.8.
Box9.9maintains the Accounting Quality Watch begunin the lastchapter.
316
317
Trend analysis reveals growth. Four particular year-to-year

growth rates are important to the growth component of
Growth in NOA = Change in netoperating assets

Beginning NOA
valuation:
Growth fateinsales
Change insales
Prior period' 5sales
Growth in CSE
Change in CSE
Beginning CSE
Growth rate in _ Change in operating income (after tax)

operating income Prior period's 01
The Accounting Quality Watch, begun in Box 8.7 inthe lastchapter, continues herewitha listof quality issues inthe balance
sheet.The quality of the accounting in the balance sheet alsoaffects the income statement, as indicated below. TheQuality
Watch continues inthe next chapter withthe quality of cashflows. Further earnings quality issues are identified inthe Quality
Watch inChapter12, where sustainable earnings arethe focus.
Accounting Item
Assets
Held-to-maturity
debtinvestments
Held-to-maturity
equity investments
Summary
We can put what we have done in this chapter in perspective by listing eight steps for
financial statement analysis:
L Reformulate the statement of stockholders' equity on a comprehensive income basis.
2. Calculate the comprehensive rateof retumon common equity, ROCE, andthe growth in
equityfromthe reformulated statement of common stockholders' equity.
3. Reformulate the balance sheet to distinguish operating and financial assets and
obligations.
4. Reformulate the income statement on a comprehensive-income basis to distinguish
operating and financing income. Makesuretaxesare allocated.
5. Compare reformulated balancesheetsand income statements with reformulated statements of comparison firms through a comparative common-size analysis and trend
analysis.
6. Reformulate the cashflow statement.
7. Carry out the analysis ofROCE.
8. Carry outan analysis of growth.
I
I
Chapter8performed the firsttwosteps. Thischaptercovers Steps3-5, the nextchapter

covers Step6,andthe analysis ofROCEandgrowth in Steps7 and 8 is donein Chapters 11
and 12.
Reformulation of the income statement and balance sheet is necessary to calculate
ratiosthat correctly measure the results of the firm'sactivities. Iffinancingitemsare classified as operating items, we get an incorrect measure of both operating profitability
(RNOA) andfinancing profitability (NBCor RNFA). Thischapterhasled youthroughthe
reformulations. Reformulation looks like a mechanical exercise. But it requires a good
knowledge of the business, an understanding of how the firm makes money. Indeed,
reformulation promptsthe analystto understand the business better.It requiresher to dig
into the footnotes and the management discussion and analysis to understand the GAAP
statements and to incorporate moredetail in the reformulated statements. Witha rich set
of reformulated statements accompanied by comparative common-size and trend statements, the analyst is preparedto proceedto the analysis of profitability and growth in
Chapters 11and 12.
You will sometimes find that lack of disclosure makesit difficult to classify items into
operating and financing categories. The problem can be serious if a significant portionof
earnings is in shares of subsidiaries' earnings under the equity method (where the firm
holds less than 50 percent of the equity of a subsidiary). Reconstructing consolidated
318
Marked-to-market
equity investments
available forsale
Receivable
allowances
Deferred taxassets
Goodwill
liabilities
Deferred (unearned)
revenue
Accrued expenses
Lease obligations
Pension liabilities
Dividends payable
Contingent liabilities
Other liabilities
Preferred stock
The Quality Problem

Held-to-maturity debtinvestments (typically classified asfinancial assets) arecarried at historical
cost. This may not indicate their "cash value." Identify market values from footnotes ifavailable.
(Historical costisusually a reasonable approximation ofmarket valoe.)
"Held-to-maturity" equity investments (permanent investments) arecarried at historical costwhen
they involve less than20 percent ownership ofanother firm (see Accounting Clinic III). Sothebalance
sheet doesnotgive an indication ofthevalue of theinvestments. Nor doesthe income statement Only
dividends from the investments arerecorded there, anddividends arenotan indicator ofvalue. The analyst needs to find a market value forthe securities (iftraded) oridentify the share of income inthe investee, asinthe equity method.
Marking equity investments to market solves the problem ofthe held-to-maturity treatment.
However, further issues arise. First, unrealized gains andlosses from the marking to market are
notreported inthe income statement but rather intheequity statement. This notonly mlsreports the
performance ofthe equity portfolio inthe income statement. butitalso permits firms to "cherry pick"
realized gains into the income statement andreport unrealized losses intheequity statement. (Reformulating the income statement on a comprehensive-income basis solves the problem} Second, market
prices canbe bubble prices, so bubbles arebrought into thefinancial statements. (They canalso bedepressed prices inan illiquid market.) Third, fair-value accounting allows estimates ofthe market price
when market prices arenotsvejebe-eo-called level 3 estimates-and these estimates canbesuspect.
Allowance forbaddebts canbebiased. Decreases inallowances increase earnings (through
lower bad-debt expense) andincreases decrease earnings. The same issue arises with allowances on
otherassets, for example, a bank's allowance against loans for default
Deferred taxvaluation allowances reduce deferred taxassets forthe probability thatthe taxbenefit will
notmaterialize. The estimates involved aresuspect, andearnings canbe increased bychanging the
allowance. Refer to thedeferred taxfootnote for details ofthe valuation allowance.
The price paid foran acquisition isdivided between thefair value of identifiable (tangible andintangible)
assets acquired andgoodwill. />s tangible andintangible assets have to besubsequently depredated or
amortized against earnings, firms might allocate more ofthe purchase price to goodwill (that isnot
amortized, butrather subject to impairment).
Revenue must be recognized asgoods areshipped or services performed. With multiyear contracts,
firms defer revenue to later years when performance takes place, creating a deferred revenue liability.
The amount deferred issubject to judgment: Firms candefer too little (aggressive revenue recognition)
ortoo much (conservative revenue recognition). ineither case, current revenues may notbea good
indication offuture revenues.
These areoftenestimates thatcanbe biased. Watch particularly forestimated warranty liabilities (for
servicing warranties andguarantees on products) andestimated restructuring costs.
Lease obligations, under capitalized leases. areon the balance sheetbutthoseforoperating leases are
not. Check the footnotes foroff-balance-sheet lease obligations.
This involves a number of actuarial assumptions andthe choice ofa discount rate, soisa "soft" number.
Pension expense (in the income statement) isaffected by changes inthe estimated liability from changing these assumptions.
This should be classified asshareholders' equity, nota liability.
Check thefootnotes forany off-balance-sheet, contingent liabilities (for product liability or environmental
clean-up lawsuits. forexample).
Dig into footnotes to seewhatthese involve.
GAAP classifies preferred stock asequity (or, ifit isredeemable, between liabilities andequity). This isa
liability from the common shareholders' point ofview.
319
Chapter 9 TheA,wlJ5is of the Balance Shw and Income Srawnm! 321
320 Part Two TheAna!)'5is of Financial Slatements
Find thefollowing on theWeb page for thischapter:

Further examples of reformulated balance sheets and
income statements.
Further discussion ondistinguishing between operating
and financing items.
obligation is recognized on thebalance

sheet. 295
operatingliabilityleverage isthe degree to
which investment in net operating assets
is made by operating creditors. 317
residual operating income(ReOI) is
operating income in excess of the net
operating assetsearningat the required
return. 312
statutory tax rate is the tax rateapplied
to corporate income by statute. 304
A discussion of financial disclosure (and lack thereof)

and how poor transparency in the financial reports
frustrates theanalyst.
Directions to finding tax rates.
The Readers' Corner.
strategic balance sheet is a reformulated

balance sheetthatgivesinsight intohow
thebusiness is organized. 299
tax allocation involves attributing income
taxesto the appropriate component of
income thatattracts the taxes. 303
tax shield is the effectthat interest on debt
has of reducing corporate taxes. 303
trend analysisexpresses financial
statement itemsas an index relative to a
baseyear. 314
statements, or preparing statements on a segmented basis, helps rectify this problem. But
to the extentthat disclosure is insufficient, profitability measures will be lessprecise. Atthe
otherextreme, if disclosures-con the profitability of segments, forexample-are plentiful,
the analysis is improved.
Key Concepts
capital lease is a leaseof an assetfor

substantially all of the asset'suseful life
and for whicha leaseasset and a lease
obligation are placedon the balance
sheet. 295
consolidationaccounting is the
accounting processby whichfinancial
statements forone or more related firms
are combined intoone set of financial
statements. 294
effective tax rate is the average tax rateon
income. 303
enterprise assets are the net assetsusedin
operating activities, otherwise callednet
operating assets (NOA). 291
enterprise incomeis income fromthe
firm's operations, otherwise called
operating incomeor net operating
profit after tax (NOPAT). 301
financial leverageis the degreeto which
net operating assetsare financed bynet
financial obligations. 317
marginal tax rate is the rateat which the
lastdollarof income is taxed. 303
minority interest is the shareof
shareholders in subsidiaries otherthanthe
common shareholders of the parent
company. 296
net financialassets (obligations) are

net assetsusedin financing activities.
Distinguish fromnet operating
assets. 291
net financialexpenseis the expense
generated by a firm's nonequity financing
activities. 301
net operating assets (NOAs) are net
assetsusedin operating a business,
otherwise calledenterprise assets.
Distinguish fromnet financial assets
(obligations). 291
net operating profit after tax (NOPAT)
is income froma firm's business
operations, otherwise referred to as
enterprise income. 301
operating cash is cashusedin operations
(compared to cashinvested in financial
assets). 292
operating incomeis income froma fum's
business of sellingproducts and services,
otherwise calledenterprise income
or net operating profit after tax
(NOPAT). 301
operating leaseis a leasewhichdoes
not entitlethe lesseeto usethe lease
assetfor substantially all of the asset's
usefullifeand for which no asset or
Analysis Tools
Reformulated balance sheets
Reformulated income
statements
Tax allocation
-c-lop-down method
-c-aottom-uo method
Common-size analysis
Trend analysis
Ratio analysis of the income
statement andbalance
sheet
Page
291
301
302
306
306
31Z
314
316
Key Measures
Page
Effective taxratefor
operations
305
Netfinancial income
(or expense) aftertax
301
Operating income
aftertax (01)
301
Ratios
Income statement ratios
316
Operating profit margin
(PM)
Sales PM
Otheritems PM
Net(comprehensive) income
profit margin
Expense ratio
Balance sheet ratios
317
Operating liability leverage
(OLLEY)
Financial leverage (FLEV)
Capitalization ratio
Growth ratios
318
Growth rate in sales
Growth rate in operating
income
Growth in NOA
Growth in CSE
Residual operating income 3 i 2
CSE common shareholders' equity
FLEV financial leverage
NBC net borrowing cost
NFA net financial assets
NFE net financial expense
NFO net financial obligations
NOL netoperating loss
NOPAT Netoperating profit
aftertax
01 operating income
OLLEV operating liability leverage
PM profit margin
ReOI residual operating income
RNFA return on net financial
assets
assets
ROCE return on common equity
322 Part Two The Anat)'s!s ofFinanciat Statements
Chapter 9 TheAnal:!sis of (he Balance Sheet and Income SUl!ement 323
BUILDING YOUR OWN ANALYSIS ENGINE FOR KMB
You might add your reformulated statements into the spreadsheet you began building in
thelastchapter. You willthenbe setupto analyze these statements within thespreadsheet as
youmove toChapters 11 and12.TheBYOAP feature onthebook'sWeb site will guideyou.
Having reformulated Kimberly-Clark's 2004 equity statement in Chapter 8, you are now
readyto move on to thebalance sheetandincome statement. These aregiven in Exhibit 2.2
in the Continuing Casefor Chapter2.You should have the reformulated equitystatement
besideyou, for allitemsin comprehensive income, identified there, mustbe included in the
reformulated (comprehensive) income statement.
At thispointit is imperative to have a goodreadof thefull IO-K, Themanagement discussion andanalysis (MD&A) andthefinancial summary have considerable detail thatwill
helpyou decide whichitems are operating and which are part ofK.MB's financing activities. If you have not downloaded the 10-K already, do so now, or retrieve it from the
Web pagesupplement to Chapter7.
Concept
Questions
C9.1. Why are reformulated statements necessary to discover operating profitability?

C92. Classify eachofthe following as a financial assetor an operating asset:
a. Cashina checking accountusedto paybills.
b. Accounts receivable.
c. Finance receivables for an automobile firm.
d. Cashin 90-day interest-bearing deposits (cashequivalents).
e. Debtinvestments heldto maturity.
f Short-term equity investments.
g. Long-term equity investments heldto maturity.
h. Goodwill.
i. Lease assets.
j. Deferred compensation.
REFORMULATION
Your task is to reformulate the balance sheets for 2004, 2003,and 2002 and the income
statement for 2004 and 2003 (only) alongthe lines of thosefor Nike, Dell,and General
Millsin thischapter. Gothrough andmarkoffthe items youconsider to be operating items
andthoseyoudeemto be involved in financing activities. As youreadthe 10-K, noteany
detailthat canbe brought up to the faceof thestatements to make themmoreinformative.
You will find, for example, that advertising expenses were$400.2 million, $401.9 million,
and $421.3 million fortheyears2002,2003, and2004, respectively, andR&D expenditure
was$287.4 million, $279.1 million, and$279.7 million for these years.
Tocarryoutthereformulation of comprehensive income for2003, youneedto examine
the equitystatement for 2003 to identify othercomprehensive income. To save you the
trouble, comprehensive income for2003 is given here,withtheinclusion ofthehidden loss
fromexercise of stockoptions:
Comprehensive income for 2003 (in millions)
Netincome
Currency translation gain
Pension liability adjustment
Loss on cash flow hedge
Stock option compensation expense (after tax)
C9.3. Classify each of the following as a financial liability, an operating liability,

or neither:
a. Accrued compensation.
b. Deferred revenues.
c. Preferred stock.
d Deferred taxliability.
e. Lease obligations.
f. Interest-bearing notepayable.
C9.4. From the pointof viewof the common shareholders, minority interest is a financial
obligation. Correct?
C9.5. 'What is meantby saying thatdebtprovides a taxshield?
C9.6. 'When can a fum losethetax benefit of debt?
C9.7. Whatdoesan operating profitmargin reveal?
$1,694.2
742.8
(146.2)
(4.3)
(13.6)
$2,272.9
Forthebalance sheet, allocate $20million to working casheachyear. Be sureyouidentify all relevant components on the income statement, separating operating income from
sales from otheroperating income, and making the appropriate tax allocation. KimberlyClark's statutory tax rate is 35.6percent.
RATIO ANALYSIS
State in one or two sentences what the reformulated statements you have prepared are
saying. Thencalculate the returnon net operating assets and net borrowing costfor 2004
and2003. Carryout a common-size analysis oftheincome statement thatreveals information about the profitability of operations. Also calculate financial leverage (FLEV) and
operating liability leverage (OLLEV).
Exercises
Drill Exercises
E9.1.
BasicCalculations (Easy)
a. The following numbers wereextracted from a balance sheet(inmillions):
Operating assets
Financial assets
Total Liabilities
$547
145
322
Of thetotal liabilities, $190million weredeemed to be financing liabilities. Prepare a

reformulated balance sheetthat distinguishes itemsinvolved in operations fromthose
involved in financing activities.
324 Part Two The AnaiJlls of Firutncia! Stctemeazs
Chapter 9 TheAnal)sis ofUle Balance Sheet and Income Sllllement 325
b. An income statement consists of thefollowing lineitems (inmillions):
Revenue
Cost ofgoods sold
Operating expenses
Interest income
Interest expense
E9.5.
$4,356
3,487
428
56
Thefollowing financial statements were reported fora firm forfiscal year2009 (inmillions
of dollars):
132
BalanceSheet
The firm paysno taxes, Prepare a reformulated income statement thatdistinguishes

items involved in operations from those involved in financing activities.
E9.2.
Tax Allocation (Easy)

A fum reported $818 million of net income in its income statement after$140 million of
netinterest expense andincome tax expense of $402 million. Calculate operating income
aftertaxandnetfinancial expense aftertax, using a statutory tax rateof 35percent.
E9.3.
Reformulation of a Balance Sheet, Income Statement, and Statement

of Shareholders' Equity(Medium)
Operating cash
Short-term investments (at market)
Accounts receivable
Inventory
Property and plant
Tax Allocation: Top-Down and Bottom-Up Methods (Easy)
2009
2008
60
550
940
910
50
500
790
840
2,840
2,710
5,300
2009
2008
Accounts payable
1,200
1,040
Accrued liabilities
390
450
Long-term debt
1,840
1,970
Common equity
1,870
1,430
5,300
4,890
From the following income statement (in millions), calculate operating income aftertax,
usingboththetop-down andbottom-up methods. Usea tax rateof37 percent.
Statement of Shareholders' Equity
Revenue
Cost of goods sold
Operating expenses
Interest expense
Income taxes
Net income
E9.4.
$ 6,450
(3,8701
(1.8431
Balance, end of fiscal year2008
(135)
(1811
$ 421
Reformulation of a Balance Sheet and Income Statement (Easy)

Reformulate the following balance sheet and income statement for a manufacturing
concern. Amounts are in millions. The firm bears a 36percent statutory tax rate.
BalanceSheet
Assets
liabilities and Equity
Operating cash
Cash equivalents
Accounts receivable
Inventory
Property, plant, andequipment
23
435
1,827
2,876
3,567
Total assets
Accounts payable
Accrued expenses
Deferred taxliability
$1,245
1,549
712
Long-term debt
Preferred stock
Common equity
Liabilities and equity
3,678
432
IncomeStatement
Revenues
Operating expenses
Interest expense
Income before tax
Income tax
Netincome
Preferred dividends
Net income available to common
$7,493
6,321
-ill
951
656
---.-1
$ 630
...1.U1
$8,728
1,430
Share issues
822
Repurchase of 24 millionshares
(720)
Cash dividend
Unrealized gainon debt investments
Net income
Balance, end of fiscal year2009
(180)
50
468
1,870
Thefum'sincome tax rateis 35%. Thefirm reported $15million ininterest income and$98
million in interest expense for2009, Sales revenue was $3,726 million,
a. Reformulate the balance sheet for 2009 in a way that distinguishes operating and
financing activities. Also reformulate theequity statement.
b. From theinformation in these reformulated statements andtheadditional information
given, prepare a reformulated statement of comprehensive income.
E9.6. Testing Relationships in Reformulated Income Statements (Medium)
Fillin themissing numbers, indicated bycapital letters, inthefollowing reformulated income
statement. Amounts areinmillions of dollars, Thefirm's marginal tax rateis 35percent.
Operating revenues
Cost ofsales
Other operating expenses
Operating income before tax
Tax as reported
Tax benefit of interest expense
Interest expense before tax
Tax benefit
Interest expense aftertax
5,523
3,121
1,429
B
_C
D
E
------"'I
Whatis thefum'seffective tax rateon operating income?
42
610
326 PartTwo The AnalY5i5 of Final:cial Srsemena
Chapter 9 TheAnalysis of(heBalance Sh~e! IlndIncome Sralemenl 327
Applications
E9.7.
Price of "Cash" and Price of the Operations: Realnetworks, Inc. (Easy)

In October 2008, the 142,562 outstanding shares of Realnetworks, Inc., tradedat $3.96
each. Themost recent quarterly balance sheet reported S454 million in netfinancial assets
and $876million in common shareholders' equity.
a. What is the price-to-book ratio forthe firm's equity?
b. What is the book value of the firm's netoperating assets?
c. Atwhat priceis themarket valuing thebusiness operations?
STARBUCK5 CORPORATION
Consolidated Statements of Earnings
(in thousands, except earnings pershare)
Fiscal Year Ended

September 30, 2007 October 1, 2006
Netrevenues:
Company-operated retail
$7,998,265
$6,583,098
1,026.338
386,894
860,676
343,158
3,999,124
3,178,791
3,215,889
2,687,815
Specialty:
E9.8. Analysis of an Income Statement: Pepsico, Inc. (Easy)

Pepsico, Inc.reported the following income statement for 1999 (in millions of dollars):
Netsales
Operating expenses
Restructuring charge
Operatfng profit
Gain on asset sales
Interest expense
Interest income
Provision for income taxes
Netincome
20,367
117,484)
Licensing
Food service and other
Total specialty
Total net revenues
7,786,942
2,818
Otheroperating expenses
294,136
1,083
(363)
253,724
Depreciation andamortization expenses
467,160
387,211
479,385
~
3,656
1,606
2,050
General andadministrative expenses

a. Reformulate this statement to distinguish operating items from financing items and
operating income from sales from other operating income. Identify operating income after
tax. Thefirm's statutory tax rateis 36.1 percent.
b. Calculate the effective taxrateon operating income from sales.
Exercise E4.l2 deals withPepsico, as doMinicases MS,2 andM6.2.
Financial Statement Reformulation for Starbucks Corporation (Medium)
(This exercise buildsonExercise E8.8 in Chapter 8,but canbe worked independently)
Below are comparative income statements and balance sheets for Starbucks Corporation,theretailcoffee vendor, forfiscal yearending September 30, 2007, along witha statement of shareholders' equity, Readthe statements along withthe notes underthem, then
answer the following questions:
a, Prepare a reformulated equity statement forfiscal year2007 thatseparates netpayout

to shareholders fromcomprehensive income.
b. Prepare a reformulated comprehensive income statement for fiscal year2007, along
with reformulated balance sheets for2007 and2006.
c. Forfiscal year2007, calculate the following: return oncommon equity (ROCE), return
on net operating assets(RNOA), and net borrowing cost (NBC). Usebeginning-ofyearbalance sheetamounts indenominators. Alsocalculate thefinancial leverage ratio
(FLEV) at thebeginning of the2007 fiscal year.
8,465,558
6,985,927
108,006
1,053,945
893,952
Income taxes
383,726
Earnings before cumulative efffectof change in

accounting principle
672,638
581,473
Income fromequityinvesrees
Operating income
Netinterest andotherincome
Earnings before income taxes
E9.9.
9,411,497
Costof sales including occupancy costs

Store operating expenses
1,056,364
Cumulative effectof accounting change for FIN 47,

net of taxes
Netearnings
$ 672.638
93,937
906,243
$ 564,259
Per common share:

accounting principles-basic
0.90
0,76
0.90
r-o:74
Cumulative effectof accounting Change for FIN 47,

net of taxes
Netearninqs-c-bask
accounting principles-diluted
0.02
0.87
0.73
Cumulative effectof accounting change for FIN 47,

net of taxes
Netearnings-diluted
0.87
Weighted average shares outstanding:
0.02
0.71
Basic
749,763
766,114
Diluted
770,091
792,556
Chapter 9
Consolidated BalanceSheets
(inthousands, exceptsharedata)
Th~
Analysis ofrhe Balance Sheer and Income Slaremc~ll
Consolidated Statements of Shareholders' Equity

(inthousands, exceptsharedata)
Fiscal Year Ended
September 30,2007
October 1, 2006
Shares
281,261
83,845
73,588
287,925
691,658
148,757
129,453
't,696,487
21,022
258,846
2,890,433
219,422
42,043
215,625
$5,343,878
312,606
87,542
53,496
224,271
636,222
126,874
1,529,788
5,811
219,093
2,287,899
186,917
37,955
161,478
$4,428,941
liabilities and Shareholders' Equity

Commercial paperand short-term borrowings
Accounts payable
Accrued compensation and related costs
Accrued occupancy costs
Accrued taxes
Otheraccrued expenses
Deferred revenue
Current portion 01long-term debt
Total currentliabilities
long-term debt
Otherlong-term liabilities
Total liabilities
Common stock($0.001 par valuel-c-autnorfzed,
1,200,000,000 shares; issued and outstandir.g,
738,285,285 and 756,602,071 shares, respectively,
(includes 3,420,448common stockunitsin both
periods)
Otheradditional paid-in-capital
Retained earnings
Accumulated other comprehensive income
Total shareholders' equity
Total liabilitiesand shareholders' equity
Additional Other Additional

Paid-in
Paid-in
Amount Capital
Capital
Common Stock
Assets
Current assets:
Short-term investments-available-for-sale securities
Short-term investments-tradingsecurities
ACcounts receivable, net
Inventories
Prepaid expenses and other cerrrent assets
Deferred income taxes, net
Total currentassets
long-terminvestments-available-for-sale securities
Equity and other investments
Property, plant,and equipment net
Otherassets
Otherintangible assets
Goodwill
Total Assets
329
Balance,October 1,
2006
756,602,071
Netearnings
Unrealized holding loss,
$756
_1_ _
$39,393
Retained
Earnings
$2,151,084
672,638
001
Translation adjustment,
net of tax
Stock-based
compensation
expense
Exercise of stock
options, including tax
benefit of 595,276
12,744,226
Saleof common stock,
including tax
provision of $139
1,908,407
Repurchase of common
stock
(32,969,419)
Balance,
September 30, 2007 738,285,285
13
Accumulated
Other
Comprehensive
Incorne/(loss)
Total
$37,273
$2,228,506
672,638
{20,380)
(20,380)
37,727
37,727
689.985
106,373
106,373
225,233
225,246
46,826
46,828
(31)
(378,432)
$738
(634,356)
539,393
$2,189,366
(1,012,821)
$54,620
$2,284,117
NOles:
710,248
390,836
332,331
74,591
92,516
257,369
296,900
775
2,155,566
550,121
354,074
3,059,761
700,000
340,937
288,963
54,868
94,010
224,154
231,926
762
1,935,620
1,958
262,857
2,200,435
1. Short-term andlong-term investments, available forsale,aredebtsecurities.

2. Short-term investments listedas trading securities ate investments illequitymutual funds as put of a defined contribution planforemployees. The
corresponding deferred ccrnpensatioaliability (S86,41){1Ihousand in 2oo7} is included inaccrued compensation andrelated COSIS.
3. 540,000 thousand of cash and cashequivalents in both 2007and2006is working cashused in operations.
4. Net interest andotherincome in the 21){17 income statementincludes thcfollowing (inthousands):
Interest income
interest expense
Realized gainonavailable-for-sale investments
Gain. onassetssales
Otheroperating charges
S19,700
(38,200)
3,800
26,032
(8,913)
S 2,419
5. Income fromequity investees is reported aftertax.

6. Thefirm's combined state andfederal statutory taxrate is38.4percent,
7. Unrealized holding losses incomprehensive income referto losses onavailable-for-sale debtsecurities.

Starbucks is dealtwithalsoin Exercises E8.8, EI 1.9, El2,8, andEl4.10.
738
39,393
2,189,366
54,620
2,284,117
$5,343,878
756
39,393
2,151,084
2,228,506
$4,428,941
E9.10, Reformulation and Effective Tax Rates: Home Depot. Inc. (Medium)
Home Depot is the largest home improvement retailer in the United States andone of the
largest retailers.
Home Depot's income statements for2003-2005 are below, along with anextract from
its taxfootnote. Reformulate the income statement for2005 withtheappropriate tax allocation between operating activities and financing activities. Apply boththe top-down and
bottom-up methods. Calculate the effective taxrateon operations for2005,
330 PartTwo The A1W!Y5il of Financial SUliemcnts
Chapter 9 The Analysts of tk Blllance Sheet and Income Sw:emem 331

The reconciliation of the provision forincome taxes at the federal statutory rateof 35% to the actual tax
expense forthe applicable fiscal years isas follows (amounts in millions):
THE HOME DEPOT, INC. AND SUBSIDIARIES

(amounts inmillions, except per-share data)

FiscalYear Ended
Fiscal Year Ended
Netsales
Cost of merchandise sold
Gross profit
Operating expenses:
Selling and storeoperating
Operating income
Interest income (expense):
Interest and investment income
Interest expense
Interest, net
Earnings before provision forincome taxes
Netearnings
Weighted-average Common shares
Diluted weighted-average common shares
January 30,
February 1.
February 2,
2005
2004
2003
$73,094
48,664
24,430
$64,816
44,236
20,580
$58,247
40,139
18,108
15,105
1,399
16,504
7,925
12,588
1,146
13,734
6,846
11,276
1,002
12,278
5,830
56
59
79
~)
(14)
~}
7,912
2,911
5,001
2,207
6,843
2,539
s 4,304
2,283
$ 1.88
2,289
$ 1.88
131
$ 227
2,216
S 2.25
(37)
42
5,872
2,208
S 3,664
2,336
$ 1.57
2,344
$ 1.56
Note 3: Income Taxes
FiscalYear Ended
Deferred:
Federal
State
Fore,~n
January 30,
February 1,
February 2,
2005
2004
2003
$2,153
279
139
2,571
$1,520
307
$1,679
239
~
1,934
2,035
304
52
(16)
573
27
5
605
$2,539
340
Total
52,911
February 1,
2005
2004
2003
$2,769
$2,395
$2,055
215
(17)
217
(29)
February 2,
156
(1)
(31)
---ill)
~)
_I)
$2,911
$2,539
$2,208
The provision for income taxes consisted of the foilowing (amounts inmillions):
Current:
Federal
State
Foreign
Income taxes at federal statutory rate

Stateincome taxes, net of federal income
taxbenefit
Foreign ratedifferences
Change invaluation allowance
Other, net
Total
January 30,
117
174
1
(2)
173
$2,20B
TheComreoys combined federal, state,andforeign effective taxratesforfiscal 2005,2004, and2003,

net of offsets generated byfederal, state,andforeign taxbenefits, were36.8%, 37.1%, and 37.6%,
respectively.
Exercises E5.12, EII.IO, E12.9,andE14.3 also dealwithHome Depot, as does Minicase

M4.1.
Chapter 9 The A:1(11Jlis of(he Balance Sheer amllncome Swt~mel11 333
332 Part Two The AnalJsil ofFinancinl Statemems
Minicases
chapters. You couldalsobuildannual reports for years after2008 intothe spreadsheet, as

they become available, so that you continue to track the firm as it evolves. The BYOAP
feature on theWeb sitewillguideyouin thistask.
Aftercarryingoutthereformulations, compare thestatements to thoseforGeneral Mills
in Exhibits 9.5 and 9.1 L Though devoted primarily to packaged food products, General
Millsis a similar brand marketing company. Dothestatements reveal thesamesortofbusinessorganization? How do theydiffer?
Now compare the statements to those for Nike (in Exhibits 9.3 and 9.9) and Dell (in
Exhibits 9.4 and 9.1O).What are the differences, and whatdo theytel! youabouthow the
respective firmsrun theirbusinesses?
M9.1
Financial Statement Analysis:

Procter & Gamble I
Formed in 1837 byWilliam ProcterandJames Gamble as a smallfamily-operated soapand
candlecompany, Procter & Gamble Co.is nowa leading consumer products company with
over $83 billionin revenues. Headquartered in Cincinnati, Ohio, the finn's products are
soldin more than 180countries.
P&G'sproduct rangecovers laundry detergents, toothpaste, baby diapers, papertowels,
beauty and health products, shampoos, snacks, coffee, and pet food. The firm is better
known by its brands: Channin,Pampers, Bounty, Tide, Downy, Cascade, Olay, Tampax,
Crest,Headand Shoulders, Pringles, Folgcrs, andmore.The maintenance of thesebrands,
alongwithinnovative packaging andeffective distribution through the retail supply chain,
is critical to the success of the company's operations. Product innovation and marketing,
along with streamlined production and distribution, have contributed to growth, but the
firmhasalso purchased brands through acquisition of othercompanies. In fisca12006, the
firm acquired Gillette for$53.4billion, adding Gillette's shaving andgrooming products to
its rangealongwithDuracell batteries.
The branded consumer products business is verycompetitive, and P&Gbattles thelikes
of Unilever, Avon, Clorox, Kimberly-Clark, L'Oreal, Energizer, and Colgate. Like these
companies, continual innovation is essential to the firm's continuing profitability, so the
firm maintains an extensive research and development operation, including marketing
research, andspends considerable amounts onadvertising and promoting its brands.
Learnmoreaboutthe firm bygoingto its Web site at www.pgcom. Go to the Investor
page,download the finn's annual report, and readthe management letterandthe Management Discussion andAnalysis. Also lookat the firm's lO-K in its EDGAR filing withthe
SEC. Thoughalways having a gloss, management communications are helpful in understanding the strategy and howthemanagement is executing on thatstrategy. The stresson
brandinnovation and research is evident in P&G'smanagement letters.
Afterunderstanding the company, go to the financial statements, which, alongwiththe
footnotes to the statements, areour mainfocus for financial statement analysis. Survey the
management certification on its financial reporting andinternal controls. Makesuretheauditor'sletterdoesnotcontain anything unusual. Make a listof thefootnote headings soyou
are reminded of where to go for more detail.
Nowyou arereadyforanalysis. Wewillbeengaged withP&Gthrough a seriesof minicases, beginning with this chapterand continuing through Chapter 12.At each stagewe
will add another aspect to the analysis so that,by the end of Chapter 12,you will have a
thorough analysis thatprepares youtovaluethefirm.
At thispoint, youare required to reformulate the income statements and balance sheets
to ready them for analysis. Exhibit 9.15 presents the published income statements for
2006--2008, alongwithstatement of shareholders' equityfor the threeyearsand balance
sheetsfor 2005-2008. Additional information provided after the statements will aid you.
As advertising and research anddevelopment (R&D) are so important to P&G, makesure
you include these as lineitemsin thereformulated statements.
If youare adeptat spreadsheet analysis, youmightput thereformulated statements into
a spreadsheet that can then be used to apply the financial statement analysis in later
A.Calculate the returnoncommon equity(RaCE) foreachyear2006-2008.

B. Calculate thereturnon netoperating assets (RNOA) for eachyear2006--2008.
C. Whatwasthe operating profitmargin fromsalesforeachyear?
D. Calculate expense ratios(as a percentage of sales) for advertising and R&D for each
year. Doyou seetrends?
E. Calculate sales growth rates for 2007 and 2008 and also growth rates for operating
income fromsales.
F. Calculate growth rates for net operating assets for 2006-2008. Do you see a trend?
Is thereanyone balance sheetitemthatparticularly affects thegrowth?
G. Calculate P&G'sfinancial leverage ratioat the endof2008.
H. Whyweretranslation gainsso largein 2008?
1. Where in the financial statements do you see how much P&G paid for the Gillette
acquisition?
1. Whydid goodwill increase so muchin 2006?

This casecontinues withMinicases Ml l.I, MI2.I, M14.l andMIS.I.
EXHIBIT 9.15
Comparative
FinancialStatements
for FiscalYear2008
for Procter &
GambleCo.
The financial
statements should be
readwiththe
accompanying
footnotes.
ConsolidatedStatements of Earnings
(amounts in millions except pershareamounts; Years endedJune30)
2008
2007
2006
Net sales
Selling, general, and administrative expense
Operating income
Interest expense
Othernonoperating income, net
Earningsbefore incometaxes
Income taxes
Net earnings
$83,503
40,695
25,725
17,083
1,467
$76,476
36,686
24,340
15,450
1,304
$68,222
33,125
21.848
13,249
1,119
462
~
14,710
4,370
$10,340
~
12,413
3,729
$ 8,684
Basicnet earnings per commonshare

Dilutednet earnings per commonshare
Dividends per commonshare
$ 3.22
$ 3.04
s 1.28
I 2.79
I 2.64
16,078
4,003
$12,075
3.85
$ 3.64
$ 1.45
$ 1.15
(continued)
334
Chapter 9 TheAnal]lisof u.e Balance Shw andIncome SwtemeJ\r 335
PartTwo The Analysis of FiI;anciaJ StmClIlems
EXHIBIT 9.15
EXHIBIT 9.15 (co/ltinued)
ConsolidatedBalance Sheets
(co/ltil/ued)
(amounts in millions; June 30)
2008
Currentassets
Investment securities
Accounts receivable
inventories
Materials andsupplies
Work in process
Finished goods
Total inventories
Prepaid expenses andothercurrent assets
Totalcurrent assets
Property,plant, and equipment
Buildings
Machinery andequipment
Land
Total property, plant. andequipment
Accumulated depreciation
Net property,plant, and equipment
Goodwill and other intangible assets
Goodwill
Trademarks andotherintangible assets, net
Net goodwilland other intangibleassets
Other noncurrentassets
Totalassets
Currentliabilities
Accounts payable
Accrued andotherliabilities
Taxes payable
Debtduewithin oneyear
long-term debt
Deferredincometaxes
Totalliabilities
Shareholders'equity
Convertible Class Apreferred stock, staled
value $1 pershare(600 shares authorized)
Nonvoting Class Bpreferred stock, stated
value $1 pershare(200 shares authorized)
Common stock, statedvalue $1 pershare
(10,000 shares authorized; shares issued:
2008-4,001.8,2007-3,989.7)

Reserve forESOP debt retirement
Accumulated othercomprehensive income
Treasury stock, at cost(snares held: 200S-969.1,
2007-857.8)
Retained earnings
Totalliabilities and shareholders' equity
3,313
228
6,761
2007
5,354
201
6,629
2006
2005
$6,693
1,133
5,725
6,389
1,744
2,262
1,590
1,537
765
444
6Z3
5,389
8,416
2,012
3,785
24,515
7,052
30,145
6,819
1,727
3,300
24031
6,380
27,492
24329
20,329
5,871
25,140
5,292
20,397
59,767
34,233
94,000
4,837
$143,992
56,552
33626
90,178
4265
$138,014
$6,775
10,154
13,084
30,958
23,581
11,805
5,710
9,586
3,382
12,039
30,717
23,375
12,015
~
72,787
1,366
4,002
60,307
(1,325)
3,746
(47,588)
48.986
69.494
$143,992
71,254
1,406
5,006
1,081
~ ~
34,721
31,881
(15,181)
(13,111)
19,540
18,770
74,498
1,424
350
6,291
1,511
~
38,086
(17,446)
20,640
945
4,185
26,325
(11,993)
14,332
~
135,695
19,816
4,347
24,163
2,703
61,527
4,910
9,587
3,360
3,802
7,531
2,265
55,306
33,721
89,027
19,985
35,976
12,354
1,451
3,990
59,030
(1,308)
617
3,976
57,856
(1,288)
(38,772)
41,797
66,760
138,014
(34.235)
(518)
35,666
62,908
135,695
25,039
12,887
1,896
3,230
43,052
1,483
2,977
3,030
(1,259)
(1,566)
(17,194)
31,004
18.475
61,527
ConsolidatedStatements of Shareholders' Equity

(dollars inmillionsfshares in thousands)
Common
Shares
Outstanding
Balance, June 30, 2005
2,472.934
Accumulated
Other
Debt
Comprehensive Treasury Retained
Capital Retirement
Income
Stock Earnings Total
Additional
Common Preferred Paid-In
Stock
Stock
52,977
$1,483
53,030
Reserve
for ESOP
$(1,2.59)
Net earnings
Other comprehenswe income:
Financial statement translation
Net investment hedges,
netof $472 tax
Other, netoftaxbenefits
Total comprehensive income
Dividends toshareholders:
5(1,566)
$(17,194) $31,004 $18,475
8,584
1,316
"1,316
(786)
(786)
518
.........ill
$ 9,732
(3,555)
(148)
Common
Preferred, netoftaxbenefits
Treasury stock purchases
Employee plan issuances
Preferred stock conversions
Gillette acquisition
ESOP debtimpacts
(297,132)
36,763
3,788
952,488
(16,821)
19)
16
1.308
(32)
983
887
(3,555)
(148)
(16,830)
(19)
1,892
27
0,134)
53,522
53,371
(29)
(29)
Balance, June 30, 2006

3,178,841
Neteamings
netof $488 tax
Adjustment to initially apply
SFAS 158, netoftax
Dividends toshareholders:
Common
Preferred, netoftax benefits
(89,829)
37,824
5,110
ESOP debtimpacts
3,976
Balance, June30, 2007

3,131,946
Net earnings
netof $1,719 tax
Cumulative impact for
adoption of FIN 48
Dividends to shareholders:
Common
Preferred, netoftax benefits
[148,121)
43,910
4,982
ESOP debtimpacts
3,990
Balance, June 3D,2008
8,584
3,032,717
1,451
57,856
(1,288)
(518)
(34,235)
35,666 62,908
10,340 10,340
2,419
2,419
(835)
(116)
(835)
(116)
$11,808
(333)
(333)
(4,048)
(151)
14
(5,578)
1,003
1,167
(45)
38
(20)
1,406
59,030
(1.308)
(ZOj
617
(38,772)
41,797 66,760
12,075 12,075
6,543
6,543
(2,951)
(463)
(2,951)
(463)
$15,204
(232)
(10,047)
1,196
35
1,272
12
(4<l)
$1,366
$60,307
(17)
$4,002
(4,048)
(161)
(5,578)
2,184
$(1.325)
(232)
(4,479) (4,479)
(U6)
(176)
(10,047)
2,480
(16)
$3,746
$(47,588) $48,986 $69,494
(continued)
336 Part Two The Ana!)',!, of financia! Stmcmems
EXHIBIT 9.15
Chapter 9 Th~ AnalJlis of lhc Balo.nce Sheel and Income Setemenr 337
(col/eluded)
Afteryouhavecarried out the reformulations, answer the following questions:
A. Why are someinvestments listedat market valueon the balance sheetwhile othersare
listedat cost?
Advertising
2008
S3.667
2126
2007
57,937
2,112
2006
$7.122
2.075
204
258
281
277
367
462
564
283
B, Why are net operating assetsin theinsurance operations negative? Whatis the business
interpretation?
C. Why is it desirable to distinguish the twotypesof income?
D. W'rrj is it desirable to have income from an insurerreported on a comprehensive basis?

Interest income
Gains (losses) from asset sales
Think: cherrypicking.
(34)
E. What, approximately, is the valueof the investment operation?
F. Summarize what the reformulated statements are tellingyou about Chubb's business.
3, 'Accrued andetherliabilities" and"ether noncurrenr Jiabilities" consist largely of pension obligations andetherpostretirement benefitliabilities.
4, Thecombined federal, stateand local statutory tax rate is 38 percent

Minicase M13.1 on Chubb extends this case to valuation.
M9.2
EXHIBIT 9.16
Understanding the Business Through

Reformulated Financial Statements:
Chubb Corporation
BalanceSheet,
ComparativeIncome
Statement,and Cornprehenslve Income
Statement for Chubb
Corporation,2007
Chubb Corporation is a property and casualty insurance holding company providing insurance through its subsidiaries in the United States, Canada, Europe, and parts of Latin
America andAsia. Itssubsidiaries include Federal, Vigilant, Pacific Indemnity, Great Northern,
Chubb National, Chubb Indemnity, andTexas Pacific Indemnity insurance companies.
The insurance operations are divided into three business units. Chubb Commercial
Insurance offersa full rangeof commercial customer insurance products, including coverage for multiple peril, casualty, workers'compensation, and property and marine. Chubb
Commercial Insurance writes policies for niche business through agents and brokers,
ChubbSpecialty Insurance offers a wide variety of specialized executive protection and
professional liability products forprivately andpublicly ownedcompanies, financial institutions, professional firms, and healthcareorganizations. Chubb Specialty Insurance also
includes suretyand accident businesses, as wellas reinsurance through ChubbRe. Chubb
Personal Insurance offersproducts for individuals with fine homes and possessions who
require morecoverage choices and higherlimitsthanstandard insurance policies.
Chubb's balance sheetsfor 2006 and 2007 are in Exhibit 9.16, Its 2007 comparative
income statement isalsogiven, alongwitha statement of comprehensive income thatChubb
reports outsideboththe equity statement andthe income statement. You are askedto reformulate thesestatements Ina waythatcaptures howChubb carriesoutitsbusiness operations
andthat reveals theprofitability of thoseoperations. Thestatutory taxrateis 35 percent, but
notethat$232million of investment income is interest on tax-exempt bonds,
Firstyou shouldunderstand howinsurers "makemoney." Insurance companies run underwriting operations where theywriteinsurance policies andprocesses andpayclaimson
thosepolicies. They are also involved in investment operations where theymanage investments in which the considerable "float"frominsurance operations is invested. Accordingly,
yousee bothinvestment assetsand liabilities on thebalancesheetas wellas assetsand liabilities associated withinsurance. You alsoseerevenues and expenses associated withboth
activities in the income statement. Your reformulation shouldseparate the itemsidentified
withthe twoactivities.
THE CHUBB CORPORATION

BalanceSheet
(in millions)
December 31
Z007
2006
Assets
Invested assets
Fixed maturities
Held-to-maturity-c-tax exempt (market S142in 2006)
Available-for-Sale
Tax exempt (cost$18,208 and $17,314)
Taxable (cost$15,266and 514,310)
s 1,839
$ 2,254
135
18,559
15,312
2,320
Equity securities (cost $1.907 and $1,561)

Other invested assets
Total invested assets
~
40,081
17,513
14,218
1,957
1,516
37,693
Cash
Securities lending collateral
49
38
1,247
Accrued investment income

Premiums receivable
2,620
440
411
2,227
2,314
Reinsurance recoverable on unpaid losses and toss expenses

Prepaid reinsurancepremiums
2,307
2.594
Deferred policy acquisition costs
1,555
Deferred income tax

Goodwill
Otherassets
Total assets
392
354
1,480
442
591
467
467
1,715
1,366
$50.574
$5O,ili
liabilities
Unpaid losses and loss expenses

Unearned premiums
Securities lending payable
long-term debt
Dividend payable to shareholders
Accrued expenses and other liabilities
Totalliabilities
$22,623
$22,293
6,599
6.S46
1,247
2,620
3,460
2,466
110
2,090
36,129
10,
2,385
~
(continued)
338 Part Two The Analysis ofFinar.cial Swummrs
EXHIBIT 9.16
(co/ltinued)
Chapter 9 Th~ Analysis of rhe Bolance Sheet andlncomc Sratement 339
EXHIBIT 9.16
THE CHUBB CORPORATION

BalanceSheet
(inmillions)
Year Ended December 31

December 31
2007
2006
liabilities
Commitments and contingent liabilities (Note 9 and 15)
Preferred stock-authorized 8,000,000 shares; $1 parvalue; issued--none
Common stco--euthonzed 1,200,000,000 shares;
$1 parvalue; issued 374,649,923 and 411,276,940 shares
375
Paid-in surplus
346
Retained earnings
13,280
444
14,445
$50,574
411
1,539
11,711
202
13,863
$50,277
2007
2006
2005
$11,946
1,738
$11,958
1,580
$12,176
1,408
49
220
115
374
14,107
245
14,003
384
14,083
6,299
3,092
6,574
2,919
7,813
2,931
444
550
512
35
34
29
48
207
161
194
10,478
190
11,636
3,525
2,447
252
10,170
3,937
1,130
$ 2,807
$ 2,528
$ 1,826
$7.13
7.01
$6.13
5.98
4.61
4.47
997
Net income
Othercomprehensive income (loss), net of tax
Change inunrealized appreciation of investments
Foreign currency translation gains(losses)
Change inpostretirement benefitcostsnotyet
recognized innet income
Comprehensiveincome
ConsolidatedStatements of Income
(In millions)
Revenues
Premiums earned
Investment income
Otherrevenues
Realized investment gains
Total revenues
Lossesand expenses
lossesand lossexpenses
Amortization of deferred policy acquisition costs
Otherosorenceoperating costsand expenses
Investment expenses
Otherexpenses
Corporate expenses
Total losses and expenses
Income beforefederal and foreign income tax
Federal and Foreign income Tax
Net income
Net income per share
Basic
Diluted
Consolidated Statement of ComprehensiveIncome
(collcluded)
621
2007
2006
2005
$ 2,807
S 2,528
S 1,826
134
81
34
(313)
(22)
115
(335)
$ 1,491
125
(17)
~
$ 3,049
$ 2,643
Chapter 10 The AnalysIs of the Cash Flow $Ui:ement 341
'~119Jysis
'~"'J"'.,/
of the
"f~>Statement
How free cash flow can be calculated from retormu-
lated income statements andbalance sheets without a

cash flow statement.
Howthecash conservation equation ties thecash flow
statement together to equate free cash flow and financing cash flow.
The difference between the direct andindirect calculations of cash from operations.
Problems that arise in analyzing cash flows fromGAAP
statements of cash flow.
After reading thischapter youshould beable to:

Calculate free cash flow from reformulated income
statements andbalance sheets.
Calculate free cash flow by adjusting GAAP cash flow
statements.
Reformulate GAAP statements of cash flow to identify
operating, investing, andfinancing cash flowsdistinctly.
Reconcile the free cash flow fromGAAP statements to
that calculated from reformulated income statements
andbalance sheets.
What reformulated cash flow statements tellyou.

Howto examine thequality of reported cash flow from
operations.
This Chapter
Thischapterreformulates
thecashflowstatement to
capture theoperating and
Wh"
adjustments
mustbemade
toGAAP
cashflow
statements?
Link to nextchapter
Chapter lllays out the
analysis of thereformulated
Linkto Web page

Review thestatement of
cashflows formore
companies-visit
thebook's WebSite at
www.mhhe.coml
penmanee.
Tounderstand the needsfor cash,she mustanalyze the abilityof the finn to generate cash.
Likevaluation analysis, liquidity analysis andfinancial planningareprospective: Thecredit
analyst and the treasurer are concerned aboutthe abilityof the firmto generate cash in the
future, and they use current financial statements to forecast future cash flow statements.
Theanalysis here,likethatof the otherstatements, prepares youforforecasting. Chapter 19
completes the task.
Unfortunately, GAAP and IFRSstatements of cashflow are not in the formthat identifies the cash flows used in these analyses, and indeedthey misclassify some cash flows.
Operating cash flows are confused with financing flows. This chapter reformulates the
statement to distinguish the cash flows appropriately. The reformulation is important for
preparing pro forma futurecash flow statements for DCFanalysis, liquidity analysis, and
financial planning. If the analyst forecasts OAAP cash flows, a DCF valuation will be
incorrectand a misleading pictureof liquidity and financing needs willbe drawn.
Animportant lesson emerges fromthischapter. Forecasting freecashflow is bestdoneby
forecasting reformulated income statements and balance sheetsrather thancashflow statements. Wecancontemplate forecasting cashflow statements, butthisisdifficult without first
forecasting the outcome of operations, understood from reformulated income statements
andbalance sheets. Oncethosestatements are forecasted, freecashflow forecasts canbe calculated immediately, as the firstsection of the chapter shows.
THE CALCULATION OF FREE CASH FLOW
I
'J
Freecashflow-the difference between cash flow from operations and cashinvestment in

operations-is the main focus in DCFanalysis, liquidity analysis, and financial planning.
Freecashflow, the netcashgenerated by operations (aftercashinvestment), determines the
abilityof the finn to payoff its debtand equity claims.
Chapter 10 The Anol)lilof (he Ca.sh Flow S(<l!emcm 343
Method 1:
C.,./"'Ol-~OA
Operating income
Net operating assets : '
Free cash flow
Method 2:
2008
2008
2007
2008
$1,883
$5,806
4,939
(8671
:2008
2008
2007
2008
2008
1(49)
$ 1,991
2,179
(188)
1,253
$1,016
If the analysthas gone through the analysis of the balance sheetand income statement
in Chapter 9, he does not need a cash flow statement to get the free cash flow. If those
statements are appropriately formatted, thenthe freecashflow is givenby a quickcalculation. In Chapter 7 we sawthat
Freecashflow == Operating income - Change in net operating assets (10.1)
C-I=OI-IINOA
That is, free cash flow is operating income (in a reformulated income statement) less the
changein net operating assetsin thebalancesheet
For this quick calculation to work, the operating income must, of course, ~e compr~~
hensive. Just as comprehensive income and changes in the book value of equityexplain
dividends to shareholders, so comprehensive operating income andthe changein the book
valueof the net operating assets explain the"dividend" fromthe operating activities to the
financing activities, the freecashflow.
The numbers for operating income and net operating assets for Nike, Inc., from
Exhibits 9.3and 9.9 in Chapter 9 are provided in Box10.1, and free cashflow is calculated
from these numbers under Method 1. Nike generated income from operations of $1,883
million, butits additional investment innet operating assetsof$867 millionresultedin free
cashflow of$I,016 million.
There is a second way to calculate free cash flow from reformulated statements. In
Chapter 7 wealso sawthatfreecash flow is appliedas follows:
Freecash flow = Netfinancial expense
- Changein net financial obligations
+ Netdividends
(10.2)
C-l= NFE-IINFO + d
that is, free cash flow is used to pay for net financial expense, reduce debt, and pay net
dividends. Ifminority interests areinvolved, the calculation is
C- I = NFE- 6NFO + d + Minority interest in income
- tlMioority interest in the balance sheet
342
C -I =ilNFA - NFl + d
$1,016
C-I",~FA-NFI+d
Net financial income

. Net financial assets
Netdividend
Free cash flow
Again,the netfinancial expense mustbe comprehensive (ofunrealized gainsand losses00

financial assets, for example, and of the tax benefit from interest expense). This second
calculation is givenfor Nike, Inc.,underMethod 2 in Box 10.LThe net dividend is from
the reformulated statement of common shareholders' equityin Chapter 8and Exhibit 9.8 in
Chapter9. AsNikeis a holderof net financial assets(ratherthannet financial obligations),
the calculation just changes the signs. Thus,equation 10.2becomes
(10.2a)
(10.2b)
If the balancesheetand income statement havebeen reformulated, thesecalculations

are straightforward. You'll agree thatthesemethods are muchsimplerthanthe alternative
approaches to calculating free cashflow in Chapter4. But,you mayask,"Can't I simply
read the cash flows on the statementof cash flows?" This is not as easy as you would
think.
GAAP STATEMENT OF CASH FLOWS AND

REFORMULATED CASH FLOW STATEMENTS
For cash flow forecasting, weneed to distinguish clearly the net cashgenerated by operations(the free cash flow) from the flows thatinvolve paying thatcash flow out to the firm's
claimants. If operations use cash (andthus have negative free cashflow), we need to dis~
tinguish that negative freecashflow fromthe cashflows thatinvolve claimants paying into
the finn to coverthe free cash flow deficit. An analystforecasting freecash flow for discounted cash flow analysis mustnot confuse the freecash flow with the financing flows.
Anda treasurer forecasting thecashneedsofthe business mustforecast thecashsurplusor
deficitas distinct from the financing flows thatwilldispose of thesurplusor willbe needed
to meetthe deficit.
As withtheincome statement andbalance sheet,thetemplate in Chapter 7 guidesthe reformulation of the cash flow statement to identify cash flows appropriately. Review that
chapterbeforebeginning this one;focuson Figure 7.3. Fourtypesof cashflow are identified there.Two are cashflows generated by the operating activities within the firm: cash
from operations (C) andcashinvestments inthose operations (I). Two involve financing activities between the firm and its claimants outside the finn: net dividends to shareholders
(d) and netpayments todebtholders andissuers (F). The reformulated cashflow statement
givesthe detailsof thesefour flows.
The four cash flows are tied together according to the cashconservation equation that
wasintroduced in Chapter 7:
Freecashflow> Net payments to shareholders + Net payments to debtholders and issuers
C-I=d+F
Freecashflow fromoperations (on the left)is applied (on the right) to financing payments
to shareholders (as net dividends, d) and debtholders and issuers (as interest and principal
payments, F). Free cash flow can be negative, in which case the financing flows 10
claimants mustbe negative, in the fonn of cashfrom shareissues, debt issues, or the liquidation of financial assets.
The GMP statement of cash flows has the appearance of giving us the freecash flow
and the flows for financing activities, but it somewhat confuses the two.The form of the
statement appears below, alongwiththeformofthe reformulated statement thatfollows the
cashconservation equation.
344
Part Two TheAna!)'sis of Fillanrial Srcrerncnrs

GAAP Statement of Cash Flows
- Cash used in investing activities
+ Cash from financing activities
~ Change incash and cash equivalents
The direct and indirect cash flow statements differ in their

presentation of cash flow from operations.
Reformulated Statement of Cash Flows
DIREGMETHOD
The direct method lists the separate sources of cash inflow
andcash outflow inoperations inthefollowing form:

- Cash investments
~ Free cashflow from operating activities
Cash paid to shareholders
+ Cash paid to debtholders and issuers
- Cash paid forfinancing activities
Reclassifying Cash Transactions

Exhibit 10.1 gives Nike's 2008 comparative statement of cash flows. This statement uses
the indirect methodof presentation. Nikereports cash from operations of$1,936.3 million
and cashinvestment of$413.8 million, so wemightconclude thatfreecashflow equalsthe
difference, $1,522.5 million. This number disagrees with our earliercalculation (in Box
10.1) ofS1,016million. Which is correct?
The GAAP statement of cashflows is governed by FASB Statement No. 95.The statementsuffers from a number of deficiencies for equityanalysis purposes, including transparentmisc1assifications of cash flow. Hereare the mainproblems we encounter in trying
to discover freecashflow fromthe GAAP statement. I Somehavealreadybeenencountered
in the discussion in Chapter4.
See Exhibit 10.1 for an example.

The indirect method has thefeature of identifying theaccruals made incalculating net income, soit reconciles net income to cash flow. But the direct method has the advantage
oflisting theindividual cash flows thatgenerate thenetcash,
sois more informative about thesources ofcash flows. (If the
direct method isused, a reconciliation of cash flow from operations to netincome must besupplied infcotnotes.) Almost
all firms use theindirect method.
2. Transactions in financial assets. Investments in financial assets such as short-term

marketable securities and long-term debt securities are included in the investments
section ratherthanin the financing section in the GMP and IFRSstatement. Nike'snet
liquidation of financial assets(maturities minus purchases) of$380.4 million is flagged
in Exhibit 10.1.These investments are a disposition of freecashflow, notan increase of
freecashflow. If a finn invests its (surplus) freecashflow from operations in financial
assets, the GAAPclassification gives the appearance that the finn is reducing its free
cash flow further. Similarly, sales of financial assets to provide cash for operations
cccesicnatpapers.
2006
Net income
- Accruals
1. Change in cash and cash equivalents. The GAAP statement is set up to explain the
change in cashand cashequivalents (flagged 1 in Nike'sstatement). But cashgenerated
has to be disposed of somewhere. Anychange in cashneeded for operations (working
cash) isan investment inanoperating assetthatshould be included in thecashinvestment
section. The change in cashequivalents thatearn interest is an investment of excess cash
(over that needed for operations) in financial assetsthatshouldbe in the debtfinancing
section.
detailed review, see H. Nurnberg. "Perspectives onThe Cash Flow Statement under FASB
Statement No. 95," Occasional Paper, Center for Excellence in Accounting and Security Analysis, Columbia
Business School, September 2006, available athttpJ/WWW.gsb.columbia.edufceasairesearchipapersi
2007
Operating activities
Sources ofcash
Cash received from customers
Cash inflows
Progress payments
7,490
6.797
Cash from sales
Other collections
24,570 23,303
Cash from rents
Interest received
21
45
Cash from royalties
Income lax refunds received
52
60
Cash from interest received
Other cash receipts
159
........ill
Cash outflows
Cash provided by operating activities
32,292 30,347
Cash paid tosuppliers
Uses ofcash
Cash paid toemployees
Cash paid tosuppliers and employees
28,024 27,389
Cash paid for other operating activities
Interest paid
366
355
Cash paid for interest
Income taxes paid
678
905
Cash paid for income taxes
Other cash payments
104
---'!Q
Cash used in operating activities
29,388 28,513
2,904
1,834
The difference between cash inflows and cash outflows is Net cash provided by operating activities
cash from operations.
The cash from operations section ofthe2007 comparative INDIREG METHOD
cash flow statement for Northrop Grumman Corp., the de- The indirect method calculates cash from operations by subfense contractor, uses thedirect method:
trading accrual (noncash) components ofnetincome:
The GAAP statement can come in twoforms, one usingthe directmethod and one using
the indirect method. Box 10.2 explains the directand indirect presentations. Referto the
Website forcashflow statement presentations underIFRS.
1 For a more
Year Ended December 31,

S in millions
Change in Cash: Nike, Inc.
Nike's cash andcash equivalents increased by $277.2 mil- operating cash of $11.5 million. So reclassify $11.5 million in 2008. In the reformulated balance sheet in Ex- lion as cash investment in operations and $265.7 million
hibit 9.3,weattributed this to investment incash equiva- as a debt financing flow for the purchase of financial
lents (financial assets) of $265.7 million andanincrease in assets.
345
I-
I
!I
I!
EXHIBIT 10_1
GAAPConsolidated
Statements of Cash
Flowsfor Nike,Inc.,
2006-2008
Numbers on the righthandsideflagthe
adjustments numbered
in the text.
Chapter 10 The Anolysis of the C1l.lh Flow Swterncnt 347
NIKE, INC.
GAAP Statement of CashFlows
(in millions)
YearEnded May 31
2008
2007
2006
Cashprovided(used)by operations;
Netincome
$1,883.4
$1,491.5
$1,392.0
Income charges notaffecting cash:

Depreciation
30H
(300.6)
141.0
Stork-based compensation (Notes 1 and 10)

Gainon divestitures (Note15)
269.7
34.1
147.7
282.0
(26.0)
0.5
12.91
54.2
17.9
acquisition and divestitures:

Increase inprepaid expenses and othercurrent assets
Increase inaccounts payble, accrued liabilities, and
income taxes payable
(118.3)
(249.8)
(11.2)
346
(39.6)
(49.5)
(60.8)
(85.1)
(200.3)
(37.2)
330.9
85.1
1,878.7
1,667.9 (3)(4)
(2,133.8)
2,516.2
(313.5)
28.3
1431
12.619.71 (2)
1,709.8 (2)
(333.7)
1.6
(34.6)
Cash(used) providedby investingactivities
(413.8)
92.9
279.4
(1,276.6)
41.8
Il511
63.7
(255.7)
52.6
16.01
11811
343.3
322.9
2253
63.0
(1,248.0)
(412.9)
55.8
(985.2)
(343.7)
(761.1)
(290.9)
Cashused by financing activities

Effect of exchange ratechanges
(1,226.1)
(19.2)
0,111.5)
42.4
185091
25.7
Net increase(decrease) in cash and equivalents

