Financial Statement Analysis

and Security Valuation

Stephen H. Penman

Prepared by
Peter D. Easton and Gregory A. Sommers
Fisher College of Business
The Ohio State University

With contributions by
Stephen H. Penman – Columbia University
Luis Palencia – University of Navarra, IESE Business School

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-1

Part III

Forecasting and
Valuation Analysis

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-2
 Part III
Page 414
Layout of Part III

Chapter 13
Valuing operations separate
from financing

Analyzing price-to-book ratios

Chapter 14
Creating simple
forecasts

Chapter 16
Analyzing price-to-earnings
ratios
Chapter 15
Creating pro-forma
financial statements to
get forecasts for
valuation

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-3

Valuation of Operations and the Analysis

of Price-to-Book Ratios

Chapter 13

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 Chapter 13
Page 417
What you will learn in this chapter

• What a perfect balance sheet is

• How a perfect balance sheet implies a zero residual earnings forecast
• What a normal P/B is
• Why forecasted residual income on financial assets and liabilities is usually
zero
• How one values firms based on forecasts of operating activities
• What residual operating income is
• The drivers of residual operating income
• The difference between the cost of capital for equity and the cost of capital
for operations
• How financial leverage effects both ROCE and the required return for equity
• The difference between levered and unlevered P/B ratios and how they are
calculated

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-5

Chapter 13
The Accrual Accounting Page 418

( )
Valuation Model

V = CSE0 + ∑ ρ E−t earn t − ( ρ E − 1) CSE t −1 + CVT ρ ET

T
E

t =1
0

The valuation of equity

– Forecast future residual income (RE)
– Calculate continuing value
– Take present values and add to current book value

Review Chapter 6

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-6
 The First Three Steps of Fundamental
Analysis

1. Identify the forecast target: future earnings and book values

(Chapter 6)

2. Establish the current information: financial statement analysis

(Part II: Chapters 7-12).
This reveals current RE (and ROCE) and its drivers

3. Forecasting: determine the transition from the current to the

future
How will future RE be different from current RE?

Forecasting involves preparing pro forma financial

statements for the future, following the template in Chapter 9

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-7

Chapter 13
The RE Forecast is a Forecast of Page 418

R E 1 = earn 1 − ( ρ E − 1 )CSE
Earnings Against a Benchmark

(1) (2)

(1) Forecast of comprehensive earnings for next year

(2) Benchmark forecast of comprehensive earnings:

CSE will earn at the cost of capital

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-8
 Chapter 13
Page 419

The Perfect Balance Sheet

MS, Inc.
Balance Sheet, December 31, Year 0

Assets Equities
Prior Prior
Year 0 Year Year 0 Year
Marketable equity
securities (at market) 23.4 20.3 Long-term debt (NFO) 7.7 7.0

Common shareholders’
equity (CSE) 15.7 13.3

NOA 23.4 20.3 23.4 20.3

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-9

MS, Inc.
Income Statement, Year 0

Operating income
Dividends from equity securities 1.2
Unrealized gains from equity securities 1.9
The Perfect 3.1
Interest expense: 0.10 x 7.0 (0.7)
Balance Net income 2.4
Sheet
(cont.) MS, Inc.
Statement of Cash Flows, Year 0

Cash flow from operations (cash dividends) 1.2

Cash flow - investment activities (1.2)
Free cash flows 0.0

Cash-financing activities 0.0

(Borrowing cost is 10%; equity cost of capital is 12%)

Chapter 13
Page 419

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-10
 Chapter 13
Forecasting from a Page 420

e a r n1 = ( ρ E − 1) CSE 0 = 0 .12 × $ 15 .7 = $ 1.884

Perfect Balance Sheet

MS, Inc.
Pro Forma Income Statement, Year 1

Operating Income 2.654

Interest Expense: 0.10 x $7.7 0.770

Net Income: 0.12 x $15.7 1.884

V 0E = CSE 0
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-11

Chapter 13
Page 421
The Normal P/B Ratio Box 13.1

• Residual earnings expected to be zero

• ROCE expected to equal the cost of equity capital

• Cum-dividend book values expected to grow at the cost of

equity capital

V = CSE0 ⇒ =1
• E V0E
0
CSE0

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-12
 Chapter 13
Page 422
Exhibit 13.1
The Imperfect Balance Sheet

P P E , Inc.
B a la nc e S he e t, D e c e m b e r 3 1 Y e a r 0

A s s e ts E q uitie s
P r ior P r ior
Y ear 0 Y ear Y ear 0 Y ear
P r op e r ty , p la n t & e q uip m e nt
(a t c os t le s s a c c um d e p r e c ) 7 4 .4 6 9 .9 L on g -te r m d e b t (N F O ) 7 .7 7 .0

C om m on s ha r e h old e r s ’
e q uity (C S E ) 6 6 .7 6 2 .9
NOA 7 4 .4 6 9 .9 7 4 .4 6 9 .9

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-13

P P E , Inc. Chapter 13
I n c o m e S ta te m e n t, Y e a r 0
Page 422
O p e r a t i n g in c o m e Ex. 13.1 & 13.2
S a le s o f p r o d u c t s 1 2 4 .9
C o s t o f g o o d s s o ld
( in c l u d e d d e p . o f 2 1 .4 ) (1 1 4 .6 )
1 0 .3
O t h e r o p e r a t in g e x p e n s e s ( 0 .5 )
9 .8
The
I n t e r e s t e x p e n s e : 0 .1 0 x 7 . 0 ( 0 .7 )
Imperfect
Balance N e t in c o m e 9 .1

Sheet (cont.) P P E , Inc.

S t a t e m e n t o f C a s h F lo w s , y e a r 0

C a s h f l o w f r o m o p e r a t io n s
O p e r a t in g i n c o m e 9 .8
D e p r e c ia t i o n 2 1 .4
3 1 .2

C a s h f l o w f r o m in v e s t in g a c t iv it ie s
I n v e s t m e n t s in P P E ( 2 1 . 4 + 4 . 5 ) 2 5 .9

F r e e c a s h f lo w s 5 .3

F in a n c i n g f lo w s
D iv id e n d s p a i d 5 .3

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-14
 Chapter 13
Page 423

A Modification of the RE Model

• RE Model:
V 0E = CSE 0 + PV of RE
Some assets and liabilities have zero expected
RE because they are measured at market value

• Modified Model:
V0E = CSE 0 + PV of RE of net assets not at market val ue

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-15

Chapter 13
Page 424
Residual Earnings Components Table 13.1

Net Income Component Book Value Component Residual Earnings Component

Operating Income (OI) Net Operating Assets (NOA) ReOI=OIt – (ρF – 1) NOAt-1

Net Financial Expense (NFE) Net Financial Obligations (NFO) ReNFE=NFEt – (ρD – 1) NFOt-1

Earnings (earn) Common Stockholders’ Equity (CSE) RE=earnt – (ρE – 1) CSEt-1

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-16
 Chapter 13
Forecasting Residual Operating Page 424

Income (ReOI)

• NFO are usually at market value on the balance sheet (or close
to it). So residual earnings from NFO are expected to be zero

• NOA are not usually at market value in the balance sheet

∑ ρ (OI − ( ρ F − 1 ) NOA )− NFO

∞
V 0E = NOA + −t
t t −1
t =1
0 F 0

(1) (2)
The Residual Operating Income Model:

(1) Value of the firm (value of the operations)

(2) Value of the net debt

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-17

The Residual Earnings Model

∑ρ (earn (ρ E − 1) CSE t −1 )
∞
V0E = CSE 0 + −t
t −
t =1
E

= NOA 0 − NFO 0 + ∑ ρ E− t [OI (

− ( ρ E − 1) NOA t −1 − NFO t −1 )]
∞
t − NFE t
t =1

( )
= NOA 0 − NFO 0 + ∑ ρ F− t OI t − ( ρ F − 1) NOA t −1 − ∑ ρ D− t NFE t − ( ρ D − 1) NFO t −1( )
∞ ∞

t =1 t =1

(
V0E = NOA 0 − NFO 0 + ∑ ρ F− t OI t − ( ρ F − 1) NOA t −1 )
∞
+ 0
t =1

The Residual Operating Earnings Model

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-18
 Nike Reebok
Base Data for 1996:
Net operating assets (NOA) 2,659 1,135
Net financial obligations (NFO) 228 720
Total equity 2,431 415
Minority interest - 34
Residual Common stockholders’ equity (CSE) 2,431 381
Earnings Analysts’ earning forecast for 1997
Forecast Earnings forecast 648 143
Components Less NFE forecast (NFO x Core NBC) (8) (29)
Less minority interest in earnings - (15)
Analysts’ implicit OI forecast 656 187

Calculation of residual earnings components:

Residual operating income (ReOI) forecast
Nike: 656 − (0.110 x 2,659)
Reebok: 187 − (0.101 x 1,135)
364
72
Residual net financial expense (ReNFE) forecast
Chapter 13 Nike: 8 − (0.035 x 228)
Reebok: 29 − (0.040 x 720)
0
Page 425
Box 13.2
0
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-19

Chapter 13
Continuing Values for the Residual Page 426
Box 13.3
Operating Income Model

Case 1: CV T = 0

CV T =
Re OI T +1
ρF −1
Case 2:

CV T =
Re OI T +1
ρF − g
Case 3:

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-20
 Chapter 13
Reebok Int’l. Ltd. Residual Operating Page 427
Table 13.2
Income Valuation
1996A 1997E 1998E 1999E 2000E
Operating income 187.0 200.4 214.4 229.4
Net operating assets (NOA) 1,135 1,214.5 1299.5 1390.4 1487.8
RNOA (%) 16.5 16.5 16.5 16.5
ReOI (0.101) 72.4 77.7 83.2 89.0
PV of ReOI (1.101t) 65.8 64.1 62.3 60.6
Total PV of ReOI 253
Continuing value (CV)1 3,071.9
PV of CV 2,091
Value of NOA 3,479
Book value of NFO 720
Value of equity 2,759
Value of minority interest2 210
Value of common equity 2,549
Value per share 45.65
(on 55.840 million shares)

1CV = (89.0 x 1.07)/(1.101 − 1.07) = 3071.9

2The value of the minority interest depends on the value of the NOA in the relevant subsidiaries. It has
been calculated here as 14 times minority interest earnings.
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-21

Chapter 13
The Drivers of Residual Operating Page 428

Income

RE t = earn t − ( ρ E − 1)CSE t −1 = [ROCE t − ( ρ E − 1)]CSE t −1

• The Drivers of RE:

Re OI t = OI t − ( ρ F − 1) NOA t −1 = [RNOA t − ( ρ F − 1)] NOA t −1

• The Drivers of ReOI:

(1) (2)
(1) RNOA

(2) NOA put in place to earn at RNOA

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-22
 Chapter 13
Page 430
The Cost of Capital for Operations

• Operations have their own risk, referred to as operational risk

• This risk determines the required return (or cost of capital) to
invest in the operations

the cost of capital for the firm: ρF

• The required return is called the cost of capital for operations or

• It is also called the weighted average cost of capital because

= ρE +
V 0E V 0D
For MS, Inc.:ρ F ρD
V 0 NOA V 0 NOA

 15 .7   7 .7 
11 .34 % =  × 12 %  +  × 10 % 
 23 .4   23 .4 

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-23

Chapter 13
Page 430
The Cost of Capital for Debt

After Tax Cost of Debt (ρD) = Nominal Cost of Debt × (1 – t)

t is the marginal income tax rate

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 Chapter 13
The Cost of Equity Capital Page 431

• The cost of capital for equity is really derived from the cost of
capital for operations (not vice versa)
ρ E = 0 E ρ F − 0E ρ D
V NOA VD
V0 V0

or ρE = ρF +
V 0D
( ρ F − ρ D )(Compare to the ROCE formula)
V 0E
Equity risk has two components
– 1. Operational risk
– 2. Financing risk
• Leverage
• Spread
• So, for MS, Inc., the equity cost of capital is
 23 .4   7 .7 
12 . 0 % =  × 11 .34 %  −  × 10 % 
 15 .7   15 .7 
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-25

Chapter 13
Cost of Operating Capital: Page 431
Box 13.5
Nike and Reebok
• Cost of equity using CAPM:
Nike: 5.4% + .95 x 6% = 11.1%
Reebok: 5.4% + 1.10 x 6% = 12.0%
• Market values at 1996 year end:
Nike Reebok
Market value of equity 14,950 2,352
Net financial obligations (assumed at market) 228 720
Market value of net operating assets 15,178 3,072
• Cost of capital for operations (WACC):
14 ,950   228 
Nike :  × 11.1% +  × 3.5% = 11.0%
 15 178
,   15 178
, 

 2 ,352   720 
Reebok :  × 12.0% +  × 4.0% = 10.1%
 3,072   3,072 
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-26
 Chapter 13
Required Return and Page 432

Accounting Return on Equity

Required Return Accounting Return

on Equity: on Equity:

ρE = ρF +
V 0D
(ρ F − ρ D ) ROCE = RNOA +
NFO
(RNOA − NBC )
V 0E CSE
market book
leverage leverage