Cash andequivalents, beginning of year
Cash and equivalents, endof year
Supplementaldisclosure of cashflow information:
Cash paid during the yearfor:
Interest, net of capitalized interest
Income taxes
Dividends declared ar.d not paid
277.2
1,856.7
$2.133.9
44.1
717.5
112.9
~~~
yielding a PIE of 52. Thefirm was a darling of technology

analysts, but some were concerned about the firm's
declining cashflowfrom operations. Netincome and cash
from operations are given belowfor the years1997-1999,
along with the investment section of the firm's cash flow
statement (inmillions of dollars).
11.8
1,936.3
Cashprovided(used)by investingactivities:
Purchases of short-term investments
(1,865.6)
Maturities of short-term investments
2,246.0
Additions to property, plant, and equipment
(449.2)
Disposals of property, plant, andequipment
1.9
Increase inotherassets, net of otherliabilities
121.81
Acquisition of subsidiary, net of cash acquired (Note 15) (571.1)
Proceeds from ovestitores (Note 15)
246.0
;i"~~
Fiscal YearEnding September30
Income taxbenefit from exercise ofstock options

Changes incertain working capital components and
otherassets andliabilities excluding the impact of
Cashprovided(used)by financingactivities:
Proceeds from issuance of long-term debt
Reductions inlong-term debt,
including current portion
Increase (decrease) in notespayable
Proceeds from exercise ofstock
options and otherstock issuances
Excess taxbenefits from share-based payment
arrangements
Dividends-c-common andpreferred
lucent Technologies is the telecommunications network

supplier that was spunoff fromAT&T in 1996.Thefirm includesthe research capabilities of the formerBeillaborateres. With the heavy network investment during the
telecom boom of the late 1990s, lucent becamea "hot
stock," with its share price rising to $60 by late 1999,
(60.6)
Amortization and other
Cashprovidedby operations
Transactions on Financial Assets: Lucent Technologies
902.5
$1.856.7
60.0
601.1
92.9
143l.91 (1)
1,388.1
$ 954.2
54.2
752.6
79.4
Netincome
Accruals
Cash from operating activities
Cash ininvesting activities:
Proceeds from thesaleor disposal of property, plant, andequipment
Purchases or equity investments
Sales of equity investments
Purchases of investment securities
Sales or maturity of investment securities
Dispositions of businesses
Acquisitions of businesses-netof cash acquired
Cash from mergers
Other investing activities-net
Netcash used in investing activities
Despite increasing profits, free cash flow (the
difference between cash from operating activities and
cash usedin investing activities) appears to be negativein
each of the three years. This is not unusual if a firm is increasing its investment to generate profits. However,
Lucent reported a shortfall of cash from operations, before investment, of $276 million in 1999 (the shortfall
after adding back after-tax net interestpayments is $191
million). Cash investment also declined in 1999, but the
$1,787 million numberis misleading. This is the amount
after selling interest-bearing investments for $1,132 million, as you see in the investing sectionof the statement.
The net proceeds from these investments, after purchases
of $450 million, is $682 million. Sothe actual investment
in operationswas $1,787 + $682 = $2,469 million, not
$1,787 million, and the deficits between reported cash
1999
1998
1997
s 4,766
$ 1,035
$ .449
(5,042)
(276)
~
1,860
(2,215)
97
(307)
156
14501
1,132
72
12641
61
(1,791)
57
Iml
71
(i,082)
686
l29
(1,078)
(1,744)
108
(149)
~
(1,787)
~
(3.100)
~
(3,371)
1,680
12
14831
356
181
(1,584)
flow from operations and the actual investment in

operationsis a $2,745 million.
Free cashflowcalculated fromGAAP numbers can be
quite misleading. A firm like lucent, faced with a cash
shortfall, can sell securities in which it is storing excess
cash to satisfy the shortfall. Under GAAP reporting, it
looks as if it is increasing free cash flow by doing so,
making it look less serious than it is. GAAP reporting
mixes the cash flow deficitwith the means employed to
deal withthe deficit.
Postscript: Lucent's negative cash flow in1999 was anindicator
ofthings to follow. With thebursting ofthetelecom bubble.
Lucent's share price declined to below $2 per share by2003. The
firm's accounting came into question. SeeMinicese M17.2 in
Chapter 17where these same cash flow statements are
investigated to raise accounting issues.
(or dividends) are classified in GAAP statements as decreases in investment flows rather
than financing flows.These sales satisfy a free cash flow shortfall, they do not create it.
Consequently, the GAAP statement can give the wrong impression of a firm's liquidity.
See the box in this section on Lucent Technologies.
3. Net cash interest. Cash interest payments and receipts for financing activities are
included in cash flow from operations under GAAP rather than classified as financing
Chapter 10 TheAnalysil of me Ca.sh Flow SraEement 349
348 Part Two TheAna1)'sis of FinancWl Srarements
flows. See the adjustment for Nike, with an accommodation for related taxes, under
point4 below. Also see the accompanying boxfor moreextreme examples. Note that
IFRS allows firms to choose between theoperating andfinancing section to classify net
interest payments.
An exception to including net interestin operations is interestcapitalized during
construction. This is classified, inappropriately, as cash investment because it is accountedfor as an investment in constructed assets(seethe noteon interestpayments
at the bottomof Nike's cash flow statement in Exhibit 10.1). But interestto finance
construction projects is not part of the costof construction and shouldbe classified
as a financing cash flow. Unfortunately, disclosure is usually not sufficientto sort
this out.
Interest Payments: Westinghouse

and Turner Broadcasting System
An extreme case ofinterest payments distorting cash flow
from operations appears inthe 1991 cash flow statement
forWestinghouse. The reported cash flow was $703 mlllion but that was after $1.006 billion of interest payments. If these interest payments had been classified asfinancin'g outflows, the cash flow from operations figure,
before tax, would have been $1.709 billion, or 243 percent higher.
The peculiarity oftreating interest asanoperating flow
can beseen inthecase ofzero coupon ordeep discount
debt The repayment of the principal at face value is a
Taxes on Net Interest Payments: Nike, Inc.

Nike's 2008 netinterest payments after taxare calculated
asfollows (in millions ofdollars):
Interest receipts
Interest payments
Net interest receipts before tax
Taxes (36.4%)
Net interest receipts after tax
$ 115.8
~
71.7
26.1
45.6
>
4"
The after-tax netinterest receipts of $45.6 million are

subtracted from cash from operations inthereformulated
statement and classified instead asa financing flow.
Note that interest receipts and payments are not the
same asinterest income and expense in theincome statement (that include accruals). Interest payments (but notinterest receipts) are often published at thefoot ofthecash
flow statements, orare provided infootnotes.
financing flow, butGAA? requires thedifference between

face value and theissue amount (the issue discount) tobe
treated asanoperating cash flow at maturity rather than
part ofthe repayment of principal. $0 repayment ofdebt
reduces operating cash flow. Accordingly, in 1990 Turner
Broadcasting System deducted $206.1 million ofissue discounts on zero coupon senior notes repaid incalculating
anoperating cash flow of $25.8 million. This iscorrect accounting according to GAAp, butthe reported operating
cash flow isan 89 percent distortion oftheactual $231.9
million number.
4. Taxon net interest. Justas cashfrom interest income andexpense is confused withoperating cash flows, so are taxes paidon financing and operating income. All tax cash
flows areincluded in cashfromoperations, even though someapply to financial income
or arereduced byfinancial expenses. We seekto separate after-tax operating cashflows
fromafter-tax financing cashflows, buttheGAAP statement blursthis distinction. The
accompanying box calculates Nike's after-tax net interest to adjust GAAP cash flow
fromoperations.
Cashinterest payments mustbedisclosed byfirms in footnotes: Nike's disclosure of
its interest payments is found at thebottom of the cashflow statement in Exhibit 10.1.
Convert theseinterest payments to an after-tax basisat the marginal tax rate. Cash interestreceipts areusually notreported. Theaccrual number intheincome statement has
tobe usedforinterest receipts; thisnumber willequalthecashnumber onlyif theopeningandclosing interest accruals arethesame.
5. Noncashtransactions.Nikehadnononcash transactions in2008, butit didreportnoncash transactions in 2000. See the accompanying box. In a noncash transaction, an
assetis acquired or an expense is incurred by the finn byassuming a liability (by writing a note,forexample) or by issuing stock. An acquisition of another firm forstockis
a noncash transaction. Capitalized leases arerecorded as assetsandliabilities, but there

is no cashflow for the purchase. A noncash transaction can involve an assetexchange
(oneassetforanother) or a liability exchange, or a conversion of debtto equity or vice
versa. With the exception of assetand liability exchanges within operating and financing categories, these noncash transactions affectthe Method 1 and Method 2 calculations of freecashflow because theyaffect NOA orNFO.lmplicitly weinterpret theseas
if there were a saleof something forcashandan immediate purchase of something else
withthatcash.TheGAAP statement recognizes thesetransactions asnotinvolving cash
flows. Thisof course is strictly correct, but it obscures theinvesting andfinancing activities, and the "as-if" cash flow accounting uncovers them. Consider the following
examples:
Debt that is converted to equity is not indicated as a payment of a loan (in the
financing section) ina GAAP statement eventhough theproceeds from theloanwere
recorded there in an earlier yearwhen the debtwasissued.
If a finn acquires an assetby writing a note,the payment of the noteis recorded in
subsequent years but theoriginal principal thatis beingpaidoffis not.
Forleases, nocashflow is recorded at theinception of thelease, butsubsequent lease
payments aredivided between interest andprincipal repayments andrecorded inthe
operating and financing sections, respectively, in the GAAP statement. The finn
appears to bepaying offa phantom loan.
Foran installment purchase ofplantassets, onlytheinitial installment isclassified as
investment. Subsequent payments are classified as financing flows. However, when
a firm sells an asset, all installments are investing inflows from the liquidation.
Obtaining details is difficult.
Theupshot ofallthisis thatwedon'tgeta complete picture of firms' investment and
financing activities in the GAAP statement. In all cases of noncash transactions, the
"as-if" cashmustbereported insupplemental disclosures so thatimplicit cashflows can
be reconstructed.
Tying It Together
Box 10.3 summarizes the adjustments that mustbe made to the GMP statement of cash
flows andmakes the adjustment to Nike'sstatement. The numbers accompanying selected
itemsflag them as oneof the five adjustments above.
350 PartTwo TheAna[:t5i5 of Financial Stmement5

I!I'~
Noncash Transactions: Nike, Inc.

At the foot of its 2000 statement of cash flows, Nike
reported the foliowing (in millions):
Assumption of long-term debtto acquire property,
plant, andequipment
$108.9
1~.'0ll
to cashinvestments and $108.9million to issue of debt in

financing activities. The transaction isequivalent to issuing
debt for cash, then using the cash to buyproperty, plant,
and equipment.
REFORMULATING GAAP CASH

FLOW STATEMENTS
GAAP free cash flow
-Jnceese inoperating cash
+ Purchase offinancial assets
- Sale offinancial assets
+ Netcash interest outflow (after tax)
- Noncash investments
::: Free cash flow
This transaction was not incorporated in the GAAP cash

flow statement. To adjust the statement, add $108.9 million
The free cash flow of $1,084 million in Nike's reformulated statement differs slightly
from the$1,016 million calculated under Method! andMethod 2 in Box 10.1. Thisoften
happens (andoften the difference is greater). Because of incomplete disclosures, precisely
reconciling the cash flow statement to the income statement and balance sheet is usually
notpossible. Thelikely reasons for thedifferences in thecalculation are
GAAP financing flow

+ Increase incash equivalents
+ Purchase of financial assets
- Sale offinancial assets
+ Net cash interest outflow (after tax)
- Noncash financing
::: Financing cash flow
"Otherassets" and "other liabilities" can't be classified into operating and financing
itemsappropriately. In particular, interest receivable andpayable (financing items) can
notbe distinguished from operating items in these "other" categories.
Cash dividends (in thecashflow statement) differ from dividends in thestatement ofequity, implying a dividend payable thatcannot bediscovered (usually lumped into"other
liabilities").
Cash received in share issues (in the cashflow statement) differs fromthe amount for
those sharetransactions in thestatement of equity, as with Nike. Thedifference implies
a receivable (for shares issued butnotpaidfor) thathasnotbeendiscovered.
The details for adjustments 3, 4, and 5 above are not available. Watch foracquisitions
withshares rather than cash.
When foreign subsidiaries are involved, balance sheetitemsare translated into dollar
amounts at beginning and end-of-year exchange rates, while cashflow items are translatedat average exchange rates. Thisresults in a difference between thechanges inbalance sheetnumbers andthe corresponding items inthe cashflow statement.
1
2
2
3,4
5
3,'
CASH FLOW FROM OPERATIONS
I
I
Free cash flow

Reported cash from operations
Net interest receipts (after tax)
$1,936
46
1,890
1
2
Cash investments reported

Investment inoperating cash
Net investment infinancial assets
Free cash flow
1
2
2
3,4
5
2
3,4
Let'snotmisstheforest forthetrees. Calculations aside, what isthe picture drawn here?

Following the reformulated statement, Nike had a free cash flow from operations of
$1,084 million because cashinvestments were less than cashfrom operations. The firm
used this cashto payout a net $1,255 million to shareholders and received $171 million
from netdebttransactions to satisfy theshortfall.
Ourcalculations following Methods 1and 2 yielda number for freecashflow butdo not
distinguish the two components, cashflow from operations and cash investments, in the
freecash flow number. Forthat weneedthe cashflow statement. But,again, werun into
problems withthe reporting. The reason is thatsomeof thecashflows that wemight view
as investment flows are included in cashfrom operations in the GAAP statement. Investmentin research and development is reported as partof cashfromoperations ratherthan
partof the investment section. Andinvestments in short-term assetsare classified as cash
NIKE,INC.
Reformulated cash Flow Statement,2004

(in millions)
$414
12
380
806
$ 1,084
Financing flows to claimants

Debt financing:
(64)
Increase innotes payable
35
Reductions inlong-term debt
Net liquidation of financial assets (380)
(40)
NE!t interest receipts (after tax)
(171)
278
investments incash equivalents
(netof exchange rate
effects on cash)
Equity financing:
(406)
Share issues
1,248
Shares repurchase
1,255
Dividends
~
$1,084
from operations. Consider inventories. Investments ininventory are necessary to carryout

operations just like plant and equipment. However, they are not treated as investments.
Rather, thecashspenton building up inventory reduces GAAP cashfrom operations just
likecashspentin inventory thatis shipped to customers.
Potentially wecouldmakefurther adjustments to cashflow from operations for these
investments. But that should be done only if there is a clear purpose. For many analysis tasks, it is free cash flow that is needed, and a misclassification of an investment as
an operating rather than investment flow does not affectthis number. Because expenditures on R&D activities, a long-run investment, are classified as a decrease in cashfrom
operations in financial statements, the R&D expenditures are added back to calculate
the appropriate cash from operations. But the misclassification does not affect the
calculation of free cash flow from the statement. The treatment of investment in brand
name through advertising, which also reduces GAAP cash flow from operations, is
similar.
Cash flow from operations is bestseenas a diagnotic tochallenge thequality ofaccrual
accounting. We willdothis inChapter 17. Buttheanalyst must handle the"cashflow from
operations" number carefully. Box lOA continues the Accounting Quality Watch with a
focus oncashflows.
351
The Accounting Quality Watch in Box 8.7 in Chapter 8 and plantandequipment. lookingat theinvestment section of the
80x9.9 in Chapter 9 continues here with quality issues that cash flow statement, the analyst wouldfind that the current
arise with reported cash flows. The three items listed below expenditure in plant andequipment was$3,040 million. These
are covered inthechapter. Further discussion of thequality of expenditures were necessary to generate cash from operations
thecash flowfromoperations number, and its use in analysis, in the future. Touting cash from operations withoutconsiderthen follows.
ingthecash expenditures (ordepreciation) needed to maintain
thecash from operations gives a false impression of theability
of thefirm to generate cash from operations.
Accounting Item
The QualityProblem
Cash flowfrom
Reported cash flowfrom operations reo
DelayingPayments
operations
ported under GAAP includes interest
Firms can increase cash flow simply bydelaying payments on
payments and receipts. These are not
accounts payable andotheroperating obligations. The delay
cash flows from operations, butrather
does not affect earnings. Home Depot, the warehouse
financing flows. (IFRS allows firms to
retailer, reported cash fromoperations of $5,942 millionfor
choose theoperating section orthe
financing section forreporting netinter- fiscal year 2002, up from $2,977 million from the year earest payments.)
lier. But $1,643 million of the amount reported in 2002
Taxes onnet
These taxes are included incash flow
came from an increase in accounts payable and taxes
interest
from operations, along withthenet
payable.
interest. They should bereclassified to
thefinancing section of thestatement.
Advertising and R&D Expenditures
Transactions in
Purchases and sales of these
Because advertising and research and development expendifinancial assets
"investments" are incorrectlydassified
tures are treated as cash from operations rather than cash
as netcash investments inoperations
investment under GAAP, cash from operations can be in(under both GAAP and IFRS). They are
creased by reducing these expenditures (withadverse consefinancing flows.
quences for thefuture).
THE QUALITY OF CASH FLOW

FROM OPERATIONS
Advancing Payments of Receivables
Firms can increase cash flow by selling or securitizing receivCommentators sometimes pointto "cash fromoperations" as abies. This does not, however, represent anability to generate
a pristine number on which to judge the operating perfor- cash from sales of products. In 2001, TRW, lnc. earnings
mance of a firm. Butthe fundamental analyst iscynical.
dropped to $68million from $438 million in 2000 whileoperating cash flow increased by $338 miJlion. Most of this inCash Flowand Noncash Charges
crease was dueto thefirmselling receivables for $327 million.
Cash flowfrom operations isoftenpromoted asabetter num(The firm disclosed thisin footnotes.)
berthanearnings on which to relybecause it dismisses noncash charges like depreciation. Analysts often view those NoncashTransactions
charges as coming from "bookkeeping rules" that do not Firms can increase cash from operations bypaying for services
affect thecash generation. However, oneignores depreciation with debt or share issues. Deferring the payment of wages
to one's peril. Depreciation is not a cash flow in the period with a payable or pension promise increases cash flow, as
when it ischarged, but it certainly comes from cash outflows, does compensation "paid" with stock options rather than
made earlier, for investments. And those investments are cash.
necessary to maintain cash from operations. If one refers
to cash flows rather than earnings, one should refer to net Structured Finance
cash f!ow--eash flow from operations less the cash invested With the help of a friendly banker, firms might structure
to deliver cash from operations-which, of course, is free borrowing to make the cash flows received from the borcash fiow.
rowing looklike operating cash flowsratherthanfinancing
In2007, Caterpillar, Inc., the manufaeturer of construction cash flows. Enron wasa case in point: Funneled through an
andmining equipment, reported cash flowfromoperations of off-balance-sheet vehicle, Joans were disguised as natural
$7,935 million. This was more than the $3,541 million re- gas trades between Enron and its bank, and the cash reported in earnings. However, thecash flow number was after ceipts from the effective loan were reported as cash from
adding back $1,797 million from earnings for depredation of operations.
352
CapitalizationPolicy Affects Cashfrom Operations
Mismatching
If a cash outflowistreated asaninvestment andthuscapitalized on the balance sheet, it falls into the investment section
of thecash flow statement rather thanthe cash fromoperations sections. So, if a firm is aggressively capitalizing what
wouldotherwise beoperating costs, it increases itscash flow
from operations. Routine maintenance costs may be treated
asproperty, plant, andequipment, for example.
The basic problem with cash flow from operations is that it

does not match inflows andoutflows well.You see thisin the
Caterpillar example above. As another example, a firm makingacquisitions increases cash flowfrom operations from new
customers acquired. But the cost of acquiring those cash
flows isnot in thecash flow section of thestatement.
Summary
The analyst looks to the cashflow statement to assess the ability of the firm to generate
cash. Free cashflow is a particular focus, forfree cashflow is necessary to anticipate liquidityandfinancing requirements in thefuture. Andfree cashflow forecasts arerequired if
theanalyst employs discounted cash flow methods forvaluation. Subsequent chapters that
involve forecasting cashwillrelyontheanalysis of thischapter.
Unfortunately, theGAAP statement of cashflows is a littlemessy. But,having reformulatedincome statements andbalance sheets appropriately, free cashflow can be calculated
simply byMethods 1and2 laidout in thischapter. Sowewillseeintheforecasting partof
thebookthatonce forecasted (reformulated) income statements andbalance sheets areprepared, forecasting free cashflow involves onesimple calculation from these statements. It
is hardto think of forecasting free cashflow without thinking of future sales, profitability,
and investments tbat will be reported in the income statement and balance sheet, so
forecasting these statements is needed to forecast free cashflow. Andif those statements
areinreformulated form, theforecasted free cashflow drops outof them immediately. This
is a veryefficient way of proceeding.
Thischapter haspresented the adjustments thatare necessary to read thefreecash flow
from the GAAP statement of cashflows. These adjustments reformulate the statement to
categorize cashflows correctly, so thatfree cashflow is identified andshown to be equal to
thefinancing flows.

Further examples of reformulated statements.
Further discussion of problems raised by the GAAP
presentation of thecash flow statement.
Further illustration of adjustments to GAAP cash flow

statements.
Presentation of thecash flowstatement under international accounting standards.
353
354 Part Two The Awl)'l;s of Financial SWlementl
Key Concepts
Chapter 10 TheAnalysis of rhe Cash. Flow SWlement 355
financial planning is planning to arrange

financing to meet the futurecashflow
needsof the business. 340
liquidity analysisis the analysis of current
and futurecashrelative to the claimson
cash. 340
noncash transaction involves the

acquisition of an assetor the incurring
of an expense byassuming a liability
or by issuingstock,without anycash
involved. 348
Concept
Questions
CIO.l. Why mightcashflow analysis be important for valuing firms?

CI 0.2. Forwhatpurposes mightforecasting cashflows be an analysis tool?
CI0.3. Fora pure equity finn (withno net debt), howis freecash flow disposed of?
C10A. By investing in short-term securities to absorb excesscash,a finn reduces itscash
flow after investing activities in its published cashflow statement. Whatis wrong
withthis picture?
CI0.5. Do you consider the direct method to be more informative than the indirect
method of presenting cashflow from operations?
CIO.6. GAAP cash flow statements treat interest capitalized duringconstruction as in.
vestment in plant.Do youagree withthis practice?
C 1O. 7. Why is freecashflow sometimes referred to as a liquidation concept?
AnalysisTools
Page
Method 1for calculating free cash flow

(equation 10.1)
Method 2 for calculating free cash flow
(equation 10.2)
Direct method for cash flow fromoperations
Indirect method for cash flow fromoperations
Reformulated cash flow statements
342
341
345
345
343
Key Measures
Page

Cash flowin financing activities
Cash flowin investing activities
Free cash flow
Net cash interest
Tax on netinterest
343
343
343
341
347
348
CIO.8. Why mightan analyst not putmuchweight ona firm's currentfreecashflow as an

indication of future freecashflow?
CIO.9. Whatfactors produce growth in freecashflow?
CIO.I0. Consider the following quote from the CFO of Lear Corp. (in The Wall Street
Journal, May 8, 2002, p. Cl): "Sales of receivables and operating cashflows are
entirely separate events. We see sales of receivables as a low-cost financing
method; it shouldn'tgenerate operating cashflow." Do youagree?
Exercises
Drill Exercises
El0.l.
State whether the following transactions affectcashflow from operations, free cashflow,
financing flows, or noneof them.
a. Payment of a receivable bya customer
b. Saleto a customer on credit
c. Expenditure on plant
d. Expenditure on research and development
e. Payment of interest
f. Purchase of a short-term investment withexcess cash
g. Saleof accounts receivable

With the equity statement, the balance sheet,and the income statement reformulated in
the Continuing Casefor Chapters 8 and 9, all that remains is to reformulate the cashflow
statement.
FREE CASH FLOW FROM BALANCE SHEETS

AND INCOME STATEMENT
Before reformulating the cash flow statement, calculate free cashflow for 2003 and 2004
fromthe balance sheetsandcomprehensive income statements youreformulated in the last
chapter. ApplyMethod 1 and Method 2.
Classification of Cash Flows (Easy)
El0.2.
Calculation of Free Cash Flow from the Balance Sheet
and Income Statement (Easy)

A firm reported comprehensive incomeof $376 million for 2009,consisting of$500 millionin operating income (aftertax) Jess $124million of net financial expense (aftertax). It
alsoreported the following comparative balance sheet(inmillions of dollars);
Balance Sheet
REFORMULATE THE CASH FLOW STATEMENT

Nowreformulate the cashflow statement for2004.Theworkyoudid in Chapter 4 willtake
youpartway. Notetheinformation given thereon interest paidduring 2004andthe tax rate.
The number for free cashflow that youget from the reformulated cashflow statement
will differ from that whichyou obtained from the balancesheetsand income statement.
Whymightthis be? Searchthe 1O-K forlikely explanations.
Statein a fewsentences whatthereformulated cashflow statement is saying. What'sthe
basicmessage?
Operating cash
Accounts receivable
Inventory
Property and plant
2009
2008
60
550
940
910
2.840
5,300
50
500
790
840
2,710
4,890
2009
2008
Accounts payable
Accrued liabilities
Ionq-term debt
1,200
390
1,840
1,040
450
1,970
Common equity
1,870
5.300
1,430
4.890
Calculate freecashflow usingMethod I and Method 2.
356 Part Two TheAnaiYJi5 of Financial Sfa!emcrlt5
E10.3.
Chapter 10 TheAnalysiJ of!he Cash Flow Sr.arement 357
Analyzing Cash Fiows (Medium)

Consider thefollowing comparative balance sheets fortheLiquidity Company:
E10,6,
December 31
2008
Operating cash
Accounts receivable
Inventories
land (unamortized cost)
Plant assets
Less: accumulated depreciation
$ 435,000
40,000
100,000
Accounts payable
Capital stock
25,000
1,050,000
$1,075,000
400,000
200,000
(100,0001
1,075,000
2007
$
50,000
-0-0800,000
200,000
-01,050,000
E10,7.
(inmillions of dollars):
-01,050,000
$1,050,000
Operating assets
Financial assets
Financial debt
Common equity
FreeCash Flowfor a Pure EquityFirm (Easy)
174.8
8.3
34.4
226.2
E10.8.
$590
110
890
700
170
20
700
130
30
540
$890
$700
FreeCash Flowand Financing Activities: General Electric Company(Easy)

Thefollowing summarizes free cashflows generated by General Electric from 2000-2004
(in millions of dollars).
Cash fromoperations
Cash investments
Free cash flow
FreeCash Flow for a Net Debtor (Easy)

The following information is for a firm that hasnetdebton its balance sheet(inmillions
of dollars).
Common shareholders' equity, December 31,2007
Common dividends, paid December 2008
Issue of common shares, December 2008
Netdebt, December 31,2007
Netdebt, December 31,2008
2008
Applications
Thefinn hadno share repurchases during 2009,

Calculate thefirm's free cash flow for2009.
E1O.S,
2009
$640
250
The firm reported $100 million in comprehensive income for 2009 and no net financial
income or expense.
a. Calculate thefree cashflow for2009.
b. How was thefreecashflow disposed of?
c. How can a finn withfinancial assets and financial liabilities have zero net financial
income or expense?
Thefollowing information is from thefinancial report of a pureequity company (one with

nonetdebt), In millions of dollars.
Common shareholders' equity, December 31, 2008
Common dividends, paid December 2009
Issue of common shares on December 31,2009
Applying Cash Flow Relations (Medium)

An analyst prepared reformulated balance sheets for the years 2009 and 2008 as follows
Thecompany paida dividend of $150,000 during 2008 andtherewere no equity contributions or stockrepurchases.
a. Calculate free cashflow generated during 2008,
b. Where didthe increase incashcome from?
c. How would your calculation in part (a) change if the firm invested in short-term
deposits rather than paying a dividend?
E10.4.
Applying cash Flow Relations (Easy)

A finn reported freecash flow of$430million andoperating income of$390 minion.
a. Byhow much didits netoperating assets change during theperiod?
b. The firm invested $29 million cash in newoperating assets during the period. What
were its operating accruals?
c. The finn incurred net financial expenses of$43 million after tax, paid a dividend of
$20million, andraised $33million from shareissues. What wasthechange in itsnet
debtposition during theperiod?
2000
2001
2002
2003
2004
30,009
37,699
39,398
40,308
34,848
61,227
36,102
21,843
36,484
38,414
(7,690)
(26,379)
14,259
(1,9301
a. Explain why suchaprofitable firm asGeneral Electric canhave negative free cashflow.
b. In 2005, thefinn announced thattheyears of building itssetofbusinesses was "largely
behind it,"so it would be slowing its investment activity. What is the likely effect on
free cashflow? How willGE's financing activities likely change? What arethealternative financing alternatives in lightof thechanged free cashflow?
174.8
8.3
34.4
226.2
54.3
37.4
Exercises E5.l3 andE6.l0 alsodealwithGeneral Electric.

There were no share repurchases during 2008. The finn reported net interest aftertax of
$4 million on its income statement for2008, andthisinterest waspaidin cash,
Calculate thefirm's free cashflow for2008,
E10.9.
Method 1 Calculation of Free Cash Flow for GeneralMills, Inc, (Easy)

Refer to the reformulated balance sheets and income statements for General Mills, Inc.
in Exhibits 95 and9.1l in Chapter 9.Calculate free cashflow for2008 from these statements.
358 PartTwo TheA1Ul!)"Si$ of Financial Swremrn!.l
Chapter 10 TheAnalysil of {h~ Cash Flow Stm~1nen! 359
RealWorld Connection
f. Whywasthe"netcashfrom investing" number reported for2004 sodifferent from that for
Coverage of General Mills in Exercises EU, E2.9,E3.9,E4.9,E6.8, E13.15, E14.8,and
2003? Is thelarge difference dueto a change inMicrosoft's investment in itsoperations?

g. Microsoft maintains $60 million in operating cash. What was its net investment in
financial assetsduringthe quarter(before anyeffectof exchange rates)?
EI5.IO.
E10.10.
FreeCash Flowfor Kimberley-Clark Corporation (Medium)
Afteranswering thesequestions, youhavethe ingredients to construct a reformulated cash

flow statement. Go aheadand do it.
Beloware summary numbers from reformulated balance sheets for 2007 and 2006 for
Kimberly-Clark Corporation, the paperproducts company, alongwith numbers from the
reformulated income statement for 2007 (in millions).
2007
Operating assets
Financial assets
Net financial expense (after tax)
$18,057.0
6,011.8
382.7
6,495.4
2006
$16,796.2
5,927.2
270.8
4,395,4
$2,740.1
147.1
Cash FlowStatements
(In millions, unaudited)
Three Months Ended

December 31
Quarter, 2005
2003
Follow Kimberly-Clark through the continuing case at the end of each chapter. Alsosee
Exercises E4.8,E6.14,E7.8,andE11.16 and Minicase 5.3.
Extracting Information from the Cash FlowStatement with a Reformulation:

MicrosoftCorporation (Medium)
Formany years,Microsoft hasgenerated considerable freecashflow. Up to 2004,it paidno
dividends and had no debt to payoff, so it invested the cash in interest-bearing securities.
Its balance sheet at the end of its second (December) quarter for fiscal year ending
June2005reported the following among currentassets(inmillions):

EXHIBIT 10.2
CashFlow Statement
forMicrosoft
Corporation for
FiscalSecond
a. The net payout to shareholders (dividends and sharerepurchases minus shareissues)

in 2007was$3,405.9 million. Calculate freecashflow usingMethod 1 and Method 2.
b. The fum reported cash flow from operations of $2,429 million in its 2007 cash flow
statement and also reported net interest payments of$142.4 million. It reported S898
million in cashspenton investing activities, but thiswasafterincluding a net$56 million from liquidating short-term interest-bearing securities. The fum's statutory tax
rateis 36.6percent. Calculate freecashflow from thesereported numbers.
E10.11.

Exercises on Microsoft are E1.6, E4.l4, E6.13, E7.7, E8.1O, E17.l0. and EI9.4. MinicasesM8.l and M12.2 alsodeal withMicrosoft.
June 30, 2004
December 31, 2004
$15,982
44,610
$ 4,556
29,948
You can see a significant reduction in both cash and short-term investments. Duringthe
secondquarter, Microsoft decided topayits first dividend in the formof a largespecial dividend. Exhibit 10.2 gives the cash flow statementfor the quarter, along with a note on
interest received on the investments listedabove. Thefirm's tax rateis 37.5percent.
Answer the following questions aboutthe quarterendedDecember 31,2004:
a. Whatwerethe cashdividends paidto common shareholders?
b. Whatwasthe net dividend paidout to shareholders?
c. Calculate (unlevered) cashflow fromoperations forthe quarter.
d. Calculate cashinvested in operations.
e. Calculate freecash flow.
Operations
Net income
Net recognized (gainsl/losses on investments
Stock option income taxbenefits
Unearned revenue
Recognition of unearned revenue
Accounts receivable
Other current assets
Other lone-term assets
Other current liabilities
Other long-term liabilities
Netcashfrom operations
Financing
Common stock issued
Common dividends
Netcashfromfinancing
Investing
Addit.'<ms to property andplant
Acquisition ofcompanies netofcash acquired
Purchases ofinvestments
Maturities of investments
Sales of investments
Netcashfrom investing
Netchange in cash and equivalents
Effect of exchange rates on cash andequivalents
Cash andequivalents, beginning of period
Cash and equivalents,end of period
s 1,549
2004
3,463
300
108
3,232
(321)
551
148
(985)
2,774
(3,166)
(1,O04)
74
99
68
3,354
(3,166)
(1,398)
607
55
373
1,256
17
129
69
4,574
3,619
189
(730)
795
(969)
(1,729)
(2.270)
(33,498)
(33,672)
(171)
(176)
(22,377)
(16,013)
825
19,536
20,068
23,414
(6,639)
11)
19,775
(1,949)
~
26
54
5,768
11.141
$ 6,149
S 4,556
Note: Interest
Micrnsofhas nodebt,so paidno interest duringthethreemonths.lntCl'e$! rt<.i ....d from;n....stmtntswasSJ7amillion
360 Part Two The Arwlysis of Financial SWfemenrs
Minicase M10.1
Analysis of Cash Flows: Dell, Inc.

At various points inthisbook, Dell,Inc.,thecomputer manufacturer, hasbeenhighlighted.
The firm's 2008 financial statements are reproduced in Exhibit 2.1 in Chapter 2 and its
reformulated balance sheets and income statements appear in Exhibits 9.4 and 9.10 in
Chapter 9. Reported cashflows for2008 were investigated in Box 4.5 in Chapter 4. This
caserequires youto pull allthisanalysis together. Thefirm's taxrateis 35 percent.
A. Using Method I, calculate Dell's freecashflow from its reformulated financial statements in Exhibits 9.4and9.10.Thencalculate the free cashflow directly from thecashflow statement. Why might thetwonumbers differ?
B. Using Method 2 for calculating free cashflows, canyoubackoutwhatthe netpayment
to shareholders (netdividend) wasin20077
C. Now calculate thenetpayout toshareholders fromthecashflow statement inExhibit 2.1
andfrom theequity statement inthatsame exhibit. Dothetwonumbers agree? Dothey
agree withthenumber youcalculated inpartB?
D. In 2008, Dellreported excess tax benefits from stock-based compensation aspart ofthe
financing section of the cash flow statement. Exhibit 2.1 shows that this item was
reported as cashfrom operations in2006. Thechange wasrequired byFASB Statement
123R. What doyou thinkis theappropriate treatment?
E. Dellreported proceeds from theissue of stockunderemployee plansof SI53 million in
its equity statement for 2008. Yet it reported $136million forthesestockissues in the
financing section of its cashflow statement. Why is there a difference?
F. The reformulated balance sheetfor2008 (in Exhibit 9.4)shows thatDellis sitting on a
large"cashpile."Whatmight Delldowiththe cash?

Dellis analyzed further in Exercises E3.7, E3.14, E5.11, E8.12, E13.16, andE19.4 andalso
in Minicase M15.2. SeealsoExhibit 2.1 in Chapter 2 andBoxes 4.5and4.6 in Chapter 4
andBox 11.5 in Chapter 11forfurther coverage of Dell.
Chapter 11 TheAnalysil ofProfitabi1i!:f 363

How ratios aggregate to explain return on common
equity (ROCE).
How financial leverage affects ROCE.
How operating liability leverage affects ROCE.
The difference between return on netoperating assets
(RNOA) and return onassets {ROA}.
How profit margins, asset turnovers, and their compositeratios drive RNOA.
How borrowing costs are analyzed,
How profitability analysis can be used to ask penetrating questions regarding thefirm's activities.
LINKS
Linkto previous chapters
Chapters 8, 9, and 10
reformulated thefinancial
statements to prepare them
foranalysis.
This chapter
ThischapterlaysOut the
analysis of profitability
thatis necessary for
forecasting future
profitability andvaluation.
V,.'
Linktonext chapter
Chapter 12laysout the
analysis of growth, to
complete the analysis of
thefinancial statements.
Link10Webpage
TheWebSiteapplies the
analysis in thischapter
to a widerrangeof firms
(www.mhhe.com/
penmanae).
Whatare the
financial
statement
drivers of
ROCE?
,.~\;iU~:;D.;'
Whatarethe
effectsof
financial and
operating
liability
leverage On
Howis
operating
profitability
analyzed?
Howare
borrowing
costs
analyzed?
ROCE?
'-c---,-,--! . ,,\~, '" ~--'

C,",'::
,.'....." ..-',....',
.,~,>: :':::;}fh
"'.' . ,,'
:'~W~~tt1
'.~:O~~;~~~"~~~t~al~a~~:~c~O~:lt~/~~~;;r~:~~~~u~
. forecastabrlb'"",,: . gs growth, whichis the sameas residual earnings growth. Residualearnings ~'detemiined bytheprofitability ofshareholders' investment, RaCE, andthe
growth in investment Soforecasting involves forecasting profitability andgrowth. Toforecast,weneed to understand whatdrives ROCE andgrowth. The analysis of the drivers of
ROCE is calledprofitabilityanalysisandthe analysis of growth is called growth analysis.Thischaptercovers profitability analysis. Thenextchapter covers growth analysis.
The reformulation of financial statements in the preceding chapters readies the statementsfor profitability and growth analysis. This andthe next chapter complete the financialstatement analysis.
Profitability analysis establishes where the fum is now. It discovers whatdrives current
RaCE. Withthisunderstanding ofthepresent, theanalyst begins to forecast byaskinghow
future ROCE will be different from current RaCE.To do so she forecasts the drivers that
welayout in thischapter. The forecasts, in tum, determine thevalue, so muchso that the
profitability drivers ofthis chapter aresometimes referred toas value drivers. PartThreeof
thebookcarriestheanalysis of this chapter overto forecasting.
Value is generated by economic factors, of course. Accounting measures capture these
factors. In identifying theprofitability drivers, it is important to understand the aspects of
the business that determine them.As you analyze the drivers, you learnmore about the
business. Profitability analysis has a mechanical aspect, and the analysis here can be
transcribed to a spreadsheet program where the reformulated statements are fed in and

Calculate ratios thatdrive ROCE.
Demonstrate how ratios combine to yield the ROCE.
Perform a complete profitability analysis on reformulated financial statements.
Prepare a spreadsheet program based on the design
in this chapter. See the BYOAP feature on the text's
Web site.
Answer "what-if" questions about a firm using the
analysis inthis chapter.
numerous ratios are spat out. But the purpose is to identify the sources of the value
generation. So as you go through the mechanics, continually thinkof the activities of the
firm that produce the ratios. Profitability analysis focuses the lenson the business.
With this thinking, profitability analysis becomes a tool for management planning,
strategy analysis, and decision making, as wellas valuation. The manager recognizes that
generating higher profitability generates value. He then asks: What drives profitability?
How willprofitability change as a resultof a particular decision, and howdoesthe change
translate intovaluecreatedfor shareholders? If a retailerdecides to reduce advertisinz and
adopta "frequent buyer"program instead, howdoesthis affectROCE andthevaluccf the
equity? Whatwillbe theeffectof an expansion of retail floorspace? Of an acquisition of
another finn?
The purpose of analysis is to get answers to questions like these. So you will find a
number of "whatif" questions in this chapter. Andyouwillseehowanalysis provides the
answers to thesequestions.
THE ANALYSIS OF RETURN ON COMMON EQUITY

As wehave seen,thereturnoncommon stockholders' equity(CSE) is calculated as
Return on COmmon equity(ROCE) = Comprehensive income
Average CSE
Figure 11.1 shows how ROCE is broken down into its drivers, so follow this figure as we
go through the analysis. The analysis proceeds over three levels. First, the effects of
financing leverage and operating liability leverage are analyzed. Second, the effects of
profit margins and assetturnovers on operating profitability are identified. Third, the individual drivers of profitmargins, asset turnovers, and net borrowing costs are calculated.
Acronyms thatwillbe usedas weproceed aregiven at thebottom of Figure 11.1.
364 PartTwo TheAnal)'5U of Financial Statements
FIGURE 11.1 The Analysis ofProfitabHity
The breakdown ofrerum oncommon equity (ROCE) into itsdrivers.

~------,
Rerumoncommon equity ~
RQCE "" Comprehensive earnings

Average (SE
Comprehensive earnings in the numerator of ROCE is
composed of operating income andnetfinancial expense, as
depicted in a reformulated income statement. Common

shareholders' equity (eSE) in thedenominator isnet operating
assets minus netfinancial obligations. Thus
Operating
liability leverage
Grossmargin and
expense drivers
ROCE
Individual assetand
liability drivers
(Balance sheet amounts areaverages over theperiod)The operating income (01) is generated by the net operating assets
(NOAl, andthe operating profitability measure, RNOA, gives
thepercentage return on thenetoperating assets. The netfinancial expense (NFE) isgenerated bythe netfinancial obliga-
Netborrowing cost
drivers
FIRST-LEVEL BREAKDOWN: DISTINGUISHING FINANCING

AND OPERATING ACTIVITIES AND THE EFFECT OF LEVERAGE
We have seen that both operating activities (which produce operating income) and
financing activities (which produce financial income or expense) affect the earnings for
cornmon shareholders. The first breakdown of ROCE distinguishes the profitability of .
thesetwoactivities. It also distinguishes the effect of leverage, which "levers" the ROCE
up or down through liabilities. Leverage is also sometimes referred to as "gearing."
Financial Leverage
Financial leverage is the degree to whichnet operating assets are financed by borrowing
with net financial obligations (NFO) or by common equity. The measure FLEV :::
NFOICSE, introduced in Chapter 9, captures financial leverage. To the extent that net
operating assetsare financed by net financial obligations ratherthanequity, the returnon
the equityis affected. Thetypical FLEV is about 0.4, but thereis considerable variation
among firrns.
Financial leverage affects ROCE as follows (seeBox11.1):
Return on COmmon equity = Return on netoperating assets
+ (Financial leverage x Operating spread)
ROCE~
OI",NFE
NOA-NFO
(11.1)
RNOA + [FLEVx (RNOA - NBC)J
Thisexpression forROCE says thatthe ROCE canbe broken down intothree drivers:
1. Return onnet operating assets (RNOA::: OIfNOA).
2. Financial leverage (FLEV ::: NFOICSE).
3. Operating spreadbetween thereturnon netoperating assets andthenetborrowing cost
(SPREAD = RNOA - NBC).
tions (NFO), andthe rate at which theNFE isincurred isthenet

borrowing cost (NBC). So theROCE can beexpressed as
ROCE
=(NOA x RNOA) _ (NfO x NBC)

\ CIE
CIE
where, to remind you, RNOA = OIlNOA andNBC = Netfinan-
cial expenselNFO. This expression for ROCE is a weighted

average of the return from operations and the (negative)
return from financing activities.
Wegetmore insights by rearranging thisexpression:
ROCE = RNOA +
[~~~ x (RNOA -
NBCl]
=RNOA + (Financial leverage x Operating spread)

=RNOA + (FlEV x SPREAD)
Bothoperating income andnet financial expense mustbe after tax and comprehensive of
all components, as in the reformulated income statements of Chapter 9; otherwise, this
breakdown willnot work.
Thisformula saysthattheROCE is levered upoverthereturn from operations ifthefinn
has financial leverage and the return from operations is greater than the borrowing cost.
The firm earns more on its equity if the net operating assets are financed by net debt,
provided those assets earn more than thecostof debt.
Figure 11.2 depicts how the difference between ROCE andRNOA changes withfinancial leverage according to the formula. If a firm haszerofinancial leverage, equation 11.1
says that ROCE equalsRNOA. If the firm hasfinancial leverage, then the difference between ROCE and RNOA is determined bythe amount of the leverage andthe operating
spread between RNOA andthe net borrowing cost.We willsimply referto the operating
spread as the SPREAD. If a firm earnsan RNOA greaterthanits after-tax netborrowing
cost,it is saidto have favorable financial leverage or favorable gearing: TheRNOA is
"levered up"or"geared up"toyielda higher ROCE. Ifthe SPREAD is negative, the leverage effect is unfavorable. Box 11.2 gives a demonstration with General Mills, whose
reformulated balance sheet is presented in Exhibit 9.5 in Chapter 9. The example highlights the"good newslbad news" nature of financial leverage: Financial leverage generates
a higher return for shareholders if the firm earns more on its operating assets than its
borrowing cost,butfinancial leverage hurts shareholder return if it doesn't. Accordingly,
leverage is a component of the riskof equity as weli as its profitability, as we will see in
Chapter 13.We willalsoaskthefollowing question inthatchapter: Cana firm increase its
equity value by increasing its ROCE through financial leverage, or will it reduce itsequity
value because ofthe increase inrisk?
How does the analysis change when a firm like Nike has net financial assets (NFA)
rather thannet financial obligations (NFO)? In this case, financial income will be greater
than financial expense and the firm will have a positive return on financing activities
365
366 Part Two TheAndysis o[F:iumcial S<alementl
FIGURE 11.2
HowFinancial
Leverage Affects the
Difference Between
ROCE and RNOA
for Different
Amountsof
Operating Spread
FLEV is financial
leverage andthe
SPREAD is the
difference between
RNOAandthenet
borrowing cost.
r "~ >=
~B
General Mills, a large manufacturer of packaged foods, has

had considerable stock repurchases over theyears, leaving it
fairly highly leveraged. in Exhibit 9.5 in Chapter 9 you see
that, for fiscal 2008, its average shareholders' equity was
$6.458 billion on average netoperating assets of $12.572 billion. Its average financial leverage was 0.947, based on these
average balance sheet amounts.
The firm's ROCE for 2008 was 25.5 percent. Further analysis reveals that this number was driven by the highleverage:
g~
ROCE = RNOA + [FLEV x (RNOA - NBC)]
6z
~
4% 1
SPREAD ",2%
------~---~--------------
o~
tj~
OZ
P::::
P::::
"I
2%
---~~~-
----
----~~------
SPREAD",
1%
_
]?2
<J
SPREAD",Q%
0%
-2%
25.5% = 15.1 % + [0.947 x 05.1% - 4.1 %)]
-----~-------------
SPREAD ",-1%
--
SPREAD ",-2%
-4%
+--,-,--,--,--,-"-,-':::0,,,
0.00
0.25
0.50
0.75
1.00
1.25
1.50
1.75
2.00
FLEV
ROCE",RNOA+ (FLEV x SPREAD)
(RJ.'\l:FA) rather thannetborrowing costs. Return on common equity is related to RJ."JOA as

follows:
NFA
ROCE=RNOA- x (RNOA - RNFA) ]
[ CSE
(11.2)
where (as in Chapter 9) RNFA = Net financial incomeINFA, the return on net financial
assets. Herea positive spreadreduces the ROCE: Some of shareholders' equityis invested
in financial assets andif financial assets earnlessthanoperating assets, ROCE is lower than
RNOA. Box11.3 demonstrates withNike.
Operating Liability Leverage

Justas financial liabilities can lever up the ROCE, so canoperating liabilities leverup the
returnonnetoperating assets. Operating liabilities areobligations incurred in thecourse of
operations and are distinct from financial obligations incurred to finance the operations.
Chapter 9 gave a measure of the extent to which the net operating assets (NOA) are
comprised of operating liabilities (OL), the operating liability leverage:
ROCE can exaggerate underlying operating profitability: RNOA

is 15.1 percent butthehighfinancial leverage, combined with
a SPREAD over abcrrowinq cost of 4.1 percent, yields a much

higher ROCE. Beware of firms boasting highROCE: Isit driven
by financial leverage rather thanOperations?
A what-lf Question
What if the RNOA at General Millsfell to 2 percent? What
wouldbethe effect on RaCE?
The answer is that the RaCE would fall to zero percent:
0.0% = 2.0% + [0.947 x (2.0% - 4.1 %)]

The unfavorable leverage would produce zero ROCE on a
positive RNOA. An RNOA of less than 2 percent wouldresult
in a negative RaCE.
General Millshas minority interest on its balance sheet.
This complicates the ROCE calculation. See Box 11.5.
can get credit in its operations with no explicit interest, it reduces its investment in net
operating assets andlevers itsRNOA. Butcredit comes witha price. Suppliers who provide
credit without interest alsocharge higher prices forthegoods andservices they supply than
would be the case if the firm paidcash. And so operating liability leverage, like financial
leverage, canbe unfavorable as well as favorable.
To compute the leverage effect, first estimate the implicit interest thata supplier would
charge for credit, using thefirm's short-term borrowing rateforfinancial debt:
Implicit interest on operating liabilities = Short-term borrowing rate(aftertax)
x Operating liabilities
Then calculate a return onoperating assets, ROOA, as if there were nooperating liabilities:
Return on operating assets(ROOAl
01 + Implicit interest (aftertax)

Operating assets
RNOA is driven byoperating liability leverage as follows:

Return on netoperating assets = Return onoperating assets
(11.3)
+ (Operating liability leverage
x Operating liability leverage spread)
RNOA = ROOA + (OLLEV x OLSPREAD)
where OLSPREAD is the operating liabilityleverage spread, that is, the spread of the
return on operating assets overtheafter-tax short-term borrowing rate:
OLSPREAD "" ROOA - Short-term borrowing rate(after tax)
. l'b"
Operatmg
ia ility Ieverage (OLLEY) = -OC
NOA
The typical OLLEY is about0.4. Operating liabilities reduce the net operating assets
thatare employed andso leverthereturn on net operating assets. To theextentthata firm
This leverage expression for RNOA is similar in form to the financial leverage equation(11.1) forROCE: RNOA is driven bythe rateof return onoperating assets as if there
were nooperating liability leverage, ROOA, plusa leverage premium thatisdetermined by
the amount of operating liability leverage, OLLEY, and the operating liability leverage
spread, OLSPREAD. Theeffect canbe favorable operating liabilityleverage-if ROOA
367
Nike hasbeen very profitable. lookat thefirm's reformulated

statements for fiscal year 2008 in Exhibits 9.3 and 9.9 in
Chapter 9. For fiscal 2008, thefirm reported an ROCE of 25.9
percent on average common equity of $7.458 billion. But
Nike had considerable (average) financial assets of $2.086 billion from cash generated from its operations, giving it an
average financial leverage that was negative: -0.280. The
firm's return on average netfinancial assets was 2.3 percent.
The ROCE masks the profitability of operations of 35.0
percent:
ROCE::: RNOA- [NFNC5E x (RNOA - RNFA)]
The RNOA of 35.0 percent is weighted down bythe lower

return onfinancing activities intheoverall ROCE.
AWhatlf Question
What if the company used $1.0 billion of itsfinancial assets
to pay a special dividend? What would betheeffect onROCE?
The answer isthatwith $1.0 billion less inaverage financial assets and common equity, the average financial leverage would have been ~O.168 rather than -0.280, and the
ROCE would have been
29.5% ::: 35.0% - [0.168 x (35.0% - 2.3%)]
Dividends (and stock repurchases) increase ROCE.
25.9%::: 35.0% - [0.280 x (35.0% - 2.3%)J
General Mills hadaverage netoperating assets of$12.572 billion during fiscal year 2008 ofwhich $5.552 billion wasin operating liabilities. Thus itsoperating liability leverage ratio was
0.442. Its borrowing rate on itsshort-term notes payable was
3.6 percent, or 2.3 percent after tax. It reported operating
income of$1.901 billion, butapplying theafter-tax short-term
borrowing fate to operating liabilities, this operating income
includes implicit after-tax interest charges of$127.7 million. 50
onaverage operating assets of $18.124 billion,
ROOA 1,901 + 127.7 11.2%
18,124
The effect of operating liability leverage isfavorable:
A What-IfQuestion
What if suppliers were to charge the short-term borrowing
rateof2.3percent explicitly forthecredit supplied inaccounts
payable? What would betheeffect on ROCE?
The answer is probably none. The interest would be an
additional expense. But to stay competitive, the supplier
would have to reduce prices of goods sold to the firm bya
corresponding amount so that the total price charged (in
implicit plus explicit interest) remains the same. But supplier
markets may notwork as competitively as this supposes, so
firms canexploit operating liability leverage if they have power
over their suppliers. likeDell, lnc., they can addvalue intheir
supplier relationship, that is, through operating liability leverage. Refer back to thediscussion of Dell inChapter 9.
RNOA::: 15.1 %:=: 11.2% + [0.442 x (11.2% - 2.3%)]
is greater than the short-term borrowingrate-or unfavorable-if ROOA is less than the
short-termborrowingrate. See Box 11.4 for an analysisof GeneralMills'soperatingliability leverage.
Operatingliability leverage can add value for shareholders, so is importantto identify
if the analystis to discover the sourceof thevaluegeneration. A finn that carries $400 million in inventory but has $400millionin accountspayableto the suppliers of the inventory
effectively has zero net investment in inventory. The suppliersare carryingthe investment
in inventory which represents investment in the operations that the shareholders do not
have to make (and can, rather, invest elsewhere to generate returns). Dell, Inc., whose
reformulated balancesheets and incomestatements are presented in Exhibits9.4 and 9.10
in Chapter9, is a case of a firmusingoperatingliabilityleverage. Indeed., Dell has so many
operatingliabilities that its net operatingassets are negative. Castback to the discussion on
Dell surroundingthose exhibits to see how its extreme operating liability leverage adds
value to shareholders: The operating liability leverage produces residual income from
operationsthat is greater than incomefromoperations!
A coupleof complications can arise whenanalyzing leverage effects. First, the presence
of a minority interest calls for a modification. See Box 11.5. Second, if net borrowing is
closeto zero, it can happen that firms report net interest expense (interest expense greater
thaninterestincome) in the incomestatement but an average net financial asset position in
the balance sheet (or vice versa). Also, because of small average net financial obligations
(in the denominator), you can sometimes calculate a very high net borrowing cost.These
problems arisebecause, strictly, average net borrowing shouldbe average of dailybalances,
not just the beginning and ending balances. An analyst typically does not have access to
thesenumbers, although using amountsfrom quarterly reportsalleviates the problem. The
problem is not very important; for firmswith net borrowing closeto zero, the investigation
of financing leverage effects is uninteresting. Andone can always refer to thedebt footnote
for borrowing costs.
Return on Net Operating Assets and Return on Assets

A commonmeasure of the profitability of operations is the returnon assets(ROA):
Summing Financial Leverage and Operating Liability

Leverage Effects on Shareholder Profitability
Shareholderprofitability, ROCE, is affectedby both financial leverage and operatingliability leverage. Withouteither type of leverage, ROCEwouldbe equal to ROOA, the rate
of return on operatingassets. Operating liabilityleverage levers RNOAover ROOA and
financial1everage leversROCEoverRNOA:
ROCE ~ ROOA + (RNOA - ROOA) + (ROCE - RNOA)

So, for the GeneralMil1s examplesin Boxes 11.2 and 11.4,the ROCEof25.5 percent is
determinedas follows:
ROCE== 11.2%+ (l5.1% - 11.2%)+ (25.5% ~ 15.1 %)
:=:
I J.2% + 3.9% + 10.4%
'" 25.5%
368
ROA
Net income + Interestexpense(after tax)

Averagetotalassets
(Minority interest in income, if any, is added to the numerator.) The net income in the
numerator is usually reported net income rather than comprehensive income. But, this
aside, the ROA calculation mixes up financing and operating activities. Interest income,
part of financing activities, is in the numerator. Total assets are operating assets plus
financial assets, so financial assets are in the base.Thus the measure mixes the return on
operations with the (usually [ower) return from investing excess cash in financial assets.
Operating liabilities are excluded from the base. Thus the measure includes the cost of
operating liabilities in the numerator (in the form of higher input prices as the price of
credit) but excludes the benefit of operating liability leverage in the base. The RNOA
calculation appropriately distinguishes operatingand financial items. As interest-bearing
financial assets are negative financial obligations, they do not affect the return on
369
Chapter 11 TheAna!Jsis ofProfiUlbilit), 371
The presence of minority interest calls fora slight revision in

the calculations of the effect of toanoallevereqe. Minority
interest, unlike debtholder interests, does not affect the
overall profitability of equity, the leverage, or the SPREAD. It
just affects the division of rewards between different equity
claimants. The minority, like the majority common, shares the
costs and benefits of leverage. So the additional step with
minority interest (Mil is to distinguish RaCE forall common
claimants from thatforthe (majority) common owners of the
parent corporation intheconsolidation:
RaCE = RaCE before Ml x Ml sharing ratio
where ROCE is the return on common equity to the shareholders ofthe parent company (themajority) and
Comprehensive incorr.e before Ml

ROCEt:cioreMI
CSE+MI
Cormehersse incorr.e I
Minodty interest COl"f1Pi'?hensive incorr.e before MI
sharing ratio CSE/(CSE+MO
The first ratio here gives thereturn tototatconmon equity, minorit)'andmajority. The second ratio gives thesharing ofthereturn.
Use ROCE before minority interest when applying thefinancing
leveraging equation 11.1, aswedidwith General Millsin Box 11.2.
This calculation is cumbersome. Minority interests are
typically small in the United States, and one can (as an
approximation) usually treatminority interest asa reduction in
consolidated operating income andnetoperating assets.
operations. Operating liabilities reduce the neededinv:stmentin operatingassets,providing operating liability leverage, so they are subtracted In thebase.
.
Thus ROAtypically measures a lowerrate of return than RNOA. The medianROA for
allU.S.nonfinancial firmsfrom 1963to 2007was7.1percent. Thisis belowwhatwewould
expectfor a returnto risky business investment: It looksmorelike ~ bond rate.Themed.ian
RNOA was 10.5percent, morein linewithwhatweexpectas a typicalreturnfromrunning
businesses. ROA is a poormeasure of operating profitability.
Table11.1 compares ROA andRNOA for selected firmsfor2007.You can seetbatROA
understates operating profitability. Lookparticularly at NikeandGeneral~ills. The RN?A
measuresidentify Microsoft, Genentech, and CiscoSystemsas the exceptional comparues
they indeedare.
.
.
Operating liabilityleverage (OLLEY) andthe amountoffinancial asse~ relative to total
assets explainthe difference between RNOA and ROA, and you can see In the table that
firms with the largest differences have bigh numbers for these ratios. Microsoft had an
TABLE 11.1
ReturnonNet
Operating Assets
(RNOA) andReturn
onAssets (ROA) for
Selected Firmsfor
2007 Fiscal Year
ROA typically
understates operating
profitability because it
fails toincorporate
operating liability
leverage and includes
theprofitability of
financial assets. (The
numbers forNike and
General Mills arefor
fiscal year 2008, which
covers partof2007).
370
Industry and Firm

Biotech
Genentech, inc.
Amgen, Inc.
High-tech
Microsoft Corp.
Oracle Corp.
Cisco Systems, Inc.
Retailers
Wal-Mart Stores, Inc.
The Gap, Inc.
Oil producers and refiners
ExxonMobil Corp.
Chevron Corp.
Nike and Genera! Mills
Nike, Inc.
General Mills, Inc.
Operating liability Financial Assetsl

RNOA. % ROA,% leverage (OLLEY) TotalAssets, %
40.4%
15.3
134.3
27.8
49.1
20.9%
9.9
0.44
0.25
30.2%
19.6
21.2
14.1
14.8
2.86
0.59
1.02
43.4
23.0
41.4
14.4
25.5
8.9
11.1
0.50
1.12
4.2
27.9
41.4
26.0
17.7
13.4
0.95
0.82
14.6
6.9
35.0
15.1
16.5
8.5
0.65
0.44
23.6
2.5
RNOA of 1343 percent in 2007, but inclusion of financial assets (43.4 percent of total
assets) in the ROA measure and the omission of the operating liability leverage of 2.86
reducestheprofitability measure to 21.2 percent.
Theseobservations reinforce twopoints.To analyze profitability effectively, two proceduresmustbe followed:
1. Incomemustbe calculated on a comprehensive (clean-surplus) basis.
2. There mustbe a cleandistinction between operatingand financing itemsin the income
statementandbalancesheet.
You will get "clean" measures only if these two elementsare in place.So you can see the
payoffto yourworkin this and the preceding chapters.
Financial Leverage and Debt-to-Equity Ratios

A common measure of financial leverage is the debt-la-equity ratio, calculated as totaldebt
divided by equity. This measure is useful in credit analysis (see Chapter 19) but, for the
analysis of profitability, it confuses operating liabilities (which create operating liability
:everage) withfinancial liabilities (which createfinancial leverage). And, as usually defined,
It doesnot net out financial liabilities againstfinancial assets.
The difference can be sizable: The mediandebt-to-equity ratiofor U.S. firms from 1963
to 2004 was 1.22whilethe medianFLEVwas 0.43. Microsoft bad 43.4 percentof its assets in financial assetsat the end 2007and,withan operatingliability leverage of2.86, bad
no financial obligations. Its debt-to-equity ratio was 1.02,but all the debt in the debt-toequityratio was operating debt. Sousingthe fum's debt-to-equnv ratioas an indication of
financial leverage would be quite misleading: Microsoft's FLEV (which includes the
financial assetsas negative debt) was-0.619.
SECOND-LEVEL BREAKDOWN: DRIVERS

OF OPERATING PROFITABILITY
In the first-level breakdown, RNOA is isolated as an important driver of the ROCE. Followingthe scheme in Figure 11.1, fu"iOA can bebrokendownfurther intoitsdrivers so that
ROCE = RNOA + [FLEVx (RNOA - NBC)]
(11.4)
= (PMxATO) + [FLEVx (RNOA- NBC)]
The twodrivers ofRNOA are

1. Operating profitmargin (PM):
PM = OI (aftertax)/Sales
This we calculated as a common-size ratio in Chapter9. The profitmargin reveals the
profitability of each dollarof sales.
2. Assetturnover (ATO):
ATO = SalesINOA
The asset turnover reveals the sales revenue per dollar of net operating assets put in
place. It measures the abilityof theNOAto generate sales.It is sometimes referredto as
its inverse, lIATO = NONSales, whichindicates the amountof NOA usedto generate a
dollar of sales: If the ATO is 2.0, the fum is using 50 cents of net operating assets to
generatea dollarof sales.
372 Part Two TheAnalysis ofFillllncia! Statements
Chapter11 The AllIllYlis ofProfirab:1iry 373
This decomposition of operating profitability is known as the DuPont model. It says

thatprofitability inoperations comesfromtwosources. First, RNOA ishigherthe more of
eachdollarof salesendsup in operating income; second, RNOAis higherthe moresales
aregenerated fromthenetoperating assets. Thefirstis a profitability measure; the second
is an efficiency measure. A finn generates profitability by increasing margins and can
leverthe margins upbyusingoperating assetsandoperating liabilities moreefficiently to
generate sales.
Theaverage (after-tax) profitmargin is about 5.3 percent andtheaverage assetturnover
is about 2.o. Butit is clearthata firm canproduce a given level of RNOA witha relatively
high profit margin but low turnover, or witha relatively highturnover but a low margin.
Figure 11.3 plotsmedian PM andATC for various industries from 1963 to 2000.You see
fromthefigure thatindustries withlow assetturnovers tendtohavehighprofit margins, and
industries with high asset turnovers tend to have low profit margins. The figure draws a
curve-sloping down tothe right-that connects dotswiththe same 14percent RNOA but
different PMsandATOs. An industry with a 30 percent margin and an ATO of 0.47 (like
watersupply) hasthesame 14percent RNOA as a firm witha 2 percent margin andanATC
of 7.0 (likegrocery stores).
Table 11.2 gives median RNOAs, PMs, andATCs for a number of industries. It ranks
industries on theirmedian RaCE and alsogives theirmedian financial leverage (FLEV)
and operating liability leverage (OLLEY). This table gives you a sense of the typical
amounts for thesemeasures. The median ROCE overall industries is 12.2 percent, and
the median RNOA is 10.3 percent. Thedifference is dueto financial leverage anda positive SPREAD. The median FLEVoverall industries is 0.403, but there is considerable
variation. You can see that some industries-pipelines, utilities, and hotels-have
produced ROCE through highly favorable financial leverage. Others-business services,
printing and publishing, and chemicals-use little financial leverage to yield a high
ROCE. Some-such as business services-have used operating liability leverage rather
thanfinancial leverage to leverRaCE. Others-such as trucking andairlines-have used
both forms of leverage.
FIGURE 11.3
Profit Margin and
AssetTurnover
Combinations for
VariousIndustries,
1963-2000
Industries with high
profitmargins tend
to havelowasset
turnovers, and
industries withlow
profitmargins tend 10
have highasset
turnovers.
So:m:e: M. Soliman, "Uing
IndusttyAdjU51ed DuPon!
Analysis 10Predict Future
Profitability, working 1'3"""
Sta."lfom Unr.er;ity, 2003.
Withpermission.
Median Return on
CommonEquity
(ROCE),Financial
Leverage(FLEV),
Operating Liability
Leverage(OLLEV),
Return onNet
Operating Assets
(&~OA), Profit
Margins (PM), and
Asset Turnovers
(ATO) for Selected
Industries,1963-1996
Source:
Company: Standard & Poor's
Compustat" d:l::<.
Industry
Pipelines
Tobacco
Restaurants
Printing and publishinq
Business services
Chemicals
Food stores
Trucking
Food products
Telecommunications
General stores
Petroleum refining
Transportation equipment
Airlines
Utilities
Wholesalers, nondurable goods
Paper products
Lumber
Apparel
Hotels
Shipping
Amusements and recreation
Building andconstruction
Wholesalers, durable goods
Textiles
Primal)' metals
Oil andgasextraction
Railroads
ROCE, % FLEV OLLEV RNOA, % PM. % ATO

17.1%
1.093 0.154
12.0% 27.8% 0.40
15.8
0.307 0.272
14.0
9.3
1.70
15.6
0.313 0.306
14.2
5.0
2.83
14.6
0.154 0.374
13.6
6.5
2.20
14.6
0.056 0.488
13.5
5.2
2.95
14.3
0.198 0.352
13.4
7.1
1.91
13.8
0.364 0.559
12.0
1.7
7.39
13.8
0.641 0.419
10.1
3.8
2.88
13.7
0.414 0.350
12.1
4.4
2.74
13.4
0.743 0.284
9.1
12.5
0.76
13.2
0.389 0.457
11.3
3.5
3.55
12.6
0.359 0.487
11.2
6.0
1.96
12.5
0.369 0.422
11.2
4.5
2.47
12.4
0.841 0.516
9.0
4.3
1.99
12.4
1.434 0.272
8.2
14.5
0.59
12.2
0.584 0.461
10.2
2.3
3.72
11.8
0.436 0.296
10.2
5.9
1.74
11.7
0.312 0.384
10.4
4.0
2.60
11.6
0.408 0.317
10.1
4.0
2.55
11.5
1.054 0.201
8.5
8.2
1.04
11.4
0.793 0.205
9.1
12.6
0.61
11.4
0.598 0.203
10.1
9.5
1.10
11.4
0.439 0.409
10.6
4.5
2.06
11.2
0.448 0.354
9.9
J.4
2.84
10.4
0.423 0.266
9.3
4.3
2.09
9.9
0.424 0.338
9.4
5.0
1.80
9.1
0.395 0.263
8.3
13.0
0.57
7.3
0.556 0.362
7.1
9.7
0.78
0.45 ]
OA
+ Healthservices,
hospitals, etc.
Petroleum pipelines
0.35
\ Water
OJ
+ Pulp mills
supply
.~ 0.25
2
~
t.
0.2
Communications
0.15
;.+ + +
0.1
+ Accounting services
Business services, photocopying, art
~1I!l~~''iJ+....
.
....+,~,
0.05
Durable goods, wholesale +
0
0
Hotels,
Mobile homes M bil h

lodging
+ +
I+oeomes
++ ~
dealers Grocery stores
6
Assetturnover
372
TABLE 11.2
Wholesale
ccers
The PM andATO tradeoff is apparent from the table. Some industries-printing and
publishing and chemicals-produce a higher than average RNOA with both highprofit
margins and high assetturnovers. But industries with highmargins typically have lower
turnovers, andviceversa. Compare pipelines with food stores: Similar RNOAs are generated with quite dissimilar margins and turnovers. Capital-intensive industries such as
pipelines, shipping, utilities, and communications have low turnovers but high marains.
Firms in competitive businesses-food stores, wholesalers, apparel, and general retail-coftenhave lowprofit margins butgenerate RNOA through higher turnover.
Margins and turnovers reflect the technology for delivering products. Businesses
withlarge capitalinvestments-like telecommunications-typically havelowturnovers
and high margins. Finns that generate customers with advertising-c-like apparel
makers-typically have lower margins(afteradvertising expense) but, as a resultof the
advertising, high turnovers. Margins and turnovers alsoreflect competition. An industry where highturnover canbe achieved-food storesthatcan generate a lot of salesper
squarefootof retail space-will attract competition. Thatcompetition erodesmargins,
if there is little barrier to entry, as sales prices fall to maintainturnover (as with food
stores).
374 Part Two TheAnalysis of financial Seuemeurs
Chapter"
THIRD-LEVEL BREAKDOWN
conventionally, individual turnoverratios are expressed as sales per dollar of investment

in the asset Forexample,
Profit Margin Drivers

We now moveto the final step in the scheme in Figure 11.J, breaking. down th~ profit
marzin and asset turnover into their drivers. The common-size analysis of the income
statementin Chapter9 brokethe profitmargininto twocomponents:
PM = SalesPM + Otheritems PM
SalesPM = Grossmargin ratio- Expense ratios

Grossmargin
Sales
Administrative expense
Sales
(11.6)
PPE turnover =
Sales
Property, plant, and equipment (net)
(The PPEturnover is sometimes calledthefixedassetturnover.)

A firm increases itsturnover (andthusRNOA) by maintaining operating assetsat a minimumwhile increasing sales. But the ATO is also affected by operating liability turnovers,
and thisof coursereflects operating liability leverage: Operating liability leverage increases
ATO and,if operating liabilityleverage is favorable, RNOA.
Turnover ratios are sometimes referred to as activity ratios or assetutilization ratios.
Someactivity ratios arecalculated in different ways but with thesameconcept in mind. So,
for example,
. accounts receivable
.
Days m
=
----'3,,6=-5,-_ _
Accounts receivable turnover
Subsidiary income Otherequityincome

+
Sales
Sales
and
Sellingexpense
Sales
__R_&_D_ _ Operating taxes

Sales
Sales
Otheroperating items PM-
.
Sales
Accounts receivable
turnover = -,-_ _---'""'''--:-:---,--"
Accounts receivable (net)
(11.5)
Otheritemsin the income statement include shares of subsidiary income, special items,
and gainsand losses. Thesesources of income are ~ot a resultof ~les re~enue at the top
of the income statement. So calculating a PM that includes these Items dl~torts t?e profitability of sales.The sales PM, based on ope.ratin~ income befo~ .other Items, includes
onlyexpenses incurred to generate sales, thus isolating the profitability of sales.
The twocomponents of the profit margin havefurther components:
(11.7)
(sometimes calleddayssalesoutstanding). Thisgivesthe typical number of daysit takesto

collectcashfromsales.It highlights that efficiency is increased by turning sales intocash
quickly and is often used as a metric to evaluate collection departments. The inventory
turnover ratiois sometimes measured as
Specialitems . Othergainsand losses

Sales
T
Sales
Inventory turnover
Thesecomponent ratiosare known as profit margin drivers. A good pert of mana~erial

accounting and costaccounting textsis devoted to ~ analysis of thes~ drivers. The drivers
shouldbe analyzed further by segment if segment disclosures are available. Clear:ly, profit
margins are increased by adding to grossmargins (reducing costof sales),by addmgother
itemsincome, and by reducing expenses per dollarof sales.
Costof goodssold
Inventory
This differs from the sales/inventory calculation by not being affected by changes in
profit margins. Using this definition, the efficiency of inventory management is sometimes ~
expressed in tenus of the average numberof daysthatinventory is held, itsshelflife:
..
Days In
inventory -
365
Inventory turnover
Turnover Drivers
The net operatingassets are madeup of manyoperating assets and liab~liti.e~ .and so the
overall ATO can be broken down intoratiosforthe individual assetsandliabilities:
I _ Cash + Accounts receivable + Inventory + ... + PPE
Sales
Sales
Sales
ATQ - Sales
TheA1lll!ysis of Profi[(Joilil)' 375
Accounts payable
Sales
(11.8)
Pension obligations
Sales
Again, the balancesheet amountsare averages overthe year.The tu~over is expressed

here as a reciprocal of the ATO, which is the amount of net ope~atl~~ assets to support a dollar of sales, as are the individual turnovers. Thus the individual turnovers
aggregateconveniently (in a spreadsheet, for example) to the overallturnover. However,
Thisratio is best applied in wholesaling or retailing concerns where thereis just onetype
of inventory, finished goods inventory. In a manufacturing concern, inventories include
materials andworkin progress, which takedifferent timesto complete intofinished goods.
Footnotes sometimes break downinventory into finished goodsand other inventories, in
whichcaseratiosfor finished goods inventory canbe calculated.
A metricthatassesses the abilityto get operating liability leverage by extending credit
fromsuppliers is
365 x Accounts payable

Daysin accounts payable _ '-'-'--':::---,c"''-'-''--'
Purchases
where
Purchases = Costof goodssold + Change in inventory
376 Part Two TheAnalysis of financial Stercmenrs

The turnover drivers can be reduced to two summary drivers, the operating working
capital driver andthe long-term netoperating assetdriver:
_1__ Operating working capital + oL:.:o"ng,,---::te::nTI:::..:N::'O::;A:.:
ATO
Sales
Sales
Working capital is often defined as currentassets minus currentliabilities, but these may
include financial items not involved in generating sales. So Operating working capital =
Currentassets- Currentliabilities - Currentfinancial assets+ Currentfinancial liabilities.
The long-term NOA of course also exclude financial items and are usually made up of
property, plant,and equipment, intangibles, and investments in equities.
The profit marginsand turnovers for Nike and General Mills are given in Table 11.3,
along with their drivers. The profitmargindriverssum to the overallPM, and the inverse
of the turnover driverssum to the inverse of the overall ATO, as laid out in equations
11.5, 11.6,and 11.8.Examine sourcesof the differences in RNOA for the two firmsand
also look at changesfrom2007 to 2008.
TABLE 11.3
What if Nike increased itsaccounts receivable turnover from profit margin from 10.1 percent to 9.4 percent and a drop on
7.04to General Mills's level of 13.3 while maintaining thecur- RNOA from 35.0percent to 32.6percent.
rentlevel ofsales? How would RNOA change?
Whatif General Mills increased its annual advertising expendiAnswer: The increase would reduce average accounts
tures by $200 million to$828 million, resulting in $1,200 million
receivable by $1,245 million to $1 AOO million, increase the
inadditional sales at thesame gross margin percentage?
overall asset turnover from 3.47to 4.51, andincrease RNQA
AnsNer: The increased advertising would result inanextra
from 35.0 percent to 45.6percent. However, this isso only if
$428
million of gross margin at thecurrent gross margin ratio
the reduction incustomers' payment terms hasno effect on
of 35.7 percent. Net ofthe$200 million inadditional advertissales and margins. Acomplete sensitivity analysis traces the
ing expenses, theadditional pretax income would be$228 mileffects through to all thedeterminants of RNOA.
lion, or $140 million aftertax. Accordingly, the profit margin
WhatIf Nike'S gross margin ratio of 45.0percent in 2008 is ratio would increase to 14.1 percent. Ifreceivables, inventory,
likely to decline tothe43.9percent in2007 dueto higher pre- and other net assets increase proportionally to support the
duction costs?
sales, the ATO remains the same, so RNOA increases to
Answer: Areduction inthe gross margin ratio of 1.1 per- 14.1 percent x 1.09 = 15.4 percent. Clearly, if the increased
centisan after-tax reduction of 0.70 percent at Nike's 36.4 sales that theadvertising draws were lower margin sales, the
percent taxrate. This results in a drop inthe(after-tax) overall RNOA would be less.
Second- andThird-Level Breakdown: Nike and General Mills, 2007-2008
Nike
General Mills
2008
2007
2008
2007
35.0%
10.1%
3.47
33.5%
10.1%
3.31
15.1%
13.9%
1.09
12.9%
12.9%
1.00
Second level
RNOA
Profit margin
Asset turnover
Third level
Profit margin drivers (%)
Gross margin ratio
45.0
Administrative expense ratio (19.6)
Advertising expense ratio
(12.4)
Other expense ratio
JML
Sales PM before tax
12.6
Tax expense ratio
(3.11
Sales PM
9.6
Other items PM
~
Asset turnover drivers (inverse)
Cash turnover
0.005
0.142
Inventory turnover
0.122
Prepayment turnover
0.027
PPE turnover
0.096
Goodwill and intangibles
turnover
0.047
Otherassetturnover
0.037
Operating assetturnover
0.475
Accounts payable turnover
(0.060)
Accrued expenses turnover
(0.081)
Taxes payable turnover
(0.005)
Otherliability turnover
(0.041)
Note:Columnsm:I)' Ml uld p",ci""ly doe to rQWlding """.
43.9
(19.1)
(11.7)
35.7
(13.1)
(4.6)
36.1
(1J.J)
(4.4)
JQ&
Jl2L
Jl2L
1J.l
(4.1)
8.9
10.1
.J..L
0.005
0.150
0.129
0.024
0.102
0.288
--
--
0.030
0.035
0.475
(0.058)
(0.074)
(0.006)
10.036)
10.1
16.5
~
10.6
3.J
0.004
oms
--1L
12.9
0.772
0.125
1.328
10.063)
10.107)
0.835
0.140
1.419
10.058)
10.126)
0.J02 (0.237)
0.920 (0.244)
- ( -FA
- x Unrealized gains on FA + Preferredstock X Preferred dividend +.
oms
0.090
0.033
0.242
_ [FA x After-taxintereston financial assets(FA)]

NFO
FA
J(
0.004
0:093
0.QJ5
0.224
Borrowing Cost Drivers

The final component ofROCE is the operating spread. RNOA - NBC.As the RNOA componentof this spread has beenanalyzed. this leaves the analysis of the net borrowing cost
or, in the caseof net financial assets,the return from net financial assets.
The net borrowing costis a weighted average of the costsfor the different sources of net
financing. It can be calculated as
[FO
After-tax intereston financial obligations (FO)]
NBC = --x
NFO
FO
16.9
~
10.9
13.9
Analysis doesnot endwiththe calculation of ratios. Indeed thecalculations are thetools

of analysis. Theanalysttakesthesetoolsandaskswhat-ifquestions-and getsanswers. See
Box 11.6.
NFO
FA
NFO
Preferred stock
General Mills's 2008 after-tax net borrowing cost of 4.1 percent is made up of after-tax
interest expense and interest incomecomponents, weighted as follows. Referagainto the
reformulated statements in Exhibits 9.5 and 9.11.
NBC=[6,603 x 276 ]_[ 489 x~]
6,458 6,603
6,458 489
0.991
--
=[6,603 x 4.2%]_[ 489 X3.3%]

6,458
6,458
= 4.1% (allow forrounding error).
377
Chapter 11 The Anab'sis of Profiwbi~()' 379
Web site, which pro.. .ides a full analysis of the firm from
200D-2008. Here aresome ofthesalient numbers:
The proritabHity analysis for Nike iscontinued on the Build

Your OwnAnalysis Product (BYOAP) feature onthebook's
Sales revenue ($ billions)

Profitability:
Return oncommon equity (%)
Return onnetoperating assets (%)
profit margin {%)
Asset turnover
leverage:
Financial leverage
2008
2007
2006
2005
2004
2003
2002
2001
2000
18.6
16.3
15.0
13.8
12.3
10.7
9.9
95
9.0
25.9
35.0
10.1
35
25.1
33.5
10.1
33
24.1
29.5
9.6
3.1
26.1
29.4
10.0
3.0
23.0
23.3
8.4
2.8
10.3
9.6
4.0
2.4
17.0
14.4
65
2.2
16.5
12.9
6.1
2.1
-0.280
0.646
-0.269
0579
-0.198
0.515
-0.116
0.479
-0.160
0.462
You see that Nike's return on common equity {ROC E)

increased over the years even though financial leverage
declined: In 2000, Nike waspositively levered, butby 2004 it
had become a holder of netfinancial assets. The increase in
ROCE is explained by operations: RNOA increased from 13.3
percent in2000 to 35.0 percent by 2008. Not only did profit
margins from operations increase, butsodid asset turnovers,
0.116
0383
0.216
0.283
0.342
0.258
16.6
13.3
6.2
2.1
0.295
0.290
Further exploration oftheeffects offinancial leverage,

with consideration ofboth risk and profitability effects.
Further exploration of operating liability leverage and
how itisparticularly pertinent foraninsurance company.
Profitability analysis for more firms, including a comprehensive analysis ofHome Depot, Inc.
Aspreadsheet engine tocarry outprofitability analysis.
Summary
This chapterhas laid out the analysis of profitability. The analysis is summarized in figure 11.1. The methods areorderly, withlower levels of analysis nested inhigherlevels. And
theanalysis aggregates up from thebottom to ROCE at thetop,so it is amenable to simple
programming. Oncethe reformulated income statement and balance sheetareentered into
a spreadsheet program andthetemplate in Figure 11.1 overlaid, theanalysis proceeds at the
press of a button.
The analysis uncovers the financial statement drivers of thereturn on common equity,
but each of these drivers refers to an aspect of business activity. The analysis here is a
way of penetrating the financial statements to observe thoseactivities. But it is alsoa way
of organizing yourknowledge of the business and understanding the effects of business
activities on value. Understanding how the business affects the financial statement drivers
means that the analyst understands howthe business affects ROCE and, in turn, how the
business affects residual earnings and the value of the business. So, for example, the
analyst understands how a change in the profit margin or asset turnover affects residual
earnings. Andthe analyst-c-or the manager of the business-c-can ask "what-if"questions
of how ROCE and the value might change with a planned or unplanned change in
margins or turnovers.
Key Concepts
favorable financialleverage (or favora ble

gearing)is an increase in ROCE over
RNOA, induced byborrowing. 365
favorable operating liabilityleverage is
an increase in returnon netoperating
assets overreturn onoperating assets,
induced by operating liabilities. 367
growthanalysisis the analysis of the
determinants of growth in residual
earnings. 362
operatingliabilityleverage spread is
thedifference between thereturnon
operating assets and the implicit
borrowing rate foroperating
liabilities. 367
accompanied by an increase in operating liability leverage.

The increased asset turnover was accompanied by significant
sales groVYth butwith thefirm requiring lower netoperating
assets tosupport sales.
These measures arethedrivers ofgrowth. We turn tothe
formal analysis of growth inthenext chapter.
The weights are calculated from balance sheet averages. This calculation separates the
after-tax borrowing costfortheobligations (4.2 percent) from thereturnonfinancial assets
(3J percent).
A lower rate of return on financial assets than the borrowing rate on obligations
increases the composite net borrowing cost overthat for the obligations. The difference
in the rates for the twocomponents is called the spread betweenlending and borrowing rates (-0.09 percenthere). Banksmakemoney with higherlending thanborrowing
rates and thus (if they are successful) their overall net rate is higher than the borrowing rate. General Mills has a negative lending and borrowing rate spread, typical of
nonfinancial firms.
The profitability analysis for Nike is continued on the BYOAP feature on the book's
Web site. See Box 11.7.
As with all calculations, these numbers should be checked for their reasonableness.
Footnotes give rates for some borrowings as a benchmark. If your calculated borrowing
costs seem "out of line," you may have misclassified operating and financing items(and
this means that yourRNOA is also incorrect). It maybe thatdisclosures are not sufficient
to make a clear distinction. To the extent this is material, it will affectnot only the net
borrowing cost but also financial and operating leverage calculations. The inability to
unravel capitalized interest will introduce errors. Anderrors will be madeif theaveraging
ofbalance sheetamounts doesnotreflect thetiming ofchanges in those amounts during the
period.
378
Find thefollowing on theWeb page for this chapter:
operating spread is thedifference

between operating profitability andthe
netborrowing cost. 365
profitabilityanalysisis theanalysis of the
determinants of return oncommon equity
(ROCE). 362
spread is a difference between tworatesof
return. Examples are the operating
spread, theoperating liabilityleverage
spread, and thespread between
borrowingand lending rates. 365
spread between borrowingand lending
rates is thedifference between thereturn
on financial obligations andthereturnon
financial assets. 378
380 Part Two The Analysis of Financial S=mencs
Chapter 11 ThcAnalysis ofPro,liwbi!ilY 381
PROFITABILITY ANALYSIS FOR KMB

AnalysisTools
Page
The analysis of financial

leverage
equations 11.1,11.2
The analysis of operating
liability leverage
equation 11.3
DuPont analysis of return on
netoperating assets
equation 11.4
Analysis of profit margin
equations 11.6, 11.7
Analysis of asset turnovers
equation 11.8
Analysis of borrowing costs
What-ifanalysis
364
367
371
374
374
377
377
Key Measures
Probability ratios (afull set,
including those introduced
in previous chapters):
Return on common equity
(ROC E)
Return on netoperating
assets (RNOA)
Netborrowing cost{NBC}
Return on net financial
assets (RNFAl
(OLLEY)
Theoperating spread
(SPREAD)
spread (OLSPREAD)
Return on operating assets
(ROOA)
Minority interest sharing
ratio
Operating profit margin
(PM)
Asset turnover (ATO)
Sales profit margin
Other operating items
profit margin
Gross margin
Expense ratios
Individual asset turnover
ratios
Days in accounts receivable
Days in inventory
Days in accounts payable
Borrowing costdrivers
Spread between lending
andborrowinq rates
Page
363
364
364
366
364
366
364
367
367
370
371
371
374
374
374
374
374
375
375
375
377
Proceed witha comprehensive profitability analysis of Kimberly-Clark for2004 and2003.

LetFigure 11.1 inthischapter be yourguide; proceed through the three levels of analysis.
Be sure to distinguish operating profitability from the effects of financing activities, and
then analyze the operating activities in detail. Show how the leveraging equations for
financial leverage and operating liability leverage work for KMB. For the latter, set the
short-term borrowing rate, before tax,at 3.5 percent.
ATO asset turnover =salesINOA
equity
FLEV financial leverage =
NFO/CSE
NBC netborrowing cost=
NfEINfO
NfA netfinancial assets
NfE netfinancial expenses
Nfl netfinancial income
NOA netoperating assets
OA operating assets
01 operating income
OL operating liabilities
OLLEV operating liability leverage
=OUNOA
OLSPREAD operating liability
leverage spread =ROOA - shorttermborrowing rate
PM profit margin = OVsales
PPE property, plant, and
equipment
RNfA return on netfinancial
assets e NFVNFA
RNOA return on netoperating
assets =OIlRNOA
ROA return on assets :::
net income + interest expense
(aftertaxytotal assets
ROOA return on operatinq
assets "" 01 + implicit interest on
OUOA
SPREAD operating spread =
RNOA- NBC
378

In the Continuing Casefor Chapter 9, you reformulated Kimberly-Clark's balance sheets
andincome statements. The reformulation prepares thestatements foranalysis, which you
willcarryouthere.
WHAT DOES THE ANALYSIS MEAN?

After making the requisite calculations, state in words what the array of numbers mean.
How would youdiscuss KME's performance ifyouwere ananalyst talking to clients?
SENSITIVITY ANALYSIS: WHAT IF?

Afteryouhave completed theanalysis, introduce some"what-if"questions andsupply the
answers. Examine the effects of changes in margins andturnovers on profitability. What if
gross margins decline? What if advertising becomes less productive? What if individual
assetturnovers change?
BUILDING YOUR OWN ANALYSIS ENGINE FOR KMB

If youentered KM:B's reformulated statements intoa spreadsheet inChapter 9, youmight
add profitability analysis to that spreadsheet. The BYOAP feature on the book's Web
page will guideyou.Also look at the profitability analysis engine on the Web pagefor
this chapter. Once you have the analysis automated, you can apply it to the sensitivity
analysis thatsupplies answers to the what-ifquestions you raised above. Justchange the
inputs (the reformulated statements) andthe program willsupply the answer at thepress
of a button.
Concept
Questions
Cll.1. Under what conditions would a firm's return oncommon equity (RaCE)beequal
to its return on netoperating assets (RNOA)?
C11.2. Underwhat conditions would a firm's return on net operating assets (RNOA) be
equalto its return on operating assets (ROOA)?
C11.3. Statewhether the following measures drive return on common equity (ROCE)
positively, negatively, or depending on thecircumstances:
a. Gross margin.
b. Advertising expense ratio.
c. Net borrowing cost.
d. Operating liability leverage.
e. Operating liability leverage spread.
f. Financial leverage.
g. Inventory turnover.
CllA. Explain why borrowing mightlever up thereturn oncommon equity.
C11.5. Explain why operating liabilities might lever upthereturn onnetoperating assets.
382 PartTwo
TII~
A1I<1I)'sis (If Financial SW(~Ill~11!5
Chapter 11 The AnaJ)'5i~ of Pmjiw&ifi(] 383
C11.6. Afirm should always purchase inventory andsupplies On creditratherthanpaying

cash. Correct?
2008
Operating assets
Short-term debtsecurities
Book value
Sales
Operating expenses
Interest revenue
Tax expense (tax rate =:; 34%)
Earnings
CII.7. A reduction in the advertising expense ratioincreases return on common equity

andshare value. Correct?
C11.8. A firm states that one of its goals is to earn a return on common equity of
17-20percent. What is wrong withsettinga goalintermsof returnon common
equity?
CII.9. Why might operating losses increase after-tax borrowing cost?
e11.10. Some retail analysts use a measure called "inventory yield," calculated as gross
profit-to-inventory. What doesthismeasure tell you?
CII.II. Return on total assets (ROA) isa common measure of profitability. The historical
average is about 7.0 percent. The historical yield on corporate bonds is about
6.6 percent. Why is the ROA so low? Would not investors expect more than a
0.4 percent higher return on risky operations?
C11.12. Lowprofit margins always imply low return onnetoperating assets. Trueor false?
Drill Exercises
Exercises
Ell.l.
Leveraging Equations (Easy)

Thefollowing information isfrom reformulated financial statements (inmillions ofdollars):
Operating assets
Short-term debtsecurities
Bonds payable
Book value
2008
2007
\2,000
400
(100)
(1,400)
$ 900
$2,700
100
(300)
(1,300)
1,200
Sales
Operating expenses
Interest revenue
Interest expense
Tax expense (tax rate =:; 34%)
Earnings (net)
2,100
(1,677)
27
(137)
(106)
$ 207
a. ([) Calculate thedividends, netof capital contributions, for2008.

(2) Calculate RaCE for2008; useaverage book value inthe denominator.
(3) Calculate RNOA for2008; usetheaverage net operating assets in the denominator.
(4) Supply the numbers for the formula
El1.2,
RNOA = ROOA + (OLLEY x OLSPREADj

c. Repeat the exercise in part(a) using thefollowing information:
$2,700
1,000
(300)
3,400
2,100
(1,677)
90
(174)
$ 339
First-Level Analysisof Financial Statements (Easy)

A finn whose shares traded at three times their book value on December 31, 2008, had
the accompanying financial statements. Amounts are in millions of dollars. The firm's
marginal tax rate is 33 percent. Thereare no dirty-surplus income items in the balance
sheet.
a. Thefirm paidnodividends andissued noshares during 2008, but it repurchased some
stock. Calculate theamount of stockrepurchased.
b. Calculate the following measures:
Return on common equity (RaCE)
Return on netoperating assets(RNOA)
Theoperating spread (SPREAD)
Freecashflow
c. Does it make sensethatthis firm's shares should trade at three times book value?
Balance Sheet, December 31, 2008

Assets
2008
Operating cash
Accounts receivable
inventories
Property andplant(net)
50
150
300
420
~
$1,760
2007
$
20
150
250
470
liabilities and
2008
Accounts payable
Long-term debt
S 215
450
450
Common equity
1,095
1,025
$1,760
$1,680
2007
205
.za,
$1,680
Income Statement, YearEnded December 31, 2008
RaCE = PMx ATO + [Financial leverage x (RNOA - Borrowing cost)]

b. The firm's short-term borrowing rateis 4.5 percent aftertax.Supply the numbers for
the formula
\2,000
800
(100)
$2,700
2007
Sales
interest income
Operating expenses
Interest expense
Tax expense
Net income
$3,295
9
$3,048
36
61
384 Part Two TheAiwl)".5is ofFinancial Sw{cm~n!.S

E11.3.
Chapter 11 TheAnalYSiS of Pro/iwbili(J 385
Reformulation and Analysis of Financial Statements (Medium)

Thisexercise continues Exercise 9.5 in Chapter 9.Thefollowing financial statements were
reported for a firm for fiscal year2009(inminionsof dollars):
Balance Sheet
Operating (ash
Accounts receivable
Invent0l)'
Property and plant
2009
2008
60
50
500
790
840
550
940
910
2,840
5,300
W.Q
2009
2008
Accounts payable
Accrued liabilities
tone-term debt
1,200
390
1,840
1,040
450
1,970
Common equity
1,870
5,300
4,890
4,890
1.430
Statement of Shareholders'Equity
Balance, endoffiscal year 2008
Share issues
Repurchase of 24 million shares
Cash dividend
Unrealized gain on debt investments
Net income
Balance, endof fiscal year2009
1,430
822
020)
(180)
50
468
1,870
a. Prepare a reformulated balance sheet and comprehensive income statement (as

required in Exercise 9.5).
b. Calculate freecashflow for 2009.
c. Calculate the operating profit margin, asset turnover, and return on net operating
assets for 2009. (Forsimplicity, use beginning-of-period balance sheet amounts in
denominators.)
d. Calculate individual asset turnovers and show that they aggregate to the total asset
turnover.
e. Showthat the financing leverage equation holds for this firm:
ROCE = RNOA + (FLEV x Operating spread)

in the future, whatwouldthe rateof returnof common equity(RaCE) be if operating
profitability (RNOA) felito 6%and financial leverage decreased to 0.8?
g. The implicitcostof creditforaccounts payable andaccrued liabilities is 3%(aftertax).
Showthat the following leverage equation holdsin this example:
RNOA = ROOA + [OLLEV x (ROOA - 3.0%)J
E11.4.
Relationship between Ratesof Returnand Leverage (Medium)

a. A firm has a return on common equity of 13.4 percent,a net after-tax borrowing cost
of 4.5 percent,and a returnof 11.2 percent on net operating assets of $405 million.
Whatis the firm's financial leverage?
b. Thesame firmhas a short-term borrowing rateof 4.0percentaftertax and a returnon
operating assets of 8.5 percent. Whatis the firm's operating liabilityleverage?
c. The firm reported totalassetsof$715 million. Construct a balance sheetfor this firm
thatdistinguishes operating and financial assetsand liabilities.
2(}OS
$18,057.0
6,011.8
382.7
$16,796.2
5,927.2
270.8
6,496.4
4,395.4

s 2,740.1
147.1
a. Calculate the following for2007and 2006:

(1)Net operating assets
(2)Netfinancial obligations
(3) Shareholders' equity
b. Calculate returnon common equity(ROCE), return on net operating assets(RNOA),
financial leverage (FLEV), andnet borrowing cost(NBC) for2007.Usebeginning-ofperiodbalance sheetnumbers in denominators.
c. Show thatthe financing leverage equation works withyour calculations.
d. Calculate the operating profit margin (PM)and asset turnover (ATO) for 2007 and
show thatRNOA = PMx ATO.
Thefirm's income taxrateis35%.Thefirmreported $15million in interest income and$98

million in interest expense for 2009.Salesrevenue was$3,726million.
f. Calculate the after-tax net borrowing cost.If this borrowing cost were to be sustained
201)7
Operating assets
Financial assets

Exercises E4.8,E6.14,E7.8 andEl 0.10 alsocoverKimberly-Clark, as doesMinicase M5.3.
TheContinuing Caseat the end ofeachchapter is a comprehensive analysis of the firm.
E11.7.
Analysis of Profitability: The Coca-Cola Company (Easy)

Hereisareformulated income statement forthe Coca~Cola Company for2007(inmillions):
Sales
Costof sales
Gross margIn
Other expenses {net)
$28,857
~
18,451
2,800
8,145
__8_'
7,425
T"
1,972

Equity income from bottling subsidiaries (after tax)
Operating income
Earnings
5,453
...........
6,121
~
$ 5,981
386 PartTwo The AoolY5i5 of Fiooncial S{(lfcm~nt5
Chapter11 Th~ Ancl1)'.lis of Profirabilir)' 387
Summary balance sheetsfor 2007and2006are as follows (inmillions):

2007

$26,858
521,744
2006
518,952
2,032
516,920
Forthe following questions, use average balancesheetamounts.

a. Calculate return on net operating assets (RNOA) and net borrowing cost (NBC) for
2007.
b. Calculate financial leverage (FLEY).
c. Showthat the financing leverage equation that explains the returnon common equity
(ROCE) holdsfor thisfinn.
d. Calculate the profit margin (PM) and asset turnover (ATO) for 2007 and show that
RNOA" PM x ATO.
e. Calculate the gross margin ratio, the operating profit margin ratio fromsales, andthe
operating profit margin ratio.

Coca-Cola is covered in Exercises E4.5, E4.6, E4.7, E12.7, E14.9, E15.12, E16.7, and
EI9.4, andalsoin Minicases M4.1, M5.2 andM6.2.
E11.8. A What-If Question: Grocery Retailers (Medium)
In the late 1990s, many grocery supermarkets shifted from regular storewide sales to
issuing membership in discount and pointsprograms, much like frequent flyer programs
run by the airlines.
A supermarket chainwith$120million in annual salesandan assetturnover of 6.0ponderswhether to institute a customer membership program. It currently earnsa profitmargin
of 1.6percent on sales. Its marketing research indicates that a customer membership
program would increase salesby$25million andwouldrequire an additional investment in
inventories of $2 millionbut no additional retailfloor space. Coststo run the membership
program, including the discounts offered to members, would reduce profit margins to
1.5percent.
What would be the effecton the fum's return on net operating assets of adopting the
customer membership program?
E11.9.
Financial Statement Reformulation and Profitability Analysis for Starbucks

Referto the financial statements forStarbucks, the coffee vendor, in Exercise E9.9 in
Chapter 9. Besure to readthe notesunderthe financial statements.
a. Prepare a reformulated income statement for fiscal year2007 and reformulated balance
sheetsfor 2007 and 2006in a way that distinguishes operating and financing activities
and identifies taxesapplicable to various components of income.
b. Forfiscal year 2007, calculate the following: return on common equity(RaCE), return
on net operating assets(RNOA), and net borrowing cost(NBC). Use beginning-of-year
balance sheetamounts in denominators.
c. Calculate the financing leverage ratio(FLEV) at thebeginning of the yearand show that
the following leverage equation for2007is satisfied:
ROCE" fu'lOA + [FLEV x (RNOA - NBC)J
d. Calculate the operating profit margin ratio (PM) and the asset turnover (ATO). Also
calculate the operating profit margin ratiofromsales.
e. Calculate the operating liability leverage ratioat the beginning of2007.
f. The firm's borrowing cost on its short-term commercial paper is 5.5 percent, or
3.6 percent after tax. Showhowoperating liability leverage levers up the return of net
operating assets.

SeeExercises E8.8,E9.9,E12.8,and E14.1O Oil Starbucks Corporation.
E11.10. Operating Profitability Analysis: Home Depot, Inc. (Medium)
Comparative balance sheetsandincome statements forfiscal yearended2005 aregiven below
forthe warehouse retailer Home Depot. Amounts arein millions, except per-share data.
a. Reformulate the 2005 and 2004 income statements and the 2005, 2004, and 2003
balance sheets. In addition to net income, Home Depotreported othercomprehensive
income of $137 million in currency translation gains in 2005 and $172 million of
translation gainsin 2004. Details of Home Depot s taxesare given in the tax. footnote
included in Exercise 9.10 in Chapter 9. For the reformulation of the balance sheets.
include $50 million as operating cash.
b. Carryout a comprehensive analysis of operating profitability for2005 and 2004.
See Exercises E5.l2, E9.1O, EI2.9, EI4.13 and E14.l4 and Minicase M4.1.
THE HOME DEPOT, INC. AND SUBSIDIARIES

ConsolidatedStatements of Earnings
Fiscal Year Ended

Net sales
Costofmerchandise sold
Gross profit
Operating expenses:
Selling andstore operating
Operating income
Interest income(expense):
Interest and investment income
interest expense
Interest. net
Net earnings
Weighted-average common shares
January 3D, 2005
February 1, 2004
$73,094
48,664
24,430
$64.816
44.236
20,580
15,105
1,399
12,588
1,146
13,734
6,846
16,504
7,926
56
59
---'l'J)
~
(62)
7,912
2,911
s 5.001
2,207
5 2.27
2,216
$ 2.26
(3)
6,843
2,539
$ 4,304
2,283
1.88
2,289
$ 1.88
388 PartTwo The Anal)sis ofFinal1ci(l1 Stalem~l1~
Chapter 11
January 30, February 1, February 2,

2004
2003
Assets
Currentassets:
Receivables, net
Merchandise inventories
Totalcurrentassets
506
1,659
1,499
10,076
450
14,190
Propertyand equipment, at cost

land
Buildings
Furniture, fixtures, andequipment
leasehold improvements
Construction inprogress
Capital leases
less accumulated depreciation andamortization
Net property andequipment
Notes receivable
Cost inexcess of thefair value of netassets
acquired, netof accumulated amortization
Other assets
Totalassets
1,103
1,749
1,097
9,076
2,188
65
1,072
8,338
254
~
13,328
369
6,397
10,920
5,163
942
820
352
24,594
4,531
20,063
84
5,560
9,197
4,074
872
724
306
20,733
3,565
17,168
107
1,394
228
$38,907
833
129
$34.437
--''
$30,011
5,159
801
419
1,281
175
509
4,560
809
307
998
227
7
--.!dlQ
~
8,035
1,321
6,932
12,325
6,195
1,191
1,404
390
28,437
22,726
575
liabilitiesand Stockholders' Equity

Currentliabilities:
Accounts payable
Accrued salaries and related expenses
Sales taxes payable
Deferred revenue
Income taxes payable
Current installments oflong-term debt
Other accrued expenses
Tota! current liabilities
Long-term debt,excluding current installments
$ 5,766
1,055
412
1,546
161
11
1,578
10529
2,148
763
1,309
ofProfilabilit-y 389
Stockholders' Equity
THE HOME DEPOT, INC., AND SUBSIDIARIES

Consolidated Balance Sheets
2005
Th~ Anal)sis
9,554
856
653
967
491
362
Common stock. pervalue $0.05; authorized:

10,000shares; issued 2,385 shares
at January 3D, 2005, and 2,373shares at
February 1, 2004; outstanding 2,185
shares at January 30,2005, and 2,257shares
at February 1, 2004
Paid-in capital
Retained earnings
Accumulated othercomprehensve income
Unearned compensation
Treasury stock, at cost, 200 shares at January
3D, 2005,and 116shares at February 1, 2004
total stockholders' equity
Total liabilities and stockholders'equity
119
6,650
23,962
227
(108)
(6,692)
24,158
$38,907
119
6,184
19,680
90
(76)
(3,590)
22,407
$34,437
118
5,858
15,971
182)
(63)
(2,000)
19,802
$ 30,011
390 Part Two TheAnalysis of Fi!1(1llcial SEaremell~
Minicase
M11.1

Gamble II
Financial statements for the Procter & Gamble Co. arepresented in Exhibit 9.15in Chapter 9. If youworked Minicase 9.1,youwill have reformulated thestatements in preparation
forfinancial statement analysis. If not,doso now.
Proceed to carry out a comprehensive profitability analysis for fiscal years 2006-2008
along thelines of thischapter. Figure 11.1 will guide you. Ifyouhave builtthereformulated
statements intoa spreadsheet, you might add thisprofitability analysis to the spreadsheet.
TheBYOAP guide on thebook's Web sitewill help. You might alsoextend the analysis to
subsequent years, as they become available, totrack P&G's profitability and itsdrivers asthe
firm evolves.
Your analysis should have the following features:
A. Operating profitability should be distinguished from return on common equity. Apply
the financing leverage equation to highlight the difference. How much leverage does
P&G carry? Is thefinn favorably leveraged?
B. Distinguish operating income from salesfrom otheroperating income. In someyears,
translation gains have a bigeffect ontotal operating income. Calculate return On netoperating assets (RNOA) withtotal operating income andthen onlywithoperating income
from sales.
C. Carry out an analysis of operating liability leverage. Footnotes to the firm's financial
statements reveal that its short-term borrowing rateaveraged 4.2 percent (before tax)
fortheyears 2006-2008. Thefirm's combined federal, state, andlocalstatutory tax rate
is 38 percent.
D. Carryout a comprehensive analysis ofprofit margins andassetturnovers.
Aftermaking thevarious calculations, stepbackandaskwhat theyallmean. Refertothe
background onP&G inMinicase 9.1 before youbegin yourinterpretation. Asa benchmark,
you might compare the measures you have calculated withthose for General Mills in this
chapter. As a packaged food products company, General Mills is not quite a comparable
company but,likeP&G, it is primarily a brandmanagement operation.
Comment on the change inP&G's profitability from 2006 to 2007.
Now conduct somesensitivity analysis. Asksome"what-if"questions. What would be
the effect on ROCE if operating profitability fell? What would be the effect on RNOA if
profit margins changed? If assetturnovers changed? How might an increase in advertising
expenditures affectprofitability? If youhave builttheanalysis intoa spreadsheet, youwill
be ableto answer thesequestions withthepress of a button.
A final question: Afterexcluding currency gains andothernonsales items fromoperating income, thereturn onnetoperating assets is quitelow. Why?

Minicases M9.I, MI2.!, MI4.! and MIS.! also deal with the analysis and valuation of
Procter & Gamble. Seealso Exercise 3.17.
Chapter 12 The Analysis of Growth and SusCllino.ble Earnings
of Growth
Earnings
LINKS
Link to previouschapter
I
I
I
!ii
I,
Chapter II laidout the

analysis of profitability,
{7
Why theanalysis ofgrowth isimportant for valuation.

Why growth analysis focuses on residual earnings
growth and abnormal earnings growth, rather than
earnings growth.
What a growth firm is.
What constitutes sustainable earnings.
What is meant by transitory earnings.
How toanalyze sustainable profitability.
How sustainable earnings and growth analysis help answer thequestion ofwhether a firm has durable competitive advantage.
How changes inROCE can beinduced by borrowing.
What drives growth of the common shareholders'
investment.
How PIE and PIB ratios relate to each other.
393

Complete an analysis ofa change inreturn on netoperating assets (RNOA).
Complete ananalysis ofa change inROCE.
Complete ananalysis ofgrowth ininvestment.
Complete an analysis of growth in residual earnings.
Identify core or Sustainable earnings in income
statements.
Identify transitory or unusual items in income
statements.
Analyze theeffect ofchanges infinancial leverage on
ROCE.
Identify core netborrowing cost.
Thischapter
This chapterlaysout the
analysisof growth
that is necessary to
complete the evaluation
of PIBand PIEratios.
{7
PartThreeof the book
applies theanalysis of
profitability and growth to
forecasting and valuation.
{7
Link to Web page
Explore the textWebsite
for moreapplications of
Chapter12content
(www.mhhe.eoml
pcnman4e).
Row is
growth in
investment
analyzed?
How is the
analysis of
growth
incorporated
in the
evaluation
ofPtEand
PIBratios?
The price-to-book (PIB) valuation model of Chapter 5 show.ed that !fins increase t~eir
price-to-book ratiosif theycangrowresidual earnings. The pnc.e-eam:ng~ (pIE) valuation
model of Chapter 6 showed that firms increase their price-earning ratiosIf they ca~ gr~
abnormal earnings. Clearly, then,an assessment ofa fum'sability to deliver growthIS cnticalto valuation. This chapter laysouttheanalysis of growth.
Analysts oftentalk ofgrowth in termsof a firm's ability to growearnings. The cha~ter
begins by reminding you thatearnings growth is not a valid gr~wth c~ncept for.valuatlOn
because, as explained in Chapters 5 and6, firmscan growearmngs Without adding value.
Rather, residual earnings growth andabnormal earnings growth are therelevant meas~res.
Residual earnings growth is thefocus whenevaluating PIB ratios, and abnormal earnmgs
growth is the focus whenevaluating PIE ratios,but they are both measures for the same
purpose: detecting addedvaluefromearnings growth.
.
The ability to grow residual earnings is very much at the hea~ of the questl~n of
whether a firm has durable competitive advantage: Canthe firm sustain and grow residual
earnings? Accordingly, the evaluation of sustainable earnings features prominently in this
chapter.
WHAT IS GROWTH?
The term growth is often used vaguely, or with a variety of meanings. People talk of
"growth firms't-c-and of paying more for a growth firm-c-but theirmeaning is not always
clear. Sometimes thetermis usedto meangrowth in sales,sometimes growth in earnings,
andsometimes growth in assets. Generally growthis seenas a positive attribute, an ability
to generate value. Butwhatis growth? Whatis a growth firm?
The valuation models of Chapters 5 and 6 provide theanswer to thisquestion.
Chapter 5 showed thatonepaysa premium overbookvaluebased ontheability of a firm
to growresidual earnings (RE), whereresidual earnings is thedifference between earnings
and therequired return on bookvalue. Foranyyeart,
Residual earnings, (REI) = Eamings.>- [(PE - 1) x Common shareholders' equityc.]
where PE - I is the required return for equity. Shareholders invest in firms, and thebook
value of theirequity-c-the firm's net assets-measures thisinvestment. Finnsapply thenet
assets in operations to add value for shareholders. Residual earnings measure the value
added to book value overthat required to coverthe cost of capital. So a sensible way of
viewing growth that ties into value creation is in termsof growth in residual earnings: A
growth firm is one thatcan growresidual earnings.
Chapter 6 showed thatone paysmorethana normal PIE based on theability of a firm to
generate abnormal earnings growth (AEG), where abnormal earnings growth is thedifferencebetween cum-dividend earnings anda charge for theprioryear'searnings growing at
therequired rate. Foranyyeart,
Abnormal earnings growth, (AEGI ) = [Earnings, + (PE - l)dHl - PEEarningsl_1
'I
394 Part Two The Analysts of Financial Srat~mentS
where dt _ 1 is the net dividend paid in the prioryear. Firms do not add to theirPiE ratio if
theycan onlygrowearnings at the required rateof growth. Theyaddvalueonly if theycan
growearnings at a rate greaterthat the required rate, thatis, if theycan deliver abnormal
earnings growth. So another way of viewing growth that ties intothe valuecreation is in
termsof the abilityof a firmto deliver abnormal earnings growth.
In both Chapters 5 and 6, wewarned againstpaying too muchfor earnings growth. We
emphasized that earnings growth alone isnota good measure ofgrowth because earnings
growth can be createdby investment (thatdoes notadd value) and by accounting methods
(that also do not add value). We showed how residua! earnings and abnormal earnings
growth measures isolate that part of earnings growth that is to be valued from the part
whichis not. Charging earnings forrequired earnings-required earnings on bookvaluein
the case of residual earnings and required earnings on priorearnings in the case of abnormalearnings growth-protects theinvestor frompaying too much forearnings growth createdby investment and accounting methods. In short,residual earnings growth and abnormal earnings growth are the growth measures we mustfocus on if we have valuation in
mind.
Residual earnings is the relevant growth measure when evaluating the price-to-book
(PIB) ratio.Abnormal earnings growth is the relevant growth measure when evaluating the
price-earnings (PIE) ratio.However, we showed in Chapter 6 (inBox6.3)thatthe twomeasures are just different ways of looking at the same thing: Abnormal earnings growth is
equalto the change in residual earnings. If a firm has no growth in residual earnings, its
abnormal earnings growthmustbe zero:Thefirmisa "no-growth" fum. If a firm hasresidual earnings growth it must also have abnormal earnings growth: The fum is a "growth
company." For most of this chapter, we will analyze growth in residual earnings with the
understanding that the factors that growresidual earnings alsoproduce abnormal earnings
growth. Residual earnings growth involves bothbalance sheetand income statement features,so we gain a better appreciation of the determinants of growth from the analysis of
growth in residual earnings.
Box12.1 introduces youtosomegrowth andno-growth firms. In eachcase,observe that
abnormal earnings growth is equalto the changein residual earnings.
CUTTING TO THE CORE: SUSTAINABLE EARNINGS

The analysis of growthstarts withan identification of earnings on whichgrowth is possible.Earnings froma one-time special contractcannotgrow;earnings depressed by a labor
strikeare not a basis for continuing growth; earnings fromgainson assetsales or restructuringsprobably will not be repeated in the future. Earnings that can repeatin the future,
and grow, are caned sustainable earnings, persistent earnings, core earnings, or underlying earnings. We will mostly use the term,coreearnings. Earnings basedon temporary factors are called transitory earnings or unusual items.
As coreearnings are thebaseforgrowth, webeginthe analysis of growthwithan analysis that distinguishes core earnings purgedof transitory components. Earnings are composed of operating income fromthe business and net financing expenses, so the exercise
amounts to an identification of coreoperating income andcorenet borrowing cost Identifying core earnings is sometimes referred to as normalizing earnings because it establishes "normal"ongoing earnings unaffected by one-time components.
Identifying these core earnings is a starting point not only for evaluating growth
prospects,but also for answering this question: Does the firm have durablecompetitive
advantage?
Growth and No-Growth Firms

,;.
A GROWTH FIRM: GENERAL ELECTRIC

(Dollar amounts inmillions)
w'
\{:
0::
:':
12.1
Sales
Sales growth rate
Common equity
Common equity growth rate
ROCE
Residual earnings (12%)
Abnormal earnings growth (12%)
2002
2001
2000
1999
1998
1997
1996
131,698
4.6%
63,706
16.2%
25.8%
7,539
125,913
129,853
16.3%
50.492
18.6%
29.9%
7,628
1,563
111,630
11.1%
42,557
9.5%
27.6%
6,065
100.469
10.6%
38,880
12.9%
26.2%
5.221
79.179
13.1%
31,125
5.1%
225%
3,190
844
227
90,840
14.7%
34.438
10.6%
27.2%
4,994
1,804
(86)
(3.0%)
54,824
8.6%
27.1%
7,625
(3)
1995
70,028
165%
29,609
16.7%
23.9%
3.273
(83)
1,620
. General Electric. has mai~tained a .high growth rate in sales, which translates into both increasing RaCE and increasing
mvestment Ac.cordlngly, residual earnings (based on a required return of 12 percent) wason a growth path upto 2000 and
abnormal earnings growth was (mainly) positive. Growth slowed after 2000. Can GE generate more growth inthefuture?
A GROWTH FIRM: NIKE

(Dollar amounts inmillions)
2004
2003
2002
2001
2000
1999
1998
Sales
Sales growth rate
Common equity
ROCE
Residual earnings (11.1 %)
Abnormal earnings growth (11.1 %)
12,253
14.6%
4,840
19.8%
23.0%
10.697
8.1%
4,028
4.0%
103%
9,893
43%
3,839
9.8%
19.1%
9,489
5.5%
3,495
11.4%
18.8%
8,995
2.5%
3,136
-6.0%
17.4%
8.777
-8.1%
3,335
2.2%
13.0%
9,553
4.0%
3,262
3.4%
12.0%
642
572
280
39
241
210
146
64
36
28
(311)
(31)
31
. Apart .f:om 2003, Nike gr.ew sales and earned a high RaCE, increasing investment, increasing residual earnings, anddelivenng oosmve abnormal earnings growth. Can Nike maintain growth inthefuture?
A GROWTH FIRM?: REEBOK

(Dollar amounts in millions)
2004
2003
Sales
Sales growth rate
Common equity
Common equity growth fate
ROCE
Abnormal eaminqs qrowth (12%)
3,785
8.6%
1,226
18.5%
18.9%
3,485
11.4%
i,035
16,8%
18.1%
2002
886
720
608
529
524
23.1%
16.6%
18.4%
16.9%
14.9%
15.3%
1.0%
2.1%
3.4%
5.8%
78
20
58
21
37
7
30
13
17
(52)
(32)
69
(201
(87)
3,128
4.5%
2001
2000
1999
2,993
4.5%
2,865
-1.2%
2,900
-10.1%
1998
3,225
-11.5%
After decreasing residual earnings andabnormal earnings growth inthe late 1990s from declining sales growth rates and
low RaCE, Reebok moved to a growth path in 2002-2004. Will it be a qrowth company inthe future? (Reebok wassubsequently acquired byAdidas.)
(continued)
Core Operating Income

Operating income consists of core(sustainable) operating income and unusual (transitory)
items:
Operating income = Coreoperating income + Unusual items
395
A CYCLICAL FIRM: AMERICAN AIRLINES

2000
{Dollar amounts in millions}
Sales
Sales growth rate

Common equity

ROCE

Abnormal earnings growth(14%)
19,703
11.1 %
7,176
4.6%
11.9%
(147)
(232)
1999
17,730
8,8%
1998
16,299
1997
1996
1995
1994
1993
15,856
15,135
15,610
5.2%
14,837
0.7%
14,731
3,545
3,233
2.1%
2.8%
4.8%
-3.0%
6,858
6,428
6.7%
20.1%
18.0%
5,354
18.2%
16.2%
107
(5)
4,528
24.2%
16.7%
112
386
15.3%
85
(153)
238
131
12.8%
6.0%
(274)
(94)
8.4%
(180)
217
85%
3,168
1.4%
0.7%
(397)
American Airlines, theair carrier. grewresidual earnings from 1996 to 1998. (Residual earnings iscalculated using a 14percentrequired return, asbefits a risky airline.) Butairlines are cyclical, asthe residual earnings andabnormal earnings growth for
the earlier and later years show. Sales growth has been modest andvariable, andthe increase inROCE from 1996to 1998was
also modest, with growth coming from growth in investment. ROCE declined after 1998,even with growing sales, andresid-
ual earnings also declined.

In analyzing growth, the analyst has her eye onthe future: Can the firm grow residual earnings inthe future? Past growth
is only an indicator of future growth. So, inasking whether American Airlines, Reebok. Nike, andGeneral Electric are qrowth
companies, thequestion iswhether past growth can besustained inthefuture.
As operating income consists of operating income from salesand otheroperating income

(in Chapter 9),
Operating income = Coreoperating income fromsales+ Coreotheroperating income
+ Unusual items
01 = Core01 fromsales + Coreother01 + UI
Exhibit 12.1 laysout a template thataddsto the reformulation of income statements in
Chapter9 to distinguish core (sustainable) and unusual operating income. Typical unusual
itemsare listedtherebutthe list isnotexhaustive. Thestandard income statement identifies
some itemsas "extraordinary" and these are of courseunusual. But unusual itemsoften
appear above the extraordinary itemssection of the income statement also. Indeed, you
mightidentify aspects of the grossmargin that are unusual because they are due to a special orderor the effectof a strikethat won'tbe repeated. Readthe footnotes and ManagementDiscussion and Analysis for clues. See Box 12.2. The betteryouknowthe business,
the betteryou will be in identifying theseitems. See Box12.3.
Withforecasting in mind, we are interested in components that haveno bearingin the
future. Thus the unusual items category should include not only items that won't be
repeated in the future but also items that appear each periodbut can't be forecast. Currencygainsand lossesand gainsand lossesfrom derivatives tradingforan industria! firm
are good examples. Wemightexpectthese as a normal feature of operations each period
but presumably we cannot predictthem:Therewill be eithergains or losses in the future
but we can't predict which, so their expected value is zero. A currency gain or loss is
transitory; we don't expect it to persist. And so with all income itemsthat are a resultof
marking balance sheet items to market value, because changes in market values are
typically not predictable. Separate these gains and losses from current core income;
otherwise, core incomewill be affected by an itemthatis notrepresentative of the future.
Accordingly, we establish core operatingincome, which is a basis for predictingfuture
operatingincome.
396
The Management Discussion andAnalysis (MO&A) ismanagement's report onthe business anditsprospects. It can sometimes be toooptimistic, brushing over problems. But it often
identifies elements of the business that are unusual. Indeed
theSEC requires theMO&A to "describe any unusual or infrequent events or transactions or any significant economic
changes that materially affected the amount of income from
continuing operations and, ineach case, indicate theextent to
which income was soaffected."
EXHIBIT 12.1
Reformulation of the
OperatingIncome
Section of the Income
Statementto Identify
CoreIncomeand
UnusualItems.
Core operating income

iscore income from
sales plus core other
operating income.
Taxes areallocated to
eachcomponent.
As well as discussing unusual items, the MO&A often

reveals management's plans forthe future thatcan indicate
how the business might change and, accordingly, features of
the current business that might notpersist.
Focus ontheresults ofoperations section. ltcompares results
over therecent three years, ormore, with accompanying discussion ofthechanges. Be particularly sensitive tothediscussion of
changes ingross margins, because small percentage changes in
those margins can have a large effect onthebottom line.
Reformulated Operating Income
Coreoperating income
Core sales revenue
- Core costof sales
= Core gross margin
- Core operating expenses
= Core operating income from sales before tax
- Tax on core operating income from sales
+ Tax as reported
+ Tax benefit from net financial expenses
~ Tax allocated to core otheroperating income
~ Tax allocated to unusual items
"" Core operating income from sales
+ Core otheroperating income
+ Equity income insubsidiaries
+ Earnings on pension assets
+ Other continuing income notfrom sales
Tax on coreotheroperating income
~ Core operating income
Unusual items
- Special charges
- Special liability accruals
Nonrecurring items
- Asset write-downs
Changes inestimates
- Start-up costs expensed
Profits and losses from assetsales
- Restructuring charges
Profits and losses from discontinued operations
Extraordinary operating items
Accounting changes
Unrealized gains and losses on equity investments
+ Gains from share issues insubsidiaries
Currency gains and losses
Derivative gains and losses {operations)
Tax allocated to unusual items
= comprehensive operating income
397
Chapter 12 TheAno.l)"sis ofGrowth and Sustainable Earningl 399
statement (between net incomeand cashflow fromoperations), Microsoft reported the

following (in millions):
As withallanalysis, knowing thefirm's business isessential to new products? Is the lower operating income in2004 due to
identifying itscore income. A firm's core business isdefined by temporarily high R&D thatwill decline inthefuture?
its business strategy, so the analyst mustknowthe firm's busi- THE ANALYSIS OFADVERTISING COSTS:
ness model before classifying items inthe income statement

Start-up costs for beginning new businesses areexpensed
in the income statement andwould appear to be one-time
COCA-COLA CO.
Marketing isan essential partof most firms' core strategy. A

firm like Coca-Cola spends heavily on advertising to maintain
charges. Butfora retail chain like TheGap, the clothes retailer, its brand name. A one-time marketing campaign might be
or Starbucks, the coffee vendor, which arecontinually open- a transitory item but repetitive advertising, like Coke's, is
ing newstores asa matter of business strategy, these costs are
persistent.
ongoing.
Research and development expenditures on a special projectmightbeconsidered a one-time expense, but R&D expen-
ditures as part of a continuing R&D program-as isthe case
fora drug company like Merck &Co.c-ere persistent.
THE ANALYSIS OFR&D: MERCK &CO.

(in
billions of dollars)
Sales
II
II
R&D
R&D/Sales
Sales qrowth rate
Income from continuing
operations
2004
22..9
4.0
17.5%
2.0%
2003
225
3.3
14.7%
4.8%
2002
21.4
2.7
12.5%
1.2%
(inbillions of dollars)
2004
2003
2002
Revenues
Cost of goods sold
Gross profit
Seliing, administrative, and general
Operating income (before tax)
Advertising ecenseszsaes
22..0
7.6
14.4
8.7
5.7
21.0
19.6
7.1
5.2
5.5
12
1:7
10.0%
2&
13.2
8.0
8.6%
ill
7.0
8.7%
Coke's income statement isvery aggregated, with only two

operating expense items. Advertising expenses areincluded in
selling, administrative, andgeneral expenses but aredetailed
9.7
9.9
9.1
infootnotes. Advertising expenses historically have been a reasonably constant percentage of sales, at about 8.6%, so an
Merck's sales growth rates are low. Expenditures for R&D analyst might apply this ratio to sales forecasts to estimate
arepersistent andgrowing, andincreasing asa percentage of future advertising expenses. But, aswith R&D, theanalyst must
sales. The analyst views R&D expenses as core expenses but besensitive to a change intheadvertising-to-sales ratio. Is the
sees theincrease inR&D asa percentage ofsales as a red flag. increase in 2004 to 10.0%temporary? Is it dueto higher adWill R&D as a percentage of sales revert to pre-2004 levels in vertising expenditures orlower sales qrowth? Ifthelatter, why
the future? Is research becoming less successful inproducing aresales declining with higher advertising?
Issues in Identifying Core Operating Income

Here are the mainissuesin identifying sustainable operatingincome:
I. Deferred (unearned) revenue. Firmstypically recognize revenue whengoods are delivered or services are rendered. In sales contracts that covera numberof years-for
example, a contractfor the sale of computer hardware withsubsequent servicing,ceosuiting, and software upgrades-revenue from the contract is deferred (as unearned)
until the rendering of serviceand booked as a liability, deferred (unearned) revenue.
Estimates are involved so firms can be aggressive (booking too muchrevenueto the
current income statement) or conservative (deferring too much to the future). Both
have implications for the sustainability of earnings. The latter is actually more common:Deferrevenue andbleedit backtothe incomestatement in the futureso as to give
a pictureof growth.
Microsoft Corporation defersa largeamountof revenue. At theendof its2008fiscal
year,its unearned revenue liability stoodat $15,297 millioncompared with 2008 revenuein theincomestatemcntof$60,420million. In theaccrualsectionof the cashflow
398
Unearned revenue
Recognition of unearned revenue
2008
2007
2006
$ 24,532
(21,944)
$ 21,032
$ 16,453
(19)82)
(14.729)
(Thenumbers in parentheses are the "bleedback" for previously deferred revenue recognized in the current period.)One can see the amount by which current revenue is
being reduced by deferrals and increased by bleedback. One would be concerned if
morecurrentrevenue was comingfrombleedback thanwas being deferred for, if revenuecontracts are growing, it shouldgo the otherway. If salesgrowthis reported, but
with considerable bleedback, the growthis not likelyto be sustainable. Unearned revenueis sometimes referred to as a "cookiejar"; Firmscan dip into the cookie jar when
theyneedmoreearnings in the incomestatement.
Microsoft is helpful in reporting these two lines,so is transparent aboutthe matter.
Manyfirmsdo not reportthis detail.Beware affirms that havemultiyear revenue contractsand inspectthe revenue recognition footnote carefully.
2. Restructuring charges, asset impairments, and special charges. These are mostly
unusual, but note that firms can have repetitive restructuring charges. Eastman
Kodak, the photographic company, reported restructuring charges every year from
1992 to 2003 as it adapted its technology to the arrival of the digital age, and in
2004 Kodak indicated that $1.5 billion more charges would be made from 2004 to
2006.
Restructuring charges and asset impairments mustbe handled with care-their effects maynot be just "one-time," If a fum writesdowninventory, futurecostof goods
sold willbe lowerif the inventory is subsequently sold.If a fum writesdownproperty,
plant,and equipment, future depreciation will be lower. Lower expenses meanhigher
futurecore income; the perceptive analystrecognizes this andadjustsher forecasts accordingly. Worse, if a finn overestimates a restructuring charge, it must"bleedit back"
to futurecore income, creatingearnings. SeeBox 12.4. As a reminder, the accountingbased valuation modelsof Chapters 5 and 6 protectus from payingtoo much for the
earnings generated by thesewrite-downs, but the analyst mustidentify the multiperiod
effects in her forecasts to be protected.
Merger charges taken to cover the costs of mergers and acquisition also require
scrutiny. Is the firm lumping operating expenses intothesecharges? Is the firm overestimating the chargein orderto increase future income 10makethe merger appearmore
profitable?
3. Research anddevelopment. A drop in R&D expenditure increases currentearnings but
maydamage futureearnings. Investigate whetherchanges in R&D are temporary. See
Box 12.3.
4. Advertising. A drop in advertising expenditures increases current earnings but may
damage futureearnings. Investigate whetherchanges in advertising aretemporary. See
Box 12.3.
5. Pension expense. Finns report the cost of providing defined benefitpension plans as
part of the cost of operating expenses. Pension expense, however, is a composite
number, and the analyst must be aware of its makeup. The following summarizes the
pension expense footnote for IBM from2001 to 2004.
Chapter 12 TheAnarylis o!Growrnand$llllilinable Earningl 401
theyhave anincreasing effecton income: Income wouldhave

been lowerbythese amounts hadthecharges been recorded
asincurred. Buta further issue needs to beinvestigated: If IBM
had overestimated the restructuring charges in 1991-1993,
the differences between subsequent income and cash from
operations could, in part, be due to the reversal of the restructuring charges. Was IBM bleeding back the earlier restructuring charges to increase operating income? See Minicase M12.3.
When new management arrives at a firm, they are
tempted to take restructuring charges to show theyare innovating. The market often greets the restructuring as good
news. If the new managers overestimate the restructuring
charge, theyget an added benefit: They can bleed it back to
future income and report earnings improvement on their
watch. This isa scheme to growearnings. The diligent analyst
isattuned to these schemes.
1994
1995
1996 1997 1998
FASB Statement 146, issued in 2002, restricts afirm's ability
Effect of restructuring
to manipulate income with restructuring charges. Firms must
charges (inmillions} (2,772) {2,119} (1,491) (445) (355)
recognize the restructuring liability when anobligation to pay
restructuring costs is incurred, not when the firm merely deThese amounts are negative; that is, theyare deductions
velops a plan to restructure.
from net income to get cash from operations. Accordingly,
When firms decide to restructure, they oftenwriteoff theexpected costs of restructuring against income before theactual
restructuring begins, and recognize an associated liability, or
"restructuring reserve," that is reduced lateras restructuring
costs are incurred. Ifthefirmlater finds thatit has overestimated
thecharge, it must increase income for thecorrection. Aswith
deferred revenue, thisis known as bleeding back to income.
In moving its business away from computer hardware
to a focus on information technology in theearly 19905, IBM
wrote off considerable income with restructuring charges~
$3.7 billion, $11.6 billion, and $8.9 billion, respectively, for
1991~1993, a totalof $24.2 billion. Examination of thefirm's
cash flow statement for subsequent years reveals the following item as an adjustment to net income to calculate cash
fromoperations:
INTERNATiONAL BUSINESS MACHINES (IBM)

Components of Pension Expense,2001-2004
Service cost
Interest cost
Expected return onplan assets
Amortization of transition asset
Amortization of prior service cost
Actuarial losses (gains)
Net pension expense
2003
2002
2001
1,263
1,113
1,155
1,076
4,071
3,995
3,861
3,774
(5,987)
(5,931)
1159)
78
101
1803)
(6,253)
16,264)
(153)
80
(82)
66
764
(156)
89
105
(1,199)
(24)
{1,51l)
Pension expense has six components, and you see all six components in IBM's
summary.
II \
Service cost: Thepresent value oftheactuarial costof providing future pensions for
services of employees in the current year. Thiscostis, ineffect, wages foremployeesto be paidinpension benefits when employees retire.
Interest cost: The interest cost on the obligation to pay benefits, the effect of the
time value of money as the dateto paypensions comes closerandthe net present
value of the obligation increases.
Expected return onplanassets: Theexpected earnings on theassets of the pension
fund, which reduce the costof theplanto the employer. Theexpected earnings on
planassetsis themarket value of theassets multiplied byanexpected rateof return.
II
I\
II
2004
400
ACCOUNTING FOR PENSIONS

Accounting Clinic VI!on the book's Web sitegives a more
thorough coverage of the accounting for pensions. The
clinic explains how pension plans work andhow defined
benefit plans differ from defined contribution plans. The
clinic also explains howthepension liability in the balance

sheet iscalculated aswellasproviding more detail on the
pension expense in the income statement. The Web page
for this chapter goes through the pension expense for
Boeing company.
Tomake the pension expense lessvolatile in the financial statements, the expected
return on planassets is deducted in the calculation of pension expense, not actual
gains and losses. If the difference between accumulated actual andexpected gains
andlosses exceeds a limit, the difference is amortized into pension expense (none
appears in IBM's pension expense).
Amortization of priorservice cost: The amortization of the costof pension entitlements forservice periods priorto theadoption or amendment of a plan. Theamortization is overthe estimated remaining service years foremployees at thetime ofthe
change in theplan.
Amortization of transition assetor liability: Theamortization of the initial pension
assetor liability established when pension accounting was first adopted.
Actuarial gains andlosses: Changes in thepension liability dueto changes inactuaries' estimates of employees' longevity and turnover and gains and losses that
occur when actual returns onplanassets differ from expected returns.
Service cost is a part of the core costof paying employees. Interest costis alsoa core
cost;it is the cost,effectively paidto employees, to compensate themfor the timevalue
of money from receiving wages later, as a pension, ratherthanin the current year. Like
service cost, interest cost is repetitive. Amortizations of priorservicecostsand transition assets and liabilities smooth out these itemsso, while they mayeventually disappear,thesmoothing is doneoversucha longperiodthat they shouldbe treated as repetitiverather than unusual. Actuarial gainsand lossesare also smoothed, but are subject
to shocks.
Expected returns on plan assets, however, mustbe handled withcare. You will notice
that, from 2001 to 2003, IBM'snetpension expenses were negative (thatis, gains), primarily because of this item. These earnings on pension planassets reduce IBM's obligationtosupport employees inretirement, so theyarelegitimately partof income. However,
theyarenot earnings from the corebusiness (of selling computers andtechnology in the
caseofIBM).Theanalyst mustbecareful to disentangle these earnings andattribute them
to theprofitability ofthepension fund rather thantheprofitability ofthebusiness. Forthis
reason they areidentified outside ofcoreincome fromsales inthetemplate inExhibit 12.1.
Other dangers lurkin thepension expense number. SeeBox 12.5.
Accounting Clinic VIItakesyouthrough the accounting for pensions.
6. Changes inestimates. Some expenses likebaddebts, warranty expenses, depreciation,
andaccrued expenses are estimates. When estimates for previous years turnout to be
incorrect, thecorrection is made inthecurrent year. Baddebts areusually estimated as
a percentage of accounts receivable thatis likely to gobad.If theestimate forlastyear
Chapter 12 TheAnalysis Q/Growlh and Sustainable Earnings 403
The expected return on plan assets component of pension expense must be handled with care. Below arethree warnings.
1. RETURNS ON PENSION FUND ASSETS CAN BE

A SIGNIFICANT PORTION OF EARNINGS
Pension expense isreduced byexpected earnings onassets of
the pension fund, and expected earnings on a fund's assets
areofcourse based on the amount of the fund's assets. Pension plans invest inequities and, during the 1990s bull market, the prices of equities increased significantly, increasing
the assets in these plans and the expected earnings on the
olars. Such wastheincrease thatforsome firms, theexpected
eamlnqs on fund assets, reported as a reduction in pension
expense, wasa significant partofthefirm's earnings.
GeneralElectric
Genera! Electric sponsors a number of pension plans for its
employees. Its 2001 pension footnote reported a service cost
of $884 million, but $4,327 million in expected returns on
plan assets wasalso reported, along with $2,065 million ininterest on the pension liability. The net pension expense (with
all components) was actually a gain of $2,095 million. This
pension gain wasnetted against otherexpenses inthe income
statement. The $4,327 million in expected returns on plan
assets was22.0percent of earnings before tax.
[BM Corporation
IBM reported a pension service costof $931 million for1998.
But italso reported $4,862 million inexpected returns onplan
assets, along with $3,474 million in interest on the pension
liability. The expected returns on plan assets were 53.1 percentofoperating income before tax. IBM's expected return on
plan assets for 1999-2001 (in the text) were 45.9 percent,
51.5 percent, and57.2 percent ofpretax income, respectively.
Earnings on pension plan assets areearnings from theoperation of running a pension fund, not earnings from products andservices. In all cases, list the expected return on plan
assets as a separate component of core income so profit
margins can be identified without this component, as in
Exhibit 12.1.
2. RETURNS ON PENSION ASSETS CAN

PERPETUATE A CHAIN LEITER
Consider thefollowing scenario. In an overheated stock market, the assets of pension funds are inflated above their intrinsic values. Accordingly, the earnings of the firms sponsoring thepension funds fortheir employees areinflated through
the reduction of pension expense forearnings of the pension
aoz
funds. Analysts thenjustify a higher stock price forthese firms

based on the inflated earnings. Soinflated stock prices feed
onthemselves. Achain letter iscreated.
Asanextreme, consider thecase ofa company during the
stock market bubble whose pension fund isinvested solely in
the shares of the company (so employees could share inthe
success of the company). The earnings of the company
would be exaggerated by the returns on the pension fund
from the run-up of the firm's share price. Analysts look to
earnings to assess theworth offirms' shares relative to their
market price, but ifthe earnings reflect the market price of
the shares, the analysis-if not done carefully-is circular.
Good analysis penetrates the sources of firms' earnings and
understands that stock prices are based on firms' ability to
generate earnings from their core business, nottheappreciation instock prices.
Pension funds in the United states are permitted to hold
only 10 percent oftheir assets inthesponsoring firm's shares,
butthey may well hold shares whose returns arehighly correlated with thefirm's own shares, inducing a similar effect.
3. BEWARE OF EXPEGED RATES OF RETURN

ON PLAN ASSETS
Expected earnings ofplan assets arecalculated asanexpected
rateof return multiplied by the market value of the plan assets. The expected rateof return isanestimate thatcanbebiased. Indeed, inthelate 1990s, firms were using anexpected
rateof return of 10 percent and higher, considerably more
than the7 percent rateused intheearly 1980s. This ambitious
rate-perhaps influenced by the high bubble returns during
the 1990s-led to higher pension gains inearnings when applied to high pension asset values.
The subsequent bursting of thebubble led to much lower
returns-indeed, large negative returns-and firms revised
their expected rates of return downward. The consequence
was much lower pension gains in earnings in 2002, due in
partfrom the drop inasset prices andinpartfrom the lower
expected rates of return. Indeed, many firms with defined
benefit plans found that their pension obligations were underfunded and, in retrospect, their pastearnings that incorporated the pension gains were overstated. An analyst with
an understanding of pension accounting would have anticipated this scenario during thebubble.
Should firms lower their expected returns on plan assets in
overheated stock markets-to anticipate the expected lower
returns as prices drop inthe future? If firms do not, the analyst should consider doing so.
(say)was foundto be too high-s-fewer creditors wentbad than expected-the correction is madeto the currentyear'sbad debtexpense. Thus thereportedexpense doesnot
reflectthe credit costs of the current period'ssales. Finns also changeestimates of
residualvalues of leasereceivables. The effectof thesechanges in estimates shouldbe
classified as unusual, leaving the core expense to reflect currentoperations. Unfortunately, published reports often do not give the necessarydetail. A particularly perniciouschangein estimatecanfollowrestructuring changes. See Box 12.4.
7. Realized gains andlosses. Manyrealizedgainsand losses(onassetsales,forexample)
are not detailed in the income statement. Butthey can be foundin the cash flow statement in the reconciliation of cash flow from operations and net income. Beware of
"cherry picking." SeeBox 12.6.
8. Unrealized gains andlosses on equity investments. Thesearisefrom equity holdings of
lessthan20percent. Theyaredueto marking theholdings to marketvalue inthebalance
sheet.Themarketvalue oftheholdings indicates theirvalue, butchanges inmarketvalue
do not.Market values follow a "random walk," so changes inmarketvalue donotpredict
futurechanges in marketvalue. Treattheseunrealized gainsand losses as transitory.
9. Unrealized gainsandlosses from applying/air value accounting. Finns mayexercise
a "fair valueoption"underFASB Statement 159or LAS 9 to revalue certainassetsand
liabilities to fairvalue.Theassociated unrealized gainsand losses aretransitory, except
whentheyoffseta component of core income.
10. Income taxes. Unusual aspects of income tax expense such as one-time or expiring
creditsand loss carryforwards can be foundin the tax footnote.
11. Other income. Review the detailsof "other income" in footnotes, if provided. Often
interestincomeis included with operating income in "other income."
Mostoperating itemsreported in other comprehensive income (in the equitystatement)
are unusualitems ratherthan core income. Although includingthese items in a reformulatedstatementonly to take them out againto identify core income seemspointless, there
are four reasons for doing so. First, the discipline of identifying all the sources of profitability is important; otherwise, something mightbe left out. Forexample, hidden dirty.
surplus expense must be identified for a complete evaluation of management's actions;
cherry picking (in Box 12.6) is identified only if income is on a comprehensive basis.
Second, the accounting relationships that govern the financial statement analysis workonly
if earningsare on a comprehensive basis. Forexample, the leveraging equations of Chapter 11 requireearnings to be comprehensive; the short-cutcalculations of freecash flow in
Chapter 10 (Freecash flow> OI - tu"'JOA) workonly if earnings are on a comprehensive
basis.Third,the other comprehensive incomeitemsrevealthe riskto whichthe business is
subject. Translation gainsand losses,forexample, showhowa firm can be hit by exchange
rate changes. Fourth, wewill see whenwe cometo forecasting in Part Threeof the book
that the integrity of the forecasting processrelieson financial statements prepared (and reformulated) on a comprehensive income basis. Indeed, an analysis and valuation spreadsheet,like that in BYOAP, will not workotherwise.
For many firms, the separation of operatingincome into operating income from sales
and other operating income (in the Chapter 9 reformulation of the income statement)
makes the division between core income and unusual, transitory items. So operating incomefrom salesis coreincomeand other operating incomeidentifies unusual items. That
is the case withNike (in Exhibit9.9) and Dell(in Exhibit9.10).
However, this is not the case for General Millsin Exhibit9.11.General Millsreportsa
shareof earningsfromjoint ventures. As theseearnings arenot fromtop-line sales,theyare
otheroperatingincome. However, theyare coreearnings,for the ventures continue into the
Chapter 12 The Analysis ofGrowth and Su.sroinable Earnings 405
EXHIBIT 12.2 Identification ofCoreOperating Income and Unusual Items forGeneral Mills, Inc., forFiscalYears
In the rising stock market of the 1990s, firms' holdings of equitysecurities appreciated. The sale of the shares sometimes
provided a significant portion of profits.
INTEL
In itsthirdquarter report for 1999, Intelreported net income
of $1,458 million, with noindication of unusual items. Itscash
flow statement, however, reported $556 million in gains on
sales of investments, along with a $161 million loss on retirements of plant, asaddbacks to netincome to calculate cash
fromoperations.
2002 andcanrealize gains intoincome should operating profitability from otheroperations decline.
Aswith gains from pension plan assets, gains from share
appreciation can lead to mispricing and even create share
price bubbles. Firms may se!1 shares when theyfeel that the
shares are overvalued in the market. If an analyst mistakenly
attributes profits thatinclude these gains to persistent operating profits, hewill overprice the firm. Buthewill overprice it
more if the gains themselves are generated bymispridng. So
the mispridng feeds onitself.
BEWARE OF CHERRY PICKING
DELTA AIR LINES
Delta reported operating income (before tax) of $350 million Firms holding available-for-sale equity investments recognize
for its September quarter in 1999. However, notes to the re- unrealized gains andlosses aspartof othercomprehensive inport indicated that these earnings lnduded pretax gains of come in the equity statement asmarket prices of the equity
$252 million from selling its interest in Singapore Airiines and shares change. They recognize realized gains andlosses in the
income statement when shares are sold. Refer again to AcPriceline.com.
counting Clinic III.It istempting--especially in a year when income is down-to sell shares whose prices have appreciated
IBM
IBM reported before-tax operating income of $4,085 million in order to increase income reponed intheincome statement,
for itsquarter ending June 1999. However, footnotes revealed while keeping shares whose prices have declined unsold, with
that thisincome included a $3,430 million gain from the sale the unrealized losses reported in the equity statement. This
of IBM's Global Network to AT&T. This gain reduced selling, practice is referred to ascherry picking. Beware of firms with
general, andadministrative expenses intheincome statement! large investment portfolios. like Intel and Microsoft. Beware
You see that the disclosure of these gains is often not of the practice with insurance companies who hold large
transparent. The analyst must be careful to look for these investment portfolios.
The lesson is clear: Investment portfolios must be evalugains-in the cash flow statement or in the footnotes-and
separate themfromcore income from core operations. These ated on a comprehensive income basis sothat gains, possibly
gains or losses wouldbecore income onlyif thefirm isaport- cherry-picked, arenetted against losses for a comprehensive
foliomanagement company. Andwatch firms with bigequity assessment of portfolioperformance. Appropriate reformulaportfolios: Microsoft had $9 billion in equity investments in tion of the income statement takes care of the problem.
future. General Mills also has a defined benefit pension plan, and expected returns from
plan assetsare included in operating income fromsalesbut, of course, are not part of the
income fromsales.Exhibit 12.2 presents a reformulated statement for General Mills that
includes income fromjoint ventures in core income (but not core income fromsales)and
separates earnings frompensionassetsfrom income from sales. Pension returnsare continuing(andthuscore)butthe separation allows the assessment of coreprofitmargins from
sales without the contamination of pension returns.' Given our discussion of pension returns in Box 12.5,the analyst questions thesustainability of pension returns.
To assess the profitability of the component parts of the income statement effectively,
income taxes must be allocated to the component income that attracts the taxes, as in
Exhibits 12.1 and 12.2. Taxes mustthusbe allocated notonlyoveroperating and financing
components, but withinthe operating components also.SeeBox 12.7.
2008 and 2007
Core operating income consists ofcontinuing, sustainable income while unusual items are one-time components. Core income
from sales isdistinguished from core income not from sales. All income components areafter tax (inmillions ofdollars).
Year Ending May 25
Coreoperating revenues
Costof sales
Gross margin
Administrative and general expenses
Advertising
Expected returnon pension assets
Coreoperating income from sales
(before tax)
Taxes
Taxes asreported
Tax On pension returns
Tax benefitfrom restructuring charge
Tax benefitfrom net interest expense
Core operating income from sales
(after tax)
Core other operating income
Expected returnon pension assets
Tax (at 38.5%)
Earnings from joint ventures (aftertax)
Unusual items
Restructuring andimpairment charges
Tax benefit(at 38.5%)
Gain (loss) on hedge derivatives
Other
2008
2007
13,652
8,778
4,874
1,792
628
12,442
7,955
4,487
1,655
543
---1Q2
...JR
2,249
(391)
2,097
(362)
1,858
622
(150)
8
~
391
150
21
8

Net financing expense
Interest expense
Interest income
Netfinancing expense after tax
Comprehensiveincome
1,735
560
(39)
15
--0Q
1,208
1,135
362
241
139
111
223
73
1,560
1,431
(13)
246
(2)
39
15
(24)
194
22
--'.1.0
..-ill2
1,901
1,602
449
458
--.Il.
__3_'
422
427
~
263
1,339
(170)
252
1,649
Core Operating Profitability

With the identification of coreoperatingincome, the analyst can distinguish corereturnon
net operating assets(RNOA) fromthe transitory effectson RNOA:
Return on net operating assets =: Core RNOA + Unusual itemsto net operating assets
Pension gains are subtracted from core income from sales on one line inthereformulated statement.
GAAP credits these gains to various line items, depending onwhere thepension cost isrecorded. Unfortunately, firms donotreport theallocation of the credit to line items.
t
404
Core 01
Ul
RNOA' NOA + NOA
Chapter 12 The Analysis ofGrowth and Slwainable Eomings 407
If an income statement isreformulated to identify different sources of income, each type of income must be allocated the
come taxes it attracts sothe after-tax contribution of each source of income isidentified. GMPincome statements arereformulated asfollows, The firm has a 35 percent statutory taxrate.
This coresalesPM uncovers a profitmargin that is unaffected byotherincome or unusual

items,so it really"cutsto the core"of the firm's abilityto generate profits fromsales.General Mills had a coresales PM of 8.85 percent in 2008, which, with an asset turnover of
1.09,explains its core RNOA from sales of9.6 percent.
Core Borrowing Cost

Reformulated Statement
GAAP IncomeStatement
Revenue
Operating expenses
interest expense
Income before tax
Income tax
Net earnings
$ 4,000
(3,400)
(300)
(100)
--mo
~
Core revenue
Core operating expenses
Core operating income before tax
Taxes:
Tax reported
Tax benefit ofinterest
Tax onbenefit unusual items
Core operating income after tax
Unusual Items:
Tax deduction
Operating income
Interest expense
Tax oninterest
Net earnings
$ 4,000
(3,4001
~
$ 45
35
105
$300
..l!Qj)
Netborrowing cost- Corenet borrowing cost+ Unusual borrowing costs

NBC"" Corenet financial expenses + Unusual financial expenses
185
---m.
........12?.
220
$100
Thenet financing expense component of the income statement canalsobe brokenintocore

expense and one-time effects. The breakdown yieldscore net borrowing cost, the number
to applyin forecasting futureborrowing costs:
65
$ 155
Net earnings arethesame before andafter the taxallocation, ofcourse. The restructuring charge, like interest expense,
a taxdeduction, sounusual items after taxare$195. The taxsavings from the restructuring charge, like thatfrom interest. isan
adjustment to reported taxto calculate taxon operating income. Accordingly, thetotal taxon operating income is$185, that
is, the taxthatwould have been paid hadthe firm nothada deduction for the restructuring charge andinterest. In the same
vein, taxes areallocated to pension earnings inGeneral Mills's income statement inExhibit 122.
NFO
NFO
Asbefore, unusual financial itemsarethosethatarenot likely to be repeated in the future or

are unpredictable. Theyinclude realized and unrealized gainsandlosses on financial items
and unusual interest income or expenses. The before-tax core ratesshouldagree roughly
with the borrowing rates reported in the debt footnote. Core borrowing cost will reflect
changes in theseratesand, as the ratesare aftertax,this includes changes dueto changes in
tax rates.The analysis fora net financial assetposition proceeds along thesamelines.
ANALYSIS OF GROWTH
Residual earnings, the focusfor growth, are driven by returnon common equity(ROCE)
andthe amount of common shareholders' equity:
Residual earnings, = (ROCE, - Costof equitycapital) x CSE1_ 1
So, growth in residual earnings is drivenby increases in ROCE and growth in common
shareholders' equity. Weconsidereachin tum.
Thefirstcomponent isthe coreR.NOA. Separating income fromsalesfromotheroperating

income withinthe core RNOA,
RNOA == Core01 from sales + Core other01 + ~
NOA
NOA
NOA
To the extentthat RNOA is driven by unusual, transitory items, it is said to be of "low
quality." It is not sustainable.
Withaverage net operating assetsof$12,572million, General Millsearnedan RNOA of
15.1 percentin 2008. Usingincome components in Exhibit 12.2, we see that the RNOA
wasgenerated by a returnof coreoperating income fromsalesof 9.6percent, plusa return
of 2.8 percent from other core income and a return from one-time items of 2.7 percent.
Clearly, the return from the core business is lower than the overall RNOA wouldsuggest.
Having identified core RNOA, break it down into its profit margin and turnover
components:
RNOA == (CoresalesPM x ATO) +
CoreotherOI
ill
+-NOA
NOA
where
CoresalesPM
406
CoreOI fromsales
Sales
Growth Through Profitability

With the analysis of ROCE in Chapter 11 and the identification of core income here, we
nowhavethe full set of drivers of ROCE. The financing leverage equation in Chapter 11
tells us that ROCE is driven by operating profitability (Rt'lOA), the amount of financial
leverage (FLEV), and the spread of operating profitability over the net borrowing cost
(NBC):
ROCE = RNOA + [FLEV x (RNOA - NBC)]
Figure 12.I addsthe analysis of sustainable earnings aboveto thisbreakdown. Withvaluation in mind, we are concerned with growthin the future, and the analysis of sustainable
earnings identifies the components of RNOA and NBC-the core RNOA and the core
NBC-that bearon the future. The analystidentifies the numbers in Figure12.1 fromthe
currentfinancial statements-as we did withGeneral Mills-and, disregarding profitability from unusual items,asks howthey mightchangein the future. Can the fum maintain
core profitability? Can it increase core profitability or is it likely to be competed away?
What is the likely change in core profit margins? These are the questions we ask when
querying whether a firm has durable competitive advantage.
Togain insights intothese forecasts, the analystdiscovers howprofitability changed in
the currentperiod. By far the most important issue is the explanation for the change in
currentcoreprofitability. Following the designin Figure12.1,Box12.8carriesoutsuchan
Chapter 12 TheAnalysis ofGrowrh <md Smwinabte Earnings 409
Change in
Change incore sales
Change dueto
RNOA
'" profit margin at
+ change inasset
previous asset
turnover
turnover level
Change dueto
Change dueto
+ change inother
+ change inunusual
core income
items
L\RNOAm> '" (ecore sales PM= xATO=)

+ (MTO= x Coesales PM=)
bRNOA xoo :: 1.5%

::: (0.77% x 3.31} + (0.15 x 9.64%)
+0+(1.62%-4.13%)
(allow for rounding error). You see that core profit margins
increased, by0.77 percent, producing a 2.55 percent boost to
RNOA. Turnover also increased by0.15, producing a 1.45 percent increase. Accordingly, core profitability increased by
4.003%. Unusual items actually lowered RNOA, obscuring a
considerabl'y larger increase in RNOA from core profitability.
GENERAL MILLS
+o(coreNOA
OtherOIJ+'(~J
NOA
General Mills's increase inRNOA from 12.9 percent in2007 to

15.1 percent in 2007 isexplained asfollows:
6RNOA= ::: 2.2%
Table 11.3 in Chapter 11 reports RNOA, profit margins,

andasset turnovers for 2008 and 2007 for Nike andGeneral
Mills. The following analyzes the year-to-year changes. Nike's
core operating income isequal to its operating income from
sales inExhibit 9.9 inChapter 9. General Mills's core operating
income isidentified in Exhibit 12.2.
:::(-0.27%x 1.00) + (0.08 x 8.85}
+(2.80% - 2.40%) + (2.71% -1.39%)
The increase inRNOA of 2.2 percent is dueto a 1.32 percent

increase from one-time items and a 0.40 percent
from core income outside of sales. Core income from sales
NIKE
contributed only 0.48 percent to the increase in RNOA, and
Nike's increase inRNOA of 1.5 percent, from 33.5 percent in thatincrease came from an increase inasset turnover rather
2007 to 35.0 percent in2008, isexplained as follows:
than core profit margins.
FIGURE 12.1
Sustainable Drivers of Return on Common Equity (ROCE)
Return oncommon equity isdriven bycore operating profitability, financial leverage, and net
borrowing-costs. Operating profitability, RNOA, isdriven bycore (sustainable) profitability and
one-time, unusual items. Net borrowing costs (NBC) aredetermined bycore borrowing costs and
one-lime, unusual items.
ROCE::: RNOA + [FLEV x (RNOA - NBC)]
Core 01 from ~ales

NOA
Core other items

NOA
Core sales PM
D.in core sales PM xATO
408
Unusual items
NOA
COre NBC
Unusual
financing items
analysis forNike,Inc.,and General Mills,Inc.,the twofirms analyzed in Chapter 11.Note

the formula at the beginning of the box (that is also indicated in Figure 12.1). The
contribution of a change in the core sales profit margin is assessed holding the asset
turnover for the previous year constant, while the contribution of the change in asset
turnover is assessed holding thecurrentprofit margin constant. FromBox 12.8 youseethat
Nike's operating profitability is drivenby an increase in core income from sales,withboth
an increase in core profit margin and an increase in asset turnover contributing. General
Mills's increase in profitability, on the other hand, came from unusual itemsand core incomeotherthanfromsales. Thecore profit margin actually declined.
Operating Leverage
Changes in coresalesPMare determined by how costschange as saleschange. Somecosts
are fixed costs: They don't change as sales change. Othercosts are variable costs:They
change as saleschange. Depreciation, amortization, and many administrative expenses are
fixed costs, while most labor and material costs in cost of sales are variable costs.The
difference between sales and variable costs is calledthe contribution margin because it is
this amount that contributes to covering fixed costsand providing profits. Thus
SalesPM "" Sales- Variable costs- Fixedcosts
Sales
Contribution margin
Sales
Fixed costs
Sales
Thefirst component hereiscalledthe contribution margin ratio. Thisissometimes calculated
"
Contnibuti
unon margm
ratioI
"" ~ _V"an:.'",ab"l"e"c:::os=ts
Sales
Contribution margin
Sales
This ratiomeasures the change in income from a change in one dollarof sales.Fora firm
withvariable coststhatare 75 percentof sales,the contribution margin ratiois 25 percent
Thefirmadds 25 centsto income for eachdollarincrease in sales(andthe fixed costsdon't
explain changes in profitmargins).
Thesensitivity of income to changes in salesis calledthe operating leverage (notto be
confused withoperating liability leverage). Operating leverage is sometimes measured by
the ratioof fixed to variable expenses. But it is alsomeasured by
OLEV"" Contribution margin _ Contribution margin ratio
Operating income
Profitmargin
(Again, don't confuse OLEVwithOLLEV)) Ifyou aredealing withcoreincome, thenthis

calculation shouldinclude onlycore items.If there are fixed costs, OLEV will be greater
than 1. The measure is not an absolute for the firmbut changes as sales change. However,
at any particular level of sales, it is useful to indicate the effect of a change in sales on
operating income. Applying it to core operations,
% Change in core OJ = OLEV x % Change in coresales
An analyst inside the fum win have a relatively easytask of distinguishing fixed and vari-
I
I
MTQ xcore salesPM
ATO
ablecosts. Butthereader of annual financial reports will find it difficult. Thedepreciation and
amortization component offixedcostsmustbereported in the 1O-K report, andit can befound
in the cashflow statement. But otherfixed costs-c-fixed salaries, rentexpense, administrative
expenses-c-are aggregated withvariable costsindifferent lineitems on the income statement.
Chapter 12 The Analysis ofGrowth (1m! SlIlrilinabre Earnings 411
Analysis of Growth in Shareholders' Equity
In 1996, Reebok hada considerable change in itsfinancing.

Itborrowed approximately $600 million andapplied the proceeds to repurchase itsshares. The consecutive reformulated
balance sheets below show the large increase innetfinancial
obligations and a corresponding decrease in shareholders'
equity. This produced a large increase in financial leverage,
from 0.187 to 0.515 (based on average balance sheet
amounts).
REEBoK INTERNATIONAL LIMITED
Summary Reformulated Balance Sheets

ROC'
RNOA
Net borrowing cost (NBC)
1996
1995
1,135
1,220
720
287
~
18.9%
14.1%
4.9%
0.515
~
19.2%
16.9%
4.8%
0.187
above RNOA. Accordingly, firms can create ROCE by issuing

debt. Beware of increases in ROCE. Analyze the change in
profitability to see if it is driven by core operations or by
changes inleverage.
firms often state that their objective isto increase return
oncommon equity. Maximizing ROCE isnotentirely satisfactory Maximizing RNOA is, andto the extent thatincreases in
ROCE come from operations, increasing ROCE isa desirable
goal, provided the cost of capital is covered. Tying management bonuses to ROCE would be a mistake: Management
could increase managerial compensation byissuing debt.
Growing residual earnings generates value, as noted. But
residual earnings aredriven by ROCE, andROCE canbe generated by borrowing (which does not create value). There
seems to be a contradiction. The riddle is solved inthe next
chapter.
BEWARE OFLIQUIDATIONS OFFINANCIAL

ASSETS
Just as borrowing increases ROCE, sodosales of financial asFinandalleveraqe (FlEV)
sets. Financial assets are negative debtand their liquidation
Peebok's ROCE dropped byonly 0.3percent in1996, butthis increases leverage. But sales ofT-bills at (fair) market value do
masks a considerably higher drop of 2.8 percent inoperating notaddvalue. Watch for firms thatsell offtheir financial asprofitability. The ROCE was maintained with borrowing. Had setswhen RNOA isdeclining; they may be masking a decline
Reebok maintained its1995 leverage of 0.187, the ROCE on in operating profitability. In the GAAP Cash flow statement,
they also look asjfthey areincreasing free cash flow, because
a 14.1 percent RNOA would have been 15.8 percent:
GAAP classifies sales of financial assets as reducing investROCE", RNOA +(FLEV x SPREAD}
ment inoperations. See the lucent Technologies example in
Chapter 10.
ROCE 1S96 '" 14.1 + [0.187 x (14.1 - 4.9)]
The overall effect of a sale of financial assets depends, of
'" 15.8%
course, onwhat theproceeds areused for. If they areinvested
inoperating assets, they may well enhance profitability-but
Instead, Reebok reported a ROCE of 18.9 percent.
For most firms, issuing debt does notcreate value: They through operations, notfinancing activities. If they areused to
buy andsell debtat its fair value. The value generation isin retire debt, there isno effect on leverage. If they areused to
the operations. Yet financial leverage can lever the ROCE pay dividends, there isanincrease inleverage.
Analysis of Changes in Financing

Changes in RNOA partially explain changes in ROCE. The explanation is completed by
an examination of financing. The leveraging effect on ROCE is given by the leveraging
equation at the topof Figure 12.1. Leverage effects on ROCE corne from two sources,
changein the amount of leverage (FLEV) and the net borrowing cost.
Box 12.9 shows howchanges in leverage can affectROCE. The analysis there comes
with a warning: Issuing debtat market value to add financing leverage does notadd value
but it can have a significant effect on ROCE. Indeed, changes in ROCE due to leverage can
mask thecontribution ofoperating profitability to thevalue creation, andit is thebusiness
operations thatadd value. We pickup on this pointin thenextchapter.
410
Residual earnings are driven not onlyby the rateof returnon common equity but alsoby
the amount of common shareholders' equitythatearns at that rate.
The shareholders' investment requirement is driven by the needto invest in net operatingassets. But to the extentthat debt is usedto finance net operating assets, theshareholders' investment is reduced:
~CSE = ~NOA
~NFO
As net operating assetsare put in placeto generate sales,salesare a driverof net operating
assets and, thus, the shareholders' investment. The asset turnover (ATD) indicates the
amount of net operating assetsrequired to supportsales.AsATD = Sa!esINOA,
NOA = Salesx _1_
ATO
So
L\CSE = 6.(sales x
_1_) ATO
6NFO
Sales require investment in net operating assets and the inverse of the asset turnover,
1/ATO, is the amount of net operating assets in place to generate $1 of sales.Nike's2008
ATO was3.47,so 1/3.47, or 28.8centsof net operating assets, were in placeto generate $1
of sales. Thechange in CSEcan be explained by threecomponents:
1. Growth in sales.
2. Change in net operating assetsthatsupporteach dollarof sales.
3. Change in the amount of net debt that is used to finance the change in net operating
assetsratherthanequity.
Sales growth is the primary driver. But sales growth requires more investment in net
operating assets,which is financed by eithernet debtor equity.
Box 12.10 analyzes Nikeand General Mills'sgrowth in common equity. Thecalculation
at the topincorporates the threecomponents of the growth. Nike'scommon equitygrewby
10.6percentin 2008 andGeneral Mills'sdeclined by7.8 percent. Box12.10 explains why.
As a benchmark, note that the median annual growth in common equity for NYSE and
AMEX firms from 1963 to 2008 was 9.0percent.
Sales are the engineof growth; to create growth in order to create value, a manager
grows sales.Salesrequire investment. Andinvestments earn through ROCE andthe factors
that drive ROCE. Together, investment and ROCE drive residual earnings and abnormal
earnings growth. Themanagerrecognizes thatthereis a tensionto growing CSE.Equityinvestment can easily be increased by issuingnewshares or reducing dividends. But the new
equity mightnot be used wisely. It couldbe invested in projects withlowR..NOA or financia! assets with low returns, reducing ROCE, residual earnings, and value. That is why
residual earnings is the focus, not ROCE or investment, but ratherbothused together. The
manager aims to increase investment but alsoaims to havea low investment per dollarof
sales-s-a highATO-and a low investment perdollarof operating income-a highRNOA.
The manager's aim is to maximize residual earnings and this involves two elements, increasing ROCE (through the RNOA) andincreasing investment. Todothis,shegrows sales
but minimizes the investment per dollar of sales (l/ATO) and maximizes the operating
income per dollarof sales (PM).
Change in
common
equity
Change dueto change

insales at previous
level ofasset turnover
+ Change due to change
inasset turnover
Change infinancial
leverage
li.CSEml =- (li.SaleS mc x- ' - )

ATO:m,
+(0_'_ x
AT0 20Ce
.!
Sa!e~ J-li.NF0
2OCe
An increase ininvestment wasrequired because growing sales

required further investment innetoperating assets. However,
an increase in the asset turnover reduced the necessary
investment. An increase innetfinancial assets required further
equity investment.
GENERAL MILLS
General MHis reduced average shareholders' equity by $450
million in2008. Sales revenue increased by$1,210 million and
the asset turnover increased from 1.00 in 2007 to 1.09 in
2008. With an increase in net financial obligations of $527
million, thedecrease inequity isexplained by
NIKE
6CSE1OOS=- ($1,210 million x 1.00)
Nike's average common shareholders' equity increased by
+ (-0.083 x $13,652 million) - $527 million
$712 million in2008. This growth isattributed to a growth in
=- $1,210 million - $1,133 million - $527 million
sales of 52,301 million, an increase in asset turnover from
=--$450 million
3.31 to 3.47, andanincrease inaverage netfinancial assets of
$274 million:
Added sales required added investment innetoperating assets
to support thesales, but an increase inthe asset turnover re6C5E.oos =- ($2,301 million x 0.302)
duced the requirement. The addition of $527 million in net
+ (-0.014 x $18,627 miltion)+ $274 million
debtmore than satisfied the investment requirement: Equity
"" $697 million - $259 million + $274 million
actually declined as some of that debtfinancing wasapplied
=- $712 million
to dividends and stock repurchases.
GROWTH, SUSTAINABLE EARNINGS, AND THE EVALUATION

OF PIB RATIOS AND PIE RATIOS
The analysis of currentandpastgrowth is a preludeto forecasting futuregrowth in orderto
evaluate PIE and PIB ratios;the next partof the book proceeds with forecasting. We have
two ratios on whichwe can base our pricing; the PIB ratio and the PIE ratio. Before proceeding to forecasting and valuation you should understand howthese ratiosare relatedto
each other, and how each is related to growth. In this section, we look at the relationship
between PIB ratiosand trailing PIE ratiosanddrawsome lessons from the comparison.
Remember that zero abnormal earnings growth (AEG) implies no growth in residua!
earnings(RE),andpositiveAEG means thereis positive growth in residual earnings. To reinforcethis idea, Box 12.11 gives the benchmark case ofa finn, Whirlpool Corporation,
with a normal forward PIEand a normal trailing PIE ratio.The normal PIEvaluation can
be developed either by forecasting zero AEG or by forecasting no growth in residual
earnings.
How Price-to-Book Ratios and Trailing PIE Ratios Articulate

The Whirlpool example is a case of normal PIE ratiosbut a normormal PIB ratio.To focus
on the question of how PIE and PIB ratiosare related, ask the following question: Musta
412
The table below gives an analyst's forecast of Whirlpool's

earnings for1995, 1996, and 1997 andthe forecasted residual earnings calculated from the forecasted earnings. The
forecast wasmade at theend of 1994.
WHIRLPOOL CORP.
Analyst Forecast, December 1994

(amounts indollars pershare)
Required return of 10%
1993A
EPS
DPS
BPS
22.85
RE
1994A
1995E
4.43
1.22
25.83
2.15
4.75
1.28
29.30
2.17
33.04
2.15
5.45
1.41
37.07
2.15
4.87
5.21
5.58
4.87
0.02
0.02
5.23
(0.02)
(0.02)
5.58
0.00
Cum-dividend
earnings
Normal
earnings
oRE
AEG
1996E 1997E
5.08
1.34
0.00
RESIDUAL EARNINGS VALUATION

ON FORWARD RESIDUAL EARNINGS
Because the 1995 RE forecast issimilar to subsequent forecasted RE, Whirlpool is valued at $47.53 pershare bycapitalizing the 1995 RE forecast asa perpetuity at thecostof capitalof 10percent:
r
V;S94 =
RE1S95
$2.17 $47.53
CSE19S4 + - =- $25.83 +--:::
Pr-1
0.10
This value isclose to Whirlpool's market price at the time of

$47.25.
FORWARD EARNINGS VALUATION

The proforma forecasts no grolNth inresidual earnings from
the forward year, 1995 onward. But no growth in residual
earnings means abnormal earnings are zero, as shown (approximately) in the pro forma. With this expectation, the
shares canbevalued bycapitalizing forward earnings, andthe
forward PIE must be10,thenormal forward PIE fora required
return of 10percent.
\I.E
_ $4.75
1S94 -
0.10
::: $47.50,or 10times forward earnings of $4.75.
RESIDUAL EARNINGS VALUATION ON

CURRENT (TRAILING) RESIDUAL EARNINGS
The actual 1994 RE is$4.43 - (0.10 x $22.85) =- $2.15. This is
similar to the RE forecasted forthefuture. So, asnogrowth in
RE isforecasted, wecould have valued thefirm bycapitalizing
the current 1994 RE:
1Ii~94 "" $25.83 + $2.15 =- $47.33

0.10
TRAILING EARNINGS VALUATION

With no growth in residual earnings from the current year
onward, andthus zero abnormal earnings growth, theshares
can bevalued by capitalizing trailing earnings, andthe(cumdividend) trailing PIE must be 11, thenormal PIE fora required
return of 10percent:
ViS94 + d1994 :::
11 x $4.43 =- $48.73
So, as the dividend is$1.22, the ex-dividend value is$47.51

(allowing forapproximation error).
This isa case ofa firm with botha normal trailing PIE and
a normal forward PIE, buta nonnormal PIB.
firm witha high PIB ratioalso havea high PIE ratio?Cana finn witha high PIB ratiohave
a low PIE ratio?
In orderto appreciate the empirical relationship between the tworatios,Table 12.1 splits
u.s. firms at their median (trailing)PIE and PIB each year from 1963 to 2001 and counts
the number of timesfirms hada high PIB (above the median) and a highPIE(above themedian),a low PIB (below the median) and a low PIE (below the median), and so on.You see
thatthe relationship between PIB and PIE is positive; Finnswith high PIB tendto havehigh
PIE, and firms with lowPfB tend to havelow PIE also. Indeedtwo-thirds of cases fall on
this diagonal. But one-third falls on the other diagonal: Finns can trade at a high PIB and
a low PIE or a high PIB and a low PIE. What explainswhich of these cells a firm will
fall into?
413
414 Part Two
Th~ Analysil
Chapter 12 The Analysis of Growlh and. SusrainaOl..c Earnings 415
of Financia! Sw[cm~ms
TABLE 12.1
PIE Ratio
Frequencyof High
and Low PIB and PIE
Ratios, 1963-2001
High
PIE Ratio
High
Low
10,848
23,146
16.0%
34.0%
23,147
10,849
Low
.16.0%
TABLE 12.2
PISRatio
CellAnalysis of the
PIB....PtE Relationship
High
PIE Ratio
High
Normal
Low
Normal
Low
TABLE 12.3
CellAnalysis of the
PIB-PIE
Relationship:Filling
in the Cells
34.1%
P/B Ratio
PIE Ratio
High
(RE> 0)
A
High
Normal
(RE- 0)
Low
(RE<O)
RE> REo
C
RE>REo
REo < 0
REo<O
RE> REo
D
RE"" REo
RE "" REo
RE=REo
REo> 0
REo=O
REo < 0
G
RE < REo
H
RE < REo
REo> 0
REo> 0
Normal
RE < REo
Low
Key: RE= bpCl:lerlfulure ""id",,1e:lmings.
RE.,'" Current residull elmiogs.
Toanswer thisquestion, let'sconsider high, low, andnormal PIBs andPIEs inTable 12.2.
Remember a normal PIB is equal to 1.0 anda normal trailing PIE is equalto PEI(PE - 1).
Thereare ninecells,labeled A to I, andwe want to entertheconditions underwhich firms
fall intoa particular cell.Aswith tic-tac-toe, startwiththecentral cell,E. Weknow thatexpected future residual earnings mustbezeroherebecause PIB is normal. Wealsoknow that
expected future REmustbe thesameascurrent RE forthe PIE tobe normal. Expected AEG
mustbe zero. Ifwe indicate thestream of expected future REbyRE(forshort)andcurrent
REby REo, it mustbe that RE = REo = 0 for firms in thiscentral cell.Thatis, for both PIB
and PIE to be normal, a finn musthave zeroexpected furore REandcurrent REthatis also
zero(andthuscurrent andfuture ROCE equal thecostof capital). Thiscondition is entered
in cellE in thesolution to theproblem inTable 12.3.
Nowlookat theothercellsfor a normal PIB, cellsB andH. Hereforecasted future RE

mustbe zero. But,forhighPIEincellB, future REmustbeforecasted as beinghigher than
current RE (and forecastedAEG is positive). Thus REo mustbe lessthanzero(andcurrent
ROCE mustbe lessthanthe costof capital). Correspondingly, firms should tradeat a normal PIB anda lowPIEin cell H whencurrent RE is greater than zero(andcurrent ROCE
is greaterthan the costof capital). In the othercellsfor a normal PIE(cells D and F), expected future REmustbeat thesamelevel as current REbut,asthesearecasesof'nonnormal PIB, it must be thatbothcurrentand future REare greaterthan zero (cell D) or less
thanzero(eel! F). Whirlpool fallsintocell D.
The conditions for the fourcornercells follow thesame logic. Toattribute botha high
PIE and a high PIB to a firm (cellA), we must forecast future RE to be greater thanzero
andthisREmustbegreaterthancurrentRE.A firm canalsohave a high PIB anda lowPIE.
This is the cell G casewhere we expectresidual earnings to be positive in the future but
current residual earnings are evenhigher. Anda firm can have a high PIE but a low PIB.
Thisis thecell C casewhere weexpect low(andnegative) REin the future butcurrentRE
is evenlower. Finally cell I contains firms thathavebothforecasts oflow and negative RE
in thefuture but currently have a higherRE thanthe long-run level.
Wecan summarize all thisin onestatement: PIB is determined by the future RE a firm
is expected to deliver but PIE is determined bythe difference between current RE and the
forecast of future RE, thatis, growth in RE from current levels.
Look at Box 12.12 for examples of firms that fall into the various cells. It looks as if
themarket isgiving these firms theappropriate cellclassification. Butwecould usetheanalysistoscreen for firms thatmight be mispriced. Certain combinations of PIE, PIB, andcurrent
REandforecasted REareruled out,so if these occur, mispricing is indicated. If a firm were
reporting a highRaCE and RE, and reliable analysts' forecasts indicated positive RE in the
future, wewould expect thestockto tradeat a PIB above 1.0. Andif analysts' forecasts indicatedthatthecurrent REwasparticularly highandwould be lower in thefuture, wewould expectthe PIE to be below normal and would classify the fum as a cell G firm. If themarket
were giving thefinn a high PIB anda high PIE (asa cell A firm), it might be mispriced. (Of
course, themarket could bevaluing earnings beyond theanalysts' forecast horizon.)
You cansummarize equity analysis andtake positions based ontheanalysis inthisway: Put
a finn in theappropriate cellbased on forecasts ofRE and then compare your classification
withthat of the market In the late 1990s, the market placed many firms in cell A. Some
claimed thatearnings at thattimewere exceptionally highandcould not be sustained. That
claim putsfirms in cellG.Who was correct? History shows thelatterapplied to many firms.
Trailing Price-Earnings Ratios and Growth

A fum witha hightrailing PIE is commonly referred to as a growth stock. Butis thisgood
thinking? Wehave seenthata highPIE implies highgrowth in earnings in thefuture. Butthe
analysis wehave justgone through gives ussomereservation about calling every high-PIE firm
a growth stock. A finn's PIE canbehighbutit mayfall intocell C.Thatfirm (like Rocky Shoes
& Boots inBox12.12) isexpected tohave lowREinthefuture (RaCEless thanthecostofcapital), andit hasa high PIE only because current REis even lower thanthatexpected in thefuture. Rocky Shoes & Boots, incellC, ishardly Nike, in cellA.Thisisnota finn thatisable to
pump outa lotof profits on book value. It is expected to have growth inearnings, yes,butlow
profitability. In contrast, a firm in cellG (like USAirways) is predicted to produce relatively
highREinthefuture, butithappens thatcurrentRE iseven higher, andthisproduces alowPIE.
Which is the growth fum, the cellC firm orthe cellG finn? It's a matter of definition,
of course, but wemightreserve the term growthfirm for a firm that is capable of deliveringresidual earnings growth (abnormal earnings growth) in thefuture.
Chapter 12 TheAoolysil ofGrow1h and Sllswioob1e Earnings 417
A. High PIE-High PIE
C. LowPIE-High PIE
Nike, Inc The market gave Nike a PIB of

4.1 and a PIE of 21 in 200S, both high
relative to normal ratios. Current residualearnings were $642 million andan-
Rocky Shoes & Boots, Inc. like Nike, a
B.Normal P/B-High PIE

Westcorp. westcorc. a financial services
holding company, reported earnings for
1998 of $0.65 pershare anda ROCE of
5.4 percent. Analysts in1999forecasted
alysts were forecasting earnings thatin- earnings of $1.72 for 1999 and $2.00
dicated higher residual earnings (and for 2000, which translate into a ROCE
positive abnormal earnings growth) in of 13.6 percent and 14.1 percent, respectively. With a forecasted ROCE at
thefuture. This isa cell A firm.
aboutthe(presumed) costofcapital but
increasing from the current level. this is
a cell Bfirm. The market gave thefirm a
PIB of 1.10anda PIE of 24.
E. NormalP/B-Normal PIE
Whirlpool Corp. Whirlpool. with a posi- Horizon Financial Corp. Horizon Finantivebut constant RE, wasa eel! D firm in cial Corp., a bank holding company, re1994.Whirlpool was priced at 11 times ported a RaCE of 10.3percent forfiscal
earnings (cum-dividend), and at 1.8 1999. Analysts forecasted that ROCE
times book value, as we saw in Box would be 10,6 percent for 2000 and
after, roughly at the same level. Ifthe
12.11.
equity costof capital is10 percent, this
firm should have a normal PIB and a
normal PIE. The stock traded at 11 times
earnings and1.0times book value.
D. HighPIB--Normal PIE
footwear manufacturer, Rocky Shoes reported a ROCE of 1.8 percent for1998

with earnings of $0.21 pershare. Analysts forecast a RaCE of 6.2 percent for
1999 and 7.8 percent for 2000, on
earnings of $0.72 and $0.95, respectively. The market gave thefirm a PIB of
0.6 and a PIE of 33, appropriate for a
firm with forecasted ROCE less thanthe
(presumed) cost of capital but with increas'lOg ROCE.
F. low P/B-Normal PIE
Rainforest Cafe Inc. In 1999, analysts
covering Rainforest Cafe, a theme
restaurant ("a wild place to eat"),forecasted earnings of $0.62 per share for
1999 and$0.71 for2000, ora ROCE of
6.8 percent and 72 percent. The stock
traded at a PIB of0.6,reflecting thelow
anticipated ROCE. The ROCE for 1998
was6.5percent. With 1998 profitability
similar to forecasted profitability, the
stock should sell at a normal PIE ratio.
And indeed itdid: The PIE at thetime of
the forecasts was11.
I. low P/B-Low PIE

UAL Corporation. United Airlines's holding company traded at a PIB of 0.7 in
mid-1999 and a PIE of 6. It reported a
year and forecast ROCE for 1999 and 15.0 percent in 1998. Analysts fore- ROCE of 29.2 percent for 19.98, butits
2000 down to 29 percent and 33 per- casted in1999 thatthe ROCE would de- ROCE wasexpected byanalysts to drop
cent. The stock traded at 12.6 times cline to 11.7 percent by2000. The mar- to 10.6percent (before a special gain) in
book value, consistent with high ROCE ketgave thestock a PIB of 1.0in 1999, 1999andto 9.1 percent in2000.
inline with the forecasted ROCE equalinthefuture. butat a PIE ofonly 4.
ing the cost of capital. But the PIE was
7, consistent with the expected drop in
the ROCE.
H. NormalPIE-low PIE.
G. High P/B-low PIE
US Airways Group. US AiflNays reported America West Holdings. America West
a ROCE of 81 percent in 1998. Analysts Holdings. the holding company for
deemed 1998to be a particularly good America West Airlines, had a RaCE of
Trailing Price-Earnings Ratios and Transitory Earnings

Because the trailing PIE is an indicatorof the difference between currentand futureprofitability, it is affected by currentprofitability. If a firm with strong ROCEforecasts has an
exceptionally goodyear,it will havea lowPIEand fallintocell G, like USAirways in 1998.
A finn with poor prospects can fall into cell C with a high PIE because its currentyear's
earningsare temporarily depressed, likeRocky Shoes.Earnings thatare abnormally high or
temporarily depressed are affected by transitory earnings or unusual earnings.
The effect of transitory earnings on the PIE has historically been referred to as the
Molodovsky effect,aftertheanalyst Nicholas Molodovsky, whohighlighted thephenomenon
416
TABLE 12.4 Subsequent Earnings Growth forDifferent Levels of PIE,1968-2004

High-PIE firms inthecurrent year (Year 0) have higher cum-dividend earnings growth in
subsequent years than low-PIE firms. However, therelationship between PIE andgrowth isnegative
inthecurrent year.
Yearafter Current Year(Year 0)
PIE Level
PIE
Cum-dividend EPS growth by PIE level

High
49.8
-35.8%
54.1 %
Medium
13.1
18.4%
14.8%
Low
6.5
23.9%
2.2%
16.6%
19.1%
14.8%
17.2%
15.6%
11.5%
14.4%
13.1%
7.1%
Earnings growth is tneye:rr.t<>-y""r cb3ngein EPSdivided by (theabsolute 1'31"" of) prioryear'sEPS.EPSis .djm;ledforpayout in
thepriorperiodandso is cum.<Jividend, wirhdividends reinvesled .1 a 10percentmle.
Sour<:e: St.nd"d & Poor'sCOmpuSb-I'" dill:L
in the 1950s. Table 12.4 shows the Molodovsky effect at work. The table shows the
relationship between trailing PIE and earnings growth for three PIE groups from 1968
through 2004.The ''high''-PIEgroup had an average PIE of 49.8, the "medium" group an
average PIE of 13.1, and the "low" group an average PIE of 6.5. The table givesmedian
year-to-year cum-dividend EPS growthrates for each PIE group, for the year when firms
wereassignedto the PIE group(Year 0) and for foursubsequent years.Lookat themedium
PIElevel. Thesefirmshad subsequent earnings in the fouryearsfollowing Year0 at 13percent to 15percent per year.Now look at the high- and 10wPIE levels.High-Pzffirmshad
relatively high earnings growthin the years following Year0, whereas 10w~PIE firms had
relatively low earningsgrowth.Thus the data confirmthat PIE indicatesfuture growthin
earnings.
Now look at the growthrates in Year0, the currentyear.Whereas PIE is positively related to future earningsgrowth, it is negatively related to current earningsgrowtb. HighPIE firmsare typicallythose whoseearningsare downnow but will reboundin the future.
The low-PrE firmsinthetablehavelargeincreases incurrentearningsbuttheseare notsustainedsubsequently. In short, the PIE is affectedby temporaryaspectsof currentearnings.
PIE Ratios and the Analysis of Sustainable Earnings

The analysis of sustainableearningsin this chapteridentifies the transitoryaspectsof current earnings and so helps to ascertainthe Molodovsky effect on the trailing PIEratio. If
earningsare temporarily high (andcannot be sustained), one shouldpay less per dollar of
earnings-the PIE shouldbe low. If, on the other hand,earningscan be sustained-or can
growbecausethey are temporarily depressed-one shouldpay a highermultiple.Sustainable earnings analysis focuses on the future-for it is future earnings that the investor is
buying-s-and helps the investor discount earnings for that part which is not sustainable.
As investors buy futureearnings,it makessensethat a PIE valuation shouldfocuson the
forward PIE and thus the pricingof next year'searningsandgrowthafterthatyear. Forward
earnings are considerably less affected by the transitory items that do not contribute to
permanentgrowth. For evaluation of the forward PIE, sustainable earningsanalysis very
muchcomesintoplayfor,to forecastforward earningsafterobservingcurrentearnings, we
wish to identifythe core earningsthat can be sustainedin the forward year.
Untilrecently, analyststalkedmostoftenin termsof thetrailing PIE. Buttalkhas shifted
to the forward PIE. In light of our discussion here, that makessense.Forthe most part, the
valuation analysisin PartThree of the book focuses on the forward PIE.
Chapter12 TheAnalysis ofGrowth and Sllstalnable Earnings 419
changes in RaCE and growth in investment. A growth firm will have the following
features:
I. Sustainable, growing sales(andwithit, growing investment).
2. High or increasing profitability thatis generated bycoreoperations.
This chapter hascautioned the analyst about a number of accounting issues that arise when identifying sustainable earnings.
These issues areaccounting quality concerns, fortheycanyield earnings that are "lowquality" asan indicator offuture earnings.
Sowe addthemto the Accounting Quality Watch, begunin Box 8.7 inChapter 8 and continued through Box 9.9 inChapter 9
and Box lOA in Chapter 10. With the full listof quality issues, youwill be prepared to tackle the formal analysis of accounting
quality inChapter 17.
Accounting Item
The Quality Problem
Deferred revenue
Firms candefer toomuch earnings to thefuture andthuscreate toomuch earnings growth.

Conversely, firms candefer toolittle earnings andsoreport unsustainable earnings currently.
Firms canmake excessive restructuring charges inoneyear andbleed them back to earnings infuture
years, giving theappearance of growth. FASB Statement 146 nowlimits thepractice.
Selling, general, and

administrate expense
SG&A isa large, aggregated number thatcovers a multitude ofsins. Penetrate itscomposition.
Gains andlosses on
asset sales
These areoften hidden in SG&A expense butarenota partofthecore business.
R&D andadvertising
Firms canincrease earnings bytemporarily reducing R&D andadvertising expenditures. This notonly
inflates current earnings, butdamages future earnings thattheexpenditures would otherwise produce.
Pension accounting
Pension accounting brings prices intotheincome statement with thedanger thatearnings canreflect
price bubbles. Returns on pension plan assets arecommingled with core operating income from the
business, contaminating profit margins. Expected returns on plan assets can beoverestimated.
Cherry picking
Firms cancherry pick realized gains oninvestments intotheincome statement andreport unrealized
losses intheequity statement Restate theincome statement ona comprehensive income basis.
Changes inestimates
Firms canaffect earnings bychanges inestimates (ofbaddebts. warranty liabilities, andaccrued

expenses, forexample).
Summary
418
Finnschange overtimeandtheirfinancial statements change accordingly. Thischapter has

laidoutthe analysis of thechanges in financial statements thatareparticularly relevant for
valuation. Thefocus hasbeenonchanges inresidual earnings andonchanges in ROCE and
growth in investment which drive residual earnings andvalue. Change inresidual earnings
is thesameas abnormal earnings growth.
A change in ROCE is analyzed bydistinguishing changes thataredueto operating profitability (changes in R..NOA) andchanges inthefinancing of operations. In bothcases, core
or sustainable components that are likely to drive profitability in the future are distinguished from transitory or unusual components thatarenonrecurring. Sotheanalyst "cuts
to the core" of what will drive profitability in the future. Growth in equity investment,
which combines with ROCE toproduce growth inresidual earnings, is determined primarilybysalesgrowth butalsobychanges inthenetoperating assetinvestment needed to supportsalesgrowth andbychanges infinancing of thisinvestment.
The analysis here has given an answer to the question raised at the beginning of the
chapter: What is a growth firm? A growth firm is one thatcan increase its residual earnings, eitherby increasing ROCE from core operations or by growing investment. Andthe
chapter hasgiven the tools required to analyze a growth finn by describing the drivers of
On the otherhand, the chapter warns against growth that comes from financial leverage.
Thenextchapter expands uponthistheme.
Durable competitive advantage is animportant feature invaluation. Theanalysis of sustainable earnings and growth in this chapter gives insights intowhether a firm has such
advantage. Sustaining high coreprofit margins indicates competitive advantage. Growing
residual earnings withsalesgrowth andhighcoremargins points to competitive advantage.
Andgrowing saleswithbothhighcoremargins andhigh assetturnover yields higher residualearnings because lessinvestment is required.
Valuation involves the residual earnings expected in thefuture, so see theanalysis here
as a toolforforecasting. How willthefuture be different from thepresent? Theanalysis of
thechapter laysoutthefeatures thatwilldrive changes inthefuture andso is a tool forforecasting, strategy analysis, andin valuation in the nextpartof the book.
Box 12.13 completes theAccounting Quality Watch, begun in Chapter 8 andcontinued
through the chapters on financial statement analysis.
Find the following on the Web pageforthischapter:

Additional examples of the analysis of core earnings
and the questions it answers, with an application to
Boeing Company.
Key Concepts
Further discussion of pension issues with a look

at Boeing Company.
A historical analysis of howpastgrowth forecasts future
crowth and an introduction to fadediagrams.
bleeding back (to income) is thepractice

sustainableearnings(also called
persistentearnings,core earnings,or
ofreversing charges in prioryearsto
underlying earnings)are current
increase income. 400
fixed costsarecosts thatdo not change
earnings thatare likely to bemaintained
in the future. Compare withtransitory
withsales. Compare withvariable
earnings. 394
costs. 409
transitory earnings(or unusualitems)
growthfirm is a firm thatgrows residual
are current earnings thatarenot
earnings (that is, it hasabnormal earnings
likely tobe repeated in thefuture.
growth). 4/5
Compare with sustainable
Molodovsky effectis the effect of
transitory earnings onthe PIE ratio. 416 earnings. 394
variablecostsarecosts thatvarywith
normalizing earnings is theprocess of
sales. Compare withfixed
purging earnings of transitory, abnormal
costs. 409
components. 394
Chapter 12 TheAnalysis ofGrowlh and Smrainable Earnings 421
420 Part Two TheAnalysis of Financial Suucments
additional synthetic fuel partnership. These partnerships arevariable interest entities that are
subject totherequirements ofFIN 46R. Although these partnerships arevariable interest
entities, theCorporation isnottheprimary beneficiary, andtheentities have not been consolidated. Synthetic fuel produced by thepartnerships iseligible for synthetic fuel taxcredits
through 2007.
Page
Analysis Tools
Analysis of sustainable
earnings
Analysis of growth in residual
earnings
Analysis of R&D expenses
Analysis of advertising
expenses
Analysis of pension costs
Analysis of gains and losses
onasset sales
Analysis of restructuring
changes
Analysis of changes in RNOA
Analysis of changes in ROCE
Analysis of operating
leverage
Analysis of growth in
Cell analysis of PIE and PIB
394
407
398
398
400
400
400
408
410
KeyMeasures
Contribution margin
Core netborrowing cost
from sales
Core other operating income
Core RNOA
Core sales profitmargin
Fixed costs
Growth in residual earnings
Operating leverage (OLE\!)
Unusual items (UI)
Variable costs

409
407
395
The production ofsynthetic fuel results inpretax losses. In2004 and 2003, these pretax
losses totaled $158.4 million and S105.5 million, respectively, and arereported as nonoperatingexpense ontheCorporation's income statement. The synthetic fuel taxcredits, aswell
astaxdeductions for thenonoperating losses, reduce theCorporation's income taxexpense.
In2004 and 2003, theCorporation's participation inthesynthetic fuel partnership resulted
in$144.4 million and $94.1 million oftaxcredits, respectively, andthenonoperating losses
generated anadditional $55.4 million and$37.2 million, respectively, oftaxbenefits,
which combined toreduce theCorporation's income tax provision by$199.8 million and
$13 IJ million, respectively. The effect ofthese benefits increased netincome by$41.4 million, $.08 pershare in2004 and $25.8 million, $.05 pershare in2003. The effects ofthese
tax credits are shown separately intheCorporation's reconciliation ofthe u.s. statutory rate
to itseffective income taxrare inNote 14.
OLEY operating leverage

UI unusual items
396
396
405
406
409
393
409
395
409
Because thepartnerships have received favorable private letter rulings from theIRS and
because thepartnerships testprocedures conform to IRS guidance, theCorporation's loss
exposure under thesynthetic fuel partnerships isminimal. Application ofFIN 46R tothese
entities didnot have any effect ontheCorporation's consolidated financial statements.
409
Defined Benefit Pension Plan
411
414
The following fromthe pension footnote gives the composition of the net pension expense
included in the income statement (dollaramounts in millions).
2004

Service cost
Interest cost
Expected return onplan assets
Amortization of prior service cost
Recognized netactuarial loss (gain)
Other
Net periodic benefit cost
Inthe Continuing CaseforChapter 11,youcarriedouta comprehensive profitability analysis for Kimberly-Clark for both 2004 and 2003 based on the reformulated financial
statements you preparedin Chapter 9. Nowits timeto compare the profitability forthe two
years.
$ 87.4
296.2
(324.0)
7.3
83.3
4.6
$154.8
2003
2002
$ 76.1
288.0
(286.3)
8.7
74.0
5.4
$165.9
$ 67.7
272.1
(330.7)
5.8
14.4
2.4
$ 31.7
ANALYSIS OF THE CHANGE IN PROFITABILITY FOR KMB

Let Figure 12.1 and Exhibit 12.1 in this chapter be your guide to identifying KimberlyClark'scoreincome andanalyzing whatdetermined thechange in itsprofitability from2003
to 2004. The template in Exhibit 12.1 simply takes the reformulation you carried out in
Chapter 9 a step further, in orderto distinguish the core component of operating income.
Somecomponents of noncore income willbe evident fromthepriorreformulation, You will
discover othersfrom the reconciliation of net income to cashflow from operations in the
cashflow statement. Hereis somefurther information that',','ill helpyourefine the analysis.
Nonoperating Expense
The IO-K footnotes indicate that thenonoperating expense in the income statement is from
a minority interestin a synthetic fuel business. Hereis the relevant note:
InApril 2003, theCorporation acquired a 49.5 percent minority interest ina synthetic fuel
partnership. InOctober 2004, theCorporation acquired a49percent minority interest in an
Concept
Questions
eI2.1. Whatis a growthfirm?

CI2.2. In analyzing growth, should the analyst focus on residual earnings, abnormal
earnings growth, or both?
C12.3. Whatmeasure tells youthata firmis a no-growth firm?
e12A. Whatfeatures in financial statements wouldyou look for to identify a firm as a
growth company?
C12.5. Why would an analystwishto distinguish the part of earnings thatis sustainable?
C12.6. Whataretransitory earnings? Givesomeexamples.
Cl2.? Are unrealized gains and losses on financial assets persistent or transitory
income?
eI2.8. Distinguish operating leverage fromoperating liability leverage.
422 Part Two The Analysis of Financial S[ar~men(5
Chapter 12 TneAlUll)'sis OfGTOWln and Sllstairulhk Earnings 423
eI2.9. The highera firm's contribution margin ratio, the moreleverage it gets from increasing sales. Correct?
2009
Return on common equity (ROCE)
Return on net operating assets {RNOA}
Sales (millions)
Average net operating assets (millions)
Average net financial obligations (millions)
Average common equity (millions)
C12.10. Would you see a high profit margin of, say, 6 percent for a grocery retailer as
sustainable?
Cl2.11. Whatdetermines growth in equityinvestment in a finn?
eI2.12. A firmcanhavea hightrailing PIE ratio,yet havean expected cum-dividend earningsgrowth rateaftertheforward yearthatis lessthantherequired rate.Is thisso?
C12.13. Fora firmwitha normal trailing PIE ratio,expected future residual earnings must
bethe sameas currentresidual earnings. Correct?
C12.14. Cana firmhavea high PIE ratioyet a low P/B ratio? Howwould youcharacterize
the growth expectations forthis firm?
e12.15. Firms with high unsustainable earnings should havelow (trailing) PIE ratios. Is
this correct?
Exercises
E12,4,
Analyzing a Change in CoreOperating Profitability (Easy)
Start-up costs for newventure

Merger-related charge
Gains on the disposal of plant
S 4.3 million
$13.4 million
$ 3.9 million
2009
2008
The finn also reports a currency translation gainof $S.9million as part of othercomprehensive income.
4.7%
2.4
5.1%
Calculate the finn'scoreoperating income (aftertax) andcorepercentage profitmargin.

Thefirm'smarginal tax rate is 39 percent.
2.5
E12.5,
Explaining a Changein Profitability (Medium)

Consider the following financial information:
Analyzing a Change in Return on Common Equity (Easy)
Cash
Accounts receivable
inventory
(netof accumulated depreciation)
Total assets
Accrued liabilities
Accounts payable
Bank loan
Bonds payable
Deferred taxes
Total liabilities
Preferred stock (8%)
Common stock
Retained earnings
Owners' equity
The following numbers were calculated fromthe financial statements for a firm for 2009
and200S:
2009
15.2%
11.28%
2.9%
$ 2,225
$ 4,756
2008
13.3%
12.75%
3.2%
$
241
$ 4,173
Explain howmuch of the changein ROCE from200S to 2009is dueto operating activities
and howmuchis due to financing activities. Box 12.9 will helpyou.
E12.3,
Calculating CoreProfit Margin(Easy)
Calculate core return of net operating assets (core RNOA) and show how much of its
change from 200S to 2009 is due to the change in profit margin and the change in asset
turnover. Box 12.S willhelp you.
Note:Exercises E12.1-E12.3 are all connected and canbe worked as one exercise.
Return on common equity (ROCE)

Return on net operating assets (RNOA)
Netborrowing cost(NBC)
Average net financial obligations (millions)
Average common equity (millions)
$ 4,756
salesof $667.3 million. Afternet interest expense of$20.5 million and taxes of$IS.3 mil~ion> its net income is $34.6million. The following itemsare included as part of operating
mcome:
and 2008:
E12.2.
$16,754
s 6,981
s 2,225
13.3%
12.75%
$11,035
$ 4,414
$ 241
4,173
A fum reports operating income before tax in its income statement of $73.4 million on
The following numbers werecalculated from the financial statements for a finn for 2009
Core profit margin

Asset turnover
15.2%
11.28%\
Explain to what extentthe changein common equity from 200S to 2009 is due to sales
growth, net assets required to supportsales,and borrowing. Box 12.10 willhelpyou.
Drill Exercises
E12.1.
2008
Analyzing the Growth in Shareholders' Equity (Easy)

The following numbers werecalculated from the financial statements for a firm for 2009
and 2008:
Summary Balance Sheets at December 31

2009
$
100
300
900
2,000
8,200
11,500
600
900
0
4,300
490
6,290
1,000
1,400
2,810
$ 5,210
2008
$
100
300
1,000
1,900
2007
$
120
330
1,250
1,850
9,000
12,300
10,500
14,050
1,000
0
4,300
500
6,300
550
1,100
3,210
1,000
600
6,460
1,000
2,000
3,000
$ 6,000
1,000
2,000
4,590
$ 7,590
---sao
424 Part Two The Ana!Jsis of Financ1c.1 Srarem~ms
Chapter 12 The Ana!Jsis ofGrotltUt. andSUS!(liMble Eaming5 425

Summary Income Statements
Sales
Costof goods sold
Seiling andadministration
Interest income
Interest expense
Earnings before taxes andextraordinary items
Tax expense
Earnings before extraordinary items
Gain dueto retirement of bonds, netoftaxes
Net income
Summary balancesheetsfor 2007 and 2006(inmillions) werealso prepared:

2009
2008
s 22,000
$ 24,000
(13,100)
(8,250)
(13,000)
(8,000)
(190)
24
(430)

o
25
(430)
(134)
(675)
-----no
1370
$270
100
$ 1,670
Analysis of Growth in Common Equityfor a Firm with Constant

Asset Turnover(Easy)
An analystsummarizes the following information for a firm (dollaramounts in millions):

Sales
2009
2008
2007
4,725
2,193
2,532
4,394
2,193
2,201
7,100
6,198
4,124
2,193
1,931
5,939
$26,858
5,114
$18,952
2,032
$21,744
$16,920
a. Coreprofitmargin from sales

b. Coreprofitmargin
c. Corereturnon net operating assets (RNOA)
Prepare a succinct analysis thatexplains the change in ROCE from2008to 2009. The marginaltax rate is 34 percent,and dividends paidon preferred stockcannotbe deducted for
tax purposes.
E1Z.6.
2006
You pointout thatthe income statement failsto identify coreoperating income fromsales.
Identify core operating income fromsales (aftertax) andthen makethe following calculations.Use average balance sheetamounts in denominators whereapplicable.
---z:m-
----:w4
2007
Exercises E4.5,E4.6, E4.7, EI1.7, EI4.9. EI5.!2, E16.7 and E19.4 deal withCoke, as do
Minicases M4.1,M5.2,andM6.2.
E1Z.8.
Identificationof CoreOperating Income and Marginsfor Starbucks

The consolidated statement of earnings for Starbucks Corporation for 2007 is given in
Exercise E9.9in Chapter 9.The firm's statutory tax rate is 38.4percent. Note4 on "net interest and other income," under the statements, identifies some components of earnings.
Forthe 2007fiscal year,identify
a. Coreoperating income fromsales.
b. Othercore operating income.

c. Coreoperating profitmargin fromsales.
d. Unusual items.

SeeExercises E8.8,E9.9,El1.9 and E14.10 on Starbucks.
Analyze the growth of average common shareholders' equityin 2009.
E1Z,9.
Applications
E1Z.7.
CoreIncomeand Core Profitability for The Coca Cola Company(Easy)

A studentin your study groupprepared the following reformulated income statement for
the CocaColaCompany for 2007 (in millions):
Sales
Cost of sales
Gross margin
Other operating expenses (net)
Tax

Equity income from bottling subsidiaries (after tax)
Operating income
Net financial expense (after tax)
Earnings
$28,857
10,406
18,451
2,800
8,145
~
Analysis of Changes in Operating Profitability: Home Depot, Inc. (Medium)

Comparative income statements andbalancesheetsforthewarehouse retailer Home Depot
are given in Exercise Ell.10 in Chapter 11 for fiscal year2005. Reformulate thosestatements and explain what determined the change in operating profitability (RNOA) from
2004to 2005.The tax ratefor 2005is 37.7percent, and 38.2percentfor2004.

SeeExercises E5.12,E9.10,E11.10, E14.13 and E14.14 and Minicase M4.1.
E1Z.10.
Explaining Changes in Income:USAirways (Hard)

USAirways Group, the holding company for USAirways, reported the following income
statements for 1997and 1998(in millions of dollars):
7,425
1,972
5,453
~
6,121
-'.1Q
5,981
Operating revenues
Passenger transportation
Cargo andfreight
Other
Total operating revenues
1998
1997
$7,826
$7.712
181
168
694
8,688
.-21l
8,514
426 Part Two The Anal~sl5 ofFina.ncial $tatemen.,
Chapter 12 TheAnal~5i5 ofGrowlh and Sustainable E(I1l1ings 427

1998
Operating expenses
Personnel costs
Aviation fuel
Commissions
Aircraft rent
Other rentandlanding fees
Aircraft maintenance
Other selling expenses
Other
Total operating expense
Operating income
Other income (expense)
Interest income
Interest expense
Interest capitalized
Equity inearnings of affiliates
Gains on sales of interests inaffiliates
Other, net
Other income (expense), net
Income before taxes
Provision (credit) forincome taxes
Net income
Preferred dividend requirement
Earnings applicable to common stockholders
Earnings percommon share
Basic
3,101
623
519
440
417
448
342
318
1,466
7,674
1,014
111
(223)
3
1997
Deferred taxliabilities
Equipment depreciation andamortization
Other deferred taxliabilities
Total deferred taxliabilities
Net deferred taxliabilities (assets)
3,179
805
595
475
420
451
346
401
1,258
7,930
E12.11.
Analysis of Effects of Operating leverage: US Airways (Medium)

Referto the 1998 income statement for USAirways Group in Exercise E12.10 above. Of
the total $7,674 million in operating expenses, suppose the following are fixed costs (in
millions):
Personnel
Aircraft rent
Other rent
Other
Total
(353)
1,025
(64)
$ 961
$12.32
$ 9.87
8.
Deferred taxassets (in thousands)

leasing transactions
Tax benefits purchased/sold
Gain on sale and leaseback transactions
Employee benefits
Net operating loss carrytorwards
Alternative minimum taxcredit carryforwards
Investment taxcredit carrytorwards
Other deferred taxassets
Total gross deferred taxassets
Less valuation allowance
Net deferred taxassets
170,966
31,352
125,169
683,416
193,575
158,441
17,841
94,640
1,475,400
(1,377)
1,474,023
1996
$ 154,732
43,441
135,308
608,948
540,495
33,459
49,802
82,744
1,648,929
(643,546)
1,005,383
966,874
45,415
1,012,289
$
6,906
---as
1997
940,784
62,791
1,003,575
$ (470,448)
SeeExercise E12.11 in thischapter for morematerial onUSAirways.
672
a. Reported operating income before interest andtaxes increased by73.6percent in 1998

over 1997 while revenues increased by only 2.0percent Why?
b. Despite the increase in operating income, netincome available to common dropped by
44.6percent W'rrj?
c. What might explain thenegative taxexpense in 1997? Thefollowing from thetax footnotemighthelp you:
1996
d. 1fyou were to forecast net income for 1999, would yourely on the 1998 or 1997 net
income as an indication of"sustainable" income?
---sB4
108
(256)
13
30
180
13
1997
12,040
440
350
318
890
$4,038
Calculate the fum'soperating leverage.
b. What wouldbe the percentage change in coreoperating income from satesbefore tax
if therewere a 1percent increase in sales?
c. Atwhatlevel of sales wouldthe airline incuroperating losses?

SeeExercise E12.10 in thischapter for morematerial onUSAirways.
Chapter 12 The AMt)"sis ofGrow!h andSusmil1abh Eamings 429
428 Part Two TheA1ll!:tsis of FinMdal Sm{~m~nrs
Minicases
Curtailment andsettlement
gain
Gross benefit cost (credit)
Dividends on ESOP preferred
stock
Net periodic benefit cost (credit)
M12.1
Financial Statement Analysis:

Procter & Gamble III
This case continues the financial statement analysis of Procter & Gamble Co. begun in
Minicase 9.1 anddeveloped furtherin Minicase 11.1. Thisfinal installment covers issuesin
dealing withcore income.
Financial statements for Procter & Gamble are presented in Exhibit 9.15 in Chapter 9.
If youworked Minicase 9.1,youwillhavereformulated the income statements andbalance
sheetsto distinguish operating activities from financing activities. Thiscase refines the reformulation to identify core,sustainable earnings. If youworked Minicase 11.1, you will
have carriedoutan analysis of profitability. Thiscase addsan analysis of growth.
To start, calculate residual earnings for the years 2006-2008 and note changes over
time.Usea required return of8.5 percent. Therisk-free rate wasabout4.5percent in 2008,
so an 8.5 percent required return implies a 4 percent risk premium suitable for a finn with
a beta less than 1.0.Whatis the trend?DoesP&Gappear to be a growthcompany? Commenton the change in residual earnings from2006to 2007.
Forvaluation, we are interested in the residual earnings (growth) that a firm can deliver
in the future. Thesepastresidual earnings numbers are affected by transitory earnings that
do not bear on the future. So cut to the core:Reformulate the income statement further to
identifycore(sustainable) income. ForProcter & Gamble, this is fairly straightforward, but
the accounting for its defined benefit pension plansposesproblems. The information given
to youat the bottom of the case willbe helpful.
With sustainable earnings identified, identify coreprofitmargins andcarryoutan analysis of core profitability (corererumon net operating assets). Explain howcoreprofitability
changed fromyearto year.
Finally, forecast operating income and totalearnings for 2009basedon your analysis.
What is your forecast of return on net operating assets (RNOA) for 2009?What is your
forecast of residual earnings for2009?
Information needed to identify coreearnings:
I. Lookat the information provided withthe financial statements in Exhibit 9.1.
2. The following, fromthe pension footnote, gives detailsof the net pension costincluded
in earnings and alsothe expected rateof return applied to pension assets.
Netperiodic benefit cost. Components of the net periodic benefit cost were as follows:
Years EndedJune 30
2008
2007
2006
Pension Benefits
Service cost
Interest cost
Expected return on plan assets
Prior service cost{credit}
amortization
Net actuarial loss amortization
S 263
539
2007
2006
Other RetireeBenefits
(557)
(454)
$ 265
383
(353)
14
13
45
7
76
$ 279
476
2008
S 95
226
(429)
$ 8S
206
$ 97
179
(407)
(372)
(21)
(22)
(22)
(36)
(176)
(4)
232
183
374
(1)
(123)
(95)
J2I
232
183
374
(218)
(2.2.2.)
(190)
(1)
(137)
(112.)
Assumption usedto determine netperiodicbenefit cost:

Years Ended June 30
2008
2007
Pension Benefits (%)
2008
2007
Other
Retiree Benefits (%)
Discount rate
5.5%
5.2.%
6.3%
Expected return on planassets

Rate ofcompensation increase
7.4
3.1
7.2
3.0
9.3
6.3%
9.3
Thepension footnote hasthe following narrative:

Several factors areconsidered indeveloping theestimate for thelong-term expected rate ofreturn onplan assets. For thedefined benefit retirement plans, these include historical rates of
return ofbroad equity andbond indices andprojected long-term rates ofreturn obtained from
pension investment consultants. The expected long-term rates of return for plan assets are
80/0-90/0 for equities and5%...6%forbonds. For other retiree benefit plans, the expected longterm rate of return reflects thefact that theassets arecomprised primarily ofCompany stock.
The expected rate of return onCompany stock isbased onthe long-term projected return of
9.5% and reflects the historical pattern offavorable returns.
Whatissuesdoesthis raise?

Minicases M9.!, MILl, M14.!, and MiS.! alsocoverProcter & Gamble.
M12.2
A Question of Growth: Microsoft Corporation

By 2005,Microsoft Corporation, the premiersoftware finn of the computer age, had maturedintoan established firm. Maturity, however, oftenbringsslowergrowth and many observers claimed that Microsoft was beginning to show such symptoms. Outside its core
business centered aroundthe Windows operating systems andrelatedapplications suchas
Microsoft Office, the fum hadstruggled to makean impact withnewproducts andservices.
In particular, in Internet-based services thatgenerate subscription, advertising, andtransactionrevenues, it laggedbehindrivals suchas Google andYahoo'. Apple's recent launch of
its i'Iunes music serviceand its successwith iPodleft Microsoft lookingsomewhat dated.
At its annual meeting with analysts on July 28, 2005, Chairman Bill Gates acknowledgedthatMicrosoft was"playingcatch-up on search"but addedthat, withinthreeyears,
it would make significant advances over the current state of the technology. CEO Steve
Ballmer announced a newfocuson growththrough an expansion intoInternet services. The
software industry, he insisted, wasmoving from"delivering bitsto delivering bitsand services. The Internet's transformative impacton the software business hasjust begun." The
Chapter12 The AM!~sis ofGrowth and Sustainable Earnings 431
430 PartTwo The Analysis ofFinancial Sraremeurs
shiftfrom software to services was hailed as a newbusiness model forgenerating growth.

Newareaswould involve communications, Web-based storage, andtools to permit workers
to collaborate better. Analysts advised caution. Few details of thenewplanwere offered at
the meeting, and Microsoft had previously emphasized Web-services initiatives with less
than stellar results.
Despite theskepticism about Microsoft's ability to deliver growth, thepressrelease accompanying fiscal 2005 results indicated otherwise. "Weclosed out a record fiscal year
withstrongrevenue growth in the fourth quarter driven by healthy, broad-based demand
across all customer segments and channels," said ChrisLiddell, chieffinancial officer at
Microsoft. "While continuing to invest illthe business, wealsoreturned $44 billion to investors through sharerepurchases anddividends during thefiscal year. These results providesolidmomentum heading intofiscal 2006, which is shaping upto be a strong yearfor
growth and investment. We expect double digit revenue growth nextyear, kicking off the
strongest multiyear product pipeline in thecompany's history."
Microsoft's income statements for 2002-2005 and balance sheets for 2001-2005 are
summarized inExhibit J 2.3.Theincome statements aresupplemented withdetails of other
comprehensive income reported in the equity statement. Reformulate these statements,
being suretodistinguish operating activities from financing activities and, within operating
activities, income from Microsoft's core software business from income from its investment portfolio. The firm's statutory taxrateis 37percent.
Discuss thefollowing. Usea required return of9 percent if needed forcalculations.
A. With valuation in mind. what measures would you focus on to evaluate Microsoft's
growth from 2002 to 2005? Focus on the corebusiness rather thaninvestment income.
Would yousaythat Microsoft hasbeena growth company? Is there anyindication that
growth is slowing?
B. Explain the change in return on common equity (ROCE) for 2005 overthatfor 2004.
C. Microsoft paidout$44billion toshareholders during fiscal year2005, including a large
special dividend of $33.5 billion. Explain how such a big payout affects return on
common equity (ROCE). What would Microsoft's ROCE for 2004havebeenif its financial leverage hadbeenthesame asthatat theendof2005?It hasbeensaidthatfirms
can increase ROCE simply by selling off theirholdings ofTreasury bills. Is thistrue?
D. Microsoft has considerable unearned revenues. Analysts have been concerned that
Microsoft might usethese deferred revenues tocreateearnings growth. How could this
happen?
E. Examine Microsoft's investment income. Is there anysuggestion of cherrypicking?
Microsoft Exercises are E1.6, E4.16, ElO.lO, and E17.10. Minicase M8.2 also covers
Microsoft.
EXHIBIT 12.3
SummaryFinancial
Statementsfor
Microsoft
Corporation,Fiscal
Years EndingJune30~
2001-2005
Yearly Income Statements

(in billions ot dollars)
Revenue
Operating expenses:
Cost ofrevenue
Sales and marketing
2005
2004
2003
2002
39.79
36.83
32.19
2836
6.20
6.18
8.68
6.72
7.78
8.30
6.06
6.60
7.55
5.70
630
6.25
EXHIBIT 12.3
(concluded)
General and administrative

Operating income
Investment income
Income before taxes
Income taxes
Net income
Investment income iscomprised ofthe following:
Interest income
Dividends
Realized gains (losses) oninvestments
4.17
25.23
14.56
2.07
15.63
438
12.25
5_00
27.80
9.03
3.17
12.2
4.03
8.17
2.43
22.54
9.55
1.50
11.05
3.52
7.53
1.84
20.09
8.27
1.27
0.19
0.61
2.07
1.67
0.20
1.30
3.17
1.70
0.18
(038)
1.50
1.76
0.27
(2.431
(OAO)
(006)
0.37
0.0
031
0.10
(0.87)
0.05
(0.72)
(0.101
1.24
0.12
1.26
(0.09)
0.01
0.08
0.00
Other comprehensive income (from equity statement):

Gains (losses) on derivatives
Unrealized investment gains {losses}
Translation adjustments
(OAO)
7.87
2.51
536
Yearly Balance Sheets

(in billions ofdollars)
2005
2004
2003
2002
2001

Accounts receivable
Inventories
Deferred taxes
Other
Property andequipment
Equity investments
Debt investments
Goodwill
Intangible assets
Deferred taxes
Other long-term assets
Total assets
4.85
32.9
7.18
0.49
1.70
1.62
48.74
2.35
10.10
0.90
331
0.50
3.62
130
70.82
15.98
44.61
5.89
6.44
42.61
5.20
0.64
2.51
1.57
58.97
2.22
11.83
1.86
3.13
038
2.16
3.02
35.64
5.13
0.67
2.11
2.01
48.58
2.27
12.19
2.00
0.24
3.92
27.68
3.67
0.08
1.52
234
39.21
231
12.70
1.66
1.51
0.40
-.l2
1.18
92.39
81.73
0.94
67.65
1.04
58.83
Accounts payable
Accrued compensation
Short-term unearned revenue
Other liabilities
tore-termunearned revenue
2.09
1.66
2.02
7.50
3.61
16.88
1.67
4.15
22.70
48.12
70.82
1.72
1.34
1.57
1.42
2.04
7.23
1.71
13.97
1.79
1.06
16.82
64.91
81.73
1.21
1.19
0.74
1.47
4.40
NOlO: Fo,2001-2002. d.forre<l
OA2
2.10
1.57
70.57
233
10.73
1.48
3.12
0.57
1.83
3A8
6.51
~
14.97
1.66
0.93
17.56
74.83
9239
..., ,,,,, nolliabilityand....reindude<l inmh.,li,bililies.
1.43
1.15
2.02
5.92
2,45
12.75
1.82
0.90
15A7
52.18
67.65
lA5
9.25
1.22
1.07
11.54
47.29
58.83
432 Part Two The All<1!)'5il of FirWllC:<1! Swrements
Chapter 12 TheAna1Y5is <11 G,ol<'rh <1:J1d SH5mill~&!e Earning.; 433
M12.3
EXHIBIT 12.4
(concluded)
Analysis of Sustainable Growth:

International Business Machines
International Business Machines Corporation (IBM) was once the dominant computer
manufacturer intheworld and, from 1960 to 1980, the leading growth company. Indeed, in
those years IBM became the verypersonification of a growth company. However, withthe
advent of decentralized computing andthepersonal computer in the 1980s, IBM's growth
began to slow. Under the leadership ofLouis Gerstner Jr.,thefinntransformed itselfin the
early 1990s from a mainframe manufacturer to an information technology company, providing technology, system software, services, and financing products to customers.
Mr. Gerstner's book, Who SaysElephants Can 't Dance? Inside IBM's Historic Turnaround,
published in 2002, gives the play-by-play. From revenues of $64.8 billion in 1991, IBM
grew to a firm with $88.4 billion inrevenues in 2000.
In turning around the business, IBM tooklarge restructuring charges against its income
in the early 1990s, resulting in netlosses of$2.861 billion, $4.965 billion, and$8.101 billionfor 1991-1993, respectively. SUbsequently the firm delivered the earnings growth of
yesteryear. You canseeat thebottom oftheincome statements inExhibit 12.4 thatearnings
persharegrew from $2.56 in 1996 to $4.58 in2000.
At a number of points, this chapter hasanalyzed the components of IBM's earnings in
order to understand their sustainability. From the information extracted from IBM's
financial statement footnotes below, restate the income statements from 1996to 2000 in
Exhibit 12.4 to identify core operating income that arises from selling products to customers. Thefootnotes arefrom thefirm's 1999 1O-K filing; youmayalsowishto lookat the
corresponding footnotes forotheryears. Theextracts from thefirm's cashflow statement in
Exhibit 12.4 will alsohelpyouinyourtask.
Doyouget a different picture of IBM's income growth during the lasthalfof the 1990s
thanis suggested bygrowth in earnings pershare?
EXHIBIT 12.4
INTERNATIONAL BUSINESS MACHINES CORPORATION AND SUBSIDIARY COMPANIES

(dollars in millions exceptpershareamounts)
For the Year EndedDecember 31

Revenue
Costof revenue
Gross profit
Operating expenses
Selling, general, and
administrative
Research, development
and engineering
Tota\ operating expenses
Operating income
2000
1999
199B
1997
1996
$88,396
55,972
32,424
$87,548
55,619
31,929
$81,667
50,795
30,872
$78,508
47.899
30,609
$75,947
45,408
30,539
15,639
14,729
16,662
16,634
16.854
5,151
20,790
11,634
5,273
20,002
11,927
5,046
21,708
9,164
4,877
21,511
9,098
5,089
21,943
8,596
Otherincome, principally interest

Interest expense
Income beforeincome taxes
Provision for income taxes
Netincome
Preferred stockdividends
Netincome applicable to
common stockholders
Earnings pershareof common
stock:
Assuming dilution
Basic
617
717
557
589
713
657
728
707
716
9.040
8,587
3.158
5,429
~
8,093
727
11,757
4,045
7,712
6.328
9,027
2,934
6,093
_ _2_0
20
20
20
20
$ 8,073
I 7.692
S 6,308
$ 6,073
$ SA09
s
s
$ 3,29
$ 3.38
3.00
3.09
s
s
1997
1996
6.328
$ 6,093
S 5.429
11,534
4.44
4.58
4,12
4.25
2.51
2.56
Operating and Investing Section of (ash FlowStatements

(dollars in millions)
At December31
Cashflowfromoperating activities
Netincome
Adjustments to reconcile net income to cash
provided fromoperating activities
Depreciation
Amortization of software
Effect of restructuring charges
Gain on disposition of fixed and
other assets
Otherchangesthat (used) provided cash
Receivables
Inventories
Otherassets
ACCOunts payable
Otherliabilities
Net cashprovided from operating activities
Cashflowfrominvesting activities
Payments for plant,rentalmachines,
and other property
Proceeds fromdisposition of plant,
rentalmachines, and other property
Investment insoftware
Purchases of marketable securities and
other investments
Proceeds frommarketable securities
and other investments
Proceeds fromsaleof the Global Network
Netcashused ininvesting activities
2000
1999
$ 8,093
s 7,712
4,513
6,159
4.475
4.018
482
426
517
983
(713)
(355)
(606)
(445)
29
358
3,676
1,336
(1.491)
11
(792)
(4,791)
(261)
(273)
(300)
(4,720)
155)
(643)
(1,677)
(2,736)
(3,727)
432
(650)
196
2,245
(3)
73
219
362
122
2,817
9.274
301
(130)
1998
$
(1,O87)
699
(545)
.siu
1,257
9,273
~
8,865
2,294
10.275
(5,616)
(5.959)
(6,520)
(6,793)
(6,599)
1,619
1,207
1464)
905
1250)
1,130
(314)
1,314
(5651
(1,079)
(3.949)
(4.211)
(1,617)
(1,613)
1,393
2,616
4,880
3,945
1.439
1,470
114.2481
$(1.6691
$(6.1311
319
(295)
$(6.155) $(5.723)
434 Part Two The Analysis ofFinancial Senemenrs
Chapter 12 The Analysis ofGrowdl and SllsrainabJe Earnings 435
Extracts from 1999 Footnotes
DeferredTax Liabllltles (dollars inmillions)
D. Acquisitlons/Divestimres
In December 1998, the company announced thatit would sell its Global Network business
to AT&T. During1999, the company completed the sale toAT&T for $4,991 million. More
than5,300 IBM employeesjoinedAT&T as a resultof thesesalesof operations in 71 countries.Thecompany recognized a pretaxgainof$4,057 million ($2,495 million aftertax,or
$1.33 per dilutedcommon share). The net gain reflects dispositions of plant, rental machines, and other property of $410 million, otherassetsof $182 million, and contractual
obligations of$342 million.
At December 31
Retirement benefits
Sales-type leases
Depreciation
Software costdeferred
Other
Gross deferred tax liabilities
1999
1998
1997
$3,092
2,914
1,237
250
2,058
19,551
$2,775
3,433
1,505
287
1,841
19,841
$2,147
3,147
1,556
420
M. Other Liabilities
Otherliabilities (of $11,928 million in 1999) principally comprises accruals for nonpensian postretirement benefits for U.S. employees ($6,392 million) and nonpension postretirement benefits, indemnity, and retirement planreserves for non-U.S. employees ($1,028
million).
Alsoincluded in otherliabilities arenoncurrent liabilities associated withinfrastructure
reduction and restructurinz actionstakenthrough 1993. Other liabilities include $659 millionforpostemployment preretirement accruals and$503million (netof sublease receipts)
for accruals for leasedspacethat the company vacated.
R Taxes
The significant components of activities thatgaveriseto deferred tax assetsand liabilities
thatare recorded on the balance sheetwere as follows:
The valuation allowance at December 31,1999, principally applies to certain state and
localandforeign tax losscarryforwards that,in the opinion of management, are morelikely
than notto expire beforethe company can usethem.
As part of implementing its global strategies involving the relocation of certainof its
manufacturing operations, the company transferred certain intellectual property rights to
several non-U.S. subsidiaries in December 1998. Since these strategies, including this
transfer, result in the anticipated utilization of US. federal tax credit carryforwards, the
company reduced the valuation allowance from that previously required. The valuation
allowance at December 31, 1998, principally appliesto certain stateand localand foreign
tax losscarryforwards that, in the opinion of management, are morelikely thannot to expire before the company canutilizethem.
A reconciliation of the company's effective tax rate to the statutory U.S. federal tax rate
is as follows:
DeferredTax Assets(dollars in rnillions)
At December 31
At December 31
Employee benefits
Alternative minimum taxcredits
Bad debt, inventory, andwarranty reserves
Infrastructure reduction charges
Capitalized research and development
Deferred income
General business credits
Foreign tax loss carryforwards
Equity alliances
Depreciation
Stateand local taxloss carryforwards
Intracompany sales and services
Other
Gross deferred taxassets
Less: Valuation allowance
Netdeferred tax assets
1999
1998
1997
$ 3,737
3,909
1,169
1,249
863
913
686
555
304
387
201
212
182
2,614
13,244
488
$12,756
$ 3,707
1,092
1,244
1,093
918
880
870
605
406
377
326
227
153
2,763
13,599
647
$12,952
1,413
$8,683
1,027
1,163
1,196
893
492
202
378
132
203
235
2,507
13,227
2,163
111,064
Statutory rate
Foreign taxdifferential
Stateand local
Valuation allowance related items
Other
Effective rate
1999
1998
1997
35%
35%
(6)
35%
(2)
1
1
(1)
(3)
1
...L
34%
30%
33%
For tax rerum purposes, the company has available tax credit carryforwards of approximately SJ,919 million, of which $1,244 million have an indefinite carryforward period,
$199 million expirein 2004and the remainder thereafter. The company also has stateand
localand foreign tax losscarryforwards, the tax effectof which is $633 million. Mostof
these carryforwards are available for 1 years or have an indefinite carryforward period.
Q. SellingandAdvertising
Selling and advertising expense is charged against income as incurred. Advertising expense, which includes media, agency, and promotional expenses, was $1,758 million,
$1,681 million, and $1,708 million in 1999, 1998,and 1997, respectively.
S. Research, Development, andEngineering

Research, development, and engineering expense was$5,273 million in 1999, $5,046 million in 1998, and $4,877 million in 1997. Expenses for product-related engineering
included in these amounts were $698 million, $580 million, and $570 million in 1999,
1998, and 1997,respectively.
436 Part Two TheAna!ysis af Financial $rateme111s
The company had expenses of $4,575 million in 1999, $4,466 million in 1998, and
$4,307 million in 1997 for basic scientific research and the application of scientific advances to thedevelopment ofnew andimproved products andtheiruses. Ofthese amounts,
software-related expenses were $2,036 million, $2,086 million, and $2,016 million in
1999, 1998, and 1997, respectively. Included in the expense each year are charges for
acquired in-process research anddevelopment.
Extracts from Footnotes for 1996-2000

Retirement Plans
Costof the Defined BenefitPlans (dollars inmillions)
2000
Service cost
Interest cost
Net amortization of unrecognized
net actuarial gains, nettransition
asset. andprior service costs
Net periodic pension (benefit) cost
Discount rateforliability
1999
1998
s 1,008
(126)
-UJl)
$(1,266) I (799)
10.0%
9.5%
7.75%
7.25%
(93)
I (550)
9.5%
6.5%
$ 1,041
3,787
3,686
(5,944) (5,400)
931
3,474
(4,862)
1997
1996
$ 763 $ 96
3,397
3,427
(4,364) (4,186)
(173)
(377)
9.5%
7.0%
$ (159)
9.25%
7.75%

See how leverage also contributed to IBM's earnings-per-share growth in Chapter 13.
Exercises E3.9, E6.15, andE14.8 alsocover Microsoft.
Chapter 13 TheVartl~ of Operalions and the EwilHation of Enterprise Price-co-Book Rarios and Price-Earnings Rotios 441
TheValue of Operations
atlcl~~~cEvaluation
LINKS
Link to previouschapter
Pan: Twoof thebook
showedhow10 analyze the
operatingand financing
activitiesof a firm
and the profitability
and growth theygenerate.
ofEn.f~i]Xise Price-to-
Boo~j~~ios and Price--
Earni~gS:Ratios
This chapter
This chapter develops
valuations basedonly on
operatingprofitability lind
growth lindshowshowto
calculate intrinsic
price-to-bock ratiosand
price-earnings ratios
foroperations.
Howcan
forecasting and
valuation be
simplified?
l.
! ,-
Can financing
activitiesbe
ignored in
valuation if
they do not
generate
value?
What is an
"economic
profit"
valuation
model?
Howare
intrinsicpriceto-bookratios
and intrinsic
price-earnings
ratioscalculated
for a firm's
operations?
How, for an asset at market value on the balance

sheet, expected residual income inthe future must be
zero.
Howavaluation based onforecasting residual income
from operations differs from a residual earnings (RE)
valuation based on forecasting fun comprehensive
income.
W~ forecasted residual income (or expense) onfinancial assets andliabilities is typically zero.
How return on netoperating assets andgrowth innet
operating assets arethetwo drivers of residual operating income.
How a valuation based onforecasting abnormal operating income growth differs from an abnormal earnings
growth (AEG) valuation.
How the required return for operations and the required return for equity arerelated.
How financial leverage affects ROCE, earnings growth,
andtherequired return for equity.
How financial leverage affects a valuation.
Why earnings growth that is created by leverage
should notbevalued.
The effects ofstock repurchases onvalue.
The difference between enterprise (unleveredl price
multiples andlevered multiples.

Calculate residual operating income.
Calculate abnormal operating income growth.
Value a firm using theresidual operating income model
andtheabnormal operating income growth model.
Identify thedrivers of residual operating income.
Use reformulated balance sheets to value thefinancing
activities ofa business.
Analyze theeffect ofa change in financial leverage on
thevalue ofa firm.
Analyze the effect of financial leverage on ROCE,
earnings growth. equity cost ofcapital, andP/B andPIE
ratios.
Calculate a weighted-average cost of capital using
market values fordebtandequity.
Calculate the cost ofcapital forequity from thecost of
capital for operations andthecost of debt.
Explain thedifference between a levered andonlevered
price-to-book ratio.
Explain the difference between a levered an unlevered
price-eaminqs ratio.
Calculate an uoevereo price-to-book ratio using the
residual operating income model.
Calculate an unlevered PIE ratio using the abnormal
operating income growth model.
Reconcile levered andunlevered multiples.

Chapter 14will develop
simple forecasting and
valuation methods basedon
the valuation modelsfor
operations in this chapter.
Link to Web page

Applythe methodsof this
chapterto valuing the
operations of firms-visit
the textWebsite at
www.mhhe.com/penman4e.
The residual earnings model of Chapter 5 and the abnormal earnings growth model of
Chapter 6 give us two approaches to value equities from the financial statements: price
bookvalues or priceearnings. Theanalysis of financial statements in PartTwo of the book
provides an understanding of what drives residual earnings and earnings growth. We are
now in a position to apply the analysis tools of Part Two to develop valuations using
residual earnings and abnormal earnings growth methods.
With valuation in mindwe want to forecast the aspects of the business that generate
value. In Part Two of the book, we took pains to distinguish operating activities from
financing activities with the understanding that it is operations that generate value. This
chaptershowshow this distinction is incorporated in developing forecasts for valuation.
It shows that if net financial obligations are measured in the balancesheetat marketvalue,
financing activities can be ignored in forecasting. You will see that this makesforecasting
easier. In particular, complications that arise from the effect of financial leverage on
residual earnings, abnormal earnings growth, and the cost of capitalcan be ignored. You
wilt also see that this protects you from paying too muchfor earnings growth, for leverage
creates earnings growth but usually doesnot addvalue. The simplification leadsto a focus
on income from operations rather than earnings that includes financing income and
expense, and to a focus on net operating assetsratherthancommon equity in the balance
sheet.
The focus on operations brings a focus to enterprise or unlevered price-to-book ratios
and price-earnings ratiosratherthanthe moreconventional levered ratios. If the financial
assets and liabilities are measured at market value on the balance sheet, they do not
contribute to the premium overbookvalue.Ratherit is the net operating assetsthatdeterminethe premium. So an (enterprise) price-to-book ratiothatreflects the pricing of the net
operating assetsgivesa bettermeasure of the omitted valuein the balance sheetand of the
valuethat,oncecalculated andaddedto bookvalue,gives thevalueof thefinn. Similarly, as
valuegenerating growth comes fromthe operating activities, an (enterprise) price-earnings
ratio that pricesoperating income gives a better indication of the abilityof a finn to add
value through earnings growth.
442 Part Three Forecasring and Vahlarion Analysis
Chapter 13 TheValue of Operations and {he EtIC!uation of EnleTprise Price-to-Book RariOl and Price-Earnings Ratios 443
A MODIFICATION TO RESIDUAL EARNINGS FORECASTING:

RESIDUAL OPERATING INCOME
Let's remind ourselves of theresidual earnings model forvaluing equity:
Vl : : CSEo + Present value of forecasted residual earnings
{13.1}
REI RE2 RE3

::::CSE o +- ++- +PE
pi
p~
where
Residual earnings (RE) :::: Earnings - Required earnings on bookvalue of equity
REI:::: Eam.>- (p-l) CSE/-l
This RE model instructs us to anchor the valuation of equity on the bookvalue of equity,
thenadd value for earnings forecasted in excess of the required earnings on bookvalue.
Therequired rateof return is thecostof capital forequity, PE-l.
We understand from thismodel that, if an asset is forecasted to earnat itsrequired rate
of return, forecasted residual earnings will be zero and the assetwill be worth its book
value. Correspondingly, if the book value ofan assetis equal to itsintrinsic value, then the
residual earnings thatit is expected toyieldwillbe zero. We canmake useof these properties in valuing equities even though thetotalbookvalue of equity is notequal to itsvalue.
Ifsome assets aremeasured inthebalance sheetat market value andif market value equals
intrinsic value, thenweknow wedon'thave to forecast the residual earnings thatthey win
produce; theirforecasted residual earnings arezero. We onlyhave toforecast residual earn.
ings from assets not at market value. Accordingly, wecan calculate the value of equity as
vg : : CSEc + Present value of forecasted residual earnings from netassets notat

market value
Tocarryout this valuation we have to be ableto distinguish the earnings from assets or
liabilities at market value from those thatarenot.Theincome from operating assets isusuallyearned byusingassets jointly, which makes it difficult to identify the income from the
separate assets. However, we have seen that we can usually separate operating income
(generated by the net operating assets) from net financial expense (generated by the net
financial obligations). And,netfinancial obligations are typically measured onthebalance
sheetat market value.
Thetwo components of earnings identified bythe reformulation of financial statements
inPartTwo ofthebookarelisted inTable 13.1 along withthebalance sheetcomponent that
TABLE 13.1
Components of
Earningsand Book
Value, and
Corresponding
ResidualEarnings
Measures
Earnings Component
Book ValueComponent
Residual Earnings Measure
Operating income (Ol)
Netoperating assets
INOA)
INFO)
Common stockholders'
equity(eSE)
Residual operating income:

Olt":' (PF-1) NOA t_1
Residual netfinancial-expense: -
Netfinancial expense (NFE)

Earnings
NFEr - (Po -1) NFOt_l
Residual earnings:
Earn, - (PE-1) CSEH
generates them. Beside eachcomponent is the corresponding residual earnings measure.

Toget the residual earnings measure, eachincome component is matched withthe corresponding balance sheetcomponent andcharged withtherequired earnings rate(thecostof
capital) for the component. Wewill discuss the cost of capital in the nextsection but for
now recognize thattherequired return forthe different sources of income depends on the
riskiness ofthatactivity. Notethat PD is 1plusthecostof capital fornetdebt(or,as it may
be, the required return on net financial assets), and PF is 1 plus the cost of capital for
operating activities. In all cases the residual earnings is earnings in excess of theearnings
(or expense) required for the asset(or liability) in the balance sheet to be earning at the
relevant costof capital.
Residual earnings from net operating assets is residual operating income, andwewill
referto it as Re01:
Residual operating income> Operating income (after tax)
- Required income onnetoperating assets
ReOI,=OI,-(PF- I)NOA,_1
Residual operating income charges theoperating income witha charge forusing thenet
operating assets. Residual operating income is also referred to as "economic profit" or
"economic value added," andsome consulting firms have taken these terms as trademarks
fortheirvaluation products. ForNike,withafter-tax operating income of$1,883 million in
2008 and netoperating assets at the beginning of the yearof $4,939 million, the residual
operating income for2008 wasReOhoos:::: 1,883 - (0.086 x 4,939):::: $1,458.2 million for
a required return of8.6 percent.
Similarly, residual earnings from the net financial obligations is residual netfinancial
expense, ReNFE:::: NFEr - (PD-l)NFO r_lt or,if the firm hasnetfinancial assets, residual
netfinancial income. Thusresidual netfinancial expense is netfinancial expense lessthe
required costof thenetdebt.
With forecasts of ReOI andReNFE, wecanvalue theNOA andNFO. The value of the
netfinancial obligations, V~FO, thatmature at some timeTin thefuture is
Value ofNFO:::: NFO + Present value of expected residual netfinancial expense
T
NFO + ReNFE\ + ReNFE2 + ReNFE} +.. + _R_eN_IF_E_
PD
Pb
pb
Pb
Vd"iFO ::::
(13.2)
If theNFO aremeasured at market value, it mustbethatforecasted ReNFE arezero: For

$100 million of debt at an interest rate of 5 percent, interest expense is $5 million and
ReNFE:::: $5- (0.05 x 100):::: O. Thus, V~FO:::: NFO. Thebookvalue of the netfinancial
obligations is theirvalue.
Thevalue of thenet operating assets, VlJIOA, fora going concern is
Value of cperations e Netoperating assets + Present value of expected residual
operating income
NOA
V'
ReOl,
Re0l
ReOl]
PF
p~
p~
2
=NOA +--+--+--+...
ReOI
CV
r
r
+--+--
P:
p~
(13.3)
Chapter 13 TheVallie ojOperatiolll and the Evaluatian ofEnt~e Priceto-Book Ratio~ ami Price.Earning~ Ratios 445
444 Part Three ForeClllting and Valuation Anal,sis
Thatis,the value is thebookvalue oftheNOA, plusthepresent value of expected residual

operating income fromtheseassets to a forecast horizon, plusa continuing value thatis the
value ofexpected residual operating income afterthe horizon. Thismodel is the same form
as theresidual income model butapplies to thenetoperating assets instead of thecommon
shareholders' equity. Continuing values summarize the analyst's expectation of a finn's
performance beyond a forecast horizon. Continuing values can be calculated at a point
wherethe analyst forecasts thatperformance willfollow a regular pattern.
Corresponding to the three cases for the residual earnings model in Chapter 5, the
continuing value for theresidual operating income model cantakethree forms:
Case 1:
CVr =0
Case2:
CVr = ReOIr+!
200BA

Net operating assets (NOA)
RNOA(%)
Residual operating income(ReOI)
Discount rate(1.086 t )
PVof ReOI
Total PV of ReO!
In Case1weexpect residual operating income (ReO!) tobe zeroafterthe forecast horizon because weexpect thenet operating assets to earn at the costof capital. In Case2 we
expect ReOlto be at a constant, permanent level, and in Case3 weexpect ReOI to grow
perpetually attherateg. Theanalyst's task, then,is toforecast thelevel andgrowth ofresidual operating income at the forecast horizon.
Thevalue oftheoperations isalsocalled the valueofthefinn. Itisalsosometimes referred
to asenterprisevalue.Thevalue oftheequity is = Vci'A _1-fF0. SoiftheNFOaremeasuredat market value onthebalance sheet-that is,expected residual netfinancial expenses
(ReNFE) arezero-then (recognizing thatNOA - NFO = CSE) thevalue ofthe equity is
vt
(HA)
V,E = CSEo + ReOlt + ReOh + ReOI:! +... + ReOIr + CVr

o
PF
p}
P}
p~
P~
Thismodelis the residual operating income model.
Table 13.2 values Nikeusing the model. Theforecasts areforoperating income andnet
operating assets, nottotalearnings andcommon shareholders' equity; the financing componentsoftheincome statement andthebalance sheetareignored. Theforecasts imply thereturn on net operating assets (RNOA) numbers indicated, withdeclining profitability up to
2012, as is common, Residual operating income, calculated as described at the bottom of
thetable, is forecasted togrow after2012 at the4 percentaverage GDP growth rate.With the
continuing value implied bythisgrowth rate,thevalue oftheoperations at theendof2008the enterprise value-is $33,165 million and the value of the equity (thatincludes Nike's
2008netfinancial assets) is$35,157 million, or$71.59 pershare. Nike's shares traded at$68
at the time, so onecouldview thepro forma hereas onethatis (approximately) consistent
with the forecasts implied by the market price. Wemight thenask whether thispro forma
(thatjustifies the current market price) is a reasonable one. If, through analysis, we forecasted higher residual operating income in the future, we would conclude that Nike is
underpriced, given weaccepted the8.6percent required return as reasonable.
The residual operating income model makes sense. If debtandfinancial assets are zero
residual earnings producers, then theyaddno value to theirrecorded value. We are going
to get the valuation by forecasting the profitability of the operations that do add value.
2009E
2010E
2011E
2012E
1,800
6,287
1,892
6,549
1,952
6,814
1,996
7,089
31.0%
30.1%
29.8%
.':29.3%
1,301
1.086
1,198
1,351
1.179
1,146
1;388
1.281
1,084
1,410
1.391.
1,014
5,806
4,442
31,878
22,917
33,165
1,992
35,157
$ 71.59
Enterprise value
Book value of net financial assets
Value of common equity
Value pershare (on 491.1 million shares)
CV = ReOI r +1
r
PF - g
Value of common equity = Bookvalue of common equity

+ Present value of expected residual
operating income
Residual Operating Income Valuation for Nike, Inc.
Required return for operations ts 8.6%. (Amounts inmillions ofdollars except per-share numbers)
PVo!CV
PF -1
Case3:
TABLE 13.2
CV 1,410x1.04 -31,878
1.086-1.04
PVofCV = 31,878 = 22917

1.391
'
Residual operating income(ReOI) isOl, -
{PF- 1)NOAt_l .
So, for2010,
ReOI = 1,892- (0.086x 6,287)= 1,351

Allowforroundingcrrors.
The model makes the forecasting task easier, too. It requires us to forecast operating incomeand net operating assetsbut we can forget about forecasting net financial expenses
andnetfinancial obligations. Ofcourse if financial itemsarenotmeasured at market value,
theREmodel inequation 13.1 mustbeused. Butif themarket value oftheseitemsis available wecansubstitute the market value for thebookvalue andproceed withReOI valuation.' Fair values of many financial items canbe found in statement footnotes. If the financial reporting is such that operating and financing activities cannot be separated, the RE
model mustbe used.
Remember that forfinancial institutions, apparent interest-bearing financial assetsand
liabilities arereally operating assetsandliabilities. These firms make profits from financial
assets and liabilities. The market value of these assets and liabilities might reflect their
value generally, but they mightnot reflect thevalue inuseto aparticular finn. The m:alyst
must explore how the firm makes money from financial itemsand forecast the residual
operating income from them.
A final caveat: The market value of assets and liabilities on the balance sheetcanbe
taken as theirfairvalue onlyif the market value is anefficient one. SeeBox13.1.
The Drivers of Residual Operating Income

We sawin Chapter 5 thatresidual earnings canbebroken down intotwocomponents:
Residual earnings = (ROCE - Required return forequity) XCommon equity
RE,= [ROCE,-(PE-11] CSEH

(1,)
(2)
Chapter 13 TheValue of Opemnons andtheEvallUlrion of Emerprise Pnce-ro-Bcck Rarios andPrice-Earnings Rcrlcs 447
Equity investments that involve less than 20 percent ownership and are "available for sale" arecarried on the balance
sheet at market value. Market values are also given in the
footnotes for "held-to-maturity" equity investments that are
carried at cost on the balance sheet.
Microsoft Corporation held the following equity investments on its 1999 balance sheet:
EquitySecurities
At market value onthe
balance sheet
Comcast Ccrporatlon-,
common stock
Cost
Gains
Market
Recognized
Value
500
$1,394
s 1,894
14
849
1,088
1,102
1,102
1,951
(785)
()85)
MCIWoridCom, Inc.-
common stock
Other
Unrealized hedge loss
At cost onthebalance
sheet
The analyst mightaccept the market values of these equity

investments as their values, considerably simplifying the
valuation.
Butwhatif these securities were misprtced inthemarket? In
1999, theinvestments were in "hot" technology andtelecommunications stocks during a bubble. Might not the shares of
technology companies beoverpriced? Basing Microsoft's intrinsic value on themarket price of these stocks could result in an
overvaluation: One wouldbeincorporating bubble prices inthe
valuation. Indeed, Microsoft recorded subsequent losses on its
investment portfolio.
These considerations require the analyst to investigate
the value behind the market values of equities. Just as the
analyst queries the market price of Microsoft through
fundamental analysis, healso queries the price of Microsoft's
equity investments through fundamental analysis of those
investments.
A MODIFICATION TO ABNORMAL EARNINGS GROWTH FORECASTING:

ABNORMAL GROWTH IN OPERATING INCOME
Let us remind ourselves ofthe abnormal earnings growth model for valuing equity:
vg:::: Capitalized [Forward earnings + Present value of abnormal earnings growth]
= _1_[Eaml + AEG, + AEG, + AEG, +...
PE-l
PE
Pi:
pl
(13.5)
where
Abnormal earnings growth, (AEG) = Cum-dividend earnings, - Normal earnings,
:::: [Earnings, + (PE- l)dt_1] - PEEamingst_1
[Gt - PEl x Earningsc.,
3,845
$5,208
6,100
$10,262
We referred to the two components, ROCE and book values, as residual earnings
drivers: RE is driven by the amount of shareholders' investment and the rateof returnon
this investment relative to thecost of equity capital. Residual operating income cansimilarly be broken down intotwocomponents:
Residual operating income>(RNOA - Required return foroperations)
x Net operating assets
ReOI t = [RNOA t - (PF- I)] NOAt _ 1
(1)
(2)
Thetwocomponents of ReOI areRNOA andnetoperating assets, andwereferto theseas

residual operating income drivers: ReOI isdriven by theamount of netoperating assets put
in place andtheprofitability of those assets relative to the costof capital. Thevaluation of
Nike inTable 13.2 involved forecasts ofR1'\JOA, as indicated, andgrowth in netoperating
assets. Thecombination produces growing residual operating income.
Residual net financial expense (or income) alsocan be broken down intotwodrivers:
Residual net financial expense> (Netborrowing cost- Costof net debt) x Netdebt
ReNFE, = [NBC,- (Po- I)] NFO H
So ReNFE is driven bytheamount of netfinancial debtandthenetborrowing costrelative

to the costof debt. Fora firm thatissues debtforfinancing, expected borrowing costsare
equal to thecostof thedebt. Sonomatter howmuch debt isputinplace, novalue is added
through the twodrivers, andexpected ReNFE is zero.
446
Rather, value is added to book value through the operations, and our breakdown tells
us thatthis is done by earning an RNOA thatis greater than the cost of capital foroperations and by putting investments in place to earn at this rate. Accordingly, forecasting
involves forecasting thetwodrivers, future RNOA andfuture NOA. We willseehow these
forecasts aredeveloped in thenexttwochapters.
where G,is thecum-dividend earnings growth ratefortheperiod. TheAEG model instructs

us to forecast forward (one-year ahead) earnings, then add value for subsequent cumdividend earnings forecasted inexcess ofearnings growing at therequired rateof return for
equity. Forecasted earnings include earnings from reinvesting dividends, fora firm delivers
twosources of earnings, onefromearnings within thefinn andtheotherfrom earnings that
canbe earned fromreinvesting dividends paidbythefirm. We understand from thismodel
that earnings growth in itselfdoes not add value, onlyabnormal growth over the required
growth. If abnormal earnings growth is expected to be zero, the equity willbe worth just
the capitalized value of itsforward earnings.
Consider now where abnormal growth comes from. Growth doesnot come from financingactivities. Debtinvestments anddebtobligations work justlikea savings account: Debt
is always expected to earn(orincurexpenses) at therequired returnon thedebtso, adjusting foranycashpaidonthedebt(the"dividend" fromdebt), netfinancial expense cangrow
onlyat a rateequalto the required return. Tosee it another way, wehavejust recognized
that, if the net financial obligations are at market value on the balance sheet, residual incomefrom thefinancing activities is expected tobe zero. Sothe change inresidual income,
period-to-period, is alsoexpected tobezero,andabnormal earnings growth is always equal
to thechange in residual income.
Abnormal earnings growth is generated byoperations. Thismakes sense for, onceagain,
it is the operations thataddvalue. As the financing activities do not contribute to growth
overthe required return, wefocus on abnormal growth in operating income.
Abnormal Growth in Operating Income and the "Dividend"

from Operating Activities
When introducing earnings growth in Chapter 6, we recognized that growth in (exdividend) earnings-the growth thatanalysts typically forecast-s-is not thegrowth thatwe
should focus on. Earnings growth rates will be lower the more dividends are paid, but
dividends canbereinvested toearnmore, adding togrowth. Soanyanalysis ofgrowth must
Chapter 13 TheValue ofOperarions cmd Ute Eva!Ualion of Enterprise Priceto-Book RatiDs andPrice-Earnings Ratios 449
448 PartThree Forecasting and. Vnluation Analysis
focus on cum-dividend earnings growth. In focusing on growth in the operating income

component of earnings, wealsomust notmake the mistake of focusing on growth in operating income if cash that otherwise could be reinvested in operations is paid out of the
operations. Dividends are netcashpayments toshareholders outof earnings (thattheycan
reinvest). What is thecashpaidoutof operations (thatcanbe reinvested elsewhere)? What
arethe"dividends" from theoperating activities?
Our depiction of business activities in Chapter 7 supplies the answer to this question.
Lookat Figure 7.3, which summarizes business activities, andFigure 7.4, which summarizes how those activities are represented in reformulated financial statements. Net dividends, d, arethe dividends from the financing activities to theshareholders. Netpayments
to bondholders and debt issuers, F, are the "dividends" from the financing activities to
theseclaimants. Butthe "dividend" from theoperating activities to thefinancing activities
isthe freecashflow. Business works as follows: Operations paya dividend to thefinancing
activities-in theform of freecashflow-and thefinancing activities apply thiscashtopay
dividends totheoutside claimants. Indeed, the reformulated cashflow statement is a statementthatreports the cashdividend from the operating activities (freecashflow) andhow
thatdividend is divided among cashto debtholders andcashto shareholders inthefinancingactivities: C -I =: d + F.
Accordingly, abnormal operating income growth is calculated as
Abnormal operating income growth, (AOIG)
=: Cum-dividend operating income, - Normal operating income,
:=
[Operating income, + (PF- 1)FCFI_1] - pr Operating incomeo
where free cash flow (FCF) is, of course, cash from operations minus cash investment
(C-/). Compare this measure to abnormal earnings growth (AEG) above. Operating incomeis substituted forearnings, andfreecashflow is substituted fordividends. And, as the
income is from operations, the required return thatdefines normal growth is the required
return foroperations. A finn delivers abnormal operating income growth if growth in operating income-scum-dividend, afterreinvesting freecashflow-is greater thanthenormal
growth rate required for operations. Note thatjust as AEG equals the change in residual
earnings, soAOIG equalsthe change in ReOL
Just as AEG can be expressed in terms of cum-dividend growth rates relative to the
required rate,so canabnormal operating income growth:
Abnormal operating income growth, (AOlG):= [G{- PF] x Operating incomec,
where G1 is now the cum-dividend operating income growth raterather thanearnings.
Table 13.31ays outthe abnormal earnings growth measures thatcorrespond to theoperating and financing components of earnings, in a similar way to the residual earnings
TABLE 13.3
Earnings
Componentsand
Earnings Component
Abnormal Earnings GrowthMeasure
Operating income (Ot)
Abnormal operating income growth:
Corresponding
Abnormal Earnings
Growth Measures
Netfinancing expense (NFE)
[01,+ (PF-1)FCF,_,] - p,oIH
Earnings
[Gt-PF]xOlt_l
Abnormal netfinancial expense growth:
[NFE t + (Po-l)F t- 1] - PoNFE t_1
Abnormal earnings growth:
[Earn t + (PE-1)dt-l] - pEfarnt_l
[Gf - PEJ X Earnt_1
breakdown inTable 13.1. A calculation forabnormal growth in netfinancial expense is included there, forcompleteness, but(likeresidual net financing expense) it is nota measure
we will make use of because it is expected to be zero. (Note, for completeness, that the
"dividend" fordebtfinancing is the cashpayment to debtholders, F.)
With an understanding of abnormal growth in operating income, wecan layout an abnormal operating income growth model to value theoperations andtheequity. Forecasting
abnormal operating income growth yields the value of the operations, just as forecasting
residual operating income yields thevalue oftheoperations. Subtracting thevalue ofthenet
financial obligations yields the value of the equity and, ifnet financial obligations aremeasured at market value on thebalance sheet, thebookvalue suffices fortheirvalue. So,
Value of netoperating assets> Capitalized [Forward operating income
+ Present value of abnormal operating
income growth]
~NOA :=
_1_[01
+
PF-l
1
(13.6)
AOlG 2 + AO~G3 + AO;G~ + ..]

PF
PF
PF
Thevalueof theequitysubtracts thenet financial obligations. You seethatthis is the same

form as the AEG model (equation 13.5) except that operating income is substituted for
earnings, andthecostof capital for theoperations is substituted for theequity costof capital.Likethe ReO! model, thisAOIG model simplifies the valuation task, for weneedonly
forecast operating income and can ignore the financing aspects of future earnings. As the
model values the enterprise or the finn before deducting the netfinancial obligations, the
model (likethe ReOI model) is referred to as an enterprise valuation model or a valuation
modelfor thefirm.
Table 13.4 applies the modelto valuing Nike,as inTable 13.2. The layout is the same
as that for the abnormal earnings growth valuations in Chapter 6. As with the ReOI
model, operating income and net operating assetsare forecasted, but the net operating
assetforecasts arethenapplied to forecast freecashflows: C- I =: O! ~ mOA, as in the
Method 1 calculation in Chapter 10.Freecashflow doesnot haveto be forecasted in addition to the otherforecasts-it is calculated directly from those forecasts. Expected abnormal operating income growth is calculated from forecasts of operating income and
freecashflow, as described at thebottom ofthe table, andthose forecasts areconverted to
a valuation as prescribed by the model. NotethatAOIG is equal to the change in ReO! in
eachperiod(inTable 13.2). The valuation is, of course, the same as thatobtained using
ReO! methods.
THE COST OF CAPITAL AND VALUATION

Step4 of fundamental analysis combines forecasts from Step3 withthe costof capital to
get a valuation. Thepreceding models have shown howthis is done, but now wehaveencountered three costsof capital: thecostofcapital forequity, ps;thecostofcapital fordebt,
PD; and the costof capital for operations, PF. These needa little explanation. We will not
calculate themherebut notethat this is doneusing the beta technologies discussed in the
appendix to Chapter 3, which arecovered in corporate finance texts. (We willdiscuss how
fundamental risk affects the cost of capital in Chapter 18.)Hereyoushould be sureyou
have a goodappreciation of theconcepts, because withthis understanding, forecasting and
450 Part Three Farecmting and Valuation Analysis
Chapter 13 The Value ofOperations end the El'allllrion of Emerprile Price-to-Book Ratios and Price.Earnings Ratios 451
TABLE 13.4 Abnormal Operating Income Growth Valuation forNike, Inc.

Required return for operations is 8.6%. (Amounts inmillions ofdollars except per-share number)
200SA

Free cashflow (C -I = 01- t.NOA)
Income from reinvested free cash flow (at 8.6%)
Cum-dividend 01
Normal 01
Abnormal 01growth (AOIG)
Discount rate
5,806
2009E
1,800
6,287
1,319
PVof AOIG
Total PV ofAOIG
2011E
20m
1,892
6,549
1,630
113.4
2,005.4
1,954.8
50.6
1.086
46.6
1,952
6,814
1,687
140.2
2,092.2
2,054.7
37.5
1.179
31.8
1,996
7,089
1,721
145.1
2,141.1
2,119.9
2U
1.281
16.5
94.9

PV ofcontinuing value
Forward 01for 2005
1,226
Capitalization rate
Enterprise value
Book value of netfinancial assets
Value pershare (on 491.1 million shares)
Cum-dividend growth ratein 01
CV_
2010E
957.1
1,800.0
2,852.0
0.086
33,165
1,992
35,157
$ 71.59
Payoffs mustbe discounted at a rate that reflects theirrisk,and the risk for the operations
maybe different from theriskfor equity. The riskin theoperations is referred to as operational risk or firm risk. Operational risk arises from factors that may hurt operating
profitability. The sensitivity of salesand operating expenses to recessions andothershocks
determines the operating risk. Airlines haverelatively high operating risk because people
flyless during recessions, andfuel costs are SUbject to shocksin oil prices. The required
return that compensates for thisrisk is calledthe costoj capitalfor operations or the cost
ofcapitalfor thefirm. This is whatwe havelabeled PF (where F is for "firm").
If youhave takena corporate finance class, youare familiar with thisconcept. The cost
of capital for operations is sometimes referred to as the weighted-average costof capital,
or WACC, because of the following relationship:
Costof capital for operations = Weighted-average of costof equity
andcost of net debt
::::
..J
Value of equity
.
( Valueof operations
+(
11.4%
10.6%
9.7%
56.4
1,226.1
1.086-1.04
PVofCV = 1,226 =957.1
1.281
The forecast of 2013 AOIG of 56.4 forthe continuing value calculation is 2012 residual operating residual earnings
of $1,410 growing at the 4% GDP growth rate(tobe consistent with the ReOI valuation inTable 13.2).
Income from reinvestedfree cash flow isprior year's free cash flow earning at the required return of 8.6%. $0,
for 2010, income from reinvested free cash flow is 0.086 x 1,319= 113.4.
Cum-dividend 01 isoperating income plus income from reinvesting free cash flow. $0, for 2010, cum-dividend 01
is 1,892+ 113.4 = 2005.4.
Normal 01isprior years' operating income growing at the required return. $0, for 2010, normal 01 is 1,800 x
1.086= 1,954.8.
Abnormal 01growth (AOIG) iscum-dividend 01 minus normal 01. $0, for 2010, AOIG is 2,005.4- 1,954.8= 50.6.
AOIG isalso given by 01t_1 x (G t - PF). $0, for 2006, AOIG is (1.114- 1.086) x 1,800= 50.6.
PF =
(13.7)
.
. )
Equity cost of capital
Valueof debt
. )
x Debtcostof capital
Valueof operations
v,E
v.D
V,~OA . PE + V,~OA . PD
That is, the required return to invest in operations is a weighted average of the required
returnof the shareholders and the cost of net financial debt,and the weights are given by
the relative values of the equityand debt in the value of the firm. See Box 13.2for examples of the calculation.
The Costof Capital for Debt

The costof capitalfor debtis a weighted average of aU components of netfinancial obligations, including preferred stock and financial assets. It is typically referred to as the
cost of capital for debt but is betterthoughtof as the cost of capitalfor all net financial
obligations.
In Chapter 9 we allocated income taxesto operating and financing components of the
income statement to restate net financial expenses on an after-tax. basis. So too mustthe
costof net debtbe calculated onan after-tax basis. The calculation is
After-tax costof netdebt (PD):::: Nominal costof netdebtx (l - t)
valuation can be simplified. We will seethat, justas residual income can be brokendown
intooperating andfinancing components, so cantheequitycostofcapital. Andwe willsee
howthe financing element of the costof equity capital can be ignored in valuation.
The Costof Capital for Operations

Residual earnings is earnings for the equityholders and so is calculated and discounted
using the cost of capital for equity, PE. Residual operating income is earnings for the
operations andso is calculated anddiscounted usinga costof capital fortheoperations, Pr.
where I is themarginal income tax ratewe usedin Chapter 9. IBM (in Box 13.2) indicates
in its financial statement footnotes that its average borrowing rate for debt in 2007 was
about5.2percentperyear. With a taxrateof36 percent, this is an after-tax rateof3.3 percent.The after-tax cost of debtis sometimes referred to as the effective cost of debt,just
likeNFE is the effective financial expense, because whatthe firm effectively paysin interest is not the nominal amount but that amount lessthe taxes saved So whenweuse PD to
indicate the cost of debt, always remember that this is the effective costof capital for net
financial obligations.
As both NFE and the cost of debt are on an after-tax. basis, so is residual net financial
expense. If theNFOarecarried at market value, thenforecasted Re~':fE willbe zero.
Chapter 13 TheValue ofOperations and (he EooJuation ofEmerprise Price-to-Book Ratios and Price-Earnings Ratios 453
Required returnfor equity= Required returnfor operations
(13.8)
+ (Market leverage x Required returnspread)
~D
PE = PF + --"--(PF - PD)
The cost ofcapital foroperations (also referred to asthecost
ofcapital forthefirm) iscalculated astheweighted average of
thecost ofcapital forequity and the(alter-tax) cost ofcapital
forthenetdebt (the netfinancial obligations). Accordingly, it
isoften called the weighted-average costof capital (WACC).
The calculation isdone intwosteps:
1. Apply anasset pricing model such asthecapital asset pricing model (CAPM) to estimate the equity cost of capital.
For theCAPM, the inputs arethe risk-free rate, thefirm's
equity beta, and themarket risk premium. See theappendix to Chapter 3.
2. Apply theWAce formula 13.7 to convert theequity cost
of capital to the cost of capital for the operations. The
weights aredetermined, inprinciple, by the(intrinsic) value
oftheoperations and thevalue ofthenetfinancial obligations. As thevalue of the equity isunknown, the market
value oftheequity istypically used. The book value ofthe
netfinancial obligations approximates their value.
General
Nlke
Mills
Equity beta
Equity cost ofcapital
Cost ofcapital for debt
(aftertax)
Market value ofequity
Market value ofoperations
Cost ofcapital for
operations
ff
Dell
IBM
0.8
8.3%
0.4
1.4
6.3% 11.3%
1.0
9.3%
3.2%
4.1%
3.3%
2.5%
33,375 20,250 41,200 141,290

(1,992) 6,389 (8,811) 19,619
31,383 26,639 32,389 160,909
8.6%
5.8%
13.7%
(1)
8.6%
For General Mills and IBM, with netfinancial obligations, the

cost ofcapital for operations isless thanthatforequity, while
forNike and Dell, with netfinancial assets, thecost ofcapital
for operations isgreater than thatforequity. For a given level
ofoperating risk, holding (low-risk) financial assets makes the
equity cost ofcapital lower than ifthefirm borrows.
The WACC calculation for General Mil!s:
Here arethecalculations for four firms. IBM, Dell, Nike, and

General Mills for 2008 when the to-year Treasury rate was
20,29) x 6.3%) + (6,389 x 4.1%) = 5.8%
4.3 percent and the market risk premium was deemed to be
( 26,639
26,639
5percent. Equity beta estimates arethose supplied by beta services. The cost ofcapital for debt isitself aweighted average of The WACC calculation for Nike enters the netfinancial assets
theinterest rates onthevarious components ofnetdebtand is
asnegative debt:
ascertained from thedebtfootnote and theyield onfinancial
assets. The rates for Dell, Nike, and General Mills areyields on
33,375 X8.3%)+(-1,992 X3.2%)=8.6%
( 31.383
their netfinancial assets. The market value ofoperations is the
31,383
market value ofequity plus thebook value ofthenetfinancial
The
calculation
comes
with
a warning. See Box 13.3.
obligations. (Market values areinmillions ofdollars)
(2)
For IBM (in Box 13.2), the cost of equitycapital is 8.6% + [19,6191141,290 x (8.6%3.3%)] = 9.3%. Just as the payoffto shareholders has two components, operating and financing, therequired returnto investing for thosepayoffs hastwocomponents, operating
risk andfinancing risk components. Component 1 is therisktheoperations impose on the
shareholder, andthe returnthisrequires is the costof capitalfor theoperations. If the firm
has ~o net debt, thecost of equitycapital is equalto the costof capital for the operations,
that IS, PE = PF. If IBMhadno netdebt, theshareholders would require a returnof8.6 percent,according to the CAPM calculation. This is sometimes referred to as the caseof the
pure equity firm.Butiftherearefinancing activities, component 2 comes intoplay;thisis
theadditional required returnforequitydueto financing risk.Asyoucansee,thispremium
for financing riskdepends on the amount of debtrelative to equity (thefinancial leverage)
and the spread between the cost of capital for operations and that for debt.This makes
sense. Financing risk ~ses because ofleverageandthe possibility of thatleverage turning
unfavorable. Leverage IS unfavorable whenthereturnfromoperations is lessthanthe cost
of debt,sothe equityis moreriskythemoredebtthereis andtheriskiertheoperations are
relative to the costof debt. In Box 13.2, the CAPM required returnfor operations is lower
forIBMthanforDell.Butthe equityinvestors requirea higherfinancing premium forIBM
than for Dellbecause ofIBM's higher leverage. So the financing riskpremium is 0.7percentfor IBM(9.3% - 8.6%)and a negative 2.4percent for Dell(11.3% - 13.7%) because
Dellhas negative leverage.
The leverage hereis measured withthevalues of the debtandequity; it is referred to as
market leverage todistinguish it from thebookleverage(FLEV) discussed in Chapter 11.
If the firm hasnet financial assets ratherthannet debt(as withDell),
Costof equitycaptial = Weighted-average of costof capitalforoperations
andrequired return. on net financial assets
(13.9)
V. NOA
V!,FA
PE = _0_ _ . PF + _0_. PNFA
OperatingRisk, Financing Risk, and the Cost of Equity Capital

The calculation of theWACC inequation 13.7 is a bitmisleading because it looksas if the
cost of capital for operations is determined by the costsof debt and equity. However, the
operations havetheirinherent risk,andthisdepends on theriskiness ofthebusiness andnot
on how the business is financed. Thus a standard notion in finance-another Modigliani
andMiller concept-estates thatthe costof capital forthe firm is unaffected bytheamount
of debtor equity in the financing of theoperational assets. Rather thanthe required return
for operations beingdetermined by the cost of capital for equityand debt, the returnthat
equity and debtinvestors require is determined by theriskiness of the operations. The operations have theirinherent risk,andthisisimposed ontheequityholders andthedebtholders.The wayto think about it is to see thecost of equity determined by the following formula. This is just a rearrangement of the WACC calculation (equation 13.7), putting the
equity cost of capital on the left-hand sideratherthanthecost of capital foroperations:
452
vg
wherePNFA is therequired return(yieldto maturity) on thenetfinancial assets. Asfinancial

assets aretypically lessriskythanoperations, thecostofequitycapital is typically lessthan
thecost ofcapital forthe operations in thiscase.As an exercise, express thisin the form of
equation 13.8.
Box 13.3 provides a warning about using cost of capital estimates in fundamental
analysis.
FINANCING RISK AND RETURN AND THE VALUATION OF EQUITY

Leverage and Residual Earnings Valuation
You willhavenoticed thatthe expression for therequired returnforequity in equation 13.8
has a similar fonn to theexpression for the drivers ofROCE inChapter 11.Bothformulas
are given on thenextpage,so youcan compare them:
Chapter 13 TheValue ofOperations and !he Evaillation of En!erprise Pnce-ro-Bcck Ratias and PriceEarnings Ratios 455
A basic tenet of fundamental analysis (introduced in

Chapter 1)dictates that the analyst should always be careful
to distinguish what she knows from speculation about what
she doesn't know. Fundamental analysis isdone to challenge
speculative stock prices, so it must avoid incorporating speculation in arrJ calculation. Unfortunately, standard cost-ofcapital measures are speculative, so they must be handled
with care. Theappendix to Chapter 3 explained that, despite

the elegant asset pricing models at hand, we really do not
have a sound method to estimate the costof capital.
I,
I
I
SPECULATION ABOUT THE EQUITY

RiSK PREMIUM
Cost of capital measures that use the capital asset pricing
model-dike those in Box 13.2-require an estimate of the
market risk premium. We used 5 percent, but estimates
range, in texts and academic research, from 3.0 percent to
9.2 percent. With such a range, Dell's equity cost of capital
(with a beta of 1.4) would range from 8.5 percent to
17.2 percent.
The truth isthatthe equity risk premium isa guess; it isa
speculative number. Add tothis theuncertainty asto what the
actual betais, andwe have a highly speculative number for
the cost of capital. Building this speculative number into a
valuation results ina speculative valuation.
\I
USING SPECULATIVE PRICES IN WEIGHTEDAVERAGE COST OFCAPITAL CALCULATIONS

We have warned against incorporating (possibly speculative)
stock prices in a valuation. Thus, we warned of speculative
pension fund gains in earnings in Chapter 12 and, in this
chapter in Box 13.1, we warned about relying on (possibly
speculative) equity prices onthe balance sheet.
The WACC calculation in equation 13.7 weights equity
anddebtcosts of capital bytheir respective (intrinsic) values.
The standard practice isto use market values instead of intrinsic values intheweighting, as inthecalculations inBox 13.2.
This isdone under the assumption thatmarket prices areefficient. But we carry out fundamental valuations to question
whether market prices areindeed efficient. If webuild speculative prices into ourcalculation, wecompromise ourability to
challenge those prices.
Indeed, you can seethat the WAC( calculation in equation 13.7 iscircular: We wish to estimate thecost ofcapital in
order to estimate equity value, butthe estimate requires that
weknow theequity value! We need methods to break this circularity-without reference to speculative market prices. We
turnto this problem inChapter 18.
As with all instances where wehave uncertainty, weget a
feel for how thatuncertainty affects valuations with sensitivity
analysis. Sensitivity analysis isa feature of the cost of capital
analysis ofChapter 18, andalso ofthe pro forma analysis that
leads to valuation inChapter 15.
I,
.
Return on common equity= Returnon net operating assets

+ (Book leverage x Operating spread)
ROCE = RNOA + [NFO x (RNOA - NBCl]

CSE
Required return for equity= Required return for operations
PE
VD
PF + v:~ (PF - PD)

o
The equity return in both cases is driven by the returnon operating activities plus a premium for financing activities, where the latter is given by the financial leverage and the
spread. The onlydifference is thatthesecond equation refersto required returns ratherthan
accounting returnsand the leverage is market leverage ratherthanbookleverage.
Thecomparison is insightful. Leverage increases theROCE (andthusresidual earnings)
if thespreadis positive, as wesawin Chapter 11.Thisis the"goodnews" aspect of leverage.
But at the same time, leverage increases the required return to equity because of the
454
increased riskof gettinga lower ROCE if thespreadturnsnegative. This is the"badnews"

aspectof leverage. "More risk,morereturn"is an oldadagethat youcansee at workhere.
And youcansee it at workin the RE valuation model: Equity valueis basedon forecasted
REandthe rateat whichREis discounted to presentvalue. TheROCE drives residual earnings. Given a positive spreadbetween RNOA and the net borrowing cost, leverage will
yield a higherROCEand thus a higher RE. This is the good news effect on the present
value. But at thesametimethe discount ratewillincrease to reflect the increased financing
risk.This is the bad newseffecton the presentvalue. Whatis the net effecton the calculatedvalue?
A standard notion in finance is that the two leverage effects are exactly offsetting, so
leverage has no effect On the valueof the equity. This is demonstrated in Table 13.5.The
firstvaluation (A)valuesthe equityfroman operating income forecast of$135 million for
an yearsin the futureon a constantlevelof net operating assets. The perpetual forecasted
ReOIof $18 millionis capitalized at the cost of capitalfor operations of9 percentto get
a valuation (on 600 millionshares)of $2.00per share.The tablethen gives the valuation
(B) for the equity using the RE model.The RE is calculated and capitalized using the
equity costofcapitalof I0 percent ratherthanthe costofcapitalforoperations of9 percent,
but the valuation remainsthe same. Free cash flow after interestpayments is paid out in
dividends so, to keep it simple, there is no changein leverage forecasted fromusingfree
cashflow to buy downdebt But the final valuation (C) does havea leverage change. It is
an RE valuation for thesamefirmrecapitalized witha debt-for-equity swap. Two hundred
sharesweretenderedin theswapat theirvalueof$2.00 pershare,reducing equityby$400
millionand increasing debtby$400 million(leaving the net operating assetsunchanged).
The resulting leverage change increases the required return that shareholders demand
from 10 percentto 12.5 percent,as indicated, to compensate them for the additional financing risk. It also increases ROCE from 12 percentto 16.7percent,and residual earningsfrom$20millionto $25 million. But it doesnotchangethe per-share valuation of the
equity.
In Chapter 12(Box 12.9) wesaw that Reebok's changein residual earnings and ROCE
in 1996was driven largely by a largechangein financial leverage. Nowlookat Box 13.4.
It analyzes theeffectofReebok'slargestockrepurchase onthe valueof thefinn andits equity. You'II noticethe largeincrease in ROCE that resulted fromthe big change in leverage
in this transaction. Firmscan increase ROCE with leverage. Butthe increased ROCE has
no effect on the valueof the firm.
The equivalence of valuations A, B, and C in Table 13.5 demonstrates that we can use
eitherRE or ReO!forecasting to valueequity. But the RE valuation is morecomplicated.
Theexamples wereconstructed withjust one leverage change. In reality, forecasted leveragewillchange everyperiodas earnings, dividends, debtissues, and maturities change the
equity and debt. So we haveto adjustthe discount rate everyperiod. Thistedious process
requires more work, but there will be no effect on the value calculated. If, however, we
apply residual operating income valuation, we remove all need to deal with financing
activities. Theoperating income approach is a moreefficient way of doingthe calculation.
It notonlyrecognizes thatexpected residual earnings fromnet financing assetsarezerobut
alsorecognizes thatchanges inREand theequitycostofcapitalthatare dueto leverage are
nota consideration in valuation. Accordingly, the non-valuegenerating financing activities
are ignored andwecan concentrate on the sourceofvaluecreation, the operating activities.
Leverage and Abnormal Earnings Growth Valuation

You will notice that, as financial leverage increased with Reebok's stock repurchase in
Box. 13.4,forecasted earnings persharealsoincreased-from $2.30without therepurchase
456 Part Three ForecasrillR (!lui Valuation Anll/:;sis
TABLE 13.5
Leverage Effects on
theValue of Equity:
Residua! Earnings
Valuation
a
A. ReOI Valuation of a Firm with 9% Cost of
Capitalfor Operations and 5% After-Tax
Cost of Debt
1,300
.2QQ
1,000
Operating income
Netfinancial expense (300 x 0.05)
Earnings
Residual operating income, ReOI
[135- (0.09 x 1,300)1
PVof ReOI (18/0.09)
Value pershare (on600 shares)
1,200
PIB=1,000 = 1.2
Note2 to Reebok's 1996financial statements reads:
1,300
300
1,000
135
120
1,300
300
1,000
135
15
120
---..1lQ-7
18
18
IS...,
---.l2
1,300-7
300-7
1,OOO-t
135-7
2. Dutch Auction Self-Tender StockRepurchase
OnJuly 28, 1996,theBoard of Directors authorized the

purchase bythe Company of upto 24.0 million shares of
the Company's common stock pursuant to a Dutch Auction
self-tender offer. The tender offer price range wasfrom
$30.00 to $36.00 net pershare incash. The self-tender offer,
commenced onJuly 30, 1996,andexpired on August 27.
1996.As a result oftheself-tender offer, the Company
repurchased approximately 17.0 million common shares at
a price of $36.00 pershare. Prior to the tender offer. the
Company had 72.5 million common shares outstanding. As
a result ofthetender offer share repurchase, the Company
had 55.8 million common shares outstanding at December
31, 1996. In conjunction with thisrepurchase andas
described inNotes 6 and 8, the company entered into a
newcredit agreement underwritten bya syndicate of major
banks.
15...,
200
1,200
2.00
B. RE Valuation of the Same Firm:

Cost of equity capital
= 9.0% + [300/1,200 x (9.0% - 5.0%)]
= 10.0%

1,300
300
1,000
Earnings
ROCE
Residual earnings, RE [120- (0.10 x 1,000)]

PVof R[ (2010.10)

Value pershare (on600shares)
1,300
-.lQ9
1,000
120
12%
20
1,300
1,300-7
300
300
1,000
1,000
120
~->
12%-4
12%
20...,
20
At a purchase price of $36.00 per share, $601.2. million

was paidto repurchase the 16.7 million shares. Thecompany
borrowed thisamountat current market borrowing ratesand
so,witha reduction inequity and an increase indebt,leverage
increased substantially. Here is the 1996 balance sheet and
financial leverage compared withbalance sheet and leverage
as theywould have been ifthe repurchase and simultaneous
borrowing hadnot takenplace (in millions of dollars):
200
1,200
2.00
P/B= 1,200 -12

1,000 - .
Actual 1996
-As1f'" 1996
Balance Sheet Balance Sheet
with Stock without Stock
Repurchase
Repurchase
C. RE Valuationfor the Same Firm after
Debt-far-Equity Swap:
Cost of equity capital
:= 9% + [7001800 x (9%- 5%}]:= 12.5%
1,300
-.2Q(J
600
Operating income
Net financial expense (700x 0.05)
Earnings
Residual earnings, RE [100- (0, 125x 600)J
Value pershare (on400shares)
.-2Q9
135
35
100
16.7%
ROCE
PVof RE (25/0.125)
1,300
700
25
1,300
700
600
135
35
1,300-4
700-4
160
--WO-4
600~
135-4
35...,
'i,
f'
,,-
1.
,i
16.7% 16.7%-4
25
25...,
200
800
2:00
BOO

Total equity
Minority interest
Financial leverage (REV)
1,135
1,135
-.ll.Q.
...ill
415
1,016
..-M
..l.?J..
..-M
113
ProForma
1997 Income
Statementwith
Stock
Repurchase
Operating income
Net financial expense
(4% of NFO)
Minority interest in
earnings
Earnings forecast
Shares outstanding
(millions)
Forecasted EPS
Forecasts for 1997
RNOA
SPREAD
ROCE
187
187
(29)
(5)
~
143
-ili)
167
55.840
2.56
72.540
2.30
16.5%
12.5%
37.5%
16.5%
12.5%
17.0%
The forecast of operating income is unchanged by the

changein leverage, sinceno NOA havebeen affected. Forecasted RNOA and the SPREAD also remain unchanged. But
the changein leverage produces a big change in forecasted
ROCE.
You see that a firm can earn a higher ROCE simply by

increasing leverage (provided the spreadis positive). But this
hasnothing to dowiththe underlying profitability ofthe operations. Thefinancing adds no value. Here a $2,542 mil!ion
valuation of seebok's equity iscompared withan "as-if" valuationofthe 72.54 million shares hadthe leverage notchanged:
982
Cl.12
"As-If" Pro
Forma 1997
Income
Statement
without Stock
Repurchase
Value of NOA
Book value ofNFO
The following is the forecasted 1997 income statement
Value ofequity
based on analysts' consensus EPS forecast of $2.56 made in
Value of minority interest
early 1997.Itiscompared withan "as-if" statementshowing
Value ofcommon equity
how that forecasted statement would have looked without Value pershare
the financing transaction:
"As-If'
Valuation
with
Stock
Repurchase
Valuation
without
Stock
Repurchase
3,472
3,472
720
---.l.!2
2,752
-ll.Q
2,542
45.52
3,353
210
3,143
4333
(continued)
PIB = 600 = 1.33
I'
I
l
457
Chapter t3 The Vaftle o[Operanons and lhe E~aluarion ofEnterprise Price-to-Book RatiOl andPn'ce-Earnings Ratios 459
The operations were not affected bythe financing, so their

value is unaffected. Itseems, however, that value pershare
increased. But the $45.52 per-share valuation is based on
analysts' forecasts at the end of 1996 and is approximately
the market price at that date. The stock wasrepurchased in
August 1996, however, at $36pershare. If the 16.7 million
shares hadbeen repurchased at the$43.33 price that reflects
thevalue inthe later analysts' forecasts, thevaluations before
andafter thetransaction would beasfollows:
Value of NOA
Book value of NFO
Value ofequity
Value ofminority interest
Value ofcommon equity
Value per share
Valuation
withRepurchase
at $43.33
perShare
Valuation
without
Repurchase
3,472
3,472
843
119
2,629
210
2,419
3,353
43.33
210
3,143
43.33
The valuation without the repurchase is the valuation at the

endof 1996 as ifthere hadnot been a share repurchase, as
before. The valuation with the repurchase just reflects a
reduction of equity by the amount of the repurchase of
$43.33 x 16.7 million shares = $724 million, andan increase
indebtbythesame amount. We sawinChapter 3 thatissu-
ing or repurchasing shares at market value does not affect

per-share price, and we seeit here again. But wefurther see
that issue of debtat market value also does not affect pershare value of$43.33. And weseethata change inleverage
does notaffect per-share value.
O! course, ex post (after the fact) the shareholders who
did notparticipate inthestock repurchase did benefit from it.
The $36.00 may have been afair prise, butthevalue wentup
subsequently: Our calculated value is $45.52 pershare and
that is close to the market value in early 1997. Without
the repurchase, the per-share value would have gone from
$36.00 to $43.33 based on analysts' forecast revisions. But
the per-share value went to $45.52. The difference of $2.19
isthe per-share gain to shareholders whodidnot participate
in the repurchase from repurchasing the stock at $36.00 in
August rather thanat the later higher price. Itisthe loss to
those who did repurchase (from selling at $36.00 rather than
$43.33) spread over theremaining shares.
Could Reebok have made the large stock repurchase because itsanalysis told it that the shares were underpriced?
Reeboks share price rose from $36, the repurchase price in
August 1996, to $43in early 1997, so after the fact, share-holders who tendered their shares inthe repurchase lost and
those who did notgained. Did Reebok's management choose
to make the stock repurchase when they thought the price
was low? (Reebok's share prices subsequently dropped consloerebly) Again, be careful which side of a share repurchase
you choose to beon!
to $2.56 after the repurchase. Just as financial leverage increases ROCE (provided the
spread is positive), financial leverage also increases earnings per share. An increase in
leverage alongwith a stock repurchase increases earnings per shareevenmore. Withabnormal earnings growth valuation, we havesaid that we should pay more for earnings
growth. But should we pay for EPS growth that comes from leverage? Table 13.6shows
that the answer is no.
Thistableappliesabnormal earnings growth methods to the same firm as inTable 13.5.
The first valuation (A) appliestheAOIO model of this chapter. As net operating assetsdo
not change, free cash flow is the sameas operating income, and cum-dividend operating
income (afterreinvesting free cashflow) is forecasted to equalnormal operating income.
Thus abnormal operating income growth from Year 2 onward is forecasted to be zero and,
accordingly, the valueof the operations is equal to forward operating income ($135 million)capitalized at the required returnfor operations of9 percent, or $1,500 million. The
valueof the equity, aftersubtracting net financial obligations, is Sl,200, or $2.00per share,
the samevaluation (of course) as that usingReOI methods.
458
TABLE 13.6
Leverage Effectson
the Value of Equity:
AbnormalEarnings
GrowthValuation
A.AOIG Valuationof a Firm with 9%

Costof Capitalfor Operations and
5% After-Tax Costof Debt
Operating income
Netfinancial expense GOO x 0.05)
Earnings
EPS (on 600 million shares)
Free cashflow (C ~ I = 01- bNOA)
Reinvested free cashflow (at 9%)
Cum-dividend operating income
Normal operating income (at 9%)
Abnormal operating income growth (AOIG)
Value of operations (135/0.09)
Value of equity
Value pershare (on 600 million shares)
forward PIE = 2.0010.20 =-10
135
15
120
0.20
135
135
15
120
020
135
12
147
147
0
135-7
----!.2-7
120-7
0.20-7
135-->
12-->
147-7
147~
0-->
1,500
300
1,200
2.00
B.AEG Valuation of the Same Firm:

Costof equity capital =
9.0% + [300/1,200 x (9% - 5%)]=

10.0%
Operating income
Earnings
Dividend (d = Earn - bCSE)
Reinvested dividends (at 10%)
Normal earnings (at 10%)
Abnormal earning growth (AEG)
Value of equity (120/0.10)
Value pershare (on600 million shares)
Forward PIE = 2.00/0.20 =- 10
135
15
120
0.20
120
135
~
120
0.20
120
12
132
132
0
135-7
~-7
120-7
0.20-7
120-7
12-->
132-7
132~
0-->
1,200
2.00
C.AEG Valuation for the Same

Firm after Debt-far-Equity Swap:
Costof equity capital =
9%+ 1700/800 x (9% - S%)] =
12.5%
Operating income
Earnings
Dividends (d = Earn - 6CSE)
Reinvested dividends (at 12.5%)
Normal earnings
Value of equity (100/0.125)
Value pershare (on400 million shares)
Forward PIE:;:: 2.00/0.25 = 8
135
-"?
100
025
100
800
2.00
135
-12
100
0.25
100
12.5
112.5
112.5
0
135-7
~-7
100~
0.25~
100-7
12.5-7
112.5~
112.5-7
0-->
460 PartThree Forecasringand Valuarion Analysis
Valuation (B) applies anAEG valuation ratherthananAOIG valuation. Thus, earnings

and reinvested dividends are the focus rather thanoperating income andfree cashflows.
There is fullpayout, so dividends arethesameas earnings. Now, however, thecostof equitycapital is 10.0 percent, so abnormal earnings growth afterthefirst yearis forecasted to
be zero. Therefore, thevalue of theequity is forward earnings of$120 million capitalized
at 10percent, or $1,200 asbefore. Value pershare is$2.00, which is forward EPS of$0.20
capitalized at 10percent.
Valuation (C) is after the samedebt-for-equity swap as in Table 13.5. The change in
leverage decreases earnings (as thereis now more interest expense withthesameoperatingincome) butincreases EPS to $0.25. Thevaluation shows thatthisincrease inEPSdoes
not change the per-share value of the equity, for the cost of equity capital increases to
12.5 percent as a result of theincrease inleverage to offset the increase in EPS. Theequity
value-forward EPS of $0.25 capitalized at a cost of equity capital of 12.5 percent-is
$2.00, unchanged.
This example confirms that we can use either AEG or AGIO valuation methods to
priceearnings growth. But it also suggests that we are better off using AOIG methods
that focus on the growth from operations. In practice, leverage changes each period so, if
we were to useAEG valuation, we would have to change the equity cost of capital each
period. It is easier to ignore the leverage and focus on the operations. Indeed, financing
activities donotgenerate abnormal earnings growth, so why complicate thevaluation (with
a changing cost of capital from changing leverage) when leverage does not produce
abnormal earnings growth?
Ignoring financing activities makes sense if you understand that a finn can't make
money by issuing bonds at fairmarket value: These transactions arezero-NPV (andzeroReNFE). If you forecast that a firm will issue bonds in the future and thus change its
leverage-and the bondissue willbe zero-NPV---current value cannot be affected. Similarly, an increase in debt to finance a stock repurchase cannot affect value if the stock
repurchase is alsoat fairmarket value.
leverage Creates Earnings Growth

The example inTable 13.6 provides a warning: Beware of earnings growth thatis created
byleverage. Leverage produces earnings growth, butnotabnormal earnings growth. Sothe
growth created by leverage is notto be valued. SeeBox13.5 fora full explanation.
During the1990s, manyfinns made considerable stock repurchases while increasing borrowings. Theeffect wasto increase earnings pershare. Below aresome numbers forIBM.
INTERNATIONAL BUSINESS MACHINES (IBM)
Share gepurchases and Financial Leverage,1995-2000
Share repurchases, net ($ billions)

Increase in net debt ($ billions)
Financial leverage (FlEV)
Earnings per share
2000
1999
199B
1997
1996
1995
6.1
2.4
1.21
4.58
6.6
1.2
1.10
4.25
6.3
4.4
1.22
3.38
6.3
4.6
0.98
3.09
5.0
0.8
0.68
2.56
4.7
2.3
0.62
1.81
IBM delivered considerable per-share earnings growth during the 1990s. We saw in
Chapter 12 that a significant portion of that growth came from pension fund gains, asset
sales, andbleeding back ofrestructuring charges. Thesignificant stockrepurchases andthe
increase in financial leverage further callintoquestion thequality of IBM's earnings-pershare growth.
In{ntroducing thePIB andPIE valuation models, Chapters 5 and6 warned aboutpaying too much for earnings andearnings
growth. Beware of paying for earnings created by investment, for investment may growearnings but not growvalue. Donot
pay for earnings created byaccounting methods, for accounting methods do not addvalue. Wenow have another warning:
Donot pay for earnings growth created byfinancing leverage. Here isthe complete caveat:
Beware of earnings growth created byinvestment.
Beware of earnings growth created byaccounting methods.
Beware of earnings growth created byfinancial leverage.
Just asvaluation models protect the investor from paying too much for earnings growth from the first wo sources, so the
models, faithfully applied, protect the investor from paying too much for earnings growth created byleverage.
The examples in Tables 13.5 and 13.6 looked at the effect of a one-time change in leverage. However, leverage changes
each period, andif leverage increases each period (and the leverage isfavorable), forecasted earnings andEPS wil! continue to
grow. Butthe growth isnot growth to be paid for. The following proformas compare the earnings growth andvalue of two
firms with thesame operations, onelevered andtheothernot.The levered firm has higher expected earnings growth, but the
same per-share equity value asthe enlevered firm.
EARNINGS GROWTH WITH NO LEVERAGE

The proforma below gives a forecast of earnings andEPS growth for a pure equity firm(nofinancial leverage) with 10million
shares outstanding. The forecast isat the end of Year O. The firm pays no dividends andits required return on operations is
10percent (and so, with noleverage, therequired return for theequity isalso 10percent). Dollar amounts are inmillions, except
per-share amounts.
0
Common equity
Operating income (equals comprehensive income)
EPS (on 10million shares)
100.00
100.00
Growth in EPS
RNOA
RaCE
Residual operating income
Free cash flow (= 01- t.NOA)
Cum-dividend 01
Normal 01
Abnormal 01growth
Value of equity
Per-share value of equity (10 million shares)
Forward PIE ratio
PIB ratio
110.00
110.00
10.00
1.00
10%
10%
0
0
121.00
121.00
11.00
1.10
10.0%
10%
10%
0
0
11.00
11.00
0
133.10
133.10
12.10
1.21
10.0%
10%
10%
0
0
12.10
12.10
0
146.41
146.41
13.31
1.33
10%
10%
10%
0
0
13.31
13.31
0
100.00
10.00
10.0
1.0
The forecast of RNOA of 10 percent yields residual operating income of zero. As forecasted residual income is zero, the
equity isworthitsbookvalue of $100million in Year 0,andthe per-share value is$10. The PIB ratiois 1.0,a normal PIB.
The forecasts of operating income and free cash flow yield a forecast of zero abnormal operating income growth. So the
firm(and the equity) isworthforward operating income capitalized at the required return of 10percent, or $100 million, and
$10pershare. The forward PIE ratiois 10.0, a normal PIE for a cost of capital of 10percent.
The earnings andEPS growth rates are bothforecasted to be 10percent and, accordingly, as10percent isalso the required
rate of return, abnormal earnings growth isforecasted to bezero.
(continued)
461
Chapter 13 The Vtlltle ofOperadons and theE~'Illuation ofEmerprue Price-w-Book RariOI andPrice-Earnings Rados 463
O'l
O'l--------------------
FIGURE 13.1
Median Financial
Leverage forU.S.
Firms, 1963-2001
EARNINGS GROWTH WITH LEVERAGE

The proformabelow is for a firm with the same operations, butwith theoperating assets in Year 0 financed by$50million in
debtand$50million in equity (nowwith 5 rnilllon shares outstanding). The after-tax cost of the debtis5 percent.
Netoperating assets
100.00
50.00
50.00
Common equity
Operating income

EPS (on 5 millionshares)
110.00
52.50
57.50
10.00
2.50
7.50
121.00
1.50
1:68
Growth in EPS
RNOA
ROCE
10%
15.0%

Free cash flow ("" 01- fiNGAl
0
0
Cum-dividend 01
Normal 01
Abnormal 01 qrowth
Value of equity
Per-share value of equity (S million shares)
Forward PIE ratio
PIB ratio
65.88
133.10
57.88
75.22
11.00
12.10
2.63
2.76
9.34
55.12
8.37
11.67%
10%
14.6%
0
0
11.00
11.00
0
1.87
145.41
60.77
85.64
13.31
2.89
10.42
2.08
11.57%
11.48%
10%
'0%
13.9%
0
0
13.31
13.31
0
14.2%
0
0
12.10
12.10
0
50.00
10.00
6.67
1.00
You will notice that,while earnings are lowerthaninthe no-leverage case, EPS ishigher andbothearnings growth andEPS
growth are higher. Ananalyst forecasting the higher growth rate of over 11 percent mightbetempted to give thisfirm ahigher
valuation thanthepure equity firmwhere thegrowth rate isjust10percent. Butthatwouldbeamistake. Both ReOI andAOIG
valuations yield thesame $10per-share value asisthe case with noleverage. Just asthe higher ROCE here isdiscounted bythe
appropriate valuation, soisthe higher earnings growth.
While thevaluation does not change with leverage, thePIE does. The forward PIE ratio isnow 6.67 rather than 10.0, even
though abnormal earnings growthisexpected to bezero. You will understand thereason inthe nextsection, but here isa hint:
PIE ratios aredetermined not only by growth but also by the cost of capital. and the equitycost of capital increases with
financing leverage. Exercise E13.9 explores thisexample further.
The increase in corporate debtduring the 1990s contributed to strong earnings growth
thatthemarket rewarded with high earnings multiples. Figure 13.1 tracks financial leverage
(FLEV) andearnings pershare forUS.firms from 1963 to 2001. For IBM, theouteome was
favorable-c-it wasable to maintain a favorable leverage position. Butdebt hasa downside,
andthisdownside riskincreases therequired return: Ifleverage becomes unfavorable, earnings will decline, perhaps precipitously. For some firms, the downside of debt became
apparent intheearly 2000s asthey struggled tocover debtservice, withlarge losses ofshareholder value. Vivendi, Quest (and the many telecoms), United Airlines (and the many air
carriers) are just a few examples. The episode was repeated in the 2008 credit crisis,
462
Financial leverage
is netfinancial
obligations to common
equity (FLEV).
Sourco,
Slandud &. Poor~
Compustart data
~ 0.5 - j - - - - - - - - - - - - - - - -
--j'-_
!S
-t---'---------'r-,"---------
ii 0.2
T----------------------
0.1
-t--------------------
'a OJ
'j
0
r-.
'6 '3 :;:
'" '"
~
~
;:
r-,
~
~
10
00
'" '" '" '" '" '" '" '"
00
'" '"
~
~
~
~
'" '" '" '"
,;
0
N
especially among highly levered financial firms. In many cases, thedebtwas issued tomake
acquisitions that also produced earnings growth. Analysts must be aware of earnings
growth from acquisitions, but especially when the growth is financed withdebt. A similar
warning attaches to stock repurchases. SeeBox 13.6.
Debtand Taxes
Some people argue that, because interest istax-deductible ifpaidbya corporation butisnot
deductible if paid by Shareholders, there are tax savings to corporate borrowing. Shareholders canborrow onpersonal account to lever theirequity, buttheycanalsolever their
equity byborrowing within thefum.If theyborrow within thefirm, theyaddvalue because
they geta taxdeduction forthe interest costincurred.
Theclaimis controversial. First, interest can(intheUS.) be deducted on shareholders'
own taxreturns to theextent thatit is matched by investment income. Second, the interest
thatis deductible by corporations is taxable in the hands of debtholders who receive the
interest, andtheywillrequire a higher interest rateto compensate themforthetaxes, mitigating thetaxadvantage tothecorporate debt. Thespread between interest rates ontax-free
debt (like municipal debt) andcorporate debtsuggests thisisso.Third, free cash flow must
either be used toreduce corporate netdebtor to make distributions to shareholders: C- 1=
d +F. Both useshave taxeffects. If cashflow is applied to reduce debt, shareholders lose
thesupposed taxadvantage of debt; if thefirm wishes to maintain the debt, it must distributecashflow to shareholders whoarethentaxedonthe distributions. Either way, free cash
flow is taxed, andshareholders cannot getthe tax advantage of debt without incurring taxes
at thepersonal level.
You candelve intothese issues in a corporate finance text. Armed with theshareholders'
personal taxratesandthecorporate tax rate, youcanrevise thevalue calculations here by
incorporating the present value of tax benefits if you are convinced that debtaddsvalue.
But,withan eyeontheshareholder, donot fallintothetrapof thinking onlyabout thetax
benefit of debtwithout considering taxes on distributions to shareholders.
Box 13.7 considers two otherways that firms might generate value for shareholders
from debt.
Firms make stock repurchases forvery good reasons: They are 4. Alternatively, management can create value for shareholders by actively timing the market: "Buy low" applies to
a method ofpaying outcash to shareholders. If a firm hassigfirms buying their own stock as well as to investors. Acnificant holdings of financial assets andnoinvestment opporcordingly, management should be aware of the intrinsic
tunities for thecash, itshould pay itoutto shareholders, who
value of the shares when they engage inshare purchases
may indeed have those opportunities. The shareholders can
(or issues). The 2003 management survey found that
be noworse off, for at thevery least, they can invest the cash
86.4 percent of managers say they repurchase when they
inthesame interest-bearinq financial assets asthefirm.
consider their stock a good value.
However, stock repurchases must be evaluated with care.
Selling financial assets at fair value and paying the proceeds
If management arerepurchasing stock with shareholders'
out with a fair-value repurchase of stock does not create
funds, check their insider trading filings with the SEC: Are
value; nordoes issuing debtat fair value to finance a repurmanagement buying orselling ontheir own account? Be parchase. But management may have reasons for stock repurticularly vigilant when you estimate that the stock is overchases other than passing out idle cash:
priced inthe market.
During the late 19905 Microsoft made a number ofstock
1. in a 2003 management survey,* 76 percent of respondents said that increasing earnings pershare was an im- repurchases when its stock price was as high as $60 (on a
portant factor inshare repurchase decisions. Repurchases split-adjusted basis). Commentators questioned whether
indeed increase earnings pershare, butgrowth inearnings Microsoft was buying its "overpriced stock." See Box 8.6 in
pershare from share repurchases does notcreate value. If Chapter 8 for a commentary. In September 2008, Microsoft
management's bonuses aretied toearnings pershare, one announced a $40 billion stock repurchase when itsprice was
down to $25. Could it be that Microsoft thought its shares
canseehow they might favor repurchases.
2. In the same survey 68 percent of respondents said that were underpriced?
In 2004, Google, nc., theInternet search engine company,
reversing the dilutive effects of employee stock options is
also important. But stock repurchases do notreverse dilu- went public with an IPQ price of just under $90 pershare.
Within a year, its stock price had soared to over $300 and its
tion. See thediscussion inBox 8.6 inChapter 8.
forward Pitto 90, The firm then announced a share issue to
3. Share repurchases are sometimes made when a firm is
raise a further $4 billion. With $3 million in financial assets,
flush with cash as a result of itssuccess. That can coincide
strong cash flow, andnoobvious investment plans, commentawith a high stock price. Buying back overpriced stock de- tors questioned why Googlewould raise additional cash. Could
stroys value forshareholders, even though increasing earn- it have been thatGoogle's management considered the stock
ings pershare. Indeed, ifthestock price isEPS driven, manto beoverpriced at a Pitof 90 and thus a good time to sell?
agement may betempted to buy back overpriced stock to
perpetuate EPS growth. You seehow a price bubble could ~A Brav, J. Graham, C. Harvey, and R. Michaely, "Payout Policy in the
zist Century," Joumal of Financial Economics. 2005,pp.483-527.
result
MARK-TO-MARKET ACCOUNTING: A TOOL FOR INCORPORATING

THE COST OF STOCK OPTIONS IN VALUATION
The distinction bet~een operating activities and financing activities shows us thatth.ere. ~re
two ways to proceedin valuation. We can forecast future earnings from an assetor liability
(and add the present valueof its expected residual earnings to its bookvalue), or we can
mark the asset or liability to market. Marking to market is attractive because it relieves us
of the forecasting task. But marking to market can onlybe done if marketvaluesare reliable measures of fair value. Market values of financial assetsand liabilities typically measureup to thiscriterion, so wedo nothaveto forecast the income andexpenses arising from
Chapter 8 explained that shareholders incurlosseswhen employees exercise th~ stoc.k
optionstheyhavereceived as compensation. Yet GAAP accounting doesnot recognize this
loss. In thatchapter, weshowed how losses from theexercise onstockoptions are calculated.
464
Typically it isargued thatfirms cannot create value byissuing

techniques will incorporate this value. If the scenario is
debt: If thedebtisissued at fair market value, thetransaction
anticipated, the analyst forecasts a realized gain from
is a zero-net present value transaction-or, equivalently, a
the redemption of bonds and, accordingly, a negative
zero-residual net financial expense transaction. Banks and
residual net financial expense (that is, residual income
other financial institutions make money from the spread befrom bonds).
tween lending rates and borrowing rates andsocreate value 2. Just as management might time a share issue or repurfrom transacting indebt. And bond traders who discover mischase, they can time debtissues andrepurchases. If manpricing of bonds also create value from transacting indebt.
agers think thatthefirm's bonds areoverpriced-because
But for thefirm thatuses debtforfinancing, debttransactions
the market underestimates the default probability-they
aredeemed notto create value.
might issue bonds to takeadvantage oftheperceived misThere areexceptions, however.
pricing. Correspondingly an underpricing of bonds may
promote a repurchase of thedebt.
1. Consider the following scenario. A firm with a particular
risk profile that isgiven an ME bond rating issues debt
with a yield to maturity of 8 percent. Subsequently, it engages inmore risky business andthebonds accordingly are
downgraded to a BBB rating. The price ofthebonds drops
to yield an 11 percent return commensurate with the
firm's new risk level. The firm then redeems the bonds and
books a gain.
Firms can transfer value from bondholders toshareholders inthis way. There isa message for bondholders: Beware
andwrite bond agreements thatgive protection from this
scenario. There isalso a message forshareholders: Bond
holders canbe exploited inthis way. There isalso a messagefor the valuation analyst: Firms can create value for
shareholders in this scenario. Applying residual earnings
Corporate finance is usually taught with the view that

markets are efficient, so firms buy and sef their debt and
equity at fair market prices. ifso,financing activities addlittle
value. But ifoneentertains market mlspricirq, a different view
of corporate finance emerges: like an activist investor, the
firm buys itsdebtandequity when they arecheap andissues
them when they areoverpriced. (Of course, issues have to be
coordinated with the need for investment funds for operations.) Ata minimum, thefirm takes theview ofthedefensive
investor and avoids trading at the wrong price. Accordingly,
capital structure-the debtversus equity composition of the
financing-is not an indifferent or "irrelevant" issue but
rather anoutcome ofthe firm's activist approach to the capitalmarket.
Butthatis nottheendof the matter. While recognizing the effect of option exercises on current income, it does not accommodate outstanding options that mightbe exercised in the
future, decreasing future comprehensive income. A valuation based on forecasting GAAP
operating income willoverestimate the valueof the firm, leaving the investor withthe risk
of paying too much for a stock. The analyst mustmake adjustments. One might thinkthe
solution would involve reducing forecasts of GAAP earnings by forecasts of future losses
from the exercise of options. Indeed, this is a solution. But forecasting those losses is not
an easytask:As the loss is the difference between the market price and the exercise price
at the exercise date, one would have to anticipate not only exercise dates but the market
price of thestockat thosedates.
Mark-to-market accounting-the alternative to forecasting-e-provides a solution. Fair
values of outstanding options can be estimated, with reasonable precision, using option
pricing methods. Nike, lnc., wasthe focus in Chapter 8. Nike'sstockoption footnote says
there were 36.6 million outstanding options at the end of 2008, with a weighted-average
exercise price of $40.14. With Nike's stock trading at $67.20 at fiscal-year end, the
weighted-average exercise price indicates that many of the outstanding options are in the
money. The valueof theseoptions-the option overhang-amounts to a contingent liability for shareholders to surrender valueby issuing sharesat lessthan market price,just like
an obligation undera product liability orenvironmental damage suitisa contingent liability.
Thatcontingent liability mustbe subtracted in calculating equityvalue.
465
Chapter 13 The Value ofOperationo and !he Evaluntion ofEmerprise Pnce-ro-Bock RaciOl and Price-Earnings Ratios 467
466 Part Three Forecasting and Valllation AnalY5is
The valueof this contingent liabilityis estimated usingoptionpricingmethods applied

to the outstanding options. This optionvaluereduces the valuation basedon forecasts of
GAAP income inTables 13.2and 13.4,as follows (in millions):
Value of equitybefore optionoverhang (from Tables 13.2 and 13.4)
liability for optionoverhang:
Bleck-Scholes value of outstanding options: 36.6x $42.40
Option liability, aftertax
Value of equity
Value pershare on 491.1 million shares
$35,157
Enterprise Price-to-Book Ratios

T~e valueof e~uit.Y i~ the.value
of the operations minus thevalueof the net financial obligatreus. So the mtnnsic price-to-book (PIB) ratiocan be expressed as
$1,552
(5651
987
$34,170
$ 69.58
The optionoverhang is basedon a weighted-average valueof all options outstanding, here

estimated at $42.40. As the losson the exercise of optionis tax deductible, the overhang is
reduced by the tax benefit. Therecognition of the optionoverhang reduces Nike'svalueto
$69.58 per sharefromthe $71.59 inTables 13.2and 13.4.
The adjustment here is only approximate. First, Bleck-Scholes option valuations are
onlyapproximate. Because employee options havefeatures different fromstandard traded
options-they may not vest and may be exercised before expiration, for examplemodifications are often made. Second, basing the option value on the market price is
appropriate onlyif that pricerepresents value. Theanalystwishesto get intrinsic valueindependent of the marketprice,and this valuedepends on outstanding options. However,
optionvalue and equityvalueare jointly determined, so this presents problems. Iterative
methods can be applied: Start with optionvaluesbased on intrinsic equity valuesbefore
considering options (the$71.59 inTables 13.2and 13.4), theniteratively change equityand
option values until convergence is reached. Warrant pricingmethods also deal with this
problem.' Unlike optionpricingmodels thatapplyto (nondilutive) tradedoptions, warrant
pricingmodels recognize the dilutive effectof employee options. Third,mark-to-market
accounting for outstanding options does not quite avoid the need for forecasting. To the
extentthat future optiongrantsare predictable, the optionvalue to be givento employees
as compensation at grantdateandamortized to income mustbe anticipated. Thisis a tricky
matter. But,if a firmrecognizes grant-date expense, the expense willbe included in GAAP
profitmargins thatcan be extrapolated to the future, leaving the analyst onlywiththe task
of marking the optionoverhang to market.
Mark-to-market methods essentially restate the bookvalueon the balancesheet for an
omittedliability. Mark-to-market accounting canbe applied to othercontingent liabilities.
Apply the procedure above to incorporate outstanding putoptions onthe firm's stock,warrants,and otherconvertible securities intoa valuation. Forcontingent liabilities from lawsuits,deductthe present valueof expected lossesto be incurred. The contingent liability
footnote provides (sparse) information abouttheseliabilities.
ENTERPRISE MULTIPLES
In the example of leverage effectsin Table 13.5 you will havenoticed that the PIBratio
increased withthe increase in leverage, from1.2to 1.33. You alsowillhavenoticedthat the
PIE ratio decreased withthe increase in leverage in Table 13.6,from 10to 8. Yet, in both
1 Foran application, see F. Li and M. Wong, "Employee Stock Options, Equity Valuation, and the Valuationof Option Grants Using a Warrant-Pricing Model. Journal of Accounting Research, March 2005,
pp.97-131.
N
cases, the valueof the equitydid not change. Thissuggests that wemightbe betterserved
to thinkofPIB and PIEratioswithout the effectofleverage.
v,E
_,_
V NOA _ VONFO
O
eSE,
NOA-NFO
If the net financial obligations are measured at marketvalue, theydo not contribute to the
pr:miumoverboo.k value; the difference between priceandbookvalueis dueto net operanngassetsnotbeingmeasured atmarketvalue. Yetthe expression heretellsus thatthe PIB
ratio willva;r as the ~n:ount o.f.net financial obligations changes relative to the operating
assets. That IS, the ratio IS sensitive to leverage. So differences in firms' PIB ratioscan derivefromtheirfinancing eventhoughpriceequalsbookvaluefor financial items.
To avoid this confusion we shouldfocus on the valueof the operations relative to their
book value. The ratio of the value of the net operating assets to their book valueis the
enterprise PIB ratio or the unlevered PIB ratio:
. PIB,'
Valueof net operating assets
En,erpnse
ra 10 =
Netoperating assets
= VONOA
NOAa
The value of the net operating assets is, of course, the value of the equity plus the net
financial obligations. So, to calculate a market (traded) enterprise PIB, just add the net
financial obligations to the marketvalueof the equity.
The standard price-to-book ratio for the equityis referred to as the levered PIB ratio.
Thetwo PIB ratiosreconcile as follows:
Levered PIBratio = Enterprise PIB ratio
+ [Financial leverage x (Enterprise PIB ratio- I)]
v,E
eSE,
V;NOA
_,-=~a_+FLEV
NOA,
( V;NOA
_'
NOAa
(13.10)
1)
where FLEV is bookfinancial leverage (NFOICSE), as before. The difference between the
two PIB ratiosincreases with leverage and the distance that the unlevered PIB is fromthe
normal of 1.0.Foran unlevered PIB of 1.0,the levered PIBis also 1.0regardless of leverage.Figure13.2A showshowthe levered PIB ratiochanges with leverage for six different
levels of the unlevered PIB ratio. The conversion chart in Figure 13.2B chartsunlevered
PIB ratioscorresponding to levered PIB ratiosfor different leverage levels.
Thelevered PIB ratiois the onethatis commonly referred to.But it is theenterprise PIB
on which we should focus. Reebok's levered PIB before its large stock repurchase and
change in leverage (in Box 13.4) was 3.3, but immediately after it was 6.3.This change
d~es notreflect a changein the expected profitability of operations or a change in the prermum one wouldhave paid for the operations. It's a leverage-induced change: Reebok's
e~terprise PIB remained the sameat 3.0.Andthestockpricewasunchanged at about$36;
this repurchase and financing transaction had no effecton shareholders' per-share value,
and thisis also indicated by no changein the enterprise PIB ratio.
468 Part Three Foreca.sting and Valuation Ana!)">i!
Chapter 13 TheVaJue ofOperations and meEvaluation of Emcrpri5e Price-w-Book Ratiol and Price-Eamings Ratios 469
Levered PIBversus Financial Leverage
FIGURE 13.2A
Levered PIBRatios
and Leverage
The figure shows how
the levered PIB ratio
(VEICSE) changes
with financial leverage
for different levels of
unlevered PIB
FIGURE 13.28
Levered PIBand
7.0
VNOA/NOA = 3
6.0
Levered versus Unlevered PIB
Unlevered PIB Ratios

Thefigure shows how
the levered PIB ratio
(VEICSE) and the
30
T------------------------------------i~,~:~-,~~ ,~~--
25 ~------------------------------------0
-'"'
,"'~_
-- -
~';;
unlevered PIB ratio

yNOA/NOA =2.5
5.0
(VNOAfNOA) relate for
2.0
different levels of
financial leverage
(VNWt./NOA).
(FLEV).
G 4.0
15
yNOA/NOA =2
Q
"J
::
~
3.0
2.0
yNOA/NOA =1.5
Ii
10
0,0
1.0
~.5i
0.0
0.3
0.5
0.8
l.0
15
18
2.0
-- -- ---- -- --- --- ----------- ------- ------- --- -- -----
I
2.3
----------------- ----- - --- --- - ---- ---- ----- - -------- ----
13
15
VtiOA/NOA= I
2.0
Leverage (NFOfCSE)
vE VNOA
(VNOA)
CSE = NOA + FLEV NOA - I
Unlevered PIB W",oA/NOA)
CSE
Figure 13.3 plots the median levered andunlevered price-to-book ratios for u.s. firms
from1963 to 2003. When unlevered PIB ratios were around 1.0in the mid-1970s, so were
the levered ratios. But when unlevered PIB ratios were above 1.0, the levered PIB ratios
were higher thantheunlevered ratios, themoreso thehighertheunlevered PIB.
Enterprise Price-Earnings Ratios

The PIE ratio commonly referred to prices earnings after net interest expense, so it is a
levered PIE. A levered PIEratioanticipates earnings growth. However, earnings growth
is affected by leverage, and anticipated growth from leverage is not growth to be valued
because it creates no abnormal earnings growth. So it makes senseto think of a PIEratio
in terms of growth in earnings from operations. The enterprise PIE ratio or unlevered
PIE ratio prices the operating income on the basis of expected growth in operating
income.
Theforward enterprise PIEis thevalue ofthe operations relative toforecasted one-yearaheadoperating income:
Forward enterprise PIE
Value of operations
= VoNOA
Forward operating income
011
FIGURE 13.3
Median Levered and
Unlevered Price-to-
2.50
I -.. . - PIBlevered
,
-,
=-
- - PIB unlevered
VNOA
(V~WA)
NOA + FLEV NOA - 1
-",
; "
,
,," ,,,
,,
,
BookRatiosfor U.S.
Firms, 1963-2003
.'
s<'lUrcO:
\,
Stand,rd& Poor's
CompU\t:lI~ d.l:l
100
-t-----+-----,;==..-"='-----------------
.50
-t--------'------------------
.00
~
-o
-c
'"
-o
~
~
e~
r-.
e--
'"
r~
00
00
:,:
o-:
00
e,
~
~
e-
e!
~
~
:;
0
N
s
0
N
Chapter 13 TheValue of Operations and the El'01uation of Emerprise Pnce-ro-Bock Ratios and Price-Earnings Ratios
470 Part Three Forecll.Iring andValllQ.::ion Anal1sis
The value of the operations is the value of the equityplusthe net financial obligations.
In Table 13.6, the forward enterprise PIE is the valueof the operations, $1,500million
relative toYear 1 operating income of $135million, or 11.1 L This PIE doesnot change
withthe increase in leverage inTable 13.6,whereas the levered PIE drops from 10 to 8
despite no change in operating income growth. The dropin the levered PIE reflects an
increase in the required returndue to leverage, but not a change in the pricewe would
payfor growth.
The enterprise PIE in theTable 13.6 example is a normal PIE, for abnormal operating
income growth aftertheforward yearis forecasted to be zero. Indeed, the normal forward
PIE for a 9 percent required return is 1/0.09 = 11.11. Onewould payhigherthan 11.11
times forward earnings only if abnormal growth in operating income were forecasted.
Nike's forward enterprise PIE (from Table 13.4) is 33,16511,800 = 18.4, which is higher
than the normal PIE for a required -return of 8.6 percent for operations (that is, 11.6)
because abnormal operating income growth is forecasted: Thechange in leverage withthe
Reebok stock repurchase increased forward earnings from 2.30to 2.56 (in Box 13.4) and
reduced the forward levered PIE from 18.8 to 16.9, but with no effect on the value per
share. Theenterprise PIE did notchange.
The trailingenterprise PIEcompares the value of the operations to current operating
income. There is an adjustment, however. Just as the levered trailing PIE must be
cum-dividend (with dividends added tothenumerator), somusttheunlevered PIE. Thedividend from operations is thefree cash flow, so
Trailing enterprise PIE =
Fora given borrowing cost, youcan set up conversion charts like those forenterprise and
levered PIB ratios in Figures 13.2A and 13.2E. Figure 13.4 plots median levered and
unlevered trailing PIE ratios from 1963 to 2003. Typically, levered PIE ratios arelessthan
unlevered ratios.
Thefonn of therelationship between levered andunlevered PIB ratios and PIE ratios is
familiar: Thelevered amount is the unlevered amount plusa premium thatdepends on the
leverage and a spread. We saw this in the relationship between levered and unlevered
accounting returns and required returns. Table 13.7 summarizes the leverage effects we
have discussed inthischapter.
FIGURE 13.4
I.....- PIElevered
25.00
Price-te-Eamings
Ratiosfor U.S. Firms,

1963-2003
Source:
20.00
15.00 +--'Ci--/----'-....c-'c\--------,....----]'---lC---~-
St:lndml& 1'oor's
Compust;Jl> data
Value of operations + Freecashflow

. .
Current operatmg income
v,NOA
_0
= _0
_ _ + ELEV (V,NOA
OIl
011
10.00
+-----fl-"F'=7+---------,,
.,, ,,.. ....... ....

~
1
_ )
NBC j
5.00
-f-------''--------------
.00 i i i i i i i i i i
i i i i i i i i
~
~
n
~
n
~
G ~
~
e- ~
~
~
~
r-. 00
Eamo
V. NOA + FCFo
(.V,,,-oN_OA---,-+"-F=CP,,,o
o
+ELEVo 010
010
_I-I)
NBC o
i i i i i i
n
00
00
00
i I I i i i I i i i i I i I I
~
00
~
~
""""" """""""""""""
TABLE 13.7 Relationships between Leveredand Unlevered Measures
Earnings leverage is the extent to which netfinancial expenses affect earnings: ELEV ;::
NFElEamings, andNBCis the net borrowing cost.Thinkof thetermsin parentheses as
their reciprocals, operating income yield and the net borrowing cost. If the operating
income yield, OIINoNOA, is higher than the borrowing cost, the levered PIE is lower
than the unlevered PrE, with the amount of the difference depending on the amount of
earnings leverage, ELEY. Thetworatiosarethe samewhen theoperating earnings yield
is equal to the net borrowing cost.When the unlevered PIE is particularly high(because
a lot of operating income growth is expected), the levered PIE is higherthan the unlevered PIE.
Thetwotrailing PIE ratios reconcile in a similar way:
Vf +do
t\--B:-------------.--,---.,--{,-
Levered forward PIE;:: Unlevered PIE + [Earnings leverage

(13.11)
x (Unlevered PIE -llNet borrowing costf]
Barn,
---- PIEunlevered
Median Levered and

Unlevered Trailing
Thevalue of the operations is reduced by free cashflow (paidout to thefinancing activities)so,as thevalue ofthe operating income is independent of thecashpaidout,free cash
flow mustbe added tothenumerator.
Theforward levered andunlevered PIE ratios reconcile as follows:
v,E
_0_
471
(13.12)
Concept
Profitability
Levered
Measure
. ROCE
Unlevered
Measure
Relationship
RNOA
ROCE = RNOA + FLEV (RNOA CNBC)
V'
Cost of capital
p,
p,
Pf;::PF+~E(P~-PO)
PIB ratio
VtlCSEo
V~oAINOAo
\.olr0A _NFOo ( VO'lOA

)
1
CSE, = NOA o + CSE, NOAo -
Forward PIE ratio
VtlEarnl
VSW A/Ol1
_o~~~
Trailing PIE ratio
vt +do
VJ'OA + FCFo
Eamo
O.
vt _
V' = _0_
I!.t'0A + ELEV
. (VNOA
_0_. _ _1_
1
Earnl Olt'
_all NBC1
Vo! +do VoNOA+FCFo +ElEV VoNOA+FCFo

1 1)
o(
Eamo
01 0
o,
NBc"
,; 8
0
0
~
Chapter 13 TheValue of O~rations andthcEt",hl(ltioll ofEnlerprise Price-tv-Book Ralios and Pric~-Eamings Ratio> 473
472 Part Three Forecastingand Valuatian Analysis
Summary
To the extent that accountants get the balance sheetcorrect, the analyst does not haveto
make a valuation. If,intheextreme, thebalance sheetwere perfect-giving thevalue ofthe
equity-the analyst would havenothing to do;the accountant would have done the valuation.Balance sheets aretypically not perfect, so the analyst hasto forecast to getthe missing value. But to the extent that the balance sheetgives the value, the analyst can avoid
forecasting.
This chapter has introduced valuation approaches that recognize the balance sheet
values of net financial items as approximating theirmarket values, but recognize thatbalancesheetamounts for netoperating assets aretypically nottheirvalues. Accordingly, valuation is based on forecasting residual income or abnormal earnings growth from operations. Thevaluation gives thevalue oftheoperations, andthevalue of theequity isthenthe
value of theoperations lessthe balance sheetvalue of the netdebt(or the fairvalue of the
netdebt inthe fair-value footnote).
Find thefollowing ontheWeb page forthis chapter:

Further explanation of residual operating income
methods.
Further explanation of abnormal operating income
growth methods.
Afurther demonstration oftheequivalence ofresidual
earnings valuation and residual operating income valuation (and thecost ofcapital adjustments required).
Demonstrations of how leverage affects ROCE, earnings growth, and valuations.
Key Concepts
More discussion of stock repurchases and their effect

onvalue.
More coverage of levered and unlevered PIB and PIE
ratios.
Further examples oftheoption overhang.
Demonstration of how residual earnings valuation
methods can beapplied totheimpairment ofgoodwill.
Look at theReaders' Corner.
Ifthenetdebtonthebalance sheet isclose toitsfairvalue, theappropriate way ofthinking

of a book value multiple is in terms of theunlevered orenterprise price-to-book ratio, thatis,
thepricing ofthe netoperating assets rather than theequity. Thechapter haslaidoutthecalculation of theenterprise price-to-book ratio andhasshown how it relates, through leverage,
tothelevered price-to-book ratio.
Thischapteralso focused on enterprise price-earnings ratios. It recognized thatstandard PIE ratios-levered PIE ratios-are basedon prospective earnings growth that incorporates growththat is createdby leverage. Yet, growth from leverage is not valued.
Levered PIE ratioschange withleverage, evenif leverage has no effecton equityvalue.
Theanalysttherefore pricesgrowthfrom operations withan enterprise or unlevered PIE
ratio.He is thus protected frompayingtoo muchfor earning growth.
We always want to carry out valuations efficiently. The residual operating income valuationapproach andthe abnormal operating income growth approach bothreduce the forecasting taskon which wewillembark in thenexttwo chapters. Only the operating components of comprehensive income andthenetoperating assetcomponent onthebalance sheet
need to be forecasted. Further, in converting forecasts to a valuation using a required
return, one can ignore changes in required returns that are due to changes in financial
leverage.
book leverage is the book value of net

financial obligations relative to the
book value of common shareholders'
equity. 453
effective cost of debt is theafter-tax cost
of borrowing. 451
enterprisevalueis thevalue of the
operations. 444
financing risk is theriskshareholders have
of losing value in borrowing andlending
activities. 453
levered price-earningsratio is theprice
multiple thatprices (net) earnings.
Compare withunlevered prlce-earnlngs
ratio. 468
levered price-to-book ratio is the
price multiple of common equity.
Compare withunlevered price-tobookratio. 467
Analysis Tools
'.,
; f
;t
0;1

valuation model
(equation 13.4)
Abnormal operating income
growth model
(equation 13.6)
Weighted-average cost of
capital0NACC)
(equation 13.7)
Effective costof debt
Equity costof capital
(equation 13.8)
Valuation andleverage
Valuation andstock
repurchases
Valuation andstock options
Levered and unlevered
price-to-book (PIB) ratios
Levered and unlevered priceearnings (PIE) ratios
Page Key Measures
market leverage is financial leverage

measured bytheratioof the value of net
financial obligations to the value of
common equity. 453
operating risk is theriskshareholders and
bondholders have of losing value in
operations. 453
pure equity firm is a firm with nonet
debt. 453
unlevered price-earningsratio or
enterprise price-earnings ratio is the
pricemultiple thatpricesoperating
income. Compare with levered priceearningsratio. 468
unlevered price-to-book ratio or
enterpriseprice-to-book ratio istheprice
multiple of netoperating assets. Compare
with levered price-to-book ratio. 467

growth(AOIG)
444
449
451
451
After-tax costofdebt
Earnings leverage (ELEV)
Levered PIE
levered PIB ratio
Market leverage
Residual netfinancial expense
(ReNfE)
456
464
467
468
443

(ReOI)
453
453
448
451
470
468
467
453
Unlevered PIB ratio

Unlevered PIE ratio
Weighted-average cost
of capital0/VACC)
443
467
468
451
AOIG abnormal operating

income growth
CAPM capital assetpricing model
equity
CV continuing value
ELEV earnings leverage
fA financial assets
fCf free cash flow
flEV financial leverage
NBC netborrowing cost
NfE netfinancial expense
NfO netfinancial obligations
01 operating income
ReNFE residual netfinancial
expense
assets
WACC weighted-average cost
ofcapital
474 Part Three
For~C<l5fing all<! Valuation
Ana!;;sis

A Self-8tlldy Exercise
In the next chapter you wilt beginto develop a valuation of KtvIB's sharesbased on the
analysis work youhave done tothispoint. Inpreparation, expand youranalysis oftwoyears

of income to a full six years. The income statements for the threeyears2002-2004 are in
the continuing casefor Chapter 2, and youhave thoroughly analyzed thosefor 2003-2004
in Chapters 9-12. Below are the income statements for 1999-2001, alongwithsomesupplemental Information on the finn's net pension expense and the operating cash flow
section of thecashflow statement forthose years. Alsogiven isa summary ofthefirm's net
operating assets and net financial obligations for 1998-2001.
Your task is to track Kimberly-Clarks residual operating income over the years
1999-2004. Alsocalculate abnormal operating income growth overtheyears. Thishistory
will giveyou some insight into the likely path in the future. To do this, you will haveto
identify after-tax operating income for all years. You will alsohave to estimate the costof
capital foroperations.
THE COST OF CAPITAL FOR OPERATIONS

Follow the procedures in Box 13.2. Strictly the cost of capital should be reestimated each
year, butthisis a verystable finn,so make thecalculation for2004andapplyit to all years.
Calculate themarket valueofthe equity on thebasisoftheper-share stockpriceof$64.81
in early2005 (see the Continuing Case for Chapter 1).You calculated the equitycost of
capital, basedon a betaof 0.88, in theContinuing CaseforChapter 3. Thefirm's debtfootnoteindicates a weighted-average borrowing rateof 5.77 percent (before tax). Be skeptical
of thesecalculations. SeeBox 13.3.
TRACK THE DRIVERS OF RESIDUAL

OPERATING INCOME
How muchof thechange in residual operating income overtheyearsis dueto profitability
(RNOA) andhow muchtogrowth innetoperating assets? Examine theeffect ofsales growth.
How muchofoperating income growth comes fromcoreoperations? Compare thegrowth in
coreoperating income withthegrowth inearnings pershare. Whyaretheydifferent?
THE 2005 STOCK REPURCHASE

The$1.6billion stockrepurchase in2004wasa significant event. Whateffectwillthishave
on future operating profitability, returnoncommon equity, andearnings-per-share growth?
Whateffectwould the repurchase have on the value per share?
OPTION OVERHANG
The stockoption footnote indicates that thereare 31.720 million employee stockoptions
outstanding at the end of 2004 with a weighted-average exercise price of $55.57. The
weighted-average value of these options is estimated at $16.25. Calculate the after-tax
option overhang.
Chapter 13 The Value of Operalions and (he Eva1wllion of Emerpril"~ Price-co-Book Rarios and Price-Earning> Rarios 475
ENTERPRISE P/B AND PIE RATIOS

Calculate thelevered andenterprise price-to-book ratiosinearly2005 whenthe stockprice
was$64.81. Alsocalculate the levered andenterprise trailing PIEratios. (KMB's 2004dividendwas $1.60per share.) Showthat the levered and unlevered multiples reconcile according to standard formulas.
Consolidated Income Statements

(Millions of dollars, except per-share amounts)
Net sales
Gross profit
Advertising, promotion and selling expenses
Research expense
General expense
Goodwill amortization
Other (income) expense, net
Operating profit
Interest income
Interest expense
Income before income taxes
Income before equity interests
Share of net income of equity companies
Minority owners' share of subsidiaries'
netincome
Netincome
Net income pershare
Basic
Diluted
2001
2000
1999
$14,524.4
8,615.5
5,908.9
2,334.4
295.3
767.9
89.4
83.7
2,338.2
17.8
(191.6)
2,164.4
645.7
$13,982.0
8,228.5
5,753.5
2,122.7
$13,006.8
7,681.6
5,325.2
2,097.8
249.8
707.4
41.8
(207.0)
277.4
154.4
742.1
81.7
(104.2)
2,633.8
24.0
(221.8)
2,436.0
758.5
1,677.5
186.4
(63.2)
$ 1,609.9
(63.3)
$ 1,800.6
2,435.4
29.4
(113.1)
2,251.7
730.2
1;5215
189.6
$ 1,668.1
3.04
3.02
3.31
309
Consolidated Cash Flow Statement (cash from Operations Section)
Operations
Net income
Depreciation
Deferred income taxprovision
Netlosses (gains) on assetdispositions
Equity companies' earnings inexcess of
dividends paid
Minority owners' share of subsidiaries'
net income
Increase inoperating working capital
Postretirement benefits
Other
Cash provided byoperations
2001
2000
1999
$1,609.9
650.2
89.4
39.7
102.0
$1,800.6
591.7
81.7
84.1
19.3
$1,668.1
586.2
41.8
126.2
(143.9)
(39.1)
(67.0)
(78.7)
63.2
(232.6)
(54.7)
63.3
(338.3)
(121.9)
.....Ji&
--1ll.
2 253.8
-'JJll
43.0
(61.5)
(43.1)
__
'._8
2 139.9
(continued)
Chapter 13
476 PartThree Fom:ll.lting andValuation AnalYlil
e13.11.
Net PensionExpense
Pension Benefits
Components of net periodic
Benefit cost
Service cost
Interest cost
Amortization of priorservice cost
Amortization of transition amount
Recognized netactuarial loss (gain)
Curtailments
Other
Net periodic benefit cost (credit}
C13.12.
2001
2000
1999
$ 65.4
$ 63.4
$ 733
266.8
(368.1)
8.6
(4.4)
4.5
(1.4)
263.6
(397.6)
9.1
(4.4)
(20.2)
-----'CQ.
__
'._0
I (85.1)
$ (19.6)
Th~
e13.13.
251.1
(352.8)
9.5
(4.6)
4.8
18.0
6.1
I 5.4
C13.14.
CI3.1S.
Val!U of Operations and the Evaluarion of Emerprise Pricc-IO-Book RaliOs and Price-Eaming; RanOl 477
Levered price-to-book ratios are always higher than unlevered price-to-book

ratios. Is thiscorrect?
During the 1990s and 2000s, many firms repurchased stockand borrowed to do
so. What is the typical effect of stockrepurchases on earnings-per-share growth
and return on common equity? Predict how a firm that excessively engaged in
thesepractices would have fared in thedownturn in 2008.
If an investor wants to buy a stock with high earnings growth but with low risk,
she mustpay a highmultiple of earnings for it. Correct?
Doesan increase infinancial leverage increase ordecrease the(levered) PIE ratio?
Established firms, likeGeneral Electric, have lowbetarisk, lowearnings volatility,
but consistently highearnings growth rates. These firms should have particularly
high PIEratios. Correct?
Balance Sheet Summaries
Netoperating assets
2001
2000
1999
1998
9,769
4,122
5,647
9,354
3,587
5,767
7,745
2,652
5,093
6,814
2,782
4,032
Exercises
Drill Exercises
E13.1.
Herearesummary financial statements fora firm(inmillions of dollars):
CI3.1. If assets are at fair market value in the balance sheet, the income reported from
those assetsintheincome statement does notgiveanyinformation about thevalue
of the assets. Is thiscorrect?
C13.2. If assets aremeasured at theirfair(intrinsic) value, theanalyst mustforecast that
residual earnings fromthose assets will bezero.Is thiscorrect?
C13.3. Why might the market value of the assets of a pure investment fund that holds
onlyequity securities not be anindication of the fund's (intrinsic) value?
C13.4. What drives growth in residual operating income?
CllS. Canresidual operating income increase while, forthesameperiod, residual earningsdecrease?
C13.6. Explain whatis meant by a financing risk premium in the equity cost of capital.
When willa financing riskpremium be negative?
C13.7. A firm withpositive net financial assets willtypically havea required returnfor
equity that is greater than the required return for its operations. Is this correct?
C13.8. What is wrong with tyingmanagement bonuses to earnings pershare? Whatmeasurewould youpropose as a management performance metric?
C13.9. Themanagement of a firm thattiesemployee bonuses toreturn oncommon equity
repurchases some ofthe firm's outstanding shares. What is theeffect of thistransaction on shareholders' wealth?
C13.10. Anincrease infinancial leverage increases returnoncommon equity(if the operatingspread is positive), andthusincreases residual earnings. Thevalue ofequity
is basedon forecasted residual earnings, yet it is claimed that thevalueof equity
is not affected by a change in financial leverage. How is this seeming paradox
explained?
BalanceSheet, Endof 2008
IncomeStatement, 2009
(Minority ;ntercstis included in net nn.ndnl obligations)
Concept
Questions
Residual Earnings and Residual Operating Income (Easy)
Operating income
Interest expense
Netincome
1,400
500
900
Netoperating assets
Financing debt
Common equity
10,000
5,000
5,000
Therequired return forequity is 12percent, therequired return foroperations is II percent,

andtherequired returnfordebtis 10percent. The firm paysno taxes.
Calculate residual earnings, residual operating income, and residual income from
financing activities for2009.
E13,2,
Calculating Residual Operating Incomeand Its Drivers (Easy)

Herearesummary numbers from a finn's financial statements (in millions):
2006
Operating income
Netoperating assets
187.00
1,214.45
2007
2008
2009
200.09
1,299.46
214.10
1,390.42
229.08
1,487.75
The required returnfor operations is 10.1 percent. Calculate residual operating income,
return onnetoperating assets (Rt"\l"OA), andthegrowth ratefor netoperating assets foreach
year 2007-2009.
E13.3. Calculating Abnormal Operating Income Growth (Easy)
Herearesummary numbers from a firm's financial statements (in millions):
2006
Operating income
Netoperating assets
187.00
1,214.45
2007
2008
2009
200,09
1,299.46
214.10
1,390.42
229.08
1,487.75
478 Part Three
For~casrillK and ValtUltiull
Anal)'sis
Chapter 13 The Value ofOperarionl and the E,'<1hwfioll 0/ Emcrprile Pn'ce-ro_Book Ratios and Price-Earning> Rariol 479
The required return for operations is 10.1 percent. Calculate abnormal operating income
growth for eachyear2007-2009.
E13.4.
E13,9.
Residual Operating Income and Abnormal Operating IncomeGrowth (Easy)

Hereare financial statements fora firm (in millions of dollars):
Operating income
Interest expense
Netincome
Whydoesthe stockrepurchase haveno effecton the per-share valueof the equity?

Whydoesforecasted earnings forYear I decrease from$10.00 million to$7.50 million?
Whydoesforecasted EPS forYear I increase whileforecasted earnings decrease?
The required return priorto the stockrepurchase was 10 percent. Whatis the required
returnfor the equityafterthe stockrepurchase?
e. Whatis the expected residual earnings (onequity)forYear I afterthe repurchase?
f. Forecast the valueof the equityat the end ofYear 1 for both the case withno leverage
and the casewithleverage.
g. Forecast the PIEat the end of Year I for both the case with no leverage and the case
withleverage. Whyare theydifferent?
a.
b.
c.
d.
Balance Sheet, End of Year
Income Statement
2009
2008
2,700
800
1,900
2,300
500
1,800
Netoperating assets
Financing debt
Common equity
2008
2007
20,000
10,000
10,000
18,500
6,250
12,250
The firm has a required returnof 10 percent for operations. Calculate residual operating
income for2009and 2008usingbeginning-of-year balance sheetnumbers. Thencalculate
abnormal operating income growth for 2009.
E13,10.
En.5.
Cost of CapitalCalculations(Easy)
U.S. Government long-term bondrate

Market risk premium
Equity beta
Per-share market price
Shares outstanding
Netfinancial obligations on balance sheet
Weighted-average borrowing cost
Statutory taxrate

Common equity
Operating income
Netfinancial expense
Earnings
4.3%
5.0%
1.3
$40.70
58 million
$1,750 million
7.5%
36.0%
Calculating the Required Returnfor Equity(Medium)
ResidualOperating IncomeValuation(Easy)
The following forecasts were made for a firm with net operating assetsof S1,J35 million
and net financial obligations of $720million at the end of2005 (inmillions of dollars):
2006E
2007E
2008E
2009E
187.00
1,214.45
200.09
1,299.46
214.10
1,390.42
229.08
1,487.75
The required return foroperations is 10.1 percent Forecast residual operating income for
theseyearsand, fromtheseforecasts, valuethe operations and the equity.
E13.S,
...J..1
122
a. Calculate the levered PIEratiofor this finn.

b. Calculate the enterprise PIBand PIEratios.
A firm with a required returnof 10percent for operations has a bookvalueof net debtof
S2,450 million witha borrowing costof 8 percent and a tax rate of37 percent. The finn's
equityis worth $8,280 million. Whatis the required returnfor its equity?
Operating income
$469
236
$233
$ 70
Thefinn heldthesameamount of net financial obligations duringthewhole yearforwhich

theearnings were reported. Theequityofthis firmtrades at a PIB ratioof2.9.Thefinn pays
no dividends.
Explain whythe costof capitalfor operations is different from that forequity.
E13.7.
levered and Unlevered P/B and PIE Ratios(Easy)

A fum has the following summary balance sheetand income statement (in millions):
From the following data, calculate the cost of capital for operations (WACC). Use the
capital assetpricingmodel to estimate the cost of equitycapital.
E13.6.
Growth, the Costof Capital,and the Normal PIE Ratio (Hard)

Box 13.5in thischapter demonstrated how stockrepurchases and leverage changes can increaseearnings-per-share growth. Answer the following questions regarding the effectof
thestockrepurchase.
Abnormal Operating Income Growth Valuation(Easy)

Using the forecasts in Exercise E13.7, forecast abnormal operating income growth and,
from theseforecasts, valuethe operations andthe equity. Therequired return foroperations
is 10.1 percent.
E13.11.
levered and Unlevered PIE Ratios (Medium)

The following pro forma waspreparedfor a finn at the end of2009 (inmillions of dollars):
Netoperating assets
Operating income
Earnings
2009A
2010E
2011E
1,300
300
1,000
1,300
300
1,000
135
15
120
1,300
300
1,000
135
-l2
120
20UE
1,300
300
1,000
135
15
120
The firmhas a required returnfor its operations of9 percentand a 5 percent after-tax cost
of debt. Pro forma financial statements after 2012are forecasted to be similarto those in
2012.
a. Forecast the valueof the operations andthe valueof the equity at theendof years2010
to 2012.
b. Forecast the levered and unlevered PIEratios at the end of years2010to 2012. Make
calculations forboththe expected trailingPIE and the forward PIE.
c. Canyouinferthe required returnfor equityfromthe levered PIE ratios?
480 Part Three
F(lr~Ca5lillg lllld Vlllulllioll
Chapter 13 Th..' Vllrtl~ ofOperations amithe EmlU{lliOll of Emerprile Price-EO_Bool! Ratio'! nnd PriceE1lTIling'l Rmiol 481
Al1111ysil
c. Enterprise price-to-bock at theendof2008.

d. Trailing enterprise PIE at theendof2008.

Thisexercise builds on theexamples inTable 13.5 andTable 13.6.
Doyoufeel comfortable using the 5.8percent required return from Box 13.2?
Applications
E13.12.
In 1993, SunTrust Bank of Atlanta reported investment securities on its balance sheet of
$10,644 million, anincrease over the$8,715 million reported for1992. Footnotes revealed that
most ofthesecurities were interest-bearing debtsecurities. But$1,077 million ofthe 1993 securities were shares held intheCoca-Cola Company, carried atmarket value. In1992, thebank
hadcarried these securities onthebalance sheet attheirhistorical cost of$110million.
Which carrying value for theCoca-Cola shares doyousee as thebetterquality number,
themarket value or thehistorical cost?
E13.13.
The Quality of Carrying Valuesfor EquityInvestments:SunTrust Bank (Easy)
SeeExercises El.5, E2.9, EJ.9,E4.9, E6.8, EIO.9, E14.8 andE15.l0.
E13.16.
Using Market Values in the Balance Sheet: Pennzoil (Easy)
Pennzoil (now PennzEnergy Corporation), the oil company, has a substantial holding of
Chevron Corporation, another oil company. But the holding (of 7.1 million shares at the
endof 1998) is lessthan20percent of Chevron. TheChevron shares areclassified as available for sale, so are carried at fair value on the balance sheet, withincome recognized as
dividends received plus unrealized gains or losses on the investments. PennzEnergy reported the following for 1998 (inthousands):
Further Dell Exercises are in E3.7, 3.14, E5.11, E8.12, andE19.4. Minicases MIO.l and
M15.2 cover Dell also.
Dividend income
Unrealized gains onsecurities
E13.17.
Investment inChevron Corporation
134,026
36,373
Balance Sheet

Accumulated
Cost
Estimated
Fair Value
Unrealized Gains
1238,847
1588,228
1349,381
Enterprise Multiples for IBM Corporation (Easy)

IBM's 1,385.2 million outstanding shares traded at$102eachwhen its2007 financial statements were published. Those statements reported common shareholders' equity of$28,470
million andnetfinancial obligations of$19,619 million. Footnotes reveal thatthefinn'snet
borrowing cost(after tax) is 3.3percent.
a. Calculate the levered price-to-book and enterprise price-to-book ratios at the time.
What explains the difference between the two multiples?
b. Analysts were forecasting earnings pershare of $8.73 for2008. Calculate the forward
levered PIE andforward enterprise PIE ratio.

Exercises E6.9andE14.11 dealwithIBM, as do Minicases M8.1 andM12.3.
Residua! Operating Income and Enterprise Multiples: General Mills, Inc. (Easy)
Reformulated balance sheets and income statements for General Mills's 2008 fiscal year
are in Exhibits 9.5 and 9.11 in Chapter 9. The firm's 337.5 million outstanding shares
traded at $60 eachat the time the 2008 statements were published. Fromthesefinancial
statements, calculate thefollowing forfiscal year2008:
a. Freecashflow.
b. Residual operating income basedOn beginning-of-year balance sheet numbers. Use a
required return foroperations of5.8 percent (thenumber in Box 13.2).
2004
2003
4,551
289
4,330
(302)
IncomeStatement
2004
Operating income
961
16
a. Calculate the levered and unlevered (enterprise) price-to-book ratios at which Nike
traded at theendof fiscal year 2004.
b. Calculate residual operating income for 2004 using beginning-of-year balance sheet
amounts.
c. Calculate return onnet operating (RNOA) assets for2004.
d. With this RNOA, forecast operating income and residual operating income for2005.
Usea required return of 8.6percent for operations.
e. Calculate the value of a Nike shareifthe residual operating income youforecasted for
2005 is expected to grow at a 4 percent annual rateafter2005.
Outline howyouwould incorporate thesenumbers ina valuation of PennzEnergy.
E13.15.
Residual Operating Income Valuation, Nike, lnc.,2004 (Medium)

Attheendof its2004 fiscal year, the263.1 million outstanding shares of Nike, Inc., traded
at$75each. Thefollowing summary numbers arefrom the2004 financial report {inmillions
of dollars}.
In itsfair-value footnote thecompany gave thefollowing information (in thousands):
E13.14.
Calculating Residual Operating Income:Dell, Inc.(Medium)

Dell, Inc., reported after-tax operating income of$2,618million forfiscal year 2008, along
withoperating assets at thebeginning of theyearof$13,230 million andoperating liabilitiesof$20,439 million.
Using a cost of capital foroperations of 12percent, calculate Dell's residual operating
income for theyear. Describe, inwords, how Dellgenerated value during theyear.
E13.18.
Valuation of Operations: Nike, lnc.,2005(Medium)

Thefollowing summary numbers (in millions of dollars) were calculated from Nike's 2005
balance sheet:
Common equity (261.1 million shares outstanding)
4,632
1.012
~
Analysts were forecasting $5.08 in earnings per share for2006. Nike's after-tax return on
its net financial assetsis 3.2 percent and its required return for operations is 8.6 percent.
a. What return on net operating assets(RJ'iOA) are analysts implicitly forecasting for
2006'
b. Value a share ofNike ontheassumption thattheforecasted 2006RNOA will continue
indefinitely andresidual operating income (ReOI) andnetoperating assets will grow at
4 percent peryear.
Chapter 13 Tile Value ofOperatiOl!S mid theEvalHation of Emerprile Price-to-Book Ratios andPrice-Eamings Ratios 483
482 Part Three Forecasting and Valuarioll Anal)lis
c. Repeat thevaluation from forecasts ofabnonnaloperating income.

d. What is thevalue ofNike'soperations withthese forecasting assumptions?
e. If forecasted RNOA is expected tobeconstant inthefuture, how canresidual operating
income grow?
f. Calculate Nike's levered forward PIE and its enterprise forward PIE. Show how they
relate to eachother. Explain why one ishigher thantheother.
g. In thepressrelease announcing 2005 results, Nikemade the following statement:
During the fourth quarter, the Company purchased a total of 1,853,500 shares fo~ .
approximately $1 52.7 million inconjunction with the Company's four-year, $1.5 billion
share repurchase program that was approved by the Board of Directors inJune 2004.
To date,the Company has repurchased a total of 6,924,400 shares under this program.
Discuss how the stock repurchases will affect forecasts of future operating income and
earnings per share.

Exercises E2.14, E6.7, E8.1J, EIJ.l7, EI5.11, EI5.1J,E18.J andE19.4 deal with Nike as
doesMinicase M2.1. Also see the coverage of Nike in the BYOAP feature on the book's
Web site.
E13.19.
Stock Repurchases: Expedia,lnc. (Medium)

InJune2007, theWeb travel firm Expedia, Inc., announced thatit would buybackasmuch
as 42 percent of itsshares, with therepurchase financed bynewborrowings.
a. What is the likely effect on earning pershare andearnings pershare growth?
b. What is the effect onthe riskthatthe shareholders bear?
c. Will therepurchase addvalue toshareholders?To answer, consider thattheshares traded
at a rather highmultiple of26 time analysts' forward earnings estimates at thetime.
d. The finn's proxy statement says that executive compensation is tied to (among other
things) earnings pershare. Is thisa desirable way to reward management?
Minicase
M13.1
Valuing the Operations and the Investments

of a Property and Casualty Insurer:
Chubb Corporation
Chubb Corporation is a property andcasualty insurance holding company providing insurance through itssubsidiaries intheUnited States, Canada, Europe, andparts ofLatin America
and Asia. Its subsidiaries include Federal, Vigilant, Pacific Indemnity, Great Northern,
Chubb National, Chubb Indemnity, andTexas Pacific Indemnity insurance companies.
The insurance operations are divided into three business units. Chubb Commercial
Insurance offers a fullrangeof commercia! customer insurance products, including coverage for multiple peril, casualty, workers compensation, and property and marine. Chubb
Commercia! Insurance writes policies for niche business through agents and brokers.
Chubb Specialty Insurance offers a widevariety of specialized executive protection and
professional liability products for privately andpublicly owned companies, financial institutions, professional firms, andhealth careorganizations. Chubb Specialty Insurance also
includes surety and accident businesses, as wellas reinsurance through Chubb Re.Chubb
Personal Insurance offers products for individuals withfine homes and possessions who
require more coverage choices andhigher limits thanstandard insurance policies.
Before proceeding withthis case,youshould understand how insurers "makemoney."
Insurance companies rununderwriting operations where they write insurance policies and
processes and pay claims on those policies. The delay between receipt of premiums and
payment of claims produces a "float,' so they are also involved in investment operations
where theymanage investments inwhich thefloat is invested. Accordingly, youseeboth investment assets andliabilities onthebalance sheetaswellas assets andliabilites associated
withinsurance. You also see revenues and expenses associated withboth activities in the
income statement.
A frequently usedmeasure of property and casualty insurance underwriting results is
thecombined lossandexpense ratio. Thisratioisthesumofthe ratioof incurred losses and
related lossadjustment expenses to premiums earned (theloss ratio) andthe ratioof underwriting expenses to premiums written (theexpense ratio), afterreducing bothpremium
amounts by dividends to policyholders. When the combined ratio is under 100percent,
underwriting results are generally considered profitable; when the combined ratio is over
100percent, underwriting results aregenerally considered unprofitable.
Chubb's ratios for years2001-2007 are below. In theirdiscussion of results for 2007,
management noted that underwriting results were significantly moreprofitable in 2007 and
2006 compared with2005. Thelossratio for2005wasattributed to catastrophic losses primarily from Hurricane Katrina. The lower results in 2003 were due to large asbestos and
toxic waste claims, butevenexcluding these, the combined lossand expense ratio would
have been97.5 percent. The200I ratiowasaffected byclaims arising from theSeptember 11
attack in NewYork andsurety bondlosses relating to theEnron ban kruptcy. Without these
claims, thecombined ratiowould have been100.5 percent.
484
Part Three
Forecasting andValiwrion Analysis
2007
2006
2005
2004
2003
2002
2001
loss ratio
52.8%
55.2%
64.3%
63.1%
75.4%
80.8%
Expense ratio
Combined ratio
2Q,L
29.0
84.2%
28.0%
92.3%
29.2
67.6%
30.4
92.3%
98.0%
82.9%
...ill- ...RL
106.7%
113.4%
These ratios give a good indication of the profitability of the insurance operations, but
weneeddollar numbers toget to thevaluation implications. Further, theydo notconsider
the performance of the investment operations. Chubb's balance sheets for 2007 and2006
are in Exhibit9.16 in Chapter9 as part of the Chubb case M9.2 there. Its 2007 income
statement is also given, along with a statement of comprehensive income that Chubb
reports outside both theequity statement and the income statement. If you worked case
M9.2, you will havereformulated thesestatements. If not, do so nowbeforeyouproceed.
The reformulation shouldcapture the waythat Chubbcarriesout its business operations,
with the analysisof the profitability of the business in mind. In particular, makesure you
distinguish the underwriting operations from the investment operations. Chubbhas some
relatively small real estateoperations. Groupthese with the underwriting operations. The
firm's statutory tax rate is 35 percent, but note that tax-exempt securities account for
$232millionof investment income.
Chubb's loss and expense ratios indicate that 2007 was a very good year. The stock
price,underthe ticker eB, rosefrom $50 to $54 on theseresults. You are required to carry
out an analysis that challenges this stock price.You do not havethe complete information
thatyouwouldlikefor forecasting, butyou willbe surprisedhowfar you get simply on the
basis of the financial statement information beforeyou.
As you proceed, also dealwiththe following:
A. Calculate the residual income from underwriting operations and from the investment
operations and decide how you will use these numbers for your valuation. Use a requiredreturn of 9 percent for the underwriting operations and 6 percentfor investment
operations. Whywouldthe twooperations havedifferent requiredreturns?
B. Explain howyou dealtwith thefollowing features in your valuation:
I. Investment income
2. Realized investment gains
3. Unrealized appreciation of investments
4. Bookvalueof investments
5. Equityinvestments
6. Net operating assets
7. Taxallocation
C. Insurance companies are suspected of cherry-picking investments. How did you deal
with this?
D. What features of Chubb's accounting-and insurers in general-might giveyou pause
in basingyour valuation on the financial statements?

Minicase M9.2in Chapter9 dealswiththe reformulation on ChubbCorporation's financial
statements.
Chapter 14
~~~~Q~illg on the
Li"kt,pre"'",'h'Pt"D'~~~~&@:lS tatements:
'i:~I~j~~:~~~i~i;'1 's!fNl~tw!~1.t:~recas ting
LrnKS
,"d
..
g~:~~,:~~:"m,m
'. .' J~)(t'(~.\i1t~i'r;/.VI'
~~~, ~;:=1~ ~ uanon
simple valuation models

basedon forecastsof
operatingprofitability and
growth, from information
in thecurrent financial
statements.
Whatforecasts
can bemadeon
the basisof
currentfinancial
statements?
Howcan a
growth forecast
be combined
with information
inthecurrent
financial
statements to
provide a
valuation?
Linkto nextchapter
Chapter 15develops
compbrevaluaticns based
on information both within
and outsidethe financial
statements.
Link to Webpage
Learnmoreaboutsimple
and valuationIforecasting
check out the text
Website at
www.mhhe.comfpenman4e.
In valuation, analysts aimfor simplicity. Theystripaway anyfeatures of thebusiness that

are not involved in value generation. Andif somefeatures are relatively important andothers are of minorimportance, analysts concentrate theirefforts on thosethatare important.
Andtheylookforuseful approximations thatgive a quickbenchmark valuation before proceeding to a morecomplete, but morecomplex, valuation.
In thisspirit,thelastchapter stripped away theforecasting offinancing activities to simplifythe valuation. If the balance sheetmeasures thevalue ofthenetfinancial obligations,
this is appropriate. The efficiencies are clear: Notonlyis the forecasting taskreduced, but
theanalyst doesnot have to dealwithchanges in the discount ratearising from changes in
leverage.
Simplicity comes notonlyfrom fewer factors to forecast, but alsofromusinglessinfermation to makeforecasts. A potentially largeamount of information-from strategic planning, marketing research, theanalysis of production costs, andan assessment oftheviabilityof R&D, to name a few-is involved in forecasting. Ifwe canlimitourselves to a small
setof information thatcaptures muchofthebroader information, yetstillobtain reasonable
value approximations, weare parsimonious in our endeavor. Simple schemes arejustified
if thebenefit from reduced information analysis outweighs the costof having onlyapproximate valuations.
Anchoring-on rhe FinancialSt.'lt~menll; Simple Far~casting and Simple Valuation
487

How simple forecasts yield simple but insightful
Make thethree simple forecasts--SF1, SF2, and SF3valuations.
thatareindicated by current financial statements.
How forecasts can be developed from the current
Integrate sales forecasts into a simple forecast.
Calculate simple valuations from simple forecasts.
How components of income statements combine
Calculate enterprise price-to-book ratios and pricewith components of balance sheets to give a simple
earnings ratios from simple forecasts.
forecast.
Value firms from short-term and long-term growth
How sales forecasts combine with financial statements
forecasts.
to provide simple forecasts.
Use simple forecasting insensitivity analysis.
When simple forecasts andsimple valuations work as
Use simple valuation models inreverse engineering to
reasonable approximations.
challenge market speculation.
How simple forecasting works as an analysis tool in
Use simple valuation models toscreen stocks.
sensitivity analysis.
How simple valuation models work in reverse
engineering.
How simple valuation models enhance screening analysis.
Thischapter develops simple valuations basedonlimited information asaprelude to the

next chapter, which utilizes the full set of information for forecasting. The focus is On
the (limited) information that is available in the financial statements. In many casesparticularly for relatively mature finns-the financial statements aggregate considerable
information andcan be a reasonable indicator of the future. Forexample, coreprofit marginsand assetturnovers in current statements are oftengoodindicators of future margins
and turnovers. The chapter asksthe question: What forecasts and valuations can be made
solely from information in thefinancial statements? In thischapter youwillunderstand that
historical financial statements arenot "backward looking" butverymuchforward looking.
(You willalsogeta senseof thelimitsof theinformation provided byfinancial statements.)
With this in mind, the financial statement analysis of PartTwo of the book-with its emphasis oncoreoperating income as a basisfor forecasting-is set up to elicitthe information in thefinancial statements thatis required for forecasting. It is nowthatyouwillstrike
paydirt from the thorough reformulation andanalysis of financial statements.
The focus of financial statement information has particular importance in fundamental
analysis. The fundamental analyst, you'l1 remember, follows theruleof notmixing whathe
knows withspeculation. Forecasting involves considerable speculation-particularly when
forecasting the "long term" (for a continuing value calculation, for example). Financial
statement information is whatweknow aboutthepresent (subject, of course, to thequality
of the accounting). By isolating this more reliable information, we ensure we do not
contaminate it withmorespeculative, softerinformation. Referto the "building blocks" of
a valuation in Figures 5.5 and6.3 (in Chapters 5 and6) for a reminder. Speculation canbe
added to theforecasting later(inthenextchapter), but let'sunderstand therelatively "hard"
and"soft" inputs to our forecasting and givethe former more weight.
Chapter14 Anchoringon me Financial Seremerus: Simple Forecroling andSimple Valualion 489
488 Part Three Forecroril1g andValtimian AnalYlis
Simple valuations are only approximate-s-and sometimes are not only simple, but
simple-minded. Yet evena simplevaluation can serveas an analysis tool.The chapter will
show that, by reverse engineering simple models, the analyst can compare the market's
implicit forecast of profitability and growth with the forecasts provided in the financial
statements. Simple valuation models also enhance stockscreening. The markets forecast
presumably useswiderinformation, butthe market valuation isa speculation to be checked
against"whatwe know"from the financial statements.
assets (equity investments) at market valueon its balancesheet.The pro forma income
statement usingSF1 forecasts follows, alongwiththeYear 0 balance sheet
MS,INC.
Balance Sheet, Year 0
Assets
Marketable equity securlues (at market)

Netoperating assets {NOA}
SIMPLE FORECASTS AND SIMPLE VALUATIONS

FROM FINANCIAL STATEMENTS
23.4
long-term (10%) debt(NFO)

Common shareholders' equity {CSE}
7.7
15.7
23.4
23.4
Pro PennaIncome Statement,Year1
Theanalysis of current financial statements reveals currentprofitability and growth. Simple forecasts-s-and the simple valuations derived from them-e-assume that currentprofitability and/orgrowth will continue in the future. Welayout threesimpleforecasts from
the financial statements in the threesections that follow.
Forecasting from Book Values: SF1 Forecasts

A balance sheethasan implied forecast thatisobtained by applying a required returntothe
balance sheetamount. The required returnis the expected earnings rate, indicating future
earnings that are expected if the book values (the net assets) earn at this rate.Table 14.1
gives one-year-ahead forecasts of earnings components that can be made from balance
sheetcomponents. We referto this type of simpleforecast as an SF1 forecast. Operating
income is forecasted by projecting thenet operating assetsto earnat the required returnfor
operations. Netfinancial expense is forecasted byprojecting thenet financial obligations to
incur the expense at the cost of net debt. Full comprehensive earnings is forecasted by
projecting the common shareholders' equity to earnat the required returnfor equity. These
forecasts also can be restated as residual earnings forecasts, which are also given in the
table. SF1 forecasts always forecast that residual earnings for the relevant component will
be zero.
We know fromthe discussion in the last chapter that theseSFI forecasts are goodforecasts if the relevant balancesheetamount is at fairvalue. So an SFl forecast is a typically
good forecast for the financing activities, but a poor forecast for the operating activities.
To see howthese SFl forecasts tie together, consider the pro forma forecasted income
statement for Year I for MS, Inc., an equity investment fundthat carriesits net operating
TABLE 14.1
Simple Forecasts
from BookValues
(SFl)
Earnings
Component
Operating
Financing
Earnings
Operating income
Netfinancial expense: 0.10x 7.7
Earnings: 0.12 x 15.7
Forecast of Residual Earnings

(forecastthat residual
earnings and its components
will be zero)
01, = (PF-l)NOAo
NFE 1 '" (Po - 1)NFOo
Earn- '" (PE - 1)CSEo
01,-(PF-llNOAo=O
NFEI - {Po - 1)NFOo '" 0
Earn, - (PE - l)CSEo = 0
1.884
If the equityinvestments and debtare at fair marketvalue, weknow thatthe equityof this
firm is worthits bookvalue, 15.7.The valueof the operations is 23.4.This is a fair value
balancesheet.
The required returnfor equityis 12 percent, which,whenapplied to the bookvalueof
the equity, yields aYear I earnings forecast of $1.884million. Forecasted net financial expenseis the cost of debt(10 percent) applied to the bookvalueof the debt. The forecasted
operating income is $2.654million,and youmayhavewondered howwe got this. A plug,
you say, because net financial expense was forecasted as $0.77 million, so operating incomemustbe $1.884million +$0.77million. But it's morethan a plug.Theforecast of operatingincome is 11.34 percentof the$23.4million invested in equitysecurities at thebeginningofYear 1.And11.34percentis therequired returnforoperations forMS,Inc.using
the weighted-average cost of capitalcalculation.' Knowing this cost of capital,we would
haveforecasted operating income forYear I as 0.1134x 23.4=2.654.TheproformaYear 1
income statement would havebeendeveloped as follows:
MS, INC.
SF1 Pro FonnaIncome Statement, Year 1
Earnings Component
Operating income
Earnings
Forecast of Earnings.
Component(forecastearnings
and its components by
forecasting that the
relevant balancesheet
component will earn at
the required return)
2.654
(0.770)
Required Return x Balance Sheet Component

0.1134x23.4
0.10x7.7
0.12x15.7
2.654
(0.770)
1.884
So yousee thateachcomponent of earnings is forecasted by applying the relevant required

returnto thebeginning balance sheetamount, andtheseforecasts totaltotheearnings forecast
thatapplies therequired return forequity to thebeginning common stockholders' equity.
1
Therequired return foroperations weights the equity costof capital (12 percent) and the costof debt
(10 percent) bytheirrespective values. given inthe fair value balance sheet:
15.7
] + -x10.0%
7.7
] =11.34%
Requiredretumforoperations= -x12.0%
[ 23.4
l23.4
Chapter14 Anchoring ontheFinancial Swtements: Simple Forecasting and Simple Valuation 491
490 PartThree Forecasting and Val1llltian Anal1li.l
The SFl residual earnings forecasts are zero for all future years. Thusthe valuation of
the common equity implied by the forecasts is
Value of common equity = Bookvalueof common equity
TABLE 14.2 Simple Forecasts from Earnings andBookValnes (SF2)
Earnings
Components
Forecast of Operating Income

and Earnings (forecast that
earnings will be the same as
in the current year, adjusted
for changes in the balance sheet
earning at the required return)
Operating
Earnings
Ol, = 010 + (PF - 1)j,NOAo

Earn, == Eamo + (PE - 1)j,CSEo
(14.1)
vi = CSE,
and this is appropriate for MS Inc.'s balance sheet.Also,the valueof the operations is the
bookvalueof the net operating assets.
AnSF1 forecast is usually a goodforecast for the financing activities. But, if operating
itemson the balance sheetare notat market value,theywillnot yieldsoundSF1forecasts.
This is usually the case, of course. Even for an investment fund like MS Inc., where
investments aremarked to market, themarket valuesonthebalancesheetmaynotbe a good
indicator offuture earnings (norof value) if the market pricesat which theyarerecorded are
not efficient prices. Indeed, foran activefundthatattempts to buyunderpriced investments,
we expectthe market valueto be lower thanfair valueandthe fund to be wortha premium
overbookvalue.
Forecasting from Earnings and Book Values: SF2 Forecasts

Withthebalancesheetan imperfect predictor, we can tum to the income statement anduse
currentearnings as a predictor. If we were to conclude that current(core) earnings are a
goodindicator of future earnings, wemightforecast nextyear'searnings as equalto current
(core)earnings. Butthat wouldbe toosimple, too naive. In making this extrapolation we'd
wanttotakeintoaccount anynewinvestments thatwould increase theearnings. Recognizing
this, simple forecasts of earnings components based on current income statement and
balance sheet numbers are given in Table 14.2, along with corresponding forecasts of
residual earnings and abnormal earnings growth. Werefer to these forecasts as SF2forecasts.Because forecasts forfinancing activities areadequately provided by an SFI forecast,
we apply SF2 forecasts onlyto the operating income andtotalearnings.
TheSF2operating income forecast predicts thatoperating income willbe the sameas in
the current year, but there will be an increase in operating income if there has been an
increase in net operating assetsin the currentyear; it further predicts that the addition to
investment will earn at the required return.The comprehensive earnings forecast predicts
an increase in earnings if therehasbeenan increase in common shareholders' equity in the
currentyear,withthe increase earning at the required returnfor equity.
We illustrate the SF2 forecast using the financial statements for PPE, Inc., a manufacturer with just one asset: property, plant, and equipment (PPE). The cash flow statement is derived from the income statement and balance sheet Make sure you can prepare this.2
In Chapter 2 we discussed the reasons whyaccountants do not produce perfectbalance
sheets, the reasonswhyPPE,Inc.is moretypicalthanMS,Inc.PPE,Inc. lookssimplebut
it is representative. The typical firm hasmanymorenet operating assetsand net financial
obligations, but they all fall into these two categories. And, typically, net financial
obligations are measured at or closeto market value,butmost net operating assetsarenot.
Manyoperating assetsare measured at depreciated historical cost,as is the property, plant,
cash flow =01- 6NOA =9.8- 4.5 = 5.3.Net dividends paid canalso bededuced from thechange
inshareholders' equity using theclean-surplus equation: d = Earnings - 6C5E == 5.3.The investment in
property, plant, andequipment (PPE) isthe change inPPE inthebalance sheet(4.5 mmion) plus the
reduction of PPE of 21.4million through depreciation.
2 Free
Forecast of Residual
Earnings (forecast that
residual earnings will
be the same as
in the current year)
Forecast of Abnormal
Earnings Growth (forecast
that abnormal earnings
growth will be zero)
aeot, = ReGlo
AOIG=O
AEG=O
RE 1 = REo
and equipment here;someoperating assetsare measured at zero, as in the case of omitted

knowledge assets and other intangibles. This leaves us with the challenge of forecasting
future residual earnings or abnormal earnings growth to determine theamountat whichthe
equity shouldtrade.
PPE, INC.
Balance Sheet,December 31, Year 0
Year 0
Assets
Property, plant. andequipment
{at costless accumulated
depreciation)
74.4
74.4
Prior
Year
69.9
69.9
Year 0
tcrq-termdebt(NFO)
Common shareholders'
equity (CSE)
7.7
7.0
66.7
74.4
62.9
69.9
Income Statement Year 0
Operating income
Sales ofproducts
Cost ofgoods sold (including depreciation of 21.4)
Other operating expenses
124.9
(114.6)
10.3
(05)
9.8
10.7)
9.1
Net financial expense: 0.10 x 7.0

Earnings
Statement of CashFlows, Year0
Operating income
Depreciation
Investment inPPE {21.4 + 4.5)
Free cash flow
Cash flow infinancing activities
Net dividends paid
Prior
Year
9.8
21.4
31.2
125.9!
53
492 Part Three
Forecasting andVa/llation AlUllJsis
Chapter 14 Anchoring on the FifUlnda! Statements:Simp!e Forecasting endSimpleValuatiOJ1 493
To develop a forecast of PPE, Inc.'s Year 1 income statement with SF2 forecasts,
suppose that the costof capital for the firm's operations is the sameas thatfor MS,Inc.,
11.34 percent:
Operating income
Net financial expense (SF])
Earnings
Current Earnings + (Required Return

x Change in Balance Sheet Component)
9.8+ (0.1134 x 45)
10310
O.lOx7.7
(0770]
9.1 +(7
x 3.8)
9540
Thechanges in thebalance sheetcomponents here arethe changes inYear 0 over theprior

year. Theearnings forecast netstheforecasts ofoperating income andinterest expense. The
earnings forecast cannot beobtained byforecasting from thecurrent earnings andthechange
in equity for the current yearuntil we know thecost of equity capital (thus the question
mark in the pro forma statement). And we can't calculate that (using market leverage in
equation 13.8 in theprevious chapter) until weknow thevalue of theequity.
These SF2forecasts are thesame thing as forecasting thatthe relevant residual income
will bethesamenext yearasit iscurrently, asindicated inthemiddle column ofTable 14.2.3
ForPPEInc.,theforecast ofoperating income of 10.310 forYear 1means forecasted ReOI
forYear 1is 10.310 - (0.1134 x 74.4):= 1.873, which is thesame as itsReOI inYear 0, that
is, 9.8- (0.1134 x 69.9) = 1.873.
Extrapolating to future years, theSF2forecast says thatresidual earnings is expected to
be thesameas it is now perpetually intothe future. Using the residual operating income
model, thevaluation of theequity witha perpetuity in ReO! at thecurrent level is
Value of common equity e Book value of common equity
+ Capitalized current ReOI
(14.2)
vg := CSEo + ReOIo
PF -I
ForPPE, Inc.,theequity valuation is 66.7+ 1.873/0.1134:= 83.22 andthelevered price-tobookratio is 83.22166.7:= 1.25. Justas the benchmark SFI forecast gives us a benchmark
valuation (of vt:::: CSEQ), thebenchmark SF2forecast alsogives usa benchmark valuation.
The value of the operations is V~OA := 83.22 + 7.7 := 90.92, and the enterprise PIB is
90.92/74.4:= 1.22. Thisvalue fortheoperations canalsobe calculated as
VoNOA = NOA + 01, - (PF -1)NOAo
o
PF -I
3 to seethis
algebraically.
isthe same as
rhus
all - (pp-l}NOAo'" OIO-(PF-1)NOA..l
and soon for the othercomponents.
Value of operations e Capitalized operating income forecasted fornext year

V;NOA _
PPE, ]NC
SF2 ProForma Income Statement,Year1
Earnings Component
But, by dividing through by PF-I, youcan see that it can be calculated in an easier way:
--.2.!L
(14.2.)
- PF-1
thatis,byjustcapitalizing theSF2 forecast ofoperating income fornextyear. ForPPE, Inc.,

thiscalculation is 10.310/0.1134:= 90.92, as before.
Thevaluation in equation 14.2a looks familiar: Ifvaluecanbecalculated bycapitalizing
forward operating income, it mustbe that abnormal operating income growth (AOIG) is
expected to be zero. Indeed, Table 14.2 shows thatan SF2 forecast is also a forecast that
abnormal income growth is zero. Thismust, of course, be thecase,for abnormal income
growth isalways equal tothechange inresidual income, andanSF2 forecast is a forecast of
no growth in residual income. ForPPE, Inc.,expected abnormal operating income growth
(AOIG) forYear I (from operating income of9.8 andfree cashflow ofS.3 inYear 0) is also
[10.31 + (0.1l34x 5.3)] - (1.l134 x 9.8)= O.
Accordingly, an SF2 forecast has a particular significance. Whereas an SF1 forecast
implies a normal PIB ratio, anSF2forecast implies anormal PIE ratio. Tosuggest thatthePIE
should bedifferent from normal, onemustmake a forecast thatdiffers from anSF2 forecast.
With the equity value now determined, we can calculate the equity cost of capital
following equation 13.8 inthe Jast chapter:
Equity costof capita! :::: 0.1134 +
=
[..r!.x (0.1134 - 0.10)]

83.22
0.1l46
Andnow wecan complete the SF2pro forma income statement forYear I by forecasting
earnings directly usingthis costof capital: Forecasted Year 1 earnings is 9.1 + (0.1146 x
3.8):= 9.54. Note, however, thatwedo not needthisequity costof capital to calculate the
value of theequity. Valuing theoperations suffices.
Box 14.1 gives an SF2valuation forNike. Thereisjust onemodification. Forecasts of
future operating income, ReOI, andAOIG arebased oncurrent coreoperating income, that
is, operating income purged of unusual items. As unusual items willnotbe repeated in the
future, weexclude them in forecasting. Thisis whattheanalysis of coreincome in Chapter
12 was designed to achieve-to give us a better forecast of future operating income.
Always work withcore(sustainable) income in forecasting.
Forecasting from Accounting Rates of Return: SF3 Forecasts

An SF2forecast predicts thatcurrent income from assets in place at the beginning of the
current period earning at thecurrentrateof return willpersist, but anyaddition to assets

overtheperiod willearnat therequired rateofreturn. Ifthe current rateofreturn is higher
than therequired return, theSF2forecast is a conservative forecast, andoneshould always
ponder a conservative forecast. An alternative forecast predicts thatalI assets, boththose
in place at the beginning of the currentperiodand those added over the period, will earn
at thecurrent rateof return. Thatis, an SF3 forecast predicts thata firm willmaintain its
current rateof return in thefuture. Table 14.3 summarizes SF3 forecasts.
TheSF3 operating income forecast is made bypredicting thatthenetoperating assets in
placeat thebeginning ofYear 1 (those at theend ofYear 0, NOAo) willearn,inYear 1,at
the RNOA in the current year, RNOAo. Thatis, RNOA 1 := RNOAo. If there are unusual
Chapter 14 Anchoring on!he Financial Srmemems: Simple Forecasting and Simple Vahll'ltion 495
TABLE 14.3
NIKE, INC.
Required return foroperations
Coreoperating income
Netoperating assets
8.6%
2008
2007
2008
2008; 1,796- (0.086 x 4,939)
2009:1,796+ (0.086 x 867)
2009:1,871 - (0.086 x 5,806)
2010
Core residual operating income

SF2 forecast of operating income
SF2 forecast of ReOI
SF2 forecast of MIG (change inReOI)
$1,796million
$4,939 million
$5,806 million
$1,371.2million
$1,870.6million
$1,371.3million
xes
+ ReO~ =7 797+t371.3
0.086
'
$23,742million
0.086
$48.35
Value per share on 491.1 millionshares
ReO! Valuation of Operations
$21,750 million
V"~ =V~ -NFA2OC(l = 23,742-1,992
Vh'OA=NOA
$21,570million
+ ReOllOC') =5806+ 1,371.3
=
l<XlS
0.086
'
AO'G Valuation of Operations
0.086
VNO'. = 0\200:1 = 1,870.6

2COO
0.086
$21,750million
0.086
items inthe current year, thecoreRNOA oshould be used. Anaverage RNOA overthepast
few years can alsobe applied. The full earnings forecast is the current ROCEo applied to
thecommon equity at the beginning ofYear 1 (CSEo).
For PPE, Tnc., the current (Year 0) core RNOA, NBC, andROCE (with beginning-ofyearbalance sheetamounts inthedenominator) are 14.02 percent, 10.00 percent, and14.47
percent, respectivelyvlhe SF3forecast of theincome statement is as fellows:
PPE, INC.
SF3 Pro FormaIncomeStatement, Year1
01, = RNOAa x NOAa

Earn, = ROCE o x CSEc
[RNOA, -(PF-1)] NOAa = [RNOAa-(PF- 11] NOAa

[ROCE, - (p,- 1)] CSEa = [ROCE a- (p,- 1)) CSEa
Theforecasted OT minus interest expense netsto 9.661, butthisearnings amount differs

from the current ROCE applied to CSE. PPE's ROCE forYear 0 is 14.47 percent, so you
might forecast Year 1earnings as0.1447 x 66.7 = 9.651, not9.661 (sotheappropriate ROCE
is leftas a question mark in the profonna statement). What's wrong? ROCE is affected by
financial leverage. TheROCE ofl4.47 percent forYear 0 is based onCSE at thebeginning of
theyear andisreconciled totheRNOA of 14.02 percent byfinancial leverage atthebeginning
of the year. Butthe leverage haschanged from thebeginning ofYear 0 to the beginning of
Year 1 (which is the endof Year O). Sowewould expect the ROCE to change even though
RNOA isnotexpected to change. We canremedy thisbyforecasting thattheROCE inYear 1
will bethesame asthatinYear 0 but with anadjustment forfinancial leverage:
.
NFO a (end)
Leverage-adjusted ROCE o = RNOAo +
(RNOAo - NBCo)
CSEo (end)
CurrentRateof Return x Balance Sheet Component

0.1402 x 74.4
0.10x7.7
(7 x 66.71
10.431
0.770
9.661
Leverage-adjusted ROCEa = 0.1402 +
[22.
66.7
x (0.1402 - 0.10)] = 0.1448
Accordingly, the forecast of earnings forYear 1 is 0.1448 x 66.7 = 9.661 (corrected for
rounding error). Thisis indeed thenetamount oftheOIandNFEforecasts intheproforma
income statement The adjustment doesn'tmake much difference here and, given uncertaintyabout thecostof capital anyway, canusually be ignored. Butit cannot be ignored if
there hasbeenabigchange inleverage. Noteagain, however, thatwedonotneedtheequity
costof capital forvaluation. Valuing the operations suffices.
Just as an SF2 forecast implies a particular residual income and abnormal earnings
growth forecast, so doesan SF3forecast. Residual operating income is driven by RNOA
and investment in net operating assets. So residual operating income one year ahead,
ReOT[, is ReOI l = (RNOAj-(PF-I)]NOAI). But,if weforecast thatfuture RNOA willbe
the same as current coreRNOA, so thatRNOA l = CoreRNOAu, then
SF] forecast of ReOI, = [Core RNOA, - (PF-])]NOAo
Earnings Component
Operating income
Netfinancial expense (SF1)
Earnings
e These rates of return are 1358 percent. 9.52 percent, and 14.04 percent ifaverages are used inthe
denominator. Averages wereusedinthe denominator inChapter 11 and, as thesemeasure the earning
ratesbetter. theyshould be applied to assets put inplace. Weusebeginningof-year amounts inthe
denominator hereto keepthe calculations clear. When itcomes to forecasting. it iseasierto think of
assetsand liabilities to be put in place at the beginning of a future period rather than average assetsfor
the period. Andit usually makes little difference because the timing of future investments within a year
is usually notpredictable.
III,
I!
Earnings
Forecast of Residual Earnings (forecastthat

residualearnings will change, not because
of changes in profitability, but becauseof
changes in the relevant balancesheet
amounts earning at the current profitability)
where thefinancial leverage, NF0olCSEo, is atthebeginning ofYear 1.When thisROCE is

used to forecast, the RNOA will be the same as in Year 0 but ROCE will be different
because of thechange in leverage. ForPPE, Inc.,
Nike traded at $68 pershare when fiSCal year 2008 results were reported.
I
!I
Operating
Forecast of OperatingIncome
and Earnings (forecastthat the
relevant balancesheet
component will earn at the
current profitability)
Value of Common Equity
VE =[SE
Earnings
Component
Simple Forecasts from CurrentAccounting Rates ofReturn (SF3)
494
Theforecast forresidual earnings (RE) is similar, asTable 14.3 indicates. ForPPE, Inc., the
ReOI forecast forYear 1is 10.431- {O.1134 x 74.4} = 1.994, which is also equal to theYearO
RNOA of14.02 percent applied toYearO netoperating assets of74.4: (0.1402 - 0.1 134) x 74.4
= 1.994. Asthisis greater than current residual operating income of 1.873, thisSF3 forecast
predicts growth. Indeed, abnormal operating income growth (AOIG) istheincrease inReOI:
whereasforecasted AOIO foran SF2forecast was zero, it is 0.121 foranSF3 forecast.
496 Part Three
Chapter14 Anchoring on the Financial Statement!: Simple Forecasringarul Simple VlllUllrion 497
Forecasring andValU1lrion Analysis
With an SF3 forecast, growth is forecasted by thecurrent growth innet operating assets.
Oneplusthegrowth ratein ReOI from Year 0 toYear 1 is
. R or [RNOA I -CPr -I}]NOAo
Growth rate 10 e I:::
[RNOAo -CPr -I}]NOA_I
However, if weforecast RNOA j = RNOAI), as wedo withan SF3forecast, the growth rate
becomes
TABLE 14.4 Simple Forecasts and Simple Valuation Models

Simple Forecast
Simple Valuation of the Equity
SimpleValuation of the Operations
SF1
VJ := (SEn
VONOA
SF2
VJ := (SEo + ReOb
pr -1
llNOA _
Vo
=:
PF -1
NOAo
Growth rate 10 ReOI l ::: - - NOA_I
SF]
VJ := (SEo
+ [Core RNOAo -
(PF -1)]NOAo
(Pr -1)JNOAo
(14.3)
PF - g
Thegrowth rateis the forecasted growth in ReOI fromYear lon, butin thiscase it is the
forecasted growth in NOA at the current rate,NOAo/NOA-- I . ForPPE,Inc., we forecasted
ReOI) tobe 1.994 andthecurrentNOA grewat 74.4/69.9::: 1.0644 from theprevious year.
So,usingSF3forecasts, thevalue ofthe equity is 66.7+ 1.994/(1.l134 - 1.0644) = 107.39
andthe levered PIB ratiois 1.61. Thevalue ofthe operations is 107.39 + 7.7:::115.09, and
theenterprise PIBis 1.55. Thevalue ofthe operations canalsobecalculated as
NOA _
VI)
NOA
[Core RNOAo - (Pr -1)JNOAo

PF - g
With a littlerearrangement,
VONOA
= NOA x CoreRNOA o - (g -I)

o
(14.3a)
Pr - g
(prove this for PPE, Inc.)The multiplier here is the enterprise price-to-book ratio. The
multiplier compares RNOA relative to the growth rate(in the numerator) to the required
returnrelative to thegrowth rate (in the denominator). You cansee thetwo ReOI drivers,
RNOA andNOA, working together here. Remember that g is I plusthe growth rate,so
g - I is the growth rate. If the RNOA is greater thanthe required returnfor operations,
thenmorevalue is addedto bookvalue thehigherthe RNOA is relative to thegrowth rate.
But growth also contributes: Fora given RNOA (higher thanthe required return), more
valueis added if growth is higher. IfRNOAequals the required return, the enterprise PIB
is normal.
Correspondingly, an abnormal operating income growth valuation applies a multiplier
to the SF3forecast of forward operating income:
VoNOA
= OIl
X_
_[I+Pr-g
-PF]
Pr-1
1
G,
VONOA
:=
pr - 9
That is, the forecasted growth in ReOI for thenextyearis given by the current growth of
NOA. Thegrowth forecast is given by information in thebalance sheet.
Now suppose we use the SF3 forecasts for all future periods. That is, we predict that
RNOA will be the same as current core RNOA indefinitely but NOA investments will
continue to grow at the current rate. In this case,ReOI willalsogrowindefinitely at this
rate.Capitalizing the SF3forecast of ReO! forYear I as a perpetuity withgrowth:
= CSE + [Core RNOAo -
NOA 0+-ReOIo
Pr -1
:=~
vg
NOAo
:=
NOA + [Core RNOAo - (Pr -1)]NOAo

o
PF -g
NOAI) x Core RNOAo - (g -1)

pr-g
VONOA :=Ohx-1-[1+ G2-PF]

Pr-1
PF-g
growth in operating income to the required return, and the denominator compares the
required return to thegrowth rate.
Thecalculation in equation 14.4 requires a pro forma forYear 2 in order to forecast G2.
This is 1.1257 (a 12.57 percent growth rate) for PPEInc.' The forward operating income
multiplier is
-1- [1 + l.l257 -l.l134] =11.03

0.ll34
l.l134 -1.0644
Applying thismultiplier totheSF3forecast ofYear I operating income of 10.431, thevalue

of the operations is 10.431 x I L03= 115.09, as before (allowing forrounding error).
Thegrowth rateforNOA foroneyearcanbe temporarily highor low, so it is bestto use
an average growth rateovera number ofprioryears. Box142 carries outan SF3 valuation
forNike, Inc.using average NOA growth overfive yearsof 53 percent andthecoreRNOA
of33.4 percent Thecalculated value of$104.72 pershareis higher thanthe market price
of $68.TheSF3valuation establishes a benchmark fortheanalyst: What otherinformation
tellsmethatfuture profitability andgrowth willbe different from thatin thecurrent financial statements? Whatinformation aboutprofitability and growth would justifya market
pricethatis different from the SF3valuation?
TheSFl, SFl, andSF3forecasts aresummarized inTable 14.4, along withthesimple valnationstheyyield. These valuations use onlyinformation in the financial statements. They
should be seen as approximations, as starting points for more comprehensive valuations.
Sometimes these simple valuations donotwork.The SF2andSF3 forecasts areofnousefor
a fum with losses. TheSF3 valuation works onlyforfirms withpositive residual income and
moderate growth in NOA.
5For PPE. inc.. theproforma isdeveloped asfollows:
(14.4)
where G2 is 1 + the cum-dividend growth rate in operating income forYear 2 ahead (with
free cash flow dividend from Year 1 reinvested), and g is still the growth rate in net
operating assets. Themultiplier is forwardenterprise PIEratio. Thismultiplier hasa similar form to the net operating assets multiplier: The numerator compares cum-dividend
Forecasted NOA I = NOAoxg=74.4 x 1.0644 = 79.191

Forecasted 012 = NOA I X RNOAo:= 79.191 x 0.1402 =
FCF1 = all - ""NOAl = 10.431 ~4.791 =5.64
Reinvested FCF =5.64 x 0.1134 =
Cum-dividend 01
11.103
0.640
11.743
G2 (cum-dividend growth rate in OJin Year 2) = 11.743/10.431=1.1257.
Chapter14 Anchoring on !I.e Fifll11cial SW!emeTlrs: Simple Foreca.sring andSimp!.: Valuation 499
Weighed-Average Forecasts of Profitability and Growth

NIKE, INC.
Cost of capital for operations
Core RNOA
Five-year growthratefor netoperating assets
Netoperating assets
SF3 forecast of operating income
SF3 forecast of ReOI
SF3 forecast of G2 (for 2010)
2008
2004-2008
2008
2009;5,806x 33.4%
2009: (0.334 - 0.086) x 5,806
8.6%
33.4%
5.3%
5,806million
$ 1,939million
$1,439.9 million
12.55%
Value of Common Equity:

ReOi lm
7797+ 1,439.9
V= '" CSE:!W> + 1.086-1.053'
0.033
Value pershare on491.1 million shares
$51,430 million
$104.72
ReO! Valuation of Operations:
V;: '" V~ -NFA;mo ",51,430-1,992

f:Qt.
V= ",NOAxee +
$49,438 million
Weighted-average forecast ofR..'NOA =- (0.70X Current core fu~OA)

+ (0.30 X Required return) (14.5)
(RNOA NIl-D.086)xNOA=
1.086-1.053
",5806 (0.334-0.086)xS,806
,+
0.033
$49,438 million
N(>\_N A
RNOA=-(g-l)
Vl(UI - 0 zce x 1.086-1.053
'" 5 806 x 0.334-0.053

,
0.033
$49,438 million
Theforward enterprise P/B is 8.52.
AOfG Valuation of Operations:
1 [1 +
G -1.086]
Vci'<Q.\",OI\x--'-0.086
1.086-9
1 [ 1.1255-1.086]
"'1,939 x 0.086 1+ 1.086-1.053
If current RNOA is higherthantherequired return, theSF2forecast is a conservative forecastbecause it predicts that additions to NOA will earn onlyat the required returnrather
thanat the currentRNOA. The SF3 forecast, on the otherhand, can be optimistic: It predictsthatNOA willearnat thecurrentRNOA andthatcurrent RNOA andgrowth in NOA
will continue indefinitely intothe future. You will have noticed that the SF3 forecast and
valuation for Nike are considerably higher than the SF2 forecast and valuation. The SF3
valuation is also higherthanthe market price. History tellsus that highprofitability tends
todecline: Competition erodes profitability andgrowth, soRNOA fades toward theaverage.
Nikeearneda 33.4percent corereturnon netoperating assets in 2008,butcan it maintain
that level of profitability in the future? This question is oneof durable competitive advantage,of course, andNikehas indeed shown that its profitability is durable.
The issue of the duration of competitive advantage comes to the forewhen we lookat
full-information forecasting in the nextchapter. Butthe factthathistory tellsus thatprofitability tends to decline overtime can be built into our simple forecasts and valuations;
afterall, it is part of "whatweknow." In recognition thatprofitability declines toward the
required return on which the SF2 forecast is based, weight down the SF3forecast of profitability andshiftthe weight to the SF2forecast:
$49,438 million
The forward enterprise PIE is 25.55(allowing for rounding error).

Nike traded at $68whenof fiscal year2008results werereported.
The weights are somewhat arbitrary but are borne out by experience. The weights will
vary by industry, and a diligentanalystwill carry out research to discover the historical
rates for the relevant industry. For Nike,currentRNOA is 33.4 percent and the required
return is 8.6 percent. So the weighted-average forecast is 26.0 percent. Applying this
RNOA (with the NOA five-year average growth rate of 5.3 percent) produces a modified
SF3valuation of$78.22 pershare.
Just as RNOA tends to revert toward an average level, so does net operating asset
growth; high growth in net operating assetstypically cannot persist. Withthe expectation
that growth in the long run will be at the GDP growth rate, high growth rates might be
weighted down to the GDPgrowth rateof 4 percent:
Weighted-average growth rate forNOA = (0.70 X Current growth in NOA)
+ (030 X 4%)
(14.6)
Weighting thehistorica15.3 percent NOA growth rateweusedin the SF3valuation ofNike
in Box 14.2with 4 percent growth yieldsa weighted-average growth rate of 4.9 percent.
Combined withthe weighted-average RNOA forecast of26 percent, thisproduces an SF3
valuation of$71.47pershare. Thisis closeto themarket priceof$68,so wehave identified
theforecasted decline in profitability andgrowth thatis implicit in themarket price.
Growth in Salesas a Simple Forecast of Growth
SIMPLE FORECASTING: ADDING INFORMATION TO FINANCIAL

STATEMENT INFORMATION
TheSF3 valuation is based solely on information infinancial statements. Thisinformation
is (presumably) reliable information-thoughwewillchallenge thispresumption withthe
accounting quality analysis inChapter 17-but it is limited information. Toenhance thevaluation, theanalyst addsinformation about how thefuture might bedifferent from thepresent.
Here are twoexamples.
498
The SF3 models in equations 14.3 and 14.4 forecast growth based on past growth in net
operating assets. Growth ratesare typically slow, however, so pastgrowth ratesmaynotbe
a goodindication of future growth rates. Weighted-average growth ratesaddress the issue,
but another method can be used: A simple forecast of NOA growth thatcan be madefrom
forecasted sales growth. Net operating assets are driven by sales and the asset turnover:
NOA = Salesx l/ATO. Thus if ATO is expected to be constant in the future, forecasting
growth insalesis the sameas forecasting growth in NOA. A sales forecast, you'llagree, is
mucheasierto thinkaboutthanan NOAforecast.
Chapter 14 Anchoring onrile Financid SwrementJ;: Simple Forecasting andSimple ValuaO011 501
The 2,318 million outstanding shares of the Coca-Cola Com- VNOA", 26 858 (0.269 0.09)x 26,858
2007
,
+
1.09 1.054
pany traded at $60eachwhen its 2007 financial statements
were issued. Analysis ofthose and earlier financial statements
establishes the following history (dollar numbers. are in Net debt
ViOO7
millions):
Value pershare on 2,318 million shares
2007 2006
2005
2004
2003
$160,402 million
5,144
$155,258 million
$66.98
2002
20.7% 20.4% 21.4% 22.4% 21.3% 22.1%

Core profit
margin
Asset turnover 1.30 1.32 1.36 1.32 1.32 1.35
Core RNOA 26.9% 26.9% 29.1% 29.6% 28.1% 29.8%
Net operatinq assets

$26,858
Net financial obligations 5.144
Common equity
$21,714
Coke's core profit margin has declined somewhat over the
years, butitsasset turnover isvery stable. That means that net
operating assets growat the same rate as sales. The average
annual sales growth rateover the five years up to 2007 was
5.4 percent (ignoring growth from acquisitions in 2007), and
thisrate is in line with the rate analysts wereforecasting for
the future. Using thisgrowth rate for the NOA growth rate
along with 2007 core RNOA, Coke's value is calculated as
follows witha 9 percent required return:
The $66.98 valuation suggests that the market price isa little
low, butthisisjusta simple valuation. Observe howfarweget
with just a few ingredients once financial statements have
been reformulated and analyzed to highlight the relevant
value drivers. And observe that an historical sales growth rate
isan inputwhen assetturnovers arefairly stable, astheyoften
are.
You see howsimple valuations canbe used to challenge a
stock price. But thereisanother lesson here. Coke hasa big
brand-name assetthat isnotinthe balance sheet. Some claim
that because accountants do not record brand assets, it isdifficult to value such firms. Notso. Valuation involves boththe
balance sheet and the income statement, and we see here
that a valuation with both isindeed plausible. The simple valuation might betoosimple, butyoucanseethat modifying it
with a more intelligent forecast offuture RNOA andgrowth in
RNOA will give an intelligent valuation even with a deficient
balance sheet.
Recognize thatRNOA = Profit margin xATO. So if weforecast a constantATO, weforecastthe constant RNOA in the SF3forecast if we alsoforecast constant margins. You see,
then,that the SF3 valuation is likely to workbest for firms that havefairly constant profit
margins and turnovers andsteadysalesgrowth. Many retailers havethisfeature: TheircurrentRNOA alongwitha salesgrowth forecast oftengivea goodapproximation. Lookalso
at the valuation for the Coca-Cola Company in Box 14.3.On the otherhand, firms thatare
changing theirtypeof business (andthustheirsalesgrowthrates,profitmargins, andasset
turnovers) are notgoodcandidates foran SF3valuation. Moreanalysis (as inthenextchapter) is required.
THE APPLICABILITY OF SIMPLE VALUATIONS

TheSFI, SF2,andSF3valuations have theadvantage of requiring littleanalysis of thefuture.
Theyassumethe future will be muchlikethepresent. Tneyare thevaluations wecan make
from the current financial statements-sometimes modified using a weighted-average
500
forecast or a sales growthestimate-without analyzing much information outside the financial statements. Theyarequickand, yes,dirty. Buttheyarebenchmarks, starting points,
to conduct a morethorough analysis. Thethorough analysis requires extrawork, as wewill
see;youmustalways askhowmuchthe extraworkwillimprove the valuation overonethat
assumes future profitability andlorgrowth in bookvalueat the currentleveL Askyourself:
Will the morethorough analysis giveme an edge?Forwhichfirms are thesimpleassumptionsin thesimplevaluations inappropriate?
Figure 14.1 gives some idea of howapplicable thesimplevaluations are.Thetwopanels showhowRNOA and growthin NOA typically behaved for NYSE and AMEX firms
overfive-year periodsbetween 1964and 1999. Forthese figures firms wereplaced in one
of 10 groups basedon their current (Year O) RNOA (for Figure l4.la), and their current
growth rateinNOA(forFigurel4.1b),withthefirms withthehighest 10percentofthe relevant measure in the top groupand firms withthe lowest 10 percent of the measure in the
bottomgroup. The medianmeasure for each groupwasthen tracked overthe subsequent
five years, Years 1,2,3,4, and 5 in the figures. The figures givethe typical patterns forthe
threemeasures overtime. Readthe captions to the figures to be sure you understand what
theyare saying.
Whatyou observe in these patterns is typical of manyaccounting measures: Extreme
(highor low) measures tend to become more like the average measure as timegoeson. In
Figure la.lc, which plots how RNOA behaves over time, large differences in current
RNOA appear in Year 0, ranging from -7}) percentfor the lowest group to 33 percent for
the highest RNOA group. But after five years the differences are smaller, with the range
reduced to 8 percentto 19 percent,and all groupsexceptthe top are in the rangeof 8 percentto 15percent. Thissaysthat,basedon pasthistory, wetypically expectR...NOA to be in
the rangeof 8 percent to 15 percentafter fiveyears. And similarly for growth in NOA in
Figure 14.1b.
Thistendency for these measures to converge to typical, average levels is calledmean
reversion.Highor low measures revertto the mean(the average) overtime. Mean reversionmeansthathighandlowRNOA andgrowthin NOA aretypically transitory as theyare
onlytemporarily highor low. Indeed, it waswiththesepatterns in mindthatfinancial statementanalysis is designed to uncover transitory elements in RNOA. Andit is thesepatterns
thatjustifythe weighted-average forecast modification to SF3forecasts.
Analystsrefer to these diagrams as jade diagrams. They keep these patterns in mind
whenforecasting because typicalpatterns are a good point of departurewhenforecasting for individual firms. The patternsare even sharperwithinindustries. Wewill see (in
the nextchapter)howthe economics of businesscausesmeanreversion and (in Chapter
16) how the accounting also contributes. For now, look at the patterns to judge how
applicable the simplevaluationsare.The SF3valuation, whichforecasts growthin NOA
at the current level but with constant RNOA, will work best for finns with average
RNOA and average growthin NOA,that is, firms in centralgroupsin Figures 14.la and
b. It is for these firms that both current RNOA and growthin NOA are indicative of
futureRNOA and growthin NOA. The SF3valuationalso works wellfor firms withreasonably constantprofit margins and turnovers and steady sales growthrates (like Coke
in Box 14.3).
Indeed, theterm"steady-state" isthe keyto theeffectiveness of simplevaluations. If the
firmhas steady-state RNOA, growth in NOA,or growthin salesthatare a goodindication
of the future, the currentlevels of thesemeasures are a basisforvaluation. If not, thesimple valuations are approximate-s-or very wrong.They are just a starting point for fullinformation forecasting.
Chapter 14 Anchoring on the Financial Staremenr,s; Simple Forecasting and SimpJ.e ValUlltion 503
502 Part Three forecasting andVOIUlltioll Analysis
FIGURE 14.1
Patternsof Return on
NetOperating Assets
(a) and Growth in
NetOperating Assets
(b) overFive-Year
Periods for NYSE
andAMEX Firms
between 1964and
(a)Return onnetoperating assets (RNOA). RNOA tends to move toward a common level fora11
firms, butfirms with high RJ'JOA inthecurrent year, intheupper groups, tend tomaintain high
RNOA inthesubsequent five years while firms with low RNOA inthe current year, inthelower
groups, tend tohave low RNOA inthesubsequent years.
40%
35%
,
,
30%
1999
0
Z
Source: D,Nissim and
EO
25%
S. Penmor., "R:ltioAnolysi< "nd

EqoityV,loation: fromRe.
search to Pr.lClitc," Review"!
AcroU!IIingSll1di"". M"",o
2001.pp.l09-1S4.
u
~
20%
o.
1"
15%
'~"-'"---o
10%
g
0
5%
~
u
-5%
-10%
SIMPLE VALUATIONS WITH SHORT-TERM

AND LONG-TERM GROWTH RATES
The simple forecasts above are based on one perpetual growth rate; they forecast that
growth willcontinue at thespecified rate into thelong lerm. In many cases weexpect firms
tomaintain relatively highgrowth rates in theshortterm but to falloff to a lower rate inthe
longtermas competition challenges theirbusiness(as Figure 14.1 suggests).
Accommodating this patternin a simple valuation is desirable not only because it fits
with the facts, but becauseit also accommodates OUf dictumto separatemore speculative
aspects of a valuation from aspects about which wearemore confident. Long-term growth
rates arehighly speculative, the mostspeculative partofanyvaluation. Thediscomfort you
may have experienced in calculating continuing values (for the long term) is understandable.Analysts are morecertainabout their forecasts for the short run.They typically make
pointestimatesof earningsfor onlyone and twoyearsahead, then provide a growth ratefor
the following threeto fiveyears.Althoughthesegrowthrates are referredto as "long-run"
rates,they apply to only fiveyears at most, and even for this period,they are usuallyconsideredto be so speculative that they are oftendismissed.
The simple valuation schemes can be modified to differentiate between short-term and
long-term growth rates. A simpleAOIG model accommodates the case wherean analyst
forecasts forward earnings, earnings for two years ahead, thenaddsa long-term growth rate:
Vd-lOA = OIl X_1_[G2 ~ Gong]
Pr-l Pr-Glong
(14.7)
Yearrelative tocurrentyear
(b)Growth rateofnetoperating assets (growth inNOA). Growth innetoperating assets alsotends

tomove toward a common level. Thegrowth rate forfirms with high current growth in theupper
groups tends todrop off, while growth forfirms with low current growth inthe lower groups tends
to increase.
60%
50%
OIJ is a forecastof forward operatingincomethat is multipliedby a multiplierthat incorporates two growth rates. G2 is (I plus) the growth rate forecasted for cum-dividend
operating incometwoyearsahead,and Giang is the growthrate for the longtermusuallyset
to the GDPgrowthrate.v'Ihemodelimpliesa gradual(geometric) decayof thegrowthrate
overtime fromthe short-term to the long-termrate, as depictedin Figure 6.2 in Chapter6.
Note that we are anchoringon short-termforecastsand a GDP growthrate, both of which
we are relatively confident about. For the model to work, the short-term rate must be
higherthan the long-termrate (whichit usuallyis). Box 14.4appliesthis two-stage model
to Nike.
40%
H
eo
"
,
30%
.~
&
0
20%
,e
10%
SIMPLE VALUATION AS AN ANALYSIS TOOL
0.
,
i
Reverse Engineering
Chapters5 and 6 showed how valuationmodelscan be invertedto understand the growth
rates and expectedrates of return implicitin the marketprice.The reverse engineering was
applied with levered valuation models. Now that we have isolated the value-adding
-10%
Simple models provide a rough valuation, but they come to their fore as analysis tools.
Theyprovidethe formula for reverseengineering. They facilitate intelligentstock screening.They are a tool for sensitivityanalysis.
-20%
Yearrelative to currentyear
6Thetwo-stage qrowth model wasdeveloped byOhlson and joettner-Nauroth. SeeJ. Ohlson and
B.Juettner-Nauroth, "Expected EP5 and EPS Growth as Determinants of Value," Review of Accounting
Studies, July-September 2005, pp. 347-364.
Chapter 14 Anchoringon me Financial S(llCeJ11Wtl: Simple Forecasting and Simple Valuanon 505
In early fiscal year 2009, analysts following Nike were fore- Forthevaluation: G2 =1.1166
casting EPS of $4.00 for 2009and $4.23 for 2010, up from
GrOO9 = 1.04 (the GDP growth rate)
$3.74 in 2008. Adjusting for expected net interest income
Pr '" 1.086
these forecasts translated into operating income forecasts of
$1,904 million and$1,989 million. With anexpectation of net The value of theoperations is:
operating assets in the 2009 balance sheet of $6,114 million,
V= = 1904X_'_[1.1166-1.04 36 861
atwo-year proforma is developed asfollows:
=,
0.086 1.086-1.04
'
J'",
2008
Operating income
Free (ash flow (01- LlNOA)
Reinvested free (ash flow
(at8.6%)
Cum-dividend operating
income
Cum-dividend operating
income growth rate: 2,126/1,904
2009
2010
v'200S = V;: + NFA '" 35,867 + 1,992= $38,859 million
s 1,904 $ 1,989 Value pershare on 491.1 million shares is$79.13.

The market price was $68at thetime. Wewouldconclude
$5,806 6,114
1,596
that either the market price istoo low, analysts' forecasts are
too optimistic, or thelong-term qrowth rate istoo high. Note,
however, that the modification of the long-term growth rate
has yielded lowervaluation thanthe$104.72 SF3 valuation in
Box 14.2.
11.66%
operations in a valuation model and have identified thedrivers involved, we canrefine the
analysis. Further, we can anchor on whatwe know-that is, information in the financial
statements-in orderto challenge themarket price.
Themarket price of operations (enterprise price) is simply the market priceoftheequity
plusthenet financial obligations. Setting V~OA equal to themarket priceof theoperations,
p~OA in SF3 model 14.3a, it is clearthat, given we have core RNOA from the financial
statements and are comfortable withour forecast of growth in net operating assets, g, we
can calculate the expected rate of return from investing at the currentmarket price. If the
return is greater thanwhatwefeel is reasonable forthe risktaken, we would conclude the
stockis overpriced; if less, we would conclude that it is underpriced. Alternatively, if we
are comfortable withspecifying a required return, we mightcalculate the implied growth
rate, g, and compare it witha reasonable estimate of feasible growth.
The market value of Nike's equity at the end of2008 was $68 x 491.1 mil1ion shares
outstanding = $33,395 million, so with $1,992 million in net financial assets, enterprise
market pricewas$31,403 million. With an SF3forecast of forward coreRNOA of33.4percentanda growth rateforresidual operating income of5.3 percent (as inBox14.2), the SF3
residual income modell4.3a reverse engineers as follows:
p'" = $31403=5 806x 0.334-0.053

zcca
,
,
PF - 1.053
So, PF = 1.105, or a 10.56 percent return. This is the expected return from buying at the
current price,not the required return. If webelieved therequired return wasonly8.6percent, wewould saythatNike wasunderpriced. The formula for the implied expected rate
of return is
(14.8)
sO'
where ~?o~ istheenterprise book-to-price ratio(0.185 forNike). Thus,theexpected return

is a weighted average ofRNOAandgrowth, withtheweights given by theenterprise bookto-price ratio.Onecanreverse engineer withanyforecast of future profitability andgrowth:
SetcoreRNOA andthegrowth rateto theirweighted-average values in equations 14.5 and
14.6, andcalculate theexpected return.
TheAOIO model 14.7 can be reverse engineered in a similar way. Given analysts' forward operating income forecast of$ I,904million, a short-term growth rateforecast, O2 of
11.66 percent, anda long-term forecast, Glong of 4 percent (as in Box14.4), model 14.7 reverse engineers for Nikeas follows:
p,,: = $31,403=$1,904X_I_[1.I166-1.04]
PF-l
Pr - 1.04
Thisvaluation solves for PF = 1.091, ora 9.1percent expected return. Ifwe felttherequired
returnwas8.6percent-and were confident in theanalysts' forecasts-we would conclude
thatNikewasslightly underpriced.
You can seethat, with thesetechniques, we viewthe expected return, PF, not as the required returnforrisktaken(thecostof capital) but as the expected returnfrom buying the
stock. If thestockis cheap,the implied return is highandif thestockis expensive, theimpliedreturnis low. Thefundamentalist seesthatthemainriskinbuying stocksis paying too
much(or selling for too little). The implied expected returncalculation informs aboutthis
risk.Chapter 18expands.
In a similar way, one can specify the required rate of return (commensurate with the
risk)and calculate implied growth rates, g, ratherthan implied expected returns. This reverse engineering canbe extended to constructing fade diagrams for implied operating incomegrowth, just likethose(for full earnings) in Figure 5.4 inChapter 5 andFigure 6.2 in
Chapter 6.Buyandsell regions in thesediagrams are identified bycomparing themarket's
fade diagram with the analyst's own.Accordingly, the analyst formally tests the market's
forecasts against his ownviewof thefuture.
Enhanced Stock Screening

Stock screening was introduced in Chapter3 as a simple (simple-minded?) method of
stock selection: Rank stockson PIE, PJB, Price/Sales, or other multiples and buy those
with low multiples and sell thosewith high multiples. The strategy came with a warning: Because multiples ignoreinformation aboutthe future, youare in dangerof trading
with someone who knows more than you.You can Screen on forward multiples......-on a
forward PIEfor example-but, better still, screenon the output of a modelthatbuildsin
anticipation of the future and appropriately identifies the value implications of those anticipations. Simple valuation models do this.
The screening works as follows. Fora set of stocksin an investment universe, calculate
for eachstockthe expected rate of return implicit in the market price, as just described.
Thenrank-the firms on this expected return. Buyfirms withhighexpected returns andsell
firms with low expected returns. One can also screen on implied growth rates. While
screening withsimple valuation models does not build in the compete anticipation of the
future that pro forma analysis (in Chapter 15)does, it is a significant enhancement over
simple multiple screening while stillretaining somesimplicity.
Sensitivity Analysis
Foran SF3 valuation of'Nike, weset core R.<~OA equalto the 2008 number of33.4 percent
and the growth rate at the historical rate for net operating assets of 5.3 percent. But the
506 Part Three Forecasting and Vaillarion Anal~sis
Chapter 14 Anchoringon rhe Fin~l1dal
simple valuation formulas allow us to enterany values. Accordingly we could entertain

what the valuation might be underdifferent scenarios for future profitability and growth.
Setting different values forthesefeatures is called sensitivity analysis. Thistestshow a
valuation changes as inputs to a model change, how the valuation is sensitive to alternative
speculations about thefuture. TheSF3valuation model gives theform inwhich to conduct
sensitivity analysis. Theonlydrawback is thatforecasts ofRNOA andgrowth in NOA must
be for constant amounts in the future. But,as an expediency, you might think of varying
RNOA or NOA growth in terms of theiraverage levels expected inthe future. Remember
weare always looking forshortcuts thatgive reasonable approximations.
'
Sensitivity analysis involves varying forecasts of Rt'l'OA and growth and observing
theeffectonthe valuation. How doesNike'sSF3valuation inBox14.2 change if weforecast that future RNOA will be 30.0percentratherthan 33.4percent? Or if we forecast
growth to be 3 percentratherthan 5.3 percent? Indeed, usingmodel 14.3a, we can constructa valuation grid thatgivesper-share values fordifferent combined forecasts ofthe
twodrivers:
Valuation Grid forNike, Inc., 2004 Required Return forOperations: 8.6%
I~
~~~:
0%
3%
4%
5%
6%
25%
30%
33%
36%
3437
46.45
53.97
65.68
86.39
41.24
57.00
66.86
82.10
109.13
45.37
63.33
74.53
91.95
122.77
49.49
69.67
82.24
101.80
136.41
The valuation grid can be three-dimensional to incorporate different estimates of the