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-27

Chapter 13
Page 434
Leverage and Valuation Table 13.3

ReOI Valuation of Firm with 9% cost of capital for operations & 5% after-tax cost of
debt
0 1 2 3
Net operating assets 1,300
Net financial obligations 300
Common shareholders’ equity 1,000
Operating income 135 135 135---→
Net Financial expense (300 x 0.05) 15 15 15---→
Earnings 120 120 120---→
Residual operating income, ReOI (0.09) 18 18 18---→
PV of ReOI 200
Value of common equity 1,200
Value per share (on 600 shares) 2.00

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-28
 Chapter 13
Page 434
Leverage and Valuation Table 13.3

x [9 .0 % − 5 .0 % ] = 10 .0 %
RE Valuation of the Same Firm
Cost of equity capital = 9.0% +
300
1,200
0 1 2 3
Net operating assets 1,300
Net financial obligations 300
Common shareholders’ equity 1,000
Earnings 120 120 120---→
ROCE 12% 12% 12%--→
Residual earnings, RE (0.10) 20 20 20---→
PV of RE 200
Value of common equity 1,200
Value per share (on 600 shares) 2.00

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-29

Chapter 13
Page 434
Leverage and Valuation Table 13.3

x [9 % − 5 % ] = 12 .5 %
RE Valuation for the Same Firm after Debt for Equity Swap
Cost of equity capital = 9 % +
700
800
0 1 2 3
Net operating assets 1,300
Net financial obligations 700
Common shareholders’ equity 600
Operating income 135 135 135---→
Net Financial expense (700 x 0.05) 35 35 35---→
Earnings 100 100 100---→
ROCE 16.7% 16.7% 16.7%
Residual earnings, RE (0.125) 25 25 25---→
PV of RE 200
Value of common equity 800
Value per share (on 400 shares) 2.00

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-30
 Chapter 13
Page 438
Levered and Unlevered P/B Ratio

P/B =
V0E
Levered
CSE 0

P/B =
V 0NOA
Unlevered
NOA 0

V0NOA − V0NFO  V0NOA 

Levered P/B = = 0 + FLEV  − 1
V NOA
NOA − NFO NOA 0  NOA 0 
[FLEV is the leverage ratio, NFO/CSE]

McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-31

Le ve re d P/B vs. Financial Le ve rage

7.0

VNOA/NOA = 3

6.0

Levered VNOA/NOA = 2.5

P/B vs. 5.0

Financial VNOA/NOA = 2
4.0
Levered P/B (V / CSE)

Leverage
E

3.0

VNOA/NOA = 1.5

2.0

1.0 VNOA/NOA = 1

0.0
0.0 0.3 0.5 0.8 1.0 1.3 1.5 1.8 2.0 2.3
VNOA/NOA = 0.5
-1.0
Lev erag e (NFO/CSE)

 V NOA 
Chapter 13

= + FLEV  − 1
Page 439 V E V NOA
 NOA 
Figure 13.1a
CSE NOA
McGraw-Hill/Irwin © The McGraw-Hill Companies, Inc., 2001 All rights reserved. 13-32
 Le ve re d vs. Unle ve re d P/B

3.0

2.5
FLEV = 1.5

FLEV = 1.0

Levered vs. 2.0 FLEV = 0.75

Unlevered
1.5
P/B FLEV = 0.5
Levered P/B (V /CSE)

FLEV = 0.25

1.0
E

FLEV = 0

0.5

0.0
0.0 0.5 1.0 1.5 2.0

-0.5

-1.0

Chapter 13 -1.5
Page 440 NOA
Un lev ered P/B (V /NOA )

 V NOA 
Figure 13.1b
= + FLEV  − 1
E NOA
V V
McGraw-Hill/Irwin CSE ©NOA  NOA
The McGraw-Hill  Inc., 2001 All rights reserved.
Companies, 13-33

Chapter 13
Median Levered and Unlevered P/B Ratios, Page 441
Figure 13.2
1963-96 for NYSE & AMEX Firms

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 Chapter 13
Page 441
The Leverage Effects Table 13.4

Levered Unlevered
Concept Measure Measure Relationship

Profitability ROCE RNOA ROCE=RNOA+FLEV[RNOA-NBC]

Cost of Capital ρE ρF ρE = ρF +
V 0D
[ρ F − ρ D ]
V 0E
NFO 0  V 0NOA 
= 0 +  − 1
V 0E V NOA
NOA 0 CSE 0  NOA 0 
P/B Ratio V0E / CSE 0 V0NOA / NOA0
CSE 0

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