required return. The two-dimensional grid heregives priceper share, which we calculate
fordifferent combinations of RNOA andgrowth in NOA_ If assetturnovers are forecasted
to be constant, growth in NOA is replaced bysalesgrowth.
As weI! as answering "what-if"questions, the gridexpresses ouruncertainty. Wemight
beunsure about Nike's profitability inthefuture, so thegriddisplays thevalue of uncertain
outcomes: What couldthevalue dropto,or increase to, underreasonable scenarios?
The valuation gridalsoindicates what combinations ofRNOA andgrowth in NOA justify the current price. A $68pricecanbe legitimized by forecasting RNOA of30 percent
witha growth rateof 4 percent or,alternatively, an RNOA of25 percent anda growth rate
of 5 percent. If we ruleout a growth rateof 5 percent as too high, we mustdemand that
Nikemaintain an RNOA of at least25percent to justifyits$68price.
Summary
Benjamin Graham, the fundamentalist of yesteryear, warned of using valuation formulas,

for he sawthem as an excuse forspeculation:
The concept offuture prospects and particularly ofcontinued growth inthe future, invites the
application offormulas out ofhigher mathematics toestablish the present value ofthe
favored issue. But the combination ofprecise formulas with highly imprecise assumptions
Sra!~mems: Simf'l~
Forec(1Jtir.g and Simple Valll~cion
507
can beused toestablish, orrather tojustify, practically any value one wishes, however high,
for a really outstanding issue."
Hiswarning must betaken toheart. A formula canbeusedtojustifyanyprice, as so-called
"due diligence" valuations for IPOs, acquisitions, and litigation sometimes do. Graham
was particularly concerned about speculating about growth; it is so easyto pluga "g" into
a formula. Sohe emphasized value justified bythefacts, placing weight onthepresent and
far lesson speculation about future growth.
Yet it hasbeensaidthat, if investors hadfollowed Grahamite principles, they would have
missed out on the greatgrowth companies of the last halfof the 20thcentury, like IBM.
Growth mustbe entertained, but in a disciplined way. The building blocks of a valuation
introduced in Chapters 5 and 6 separate what we know (about thepresent) from what we
don't know (speculation about growth), but they recognize growth. This chapter emphasizes what we know-from the financial statements-and the valuation implied. This
supplies a building block. Thenextchapteraddsthebuilding blockofspeculation about the
future, but in a disciplined way that protects us from being carried away withspeculation.
Thischapter shows how simple forecasts canbe developed from current andpastfinancialstatements. These forecasts utilize the financial statement analysis of PartTwo of the
book to forecast the future. If core profitability is identified in that analysis, forecasts can
be developed as if thatcoreprofitability is sustainable. Addto coreprofitability a measure
of growth, andthe analyst hasa simple forecast (an SF3forecast). Add durability of competitive advantage, andtheanalyst has a weighted-average SF3forecast. If assetturnovers
areconstant, sustainable growth is given by a salesgrowth forecast.
Thethree simple forecasts yieldsimple valuations thatgivetheanalyst a first, quick-cut
feel for the valuation and quick enterprise PIB and PIE ratios. Without much extra work,
this is a considerable improvement overscreening on multiples of current earnings, book
values, andsales.

More demonstrations of simple forecasts.
More applications of two-stage growth forecasting.
More coverage of sensitivity analysis.

More on weighted-average forecasts anddurable competitive advantage.
The analyst who ignores information is at peril. The simple valuations will not work
wellwhen information outside the financial statements indicates that future profitability
andgrowth will be different from current profitability and growth. Theanalyst calculates
thesimple valuations as starting pointsbutthen turnsto full-information forecasting (as in
thenextchapter).
Notwithstanding, the simple valuations are an analysis toolto examine how valuations
are sensitive to different scenarios for future profitability and growth-for asking "whatif" questions. Andtheylendthemselves to reverse engineering to uncover the forecasts of
profitability and growth thatare implicit in themarket price.
7 B.
Graham. The Intelligent Investor, 4threv. ed. (New York: Harper & Row, 1973), pp. 315-316.
508 Part Three
FOfCCa5!ini< and VllllI(l!rml
Chapter 14 Anchoring on rhe Financial Srcrcmems: Simple Forecmci"g and Simple Va1:t(l(ion 509
An<1I}',i,
TRACKING THE PRICE AND VALUE HISTORY

Key Concepts
Analysis Tools
mean reversion is thetendency of a

measure to move overtimetoward
the average or typical level for the
measure.. 50]
sensitivity analysis testshow value
changes withdifferent forecasts of the
future or with different measures of
the required return. 506
Page
SFl forecasting
SF2 forecasting
SF3 forecasting
SF1 valuation (equation 14.1)
Enterprise PIB multiplier
(equation 14.3a)
Enterprise PIE multiplier
(equation 14.4)
Weighted-average forecasts
Combining sales forecasts
with SF3 forecasts
Two-stage growth forecasting
(equation 14.7)
Fade diagrams
Reverse engineering
Enhanced stock
screening
Valuation grid
488
490
493
490
492
496
496
496
499
Key Measures
simpleforecasts involve forecasting from

information inthe current financial
statements. 488
simplevaluations arevaluations
calculated from simple forecasts. 497
Page

growth (AOIG)
493
Core residual operating
income
496
Growth rate for cum-dividend
operating income (G)
496
Growth rate in netoperating
a~e~
496
Leverage-adjusted ROCE
495
Sales growth rate
499
499
503
501
503
At the end of 1999, Kimberly-Clark's stock traded at $60 per share. Subsequent annual
dividends andstockprices arebelow.
2000
Dividends pershare
Price, end of year
2003
2004
1 1.08
2001
1.12
2002
1.20
1.36
169.50
5930
47.80
59.00
1.60
65.00
Calculate the total return from holding KMB shares overthe five years and alsothe averageannual rateof return. How doesthis compare withthe required equity return thatyou
have beenusing in theContinuing Caseto thispoint?
Now lookat theresidual income numbers youcalculated for these years in theContinuing CaseforChapter 13. Would yousaythatthestock pricehasmirrored theadded-value
numbers that you have been calculating? At the end of 1999, Kimberly-Clark reported
$7,745 million innetoperating assetsandcommon stockholders' equity ofS5,093 million,
with 540.6 million shares outstanding. Would you say that the enterprise price-to-book
ratio at the time was justified, afterthefact, bytheresidual income from operations thatthe
finn subsequently earned?
AOIG abnormal growth in

operation income
equity
G (1 plus) growth rate in cumdividend operating income
NFE netfinancial expense
NFO netfinancial obligations
01 operating income
assets
SFl simple forecast, type 1
SF2 simple forecast, type 2
SF3 simple forecast, type 3
A SIMPLE VALUATION
Proceed to a simple valuation, usingthe required return foroperations youhavepreviously
calculated. Limit yourself solelyto information you have discovered in current and past
financial statements. Calculate enterprise price-to-book and enterprise PIE ratios from the
information. What does that information imply the stock price should be at the end of
2004? Remember to deduct theoptionoverhang youcalculated in the Continuing Casefor
Chapter 13.How does yourvaluation compare with the market price (in March 2005) of
$64.81 pershare?
REVERSE ENGINEERING AND SENSITIVITY ANALYSIS

The market price embeds expectations of future growth. Assuming Kimberly-Clark can
maintain future operating profitability at the level of current coreRNOA, what growth in
residual earnings is the market projecting for the future? Would you say this forecast is
reasonable, given the history? What tools might you use to get better insights? Lookat
Figure 5.4,forexample.
Now start to experiment. Whatscenarios would justify the market price? Do you see
theseas reasonable scenarios? Do you see scenarios that would suggest that the stockis
underpriced or overpriced? Ale thesespeculations consistent withwhat youknow fromthe
"financial statement history?
505
506

You finally have arrived at the pointto value Kimberly-Clark's shares. In thischapter, you
willcarryouta simple valuation, limiting yourinputs tothose from thefinancial statements
that youhavediligently beenanalyzing. Then, inthe nextchapter, youwillcarryouta ful!
proforma analysis andvaluation.
Concept
Questions
CJ4.1. Why is a simple forecast of operating income based on book value usually not a
goodforecast? When might such a forecast be a goodforecast?
C14.2. A valuation thatsimply capitalizes a forecast of operating income for thenextyear
implicitly assumes that residual operating income willcontinue as a perpetuity. Is
this correct?
C14.3. What is thedifference between an SF2andan SF3 forecast?
510 Part Three
For~cm(ing and
Chapter 14 Anchoring on rh~ Financial Smremenrs: Simpl~ Fareca.srillg and Simple Valuation 511
'v,l!llmirm Allal)'5i5
CI4.4. An analyst forecasts that next year's core operating income for a firm will be the
same as the currentyear's core operating income. Underwhat conditions is this a
goodforecast?
CI4.5. When is the forecasted growthrate in residual operating income the same as the
forecasted growth ratein sales?
CI4.6. Would youcalla firm thatisexpected to have a highsalesgrowth rateagrowthfinn?
C14.7. Thehigherthe anticipated return onnetoperating assets(RNOA) relative to the anticipated growth in net operating assets, the higher will be the unlevered priceto-book ratio. Is this correct?
E14.4. Reverse Engineering (Easy)

A firm reports$3,721 million of net operating assets and $560 million of net financial
obligations at the end of 2008. Its 105million shares outstanding trade at $53 each. You
expectitscurrentcoreRNOA of 18.6percentto continue at thesamelevel in the future and
also expect net operating assetsto growat 4 percent per year. What rate of return do you
expect from investing in thisstock?
E14.5. Reverse Engineering with Two-stage Growth Rates (Medium)
An analyst develops the following pro forma at the endof2009 (in millions):
Drill Exercises
Exercises
b. Using the two-stage growth model 14.7, valuethe equity witha long-term growth rate
of 4 percent.
c. Whatis the forward enterprise pricefearnings ratioimplied by the valuation?
E14.1. An SF2 Forecast and a Simple Valuation (Easy)

An analyst calculates residual operating income of535.7 million fromfinancial statements
for 2009, usinga required returnfor operations of 10 percent. She also forecasts residual
operating income at the same level for 2010 and years after on net operating assets of
$1,257 million at the end of2009.
Operating income
Netoperating assets
Common equity
a. Whatis the analyst's forecast of operating income for20l0?

b. Whatis the valueof the operations basedon theseforecasts?
c. Whatis the forward enterprise PIEratioimplied by the forecasts?
Netoperatinq assets
2008
19,682
1,987
17,695
19,400
1,876
17,524
Coreoperating income (aftertax)for2009was$990million. Therequired returnforoperations is 9 percent. Forease,use beginning-of-year balancesheetnumbers where pertinent
in calculations.
a. Whatwas the core return on net operating assetsfor 20091
b. Prepare an SF3 forecast of operating income and residual operating income for 2010
based on this financial statement information.
c. Value the equitybasedon the information.
d. Whatisthe intrinsic enterprise price-to-book ratio?
E14.3.
Two-Stage Growth Valuation (Easy)

An analyst develops the following pro forma at the endof2009 for a firm thatusesa 9 percent hurdle ratefor its operations (in millions);
2009A
Operating income
Netoperating assets
Common equity
$6,400
756
$5,644
2010E
2011E
$ 781
6,848
$ 868
a. Forecast the cum-dividend operating income growth ratefor 2011.
7,190
2010E
20m
$6,400
1 782
6,848
1 868
7,190
$5644
a. Forecast the cum-dividend operating income growth rate for 2011 using a 9 percent
return for reinvesting cashflows.
b. You consider 9 percentto be a reasonable returnfor investing in the operations of this
firm and also view the GDP growth rate of 4 percent to be a reasonable long-term
growth rate.The 450 million sharesof the finn are trading at $52 each. Do youconsiderthemto be cheapor expensive?
E14.2. An SF3 Forecast and a Simple Valuation (Easy)

An analyst prepares the following reformulated balance sheet(in millions of dollars):
2009
2009A
E14.6.
Simple Valuation with Sales Growth Rates (Medium)

An analyst forecasts thatthe currentcorereturnon net operating assetsof 15.5 percent will
continue indefinitely in the future with a 5 percent annual sales growth rate. She also
forecasts that the current asset turnover ratio of 2.2 will persist. Calculate the enterprise
price-to-book ratio if the required returnfor operations is 9.5 percent.
E14,7.
Simple Forecasting and Valuation (Medium)

An analyst uses the following summary balancesheet to valuea firm at the end of 2009
(in millions of dollars):

2009
2008
4,572
1,243
3,329
3,941
1,014
2,927
The analyst forecasts that the finn will earn a return on net operating assets (RNOA) of
12percent in 2010and a residual operating income of$9l.4 million.
a. Whatisthe implied rateof required returnforoperations thatthe analyst isusingin his
residual operatingincome forecast?
b. The analyst forecasts that the residual operating income in 2010 will continue as a
perpetuity. Whatvaluedoes this implyfor the equity?
c. Calculate the forecast of residual earnings (oncommon equity) thatis implied bythese
forecasts. The firm'safter-tax costof debt is 6.0percent.
512 Part Three
For~ca.st;ng and
Vahwci(1ll A'ialysis
Chapter 14 Anchoring on rn~ Financial Statemems: Simple Forecasting andSimple Va!twtion 513
Applications
E14.8.
The following information was garnered from the firm's financial statements (in
millions):
Simple Valuation for General Mills, Inc. (Easy)

The following are from the financial statements for General Mills (in millions):
Netoperating assets
Common equity
Core operating income (after tax)
2008
2007
$12,847
6,216
1,560
$12,297
5,319
Revenues
Netoperating assets
Common equity

See Exercises El.5, E2.9, E3.9, E4.9, E6.8, EIO.9,E13.l5 and E15.l0.
Sales
23,104
4,944
Core operating income, aftertax
Netoperating assets (average foryear) 17,184
2003
2002
21,742
4,870
16,563
20,857
4,443
15,735
19,564
4,324
14,932
a. Calculate the core operating profit margin and asset turnover for each year
2002-2005.
b. Calculate the average salesgrowth rateoverthe years2003-2005.
c. The firm reportedcommon shareholders'equityat the end of2005 of$16,945 million, along with $1,010 billion in net financial obligations. Usingthe numbersyou
calculated, estimate Coke's enterprise value at the end of 2005 and also the value
per share. Use a required return for operations of 10 percent. Box 14.3 will help
you.
See Exercises E4.5, E4.6, E4.7, E11.7, EI2.12, E15.12, E16.7 and E19.4. Also see
Minicases M4.1,M5.2and M6.2 forcoverage of Coke.
14.10.
Reverse Engineering for Starbucks Corporation (Medium)

In January 2008, the 738.3 million outstanding shares of StarbucksCorporation tradedat
$20 each.Analysts' consensus earning-per-share estimates of$I.03 for the fiscal yearending September 30, 2008,gavethe finn a forward PIEof 19.4. The firm reported earnings
persharefor 2007of$0.90, up from$0.74a yearearlier.
$7,787
2,565
337
2,228
b. Usingthesenumbers and a required returnof9 percent, forecast residual operating income(Real) for fiscal year2008.
c. Whatis the stockmarket's implied rate of growthfor residual operating income after
2008'
d. Suppose that you forecast that Starbucks will grow residual operating income at a
3.5 percent rateafter 2008.Whatis yourexpected returnfrombuyingthe Starbucks's
business at the currentmarket price?
Simple Valuation for the Coca-Cola Company (Medium)

In early 2006, the 2,369 million outstanding shares of the Coca Cola Company tradedat
$48.91 each.The price-to-book ratio was6.3 and the forward PIE was 19.3 basedon analysts' consensus EPS forecast for 2007. An analyst extracted the following numbers from
Coke's financial statements (in millions of dollars):
2004
$9,412
671
3,093
915
2,178
(l) Coreoperating profit margin

(2) Corereturnon net operating assets(coreRNOA)
(3) Assetturnover
(4) Growth ratefor net operating assets.
a. Whatis General Mills's SF2 per-share valuation?

b. Whatis General Mills's SF3per-share valuation?
2005
2006
a. From these statements, calculate the following for 2007 (with beginning-of-period
balancesheetnumbers in denominators where applicable):
Therewere337.5million shares outstanding at the endoffiscal year2008 andthey traded

at $60 each. Use a required return for operations of 8 percentin answering the following
questions:
E14.9.
2007

Exercises on Starbucks are E8.8,E9.9,El1.9 and E12.8.
E14.11,
A Simple Valuation and Reverse Engineering: IBM (Easy)

The following are keynumbers from IBM'sfinancial statements for 2004.
Net operating assets, end of year

Net financial obligations, end of year
Common equity, end of year
Common shares outstanding, end of year
Core return on net operating assets
Sales qrowth rate
$ 42,104 million
12,357 million
29,747 million
1,645.6 million
18.8%
8.8%
IBM'ssharestradedat $95 when 2004results were announced. Use a required return for
operations of 12.3 percentto answer the following questions:
a. Forecast operating income and residual operating income for 2005 if IBM maintains
thesamecore RNOA as in 2004.
b. Calculate the per-share valueof the equityifIBM wereto maintain thisprofitability in
the future and if residual earnings were to grow at the 2004 sales growth rate. Also
calculate the implied forward enterprise PIEratioandthe enterprise PIE ratio.
c. Calculate the expected rateof returnon buying rEM's stockat $95underthe scenario
in partb. Is $95 cheapor expensive?
d. Whatgrowth ratein residual operating income would justifythe currentstockpriceif
you were surethat 12.3percentwasa reasonable required return?
Chapter 14 Anchonilg 011 !h~ FJiwncial Stlltcl/1c'nts: Simple Fnreca>!i11g lIodSimp!e YillllMioll 515
514 Part Three Forecasting lind VIIIIlIl!ir!l\ Anlll).lis
Fromthe balance sheet(in millions):
Exercises E6.9and 13.14dealwithIBM,as does Minicase MI2,}.
E14.12.
A Simple Valuationwith Short-farm and Long-Term Growth Rates:

Cisco Systems(Easy)
In late 2002,analysts were forecasting fiscal 2003 and 2004earnings per share for Cisco
Systems of $0.54 and SO.61, respectively. Cisco's shares traded at $15 at the time.
Assuming the long-term growth rate will be at 4 percent, the average rate of growth for
gross national product. valueCisco usingthe model in equation 14.7in this chapter. Apply
the formula to earnings rather thanoperating income and use a required returnfor equity
of9 percent.
See Minicases MS. 1, M6.1,and M14.2 on Cisco, and alsoExercise 2.11.
E14.13.
Comparing SimpleForecasts with Analysts' Forecasts: Home Depot, Inc.

(Medium)
Home Depot,the warehouse retailer, tradedat $42per sharewhen its 2005 financial statements were published. Analysts were forecasting $2.59 earnings per share for 2006 and
S2.93 for2007.Therewere 2,185millionshares outstanding at thetime.Beloware income
statements for fiscal years 2003-2005, along with information extracted from balance
sheets. Home Depot'scombined federal and statestatutory lax rateis 37.7percent.
Develop forecasts of earnings for 2006 and 2007 from the financial statements. How
closeareyourforecasts to the analysts' forecasts?
THE HOME DEPOT, INC. ANDSUBSIDIARIES
(In mi!lions except per-share numbers)
Fiscal YearEnded
Net sales
Cost of merchandise sold
Gross profit
Operating expenses:
Selling andstore operating
Tota Ioperating expenses
Operating income
Interest income (expense):
Interest andinvestment income
Interest expense
Interest, net
Net earnings
Weighted-average common shares
January 30,
February1,
February2,
2005
2004
2003
$73,094
4B,664
24,430
$64,816
44,236
20,580
$SB,247
40,139
lB,108
12,588
13,734
6,846
11,276
1,002
12,278
5,B30
79
15,105
1,399
16,504
7,926
56
59
-'22.)
-E)
~)
7,912
__
(3)
.zsu
2,539
$ 4,304
2,283
$ 1.88
2,289
1.88
$ 5,001
2,207
LW
2,216
$ 2.26
6,843
-...-B
42
5,B72
2,208
$ 3,664
2,336
L...12
$
2,344
1,56

Common equity
E14.14.
2005
2004
2003
2002
$23,833
325
24,158
$20,886
1,521
22,407
$18,820
982
19,802
$16,753
1,329
18,082
ValuationGridand Reverse Engineering for Home Depot, Inc. (Medium)

a. Using the information in Exercise 14.13, calculate the implied growth rate in residual
operating income that is implicit in the marketpriceof $42per share.
h. Ifyouforecast thatthe growth ratein residual earnings afterfiscal year2006willbethe
GDPgrowthrateof 4 percent,what is the expected returnto buyingthe stockat $42?
c. Preparea valuation grid showing whatthestockis worthfor alternative forecasts of return on net operating assetsand growth in netoperating assets.

Exercises onHomeDepotare E5.12, E9.10,El1.10, EI2.9, and14.13. Minicase q.l deals
withthe finn also.
516 Part Three
Minicases
Forcc(llting and Vailialion Analysis
M14.1
Simple Forecasting and Valuation:

Procter & Gamble IV
This case continues the financial statement analysis of Procter & Gamble Co. begun in
Minicase 9.1 anddeveloped further inMinicases 11.1 and12.1. Thisinstallment focuses on
forecasting andvaluation, with further development in Minicase lS.! in thenextchapter.
Financial statements for Procter & Gamble arepresented in Exhibit 9.15in Chapter 9.
If youworked Minicase 9.1,youwillhave reformulated theincome statements andbalance
sheets to distinguish operating activities from financing activities. If youworked Minicases
Mll.1 and 12.1, you willhave reached an understanding ofP&G's coreprofitability and
the factors thatdrive thatprofitability. If not, youshould doso now.
To start, calculate residual core operating income for the years 2006-2008 and note
changes overtime. Usea required equity return of8.5 percent butconvert it to an unleveredrequired return (foroperations). InJuly 2008, just afterthefiscal yearended, the3,033
million outstanding shares of P&G were trading at $64.The risk-free rate wasabout 4.5
percent, so an 8.5 percent required return implies a 4 percent risk premium suitable for
equity witha beta lessthan 1.0. What is thetrend in residual operating income? DoesP&G
appear to be a growth company? What drives thetrend?
A. Develop forecasts of residual operating income for2009 andgrowth thereafter based
solely on information inthe financial statements. Your analysis should include a nogrowth (SF2) forecast, along witha (SF3) forecast thatincludes growth. Consider a
weighted-average SF3forecast. Doyouthinktheseforecasts areapplicable toP&G?
Carryout a sensitivity analysis to changes in inputs by developing a valuation grid.
B.Analysts were forecasting $4.28 in earnings pershare forfiscal year2009. How does
the analyst forecast compare withyours?
C. Calculate the (traded) enterprise price-to-book ratio and reconcile it to the levered
price-to-book ratio. Now calculate anintrinsic enterprise PIBusing equation 14.3a in
thischapter. Doyou thinkthe$64price is reasonable?
Chapter 14 Anchoring on rhe Financial Srcremenu: SimpJ~ Forecasring andSimple Vailimion 517
By any stretch of the imagination, Cisco Systems (CSCO) has been a strong growth
company. A darling of the Internet boom of the late 1990s, it wasone of the few technologycompanies tiedto theInternet andtelecommunications that prospered during thatera.
Its products builtthe infrastructure of the Internet. While most Internet andtelecommunications firms struggled andfailed, theirsupplier, Cisco, capitalized on thenew technology.
At one pointin 2000, its market capitalization wasoverhalfa trillion dollars, the largest
market capitalization of anyfirm, ever. Its PIE wasover130. Thestockpriceincreased from
$10 in 1995 to $80 in 2000, supported by sales growth from $2.0 billion in 1995 to
118.9 billion in 2000.
However, with the subsequent collapse of the technology bubble and the demise of
telecommunications firms suchasWorldCom, Qwest, andAT&T, growth slowed considerably. Sales thatpeaked at $22.3 billion in fiscal year2001 dropped to $18.9 billion by 2003
andrecovered to the2001 level onlyin 2004. Thestockpricealsotumbled, reaching a low
of a littleover$8 inlate2002 afterthefirm reported a net lossfor the year.
Cisco's 6,735 million shares traded at$21 eachin September 2004, just afterits results
for fiscal yearending July2004had been published. You are asked to challenge this stock
price, butonlywithinformation youglean from the financial statements. Exhibit 14.1 presentsCisco's comparative income statements andbalance sheets for2004 along withsome
additional information.
You should prepare simple valuations based on thesestatements. Usea required return
of 10 percent for Cisco's operations. You might then introduce some scenarios for the
future-s-speculation aboutsalesgrowth andthelevel ofprofitability, forexample-e-tc seeif
the current pricecanbe justified or whether reasonable speculation might justify an even
higher price. You might alsotest how yourvaluations are sensitive to the required return
you use. Andyoushould apply reverse engineering toolsto understand the forecasts that
are implicit in themarket price.
Minicases MS.l and M6.1 also deal withthe valuation of Cisco Systems, as does ExerciseEl4.l2.
Additional Information
1. Long-term investment arecomprised of thefollowing (inmillions of dollars):
Minicases M9.1, M11.1, M12.1 andMJ 5.\ alsocover Procter &Gamble.

2004
M14.2
Simple Valuation and Reverse Engineering

for Cisco Systems, Inc.
Cisco Systems, Inc. (CSeO), manufactures and sells networking and communications
equipment for transporting data, voice, and video and provides services related to that
equipment Its products include routing andswitching devices; home andoffice networking equipment; and Internet protocol, telephony, security, network management, and
software services. The firm has grown organically but also through acquisition of other
networking andsoftware firms. Cisco's Web siteis at wwwctsco.com.
Equity investments
Debt investments
1,134
2003
745
2002
567
9,464
11,422
8,233
10,598
12167
8800
All short-term investments are debt investments.

2. S50million of cashandcashequivalents areregarded as operating cash.
3. Other income (loss) applies to gainsandlosses on investments.
4. The change in accumulated other comprehensive loss for both years was due almost
entirely to unrealized gainsandlosses oninvestments.
5. The cashflow statements for 2004 and 2003 did not reveal any unusual accrual items
affecting coreincome.
6. Cisco Systems' income tax rate(combined federal andstate)is 36.8percent.
518 Part Three
For~'(IS!ing and V(l!llanOll Alw!)"si~
EXHIBIT 14.1
Chapter 14 Anchon"ngon rhe Financial $rl1tcmenn: Simple ForeclLlring and Srmplc Valut:nion
EXHIBIT 14.1
Consolidated Statements of Operations

(in millions. except per-share amounts)
Comparative Finan-
519
(in millions, except parvalue)
(concluded)
cial Statements for
Cisco Systems, Inc.,

2004
Years Ended
Net Sales:
Product
Service
Tota\ netsales
July 31, 2004 July 26, 2003 July 27, 2002

$18,550
3,495
22,045
$15.565
3,313
18,878
$15,669
3.246
18,915
5,766
1,153
4,594
--..1.Q2.1.
Cost of Sales:
Product
6,919
5,645
5,914
988
6,902
15,126
13,233
12,013
3,135
3,448
4,264
618
699
Service
Total costof sales

Gross Margin
Operating Expenses:
Sales and marketing
Amortization of purchased intangible assets
In-process research anddevelopment
3,192
4,530
867
242
3
8,834
Operating Income
Interest income
Other income (loss), net
Interest andotherincome (loss), net
Income before Provision for
Income Taxes and Cumulative
Effectof Accounting Change
Provision tor income taxes
Income before Curmrlatlve Effect
of Accounting Change
Cumulative effect of accounting change,
net of tax
NetIncome
Income per share before cumulative effect
ofaccounting change-basic
Income pershare before cumulative effect
of accounting chanqe-cdiluted
Net income pershare-basic
Net income pershare--o'iluted
July 31. 2004 July 26, 2003 July 27. 2002

Assets
6,292
512
188
700
4,116
702
394
4
9,094
4,882
660
2,919
895
(1.104)
131
~)
6,992
2,024
5.013
~
-.lli
4,968
3,578
1,893
2,710
~
S 4,401
$ 3.578
$ 0.50
$ 0.26
$ 0.70
$ 0.50
0.64
I 0.50
0.62
0.50
$ 0.25
$ 0.26
$ 0.25
s
s
0.73
$ 1,893
Current assets:
Accounts receivable, netof allowance
for doubtful accounts of $179 and $183
Inventories
Deferred taxassets
investments
Property andequipment, net
Goodwill
Purchased intangible assets, net
Other assets
Total Assets
liabilitiesand Shareholders'Equity
Accounts payable
Deferred revenue
Other accrued liabilities
Total Current liabilities
Deferred revenue
Total liabilities
Commitments andcontingencies (Note 8)
Minority interest
Preferred stock, no parvalue: S shares
authorized; noneissued andoutstanding
Common stock andadditional paid-in
capital, $0.001 parvalue: 20,000 shares
authorized; 6,735 and6,998 shares issued
andoutstanding at July 31,2004and
July 26, 2003, respectively
Retained earnings
Total shareholders' equity
Total liabilitiesand Shareholders'Equity
$ 3,722
4,947
$ 3.925
4,560
9,484
3.172
1,825
1,207
1,827
815
14,343
10,598
3,290
4,198
325
2,840
$35,594
1,351
873
1.975
753
13,437
12.167
3,643
4.043
556
3,261
$37.107
1,105
880
2.030
762
17,433
8,800
4,102
3.565
797
3.098
37,795
594
739
1,470
3.034
2,457
8,294
774
9.068
470
579
1,365
3.143
2,818
8.375
749
90
10
15
22,450
3,164
212
25.826
535,594
21,116
20,950
6,559
7,733
(27)
28,656
37.795
657
963
1,466
3,527
2,090
8,703
975
9,678
354
28,029
$37.107
9,124
520 PartThree Forecasdng and V(1ltllnon AJl<1IYli5
7. The stockoptions footnote for 2004reported the following (inmillions of options):
Options Outstanding
Options Available
for Grant
Number
Outstanding
WeightedAverage
Exercise Price
per Share
526
(195)
52
1,303
195
(96)
(52)
25.29
20,00
10.03
32.33
7
390
1,350
$25.34
Balance at July 26, 2003

Granted and assumed
Exercised
Canceled
Additional shares reserved
Balance at July 31, 2004
Options Excercisable
Options Outstanding
Weighted- WeightedWeightedAverage
Average
Average
Remaining
Exercise Aggregate
Exercise Aggregate
Price per
Intrinsic
Number Price per
Intrinsic
Rangeof
Number
Contractual
Exercise Prices Outstanding Life (inYears)
Share
Value Exercisable
Share
Value
$ 0.01-9.75
9.76-13.04
13,05-16.15
16.16-18.57
18.58-19.59
19.60-26.42
26.43-50.38
50.39-64.38
64.39-72.56
Total
210
156
180
96
144
185
184
160
35
3.61
5.20
6.25
6.12
7.91
5.78
4.93
4.57
4,86
1,350
5.41
s 7.13
12.52
15.61
18.19
19.56
22.95
43.30
55.12
67,28
$25.34
$2,896
1,310
956
262
196
31
159
97
89
51
5
109
145
140
28
$ 6.57
12.28
15.68
18.21
19.19
24.37
42.46
55.09
69,17
$2,282
838
466
138
9
15
$5,651
823
528.09
$3,748
Theaggregate intrinsic value inthepreceding table represents thetotalpretax intrinsic value

basedon Cisco's closing stockpriceof$20.92as of July30,2004, which would havebeen
received by theoption holders hadall option holders exercised theiroptions as ofthatdate.
Thetotalnumber of in-the-money options exercisable as ofJuly31,2004, was436million.
As ofJuly26,2003,748million outstanding options wereexercisable, andtheweightedaverage exercise pricewas$26.12 Asof July27,2002,634million outstanding options
were exercisable, andtheweighted-average exercise pricewas$23.51.
Chapter 15 Fun-Information Foreco.>cing, Valuation, and Business SlTotcg)' Analysis 523
.Full..Information
~Hi{~~i9Jecasting,
" i:i(~Valuation and

,;tatfiness Strategy
"'AJfialysis
LINKS
link m prevlcuschapter
Link to previouschapters
Chapter14developed
simpleforecasting
schemes based
on information in
financial statements-
Chapters II and 12 laid

out theanalysisof
financial statements that
uncovers drivers of
profitability and
growth.
;
., ;c;;;:'
..
How forecasting is a matter of financial statement

analysis for thefuture.
How financial statement drivers translate economic
factors into a valuation.
What a driver pattern is and what economic forces
affect them.
How to identify key drivers.
How to conduct full-information proforma analysis.
The 15 steps inproforma analysis.
The seven steps involved inforecasting residual operating
income andabnormal operating income growth.
How mergers andacquisitions areevaluated.
How buyouts are evaluated.
How pro forma analysis is used as a tool in strategy
analysis.

Develop pro forma income statements and balance
sheets forthefuture.
Get forecasts of future residual operating income,
abnormal operating income growth, andfree cash flow
from proforma financial statements.
Get valuations from proforma financial statements.
Show how changes in forecasts for specific drivers
change proforma financial statements andvaluations.
Use proforma analysis forsensitivity analysis.
Calculate the effect of a proposed merger or acqeislton on per-share value.
Use proforma analysis to evaluate strategy scenarios.
c:;DC
..",'.,.
'-oj.-
'.'
This chapter
This chaptershowshow
information outsidethe
financialstatements is
utilizedto make
forecasts thatimprove
uponthe simpleforecasts
in Chapter 14.
This chanteruses the

financial statement
analysis of Chapters II
and 1210develop a
framework for
full-information
forecasting.

Chapter16beginsan
investigation of
accounting issuesthat
arise in forecasting and
valuation.
Link to Web page
Learn howto develop

spreadsheet financial
modelsto convertforecasts
to valuations-visit the
textWebsite at
www.mhhe.comJpenman4e.
Howis
knowledge
of the
business
incorporated
in forecasting?
'!j7
'!j7
il
Howls
financial
statement
analysis
utilized in
forecasting?
Howare
proforma
future
financial
statements
prepared?
Howis
proforma
analysis
usedin
strategy
decisions?
The simple forecasting schemes in the last chapter embedded all

the concepts needed for valuation. But theydid not exploit all of the
information thatis necessary to makethe analyst feel secureabouta
valuation. The simple schemes focused on operating income and
growth in net assetsemployed in operations, but they reliedon current measures. Pull-information forecasting digs deeper. It forecasts
the full set of factors that drive operating income and net operating
assetsand, fromtheseforecasts, buildsup a forecast of residual earnings and abnormal earnings growth from Which a valuation can be
made.
Chapters 11 and 12 outlined the factors that drive profitability
and growth enabling us to analyzecurrentfinancial statements. But
because those same factors drive future profitability and growth,
the driver analysis of those chapters also gives us the framework
for forecasting: The analyst forecasts the drivers-c-future coreprofit
margins, turnovers, and so on-e-to develop forecasts. Financial statement analysis is an

analysis of the past, to provide information for forecasts of the future. However, you will
see in this chapter that forecasting is a matter of financial statement analysis of the
future. Muchof this chaptertakesthe analysis of Chapters 11 and 12androllsit overto the
future.
The drivers of profitability and growth are themselves driven by the "real" economic
factors of the business. So knowing the businessis an essential firststep to discovering the
information for full-information forecasting. You will see here how financial statement
analysis provides the means of interpreting the many dimensions of business activity in a
form that can be usedfor forecasting. Knowing the firm'sstrategy is alsoa prerequisite for
forecasting, and you will also see how financial statement analysis interprets strategy.
Moreover, you will see how the methodsof forecasting are also the methods by which a
managerevaluates alternative strategies.
The chapter develops a formal scheme for forecasting. The scheme ensures that all
relevant aspects of the business are incorporated and irrelevant aspects are ignored. It is
comprehensive and orderly so that no elementis lost. By forcing the analyst to forecast in
an orderly manner, the schemedisciplines speculative tendencies.
The simple forecasts of the last chapterare a starting point for full-information forecasting. They are based on current profitability and growth in net operating assets. Fullinformation forecasting asks how future profitability and growthwill differfrom current
levels. If, throughanalysis of additional information, we forecastthatindeedtheywill,then
wewill haveimproved on the simpleforecasts andthe simplevaluations.
524 Part Three Forecasting and Valuation Anal)'sis
Chapter 15 Full-Informaricm Forecasting, Valuarion, and Busine5s Srrateg)' Analysis 525
FINANCIAL STATEMENT ANALYSIS: FOCUSING THE LENS

ON THE BUSINESS
(It is often the case, however, that unusual items are expected to be zero.) The ATO is
Wehaverepetitively saidthatonecannot value a business without a thorough understanding

of thebusiness; knowing thebusiness is a prerequisite to valuation andstrategy analysisStep 1 of fundamental analysis. Before embarking on thischapter, lookbackto the section
titled"TheAnalysis of Business" in Chapter 1,where themainfactors thatdetermine businesssuccess arediscussed. Theanalyst mustunderstand thebusiness model andalternative,
adaptive strategies available tothe finn. Shemustunderstand thefum's product, its marketingandproduction methods, anditsknowledge base.Shemustunderstand thelegal, regulatory, andpolitical constraints onthe finn. Mostimportant, shemustdevelop anappreciation
of thedurability ofthefinn'scompetitive advantage, if any.
Understanding these many economic factors is a prerequisite to forecasting. But we
needa wayof translating thesefactors intomeasures thatleadto a valuation. We must recognize thefirm's product, thecompetition intheindustry, thefirm's ability to develop product innovations, andso on,but wemustalsointerpret thisknowledge in a waythatleadsto
a valuation. Economic factors are oftenexpressed in qualitative termsthatare suggestive
but do not immediately translate intoconcrete dollar numbers. Wemight recognize thata
finn has"market power," butwhatdoesthisimply forits value? We might recognize thata
firm is "under threat of competition," but what does this imply for its value? How are
"growth opportunities" valued?
Accounting-based valuation models and the financial statement analysis of Chapters 11 and 12provide the translation. 'Market power translates intohigher margins; competition reduces them. The technology to produce salesis reflected in the assetturnover.
And margins and turnovers are the drivers of profitability on which valuation is based.
The structure of financial statement analysis is the means to interpret whatwe observe
aboutbusiness. It focuses the lenson thebusiness. Thereis danger in relying on suggestive notions such as ''market power," "competitive advantage," and "breakthrough technology" without a concrete analysis of whattheymean. Investors cangetcarriedaway by
enthusiasm for such ideas, leading to speculation in stock prices. Forecasting within a
financial statement analysis framework disciplines investor exuberance and, indeed,
investor pessimism. It brings boththe bullsandthe bearsto a focus on the fundamentals.
Therearefourpoints of focus for translating business activities intoa valuation.
1. Focus on Residual Operating Income and Its Drivers

The focus for the valuation of operations is on residual operating income (ReOI) for a
PIB valuation or abnormal operating income growth (AOIG) for a PIE valuation. But
AOIG is just the change in ReOL So business activities are interpreted by theireffect on
ReOl.ReOI is driven by returnonnet operating assets (RNOA) andgrowth in net operating assets (NOA). RNOA is driven by fourdrivers:
RNOA = (Core salesPM x ATO) +
Coreother01 Unusual items

'0
+
NO
N A
. A
Combining these RNOA drivers withgrowth in NOA, wecancapture thedrivers ofresidual

operating income inoneexpression thatcontains five drivers:
ReOI= Sales x
l[" Core sales PM
Required return foroperations]

ATO
+Coreotheror+ Unusual items
(15.1)
salesper dollarof net operating assets, so the ratioof the required return on operations to
ATO hereis a measure of operational efficiency in using net operating assets to generate
salesrelative totherequired rateofreturnfor those assets. We willreferto itasthe turnover
efficiency ratio, witha smaller ratiogenerating moreReCI.TheRNOA drivers--core profit
margin, asset turnover, core other income, and unusual items-are in this formula. And
growth in NOA is embedded through its drivers: Since NOA is put in placeto generate
sales, NOA is driven by salesand 11ATO, that is, by salesand the net operating assets
required to generate a dollarof sales.
Forecasting residual operating income involves forecasting these drivers so,withvaluation
inmind, observations about thebusiness aretranslated intoforecasts ofthefive drivers:
L Sales
2. Core salesprofit margin
3. Turnover efficiency
4. Coreotheroperating income
5. Unusual items
Sales is the primary driver because, without customers and sales, no value can be
added in operations. Muchof ourknowledge of thebusiness-its products, its marketing,
its R&D, its brandmanagement, to name a few factors-is applied to forecasting sales.
And as every basic economics course teaches, dollarsales is sales price multiplied by
quantity sold. Bothpriceandquantity involve analysis of consumer tastes, thepriceelasticity of consumer demand, substitute products, the technology path,competitiveness of
the industry, and government regulations, to namea few. But equation 15.1 tens us that
salesgenerate positive ReOI onlyif theyare turned intopositive margins. Andsalesgeneratepositive ReOI onlyif thesemargins are greater thanthe turnover efficiency ratio.
As a firststepin organizing yourbusiness knowledge, attach economic factors to ReOI
drivers. What factors drive product prices andproduct quantities (andthussales)? Among the
answers willbe competition, product substitutes, brand association, andpatent protection.
What factors drive margins? Among theanswers willbetheproduction technology, economies
ofscaleandlearning, andthecompetitiveness in laborandsupplier markets.
2. Focus on Change
A finn's current drivers are discovered through financial statement analysis. Forecasting
involves future drivers, so focus onbusiness activities thatmaychange ReOI drivers from
their current levels. The analysis of changes in drivers is a question of earnings sustainability, or morestrictly, ReOlsustainability, Analyze change inthreesteps.
StepA. Understand the Typical Driver Pattern for theIndustry

Figure 14.1 in the lastchapter displays historical patterns thatare starting points forforecasting. Thedisplays areoftypical mean-reversion behavior ofRNOA andgrowth in NOA
to long-run average levels. Similar displays canbe made foreachindustry or product sectorfrom thehistorical data. And similar displays can be developed forcoreprofitmargins,
assetturnovers, andthe otherdrivers of ReO!.
These driver patterns aredetermined bytwoelements:
1. Thecurrent levelof the driver relative to its typical (median) level for a comparison set
of'firms.
2. Therateof reversion to a long-run level.
526 Part Three F[)Tecasting and Valuation Anal;!sis
Element 1 is established by the analysis of the current financial statements andelement 2

is the subject of forecasting. The rate of reversion to a long-run level is sometimes
referred to as the fade rate or persistence rate. Some analysts market their equity research as an analysis of fade rates. How long will a nontypical ReO! and nontypical
ReOI drivers taketo fade to the typical long-run level? How longwill a nontypical level
persist?
Economic factors affect firms in similarways within industries, so driver pattern diagramsarebest developed by industry. Industry is usually defined by the product brought
to market. There are standard classifications, like the Standard Industrial Classification
(SIC) system, which classifies firms by nested four-digit industry codes. Within an
industry, firms tend to become more like each other overtime, or they go out of existence. Thus,analysts talkof ReOland its drivers fading to levels that are typical for the
industry. Firms may have temporary advantages, new ideas, or innovations that distinguish themfrom others, but the forces of competitionandthe ability of existing andnew
firms to imitate them drive out the temporary advantage. Correspondingly, if thesecompetitive forces are muted, we expect to see more sustained driver patterns than for a
strongly competitive industry. As fade rates are driven by competition, some analysts
refer to the period over which a driver fades to a typical level as the competitive
advantageperiod.
Figure 15.1 gives historical patterns overfive-year periods between 1964 and 1999 for
the core RNOA driver for all NYSE andA1vlEX firms, along withpatterns for coreother
income (relative to NOA) and items classified as unusual (alsodivided by NOA).l These
figures, like those in the last chapter, trackthe drivers overfive yearsfrom a base year
(Year 0) for 10 groupsof firms that differin the. amount of the drivers in the baseyear.
They are referred to as fade diagrams. The top group contains firms with the highest
10 percent of the driver in the base year and the bottom groupcontains firms with the
lowest 10 percent. As you would expect, unusual items (in Figure 15.lc) fade out
quickly-they are very transitory-but core RNOA (in Figure I5.1a) and other core income (in Figure 15.1b) also fade toward central values, with high profitability (in the
uppergroups) declining and low profitability (in the lower groups) increasing. The diagrams indicate that the forces of competition are at playto drivecoreIl'N"OA to common
levels. Finnsinthetop 10percent of coreRNOA in thecurrent yearhavea median 29percent RNOA that fades to 18 percent five yearslater. But there are long-run differences
between coreRJ'JOA thathavetobe forecastFirmswithhighercoreRNOA currently tend
to have higher core RNOA later,but differences in core RNOA decrease overtime. We
willsee in PartFourthat the accounting partlyexplains thesepermanent differences.
Driver patterns also can be established for change drivers that were analyzed in the
analysis of growth in Chapter 12.Figure 15.2 gives historical patterns for sales growth
rates, changes in core sales profit margins, and changes in asset turnovers. These patterns indicate the sustainability of increases or decreases in the drivers. Sales growth (in
Figure I5.2a) is strongly meanreverting: Firms with large increases in salestendto have
lower increases in the future. Andlarge increases or decreases in coresalesprofit margins
(in Figure l5.2b) and assetturnovers (in Figure lS.2c)alsotendto be temporary. Average
changes in both drivers (represented by the fifth group from the top in Year 0) are close to
zero, butall groups converge to thisaverage overtime.
Chapter 15 FuU-lnformaritm F[)Tec.a.sting, Valuari[)T\, and Bminess SrrlUeg)' Ana!)'$is 527
FIGURE 15.1
Driver Patternsfor
Core RNOA, Core
Other Income, and
Unusual Operating
Items,NYSE and
A1'fEX Firms,
1964-1999
Thepatterns trace
themedian drivers
overfive yearsfor
10groups formed for
different levels of the
drivers in Year O.
Firms in theupper
groups have high
(a)CoreRNOA. Firms withhighcoreRNOA currently (in theuppergroups) tend to have declining

profitability in thefuture; firmswithlowcoreRNOA (inthelower groups) tendto have increasing
profitability inthefuture.
'"j
30%
-~~'- ..,.._'~
20%
-e
0
15%
drivers in thecurrent
year (Year 0) andfirms
in the lower groups
have lowdrivers in the
current year.
10%
5%
0%
-5%
~urte:
.-._--.,..~.
25%
,+
O. Ni.<lim and
S. l'ennun,"Rotio Analysis
""dEquio/ V31Il3tioo: From
Research to procti~e; Rmew
O!AccOlinlillgSrudies. March
2001, lIP- 109-154. B=<l 00
SWldard & Poor;;
-10%
Yearrelative tocurrent year(YearO)
COMPUSTAT data.
(b) CoreotherincomeINOA. Highcoreotherincome (for firms in theupper groups) tendsto

decline subsequently as a percentage of net operating assets; lowcore otheroperating income
(forfirms in thelower groups) tendsto increase.
6%
5%
4%
3%
\i
.g
~
-,
2%
~
1%
0%
0-
-0
i ; i
0-
4:
0
0
0
-1%
+'
-2%
1 k, with Figure 14.1 in Chapter 14,the patterns in thefigures here areaverages of patterns from
grouping firms ontheir drivers in 1954, 1969, 1974, 1979, 1984.1989,and 1994, andtracking their
subsequent path.
234
Yearrelative to current year(Year 0)
528 Part Three Forecasting andValuation AMlysis
Chapter15 FuU-lnfonnanon Farecasnilg. Valuation, and Business Stl'meg)' Ana~sis 529
FIGURE 15.1
(c) Unusual operating items/NOA. Unusual items tendto disappear veryquickly-as expected fora
(concluded)
transitory item.
8%
T
6%
4%
Source: D.Nissim and

S. Penman, "RatioAnalysis
andEquity V.luation: From
Research to P!3tlite,~ Rrview
cfAccc,mting Stw:lits. M:m:h
2001, pp.l09-154. Based On
2%
.~
g
;
0%
"
Standard& Poor's
COMPUSTAT data-
i:
Ii
I:
['
I
I
I
30%
20%
e
~
10%
-2%
-4%
40%
1964-1999
;
~
(a) Salesgrowth rates.Salesgrowth tends to fadequickly: Firmswith highsalesgrowth currently

FIGURE 15.2
(in theuppergroups) havelower salesgrowth subsequently; firms with lowcurrentsalesgrowth
DriverPatterns for
(in the lower groups) have highersalesgrowth subsequently.
SalesGrowth Rates,
Changesin Core
Sales Profit Margins,
lind Changes inAsset
T
50%
Turnovers,NYSE lind
AMEXFinns,
0%
-10%
-20%
-6%
2
Yearrelative tocurrent year (Year 0)
Thecontrarian stockscreening strategy (inChapter 3)shorts stocks withhighgrowth in

sales andprofits andbuysstocks with low growth. Thecontrarians have these change patterns in mindbut believe thatthe market doesnot.Theybelieve thatthe market getstoo
excited withhighsalesandprofit growth and thinks growth willcontinue rather than fade;
and theybelieve the market doesnot understand that drops in sales and profits are often
temporary.
-30%
Step C. Forecast Howthe Firm ~ Drivers WillBe Different

from the Typical Pattern
Understanding typical drivers foran industry disciplines speculative tendencies. Butfirms
have idiosyncratic features thatyielddrivers thatarepredictably different from industry patterns. So full-information forecasting is completed by asking how the firm's future drivers
will be different from the typical pattern forthe industry.
(b) Changes in coresalesprofitmargins. Changes in coresalesprofit margins tend to fadequickly

toward common levels closeto zero.
6%
Step B. Modify the Typical Driver Pattern for Forecasts

for the Economy and theIndustry
Historical industry patterns are a good starting point if thefuture is likely to be similar to
the past.Butindications maybe to the contrary. Government or tradestatistics may forecast a change in the direction for the(global) economy or for the specific industry. Forecasts of recession or a slowdown ofGDPgrowth maysignal a change from thepast. Shifts
in industrywide demand for the product maybe indicated by changing demographics or
changing consumer tastes. Knowing the business requires a knowledge of industry trends
anda knowledge of thesusceptibility of the industry to macroeconomic changes.
Historical driver patterns, adjusted if needbeformacroeconomic andindustry forecasts,
modify the simple forecasts of the last chapter; forecasts based on currentlevels of the
drivers aremodified to incorporate typical fade rates.
2
Yearrelative tocurrentyear(Year0)
4%
T,
'~
2%
0%
~.
-.
"
~
2
0
0
-2%
-4%
~~
II
(j
--6%
-8%
234
Yearrelative tocurrent year(Year0)
(continued)
Chapter 15
530 Part Three Forecoscing and Valuaticm AnaI)'5is
FIGURE 15.2
(concluded)
(c) Changes inasset turnovers. Changes in asset turnovers tend to revert toward common levels very
quickly; large increases inasset turnovers (in the upper groups) aretemporary, asarelarge decreases
in asset turnovers (inthelower groups).
0.8
0.6
FIIUlnfonnaticm Forecalring, Valll(1(ion, and Bll51ness Strategy Analysis 531
Exploiting first-mover advantages (Wal-Mart, Google, Internet portal pioneers).

Mergers (banking, financial services).
Creating superior production andmarketing technologies (Deli, Inc.).
Staying ahead ontechnological knowledge andproduction learning curve (Intel).
Creating economies of scale that are difficult to replicate (telecom networks, banking
networks).
Creating a proprietary technological standard or a network that consumers and other
firms must lockinto (Microsoft).
Government protection (agriculture).
OA
0.2
0
\;:
.=
a
~
-0.2
-0.4
-0.6
-0.8
-1
Year relative to current yw (Year 0)
Themainfactor in determining fade ratesis competition andfirms' reactions to it.Competition causes abnormal Rt~OA to fade, andtheability of thefirm to counter theforces of
competition sustains RNOA higher thanthe industry average. Firms bothcreate theforces
of competition andcounter those forces. Among the ways thattheychallenge otherfirms
(with examples of specific firms or industries) are:
Product pricereductions (Wal-Mart, Home Depot, andotherdiscount retailers).
Product innovations (software developers, pharmaceutical companies).
Product delivery innovations (Dell, Inc.,Amazon, andelectronic commerce).
Lower production costs (manufacturers moving production to countries withlow labor
costs).
Imitation of successful firms (pC cloners copying IBM; imitating Dell's inventory and
distribution system).
Entering industries where firms areearning abnormal profits (software, biotechnology).
Among ways that firms counter competitive forces (with examples of specific firms or
industries) are:
Brandcreation andmaintenance; franchising (Coca-Cola, McDonald's).
Creating proprietary knowledge thatreceives patent protection (phannaceutica1 firms).
Managing consumer expectations (beerandwinemarketing).
Forming alliances andagreements withcompetitors, suppliers, and firms withrelated
technology (airline alliances, telecom alliances).
Understanding thetension between theforces ofcompetition andthecounterforces iscrucialto forecasting fade rates. Many actions of:firms thatchallenge andcounter competition
create temporary advantages, butthese advantages oftendisappear over time. Product innovation draws customers but ultimately is imitated if there is no patent protection. Success
draws imitators unless therearenatural or government-enforced barriers toentry. These factorsyield decreasing returns (touseeconomists' language). Firms strive to maintain returns
orgenerate increasing returns. A firm that cancreate a technological standard (like Microsoft
withWindows) willenjoy sustained oreven growing ReOI ascustomers arelocked in.Sowill
apharmaceutical firm withpatents forproducts instrong demand (Genentech). Sowill a finn
thathascreated consumer demand through a strong brand name (Coca-Cola).
Government policy attempts to balance the forces of competition against the forces to
counter them. So government policy must be understood. Is the government disposed to
free tradeand competition? To protection? Topolitical favoritism? What is the antitrust
(monopolies) law? What arethe tradelaws andinternational trade treaties?
Thedriver pattern diagrams indicate notonlythathighprofitability tends to decline but
alsothatlowprofitability tendsto increase. Firms on thelattertrajectory include those that
are entering an industry or establishing newproducts. Theseoftenhave low initial profitability thatgradually improves. Theforecasting challenge is toassess thelikely success of
newproducts or innovations. Firms thatfade upratherthandown alsoinclude those whose
coreincome is temporarily depressed because ofproduct transition, competitive challenge,
or a laborstrike. The forecasting challenge is to assess the extent to which the low profitability is indeed temporary (sowillrecover) or ispermanent. The diagrams here arebased
on actual data; thepatterns therefore areforfirms which survived to eachfuture year. Forecasting survival and recovery is important forthese low-profitability firms: The forces of
competition drive outfirms thatcannot sustain ReOI in thelongrun. Chapter 19deals with
bankruptcy prediction.
Fading (upor down) is a typical pattern, butmany otherdriver patterns arepossible. A
notuncommon pattern is continuing highRNOA, without anyfading, along withgrowth in
ReO! because of growth in net operating assets. Theseare firms that counter competition
successfully. Nikeis a good example of a :firm thathas grown ReOI through brand management. Coca-Cola, oncea company thatcontinually grewReOI, hasjustmanaged tosustainReOI in the2000s. SeeBox 15.1.
3. Focus on Key Drivers

~s~~,~~~m~~~~~A~cl~
might change slightly, but one or two drivers might change significantly. Drivers that
require particular focus are key drivers. For Coca-Cola (in Box 15.1) sales and profit
margins arekeydrivers. A simple forecast might suffice for a non-key driver, butkey drivers require thorough investigation of thefactors that determine them. In retailing, profit
SELECTED INDUSTRIES
NIKE, INC.
Inthe face of stiff competition from Adidas, Beebok, and Puma brands, Nike has been able to grow sales andincrease COre
profit margins and cere RNOA on growing net operating assets. Accordingly, residual operating income (ReOI) has not only
been sustained buthas grown:

2008
Sales (billions)
Sales qrowth rate

Core profit margin
Asset turnover
Core RNOA
Average NOA (billions)
ReOI (billions)
$18.6
14.1%
9.6%
3.47
2007
$16.3
9.2%
2006
$15.0
8.8%
9.2%
8.9%
3.31
29.4%
2005
$13.8
2.1%
9.3%
3.09
2.95
28.3%
27.4%
33.4%
$ 5.4
s 4.9
s 4.8
$ 137
$ 1.03
$ 0.95
$ 4.7
S 0.88
2004
$12.3
14.5%
7.9%
2.76
21.7%
$ 4.4
$ 0.58
2003
$10)
8.1%
7.1%
2.43
Coke's management says in its lO-K that "our goal isto use the Company's assets-sour brands, financial strength, unrivaled
distribution system, global reach and talent, and strong commitment to our management and associates-tobecome more
competitive and accelerate growth in a manner that creates value for our shareholders. Up to 2000, Coke continually grew
residual operating income (ReOI) with strongsales growthandsustained coreRNOA. Since 2000, Coke hassustained ReOI but
without muchgrowth.Whileasset turnovers have beensustained, slowersales growth hasbeenaccompanied by a decline in
coreprofit margins:
N
Sales (billions)
Sales qrowth rate
Core profitmargin
Asset turnover
CoreRNOA
Average NDA (billions)
Real (billions)
Sal~
$24.1
4.3%
20.4%
1.32
26.9%
$18.4
$ 3.3
2005
2004
2003
2002
$23.1
6.3%
21.4%
1.36
29.1%
$17.2
3.5
$21.7
4.2%
22.4%
1.32
29.6%
$16.6
3.4
$20.9
6.6%
21.3%
1.32
28.1%
$15.7
$ 3.0
$19.6
11.5%
22.1%
1.35
29.8%
$14.9
$ 3.1
growth in2007indcdesthe effectof on acquis~ion.
margins are often fairly constant, so forecasting focuses on salesandATO where there is
more uncertainty. Because salesand ATO are driven by sales per square foot, the retail
analyst cutsthrough to thisnumber first.
Box 15.2 identifies key economic factors for selected industries and the ReOI drivers
associated withthem. It alsogives ananalysis of keydrivers forairlines.
Analysts sometimes identify firms by value types according to their key drivers. So
Coca-Cola is a brand managementfirm where value is driven by exploiting a brand. A firm
where profit margins andassetturnovers quickly revert to typical levels is called a company
of averages. A firm where value comes from growing salesand net operating assets with
sustained RNOA is calledagrowthfirm. Afirm thathaslarge fixed costs tobecovered and
where mostof sales goto thebottom line afterfixed costs are covered-e-like telecoms-is
referred to as being sales driven. (Thistype offirm hasincreasing ATO as salesincrease.)
II
I!
$28.9
19.8%
20.7%
1.30
26.9%
$23.0
$ 4.1
2006
532
KeyEconomic Factors
KeyReOI Drivers
Model design and production efficiency

Brand management andproduct innovation
Population covered (POP) andchurn rates
Square footage, rentper square foot, andoccupancy rates
Technology pathandcompetition
Brand management anddesign
Hits perhour
production efficiency
Retail space and sales persquare foot
Sales andmargins
Sales
Sales and ATO
Sales and ATD
Sales andmargins
Sales, advertisingfsales
Sales and ATD
Margins
Sales
Sales andATO
17.3%
$ 4.4
s 0.38
THE COCA-COLA COMPANY
2007
Industry
Automobiles
Beverages
Cellular phones
Commercial real estate
Computers
Fashion clothing
internet commerce
Nonfashion clothing
Pharmaceuticals
Retail
AIRLINES
Airlines typically operate with a given fleet anda given gate allocation at airports, at least in theshortrun. Thus with a fixed
numberof flightstheir costs are mainly fixed costs, and profitability is driven largely by revenues. Below arestatistics for the
10 largest carriers in the United States for 1994to 1996.
u.s. Industry Statistics
Revenue miles seat (RMS) (thousands)
Available seat miles (ASM) {thousands}
load teeter
Yield (cent perRMS)
Revenues ($ millions)
Passenger
Cargo andother
Total
Costs ($ millions)
labor
Fuel
Commissions
Rentals andlanding fees
Maintenance
Other
Total costs
Commission rate
Fuel price/gallon {$}
Average compensation ($ millions)
Labor productivity'
Unitlabor cosVASM
1994
Change
1995
Change
1996
Change
499,715
752,841
66.38%
12.47
4.34%
1.16%
3.14%
-1.88%
512,612
762,550
67.22%
12,84
2.58%
1.29%
1.27%
2.93%
546,896
784,502
69.11 %
13.08
6.69%
2.88%
3.70%
1.90%
62,332
7,572
69,904
2.38%
-0.88%
2.02%
65,816
7,653
73,469
24,171
8,099
6,386
7,501
3,210
3,840
14,741
67,948
10.2%
56.1
58,147
1,811
3.21
2.36%
-8.35%
-0.05%
1.54%
4.36%
1.61%
3.92%
1.01%
-2.86%
-8.55%
6.47%
5.22%
1.19%
24,093
8,193
6,308
7,824
2,989
3.191
15,061
68,259
9.6%
57.4
59,849
1,894
3.16
5.59%
1.07%
5.10%
-0.32%
1.16%
-1.22%
4.31%
-6.88%
-1.28%
2.17%
0.46%
-5.88%
1.23%
2.93%
4.59%
-1.59%
71,553
7,767
79,320
8.72%
1.49%
7.96%
25,507
10,275
6,307
7,739
3,485
3,825
15,767
72,905
8.8%
70
61,773
1,900
3.25
5.87%
25.41%
-0.02%
-1.09%
16.59%
0.09%
4.69%
6.81%
-833%
21.95%
3.21%
0.30%
2.91%
Note; Industry edodes Alaska, Armrica West. American, Ccntirn!ntal. Delta, Northwest. Southwest. TINA, United, and US Airwar;.
'Thousands ofavailable seatmiles peremployee.
(continued)
533
Chapter 15 FulJ-Infol7l1alion Farecll$tlng, VallUt~"an, and Business Srratep AnalYILl 535
The size ofthefleet and gateallocation defines whatthe industry calls available seatmiles (ASM). A loadfactordetermi
revenue miles sear (RMS) andticket prices determine the dollar yield perRMS. This yield, along with RMS, drives revenues
fora given ASM, load factors andyields arethe key drivers forairlines. The analyst cutsto these key factors butisalso senstt
to arr-; changes inavailable seatmiles with newroutes and newgateallocations. Other drivers such aslabor productivity, labor
costs, commission rates to travel agents, andfuel costs permile (given inthetable above) arealso monitored.
HOTELS AND RESORTS

Hotel and resort firms, like Hilton, Marriott, and Starwood. runlarge fixed-cost facilities withadded (fixed andvariable) labor
costs. Occupancy rates arean important driver butthese depend onthe price charged fora room. Acomposite ddver-revemj'e
peravailable room-captures both,so leads theset offactors thatdrive profitability. These factors are:
Revenue peravailable room (REVPAR) at existing properties, calculated asthe product oftheoccupancy rateandtheaverage:',
daily ratecharged (ADR).
Construction of newhotels anddisposition of underperforminq hotels.
New contracts to manage orfranchise hotels.
Enhancements intechnology to streamline operations and reduce costs.
Starwood Hotels and Resorts (which manages Westin, Sheraton, W, andStRegis hotels, among others) reported the following
REVPAR forthe years 2001-2004:
Worldwide (138 hotels with

apprOXimately 49,000 rooms)
REVPAR
ADR
Occupancy
North America (93 hotels with
approximately 36,000 rooms)
REVPAR
AD'
Occupancy
International (45 hotels with
approximately 13,000 rooms)
REVPAR
ADR
Occupancy
Stock price, end of year
2004
2003
2002
$110.81
$161.74
68.5%
s 98.03
$151.49
64.7 %
$ 95.46
$150.42
63.5 %
$101.44',.)
$155.77 '
65.1 %:
$110.13
$156.65
70.3 %
$ 98.21
$147.15
66.7%
$ 94.40
$145.61
64.8%
$100.42,::,
$152.39'::;
65.9 o/~'.:'';
$112.72
$177.57
63.5 %
S 59.50
s 97.52
$ 98.65
$166.35
59.3 %
$ 26.01
$104.55..
$166.55
62.8 % :\.
$ 30.59
$165.37
59.0%
$ 37.60
2001
------------------------\\
You see that the stock price tracks REVPAR. Occupancy rates dropped after September 11, 2001, and, in the international: :.. :-,
operations, after the SAR$ outbreak in2003.
A firm whose product is not yet clearly defined-like a start-up research biotech-is a
speculative type.These namesare helpfulto bring focusbut are oftenoversimplifications;
be careful not to presumetoo muchby typinga firm.
4. Focus on Choices versus Conditions

Economic factors andReO!drivers can change in twoways. Theyare determined eitherby a
changeintheenvironment the firmis inorbychoices madebymanagement. Government regulations andtaxratesare determined outside the fum (although the firmmighttry to influence
regulations). Product priceis oftenset by themarket The degreeof competition in theindustry is oftenoutside management's control. Thesearebusinessconditionsunderwhichthe finn
mustoperate. Butotherfactors aretheresultofstrategic choicesmadeby management. Management chooses the product. Management chooses the location and form of the production
process. Theychooseproductquality. Theydecide on the R&D program. Theymakealliances
withotherfinns.Thesechoices, takenas a whole, amountto thefum's strategy.
Understanding both business conditions and the firm's strategy is a prerequisite for
sound forecasting and valuation. When forecasting, the analyst asks how business
cond~tions might c~ange. and how management's strategy might change-perhaps in
reaction to changes In business conditions. But strategy, as a matter of choice,is itself the
subjectof valuationanalysis.
FULL-INFORMATION FORECASTING AND PRO FORMA ANALYSIS

Full-information forecasting builds up pro forma future financial statements from forecasts of drivers.This is done in an orderly way to ensure that no element is overlooked.
The forecasting schemefollows a straightforward outline.Salesforecasting is the start~ng point.Then forecasted profitmarginsareappliedto sales to yield forecasts of operating
Income. And forecasted ATC appliedto sales yields the forecastof NOAto complete the
ReOl calculation.
Wewill demonstrate the schemewith PPE, Inc., the merchandising companyfor which
we developed simple forecasts in the last chapter. Here are the relevantnumbersin PPE's
Year 0 statements(in millionsof dollars):
Sales
Operating income
Netoperating assets
124.90
9.80
74.42
Thesenumbersindicate a sales PM of7.85 percentand an ATO of 1.68.Suppose weforecastfroma marketing analysisthat salesfor PPE,Inc.,will increaseat a rateof 5 percentper
year. Supposealsothatwe forecast that coreprofitmarginswill be the same in the futureas
theyare currently (7.85percent) and that therewillbe no otheroperating incomeor unusual
items. To produce sales, an investment of net operatingassets (more property, plant, and
equipment) of 56 3/4centsfor each dollarof sales will haveto be in place at the beginning
of eachyear.This isjust the inverse of the forecastedATO, so the forecastedATO is 1.762.
Based on these forecasts, we can develop the pro forma of Exhibit 15.1. Sales, as you
see, are growingat the predicted 5 percent rate.Applying the forecasted PM to forecasted
sales each year yields operatingincome: Ol := Salesx PM. Applyingthe forecasted ATO
to sales yields the forecast of net operating assets at the beginningof the year: NOA =:
Sales/ATO. So we produce the ingredients of residual operating income, 01 and NOA.
(Allow for some roundingerrors whenproofingthese calculations.) The forecasted ReO!
is givenat the bottomof Exhibit 15.1.This is growing at a rate of 5 percentper year. So,
with PPE's requiredreturn for operations of 11.34percent,the value of the equityis
vt
:=
(pr - g)
=66.72+
:=
534
CSEo + ReOll
1.855
1.1134 - LOS
$95.98million
Chapter 15 FuU-InjormQtiQn Forecasting, Va!llQ[jon, andBusiness Srrateg'j Analysis 537
536 PartThree Forecasting andValWltion Anal~5i.l
or 0.96 per share (allow for rounding error.) That is, the equityvalueis the value of the
operations less the valueof the net financial obligations.
Theforecasted 01 andNOA arealsothedrivers offree cashflow (C- I = OI-lJ.NOA), so
thecashflow forecast in thepro formafallsout immediately.' Thesefreecashflow forecasts
can, in this case,be usedto valuethe firmusingdiscounted cashflow analysis. As the free
cashflows are forecasted to growat 5 percent peryearafterYear 1,thevalueof theequity is
EXHIBIT 15.1
PPE, INC.
Pro Forma Financial Statements, Operating Activities
(Required return for operations is 11.34%.)
Year-1
IncomeStatement
Sales
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
124.90
115.10
131.15
120.86
10.29
137.70
126.89
10.81
144.59
133.24
11.35
151.82
139.90
11.92
159.41
146.89
12.51
9]0

Financial income (expense)
v'o
6.574
Earnings
= $95.98 million
--
Balance Sheet
Netfinancial assets
69.90
(7.00)
74.42
(7.70)

(IOO million shares outstanding)
62.90
66.72
78.14
82.05
86.15
90.46
94.98
9.80
4.52
5.28
10.29
3.72
657
10.81
3.91
6.90
11.35
4.10
7.25
11.92
4.31
7.61
1251
452
7.99
14.02
7.85
1.787
65
1.87
13.83
7.85
1.762
5.0
1.855
5.0
13.83
7.85
1.762
5.0
1.948
5.0
0.093
5.0
13.83
7.85
1.762
5.0
2.046
5.0
0.097
5.0
13.83
7.85
1.762
5.0
2.148
5.0
0.102
5.0
13.83
7.85
1.762
5.0
2.256
5.0
0.107
5.0
CashFlowStatement
01
"NOA
Free cash flow (C-I)
RNOA{%)
Profit margin (%)
Asset turnover
Growth in NOA (%)
Re5idual 01(0.1134)
Growth in ReOI (%)
Abnormal 01 Growth (A01G)
Growth inAOIG (%)
-7.70
1.1134- LOS
(0.70)
---g:jO
AllowfOrTQWlding etmr'.
andthe intrinsic levered PIB ratiois 1.44. Thevalueof the operations is $103.68 million and
the unlevered PIE is 1.39. On 100 million shares outstanding, theper-share valueis $0.96.
Thedrivers ofReOI aregivenin theproforma. TheRNOA in allyearsis thesameas that
forecasted forYear 1 because itsdrivers, PMandATO, areforecasted to staythe same: This
is a firmwithconstantprofitability butgrowing investment inNOA. Butthe forecast andthe
valuation implieddifferfrom an SF3 forecast because ATC and growth in NOAare predietedto bedifferent fromcurrentlevels. Moreover, growthisnotassumed butis forecasted
by forecasting salesandthe technology forproducing salesthatis captured by theATO.
The pro forma in Exhibit 15.1 also forecasts abnormal operating income growth
(AOIG). By recognizing that AOIG is the change in ReOI,the analysis avoids forecasting
cum-dividend operating incomeand the free cashflow needed to calculate it. As AOIG is
forecasted to growat 5 percentperyear,theAOIG equity valuation is
v,cs' = _1_[10.295 +
0.1134
= $95.98 million
0.093 ] -7.70
1.1134 - LOS
or $0.96 per share(allow for rounding error).

Thisis a simplescenario, of course,but it highlights the ingredients in forecasting. The
changein asset turnover and growthin net operating assetsfrom currentlevels might be
accompanied by changes in profitmargins, but always the threeforecasts-sales, PM, and
AT0--along with any other operating income and unusual items, will determine the
RNOA and growth in NOA, whichproduce residual operating income and abnormal operatingincome growth. You mightput the PPE example intoyour spreadsheet program and
see howthe valuation changes withdifferent predictions of the drivers.
The pro formafinancial statements are not complete, but we can fill out the rest of the
pro forma with just two further forecasts, one for net dividends and one for borrowing
costs.Thepro forma has freecashflow forecasts andso, if we forecast dividends andborrowing costs,wecan forecast net financial obligations andexpenses andfillout the income
statement andbalancesheet
NFO,= NFO'_I-(C-I),+ NFE,+d, and NFE,=(Po-l)NFO~1
Suppose borrowing costsare 10 percenthere.Let'sset the futuredividend at 40 percent of

net income (a 40 percent payoutratio).The proformarollsout as in Exhibit 15.2.
Interest expense inthe income statement is always 10percentofnet financial obligations
in placeat the beginning of the periodandthe changein net financial obligations is always
determined by the treasurer's rule: Sell debtto coverthe deficiency of freecashflow over
interest and dividends. In this case there is a surplus, as indicated by the debt financing
flows in the forecasted cashflow statement. Thisbasbeenapplied to buyingbonds,firstthe
fum's ownbondsuntilYear 3 and thenothers'bondsafterYear 3, to yieldnet financial assetsratherthan obligations. With bothNOA andNFO forecasted, wehaveforecasted commonstockholders' equity: CSE= NOA- NFO.
2With theseforecasts offreecash flow, one canforecast AOIG. The proforma isdeveloped asfollows:
01
Free cas h flow

Reinvested FCF
Cum-dividend 01
Norma\OI
AEG (for 01)
Year1
Year 2
Year 3
Year 4
YearS
10.295
6.570
10.810
6.900
0.745
11.555
11.462
0.093
11.351
7.250
0.782
12.133
12.036
0.097
11.918
7.610
0.822
12.740
12.638
0.102
12.514
7.990
0.863
13.377
13.270
0.107
By forecasting AO\G asthe change in ReOI, theforecasting ismore efficient, foroneavoids these
calculations.
538
Part Three
Forecasting andValiwcion Analysis
EXHIBIT 15.2
After reformulating Nike's financial statements for 2004, ananalyst prepares a forecast inorder to value Nike's shares. With a
thorough knowledge ofthe business, itscustomers, andtheoutlook for athletic andfashion footwear, hefirst prepares a sales
forecast Then, understanding the production process andthecomponents ofcost ofgoods sold, heforecasts how much gross
margin will beearned from sales. Adding forecasts of expense ratos-cparticular'y the all-important driver, the advertising-tosales ratio-he finalizes his pro forma income statements with a forecast of operating income, His forecasted balance sheet
models accounts receivable, inventory, PPE, andother netoperating assets based on his assessment ofturnover ratios for these
items. He arrives at thefollowing forecasts:
Income statement forecasts:
PPE, INC.
ProForma Financial Statements, All Activities
Year-1
Year0
Year1
Year 2
Year 3
Year4
Year5
114.90
115.10
9.80
(0.70)
9.10
131.15
110.86
10.29
(0.77)
9.51
137.70
116.89
10:81
144.59
133.14
1135
(057)
10.14
(0.35)
11.00
151.81
139.90
11.91
(0.10)
11.81
159.41
146.89
1151
0.18
11.69
69.90
(7.00)
74.42
(7.70)
78.14
(5.71)
81.05
(3.47)
86.15
(0.97)
90.46
---l.L
94.98
~
61.90
66.71
71.44
7858
85.19
91.17
99.89
10.19
3.71
657
3.81
1.76
657
10.81
3.91
6.90
4.10
1.80
6.90
11.35
4.10
7.15
4.40
1.85
11.91
4.31
7.61
4.73
1.88
12.51
451
7.99
5.08
~
7.99
IncomeStatement
Sales
Earnings
Balance Sheet
Netoperating assets
(100million sharesoutstanding)
CashFlowStatement
01
bNOA

Dividends (payout 40%)
Debt financing
9.80
451
5.18
5.28
0.00
5.18
7:2S
7.61
1. Sales for 2005 will be $13,500 million, followed by$14,600 for 2006. For 2007-2009, sales areexpected to grow at a rate
of9 percent peryear.

2. The gross margin of 42.9 percent in2004 isexpected to increase to 44.5 percent in 2005 and 2006 asbenefits ofoff-shore
manufacturing arereaped, butdecline to 42 percent in 2007 andsubsequently to 41 percent as labor costs increase and
more costly, high-end shoes arebrovght to market.

3. Advertising, standing at 11.25 percent ofsales in2004, will increase to 11.6 percent ofsales to maintain theambitious sales
growth. The recruitment ofvisible sports stars to promote the brand will also addto advertising costs.
4. Other before-tax expenses areexpected to be 19.6 percent ofsales, the same level as in2004.
5. The effective taxrate onoperating income will be 34.6 percent.
6. No unusual items areexpected ortheir expected value iszero.
Allow [Of rounding errOn.
't'
1',-
:
The forecasting schemecan get into more detail,and that added detail will add further
line items to the pro forma statements. Rather than forecasting profit margins, the detailed forecast predictsgross margins and expense ratiosfor eachcomponent of the margin and so buildsup further line items for the forecasted income statement. And rather
than forecasting the (total)asset turnover, the detailed forecast predictsindividual asset
and liability turnovers and so buildsup the line items for the forecasted balancesheets.
The forecaster decideswhatlevelof detailis necessary to improve a forecast, keeping in
mindthe cost of researching for moreinformation. Box 15.3 buildsup a detailed forecast
for Nike.
These forecasts result inthefollOWing pro forma andthe valuation itimplies (in millions of dollars):
Wecan pull all this forecasting together as a seriesof steps thatcanbe builtintoa spreadsheetprogram.
Step 1. Forecast Sales
1. The firm's strategy, Whatlinesof busmessis the fum likely to be in?Are newproducts
likely? Whatis theproductquality strategy? At whatpointin theproductlifecycleisthe
firm? Whatis the finn's acquisition and takeover strategy?
20MA
200SE
200GE
2007E
2008E
2009E
Sales
Cost ofsales
Gross margin
12,253
7,001
5,252
13,500
7,492
6,008
14,600
8,103
6,497
15,914
9.230
6,684
17,346
10,234
7,112
18,907
11,155
7,752
Advertising
Operating expenses
Operating income before tax
Tax at34.6%
1,378
MQQ
1,474
1,566
2,646
1,694
2,862
1,941
1,846
3.119
1,719
2,012
3,400
1,700
2,193
3,706
1,853
S9S
1,175
1,269
1,124
951
Core profit margin
7.84%
8.69%
8.69%
7.06%
6.41%
6.41%
Income Statement
A Forecasting Template
The sales forecast is the starting pointand usually involves the mostinvestigation. Simple
extrapolations withsalesgrowth ratesareawayto getgoingbutacomplete analysis involves
a thorough understanding of thebusiness. The following issues haveto be considered:
Balance sheet forecasts:

1. To maintain sales, thecarrying value ofinventory will be1238 cents perdollar ofsales (an inventory turnover ratio of 8.08).
2. Receivables will be 16.5 cents perdollar ofsales (aturnover ratio of 6.06).
3. PPE will fall to 12.8 cents perdollar ofsales in 2005 and 2006, from the 13.1 cents in 2004, because of more sales from
existing pant. However, with new production facilities coming on line-eat higher construction costs-to support sales
growth, PPE will increase to 13.9 cents ona dollar ofsales (aturnover ratio of 7.19).
4. The holdings ofall other netoperating assets, dominated by operating liabilities, will be-6.0 percent ofsales.
5. Acontingent liability forthe option overhang of $452 million isrecognized.
1,796
1,112
1,212
(continued)
2. Themarket forthe products. Howwillconsumer behavior change? What is theelasticity

of demand forproducts? Aresubstitute products emerging?
3. The firm's marketing plan.Are newmarkets opening? Whatis thepricingplan? Whatis
the promotion and advertising plan? Does the firm have the ability to develop and
maintain brandnames?
539
Chapter 15 FuII.lnfOlTI\Llrian Forecasring, ValWlrion, andBusmess StTategy Ana~lis 541
Balance Sheet
Accounts receivable
Inventory
PPE
OtherNOA

Asset turnover (ATO)
Operating income
2004A
200SE
2,120
2,228
1,671
1,634
1,587
090)
4,551
Change in NOA
Free cash Flow

RNOA (on beginning NOA)
Total PV to 2009
Continuing value (CV)*
Enterprise value
2aD7E
200SE
3,120':
2,341 ."
2,626
1,970
2,212
(955)
5,853
2,147
2,411
(1,O41)
4,817
1,807
1,869
(876)
5,209
6,379
6,955
2.803
1,175
2.803
1,259
2.719
1,124
2.719
1,112
2.719 i",
1,728
2,409
~
909
.....2l
25.82%
26.34%
854.7
724.7
ReOI (8.6% required return)

Present value(PV) of ReOI
200GE
783.6
721.5
877
~
480
21.58%
575.0
527.8
2,852
-.lli.
586
2,628.
(1,134)
1,212 .., '0
-lli......
=
636
19.00%
608.6
19.00%
437.5
439.2
2,851
12,809
663.4 .
19,349
20,211
Option overhang
~
20,500
452
20,048
Value per share on263.1 million shares: $76.20

663.4>0: 1 05
-cv 1.086-1:05 "-19,349
The analyst feels comfortable forecasting five years ahead, butisunsure about thelong-term growth rate. Understanding
thatNike isanexceptional firm with long-run prospects, hesets thelong-term growth rate at5percent, above theaverage GOP
growth rate, but has his reservations. With thatqrowth rate, thevalue comes to $76.20 pershare, a little above the market
price of$75 pershare. With concerns thatinterest rates are rising-so the required return foroperations may well increasetheanalyst decides to place a weak sell recommendation onthestock.
With this Nike model ina spreadsheet program, theanalyst isready to adjust thepro forma and thevaluation when new information arrives. When Nike announced actual results for2005, operating income, after tax, was $1,209 million, considerably
above his forecast. He revised his forecast for subsequent years and recalculated thevalue at $82 pershare. The market price,
he noted, increased to $87 pershare.
The analyst can also change thenumbers toseehow sensitive his valuation istodifferent scenarios about thefuture. He has
a tool for sensitivity analysis. He also has a tool for risk analysis. See Chapter 18. With this example inhand, goto the BYOAP
product onthebook's Web site where Nike isfeatured.
Step 2. ForecastAsset Turnover and Calculate Net OperatingAssets

The forecasted asset turnover, applied to sales, yields the NOA: NOA = Sales!ATO.
Forecasting overall ATO involves forecasting its elements: receivables turnover, inventory turnover, PPE turnover, and so on. Accordingly, the forecaster develops line items
on forecasted balance sheets for receivables, inventories, PPE, and so on, that total to
NOA.
The ATO forecast asks whatassets need to be put in place to generate the forecasted
sales. Thisof course requires a knowledge of theproduction technology: Whatplants need
i,,
II:
540
to be builtandwhatlevel of inventories andreceivables needto be carried to maintain the

forecasted sales? Italso requires a forecast of costs: How muchwillplants costtobuild? In
tbeAmericas, inAsia,inEurope?
ForPPE,Inc.weforecasted thatthe amount of assets to be put inplacewillbe proportionaltosales. Butthisis probably unrealistic. Because plants donotalways runattbesame
level of capacity, evenwithout changes in technology the ATO win change if moresales
canbe generated withexisting plants or if a forecasted drop in demand produces idlecapacity. The ATO forecast captures the cost (in value lost) of idle capacity and the value
gainedbyproducing saleswithexisting capacity. If fullcapacity is reached, newplants wilt
have to be built, but they may result in idle capacity to begin with. The Nike forecast in
Box 15.3 involves both an increase in PPEturnover as capacity is usedand a decrease as
newplants comeonline.
Step 3. ReviseSalesForecasts
Capacity constraints limitsales. ForecastedATOyields forecasted netoperating assets, but
if the assets cannot be putin placeto produce the sales, tbe salesforecast mustberevised.
Step 4. Forecast Core SalesProfit Margins

CoreOIfromsales Salesx CoresalesPM,so nextforecast coresalesPM.Thisinvolves
forecasting allitscomponents, grossmargins, andexpense ratios. Thisalsorequires a good
knowledge of thebusiness. Whatwillbeproduction costs? Is therea learning curve inproduction? Willtechnological innovations reduce costs? Willlabor costs or material prices
change? Whatwillbe the advertising budget? How much of each dollarof sales will be
spenton R&D?
Forfirms withoperating leverage, profit margins andexpense ratios, likeKfO,maynot
beproportional tosales. Variable costs might increase asa constant percentage of sales, but
if somecosts are fixed overa rangeof forecasted sales, margins willincrease as sales in"
crease overthatrange. Of course, as salescontinue to increase allcostsbecome variable as
additional fixed costs are incurred to support the sales, but these fixed costs increase in
lumps ratherthancontinuously.
Step 5. Forecast OtherOperating Income

The share of income in subsidiaries is the main itemhereand requires goingto the subsidiaries andforecasting theirearnings.
Step 6.Forecast Unusual Operating Items

These often can't be forecasted (they areforecasted to be zero). But if youcanforecast a
restructuring or a special charge, this is subtracted from coreoperating income to gettotal
operating income.
Step 7. Calculate ReOl andAOIG

With theoperating income andnetoperating assetforecasts andtheoperating costofcapital,
calculate residual operating income: ReOlr "" 01/- {PF ~ I)NOAr_I. Remember theshortcut:
ReO! "" Sales x CoresalesPM
(
Required returnforoperations)
+ Coreother01 + ill
ATO
Abnormal operating growth is the change in ReO! overtheprevious period.

The valuation can now be done. In the PPE example, we forecasted that the cost of
capital was to remain constant, but we coulduse different ratesin eachperiod if the cost
of capital were forecasted to change.
542 Part Three Forecasting and Valuation Analysis
Chapter 15 FuU-Informarion Forecasting, Vduation. aMBu.liness Strateo Analysis 543
Step 8. Calculate Free Cash Flow

This is simply calculated fromotherforecasted amounts: C- I = or- .6.NOA.
Step 9. Forecast Net Dividend Payout

What will be the payout policy?Are stock repurchases anticipated? How much of new
financing will comefrom share issues? Remember the net dividend is payout minus net
shareissues.
Step 10. Forecast Financial Expenses orFinancial Income

With a forecast for NFO for the beginning of each year, the forecasted }..1'fE for the next
yearappliesa forecasted borrowing rate:NFE/ = (PD - l)NFOI~h and similarly for finan~
cial income withnet financial assets. Remember thatNFEis aftertax and so too is the cost
of capitalfor debt.
Step11. Calculate NetFinancial Obligations orFinancialAssets

This,too, is by calculation: dNFO/= NFEr- (C1 - I I) + d.: The net dividend is keyhere as
it increases the borrowing requirement. Correspondingly, if funds are raised by share
issues, the borrowing requirement is reduced. The amount of net financial obligations
mightbe a matterof firmpolicy: The firmhas a targetleverage. If so, net dividend payout
is determined by the leverage policy.
Step12.Calculate Comprehensive Income

Earnings = 01- NFE.
Step13.Calculate Common Stockholders' Equity

CSEI = NOA1 - NFOr= CSEH + Earnings, - d,
Step 14.Adjustthe Valuation for Any StockOption Overhang

See Chapter 13.
Step 15.Adjustfor the Value ofAny Minority Interest

The valuecalculated at Step 14 is the valueof the equity, to be divided between the common shareholders and the minority interest in subsidiary corporations. Done thoroughly,
this involves valuing the subsidiaries in question and subtracting the minority's share.
Usually the minority interest is small, so simpleapproximations work. From the equity
valueat Step 14,subtract minority interest earnings (in the income statement) multiplied by
the intrinsic PIE you have calculated; or subtract minority interest in the balancesheet
multiplied by the PIB ratioyou havecalculated.
Steps l-{i and 9-10 require forecasting. All othersteps up to Step 14 are calculations
from forecasted amounts usingthe accounting relations with whichwe are familiar from
Chapter 7. (Step 7 could also involve a forecast of a change in the cost of capital for
operaticns.} OnlySteps 1-7 are necessary for valuation (before the adjustments for stock
options and minority interest). Yes, the seven steps. These seven steps are depicted
diagrammatically in Figure 15.3.
The analystcan takesomeadditional stepsto testthe pro formastatements:
1. Ensurethat the two calculations of CSE in Step 13 agree.This validates that the pro
formaarticulates. Wethenknow thatwehavebeentidyandhavenotlostanyelement in
the valuation. Notealso that
NOA CSE
I
1
CSE = Salesx - - x - - = Salesx - - x - - Sales NOA
ATO 1+ FLEV
FIGURE 15.3
(4)Forecast PM:
Grossmargin
~ Expense ratios
Forecasting Residual
OperatingIncome
(ReOl) andAbnormal
OperatingIncome
Growth (AOIG)
The diagram
summarizes the
forecasting template;
numbers indicate steps
in theforecasting
template. Beginning
with a sales forecast,
residual operating
income forecasting is
accomplished in the
seven stepsindicated.
The abnormal
operating income
growth forecast isthe
change in forecasted
residual operating
income.
ApplyPM:
Core 01 '" salesx PM
(5) Forecast other01
Other01
~
~
"
'""
-s
""
~
~
~
Apply ATO: NOA '" Sales/ATO
2. Do a common-size analysis onthe proformastatements andtestthenumbers againstindustrynormsto see if they are reasonable. Are theyconsistent with yourprediction of
bowthe finn's fade rateswilldifferfromindustryfaderates?
3. Watch forfinancial asset buildup. If operations are forecasted to generate positive free
cash flow, financial obligations will be reduced and ultimately financial assetswill be
generated, as with PPE, Inc. This can't go on indefinitely. You have to ask:What will
theydo withthe financial assets? Willthey paythemout as dividends, or doesmanagement have a strategy that anticipates new investment that I have overlooked? These
questions leadbackto the issuethat requires ananswer beforeforecasting begins: What
is the firm's strategy? Rethinking strategy as a result of forecasted financial asset
buildup can induceyouto revise the pro forma.
You nowhaveall the toolsrequired for building yourownanalysis andvaluation product. SeeBox 15.4.
Features of Accounting-Based Valuation

The pro forma analysis highlights a numberof desirable features of forecasting ReO! to
valueequity:
1. Themethodis efficient. It comes down to forecasting a fewdrivers: sales,PM,ATO, and
theircomponents.
2. The focus is on operations. The methodfocuses on the part of the business that adds
value, the operations.
3. Dividends are irrelevant. Thevaluation is insensitive to dividend payout, and this is appropriate given ourdiscussion of dividend irrelevance in Chapter3.Wevalued PPE,Inc.
without a dividend forecast. Thedividend forecast comes afterStep7 in the forecasting,
andit is at Step7 that a valuation is made.Indeed, youcan changethepayoutin the example and you will see that the valuation is unaffected. Higherpayout just meansless
cash to buy bondsunderthe treasurer's rule. Accordingly, onlynet financial assets are
Chapter 15 Ful1-1nf=oon Forecasting, Valuation, and Business StrareD AnalYli.> 545
With thefinancial statement analysis ofPart Two ofthebook

.and theforecasting and valuation analysis of Part Three, you
have all the equipment necessary to build a comprehensive
analysis and valuation tool. The BYOAP feature onthebook's
. Web site leads you through the construction of your own
product. AS anillustration, itvalues Nike.
You will find developing a product to be very satisfying.
The concepts and tools inthebook come to life asyou apply
them; you will understand them better and will appreciate
how helpful they are. You will be gratifi~df~~~ ~orking wit~

a tool that has integritY, isconsistentwith the principles of': ;
sound fundamental analysis, and is disciplined _by the ar- ,~
counting relations that must be obeyed if'we are to avoid '-'mistakes. Accordingly, you will have some added security in,-.
equity investing, by protecting yourself from therisk ofpaying
toomuch for stocks. Take the product into your professional
life and use itfor your own personal investing. Add bells and
whistles asyou learn more.
.
affected, notoperating assets or operating income. Tostateit again, ReOI andAOIG are
not affected bypayout.
4. Financing is irrelevant. Thevaluation is not sensitive to financing. Buying and selling
debtandtheinterestincurred ondebtdonotaffect operating income ornetoperating assets. We could forecast stockissues inthePPE, Inc.proforma withtheproceeds usedto
reduce debtor purchase financial assets, but this has no effect on the valuation. This
complements point 2 above. The focus is on value added andthe valuation ignores the
zero-Nl'V (zero-ReNFE) financing activities.'
5. Investments thataddnovalue donot affect thevaluation. Toseethis,suppose wemodify theNOA forecast forPPE,Inc. andpredictthatat theendof Year 2 PPEwillinvest
another $50 million in operations, financed by an issue of debtat 10percent. This investment is expected to earnat the samerateas the costof capital of 11.34 percent and
thus will increase the OJ forecast by 5.67percentinYear 3 and on.The ReOI will of
course notbe affected bythenewdebtor interest onthedebt,but it willnotbe affected
by the investment either. Theexpected addition to ReOI inYear 3 from the investment
willbe 5.67~ (0.1134 x 50)::: O. Theeffect onAOIG (thechange in ReOI) willalsobe
zero. Andso forsubsequent yearsofthe investment's life.Accordingly, the finn'svalue
basedon thepresent value of ReOI is unaffected by thenewinvestment. Thiswould be
called a zero-NPY investment inDCFanalysis, a zero-ReO! investment here.Proforma
ReOI is affected onlyby investments thatadd (or decrease) value by earning at a rate
different from thecostof capital.
6. Value-generating investments are uncovered and the source of the value generation is
identified. By the same reasoning as in point5, positive andnegative ReOI investments
thatgenerate ordecrease value arediscovered bytheproforma analysis. In addition, the
pro forma will reveal the reason for the value effect-in the PM or ATG. Suppose we
forecast that inYear 1 management willmake a new investment that willnot produce
anyincrease in sales. Theforecasted ATD willdecline, RNOA willdecline, andso will
ReOl Accordingly, the effect on the valuation willbe negative: Wehave uncovered a
negative-value generator. This is an unlikely case, but it couldbe thatfrivolous corporatejet. It is sometimes saidthatmanagement indulges in negative-value projects after
freecashflow and financial assetbuildup. Thisscenario is the so-called free cash flow
hypothesis of management behavior: Management makes poor investments when they
have a lotoffree cashflow. Thishastobemonitored andproforma analysis provides the
means of anticipating financial assetbuildup.
3 If you believe that there are tax advantages from corporate debt ortax disadvantages from paying
dividends, the valuation can beadjusted by thepresent value ofthese tax effects.
544
7. In applying the discount rate,wehaveto be concerned about onlyonediscount rate,the

cost of capital for operations. Fromthe fullpro forma statements in Exhibit 15.2, we
could calculate RE and AEG from forecasted earnings and CSE and value PPE, Inc.
from forecasts of RE and AEG rather than ReOI and AOlG. This would require the
calculation of the costof equity capital. Butthis varies withfinancing riskandmust be
recalculated foreachperiod asfinancial leverage changes. Thecostofcapital foroperations mayalsochange as operations change but thetaskof forecasting thediscount rate
isreduced. Given thedifficulty inestimating discount rates, changes inthediscount rate
foroperations arelikely to be not onlysmallbutalsoimprecise. So work withconstant
ratesunless thenatureof thebusiness changes significantly.
8. Thevaluation avoids forecasting when mark-to-market accounting suffices, as withthe
valuation of financing activities andthecostof stockoptions.
VALUE GENERATED IN SHARE TRANSAalONS

In introducing theresidual earnings model in Chapter 5,weemphasized thatthemodel does
not capture value that maybe generated or lost in sharetransactions. If no shareissues or
repurchases areanticipated in the future or these transactions areexpected to be forcashat
fairvalue, then there is noproblem. Butif a firm canissue overpriced shares or repurchase
underpriced shares, theresulting gainis not reflected in earnings or residual earnings. Nor
isit captured bya discounted cashflow valuation. Two types of corporate transactions inparticular caninvolve these gains: mergers (acquisitions) andbuyouts.
Mergers and Acquisitions

Mergers andacquisitions ofteninvolve theissueofshares. Theacquiring finn issues shares
to shareholders ofthe acquired firm (whose shares areretired), or sometimes shareholders
ofboth firms receive shares in a new finn. Theacquiring firm canaddvalue in three ways:
L Buying theacquiree's shares at lessthanfairvalue.
2. Using its own overvalued shares (as "overvalued currency") to buy the shares of the
acquiree cheaply.
3. Generating value-synergies-by combining the operations ofthe twofirms.
Residual earnings techniques anticipate the value of a business acquired andthe synergiesgenerated with proforma analysis. Buttheydon'tcapture thedivision of value between
the shareholders of acquired andacquiring firms. Bothhave shares in the merged finn but
theirrelative share of value depends on the terms of the share transactions. Points 1 and 2
determine those termsandthose termsdetermine howthe synergies inpoint3 aredivided.
The acquirer buysthe acquiree cheaply-for eitherreason 1 or 2-if it issues fewer of its
shares for the shares of the acquiree, andso its shareholders geta larger share of anysynergiesfrom themerger.
Thedivision of value in a merger is resolved in Box 15.5 from the pointof view of the
acquiring firms' shareholders. The same principles apply if the acquirees' shareholders
wishto value ananticipated acquisition oftheirfum.Thefocus ofthe analysis is onthe effectof the acquisition on theper-share value of an outstanding share.
A manager evaluates a potential acquisition by goingthrough the sameanalysis: What
is the effect of thetransaction on theper-Share value of thestock? Points 1, 2, and3 above
determine the answer. If the acquisition is made"cheaply," value is added to eachshare. If
the acquiring fum overpays (either because it paystoomuchfor theacquiree's shares or its
ownshares areundervalued), per-share value is lost. If therearesynergies and, bytheterms
Chapter 15 Fu1l.!nformation Forecasting. Voluacion, andBUlincss SlTategy Analysis 547
original PPE shareholders and 50 million by theshareholders

of the acquired firm), the per-share value is $120. The
value ofoneofPPE's 100 million shares outstanding at Year 0
iscalculated asfollows:
1. Forecast thevalue ofthe new merged firm at theend of
Present value (atYear 0) ofper-share Year 2 value:
Year 2 from the forecasted balance sheet of the new
merged firm at thatdate and the present value of subse1.20
quent residual earnings that the balance sheet is antici1.11342
$0.97
pated to generate.
Present
value
ofYear
1and
Year
2 dividends pershare:
2. Calculate theanticipated value per share at theacquisition
date (at theend ofYear 2) by dividing the merged firm's
0.Q38
0.041
- - + - - -2
value by thetotal shares outstanding for thenew firm.
1.1134 1.1134
0.07
3. Calculate the present value of this per-share value at
Per-share
value
ofPPE,
Inc.
$1.04
YearO.
AsPPE was valued at $0.96before theanticipated acquisi4. Add the present value of expected per-share dividends
tion, this calculation indicates thattheacquisition adds value
from thepremerged firm uptothemerger date.
tothecurrent shareholders.
Suppose pro forma analysis calculates a value for the
merged firm at the end of Year 2 of $180 million. With Real World Connection
150 million shares outstanding (100 million held by the See Exercise E15.14 forfurther calculations.
PPE, Inc. isexpected toacquire another firm attheend ofYear 2

by issuing 50 million shares to that firm's shareholders. The
analyst follows thefollowing steps:
of the share transaction, the acquiring firms' shareholders share in those synergies, persharevalue is added. Theanalysis in Box 15.5 shows thatPPE'sacquisition is expected to
increase per-share value from the$0.96 calculated from thepreacqaisition proformaa earlierto $1.04. Thisvalue added is based on issuing 50million shares in the merger. Theacquisition analyst canask: What would be the value added ifthe acquisition couldbe made
by issuing only40 million shares?
Asa historical note,empirical studies have shown that much of the value generated in
mergers and acquisitions typically goesto the shareholders of the acquiree. Prices of acquirees' shares tendto increase-often bysignificant amounts-while prices of acquirers'
shares tend tobe unaffected or even decline. These observations suggest thatacquirees can
extract most of the value in mergers. Theacquirer's share pricemight decline because the
market feels that it is overpaying for the acquisition. Theprice might alsodecline because
the market interprets the bidas a signal thatthe acquirer's shares areoverpriced.
Share Repurchases and Buyouts
!!
II
"
If members of management feel thattheirfirm's shares areundervalued in themarket, they

might generate value for shareholders-thatis, increase per-share value-by buying back
shares. It is forthisreason thatannouncements ofshare repurchase programs areoften seen
as a signal ofundervaluation, resulting in a share priceincrease. Research suggests thatthe
market isslow toreact,so thatbuying theshares ontheannouncement captures subsequent
abnormal price appreciation as the market comes to realize that the shares are indeed
undervalued.
Buttheinvestor mustbecareful. Share repurchases mayjustbe thefirm paying effective
dividends. And theymayinvolve distributions of cashnotneeded forinvestment-financial
IiI!i
546
assetbuildup-e-tc shareholders. Indeed, theannouncement of a repurchase maysignal that

the finn doesnot have investment opportunities.
Theanalyst mustalsobe careful in interpreting repurchases in overheated markets: The
firm maybe paying too muchfor the shares, and the analyst teststhisproposition withan
analysis of intrinsic value. Many of the share repurchases in the bull market of the late
1990s didnotresultin priceappreciations. Review Box 13.6 in Chapter 13.
The buyout is a stockrepurchase on a larger scale,often withborrowing (andis thena
leveraged buyout, or LBO). If management is involved in gaining equity, the buyout is a
management buyout. These transactions may addper-share value ifmanagements who participate are more motivated to generate value in operations. But they also add value if
shareholders interpret thebuyout as a recognition thatshares areundervalued.
Forthisreason, firms addthe buyout to theirset of tools forcreating shareholder value.
Buyouts were popular after the 1987 stock market crash. They also were proposed as a
remedy for increasing the stockprices ofvold-economy" firms in the late1990s.Ata time
wheninvestors were pricing technology stocks at veryhighmultiples, old-economy firms
traded at relatively low multiples. Their managements felt they were undervalued and
proposed buyouts. Airlines were trading at multiples of earnings below 10. The Wall
Street Journal (March 10,2000,p. I) reported the chiefexecutive of Continental Airlines
as saying, "If the market says this is all we're worth, then Vie ought to just buy the
company."
FINANCIAL STATEMENT INDICATORS AND RED FLAGS

Much of the information needed to determine howfuture operating income willbe different from current coreoperating income comes from outside the financial statements. But
the financial statements themselves provide information thatsuggests thatcurrent income
maynotbe indicative of the future. Box15.6 listsfeatures infinancial statements thatraise
questions. Eachsuggests thatsomething might be unusual incoreincome or net operating
assets. Theanalyst investigates to seewhether the indicator points to transitory income or
whether drivers have shifted to a newpermanent level. Some indicators are red flags that
warnabout the future.
BUSINESS STRATEGY ANALYSIS AND PRO FORMA ANALYSIS

Wehave observed thatproformaanalysis andvaluation cannot begin without an appreciationof a firm's strategy. Butpro forma analysis is alsoa means ofevaluating strategies. Pro
forma analysis uncovers thevaluegeneration. Thusit is alsoa means of investigating management strategies thatgenerate value.
Pro forma analysis of residual operating income substitutes for discounted cashflow
analysis. Fora manager whowishes tomaximize thevalue ofthe finn,thecriterion ofmaximizing the present value of ReOI replaces the criterion of maximizing the net present
value ofcashflows. Forecasting ReOI cutstothe coreof what drives value. It forecasts the
drivers of the profitability of operations thatconnect management choices to value. Much
of the framework wehavedeveloped in this bookfor the outside shareholder is, then,the
framework forstrategy analysis.
Strategy begins with ideas and good strategies begin with innovative ideas. Business
strategy books layout howto thinkaboutstrategy in a waythatleadsto innovative ideas.
Pro forma analysis converts thoseideas intoconcrete numbers from which the ideas can
be valued. But the forecasting framework is notjust a method of analysis; it is a way of
Chapter 15 FuU-!nf0111Ultion Forecasting, Valuarion, a.nd BlLIinm StrG.teiJ Ana!;fsis 549
thinking about thebusiness. Anditsimplifies thatthinking. Themanager knows thattogenerate value, hemustfocus onthedrivers:
Each of the following features of financial statements may
indicate aspects of the current operational profitability that
wi!1 not persist into the future. They are flags that cue the
analyst to investigate causes and ask whether those causes
indeed indicate thatcurrent operating income isnotindicative
offuture income.
Unusually high sales growth rates. High sales growth rates
do notpersist, asfade diagrams suggest.
Unusually large changes in core RNOA. large changes
incore RNOA often don't persist, as fade diagrams
suggest.
Unusual changes inRNOA components.
PM components:
Gross margin ratio
Advertising-to-sales ratio
General andadministrative expenses-to-sales ratio
R&D-to-sales ratio
ATO components:
lnventories-to-sales ratio
Accounts receivable-to-sales ratio
Doubtful debts-to-sales ratio
Other assets-to-sales ratio
Operating liabllites-to-sales ratio
typical~
Ij
RNOA is different from the industry average.

Operating profitability typically reverts to the average for
the industry.
Components of RNOA are different from the industry
average.
Changes in RNOA components are different from the
industry average.
Changes in NOA aredifferent from the industry average.
Low effective taxrates. Low effective taxrates on operating income areusually duetotaxconcessions thataretemporary: Firms' tax rates tendto revert to a common level
doseto the statutory rateover time.
Footnotes and the management discussion and analysis
also provide indicators. Investigate thefollowing:
Order backlog.
An accumulated order backlog indicates pending demand
for the product. Computer and technology companies
use the book-to-bill ratio-the ratio of sales orders outstanding to sales orders filled-asan indicator.
543
Management earnings andsales forecasts.

Changes inper-unit sales prices.
Investment plans.
Operational plans.
Changes inlabor force.
Contingent liabilities andprovisions.
Expiration of loss carryforwards andloss oftaxcredits.
Some indicators are referred to as red-flag indicators
because they indicate deterioration oreven distress:
Slower sales growth.
Decline inorder backlog.
Increasing sales returns.
This ratio may indicate growing customer dissatisfaction
with the product
Increasing accounts receivable-to-sales ratio.
This ratio may indicate customers arehaving credit problems orthefirm ishaving difficulties making sales.
Increasing inventory-to-sales ratio.
This ratio may indicate inventory is building up
difficulties in making sales. But it may alsoindicate
production buildup in anticipation of higher sales in the
future.
Deterioration ingross margin ratio.
gross margin ratio has a large effect onoperating income.
Increasing advertisinq-to-ezpense ratio.
Increases inthis ratio can indicate a decreasing effectiveness inadvertising generating sales. But itcanalso indicate
increased investment in advertising that will generate
more future sales.
Increasing sao-to-se'es ratio.
If there isa pattern ofhigher R&D expense relative to sales;
the firm may be having less success in generating new
sales with product innovations.
Increasing selling and' administrative expenses-to-sales
ratio.
This ratio will increase when sates decline ifpart of theexpenses arefixed costs. Look at increases inthe ratio dueto
variable costs; investigate an increasing ratio onincreasing
sales because, with fixed costs, theratio isexpected to decline with increases insales.
Maximize RNOA relative to the required return.

Grow netoperating assets (ifRNOA is greater than the required return).
Tomaximize RNOA, he maximizes (long-run) profit margins andassetturnovers. Togrow
net operating assets, he grows sales and maximizes asset turnovers. To maximize profit
margins, heminimizes expense ratios, andso ondown through thedrivers ofRNOA.
The manager understands theeconomic factors andhowthey affect ReOI drivers. She
identifies which factors are business conditions andwhich involve her choices. Herfocus
is on change. Sheanalyzes theeffects of changes in business conditions andalternatives to
dealwiththose changes (andcreate changes) withpro forma analysis. Sheknows key driverswhere thebusiness is mostsusceptible. Andherstrategy is always to sustain a highor
growing ReOI. Sheunderstands theforces of competition thatcause ReOI to fade andunderstands how shecancounter theforces of competition to sustain a highReOI.
Unarticulated Strategy
During the1990s bubble, it was fashionable toreject financial analysis asthefocus forstrategic analysis. Some claimed that financial models constrain thinking and leadto mediocre
organizations. Thenew strategists claimed thatgood thinking cannot be scripted. "Nonlinear
thinking" must replace "linear thinking." The"intellectual capital model" mustreplace the
financial model based onbalance sheets andincome statements, sothatfirms replace physical assets with knowledge assets as sources of value. Finnsmust be organized in ways that
foster creativity andadaptability to change rather thanfocusing onthebottom line.
Such ideasare stimulating. Theyrecognize thesources of value in modern economies,
the value in human capital, adaptability, and invention. Butrejecting financial analysis to
embrace these ideasentails considerable confusion. Ultimately firms mustgenerate sales to
addvalue, whether those sales are generated from investments inphysical assets or investments inhuman capital andknowledge assets. Those salesmustgenerate positive margins.
AndtheRNOA mustbehighenough to recover investors' required return. Wemusthave an
idea of what future income statements and balance sheets will look like.The financial
model mustbe used in conjunction with new ideas, to test those ideas and to discipline
over-enthusiasm forandspeculation in ideas.
At some level of strategic analysis, however, financial analysis is difficult to apply.
Strategic thinking canbegin withgeneral ideasthatmature to specifics onlyasthe thinking
is executed. A fum might adopta strategy ofinvesting in basic R&D withthechance of discovering valuable products but,without anindication of whatthatproduct willbe(letalone
the sales andmargins), financial analysis is verylimited. Tovalue a start-up biotech fum,
study biochemistry. A fum might invest in reorganizing itselfto be moredynamic, to foster creative thinking, and to develop itshuman capital andknowledge assets, butthe form
thepayoffs willtake is not clear.
Such strategies are unarticulated strategies.The lessarticulated the strategy, the less
amenable it isto financial analysis. Investments in unarticulated strategies arehighly specillative, approaching theformof a puregamble. Financial information is of minimal useto
reduce theuncertainty, although some technical information canbeusefuL It is forthisreason that capital tends to flow to start-ups through venture capitalists (whospecialize in
technical information) rather than public stock markets where stocks are analyzed by
financial analysis.
Nevertheless, the investor understands that ultimately a good strategy must"tum a
profit." Strategic thinking, in its initial stages, doesnot submit to financial analysis welL
Chapter 15 FH!1-lnfOl71llltion Forecasting, VallWtian. and Brsiness StTategy AnalY511 551
550 Part Three Forecillting and VallWtion Analysis
The formal structure of the accounting is of greatbenefit in valuation. We often have

hazy concepts about firms' activities, butgetting a handle ontheirvalue implications is difficult. We canthinka finn is "worth a lot," butmeasuring the worth is another thing. The
accounting forces us to interpret imprecise notions in concrete tenus such as margins and
turnovers in a way thatleads to a value inference. "Competitive advantage" translates into
sales growth withhigher profit margins. "Strategic position" translates intohigher margins
and higher turnover. "Technological advantage" translates into lower expense ratios.
Saying that an industry willbecome more competitive translates into lower profit margin
forecasts andan explicit calculation of thelossin value. The"costof idlecapacity" is captured in the asset turnover andmeasured through the value calculation that forecasts this
asset turnover. Andwe can go on. Accounting relations also play an important role, for
these relations tie thepro fonnatogether andmake its components reconcile so no aspect
of thevalue generation is lost. Most importantly, theanalysis disciplines ourspeculation.
Butlet'snotgetcarried away. Theanalysis hererelies ongetting a good handle onlongterm growth. Thatmay be hard to do when oursense of a firm's value comes from theopinion that it is "strategically poised" to benefit from changes in technology or changes in
consumer behavior. Measuring these potential benefits ina proforma analysis might notbe
easyif thechanges arenotyetdefined. We may feel thata firm has"superior management"
thatwingenerate value, buthow the management mightact to dothismight notbeclearly
articulated. Thefirm might have R&D thatmay leadto newproducts, butwhat those products will be may be unclear, not to mention the profit margins and turnovers they will
deliver. Thefirm may be positioned to make takeovers, butthefirms involved andthe timingmight be unclear. Proforma analysis serves toreduce ouruncertainty. Proforma analysis canbe usedto model ouruncertainty (with scenario analysis). Butpro forma analysis
cannot eliminate ouruncertainty. Equity investing is risky.
But ultimately it must. Accordingly, the needfor financial analysis of strategy enforces a
discipline onstrategic thinking, even at itsmostunarticulated level. Thestrategic thinker is
pressed to develop her ideas further, to refine themto a level of specificity where theycan
be evaluated withfinancial analysis. By so doing, unarticulated strategies are articulated.
Thescriptis written. And, through thelensof financial analysis, thevalue generated bythe
ideabecomes more transparent, theinvestment less speculative.
Scenario Analysis
Thepro formas prepared for PPE, Inc.in Exhibits 15.1 and 15.2 andforNikein Box15.3
arefor oneparticular scenario. Thescenario is a particularly important oneforit forecasts
expected outcomes from which wewish to derive a valuation. Expected values areaverages
overa whole range ofpossible outcomes, however, andtheproforma analysis canbeused
to model allpossible outcomes. What does theproforma (and thevaluation) looklikeifthe
sales growth rate is 4 percent rather than 5 percent? What is the effect if the forecasted
profit margin drops to 6 percent? Thepro forma undereachcondition is called a scenario,
andananalysis thatrepeats theproforma analysis underalternative scenarios forthefuture
is called scenarioanalysis. Scenario analysis is thefull-forecasting equivalent of thevaluationgridapplied to simple forecasting in thelastchapter.
Ifyouhave builttheproforma forecasting framework intoa spreadsheet (following the
BYOAP roadmap) youcaneasily conduct scenario analysis. In doing so, youwillunderstand thefull range ofpossible outcomes andappreciate theupside anddownside potential
to the investment. Accordingly, scenario analysis is an important toolfor assessing fundamental risk-as we will see when wetakeup the issue of riskand the required return in
Chapter 18.
Find thefollowing on theWebpage for thischapter:

More detailed and "realworld"applications of proforma
analysis.
Summary
More on the "one-stop" formula for forecasting residua! operating income.

Demonstration of howalternative valuation models produce thesame value, withspreadsheet programs to help.
This chapter has shown how to convert knowledge of a business into its valuation. Pro
forma financial statement analysis is thetool. Proforma analysis interprets thebusiness in
terms of itseffect on value. Andit provides a framework fordeveloping forecasts andconverting those forecasts to a valuation.
Theforecasting template inthechapter develops theforecasting andvaluation ina series
of steps. Be sure youunderstand these steps andhowthe structure of thefinancial statements is usedas a toolforforecasting.
Asvaluation involves forecasting future financial statements youcanseethatvaluation
and accounting are the same thing. Valuation is really a question of accounting for the
future. Accounting is oftenthought of as a method to record the present, but really it is a
system to think orderly about thefuture, a system to guide the development of forecasts of
investment payoffs thatcanbe converted to a valuation.
Key Concepts
business condition is an economic factor

thatcannot be altered by management.
Compare withstrategicchoice. 534
competitive advantage periodis the time
thatunusually high profitability takes to
revert to a normal level. 526
driver pattern is thebehavior ofa driver
over time. 525
fade rate is therateat which a driver
reverts to a typical level; also called
persistence rate. 526
financial assetbuildupis increasing
financial assets (from free cashflow net
of dividends). 543
financial statementanalysis of the future
is thestructure of financial statement
analysis applied in forecasting. 523
forces of competition is thetendency
of economic factors to force drivers
totypical levels. 526
full-information forecasting is forecasting

withcomplete information aboutthe
economic factors affecting thebusiness.
Compare withsimpleforecasting. 535
keydriver is a driver thatis particularly
important to thevalue generation of a
fum. 531
red-flag indicator is information that
indicates deterioration in a firm's
profitability.
548
strategicchoice or strategicplan is a
decision to determine aneconomic factor.
Compare withbusiness condition. 535
unarticulatedstrategyis a strategy thatis
notspecific enough to evaluate withpro
forma analysis. 549
valuetype classifies a firm byits key
driver. 532
552 Part Three Forrcostillg am! V~r1larioll AlUttysis

Chapter 15 FuU-lnfonnnrion Forecasting, Valuation, and Business Strategy Anal)"ll 553
Now you are ready to go. Try different scenarios for the future and observe how
profitability, growth, cashflows, and per-share valuechange. You should alsoentertain the
following scenario.
Analysis Tools
Page
Shortcut residual operating

income calculation
equation 15.1
Fade diagrams
Pro forma analysis
Forecasting template
Seven steps to valuation
Merger and acquisition
valuation
Strategic planning analysis
Scenario analysis
524
526
535
538
Key Measures
Page
Fade rates
Financial statement indicators
Red-flag indicators
Turnover efficiency ratio
526
A01G abnormal operating

income growth
ATO asset turnover
equity
CV continuing value
DCF discounted cash flow
LBO leveraged buyout
NOA netoperating value
NPV netpresent value
01 operating income
PM profit margin
assets
Ul unusual items
538
545
547
550
548
548
525
THE 2005 RESTRUCTURING ANNOUNCEMENT

OnJuly22,2005, Kimberly-Clark announced a restructuring planthatwouldcut6,000 jobs
worldwide, shutter20 plants, and focus on building relationships with retailers. The announcement cameafter the finn reported a 7.2percentdropin second-quarter earnings even
though salesincreased modestly. The spinoffof Neenah Paperin 2004had hurt earnings,
alongwithrisingprlces forpaperpulpandoil,andthe finn wasunderincreasing competitive
pressure fromProcter& Gamble, whichhad earlier revamped it business model.
Ashomemarkets mature, consumer-product companies lookto developing markets for
growth, andThomas J. Falk, thecompany's CEO, said he wanted to focus the company on
these markets. He also announced a 50 percent increase of R&Dspending overthe next
several years, to $400minionby2009,andan increase in marketing outlays by60 percent.
In 2004, thefirmspent$279.7 million on R&D and$421.3 million onadvertising.
The restructuring is expected to cost$900million to $1.1 billion, before taxes, overa
three-year period and to generate annual cost savings, before taxes, of $300 million to
$350 million by 2009.
KMB's stockprice rose by a dollaron the announcement but, within a few days, had
returned to its preannouncement price of$63. Model the effectof the restructuring, and
estimate howmuchit is likelyto add to the fum's stockvalue. The effectof therestructuringonsalesis,of course, a bigunknown, butyoumightask whatsalesimpactis necessary
to addvalue. Wasthe market correct in notbeingveryimpressed?
CONTINUING THE CONTINUING CASE
The Continuing Caseconcludes at thispointofthebook. However, youwillfindthat, when

youcome toChapters 18and 19,youwillwantto return to yourspreadsheet to model valueat-risk and to gainan appreciation of the firm's prospective liquidity and creditrisk. Build
the features in thosechapters into yourspreadsheet andyou will have a product of which
youcanbe proud. Alsoask:"What bellsandwhistles canI add to enhance the product?
The sensitivity analysis youconducted in the Continuing Case in Chapter 14 gave you a
good feel for the pricing of KMB shares. Proforma analysis enhances sensitivity analysis
by allowing for a full range of scenarios that accommodate not onlyfinancial statement
information but also otherinformation that bears on thefinn.
SPREADSHEET ANALYSIS AND INITIALIZATION

If youhavenotdoneso already, youshouldenterKMB dataintoa spreadsheet likethe one
outlined in the BYOAP feature on the book'sWeb site.Calculations will thenbe so much
easier. To incorporate a newscenario, you will simply haveto change the inputs, andthe
restofthe analysis and valuation will be taken careof bythespreadsheet program.
Asabenchmark scenario, entera proforma implied bythesimple forecasting intheContinuing CaseforChapter 14.Remember thekeyitemstobeforecasted areoperating income
and netoperating assets. With thesetwosummary numbers, youcan calculate the residual
operating income (ReOI) for eachfuture period (andabnormal operating income growth)
that leadsdirectly to a valuation. Afterentering the forecasts and calculating ReOl, make
surethe one-stop formula 15.1 in thischapter works. A fullproformaanalysis contains the
line itemsnecessary to get to the twosummary numbers, so yourspreadsheet shouldcontainall thelineitems in thefinn'sreformulated income statement andbalance sheet.
Concept
Questions
CIS.l. "Why is it important to understand the "business concept" before valuing a firm?
C15.2. Explain why a fade diagram is helpful for forecasting.
CIS.3. Whatfactors determine the rate at whichhigh operational profitability declines
over time?
C15A. Whatis meantby the"integrity" of a pro forma?
CIS.5. Forecasted dividends affectforecasted shareholders' equitybut do not affectthe
value calculated fromforecasted financial statements. Why?
C15.6. Whatis a red-flag indicator?
CIS.7. Whatis an unarticulated strategy?
CI5.8. "Why musttheeffectof'a merger or acquisition onshareholder valuebe calculated
ona per-share basis?
C15.9. "When mightmanagement of a firm consider a leveraged buyout?
C15.l0. Why might the shares of the acquiring finn in an acquisition decline on
announcement of the acquisition?
Chapter 15 FlI11-lllfonnation Forecasting, Valuation, and BlIsinm $trmog:! Anal)'sis 555

554
Part Three Forecastillg GTId VClluation Analysis
Exercises

Drill Exercises
E15.1.
A One-Step Forecastof Residual Operating Income (Easy)
441
.2
389
Ananalyst predicted the following:

The firm is currently earning a return on net operating assets (RNOA) of 14 percent
from salesof $857 million and after-tax operating income of $60 million. Its required retum on operations is 10percent. Forecasts indicate that RNOA is likely to continue at the
samelevel in the future with growth in salesof3 percent per yearand growth in netoperatingassetsto support thesalesof 3 percent peryear.
Management is considering a plan to introduce new products that are expected to increase the sales growth rate to 4 percent a yearand maintain the current profit margin of
7 percent. But the planwill require additional investment in net operating assets that will
reduce the firm's assetturnover to 1.67.
Whateffectwill thisplanhave on the value of thefinn?
1. Salesof$1,276 million.
2. Coreprofitmargin of5 percent.
3. Assetturnover of2.2.
4. Coreotheroperating income and unusual items are zero.
The firm's required return for operations is 9 percent.
a. Apply formula 15.1 tocalculate theresidual operating income (ReOl) implied by these
forecasts.
b. Howwould ReOI change if the analyst dropped her forecast of the coreprofit margin
to 4.5percent?
c. Given a 5 percent profit margin forecast, whatlevel of assetturnover would yieldnegativeresidual operating income?
E15.2.
E15.5.
A Revised Valuation: PPE, Inc. (Easy)

Referto thepro forma for PPE, Inc.in Exhibit 15.1. Modify thispro forma for thefollowingrevised forecasts:
a. Value the operations of this finn for a required return on operations of II percent.
b. The marketing team believes that if it can structure extended delayed-payment terms
withcustomers, it can increase the salesgrowth rate to 6.25percent peryear, withno
change in profit margins. Theeffectof theincreased receivables would beto reduce the
assetturnover ratio to 1.9.Should the marketing planbe adopted?
1. Salesare expected to growat 6 percent from theirYear 0 level of$124.90million.

2. Coreprofitmargins areexpected to be 7.0 percent.
3. Assetturnovers (onbeginning-of-year netoperating assets) areexpected to be 1.9.
Thenanswer the following questions:
a. Afterrevising thepro forma, calculate thevalue of a PPE share. Thereare lOO million
sharesoutstanding.
b. If dividend payout is expected to be 40 percent of earnings each year, what do you
expectthefirm's position in netfinancial obligations to be at theendofYear 3?
E15.3.
Forecasting Free Cash Flows and Residual Operating Income,

and Valuing a Firm (Medium)
The following forecasts wereprepared in 2008fora firm witha costof capital for its operations of 12percent. Amounts arein millions of dollars.
Year
Dividends
Net debt
Investment expenditures
Evaluating a Marketing Plan(Medium)

A firm with a current return on net operating assets of ! 5 percent anticipates growth in
salesof6 percent peryearfrom its currentnetoperating assetbaseof$498 million. It also
anticipates that sales will deliver 7.5 percent after-tax profit margins and an RNOA of
15 percent on a consistent basis.
2009E
20l0E
20m
20l2E
201lE
70
0
80
635
75
0
89
665
75
0
94
689
75
0
95
703
75
0
95
712
The common stockholders' equityat thebeginning of2009 is 596andthereis no netdebt.
E15.6.
Forecasting and Valuation (Medium)

Thereformulated balance sheetandincome statement fora firm's 2009fiscal yeararegiven
below.
Comprehensive IncomeStatement
Sales
Operating expenses
01 before stock compensation
Stock option compensation
Operating income
Interest expense
Interest income
ill)
Tax benefit
3.726
(3,204)
522
(22)
500
98
83
Unrealized gain on investments

Losses on putoptions
54
(50)
120
(124)
376
Balance Sheet
a. Forecast cashflow from operations andfreecashflow for eachof thefive years.

b. Useresidual operating income techniques to value this firm.
c. Attempt to value the finn using discounted cashflow analysis. Do you get the same
answer as thatfor part(b) of theexercise?
E15.4.
Analysis of Value Added (Medium)

A firm has the following summary balance sheet(in millions of dollars):

2009
2008
3,160
1,290
1,870
2,900
1,470
1,430
556 Part Three
Forccaslillg endVah":1l10ll Analysis
Chapter 15 FlllI.fnfamlmion
At the end of 2009,saleswereforecasted to growat 6 percentperyearon a constant asset

turnover of 1.25. Operating profit margins of 14percent (aftertax)are expected eachyear.
The firm's tax rateis 35 percent.
(in millionsof dollars)
Balance Sheet
Operating assets associated with underwriting

Unpaid claims and unearned premiums
Net operating assets in underwriting activities
Investments in debtandequity securities, at market
Common equity
2009
2008
$2,450
5,300
(2,850)
6,050
3,100
$2,300
5,600
(3,300)
5,940
1,640
Net income of $848 million for 2009 comefrom the following to which taxes havebeen
allocated.
Loss on underwriting activities, aftertax
Investment income and realized gains on investments, aftertax
$ 43
891
In addition to net income in the income statement, unrealized losses on available-far-sale

investments of $124 million were reported as part of other comprehensive income in the
equitystatement.
a. Calculate the residual income fromunderwriting activities for2009.Usebeginning-ofyearbalancesheetnumbers in the calculation and a required returnof9 percent.
b. Value the equityundera forecast thatthe residual income fromunderwriting will grow
at 2 percentperyearin the future.
E15,8,
Integrity of Pro Forma,(Hard)

An analyst developed the following set of pro forma financial statements as an inputintoa
valuation:
2009A
Netoperating assets
Common equity
ValtlIItillll, and BlIsjn~ss Strmegy Analysis 557
2010E
Sales
Operating expenses
Operating income
Netfinancial expenses
a. Forecast returnon net operating assets(RNOA) for 2010.

b. Forecast residual operating income for 2010. Use a required return for operations of
9 percent.
c. Value the shareholders' equityat the end of the 2009fiscal yearusingresidual income
methods.
d. Forecast abnormal growth in operating income for 2011.
e. Value the shareholders' equity at the end of 2009 using abnormal earnings growth
methods.
f. After reading the stock compensation footnote for this firm, you note that there are
employee stockoptions on 28 million shares outstanding at the end of 2009.A modifiedBlack-Scholesvaluation of these options is $15 each. Howdoesthis information
changeyourvaluation?
g. Forecast (net)comprehensive income for 2010.
E15.7. Valuing a Property-Casualty Insurer (Hard)

The following summarizes the balance sheetand income statement fora property-casualty
insurer. Numbers are in millions of dollars.
For~'Mting,
117.0
130.0
97.0
Net dividends
Free cash flow
2011E
20m
454.0
481.2
510.1
408.6
45.4
433,1
48.1
---.M
-'Q2
39.0
37.6
459.1
51.0
129
381
240.6
130,0
110.6
155.1
130.0
170.4
130.0
125.1
140.4
15.0
28.0
15.0
19.6
15.0
(19.0)
a. Spotthe errorsin the pro forma.

b. The analyst forecasts from thesepro formas that residual operating income willgrow
at a rateof8 percent per year. Do the pro formas justify thisprediction?
E1S.9.
Comprehensive Analysis and Valuation (Hard)

Thisexercise comesin twoparts. Part I involves an analysis ofa setof financial statements
and Part II involves forecasting and valuation basedon thosefinancial statements.
Part J:Analysis
The following is a comparative balancesheetfor a finn for fiscal year2009(in millions of
dollars):
2009
Operating cash
(atmarket)
Accounts receivable
Inventory
Property and plant
60
550
940
910
1,840
$5,300
2008
$
50
500
790
840
1,710
2009
2008
Accounts payable
Accrued liabilities
$1,200
390
$1,040
450
Long-term debt
1,840
1,970
Common equity
1,870
$5,300
1,430
$4,890
$4,890
The following is the statement of common shareholders' equity for 2009 (in millions of
dollars):
Share issues fromexercised employee stock options
Repurchase of 24 million shares
Cash dividend
Tax benefit fromexercise of employee stock options
Unrealized gain on investments
Net income
$1,430
810
(710)
(180)
12
50
468
$1,870
The firm's income tax rate is 35 percent. The firm reported $J5 million in interest income
and $98million in interest expense for 2009.Salesrevenue was$3,726million.
a. Calculate the lossto shareholders fromthe exercise of employee stockoptions during
2009,
558 Part Three ForU(lSrillg andVllllr<1ti(ln Allalysis
Chapter 15 FuU-lnfarma.cion Forcc(lSting. Valuarion, andSILliness Strategy Anat)'~is 559
b. The shares repurchased werein settlement of a forward purchase agreement. Themarket priceof the sharesat the timeof the repurchase was$25 each.Whatwasthe effect
of thistransaction on the income for the shareholders?
c. Prepare a comprehensive income statement that distinguishes after-tax operating income from financing income and expense. Include gainsor lossesfrom the transac,
tionsin parts(a) and (b) above.
d. Prepare a reformulated comparative balance sheetthatdistinguishes assetsand liabilities employed in operations from thoseemployed in financing activities. Calculate the
firm's financial leverage and operating liabilityleverage at the end of2009.
e. Calculate freecashflow for 2009.

Exercises on General Mills are E1.5, E2.9, E3.9, 4.9, E6.8, EI0.9, E13.15, and E14.8.
E15.11.
Part II: Forecasting and Valuation

Usea costofcapital foroperations of9 percent. Salesrevenue isforecasted to grow at a6 percent rate per year in the future, on a constant asset turnover of 1.25.Operating profit margins of 14percent are expected to be earnedeachyear.
a. Forecast return on net operating assets (RNOA) for 2010.
Pro Forma Analysis and Valuation: Nike, Inc. (Medium)

At the end of fiscal year 2008, Nike reported $5,806 million in net operating assets and
common shareholders' equityof $7,797 million. Develop a pro forma andvaluation at the
end of fiscal year2008withthe following forecasts. Then calculate the per-share valueof
the491.1million sharesoutstanding at the endof fiscal year2008.Usea required returnfor
operations of8.6 percentandforecast thatresidual operating income willgrowat an annual
rateof 4 percent after2012.
Forecast
2009E
Sales qrowth rate

Core profit margin
Asset turnover
10.0%
9.0%
3.4
2010E
2011E
2012E
9.0%
8.0%
8.0%
7.0%
7.5%
3.6
8.5%
3.4
3.5
b. Forecast residual operating income for2010.
c. Value the shareholders' equityat theend of the 2009fiscal year usingresidual income
methods.
d. Forecast abnormal growth in operating income for 201 J.
e. Value the shareholders' equity at the end of 2009 using abnormal earnings growth
methods.
f. After reading the stock compensation footnote for this finn, you note that there are
employee stock options on 28 million shares outstanding at the end of 2009. These
options vest in 2011 and after. A modified Black-Scholes valuation of theseoptions is
S15each.Howdoesthis information changeyourvaluation?
g. Forecast (net)comprehensive income for 2010.
E15.12,
One-Stop Residual Operating Income Calculation:

Coca-Cola Company (Easy)
The Coca-Cola Company reported an after-tax profit margin of 20.0percent on its salesof
$24,088 million in 2006. It also reported $102 million of othercore income, mainly from
equity investments in its bottling companies. Furtheranalysis of the financial statements
reveals an assetturnover (onnet operating assets) of 1.32. Cokeusesa hurdle of9 percent
for its investment in operations.
a. WhatwasCoke's residual operating income for 2006?
b. Whatwould Coke's residual operating income be if the assetturnover increased to 1.7?
Applications
E15.10.
(After working this exercise, you might go to the BYOAP feature on the Web site and
develop alternative forecasts and valuations for Nike usingthe technology there.)
Forecasting and Valuation for General Mills, Inc. (Easy)

The following are fromthe financial statements for General Mills(in millions):

Common equity
Sales
2008
2007
$12,847
6,216
$12,297
5,319
13,652
1,560
At the end of fiscal year 2008, 337.5 mi11ion shareswere outstanding, and they traded at
$60 each.The following forecasts were prepared:
Sales growth rate, 2009-2010

Sales growth rate, 2011-2012
Sales growth rateafter2012
9% per year
6% peryear
5% peryear
Prepare a pro forma for the years2009-2012 with a forecast that core profit margins and
assetturnovers willbe the sameas in 2008. Thencalculate theper-share valueat the endof
fiscal year2008withthe forecast that residual operating income willgrowafter2012at the
salesgrowth rate.Use a required returnforoperations of 8 percent.

See exercises E4.5, E4.6, 4.7, El1.7, EI2.7, E15.12, 16.7 and 19.4, and MinicasesM4.1,M5.2, andM6.2.
E15.13. A Valuation from Operating Income Growth Forecasts:
Nlke,Inc. (Medium)
Box15.3in this chapter values Nike'sshares usingresidual operating income methods.
a. Modifythe pro formain Box 15.3to forecast abnormal operating income growth, and
valuethe shares fromtheseforecasts.
b. Apply the simpleforecast model (equation 14.7 in Chapter J4) that combines shortterm and long-term growthrates.
See exercises 2.14, 6.7, 8.13, 13.17, 15.11,E18.5,and 19.4. Minicase M2.1 also
covers Nike.
E15.14. Evaluating an Acquisition: PPE,Inc. (Hard)
PPE, Inc. is considering an acquisition. The acquisition, to be completed withinone year,
willbringthe acquired firm ontoPPE'sbalancesheetusingthe purchase method. Managementhas prepared the following pro forma, whichanticipates this acquisition at the endof
Year 1.Thispro formamodifies the one in the textwhich yieldeda valuation for PPE,Inc.
without the anticipated acquisition.
Chapter 15 FIIIJ-InfonTI(l(ion Forec(lSti~. ValllHion, and Business Stmtep Analysis 561

560 Part Three
For~cQ.Slillg
lind Valul1tion Anat)"sis
Year-1 Year0 Year1 Year2 Year3 Year4 Year5 Year 6
IncomeStatement
Sales
124.90 131.15 189.00 200.34 212.36 225.10 238.61
115.10120.86168.87179.00189.74201.13 213.19
Amortization of goodwill
11.00 11.00 11.00 0.00 0.00
Operating income
9.80 10.29 9.13 10.34 11.62 23.97 25.42
BalanceSheet
Netoperating assetsother
than goodwill
69.90 74.42 94.50 100.17 106.18112.55119.30 126.46
Goodwill
33.00 22.00 11.00 0.00 0.00 0.00
Netoperating assets
69.90 74.42127.50122.17 117.18 112.55 119.30 126.46
7.00
no -221
Common equity
62.90 66.72 121.79
The pro formabalancesheet for the combined finn at the end ofYear 1 includes the net
operating assetsof bothfirmsandthe goodwill onthe purchase. This goodwill is amortized
over the three subsequent years. Forecasted sales and operating expenses for the merged
firmare givenfor yearsafterYear 1.The merged firmis expected to havea required return
for its operations of 11 percent.
Management anticipates that it will haveto issue120sharesto acquirethe firm fromits
shareholders. PPE, Inc. currently has 100 outstanding shares and, according to the pro
forma in the text, is anticipated to pay a dividend of 3.81 cents per share at the end of
Year 1.
a. Review thepro formain Exhibit15.1 without the acquisition andcompare it to the One
here.Willthe proposedacquisition createvaluefor PPE'sshareholders?
b. Prior to FASB Statement No. 142, applicable from 2002 onward, firms amortized
goodwill purchased in an acquisition, as inthepro formahere.Statement No. 142does
not require amortization. Rather, goodwill is carried on the balancesheet until it is
deemed impaired; then it is written down. Reconstruct the pro forma without any
amortization of goodwill.
c. Showthat the equityvalueis the samewith therevisedpro forma.
Minicases
M15.1
Full Forecasting and Valuation:

Procter & Gamble V
This is the final installment in a series of cases on Procter & Gamble Co. that began in
Minicase 9.1 with the reformulation of financial statements andcontinuedwith a financial
statement analysis in Minicases 11.1 and 12.L Minicase 14.1 carriedout a valuation of the
firm, using only information from financial statement analysis. This final installment
applies full pro forma analysis to forecasting and valuation.
In July 2008,just after 2008 fiscal-year end, the 3,033 million outstanding shares of
P&Gweretrading at $64.Analysts were forecasting $4.28in earnings per sharefor fiscal
year 2009, giving it a forward PIE of 15. But the consensus forecast for 2010 was only
$4.21,indicating negative EPS growth. Analysts' PEG ratio,based on an estimate of five
yearsof earnings growth, was 1.46.
A. Initializing on the reformulated statements for 2008, develop a pro formathat would
justifythemarketpricebut whichrecognizes thatprofitmargins andassetturnovers that
P&Ghas reported in the past Howmuchwouldthe futurehaveto be different from the
pasttojustifythecurrentmarketprice?Tostart,usea required equityreturnof8.5 percent
but convert it to an unlevered required return(foroperations). You maywishto employ a
spreadsheet likethat inthe BYOAP on thebook'sWeb site.
B. Develop a sensitivity analysis that shows how the valueper share might changewith
different forecasts that you considerto be reasonable.

SeeMinicases M9.1, Ml L1,Ml2.!, and Ml4.l on Procter& Gamble.
M15.2
A Comprehensive Valuation to Challenge

the Stock Price of Dell, Inc.
Dell's2008annual1O-A reportbeginswith the following introduction to the company that
explainsthemain features of it businessmodel.
Dell listens tocustomers and delivers innovative technology and services they trust andvalue.
As a leading technology company, we offer a broad range ofproduct categories, including
desktop PCs, servers and networking products, storage, mobility products, software and
peripherals, and services. According toIDC, wearethe number one supplier ofpersonal computer systems intheUnited States, andthe number two supplier worldwide.
Ourcompany isa Delaware corporation and was founded in 1984 by Michael Del1 ona simpleconcept: Byselling computer systems directly tocustomers, we can best understand their
needs and efficiently provide themost effective computing solutions to meet those needs.
Ourcorporate headquarters arelocated inRound Rock, Texas, and we conduct operations
worldwide through subsidiaries. When werefer toourcompany and itsbusiness inthis
report, wearereferring tothebusiness and activities ofourconsolidated subsidiaries. We
operate principally inoneindustry, and wemanage ourbusiness inthree geographic regions:
theAmericas; Europe, Middle East andAfrica; andAsia Pacific-Japan.
562 Part Three Forec<1.1!ing lind VlllUlllian Analysis
Chapter 15 FllU.Jnfonnatioll ForeCll~ting, Vahuuion. and BllSilWI~ Sm1!egy A1H1!Ylis 563

Weare committed to managing andoperatingour business in a responsible and sustainable
manner aroundthe globe.This includesour commitment to environmental responsibility in
all areasof our business. In June2007,we announced an ambitious long-term goal to be the
"greenesttechnology company on the planet"andhavea numberof effortsthat take the
environment intoaccountat everystageof the productIifecycle. This also includesour
focus on maintaining a strongcontrolenvironment, highethicalstandards, and financial
reportingintegrity.
BusinessStrategy
Ourcore businessstrategy isbuiltaroundour directcustomer model,relevant technologies
and solutions, andhighly efficient manufacturing andlogistics; andwe are expanding that
COre strategy by addingnewdistribution channels to reachevenmorecommercial customers
and individual consumers aroundthe world. Usingthis strategy, we striveto provide the best
possible customerexperience by offering superior value;high-quality, relevant technology;
customized systemsandservices; superiorserviceand support; and differentiated products
and services that are easyto buyand use.Historically, our growth has beendriven organicallyfromour corebusinesses. Recently, we havebegunto pursuea targeted acquisition
strategy designed to augment selectareasof our business withmoreproducts, services, and
technology that ourcustomers value. Forexample, withour recentacquisition ofEqualLogic,
Inc., a leadingprovider of high-performance storage areanetwork solutions, andthe subsequentexpansion of Den'sPartnerljirect channel, we areready to delivercustomers an easier
andmore affordable solution for storingand processing data.
Ourcore valuesincludethe following:
We simplify information technology for customers. Making qualitypersonal computers,

servers,storage,and services affordable is Dell'slegacy. Weare focused on making informationtechnology affordable formillionsof customers aroundtheworld. Asa resultof our
direct relationships with customers, or "customer intimacy," we are best positioned to
simplifyhowcustomers implement andmaintain information technology anddeliverhardware,services, and software solutionstailoredfortheirbusinesses andhomes.
We offercustomers choice. Customerscan purchasesystems and services from Dell
via telephone, at a growing number of retail stores, and through our Web site,
www.dell.com. wherethey may review, configure, and price systemswithin our entire
product line; order systemsonline; and track orders from manufacturing throughshipping. Customersmayoffersuggestionsfor currentandfutureDell productsand services
through an interactive portion of our websitecalled Dell IdeaStorm.Commercial customers also can interact with dedicatedaccount teams.We plan to continueto expand
our recently launchedindirect initiative by addingnew distribution channels to reach
additional consumers and small businesses through retail partners and value-added
resellers globally.
Customers canpurchase custom-built products andcustom-tailored services. Historicallyour flexible, build-to-order manufacturing processenabledus to tum overinventory
quickly, thereby reducinginventory levels,and rapidlybring the latest technology to our
customers. The global IT industryand our competition haveevolved, and we are continuingto expandour utilizationof originaldesignmanufacturers, manufacturing outsourcing relationships, and new distribution strategies to better meet customerneeds and re,
duce product cycle times. Our goal is to introduce the latest relevanttechnology more
quicklyand to rapidlypass on component cost savingsto a broaderset of our customers
worldwide.
We arecommitted tobeing environmentally responsible inallareas ofourbusiness. Wehave
builtenvironmental consideration into every stageof theDellproduct lifecycle-from developinganddesigning energy-efficient products, to reducing the footprint of ourmanufacturing
andoperations, to customer useandproduct recovery.
Product Development
WefocusOn developing standards-based technologies that incorporate highly desirable
features andcapabilities at competitive prices. Weemploy a collaborative approach to product
design anddevelopment, whereourengineers, withdirectcustomer input,design innovative
solutions andWOrk witha globalnetwork of technology companies to architect newsystem
designs, influence the direction of future development, andintegrate newtechnologies into
our products. Through thiscollaborative, customer-focused approach, westriveto deliver
newandrelevant products andservicesto the marketquickly andefficiently. Our research,
development, andengineering expenses wereS693million for Fiscal 2008,$498millionfor
Fiscal 2007.and S458million for Fiscal 2006,including in-process research and developmentofS83 million relatedto acquisitions in Fiscal2008.
Products and Services
Wedesign, dev~lop, manufacture, market, sell,and supporta widerangeof products that in
manycasesare customized to individual customer requirements. Ourproduct categories
include desktop pes, serversand networking products, storage, mobility products, and softwareand peripherals. In addition, we offera widerangeof services.
Desktop PCs-The XPSTM andAlienware lines are targeted at customers seekingthe best
experiences and designsavailable, frommultimedia capability to the highestgamingperformance. The OptiPlex line is designed to help business, government, and institutional
customers manage theirtotalcostof ownership by offering a portfolio of secure,manageable,and stablelifecycle products. The Inspiron line of desktop computers is designed
for mainstream PC users requiring the latestfeaturesfor theirproductivity and entertainment needs. In July 2007, we introduced the Voslro line,which is designed to provide
technology and services10 suit thespecific needsof smallbusinesses.
Dell Precisionr desktop workstations are intendedfor professional users who demand
exceptional performance fromhardware platforms optimized andcertified to runsophisticated applications, such as those needed for three-dimensional computer-aided design,
digital content creation, geographic information systems. computer animation, software
development, computer-aided engineering, game development, andfinancial analysis.
Servers andNetworking-Our standards-based PowerEdge lineof serversis designed to
offer customers affordable performance, reliability, and scalability. Options include high
performance rack, blade, and tower servers for enterprise customers and aggressively
pricedtowerserversfor small organizations, networks, and remote offices. We also offer
customized Dellserversolutions forvery largedata centercustomers.
Our Powerconnecf switches connect computers and serversin small-to-medium-sized
networks. Powerconnect" products offercustomers enterprise-class features and reliability al a lowcost.
Storage-We offera comprehensive portfolio of advanced storage solutions, including storage areanetworks, network-attached storage, direct-attached storage, disk andtape backup
systems, and removable disk backup. Withour advanced storage solutions for mainstream
buyers, weofffercustomers functionality and value while reducing complexity in the enterprise. Our storage systems are easy to deploy, manage, and maintain. The flexibility and
scalability offered by DellPowerVault, DellEquall.ogic, andDell]EMCstorage systems
helps organizations optimize storage for diverse environments with varied requirements.
Mobility-The XPSTM andAlienware linesoflaptop computers are targetedat customers
seeking the best experiences and designs available from sleek, elegant, thin, and light
laptops to the highest performance gamingsystems. In Fiscal 2008, we introduced the
XPSM1330,an innovative mobileplatform featuringa 13.3~inch high definition display
and ultra-portable form factorthat received awardsfor its uniquedesign.The Inspiron
line oflaptop computersis designedforusers seekingthe latesttechnology and highperformance in a stylish and affordable package.The Latitude" line is designed to help
564 Part Three
Chapter 15 FllU-lnfonnacion For~calring:, Valuation, and BlI5in~sl S:r(l!~g)' Allal~lil 565
ForectllfinJ; and Valuation Allal:-'\i\
business, government, and institutional customers manage their total cost of ownership
through managed productlitecycles and thelatest offerings inperformance, security, and
communications. The VostroT~t line, introduced in JUly 2007, is designed to customize
technology, services, and expertise to suit the specific needs of small businesses. The
Precision line of mobile workstations is intended for professional users who demand
exceptional performance to run sophisticated applications.
Software andPeriphemls-We offer Dell-branded printers and displays and amultitude of
competitively priced third-party peripheral products, including software titles, printers,
televisions, laptop accessories, networking and wireless products, digital cameras, power
adapters, scanners, and other products.
Software. We sell a wide range of third-party software products, including operating
systems. business and office applications, anti-virus and related security software,
entertainment software, and products invarious other categories. We finalized the acquisition of ASAP Sofuvare Express lnc., a leading software solutions and licensing
services provider, inthe fourth quarter of Fiscal 2008. As a result ofthis acquisition, we
now offer products from over 2,000 software publishers.
Printers. We offer a wide array of Dell-branded printers, ranging from ink-jet ell-inone printers for consumers tolarge multifunction devices for corporate workgroups. All
of ourprinters feature the Dell Ink and Toner Management SystemTM, which simplifies
the purchasing process for supplies bydisplaying ink ortoner levels onthestatus window during every print joband proactively prompting users to order replacement cartridges directly from Dell.
Displays. We offer a broad line ofbranded and non-branded display products, including flat panel monitors and projectors. in Fiscal 2008, we extended ourconsumer monitorline-up and introduced new innovations such as"True Life" and integrated camera
and microphone into some of ourmonitors. We added the 120lMP projector to our
existing projector portfolio. Across our monitors and projector product lines, we
continue towin awards for quality, performance, and value.
The firm wasadapting, by sellingcomputers through retail storesas well as through the
Web and shutting down factories in favor of contract manufacturing (likeits rival HewlettPackardj.Itbeganto emphasize styleandcolorin its consumer notebook PCs.Cost-cutting
becameanother style.
Comparative financial statements for fiscal year2008 are given in Exhibit 2.1 in Chapter 2. Reformulated balancesheetsfor 2008and 2007are given in Exhibits 9.4and 9.10in
Chapter 9.
A. Review the reformulated statements andcalculate thekeymeasures thatwillhelpyou
forecast for2009 and beyond. Theseshouldinclude salesgrowth andcoreprofit margins. Calculate residual operating income overpast years and assess how well Dell
hasaddedvalueforshareholders. (You may go to earlieryearsto geta fullerhistory.)
B. Whatare the maindrivers of Dell'sresidual operating income?
C. When Dell'sstockprice stood at $10 in 2008, analysts were forecasting revenue of
$65.1 billionfor2009and $65.7billionfor 2010.With theseforecasts and informationyouhave garnered fromthefinancial statements, develop a proformathatwould
justify a priceof 10 each for Dell's2,060millionshares. Whataspects of the pro
forma are youmostuncertain about?
D. Doesyour pro forma suggest that the $10 price is cheap? Would you recommend
buying thestockat this price?
(Trynot to peekat what did subsequently happen to Dell when youare working this case.
But afteryouhavefinished, youmightget the commentary of hindsight)

Exercises E3.7,E3.14, E5.11, E8.J2, EJ3.16,and E19.4coverDell.Minicase MIO.l also
dealswithDell.
Services-i-Ces global services business offers a broad range of configurable IT services
that help commercial customers and channel partners plan, implement, and manage IToperations and consumers install, protect, and maintain their pes and accessories. Our service
solutions help customers simplify IT, maximizing theperformance, reliability, and costeffectiveness of IToperations. During Fiscal 2008, we acquired a number ofservice technologies and capabilities through strategic acquisitions of certain companies. These are
being used tobuild-out own service capabilities.
While priding itself on its serviceto customers, Dell has also done well by its shareholders, regularly topping rankings of firms on value added for shareholders. A $1,000
investment in the company in 1988had a marketvalueof$351,356 million by 1998, an
average compound rate of returnof 79.7 percentper year. From 1998to 2000,the stock
price increased from $20 to $58 (split~adjusted). The first few pages of Chapter 1 of this
bookspokeof Dell's"hot stock"statusat the time.
Unfortunately, Dell'sstockpricehasnot doneas well since 2000 despitesignificant sales
growth andcontinued profitability. Itappears thatthe$58price-yielding a PIE of88-was
a bubble price. By the time the 2008 financial statements were published, the stockprice
stood at $20andsubsequently declined to$10 during thecreditcrisisof2008.With analysts'
forecasting 2009 earnings pershare(EPS) of$1.34,the forward PIE wasonly7.5.
A forward PIEof7.5laoks lowfora firmthat hastraditionally been a growth firm. But
Dell'ssalesgrowth rate haddeclined andits profit margins were challenged. Prices forPCs
were falling and IT spending in the corporate sector was slowing. The forecast of $1.34
EPSfor 2009wasjust one centabove the 2008EPSof$I.33 andanalysts were forecasting
only $1.37 for 2010, although the PEG ratio based on five years of expected earnings
growth wasonly0.66.
M15.3
The Battle for Maytag:

An Analysis of a Takeover
On May 19,2005,Maytag Corporation (MYG), the homeappliance manufacturer, agreed
to be acquired by Ripplewood Holdings for$1.13 billionin cashor$14pershare,a 21 percentpremium overthe closingpriceof$11.56 the day before.
Maytag is a manufacturer of washing machines, dryers, dishwashers, and other home
appliances, including the venerable Hoover vacuum cleaner, Besides Maytag and Hoover,
its brands include Jean-Airand Amana. The company tracesits rootsback to 1893 when
F. L. Maytag startedmanufacturing fann implements, producing hisfirstwooden-tub washing machine in 1907 fromwhichevolved the appliance nowseenas a household necessity.
Ripplewood is a private equityfirmfamous for its investments in depressed Japanese firms
in the 1990s.
Maytag prospered for manyyearsbut increasingly the market for white goodsbecame
very competitive. While rivals such as Whirlpool and General Electric began shifting
production to low-cost areas in Asia in the 1990s, Maytag's production remained in
NorthAmerica witha highcostbase.In 2004,Maytag announced a restructuring involving
566 Part Three
FOT~,oSling and V<llllmiOll
Chapter 15 FuU-lllformadon Forecasting, VclU(ltion, and Business Stra!el'f Anai)'sis 567
Analysis
a 20percent cutinitssalaried staff. It dosed a large refrigerator plant inGalesburg, lllinois,

opened a new factory in Mexico, andbegan discussions with unions on lowering costs at
otherplants. However, inApril 2005, itsbonds were downgraded tojunkstatus byallthree
bigrating agencies, andthefirm cutitsdividends inhalf Thestock pricedeclined from $30
inApril 2004 to $10a yearlater.
Timothy Collins, Ripplewood's founder and chief executive, said he aimed "to take
action tobecome a low-cost producer andaccelerate growth by introducing new innovative
products, expanding in international markets, andpursuing selective acquisitions" (FinancialTimes, May 20,2005).
InJune 2004, theChinese appliance maker Haiermade abidonbehalfofa consortium of
investors to acquire Maytag for $16 per share. Then, on July 18, Maytag's competitor
Whirlpool entered the fray with a $17 bid. Two days later Haier dropped out, leaving
Ripplewood and Whirlpool as the contenders. Maytag's board was concerned that
Whirlpool's bidwould runintoregulatory hurdles astheantitrust authorities considered the
possibility of reduced competition in the market. Further, Whirlpool's offer waspartly for
stock rather thanan all-cash offer. Whirlpool, quite persistent, upped its offer to $21 per
share, or$1.68 billion.
YOIl arerequired to establish a pricefor Maytag basedon reasonable scenarios about
itsfuture. Maytag is likely tobe worth more to Whirlpool, should theantitrust department
give its blessing. The strategic options that Ripplwood refers to would seemto be availabletoWhirlpool. Whirlpool, in addition, mightproduce morecostefficiencies bymergingplantsandcombining purchasing andmarketing systems. Further, itsR&D may be of
advantage in competing against new Asian entrants such as LGElectronics. You probably
cannot estimate these synergies verywell, but youcan attempt to model the acquisition
from Ripplewood's pointof view. What scenarios, introduced intoa pro forma analysis,
would justify its bid of$14 per share? The difference in the $14 per-share offerand the
$21 Whirlpool offermightthenbeseenas theaddedvalue from combining the twooperations rather than competing against Whirlpool as a stand-alone business. Or was
Whirlpool paying toomuch?
Here areselected financial datathathighlight Maytag's problems:
2004
2003
2002
2001
2000
In thousands, except per share data

Net sales
$4,711,538 4,791,866 4,666,031 4,185,051 3,891,500
Gross profit
859,531 1,004,602
660,219
864,842
985,481
Percent of sales
14.0%
17.9%
21.5%
20.7%
25.3%
Operating income
228,293
359,495
289,152
439,715
$ 40,342
Percent of sales
4.8%
0.9%
7.7%
6.9%
11.3%
Income (loss) fromcontinuing
operations
s (9,345) 114,378 191,401 162,367 216,367
Percent of sales
-0.2%
2.4%
4.1%
3.9%
5.6%
Basic earnings (loss)
per share-continuing
operations
(0.12)
1.46
2.46
2.12
2.78
$
Dividends pershare
0.71
0.71
0.71
0.71
0.72
Total assets
$3,020,024 3,024,140 3,104,249 3,131,051 2,647,461
Total notes payable and
long-term debt
978,611
970,826 1,112,638 1,213,898
808,436
Cash and cash equivalents
164,276
6,756
8,106
6,073
109,370
s
s
However, to get a handle on the issue, youmustdownload the 2004 lO-K from theSEC
EDGAR Web siteandgointothedetails. The2004financial statements arealsoontheWeb
siteforthischapter. Toinitialize theproforma, reformulate theincome statement andbelance sheetfor2004. Thenbegin yourforecasting, lineby line, fora "bestguess" scenario.
J~vestigate the, sensitivity of yourvaluation to changes in forecasts andsee if you canjustify the$14puce-c-or the$21 price-as falling within the range of feasible scenarios. Use
a required return on operations of 10percent, the minimum thata private equity investor
would require.
. Postscript: OnAu~.st 22,2005, Maytag's board agreed to theWhirlpool offer andpaid
Ripplewood a $40million fee forbreaking theagreement.

SeeExercises E6.17 andE19.6.
Chapter 16 Crea!ing Acco~mring Value and Economic VallIe 571
Accounting
:,Economic
PartThree of thebook
developed the analysis to
calculate intrinsic price-tobook(PIB) ratiosand
price"eamings (PIE)ratios.
Thischapter showshow
accounting policies, applied
on a permanent basis,affect
forecasts of profitability and
growth andtheFIBand PIE
ratios calculated fromthese
forecasts.
_Link to neStcl1.apte.
Chapter 17reviews issues

thatariseWhen firms use
accounting methods to
shiftincome between the
present andthe future.
Linkto Webpage
Formoreexamples of how
accounting methods are
accommodated in valuation,
visitthetextWebsite at
www.mhhe.comfpenman4e.
Whatis
conservative
accounting?
Howis it
accommodated
in valuation?
Howdo
accounting
methods affect
PIBandPIE
ratios?
In this chapterwe resolve a seeming paradox: Value is calculated by forecasting future

earnings andearnings aremeasured usingaccounting methods, yeta finn'svalue cannotbe
affected by the accounting methods it uses.
Generally accepted accounting principles (GAAP) constrain the waythat firms can account for their business. However, within GAAP firms have some latitude in choosing
accounting methods, andthese choices can affect thebookvalues andearnings theyreport.
Further, these choices can affect the future earnings and book values that must be
forecasted for valuation purposes. In this chapter we ask how the choice of accounting
method-as a matterof permanent accounting policy-affects the forecasts andthevaluationsmade from them. If a finn uses LIFOratherthan FIFOfor inventory measurement,
how will forecasts of residual earnings or abnormal earnings growth differ? Willvaluationsderived from theseforecasts differ? Howwill price-to-book (PIB) ratiosand priceearnings (pIE) ratiosbe affected? Ifa firm usesan accelerated depreciation method, capitalizes leases, or expenses costs of intangible assets,what will be the effecton residual
earnings, earnings growth, valuations, and PIB andPIEratios? Discounted cashflow valuations remove the effectof accounting methods (and focus rather on cash flows) under
How accounting rates of return and residual earnings

can becreated by accounting methods.
How growth inearnings, growth in residual earnings,
and abnormal earnings growth can be created bv accounting methods.
The difference between economic value added and
accounting value added.
How appropriate valuation techniques produce valuations thatarenotaffected by accounting methods.
How accounting methods affect continuing value
calculations.
How price-to-book ratios areaffected by accounting
methods.
How PIE ratios areaffected by accounting methods.
What "conservative accounting" means and what itimplies for analysis ofprofitability, growth, andvaluation.
How firms create hidden reserves and how they can
increase earnings byliquidating hidden reserves.

Value firms inaway thatincorporates their accounting
methods.
Forecast profitability and growth for firms with different
accounting methods.
Calculate intrinsic price-to-book ratios thatreflect firms'
accounting methods.
Calculate intrinsic PIE ratios that reflect firms' accounting methods.
Identify when a firm is using conservatve accounting.
the suspicion that valuations can be distorted by accounting methods. Do accounting

methods indeed distortvaluations? Doesan analyst have to adjustfirms' earnings for accounting methods beforeproceeding to a valuation?
Wewill see in this chapterhowa finn can use accounting methods that will give it a
high rate of return and thus high residual earnings: The firm can make itselflook more
profitable than it really is. Wewill alsosee that a firm's accounting methods canproduce
high earnings growth. But we will also see that residual earnings and earnings growth
created by accounting methods do not affect the valuation of a finn. Residual earnings
and earnings growth can be created by real factors and by accounting methods, but it is
onlythe real factors that add economic value. Appropriate use of valuation methods distinguishes real value added from the accounting methods used to measure value added,
andso yields valuations thatreflect real factors only.
VALUE CREATION AND THE CREATION OF RESIDUAL EARNINGS

Consider a project that involves an investment of $400 at the end of the year 2000 and
has a required return of 10 percent per year. The project has a two-year life and is expected to generate salesof $240 in 2001 and $220 in 2002. Depreciation is the only expense. Table 16.1 uses twodifferent accounting treatments for thisproject. In Accounting
Treatment 1 the initial cost is depreciated straight-line at $200per year, soproject income
after depreciation is $40 and $20 for the two years. The book value of the project after
572 Part Four Aceounling An(l/ysil andVallll!ion
TABLE 16.1
Accounting
Treatments for a
Project with a
Required Return of
10% per Yearand a
Two-Year Life
Investment in the
Project is $400.
2000
2001
2002
Accounting Treatment 1
Sales
Depreciation
Operating income
Free cashflow
240
200
40
400
RNOA
ReOI (0.10)
PVofReOl
Total PVof ReOl
Value of project
220
200
20
200
240
10%
0
0
-0
240
180
220
180
4Q
0
220
220
10%
0
0
(40)
(40)
360
RNOA
ReOI(0.10)
Present value of ReOI

Total PV of ReOI
Value of project
VALUATION EFFECTS
Residual earnings andRNOA can be created bythe accounting. Treatment 1, yields forecasted RNOA of 10 percent for
both 2001 and 2002 while Treatment 2 yields forecasted
RNOA of 16.7 percent and 22.2 percent. Treatment 1 forecasts zero residual operating income for both years while
Treatment 2 forecasts $24and$22.
Residual earnings created byaccountlnq methods does notaffectthe valuation: The value of the project isthe same $400
under the two treatments and both treatments indicate no
value added from the investment Residual income valuation .
techniques accommodate different accounting methods so'
thatany residual income that is created bytheaccounting' has'
noeffect onthevalue calculated.
0
400
Accounting Treatment 2
Sales
Start-up costs and depredation
Operating income
Free cashflow
ACCOUNTING EFFECTS
60
180
240
16.7%
22.2%
24
21.82
22
18.18
40
400
depreciation (the net operating assets[NOA] forthe project) declines to $200at the end of
2001, yielding an expected returnon net operating assets(RNOA) of 10percentfor each
year,equal to the required return. Accordingly, residual operating income (ReOI) is forecastedto be zerofor bothyears. Thisproject doesnotadd valueoverits investment costso
its valueis its bookvaluein 2000,thatis,$400.By discounting the freecashflow numbers
(given byoperating income minusthechange in net operating assets) at the 10percentrate,
youwill alsosee that the projectis a zero-NPV project.
Theaccountant who keeps the bookswithAccounting Treatment 2 is a conservative accountant. This doesnot referto theaccountant's clothes, hairstyle,or political beliefs.The
conservative accountant likes to understate assets and overstate liabilities in the balance
sheet.So he writes down the projectto a book valueof $360 in 2000.The reduced book
valuein 2000results in reduced charges of$180 in straight-line depreciation in 2001 and
2002.The$40write-down maybe a start-up cost(as inthe table)or the partof the$400investment thatinvolves advertising to launch the project; GAAP requires boththesecoststo
be expensed. The pane! gives the ReOI forecasts with this accounting and the valuation
from theseforecasts.
Thereare twothings to noticefromcomparing the twoaccounting treatments, summarized as "accounting effects" and "valuation effects" in Box 16.1. The accounting effects
demonstrate the intertemporal feature of accounting. Reducing bookvalues lowers future
expenses (in this case depreciation) and thus increases future earnings. Future RNOA is
also higherbecause the higheroperating income is divided by a lower book valuefor net
operating assets. And future residual operating income is higherbecause higherincome is
compared to lower book values (charged withthe cost of capital), to yieldhigherresidual
income.
In practice, assetshavelowerbook values whenR&Dinvestments are expensed, when

promotion andadvertising thatcreatebrand-name assets are expensed, andwhenassets are
writtendownexcessively. Firms can also maintain lowasset values for assets on the balance sheet by usingaccelerated depreciation for property, plant,and equipment, accelerated amortization of intangibles, and maintaining high bad debtestimates for receivables,
forexample. Liabilities are overstated withhighestimates for deferred revenue, accrued liabilities, and pension liabilities, for example. These practices create higher subsequent
rates of return.Thus firms with large successful R&D programs typically generate high
RNOA and ROCE in subsequent yearswhen the R&Dpaysoff,as earnings fromthe R&D
arecompared to lowbookvalues. Drugcompanies, whichhavelargeR&D programs, often
reportRNOA over30percent. Coca-Cola hasbrand-name assetsthatarenotonthebalance
sheetand so has an RNOA on the orderono percent.
The practice of understating bookvaluesis calledconservative accounting.Butjust as
future RNOA and ROCE can be increased by writing downnet assets, so can they be decreasedbywritingassetsup.Writing up assets(orfailing to writethemdown whentheyare
impaired) is referred to as liberal accounting. Prior to the adoption of international accounting standards, firms in the UnitedKingdom andAustralia periodically revalued tangibleassetsupward, yielding lower RNOA andROCE thancomparable US. firms.
Liberal accounting is a namesometimes given to less conservative accounting: A fum
that capitalizes some software development costs but expenses other R&D (Computer
Associates, for example) is saidto use moreliberalaccounting thana firmthatexpenses all
R&D(Oracle and Microsoft, for example). But both use conservative accounting overall.
A benchmark that draws the line between conservative and liberal accounting is neutral
accounting.Thisis accounting that yieldsan expected returnon equity equalto thecost of
capital, and thus zero residual income,for investments that do not add value. Accounting
Treatment 1 is an example of neutralaccounting. Conservative and liberal accounting, in
contrast, yieldprofitability thatis different fromthe required returnwhentherein factis no
valueadded. Conservative accounting produces higherfuture profitability thanthe required
return;liberal accounting lowers futureprofitability.
So you see that economic value added and accounting value added differ. High
RNOA and residual earnings are not necessarily indicative of valueadded. So beware of
thosewho pointto accounting measures as indicators of economic valueadded. Examine
products that consultants sell as measures of economic valueadded. Allsuchmeasures are
accounting measures of someform and the formof the accounting mustbe considered in
accepting the measures as economic valueadded.
Thevaluation effectof different accounting methods (described inBox 16.1)is referred
to as the value conservation principle: Valuations usingresidual income techniques are
573
Chapter 15 Creating AccOlmring Value andEconomic Value 575

574 Part Four Accounring Analysis andValuation
notaffected by the accounting forcurrent book value. Value is calculated as current book
value plusthe present value of future residual income forecasted. An accounting method
thatchanges current bookvalue changes future residual income, butitdoesnotchange the
value calculated because the change in the residua! income is exactly offset, in present
value terms, bythechange in current book value. Soexpensing R&D creates higher future
residual earnings but lower current bookvalue, and the valuation is not affected. Value is
affected onlyby residual income generated byrealeconomic profitability, notaccountinginduced profitability.
ACCOUNTING METHODS, PRICE-TO-BOOK RATIOS, PRICE-EARNINGS

RATIOS, AND THE VALUATION OF GOING CONCERNS
TABLE 16.2
NeutralAccounting:
A Firm Investing
$400EachYearwith
NoValue Added
(Requiredreturn is
10%)
2000
Sales
From investments in 2000
Operating expenses (depreciation)
For investments in 2000
Accounting Methods with a Constant Level of Investment

Going concerns have repetitive investment. Table 16.2, the first in a series of five tables
illustrating accounting methods, gives thevaluation fora finnthatinvests $400inthesame
zero-value-added project in 2000 (as before) but is also forecasted to invest $400in each
subsequent year, again with zerovalue added. Thetable gives forecasted operating income
andnetoperating assets forthefirm, anditcalculates forecasted RNOA, residual operating
income (ReDl), and abnormal operating income growth (AOIG) from these forecasts,
along withprofit margin, assetturnover, and growth drivers. As before, theproject generates$240in sales in its first yearand $220in its second, and again itscost is depreciated
straight-line overtwoyears. The totals for operating income after2001 are thesumof incomes from theprojects putinplace overthepriortwoyears, andnetoperating assets is the
sumof the investments just made ($400) andthe (partially depreciated) book value of the
continuing investment inplace.
You seethatoperating income is$60oncethefinnreaches itspermanent level of netoperating assets of $600. Accordingly, the RNOA is forecasted to be 10percent in all years,
equal to the costof capital; the ReOI is forecasted to be zero; and the value of the firm is
$400, itsbookvalue in 2000. TheAOIG is alsoforecasted to bezeroaftertheforward year
(2001), so the value of $400is alsoequalto capitalized forward operating income. This is
neutral accounting: Thefinn does not addvalue to itsinvestments (liketheproject before)
andthe accounting method confirms thissincethe rateof return equals the costof capital,
and abnormal income growth equals zero. And for a zero-value-added finn, neutral
accounting yields a normal intrinsic P!Bratio of 1.0and normal trailing and forward PIE
ratios, as you see at the bottom of the table. For this reason neutral accounting can be
referred to as normal accounting.
Look now at Table !6.3. Here the finn's investment and sales are the same as in
Table 16.2 in all years, butnow conservative accounting is used. Theaccountant writes off
10percent (or $40) of investment immediately, charged against income. Consider this as
the R&D component of theproject or promotion costs that are expensed immediately according to GAAP. Comparing Table 16.3 withTable 16.2, youobserve the accounting and
valuation effects of conservative accounting relative to nonnal accounting. Liberal accounting would have the same effect, except in the opposite direction. Box 16.2 lists the
Netoperating assets (NOA)

Investment
Free eash flow
400
400
400
(400)
RNOA(%)
Profit -margin (%)
Assetturnover
Growth inNOA (%)
ReOI (0.10)
AOIG (0.10)
Value of firm
Premium over bookvalue
PIB
Trailing PIE
Forward PIE
2002
240
220
240
240
460
200
200
. 200
200
40
Operating income
Theexample inthe lastsection involves a single project. Similar observations canbemade

about a going-concern firm which keeps its book values low (or high) continually. Here
again thevalue doesnotdepend ontheaccounting. ButPISand PIE ratios will. Theeffects
depend on the amount of investment growth, so first we lookat the caseof no growth in
investment and then at thecasewhere a firm grows itsinvestment.
2001
400
0
1.0
10.0
200
400
400
60
200
400
2003
2004
240
220
240
460
460
200
200
400
60
200
400
600
400
(160)
600
400
60
600
400
60
10.0
16.7
0.60
50
0
10.0
13.0
0.77
0
0
0
10.0
13.0
0.77
0
0
0
600
0
. 1.0
11.0
10.0
600
0
1.0
11.0
10.0
600
0
.1.0
11.0
10.0
200
200.
400
60
200
400
600
400
60
10.0
13.0
0.77
0
0
1.0
. 11.0
10.0
ReOI value of firm =Book value == 400

AOIG value of firm:=.c.a,~ita1i~~d'forward ,i.neome =o~~o =, 400
Values inall;=s in Tables 16.2-16.5 3lld16.7 an:the value i02000growioga!the 10percentcostofeapilJ1.less rreecash flows j)3id
out So the forecasted valueat thcendof2001 is (400x 1.l0)+ 160'" 600andthar3tthe endof2002is(600x UO)-6O=600. The PIB
ra~os ~ l.III!evmrl PIBntios tot levered PIB!ftherei.s00dl:bt financing). Aspremiums an:Ut13!fccted by financing theyan:boththe
premiwns forthe firmandpremiwm furthe equity. PIEntios an:alsounlev=d PIEn~os. Foreachyt3~ theyee ealculaled 3~ ~Iue +
Fm:cashflOWYor.3S in Chaptet' 13.Thee!f= onlevered PrEntios an:similat; the PfErntiOI herean:ondeed levered PrErat><>; ,fthe
firm has nonetdebt.and free ca.sh flows c<jll31 dividl:nds.
accounting andvaluation effects of conservative accounting fOT this firm thatinvests a constantamount eachyear.
The valuation of $400inTable 16.3 is the sameas that with neutral accounting; again
the accounting does not affect the valuation. But note now that intrinsic price-to-book
ratiosarehigher-and permanently so-c-because of the lower bookvalue. Intrinsic trailing
andforward PIEratios are affected temporarily (because earnings are transitory) but they
areunaffected oncethe permanent levelof investment is reached: Earnings areunaffected
bytheaccounting (as,of course, is value). TheAOIG isexpected tobe zero, so thePIEratio
576 Part Four Accounting Anal)"lis andV<lllwlion
TABLE 16.3
Conservative
Accounting: A Firm
Investing$400Each
Yearwith NoValue
Added;10% of
InvestmentExpensed
Immediately
(Required return is
10%)
2000
2001
2002
2003
2004
Sales
240
220
240

240
460
180
40
180
180
40
220
240
460
ACCOUNTING EFFEGS
Operating income isnotaffected byconservative accounting once a permanent level of investment is reached.
Income is lower with the conservative accounting while
the level of investment isbeing built up(in 2001) but it is
the same $60after 2001. This isalways a feature of accounting: Accounting methods don't affect income if
there is no change in investment because expenses and
revenues arealways the same, regardless of whether the
accounting isconservative or not.
2. Netoperating assets, although constant, are lower with
conservative accounting andpermanently so. As with the
project, the accounting affects book value, but it doesso
permanently.
3. RNOA and residual operating income (and ROCE and
residual earnings) are permanently higher with conservative accounting than with neutral accounting.
1.
Operating expenses
For investments in2001
40
180
180
40
400
400
180
180
40
400
60
60
60

Forinvestments in 2004
40
Operating income
(40)

360
220
20
180
360
180
360
180
360

360
540
Investment
Free cash T10w
400
(400)
400
(160)
RNOA(%)
Profit margin (%)
Asset turnover
Growth in NOA (%)
ReOI(0.101
AOIG (0.10)
Value of firm
Premium over book value
PIB
Trailing PIE
Forward PIE
ReOI value of firm = 360 -
220
240
460
400
540
400
60
11.1
13.0
11.1
13.0
0.67
50
(16)
0.85
a
6
22
0.85
a
6
0
1.11
22.0
)0.0
20
400
60
5.6
8.3
600
60
1.11
540
600
60
1.11
11.0
10.0
600
60
1.11
11.0
10.0
180
360
540
=
400
Value is unaffected by the accounting. As with the single

project, residual earnings created bythe accounting have
noeffect onthevalue calculated.
2. PIB ratios are nonnormal (greater than 1). Conservative
accounting reduces book values and thus induces a premium over book value. Not only istherean effect oncurrent premiums, but there is also a permanent effect on
subsequent premiums.
3. PIE ratios are not affected by the accounting once the
permanent level of investment is reached: Earnings and
value areboth unaffected bythe accounting.
1.
11.1
13.0
0.85
o
6
o
600
60
1.11
11.0
required return. It is sometimes said that continuing valuesshouldbe calculated at a point

in the future wherethe rate of returnis expected to equalthe costof capital. Ratesof return
decline toward a normal return, it is said, as competition drives excess profits to zero.
Excesseconomic profits may indeedbe dissipated through competition, but that does not
mean that the accounting measure of profitability, RNOA, will fall to the level of the required return: Conservative accounting will create a permanent level ofRNOA above the
required returnevenif there is no real valuegenerated. So a Case 1 valuation (whereReOl
is expected to be zero)will typically not apply to an R&Dfirm, for example.
10.0
0.10
B-] =
AOIG value of firm =_,_ [20 +

0.10
1.10
VALUATION EffEGS
60
~ + (_6_)/1.10 = 400 (ACase 2 valuation)

1.10
4. Abnormal operating income grovvth is not affected by

conservatve accounting once a permanent level of investment isreached.
400
remains a normal PIE ratio. Research and development and brand-generating firms typically have high RNOA and residual earnings, so they typically have high price-to-book
ratios. Butthat doesnot meanthat theynecessarily have high PIE ratios.
The formof the valuation for the firmwithconservative accounting differs from thatfor
the firm with neutralaccounting. As residual operating income is expected to be greater
thanzeropermanently, the ReOlvaluation is a Case2 valuation (introduced in Chapter5),
as shown at the bottom of Table 16.3: ReOI is a perpetuity, so it is capitalized at the
Accounting Methods with a Changing level of Investment

In Tables 16.2 and 16.3 the firm reaches a constantlevel of investment. But the picture
changeswhen the level of investment is forecasted to change. Table 16.4 deals with the
samefinn as inTable16.2,exceptthat investment, whichagainis depreciated straight-line,
is forecasted to growat 5 percentper year. Eachdollarof investment is expected to generate the same sales as beforebut, as investment is growing, so are salesrevenue, operating
income, and cum-dividend operating income. Becausethe finn is employing neutralaccounting, eventhoughoperatingincomeand net operating assetsare forecasted to grow,
forecasted RNOA is 10 percentand ReOI is zero.The valueof the firm is still $400:The
expanding investment with growing earnings does not add value.
Look nowatTable 16.5.Herethe conservative accountant is at work writingoff 10percent of the investment as R&Dandpromotion expenditures eachyear. This resultsin positiveresidual earnings and a nonnormal PIB ratio,as before,but thereare additional effects.
Forecasted operating income is increasing through time but is lowerin all years than in
Table 16.4because the write-offalso increases at a 5 percent rate. But the cum-dividend
operatingincome (afterreinvesting the free cash flow "dividend" at the cost of capital) is
growing at a rate that is greater than the cost of capitalratherthan the 10 percentrate in
577
Chapter 16
578 Part Four Accouming AnaI,sis and Valuation
TABLE 16.5
TABLE 16.4
2000
NeutralAccounting:
2001
2002
2003 .. 2004
Sales
A Finn with
240.0
InvestmentGrowing
at 5% per Yearwith
NoValue Added
(Requiredreturn is
From investments in2001

220.0
252.0
231.0
264.6
10%)
240.0
472.0
200.0
200.0
210.0
495.6
242.6
277.8
52004 .
Operating expenses (depreciation)

Forinvestments in2001
200.0
40.0

Netoperating assets(NOA)
Investment
Free cashflow
400.0
400.0
400
(400)
RNOA(%)
Profit margin ('Yo)
Asset turnover
Growth inNOA (%)
ReOI (0.10)
Growth in ReOI (%)
Growth incom-dividend 01(0/0)
AOIG(0.10)
Value of firm
Premium overbookvalue
P/8
Trailing PIE
Forward PIE
200.0
420.0
620.0
420
(180)~
10.0
16.7
0.60
55
0
400
0
1.0
10.0
620.0
0
1.0
11:0
10.0
410.0
62.0
210.0
441.0
651.0
441
31
10.0
13.1
0.76
5
0
0
10
0
651.0
0
1.0
11.0
10.0
210.0
'2205
4305
. 65.1
452.0
68.4
2315
486.2
.683.6 717.7
463,1
486.2
325 . .34.4
O.
0
10
683.6
0
1.0
11.0
10.0
2000
10.0
13.1
0.76
5
'0
0
10
0
717.7
0
1.0
11.0
10.0
2001
2002
240.0
220.0
252.0
2003
579
2004
Sales
From
From
From
From
investments in 2000
investments in 2001
investments in 2002
investments in 2003
240.0
472.0
180.0
42.0
180.0
189.0
44.1
231.0
264.6
495.6
242.6
277.8
520.4
Operating expenses
(Required return is
10%)

For Investments in 2004
2205
2315
2205
463.1
10.0.
13.1
.0.76
5
Conservative
Accounting: A Finn
with Investment
Growing at 5% per
Year withNoValue
Added; 10% of
Investment Expensed
Immediately
Cr~ming Accounring Vahle and Economic Vallie
40.0
Operating Income
40.0
(40.0)
222.0
18.0
360.0
180.0
3780
360.0
Investment
Free cashflow
400
(400)
RNOA(%)
Profit margin ('Yo)
Asset turnover
Growth inNOA (0/0)
ReOI (0.10)
Growth in ReOI (%)
Growth in cum-dividend 01 (%)
AOIG (0.10)
Growth inAOIG (%)
Value of firm
Premium overbookvalue
P/8
Trailing PIE
Forward PIE
558.0
420
(180)
5.0
75
0.67
55
(18.0)
413.1
58.9
189.0
396.9
1.11
22.2
620.0
62.0
1.11
24.4
105
4338
61.8
1985
416.8
1985
208.4
48.6
4555
64.9
585.9
615.2
208.4
437.6
646.0
441
31
463.1
325
486.2
34.2
10.6
125
0.85
5
3.10
127
21.10
400.0
189.0
1985
463
651.0
65.1
1.11
11.6
105
10.6
125
0.85
5
3.26
5
103
0.155
683.6
68.4
1.11
11.6
105
10.6
125
0.85
5
3.42
5
103
0.163
5
717.7
71.8
1.11.
11.6
10.5
ReOI value of firm",400

AOIG value of firm '" o:~0 '" 400
Growth io cum-<iividend or isgrowth ,n oprnuingIncome adju.sted fur",investing free =h flow at the re<juired mum of )0 pe=l
Thefree=h flowis the"dividend" fromop::",rion,.
Table 16.4.1 Further, ReOI and AOIG are increasing at 5 percent,not constantas before.
Nothing has changed here from Table 16.4 except the accounting. The conservative accountinghasproducedgrowthin operatingincome, growthin ReOI,and abnormalincome
growth:An RNOA abovethe requiredreturn combinedwith growingnet operatingassets
yields growingReOI,and growingReOI impliesabnormal incomegrowth.
Reported {ex-dividend} income grows ata slower rate butthis does notrecognize theearnings from
reinvesting dividends. The "dividends" from theoperations arethefree cash flow and thegrowth rates in
operating income incorporate earnings from this free cash flow invested at 10percent.
ReOI value of firm = 360 -
~ +(
AOIGVaIUeOffirm=_1 ..
0.10
[18+ 21.10+(
0.155 );( ]=400
1.10
1.10-1.05 1.10
Sl\m~
1.1 0
3.1 ) 11.10 = 400 (A Case3 valuation)

1.1 0 - 1.05
n"mlx" dn"'!"dd rreci,dy du~ to rounding.
As the growingReO!isjust an accounting effect,it doesnot changethe $400 valuation.

This is also a zero-value-added firm. But note that the ReOI value calculation (at the
bottomof the table)is nowa Case3 valuation that accommodates the growing ReOLReO!
is capitalized at the 5 percentgrowthrate.The AOIGvaluation also is basedon a 5 percent
growth rate but the valueof$400 is the sameas the case with no growth.
Chapter 16 Creanng Accolll1ting Value and Economic Va!lIr
581
TABLE 16.6 Summary ofAccounting Effects fora Firmwith Zero Value Added
Abnormal
ACCOUNTING EFFECTS
VALUATION EFFECTS
1 Operating income is lower with conservative accounting
1. Value isunaffected by the accounting, asalways.
<
if assets are growing.
2. PIa ratios arehigher with conservative accounting, butno

higher than in the no-growth case. But conservative accounting with growth results inincreasing premiums over
conservative accounting, as before. Although there isan
time, reflecting induced residual earnings growth. PIB raeffect on income (in the numerator of RNOA), the effect
tios do notchange from the no-qrcwth case because the
isproportionately larger on the denominator. But, due to
percentage increase inthenumerator isthesame asthatin
the effect on income in the numerator, rates of return
the denominator.
and residual earnings are not as large as with constant
investment.
3. PIE ratios arehigher than inthe no-growth case: The accounting does not affect firm value but yields lower
3. Growth inincome isinduced byconservative accounting if
earnings. The higher PIE ratios reflect the higher foreassets aregrowing.
casted growth inabnormal operating income induced by
4. Growth in residual operating income is induced by conthe accounting.
servative accounting if assets are growing.
2. RNOA and residual operating income are higher with
5. Abnormal income growth is induced by conservative accounting if assets are growing.
The accounting and valuation effectsof conservative accounting with growing investmentfor a firm withzero value addedaresummarized in Box 16.3. Theaccounting effects
for liberal accounting are in the opposite direction.
Table 16.6summarizes the effectsof conservative and liberal accounting that we have
observed for operating income, residual operating income, growth in residual operating
income, abnormal operating income growth, the PIB ratio,and the PIEratio. The effects
are the same on earnings and residual earnings, but they are compounded by the effects
of financial leverage that we examined in Chapter 13.The effectsare for the firm that
does not add value; the results of neutral accounting are given as a benchmark. The effects are given for declining investment as well as growing investment. Underall conditions (of constant, growing, or declininginvestment), PIB and PIE ratiosare normal for
normal accounting. Conservative and liberal accounting produce opposite effects, but
the direction of some of the effects depends on whether investment is growing or declining. (Note that declining investment cannotcontinue indefinitely) Price-to-book ratios with conservative accounting and growthin investment are higherthan normal,but
they are unchanged from the no-growth case. But PIE ratios are higher than in the nogrowthcase (and higherthan normal PIE ratios), because conservative accounting yields
lower earnings(and value is unaffected). A higher PIE is, of course, appropriate: PIE is
higher than normal if positive AOIO is expected, and conservative accounting creates
AGIO.
We haveobserved in earlierchapters thatPIEratiosand PIB ratiostendto be above normal.This makessensein lightof our analysis here.Conservative accounting is commonly
practiced, sofirmstendto have PIB above normal. Butfirms alsohavebeengrowing assets,
so the conservative accounting produces highPIEratios as well.
The examples wehavebeenthrough are fora firm thatdoesn'taddvalue. The ideais to
showyou howthe accounting can givethe appearance of valueaddedwhen thereis none.
Economic factors that add value will yield higher forecasted ReOl and AOlG than that
580
Accounting
Method
Investment
Pattern
RNOA
Neutral
Conservative
liberal
Neutral
Conservative
liberal
Neutral
Conservative
Liberal
Constant
Constant
Growing
Growing
Growing
Declining
Declining
Declining
Constant
Normal
Above normal
Below normal
Normal
Above normal
Below normal
Normal
Above normal
Below normal
Residual 01
01 Growth
level
Pattern
level
Pattern
Zero
Positive
Negative
Zero
Positive
Negative
Zero
Positive
Negative
Constant
Constant
Constant
Constant
Growing
Declining
Constant
Declining
Growing
Zero
Zero
Zero
Zero
Positive
Negative
Zero
Negative
Positive
Constant Normal
Constant
Constant
Constant
Growing
Declining
Constant
Declining
Growing
PIS
Above normal
Below normal
Normal
Above normal
Below normal
Normal
Above normal
Below normal
PIE
Normal
Normal
Normal
Normal
Above normal
Below normal
Normal
Below normal
Above normal
A normal RNOA ison. l""t.quals therequired returnfuroP'={;ltioM;:I nonnalPIBis equol to 1.0;:1 nOflrull tr.!iling PtE is eqU:l1 to (I + R<q"ired R'lUrn)!R"'l0ifl:d ,</Urn;
, nonn,l rorw.:tfd PIEiseqU<lllO llR<quired return.
generated by the accounting, and thus higherpremiums overbook valueand higher PIE
ratios.ReOIandAOIG are always a resultof bothreal and accounting effects.
Because accounting methods don't affectthe value, we don't haveto worryaboutdistinguishing realprofitability from accounting profitability. Butthereis a proviso. Theearningsweforecast mustbe comprehensive earnings. If anycomponent of earnings is leftout
of the forecast, we willlosevaluein the calculation.
An Exception: LIFO Accounting

Thereis oneexception to theprinciple thataccounting methods do notcreatevalue. If firms
are required to use the sameaccounting methods in theirfinancial reportsas they use for
filingtax returns, the choice of accounting will affecttheirvalues. If, for example, firms
choosemethods that reduce or postpone taxes, theywillhavehighervalues. In somecountriesthereis a linkbetween tax and financial reporting rules. In the UnitedStatesthe link
applies onlyto LIFO(last in, firstout) accounting for inventories; if a firm usesLIFOfor
tax, it mustalsouse it in its financial reports.
LIFOis a conservative accounting methodwheninventory quantities and costsare rising. Inventory on the balance sheet is measured at the low pricesof olderinventory purchaseswhile costof goodssoldismeasured at recent,higherpurchase prices. Thelowbook
valuesyieldhigherinventory turnovers, assetturnovers, ratesof return,and PIB ratios. It is
sometimes saidthatLIFOresults in lower earnings also. Butthis is notnecessarily so.Cost
of goodssold equalspurchases minuschange in inventory; thus if inventories on the balance sheetremainlevel, cost of goodssold (and earnings) are the sameunder LIFO and
FIFO(firstin,first out)accounting, equal to the cost of currentpurchases. This is another
example of whatwe saw in Table 16.3: The accounting doesnot affectincome whenthere
is no change in net operating assets (in inventories here). But if inventories are growing
(and inventory costs are rising), the effects observed in Table 16.5 surface: LIFOyields
highercostof goodssoldalongwithlower grossmargins, profit margins, andearnings, and
it yields higherPIB and PIE ratios.
If inventories and their costsare expected to grow, the higherLIFOcost of goodssold
will result in lower taxes. Finns therefore adoptLIFO for tax and book purposes and so
generate value. Whatadjustments are requiredto incorporate this addedvaluefromusing
582 Part Four Accounting AM1)'l15 and Valtuw'on

Chapter 16 Creating Accounting Value and Economic Value 583
the LIFO method? None:Thehighervalueis incorporated in forecasts of residual income.

The lower forecasted taxes increase forecasted after-tax profit margins and RNOA.
Accordingly, forecasted residual earnings are higherandso aretheirpresent values.
TABLE 16.7 Creation and LiquidationofHidden Reserves with ConservativeAccounting:A Firm with Investment
InitiallyGrowing at SOlo andThen Leveling Off,with NoValueAdded; 10% ofInvestment Expensed Immediately
(Requiredreturn is 10%)
HIDDEN RESERVES AND THE CREATION OF EARNINGS

We havejust seen that when investments are growing, conservative accounting depresses
earnings andprofit margins butraisesresidual earnings andabnormal income growth. But
it is alsothe casethatif the rateof investment subsequently slows, conservative accounting
generates higherearnings and profit margins and evenhigherresidual earnings and abnormalincome growth.
LookatTable 16.7. Thisinvolves the sameinvestment asTable 16.5 up to theyear2004.
Then, in 2005, investment is forecasted to level off at the amount in 2004 instead of
growing at 5 percent. Salesandexpenses from 2006on are thusforecasted forthis level of
investment, producing a permanent level of operating income ofS72.9.But theratioof depreciation to revenue declines, yielding higherprofit margins. So RNOA increases from
10.6 percent to 11.1 percentby 2006,thesameRNOA as thatwithno growthin investment
inTable 16.3. Residual operating income also increases, driven by the higherRNOA, and,
as inTable 16.3,is forecasted to be constant. The decline in the rate of growth has generatedprofitmargins, turnovers, RNOA, residual operating income, and(temporarily) abnormaloperating income growth.
Thisexample illustrates thephenomenon of hidden reservesandtheirliquidation. Hidden reserves are profitsthat might havebeen booked with less conservative accounting.
Conservative accounting, with growth, reduces earnings because of higherexpenses. But
the charging of higherexpenses buildsup hidden profit reserves thatcanbe realized witha
slowing of investment. Theyare"hidden" because theyare bookvaluethatis missing from
the balancesheetdue to conservative accounting: Reporting lower earnings meansthat net
assets(andequity) mustbe lower by exactly the sameamount- If the accounting were not
conservative, the net operating assetswould be carriedat a higheramount. If the growth of
investment slows or levelsoff,or if investment declines, moreprofits canbe generated; this
is referred to as liquidating bidden reserves.Yes, this is strange! Firmscan generate profits by reducing investment. Table i 6.5 shows the effectof the creation of hidden reserves
(reducing income); Table 16.7 shows the effects of theirliquidation (increasing income).
The use of LIFO is a case in point.If physical inventories and inventory costs are increasing, LIFOproduces highercostof goodssold andlower earnings, creating hidden reserves. Thesehiddenreserves are reflected in a lower balance sheetnumber forinventories
overwhatit would havebeenunderFIFO. In the UnitedStates GAAP requires the amount
of the hiddenreserve, referred to as the LIFO reserve, to be reported. It is typically given
in footnotes. The LIFOreserve isthe cumulative amount of additional earnings that would
havebeen recognized in the past if the firmhad used FIFO. It is always the casethat
LIFOinventory>FIFOinventory - LIFO reserve
so you can always calculate what the inventory number would havebeen if the firm used
FIFO. Andit is always the casethat,for anyfiscal period,
LIFOcostof goodssold e FIFOcostof goodssold+ Change in LIFOreserve
2 Theterm,
"hidden reserves" issometimes usedto referto allowances andliabiiities that have been
overestimated, so excessive baddebtallowances andunearned revenue estimates create hidden reserves.
These arejustparticular casesof conservative accounting. Theunderstatement or omission of anyasset,
or overstatement of anyliability, creates a hidden reserve.
2000
Sales
2001
2002
240.0
220.0
252.0
2003
231.0
264.6
2004
242.6
277.8
2005
254.7
291.7
472.0
Operating expenses
40.0

for investments in2000
for Investments in2002
for investments in 2006
180.0
42.0
40.0
(40.0)
222.0
18.0
360.0
180.0
378.0
360.0
558.0
Investment
400
420
Free cashflow
(400)
(l80)
RNOA(%)
5.0
Profitmargin(%}
7.5
Asset turnover
0.67
Growth in NOA (%)
55
ReOI (0.10)
(18.0)
Growth in ReOI (%)
Growth incum-dividend 01 (%)
AOIG(0.10)
ReOl value offirrn
400.0
620.0
Premium overbook value
62.0
PIB
1.11
1.11
Trailing PIE
24.4
forward PIE
22.2
10.5
180.0
189.0
44.1
Somenumbers don't ,dd e>:aetly d~ 10rounding,
1.21
267.4
291.7
559.1
189.0
198.5
46.3
198.5
208.4
48.6
208.4
218.8
48.6
218.8
218.8
48.6
413.1
58.9
189.0
396.9
198.5
416.8
585.9615.2
441
463.1
31
..32.5
10.6
10.6
12.5
12.5
0.85
0.85
5
5
3.10
3.26
5
127
10.3
21.10
0.155.
651.0 683.6
65.1
68.4
1.11
1.11
11.6
11.6
10.5
10.5
208.4
437.6
646.0
486.2
34.2
218.8
437.6
656.4
486.2
60.2
1331 1464
1.611
0.10
218.8
437.6
656.4
486.2
72.9
2007
267.4
29U
. 559.1
218.8
218.8
48.6
486.2
72.9
218.8
437.6
656.4
486.2
72.9
jU-
10.6
10.9
11.1
12:5
12.9
13.0
13.0
0.85
0.85
0.85
0.85
5
1.6
0.0
0.0
3.42
6.02
7.29
7.29
5
76
21
o
10.3
14.0
11.8
10.0
0.163
2.602
0.0
1.270
717.7
729.3
729.3
729.3
71.7
72.9
72.9
72.9
1.11
1.11
1.11
1.11
11.6
11.2
11.0
11.0
10.2
10.0
10.0
10.0
ReOlva!ueoHrm:=360-~+i..1...+ 325 + 342 + 602 + 729/ 1 611:=400

110
2006
Chapter 16 Creatir.g Accounting Value andEconomic VII1\(~
585
584 PartFour Accounting Analysis and Vahllluan

TABLE 16.8
LIFO Reserves and Changesin LIFO Reserves for NYSE andAMEXFirms,1976--2004
LIFO Reserve/Shareholders'
Equity, %
Change in LIFO Reserve/

Revenue, %
25th
75th
Year
% Change
in (PI
Percentile
Median
25th
Pencentile
Percentile
Median
Pencentlle
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
4.86
6.70
9.02
13.29
12.52
8.92
3.83
3.79
3.95
3.80
1.10
4.43
4.42
4.65
6.11
3.06
2.90
2.75
2.67
2.54
3.32
1.70
1.61
2.68
3.39
1.55
2.38
1.88
3.26
14.96
15.48
16.72
20.93
22.63
21.46
20.10
18.14
16.48
14.89
12.65
12.60
13.37
12.98
13.30
12.01
12.15
10.71
10.15
9.80
8.49
7.61
6.37
6.42
6.56
6.37
7.42
6.70
8.75
10.07
10.20
10.70
12.85
13.49
12.72
11.57
10.40
9.48
7.98
6.18
6.16
6.31
6.04
6.08
5.42
5.28
4.52
4.41
4.50
3.96
3.31
2.85
2.64
2.90
2.52
2.99
2.90
3.00
5.13
4.98
5.36
6.52
6.65
6.35
5.24
4.72
4.12
3.23
2.27
2.35
2.33
2.32
2.05
1.86
1.73
1.41
1.65
1.94
1.53
1.29
1.09
0.93
1.09
0.83
0.88
0.79
0.96
0.88
0.93
1.04
1.84
1.50
1.10
0.28
0.19
0.25
0.08
0.08
0.35
0.56
0.38
0.32
0.12
0.09
0.06
0.26
0.32
0.11
0.06
0.01
0.07
0.16
0.06
0.12
0.15
0.48
0.39
0.49
0.55
1.06
0.53
-0.03
-0.04
0.02
-0.10
-0.10
0.11
0.25
0.13
0.08
-0.03
-0.03
-0.05
0.07
0.10
-0.02
-0.03
-0.08
-0.03
0.03
-0.05
0.00
0.01
0.11
0.12
0.16
0.23
0.51
0.29
0.12
-0.50
-0.43
-0.24
-0.47
-0.51
-0.09
0,05
-0.05
-1).09
-0.27
-0.21
-0.30
-0.05
-0.02
-0.22
-0.19
-0.27
-0.16
-0.07
-0.22
-1).10
-0.06
0.00
14.05
6.50
2.45
0.40
0.06
-0.13
Total
75th
0.75
The tablegives rheamounl of UfO reserve (:IS a percentage ofsharehold...."'luity)andlheth.ng. inlheLIFO="" (asa percent:lge ofrevenue). TheLIfO re<erve is lhe
diffeRnce between UfO invenlorios3lld ~ FlFOcrry;ng """,unt Thedunge in theLIFO=fVe il1he differcl1-. b1:rween UFOand FIFOe()5lofgoods !Old.
Some.:A=unting d,l:Iis fromSt:mdord of Pcor's. COMPUSTAT files. Consumer priceindex(CPI)dat>. ;s fromtheU.S. Dep.rtment of Labor Bureau of 1.>bor Statisticl.
The difference in after-tax operatingincome under FIFO and LIFO is the change in the
LIFO reservemultipliedby the tax rate. If you wantto compareprofitmargins, turnovers,
and RNOAof a LIFO and FIFO firm, you can put them on the same basis by using these
relationships.
Table 16.8 gives the median LIFO reserve as a percentage of shareholders' equity for
NYSE and AMEXfirmsusing LIFO for the years 1976to 2004, along with the 75th and
25th percentiles. You see that the median reserveranged from a high of 13.5 percent of
shareholders'equity in 1980to 3.0 percentby 2004. So, at the median,firmswouldhave
had 13.5percenthigherequityin 1980if they had used FIFO, and 3.0 percentmoreequity
in 2004.LIFO reservesincreasewheninventory costs riseand the changeinthe Consumer
Price Index (CPI) reportedin the table indicatesthat 1980was a high inflation year, with
inflation, and LIFO reserves, decliningthroughto 2004.The table also givesnumbers for
changesin the LIFO reserveas a percentage of revenue. Changes in LIFO reservesare the
difference between LIFO and FIFO cost of goods sold, so, as the changes are divided by
revenueinthe table,the numbersare theLIFOeffecton before-tax gross marginsandprofit
marginsrelative to FIFO. At the median, theyrangedfrom 1.06percentin 1979to -0.1 percent in 1985and 1986as a percentage of revenues.
Just as growing LIFOinventories reduceearningsand increase(hidden) LIFOreserves,
declining LIFO inventories create earnings by liquidating LIFO reserves: Lower, older
costs are brought into cost of goods sold, yielding higher earnings than under FIFO.
The additional earningsare called LIFO tiouidation profits. (faxes, deferredbyusingLIFO
when inventories were growing, will also be realized against the liquidation profits.)
Table16.8indicatestherewere 12yearswhenmedianchangesin LIFO reserveswere negative,and in eachyearfrom 1982to 2003, except 1988, LIFOreservesdeclined at the25th
percentile: Over 25 percent of LIFO firms reported higher profits than they wouldhave
under FIFO.
A declinein physical inventories reducesthe LIFO reserveif inventory costs are rising.
But the LIFO reservewill also declineif inventory costs fall, becauseLIFOcostsof goods
sold (basedon recent,lowerprices)are thenlowerthan underFIFO(basedon older,higher
prices). Often quantities and prices both faU as a result of lower demandfor the product.
Some companies separate LIFO reserve declinesdue to inventory liquidation from those
due to price declines in their footnotes.
Hidden reserves can arise from any application of conservative accounting. Reducing
investment in plant and equipment that has been depreciated rapidlywill generate profits.
Constantor declining sales after a periodof sales growthwillyieldprofitsif therehas been
a policyof overestimating warrantyliabilitieson bad debts provisions.
Someanalyststake special care to recognize hidden reservesand add value to the finn
for them. Some maintain that LIFO reserves, which must be reportedunder U.S. GAAP
(usuallyin footnotes), are an asset whose value must be added to correct the book value.
But we haveto be careful. Hiddenreservesare an accounting phenomenon, and accounting can't generate value.Look at the valuation at the bottomofTable 16.7.This is the same
firm as in the previoustables; it does not generate value. And applyingresidualearnings
techniques-now with the forecast horizon at the steady-state year beginning2006--we
get the samevaluation as before,$400. (You mightdo the AOIG valuationalso.)The presence of unrealized hiddenreserves inTable16.5didnot giveus an incorrectvaluation. Provided we forecast Rear to a steady-state levelthat recognizes the investment path, hidden
reservesare not a concern.Perpetual growth (in the Table 16.5 valuation) meanswe anticipate hidden reserveswill never be realized. But expected realization of hidden reserves
(inTable 16.7)does not changethe valuation. A forecastof higher Reul (inTable 16.7)is
exactly offsetby a forecastof a lowergrowthrate for ReOI.
By now you should be aware of a number of fallacies with respect to interpreting
accounting data. These fallacies often lead to misstatements-in the press and even by
analysts-so it is useful to flag them. Box 16.4 lists statements that are sometimes erroneously made about the relationship betweenaccounting numbersand value. Each statement can be true if the accounting capturesrealphenomena, and often that is the case.But
each attribute can also result from accounting methods. Most of the fallacies arise from
naivelyfocusing on earningsgrowth or ratesof return. Earnings growthand ratesof return
can be affected by the accounting,so they must be interpreted by combiningforecasted
residualearningswith current book value in a residual earningsvaluation, or by charging
earningsgrowth for requiredearningsgrowthin an AOIGvaluation. Don't be too quickly
impressedwithgrowingearnings,growingresidualearnings,and high rates of return.Reserve judgmentuntil youhave testedto see if these attributesare real or induced.
These statements arenotnecessarily true:

Firms with higher anticipated eaminos growth areworth
more.
Rejoinder: Earnings growth can be created by accounting
methods (and byfinancial leverage) rather than economic
teeters.
Firms with high anticipated return on equity are worth
more.
Rejoinder: High return onequity means a higher premium
over book value butnota higher value; ROCE can becreated bytheaccounting (and byfinancial leverage).
Increasing residual earnings indicate a firm that isadding
more andmore value.
Rejoinder: Probably, butgrowth inresidual earnings can be
induced with conservative accounting.
If a firm isearning an RNOA thatishigher than thecost of
capital. itwill addvalue by investing more.
Rejoinder: A firm can create a high RNOA through accounting methods but may not be able to add value
through investment.
If RNOA ishigher than the cost of capital. a reduction in

investment (or slowing ofitsgrowth rate) reduces residual
earnings.
Rejoinder: A reduction of investment can create residual
earnings if conservative accounting has created hidden
reserves.
low profit margins mean a firm cannot generate much
value from sales.
Rejoinder: low profit margins may be induced byconservative accounting depressing earnings, if net assets are
growing.
High asset turnovers mean a firm isefficient ingenerating
sales.
Rejoinder: High turnovers can be produced by keeping
asset values low with conservative accounting.
Conservative accounting reduces profits and results in
higher PIE ratios.
Rejoinder: Not always; only ifinvestment isgrowing.
With respect to earnings growth, you now have threewarnings about interpreting earningsgrowth. In Chapters 5 and 6 wesawthat investment can generate earnings growth but
may not add value. In Chapter 13 we saw that financial leverage can generate earnings
growth butdoes notaddvalue. And herewe see thatconservative accounting can generate
earnings growth but doesnotadd value. Inall cases, the use of appropriate valuation techniques determines whether growth addsvalue. The techniques protectyoufrom paying too
much forearnings growth.
CONSERVATIVE AND LIBERAL ACCOUNTING IN PRACTICE

While the focus of someaccounting methods is on measuring earnings, all methods have
an effecton bothearnings andbookvalue. Thisisjust the debitsandcreditsofaccounting:
One can't affectearnings without also affecting the balance sheet.So all methods can be
thought of in terms of their effect on bookvalueand thus on accounting rates of return,
residual income, andthe PIB ratio. Theycanbe thought of in termsof theireffects on earnings,profit margins, andthe PIE ratio, but onlywithchanging investment. So thinkfirst in
termsof the effect on bookvalues. Forexample, "accelerated depreciation" results in lower
bookvalues forproperty, plant,andequipment; highbad debtestimates result in lower net
receivables; and UFO measurement of cost of goods sold results in lower inventories
(when inventory prices are rising). These conservative methods yield higher PIB ratios.
Theyyield lower earnings and higher PIE ratios onlywith increasing property, plant,and
equipment, receivables, and inventories.
The accounting profession in mostcountries typically takesa conservative approach. It
is sometimes claimed that this conservative accounting leads to lower income and lower
586
CONSERVATIVE ACCOUNTING
Practices thatdecrease book values:

Accelerated depreciation of tangible assets.
Accelerated amortization of intangible assets such as
patents andcopyrights.
UFO inventory methods.
Underestimates of:
Net accounts receivable (high bad debtestimates).
leasereceivables (low residual value estimates).
Impairment values (high impairment write-offs).
Overestimates of:
Pension and postemployment benefit liabilities.
Warranty liabilities.
Provisions for restructurings and other future events.
Deferred revenue.
Accrued expense liabilities.
Practices that record nobook values at all:

Expensing R&D expenditures.
Expensing advertising expenditures.
Expensing investment in intellectual and human capital.
LIBERAL ACCOUNTING
Practices thatincrease book values:

Revaluing tangible assets upward.
Booking brand-name assets.
Charging nodepreciation (some firms inU.K.).
Overstating deferred tax assets through low valuation
allowances (U.S.).
Practices that record nobook values at all:
Omitting contingent liabilities for environmental damage,
lawsuits, andstock compensation, forexample.
rates of return, givinga "conservative" pictureof the firm. Don't be confused. Conservative accounting policies will yield lower profitsif investments are growing. But they will
always resultin higherratesofreturn and thus higherapparent profitability. And ifinvestments are growing, theywillresultin growing residual income and higherearnings growth.
Conservative accounting-supposedly designed to yield a conservative balance sheetactually produces higherprofitability, which is not a conservative view.
Box 16.5 lists common accounting practices that affect book values and accounting
rates of return. They are classified as conservative or liberal but many of the conservative
methods can be liberal (andsome liberal methods conservative) if applied in the opposite
direction. For example, accelerated depreciation and amortization methods yield lower
bookvalues andhigherratesof return and so are conservative. Butmethods thatdepreciate
or amortize assetsveryslowly are liberal methods, just likeassetrevaluations.
The restof this chapter illustrates the effectsof accounting methods.
LIFO versus FIFO

In 1997 NikehadhigherRNOA thanReebok, 25.7percent compared to Reebok's 16.0 percent.ButNikeusedLIFO for its U.S. inventories while Reebok usedFIFO. Table 16.9 lists
somemeasures for 1996and 1997that reflect inventory accounting for the twofirms.
Nike'sinventory turnover ratios are higher than Reebok's. due in part to lower LIFO
inventories. This contributes to a higher RNOA. Nike'slarge growth in inventory has the
effect of lower profit margins because of highercost of goodssold,but the effect of lower
margins on the RNOA is not as greatas thatof the assetturnover, so RNOA is larger than
it would be underFIFO. With the amounts for the LIFO reserve (taken forTable 16.9 from
the inventory footnote), we can calculate Nike's RNOA for 1997as ifit were usingFIFO.
Inventories would be higher by the amount of the LIFO reserve and so then would net
operating assetsin the denominator of RNOA. Operating income in the numerator would
587
SSS Part four
Chapter 16 Creating Accounting Vallie and Economic Vahle 589
Acc01mring Anal)'si> and VahlCl.rian
TABLE 16.9
1997
Nike versus Reebck:

LIFOvs. FIFO
RNOA(%)
Asset turnover
Inventory turnover
Gross margin (%)
Profit margin (%)
Inventory ($ thousand)
Growth ininventory (%)
LIFO reserve ($ thousand)
TABLE 16.10
theprobability of R&D success, arebased onexperience in thedrugindustry, lending them

a certainrealism.
The numbers in Table 16.10 areaverages overmanytrialsin thesimulation. Thisrepresentative firm startsan R&D program inYear 1,and inearlyyears thereare no revenues as
drug development moves through to commercial launch. The development period is quite
long,andYear 14 is the firstyear thatrevenues are generated. The tablegives ROCE, PIS,
and ElP for that year, as well as Years 20, 26, and 32. The firm is not leveraged, so the
ROCE isequal to theRNOA. Thethreeratiosaregivenforthreedifferent accounting methods. The expensing method expenses all drug development costs when incurred, as required underGAAP. The full costing method capitalizes development costsandamortizes
themstraight-line over 10 years from commercial launch. The successful efforts costing
method capitalizes all development costs, writesoff unsuccessful projects whentheyfailto
move to the next stage of development, and amortizes successful projects over 10 years
from commercial launch. Prices in the EIP and PIB ratiosare intrinsic prices calculated
fromforecasting cashflows in thestimulation.
Expensing R&D is themostconservative accounting, full costing theleast. Steady state
is reached inYear 26and youcan seethatat thatpointexpensing yieldsthehighest ROCE,
full costing the lowest. Accordingly, PIB ratios are highest under the expensing method,
lowest under full costing. Because the firm commits a set amount of expenditure to R&D
eachyear, oncesteadystate is reached thereis nogrowth in investment. Correspondingly,
there is littlechange in earnings andROCE (fromYear 26 toYear 32),as in theTable 16.3
example earlier. There is also little change in EIP ratiosand PIB ratiosregardless of accounting method, again as in Table 16.3. AndElPratioslooknormal: Asthereis nogrowth
in ROCE or growth in expenditures (andno growth in earnings or bookvalues), residual
earnings areconstant, so PIEs are normal.
Thesteady-state ratios are typical ofa mature R&D firm withnogrowth in itsR&D program. With growth, steady-state ROCE would be lowerbut PIE higher: The steady state
would beaTable 16.5 ratherthanaTable 16.3 example. Theratiosfortheexpensing method
priortosteady statearetypical of an R&D start-up. Expenditures for R&D areexpensed but
revenues arenotyetforthcoming, so thefinn reports verylow profitability.
1996
Nike
Reebok
Nike
Reebok"
25.7
3.0
8.1
40.1
8.7
1.338.640
43.8
20,716
16.0
3.2
6.6
37.0
4.9
563,735
3.5
22.6
2.7
8.3
36.9
8.5
931,151
47.8
16,023
14.1
2.9
5.8
38.4
4.8
544,522
-14.2
Ratios from a Simulated Research andDevelopment Program Using Different Accounting Methods
Year from
PIB Ratios
EIP Ratios
ROCE, %
Beginning
Expense Full Successful Expense Full Successful Expense Full Successful
of R&D
Method Costing Efforts
Method Costing Efforts
Program Method Costing Efforts
14
20
26
32
-92.3
8.1
54.8
54.0
-3.4
10.7
27.8
26.4
-15.2
11.0
39.6
39.3
17.9
11.4
7.3
7.4
2.7
2.9
2.7
2.6
4.5
5.2
4.5
4.5
-0.043
0.016
0.098
0.096
-0.012
0.029
0.101
0.097
-{).035
0.018
0.098
0.096
ThetoblcshowshowROCE. PISrolios. ,rodEll' ",I,OS ch:lOge ,s R&Dpr1lgrorns motu",.fo' th= difforonl ,ccountingmelhods I~Jl diffcrin thedegreeof conservative
o=~nling. bpon,;r.g R&D;sIhemostconsc,","'live lc<:oun!;ng. fullcostingne leesr~nscr""li\"e. n,e R&Dprog,",,"' ge<\O"'les lossesup toVe"r14(for"IIthreemelhodsl
be<:"usc R&D"'pen,,,, exceedreVCnues. Posil;vc profilobility is reportedalterYeo'14.b'JIlhe prnfil~bility is highe'th" mo'" "OlIscrv,ti,'e the ac<:o"nling melbod.
SOU",,: P.Hc,ly.S. Mye,.,.. ,od C. Howe. ~R&DAcco"nling andthe RcI,.,,"ce-Objccl;v;lyT,,,dcoff: A Simulalion UsingO.t, fromthe Ph,rma,eul;d Industry."' Slo.n
School arMon.s,m,n!. MIT. 1998.Sec.1'0 "R&DAc'COunting ,mllbc T",dc:offbctwecn R,I=o". 'od ObjecliviIY:' )011",,,1 O!:l<"<:Olllllillg R,s<:",,". Jun" 2002.
pp.6i7-71O.bythe""meaulhors"
be higherby the amount of the change in the LIFO reserve from 1996 to 1997, that is,
$4,693 thousand beforetax and52,886 thousand after tax at Nike's38.5percent tax rate.
Theadjusted RNOA (based onaverage netoperating assets inthedenominator) is 25.6percent,immaterially different from the LIFO RNOA. We seethatNikehadlargeincreases in
inventory but conclude that with the small increase in the LIFO reserve relative to its
inventory, it does nothave significant cost increase in manufacturing inventories.
Theseadjustments helpin the comparison of firms'ratios. But for valuation purposes
theyare unnecessary: We can value bothNikeand Reebok by forecasting theirRNOA as
measured, without adjustment for differences in theaccounting. However, otherconsiderations aside,Nike, with lower net operating assets underLIFO, has a (slightly) higherintrinsic PIB ratio than Reebok and, with its growth in inventories depressing earnings, a
slightly higherintrinsic PIE.
Expensing Goodwill and Research and

Development Expenditures
The first lineofTable16.11 gives the reported operating profitability forGlaxoWellcome,
the largeIl.K. phannaceutica1 finn, from 1991 to 1996. Glaxobought Wellcome in 1995,
so earlierfigures arepreacquisition (thefirm is nowpartofGlaxoSmithKline PLC). Glaxo
Wellcome expenses R&D expenditures. The second line gives the profitability recalculated by capitalizing R&D and amortizing it at a rate of 25 percent of declining balance
each year. The period was one of growing investment in R&D which, when expensed,
reduces operating income in the numerator. But the overall impactof the conservative
accounting is to increase the return on operating assets over that from capitalizing and
amortizing.
Research and Development in the Pharmaceuticals Industry

Table 16.10 gives ROCE, PIB, andElPratios(thereciprocal of thePIEratios) generated by
a simulation of a firm's R&D program. In the simulation a finn spendsa set amount each
yearfor basicR&Don a number of drugswitha set probability of success. If theresearch
on a drugis successful, the firm moves to preclinical testing andclinical trials, againwith
a set probability of a successful outcome. Successful drugs are launched commercially
with estimated revenues, production costs, and marketing costs. All estimates, including
TABLE 16.11
ClareWellcome
PLe: Effects of
Expensing R&D
Returnon Operations, %
1991
'992
1993
1994
1995
1996
As reported
With R&D capitalized
50.6
39.8
54.2
41.2
51.5
39.4
55.5
39.4
75.5
50.5
96.4
55.0
Source: C. Higson, "'V,,!ue ~1eIri"s,n Equity Analys;s.~ In,t,lUIeofFinarttt andA"cou~ting. London Business School, 1998.
111
590
PartFour
ACCOlmtin!: Alllll)'sis end Vdl(C{irm
TABLE 16.12
Forte versus Hilton:
Liberal vs.
Conservative
Accounting
Chapter 16 Creating AccOlmring Vafue andEconomic Value 591
1991
1992
1993
1994
1995
Forte PlC
ROCE (%)
Depreciation/sales (%)
Revaluation reserve/equity (%)
PIB
HiltonHotels Corp.
ROCE(%)
Depreciation/sales (%)
PIB
1.2
3.0
69.8
0.58
1.2
71.0
0.61
9.0
9.1
2.01
10.6
8.9
2.06
3.3
4.1
3.6
67.5
0.58
24
4.6
73.9
1.03
3.8
4.9
70.9
0.94
10.3
11.1
8.9
2.90
14.5
8.6
2.37
8.5
2.75
Prior10 1998, firms in theUnited Kingdom expensed all goodwill intheyear thatit was
purchased as a dirty-surplus charge to equity. (They nowcapitalize it and subject it to impairment rules.) Thiswas veryconservative accounting. You canseethatthewrite-off from
the acquisition of Wellcome in 1995 produced a largereported rateofretum of96.4 percentin 1996. Whengoodwill is capitalized, the 1996 return falls to 38.6percent; it falls to
31.5percent when bothR&Dandgoodwill arecapitalized.
Liberal Accounting: Breweries and Hotels

Many breweries, hotels, and leisure companies in the United Kingdom regularly revalue
assetsupward andalsocharge littlein depreciation. Theirargument is thatassetvalues increase rather than decline and regular maintenance slows economic depreciation. Such
firms accordingly have lowaccounting rates of return andlowPIB ratios. Table 16.12 comparesnumbers forForte PLC,a l.l.K. hotel andrestaurant chain(before it wastakenover by
Granada in 1996), and Hilton Hotels, the U.S. hotelchain.These firms have largeinvestments in depreciable assets (hotels), yet Forte's depreciation-to-sales ratio is muchlower
thanHilton's. Anda highpercentage of Forte's bookvalue comes from revaluations (which
are not permitted in the United States). Accordingly, its liberal accounting produced low
ROCE andlowPIB ratios. Forte's PIB ratios ofless than1.0forecast negative residual earningsfor thefuture. Hilton's PIB ratios forecast positive residual earnings.
Profitabilityin the 1990s

In the middle to late 1990s many firms reported strong profitability. In the early 1990s
manyof those samefirms reported lowprofitability. The lowprofitability wasdue partly to
recession and also to majorrestrucrurings and to the recognition of employee benefit liabilities. Someclaimthatthe subsequent highprofitability andearnings growth, though no
doubtderiving from cost efficiencies introduced by the restructurings, was partly created
by the lower book values from assetwrite-offs and the recognition of the new liabilities.
Correspondingly, the high PIB ratiosof the middle to late 1990s were due partly to the
accounting having become more conservative.
In the late 1980s, General Motors Corporation traded below book value with correspondingly lowbookrates ofretum, as youcan see inTable 16.13. Aftera period of very
low profitability in the early 1990s, due significantly to restructuring and recognition of
postemployment liabilities, profitability recovered to higherlevels in 1994 and 1995, and
the firm tradedat a premium. Coreprofit margins recovered, butthe higher RNOA relative
to 1988 and 1989 wasdriven by a higher ATO. The higherATO probably reflects realefficiencies in using assets but also is a resultof the accounting in 1990 to 1992. And the
higherPIB ratiosreflect the lower bookvalues of netoperating assets.
TABLE 16.13
General Motors
Corporation: Effects
ofLower BookValues
1988
Unlevered PIB
RNOA(%)
Core PM (%)
ATO
NOA ($ billion)
1989
1990
0.7
0.8
0.7
9.7
7.2
2.5
6.7
4.1
6.9
15
1.0
1.0
118.3 125.1 124.1
1991
1992
0.7
1.2
0.0 -20.8
1.5
1.8
1.0
1.3
118.4 81.8
1993 1994 1995 1996

1.5
6.3
4.2
1.9
63.3
1.3
11.1
5.0
2.2
76.7
Ii
1.2 1.2
11.0 75
5.5 3.8
1.9 1.7
96.2 95.3
Economic-Value-Added Measures
Consultants in recentyears have developed residual earnings measures that adjust GAAP
accounting to measure "economic value added"or "economic profit." These products may
be goodas value-based management tools-as performance incentives to maximize shareholder value-but users should be careful aboutdemanding the adjustments for valuation.
These measures redotheaccounting, buttheaccounting maynotmatter. Themeasures typically undoaccounting conservatism-by capitalizing and amortizing R&D andadvertising, for example-but we have seen that this is not necessary. Indeed capitalizing and
amortizing introduces theproblem of estimating amortization ratesto measure the decline
ineconomic value of intangibles. This is a nontrivial exercise.
ACCOUNTING METHODS AND THE FORECAST HORIZON

The analysis in this chapter has shown that, for valuation purposes, we do not have to
distinguish real economic profitability fromaccounting profitability: Accounting methods
do not affectthe valuation. Thatis just as well, for-e-despite consultants' claims that their
products measure "economic profit" and "economic valueadded"-we really cannotobserve true economic profitability. While accountants and consultants strive to improve
measurement, we are ultimately forced to work with imperfect measurements. Thereare,
however, twoprovisos to ourconclusion:
1. Theearnings forecasted mustbecomprehensive earnings. If anycomponent of earnings
is leftout of theforecast, value is lostin the calculation.
2. Thevaluation is insensitive to theaccounting onlyif steadystateis predicted. Different
accounting methods resultin different (Case 1,2, or 3) steady-state profitability, but
oncethisdifference inpermanent profitability isrecognized, thevaluations arethesame.
Ifwevaluefirms withforecasts upto a pointbefore steadystateis reached, however, we
willnot get the samevaluation.
Thefirstpointhasbeenemphasized consistently throughout thebook. Thesecond point
is clearfrom comparing thevaluations inTables 16.4and 16.5. With neutral accounting (in
Table 16.4), the forecast horizon is veryshort;steadystateis reached oneyearahead. With
conservative accounting (Table 16.5), theforecast horizon is longer; steadystateisreached
twoyears ahead. In thecaseofthepharmaceuticals industry inTable 16.10, theaccounting
takes a considerable amount of time to uncover the profitability of bringing drugsto the
market, themoreso for(very conservative) GAAP accounting thatexpenses investment in
R&D immediately.
These observations giveyoua senseof another feature of theaccounting thatbearsupon
the valuation. Valuations are uncertain, but more so the further into the future we have
to forecast. All else being equal,we prefer to value a firm from forecasts over a short
592 Part Four Accouming Anal)'sis and Valuadon
forecasting horizon. Accounting methods that recognize value added earlierare to be preferred to accounting methods that require us to forecast well intothe future. Accordingly,
we can thinkof "good accounting" as accounting that shortens the forecast horizon and
"badaccounting" as accounting thatforces us to forecast intothedistant future. Thatis,accounting is judged by the practical criterion-cestablished in Chapter 3--of establishing
valuations from relatively shortforecast horizons. Mark-to-market accounting forfinancial
assetsand liabilities is considered good accounting because it removes the needfor forecasting. Thesimple valuations of Chapter J4 useveryshortforecast horizons. Indeed, the
forecast horizon is immediate because those valuations relyonlyon the current financial
statements. Butthosevaluations onlywork iftheaccounting forthepresent is good enough
to giveus an indication of the long run.
The neutral accounting outlined in this chapter is ideal, for it uncovers economic profitability andresults in shortforecast horizons. Thisis theaccounting thatconsultants strive
for when theyattempt to measure "economic profit." However, care is required in reconstructing GAAP accounting to thisideal. Accounting thatpurports to be closerto theideal
is a good forecast ofthe long runonly if it is reliable. If,with thepretense ofmeasuring real
profitability, theaccountant builds ina lot of speculation, wehavelostouranchor; wehave
contaminated what we know with what we don't know. Consultants who measure "economic value added" typically capitalize R&D expenditures as assets on the balance sheet
andthenamortize thiscostto earnings. Iftheoutcome of theR&D program is highly speculative, thebookvalue is alsohighly speculative. If, in addition, the amortization ratesare
highly uncertain, earnings alsoare contaminated by the speculation aboutthe future, and
weloseinformation about what wedoknow about the current profitability thatmight help
us forecast future profitability. Conservative accounting (thatexpenses R&D immediately,
forexample) excludes suchspeculation andforces us tospeculate overlongerforecast horizons. Conservative accounting thatisjustified byuncertainty satisfies the fundamental analyst's desire to leave speculation to theanalyst andexclude it from the accounting.
TheWeb pagefor this chapter lays outthe accounting issues thatdetermine the length
of the forecast horizon.
The Quality of Cash Accounting and Discounted

Cash Flow Analysis
This discussion brings us backto the pointwhere we embraced accrual accounting valuationmodels (in Chapter 4).We didso because cashaccounting-and discounted cashflow
analysis-ean lead to longforecasting horizons to uncover theunderlying value, especially
iffree cashflows in theshorttermarenegative. Using thelanguage above, cashaccounting
is notgood accounting for valuation.
Discounted cashflow analysis forecasts cashflows, and its seeming appeal is thatit uses
reliable numbers. Cashflows are saidto be "real" andnot affected by accrual accounting
rulesandestimates. "Cashis king" is the cry, so forecast cash. Theimplication is thatcash
flow forecasts are betterquality thanearnings forecasts for capturing value. But we saw
earlier in the book that free cash flow is doubtful as a value-added measure. It is the
"dividend" fromtheoperations, notthevalue created bythe operations.
To remind ourselves, Table 16.14 gives the free cash flows for Starbucks during its
growth period from1994to 1997. AsC- I:::: OI- ~OA, thefirst twolinesgive operating
income andnet operating assets. Thefreecashflows herearenegative. Was Starbucks losing value overthis period? If wewere valuing the firm in 1993 andhad beengiven these
cashflows as short-term forecasts for 1994to 1997, would weacceptthemas goodquality
indicators of profitability? As measures of cashflows, theyare of course "real,"But they
are notgood quality for valuing the firm.
Chapter 16 Creaa'ng AccOlmdng Value and Economic Vahle 593

TABLE 16.14
Starbncks
Corporation: Free
Cash Flowsand
AccrualAccounting
Measures,1994--1997
(in thousands of
dollars)
1993
Operating income
Netoperating assets
Core profit margin (%)
Asset turnover
Core RNQA (%)
Growth in NQA (%)
93,589
1994
1995
1996
1997
15.051
191.416
(82,776)
5.3
2.00
10.6
104.5
24.406
342,648
(126,826)
5.2
1.74
9.0
80.5
31,081
412,958
(39,229)
4.5
1.84
8.3
20.6
53,252
578,237
(112,027)
5.6
1.95
10.9
40.0
In contrast, the accrual accounting numbers for Starbucks inTable 16.14----profit margins, assetturnover, RNOA, and growth in net operating assets-give some indication of
profitability. Theydo not necessarily indicate long-run profitability, buttheyarea starting
pointtoproject how thisfirm canaddvalue from profitability andgrowth. We begin byrecognizing the current profitability and growth and then, with otherinformation about the
fum'sbusiness plan,product demand, andso on,weforecast intothefuture. Butstarting at
the freecashflows does not help. Starbucks's newinvestment eachyearis large relative to
cashflow from operations, so forecasted free cashflows are negative. If investment continuesapace as thefinn expands intoEurope andtheAsiafPacific region, forecasted freecash
flows might be negative for a longtimeafter1997. The forecast horizon might haveto be
verylongindeed to capture thevalue thefirm cangenerate.
In practice, DCFanalysts oftenadjust forecasted cashflows to geta better quality forecast.Theyrecognize liabilities forpension costsanddeferred taxes. They adjust forinvestments theyconsider to beunnecessary forsustaining thecashflows. This effectively yields
a normal depreciation charge. But anyadjustment to a cashflow is an accrual thatserves
the roleof producing higher quality measures of value added. The adjustments are effectively redoing the accounting withparticular accrual methods. Intheend, thequality ofthe
forecast willdepend onthequality of theadded accruals, which raises thequestion ofwhat
is good accrual accounting andwhat is pooraccrual accounting.
The alternative approach is to start with GAA? earnings forecasts which already have
manyof thedesired accruals. An analyst might be so distrustful of theestimates in accrual
accounting as to backthem outaltogether. Buthe would have to thenconsider whether the
resulting number-free cashflow-is really a higherquality number.
In a "fundamental" sense, the forecasting of accrual earnings is unavoidable. Evenif we
weresatisfied withforecasted cashflows, it is difficult to imagine forecasting them without
getting a feel for profitability. Try to forecast the cashflow statement without a forecasted
income statement. How would youforecast investment without a senseof theprofitability
of investment? And how would youforecast the cashflow from operations without forecasting earnings andtheprofitability of investments? Indeed forecasting cashsalesis more
difficult thanforecasting sales: Onehasto forecast customers' payment patterns as well as
sales. Forecasting RNOA is particularly important. The RNOA, PM, andATO givetransparency; youseewhere thevalue is coming from. Soprescriptions forDCFanalysis require
you to firstforecast theearnings andthen"backout the accruals" to getto the cashflows:
C -1 = 01 - liNOA. Thus, much of the proforma analysis wehave beenthrough is essential for nCF analysis. Having donethe analysis, wemustaskwhether the accruals should
be eliminated if theresultis a lower quality number.
Discounted cash flow analysis always gives the same valuation as residual earnings
techniques if the forecast horizon is long enough. If one forecasts freecashflow to steady
594 Part
Chapter 16 Cremin!: Accounting Valtl~ andEconomic Va!ll~ 595
Four Accounting Analysis andVa/antion

state,one recovers the valuation. Again, the issue is a question of working withreasonable
horizons. But there are also circumstances where the DCF valuation is the same as the
residual earnings valuation withthe sameforecast horizon. TheWeb pagefor this chapter
laysoutthesecircumstances andalsocontrasts otherfeatures ofDCF andresidual earnings
valuation.
Summary
Key Concepts
Residual earnings andabnormal earninggrowth areaccounting measures. Soaremeasures

marketed by consultants as"economic profit," "economic valueadded," andthe like.These
measures are not necessarily measures of (real) valueadded. They are measures that are
determined by real economic factors, but also by the accounting used in their calculation.
In a series of examples, this chapterhas shown how accounting can create earninss
profitability, and residual earnings. Andit has shown how accounting can create growthin
earnings and growth in residual earnings, with the resultant effecton PIB ratios and PIE
ratios. A benchmark case of a finn that adds no value with its investment was used to
demonstrate the accounting effects. In general, profitability and growth result from both
accounting effectsand realeconomic factors thatcreatevalue.
The chapterhas shown that the way to view accounting methods is in terms of their
effect on book value, for it is the accounting for book value that generates higher profitability and growth. So accounting methods werecategorized as "conservative," "liberal,"
or "neutral"depending on theireffecton bookvalue. Indeed, whilepeople oftenthink of
accounting methods in termsof theireffecton earnings, the chapterhasshown that theaccounting does not affect earnings or PIE ratios if investment is constant. But the accountingdoes,in this case,affect profitability, residual earnings measures, and PIB ratios. Only
if investment is increasing doesthe accounting affectearnings and PIE ratios, and in this
case it createsgrowth in earnings and residual earnings even though no valueis added by
the growing investment.
accountingvalue added is (accounting)

earnings in excessof that required for
bookv-alue to earn at the required return.
Compare with economic value
added. 573
conservative accounting is accounting
that understates assets on the balance
sheetor overstates liabilities. Compare
withliberal accounting. 573
economic value added is valuegenerated
frominvestment in excessof thatto
compensate for the required returnon the
investment. Compare with accounting
valueadded. 573
hidden reserveis income that has not
beenrecognized in the past because
conservative accounting has been
practiced. Equivalently, hidden reserves
are amounts of net assetsthat havenot
been recognized on the balancesheet
because of conservative accounting. An
example isthe LIFO reserve. 582
Analysis Tools
Find thefollowing ontheWeb page forthis chapter:

Metrics that measure the amount of hidden reserves
andthe release ofhidden reserves.
A spreadsheet program for analyzing the effect of
conservative accounting onprofitability andgrowth.
Alook atcases inwhich discounted cash flow methods

give thesame valuation asaccrual accounting methods
with the same forecast horizon.
An examination of the accounting issues involved in
making valuations from short-term forecasts, with an
application to Starbucks Corporation.
Despite the fact that book value and earnings are determined by both economic and
accounting factors, the chapter comeswith the assurance that if accrual accounting techniques are applied, firms can be valued and valueaddedcan be measured. The proviso is
thatsteadystatemustbe forecasted so thata continuing valuecanbe calculated. Thechapter also reconsidered the casewherethe analyst removes the accrualscompletely and uses
discounted cashflow analysis, reiterating thatthiscashaccounting is poorquality forvalue.
Analysis of profitability
and accounting methods
Analysis of growth and
accounting methods
Analysis of effects of
conservative and liberal
accounting
LIFO-FIFO relations
Analysis of the effect of
LIFO on profitability
Analysis of R&D and
profitability
liberal accounting is accounting that

overstates (or givesrelatively higher)
assetson the balance sheetor understates
liabilities. Compare withconservative
accounting. 573
liquidation of hidden reserve is an
increase in income thatarisesfrom
slowing investments in assetsthat have
beenmeasured withconservative
accounting. 581
neutral accounting or normal
accounting is accounting that yields an
accounting rateof return equalto the
required return for investments thatadd
no (economic) value. 573
value conservation principle is the
principle by which valueis insensitive to
the accounting for bookvalues:
Accounting methods affectforecasts of
residual earnings but,because of the
offsetting effecton bookvalue, do not
affectvalue. 573
Page
Key Measures
Page
574
LIFO liquidation profits

LIFO reserve
582
582
AOIG abnormal operating

income growth
ATO assetturnover
CV continuing value
EIP reciprocal of PIE ratio
FIFO first in, first out
LIFO lastin, first out
01 operating income
PIE price-earnings ratio
PM profit margin
PV present value
assets
577
581
587
587
588
596 Part
Four Accollming Anal)'lil and Vall(j11ion

C16.1. Firms with a return on net operating assets (RNOA) that is higher than the requiredreturn on operations areaddingvaluewiththeir investments andso should
tradeat a premium overtheir bookvalue. Is thisstatementcorrect?
CI6.2. Whyare LIFO accounting andthe expensing of R&Dexpenditures referred to as
conservative accounting policies?
CI6.3. Explain how intrinsic price-to-book (PIB) ratios are affected by conservative
accounting (suchas expensing R&D expenditures).
CI6.4. Doesconservative accounting resultin higheror lower accounting ratesofretum?
C16.5. Explain howintrinsic PIE ratiosare affected by conservative accounting (suchas
expensing R&D expenditures).
C16.6. Consultants talkof "economic profit," or"economic valueadded." Whatis it?Can
it be observed?
CI6.7. Howis it thataccounting policies affectthe measurement of residual income but
the value calculated using residual income methods may not be affected by
accounting policies?
CI6.8. A finn thatuses UFO accounting for inventory in timesof risinginventory costs
will always report lower profit margins than if it usedFIFO. Is this correct?
CI6.9. A firm usingLIFO accounting for inventory is likely to have a lower inventory
turnover ratiothanone usingFIFO. Is thiscorrect?
CI6.10. Firms with anticipated earnings-per-share growthare worth more. Is this statementalways correct?
C 16.11. Whatis a "hidden reserve"? Whatdoesit mean to "releasehidden reserves"?
C16.12. Whatis meant by "steady state"?
Concept
Questions
Chapter 16
E16.2.
A Simple Demonstration of the Effect of Accounting Methods

on Value(Easy)
You invest $100(at time0) and expectto receive $115in cash in one year. Your required
return is 9 percent.
a. Calculate the value of yourinvestment at time 0 using discounted cashflow techniques.
b. Calculate the valueof yourinvestment usingresidual earnings techniques.
c. Suppose that youraccountant demanded that youexpense $20 of yourinvestment immediately suchthat the bookvalueof the investment wasS80at time O. Calculate the
value of yourinvestment underthis accounting.
$1.500
700
$2,200
$1.540
11,540
All revenue is received in cash.Investments are depreciated usingthestraight-line method.

a. Value the projectand its valueaddedusingdiscounted cashflow techniques.
b. Value the projectusing residual earnings techniques with the total initial investment
capitalized on the balance sheet.Alsocalculate expected return on net operating assets
(RNOA) for eachperiod.
c. Repeat part b of the question, but with depreciation of $1,300 million in Year 1.
Explain whynumbers differ. Howdoesthe valueof the investment change?
d. Repeat the valuation usingstraight-line depreciation but withthe initialinvestment in
advertising expensed immediately, as required by GAAP.
e. Compare the price-to-book ratio and the forward PIE ratio under the alternative
accounting treatments for investments in advertising.
E16.3.
Valuation of a Going Concern under Different

Accounting Methods {Medium}
An entrepreneur develops a business planthat requires an initialinvestment of $2,200 millionwitha further investment of$2,200millioneachyearon an ongoing basis.Investment
is expected to yieldsalesrevenue equal to 70 percent of the investment in eachof the two
yearsfollowing the investment. Accounting rulesrequirethe investment to be depreciated
straight-line overthose two years. She asks you whether you would like to invest in this
business. You havea hurdlerate for investment of thissort of 9 percent per year.
a. Develop a proformato assistyouin yourvaluation and calculate the valueimplied by
that pro forma. Whatare the price-to-book ratioand the forward PIE ratio?
b. After running the analysis by your accountant, you find that GAAP rules require
20 percent of the projected investment each year to be expensed immediately. Revise
yourpro formaand findour howyourvaluation will change.
c. Repeatthe evaluations in partsa and b for a scenario where investment is expected to
growby 5 percenteachyear.
Applications
Drill Exercises
E16.1.
597
Valuation of a Project under Different Accounting Methods (Easy)

Here are some detailsof an investment in a project with a two-year life and a required
returnof9 percent peryear. Dollar amounts are in millions.
Initial investment in equipment
Initial investment in advertising
Total investment
Expected revenue, Year 1
Expected revenue, Year 2
CI6.13. In the United Kingdom, firms revalue tangible assets upward and recognize the
valueof brands on the balance sheet.Tn the UnitedStates,this accounting is not
permitted. In which country would you expect the average return on common
equityfor firms to be higher?
CI6.14. On January 29, 1999, TheWall Street Journal reported: "Sears,Roebuck & Co.is
moving toward moreconservative accounting methods usedby competing creditcard issuers, which willboostitsloanlosses by about$200million during thenext
5 quarters." Whateffectshould this new policy havehad on future returnon net
operating assets?
CI6.15. Expensing research and development costsraisesaccounting qualityissuessimilar to thoseraised in cashaccounting. Explain.
Exercises
CT~ating Accounting Vahl~ andEconomic Value
E16.4.
Inventory Accounting, PIS, and PIERatios: Ford Motor Company (Medium)

FordMotorCompany uses the last in, first out (LIFO) method for mostof its inventories
in its Automotive Division. The amounts of the LIFO reserve reported in footnotes for
1999 were
LIFO reserve
1999
1998
$1.1 billion
$1.2 billion
Ford reported total shareholders' equity of $27.537 billion at the end of 1999 and
$23.409 billionat the end of 1998, and it reported earnings for 1999of $7.237 billion.
598 Part Four Accounting Analysis and Valuarion
Chapter 16 Creating Accounting Valll~ and Economic VIII!f~ 599
The firm's 1.21 billionoutstanding sharestradedat $53 at the end of 1999. Ford faces a
statutory tax rateof 36 percent.
The founders of the firm are keento lookprofitable whentheyexpectto take the firm
publicin an initialpublicoffering (IPO) in early2014.Afterawarding him stockoptions,
theyask the newly hired chieffinancial officer(CFO) to prepare pro forma statements of
earnings andreturnon investment. The marketing manager supplies the CFOwiththe following salesforecasts (inmillions of dollars), and he andthe production manager estimate
thatoperational expenses beforedepreciation willbe 70 percent of sales.
a. Whatwould havebeenFord'sshareholders' equity at theend of 1999 and1998if it had

usedthe first in, first out(FIFO)method to recordits inventories?
b. What return on common equity would Ford have reported in 1999 if it had used
FIFO?
c. Compare Ford's price-to-book ratiosat the endof 1999 underLIFOand FIFO, andexplainthe difference.
d. Compare the firm's PIE ratiounderLIFO and FIFO, and explain the difference.
E16.5.
Sales
TheAccounting for Research and Developmentand Economic Profit

Measures(Medium)
R&D expenditure
2010E
2011E
2012E
20BE
2014E
100
80
100
80
100
80
100
80
100
100
80
100
80
80
Calculate expected operating income, return on net operating assets (RNOA), and
residual operating income foreachyear, 2009to 2014, underGAAP accounting (where
R&D expenditures are expensed against income). Usea required returnfor operations
of 10percent.
b. Now calculate the R.NOA and residual operating income for each year under an accounting thatcapitalizes R&Dexpenditures and amortizes themoverfiveyears.
c. Compare the RJ."'JOA and residual operating income calculated underthe twoaccounting treatments for eachyear. Whyare theydifferent?
d. Forecast RNOA and residual operating income for 2015 under the two accounting
treatments. Why do theseforecasts differ?
e. Value the finn at the endof2008 usingthe twodifferent accounting treatments. Dothe
valuations differ? Why?
f. If youtriedto valuethis firmby forecasting onlyto 2011,whatdifficulties wouldyou
faceunderthe twomethods?
E16.6.
Depredation Methods, Profitability, and Valuation (Hard)

A start-up finn embarks on an investment program in 2009 to manufacture and marketa
newswitching deviceto be used in communications. The program requires an initial investment of$600 million in plantandequipment, increasing by S100million eachyearfor
fouryearsup to 2013,andthencontinuing at SI,OOO million per yearthereafter.
2012E
20m
2014E
2015E
2016E
1.530
3.540
4.295
4.305
4,410
4,500
a. Prepare the operating sectionof the pro formaincome statements and balance sheets
underbothdepreciation methods. Ignoretax effects.
b. Which set of pro fonnas shows the finn to be moreprofitable in 2013,just priorto the
anticipated publicoffering? Why?
c. TheCFOwishesto showthe management thatthe depreciation methoddoesnotaffect
the intrinsic valueof the firm at the time of the IPO.Prepare the calculations to give
this demonstration, usingthe hurdlerate of 10percentthat the founders haveset for
investments.
d. Despiteyour calculation, the founders insistthat the market will givea highervalue
if higher earnings are reported at the time of the IPO. What wouldbe your reply to
them?
e. The CFOpoints out that his and the founders' stock options vest in 2018, not at the
time of the IPQ in 2014. He therefore suggests that the focus should be on profits
expected to be reported in 2018.Whatarguments mightbe madeto justifyusingone
depreciation method overthe other?
a. Below is a seriesof R&D expenditures that are expected for the years 2009 to 2014
undera firm's R&D program (inmillions of dollars).The R&D program beganin 2008
with a S100 million investment. Expected net operating assets for the firm are also
given for net assets otherthan those created by the R&D expenditures. Expenditures
for R&Dare expected to generate $1.60 of revenue overeach of the subsequent five
years for each dollar spent. Expenses other than R&D expenses are expected to be
80 percent of sales.
2009E
2011E
250
Salesafter2016are expected to be at the levelof those in 2016.

The CFO understands that with the rapid technological change that is expected, estimatedusefullivesof assetsare quiteuncertain and thinkshe canjustifyeithera three-year
estimated lifeor a five-year estimated life for the plantand equipment. So he prepares two
sets of pro formas, one depreciating the investments in plant and equipment straight-line
overthreeyears, andone depreciating themstraight-line overfive years.
Many consultants recognize that expensing R&Dinvestments givesa poor indication of

the performance of a firm or its managers because investing in R&D resultsin lower income. So theyadjust GAAP accounting by capitalizing R&Dexpenditures and amortizing the capitalized amount overthe estimated life of the revenues that flow from the expenditures.
2008A
2010E
E16.7.
The Qualityof FreeCash Flowand Residual Operating Income:

Ceca-Cola Company(Easy)
At one time,the Coca-Cola Company reporteda number called"economic profit" that is
verysimilarto residual operating income. It also reported freecashflow in its annual summary of selected financial data.The respective numbers for 1992~1999 are given below
(in millions of dollars), alongwith what Coke callstotal capital(similarto net operating
assets) andreturnon totalcapital(similarto returnon net operating assets):
1992
Economic
profit
1,300
Free cashflow 873
Total capital 7.095
Return on
capital
29.4%
1993
1994
1,549
1,623
7,684
1,896
2,146
8,744
1995
2,291
2,102
9,456
31.2% 32.7% 34.9%
1996
1997
1998
1999
2,718
2,413
10,669
3,325
3.533
11,186
2,480
1,876
13,552
1,128
2,332
15,740
36.7%
39.4%
30.2%
18.2%
a. Economic profitand freecashflow are similar, in mostyears, andtheirgrowth patterns

are similar. Why?
600 Part Four
Chapter 16 Creating ACCOlmting Value andEconomic Value 601
ACC0l111ling AllQlysis and ValuMioll
b. Basedon this past history, would you be indifferent in valuing Cokeusingdiscounted

cash flow methods or residual operating income methods?

See Exercises E4.5, E4.6, 4.7, El1.7, EI2.7, E14.9, EI5.12, and E19.4, and Minicases
M4.1, M5.2, and M6.2.
E16.8.
Research and DevelopmentExpenditures and Valuation (Medium)

A new pharmaceutical firm has patented a technology and has committed to spending
$350million annually forthe nextfive years to develop further products fromthe technology. The program is currently spending $350 million on R&D, yielding SI,OOO million in
sales and a loss of$150 million after R&D, production and advertising costs, and taxes.
However, revenues from the R&D are expected to growby $500million per yearoverthe
nextfiveyears, reaching $3,500million. Afterthat,revenues are expected to growat5 percent per year,withgrowth in R&D expenditures also of 5 percent peryear to support the
additional sales. Production and advertising costsare expected to be at the same percentageof sales as currently. The firm requires an investment in net operating assetssuchas to
maintain an assetturnover of 1.4.Currently net operating assetsstandat $714million.
a. Value the firmusinga hurdleratefor operations of 10 percent.
b. Comment on thequalityof the earnings forecasts for the nextthreeyearsas a basisfor
valuation.
c. Calculate the forecasted R&D-to-sales ratioforeachof the nextfive years. Whyisthis
ratio an indicator of the qualityof the earnings forecasted?
E16.9. The Quality of Forecasted Residual Operating Income

and FreeCashFlow (Medium)
A start-up begins operations in 2009 by investing $400 million in plant and equipment.
It expects to increase investment by $40 million each year, indefinitely, depreciating it
straight-line overtwo years. The investment program is expected to generate sales for the
nextfiveyears, as follows (inmillions of dollars):
2009A
Sales
Investment
400
2010E
2011E
20m
20m
2014E
240
484
440
480
530
520
576
560
622
600
a. Prepare a schedule of pro forma operating income, return on net operating assets
(RNOA), residual operating income, and net operating assets for the years 2010 to
2014. Depreciation of the investment is the only operating expense. The finn has a
10percent hurdle ratefor its operations. Calculate the value of thisfinn usingresidual
operating income methods.
b. Forecast freecashflow [or2010 to 2014. Doyouthinkthatforecasted freecashflow is
a good quality number on which to basea valuation? Whatfeatures in the pro forma
explain whythe pattern of freecash flows is different fromthatfor residual operating
income?
Minicase
M16.1
Advertising, Low Quality Accounting,

and Valuation: E*Trade
New businesses take timeto get established, and the new Internetfirms of the late 1990s
wereno exception. Internetportalfirms and e-cornmerce firms traded at highmultiples of
sales on the promise of largeprofits, but most of themweregenerating lossesfrom their
sales.
In statements to the press,thesefirms maintained thattheir"businessmodel" required
them to incur substantial lossesin order to generate future profits. Investments were required in infrastructure. Considerable expenditure wasrequired foradvertising andpromotion to establish a customer base and to createbrandrecognition. So thesefirms appealed
to investors to ignorethe bottomlineand focus ratheron theirabilityto generate revenues.
Accordingly, the price-to-sales ratiobecamethetypical multiplier thatinvestors referred to.
Andanalysts referred to otherindicators like"hit rates"and"pageviews"(onWeb sites)to
assess the price-to-sales ratio.
In arguing that the lossesthey were reporting werenot indicative of the value in their
business model, Internetentrepreneurs argued that the GAAP accounting they were requiredto usewasof lowquality. Butclearly investors wereleftwiththequestion of whether
these firms would actually become profitable in the end and whether thesizeof the profits
would justifythe highstockpricesat whichthesefirms traded. Ratherthanthe crudeindicatorslikehit rates,theylooked formore substantial financial analysis.
ONLINE TRADING FIRMS

During1999therewasa dramatic shift by investors to onlinestocktrading on the Internet.
E<Irade, TD Waterhouse, National Discount Brokers, and others battled with Charles
Schwab, the traditional discount broker, and with each other for market share. Morgan
Stanley DeanWitter, a moretraditional broker, offeredonlinetrading through its Discover
brokerage. MerrillLynch, afterinitiallyindicating that it mightshun the onlinebusiness,
entered the fray in late 1999 witha $29.95 per-trade fee.
Figures as of September 1999 for some of the firms selling online trading services
follow. Earnings and sales arerolling 12-month numbers to June 30, 1999 (M:=millions;
B:= billions):
Sales
Ee'Irade
$464M
TO Waterhouse
896M
National Discount Brokers 250M
Ameritrade
274M
Charles SChwab
3.361B
EPS
-0.23
0.25
1.28
0.15
4.11
Price-toMarket PIE Price-toValue Ratio BookRatio SalesRatio

$ 5.75B
5.13B
458.6M
3.28B
27.6B
47
20
119
56
5.s
2.6
2.6
9.2
12.4
14.4
8.2
5.7
1.8
12.0
In the fallof 1999, thesefirms beganan advertising war. In the industry, market shareis
referred to as "share of voice." Customers are sticky, it is said:They tendto staywiththe
602 Part Four A"OHming Ana[ysi, andVa[tlmin!1
t~jj
~%N
~l
~;r.t{~
~~~
17.if,!
:ttx.1=
~'~""l
I
~~'1
samebrokerage, so attracting them-and building a brand name to attract them-is seenas

the driver of ultimate success.
Schwab, with a large discount brokerage business priorto theadvent of online trading,
led with a 25percent share of voice Oil the Internet. Butin early 1999, Ee'Irade increased
its share to 14 percent with what wasjudged a very successful advertising campaign on
prime-time TV shows suchas Ally McBeal and E.R. and on the Super Bowl, the most expensive advertising timeof all. Others imitated, so that by theendof 1999 it wassaidthat
these firms had committed to a total of $1.5 billion in advertising overthe subsequent
18 months. 3 Togivea sense of perspective, this amount is roughly equalto the annual advertising budget of Coca-Cola.
Estimates varied, but industry analysts maintained that in a market saturated with
competitors, it takes $400 to $500in advertising and inducements to sign up each new
customer, with repeat advertising of SI00 per customer to retain themand maintain the
brand.
E*TRADE
E*Trade wasoneof the first online trading firms to challenge Schwab and the traditional
brokers. It spent$322million on salesmarketing for its fiscal yearended September 30,
1999, increasing the number of trading accounts by J million to 1.55 million and producingrevenues of$657 million. Based on its marketing expenses forthefirstquarter of fiscal
2000, itsannual advertising budget was running at $450million.
Exhibit 16.1 presents summary financial statements for E Trade Group, the finn that
runs Et'Trade, forthe September 1999 fiscal year.
A. Why are the earnings reported by start-up firms considered to be a "low quality"
number?
B. Why should investors be wary of price-to-sales ratios? Why should they be skeptical
about hit rates andpageviews on Web sites?
C. Develop ananalysis thattestsEe'Irade's business model with themarketing information
in thecase.
D. ETrade Group traded at $25pershare at theendof September 1999, giving it a priceto-sales ratio of 10.5. Given youranalysis inpart (C), was thefirm appropriately priced
at thetime?
E. What otherstrategies might E*Trade pursue to addvalue?
F. By early 2000,the number of online brokerage firms had exploded to about 140and
competition was fierce. Theindustry needed consolidation, it wassaid, to dealwiththe
glut in capacity. Should Ee'Irade consider acquisitions to consolidate the dominant
position it holds andcompete more effectively withCharles Schwab? Stockmarket valuesforthelarger online firms inthepreceding table were suchastovalue eachcustomer
account at about $3,000 each.
3 As reported inJoseph Kahn's articles "The Media Business: Advertising: The On-line Brokerage Battle, n
The New York Times, October 4,1999, p. (1. Copyright 1999 byThe New York Times Co.Reprinted
with permission. Text not being quoted, but iscitedinpublication.
f~;
i&i:$.
Ift~-s
\~I
i [;;!j
Chapter 16 CuatingAccounting Vallie and Economic V(t!lle 603
EXHIBIT 16.1
SummaryFinancial
Statements for
ETradeGroup,Inc.
for 1999
ETRADE GROUP, INC.

(in thousands, except per-share amounts)
September 30
1999
Assets
Cash and investments required to be segregated
under federal or otherregulations
Brokerage receivables-net
Mortgage-backed securities
Loans receivable-s-net
nvestments
Property and equipment-net
Goodwill and otherintangibles
Other assets
Total assets
Liabilities and Shareowners' Equity
Liabilities
Brokerage payables
Banking deposits
Borrowings bybank subsidiary
Subordinated notes
Accounts payable, accrued and otherliabilities
Total liabilities
Company-obligated mandatorily redeemable
preferred securities
Shareowners' equity
(275 million shares outstanding in 1999)
Total liabilities and shareowners' equity
124,801
104.500
2.912.581
1,426.053
2.154.509
830.329
1998
$
71,317
159.386
7,400
1.365.247
1.012.163
904.854
812.093
54.805
19.672
101.372
$7,908,224
$4,348,923
12.824.212
2.162.682
1.267,474
0
$1.244.513
1.209,470
876.935
29.855
178,854
t7,211
203,971
101,920
6.458.339
3.462.693
30.584
38.385
1,419,301
847.845
$4.348.923
17.908.224
(continued)
604 Part Four Accounting Analysis end ValWltion
EXHIBIT 16,1
Consolidated Statements of Operations
(in thousands, except per-share amounts)
(colltilJued)
Revenues
Transaction revenues
Interest income
Global and institutional
Other
Gross revenues
Interest expense
Provision for loan losses
Netrevenues
Cost of services
OperatingExpenses
Selling and marketing
Technology development
Merger-related expenses
Total cost of services and operating expenses
Operating income (loss)
Nonoperating Income (Expense)
Corporate interest income-net
Gain on sale of investments
Equity in income (losses) of investments
Other
Total nonoperating income
Pretax income (loss)
Income taxexpenses (benefit)
Minority interest in subsidiary
Income (loss} before cumulative effect of accounting
change and extraordinary loss
Cumulative effect of accounting change, netof tax
Extraordinary loss on early extinguishment of
subordinated debt, netof tax
Netincome (loss)
Income (loss) applicable to common stock
1999
1998
$ 355,830
368,053
110,959
40,543
875,385
(215,452)
12,783)
657,150
292,910
$162,097
185,804
95,829
28,163
471,893
(120,334)
321,620
76,878
102,138
7,174
507,810
800,720
$(143,570)
s 19,639
~
350,654
145,018
124,408
33,926
50,067
1,167
209,568
354,586
$ (3,932)
$ 11,036
0
531
~
10,469
6,537
1,873
~
149,638)
(469)
3,302
0
(1,985)
152,092)
222
($52,314)
___
O
3,302
2,352
$ 950
54,093
(8,838)
-iliJ
64,823
(78,747)
(31,306)
Income (loss) pershare before cumulative effect of

accounting change and extraordinary loss
Basic
Diluted
($O~ 19)
Income (loss) pershare

Basic
Diluted
($0~20)
($O~ 19)
($0~20)
0,00
O~OO
s
$
0.00
0.00
Chapter 17 Analysis of the QUIlJiry ojFil1anciai Suuement\ 607
of the Quality
Statements
Chapter 16showed how
accounting policies,
consistently applied, affect
profitability andearnings
growth on a
permanent basis.
How accounting methods and estimates affect the

sostainabhty ofearnings.
What "quality ofearnings" means.
The accounting devices that management can use to
manipulate earnings.
How firms can time transactions to determine their
earnings.
What disclosure quality means.
Situations where accounting manipulation is more
likely.
Why change in netoperating assets isthefocus of a
quality analysis.
How diagnostics aredeveloped todetect manipulation
infinancial statements.
How composite quality scoring works.

Carry out a complete accounting quality analysis on a
Set offinancial statements.
Identify sensitive situations where manipulation ofthe
financial statements is more likely
Apply a set of diagnostics that raises questions about
the quality of the accounting infinancial statements.
Combine accounting quality analysis with thefinancial
statement analysis and red-flag analysis discussed earlier inthebook to assess thesustainabllity ofearnings.
Engage inquality scoring.
Thischapter
Thischaptershowshow
accounting methods can
affectearnings
temporarily, making current
eamings a poorindicator
of future earnings. It also
develops diagnostics to
detectwhcn reported
earnings areof poor
quality.
Link to nextchapter
PartFiveof thebook
analyzes thefundamental
determinants of riskand
theCOSt ofcapital.
Linkto Webpage
Explore further examples
ofaccounting quality
analysis by visiting the
textWebsiteat
www.mhhe.comlpenman4e.
Howdoes
accounting
affectthe
analyst's ability
to forecast
future
earnings
fromcurrent
earnings?
Whatis
involved in a
quality-ofearnings
analysis?
Howare
manipulations
ofearnings
detected?
Some analysts specialize in examining the quality of the accounting in financial reports.
Quality analysts advise clients-some of whom are otheranalysts-on the integrity of the
accounting in representing the underlying performance of the finn. Accounting methods
canbe usedto "package" thefinn,to make it lookbetterthanit is. Quality analysts unwrap
thepackaging, and if the accounting is beingused to obscure, they issue warnings. This
chapterleadsyouthrough a quality analysis.
Analysts' quality warnings andannouncements ofSECinvestigations hitthenews hceclines, causing sudden dropsin shareprices. The equityanalyst triesto avoidbeingcaught
by surprise; the analyst who first gets a sense that there is something wrong with the
accounting is very muchat an advantage.
Withthebursting of the stockmarket bubble in 2001,accounting qualityproblems surfaced formanyfirms. Thepressure to produce earnings wastoomuchforsomefirms, leading them to apply a variety of accounting "tricks"to deliver earnings growth. But such
methods can onlymaintain growth in the shortrun.As the bubble burst,firms likeXerox,
Enron, Tyco, Lucent Technologies, WorldCom, Bristol-Myers Squibb, Qwest, Krispy
Kreme, and Royal Ahold found their accounting calledinto question, in mostcaseswith
disastrous effects on theirstockprices.
WHAT IS ACCOUNTING QUALITY?

Withvaluation in mind, weare interested in future earnings; indeed, "buyfuture earnings"
is the investors' creedthatwehavefollowed, withall duecare,in thisbook.Weusecurrent
earnings, andentirefinancial statements, to helpus forecast future earnings. Thecurrentfinancial statements areof poorquality if theymislead us in forecasting. So,if current earningsare not a good indicator of future earnings, the investor would say that the earnings
quality is poor. Thus, for example, if those earnings contain one-time, unusual items, the
analyst recognizes thatthe earnings quality is poor,so works witha betterquality number,
coreearnings. We did so in Chapter 12. Butif, in addition, thefirm usesaccounting methods thatdegrade coreearnings as an indicator of future earnings, coreearnings canbe poor
quality. So, for example, if a firmunderestimates bad debts,warranties, deferred revenue,
or depreciation, it reportsa higherearnings number that is likely to be lower in the future.
So, to a core-earnings analysis, weaddan analysis of theaccounting quality thatproduces
theearnings.
An accounting quality analysis is imperative because of the reversal property of
accounting:Earnings induced by accounting methods always reverse in the future. So, if
currentbaddebtestimates are too low(andearnings too high), bad debtexpense mustbe
higherin the future (and income lower); if the currentdepreciation charge is too low, then
depreciation mustbe higher in the future or the firm mustimpair assets or reporta losson
the saleof theasset. If,as wesawin Chapter 12,a restructuring charge is toohigh,it must
be bled backto income in the future. Indeed, this feature of accounting defines earnings
quality: Earnings areof goodquality if theydo not reverse.
608 Part Four Accounring Analysis andVallwoon
If the low-quality earnings are detected, forecasts can be adjusted to anticipate the
reversals. If leftundetected, however, low-quality accounting leads to low-quality forecasts
and low-quality valuations. Undetected low-quality accounting exposes the investor to a
"torpedo," a drop in stockprice-not onlywhen accounting malfeasance is exposed by an
analyst or anenforcement agency but,more likely, through earnings surprises when subsequent earnings containing thereversals arereported.
Manipulation is often referred to (politely) as earningsmanagement. Manipulation that
inflates current income is referred to as borrowing income from the future. It always
involves either an increase in sales or a decrease in expenses, with thereverse inthe future.
Manipulation can also be done in the other direction. Manipulation that reduces current
operating income is canedsaving or banking income for the future. It always involves
either a decrease insalesor anincrease inexpenses, again withthereverse inthefuture. The
motivation for borrowing from the future is fairly clear: Management wants to make profitability look better than it really is.Saving income forthefuture might arise when managers'
bonuses aretiedto future earnings. An extreme version is called "taking a bigbath": A new
management writes offa lotofexpenses, attributes thelower income (orloss) to theoldmanagement it hasreplaced, andgenerates more future income onwhich it will berewarded.
This intertemporal shifting of income, the hallmark of manipulation, means that earningsquality isnotonlydoubtful intheyearofthemanipulation butalsoinsubsequent years
when theborrowing or saving of income "comes hometo roost." Some claim thatthelarge
amount of restructuring in the early 1990s produced excessive restructuring charges and
liabilities, which created higher profits inthelate1990s. Themarket wasveryexcited about
earnings in the late 1990s, resulting in high multiples. But these earnings were partly
created bytheearlierrestructuring charges.
Do not confuse the accounting issues in this chapter with those in the last.The last
chapter dealtwithaccounting methods thatareapplied ona consistent, permanent basisalways expensing research and development (R&D) and advertising expenses, always
maintaining accelerated depreciation methods, or always using LIFO forinventory, for instance. Thoseconservative accounting methods, consistently applied, consistently produce
higher accounting ratesof return andearnings growth, andliberal accounting doestheopposite. This chapter deals withthe effects of accounting that are temporary, thus making
currentearnings a poor indicator of future earnings. If a firm always overestimates bad
debts (so always to be "conservative"), it will consistently reporta higher return on net
operating assets. But if it temporarily increases or lowers its bad debtestimate to change
current earnings, it will produce a return on net operating assets that is a poor indicator
of future profitability. Accordingly, the term aggressive accounting(not liberal accounting)is bestusedto indicate manipulation thattemporarily increases income. Andthe term
big-bath accounting might be used to indicate manipulation that temporarily reduces
income (notconservative accounting), although thetermis typically usedwhen income is
reduced by large amounts.
Accounting Quality Watch

It should be clearthat much of the apparatus thatwe have laidout in this bookinvolves a
quality-of-earnings analysis. The identification of hidden expenses (in Chapter 8) yielded
higher quality earnings. The separation of operating from financing items (in Chapter 9)
identifies a component of netincome-operatingincome-that is pertinent forforecasting
what's important for value. The financial statement analysis in Chapter 12drove barder to
purgeoperating income of unusual, transitory items, to cut to sustainable core operating
income and core profit margins thatare "higher quality" numbers to forecast the future.
Andtheanalysis in Chapter 15hoisted some red flags.
Chapter 17 Analysis of Me Quality ofFinancia.! S!atwenr5 609
In carryingout this analysis, we havemaintained an Accounting Quality Watch that

identified quality issues as they arose and which accumulated as you worked through
the book. Lookbackat Box 8.7 in Chapter 8, Box 9.9 in Chapter9, Box lOAin Chapter 10,and Box 12.13 in Chapter 12,so you are wen attunedto the issue of accounting
quality.
Onefurther element is needed to complete anearnings-quality analysis. Coreoperating
income anditscomponents maybe affected byaccounting methods. Sowehave to analyze
the quality of the accounting for core operating income. We have to cut through the accounting to getto the core. Thisis the issue of accounting quality.
Five QuestionsAbout Accounting Quality

In analyzing the quality of the accounting, the analyst seeksanswers to five questions:
1. GAAPquality: Are generally accepted accounting principles deficient? If forecasts are
basedon GAAP statements but GAAP doesnotcapture allthevalue-relevant aspects of
thefum,valuations willbe deficient. We sawinChapter 8 thatGAAP fails to capture the
expense of stock compensation comprehensively. In Chapter 12 we saw that GAAP
earnings can include stockmarket bubble gains.
2. Audit quality: Is the firm violating GAAP or committing outright fraud? GAAP accounting might beappropriate, buta firm might notbeapplying GAAP according tothe
rules. Is it booking receivables without having firm commitments from customers? Is it
failing to recognize expenses orrecognize liabilities as required? Is it using methods not
approved by GAAP? To answer these questions the observer usually hasto be closeto
the business, so auditquality is theprovince of the auditor andthe audit committee of
the board of directors. Agencies such as the Securities and Exchange Commission
(SEC) and the Public Company Accounting Oversight Board (PCAOB) in the United
States playan enforcement role.Theanalyst typically relies onthe audit. Butshe needs
to be sensitive to thepossibility of auditfailure or to situations where anauditor witha
conflict of interest might be generous to management in drawing a linethrough a gray
area.
3. GAAPapplicationquality: Is thefumusingGAAP accounting tomanipulate reports?
Generally accepted accounting principles restrict theaccounting methods thata fumcan
usebutpermitsomechoice among methods. Thatchoice canbetaken asa license tomanipulate thenumbers toachieve a desired effect, andwithapproval ofauditors. Theissue
is particularly sensitive when estimates are involved--estimates of bad debts, useful
lives of assets, warranty expenses, pension costs, andrestructuring charges, forexample.
Managers manage firms but theycanalsomanage earnings.
4. Transaction quality: Is the firm manipulating its business to acconunodate the accounting? A firm mayemploy GAAP faithfully butthenarrange transactions around the
accounting to achieve desired results. Thisis manipulation of the business, not the accounting, but it exploits features of theaccounting. It takestwoforms:
a. Transaction timing controls the timing of transactions to affect income. Bothrevenue timing andexpendituretimingcanbe involved. Revenue timing-sometimes
known as channel stuffing-times transactions around revenue recognition rules.
Typically GAAP requires revenue to berecognized whengoods andservices aredelivered to customers. Firmsmight shipa lotof goods priorto theendof theperiod to
increase profits for the period or delay shipping when they wish to defer profits.
Expenditure timing times expenditures thatgo straight to the bottom linein orderto
manipulate income. Deferring R&D and advertising outlays to the next period
Chapter 17 Anal1sis of!he Quality ofFinancial Statements 611
610 Part Four Accounting Ana!Jlis and Valt!a!iml
increases income, for example, whereas advancing them to the current period
decreases income.
b. Transaction structuring creates fonn oversubstance: Business arrangements are
structured to takea form thatreceives thedesired accounting treatment, but investigalion of the substance of thetransaction reveals a sham.
5. Disclosure quality: Aredisclosures adequate to analyze the business? Disclosures are
made within the financial statements, in the footnotes, and in the management discussion and analysis. Management also gives additional commentary in meetings with
analysts. Much of the financial analysis that we have been through relies on good
disclosures, to understand the business and how it is represented in the financial statements. Forvaluation, fourtypes of disclosures areparticularly important
a. Disclosures that distinguish operating items from financial items in the
statements.
b. Disclosures thatdistinguish coreoperating profitability from unusual items.
c. Disclosures thatreveal thedrivers of coreprofitability.
d. Disclosures thatexplain the accounting usedso theanalyst caninvestigate the quality of the application ofGAAP.
Without adequate disclosures it is difficult to forecast from a good measure of current
coreoperating income, so low-quality disclosures leadto low-quality valuations.
All five quality questions must be answered to discover the quality of the accounting.
GAAP quality (question 1) has arisen at several points in this book, particularly in Chapters 2, 8, and 12.Audit quality (question 2) is a matter of auditing principles andis leftto
auditing books. In thischapter, wedeal withthe problem of earnings manipulated by the
application of GAAP accounting (question 3) or by transaction timing and structuring
(question 4). But disclosure quality (question 5) arises at many points because we can't
carryoutanyanalysis withconfidence if disclosures arepoor.
FIGURE 17.1
How Accounting
Manipulation Leaves
a Trail intheBalance
Sheet: Four Scenarios
Scenario A:Thecaseof nogrowth withnoincome shifting

Year-2
Yearr-I
Year 0
Year +1
100
100
100
100
12%
12%
12%
Freecashflow
Netoperating assets
RNOA
Scenario B:The caseof no growth withincome shifting
Year -2
Year-1
YwO
Year +1
100
100
no
100
Freecashflow
CUTTING THROUGH THE ACCOUNTING:

DETEGING INCOME SHIFTING
Manipulation of earnings withaccounting methods or estimates always leaves a trail: By
the debits and credits of accounting, one cannot affect the income statement without
affecting the balance sheet. Higher revenues mean higher receivables (an asset) or lower
deferred revenues (a liability), for example, and lower expenses mean higher prepaid
expenses (an asset) or lower accrued expenses (a liability). So, investigation of balance
sheet changes provides the clues. For valuation, the focus is on operating income and,
correspondingly, netoperating assets, so changes innetoperating assets arethe focus.
Figure 17.1 depicts the effects of earnings manipulation of the accounting numbers. It
gives freecashflows, netoperating assets (NOA), operating income, andreturn of netoperating assets (RNOA) forscenarios withandwithout growth innetoperating assets. Then,
within eachscenario, the figure depicts theaccounting numbers withandwithout earnings
manipulation. In the no-growth case, without income shifting, Scenario A, freecashflow
andoperating income are 12eachyearonNOA of 100and, withnogrowth in NOA, RNOA
is a constant 12percent. In Scenario B, themanager decides to increase operating income
in the current year, Year 0, by 10,up to 22. But he cannot do this without affecting the
balance sheet: He must alsoincrease net operating assets by the extra 10,up to 110. His
manipulation results in an RNOA of22 percent forYear 0 Which, ifshe were not careful,
Operating income
2
RNOA
12%
22%
1.82%
(continued)
Chapter 17 Analysis of me Qualil)' of Financial SUl{ements 613
612 Part Four Accounting Allll1ym- and Valuation
FIGURE 17.1
ScenarioC:The caseof growth withnoincome shifting
(Concluded)
Year-2
7.35
100
Growth ratein NOA

R.NOA
lOS
Year+ 1
Year0
_~IIL.. . ---ll
Freecashflow
Netoperating assets
Year-1
L.. . I
7.72
---l
115.76
110.25
5%
5%
5%
12%
12%
12%
ScenarioD:Thecaseof growth withincome shifting

Year-2
Freecashflow
100
Year -1
Year 0
,---~I
I_I
lOS
120.25
7.35
Year+1
772
115.76
an analyst might takeas indicative of future RNOA. However, theoperating income must
fallto 2 in Year 1andthe RNOA to 1.82 percent.
You have just observed income shifting andthe reversal it always involves: Booking 10
more in income in Year 0 means 10less in income inYear 1.Accounting cannot change
totalincome over a number of years for a finn; it just moves it between periods. But you
have alsoseenthattheincome shifting haslefta trailinthefonnof higher netoperating assetsinYear O.
The analyst has a problem, however, for NOA can increase with normal business
growth. The growth case in Figure 17.1 without income shifting, Scenario C, show NOA
growing at 5 percent per year, alongwithfree cashflow andoperating income. However,
RNOA is still 12 percent. Introduce income shifting in Scenario D-with an extra 10
recognized in operating income inYear Oc-end the RNOA increases to 21.52 percent. The
reversal is still evident, however, with operating income falling to 3.23 and RNOA to
2.69percent in Year 1. Theonly difference is thatgrowth has muted the reversal; indeed,
income shifting managers often engage in the practice in the hope that subsequent growth
will bail them outso thatthereversal will notlookas damaging.
Figure 17.1 teaches us two things. First, change in netoperating assets-the trailleftby
income shifting-is thefocus of quality analysis. Second, normal business growth complicates theanalysis, soanydiagnostic forabnormal changes inNOA mustaccommodate normalbusiness growth.
separating What We Know from Speculation

Beginning in Chapter I, we have abided by the fundamentalist's maxim to distinguish
what we know from speculation. We designated the financial statements as concrete
information-what we know-that is relatively free from speculation. Yet financial statements contain estimates andestimates involve some speculation. The reliability principle
of accounting says thatestimates mustbe based on finn evidence, but estimates theyare.
There is a tension in accounting: Toremedy the defects of cash accounting, accrual accounting addsestimates, but these estimates inevitably add some speculation. Unbiased
management and unbiased auditors constrain the speculation, but unfortunately, these
agents arenotalways to be relied on.
In dealing withthe resulting quality problem, wemaintain therule to distinguish what
weknow from thatwhich is more speculative. As a starting point, what do weknow? Well,
Figure 17.1 simply demonstrates the effect of an accounting relation withwhich we have
beenfamiliar sinceChapter 7:
Operating income = Free cash flow + Change in netoperating assets
OI=C-I+WOA
Operating income
LiJ
[~[]
Growth ratein NOA
5%
14.52%
RNOA
12%
21.52%
(17.1)
Make the calculations and youwill see that thisrelation is honored in Figure 17.1. Free
cashflow is hard; that is, it cannot be affected by the accounting, as you alsosee in the
figure. Thesoftpartofoperating income thathastobe challenged is liNOA. Abigincrease
inNOA creates operating income anda higher current RNOAo, butresults in a highNOAo
that becomes the basefor nextyears RNOA: RNOA I = OI/NOAo. Accordingly RNOA 1
declines ifNOAohasbeeninflated.
3.23
-3.73%
2.69%
Yet another accounting relation helpsus further:

Change innetoperating assets = Cash investment + Operating accruals
LINDA = I + Operating accruals
(17.2)
614
Part Four
AcwunlingAnalysis and Va/uano>l
Accordingly, in challenging the tlNOA, the analyst follows twoavenues of investigation:

1. Areinvestments appropriately booked to thebalance sheet? Booking investments to the
balance sheetis sometimes referred to as capitalization. Appropriate accounting capitalizes costs thatare incurred to generate revenue in future periods butexpenses costs
that pertain to revenue in the current period. In this way revenues and expenses are
appropriately matched. GAAP demands some mismatching-by expensing R&D and
investments in advertising, for example-as wesawin Chapter 2. However, firms have
discretion with otheritems. Investments in property, plant, and equipment are put on
the balance sheet(appropriately), but if a firm capitalizes periodic repairs andmaintenance in PPE,it increases current earnings andreduces future earnings through higher
depreciation charges. Thissame result occurs byrecognizing toomuch prepaid expense,
allocating too much costto inventories, capitalizing promotion costs, and capitalizing
thecostsof acquiring customers.
2. Are the accruals appropriate? Thelistof accruals is long: allowances forbad debts, allowances forsalesreturns, deferred revenues, warranty accruals, accrued expenses, and
pensions liabilities, to name a few (which wewillcomebackto).Theaccruals are particularly soft numbers; they embed the estimates that are necessary to apply accrual
accounting, butestimates canbe biased.
With a focus ontlNOA, Table l7.llists typical balance sheetitems thatlendthemselves
tomanipulation. It alsogives theincome statement effect ofthe manipulation. Thetable is,
ofcourse, a roadmapforthemanager who wants toengage inearnings management {reluctantly offered). However, it is also a road mapfor the analyst who wishes to investigate
earnings management. The last column points the analyst to situations where earnings
management ismore likely tooccur. Theearnings management inthetable isinthedirection
of increasing earnings; earnings management to decrease earnings is applied in the other
direction. So,forexample, lower costof goods soldis reported if a firm fails to writedown
obsolete inventory, but higher cost of goods sold results from excessive inventory writedowns (leading tolower future costofgoods sold).
.
c;
"C
o
c
o
t:
Prelude to a Quality Analysis

Before beginning a quality investigation, theanalyst should understand fourthings well:
I. Thebusiness.
2. Theaccounting policy.
3. The business areas where accounting quality is most doubtful.
4. Situations inwhich management is particularly tempted to manipulate.
Onthefirstpoint, knowing the business is necessary to geta feel forwhattheappropriateaccounting is for thetypeof business. What arenormal baddebtratesforthe business
and doesthe firm's allowance for baddebtsseem out of line?What is the standard useful
lifeof depreciable assets inthislineof business?
Onthe second point, the accounting policy forthe finn establishes a benchmark fordetecting deviations from the policy. A firm's accounting policy is determined from its
accounting footnote (usually the first footnote). Thepolicy maybeconservative, liberal, or
neutral. Itdetermines thelevel of current andfuture RNOA. Thispermanent effect doesnot
frustrate thevaluation, as wesawinthelastchapter. Butdeviations from thepolicy maybe
manipulations. Beware offirms whose accounting policy is different from thestandard for
theindustry. Watch forfirms whose accounting estimates havebeenincorrect inthepast.If
a firm regularly recognizes large gains from assetsales, its depreciation charges might be
'"c
s
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'E
..
TI
.~
=">
615
Industry
Flash Point
Banking
Computer hardware
Computer software
Credit losses: Quality of loan loss provisions

Revenue recognition: Quality ofdeferred revenue and warranty liabilities
Marketability ofproducts: Quality ofcapitalized research and development
Revenue recognition ofservicing contracts: Quality ofreceivables and deferred revenue
Credit losses: Quality ofnet accounts receivable
Rebate programs: Quantity ofsupplier rebates recognized
Warranties: Quality ofwarranty liabilities
Product liability: Quality ofestimated liabilities
Overcapacity: Quality ofdepreciation allowances
Technological change: Quality ofdepreciation allowances and carrying value for inventories
Lease values: Quality ofcarrying values forleases, particularly estimated residual values
Liabilities for health effects ofsmoking: Quality ofestimated liabilities
R&D: Quality ofR&D expenditures
Product liability: Quality ofestimated liabilities
Property values: Quality ofcarrying values forreal property
Revenue recognition: Quality ofestimates under percentage ofcompletion method and
Retailing
Manufacturing
Automobiles
Telecommunications
Equipment leasing
Tobacco
Pharmaceuticals
Real estate
Aircraft and ship manularturinq
"proqram accountoo"
Subscriber services
Development ofcustomer base: Quality ofcapitalized promotion costs

SUbscriptions paid inadvance: Quality ofdeferred revenue
too high. If it regularly reportslosses from assetsales,or restructuring charges, its deprcciation mightbe too low.
On the third point.some businesses have particularflash pointswhere manipulation is
more likely. In equipment leasing, it is the estimate of leases' residual values and allowances for defaults. For computer manufacturers, it is sales returns. They could book
saleson shipment to retailers butallowreturns. They couldguarantee distributors' inventories off balance sheet. Product obsolescence is a factor in this industry, so the qualityof
sales is also in doubt. Box 17.1 givesthe typical flash points for a numberof industries.
On the fourth point a number of conditions coincide to make manipulation more
attractive to managers. Box 17.2 liststhem.The qualityanalyst needsto be aware of these
flash pointsin order to directher effortsto cases wheremanipulation is morelikely.
Quality Diagnostics
Following the trailto changes innet operating assetsis notas straightforward as onewould
like. With adequate disclosure and diligence on the part of the analyst, the trail can be
uncovered. Unfortunately, disclosures are often inadequate. In response, the analyst develops quality diagnostics to helpwiththe detection.
Qualitydiagnostics are onlyred flags; theyraise questions aboutaccounting qualitybut
do not resolve the question. Eachdiagnostic can arisefor legitimate reasons, andit is up to
the quality analystto dig further to discover whetherreal operations or the application of
accounting methods is the cause. It isat thispoint that disclosure qualityis important, particularly disclosures abouttheaccounting. If disclosures are inadequate, the qualityanalyst
can only flagthe possible problem but cannotsort it out. As it happens, red flags are explainedby legitimate operational factors in manycases.
Figure 17.2summarizes a qualityanalysis that employs these diagnostics. Many of the
diagnostics are accounting ratios. Likeall financial statement ratios,they shouldbe evaluated relative to the past(in time series)and relative to thoseforcomparison firms(in cross
616
Institutional conditions:
The firm isintheprocess ofraising capital orrenegotiating
borrowing. Watch public offerings.
Debt covenants arelikely to beviolated.
Management changes.
Auditor changes.
Management rewards (like bonuses) aretied to earnings.
Inside trading isstrongly inonedirection.
Management isrepricing executive stock options.
Governance structure isweak: Inside management dominates the board; there isa weak audit committee or none
et all.
Regulatory requirements (like capital ratios for banks and
insurance companies) arelikely to beviolated.
Transactions areconducted withrelated parties rather than
at arm's length.
Special events such asunion negotiations andproxy fights.
The firm is"inplay" asa takeover target.
Earnings meet analysts' expectations, butjustbarely.
The firm engages in exotic arrangements like off-balancesheet special-purpose entities and stylized derivative
contracts.
Differences in expenses for tax reporting and financial

reporting.
Financial reports are used for other purposes, like tax
reporting andunion negotiations.
Accounting adjustments inthelastquarter oftheyear.
CAVEAT EMPTOR: BEWARE WHEN BUYING

SHARES FROM THE FIRM
Beware when buying shares, but beparticularly careful when
buying shares from thefirm itself. It iswell known thatreturns
to buying stock inaninitial public offering (IPQ) arenotparticularly good; indeed, after an initial period when an IPQ might
be "hot," risk-adjusted stock returns subsequent to anIPQ are
negative onaverage. lookatthediagnostics inthetable below.
They are medians from 1,682 IPQs between 1980 and 1990.
The net income-to-sales ratio washigh forthese firms inthe
year they wentpublic but declined thereafter. Was management manipulating theaccounting to give a better profitability
picture forthe IPO? Well, look at theabnormal accounting accruals inthe table. These areaccruals in excess of those you
would expect from theincrease insales andcapital investments
fortheyear (expressed relative tobook value inthetable). They
were high inthe IPQ year, increasing income, butconsiderably
lower later. Indeed they were negative later; they reversed. And
allowances for bad debts were low inthe IPQ year, increasing
later. As always, the analyst asks whether these patterns are
Accounting andfinancial statement conditions:
dueto legitimate business orto manipulation.
Achange inaccounting principles or estimates.
Does the apparent manipulation explain the poor returns
An earnings surprise.
from buying !pas? The market might indeed have been deAdrop in profitability after a period of good profitability. ceived bythe good earnings reported with theIPQ, thusvaluing the firms too high. And then, when prices dropped as
Constant sales orfalling sales.
lower earnings were reported, the market realized that the
Earnings growing faster thansales.
earlier earnings were "low quality." Indeed, there isevidence
Very low earnings (that might be a loss without
that the amount of implied manipulation predicts post-IPO
manipulation).
returns.' Ifso,aquality analyst whodiagnosed theaccounting
Small or zero increases in profit margins (that might be a would have been able to earn superior returns.
decrease without manipulation).
'See S.Ieoh, I. welch, and T. Wong, "Earnings Management and the
A firm meets analysts' earnings expectations, but just Lonq-Run Market Performance ofInitial Public Offerings," Joumalof
barely.
Finance, December 199B, pp.1935-1974.
Accounting Numbers around Initial Public Offerings

Yearafter lPO
Yearof
Diagnostic, %
Net income/sales
Abnormal eccnalvbook value
Allowance for uncollectibles/gross
accounts receivable
IPO
4.6
S5
2.91
2.8
1.6
3.32
2.1
1.6
-0.4
-0.8
3.46
3.62
1.3
-2.0
13
3.B1
-1.4
3.77
1.8
-2.7
3.85
Source: s. 'tech,T.WOfl9. andG.aao, "AreAccruals During Inhial Public Offerings Opportunistic'" ReviewofAccOlJnting Swdies. 1998,pp. 175--208.
617
618 Part Four Accol.lnling Analysis andVaJualion
FIGURE 17.2
Diagnostics to Detect
Manipulation in
OperatingIncome
To derectmanipulated sales
Netsales/Cash fromsales
Netsales/Net accounts receivable
First investigate the

quality of sales
revenues. Then
investigate the quality
ofcore expenses.
Finally investigate
unusual items.
NetsaleslUneamed revenue
Netsales/warranty liabilities
Compare percentage changeinsales10 percentage change
in netreceivables, unearned revenue, andwarranty
liabilities
Baddebtandwarranty expense ratios
The focusst anaccountinq quality analysis isondistinguishing

"hardt numbers, which result from cash f10\NS, and "soft"
numbers inthe accruals, which aresubject to estimates. The
cash flow statement separates "hard" cash flows (from Operations andinvestment) from the accruals.
Accruals arereported between net income andcash from
operations in an indirect-method statement of cash flows.
These accruals areused inquality diagnostics asfollows:
Todetectmanipulated coreexpenses
Apply a normalized assetturnover
Normalized operating income/Operating income
Compare changes innetaccounts receivable with changes

insales for sales quality diagnostics.
Compare changes inunearned revenue andwarranty liabilities with changes in sales forsalesquality diagnostics.
Use the depreciation and amortization number for the
adjusted ebitda anddepreciation diagnostics.
Compare. changes in prepaid expenses with changes in
sales.
Compare changes in accrued expenses with changes in
sales.
Use the deferred taxnumber for deferred taxdiagnostics.
Track restructuring charges andtheir reversals.
Investigate changes inATO

Watch fordeclines in ATO
Investigate changes in individual ATOs
Challenge depreciation andamortization
Adjusted ebitda
Depreciation/Capital expenditures
Challenge allaccruals
Cashfromoperations/Operating income
'CashfromoperatioruiNOA
Accruals/Change in sales
Challenge expenses that aresensitive toestimates
Pension expenselSG&A
Otheremployment expenselSG&A
Challenge tax expense
Effective tax rateon operating income
Deferred tax components
Valuation allowances
Challenge thebalance sheet
Carrying values abovemarket value
Carrying values sensitive toestimates
Estimated liabilities
Off-balance-sheer liabilities
Challenge othercoreincome
Challenge restructuring charges

Challenge merger charges
section). Lookfordifferences fromthepastanddifferences from otherfirms, andcompare

changes fromthepastwithchanges from thepastforcomparison firms.
Equation 17.2 instructs thatexamining LlliOAinvolves examining cashinvestments and
examining the accruals. So, before beginning, spreadthe cashflow statement before you.
Cashinvestments arereported in theinvestment section andtheaccruals arereported asthe
difference between net income andcashfromoperations in the cashflow from operations
section SeeBox 17.3.
Diagnostics to Detect Manipulated Sales

Sales areof goodquality if they are unbiased estimates of the cashthatthe saleswillgenerate. A salemightbe booked butthereis a chance thatgoods maybe returned, a warranty
claim may be made,or a receivable may not be paid. Focus, then, is on net sales after
allowances forsalesreturns, warranties, andcreditlosses:
Netsales = Cashfrom sales+ met accounts receivable - Mllowanceforsalesreturns
anddiscounts - 11Unearned revenue - 11Warranty liabilities
Cash from salescannot be manipulated by the accounting, so anyquality question arises
from accruals that affect changes in net receivables (thatare net of estimated baddebts),
allowances for sales returns and discounts, unearned revenue, and warranty liabilities.
Manipulation diagnostics lookforchanges in salesrelative to cashgenerated by sales and
changes in salesrelative to changes in thenet operating assets that relate to sales:
Diagnostic: Netsales/Cash fromsales
Diagnostic: Netsales/Net accounts receivable
Diagnostic: Netsales!Allowance forsalesreturns anddiscounts
Diagnostic: NetsaleslUnearned revenue
Diagnostic: NetsaleslWarranty liabilities
Schedule II in the lO-K reports allowances for salesreturns, discounts, andbad debts.
Thedeferred tax footnote alsogives details of allowances not permitted for taxpurposes.
Warranty liabilities areofteninthedetail foraccrued expenses. Butlackof disclosure may
frustrate someofthesecalculations. If netsalescannot becalculated asabove, usenetsales
as reported underGAAP, thatis, saleslessestimated salesreturns anddiscounts.
If firms are aggressively recognizing revenue or underestimating returns and credit
losses (andthushave nolegitimate receivables thatarebeing paidoffin cash), the first ratio
will increase and the second will decrease. If net salesare increasing because of reduced
estimates of unearned (deferred) revenue or warranty liabilities, the lasttworatios willincrease. Changes in theseratiosshould be investigated overtime. Comparisons of percentagechanges in net salestopercentage changes in net receivables, warranty expenses, and
619
620 Part Four Accounting AnalysIs and Valnlltion
unearned revenue are also revealing. Watch increases in sales that are accompanied by
decreases in warranty liabilities or unearned revenue.
Ofcourse these ratios canchange forlegitimate reasons, likeunusual credit sales growth
andcustomers taking longer to payreceivables. Receivables willdecline if theyaresecuritizedor sold. Theratios canalsobe redflags about the business, to signal lower Customer
interest inproducts orprice discounting to attract customers. These areissues pertaining to
theoverall quality of earnings butnotaccounting quality.
Challenge baddebt expense withthree diagnostics:
Diagnostic: Baddebtexpense!Actual credit losses
Diagnostic: Baddebtreserves/Accounts receivable (gross)
Diagnostic: Baddebtexpense/Sales
Similarly investigate warranty liability estimates. Firms arerequired to reconcile warranty
liability estimates to actual experience with warranty claims.
Chapter 17 Analysis of the Quolity of Financia.l Seremenu 621
Diagnostics to DetectManipulation of Core Expenses

Manipulations are also perpetrated through the recording of expenses. Here is a way to
investigate.'
1. Investigate Changes in Net Operating Assetswith NormalizedAsset Turnover

As we have shown, manipulation of operating income leaves a trail: Net operating assets
mustalso change as operating income changes. We have alsoseen, however, thatoneexpects
changes inNOA because ofnormal business growth. Thefirst metric controls forthatgrowth.
We saw in Chapter 12thatnetoperating assets aredriven bysales andtheasset turnover:
NOA = Sales/ATO. Theamount ofNOA that is required fora given level of salesis determined by thenormal or usual ATO, andthe.6NOA thatshould be recorded forthe current
change in sales is determined bythenormal or usual ATO. If the llNOA is higher than that
expected from thechange in sales, suspect manipulation of theexpenses.
If youaresatisfied withthe integrity of sales(from thediagnostics above), calculate
Diagnostic: Warranty expense/Actual warranty claims

Diagnostic: Warranty expense/Sales
Alsomonitor estimated liabilities for rebate programs such as frequent-flier programs and
incentives on retail credit cards.
Normalized OI = Free cashflow + llNormalized NOA

= Freecashflow + llSalesJNonnal ATO
This, obviously, is a normalized version of equation 17.1. The normalized ATC is

calculated from average assetturnovers overpast years or from comparison firms with
similar operations and accounting policies. The following diagnostic flags the possible
manipulation:
Diagnostic: (Normalized OI)/OI
In 2000, Gateway, the personal computer manufacturer decided to finance computer sales to
high-risk customers that outside financing companies were shunning. Its consumer finance
receivables, netofallowances forbaddebts, increased from 3.3 percent ofsales to 7.3percent
of sales over the year. In the first quarter of 2001, the firm wrote off $100 million of these
receivables.
Atthe end of 1999, Bank of America's allowance forcredit losses on itsbank loans stoodat
1.84percent of outstanding loans of $370.7 billion, and inthe prior three years this ratio had
not fallen below 1.9B percent. However, at the endof 2000, the ratio was down to 1.75 percent, even though actual charge-ofts for bad loans increased to 0.61 percent of loans from
0.55percent.
If thisratio differs from 1.0, a flag is hoisted.

Gateway, the computer manufacturer, hadalways operated on a high asset turnover. In 1999,
its ATQ was 13.2 on sales of $8,965 million, and even higher inearlier years. In 2000, sales increased by$636million to $9,601 million, resulting inoperating income, after tax, of $231 million. Net operating assets, however, grew by$1,086, more thansales, resulting ina negative
free cash flow of $855 million. The firm wasinvesting rapidly innewstores andinventory, providing consumer credit, and increasing accruals, yet sales growth was modest. Normalized
operating income was-$855 + (636/13.2) = -$807 million, considerably less thanreported operating income. In 2001, Gateway wrote off$876million of netoperating assets andreported
an after-tax operating loss of $983 million.
2.Investigate Changes in AssetTurnover

Xerox Corporation sells copiers to customers under sales-type leases. Itbooks the present value
of lease payments plus an estimated residual value of the equipment at the end of the lease.
This present value isrecognized asrevenue andasa lease receivable. In 1999, gross receivables
declined from $16,139 million to $14,666 million ascustomers moved away to digital technology that Xerox was slow to embrace. However, estimated residual values on the leases
increased from 4.33percent of gross lease value to 5.13 percent (even though the equipment
wasmore likely to become obsolete). The stock price subsequently declined dramatically and
the firm came under SEC investigation.
In March 2000, the shares of MicroStrategy, a software firm, fell from $227 to $87 (aloss of
market value of $6 billion) on revelations that it hadpracticed aggressive revenue recognition
on itssoftware contracts. The firm had booked revenue from multiyear contracts in the first
year of the contract.
Manipulation of operating expenses always changes bothprofit margin (PM)andATO, but

inopposite directions: Lower expenses mean higher income to sales but,asnetoperating assetsincrease, lower expenses alsomean lower sales to netoperating assets. So a change in
ATO may indicate manipulation. Andiffumsareusingmanipulation to increase ormaintain
profit margins, the corresponding decrease in ATO will signal a subsequent decrease in
future profit margins astheaccounting reverses.
Table 17.2 pertains to firms grouped on theircore R..~OA before taxes (Year 0) for the
years 1978 to 1996. Group 1hasthehighest RNOA, group 10the lowest. Theaverage core
RNOA foreachgroup is given under the groupnumber inthecolumn headings. Thetable
then gives median changes in RNOA and profit margins for eachgroup in the nextyear
(Year I). These aregiven for firms withthe topthirdof changes in assetturnover inYear 0
1 This
material incorporates teaching notes of Jim Ohlson at New York UniverSity.
622 Part Four Accounting Analysis and ValMtion
Chapter 17 Analysis ofthe Quali!y ofFinancial Statements 623
TABLE 17.2 Changes in Return on NetOperating Assets (RNOA) and Profit Margins (PM) forDifferent Changes
inAsset Turnover (ATO)
Group,Year 0:
1 (High)
10 (low)
Core RNOA (%)
57.4
35.5
28.3
23.8
20.2
17.3
14.2
11.3
8.2
3.9
-0.61
-2.54
0.12 0.35
-1.41 -D.13
0.74
-0.63
0.69
-0.45
0.97
0.12
1.49
0.59
-D.32 -0.Q4 -D.13

-1.68 -0.94 -1.07
-D.15 -D.08
-0.54 -0.51
-0.31
-0.32
0.06
-0.14
0.32
0.04
0.88
0.29
Change in RNOA NextYear, Year1 (%)

High MTO
lowMTO
-D.72
-12.57
-0.77
-4.90
-0.18
-2.92
Change in PM NextYear, Year1 (%)

HighMTO
LowMTO
-1.14
-2.74
Sou:o: P.J",,;rlidd andT. Yohn. "UsiogAssotTurnoverand Profi~ Margin ~o for"em Choogos in ProfuabiTity."unpublishedpapot, S::hoolofBusinessAdministr:l1ioo,
G~org"town Univ""ity. 1999.A publishod version orlhis papor[bu: wilhoullhis I.:tblo) il;n Re>';""'ofAITO"'lling Slu<fios. 2001, pp.J71-J8S.
in eachgroup(high-MTD firms) andfor firms withthe lowest thirdof MTD (low-MTD

firms). Forall groups, nextyear'schange in RJ.~OA is lower if thecurrentchangeinATD is
low, and forali except one group, nextyear'schangein profitmargin is lowerif the current
change in ATO is low. And the differences are higher for firms that have high current
RNOA: A highcurrentRNOA is likely to be followed by a decrease in RNOA, but the decreaseis likely to be greaterif the firmhas a smallchangein ATO.
These relationships may not arise from accounting quality but certainly bear on the
overall question of earnings quality. So analyze changes in Al'O.Compare changes in sales
to changes in ATD. Be sensitive to caseswhereprofitmargins increase or are constant but
the asset turnover declines. This maybe the case of a finn that is otherwise experiencing
falling margins but wants to maintain profitmargins and RNOA at previous levels. And
watch for cases where there has been a large increase in NOA but a small or negative
changein ATG.
Changes in individual turnovers shouldbe investigated to isolate the possible manipulation. Pay attention to turnovers involving estimates: accounts receivable turnover, PPE
turnover, deferred asset turnover, pension liability turnover, and other estimated liability
turnovers. Watch for declines in turnovers (or increases in individual items relative to
sales).Is therean explanation?
Cisco Systems supplies the infrastructure for the Internet economy. Up to 2001, it saw rapid
revenue growth on lowinventories. For the four quarters of its 2000 fiscal year, the ratios of
inventory-to-sales, in percent, were 16.9, 16.0, 17.8, and 21.3, respectively. By the second
quarterof 2001, the ratio had increased to 37.5 percent. In the third quarter of 2001,the firm
tooka charge foran inventory write-down of over$2.2 billion dollars and sales and earnings
subsequently slowed dramatically. The inventory buildup represented inventory whose sale
prices had declined as the Internet bubble burst.
Sunbeam Corporation, the household appliance manufacturer, hired newmanagement in1996
to turn its ailing business around. After a major restructuring, itsstock rose 50 percent during
1997 with earnings improving to $109 million from a loss of $228 million in 1996. Sales
increased by18.7 percent. However, accounts receivable grew 38.5percent, from 21.7percent
of sales to 25.3 percent, and inventory grew 57.9 percent, from 16.5 percent of sales to
21.9 percent. The SEC subsequently investigated Sunbeam, leading to a restatement and,
ultimately, the bankruptcy of the firm.
3.Investigate LineItemsDirectly
a. Challenge Depreciation andAmortizationExpense. Lowdepreciation or amortization
usually means there will be future write-downs of assets, usually through restructuring
charges or losseson disposals of assets. Too high depreciation or amortization results in
latergainsfromassetdisposals.
In 1988, General Motors reported $4.9billionin profits. Analysts claimed that$790million of this came from extending the useful lives of assets from 35 to 45 years, thereby
reducing depreciation, and $270 million came from changing assumptions for estimated
residual valueson car leases. This accounting continued for a fewyears, butthencamethe
largerestructuring charges of the early 1990s. Thesecharges, it was claimed, were partly
corrections forunderdepreciation in thepast Indeed, OMhadso manyrestructurings in the
1990s thatanalysts claimed theycouldnotat anytimeworkout whatprofits OMwasreally
making.
To investigate, adjust operating income before depreciation and amortization (ebitda)
witha normal capitalcharge:
Adjusted ebitdae OI (beforetax) + Depreciation andamortization

- N0!IDal capital expense
The diagnostic compares this adjusted ebitdato operating income beforetax (ebit), which
is basedon the reported depreciation and amortization:
Diagnostic: (Adjusted ebitda)/ebit
Norrnal capital expense is approximated by the average capital expenditure over past
years or, to accommodate growth, normal depreciation and amortization for the levelof
sales, calculated from past (Depreciation + Amortizationj-to-sales ratios. Also calculate,
for the past fewyears,
Diagnostic: Depreciation/Capital expenditures
If this ratio is less than 1.0,futuredepreciation is likelyto increase.
Electronic Data Systems (EDS) hashad many restructurings over the years. Restructurings are a
response, inpart,to depreciation charges being too low. In the third quarter of 2001, the firm
reported (in the cashflow statement) depreciation and amortization expense that was6.6 percent of revenues, down from 7.2 percent of sales a year earlier, accounting for nearly half of
the qrowth in operating income. Analysts asked: Was the lower charge due to better asset
utilization or did it forecast further restructuring charges?
AMR, the parent of American Airlines, reported that operating income, before tax,increased in
2000 to $1,381 million from the $1.156 million in 1999. Notes to the financial statements
reveal that the firm increased estimated lives on someof itsaircraft from 20 to 25 years and
also increased estimated salvage values from 5 percent to 10 percent of cost. The effect wasto
reduce depreciation for the year by $158 million, with an after-tax effect on income of
$99 million, accounting for 80 percent of the increase in income before discontinued operations. Was management correct to claim that the change "more accurately reflects the
expected life of itsaircraft"?
Someanalysts employ modelsof required depreciation that are moreforward looking,
These models identify under- or overdepreciation by forecasting write-downs and disposalgains andlosses,and theyset the appropriate depreciation chargeas that whichwill
produce no write-downs, gains, or losses. For example, if there is overcapacity in an
Chapter 17
In June 1998 AT&T, the largest U.S. telecommunications

group, made a bid of$45.5 billion toacquire Ielecommunicatons Inc. (TCI), thecountry's biggest cable television company.
AT&T's strategy was tobuild systems fordelivery ofvoice, tele-vision, andInternet service to homes, circumventing theBaby
Bells (the local telephone companies).
The press at the time claimed that the purchase price of
14times 1997 earnings before interest, tax, depreciation, and
amortization (ebitda) was "a bit stiff:' and indeed AT&T's
shares dropped 1Spercent inthetwoweeks after thebid. High
or not, quoting prices asmultiples of ebitda isappropriate if,
with rapid technoiogical change: there isa question ofwhethef::'~

reported depreciation istooI?w. Indeed themany restructuring'
charges intheindustry atthetime were inpart adjustments for
low depreciation charged inthepast. Itwas also recognized
thatAT&T would have to spend heavily to upgrade TO's network to maintain thebusiness under competition.
Quoting a bid price as a multiple -of earnings before
depreciation and amortization allows theanalyst to plug ina
normalized depreciation calculated to accommodate technological change and to anticipate expenditures necessary to
sustain thebusiness.
industry-as with automobile manufacturing and telecoms in the 1990s-these models

forecast that firms will have to write off the excess plant unless currentdepreciation is
adjusted to reflect the cost of the investment in overcapacity. Or if technological change
willrender thecurrent plantobsolete, depreciation is adjusted. These models mayalsoattempt to calculate the depreciation that is necessary to sustain sales, usually approximated by annualizing capital expenditures necessary to replace facilities. This is desirable when there are anticipated increases in the cost of new plants that will replace
current plants but will generate the same sales, or where technological change will requirethe updating of the production facilities to deliver sales. Current depreciation, so
adjusted, becomes a better predictor of future depreciation, a higher quality number.
Technological change has been rapid in telecommunications and So these methods are
desirable there. SeeBox 17.4.
Otheranalysts, waryof depreciation andamortization charges, addbackdepreciation to
operating income andworkwithebitda as a measure of income from operations for prof.
itability analysis. Thisis bad analysis. Depreciation is a costof generating sales, just like
wages. Plants rust,wearout,andbecome obsolete, so value is lost.Depreciation captures
value loss; ebirda is a low-quality measure of value added. If the analyst bas questions
about the quality of depreciation and amortization, she can work with adjusted ebitda,
which usesa normal capital charge.
b. Challenge Total Accruals. We haveseenthatcashflow from operations = 01 - New

operating accruals. Thuscalculate
Diagnostic: CFOlor
As the accounting doesnot affect cashflow from operations (CFO), manipulation of operating income (01)withunjustified accruals willaffect this ratio. Alsocalculate
Diagnostic: CFOINOA
Any increase in NOA duetomanipulation willaffect theaverage NOA in the denominator.
Becareful of cashflow metrics, however. Cashflow fromoperations canitselfbemanipulated. SeeBox 10.4 in Chapter 10.Nevertheless, the CFOforfinnslikeEnron andWorld
Comfell dramatically, relative to operating income, prior to theirdemise.
s2.
Anal1lls of the Quality ofFinancial Sultemems
625
With newmanagement on board, Sunbeam Corporation reported earnings of $109 million in

1997, upfrom a loss of$228million. However, cash flow from operations for1997 was(aneg
ative) -$8.2 million compared with $14.2 million in 1998. The earlier torpedo box gives some
reasons. Seealso Exhibit 17.2 inExercise 17.14. Sunbeam wasmanufacturing sales with a "bill
andhold" scheme whereby the firm billed customers whodid not need products immediately,
with deepdiscounts andeasy credit terms, andstoring the merchandise initsown warehouse.
The SEC subsequently made the firm reduce 1997 earnings by $71 million.
c. Challenge IndividualAccruals Inspect eachaccrual listedin thereconciliation of net

income to CFOin the cashflow statement, suchas changes in prepaid expenses, deferred
revenues, andaccrued expenses. Foreachaccrual otherthandepreciation andamortization,
lookat
Diagnostic: Accruall6.Sales
Forexample, a dropin the change in accrued expenses (an accrual in thecashflow statement) mayindicate that too few expenses have beenrecognized. Be particularly aware of
accruals thatincrease income, especially when thechange in sales is close to zero, lower
thanin thepast,or negative. (If the change insalesis zeroornegative, theratiofonnof the
diagnostic willnotworkbutaccruals and change in salescanstillbe compared.)
Shared Medical Systems, a supplier of information systems to hospitals and physicians, reported earnings of $18.3 million in its first quarter of 1999, almost unchanged from the
previous quarter. However, revenues declined from $339.3 million to $287.1 million. Level or
increasing earnings on declining sales always waves a redflag. The cash flow statement revealed further ones: Accrued expenses declined from $86.5 million to $61.5 million and the
amount of computer software capitalized inthe balance sheet increased from $75.7 million
to 81.1 million. Manipulation or legitimate business? Well, earnings significantly increased
throughout the next year, on rising revenues, so a reversal was notapparent.
Microsoft Corporation writes software contracts with multiple deliverables and defers a
significant portion ofthe revenue onthesecontracts. Atthe endofits2005 fiscal year, deferred
revenues stood at $9.17 billion or 23.0 percent of sales. The prospect ofthe firm bleeding this
deferred revenue back intoincome isreal, sotheanalyst hasMicrosoft On a watch. In 2005, the
cash flow statement reveals that Microsoft added $12.5 billion to deferred revenue andtransferred $11.3 of deferred revenue to revenue to the income statement. There isno sign of an
excessive bleed back.
As it promises upgrades andadd-ons. Microsoft historically followed the practice of recogniz-
ing upto 25 percent of revenue from itsWindows software over three orfour years. With the
launch of Vista in2008, it changed the policy to record most of the revenue inthe period in
which the software wassold. In thethird quarter forfiscal year 2008, Microsoft reported anincrease inearnings of 65 percent. The increase came from sales of the newVista program and
also from the acceleration inrevenue recognition.
Cisco Systems reported revenue of $4,816 million foritssecond quarter of 2002 up from the
$4,448 million inthe preceding quarter and exceeding projections. It looked like the revenue
decline, from the $6,000 million perquarter in 2001, was over. However, thefirm pointed out
that, for the first time, deferred revenue had reversed: The firm had recognized an unusually
large amount of revenue on conditional shipments from prior periods.
II
\
626
Part Four Accounting Analysis and Valuation
d. Challenge Other Expense Components thatDepend all Estimates.

Diagnostic: Pension expense/Ictal operating expense
Diagnostic: Otherpostemployment expenses/Total operating expense
Pensions and other employment expenses can be manipulated by changing actuarial estimates of projected payouts and discount rates for the liabilities, and by changing the expectedreturnon planassets. Go to the pension footnote and investigate the components of
pension expense (as in Chapter 12).Tothe extentdisclosure allows, investigate othercomponents of SG&A expenses; this itemtendsto be a largeone on the income statement.
e. ChaIIenge Tax Expense. Effective tax ratesusually converge to thestatutory rateover

time.So investigate
Diagnostic: Operating tax expense/Of beforetaxes
If thisrateisbelow thestatutory rate,find outwhentax credits arelikely to expire. Butalso
investigate the portion of the tax expense thatis subjectto estimates: deferred taxes. Go to
the tax footnote and investigate reasons for changes in deferred tax assetsand liabilities. If
theseare changing at a ratedifferent fromsales,a flagis raised.
Deferred taxes are taxes on the difference between income reported in the financial
statements (usingGAAP) and income reported on the tax return(using tax rulesfor measuringincome). If the finn is usingestimates to generate higherGAAP income, it mustrecognizemoredeferred taxes. So investigate the extentto which tax expense is composed of
deferred taxes. Investigate the components of deferred taxes (in the tax footnote). Watch,
particularly, deferred taxesarisingfromdepreciation: If the deferred tax fromdepreciation
relative to depreciation expense is high(compared tosimilarfirms) or increasing relative to
investment growth, the firm maybe reporting lowGAAP depreciation expense byestimating longuseful lives for assets. Investigate deferred taxesarisingfrombad debtestimates,
unearned revenue, and warranty expenses. If a fum increases GAAP income by lowering
its bad debtestimate, for example, it will also recognize moredeferred taxesbecause bad
debtsare accounted for on a cash basis on tax returns. Watch deferred taxesarising from
sales-type leasesthat require estimates of residual values for GAAP income measurement.
If a firm has deferred tax assets, one feature requires particular monitoring: the valuation allowance. Deferredtax assetsarise from features that yield lower GAAP income to
taxable income. If the income taxbenefits intheseassetsaredeemed "morelikelythannot"
not to be realized in the future, deferred taxassetsare reduced by the allowance. But,to say
the least,the allowance is a subjective number.
4. Investigate Balance Sheet LineItemsDirectly

If carryingvalues of operating assetsaretoo highin thebalancesheet,theywillhaveto be
written off in the future, reducing IlN'OA. Particular suspects are:
Assets whose carryingvalues are above their marketvalues: Theseare likely impairmentcandidates. (Market values maybe difficult to ascertain, however.)
Assetssusceptible to nontypical capitalization of expenses, such as start-up costs,advertising andpromotion, customer acquisition and product development costs,and software development costs.Lookat trends in theseassetsrelative to totaloperating assets.
See Box 17.5.
Intangible assets whosecarryingvalues and amortization rates are subjectto estimate,
likesoftware costsand assetsacquired in acquisitions.
Assets recorded at fair value. If estimates of fair valueare used, they may have to be
revised in the future.
"
.c.':':
'
Prior to1996,'Am'erica Online (AOL) capitalized ma~keting

costs lndevelopinq a subscriber base on'its balance sheet and
amortized them over a two-year period. It had been a "hot
stock/ Jncreesnu tts' share price from $10in early 1995 to
over $35 iri April 199fiBut concerns about the quality of its
capitalized marketing costs set in during 1996 and itsprice'
dropped back almost to $10 bySeptember 1996. Analysts
queried whether subscribers would renew. To meet the concerns, AOL wrote offthe $385 million capitalization initsfirst
fiscal 1997 quarter ending September 1996, producing a loss'

of$3.80 pershare for thequarter. Earnings pershare for1997
were -$2.61 compared to 14cents in 1996. One might say
that 1996 earnings were low quality (they did notreflect appropriate marketing expenses) and that the'lew quality resulted inlower future earnings. Inevaluating thequality ofthe
asset, onewould have to consider the retention rateinholding on to newsubscribers, andthat wasthe point on which
quality analysts were focusing.
Enron, the energy company whose demise also brought down itsBig 5auditor, Arthur Andersen,
employed fair value accounting extensively foritsenergy contracts andotherinvestments. These
energy contracts were traded invery thin markets, some of them organized by Enron, so fair
values were very much anestimate. In2000, prior to thefirm's demise, unrealized gains onmarkingthese contracts to fair value accounted for more than half on the firm's pretax income of
$1.41 billion andabouta third in1999.The profits subsequently evaporated asthe "fair" values
proved to be fictitious.
Similarly, the carryingvalueof operating liabilities shouldbe investigated. Focuson:
Estimated liabilities suchas pensionliabilities, otheremployment liabilities, warranties,
anddeferred revenue. Lookattrendsin theseliabilities relative tototaloperating liabilities.
Off-balance-sheet liabilities such as loan guarantees, recourse for assigned receivables
or debt,purchase commitments, contingent liabilities for lawsuits andregulatory penalties, and contingent obligations from off-balance-sheet special-purpose entities. These
liabilities areusually mentioned in footnotes. Thefootnote shouldbe studied thoroughly
to avoid a surprise in the outcome of the contingency. Environmental liabilities (for
cleanup of pollution) are a currentissue.
'While focusing on thebalancesheet,this analysis is a quality-of-earnings analysis also:
If distorted carrying values were recorded at an appropriate amount or the contingent
liabilities wererecognized on the balancesheet,income wouldbe lower (through a charge).
Omission of this chargeyields low quality earnings and results in subsequent earnings
surprises.
Diagnostics to DetectManipulation of Unusual Items

Unusual itemsare isolated to identifycore income in order to improve earnings quality.
Froman earnings qualitypointof viewtheyare lowqualityand thusarediscarded for forecasting. Butthe analyst doeshaveto be carefulthat unusual itemsidentified indeedhaveno
implications forthe future.
A qualityissuearisesif unusual items involve estimates. A notorious example is estimated restructuring charges and impairments. Finns may decide to restructure in the
futurebut will include an estimateof the cost in currentincome,alongwithan estimated
liability in the balance sheet. And they may overestimate the liability, take a bath, and
bleed back income to income statements in the future as actual expenses are less than
anticipated.
627
Chapter 17 Analysis of rhe Quality' of Financial Statements 629
1~.1~992 "~old~n,: th~ .food and chemicals' co'mpany, tooC,

'a $642 '~iIIfon:,spect~l/estructuring charge against income
'and-reported 'a-',lo55 of :$439.6 million. In. 1993, under
pressure from ,the S~,C, Borden reversed $119.3 million of
the ',charge 'retrospectively, increasing 1992 income and
'reducing 1993 income. In addition, Borden was required to
reclassify $145.5 "million of _the charges that were for
"packaging modernization" and marketing asordinary6;

ating expense.
"':, " '
. _,,:y:;~
In the fourth quarterof1993~, Borden took anothi'i-?
structuring charge of $637.4 million'for estimated los'ses"
disposal of businesses, unrelated to the.earlier charge::1994 third quarter results induded a $50million credit fro"
having overestimated these losses in1993.
In thesecond quarter of its 2002 fiscal year, Cisco Systems reported anincrease inrevenue after
a period ofdecline. Ared flag wasraised onthe revenue (p.625). Gross margins were also up,
to $2,970 million from $2,692 miiJion in the preceding quarter. The gross margin ratio was
62percent, much thesame asthe ratio achieved during Cisco's peak revenue period during the
telecom bubble. However, Cisco hadwritten down itsinventory inthethird quarter of2001 by
over $2.2 billion. The analyst would have raised a redflag in2001 (p. 622) andwould have predicted that the lower inventory would reverse intolower future cost of goods sold, leading to
maintained orhigher gross margins. Move onto2002 anda redflag continues towave over the
margins: Can Cisco maintain thesemargins oncethe impaired inventory hasbeensold? (Cisco
wasquite forthcoming intracking itsutilization ofthe impaired Inventory)
DETEalNG TRANSAalON MANIPULATION

Box 17.6 is a case in point. If aggressive accounting wasin fact practiced, Borden attempted to bleed 1992income to laterperiods through an estimated restructuring charge.
Indeed therestatement ofthe 1992 charge reduced 1993 income. Theunrelated 1993 fourth
quarter charge was,it turnsout,alsoan overstimate which increased income in 1994. See
alsothecoverage of IBMin Chapter 12.
The Borden case raises another pointabout estimated charges. Borden included (what
the SEC concluded) was $145.5 million of 1992care operating expense in the 1992 restructuring charge, thusinflating coreincome. Investigate thecomponents of thecharge to
seewhether thisis going on.
Estimated merger costs also warrant investigation. Finns can overestimate thesecosts
and then bleed hack the overestimates to increase profits in the future. This makes the
merger lookmoreprofitable thanit is.
Special charges can of coursebe underestimated as wellas overestimated. The analystwatches forchargesthatshouldbe takenandarenot.AT&T tookfourmajorcharges
between 1986and 1993.Thefinn reported an average of nearly 10percentannual profit
growth overtheperiodbeforethe charges weresubtracted, from$1.21 per sharein 1996
to $3.13per sharein 1995. But the totalof the restructuring charges of$14.2 billionexceededthe totalreportednet incomeof$10.3 billionoverthe period.AT&T maintained
that the write-off's were causedby rapid technological change that hadn't been anticipated.But qualityanalysts raiseda question: Were the profits beforerestructuring low
quality, overstated profits that wouldhave to be writtenoff later?WhatwasAT&T really making in profits duringthe period? Would an insightful analysthaveadjustedthe
lowqualityearnings with "normalized depreciation"? Monitor normalized core operating income relative to reported core operating income. Watch particularly for cases
wherethis ratio is low but other coststo sales are high; these conditions maysignala
restructuring.
In view of the AT&T case, one must be skeptical about classifying restructuring
charges as unusual. Theymayberepetitive, particularly during timesof technological and
organizational change. Citicorp tookrestructuring charges six yearsin a row, from 1988
to 1993, when changes shookthe banking industry. Eastman Kodak did the same forfive
out of six yearsfrom 1989 to 1994. And Cadbury-Schweppes maintained in its 1996report that "majorrestructuring costs are now widely recognized as a recurring item in
major food manufacturers, estimated by some analysts as 0.5 percentof sales overthe
longterm," and thus felt it no longerappropriate to exclude thesecostsfrom underlying
(core)earnings.
628
Thediagnostics to thispointraiseconcerns abouta firm using accounting methods andestimates to alterincome, andso address the(third) question of GAA."P application quality in
the five quality questions webegan with. Thefourth question, concerning transaction quality, deals with firms' timing or structuring transactions to manipulate income. Short of
beingfraudulent, firms can choose accounting methods and estimates onlyas GAAP permits. Where GAAP is inflexible, they cansometimes arrange theirbusiness to eccommodateGAAP to achieve a desired result.
Core Revenue Timing

Recognizing salesbyshipping products inonefiscal yearratherthananother shiftsincome.
Unfortunately this "channel stuffing" is hardto pickup unless onehasdetails of monthly
shipments. Watch for unexpected shipments and sales increases or decreases in the final
quarter.
Core Revenue Structuring

A variety of techniques have been employed to manufacture revenue. Unfortunately, they
too are difficult to uncover; theinvestor trustsverymuchin the auditor.
Related-party andother-than-at-arm's-length transactions; forexample, shipping equipmentto an affiliate that doesnot need the equipment andbooks it as plant, while the
shipper books it as revenue; booking revenues for goods shipped "on consignment" or
with animplicit rightof return. Lookfor related-party transactions in the 10-K.
Structuring lease transactions to quality as sales-type leases.
Grossing up commission revenue to thetop line.
Swapping inventory inbartertransactions.
Krispy Kreme rose from a regional doughnut maker to a national taste sensation and a "hot
stock" IPQ in 2000. As sales faltered, however, the firm shipped hiqh-rnarqin doughnutmaking equipment to franchisees, long before they needed it. The company booked the
revenue while the equipment sat in trailers controlled by Krispy Kreme. The firm also sold
equipment to a franchisee and booked it as revenue immediately before it bought the
franchisee fora price that wasinflated forthe equipment. In 2005, thefirm wasforced to restate results as far back as 2000, reducing pretax income byover$25million. Once at a high
of $49.37, its shares traded at $7.30 in 2005 after a report from the company on its
accounting.
630 Part
Chapter 17 AnalYltsofu.eQualiEyofFinancialSEalementl 631
Four Accounting Analysis and Valuation
Global Crossing sold capacity on its extensive telecom network to telecoms under long-term
contracts. In a deal known as a capacity swap, the firm exchanged capacity with these firms
such that Global Crossing booked revenue forthe capacity it "sold" but booked the capacity
that it received inexchange as an asset. In a 2001 transaction with Qwest Communications, it
signed a $100 million contract to supply capacity, only to "roundtrip" the cash bypurchasing
a similar amount of capacity from Qwest, but booking revenue. Both companies ran into
regulatory problems and Global Crossing subsequently filed for bankruptcy.
Core Expense Timing

Firms can time expenditures, and thesewill affect income if they are expensed immediately. So lookat R&Dand advertising expenses. Investigate
Diagnostic: R&Dexpense/Sales
Diagnostic: Advertising expense/Sales
If theseratiosare low, a firmmightbe deferring expenditures to the future to increase currentincome.
Advertising andR&Dexpenses mayhavemorethe qualityof an assetbecausetheymay
produce future profits. Increasing expenditures will reduce current income but may increase futureincome. Understand the technology and the markets for products to evaluate
whether the expenditures willin factproduce future profits. Lookattrendsin theratiosover
time. Look particularly for earnings that are generated by declining R&D or advertising.
These may be lowqualityearnings because future earnings maysufferfrom the reduced
expenditures.
Releasing Hidden Reserves

If a finn usesconservative accounting (asa matterof policy), wesawin the lastchapter(in
Table 16.7)that hidden reserves are created. If the growth in investment slows, hiddenreservesare liquidated andprofitsincrease. So a firmcanslowinvestments temporarily to increaseprofitstemporarily. Thispractice is sometimes referredto as cookie-jar accounting,
dippingintothe cookiejar (of hidden reserves) to generate profits. You see this in the case
of R&D(which is an extreme case of conservative accounting). Butit applies alsoto assets
thatare put onthe balancesheetbut are measured conservatively. So watch firms you have
identified as having conservative accounting policies and inspecttheir changes in inventory, plant,and intangibles.
A particular case is a firm usingLIFOfor inventories. If inventories are reduced, LIFO
liquidation profitsare realized as hidden reserves are released. We saw in Table 16.8 in
Chapter 16 that over25 percentof NYSEandAMEX firms on LIFO increased earnings
withLIFOliquidations from 1982to 2003.Thisis referred to as LIFO dipping.The footnotesarehelpful herebecause the inventory notemustgivethe amount of the LIFOreserve
and the SECrequires thatfirms reportthe impactof LIFOdippingon income. Is it temporary?Firmscandip intoLIFOinventories to boostprofitstemporarily, but a LIFOliquidation can also be the precursor to a long-run decline in the demand for the firm's products.
Anda drop in the LIFO reserve can follow a dropin prices,not inventory liquidation, and
this is morelikely to be permanent.
FIFOaccounting is lessopento manipulation. But because costof goodssold is based
on older costs (and inventory on more recentcosts), FIFOcost of goodssold and FIFO
earnings are sometimes said to be lowquality if inventory costsare rising: Costof goods
sold does not indicate whatfirmsare currently paying for inventory or willhaveto pay in
the future. Thisis not of greatconcern, however, in the typical situation of rapid inventory
turnover.
In 2003, General Motors reported an unusually good year with $3.6 billion in pretax income
from continuing operations. Footnotes revealed thatcostofgoodssold was$200million lower
because of liquidation of LIFO inventories. Without the benefit ofthisLIFO dipping, future cost
of goods sold arelikely to increase. The increase will be greater ifthe firm needs also to replace
the inventories at higher prices: Under LIFO, lastin(at higher prices) isfirst out to costof goods
sold.
Other Core Income Timing

Lookat the resultsreported by Coca-Cola Co. from 2001 to 2004(in millions of dollars):
Operating income
Equity income insubsidiaries
Other income (loss)
Gain on Issuances ofstock byequity investees
2004
2003
2002
2001
5,698
621
(82)
24
5,221
406
(138)
8
5,458
384
(353)
5,352
152
39
91
Coke, as we have seen,has been veryprofitable. But a significant share of income from
subsidiaries has comefromgainsthat arerecognized on a parent's equityinvestment when
a subsidiary issuesshares. Someissues wereof one subsidiary's sharesto another. Coke
presumably has "significant influence" in issuing these shares and so might be able to
arrangeshareissuesto timethe recognition of gainsin its ownaccounts. Cokemightmaintain thatthis is a deviceto represent the real profitability of subsidiaries. But it can alsobe
used for manipulation. And sincethe gainsare fromshareissues, not operations, theyare
low quality.
Unusual Income Timing

Finnstimeassetsalesto increase or decrease net income by recognizing gainsor losseson
the sales. Classifying these gains and losses as unusual dealswith the quality issue, but
beware of sales that are madeof good qualitybusiness just to affectincome. A finn may
sellan assetwithlowbookvaluerelative to its marketvalueto recorda gainthatincreases
currentincome, but future income is impaired by the lossof earnings fromthe asset.
Organizational Manipulation: Off-Balance-Sheet Operations

Firms cansometimes arrange theiraffairs to getsome aspect ofoperations offthebooks. These
off-balance-sheet operations arecalled shellsandsetting themup is called theshellgame.
R&DPartnerships
Expenditures for R&D reduce income. Firms therefore sometimes set up a shell
company-c-perhaps with otherpartners-to carryout theR&D. Theoriginal company may
actually do theresearch butthenchargethe R&D partnership, creating revenue for itselfto
offsetits R&Dexpenditure. If the R&Dis unsuccessful, the investment in the shellhasto
be writtenoff,and pastrevenues fromthe R&Dwouldbe fictitious.
Pension Funds
Pension fundscanbecome overfunded, as happened in the 1990swiththe longbullmarket
in stocks (heldby pension funds). This overfunding is technically the property of the employees, but firmsfindways to use the overfunding to payfor operational expenses. They
apply it to earlyretirement plans,retireehealthbenefits, and mergerfinancing, the costof
which would otherwise be borne in the incomestatement.
632 Part Four Accouming AMI)sis and VIlIUllOOIl
Special-Purpose Entities
Theseentities aredesigned to holdassetsthat mightotherwise be on a firm'sbalancesheet
like leased assets and assets that havebeen securitized. Although the firm may not have
control of these entities (and thus the entitiesare not consolidated), it may have Some
recourse liability for the obligations of the entity.
JUSTIFIABLE MANIPULATION?
It is claimed thatCeca-Cola realizes gainsfromstockissues to reportthe underlying profitability in subsidiaries thatinvestors mightnototherwise see.General Electric is alleged to
"smooth"earnings to givea picture of regular, predictable profitgrowth (which the companydenies).
Managements smooth earnings by borrowing income fromthe future or by shifting income to the future. Theyborrowearnings in bad years and bank earnings in goodyears.
All's well and goodif theycanbe surethata bad yearwillbe followed by goodyearsfrom
which they borrow. Indeed, such practices will help with forecasting as the currentyear's
earnings willbe a betterindicator of future earnings. Onemightargue the quality of earnings is better(forforecasting) if theyare smoothed!
But whatif bad yearsare followed by bad years? Thenthe qualityof currentearnings,
increased to make them look better, is doubtful. Thus analyzing this practice is a tricky
business and the analyst has to be verysureof a finn's long-run earnings prospects before
accepting the manipulated earnings as high quality. Accepta high, manipulated RNOA
onlyif the finn hasthe rea!profitability to maintain theRNOA in thefuture. In Coke's case,
whatif profitability declined but profits couldno longerbe propped up withthe gainsfrom
sharesin subsidiaries?
DISCLOSURE QUALITY
News Corporation (of which Rupert Murdoch is chairman) is engaged in publishing,
entertainment, television, and sports franchises. Prior to 1998 it ran these businesses
throughhundreds of companies in scoresof countries. Its consolidated statements were
hard to sort out, to say the least,and analysts often requested greatertransparency. They
had difficulty discovering whereprofits were comingfrom. And,whilea large proportion
of revenues andprofitscame fromfilm, television, and sportsin the UnitedStates, News
Corporation waspriced more like a publishing concernthan an entertainment company:
It traded in 1998at 8.5 timesestimated 1998earningsas compared to 16and higher for
competitors like Disney, Viacom, and Time Warner. In June 1998 Murdoch announced
that the U.S. entertainment assets, including 20th Century Fox, the Fox television network, the Los AngelesDodgers, and part interest in the NewYork Knicks and Rangers,
wouldbe bundledinto a separatecompany-Fox Group-and a publicoffering madeof
20 percentof its stock.NewsCorporation's stockpricerose 12 percenton the newsofthe
spinoff. Wasthis the rewardfor disclosure? Other factors may havecontributed but analystshailedthe added transparency that would result as a reasonfor Valuing the earnings
higher. "Tracking" or "letter" stocksfor a division of a company-like the HughesElectronicsunit of General Motors-have the same effect(and also separate out an earnings
stream, which some investors mightwant), but the shareholder usuallydoesn't have voting rights.
The NewsCorporation spinoffindicates that poor disclosure leadsto lowervaluations:
Investors discount the price for the risk from not having information. The price effect of
Chapter 17
An(l~si\
of !h~ Qlloli!)" ofFinllllcial SIClemenC\ 633
poor disclosure is sometimes couchedin terms of the cost of capital: Low-quality disclosure raises the required returnto compensate foradditional risk.
Disclosure issuespermeate all aspects of financial analysis and by nowyou will have
accumulated a list of problems you havehad withdisclosures in gettingto this point The
following (andmany morel)shouldbe on your list
Consolidation accounting oftenmakesthesourceof profitability hardto discover.
Lineof business andgeographical segment reporting is oftennotdetailed enough.
Earnings in unconsolidated subsidiaries are hardto analyze. (Think of a finn thathas ail
its earnings in subsidiaries in which it has less than 50 percentownership: Core profit
margins are nottransparent.)
Disclosure is insufficient to reconcile free cashflow in the cash flow statement to free
cash flow calculated (as
DNOA) from the income statement and balance sheet.
Someof the problems arise from uncertainty about items to be included in operating
income andnet operating assets.
or -
Disclosures to calculate stockcompensation overhang are thin.

Detailson selling, general, and administrative expenses are oftenscarce.
QUALITY SCORING
Thearrayof diagnostics is overwhelming. Would it not be niceto have oneoverall measure
of accounting quality? Sucha measure is referred to as a composite quality score. A compositescoreweights a number of diagnostics intoone metric, as follows:
Composite score = wlD I + W1Dl + w3D3 + ...+ w,,Dn
where D is a score and w is the weight given to each of the n scores included in the
composite.
Tobuildthisscorewewould needto know whataspectof accounting quality weare trying to capture,which diagnostics are to be included, and the weights to be applied to them.
Forearnings quality, the answer to the first question is clear:Wewish to predict earnings
reversals, andtheset of diagnostics is that which bestdoesthis.Onemightdevelop ad hoc
scoring, developing a scoreon a scaleof 1 to lO, say, basedon a set of diagnostics that are
judgedimportant for forecasting earnings reversals. Or one mightdevelop expertsystems
basedon the longexperience of qualityanalysts. Buttypically the diagnostics and weights
are chosen by reference to.!hedata:Whatset of diagnostics forecast earnings reversals in
thehistoryandwhatweights givethe bestforecast? Standard statistical methods-c-ofwhich
ordinary-least-squares regression fittingis just one (and probably not the best one)-are
applied to develop estimates fromthe data.
Estimating quality Scores fromthe datahasthe advantage of reducing the large set of diagnostics to manageable proportions. The datawilltell us that a number of diagnostics are
correlated-e-they convey similarinformation-so theyarenotallneeded. Butthereisanother
feature of quality analysis thatisalsoaccommodated. Aswehavenoted, diagnostics areonly
redflags, andthere is a verygoodprobability thata measure thatindicates quality problems
may be justified for soundbusiness reasons. Thus we are open to error. Earnings quality
analysis is a probabilistic exercise and thedatacantellushowlikely weareto make anerror
witha setofdiagnostics. Thaterrorcanbea so-calledType 1error-identifying a finnashavingnoqualityproblems whenin factit does-c-or aType IIerror-identifying a firm as having
quality problems whenin factit doesnot.Thedatagiveus theprobability ofmaking eachof
thesetypesof errors.
634 Part Four ACCOlmring A1la11Sil and Valllarian
Chapter 17
A number of quality scores have beendeveloped overthe past several years. Hereare
just five of them(theWeb pagefor thischapter has more coverage):
M-scores: Detect manipulation that is likely to result in an SEC investigation:
M. Beneish, "The Detection of Earnings Manipulation," Financial Analysts Journal,
1999, pp.24-36.
F-scores: Discriminate on financial health among lowprice-to-book firms: 1. Piotroski,
"Value Investing: The Use of Historical Financial Statement Information to Separate
Winners from Losers," Journal of Accounting Research, Supplement 2000, pp. 1-41.
Qecores: Scorehow earnings areaffected by therelease of hiddenreserves when conservative accounting is being used: S. Penman and X. Zhang, "Accounting Conservatism, the Quality of Earnings, and Stock Returns," TheAccounting Review, April
2002, pp. 237-264.
Secores:Thecomposite scoreindicates whether operating income is sustainable or will
reverse: S. Penman and X.Zhang, Modeling Sustainable Earnings and PIE Ratios Using
Financial Statement Information, 2005. Available at http://papers.ssm.com/soI3/
paners.cfm?abstractJd-318967
Abnormal accrual Scores: Models have been developed that estimate the amount of
accruals thataredeemed to beabnormal. Forexample: 1.Jones,"Earnings Management
During Import ReliefInvestigations," Journal ofAccounting Research, Autumn 1991,
pp. 193-223 and P. Dechow, R. Sloan, andA. Sweeney, "Detecting Earnings Management," The Accounting RevieJv, April1995, pp. 193-225.
Figure 17.3 shows howdiscriminating thesescores canbe. It isbasedon a calculation of
asustainable earnings score, theScscore, which usesquality diagnostics, calculated from the
financial statements, to forecast whether current RNOA will be sustained, increase, or decreaseinthefuture. (Refer backtoFigure 17.1 toremind yourselfhow earnings management
FIGURE 17.3
Return ofNetOperating Assets (RNOA)
forFirms with High
S~Scores andLow
S-Scores, 1979-2002
TheSecoreranges from 0 10 I, with a score of 0.5 indicating that current RNOA win be
sustained in the future. A score greater than0.5 indicates that future RNOA willbeabove current
RNOA, and a score less than0.5 indicates that future RNOA will bebelow current RNOA. The
graph plots average R..N:OA forthetopthird ofS-scores (High S) andforthebottom third (Low S).
Both groups have thesame RNQA inthebase year, Year 0,when the Secore isestimated, but
significantly different RNOA in subsequent years.
1 __
LowS - - HighS
0.13
0.12
/
~
0.11
~ /
~
0.1
0.09
0.08
'>----5
-4
-3
-2
-I
The returns are size-adjusted tosubtract the part ofthe return that isrelated torisk associated with firm
size; that is,each firm's return isreduced by the average return for itssize. The long-short position
requires zero investment. The combined return tozero investment ispositive inall but four years.
MeanSize-Adjusted Return
0.7
0.6
0.5
E 0.4
0.3
-e
0.2
<
0.1
<;;
"
'ii'
-0.1
-n- Hhm
lin
ITT ITT
, ,
~
r~
f---f----
f- r-
-0.2
-OJ
f---
:;:
~
, ,
00
g g
.,
:;; ~ ~
~ 0~ ~ ~ ~ a-:
~ ~
~ ~ ~ ~
~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~
~
00
00
:il
e00
00
00
00
80 ,;0
M
0
0
y",
Sour<.:S. Penman andX.Zhong.2005.Modeling Susloinobl. omings ~nd PIE !t:ltios Using Finonci3] Slolem.ntlnform~l;on. Av:libbk
.t bt!tl:f'p.p.'....sm .omfsol3lp.pers.dm?b'lr2.t id=:l18967
plays outthrough theRNOA.)All U.S.-listed firms from 1979 to2002withavailable dataare

included in the analysis. The firms in the top third of S-scores bave significantly higher
RNOA thanthosein thebottom thirdin theyearsaftertheyearwhenscoreswere estimated,
Year 0, eventhough bothgroups havethesameRNOA in the Scscoring year. Thedifference
is nottrivial-12.8 percent versus 8.8percent oneyearahead.
ABNORMAL RETURNS TO QUALITY ANALYSIS

Many analysts claimthat the market is "fixated" on reported earnings. The market takes
earnings at face value, so managers are tempted to manipulate earnings to affect stock
prices. A personwho believes in efficient markets would maintain that the market sees
through anyaccounting tricksto the real profitability. But a quality analyst who ~elieved
otherwise mightfind that piercing through the accounting will discover mispricmg that
leadsto abnormal returns.
Lookat Figure 17.4.Thatfigure reportsannual returns from investing longinfirms with
highS-scores andshort in firms withlowS-scores, every yearfrom 1979 to 2002. The cancelinglongandshortpositions involve zeroinvestment (apartfrom transactions costs), so
should yieldzeroreturns if the longand shortsideshave similar risk. Butthe returns are
positive in all butfouryearsandquitelarge-IO percent or higher-in manyyears. Similar
returns havebeendocumented from trading ontheamount ofaccruals relative tocashflows
anda variety of quality diagnostics.' Of course traders are increasingly exploiting quality
analysis, so returns in the future maynot matchthesehistorical returns.
RNOA
0.14
FIGURE 17.4
Annual Returns by
Calendar Year to a
Hedge Portfolio that
Takes a Long Position
in theStocks with the
Highest 10Percent of
S-Scores anda Short
Position in Stocks
with theLowest
10Percent of
S-Scores,1979-2002
Anal1si<; oftheQualit1 of Financial Statements 635
y",
S<>=~: s. r~run'n .nd x. ZIu.'!:. 2005. Mod<:lingS=i""bl~ omi"!:, 'nd PIE 1t:1l!"S U.ing Fi,.,.,cj;l] Stale",.n: lnrorm,lion.Av:tjl,bl.
,1 httR'"R~pm.urn.com/so13loaperufm?3br;tnct id:318967
2See, for example, R. Sloan, "Do Stock Prices Fully Reflect Information in Accruals andCash Flows about
Future Earnlnqs?" TheAccounting RevieW- July1996,pp. 289-315. Also see the book's Webpage for
thischapter.
Chapter 17
636 Part Four Accmmring Anal)'5is andValumion
Whenforecasting from thecurrentfinancial statements, theanalyst mustbe concerned with

the qualityof the accounting usedin thosestatements. If accounting methods andestimates
temporarily increase or decrease reported profitability, theanalyst knows thattheeffectwill
reverse in the future.
Thischapter has developed a setof diagnostics to use in an accounting quality analysis.
These diagnostics are merely suggestive, flags to raise suspicions about the accounting
numbers. Theyleadto further investigation andto questions to management, to resolve the
suspicions thattheyraise. Toreach an overall judgmentof accounting quality, the analyst is
aware of situations when manipulation is morelikelyand is aware ofthe sensitive issuesin
particular industries. The chapter has outlined situations where the analyst must have particularconcerns aboutthe quality ofthe accounting.
Accounting quality analysis is part of the wider analysis of sustainable earnings. So
marrythe material in thischapter withthaton sustainable earnings in Chapter 12. Anduse
the red-flag analysis of Chapter 15 to raisefurther questions aboutthe abilityof the finn to
maintain currentprofitability in the future.
Find the following on the Webpage for thischapter:

More onthecuality of GAAP accounting.
A discussion of accounting quality problems that
surfaced during thestock market bubble.
Key Concepts
More on composite quality scoring and earnings

forecasting.
More ontheabnormal returns thathave been reported
from using financial statement analysis.
Look attheReaders' Corner.
aggressive accounting is accounting that

recognizes morecurrentincome than
alternative accounting methods. Compare
with big-bath accounting. 608
audit quality refersto the integrity of
the auditin ensuring thatgenerally
accepted accounting principles have been
adhered to. 609
banking (or saving)incomefor the
future refersto the practice of reducing
currentincome and deferring it to the
future. Compare withborrowingincome
from the future. 608
big-bath accounting is accounting that
reduces currentincome (usually by large
amounts). Compare with aggressive
accounting. 608
borrowingincomefrom the future refers

to the (aggressive accounting) practice of
recognizing income currently that would
otherwise be recognized in the future.
Compare withbanking income for the
future. 608
channel stuffingis the practice of
advancing salesto the currentperiodto
recognize morerevenue. 609
disclosure qualityisthedegree towhich
financial statements and theirfootnotes
givethedetail necessary to analyze
them. 610
earnings management is the practice of
shiftingearnings between periods. 608
earnings quality refersto the ability of
currentearnings to forecast future
Qwliry oJ Fillilndat Statements 637
revenuetiming is thepractice of
earnings. Earnings are of goodquality if
no earnings reversals are forecasted. 607 assigning revenue to selected accounting
periods. 609
expenditure timing is the practice of
reversal property of accountingrefersto
timingexpenditures to selected
a feature whereby higher(lower) current
accounting periods. 609
earnings will resultin lower (higher)
GAAP application qualityisthedegree to
earnings in the future. 607
which afirmusesGAAP accounting togive
a"trueandfair'tview ofthefum'sactivities: shell is an operation thatis part of a firm's
business but is organized in sucha wayas
A firmcanuseaccounting methods
to keepthe operation off the firm's
available within GAAP togiveadistorting
balance sheet. 631
view ofthefum'sactivities. 609
transaction quality refers to the amount
GAAP qualityisthedegree towhich
of transaction timing involved in
generally accepted accounting principles
determining reported earnings. 609
(GAAP) capture thetransactions that
arerelevant tothevaluation ofafinn. 609 transaction structuring involves
arranging transactions to achieve a
LIFO dipping is the practice of reducing
desired accounting effect. 610
LIFOinventories to increase current
transaction timing refers to thepractice
income by the liquidation of LIFO
of arranging a firm's business around the
reserves. 630
accounting rulesso as to recognize
quality diagnosticsis a measure that
transactions in particular accounting
raisesquestions as to the qualityof
periods. 609
accounting in financial statements. 616
Why mighta trading strategy basedon an analysis of sustainable earnings work? Well
Figure 17.3 gives a clue.If investors as a whole are not perceptive aboutearnings quality:
they will be surprised whenthesubsequent RNOA are reported. Butthe competent quality
analystwillhavetakena position in stocks to benefit fromthatsurprise.
Summary
An~l)'sis ofrk
AnalysisTools
Page Key Measures
Five questions aboutquality

Prelude to quality analysis
Diagnostics to detect
manipulated accounting:
Sales
Core expenses
Unusual items
Diagnostics to detect
transaction timing:
Core revenue timing
Core expense timing
Other core income timing
Unusual income timing
Organizational
manipulation
609
614
619
621
627
629
630
631
631
631
Page
Acronymsto Remember
ATO asset turnover

eFO cash flow fromoperations
ebit earnings before interest and
619
taxes
ebitda earnings before interest,
619
amortization
619 FIFO first in,firstout
liabilities
620 IPO initial public offering
Bad-debt ratios
620 LIFO last in, firstout
Warranty expense ratios
621 NOA netoperating assets
Normalized OVal
621 01 operating income
Change in asset turnover
623 PM profit margin
Adjusted ebitda/ebit
Depreciation/Capital
623 RNOA return on netoperating
expenditures
assets
Cash flow from
624 SEC U.S. Securities and Exchange
operations/Ol
Commission
Cash flow from
operations/Average NOA 624 5G&A selling, general, and
administrative (expenses)
Expense accrual diagnostics 625
Effective tax rateon
626
operations
630
R&D expense/Sales
Advertising expense/Sales 630
633
Composite quality score
Diagnostics
Netsales/Cash from sales
NetsaleslNet accounts
receivable
Netsales/Unearned
revenue
NetsaleSlWarranty
619
Chapter 17 AnalYlil of theQlwlityof Financillj Srmememl 639
638 Part Four ACCOll1l1ing Analysil andVa!lI.(lIion
Concept
Questions
CI7.1. A firm cancreate future income bytemporarily increasing itsbaddebtallowance.

Is thiscorrect?
C17.2. Low depreciation charges forecast losses in future income statements. Is this
correct?
CI7.3. A decrease in warranty liabilities increases net sales. Is thiscorrect?
C17.4. Increasing profit margins by underestimating expenses creates net operating
assets. Is thiscorrect?
C17.5. Why is a change intheassetturnover anindicator of future profitability?
C17.6. Why do analysts compare cashflow from operations with earnings to assess the
quality of theearnings?
CI7.7. Why should an analyst view a large merger charge suspiciously?
C17.8. Why should an analyst view an increase in deferred taxes from bad debt
allowances suspiciously?
CI7.9. IBM reported a 3 percent increase in income for itsfirst quarter of 2000, beating
analysts' estimates. But it also reported a decline in revenue. Its stock price
dropped in response to the report.
What explanations would yougive forthe dropin stockpriceon an earnings
increase?
What is your prediction for the change in IBM's asset turnover over the
quarter?
CI7.IO. Excite signed a pactwithNetscape in 1999 underwhich it paid$86.1 million to
sharerevenues from co-branded search-and-directory services. It wrote off twothirds ofthe cost-cor $56.8 million-against income immediately.
Analysts objected. Why should they?
C17.11. Shares of Pitney Bowes dropped 10 percent after it announced earnings per
sharefromcontinuing operations of $0.70 forits September quarterof 1999, up
from $0.49 in the same quarter in the year before. Revenues also increased
8 percent.
Analysts raised concerns about thequality of theearnings, citing a decrease in
the fum's effective tax rate. Why might the effective tax rate be of concern
to analysts?
C17.12. If yousawa deferred tax liability from depreciation increase significantly overa
year, what might youconclude?
C17.l3. A firm has a capital expenditure-to-depreciation ratio of 1.6 overthree years.
What might youinferfrom thisratio?
C17.14. Some firms suggest that investors focus on "pro forma" earnings rather than reportedearnings. Theirproforma earnings usually exclude amortizations of goodwill andshares oflossesin subsidiaries. Is thisgood advice?
CI7.l5. In July 1999, Federal Reserve Chairman Alan Greenspan stated that corporate
profits intheUnited States were understated, particularly in thetechnology sector.
Towhat do youthink hewasreferring?
C17.16. The realization principle, which recognizes revenues at pointof sale,is saidto be
an accounting principle thatimproves thequality of reporting. Companies cannot
estimate theirfuture revenues; rather they must have a firm customer before they
can recognize revenue. Do you see the realization principle as a desirable
accounting principle?
C17.17. Matching costs to revenue-the matching principle-c-is seenas producing "good
quality" earnings numbers. Why?
Drill Exercises
Exercises
E17.1.
Following the Trail: Identifying Hardand Soft Components of Income (Easy)

A firmreported after-tax operating income of$1,298 million. Freecashflow of$234 millionwascalcualted from the cashflow statement.
a. Identify the "hard"and"soft"components of the income.
b. Thefreecashflow is after$687million in cashinvestments. Whatwere theoperating
accruals for the year?
E17.2.
Income Shifting and Net Operating Assets (Easy)

The chieffinancial officer of a firm presented the CEO with a set of financial statements
showing $2,234 million in after-tax operating income. This number yielded a return on
beginning-of-period netoperating assets of9 percent. TheCEO complained thatthisnumber was below the 12percent RNOA target they hadpromised andasked if any"accountingtricks"were available to meetthe target.
a. How much musttheCFOaddto net operating assets to manipulate theincome?
b. What is thelikely effect of theearnings management on RNOA in thefollowing year?
E17.3.
Following the Trail to the Balance Sheet(Medium)

Indicate which items inthebalance sheetcanbe altered to implement the following earningsmanagement:
a. Increase grossrevenues (before allowances).
b. Reduce bad debtexpense.
c. Reduce depreciation.
d. Lower selling expenses.
e. Reduce software expenses.
E17.4.
Interpretation of Diagnostics (Easy)

The following listsa number of ratios against the average for the ratiooverthe prior three
years. Foreach,indicate whether the ratiosuggests thatreturn on net operating assets will
be higher or lower inthe following year.
Ratio
Bad debtexpense/Sales
Warranty expense/Sales
Net sales/Accounts receivable
mveotory/Sales
Depreciation/Capital expenditure
Deferred revenue/Sales
E17.S.
Current level
Average, PriorThree Years
2.34percent
3.59 percent
4.12percent
2.30percent
5.88
0.12
7.34
0.23
1.3
0.9
15
0.25
Normalized Asset Turnover (Medium)
A firm reported after-tax operating income of$136 million, up from S120 million theyear
before, ona salesincrease from $5,106 million to $5,751 million. Net operating assets increased from $2,321 million to $2,614 million. Thefinn'saverage assetturnover during the
priorthree years hadbeen2.2.
Calculate freecashflow fortheyearandnormalized operating income fortheyear. What
doyourcalculations indicate about the quality of the$136 million in operating income?
E17.G.
Change in Asset Turnover and Earnings Quality(Medium)

An analyst finds that,fora finn reporting a returnonnetoperating assets of 19percent, the
assetturnover haddeclined from 2.2to 1.9.

a. Calculate theprofit margin for the year.
b. What doesthedecrease in theassettumovertell youabout thelikelihood ofthe19percentRt"4"OA being maintained inthe future?
640 Part Four ACCOlln!ing Annlysis and Vnlllmioll
E17.7.
Chapter 17 Annl)'si, of !h~ Qllalil)' of Finnncia! SWICmentS 641
Red Flags in the Cash FlowStatement (Medium)
b. Exhibit 17.1 also gives the cash from operations section of Microsoft's cash flow
statement for the samequarter. Microsoft reported revenues of $5.384 billion in the
quarter to September 30,1999, and $4.193 billion for the corresponding quarter for
Identify the quality red flags for 2009 in the following portion of a cashflow statement.
Revenues for2009 declined from $456million in 2008 to $401 million.
1998.
In Millions
2009
2008
Netincome
Depreciation
Change in accounts receivable, net
Change in accrued expenses
Change in deferred revenue
Change in estimate of restructuring charge
Cash flow from operating activities
$36.5
46.0
$28.3
63.0
12.2
( 5.2)
123
(33.3)
12.4
(22.5)
Doesit appear thatthe SEC's concerns were justified inthe 1999 period?

See ExercisesE1.6, E4.14. E6.13, E7.7, E8.10, ElO.11. and E19.4
(22.0)
17.1
Cash in investing activities:

Capital expenditure
$61.0
$58.0
EXHIBIT 17,1
MICROSOFT CORPORATiON
PartialBalance Sheets
(in millions)
Applications
E17.8. The Quality of Revenues: Bausch & Lomb (Easy)
Bausch and Lomb, Inc., the optical products company, reported the following salesand
receivables from 1990 to 1993 (in millions of dollars):
Netsales
Trade receivables, less allowances
1990
1991
1992
1993
1,368.6
203.0
1.520.1
2053
1,709.1
2773
1,872.2
385.0
Sept. 30, 1999
June 30, 1999
$ 997
313
1,136
4,129
1,757
$8,332
$ 874
396
1,607
4.239
1,602
$8,718
Current liabilities
Accounts payable
Unearned revenue
Other
PartialCashFlowStatements
Subsequently it wasdiscovered that the finn hadbooked revenues incorrectly, andthe

SEC investigated. Do the numbers here raiseconcerns about the quality of the reported
revenues?
(in millions)
Three MonthsEnded
September 30
E17.9. The Quality of Gross Margins: Vitesse Semiconductor Corp.(Easy)

Vitesse Semiconductor reported thefollowing revenues andcostofgoods soldfar200 1-2003
(inthousands):
Revenues
Costof revenues
2003
2002
2001
$156,371
73,163
$151,738
110,155
$383,905
201,536
Operations
Netincome
Depreciation
Gains insales
Unearned revenue
Recognition of unearned revenue from prior periods
Other current liabilities
Accounts receivable
Net cash from operations
Calculate thegrossmargin ratio (gross margin/sales) foreachyear. In 2001 the firm tooka
charge forobsolete inventory of$46.5million and, in2002,another $30.5 million. Explain
how these charges affect the grossmargin ratioin eachof thethreeyears.
E17,10.
1999
1998
$2,191
440
(156)
1,253
(1,363)
(345)
64
(94)
$1,990
$1,683
179
(160)
1,010
(765)
360
341
(64)
$2,584
The SEC and Microsoft(Easy)

a. In 1999, Microsoft Corporation announced that the Securities and Exchange
Commission (SEC) wasinvestigating someof its accounting practices. Exhibit 17.1
presents the current liability section of Microsoft's comparative balance sheet at the
end of the first quarterof its 2000 fiscal year. Can you see a reason for the SEC's
concern?
E17,11.
Spot the Red Flags in a Cash FlowStatement:

EDS and Cerner Corporation (Medium)
Below are portions of the cash flow statements for Electronic Data Systems (EDS) and
CemerCorporation. Spotthered flags.
642 Part Four Accounting Andysi5 and Vrtltlluioll
Chapter 17 Analysis of lhe Qtlaliry of Financial $!atcmCI1rS 643
ElEaRONlC DATA SYSTEMS AND SUBSIDIARIES

{in millions)
CERNER CORPORATION
(in thousands)
Years EndedDecember31,
Six MonthsEnded
Cash flows from investing activities:

Purchase of capital equipment
Purchase of land, buildings,
andimprovements
Acquisition of business
Investment ininvestee companies
Proceeds from sale ofavailable-far-sale securities
Issuance of notes receivable
Repayment of notes receivable
Capitalized software development costs
Net cash provided by (used in) investing activities
Six Months Ended
Cashflows from operating activities:

Net earnings (loss)
Adjustments to reconcile netearnings (loss)
to net cash provided byoperating activities:
Common stock received as consideration for
saleof license software
Write-off of goodwill impairment
Gain on sale of investment
Realized loss on sale ofstock
Write-down of investment
Gain on software license settlement
Non-employee stock option
compensation expense
Equity inlosses of affiliates
Provision fordeferred income taxes
Changes inassets andliabilities
(netof business acquired);
Receivables, net
Inventory
Prepaid expenses andother
Accounts payable
Accrued income taxes
Deferred revenue
Other accrued liabilities
Total adjustments
June 29,
June 30,
2002
2001
$ 24,310
1 (62,655)
27,168
June 29,
June 30,
2002
2001
(21,493)
(8,150)
(5,484)
(13,429)
(4,356)
(1,292)
1,572
(100)
89
(18,179)
(30,416)
90,119
(22,915)
26,798
E17.12. Tracking Changes in Net Operating Assets and the Asset Turnover:
Regina Company (Medium)
(Based on an analysis by Patricia Fairfield, Georgetown University)
The Regina Company once marketed a successful line of vacuum cleaners, but then ran
intotrouble and failed As youcansee from the income statements below, the firm haddramaticsalesgrowthduringthe 1980s.
Usingthe income statements and balancesheets below, track operating income (after
tax), free cash flow, changes in net operating assets, and asset turnovers overthe period.
Use a tax rateof39 percent.
a. For 1988, calculate normalized operating income. What does this number tell you
aboutthe earnings qualityin 19887
b. Whatdothechanges inassetturnover tellyouaboutearnings quality ineachoftheyears?
c. Whatdetailin the statements raisesfurtherredflags?
23,580
(750)
REGINA COMPANY
1,272
(4,308)
385
127,616
(7,580)
34
(29,627)
(28,817)
(1,406)
(4,400)
4,895
35,413
(12,641)
(3,443)
(15,860)
8,450
56
1,093
(44,801)
(4,582)
1,166
(5,601)
6,644
5,958
(8,304)
1,160
96,040
33,385
ComparativeStatement of Income
1985--1988
(in thousands)
Year EndedJune 30
Net sales
Operating costs andexpenses
Cost of goods sold
Selling, distribution, andadministration
Advertising
Total operating costs
Operating income
Interest expense
Income taxexpense
Net income
1985
1986
1987
1988
167,654
176,144
$128,234
1181,123
43,988
9,121
9,416
673
63,198
$ 4,456
2,930
1 1,526
405
46,213
10,366
8,557
1,182
66,318
1 9,826
1,930
1 7,896
3,807
4,089
70,756
14,621
26,449
1,530
113,356
$ 14,878
1,584
$ 13,294
6,189
1 7,105
94,934
21,870
39,992
2,423
159,219
1 21,904
3,189
$ 18,715
$1,TIT
...-Z.1..l
s 10,954
(continued)
Chapter 17
644 Part Four ACCOllllfing Analysis and Valllalion

(col/cluded)
Comparative Balance Sheet
Anal)'sis of lheQIWlil)' ofFil1~flciaJ Sralemem,
2000
1984-1988
645
1999
(in thousands)
(in thousands)
Year Ended June 30

1984
Assets
Current assets:
Cash
5 328
8,551
Inventory
11,109
Other
6
$19,994
Property, plant, and equipment cost 17,219
Less accumulated depreciation
0
Other assets
1,118
Total assets
$38,331
liabilities and Stockholders'Equity
s 7,500
Current portion of term loan
1,400
Accounts payable
3,082
Accrued liabilities
3,800
2,349
$18,131
Long-term debt:
Term loan
12,600
Industrial revenue bonds
0
Subordinated note
5,000
Bank debt
0
Mississippi statedebt
0
Total long-term debt
$17,600
0
1
Common stock, $.0001 parvalue
1,100
Common stock purchase warrant
1,499
Retained earnings
0
Less: treasury stock, cost
0
$ 2,600
Total liabilities and
$38,331
1985
1986
1987
1988
36 I
63 5 514 5
885
11,719
14,402 27,801
51,076
9,762
19,577
39,135
6,325
708
1,449
475
3,015
$18,555 $24,935 $49,341 I 94,111
18,486
19,523
19,736
27,884
(4,948)
(6,336)
(1,304) (3,140)
1,775
1,884
1,112
2,481
$37,513 $43,202 $65,241 $118,140
5
s 3,732
1,400
4,724
3,091
1,145
$14,092
0 $
0
$ 2,707 $
0
900
1,250
7,344
15,072
13,288
5,468
4,710
3,127
1,554
2,619
3,782
$14,732 $24,059
23,030
0
14,800
5,000
0
0
$19,800
118
0
14,800
0
0
0
$14,800
685
0
13,900
0
5,941
0
$19,841
1,254
0
12,650
0
47,432
1,975
$62,057
1,881
1
1
1
1
1,100
0
0
0
8,Q10
8,149
8,018
1,473
5,210
12,315
23,269
1,121
(192)
(236)
(247)
(247)
$ 3,503 $12,985 $20,087 $ 31,112
$37,513 $43,202 $65,241 $118,140
E17.13. Quality Diagnostics: Gateway, Inc. (Medium)

Gateway, the computer manufacturer, wasa fast-growing company during the 1990s, with
continual revenue and earnings growth, bringing admiration from analysts. However, in
2000 revenue growth slowed, from$8,965 million in 1999 to only$9,601 million, despite
the opening of over800 newretail outlets. Operating income was down, at $231 million
(aftertax) compared with $403 million in 1999. The finn trumpeted its retail expansion,
which pleased analysts, andthe stockremained around $60.However, in 2001,a torpedo
struck: The firm took a restructuring charge of $876 million and reported an after-tax
operating lossof 5983million. Thestock dropped to $20.
Below are some numbers reported in Gateway's 2000 lO-K filing. Go through these
numbers and develop diagnostics that point to a quality of earnings issue that might.
forecast thatearnings in2001 would be degraded.
E17.14,
A Financial Statement Restatement: Sunbeam (Hard)

By the mid-1990s, Sunbeam Corporation, the oncecelebrated household appliance manufacturer, wasreporting lackluster salesandlosses. Newmanagement, engaged in 1996 totum
thecompany around, implemented amajorrestructuring andtrumpeted higher sales andprofitability. Thefirm's stockprice rose50percent over1997 asresults confirmed thepredictions.
In 1998, the firm restated its annual reports for 1996 and 1997 with the following
introduction:
Subsequent totheissuance oftheCompany's Consolidated Financial Statements forthe
fiscal years ended December 28,1997, and December 29,1996, it was determined that the
reported results generally inflated 1997 results at theexpense of 1996 results.
Thefinn'sstockpricedropped from $50 to $~O aftertheannouncement of the
restatement.
\
Partof the restatement had to do with improperly recognized sales. Netsalesfor 1997
were restated from $1.168 billion down to $1.073 billion but those for 1996 were unchanged. Expenses in both years were affected, however. Exhibits 17.2 and 17.3 are the
original and restated cash flow from operations. What were the aspects of the original
reports that hadtobe restated?
646 Part
Four
Accounring Anal)'sis ana Valll1tion
EXHIBIT 17.2
From Original Cash
FlowStatement
(inMillions)
EXHIBIT 17.3
From Restated Cash
Flow Statement
Chapter 17
E17.15,
SUNBEAM CORPORATION
Net earnings (loss)
Adjustments to reconcile netearnings (loss)
to netcash provided by(used in)
operating activities
Restructuring, impairment, andothercosts
Other noncash special charges
Loss on sale of discontinued operations, netof taxes
Increase (decrease) incash from changes inworking
capital
Receivables, net
Inventories
Accounts payable
Restructuring accrual
and liabilities
Payment of otherlong-term and nonoperating liabilities
Other, net
Net cash provided by{used in} operating activities
1997
1996
$109,415
$(228,262)
38,577
47,429
154,869
128,800
32,430
(77,828)
13,713
57,783
(84,576)
(100,810)
(1,585)
(43,378)
(13,829)
(11,651)
14,735
(9,004)
52,844
(14,682)
(26,546)
$ (8,249)
2,737
(21,942)
(27,089)
13,764
$ 14,153
SUNBEAM CORPORATION
(inMillions)
Operatingactivities
Net earnings (loss)
Adjustments to reconcile net earnings (loss) to netcash
(used in) provided byoperating activities
Restructuring andassetimpairment (benefits) charges
Other noncash special charges
Loss on sale of discontinued operations, netof taxes
Increase (decrease) incash from changes inoperating
assets and liabilities from continuing operations
Receivables, net
Proceeds from accounts receivable securitization
Inventories
Accounts payable
Restructuring accrual
Prepaid expenses andothercurrent assets and liabilities
Payment of otherlong-term and nonoperating liabilities
Other, net
Netcash (used in) provided byoperating activities
Restated
Restated
1997
1996
$ 38,301
$(208,481)
39.757
(14,582)
47,429
110,122
70,847
39,140
(69,206)
14,017
38,824
(57,843)
58,887
(140,555)
4,261
(31,957)
(16,092)
52,052
(1,401)
10,288
s (6,043)
(845)
11,289
11,029
39,657
(21,942)
(27,089)
12,213
$ 14,163
AnalY5is of tho; QlIll!itJ ofFirumcial Statemen<s 647
StockMarketReactions to Earnings Announcements:

Eastman Kodak and Intel (Medium)
ForitsSeptember quarterof 1998, Eastman Kodak, theimaging products manufacturer, reporteda netprofitof $398million, up 72 percent fromoneyearearlier andin linewithanalysts'expectations. However, when it wasalsorevealed thatitssaleshadfallen 10percent
to $3.4billion, its stockpricedropped 13percent.
For the same quarter, Intel, the world's biggestcomputer chip manufacturer, reported
that its netincome of $1.6billionwasmuchthe sameas a yearearlier, butsalesrose9 percentto $6.7billion. Its stockpriceincreased by 8 percent aftertheannouncement.
a. Calculate thechanges in the netprofit margins in the September 1999 quarterover the
quarter for theyearearlierforbothfirms. Why would thepricereaction be so different
to thetwoearnings announcements?
b. Below is the cash flow from operations section of Eastman Kodak's cash flow statements forthe first three quarters of 1998 and 1997. Saleswere$9.843 billion for the
firstthreequarters of 1998 and$10.759 billionfor thecorresponding period for ]997.
Dothese statements provide any information aboutearnings quality?
EASTMAN KODAK
PartialCashFlow Statements
ThreeQuarters
Cashflows from operating activities
Net earnings
Adjustments to reconcile above earnings to
net cash provided by operating activities,
excluding the effect of initial consolidation
of acquired companies
Purchased research anddevelopment
Deferred taxes
(Gain) loss on sale or retirement of businesses,
investments, and properties
Increase in receivables
Decrease in liabilities excluding borrowings
Other items, net
Total adjustments
Net cash provided byoperating activities
1998
1997
1,118
749
619
(63)
(107)
(216)
(334)
(553)
(26)
(680)
438
600
186
(76)
1
(57)
(156)
(285)
Jm
116
865
648 Part Four Accmmling Allal:>'sis and Valllatioll
Chapter 17 AnalJsi.l of lheQua1itJ ofFinandal S(Q.!emencs

Partial cashFlow Statements
(in millions)
EXHIBIT 17.4
Minicases
M17.1
(collcluded)
YearEnded December 31
A Quality Analysis: Xerox Corporation
1999
Xerox Corporation is a long-established company whose very namehas been lent to the
process of copying documents. Thefirm develops copying technology through an extensive
research program and manufactures and markets a large range of document processing
products. Many of its salesare made withleasefinancing arrangements through its Xerox
CreditCorporation in the United Statesand through other subsidiaries worldwide. The
firm's traditional blackand whitelenscopiers (which provided 40 percent of revenues in
1999) wereunderchallenge in the late 1990s from newdigital technology, and Xerox developed digital copiers, printers, and production publishers in response.
Xerox initiated a majorrestructuring of its operations in ! 998,andthe implementation of
therestructuring caused somedifficulties in thefield. In 1999, totalrevenues of$19.2billion
were down 1percent from $19.4billion in 1998. Anannouncement thatrevenues would not
meetexpectations in October 1999 resulted in a 24 percent sharepricedrop. During 1999
Xerox's sharepricedropped from $59to$24.However, income from continuing operations
forthefull1999 year, ending December 31,was$1.43 billion, upfrom $585 million in ! 998.
Xerox's income statements for1997, 1998, and1999 arereproduced inExhibit 17.4, along
withsections of itscashflow statements. Alsogiven areextracts from the 1999 footnotes.
EXHIBIT 17.4
XEROX CORP.
Income Statements
(in millions, except per-share data)
Year EndedDecember 31
Revenues
Sales
Service and rentals
Finance income
Total revenues
Costsand expenses
Cost of sales
Cost of service and rentals
Inventory charges
Equipment financing interest
Research anddevelopment expenses
Selling, administrative, andgeneral expenses
Restructuring charge andassetimpairments
Other, net
Total costs andexpenses
Income before income taxes, equity income,
and minority interests
Income taxes
Equity in net income of unconsolidated affiliates
Minority interests inearnings ofsubsidiaries
Net income
1999
1998
1997
$10,346
7.856
1.026
19,228
$10.696
7.678
1,073
19.447
$ 9.881
7,257
5,744
4,481
0
547
979
5.144
0
5.662
4,205
5.330
3.778
0
520
-12Z
17,192
2,036
631
68
~
1,424
_ _0
$ 1424
113
570
1.040
5,321
1,531
18,684
763
207
74
_ _4_5
585
---.U2Q2
$
395
649
1,006
18.144
1,065
5,212
0
~
16,003
2,141
728
127
~
1,452
_ _0
$ 1452
Cashflows from operating activities

$1,424
Adjustments required to reconcile income to
cash flows from operating activities
935
Provision fordoubtful accounts
359
Restructuring charge and othercharges
0
Provision forpostretirement medical benefits.
41
netof payments
Cash charges against 1998 restructuring reserve
(437)
Minorities' interests inearnings of subsidiaries
49
Undistributed equity in income of affiliated companies
(68)
Decrease (increase) in inventories
68
Increase inon-lease equipment
(401)
Increase infinance receivables
(1,788)
Proceeds from securization offinance receivables
1,495
(94)
(Decrease) increase inaccounts payable and
accrued compensation and benefit costs
(94)
Net change inothercurrent and noncurrent
liabilities
277
Change incurrent anddeferred income taxes
(78)
Other, net
(464)
Total
~
Cashflows from investing activities
Costof additions to land, buildings, andequipment
(594)
Proceeds from sales of land, buildings,
andequipment
99
Acquisitions, netof cash acquired
(107)
Other, net
--.illl
Total
$ (627)
1998
1997
$ 585
$ 1,452
821
301
1,644
33
739
265
0
29
(332)
45
(27)
(558)
(473)
(2.169)
0
(540)
127
(192)
67
(497)
(1,165)
0
88
(84)
(170)
(347)
(1.629)
0
(188)
250
361
83
~
472
(566)
(520)
74
(380)
5
$ (867)
36
(812)
45
$(1.251)
Peruse thestatements andfootnotes. Whatquestions arise aboutthequality of theeamingsreported in 1998 and 1999?
Extracts from Footnotes

The following footnote extracts referto 1999. Dollaramounts arein millions.
2 Restructuring
In 1998, weannounced a worldwide restructuring program intended toenhance our competilive position and lower ouroverall cost structure. Inconnection with this program, we
recorded apretax provision of$I,644. The program includes the elimination ofapproximately 9,000 jobs, net, worldwide, the closing and consolidation offacilities, and the writedown ofcertain assets. The charges associated with this restructuring program include $113
ofinvenlory charges recorded ascost ofrevenues and $3J6ofasset impairments. Included in
650 Part Four Accounting ATI<1I)'lil ana Valuanon
Chapter 17 Anal)'sil of die Quality of FilUlncial Sta!tlllenll 651
theasset impairment charge is facility fixed assetwrite-downs of$156andotherassetwritedowns of$160.Key initiatives of therestructuring include:
1. Consolidating 56European customer support centers into onefacility andimplementing a

shared services organization forback-office operations.
2. Streamlining manufacturing, logistics, distribution, andservice operations. Thiswillinclude centralizing U.S. partsdepots andoutsourcing storage anddistribution.
3. Overhauling ourinternal processes andassociated resources, including closing oneof
four geographically organized U.S. customer administrative centers.
Thereductions areoccurring primarily inadministrative functions, butalsoimpact service,
research, and manufacturing.
Thefollowing tablesummarizes thestatus of therestructuring reserve (inmillions):
Total
Reserve
Severance and related costs
Assetimpairment
Lease cancellation and other costs
Inventory charges
Total
$1,017
316
198
113
$1,644
Charges
against
Reserve
717
316
104
113
$1,250
12/31/99
Balance
$300
0
94
0
$394
5 FinanceReceivables, Net
Finance receivables result from installment sales andsales-type leases arising from the
marketing of ourbusiness equipment products. These receivables generally mature overtwo
to five years andaretypically collateralized bya security interest in theunderlying assets.
Thecomponents of finance receivables, netat December 31, 1999, 1998, and1997 follow:
Gross receivables
Unearned income
Unguaranteed residual values
Allowance for doubtfulaccounts
Finance receivables, net
Less currentportion
Amounts due after one year, net
1999
1998
1997
$14,666
(1,677)
752
$16,139
(2,084)
699
~
14,313
$14,094
(1,909)
557
~
12,353
~
$ 9,093
4,599
~
13,318
~
$ 8,203
Thecomponents of inventories at December 3J, 1999, 1998, and1997 follow:

1999
1998
1997
$1,800
122
363
$1,923
111
464
$1,549
97
-ill
-.ZZ.1
~
$2,792
$2,961
$3,269
Investments in corporate joint ventures andothercompanies in which wegenerally have a

20to 50 percent ownership interest at December 31, 1999, 1998, and 1997 follow:
Fuji Xerox
Otherinvestments
Investments in affiliates, at equity
406
1999
1998
1997
$1,513
$1,354
102
$1,456
$1,231
101
$1,332
~
$1,615
Xerox Limited owns 50 percent of the outstanding stock of Fuji Xerox, a corporate joint
venture with FujiPhoto Film Co.Ltd. (Fuji Photo). Fuji Xerox is headquartered inTokyo and
operates in Japan andotherareas of thePacific Rim, Australia, andNew Zealand, except for
China. Condensed financial dataof FujiXerox foritslastthree fiscal years follow:
Summary of operations
Revenues
Costsand expenses
Income taxes
Netincome
Balancesheet data
Assets
Current assets
Noncurrent assets
Total assets
liabilities and shareholders' equity
Current liabilities
Long-term debt
Ictalliabilities and shareholders' equity
1999
1998
1997
$7,751
7,440
311
201
$6,809
303
195
$ 108
$7,415
6,882
533
295
$ 238
$3,521
3,521
$7,042
$2,760
$2,461
$2,951
169
1,079
2,843
$7,042
6,506
U!.Q
3,519
2,942
$6,279
$5,403
$2,628
101
1,028
2,522
$6,279
$2,218
286
679
2,220
$5,403
8 Segment Reporting
Ourreportable segments areasfollows: Core Business, Fuj iXerox, Paper and Media, andOther.
Document ProcessingSegments
$ 7.754
6 Inventories
Finished goods
Workin process
Raw materials
Equipment on operating leases, net
Inventories
7 Investments in Affiliates, at Equity
1999
Information about profitor loss
Revenues from external customers
Finance income
Intercompany revenues
Total segment revenues

Interest expense
Segmentprofit(loss)
Earnings of nonconsolidated affiliates
Information about assets
Investments in nonconsolidated affiliates
Total assets
Core
Business
Fuji
Xerox
Paper
and Media
Other
$15,224
1,016
0
0
_ _0
$1,148
0
0
1,148
$1,830
10
206
2,046
~
16,034
930
803
2,014
13
102
25,319
580
0
55
0
0
62
0
1,513
1,513
0
0
86
0
5
0
(40)
0
0
1,896
14
652 Part Four Accollming Al1Nysh andValllmian
Chapter 17 Analysis oj rhe Quality ojFiJUlncial Statements 653
M17.2
The components of deferred tax assetsand liabilities at September 30, 1999, and 1998
are as follows:
A Quality Analysis: Lucent Technologies
September 30
Lucent Technologies, Inc.,was formed fromAT&T's BellLaboratories research organization afterthe breakup of AT&T intothe BabyBells.Lucent designs, develops, and manufactures communication systems, supplying these systems to mostof the world's telecom
operators forboth wiredand wireless services for voice, data,and videodelivery. In 1999
Lucentreponed$38.301 billionin revenues, against31.806 billion in 1998and $27.61 1
billionin 1997.
Analysts have complained about the quality of Lucent's reported earnings over the
years.
A. Whatquestions arise regarding the quality of Lucent's earnings for 1997, 1998, and
1999 from the partialcashflow statements in Exhibit J7.5?
DeferredIncome Tax Assets

Employee pensions and otherbenefits-net
Business restructuring
Reserves and allowances
Netoperating loss/credit carrytorwards
Valuation allowance
Other
Total deferred taxassets
Deferred income taxliabilities
Other
Ictal deferred taxliabilities
1999
1998
1997
$ 442
6
1,009
226
(179)
344
$1,848
$1,520
165
(261)
526
$3,326
$1,777
112
887
107
(234)
664
$3,313
$ 628
511
$1,139
$ 399
391
790
$ 478
240
$ 718
1,137
239
C. Lucentreported effective tax rates of 33.9 percent in 1999,35.3 percent in 1998, and
36.8percent1997. Do theseratesraisequalityquestions?
EXHIBIT 17.5
D. Lookat the footnote for the pension costthatfollows. Doesthis noterevise yourassessmentas to the quality of earnings reported from 1997to 1999?
PartialConsolidated Statements of Cash Flows

(dollars in millions)
YearEndedSeptember 30
1999
Net income
Adjustments to reconcile net income to net
cash (used in) provided byoperating activities,
net of effects from acquisitions of businesses
Cumulative effect of accounting change
Business restructuring reversal
Asset impairment and othercharges
Provision for uncollectibles
Tax benefit from stock options
Purchased in-process research and development
Adjustment to conform Ascend and Kenan's fiscal years
Increase in receivables-net
Increase ininventories and contracts in process
Increase (decrease) inaccounts payable
Changes inotheroperating assets and liabilities
Other adjustments for noncash items-net
Net cash(used in) provided by operating activities
$4,766
(1,308)
(141)
236
1,806
75
367
1,026
15
169
(3,183)
(1,612)
668
(2,320)
(840)
$ (276)
1998
$1,035
(100)
1,411
149
271
56
1.683
(2,161)
(403)
231
155
...-B.0
$1,860
Componentsof Net PeriodicBenefitCost
1997
$ 449
(201)
81
1,499
136
88
(21)
1,255
(484)
(316)
(18)
(397)
58
$2,129
B. Howdo deferred tax footnotes helpin ascertaining the quality of the accounting? Does
the note below (fromthe 1999 report) raiseanyquality questions?
1999
Pension cost
Service cost
Interest coston projected benefit obligation
Amortization of unrecognized prior service cost
Amortization of transition asset
Amortization of net loss
Charges forplan curtailments
Net pension credit
Postretirementcost
Service cost
Interest coston accumulated benefit obligation
Amortization of unrecognized prior service cost
Amortization of net loss {gain)
Charges forplancurtailments
Net postretirement benefit cost
Pensionand postretirement benefits
Weighted-average assumptions as of September 30
Discount rate
Expected return on planassets
Rate of compensation increase
509
1,671
(2,957)
461
(300)
2
1998
1997
$ 331
1,631
(2,384)
164
(300)
$ 312
$ (614)
$ (558)
$ 63
80
537
(308)
53
6
368
540
(263)
53
3
__
0
$ 396
7.25%
9.0%
6.0%
9.0%
4.5%
4.5%
1,604
(2,150)
149
(300)
56
$ (329)
654 Part Four
A"OImfill~ AM!~sis
andVahUl!iull
Effective October I, 1998, Lucent changed its method for calculating themarket-related
valueof planassets usedin determining theexpected return-on-asset component of annual
netpension and postretirement benefit cost.Undertheprevious accounting method, the
calculation of the market-related valueof planassets included onlyinterest anddividends
immediately, whileall otherrealized andunrealized gainsand losses were amortized on a
straight-line basisovera five-year period. The newmethod usedto calculate market-related
valueincludes immediately an amount based on Lucent's historical assetreturnsandamortizesthedifference between thatamount andtheactual return on a straight-line basisover
a five-year period. The newmethod is preferable under Statement of Financial Accounting
Standards No.87 because it results incalculated planassetvaluesthatare closer to current
fair value, thereby lessening theaccumulation of unrecognized gainsandlosseswhilestill
mitigating theeffects of annual market valuefluctuations.
Thecumulative effectof thisaccounting change related to periods priorto fiscal year
1999 of$2, 150($1,308 after-tax, or $0.43 and$0.42 per basicand diluted share, respectively) is a one-time, noncash credittofiscal 1999 earnings. Thisaccounting change also
resulted in a reduction in benefit costsin theyearended September 30, 1999, thatincreased
income byS427($260 after-tax, or SO.09 and SO.08 per basic and diluted share, respectively)
as compared withthe previous accounting method. Acomparison of pro forma amounts
below showstheeffects if theaccounting change were applied retroactively:
Proforma net income
Earnings per share-ebaslc
Earnings pershare-ediluted
1998
1997
$1,276.00
$
0,43
$
0.42
$657.00
0.23
$ 0.22
Chapter 18 The Anal;rsis of Eqt<i!] Risk <lnd Relllm 659
Afterreading thischapter you should understand:
'nalysis of Equity
The difference between the required return and the

expected return.
That precise measures of thecost of capital are difficult
to calculate.
Whatrisk is.
.eturn
Howdiversification reduces rsk.

Problems with using the standard capital asset pricing
mode! andotherbeta technologies.
The determinants of fundamental risk.
Link!(I previous chapters
The difference between fundamental risk andprice risk.

Chapter3 (and its
appendix) reviewed
standard belatechnologies
to measure theCOS! of
capital.Chapter13
distinguished operating risk
and financing risk.
Plot a distribution of return outcomes, likethose forthe

S&P SOD.
Analyze a firm's risk drivers.
Generate a value-at-risk profile.
Incorporate value-at-risk analysis instrategy formulation.
Howbusiness investment can yield extreme (high and

low)returns.
LINKS
Afterreading thischapter youshould beable to:
How fundamental analysis protects against price risk.

How pro forma analysis can be adapted to prepare
value-at-risk profiles.
Calculate afundamental beta (atleast inbroad outline).

Deal with the uncertainty about the required return.
Apply valce-at-rsk profiles to evaluate implied expected returns estimated with reverse engineering.
Assign firms to a risk class.
Carry out pairs trading.
Engage in relative value investing.
Invest with a margin of safety.
Howfundamentals help to measure betas.

Howthe investor finesses theproblem of not knowing
the required return.
Howto besensitive to therisk associated with qrowth.
This chapter
This chapteranalyzes the
fundamental determinants
of operating and financing
riskinequityinvestingh
also introduces pricerisk
andoutlineswaysto
incorporate risk when
valuing firmsandtrading
in theirshares.
Howis risk
incorporated in
valuation?
investment returns andmarket returns, and riskpremiums aredefined interms of expected

returns. Typically betasandriskpremiums aremeasured from paststockreturns. However,
risk, likereturn, isdriven bythefundamentals ofthe finn,thetypeofbusiness itis engaged
in,and its leverage; in short,a firm's operating and financing activities determine its risk.
Thischapter analyzes thefundamentals thatdetermine risk, sothatyoucanunderstand why
onefirm would have a higher required return thananother.
THE REQUIRED RETURN AND THE EXPEGED RETURN

Chapter19analyzes the
risk of firms' debt.
Linkto Webpage
Go to the text Websile at
www.mhhe.comlpenman4e
forfurther discussion
of risk.
Valuation involves bothriskandexpected return, so wehave referred toriskat many points

in this text. Risk determines an investor's required return, and expected payoffs must
cover the required return before an investment canbe saidto add value. As the bookhas
proceeded, we haveseenthat to value investments and to measure value added, expected
payoffs mustbe discounted for therequired return. Indeed, Step4 offundamental analysis
requires expected payoffs tobediscounted usingtherequired returnto arrive at avaluation.
Butwealsohaveseenthatvaluations canbequitesensitive to estimates of therequired
return. In mostapplications in the book, wehave estimated the required returnusingthe
standard capital assetpricing model (CAPM). Butwehavedone so withconsiderable discomfort because of problems inmeasuring theinputs intothemodel. Alternative multifactor models have beenproposed (asdiscussed in theappendix to Chapter 3), but thesebeta
technologies onlycompound themeasurement problems.
So-called assetpricing models seemingly do not referto fundamentals. Theyare composed of betas and risk premiums. Betas are defined by expected correlations between
Therequired return, alsoreferred to asthecostofcapital,isthereturnthatininvestor demands tocompensate himfortheriskhe bearsin making an investment. Bothassetpricing
models likethe CAPM andthe fundamental analysis of riskaimto determine what thisrequired return should be. If markets are efficient, the market price will reflect this fundamental risk: The price will be set suchthat the expected return to buying the shares will
equaltherequired return for risk.
Thisbook, however. hasentertained the notion thatprices maynot be efficient. Thatis,
prices might beset to yield a return different from therequired return thatcompensates for
risk. If theprice is lower than that indicated by the fundamentals, the investor expects to
earna return higher thantherequired return; if thepriceis sethigher thanthatindicated by
fundamentals, the investor expects a lower return than therequired return. Active investors
attempt to identify such mispricing: in other words, they attempt to identify when the
expected return is different from the required return. Hence, wedistinguish the expected
Chapter 18 The An!l1JsisofEqaity Risk andRWml 661
660 Part Five TheAnalysis ofRisk Il11d Reuen
return from the required return.The expected returnis the return from buyinga shareat
the currentmarket price. Theexpected returnis equalto the required return onlyif the rnarket pricein efficient.
This chapteranalyzes fundamental riskwith the aim of determining the required return
thatcompensates forthat risk. But it alsorejoins theearlieranalysis thatdetermines theexpectedreturn. That analysis involves reverse engineering: Given forecasts of profitability
and growth, whatis the expected return to buyingat the currentmarketprice? The comparison of thisimplied expected returnwiththerequired returnindicates a buy, sell,or hold
position.
Despite an enormous amount of research on the issue,measures of the required return
(the cost of capital) remain elusive. To be blunt, you will not find a wayto estimate the
required returnwith assured precision in this chapter. You will find the material here to be
morequalitative thanquantitative; the chapterwillgiveyoua feel for the risk youface but
willnottransform thatintoa percentage returnnumber. But theexpected return is thefocus
of the activeinvestor, so the chapterconcludes withways to finesse the difficulties of estimatingthe required return.
THE NATURE OF RISK

Each year The Wall Street Journal reports a "Shareholder Scorecard," which ranks the
1,000 largestU.S. companies by marketcapitalization on their stock return performance.
The year2007wasa below-average yearfor stocks, withtheS&P500 stocks earninga return of 5.5 percent. But therewas considerable variation around this average. Table 18.1
givesthe top and bottom 2i'f percentof performers amongthe 1,000stocks.
The historical average return to investing in U.S. equitieshas been about 12.5 percent
per year. Table 18.1 gives you some ideaof howactual returns varyfromaverage returns.
Thereis a chanceof doing better tban 12.5 percent-very muchbetteras the bestperformers in the tableindicate-and a chanceof "losingone's shirt"-as the negative returnsin
the table indicate. This variation in possible outcomes is the riskof investing.
The investor's perception of this variation determines the return she requires for an
investment-how muchshe will chargein termsof expected returnto invest-and the return required by investors is the firm's costof capital. If no variation in returns is expected,
the investment is said to be risk free. So the required return for a risky investment is
determined as
Required return> Risk-free return+ Premium forrisk
United Statesgovernment securities are seenas riskfree, andthe yieldson thesesecurities
are readilyavailable. The difficult part of determining a required returnis calculating the
premium for risk.
The Distribution of Returns

The set of possible outcomes and the probability of outcomes that an investor faces is
referred to as the distribution of returns. Riskmodels typically characterize returndistributionsin termsof probability distributions thatare familiarin statistical analysis. A probability distribution assigns to each possible outcome a probability, the chance of getting
that outcome. The average of all outcomes, weighted by theirprobabilities, is the meanof
the distribution, or the expected outcome. The investor is seenas having an expected return
butalso is aware of theprobabilities of gettingoutcomes different fromtheexpected return.
And the risk premium she requires depends on her perception of the form of the distributionaroundthe mean.
TABLE 18.1 Best andWorst 2007 Stock Return Performance for the1,000 Firms in TheWall StreetJournal's
Shareholder Scorecard
The BestPerformers
The Worst Performers

One-Year
Return, %
Company
First Solar
Onyx Pharmaceuticals
Mosaic
CF Industries Holdings
Terra Industries
SunPower
Intuitive Surgical
Foster Wheeler
AK Steel Holding
Owens-lilinois
Baliy Technologies
795.2
425.7
341.7
3300
Prkeline.com
163.4
GrafTech International
National Oilwell Varco
Chipotle Mexican Grill
Amazon.corn
Jacobs Engineering Group
156.5
140.1
136.6
134.8
134.5
133.5
132.1
1283
126.1
125.4
124.2
121.0
120.2
298.7
250.8
236.8
181.1
173.6
168.3
166.2
Apple
McDermott International
Alpha Natural Resources
MEMC Electronic Materials
GameStop
Consol Energy
FYI Consulting
MGIPharma
Company
Countrywide Financial
MBIA
Ambac Financial Group
Washington Mutual
Pulte Homes
Lennar
MGIC Investment
Office Depot
Advanced MicroDevices
SLM
Sepracor
KB Home
CIT Group
Centex
First Horizon National
Sovereign Bancorp
AMR
liz Claiborne
National City
Lexmark International
Rite Aid
D.R. Horton
Freddie Mac
Moody's
MicronTechnology
One-Year
Return, %
-78.4
-74.1
-70.6
-68.2
-68.0
-65.2
-63.6
-63.6
-63.1
-58.5
-57.4
-56.7
-55.9
-54.9
-54.9
-54.4
-53.6
-53.0
-52.7
-52.4
-48.7
-48.6
-48.6
-48.1
-48.1
Now Thebestpe,formers lislcdorc2\< pl:lttnl crue I<MI. as ~'" lhowornperformer<. Slockretu,nincludes chonsesinsbre prices.reinveslmenl ofdividends. rights ~nd
..tnloffering:;. andCJh C<iui~lcnts (suchas stockfC<:eivcd inspinoff;).
w~,
Son'ee: T!I~ %/1 S''''''' J""n1"r. Febru,ry 25,200S.An;llysis perrormed by L.E.K. Consulting LLC.Copyrighl 200Sby DowJones& Co. lot. Reprodueod wilhpermi"ioo
ofDer.< Jon" & Co.loe. in the form;lllexibook vi, Copyright C!eO"lflUCenler.
Figure 18.la plotsthe familiarbell-shaped curveof the normal distribution. If returns

were distributed according to thenormal distribution, approximately 68 percent of outcomes
would fall within 1 standard deviation of the expected return (the mean) and 95 percent
within 2 standard deviations, as depicted. The typicalstandard deviation of annual returns
among stocks isabout30percent. So,witha mean of 12.5 percent,weexpectreturns to fall
between -47.5 percent and+72.5 percent exactly 95 percent of the timeif returns follow a
normal distribution.
But look at Table 18.1. The stocks listed there are 5 percent of the Shareholder
Scorecard's 1,000, that is, 2~ percentwith the best performance and 2~ percentwith the
worst, so theirreturnsare those outside95 percentof outcomes. The top performers have
returnsconsiderably greater than 72.5 percent. Most of the worstperformers have2007
returnsbelow -47.5 percent. FarWOrse returnsare not uncommon; in 2002,for example,
all the bottom2J.5 percentof stockshad returns worse than -69 percent,in 2001 theyall
had returnsof less than -66 percent, and in the yearof the burstingof the bubble, 2000,
the 211 percentworst performers all returnedless than -74 percent. Evenin a goodyear,
662 Part Five TheAnalysis of Risk and Return
FIGURE 18.1
Chapter 18 The A1Illl)'sis of Equity Risk and Rettlrn 663
Probability
FIGURE 18.1
(a) The Normal
12
(concluded)
Distributionand
(b) theTypical
DistributionofActual
StockReturns.
(c) The Hypothetical
Normal Distribution
ofS&P 500Returns
and (d) the Empirical
Distribution of S&P
500returns
The actual distribution

of returns indicates
that the chance of
getting very low
returns orvery high
returns ishigher than
indicated bythe
Even fora large
portfolio, like theS&P
500, there aremore
extreme negative and
positive returns than
are likely under the
-3 sd
68.26%
----r:,
95.44%
,,
,,
,
-2 sd
-1 sd
osd
,,
,,
,,4 - ,
,,,
,
,I,
',
I
"d
J sd
l sd
(a) Thenormal distribution, Witha normal distribution. thereis a 68-26% probability thata
return will bewithin 1standard deviation (sd)of themeananda 95.44% probability thata
return will be within 2 standard deviations of the mean.
o
-50% .-40%
-20% ~10%
0%
!O%
20%
300/0
40%
50%
Cd) The empirical distribution of annual returns on the S&P500 stockportfolio t926-1998,
superimposed on the normal distribution.
largenegative returnsare not uncommon: In 1998, whenthe average returnwas 24.2 percent, the bottom 2~ percentall returned less than -55 percent.
Figure 18.lb compares the actual distribution of annual stock returns to the normal
distribution in Figure 18.Ia. You notice two things. First,stock returns can't be less than
-100 percent, but there is significant potential for returns greater than +100 percent, as
Table 18.1 also indicates.' Second, the probability of getting very high or low returns is
greaterthan if returnswere normally distributed. In statistical terms,the first observation
saysthat returnsare skewedto the right. Thesecondobservation saysthatthe distribution
of returnsis fat-tailed relative to the normal; thatis, thereis a higherprobability offalling
intothe tails(theextremes to the leftand rightof the 2 sd points) ofthe distribution, as the
comparison of Figures 18.1 a and b indicates.
This all saysthatin evaluating riskweshouldbe apprehensive of models thatrelyon the
normal distribution. There is a chance of being badly damaged in equity investing: The
probability of getting verybad returns(greaterthan2 standard deviations from the mean,
say)cannotbe takenlightly. This is sometimes referred to as downside risk. Correspondingly, equity investing has the potential of yielding very largerewards-c-on the order of
100 percent and greater. This is sometimes referred to as upside potential. Indeed, we
mightviewequityinvesting as buyinga significant chance oflosinga considerable amount
but with the compensation of upside potential. Amazon, in the best performers of the
Shareholder Scorecard witha 134.8percentreturnin 2007,experienced a largenegative retum of....g0.2 percent in 2000.
The mean and standard deviation do not capture this feature of investing entirely. In
assessing risk premiums, the investor mightrequire a higherpremium for downside risk
and a lower premium for upside potential. His required return for a start-up biotech finn
Sou",.:~' CRSP. CemerJ"r

Rel'ecrcfl ill $eCl/f;tyPriees.
11'0 Un;velSity of Chie~go.
Booth SchoolofBusincss.
Usedwithp<:tmi",,;on.
AlltiglliS :eso"",d.
~30%
Probability
osd
z sd
12.5%
72.5%
-2 sd
-100%
,,
I
-47.5%
(b) The empirical distribution of annual
100%
stock returns.
Probability
I
-47.5%
-zsd
,,
-27.5%
-7.5%
125%
315%
2'd
,I
525%
72.5% Return
(c)The normal distribution of annual returnson theS&P500 stockportfolio witha meanof 12.5%
anda standard deviation of20%.
I With limited liability, returns cannotbe less than -100 percent because losses are limited to the amount
invested. That is, stock prices cannotdropbelow zero. But investing inventures not protected bylimited
liability canyield returns less than -100 percent because creditors canmake claims against assets outside
the business.
Chapter 18 The Analy~is of Eqllity Risk ond Remm 665
664 Part Five TheAnalysis: ofRis:k ond Return.
FIGURE 18.2
The Effecton the
Standard Deviation
of Return from
AddingMore
Securities to 3
Portfolio
Thestandard deviation
declines as thenumber
of securities in the
portfolio increases, but
theamount of the
decline from adding
yetmore securities is
lessas thenumber of
securities inthe
portfoliogrows.
10
Number of securities
15
that hasa significant probability of losing 100percentof valuebut also a significant probabilityof generating 200 percent returnsmay be different from his required return for a
mature firm likethe consumer products firm Procter & Gamble, which has a smallchance
of either.
Diversification and Risk

A major tenet of modem finance states that the investor reduces risk by holding stocks
(or anyotherinvestment) in a portfolio withotherstocks (or investments). Positive returns
cancelnegative returnsin a portfolio, just like the positive returns in Table 18.1 compensate for the negative returns for anyone holding the 1,000 stocks covered by the Shareholder Scorecard. And if returns on the different investments in the portfolio are not
perfectly correlated, the standard deviation of the portfolio returnis less than the average
standard deviation of returnforstocksin the portfolio.
Thisreduction in the variation of returns in a portfolio is the reduction of risk through
diversification. Figure 18.2 shows how the standard deviation of return on a portfolio
declines as the number of securities in an investment portfolio increases. An investor holding One or two investment assets (stocks, for example) exposes himself to considerable
standard deviation of return,but by adding more assetshe reduces this variation. At some
point, however, adding more investments reduces the standard deviation of return only
slightly; there is little further gain to diversification. If the investor holds all available
investment assets,he is saidto holdthe marketportfolio andthe variation of returnforthis
portfolio is variation thatcannot be further reduced The variation that remains afterbeing
fully diversified is nondlversifiable risk, or systematic risk; it is risk that affects all
investments in common. Riskthat can be diversified away is called diverslfiable risk or
unsystematicrisk.
The S&P 500 stocksare typically seenas approximating the marketportfolio. Thehistoricalstandard deviation of returnsfor the S&P 500 has been about20 percentper year,
arounda meanof 12.5percent. Figure18.lc depicts a normal distribution witha meanof
12.5 percent and a standard deviation of20 percent. Witha standard deviation of20 percent,we expectreturnsto fall between -27.5 percent and 52.5 percent(within 2 standard
deviations of the mean) 95 percent of the time if they are distributed normally, as
Figure IS.Ie shows. Compare this normal distribution with the distribution of individual
stock returns in Figure 18.1 b. The probability of returnsfalling between -27 percent and
53 percent in Figure 18.1c is greaterthanthatin 18.lb because thestandard deviation of return on a portfolio is lessthan thatof the average standard deviation for individual stocks.
This comparison illustrates the benefits of diversification.
Figure 18.ld gives the actualempirical distribution of annual returns for the S&P500
from 1926to 1998. You'll noticethat the actual distribution of returns in the history does
not follow the normal distribution in Figure 18.Jc exactly. As in the case of individual
stocks,somereturns aremoreextreme thanwouldbe the Case if returns were normally distributed Soportfolios, while giving the benefit of diversification, do notentirely eliminate
the chance of getting extreme returns. Andthat chanceis greaterthanwould be predicted
by the normal distribution. In 1930the stockmarketdropped by 25 percent, followed by a
43 percent drop in 1931 and a 35 percent drop in 1937. In 1974 it dropped by 26 percent,
and on "BlackMonday" in October 1987 it dropped by29 percent in one day. Onthe other
hand, 1933 yielded a return of 54 percent, 1935 a returnof 48 percent, 1954a return of
53 percent, 1958 a returnof 43 percent, 1995 a returnof38 percent, and 1997a return of
34 percent. For2008,the S&P 500indexwasdown 38.5percent for the year, another lefttail outcome. Lookat Box 1.1 in Chapter 1 for stockmarketreturnssince 1997.
Whatdo we learnfrom theseobservations? The investor can reduce riskthrough diversification, and ifthis canbe donewithout muchtransaction cost,the market will notreward
the investor for bearingdiversifiable risk.The investor will be rewarded only for the risk
that has to be borne in a well-diversified portfolio. So we must thinkof risk in termsof
factors whoseeffect on returnscannotbe diversified away. But weshouldalso realize that
diversification does not entirely eliminate the possibility of getting large (positive and
negative) returns.
AssetPricing Models
An assetpricingmodel translates thefeatures of the returndistribution intoa riskpremium,
and so calculates a required return.Review the materialon assetpricingmodels and beta
technologies in the appendix to Chapter 3; for more detail, go to a corporate finance or
investments text. 2
The capital assetpricingmodel(CAPM), whichis widely used, recognizes the diversification property. It saysthatthe only nondiversifiable riskthathasto be borneis the riskin
the market as a whole. Accordingly, the riskpremium for an investment is determined bya
premium forthe (systematic) riskof the market portfolioandbyan investment's sensitivity
to that risk,the investment's beta.But the CAPM assumes that returns follow a normal distribution.t like thatin Figure18.la. That is, it assumes thatif youthinkaboutthe standard
deviation of return, youwillhavecaptured all aspects of an investment's risk. But wehave
seen thatthe standard deviation underweights the probability of extreme returns(andit is
the extreme downside returnsthat reallyhurtl).
Even if we accept the CAPM assumptions, we run into severe problems applying it.
Warren Buffett, the renowned fundamental investor, claims thatthe CAPM is "seductively
2See, for example. R. A. Bresley and S.C.Myers, Principles of Corporate Finance, 9th ed (New York:
McGraw-Hili, 2008); and S. A. Ross, R. W. Westerfield, and J. Jaffe, Corporate Finance, 8th eo.
(New York: McGraw-Hili, 2008).
3Ona technical point, the CAPM isalsovalid ifinvestors havequadratic utility for anyform of the return
distribution. Butwe don't knowenoughabout people's utility functions to test if theyarequadratic (and
they probably are not). whereas we know something about the actual distribution of returns.
666
Part Five TheAwlysllof Riskarul Rewm
Chapter 18 TheAl1Il1Y5i5 ofEquity Risk and Return 667
precise." It usesfancymachinery and looksas if it givesyouagoodestimate of therequired

return. But thereare significant measurement problems:
The CAPMrequires estimates of firms'betas,buttheseestimates typically haveerrors.
Abetaestimated as 1.3may, withsignificant probability, be somewhere between 1.0and
1.6. With a marketriskpremium of5.0 percent,an error in betaof 0.1 produces anerror
of 0.5 percentin the required return.
Themarketriskpremium is a bigguess. Research papersandtextbooks estimate it in the
rangeof3.0 percentto 9.2percent. Pundits keento rationalize the "high" stockmarket
at the endof the 1990swere brave enough to statethatit had declined to 2 percent. With
a beta of 1.3, the difference between a required return for a market risk premium of
3.0 percentand one fora marketrisk premium of9.2 percent is 8.06percent.
Compound the error in betaand the error in the riskpremium and you havea considerable problem. The CAPM, even if true, is quite imprecise whenapplied. Lets be honest
with ourselves: No one knows ~hat the marketrisk premium is. Andadopting multifactor
pricingmodels adds more risk premiums and betas to estimate. These models contain a
strongelementof smokeand mirrors.
Warren Buffett madeanother observation on assetpricingmodels.t'Ibe CAPM saysthat
if the price of a stockdropsmorethan the market, it has a highbeta:It's high risk. But if
thepricegoesdown because themarketismispricing thestockrelative to otherstocks, then
the stock is not necessarily high risk: The chance of making an abnormal return has
increased, and payingattention to fundamentals makes the investor more secure,not less
secure. The morea stock has"deviated from fundamentals," the morelikely is the "return
to fundamentals" and the lessriskyis the investment in the stock.
Buffett's point is that risk cannot be appreciated without understanding fundamentals.
Riskis generated by the firm, and in assessing risk,it mightbe moreusefulto referto those
fundamentals ratherthanestimating risk from(possibly inefficient) marketprices.
Toseethe difficulty in relying on marketpricesto estimate therequired return,consider
theweighted-average costof capital(JIACC) calculation for operations (orthe costofcapital forthe fum), PF, that we outlined in Chapter13:
Costof capital fur (Valueofequity

Equi
f tal)
.
=
x urtycosta capt
operations
Value of operations
+(
V:
(18.1)
Value ofdebt x Costofd ebt capital'I

Value of operations
)
FUNDAMENTAL RISK
Fundamental risk is the risk that an investor bears as a resultof the waya fum conducts
its activities. Thefirmconducts its activities through financing, investment, andoperations,
as we have seen. The risk from investing and operating activities, combined, is called
operating risk or business risk. If a firm invests and operates in countries with political
uncertainty, it has high operating risk. It has high operating risk if it chooses to produce
products for which demand drops considerably in recessions. Financing activities that
determine financial leverage produce additional risk for shareholders, calledfinancial risk
or leverage risk.
Weintroduced thesetworiskcomponents in Chapter 13.Wesawthattherequired return
for an equityinvestor is made up as follows:
Required returnfor equity= Required returnfor operations
Thisweighted-average cost of capitalrequires a measure of the equitycost of capital, PE,

as an input This is oftenestimated frommarketpricesusingthe CAPMwithout reference
to fundamentals, producing thereservations thatBuffett expresses. But, further, the costof
'Buffett'scommentary on assetpricing models, along with otheraspects of corporate finance, canbe

found in l. A. Cunningham, ed., The Essays of Warren Buffett: Lessons forCorporate America (New York:
Cardozo Law Review, 1997).
(18.2)
VD
PE = PF + v~ (PF - PD)
o
(1)
(2)
The twocomponents, operatingrisk (1) and financial risk (2), are the basic.fund~mental
determinants of equityrisk.Butjust as payoffs are determined bydrivers, so theserisksare
also driven by further fundamental determinants. Indeed, you see in the expression that
financing riskis decomposed intotwodrivers, marketfinancial leverage and the spreadof
.
.
the required returnfor operations overthe after-tax cost of debt:
Tounderstand the determinants of operating and financing nsk, appreciate firstwhat IS
atrisk.Well, shareholder valueis at risk,and shareholder valueis driven byexpectations of
future residual earnings:
y~
PF=VNOA 'P E + y NOA 'P D

c
capitalforequityandthe after-tax costofcapitalfordebt, PD, areusually weighted notwith

intrinsic values as in equation 18.1 but with the marketpricesof equityand debt.This is
odd.Wewantto estimate the cost of capital for operations in orderto get the valueof the
firmand the valueof the equity. Wedo this to see if the marketpriceis correct.But if we
use the marketprice as an input to the calculation-and assume it is correct-we are
defeating our purpose. In valuation we mustalways try to estimate fundamental valueindependently of pricesto assesswhether the marketprice is a reasonable one.Tobreakthe
circularity in theWACC calculation, wemustassessrisk by reference to fundamentals, not
market prices.
v.t:
o
REI REz RE3

+ - - + - - +'
=CSE o + PI'
p}
P~
This valuation is based on expected residua! earnings (RE). But valueis at risk because
expected residual earnings are at risk:Thefirmmightnotearnthe earnings relative to book
valuethatareexpected, soanticipated valuemightnotbe delivered. Indeed, insteadofearningsadding to currentbookvalues, the bookvaluesmightbe usedup withlosses in operations.Accordingly, expected REare"discounted" forthispossibility witha required return,
PE, thatincorporates the risk.As a consequence, the calculated valuereflects ri~k as wellas
expected return.
Thesamedrivers thatyieldREalsocandriveREaway fromits expected level. Thus,the
analysis ofriskdeterminants closely follows theanalysis ofREdrivers inChapters 11 and12.
Chapter 18 TheAnalysis ofEquiry Risk and Retu.rn 669
668 Part Five The Anal)'sis of Rilk and Rerum
FIGURE 18.3
TheDeterminants of
Fundamental Risk
Risk ofnot earning an
expected ROCE is
determined by therisk
ofnot earning the
expected return on
operations (operating
risk I), compounded
bythe risk of financial
leverage turning
unfavorable (financing
risk). The risk of not
earning expected
residual earnings is
the ROCErisk
compounded by
growth risk (operating
risk 2).
Return on Common Equity Risk
IFundamental riskI
ROCErisk
ROCE '"RNOA + FLEvx (RNOA - NBC)
We have seen that return on common equity is driven by return on operations and a
premium for financing in the samewayas the required returnin equation 18.2:
Growth risk
(Operating risk2)
Growth inNOA '"Growth in [sales x !fAro]
ROCE = RNOA + NFO (RNOA - NBC)

CSE
IOpemting risk1 I
nsk
OI/Sa1es
-L
SalesINOA
Expense
risk
Operating
leverage risk
Expense!
Fixed cosu
Variable cost
~
Key: RQCE
RNOA
FLEV
NBC
OJ
OL
NOA
ATO
NFE
NFO
CSE
Ifinancing risk I
I Financj~1 II BorrO\~ing I
II
I
I I
I Asset ?Jrnover \1 Operating li~bility 1
Profit margin
risk
leverage nsk
II
Returnon common equity= Returnon net operating assets

(18.3)
OUNOA
{
leverage nsk
costrisk
NFOICSE
NFEiNFO
'" rate of return oncommon equity

'" rate o~ return onnetoperating assets
'" financial leverage
'" netborrowing cost
'" operating income
'" operating liabilities
'" netoperating assets
'" assetturnover
'"netfinancial expense
'"netfinancial obligations
'"common shareholders' equity
Residual earnings are generated by return on common equity (ROCE) and growth in
investment. So risk is determined by the chance that a fum will not earn the forecasted
ROCE or willnot growinvestments to earn at the ROCE. We dealwiththesedeterminants
in turn.'
Figure 18.3 depictshowthe drivers of returnon common equityand growth determine
fundamental risk. Follow this diagram as weproceed. The riskdeterminants are expressed
in termsof financial statement drivers, butjust as economic factors drive residual income
so risk determinants are driven by economic risk factors. Analyzing risk amounts to
identifying theseeconomic factors and attaching them to observable features in the financial statements. Andidentifying economic riskfactors amounts to "knowing the business."
Just as the drivers heredetermine the expected ROCE, so theydetermine the riskthat the
expected ROCE will not be earned. Weanalyze eachin turn.
Operating Risk
Thepotential variation in returnon net operating assets(RNOA) generates operating risk.
And variation in RNOA is driven by variation in profit margins and asset turnovers. We
referto the risksthat profit margins and assetturnovers will not be at theirexpected levels
as profit margin (PM) risk and assetturnover (ATO) risk. TheRNOA is alsodetermined by
operating liability leverage, andwereferto possible variation in operating liabilityleverage
as operating liability leverage (GLLEV) risk:
Assetturnover risk recognizes the chance that sales will fall, by a fall eitherin prices
or in volumes, if demand from customers changes or competitors erodemarketshare.If
net operating assetsare inflexible-they cannotbe reduced immediately-ATO falls with
a drop in sales,reducing RNOA. The decrease in ATO is, in turn, driven by lower inventory turnover (a buildup of inventory relative to sales and thus excess investment in inventory), lower property, plant, and equipment turnover (and thus value lost in idle
capacity), and other individual net asset turnovers. Firmswith fixed capitalequipment in
place,such as investments in large communications networks, are particularly susceptible
to ATO risk. Finns with large inventories for which consumer demand can shift to
substitute products, such as a new generation of computers or new models of cars, are
susceptible to ATO risk.
Profitmargin risk is the risk of profit margins changing for a given levelof sales. It is
driven by expense risk: the risk of laborand material costs increasing, per dollarof sales,
sellingexpenses increasing, and so on.Profitmargins willalsobe affected by the fixed and
variable coststructure of expenses, which we referredto as operating leverage (GLEV) in
Chapter 12. If sales fall,profitmargins fallby a largeramount if costsare fixed ratherthan
variable (andadaptable to the changein sales). Sofixed salarycommitments and atradition
that frowns on dismissing employees generate higherprofit margin risk. Long-term rental
agreements increase profit margin risk.
Operating liability leverage risk is the chance that operating liabilities will fall as a
percentage of net operating assets. If the firm gets into difficulties that causemargins and
turnovers to fall,suppliers maynotgrantcredit,reducing payables andOLLEV Theability
to collectcashaheadof salesmayfall,reducing deferred revenues and OLLEY. Thesescenariosreduce RNOA andROCE.
Financing Risk
s Ifvalue is.calculate;! as di.s:.:ounted freecashflows, the same drivers of risk apply: Free cashflowisjust
an eccounuoq transrormation of residual earnings, as we haveseen,so the teeters that drive residual
earningsalsodrive freecash flow overthe longterm.Butone wouldnot want to view the variation of
free ~as~ flowin the short termas indicative of risk: A negative freecashflowmaybe causedbylarge,
tow-risk investments ratherthan a bad outcome.
Financing riskis driven by the amount of financial leverage andthe variation in the spread,
that is,theRNOA relative to the net borrowing cost.Theoperating spreadvaries,of course,
as RNOA varies, but the financing component of the spreadis the net borrowing cost. So
we talk ofjinancialleverage (FLEV) risk and net borrowing cost(NBC) risk as the determinants of financing risk.
Chapter18 The Analysis ofEqllilJ Risk and Re!llrn 671
&70 Part Five TheAnalysis ofRisk and Return
II
A fall in RNOA reduces the operating spread andthe effect on ROCE is magnified, or
levered, by the FLEV: As long as the operating spread is positive, financial leverage is
favorable (for firms with positive leverage). Should the operating spread tum negative,
however, the leverage turnsunfavorable, reducing ROCE below RNOA.
Borrowing cost risk increases the chance that operating spreads will decline. Finns
with variable-interest-rate debt have higher borrowing cost risk than firms with fixedratedebt; ifinterest rates increase with variable-rate debt, ROCE declines, butifinterest rates
decrease, ROCE increases. Finns thathedge interest ratesreduce borrowing costrisk. Net
borrowing costs areafter-tax, so if firms incur operating losses andcannot getthetaxbenefitfrom losses carried forward or back, theirafter-tax borrowing costs willincrease.
Growth Risk
Residual earnings aredriven byboth ROCE andgrowth ininvestment, so ROCE riskis compounded by theriskthatcommon equity will notincrease asexpected. Fora given financial
leverage, growth incommon equity isdriven bygrowth innetoperating assets. Souncertainty
about whether thefirm cangrow investment innetoperating assets isanadditional aspect of
operating risk. Thatis,uncertainty about a finn's investment opportunities adds to risk.
Growth innet operating assetsis driven bysales. Fora given assetturnover, the amount
of netoperating assets to beput inplaceis determined bysales, so growth riskis driven by
the riskof salesnotgrowing as expected. Indeed salesriskis viewed as the foremost businessrisk,affecting boththe growth in netoperating assetsandthe RNOA. A reduction of
salesmaynot reduce netoperating assets because net operating assets are inflexible, butif
so, it willreduce RNOA andresidual earnings as assetturnovers decrease. If netoperating
assets areflexible, a salesdecline willreduce residual earnings through thereduction innet
operating assets. Thisgrowth riskis labeled operating risk2 in Figure 18.3 to distinguish it
from RNOA risk,which is labeled operating risk l.
You see how risk components interact, compounding sales risk through the system
depicted in Figure 18.3. A fall in sales reduces net operating assets growth and asset
turnovers. The fall in assetturnover reduces RNOA, which reduces the operating spread.
Operating creditors mayreduce credit, reducing operating liability leverage, andborrowing
costsmayincrease because of lower profitability. These effects compound to reduce residual earnings andthe compounding effect cancause considerable distress, or evenfailure.
Thesecompounding effects increase theprobability of extreme returns.
In valuing theoperations by forecasting residual operating income (ReOI), onlyoperating riskneeds to be considered, bothoperating risk 1 and operating risk2 in Figure 18.3.
VALUE-AT-RISK PROFILING
In Figure 18.1, riskwas depicted as a distribution ofpossible return outcomes. Each possible
return implies a valuation-howmuch theinvestor would bewilling to payforthatreturnso riskcanalso be depicted as a distribution of values. Plotting thatdistribution of valuesdepicting how value might differ from expected value---prepares a value-at-risk: profile.
Castback to the full-information, pro forma financial statement forecasting in Chapter 15. Following the template laid out there, we forecasted operating income and net
operating assets forthesimple firm PPE,Inc. and, from the forecasts, calculated forecasted
residual operating income. We thenconverted these forecasts to a valuation. Theproforma
financial statements that we prepared were based on expected sales, profit margins, and
turnovers. Butexpected values are averages of a whole range of possible outcomes andthe
distribution of outcomes determines the riskof the investment. Value-at-risk profiles are
developed bypreparing proformafinancial statements foreachpossible outcome andthen

calculating thevalues foreachoutcome.
Todevelop value-at-risk profiles, follow thefive stepsoutlined next.
1. Identify economic factors thatwillaffect theriskdrivers inFigure 18.3.Likevaluation

more generally, identifying these factors requires "knowing the business." Consider
airlines. What factors affect airlines' profits? General economic conditions affect asset
turnover risksince airlines sell fewer tickets at lower prices on fixed capacity in recessions thaninboomtimes. Airlines aresubject to shocks in oil prices, affecting expense
risk. Airlines are subject to changes in government regulation, affecting growth risk.
Airlines are subject to price challenges from competitors and new entrants to the industry, affecting RNOA andgrowth risk.
2. Identify risk protection mechanisms inplacewithin thefirm. An airline may hedge oil
prices to reduce theeffects of oil priceshocks. Currency riskmaybe hedged. Incorporation is a risk-protection device to limit liability. The investigation of risk exposures
is partof knowing the business. Indeed, the aspects ofbusiness thatareexposed to risk
really define the business. If a goldcompany hedges its gold reserves against changes
in the price of gold, it creates a goldmining business (withrisk in production costs)
rather thana goldmining and trading business (with risk in production costs and sale
prices). If a downstream oil company hedges oil prices, an investor should realize that
she is buying a firm that is more like a marketing company than an oil company.
A fum hedging currency riskhasdecided thatit is not inthebusiness oftrading currencies. If a fum hedges all risks, the investor is buying an investment that is more like
the risk-freeassetthan anequity.
Disclosure is important to the discovery of risk exposure. Lookat the derivatives
and financial instrument disclosures. Examine the management discussion and analysis. Just as poor disclosure frustrates the identification of operating assets (what businessthe firm really is in), so poor disclosure frustrates discovery of riskexposures. A
manager seeking to maximize themarket value of the firm indicates clearly what type
of business the firm is in and so attracts investors who seektherisk andreturns to that
typeof business. If she fails to disclose exposures, she imposes disclosure riskon the
investor."
3. Identify the effictof economic factors on thefundamental riskelements inFigure 18.3.
If valuations are made by forecasting operations, onlyoperating risk drivers need be
considered. If valuations are madeon the basisof fullresidual income, bothoperating
andfinancing drivers needto be considered.
4. Prepare proforma financial statements under alternative scenarios for thefuturefundamental riskdrivers.
5. Calculate projected residual operating income for each scenario and, from these projections, calculate the set of values that each scenario implies. Use the risk-free rate
(the rate on secure government obligations) to calculate residual incomes and to discount them. (Thereason forthis willbecome clearshortly.)
A value-at-risk profile is developed byconsidering allriskfactors to which thefirm and
its shareholders areexposed. With theprofile-and an understanding oftheriskfactors that
generate it-the investor considers his strategy to dealwithrisk.Hechooses hisexposures.
Some argue that managers should not beconcerned with protecting shareholders from risk. With the
availability of risk protection instruments on the market andwith the ability to diversify. shareholders can
protect themselves iftheywish, andsoarrange their own risk exposures. But to theextent thatfirms do
manage risk, the investor must be aware.
672 Part Five The Arw!)'sil of Risk l1nd Rem'1l
Heavoids firms withparticular riskfeatures. Heuses financial andcommodity hedging instruments toprotect himselfagainst particular exposures. Forexample, if hewants exposure
to oil price risk,he might buyan oil company, but because he doesnot want exposure to
interest raterisk,hemight hedge against interest rateeffects on a highly leveraged oilcompany. Further, the investor understands thatriskcanbediversified byholding a large portfolioof stocks. Value-at-risk profiles forindividual firms arethen an input to determining the
riskprofile ofa portfolio of stocks. And theinvestor understands thatportfolios canbeengi,
neered to give exposure to onetype of riskwhile minimizing exposure, through diversification, to other types of risk. Value-at-risk profiles help himinweighting hisportfolio toward
particular types of risk. In implementing hisrisk-exposure strategy, theinvestor appreciates
the risk protection mechanisms in place within the firm (discussed in point 2 above) and
mixes hisown strategy with thatofthefirm to engineer hisdesired exposure to risk.
The identification of economic riskfactors in Step I-and the attachment to financial
statement drivers in Step 3-follows closely the identification of the economic determinants of residual earnings in Chapter 15. Thepreparation ofproforma financial statements
in Step4 completes thefull-information forecasting of Chapter 15byconsidering notonly
information about expected residual income but information about thepossible variation in
residual income also.
The values calculated in Step 5 use the risk-free rate. So for each outcome scenario,
using residual operating income valuation,
V.oNOA -_ NOA 0
OI, - (R - I)NOA, 01, - (R - I)NOA,

+
R
R'
"~I~I
o
" ~I~!
co
?f.1rl#.
~
~~~
01,.... lf1
#m#
"~I~I
.... ro"':-<i
&10;1
co cd e- N
"'~o
#0#
o~o
-e
#r--#
oRN
/'I'l
~m~
;:"0
00
#<-:
Irl
u:i"': ai
~"'
"~I;!JI
~*
#~~
'1 0
NO
",
~'"
ON
m,
#r--#
(18.4)
"'!"'I
NN"
+ 01) -(R-I)NOA, +.
R)
where R is 1 + risk-free rate. Forecasts are made up to a steady-state year.
Mostspreadsheet programs have sensitivity analysis features thatfacilitate this analysis.The example inTable 18.2 keeps it simple by considering onlyone riskfactor (albeit
an important one), the variation in the performance of the economy as a whole as measuredby thegrowth in grossdomestic product (GDP). Thisfactor is likethe "market factor"in thecapital assetpricing model. This factor affects onlythree drivers intheexample:
sales, profit margins, andassetturnovers. Table 18.2 gives salesfortwofirms, A andB,for
seven growth ratesinGOPindicated at thetopofthe table. Bothfirms, younotice, have the
same salesfora given GDP growth scenario andso have thesame salesriskfrom the GD?
factor. Butthe twofirms differ on PM risk andATC risk. Profit margin risk is driven by
operating leverage, the ratio of fixed costs to variable costs. FinnA hasa higher fixed-cost
component to expenses thanB, 520 million compared to $4 million (as indicated at the
bottom of thetable) and accordingly, withvariable costs of 72percent of salesrather than
88 percent, FirmA has higher operating leverage riskand profit margin risk. FinnA also
has less adaptable net operating assets, with $30.7 million invested in inflexible assets
compared toS18.7 million forFirmB (asindicated at thebottom of thetable). Accordingly,
Firm A hashigher ATC risk. View theinflexible portion ofnetoperating assets as plantand
the variable portion (36 percent of salesfor A and48 percent of salesfor B) as inventory
andreceivables.
These differing sensitivities to the performance of the economy produce different
ReOI under the seven scenarios. If GDP grows at 2 percent, both firms willdeliver 5100
million of sales, a PM of 8 percent, an ATC of 1.50, and an RNOA of 12 percent. And
they will deliver $4 million in ReOI overthat required withNOA earning at the risk-free
rate (assumed to be 6 percent). But FirmA delivers lower RNOA and ReOI than B if
"#o#.
~~"'
r-- ci e- 1..0
"'''''''m
en u:i"':o
#r--#
o
~~o
"'1"'1
NON
oolo!
"I
N
-<i"':u:i
~
"'
m
"'
"1m::
ON!NI
N~O>
#0"#
o~o
eo cO"': N
0"1"1
N~~
00
#<-:
0"'1"'1
Nm~
673
674 Part Five TheAnal~sis ofRisk om! Return
FIGURE 18.4
Value-at-Risk
Profiles for Firm A
and Firm B
The profiles are
generated forseven
scenarios forGDP
growth inTable 18.2.
FinnA hashigher
profitmargin riskand
higherassetturnover
risk.Theseriskfactors
give FinnA a higher
probability oflowvalueoutcomes but
alsoa higher
probability ofhighvalueoutcomes.
Chapter 18 TheAnalysis of Eqllit)' Ri5k and Remrn
firmA
OJ
0.2
.q
~
~
0.1
,
-100
100
100
200
300
Firm value ($ million)
400
500
400
500
FirmB
OJ
l,
0.2
.~
0.1
675
(which happens alsoto be themedian sales in scenario 4).At this level of sales, bothfirms
generate 54 million in ReO! and, forecasting this Rear as a perpetuity, both firms' values
are VJ<A =66.7+ 4.0/0.06 =$133 million. Butthe distribution of values around thisexpected value differ, so the firms are not equivalent investments. Theirriskprofiles differ.
Firm Ahasthechance ofgenerating considerably higher value thanB buttakes ona higher
chance of losing value onthedownside.
Thevalue-at-risk profile forFinnA issimilar to thefat-tailed, right-skewed distribution
ofstock returns thatistypically observed, asdepicted inFigure 18.lb.Butnow wehave uncovered the drivers of those distributions through fundamental analysis. We understand
what drives firms' risk. Rather thanassuming a return distribution, likethenormal distribution, we have determined the form of the distribution through analysis. We understand
return distributions-s-and corresponding value-at-risk profiles-may not be normally
distributed. And we understand why the standard deviation of return may not capture all
aspects of risk: Operating leverage andATO riskcancombine to give thechance of large
returns butalsothechance of verypoorreturns.
The examples hereare verystylized. Theyignore otheraspects of operating risksuch
as expense risk and operating liability leverage risk. They ignore factors beside GDP
growth that might affect sales. They are based on a distribution of sales for just one
period. Growth riskis notincorporated, forgrowth risktakes onmeaning only over a longer
period of time. Nevertheless, the examples illustrate the fonn of the analysis. Other risk
factors canbe accommodated. Political riskfrom a change in government or a change in
regulations might leadthe analyst to specify sales outcomes for bothGDP and political
outcome scenarios. The analysis can be repeated for each forecast year ahead and for
steady-state sales, PM, ATO, and growth at a forecast horizon. All that changes is the
computational complexity, for which a computer is required. Many more possible
outcomes and outcome pathsover time are considered and many more values associated
withthese paths arecalculated, alongwithassociated probabilities. Accordingly, thevalue
profile typically takes a fonncloserto the"smooth" distribution ofvalues over every value
in a range, likethose in Figure 18.1.
Adaptation Options and Growth Options

-100
200
300
Firm value ($ million)
GDP growth falls below 2 percent. On the other hand, Firm A delivers considerably
more R.t~OA and ReOI if GDP growth is over 2 percent: Operating leverage and ATO
flexibility determine downside risk, butthey alsowork toreward downside riskwithupside
potential.
The value of eachoutcome is given at the bottom ofTable 18.2. Thevaluation (again,
tokeep it simple) is based oneachoutcome being a perpetuity: V~OA = NO~ + Forecasted
ReOIlO.06. Forscenarios 1and2 forFirm A andscenario 1forFirm B,thenegative value
is the amount of NOA put in place: A perpetual negative RNOA implies all value is lost
and, with limited liability, the loss is limited to 100percent of investment. So the set of
possible values reflects notonlysales risk, PMrisk, andATO riskbutalsoprotection from
risk through limited liability. Value-at-risk profiles are completed by attaching the probebility of outcomes to the value of outcomes. Profiles for firms A and B are depicted in
Figure 18.4.
Thecomparison of thetwo profiles illustrates thetradeoff between upside potential and
downside risk.Theexpected value of a set of outcomes is thesumof eachoutcome multiplied by theprobability of the outcome. Soforbothfirms, expected sales are $100 million
The examples forfirms A and B specify the response of net operating assets to sales in a
simple way: TheATO riskdriver hasjust twocomponents, a fixed component anda component that is proportional to sales.This assetstructure doesnotrecognize the variety of
ways thata firm canadapt to changes insales. It is unlikely thata firm would stay in a scenario I situation. If it found that, for any reason, the demand for its products faced a
scenario I outcome, it would adapt. It might liquidate, returning some value to claimants
rather thanlosing all value as in theexamples. Orit mightadapt into otherrelated or unrelated products.
Theability to liquidate or adapt andavoid worst-case outcomes is called theadaptation
option. A firm's adaptation option depends on how it is structured, how easily itstechnologycanbe liquidated or adapted to alternative use. A fanner canadapt to falling demand
forhiscropbygrowing alternative crops or grazing animals. Amaker of gasoline-powered
automobiles presumably canadapt to solar-powered vehicles should demand shiftto them.
Buta highly specialized producer-s-the manufacturer of a drugthatis replaced bya superiordrug-may have fewoptions and may choose to adaptby liquidating. The adaptation
option is theability of firms to "reinvent themselves."
Analysts talkof valuing the adaptation option. The value is captured within the analysis hereby specifying more sales outcomes (which will result if the adaptation option is
taken) andmore complicated ATO drivers forthese outcomes, andassigning probabilities
Chapter 18 TheAnalysis ofEquitJ Risk and Rewm 677
676 Part Five TheAnalysis ofRisk and Rerllm
that the adaptation will occur. Thevalue in liquidation canalso be considered within the
analysis.
Analysts alsotalkof growthoptionsandthe needto attach a value to them. Like adaptationoptions, a growth option is an option to adapt, but in particularly goodscenarios
rather than bad scenarios. The growth option amounts to being able to put assets in
place-e-tc expand net operating assets-to exploit newopportunities. Adaptation options
limitdownside risk; growth options generate upside potential. Wecharacterized growth
risk in Figure 18.3 as the risk thatsalesmay not grow. But as with all risks, growth risk
has an upside, andfirms mayhave differential ability to capitalize on unexpected growth
in sales.
A retailer who signs a lease withan option to rentadditional floor space hascreated an
explicit growth option. But most growth operations are not as explicit. Firms create
growth options bybuilding excess capacity-in factories, telephone networks, distribution
systems, airline routes, and satellite networks. Growth options also come from a finn
placing itselfv'in the rightplaceat therighttime." Itsknowledge basemaygiveit theabilityto capitalize on technological change as it occurs. Its market position, brand name, and
customer loyalty may give it the ability to capitalize on product innovations and adapt
to changes in consumer tastes. Identifying these options adds to the upside potential in
the value-at-risk profile. Indeed we saw FirmA had a built-in growth option (relative to
Finn B) by having fixed-cost plantthatcouldbe utilized if salesmaterialized above their
expected amount.
These growth options, and the profits and value they maygenerate, are captured by a
value-at-risk analysis. As withFirmA, layout the sales, profit margin, and assetturnover
scenarios if growth options are exercised andassign a probability to thesescenarios.
Strategy and Risk

Value-at-risk profiles are a tool for analyzing strategies. The business strategist mustnot
onlyappreciate the expected value of a strategy but alsounderstand the upside potential
and downside risk it generates. And he needsto trade off upside potential for downside
risk.So beprepares a value-at-risk profile foreachproposed strategy.
FirmA and FirmB in the example above represent different strategies for structuring
a business with the samesalesoutcomes, and these strategies generate different value-atrisk profiles. Strategies with different salesoutcomes can be evaluated in the same way.
More generally, eachcomponent of fundamental riskis explicitly considered in eachstrategy and its effect on the value-at-risk profile is documented. Should the firm build in
growth options? Should it buildin adaptation options? what is the costof theseoptions?
With an understanding of risk, the manager manages risk with scenario planning. He
lays out the possible scenarios, buthe alsoplanshow to runthe business in eachpossible
scenario. He plansthe adaptation to avoid bad outcomes should pessimistic scenarios be
realized. Heplanshow tohandle growth, should it come. Thiscontingent planning, intum,
yields more detailed scenarios andmore insights intogenerating value andreducing risk.
Accordingly, value-at-risk analysis is anaidto formulating plansas wellas analyzing them
forthe riskthattheyinvolve.
Discounting for Risk

Forbothfirms A andB wecalculated a value of$133million basedonexpected sales. But
thisvaluation assumed theinvestments were riskfree: Thediscount rate usedin the calculations wastherisk-free rate.Given theriskprofiles indicated possible variation around the
value of$133 million, therisk-averse investor would paysomething lessthan$133 million
forthegambles.
Thedifference between therisk-free valuation anda risk-adjusted valuation isthediscount

forrisk. Buying atthelower risk-adjusted price creates anexpected return above therisk-free
return; therefore, thediscount for riskalso canbe viewed as anincrease intheexpected (required) return overtherisk-free rate, or as a riskpremium intherequired return. Thevaluationquestion ishow to measure thispremium (ordiscount, ifthat's how youview it).
Thestandard deviation in the values forFinnA is $198.8 million, compared to $103.3
million for Finn B. One approach might be to determine the risk premium on the basis
of this standard deviation. This approach requires a model of how the risk premium is
related to standard deviation. But such an approach does not recognize that standard
deviation canbereduced through diversification. Assetpricing models do, but they do not
yield a reliable measure of the risk premium. Further, the standard deviation and asset
pricing models donotcapture theriskinextreme returns thatis indicated bytheanalysis of
fundamental riskandobserved in stockreturns.
Thetechnology to measure the riskpremium has notyet beendeveloped in a satisfactoryway. The CAPM, the mode! thatis most frequently used, is unsatisfactory forthereasonsstated earlier. Theanalysis heredoesnotgiveyouanalternative. It doesdescribe how
business fundamentals determine risk andhow outcomes affect value. But it doesnot tell
youhow thevalue-at-risk profile translates intoa premium for risk.
FUNDAMENTAL BETAS
Fundamentals canplaya roleinthebetatechnologies thatemanate fromassetpricing models.Betaisthesensitivity of a firm's returns tosystematic marketwide factors such as GDP
growth and, as wesawwiththeexamples forfirms AandB inthelastsection, these sensitivities depend on characteristics of the firm. A finn withhighfinancial leverage or high
operating leverage, forexample, willhave a high CAPM beta,allelsebeingequal. FinnA
will have a higher betathan FirmB. So information on thesefundamental characteristics
canbeof helpin estimating betas.
Betas estimated from stock returns (without any consideration of fundamentals) are
calledhistorical betas. Theestimation of a historical beta forFirm i is done by running a
regression for returns overpastperiods in theform
Return(i) = ex + P(i) x Return on themarket + e(i)
(18.5)
The return on the market determines the systematic portion of the return; a + e(t),
sometimes referred to as residual return, is the portion of the finn's return that is not
explained by movements in themarket. Sometimes the regression is runwithreturns measuredastheexcess overtherisk-free rate.Thefirm's beta,P(i), isthesensitivity ofitsreturn
to movements in themarket.
Historical betasarecalculated afterthe fact. Thatis,theymeasure the sensitivity of returnsto themarket returnin thepast.Butthe investor is concerned withthe betashewill
experience in the future while she holds the investment. Betas change because firms
change. Firms change their typeof business, theirleverage, andtheirasset turnover risk.
All of the risk determinants in Figure 18.3 can change overtime. Indeed historical beta
estimates are known to change overtime. In particular, like a lot of financial measures
we have investigated, they are mean reverting: High betas tend to decline overtimeand
lowbetastend to increase. Forthis reason, somebeta services adjust historical betasas
follows:
Adjusted historical p(i)= 0.35 +0.65 x Historical p(i)
Chapter18 TheAnalyslsofEquiryRiskandRemm 679
678 PartFive TheAnalysis of Risk and Return
Thisadjustment has theeffectofpulling thehistorical betatoward 1.0,theaverage betafor

all firms. So if the historical betais 1.70, the adjusted betafor the future is 1.455. Butthe
adjustment is ad hoc.
Another wayto proceed is to predict future betasfrom fundamentals. If betas reflect
firms' characteristics, thentheycanbe predicted from thosecharacteristics. Suchbetasare
called predicted betas or, because they are predicted using fundamentals, fundamental
betas. The finn BARRA, Inc.,pioneered themarketing of fundamental betasbasedon academic research.
A predictive betamodel is builtin twosteps.Weillustrate it withjust twofundamental
predictors, financial leverage (FLEV) and operating leverage (OLEV). In the firststep,a
relationship between historical betas and past fundamentals is estimated from the cross
section of firms:
Historical ~(I) = bo+ bl FLEV(I) + bi OLEV(I) + ~(I)
In the second step, estimated coefficients from the firststep, bj, and b2, are usedto
predict future betasforparticular firms from theirmostrecent fundamentals:
Predicted ~(i) = bo+ bIFLEV('J + b, OLEV(I)
Models also can be developed that incorporate both historical betas (estimated from returns) andfundamentals."
Fundamental betamodels typically include manymorefundamental characteristics than
thetwousedhere,alongwithindicators for industry sector andlinesof business.
Thesecharacteristics areusually selected on thebasisofwhatworks inthedata,withnot
a lot of theoretical justification thattheyshouldcapture risk. Lookto Figure 18.3foradditional fundamental riskattributes thatmightbe betapredictors.
PRICE RISK
Fundamental riskarisesfrom theuncertainty of outcomes to business investment, and fundamental risk contributes to uncertainty aboutstockreturns. Butthereis another aspect of
riskwithwhichthe investor mustbeconcerned. If prices deviate from fundamental value,
the investor can be at risk-and be rewarded-by trading at prices that are not at fundamental value. This risk,which has nothing to do with fundamentals, is caned price risk.
Priceriskcomes in twofonns, market inefficiency riskandliquidity risk.
FIGURE 18.5
InThese Scenarios
forEarning
Abnormal Returns,
Po Is MarketPrice
at Time 0 and Vg Is
Intrinsic Value
at Time o. piIs
Expected Cumdividend Price at
Time T and Is
Expected Cumdividend Intrinsic
Value at T
vi
In Scenario A the
investor expects the
cum-dividend price
in the future to be at
fundamental valuebut
seesthecurrentprice
as different from
fundamental value.
Thusshemakes
abnormal returns as
pricesmove toward
fundamental value.
In Scenario B the
investor seesthe
currentprice as equal
to fundamental value
but expects theprice
to movea:way from
fundamental valuein
thefuture. Thusshe
makes abnormal
returns as prices
deviate from
fundamental value.
Scenario A: Pricegravitates to fundamental value
""J]
',', j ":r.~
.......
va
,""""" ,V"PO,J"
I
7 Because betas determine expected returns (according to the CAPM), a model ofreturns issometimes
estimated inthe first step byincluding fundamental characteristics, inaddition to the market factor, in
the return model (equation 18.5).50 fundamentals areadded to the market return andthe historical
betato explain returns inthe past. Then, inthe second step,estimates from thismodel areused to
combine fundamental characteristics with historical betasto predict future stock returns rather than
betas.
TIme
Scenario B:Pricedeviates fromfundamental value
"""""""""'/1
Abnormal "rum,
pi-vi
"1
Actual return,
~'lr
Market Inefficiency Risk

Thepassive investor whotruststhatthe market for sharesis efficient recognizes thathe is
subject to fundamental risk: Efficient market prices will change in response to changes
in fundamentals. The active investor maintains that prices can be inefficient. He tries to
exploit the inefficiencies, buthe alsorecognizes thatthemarket canbe inefficient in anuncertainway. Pricescan move against him. Market inefficiency risk is the risk of prices
moving in a waythat is notjustified by fundamentals.
Abnormal "tom,
4
Time
Consider two scenarios for exploiting market inefficiency. You mightpredictthat the
priceat whichyou will liquidate the investment at somefuture time,PT, will be appropriatelypriced but recognize that the current price, Po, is mispriced. Thatis, you predict that
youwillgeta fairpricewhenyousell at time T, andyoumake an abnormal returnbybuying the stock at the current price that you judge is incorrect. Alternatively, you might
conclude thatthe stockis appropriately pricedat presentin Po but willbe mispriced in the
future in PT. Using Vto indicate an intrinsic value, thetwoscenarios aredepicted inthetwo
panelsof Figure 18.5. Eachpanel gives currentand expected future market pricesfor the
investment, Po andP:;'
(the expected future pricewitha C attached to it) indicates that
pi
Chapter 18 TheAnnlYli5 of Equity Risk and Remm 681

680 Part Five TheAnalY5i, of Ri,kandRecon
theexpected priceat time T is cum-dividend fordividends paidfrom0 to T, fordividends

arealways partofthe return. Po andp~ arecompared to intrinsic values at time0 and T, Vo
The intrinsic value at time T is alsocum-dividend.
and
In Scenario A,thefundamental analyst perceives thestocktobecurrently mispriced and
invests tocapture anabnormal return asthepricereturns to fundamental value. Aninvestor
who failsto detect overpricing might buya stockthatis overvalued and then lose value as
theprice falls in its return to fundamental value. An investor who fails to detect an underpricing (as in the figure) might sell (short) and lose the value as the price rises toward
fundamental value. In eithercase, there is a riskof trading at the wrong price. Theriskis
referred to as Scenario A risk. Scenario Acan bring rewards butit alsoinvolves risk.
In Scenario B, the investor buys a stock at its fundamental value and sees the stock
deviating from fundamental value inthefuture. Soheinvests tocapture theabnormal return
thathe predicts. However, a fundamental investor who thinks he is buying at fundamental
value butdoesnot anticipate Scenario B mayactually lose value should a Scenario B outcomematerialize andthestockdeviate down from fundamental value. We refertothisrisk
as Scenario B risk. Like all investing, Scenario B can be exploited for reward but also
brings risks.
The twoscenarios differin theexpectation of how future prices willbehave. Scenario
A predicts that the market will ultimately recognize the mispricing and correctitself(as
future earnings reports become available, for example). Scenario B predicts the market
willbe "carried away" from fundamental value. In a Scenario B one might, for example,
forecast that acquirers, in the process of "empire building," will bid up the price of
takeover targets above fundamental value. The investor might buy likely takeover targets
in anticipation of this. Or one might forecast inflated prices of takeover targets during
"merger booms" as acquirers compete for the acquisitions. One mightanticipate supply
anddemand forstocks andforecast thatstrongdemand forstocks(orlackofdemand) will
drive them away from theirintrinsic values. A number ofinvestors explained theperceived
overvaluation of stocks in the 1990s as the effect of baby boomers getting too entbusiastic about stocks and investing their wealth indiscriminately, pushing the priceup.These
areso-called liquidity theories of stockprices. Onemight forecast thatstockprices willbe
earnedaway fromfundamentals byfashions, fads, or a herdmentality thatintroduces misconceived popularbeliefs of a stock's worth. Fearmight drive stockprices down, as was
conjectured aboutthe large dropinstockprices during the creditcrisisof2008.These are
so-called psychological theories ofthe stockmarket. These theories try to explain howinvestors can be seemingly irrational. The studyof the forces that drivestocks away from
theirvalues is calledbehavioralfinance.
Scenario A riskandScenario B riskcanbe operating at thesametime. Aninvestor may
think that a stock is undervalued and so buy in anticipation of a Scenario A return, but
Scenario B forces can drive the price even lower. In the mid-1990s, many fundamental
investors sawstocksasovervalued, sotheymoved outofstocks, onlytofind thatoverthelate
1990s stocks became more overvalued (intheirview}-and theymissed outona gooddeal
of the bull market. Andthose who sold short in the mid-1990s had considerable losses.
Assured of theirinsights intofundamentals (andfundamental risk), theywere stillexposed
toprice risk.
The riskin both scenarios arises from buying or selling at the wrong price, a pricethat
is not consistent withinformation about fundamentals. Fundamental analysis is a protectionagainst pricerisk.Thiswastheappeal to fundamental analysis thatwemade inthevery
firstchapter of thisbook: Analysis reduces the uncertainty in investing.
But fundamental analysis alone may not be enough to protect against Scenario Brisk.
Scenario B arisesfrom factors thatdrive prices away from fundamentals andunderstanding
vi.
those "irrational" market forces helps to predict Scenario B. Indeed, that understanding
also helps predict Scenario A because if youthink, basedon fundamental analysis, thata
stockismispriced and, as well, youhave anexplanation of why theprices arenotat fundamental value, youaredoubly assured.
Fundamental analysis doesnotexplain stockprices fully. Stock price theory, based onbehavioral theories of pricemovements, completes the explanation. Understanding price formation protects against pricerisk. Butjustasfundamental analysis protects against price risk
while itexploits (Scenario A)mispricing, sostockprice theory helps in exploiting (Scenario B)
mispricing. Unfortunately, the behavioral theory of stockprices is not welldeveloped; it is
rather atthelevel of (interesting) conjecture. Absent sucha theory, thefundamental investor
might well takethe advice of thefundamental analysts of old:Invest forthe longtermwith
considerable patience (forprices to ultimately reflect fundamental value). Thisview asserts
the mispricing is a temporary phenomenon thatwill(ultimately) correct itself.
The manager investing in projects within the finn is not concerned with price risk.
The risk in projects and business strategies is fundamental risk. However, that manager
mustbe careful inusinghurdle ratesforinvestment thatare estimated from market prices,
like those based on historical CAPM betas. Suchhurdle ratesmight reflect pricerisk,not
fundamental risk.
Liquidity Risk
Selling at a pricelessthanfundamental value canharmreturns. But an investor canget a
poorpricebysimply notfinding otherinvestors to sellto.Desiring to sell,the investor may
find shehasto takea lowpriceto attract a buyer.
The riskof having to tradeat a pricethatis different from intrinsic value because of a
scarcity of traders is calledliquidity risk. Sellers faceliquidity risk,butso dobuyers who
do theirfundamental analysis but can't find sellers. Shortsellers run considerable risk if
they can't find buyers whentheywishto buy the stockto cover positions. Andthe more
leveraged the trading position, theworse is the effect of liquidity risk.
Liquidity risk can be a permanent feature of some markets. Shares in privately held
firms thatrarely tradehaveconsiderable liquidity risk.Shares inlarge publicly traded firms
havelowliquidity risk.Butliquidity riskcanchange unpredictably also. Investors maylose
interest in particular stocks. Andif the firm fares poorly, the investor mayfind it difficult
to dispose of shares, to find willing buyers. Entire markets face liquidity risk should
investors fiee the market in a "crash," and regulators and central bankers are concerned
withthis"systematic" liquidity risk.
Thediscount thatasellertakes forilliquidity istheliquidity discount. Market mechanisms
develop to reduce thisdiscountThestockbroker performs thefunction offinding buyers or
sellers ontheothersideofa trade andsoreduces liquidity risk(forwhich he charges a fee).
Themarket maker matches buyandsellorders on stock exchanges andso reduces liquidity
risk(forwhich traders payanimplicit feeinthebid-askspread). Investment banks find buyers forlarge issues of securities, and specialized brokers arrange for salesof private firms
(forwhich theycharge fees). Indeed, transaction costsintrading arethecostof minimizing
liquidity risk. Expected returns to investing are reduced by liquidity riskand expected reo
turnsto investing arereduced bytransaction costs (which reduce liquidity risk).
INFERRING EXPECTED RETURNS FROM MARKET PRICES

The measure of the required return is elusive, but the active investor focuses on the expected return to buying shares at their current price rather than the required return. In
682 Part Five TheAnalysis of Risk and Return
Chapter 18 The AnQ!ysis of Equiry Risk and Refilm 683
Chapters 5, 6, and 14,thisbooklaid out thereverse engineering methods to establish the

expected return. We summarize that material here. In itsshortform, the residual earnings
mode! is statedas
Po=Bo +
[ROCE, - (p, -I)J x B.
PE - g
If the market price, Po, is efficient, then PE is the required rerum.!But if not, it is just a
number that equates forecasts ofROCE[ and growth to the market price; that is, it is the
expected returntobuying at the market price. Theformula for reverse engineering thisexpeeted return (from equation 5.7 in Chapter 5) is
Expected equity return = [
~ x ROCE,
H( ~
1-
) x (g
-1)]
(18.6)
That is, the expected returnis a weighted average of forecasted profitability and growth
where the weight is supplied by the book-to-price ratio. Similarly, with an unlevered
valuation,
P, - g
where plA. is thepriceof operations (enterprise price), PFis the return forthe operations
(theenterprise return), and g is now the growth ratefor residual operating income. Reverse
engineering (asin equation 14.8 in Chapter 14),
(18.7)
where NOAr/PONDA is the enterprise book-to-price ratio. (This reverse engineering can
be adapted forlongerhorizon valuations where a growth rateis applied aftertwo, three, or
four years intothefuture.) Theinvestor asks: Is theinferred expected return commensurate
withtheriskestablished bythefundamental analysis above? Ifit is toolowforthatrisk,the
shares areoverpriced. If it is highrelative to the assessed risk,the stockis underpriced. Of
course wewould liketo havea quantification of the required returnfrom the riskanalysis
so as to compare the expected return directly witha required return, but that we do not
have.
To carryout thisreverse engineering, onehasto specify a growth rate(which financial
statement analysis helpsto elicit). Ifunsure,reverse engineer witha variety ofgrowth rates
to understand the sensitivity of the expected return to uncertainty about the growth rate.
(One suchgrowth rateshould include the GDP growth rate.) Alternatively, afterthe analysis of riskabove, specify a required return andreverse engineer a growth rate(asin Chapters 5 and 6) and challenge the market's implied growth rate. Can the finn deliver this
growth rate? Doesit accord withthe financial statement analysis andotherinformation at
hand?
Considerable research hasused thisandsimilar formulas to infer the reoulred return (cost of capital)
from market prices. Seethe Readers' Corner on the Web pageforthischapter, These estimates of the
required return arevalid only if prices areefficient.
While we would like to compare the expected return with a required return, the present
stateof thetechnology doesnotyielda reliably precise measure of therequired return. We
have laidoutthedeterminants ofriskinthischapter buthave notfound anypersuasive way
of converting riskcharacteristics intoa riskpremium.
Hereareways to incorporate theriskanalysis intoinvesting and, inso doing, finesse the
problem of notknowing therequired return.
Evaluating Implied Expected Returns with Value-at-Risk Profiles

When is an expected return extracted withreverse engineering too highor too low? That
question is answered onlyby reference to the fundamentals, so the investor refers to his
value-at-risk profile for thestock. If theexpected return from hisreverse engineering is low
but that profile indicates considerable downside risk, without compensating upside potential,he confirms bisopinion thatthe riskof paying too much is high. If, ontheotherhand,
theimplied return is highbuttheprofile indicates lowrisk,heis moreassured thatheis not
paying toomuch for the stock.
Enhanced Screening and Pairs Trading
mu
,[.RN=OA""_--,!Cp:.c,_--"I),,,]x.:.:N.:.:O=""
p. =NOA,,+-
ExpectedrelumfOrOPeIations=[~~~ XRNOA}[(I- ~~~ )X(g-I)]
FINESSING THE REQUIRED RETURN PROBLEM
These ideaspointto an improvement in screening analysis relative to the simple screens

of Chapter 3: Rankfirms on theirimplied expected returns, then buyfirms with high expected returns and sell those withlowexpected returns. However, thereis a danger here;
stocks'expected returns maybe warranted by their fundamental risk, so that, in buying
firms withhighexpected returns, onemightjust be loading up on riskyfirms. So,firstassignfirms intoriskclassesbasedonthesimilarity of theirvalue-at-risk profiles. Thenproceedto screen within risk classes. If a stock has a high expected returnrelative to other
firms withsimilarvalue-at-risk profiles, it maybe underpriced.
A further refinement involves pairs trading. Pairs trading requires canceling longand
shortpositions in stocks withsimilarcharacteristics. If thatcharacteristic isrisk(asdeterminedby a value-at-risk profile), the traderis essentially canceling her exposure to the
risk: If the risk hits the longposition, she is protected by a compensating return to the
shortposition. Placefirms in theirsameriskclass,thengo longon thosewitha highimpliedexpected return and shorton those witha lowexpected return. If the riskis indeed
thesame,the longand shortfirms should havethesameexpected return, so oneis investing on the basisof the relative assessed mispricing. But one is alsohedging against the
common riskto both.Theinvestor doesnot haveto measure therequired return; themeasurement problem is finessed.
Relative Value Analysis: Evaluating Firms within Risk Classes

Byestablishing value-at-risk profiles, wedistinguish morerisky firms from lessrisky firms.
Firm A is seenas moreriskythanFirmB in ourexample. Riskclasses groupfirms according to the shape of their profiles. Firmswith highoperating riskand high financing risk
might be distinguished from firms with high operating risk but low financing risk. And
firms withhigher upside potential but higherdownside risk(Firm A) might beplaced in a
separate riskclassfromthose thatarestructured tominimize downside riskandloseupside
potential (Firm B). Cruder risk classes mightbe based simply on industry and financial
leverage differences.
Having established a risk class,we would conclude that, withthe current state of the
technology, we cannot see any significant difference in risk between firms within the
class. We would not havea measured the required return for the class, but in selecting
684 Part Five TheAnalysis of Risk and Rewm
Chapter 18 TheArw.lysis of EquilJRisk (lnd Return 685
investments, we canproceed with relative value investing, whichalso finesses the needto
estimatethe required return. Relative valueinvesting is an alternative to screening within
risk classes.
To understand relative value investing, appreciate that the valuations we have been
making with a (presumed) estimate of the costof capitalare a form of relative valuation.
Thecalculation V[ is the amount of valuein unitsof cashthat wewould have to giveup to
buy the investment; it's a value relative to the value of cash. Cash can be invested at
the risk-free rate.The risk-adjusted discount ratein the valuecalculation gives a valuethat
is an alternative to cash, or an alternative to investing cash at the risk-free rate. So,
effectively, the use of a risk-adjusted discount rate rescales the investment to the same
risk class, so to speak, as cash. In technical terms, cash is the numeraire, the unit of
measurement.
Now, rather than calculating the valuein unitsof cash, calculate the valueper unit of
valueof anotherstock in the same risk class, that is, with a similarvalue-at-risk profile.
Rather than thinking of the alternative as investing cash at the risk-free rate, think of the
alternative as investing in anotherassetwiththe samevalue-at-risk profile. Calculate a relativevalueratio for the investment beingconsidered, investment 1,relative to the alternativeinvestment in the sameriskclass,investment 2:
Relative valueratio
vt (l)/Po(l)
vt (2)/ Po(2)
The value for both investments Vff(l) and Vg(2} is calculated by discounting expected
residual earnings at the risk-free rate. Pe(1) and Pe(2} are the respective marketpricesfor
the twoinvestments set by the market's assessment of risk.
Ifboth investments are risky, the ratioof theirvalues (calculated usingthe risk-free rate)
to the current price, Vff(l}lPo(l} in the numerator and Vff(2}/Po(2) in the denominator of
the relative value ratio, shouldbe greaterthan 1.0.If not, the numerator or denominator
would indicate sell. But a buy or sell also would be indicated if the overall relative value
ratio were different from 1.0.If the ratio is greaterthan 1.0,buy investment 1 because its
marketprice,Po(l}, discounts therisk-free equivalent valueforriskmorethaninvestment 2,
for the samerisk.And, to hedgeagainstthe risk thatis common to both,sell investment 2
short. If the relative valueratio is lessthan 1.0,reverse these positions. You can also conduct the analysis withthe alternative investment beinga portfolio of all firms in the same
riskclass.This reduces possible error fromhaving assigned investment 2 to the wrongrisk
class and averages out idiosyncratic risk in anyone stock.
Themostdifficult partof the analysis isthe assignment of firms to riskclasses. Focuson
industries that havethe sameoperating characteristics.
Analystsdo concentrate on specific industries and their knowledge of the industry
shouldenable them to generatevalue-at-riskprofiles.Table18.3gives"perceivedrisk"
measuresfrom a surveyof analystspublishedin 1985. Analystswereaskedto rank the
risk of stocks on a scale of I to 9, assuming that the stocks were to be added to a welldiversified portfolio. Thus, the risk they were asked to assess is systematic risk. The
average responses for each firm are givenalong with three fundamental attributesthat
are commonly acceptedas indicators of risk.The averageperceived risks are in ascending order and seem to be correlatedwiththe fundamentals. Indeed, the correlationsbetween perceived risk and asset size, financial leverage, and earnings variability are 0.46,0.52, and 0.48, respectively. Thisanalysisis fairlyprimitivebut givespromisethat
analysts can combinetheir knowledge of businesswith fundamental analysisto assign
firms to risk classes.
TABLE 18.3
Analysts' Perceived
Risk and
Fundamental
Attributes for 25
Stocksin 1985
Source: G. E. Farrelly, K R.
F.rris,and W R. Reich.rot,in,
"Perceived Risk, Mmel Risk.
and Accounring Determined

Risk M=U~b Accounting
RI"Vi~", April 1985,
pp.27&-288.
Perceived Risk
Name of Stock
Mean Variance
AT&T
Procter & Gamble
1.89
236
239
2.69
2.70
3.20
3.57
3.87
3.91
4.11
4.28
4.30
432
4.59
4.69
4.86
5.13
5.54
5.66
5.67
5.88
5.92
637
7.23
8.78
IBM
General Electric
Exxon
Commonwealth Edison
Dow Jones & Co.
McDonald's
Sears, Roebuck
DuPont
Safeway
Citlcorp
Dr. Pepper
General Motors
Xerox
American Broadcasting Company
Holiday Inn Worldwide
Tandy
Litton Industries
RCA
Georgia-Pacific
Emery Air Freight
H. Hutton
us. Homes
International Harvester
1.22
1.74
1.52
1.64
1.97
2.40
238
236
1.69
1.91
3.27
237
2.03
2.43
2.45
1.83
1.86
2.00
1.78
2.02
2.51
2.58
2.75
2.60
0.41
Asset Financial Variability

Size Leverage in Earnings
11.83
8.85
10.30
9.95
11.33
932
6.28
7.97
10.24
10.08
8.21
11.69
5.11
10.57
8.95
737
7.43
6.84
8.21
8.97
8.53
5.62
8.64
6.63
8.58
0.165
0318
0338
0.468
0.277
0.620
0.477
0,413
0.573
0.508
0.691
0.215
0.422
0.397
0370
0.536
0.225
0.552
0.855
0.450
0.697
1.09
2.79
1.95
1.29
2.25
1.76
2.96
232
1.42
1.64
2.01
1.52
2.26
1.04
0.47
1.34
3.27
2.52
3.13
2.28
1.80
20.18
0.704
Note: A blJ~k indi""tes thot d,~ we~ not :lVoIilable. Percei....drisk is a",nking oflilk ;>$I""rceive<! by,n,lysts. on a sealefrom I r09;
is rhe""turn\logarilllm of lOlaI assets: fi"""ei,\ I....."'&" is se~iordebtdivid.d bytolal =ts: ,nd vari,bility in",ming' i,the
p:!St standJrd deviation orthe priee-.e,mings ...tio
=ts~e
Investing is highly personal and different investors may have different risk attributes
withwhich theyare concerned whenbenchmarking witha riskclass. Investors havedifferent tolerances for risk and like or dislike different features of variance-at-risk profiles.
Accordingly, they desiredifferent exposures to risk and different hedgesagainstrisk. It is
probably for this reason that mutual fundsprovide menus of funds for investors to choose
from. A set of riskclasses is sucha menu.
Conservative and Optimistic Forecasting

andtha Margin of Safety
Theanalyst canadjustforriskbybeingconservative in forecasting, thatis, calculate values
byforecasting a conservative scenario forresidual earnings anddiscounting theseforecasts
by the risk-free rate.If themarketpriceis greaterthana valuecalculated withconservative
forecasting, do notbuy. Similarly, if sellingis beingentertained, forecast an optimistic scenarioand calculate a value (by discounting at the risk-free rate)underthisscenario. If the
market priceis greaterthanthis value,sell.
The same ad hoc accommodation of risk can be made by usingrisk-adjusted discount
ratesbutspecifying ratesthat a value-at-risk profile wouldindicate are excessive in evaluatinga buy.A high rate would tend to undervalue the firm. Similarly, use a low rate that
tendsto overvalue the firm fora sen evaluation.
Chapter 1a TheAnalysis ofEqlliry Risk and RelUm 687
6a6 PartFive The AnQ.1;fsil of Risk ondRenu
Biasing forecasts or biasing discount ratesbuilds in what traditional fundamental analysts calla margin of safety. Either form of biasproduces a valuation which is deemed to
be incorrect butwhich is wrong byan amount-the margin of safety-that is a protection
against being wrong with estimates. The margin of safety is particularly important to the
defensive investor. Investing is inherently uncertain anduncertainty about therisks requires
caution.
Summary
Beware of Paying for Risky Growth

Ouranalysis of risk, summarized inFigure 18.3, showed thatgrowth is at risk. Ifso,growth
requires a higher return. This makes sense: Expected growth is just more expected earnings, andbasiceconomics tellsusthatonetypically cannot getmore earnings without takingon more risk. Again, wedo notknow how to measure therequired return forrisk, but
the recognition thatgrowth is risky brings a warning: Do notthinkof growth andthe required return as independent inputs to a valuation. Rather, when highgrowth is forecasted,
think in tenusof a higher required return.
Consider theshort-form residual operating income model:
Thischapter hasnotgiven youa precise costof capital. Sowecannot listthecostof capital as oneof the keymeasures at theendof the chapter. We mustbe realistic and notpretend that a precise measure can be calculated. Fake precision is of no help in practical
investing. Rather, takeanhonest approach, admit thatimprecision is inescapable, andthink
of ways of finessing the problem. Indeed, thelastsection of thechapter offered some ways
of doing this.
Thecenterpiece of thischapter is thematerial in the"Fundamental Risk" section onthe
determinants of fundamental risk. Understand the drivers of fundamental risk; they are
summarized in Figure 18.3. Andunderstand howvalue-at-risk profiles, like those in Figure 18.4, aredeveloped from ananalysis of these drivers. Understand alsohow theanalysis
is usedforstrategy andscenario planning.
An understanding of the fundamental determinants yields a qualitative assessment of
risk.Wise andprudent investors understand riskevenif theycannot measure it precisely.
And they understand that price risk as well as fundamental risk is involved, and how
fundamental analysis helps to reduce pricerisk. Active investors focus on the expected
return rather thantherequired return, andthechapter hasprovided toolsto do so.
Po'''~NOA. + [RNOA, -(p, -l)]xNOA.

PF - g
In implementing this model, onemight forecast considerable growth based ongrowth innet
operating assets (NOA) or,with a constant asset turnover, high anticipated growth insales. A
high growth rate, g (fora given required return), yields a highlower denominator here and
thus a higher valuation. Butif growth is risky, therequired return, PF, should alsobehigher.
Toaddhigher growth without also adding to therequired return would be a mistake.
Onecan imagine a situation where more growth addsto the required return, one-forone,suchthatthedenominator is unaffected. If theaddition of I percent to thegrowth rate
(from a4 percent growth rateto a 5 percent growth rate, say) adds1percent totherequired
return (from 9 percent to 10 percent, say), the denominator and the value areunaffected.
We would notpayforthatgrowth because it doesnotaddvalue.
We donotknow how much toaddto therequired return forgrowth, andfirms canindeed
deliver growth thatadds tovalue. Buttheinsight points toa conservative valuation: Forevery
1percent added to g, add I percent to therequired return. AB this leaves thecalculated value
unchanged, it is probably tooconservative. It pays nothing for growth so probably builds in
toomuch margin of safety from paying toomuch forgrowth. Butit is a good starting point
forasking howmuch growth is worth. These issues are discussed in Box5.6in Chapter 5.
Note thatthereverse engineering equations (18.6 and18.7) stillwork when thegrowth they
incorporate isrisky buta high expected return identified bythereverse engineering should be
conservatively appraised: It might be dueto higher growth riskrather thanmispricing,
Expected Returns in Uncertain Times

Risk requires a higher return, so when there is considerable uncertainty in theeconomy as
a whole, the investor requires a higher return. When a recession is anticipated, the investor
takes a conservative approach andthinks in tenus of a higher required return. Hedoesso
forinvesting inthemarket as a whole andmore soforfirms where thevalue-at-risk profile
indicates susceptibility to economic downturns. Thisbuilds in a margin of safety against
badtimes. Market prices drop inanticipation of recessions andthusexpected returns from
reverse engineering might increase. However, theconservative investor evaluates these expected returns against a higher benchmark. Astheappropriate required return is indefinite,
this exercise is vague, butthinking ina conservative direction is goodpractice.
More on reverse engineering.
More discussion on extreme returns, "tall risk," and

how downside risk is rewarded with upside potential.
More on Scenario A and Scenario B investing and

behavioral factors underlying Scenario Binvesting.
More detail from the Shareholder Scorecard for 2007

andotheryears.
Key Concepts
Attempts to estimate theequity riskpremium.
adaptation optionis theability to alterthe

business aftera badoutcome. 675
behavioral finance is thestudy of
whystock prices seemingly behave
irrationally. 680
distributionof returns is thesetof
possible outcomes thatan investor faces
withprobabilities assigned to those
outcomes. 660
diversification of risk involves reducing
riskbyholding many investments in a
portfolio. 664
downside risk is theprobability of
receiving extremely low returns. 663
expected return is thereturn thatan
investor anticipates earning from buying
at thecurrent market price. Compare with
requiredreturn. 659
fat-taileddistributionof outcomes hasa

probability of extreme (high andlow)
outcomes thatis higher thanthatforthe
normal distribution. 663
fundamentalrisk is theriskthatis
generated bybusiness activities. Compare
withprice risk. 667
growth optionis theability togrow assets
(andprofits) if anopportunity arises. 676
liquidityrisk is theriskof notfinding
a buyer or seller at the intrinsic
value. 681
market inefficiency risk is the riskof
prices changing in a way thatis not
justified by fundamentals. 678
normal distributionis a setof outcomes
characterized solely by itsmean and
standard deviation. 661
ree
688 Part Five The AlUl1)'sis of Risk and Rerum

Chapter 18 The Analysis of Equi(y Risk and Return 689
pairs trading involves canceling long

andshortpositions in firms withsimilar
characteristics (forexample, thesame
risk). 683
price risk is theriskof trading at a
pricethatis different from the
fundamental value, either because of
market inefficiency risk or liquidity
risk. Compare with fundamental
risk. 678
required return or costof capital is the
return thataninvestor demands to
compensate forrisk. Compare with
expected return. 659
Analysis Tools
Page
Value-at-risk analysis
Scenario planning
Historical beta estimation
Fundamental (predicted)
beta estimation
Expected return
estimation (from market
price)
Enhanced screening
Pairs trading
Relative value investing
Conservative forecasting
Concept
Questions
670
676
677
677
681
683
683
684
685
KeyMeasures
skewed distributionof outcomes is one

thathashigher probability in oneextreme
thantheother. 663
systematic risk or nondiversifiable risk is
riskthatcannot be diversified away ina
portfolio. Compare withunsystematic
risk. 664
unsystematic risk or diversifiable risk is
theriskthatcanbe diversified away ina
portfolio. Compare withsystematic
risk. 664
upsidepotentialis theprobability of
yielding extremely highreturns. Compare
with downside risk. 663
Page
Asset turnover risk

Borrowing cost risk
Expense risk
Financial leverage risk
Fundamental beta
Growth risk
Implied expected return
Operating leverage risk
risk
Profit margin risk
Relative value ratio
Risk class
Standard deviation of returns
669
669
669
669
677
670
682
669
669
669
684
683
661
ATO asset turnover
(APM capital asset pricing model
CSE common shareholders' equity
GDP gross domestic product
NBC netborrowing cost
01 operating income
OlEV operating leverage
OlLEV operating lability leverage
PM profitmargin
RNOA return onnetoperating
assets
WACC weighted-average cost of
capital
CI8.1. Why might thenormal distribution ofreturns notcharacterize theriskofinvesting
in a business?
C18.2. Comment on the following statement. The challenge in measuring the required
return for investing is to measure the sizeof the riskpremium over the risk-free
rate, but the capita! asset pricing model largely leaves this measurement as a
guessing game.
CI8.3. Canyouexplain why diversification lowers risk?
C18.4. Why doesoperating liability leverage increase operating risk?
C18.5.
C18.6.
CI8.?
CI8.8.
Why aregrowth stocks often seen as highrisk?

Explain assetturnover risk.
Airlines aresaidtohave highoperating risk. Why?
Why mightstock returns have greater riskthanisjustified bythefundamentals of
thefinn'sbusiness activities?
CI8.9. Should firms manage riskon behalfof theirshareholders?
Cl8.10. Suppose one calculated the intrinsic value of two firms using residual earnings
techniques withtherisk-free rateasa discount rate. Theprice-to-value (PIV) ratio
of these twofirms, so calculated, should be the same if theyhave the same risk
characteristics. Is thisso?
CI8.11. Explain the difference between Scenario A andScenario B investing andtherisks
involved in each.
Drill Exercises
Exercises
E18.1.
Balance Sheets and Risk (Easy)

Below are balance sheets for two firms withsimilar revenues. Amounts are in millions of
dollars. Which firm looks more risky forshareholders? Why?
FIRM A
Assets
Cash
Accounts receivable
Inventory
long-term debtinvestments
$ 17
43
Accounts payable
tone-term debt
$ 14
200
102
194
..J..Q1
Common equity
$460
FIRM B
Assets
Cash
Accounts receivable
Inventory
Property. plant, andequipment
$ 15
72
107
-12
$483
Accounts payable
Long-term debt
$ 37
200
Common equity
E
$483
Chapter18 TheAMI)',i, of qui')' Risk end Rewm 691

690 PartFive TheAna!)',!s of Risk and Rewm
E18.2.
FIRM A
Income Statement
Income Statements and Risk (Medium)
Thestatements below arefortwo finns inthesamelineofbusiness (inmillions of dollars).

Sales
Cost ofsales
laborandmaterials
Depreciation
FIRMA
Sales
Expenses
laborandmaterials
Administration
Depreciation
Selling expenses
$1,073
$536
$345
.2!
Seliing expenses
121
214
955
$542
~
108
9
26
-'"
~
49
118

Income before taxes
Income taxes
Income aftertaxes
--'-'
Interest expense
Income before taxes
Income taxes
Income aftertaxes
93
--M
59
_7
42
-.J.?
$27
FIRMA
Balance Sheet
Assets
FIRM B
Sales
Expenses
laborand materials
Administration
Depreciation
Selling expenses
Interest expense
Income before taxes
Income taxes
Income aftertaxes
51,129
$793
42
79
91
Cash
Accounts receivable
Inventory
1,005
7
4
27
54
215
$317
Accounts payable
Long-term debt
Common equity
$42
104
171
$317
124
__
4
120
FIRM B
43
Income Statement
77
a. Analyze the riskdrivers in these income statements, Which firm looks more risky for
stockholders? Why?
b. Onthebasisofthe relationships inthese income statements, develop proforma income
statements under thefollowing scenarios:
(l) Sales drop to $532 million forbothfirms.
(2) Sales increase to $2,140 million forbothfirms. What doesthisanalysis tellyou?
Sales
Costofsales
laborandmaterials
Depreciation
Selling expenses
Research anddevelopment expenses
$796
$590
47
637
159
53
19
15
87
72
E18.3.
Ranking Firms on Risk (Medium)

Below are income statements andbalance sheets forthree firms. Rank these firms on what
youperceive tobetherelative riskiness oftheirequity from these statements. What features
inthestatements determined yourranking? Allnumbers areinmillions of dollars. Allthree
firms facea statutory taxrateof 36percent.

Income before taxes
Income taxes
Income aftertaxes
68
24
! 44
692 Part Five TheAnd)'sis of Risk and RCWlll
Chapter 18 The Analysis of EqHi,y Risk and Rewlll 693
FIRM B
BalanceSheet
Assets
Cash
Accounts receivable
Inventory
Property, plant. and equipment
S 5
47
Accounts payable
long-term debt
5 36
Common equity
341
$481
104
E18.4. Analyzing Risk (Hard)

Two firms, FirmA and Finn B, have$1,000 million invested in net operating assets in the
samelineof business. FirmA has $25 million in net financial obligations while FirmB has
$600million in net financial obligations. Bothfirms facea statutory taxrateof36 percent.
Below are forecasted pro forma income statements for the twofirms for the upcoming
year(inmillions of dollars).
78
192
159
~
fiRMA
Forecasted IncomeStatement
Sales
Fixed costs
Variable costs
$649
1,883
257
2
255
91
$ 164
$454
-.?
2J.2
fiRM B
Forecasted incomeStatement
130
Selling expenses
36
28
Sales
Fixed costs
Variable costs
_8
Netinterest expense
Income before taxes
Income taxes
Income aftertaxes
Interest expense
lncome before taxes
income taxes
Income aftertaxes
FIRM C
BalanceSheet
Assets
Cash
Accounts receivable
Inventory
1.240
Interest expense
Income before taxes
income taxes
Income aftertaxes
fiRM C
IncomeStatement
Sales
Costof sales
Labor and materials
Depreciation
$2,140
$ 643
S 6
10
Accounts payable
Long-term debt
5 39
210
66
97
-.122
$374
Common equity
...ill
$374
$2,140
$1,240
-.ill.
1883
257
~
209
----.li
$ 134
a. Calculate the forecasted return on common equity for the two firms. Would you
attribute the difference between the two measures to differences in risk?If so, why is
the risk of the equity different forthe twofirms?
b. Calculate the value of the operations of these two firms, assuming that the residual
operating income indicated by the pro forma income statements willcontinue indefinitely in the future. Use a risk-free rate of 5 percentin your calculations to derive a
valuethatis notriskadjusted.
c. Would youpay moreor lessforthe operations of FirmA thanfor FirmB?Why?
d. As an equityinvestor, would your required returnbe higherfor Firm A thanFinn B?
Why?
e. Whatwould residual operating income forthetwofirms be ifsalesfellto$1,500million?
Doesthis calculation justifyyour answer to part (c)?
694 Part Five TheAnal;;si, of Risk and Renml
Applications
E18.5.
Constructing a Value-at-Risk Profile: Nike Inc.(Medium)

Forfiscal year2004, Nikereported after-tax coreprofit margins on.84percentonanasset
turnover of 2.759. A.n analyst forecasts that thismargin and turnover willpersist in the futureona salesgrowth rateof5.1percent peryear. Nike reported $4,840 million ofcommon
equity and$4,551 million innetoperating assetsonit2004 balance sheet. Therisk-free rate
is 4.5 percent andthe required return foroperations is 8.6percent.
a. From thisinformation, calculate thevalue pershare attheendof2004on263.1 million
shares outstanding.
b. Generate a value-at-risk profile from scenarios 1-7 below:
Scenario
1
2
3
4
5
6
7
Sales Growth (%)
ProfitMargin (%)
AssetTurnover
1.0
2.0
3.0
4.0
5.1
6.0
6.5
4.0
4.5
6.0
6.9
7.84
1.5
1.9
2.3
2.5
2.759
2.9
3.1
8.0
8.9
Exercises E2.14, E6.7,E8.13, E13.17, E13.18, E15.11, E15.13, andE19.4 dealwithNike,
as doesMinicase M2.1.
Chapter 19 TheAnnlysis ofCredi! Risk and Reoon 697
After reading thischapter youshould understand:
is of Credit
LrNKS
Link to pnvious chapter

Chapter 18 showed howthe
analysis of fundamentals
helpsin theevaluation of
equityrisk.Value-at-risk
profiles weredeveloped
toassessequityrisk.
Whothe alternative suppliers of debtfinancing to the

firmare andhowtheycontract with thefirm.
Reformulate and annotate financial statements in

preparation for credit analysis.
Howdefault risk determines theprice of credit andthe

cost of debtcapital for thefirm.
Calculate liquidity, solvency, and operational ratios

that are pertinent to credit analysis.
What determines default risk.
Calculate credit scores using financial ratios.
Howdefault risk isanalyzed.

Whatbondrating agencies do.
Calculate a probability of bankruptcy using financial

ratios.
Howcredit scoring models work.
Trade off Type I andType II default forecasting errors.
The difference between Type i and Type )1 errors in

predicting default.
Prepare protorrnas for default scenarios.
Howproforma analysis identifies default scenarios.
Forecast default points.
Howvalue-at-risk analysis is incorporated into default

analysis.
Prepare a default strategy.
Prepare value-at-risk profiles for debt.
Howfinancial strategy works.
This chapter
Thischaptershowshow
fundamental analysis helps
in theevaluation of therisk
of a firm defaulting on its
debt.Value-at-risk profiles
aredeveloped to assess
default risk.
After reading thischapter you should be able to:
Do the
financial
statements give
indications of
whether a firm
mightdefault
on itsdebt?
Whatratiosare
relevant?
Howare
value-at-risk
profiles
developed for
business debt?
Howdoes pro
formaanalysis
aid in the
evaluation of
creditrisk,
liquidity
planning, and
financial
strategy?
Link to Webpage
Tolearnevenmoreabout
risk,visitthe text
Websiteat
I www.mhhe.comlpenman4e.
Mostof the analysis in thebookto this pointhasbeenconcerned withthe valuation of the

firm and the valuation of the equity claimon the firm. This chapter deals withthe other
major claimon the firm, the debt. Thusfar wehave accepted the market value of debtas
its value. But buyers and sellers of debt needto know how to establish the market value
ofdebt.
In most debt contracts, the payoffs to debtare specified in the contract. So Step3 of
fundamental analysis-forecasting payoffs-is trivial. But forecasted payoffs haveto be
discounted (in Step4) to get a valuation. Discounting requires a measure of the required
return for debt, and this required return, like that for equity, depends on the riskiness of
the debt: The required return for debt is the risk-free rate for the termof the debt plusa
default premium that varies withdefault risk. Defaultrisk, or credit risk, is the riskof
default; thatis,theriskofnot receiving timely interest andreturn of principal as specified

in the debt agreement. This chapter brings fundamental analysis to the taskof evaluating
default risk.
Analysts talkofthe required returnfordebt.Butdebttaken onbythe firm is alsocredit
supplied bythose whopurchase thedebt. Accordingly, wecantalkoftherequired return for
debtas also being the price of credit. Whatever the terminology, the amount charged by
suppliers of creditis the costof debt forthe finn.
THE SUPPLIERS OF CREDIT

Suppliers of credit to the firm include thefollowing:
Public debt market investors, who include (long-term) bondholders and (short-term)
commercial paperholders. Sometimes publicdebtis packaged bybanks intobundles of
securitized debtobligations or collateralized debtobligations, which arethentraded as
a package at a pricethatreflects theunderlying creditrisk. In turn, credit default swaps,
which insure the debtholder against default, are also pricedon the perceived credit
risk.Atall points inthischain, keeping trackof theunderlying riskis important. Often,
publicly traded debt is unsecured, that is, not collateralized by specific assets. Bondholders areprotected bybond covenants, which restrict the finn from specified actions
thatmight increase default risk, andviolation ofa bondcovenant istechnically a default.
Toevaluate default risk,investors inthistypeof debtrelyonthose corporate disclosures
about the overall health of the firm that are required by the Securities and Exchange
Commission (SEC) for all publicly tradedsecurities. Theyalso rely on bondratings,
which are published by rating agencies to indicate default risk.Accordingly, it is the
rating agencies that are particularly concerned with the analysis of risk, and they
develop rating models thatinvolve the analysis of fundamentals.
Chapter 19 TheAnalysis ofCredit Risk mul ReuiTIl 699
698 Part Five TheAnalysis ofRisk and Rezum
Commercial banks, which make loans to firms. They are usually closer to a firm's
business than a bondholder, so they haveaccess to moreinformation regarding default
risk. ~he loan officerserves as the credit analyst, and loan officers, like bond rating
agencies, have models that aid in credit scoring. Their creditscoring methods are tied
intothe.ir bank'.s internal riskmanagement, to protect the bankand to satisfyregulatory
constraints on Its exposure to risk. Banksoriginate loanson the basisof creditSCOres.
They then use credit scoring to measure the quality of loans that they sell to other
institutions and to monitor the defaultriskof loanstheyretain.
Otherfinancial institutions, such as insurance companies, :finance houses, and leasino
firms, make loans, much like banks, but usually with specific assets serving a;
collateral.Theyalsoarrange specialty financing suchas leasesof long-term assets.
Suppliers to the firm, whogrant(usually short-term) creditupondelivery of goodsand
services. Thecreditcan be grantedwith or without interest.
Each supplierof credithas a price for granting credit-the required retum-cand each
needsto analyze the riskof defaultandchargeaccordingly. Bondholders chargea yieldto
maturity basedon theirriskassessment andset bondpricesaccordingly. Bankschargeaninterestrateovera baserate(theprimeratefor theirsafestcustomers) thatdepends on default
risk.Andsuppliers chargea higherpriceforgoodsandservices if the default riskishigh.If
risk is deemed to be unacceptable, no priceis acceptable to the lender, so creditis denied.
Theexplicit priceisonlyonedimension of theprice.Justas asupplier mightcharge noexplicitinterest forcreditbutcharge a higherpriceforgoodssupplied to compensate, a bond.
holderwillcharge a lower yieldif bondcovenants havemoreprotection, a finance fum will
charge lesswithcollateral, anda bankwillchargelessforloanswithpersonal or parentCOmpanyguarantees. Suchrestrictions increase the(implicit) costof capital totheborrowingfirm.
FINANCIAL STATEMENT ANALYSIS FOR CREDIT EVALUATION

Equity analysis calls for a particular ratio analysis (of profitability and growth), which
waslaidout in Chapters II and12.Credit analysiscallsfora different analysis, andmany of
the ratios involved are different fromthosefor equity analysis. As withequity analysis, the
emphasis ison forecasting. Rather thanidentifying thoseratios thatforecast profitability and
growth, creditanalysis identifies ratios thatindicate the likelihood of default. Therefore, it is
also referred to as default analysis. As with equity analysis, the creditanalyst identifies
ratiosfrom financial statements that have firstbeenreformulated for thepurpose.
the balance sheet needs little reformulation. Indeed, it is because balance sheets are
structured withthe creditorin mindthatwehadto reformulate themforequityanalysis. For
credit analysis, thereis no needto distinguish operating debtfromfinancing debt. Bothare
claims that haveto be paid.
Somereformulation and annotation is calledfor,however. Hereare pointsto consider:
Details on different classesof debtand theirvarying maturities are available in the debt
footnotes; thesedetailscan be inserted in the bodyof reformulated statements.
Debtof unconsolidated subsidiaries (where the parentowns lessthan50 percent buthas
effective control) should be recognized. For example, oil companies sometimes raise
cashthrough joint ventures in whichthey hold less than 50 percent interest, and they
coverthe debtof thejoint venture if revenues in the venture areinsufficient toservice its
debt.The Coca-Cola Company ownsless than 50 percentof its bottling companies but
effectively borrows through these subsidiaries. The debt of these subsidiaries or joint
ventures shouldbe included in a consolidated reformulated statement, on a proportional
basis,if the parentcompany is ultimately responsible for it.
Long-term marketable securities are sometimes available for sale in the shortterm if a
needfor cash arises. For analyzing short-term liquidity, therefore, reclassify themas a
short-term asset.
Remove deferred tax liabilities thatareunlikely to revertfromliabilities toshareholders'
equity. Suchdeferred taxes, createdby a reduction of earnings and equity, areliabilities
thatareunlikely to be paid.So classifythembackto equity.
AddtheLIFOreserve to inventory andtoshareholders' equity to convert LIFOinventory
to a FIFObasis.FIFOinventory is closerto currentcost,soit isa betterindicator of cash
thatcanbe generated frominventory.
Off-balance-sheet debt can be recognized on the face of the statement. See Box 19.1.
Contingent liabilities that can be estimated should be included in the reformulated
statements. Contingent liabilities that cannotbe estimated shouldbe notedas part of
the annotation. Contingent liabilities include liabilities under product, labor, and
environmental litigation. In the UnitedStates,GA.AY requires theseliabilities to be put
on the balance sheet if the liability is "probable" and the amount of the loss can be
"reasonably estimated." Footnote disclosure is otherwise required, unlessthepossibility
of lossis "remote." Inspectthe contingent liabilities footnote.
The risk in derivatives and other financial instruments should be noted. Inspect the
financial instruments footnote.
Reformulated Financial Statements
Reformulated IncomeStatements
Fortheequity analysis financial statements were refonnuJated touncover whatismostimportant to equity investors, coreoperating profitability. Forcredit analysis, the statements must
be in a formto uncover whatis mostimportant to creditors, the ability to repay the debt.
Reformulation, as before, involves reclassifying items in the financial statements and
bringing moredollardetail intothe financial statements fromthe footnotes. In addition, the
discovery processleadsto someannotation of thestatements. Annotation involves summarizingfeatures of the financing that cannotbe expressed as dollaramounts on the balance
sheetbut whichare pertinent to the riskof default.
The analyst reviews the income statement to assess the ability of the finn to generate
operating income to covernet interest payments. Thusthe reformulated income statement
that distinguishes after-tax operating income from after-lax net financial expense serves
debt analysis well. So does the distinction in reformulated statements between core and
unusual itemsfor,witha viewto future default, the issueiswhether futurecoreincome will
coverfuture core financial expense.
Balance Sheet Reformulation andAnnotation

The abilityto repayamounts to having cashat maturity. Maturities differ, butit is standard
practice to distinguish debtas short-term (usually thought of as maturing withinone year)
and long-term (maturing in more than one year). Published balance sheets are usually
prepared with a division into currentand noncurrent (long-term) assetsand liabilities, so
Reformulated Cash FlowStatements

Thereformulated cashflow statement preparedforequityanalysis alsoservesdebtanalysis.
In particular, the reformulation ofGA.AY cashflow fromoperations to exclude after-tax net
interest identifies (unlevered) cash flow from operations that is available to pay after-lax
interest. Andthe reclassification of investments in financial assets(which GAAP placesin
the investing section) as financing flows rather than investment flows yieldsa number for
investing cash flows that has integrity, and captures net amounts of bond issuing activity.
Chapter 19 The AlUllysis ofCredit Risk and Return 701
Off-balance-sheet financing transactions are arrangements to

finance assets andcreate obligations thatdonotappear onthe
balance sheet Some types of off-balance-sheet finandng are:
Operating leases, Leases that are in substance purchases,
celled capital leases, appear on the balance sheet, with
the leased asset as partof property, plant, and equipment
andthe lease obligation aspart ofliabilities. Leases thatare
notinsubstance a purchase, called operating {eases, donot
appear onthe balance sheet; they aresummarized infootnotes. However, lessees and lessors have been creative in
writing lease agreements togetaround theletteroftherules
forcapitalizing leases. Examine operating leases inthefootnotes andassess whether these areeffectively anObligation
to use an asset for most of its useful life. If so,bring them
ontothebalance sheet asa capital lease. The lease amount
isthepresent value ofthepayments under thelease.
Agreements andcommitments can create obligations that
should berecognized:
Third-party agreements: A third party purchases an asset
forthefirm andthe firm agrees to service thethird party's
debtonthe purchase.
Throughput agreements: A firm agrees to pay forthe use
ofthefacilities of another firm.
Take-or-pay agreements: A firm agrees to pay forgoods in
thefuture, regardless ofwhether ittakes delivery.
Repurchase agreements: A firm sells inventory butagrees

to repurchase theinventory atselling price orguarantees a
resale price to the customer.
Sales ofreceivables with recourse. A firm sells itsreceivables
forcash, removing them from thebalance sheet. but has an
obligation to indemnify theholder ofthe receivables.
Unfunded pension liabilities. In some countries (but not
the United States) significant pension liabilities may not
beonthe balance sheet
Guarantees of third-party or related-party debt. Watch
for guarantees ofthedebtof nonccnsolioated subsidiaries
by a parent company.
Special-purpose entities,off-balance-sheetpartnerships,
andstructured finance vehicfes. Finns cancreate entities in
which others have control (so they are not consolidated),
to accomplished specific purposes-like the securitization
ofassets or acquiring assets with off-balance-sheet leases
("synthetic leases"). Although the firm does not have
control, itmight retain residual risk ifthese entities run into
financial difficulties. The obligations may be intheform of
recourse liabilities or putoptions on thefirm's own stock.
The Enrcn affair highlighted the danger of these specialpurpose entities, asdidbanks' holdings ofsecuritized debt
andmortgages inspecial investment vehicles (SIVs) during
thecredit crisis of 2008.
4. Prepaid expenses
5. Inventories
Each item has an expected date for realization into cash. Inventories typically have the
longest timeto cashas theyfirsthaveto be sold and converted intoa receivable, and then
the receivable has to be turned into cash. Short-term investments (to whichreadily marketable long-term securities canbe addedin thebalancesheetreformulation) maybe closer
to cashthanreceivables or prepaidexpenses, depending onthe maturity of the investments.
Underhistorical cost accounting, the carryingamountfor inventories usually understates
theircashvalue, although the lower-of-cost-or-market rule for inventories can givethema
marketvaluation whenthe finn is in distress.
Threetypesof currentliabilities appearon the typical balance sheet:
L Tradepayables
2. Short-term debt
3. Accrued liabilities
Allthreeare typically closeto their cashvalue.

Thebalancesheetis a statementof stocks,so it givesthe stocks (amounts) of net liquid
assetsat a point in time. Liquidityflows are in the cash flow statement. Liquidity ratios
involve both the balancesheetstocksof cashand near-cash itemsand flows of cashin the
cashflow statement.
Liquidity StockMeasures
Current ratio
Quick(or acidtest)ratio =
Cash + Short-terminvestments + Receivables

C
li biliti
urrent ra 1 mes
.
Cash + Short-term investments
Cashratio =
CurrentIiiabiliti
I rtres
Withreformulated financial statements in hand, the ratio analysis can begin. Withthe
two types of maturities in mind-c-short-term and long-term-s-ratio analysis groupsratios
intotwotypes,short-term liquidity ratios andlong-term solvency ratios. Bothsets of ratios
are indicators of the ability to repay, but at different maturity dates. The ratio analysis is
completed with someof the operational ratios that we havealready covered.
All three sets of ratios are benchmarked with comparisons to similar firms and with
trendanalysis overtime.The creditanalyst looksfor deteriorations in the ratiosovertime
and relative to comparison firms.
Thesemeasures indicate the abilityof near-cash assetsto payoff the currentliabilities. The
numerators of these ratios indicatedifferent cash maturities. So, for example, the quick
ratio includes only quick assets in the numerator by excluding inventories that maytake
sometimeto tum into cash(andwhosecarryingvaluesare not usually theircashvalues).
Thecashratio involves onlyassets with almostimmediate liquidity.
Short-Term liquidity Ratios
Liquidity FlowMeasures
Short-term creditors-suppliers, short-term paper holders, and long-term lenders of debt

thatis shortlyto mature, forexample-are concerned withthe fum'sabilityto haveenough
cash to repay in the near future. The long-term lender is also interested in short-term
liquidity because if the firm cannotsurvive the shortterm,thereis no longterm,
Working capital is current assets minus current liabilities. As current assets are those
expected togenerate cashwithinoneyearandcurrent liabilities areobligations duetomature
withinoneyear, working capitaland itscomponents arethe focusof liquidity analysis.
Thetypicalbalance sheethas fivetypesof currentassets:
1. Cashand cashequivalents
2. Short-term investments
3. Receivables
700
Currentassets
Current liabilities
. Cashflow from operations

Cashflow ratio =
Current liabilitities
..
_ Cash+Short-tenninvestments + Receivables x 365

Capnar
'-' expendittures
Defeusive interval.>
Cashflow to
capital expenditures
Cashflow from operations

Thefirstmeasure indicates howwellthe cashflow fromoperations covers the cashneeded

tosettleliabilities intheshortterm.Thesecond ratiomeasures the liquidity available to meet
capital expenditures without further borrowing. Multiplying by 365 yields the number of
702 Part Five The Analysis of Risk and Return
Chapter 19 TheAnalysis ofCredi{ Risk ana Retllm 703
days expenditures canbe maintained out of near-cash resources. The thirdmeasure is free
cashflow inratioform andindicates towhatextent capital expenditures canbe financed out
ofcashfromoperations. Sometimes forecasted expenditures areusedinthedenominators of
the second andthirdmeasures.
These ratios give not onlyan indication of solvency but also an indication of a fum's
debt capacity. Low coverage ratiossuggest that a firm hascapacity to assume more debt
(allelsebeing equal).
Operating Ratios
Long-Term Solvency Ratios
Long-term debtholders watch the finn's immediate liquidity, but they are primarily
concerned withitsability to meetitsobligations inthemoredistant future. Focus therefore
moves to incorporate thenoncurrent sections ofthe balance sheetin ratios.
Solvency Stock Measures

Debtto totalassets = ::-T.:.O.:.ta:::l.:.d::e:::bt,::C"C:.:urr,:"en:;-t.:.+.:.Lo=o:n"g,.,-t:.:e::nn.:.l'--,Totalassets (Liabilities + Totalequity)
Totaldebt
Totalequity
Debtto equity
Long-term debt
Long-term debt + totalequity
Long-term debtratio
Thefirsttworatios capture all debt, thethirdjust long-term debt. Thefirsttwodiffer inthe

denominator but capture similar characteristics. Net debt can be used in the numerator
when financial assets areavailable to payoff thedebt(in thiscasethe denominators of the
firstandthirdratiosarereduced by financial assets).
Solvency FlowMeasures
Interest coverage
(times interest earned)
Operating income
- 1 oU:.:n1:::e::v::er::e::d;:;c;:as::h:.:fl:.;o:.:w.:.fr::o:::ffi:.:oo!:pe::r::ah:::-0:.:0::'
Interest coverage ( cash basts
=--
Netcashinterest
Operating income + Fixed charges

- d h
Frxe -c argecoverage : : :
Fixed charges
Fixed-charge coverage
(cash basis)
Unlevered cashflow fromoperations + Fixed charges

Fixed charges
CFOto debt_ Unlevered cashflow from operations

Totaldebt
These ratiosare improved (as indicators of the future) by measuring operating income
andnetinterest ascoreincome andexpense. Thetwointerest coverage ratiosgivethenumber
of times operating earnings andcashflow fromoperations, respectively, cover the interest
requirement. Thenumerators anddenominators arefrom thereformulated income andcash
flow statements. Somedefinitions consider onlyinterest expense, in which casethenumeratorincludes interest income andthedenominator excludes it. Fixed charges areinterest and
principal repayments (including those on leases) andpreferred dividends, so fixed-charge
coverage measures thenumber oftimes totaldebtservice iscovered. Thelastratiomeasures
cashflow relative to total debtrepayments tobemade, notjustthecurrent repayment.
The ratios just listedpertain directly to liquidity andsolvency. But liquidity and solvency
aredriven inlarge partbytheoutcome ofoperations, so operating ratios arealsoindicators
of debt risk. It is sometimes the case thata finn canbe quite profitable in operations and
still have short-term liquidity difficulties, but both short-term liquidity and long-term
solvency problems arefar morelikely to be induced bypooroperating profitability.
Interest coverage, for example, is just a restatement of theFLEV x SPREAD, andso is
driven by financial leverage (FLEV) and the operating spread (SPREAD), that is, the return on net operating assets relative to net borrowing costs. Andthese measures, in turn,
are driven by lower-order drivers. Thusto complete the ratioanalysis, analyze profitability
and changes in profitability along the lines of earlier partsof the book. Andwatch for the
"redflag" indicators (in Chapter 15)thatindicate deterioration. If receivables or inventory
turnover increases, for example, liquidity problems could result.
FORECASTING AND CREDIT ANALYSIS

Liquidity, solvency, andoperational ratiosreveal thecurrent state ofthe firm. Butthecredit
analyst is concerned withdefault inthefuture. Dotheratios predict default? Some ofthem
might be symptoms of financial distress rather than predictors. Discovering thatinterest
coverage is low is important to the analyst. But anticipation of a low interest coverage
ahead of time is alsoimportant. Andso forall ratios. Indeed, onceliquidity andcoverages
have deteriorated, it might be too late.
Theanalyst thusturnsto forecasting. His aimis to produce a creditscorethatindicates
theprobability of default.
Prelude to Forecasting: The Interpretive Background

Before forecasting, the analyst must havea goodunderstanding of the conditions under
which credit is given to the finn. Suchan understanding provides theinformation necessary
for forecasting. It enables the analyst to bring her judgment to supplement quantitative
techniques. Andit provides perspective to interpret ratiosand otherfinancial data. A particular ratio-s-a current ratioofless than LO, forexample-might beseenas inadequate for
a firm withlarge inventories andreceivables butquiteadequate fora firm withno inventoriesor receivables.
The analyst needs to understand the following points and include salient ones in the
annotations to thereformulated statements:
Know thebusiness. Justas theequity analyst mustknow thebusiness before attempting
to value the equity, so must the credit analyst. Understand the business strategy and
understand thedrivers of value inthestrategy. Andunderstand therisksthatthestrategy
exposes the :firm to.
Appreciate the "moralhazard" problem of debt.Theinterest of debtholders is not the
prime consideration for management. Members of management servethe shareholders
(and themselves), not the debtholders. So they can take actions that benefit the
shareholders at the expense of debtholders. Theycanborrow to paya large dividend to
shareholders. They can pursue highly risky strategies with high upside potential and
usedebtto leverage theupside payoff. If the strategy is successful, shareholders benefit
Chapter19 TheAnalysis of Credit Risk end Rerum 705

704 Part Five TheAnal)'sis ofRisk and Rerum
enormously, but debtholders just get their fixed return. If they fail, debtholders (and
shareholders) canlosealL
Understand the financing strategy. What is thefirm's target leverage ratio? What is the
firm's target payout ratio? What sources offinancing willthefinnrelyon?Doesthe finn
hedge interest raterisk? Ifborrowing across borders, doesit hedge currency risk?
Understand the current financing arrangements. What are the firm's banking relationships? Doesit have openlines of credit? When might they expire? Whatis the current
composition ofthefinn'sdebt? What debtis secured? What debthasseniority? What are
the maturity dates for the debt? What are the restrictions on the fum in its debt
agreements?
Understand thequality of the firm's accounting.
Understand theauditor's opinion, particularly anyqualifications to the opinion.
With this background, the analyst develops forecasts. We cover two forecasting tools
here. Thefirstdevelops creditscores based onpredictions from financial ratios. Thesecond
brings the pro forma profitability analysis and value-at-risk analysis of earlierchapters to
thetaskof creditanalysis.
FIGURE 19.1 The Behaviorof Selected Financial Statement Ratios overFiveYearsPrior

to Bankruptcy,for Firms that Failed and Comparable Firms that Did nor Fail.
Ratios forfailed firms(onthe dotted line)areof lower quality thanthosefornonfailed firma (on
the solidline),andtheydeteriorate asbankruptcy approaches.
Cashflow
Totaldebt
Netincome
TOlal assets
Totaldebt
Totalassets
+.45-l-_~~_
+.,
.79 ',
+.35
.78
.0
+.25
.65
,,"
+.15
-.I
-.05
-.2
-.IS
.....
.51
:1 i~
234
Yearbeforefailure
\--_
/
,,
,,,
,,
,
\,
.58
+.05
,,
,
2
3
4
5
Yearbeforefailure
Yearbeforefailure
Ratio Analysis and Credit-Scoring

Figure 19.1 depicts the deterioration of a number of ratios over five years prior to
bankruptcy (failure). The graphs are from one of the original studies on bankruptcy
prediction by William Beaver in the 1960s, but theyapply muchthe same today. Average
ratios for bankrupt firms are compared with those of comparable firms that did not go
bankrupt. The ratios forfirms going bankrupt areoflowerquality thanthosefor nonbankrupr firms, even five years before bankruptcy. And they become significantly worse as
bankruptcy approaches. So, benchmarking ratios against those for comparable firms,
combined witha trendanalysis, doesgive an indication of future bankruptcy.
Two issues arisein getting default predictions from accounting ratios:
I. Manyratios mustbe considered, and the analyst needsto summarize the information
they provide as a whole. A low interest coverage but a high current ratio may have
different implications than a lowinterest coverage anda lowcurrent ratio. A composite
creditscoreneedsto be developed.
A bondrating of thesortpublished by Standard & Poor's andMoody's is a compositescore. Standard & Poor's ratings range from AAA(forfirms withhighest capacity to
repay interest andprincipal) through A.A, A, BBB, BB,B, CCC, CC,C to D (forfirms
actually in default). The ability to repay debt rated BB and below is deemed to have
significant uncertainty. Moody'S rankings are similar: Aaa,Aa, andA for high-grade
debt, then Baa, Ba, B, Caa, Ca, C, and D. These debt ratings are published as an
indicator of the required bondyield, and indeed the ratings are highly correlated with
yields.
A banktypically summarizes information about the creditworthiness of a firm in a
credit score. Thisscorecanbeintheform of a number ranging from oneto seven or one
to nine, or qualitative categories such as "normal acceptable risk," "doubtful," and
"nonperforming"
2. Errorsin predicting default andthe costof prediction errorshave to be considered. The
financial ratios of failing andnonfailing firms are different on average butsomefailing
firms can have ratios thatare similar to those of healthy firms. A finn goingbankrupt
couldhavethe same current ratioand interest coverage ratioas one that will survive.
Working capital
Totalassets
.42
Totalassets
Current
ratio
1---,
3.5
.36
.--_ .. ---.
.30
.24
/
,
.18
.12
3.0
2.5
,,
1/
.06-j'
.. --_ .. --_ .. -
234
Yearbefore failure
,,
'1/
2.0
i
,," ' '
,,"
234
Yearbefore failure
- - Nonfailed firms
",
>, ,
iii
Yearbeforefailure
---- Failedfirms
Soun:e: w.H.Be3ver. "Financi'l! Ratios as PTedietors ofF,il;m:,~ Journalo/AccountiNg Research. Supplemeot, 1966. p. 82.
A bankloanofficer might thenclassify bothfirms as lowdefault risk,approve loansto

both, and generate loanlosses for the bank(fromthebankrupt firm). Alternatively she
might classify them both as having high default risk and deny credit, losing good
business for thebank(fromthe nonbankrupt finn).
The first issue calls for a method of combining ratios into one composite score that
indicates the overall creditworthiness of the firm. The second issue calls for a method of
trading offthetwotypes of errorsthatcanbe made. We dealwitheachin tum.
705 Part Five The Analysis ofRisk and Realm
Chapter 19 The AnalY5is afCredit Risk and Rernm 707
Credit Scoring Models

Creditscoring models combine a set of ratiosthat pertain to defaultintoa creditscore. A
creditscoring model has theform
An earlyapplication of logitanalysis to bankruptcy prediction byJamesOhlson2 produced

the following model:
y
=:
~ 1.32~ OA07(size) + 6.03(Totalliabilities)

Totalassets
That is, the model sums ratios that are weighted by weights w. A variety of statistical
techniques can be used to determine the weights, but two common ones are multiple
discriminant analysis andlegit analysis.
Multiple Discriminant Analysis. g-scorc analysis, pioneered by Edward Altman, I

utilizes discriminant analysis techniques. The model has been refined over time but the
original model, developed in the 1960s, tookthefonn
~score
3.l Earnings before interest andtaxes)

"
Totalassets
+O
.6( Market value of equity ) ~. 1.o( Sales
Bookvalueof liabilities
1.43(working caPital) + 0.0757(Current liabilities)

Totalassets
Current assets
_ 2.37(Net income) _ 1.83(WOrking capital flowfromoperations)

Totalassets
Total liabilities
+ 0.285(1 ~fnet ~ncome wasnegative for thelast twoyears

_ I
Working capital)
4(Retained earnings)
=: 1.
I+ .
Total assets )
Totalassets
2(
)
Totalassets
Toidentify predictors ina model likethis,selecta sample offirms thatwentbankrupt in the

past and a random sample of firms thatdid not.Calculate a full set of liquidity, solvency,
andoperational ratiosforthesefirms. Discriminant analysis, applied to thehistorical data,
thenselects thoseratiosthatjointlybestdiscriminate between firms thatsubsequently went
bankrupt andthosethat didnot,andthencalculates coefficients on the selected ratios that
weight them into a Zecore. The weights are calculated to minimize the differences in
Zecores within bankrupt or nonbankrupt groups but to maximize the differences in scores
between the two groups. The z-scorc indicates the relative likelihood of a firm not going
bankrupt, so a firm with a highscoreis lesslikely, a fum witha low scoreis more likely,
and those with intermediate level scores are ina grayarea.
The Z-score model is based onfirms goingbankrupt, but models alsocanbe estimated
with default on debtor otherconditions of financial distress as thedefining event. Andthe
model can be adapted to situations having morethantwo outcomes. So a model of bond
ratings (with several classes) also can be built. Other ratios, such as asset size, interest
coverage, the current ratio, and the variability of earnings, have appeared in similar
published models.
LogitAnalysis. Logit analysis isbased ondifferent statistical assumptions from discriminant

analysis and delivers a scorebetween zeroand I that indicates the probability of default.
n(
oIf net mcome wasnot negative forthe lasttwoyears
I if totalliabilities exceed totalassets

)
0 if total liabilities do notexceedtotalassets
_ 0.52l
Change in net income
)
\ Sumof absolute values of current andprioryears' net incomes
Sizeis measured here as the natural logarithm of totalassets divided by the GNP implicit
price deflator (with a base of 100 in 1978). Working capital flow is cash flow from
operations plus changes in other working capital items. The score from this model is
transformed into a probability:
Probability ofbankruptcy =: _I_
1+ e-Y
wheree is approximately 2.718282 andy is the scoreestimated from theratiosabove.
Themodels hereserveto indicate the form of creditscoring. The estimates were made
quite a while ago, so the analyst should reestimate the models from more recentdata.
Coefficients willbe different andotherratiosmaybe found to be relevant. Nonaccounting
information might be included. The models here are unconditional models. Conditional
models mightbe estimated for different conditions, such as industry, country, or macro
conditions. Predictors and their coefficients may be different in recessions than in boom
times, for example.
It is unrealistic to expectfinancial ratiosto captureall theinformation thatindicates the
probability of default. The interpretive background and the annotations to reformulated
statements yieldotherinsights, as does the pro forma analysis of the nextsubsection. So
credit analysts use the scores from these types of models to supplement their broader
judgment (and as a check on their judgment). The creditscores that combine financial
statement scores withotherinformation are typically a ranking from one to seven or oneto
nineratherthantheg-scoresand probabilities estimated here.
Prediction ErrorAnalysis
A bank loanofficer whoassigns creditscoreson a scaleof oneto nine (say) has to decide
at whatscorehe will rejecta loanapplication. Is it three, or is it fouror five? A bondrater
has to decide whatz-scorc or probability scoreindicates significant probability of default
E. Allman, "Financial Ratios, Discriminant Analysis, andthe Prediction of Corporate Bankruptcy,"
Journal of Finance, September 1968, pp. 589-609.
2J. A. Ohlson, "Financial Ratios and the Probabilistic Prediction of Bankruptcy," Journal of Accounting
Research, Spring 1980,pp. 109-131.
708 Part Five TheAnalJsis ofRiskand Re(llm

in order to assign the firm to a BB or lower rating. Set thecutoffpointtoo highand too
many finnsaredeemed tobehighcredit risk. Setthecutofftoo Jaw andtoomany firms will
be considered safeinvestments.
Classifying a firm as not likely to default when it actually does default is called a
TypeI error.Classifying a firm aslikely todefault when it does notdefault is called a Type
II error.Both errors have costs. In aType 1error, thebank orbondholder loses inthedefault.
InaType II error, thebankorbond investor misses outona goodinvestment. Fora bank, the
costofa Type II errormay be considerable: It may losegood loans andgood customers and
business might migrate to bankswithbetter credit models andbetter erroranalysis.
Errors are reduced by developing betterscoring models. But inevitably these will be
gray areas. Inhisoriginal studyAltman found thatfirms withZ-scores oflessthan 1.81 went
bankrupt within one yearwhile scores higher than 2.99always indicated nonbankruptcy.
Scores from 1.81 to 2.99were thegrayareas.
Error analysis aims todetermine theoptimal cutoff forclassifying firms. Onesimple way
is to choose a cutoffpoint thatminimizes the total ofType 1andType II errors. Thiscutoff
canbediscovered from historical dataanalysis (preferably ona setaffirmsthatwere notused
to estimate the credit scoring model), and this historical analysis can be updated through
experience. Altman's original analysis found thataZ-score of2.675 minimized thenumber of
total errors. ForOhlson's logit analysis, a probability of 0.038 gave theoptimal cutoff.
Thissimple method assumes thatType 1andType II errors are equally costly. If thisis
not so, the bankor the investor mustanalyze the costof eachtypeand weight theerrors
accordingly in setting a cutoff. Many consider a Type I errormore costly than aType II.
Full-Information Forecasting
Credit scoring from ratios usesthelimited information incurrent financial statements. The
full information about firms is captured by the pro forma analysis of Chapter 15.This
analysis, along withthe value-at-risk analysis of thelastchapter, canreadily be adapted to
assess thelikelihood of default.
Pro FormaAnalysis and Default Prediction

Rather thanusingcurrent liquidity, solvency, andoperational ratios to forecast default, pro
forma analysis usesthefull information available to theanalyst to forecast future liquidity,
solvency, and operational ratios that result in default. Andpro forma analysis explicitly
forecasts thefinn'sability to generate cashto meetdebt payments.
Scenario 1 in Table 19.1 calculates ratios from the pro forrnas for PPE, Inc.,the firm
used in theproforma analysis ofChapter 15.More ratios could becalculated withmore detailed financial statements. The forecasts underlying these pro fonnas were a sales growth
of 5 percent per year, a profit margin (PM) of 7.85 percent, an assetturnover (ATO) of
1.762, anda dividend payout of 40 percent of net income. Under thisscenario, the fum is
projected to pay down debt from positive free cash flow after dividends by Year 4 and
become a holder of net financial assets. Debtto total assets andthedebtto equity ratio are
thus decreasing and interest and fixed-charge coverages are increasing. The debt is
expected to mature at theendofYear 4. Butthe debt is retired by thatdatewithout needof
further financing. Default is notanticipated: Scenario I is a nondefault scenario. Indeed,
the fum is projected to increase its debtcapacity.
Scenario 2 gives a different picture. Here sales areexpected to decline by5 percent each
yearandtheprofit margins are expected to be only 1 percentNet operating assets decline
with sales but they are not perfectly flexible, so asset turnover decreases. The fum is
expected todrop itsdividend in Year 1 in anticipation ofIiquidityprcblems, butthepoorcash
flow stillleaves a reduced capacity to service thedebt. When thedebt matures in Year 4, the
firm is expected to default. Scenario 2 is a defaultscenario.
Chapter 19 TheAnalysis ofCredit Risk amiRe(tlm 709
TABLE 19.1 PPE, Inc.: ProForma Financial Statements andDefault Prediction under Two Scenarios
Year 0
Year 1
Year 2
Year 3
Year 4
124.90
9.80
(0.70)
9.10
131.15
10.29
(0.77)
137.70
10.81
(0.57)
10.24
144.59
11.35
(0.35)
11.00
151.82
159.41
11.92
12.51
(0.10) .
0.18
"1T82 12.69
Net operating assets (ATO::; 1.762)

Common equity
74.42
(7.70)
66.72
78.15
(5.71)
12M
82.05
(3.47)
78.58
86.16
(0.97)
85.19
.-l.&L -ill.
Free cash flow

Dividend
Cash available for debtservice
Debt to total assets (%)
Debt to equity (O~)
Interest coverage
Fixed-charge coverage'
RNOA(%)
5.28
5.28
0.0
10.3
11.5
14.0
14.0
14.5
0.0
6.57
3.81
2.76
7.3
7.9
13.4
4.7
13.8
14.3
0.0
6.90
4.10
2.80
4.3
4.4
19.0
4.9
13.8
14.1
0.0
124.90
9.80
(0.70)
9.10
118.66
1.19
(0.77)
0.42

Common equity
74.42
(7.70)
66.72
Free cash flow

Dividend
Cash available for debtservice
Debt to total assets (%)
Debt to equity (O~)
Interest coverage
Fixed-charge coveraqe'
5.28
5.28
0.0
10.3
11.5
14.0
RNOA(%)
14.0
14.5
0.0
Scenario 1
Sales (qrowth e 5% per year)
Core operating income (PM::; 7.85%)
Net income
ROCE (%)
Debt service requirement"

Scenario 2
sales (decline = 5% peryear)
Core operating income (PM", 1%)
Net income
ROCE (%)
Debt service requirement"
952
90.46
Year 5
94.99
92.27
99.90
7.25
4.40
2.85
1.1
1.1
32.4
5.0
13.8
14.0
0.0
7.61
4.73
2.88
-2.0
-2.0
19.2
5.1
13.8
13.9
0.0
7.99
5.08
2.91
-5.2
-4.9
112.72
1.13
(0.69)
0.44
107.09
1.07
(0.60)
0.47
101.73
1.02
(0.52)
96.65
0.97
(0.42)
050
o:ss
74.00
(6.86)
67.14
73.60
(6.02)
67.58
73.20
(5.15)
68.05
72.80
(4.25)
68.55
Default
Default
1.61
0.0
1.61
9.3
10.2
1.5
1.7
1.6
0.6
0.0
1.53
0.0
1.53
8.2
8.9
1.6
.1.47
0.0
1.47
7.0
7.6
1.8
1.42
0.0
1.42
5.8
6.2
2.0
1.7
1.7
1.7
1.5
0.7
0.0
1.5
0.9
0.0
1.4
1.3
4.25
Default
13.8
13.8
0.0
72.40
1.37
0.0
1.37
'Inlt~1 tOlle"'ge " Oper.ttiog in<omelfinlnci21 eXfl(nse.

Fi.,erl-<:h:lrge eovtrnge " (Oper.lting income + O.bt s<:rvic<:Vf)ebl service.
:The deb( is zero-coupon, thusIhen: 3!1' no inlen:sl p2yments
Default occurs when cash available for debt service is less than the debt service
requirement:
Cash available fordebtservice = Freecashflow ~ Netdividends
= 01 ~ 1lli0A- Netdividends
Debtservice requirement = Required interest andpreferred dividend payments

+ Required netprincipal payments + Lease payments
Chapter 19 The Analysis of Credit Rilk and Rewm 711
710 PartFive TheAnalysIs of Riskand Return
In scenario 2, PPE, Inc. is forecasted to have $1.42 million available for debt service
in Year 4 when the debt matures. The debt service requirement is $4.25 million. Thus
it is anticipated to default. Note that cash available for debt service is after net dividends, that is, dividends net of new equity financing. So defaultcan be avoided if cash
can be raised from equity issues. Similarly, the debt service requirement is for net
principal repayments (debt repayments minus new debt issued). So default can be
avoided if cash can be raised from issuing new debt (Which debt restructuring effectively involves).
Pro formaanalysis for equityvaluation focuses on forecasting operating income and
net operating assets for the residual income calculation. Pro forma analysis for credit
evaluation focuses on forecasting cash available for debt service. Accordingly, the
"bottomline" in the pro formas in Table 19.1 is the cash available for debt serviceline.
In terms of the forecasting template in Chapter 15, the pro forma analysis for equities
is completed at Step 6, where residual income can be calculated. The pro forma
analysis for debt is completed at Step 9, wherecash available for debt service can be
calculated.
FIGURE 19.2 Value-at-Risk Profilefor Debt and the Identificationof Default Scenarios.
The profile plots cash available fordebt service under alternative scenarios and theprobability of
each outcome. The default point-where cash available for debt service isless than the debt service
requirement-distinguishes defaulting scenarios from nondefaulting scenarios. The probability of
default isthetotal probability ofdefaulting scenarios.
0.15
0.1
0.05
Value-at-Risk Profiles andtheProbability ofDefault

Scenario 2 is a default scenario, but it is just one default scenario: It forecasts a particular sales growth, profit margin, and so on. It also forecasts that the dividend would
be dropped (to increase cash available for debt service) and that no cash would be
raised from new debt to reduce the debt service requirement. Other operating and
financing scenarios are possibleand the analyst is interested in the full set of default
scenarios.
The value-at-risk analysis of the last chapteris a method for examining the full set of
likelyscenarios. The analysis wasapplied to equities but is also applicable to debt: Under
whatset of scenarios is thevalueof debtat risk?
The equityanalysis profiles thepossible variation in residual income. The debtanalysis
profiles thepossible variation incashavailable for debtservice. Follow thesesteps:
1. Generate profiles of cashavailable for debtservice for a full set of scenarios from pro
forma analysis.
2. Establish thedebtservice requirement
3. Identify the default pointwhere cashavailable for debtservice is below thedebtservice
requirement, andso identify thedefault scenarios.
4. Assess theprobability of theset of default scenarios occurring.
Asdebthasto beserviced eachyear, a profile should be generated for eachyearahead. w:ith
particular attention to yearswhere largeamounts of debt areto mature.
A profile of cash available for debtservice from Step 1is depicted in Figure 19.2. The
default scenarios aretotheleftofthepointwhere cashavailable fordebtservice is lessthan
therequired debtservice. Tothe leftof thisdefault point,value is lostto thedebtholder; to
the rightof the default point,debtvalueis preserved.
The probability of default is the sum of the probabilities of the defaulting scenarios
(about 3.5percent in thefigure). Statedformally, the default probability is
Probability of default = Pr {Cash available for debtservice < Debtservice requirement}
where Pr is probability. This probability is thebasisfor setting the priceof credit(andthe
cost of debtcapital forthe finn).
Cashavailable fordebtservice
Defaulting
scenarios
Nondefauiting
scenarios
Default point: Cashavailable fordebtservice < Debtservice requirement
Thismetric is similar to thevalue-at-risk (VaR) metric thatis commonly usedto assess

the market (price) risk of a portfolio of financial assets.' The formal definition of VaR is
given by
Prespecified probability = Pr {M1 :s; VaR}

Here M 1 is the change in market valueof a financial asset overa period t. So VaRis an
amount such that, for a prespecified probability, losses equal to or larger than the VaR
occur. A hedge fund, forexample, mightassessthat it willlose50percent of thevalue of its
fundin onemonth with a probability of 0.02percent. It mightdiscover thisfromhistorical
simulation of pricechanges for its portfolio.
Similarly, a bankmightassess, for a statedprobability, howmuchofits loanportfolio it
willloseover a year. Todo thisit mightreferto itshistorical experience in lending, just like
thehedge funddoes. Or it mightproduce the value-at-risk profiles for its current portfolio
whichemploy fundamental analysis. And a banking syndicate that wishes to sell its loans
to a pension fundmightuse theprofiles to pricethe sale.
Required Return, Expected Return, and Active Debt Investing

Creditscoring, proformadefault prediction, and value-at-risk profiling aremethods theanalystuses to assess defaultprobabilities and thus the required returnfor investing in debt.
Ifbond pricesset in the market are efficient, they will be basedon the required return for
3 VaR metres were developed andpopularized by J.P. Morgan in1994, though there were also
antecedents. See J. P. MorganlReuters, "Risk Metrics-Technical Document," 4th ed., 1996.
712 PartFive The Analysis of Risk and Renon
the risk taken. If so, the yield-to-maturlty-c-the rate that discounts the expected (coupon
andmaturity) cashflows to the marketprice-will be equalto the required return.
The creditanalystmayhaveanothergoal in mind, however: She determines defaultrisk
with the view to challenging the market price. She does so by challenging the yield-tomaturity implicit in the market price.Theyield-to-maturity is theexpected return to buying
a bondat the marketprice.If that expected returnis different fromthe returnrequired for
the risk, she deems the bond to be mispriced. She has become an active, fundamental
investor. She is engaging in bond arbitrage.
LIQUIDITY PLANNING AND FINANCIAL STRATEGY

Just as the pro forma analysis of operating profitability canbe usedto formulate business
strategy, so can thepro forma analysis herebe usedto formulate financial strategy.
Financial planningis the task of the corporate treasurer. Her task is to ensurethat the
debtand equityfinancing is in placeto support the firm's operational strategy. With targets
for the debt-to-equity mix and dividends that are set by management, she plans the
financing underthe most likely scenario. And she plans, contingently, for scenarios that
varyfrom the likely scenario. Howwill a surplusof cash under an optimistic operational
scenario be applied? To a stockrepurchase? To a purchase of bonds?And howwilla casb
deficiency be handled undera pessimistic scenario?
Planning for pessimistic scenarios sets a default strategy. Defaultplanning is part of
scenario planning thatweintroduced in thelastchapter. Scenario 2 in thePPE,Inc.example
embedsa defaultstrategy: Dropthe dividend to generate morecashfor debtservice. Other
strategies (thatgenerate otherscenarios to dealwithdefault) are
Modify operations to reduce operational risk thatgenerates defaultrisk.
Issueequity.
Issueor roll overdebt;renegotiate borrowing terms.
Establish an open lineof credit.
Sen off assets.
Selloffthe whole firm (in an acquisition).
Hedgerisks.
Somestrategies, such as issuing newdebt Or equityor rolling overa line of credit, might
not be feasible in somescenarios.
Eachstrategy hasa different setof default scenarios anda different value-at-risk profile.
And each profile yields a different probability of defaultand thus a different borrowing
cost.The benefit of lowering the cost of capital by reducing the probability of default is
traded off against the cost of lowering the probability. Open lines of credit require fees.
Hedging is costly. Do thebenefits outweigh the costs?
Two principles guidethis tradeoff:
1. Strategy indifference. In well-functioning capitalmarkets the arrangements to avoid
default might be priced to equal the benefits from avoidance. So the treasurer is
indifferent. Shemighthedge default riskwith a financial instrument, butthe cost of that
hedgewill reflect the probability of defaultandthe costof the finn's debt.
2. Shareholder indifference. Shareholders mightbe ableto hedgethemselves againstthe
consequences of defaultin financial markets and so are indifferent to the firm doingit
forthem.
Chapter 19 TheAna.lysis of Credit Risk and Rell<m 713
Find thefollowing on theWebpage for thischapter:
A pointer to special-purpose entities and the dangers

they pose.
Additional methods for bankruptcy prediction that use

option pricing techniques and exploit information in
equity prices.
References that give updated coefficients for z-sccre

and logitbankruptcy scoring models.
A review of value-at-risk metrics.
look at the Readers' Corner.
Summary
This chapter has shown how the analysis of financial statements and the development of
pro formafinancial statements aid in determining the creditworthiness of a firm.
Theriskof default istheprimaryconcern intheanalysis of debt. Togainanappreciation of
this risk, the credit analyst, like the equity analyst, is familiar with the business and its
operations. Liketheequity analyst, sheunderstands theriskintheoperations. Sheunderstands
the contracts between the debtholders and the firm. And she understands how financial
statements andproforma analysis offinancial statements canhelpherinevaluating creditrisk.
This chapter has laidout an analysis of financial statements for credit evaluation. It has
identified a number of liquidity and solvency ratiosand has shown how theseratioscanbe
combined to yieldcreditratingsand to indicate the probability of default.
Theproforma analysis forequitieshasbeenadapted to creditanalysis, thistimewiththe
objective of forecasting cashavailable for debtservice. That analysis generates a value-atrisk profile for debtthat depictscash available for debtserviceunderalternative scenarios
and identifies default scenarios. The chapter also shows how these profiles are used in
financial strategy analysis anddefaultplanning. Astheproforma analysis toolsarethesame
as thosefor equity analysis, the chapterunifies equityand creditanalysis.
Key Concepts
bond arbitrage isactiveinvesting that

attempts to discover mispriced bonds. 712
collateral refers to assetsthat can be
repossessed if a debtordefaults. 698
credit analysis or default analysisanalyzes
information to determine the likelihood of
a borrower defaulting on debt. 698
debt capacity is a firm's abilityto borrow.
703
default is a failure to maketimely
payments on debtor otherviolation of a
debtagreement. 697
default premium is theprice of debt in
excessofthe risk-free rateto compensate
for default risk. 696
default risk or credit risk is the riskthat a
debtor will default 696
default scenario is a forecastunderwhich
a firm defaults. 708
default strategy or default planning is a
strategy to dealwithdefault. 712
off-balance-sheetfinancingis financing
thatcreatesan obligation that is not
shownon a balancesheet. 700
price of credit isthe lending ratecharged
by a creditor, the creditor's required
return(and the borrowers borrowing
rate). 697
special-purposeentity is an entity(often
a partnership) set up off-balance-sheet to
accomplish a specific task,but not
controlled by the firm. 700
Type I defaultprediction error is
classifying as not likely to defaulta firm
whichdoesdefault. 708
Typen defaultprediction erroris
classifying as likely todefaulta firm which
doesnot default 708
yield-to-maturityin the ratethat
discounts the expected (coupon and
maturity) cashflows ofa bondto its
marketprice. 712
714 Part Five The Analysis If Risk and ReCUlll
Chapter 19 The Analysis ofCredit Risk and Recurn 715
Exercises
Analysis Tools
Page
Reformulation of financial
statements for credit
analysis
698
z-score (discriminant analysis)
credit scoring model
706
Logit default probability
scoring model
706
Error analysis for default
predictions
707
Pro forma analysis of default
scenarios
708
Value-at-risk analysis for debt 710
Financial strategy analysis
712
Default planning
712
Key Measures
Page
Bond ratings
Debt service requirement
Credit score
Cash available for debt service
Default point
Default probability scores
Ratios
liquidityratios
Current ratio
Quick ratio
Cash ratio
Cash flow ratio
Defensive interval
Cash flow to capital
expenditures
Solvency ratios
Debt to totalassets
Debt to equity
Long-term debtratio
Interest coverage
Interest coverage
(cash basis)
(cash basis)
CFO to debt
I-score
697
709
706
709
709
707
700
700
701
ATO asset turnover

(FO cash fromoperations
GAAP generally accepted
accounting principles
01 operating income
PM profitmargin
Pr probability
assets
SEC Securities and Exchange
Commission
SPREAD operating spread
701
701
701
701
701
702
702
702
702
702
702
702
Drill Exercises
E19.1. Credit Scoring: A Decline in Credit Quality? (Medium)
The following numbers areextracted from thefinancial statements fora firm for 2008 and
2009.Amounts arein millions of dollars.
Sales
Earnings before interest and taxes
Current assets
Current liabilities
Total assets
Book value of shareholders' equity
Retained earnings
706
2009
3,276
(423)
976
1,390
3,098
1,388
488
At the end of2008, the finn's 80 million shares traded a 525 each, but bythe end of 2009
theytraded at SIS. Commentators blamed thedropon an increase intheriskofbankruptcy.
Conduct a credit scoring analysis that indicates how much the likelihood of bankruptcy
increased overtheyear.
E19.2.
Pro Forma Analysis and Default Points (Medium)

A finn hasthe following balance sheetandincome statement (inmillions of dollars):
BalanceSheet
Operating cash
Receivables
Inventories
Plant andequipment
29
138
~
1.113
702
702
2008
4,238
154
1,387
1,292
3,245
1,765
865
long-term debt(S%)
288
983
130
Strxkholders' equity
$1.113
IncomeStatement
Concept
Questions
C19.1. Explain what a default premium is.

CJ9.2. What is the objective in reformulating financial statements for credit analysis?
How does the reformulation for credit analysis differ from that for equity
analysis?
CI9.3. Describe off-balance-sheet financing.
CI9.4. Whatis the"moral-hazard" problem withbusiness debt?
C19.5. Distinguish a Type I errorin predicting default from a Type II error.
e 19.6. What is a default point?
C19.7. How doesproforma analysis of financial statements helpincreditanalysis?
CI9.8. Why might a deferred taxliability beconsidered nota liability forcredit scoring?
CI9.9. What is a default strategy?
C19.1 O. Explain thedanger posed byspecial-purpose entities.
Revenues
Operating expenses
Operating income
Interest expense
Income before tax
Income taxes
Income aftertax
$908
817
91
55
36
---ll
~
The long-term debtis 8 percent coupon debtmaturing in five years. Thestatutory tax rate
is 38 percent. Prepare pro forma financial statements for thenextfive years underthe two
following scenarios. Also forecast cash available for debt service and the debt service
requirement underbothscenarios. Thefinnpaysno dividends.
a. Sales are expected to grow at 4 percent per year, with the current operating profit
margin beingmaintained andwithanassetturnover of l.14.
716 Part Five TheAnalysis of Risk and Retllm
Chapter 19 TheAnalysis of Credit Risk and Return 717
b. Sales are expected to decline by 4 percent per year and operating profitmargins are
expected to decline to 2 percent. With some assets inflexible, asset turnovers are
expected todecline to 0.98.
EXHIBIT 19.1
BalanceSheets
Toys "R" Us,Inc.
1997
Doeseitherof these twoscenarios forecast default on thedebt?

E19.3.
Yield-to-Maturity and Required Bond Returns(Easy)
Assets
After analyzing thedefault riskfora five-year bond with a maturity value of$I,OOO andan
8 percent annual coupon, ananalyst estimates therequired return forthe bondat 7 percent
per year. Thebondhas just been issuedat a priceof$l,OOO.
a. Whatis the valueof the bondat a 7 percentrequired return?
b. Whatis the yield-to-maturity witha marketpriceof$l,OOO?
c. Whatis the expected returnof buyingthe bondat a priceofSt,OOO?
d. Doesthe analyst thinkthat the bondis appropriately pricedby the bondmarket?
Cash
Accounts andother receivables
Applications
E19.4.
Z-Scoring (Easy)
Below are ratios for some of the firms that have appeared in this book, for their 1998
fiscal year.
Working
Capital
Retained
Earnings
Earnings before
Interest and Taxes
MarketValue
of Equity
Sales
Firm
Total
Assets
Total
Assets
Total
Assets
Book Value
of liabilities
Total
Assets
Coca-Cola
Nike
Reebok
Hewett-Packard
Dell, Inc.
Gateway Computer
Microsoft
-0.12
0.34
0.43
0.24
0.38
0.27
0.45
1.05
0.58
0.66
0.50
0.09
0.34
0.34
0.29
0.15
15.4
9.0
0.7
3.6
27.9
5.2
46.7
0.98
1.67
1.85
1.40
1.65
2.59
0.65
0.06
0.13
0.31
0.19
0.32
a. Calculate Z-scores from theseratios.

b. Explain whyNikehas a different Z-score fromReebok.
c. Whatreservations do you haveaboutthe Z-score as an indicator of creditworthiness?
E19.5.
Tracking Credit Risk Measures: Toys "R'"Us (Hard)

Toys "R" Us,Inc.,is the world's largesttoyretailer, withsalesof nearly $12billionin 1999.
It has been challenged in recent years, particularly in e-commerce, losingmarket share
from20.2percent in 1993to 16,8percentin 1999. The firm's stockpricewas down to $11
in early2000froma highof$36 in 1998. Management hadbegun, however, to take strategic initiatives to returnthe firm to the leading position it onceenjoyed.
The firm's balance sheetsandincome statements for fiscal yearsendingJanuary of 1997
to 2000 are given in Exhibit19.1,alongwithshareprice and shares outstanding information.Trackthe profitability of the finn overtheyearsand alsoits creditworthiness, as indicatedby relevent ratiosand z-scores.
$ 761
1998
$
142
Merchandise inventories
Prepaid expenses and other current assets
Net property, plant, and equipment
Goodwill
Deposits and other assets
Total assets
liabilities
Accounts payable
Accrued expenses and other current liabilities
Long-term debt
Other liabilities
Total liabilities
Common stock
Retained earnings
Foreign currency translation adjustments
Treasury
Total liabilities andequity
Share price
Shares outstanding (millions)
2,215
42
3,160
4,047
365
214
410
204
1,902
2,027
__8_'
2,904
4,212
2,597
4,226
347
~
2,873
4,455
.........L
278
1,617
304
134
156
1,280
680
1,415
231
909
160
2,325
~
3,535
30
489
467
(60)
(388)
4,191
$8,023
22
288
696
836
-..-.l2L
2,838
333
362
1,222
1,230
4,275
~
4,673
30
459
30
453
30
4,120
8,353
~
2,491
219
851
3,832
374
~
7,899
1,346
2,541
222
584
182
51
7,963
720
171
2000
175
2,464
356
491
~
8,023
1999
4,610
(122)
4,478
4,428
$ 7,963
{1,243l
3,624
$ 7,899
(137)
(1,423)
3,680
$ 8,353
27
282
(100)
17
4,757
251
11
240
Income Statements
Net sales
Cost ofsales
Gross profit
Seliing, advertising, general, and administrative expenses
Depreciation, amortization, and asset write-ofts
Restructuring and other charges
Operating (loss) income
Interest expense
Interest and other income
Earnings before income taxes
Income taxes
Net earnings (loss)
1997
1998
1999
$9,932
6,892
3,040
2,020
$11,038
$11,170
$11,862
~
3,328
2,231
~
3,541
2,743
206
60
253
0
~
2.979
2,443
255
..........lli.
__
0
2,286
2A84
844
2,992
3,021
(O)
85
102
520
91
__
(1_11
440
754
98
-D22 ......J.1.!2 --.Jm

673
.--1.
$ 427
772
~
$ 490
(106)
2000
278
.........l2. -lli...
$ (132) $
279
Chapter 19 TheAnalysis ofCredir Risk and Re/llm 719

718 Part Five The Ana11s15 ofRilk andReucn
E19.6.
CreditScoring for a Firm with a Ratings Downgrade:

Maytag Corporation (Medium)
. . ,
Miniease
Maytag Corporation is the established manufacturer of washing machines, dryers, dishwashers, andotherhomeappliances-includingthe ve~~rable Hoov~r vacuum cleaner. But
. 2004 d 2005 thefinn faceddeteriorating profitability, Competitors hadmoved manu~~cturin;~o low-dost countries whileMaytag persisted with its highlaborcostmanufactur-
Analysis of Default Risk: Fruit of the Loom

Fruitof the Loom Ltd. faredpoorly from 1997 to 1999. Between April 1997 andOctober
1999, itsstockpricedropped from $38to $3, a 92 percent loss in market value.
Fruit of the Loom manufactures men's and boys' underwear. It had an estimated
32 percent share of the U.S. market in 1999, second onlyto the Sara Lee Corporation's
Hanes brand, which holds a 37 percent share. Thefirm has hada checkered history. Itwas
controlled bya financier, William Farley, whotookthefirm through a leveraged transaction
in the mid-1980s and began considerable cost cutting. It was one of those "small-town
America" companies whereconflicts between management and laborarose with the cost
cutting associated with leveraging and reorganization and withthe shipping of production
overseas to countries withcheaper labor. Remember themovie Other Peoples Money?
With the cost cutting and dispersion of production camequality control problems and
difficulty managing inventories. Financial difficulties in other apparel holdings forced
Farley to reduce his stakein Fruitof the Loomand, analysts claimed, distracted him from
thebusiness. In late summer 1999, Farley gaveup control to Dennis Bookshester, an outside director and a veteran of the retail trade, whofound the firm's computer and control
systems were in a mess. Somenumbers on the firm are shown inTable 19.2.
The problems, mostanalysts claimed, were fixable. Product market sharehad declined
slightly butwasstillat a respectable 32 percent. Themarket waspricing these salesat a low
multiple of 0.1L The infrastructure from the cost-cutting program wasstill in place. Many
oftbe production andinventory coordination problems could be fixed withbettercomputer
systems, andcomputer consultants were working to do so.
Inthefallof 1999, someanalysts wereforecasting thatthefinn would breakevenforthe
restof 1999 and wereforecasting an EPSof$0.79 for theyearendingDecember 31,2000.
Subject to qualifications about the finn's ability to get its systems under control, these
analysts were also forecasting continuing profitability in the years after 2000. But other
analysts warned thatthe firm might be heading forbankruptcy.
Forthe ninemonths endingOctober 2, 1999, the firm reported a lossof$253.2 million
against a profitof $146.9 million for the same period of the previous year. Exhibit 19.2
presents thefinn's financial statements covering thefirstninemonths of 1999.
ingin the United States.

. '
Thefollowing shows how Maytag's sales stalled over thepenod2000-2004, witha negativeeffecton income.
2002
2003
2004
In thousands, except per share data
Netsales
Gross profit
Percent of sales
Operating income
Percent of sales
Income (loss) from
continuing
operations
Percent ofsales
2001
2000
$3,891,500
985,481
$4,711.538
660,219
14.0%
$ 40,348
0.9%
$ (9,345)
$4,791,866
859,531
17.9%
$228,293
4.8%
$114,378
$4,666,031
1,004,602
21.5%
$359,495
7.7%
$191,401
$4,185,051
864,842
20.7%
25.3%
$289,152
6.9%
$162,367
$439.715
11.3%
$216,367
-0.2%
2.4%
4.1%
3.9%
5.6%
M19.1
. b d
I A '1 ?005 the firm's bonds were downgraded to junk statusby all threemajor on
~tin~~g;ncie~. Maytag's financial statements for2004areontheWeb pageforChapter 15.

If youworked Minicase MI5.3, youwillhave reformulated these statements.
a. What aspects of the financial statements tell you about the declining creditquality
from 2003 to 20041

..
declini
b. What scoresmightyoudevelop from these statements thatwould indicate the ec mtng
creditquality?

Exercise E6.17 and Minicase M15J alsodealwithMaytag.
TABLE 19,2
FruitoftheLoom
Ltd.
1995
Revenues
Ebit
Net income
Dividends
EPI
Netprofit margin (%)
Book value pershare
PIE ratio
PIB ratio
Price-to-sses ratio
2,403
50.4
-227.3
0
-300
-9.5
11.78
1996
2,447
325.3
151.2
0
1.98
6.2
13.90
1997
2,140
-283.1
-487.6
0
-6.55
-22.8
5.87
19.1
2.11
0.77
2.70
1.19
1999numbers are based on 12 months to June30.1999.

Shares outstanding: 66.923 million.
Figuresin mjliionsordollars. except es perso"" numlxrs ~nd mdcs.
4.41
0.86
1998
1999
2,170
234.9
135.9
0
1.88
63
7.61
73
1.86
2,045
102.3
28.1
0
0.39
1.4
6.82
7.7
0.44
0.11
0.46
720 Part Five The Allal~li5 af Risk (lad R,!Unl
EXHIBIT 19.2
Chapter 19 The Analysis of Credit Risk and Rewm 721
EXHIBIT 19.2
FRUIT OFTHE LOOM LTD.

Condensed Consolidated Balance Sheet
(contil/fled)
Condensed Consolidated Statement of Operations (Unaudited)

(inthousands of dollars)
October 2,
1999
1999
Assets
Current assets
Cashand cashequivalents (including restricted cash)
Nine MonthsEnded
January 2,
37,000
1,400
80,200
109,700
Netsales
Unrelated parties
Affiliates
Notes andaccounts receivable (less allowance for
possible losses of $10,800 and 512,000, respectively)

Inventories
finished goods
Work inprogress
Materials and supplies
Total inventories
Due from receivable financing subsidiary
Other
total current assets
Less accumulated depreciation
Net property, plant.andequipment
Otherassets
Goodwill (less accumulated amortization of $356,200
645,200
135,800
52,500
833,500
26,800
45,400
1,022,900
1,157,200
745,900
411,300
666,300
500,700
183,100
742,000
41,100
894,200
1,192,100
758,200
433,900

Total otherassets
liabilities and Stockholders' Equity
Currentliabilities
Trade accounts payable
Otheraccounts payable and accrued expenses
Total currentliabilities
Noncurrent liabilities
long-termdebt
Notesand accounts payable-affiliates
Other
Total noncurrent liabilities
Preferred stock
Common stockholders' equity(deficiencyP
Gross earnings (loss)

Selling, general, and administrative expenses
Operating earnings(loss)
Interest expense
Other expense-net
Earnings (loss) beforeincome tax provision
Income tax provision
Netearnings(loss)
Sept. 26, 1999
$1,508,400
275,000
1,783,400
$1,678,900
1,253,900
355,400
1,609,300
174,100
315,400
19,900
(161,200)
(72,700)
(18,100)
(252,000)
1,200
s (253,200)
1,678,900
1,145,500
1,145,500
533,400
281,100
19.900
232,400
(74,600)
(3,100)
154,700
7,800
146,900
686,300
(continued)
and $336,200, respectively)

Other
Costof sales
Unrelated parties
Affiliates
Oct. 2, 1999
36,700
146,500
849,500
$2.283,700
36,700
238,700
961,700
$2,289,800
650,200
87,300
299,200
1,036,700
270,500
119,700
226,700
616,900
682,200
438,600
266,000
1,386,000
71,70
(211,500)
$2,283,700
856,600
A Stock screeners would saythatthisstock hasallthe features ofa buy: lowPIE, lowPiB,
andlowprice-to-sales ratio, How comfortable would yoube withissuing a buyrecommendation on this stockat a priceof $3 per share? What otherinformation would you
liketo seeto make youmoresecure in yourrecommendation?
B. Carryout an analysis of financial statement ratios that indicate the likelihood of bankruptcy in October 1999.
C. Calculate a Z-score usingthe Z-score model in this chapter. Annualize ratios basedon
ninemonths forthecalculation. How didthefirm's Z-score change between January and
October 1999?
Note: Fruit of the loom filed for Chapter 11 bankruptcy protection in December 1999.Warren Buffett
subsequently boughtthe firm out of bankruptcy.
'C~mm~n 'lockh~lders' egu;ly~! October2, 19<)9, indudes ",!~ir.ed e:m1ir.1l-' ofS20,'lOO IhOllsond wmp,,,,d to "'ll;~ t:lminesof
S276,600:ho=nd o(lon",1)' 2. 1'199.
(continued)
,.
;':
"
722 Part Five The Anal)'sb ofRisk ondRemm
EXHIBIT 19.2
(concluded)
Condensed Consolidated Statement of CashFlows (Unaudited)

Nine Months Ended
Cash flows from operating activities

Net earnings (loss)
Adjustments to reconcile to netcash provided by(used for)
operating activities
Deferred income taxprovision
Increase inworking capital
Other-net
Net cash provided by(used for) operating activities
Cash flows from investingactivities
Proceeds from asset sales
Payment on Acme Boot debtguarantee
Other-net
Net cashused forinvesting activities
Cash flows fromfinancing activities
Proceeds from issuance oflong-term debt
Proceeds under line-of-credit agreements
Payments under line-of-credit agreements
Principal payments on long-term debtand capital leases
Increase inaffiliate notesandaccounts payable
Common stock issued
Netcashprovided by(used for) financing activities
Net increase (decrease) incashandcash equivalents
(including restricted cash)
Cash andcashequivalents (including restricted cash)
at beginning of period
Cash andcashequivalents (including restricted cash)
at endof period
Oct.2. 1999
Sept. 26, 1999
$(253,200)
$ 146,900
90,200
84,900
(117.000)
(189,100)
(24,700)
(13,600)
A Summary of Formulas
(4,900)
24,200
(304.700)
(28,000)
(25.000)
20,500
68,200
CHAPTER 1
Value of thefirm = Value of debt+ Value of equity
Page 11
Shareholders' equity= Assets - Liabilities
Page34
Net income = Revenues - Expenses
Page 34
(60,800)
(19,600)
(4,100)
(27,100)
(21,700)
240,200
676,800
754,300
(486,800)
(643,400)
(236,400)
(122,200)
174,700
(1,100)
6,800
367,400
(3.000)
(7.500)
35,600
(5.000)
$ 37,000
$ 11,100
CHAPTER 2
Netrevenue - Costof goods sold> Gross margin
Page36
Gross margin - Operating expenses>Earnings before interest and tax (ebit)
Page 36
Earnings before interest andtax- Net interest expense = Income beforetaxes
Page36
Income before taxes- Income taxes> Income aftertaxes

(andbefore extraordinary items)
Page36
Income before extraordinary items + Extraordinary items= Net income
Page 36
Net income - Preferred dividends = Net income available to common
Page36
Cashfrom operations + Cashfrom investment + Cashfrom financing

:: Change in cash
Page 39
Ending equity = Beginning equity+Total (comprehensive) income

- Net payout to shareholders
Page 39
Comprehensive income = Netincome + Othercomprehensive income
Page39
Intrinsic premium = Intrinsic valueof equity- Bookvalue of equity
Page 42
Market premium = Market priceof equity- Bookvalue of equity
Page42
Value added forshareholders = Endingvalue- Beginning v-alue + Dividend
Page44
Stockreturn, = Pt - Pt- 1 +df
Page46
724 Appendix
ASummaryofFcrmu1as
Appendix
A Sumll'.<Il)' ofFmmulas 725
Perpetuity dividend model:
CHAPTER 3
Market value of equity +Netdebt
d nri eI al
UnIevere pnc 5 es e
Sales
Unlevered price/ebit
Market value of equity + Netdebt

ebit
Page 79
Page79
. PIB ::::: _M,.ark-,-et_v.,.al_u_e

-;:of_eq~U:-,i-'.ty_+"Ncce-:t "de;c-bt
En terpnse
..
Book value ofequity + NetDebt
Trailing PIE
Rolling PIE
E
d
d
d3
dT (dT+1)
ViJ=-+-+-+"'+-+
- - /Pt
PE p} P~
Pk PE - g
2
vg = _d_,_
Page79
Value of a perpetual dividend stream =
Price pershare
Most recent EPS
Page79
Value ofa dividend growing at a constant rate =vg
Price pershare
SumofEPSformost recent fourquarters
Page79
Forward or leading PIE _
Price pershare
Page 79
Forecast ofnext years BPS

Dividend-adjusted PIE _ Price pershare + Annual DPS
Page 79
EPS
vg=
PD
+ CFz + CF3 +
Ph
Ph
CF4
Ph
+ ...+_CF_T
Page90
pI,
p~
Value of the finn = Present value of expected freecashflows
V6 = q
- II + C2 - h + C3 - h + C4 - 14 + Cs - Is + ...
p}
pi
pi
p~
Page119
PF
(PF is 1 + Required returnforthe firm)
PF
+ C2
p}
h + C3 - h +... + CT - Ir + CVT _ VD
p}
P}
P}
0
p~
Page 120
Page120
PF -1
... t
p~
CFT
p~
Page91
CHAPTER 4
Value of equity = Present value of expected dividends
!!1- +!2- +!.i- +...

pl p1 pi
If freecashflows areforecasted to grow at a constant rateafterthehorizon,
CVT=(CT+,-Ir+,)
PF - g
CPp is 1 + Hurdle rate for theproject)
PE
Page 117
PE - g
CT+l - Ir+l
Vl= CFI + CF2 + CF3 + CF4 t
=_d_,_
If freecashflows after T areforecasted to be a (constant) perpetuity,
Value of a project Present value of expected cashflows
VE= :!J.. +
Page117
PE -1
vg = q - II
(PD is 1 + Required return for thebond)
Pp
Page117
Value of the equity = Present value of expected freecashflows minus value of netdebt
Value of a bond Present value of expected cashflows

CFI
Page116
Dividend growth model:

l
Market value of equity +Netdebt

ebitda
Unlevered price/ebitda
d1
d2 d 3 ...+-+
dT (dT+1)
VoE=-+-+-+
--/pk
PE p~ pi
Pk PE -1
Page 79
Page 116
(PE is 1 + Required return for the equity)

Value of equity= Present value of expected dividends + Present value of expected
terminal price
Page116
Page120
Cashflow from operations = Reported cashflow from operations

+ After-tax netinterest payments
Page125
Cashinvestment in operations = Reported cashflow from investing

- Net investment in interest-bearing
instruments
Page 126
Revenue = Cash receipts from sales+ Newsaleson credit

- Cashreceived forprevious periods' sales
- Estimated salesreturns
- Deferred revenue for cashreceived in advance of sale
+ Revenue previously deferred
Page129
Expense = Cashpaidforexpenses +Amounts incurred in generating

revenues but notyetpaid- Cash paidforgenerating revenues
in future periods + Amounts paid in the pastforgenerating
revenues in the current period
Page130
726 Appendix A Summary of Fom:ulas
Appendix A Summa!)' of FOTmU/a., 727
Earnings == Levered cashflow from operations t Accruals
CHAPTER 6
Earnings == (C- i) -l-Accruals
Page 130
Earnings == Freecashflow - Netcash interest +Investment t Accruals

Earnings == (C -1) - i +I t Accruals
Page 194
Page 130
Normal forward PIE ::::
CHAPTER 5
.
The valueof common equity (VO ) == Bo t
REI
RE2
p}
RE]
pi
-i-- - + - - t ...
PE
Residual earnings == Comprehensive earnings - (Required returnfor equity

x Beginning-of-period bookvalue of equity)
Page153
Page153
Residual earnings == (ROCE - Required returnon equity)

x Beginning-of-period bookvalue of common equity
Page156
Earn,- (PE-I)BH = [ROCE,-(PE-I)]B,_I
Simple valuation model:
Page 197
Required return
Normal trailing PIE = (l + Required return)

Required return
Page198
Value of equity= Capitalized forward earnings

t Extravaluefor abnormal cum-dividend earnings growth
v,E = Earn!
o PE-1
RE/=Earnr-(PE-1)B H
~-:--;--:-
t __
PE-1
[ AEG2 t AEG 3 t AEG 4

PE
P~
p~
t ..
=_l_[Eam I + AEG 2 + AEG] + AEG 4 + ..

PE- 1
PE
P~
pi
Page 199
Abnormal earnings growth, (AEG r) = Cum-dividend earn! - Normal earn,
Page 159
RE2
RE)
l)dr~d -
PEEarn/_1
Abnormal earnings growth, (AEG[) = [G/- PEl x Eamings..,
Case 1 valuation. REis forecasted to be zeroaftersomepoint:
REt
= [Earn/ + (PE~
RET
V[=Bot-+--+--tt-PE
p}
p~
Pk
Page 161
Case2 valuation. No growth:
RE,
VoE =Bo t + -RE,
- t t -RET
- + (RET"
--fPET
PE
pi
P~
PE -1
Page201
Value of equity(cum-dividend) = Capitalized current earnings

t Extravalue for abnormal cum-dividend abnormal
earnings growth
AEG] AEG 2 AEG] ..
VoE +do = - PE
- [ Earno+--+--+--t
Page163
Page201
PE- 1
PE
P~
pi
Page203
Case3 valuation. Growth is forecasted to continue at a constant rate:
REI RE2 RE]

RET (RET+l}
Vg=Bot-+--+--tt--+
- - - PET
PE
pi
Pi:
Pk PE - g
Page163
Po
r\
Eo
BO) (g-l)
=-ROCE,
+ 1-Po
Po
Earnings forecast,e (Bookvalue/_I x Required return) t Residual earnings/
10
Earn]
Div )
whereA=-1( g-lt--'
2
Po
Earn Po - Bo
Implied expected return == p-l == - + - - ( g
-l)
Po
Earn 1 x (Earn2 - Earn ]-(g-l))

Implied expected return = p-1 =A+ A2 +__
Page 175
Page 177
Page211
Earnings forecast = Normal earnings forecast t AEGforecast

- Forecast of earnings from prioryear's dividends
PEG ratio
PIE
l-year-ehead percentage earnings growth
Page 213
Page216
728 Appendix
Appendix
A Summary ofFormlllas
A Slmlmary ofForrnuhs 729
Change innetfinancial obligations = Netfinancial expense - Free cashflow

+ Netdividends
CHAPTER 7
C-/=d+F
Page 244
Stocks andflows equation forcommon stockholders' equity:
Page 236
Treasurer's rule:
If C ~ 1- i > d: Lendor buy down owndebt.
If C - I - i < d: Borrow or reduce lending
II) + d,
~NFOI = NFEI- (Ct -
Freecashflow =:: Netdividends to shareholders + Netpayments to debtholders and

issuers
Page 236
CSEt = CSEr_ 1 + Eamings.>- Netdividends,
Page 244
CSEI = NOA t - NFO r
Page 245
01,
+ NOAt~l)
Return onnetoperating assets (RNOA1 )
1/2 (NOA,
Page 246
Freecashflow =:: Operating income - Change innetoperating assets

C-/=OI-6NOA
Return onnetfinancial assets (RNFA I ) ==
Page 242
Freecashflow e Change in netfinancial assets - Netfinancial income

+ Netdividends
C-/=lINFA- NFl + d
Page 242
Dividend payout
0,
-(C,-I,)
Page 243
.
.
Retentron ratio
Page 243
Page 243
Page 265
Page 265
Comprehensive income - Dividends

Page 265
Page 266
Growth rate ofCSE _ Change in CSE
Beginning CSE
Page 266
_ Comprehensive income + Nettransactions with shareholders
Beginning CSE
Page 243
Growth rate of CSE == ROCE + Netinvestment rate
Page 266
Page 243
CHAPTER 9
Netfinancial obligations (end) = Netfinancial obligations (begin)

+ Netfinancial expense - Free cashflow
+ Netdividends
NFOt == NF0 1_ 1 + NFEI - (CI-It ) + d,
Dividends
-'cc::~""'
_
Bookvalueof CSE+ Dividends
= 1- Dividend payout ratio

Nettransactions with shareholders
Netinvestment rate Beginning bookvalue ofCSE
Change in netfinancial assets> Netfinancial income + Freecashflow

- Netdividends
t.NFAr = NF1I + (CI-It)-dt
Page 264
:::i,:vi"d:;;
' en"ds
::..::
+.::oS"to;'ck:.':;:
e!.pur
'7
ch"as
:::e::s_ ---;--'P:.::
a,ge 265
1 ::::: :: ---;_ ;-'D
Tota1payout-t t0- ho0 k vaue
Bookvalueof CSE+ Dividends + Stockrepurchases
Netfinancial assets (end) = Netfinancial assets (begin)

+ Netfinancial income + Free cashflow
- Netdividends
NFAr = NFA r_1 + NH+ CCt-It)-dl
Dividends
. .
Dividends-to-book
value-
Change in netoperating assets = Operating income - Freecashflow

lINOA, =
Page 248
'I, (NFO, + NFO,_,)
"_D:.:iVl:.:""de:.:n::d:.s:.:+.::S::to::.:c:::k:.:r"ep::.:=::::.:h::a:::se::s
TotaI payout ratio:::::
Page 243
Netoperating assets (end) = Netoperating assets (beginning)

+ Operating income - Freecashflow
NOA I = NOA I_ 1 + 011 - CCt-II)
Page 246
CHAPTER 8
Net dividends = Freecashflow - Netfinancial expenses

+ Changein net financial obligations
d= C-/ - NFE+ i\..'1FO
Page 242
Netdividends> Free cashflow + Netfinancial income

- Changein net financial assets
d=C-/+NFI-6NFA
NFl,
I,(NFA,+NFA H
NFE,
Netborrowing cost(NBC1 )
Freecashflow = Netfinancial expenses - Change innetfinancial obligations

+ Net dividends
C-l=NFE-6NFO+d
Page244
Taxbenefit of netdebt== Net interest expense x Marginal tax rate
Page 303
After-tax netinterest expense == Netinterest expense x (1- Marginal taxrate)
Page 303
730 Appendix A SumllUlry of Formulas

Appendix
Taxon operating income = Taxexpense as reported

+ (Netinterest expense xTax rate)
Page304
Effective tax ratefor operations =
Page305
CHAPTER 10
Freecash flow = Operating income - Change in netoperating assets
C- I = or-
Taxon operating income

Operating income before tax, equity income, andextraordinary anddirty-surplus items
Page312
. profi t margin
. (PM) = "'-'.7.;c-~
OJ (after tax)
Operatmg
Sales
Page313
or (aftertax) from sales

Sales
Page316
er iitems PM = ~O_ro.(a_ft_er_tax-,)"fr:,o=m"o"th"e"r_ite=m=s
Other
Sales
Page316
. .
.
Net (comprehensive) mcome profitmargin = =""':.:::~""-'"''"'"o:
Sales
~NOA
Page316
C-I=NFE-~NFO+d
ROCE = (NOA x RNOA)_ (NFO x NBC)

CSE
CSE
ROCE = RNOA +
= RNOA
Page365
[~~ x (RNOA- NBCl]
= RNOA + (FLEV x SPREAD)
Page316
ROCE = RNOA - [NFA x (RNOA- R.NFA)]

CSE
..
.
Operating asset
Operatmg assetcomposition ratio = ::-,-:--='-'-'-'----
Page317
Operating liability composition ratio =
Page317
Operating liability leverage (OLLEV) = Operating ~iabilities

Net operanug assets
Capitalization ratio
= NOAfCSE
Netoperating assets
Page367
Page317
RNOA = ROOA + (OLLEV x OLSPREAD)
Page 367
OLSPREAD = ROOA - Short-term borrowing rate (after tax)
Page367
ROCE = ROCE before111 x MJ sharingratio
Page 370
Page317
ROCE before minority interest (MI)
Page318
- mcome
a=ft:.:e,-rtax=)
rate iill operating
_ cC=h=an"g"-e"in"o:!p_~er=a=tin"g,,in:;;c:.:o.::m:.:e-,(
.
Growthrate
Priorperiod's01
Page318
wth i NOA Change in netoperating assets

Gro
m
= ---''-;::--;--;-'-':'::::-;'--:':=
Beginning NOA
Page318
Change in CSE
Beginning CSE
Operating assets
Return on net operating assets = Returnonoperating assets + (Operating liability

leverage x Operating liability leverage spread)
Capitalization ratio- Financial leverage ratio = 1.0
Growth in CSE
01 + Implicit interest (after tax)
Page317
Page317
Change in sales
Priorperiod'ssales
Page 366
Implicit interest on operating liabilities = Short-term borrowing rate (aftertax)

X Operating liabilities
Page 367
Return onoperating assets (ROOA)
Financial leverage ratio _ Net financial obligations = 1\lfOICSE

(FLEV)
Growth ratein sales =
Page365
Page 316
Totaloperating assets
Page 342
CHAPTER 11
Expense
.
Expense ratio = - - - Sales
1- SalesPM = Sum of expense ratios
Operating liability
Totaloperating liabilities
Page342
Freecashflow = Net financial expense - Change in netfinancial obligations

+ Net dividends
Residual operating income = ReOI t = 011 - (p -1)NOA t _ 1
SalesPM =
ASumrr.aryofFonnu1m 731
Page318
Comprehensive income before MI

CSE+MI
Page370
Minority interest _ Comprehensive income/Comprehensive income before MI Page 370

sharing ratio
CSE/(CSE + MI)
ROCE = (pMx ATO) + [FLEV x (RNOA - NBCl]
Page371
PM = OJ (after tax)/Sales
Page371
ATO = SalesINOA
Page 371
PM = Sales PM + OtheritemsPM
Page 374
732 Appendix A Summary of Formulas
SalesPM::: Gross margin ratio- Expense ratios
Appendix A Summary of Fonnulas 733
Page 374
I
Cash Accounts receivable Inventory
PPE
--=--+
+---+ ...+-ATO Sales
Sales
Sales
Sales
+..._ Accounts payable

Sales
PPEturnover :::
Pension obligations
Sales
Page 374
Page405
RNOA ::: Coreor from sales + Coreotheror + ~

NOA
NOA
NOA
Page406
RNOA::: (CoresalesPMxATO) +
Sales
Accounts receivable (net)
Page 375
Sales
Property, plant, andequipment (net)
365
. accounts recerva
. ble::: -,-----=:.,-,--Days m
RNOA = Core 01 + ~
NOA
NOA
Page 375
(sometimes calleddays salesoutstanding)
where CoresalesPM ::: Core 01 from sales

Sales
Page406
Netborrowing cost> Corenetborrowing cost+ Unusual borrowing costs
Page407
NBC Corenet financial expenses + Unusual financial expenses

NFO
NFO
Page 407
Page375
Theinventory turnover ratiois sometimes measured as:
-",o",':,:o:.:f",g"oo",d"'co',,olc:d
Inventory tumover -c
Inventory
Page 375
" Inventory ::: -::-_--=3:.:65--=_

Daysm
Inventory turnover
Page 375
.
Days Inaccounts
payable _ c3.c.65c.x=A:.:cc:.:0c:u"nts=..r:pa",Y"ab=le
.
Purchases
Page 375
Change in
RNOA
bRJ~OAI
Change incoresales Change dueto Change dueto Change dueto

profitmargin at + change in asset + change in other+ change in
previous asset
turnover
coreincome
unusual items
turnover level
Page408
::: (.6.Core salesPMj x ATO o) + (IiAT01 x Coresales PM 1)
+ 6(Core other01) + 6(~)
Page 408
Sales- Variable cost - Fixed costs

Sales
Page 409
NOA
The net borrowing cost is a weighted average of the costsfor the different sources of net
financing:
Sales PM
NBC:::( FO x After-tax interest on financial obligations (FO))

NFO
FO
Contribution margin ratio e 1
_ ( FAx Unrealized gainson FA)

NFO
FA
OLEV -
Preferred stock Preferred dividendS)

X
+
NFO
Preferred stock
NOA
Contribution margin
Sales
_ ( FAx After-tax interest on financial assets(FA))

NFO
FA
+(
VI
Coreother01
+-NOA
NOA
Page377
Fixed costs
Sales
Variable costs
Sales
01:::Core01 from sales+ Coreother 01 + VI
Page 396
Return on net operating assets> CoreRNOA

+ Unusual items to net operating assets
Page 405
Page 409
Contribution margin Contribution margin ratio

- ---::--;;:--"-Operating income
Profitmargin
(Don'tconfuse OLEV withOLLEV!)
Page 409
% Change in core01 =: OLEV x % Change in coresales
Page 409
CHAPTER 12
Contribution margin
Sales
NOA ::: Sales x - ATO
Page 411
ilCSE = 6(sal" x _1_) - <INFO
Page 411
ATO
Change dueto change Change dueto change Change in

Change incommon equity = in salesat previous + in assetturnover - financial
levelof assetturnover
leverage
734 Appendix
Appendix A Summary ofForrnuIas 735
ASummary ofFonnuJas
b.CSE I ::: (b.SaleS 1 X
_1_)+(bI
ATO o
ATO,
After-tax costof net debt (PD):= Nominal costof net debtx (1- Taxrate)
X sales l ) -
b.NF01
Page 412
Page 451
Required returnon equity= Required returnfor operations

;-:D
- PD)
PE = PF + --L(PF
Vo
CHAPTER 13
Residual operating income> Operating income - (Required return for operations
X Beginning netoperating assets)
ReOlI = 011 - (PF- 1)NOA1 _ 1
Unlevered PIB ratio =
Page 443
p}
PF
p}
pj
pj
Valueof net operating assets

N
.
IS
et operating asse
v,NOA
=_0_ _
Value of operations = Netoperating assets

+ Present valueof expected residual operating income
V~OA::: NOAo + ReOI] + ReOh + ReOb + ... + ReOlr + CVr
Page454
Page 467
NOAo
Levered PIB ratio= Unlevered PIB ratio + [Financial leverage
x (Unlevered PIB ratio- 1)]
Page 443
VE
V;NOA
V;NOA
_o_=_o
__ +FLEV( _0
Value of common equity::: Bookvalue of common equity

+ Present value of expected residual operating income
- CSE
ReOl: ReOh Re0I3
ReOlr CVr
V00 +--+--+--+ .. +--+--
PF
p}
P~
p],
P~
CSEo
Page 446
V,:t
::: Cum-dividend operating income->- Normal operating income,
rOI, + (PF- I)FCFI_d- PFOII_l
..
_ Vl +do
Trailing levered PIEratio = Earn
o
Page 448
Value ofcommon equity Capitalized (Forward operating income + Present

valueof abnormal operating income growth)
- Netfinancial obligations
V5:= _1_[0I1 + AOIGz + AO;G3 + AOIG 4 + ---J - NFO o

Pf
PF
p}
Page449
Value of equity
_
( Value of operattons
+(
V5
VD
- ' P E +.......L
PF - VNOA
n-OA PD
o
0
Page 451
Page 470
Page 470
(Vf
010
1 1)
NBC o
Page488
SFI forecast
01, = (p,- 1)NOAo

NFE, = (PD-tlNFO o
Earn, := (PE-1)C5Eo
Value of debt
. )
x Costof debtcapital
Value of operations
1)
~Il - NBC
CHAPTER 14
Earnings Forecast
.
- )
Equitycostof capital
(V;NOA
OA
v.:0NOA + FCFo + ELEV -'-_
+_FCFo
~
o
010
Costof capital for operations = Weighted-average costof equityandcost of netdebt

:=
V;NOA
Forward levered PIE ratio = ~1 = ~Il + ELEV\
= [Operating income.e- (PF-l)FCF,_Jl- pe cperating inccmec,
pf-l
Page 470
010
= [G,- PF] x 0[,_,
Page468
v.:0NOA + FCFo
Abnormal operating income growth, (AOIG)
Page467
_.
.
.
Valueof operations + Free cashflow
Trailing enterpnse PIE ratio :=
Curren
..
t operatmg mcome
Residual operating income> (RNOA - Required returnforoperations)

x Netoperating assets
ReOI,= [RNOA,-(PF-I)]NOA,_,
1)
NOAo
Valueof operations
= poNOA
Forward operating income
011
Forward enterprise PIE ratio
Page 444
NOAo
Residual Earnings Forecast
01, - (p,-1)NOAo - 0
NFE, - (PD -1)NFOo= 0
Earn, - (PE - 1}CSEo = 0
736 Appendix
A Swnmary ofFcmnulas
Appendix
SFl valuation:
Value of common equity = Book value of common equity
Unlevered price-to-book ratio:
vi =CSE
II
SF2forecast:
Earnings Forecast
I'
all =010+ (Pf- l)fl.NOAo

Eam, = Earno + (PE - 1)6CSEo
A Surnll'.Ill)' ofFcmnulas 737
Page 490
VNOA
RNOA o - (g -I)
Page491
NOAo
PF-g
Abnormal Earnings
Growth Forecast
1 [
G2-PF]
=0I1x--l+--PF-I
PF-g
ReOJ 1 = ReOlo
Page 496
RE 1 = REo
A simple valuation withshort-term and long-term growth rates:

SF2valuation:
Value of common equity = Bookvalue of common equity + Capitalized current ReO!
V[ = CSEo + ReOIo
VeNOA = OIl X _1_[G2 - GJon g]

PF-l PF-GJong
Page 492
PF -I
Reverse engineering the expected return
[0['~~tns
] [(
Page 503
]
NOA
o)
Expectedretumforoperations =PF-l= p:o:XRNOA j + 1- FQNOA x(g-l)
Value of operations Capitalized operating income forecasted for nextyear
Page 504
VoNOA -_ ~
Page 493
PF -I
CHAPTER 15
SF3forecast:
1 M Required return for operations]

ATO
ReOI= Sales x ( Core sa es P -
Page495
Earnings Forecast
+ Core otheror + Unusual items
01, = RNOA, x NOli,

Earn, = ROCE o x (SEc
Page541
[RNOA, - (PF-lIlNOA,= IRNOA, - (PF-lIlNOAo

[ROCE, - (PE -1)ICSEo = [ROC Eo- (PE-l)]CSEo
CHAPTER 17
SF3valuation:
Value of common equity:
vt = CSEo + [RNOAa - (PF -1)]NOAo

PF - g
Page496
Value of operations:
V~OA = NOAo + [RNOAo -(PF -1)]NOAo
PF - g
= NOAa x RNOAo - (g -I)
PF - g
Page 496
Quality diagnostics:
Netsales/Cash fromsales
Netsales/Net accounts receivable
NetsalesfUnearned revenue
NetsalesIWarranty liabilities
Page 619
Baddebtexpense!Actual creditlosses
Baddebtreserves!Accounts receivable (gross)
Baddebtexpense/Sales
Page620
Warranty expense/Actual warranty claims

Warranty expense/Sales
Page620
Normalized 01
01
where
Normalized 01:::: Freecashflow + flNormalized NOA

= Freecashflow + .6.SalesINormal ATO
Page621
Appendix A Summary ofFormulas 739
738 Appendix A Summary of Formulas
CHAPTER 19
Adjusted ebitda
ebit
Page 623
Page 623
Current ratio :::: Current assets

Current liabilities
Page 701
Depreciation
Page 624
Quick (oracid test) ratio Cash +Short-term investments + Receivables

Current liabilities
Page 701
Cashflow from operations (CFO)

Operating income
.
Cash ratio
Page 701
CFO
AverageNOA
Page 624
Pension expense
Page 626
Otherpostemployment expenses
Page 626
Defensive interval
Page 626
R&D expense
Sales
Page 630
Cash + Shorttenn investments + Receivables x 365

(UnJevered) cash flow from operations
Cash flow to
capital expenditures
Detta
b totaI assets
Operating tax expense

01 before taxes
Total debt(current + long-term)

Total assets (liabilities + totalequity)
CHAPTER 18
Reverse engineering theexpected return:
Page 682
Expected retumfor operations = [:,~~: XRNOA}[(l- :;~: )X(g-l)]

Page 682
V8 (1)/Po (I)
Vt (2)/Po(2)
(fortwoinvestments, I and2)
Page 684
Page 702
.
Total debt
Debt to equity :::: ~-';':==
Total equity
Page 630
Page 701
Page 701
:;:-.,-;--,--;';--,c;77-~'-;--':-c
Long-term debtratio
Advertising expense
Sales
Relative valueratio e
Cash Sbort-term investments

Current liabilities
Page702
Long-term debt
Long-term debt+ Total equity
Interest coverage
Operating income
Interest coverage e
Unlevered cashflow from operations

Netcash interest
Page 702
(times interest earned)

(cash basis)
Unlevered cashflowfrom operations

CFO to debt = -----;;;-:-"C77:-~~
Totaldebt
Cash available for debt service>Freecash flow - Netdividends
:::: or- 6.NOA - Netdividends
Page702
Page 702
Page 702
Page 709
Debt service requirement> Required interest andpreferred dividend payments

+ Required netprincipal payments
Page 709
+ Lease payments

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Contents

Valuation Models for Terminal Investments 90

List of Cases xxiii

TheSetting: Investors, Firms, Securities, and

The Analysis ofBusiness 14

Choosing a Valuation Technology

TheCash Flow Statement 38

Measurement in theFinancial Statements 41

TheArchitecture of Fundamental Analysis:

Simple Valuation Models 123

Cash Flow, Earnings, andAccrual Accounting

Earnings andCash Flows 128

Valuing a Project 150

A Model forAnchoring Value on BookValue 153

Applying the Model to Equities 160

Applying theModel to Projects and

Reverse Engineering theModel forActive

Separating Speculation from What We Know: Value

Beware ofPaying Too Much for Earnings

Prototype Valuation 195

A Model forAnchoring Value on Earnings 199

Applying theModel to Equities 204

Features oftheAbnormal Earnings Growth Model 206

Reverse Engineering theModel for

Separating Speculation fromWhatWe Know: Value

Handling DilutedEarnings per Share 270

TheEyeof the Shareholder 274

Business Activities: AllStocks andFlows 240

Accounting Relations thatGovern Reformulated

Tying It Together forShareholders:

Dirty-Surplus Accounting 262

Ratio Analysis 264

Hidden DirtySurplus 266

Reformulation of the Income Statement 301

Comparative Analysis of theBalance Sheet

Ratio Analysis 316

Cash Flow from Operations 350

Second-Level Breakdown: Drivers

TheWeb Connection 379

Core Operating Profitability

Analysis of Growth 407

Growth, Sustainable Earnings, and theEvaluation

A Modification to Abnormal Earnings Growth

TheCostof Capital and Valuation 449

Financing RiskandReturn andtheValuation

Leverage andAbnormal Earnings Growrh

Mark-to-Market Accounting: A Tool for Incorporating

TheAnalyst's Checklist 523

Full-Information Forecasting andPro Forma

Financial Statement Indicators andRed Flags 547

TheAnalyst's Checklist 487

Simple Forecasting: Adding Information to Financial

Unarticulated Strategy 549

TheWeb Connection 550

TheApplicability of Simple Valuations 500

Reverse Engineering 503

TheAnalyst's Checklist 571

Accounting Methods with a Constant Level

Accounting Methods with a Changing Level

Hidden Reserves and theCreation

Accounting Methods and the Forecast

Detecting Transaction Manipulation 629

OtherCore Income Timing 631

Justifiable Manipulation? 632