VALUATION AND FORECASTS Chapter 15. CHAPTER 15 OBJECTIVES Understand the roles of valuation and forecasting in financial statement analysis. Understand

VALUATION AND VALUATION AND FORECASTSFORECASTS

Chapter 15Chapter 15

CHAPTER 15 OBJECTIVESCHAPTER 15 OBJECTIVES

Understand the roles of valuation Understand the roles of valuation and forecasting in financial and forecasting in financial statement analysis.statement analysis.

Describe and compute three Describe and compute three measures related to corporate value.measures related to corporate value.

Discuss the advantages and Discuss the advantages and disadvantages associated with disadvantages associated with statistical and judgmental statistical and judgmental forecasting techniques.forecasting techniques.

CHAPTER 15 OBJECTIVES CHAPTER 15 OBJECTIVES (CONT.)(CONT.)

Prepare pro forma financial Prepare pro forma financial statements based on your statements based on your forecasts of future events.forecasts of future events.

Identify the primary factors that Identify the primary factors that affect financial statement forecasts affect financial statement forecasts of a company or industry.of a company or industry.

VALUATION AND VALUATION AND FORECAST OBJECTIVESFORECAST OBJECTIVES

ValuationValuation The determination of something’s The determination of something’s

worth (e.g., a business entity)worth (e.g., a business entity) Share price is one measure of an Share price is one measure of an

entity’s value (on a per share basis)entity’s value (on a per share basis) Analysts often need more specific Analysts often need more specific

information than share price to make information than share price to make decisions (e.g., the timing of cash decisions (e.g., the timing of cash flows)flows)

VALUATION AND VALUATION AND FORECAST OBJECTIVES FORECAST OBJECTIVES (CONT.)(CONT.)

Financial forecastsFinancial forecasts Project an entity’s financial Project an entity’s financial

statementsstatements Reflect an analyst’s assumptions Reflect an analyst’s assumptions

about the future about the future Compiled on a pro forma (as if) basisCompiled on a pro forma (as if) basis

VALUATION METHODSVALUATION METHODS

Investors’ assessment of the worth Investors’ assessment of the worth of an firm’s incomeof an firm’s income

VALUATION METHODS VALUATION METHODS (CONT.)(CONT.)

Price to earnings approachPrice to earnings approach Captured by the price to earning’s ratio (P-E Captured by the price to earning’s ratio (P-E

ratio)ratio) Reflects an investor’s expectations about Reflects an investor’s expectations about

the future performance of a companythe future performance of a company A high P-E ratio means the market expects A high P-E ratio means the market expects

earnings to increaseearnings to increase A low P-E ratio signals an expected decline A low P-E ratio signals an expected decline

in earningsin earnings Computed as: market price per share of Computed as: market price per share of

stock / earnings per sharestock / earnings per share


Price to cash flow approachPrice to cash flow approach A derivative of the P-E ratioA derivative of the P-E ratio Substitutes cash flow from operations Substitutes cash flow from operations

for earnings when questions about for earnings when questions about earnings quality existearnings quality exist

Computed as: market price per share Computed as: market price per share of stock / operating cash flows per of stock / operating cash flows per shareshare


Price to equity approachPrice to equity approach Alternative to the P-E (and cash flow Alternative to the P-E (and cash flow

to earnings ratio) to earnings ratio) Compares market value of a share of Compares market value of a share of

stock to its book value at one point in stock to its book value at one point in timetime

Computed as: market price per share Computed as: market price per share of stock / book value per share of of stock / book value per share of stockstock

eSTUFF’S PRICE-EARNINGS eSTUFF’S PRICE-EARNINGS RATIOSRATIOS

Market Measures 2003 2002 2001High capitalization 185 874 1,210 Low capitalization 95 506 739 Average capitalization 140 690 982 High price to earnings (20.56) 38.00 57.62 Low price to earnings (10.56) 22.00 35.19 Average price to earnings (15.56) 30.00 46.76

FORECASTING FORECASTING TECHNIQUESTECHNIQUES

Statistical methodsStatistical methods Mathematical procedures used to Mathematical procedures used to

help forecast financial statementshelp forecast financial statements

FORECASTING FORECASTING TECHNIQUES (CONT.)TECHNIQUES (CONT.)

Statistical methods are based on Statistical methods are based on characteristics exhibited in previous characteristics exhibited in previous data or industry conditionsdata or industry conditions Trend—general tendency or direction of Trend—general tendency or direction of

events events Cyclical behavior—state of the economy, Cyclical behavior—state of the economy,

ranging from prosperity to recessionranging from prosperity to recession Seasonality—changes in activity level within Seasonality—changes in activity level within

one reporting periodone reporting period Randomness—unforeseen events that affect Randomness—unforeseen events that affect

financial performancefinancial performance


Four common statistical methodsFour common statistical methods Time series analysis—extrapolates past Time series analysis—extrapolates past

trends into the futuretrends into the future Exponential smoothing—similar to time series Exponential smoothing—similar to time series

analysis, but places greater weight on the analysis, but places greater weight on the more recent disclosuresmore recent disclosures

Decompostion—specifically accounts for Decompostion—specifically accounts for trend, seasonality, cyclicality, and trend, seasonality, cyclicality, and randomness in projecting the future randomness in projecting the future

Linear regression—uses one or more variables Linear regression—uses one or more variables (e.g., time) to predict a financial statement (e.g., time) to predict a financial statement result (e.g., revenue)result (e.g., revenue)


Drawbacks to statistical forecastingDrawbacks to statistical forecasting All models are complexAll models are complex Their methods are based on assumptions Their methods are based on assumptions

that must be meet for the model to be validthat must be meet for the model to be valid Caution: only sophisticated analysts Caution: only sophisticated analysts

should use mathematical methodsshould use mathematical methods Benefit: all analysts should consider Benefit: all analysts should consider

factors such time, trend, and cyclicality factors such time, trend, and cyclicality when forecasting financial statementswhen forecasting financial statements


Judgmental methodsJudgmental methods Alternative to statistical methodsAlternative to statistical methods Based on informed opinionBased on informed opinion Acknowledges that forecasting is as Acknowledges that forecasting is as

much art as sciencemuch art as science


Incorporates knowledge about theIncorporates knowledge about the Economy Economy IndustryIndustry EntityEntity Entity’s previous financial statementsEntity’s previous financial statements CompetitionCompetition


Other forecasting considerationsOther forecasting considerations Analysts often forecast a range of outcomes, Analysts often forecast a range of outcomes,

rather than a single point estimaterather than a single point estimate They can create a best, worst, and most likely They can create a best, worst, and most likely

forecastforecast Earnings compilationsEarnings compilations

Offer a point of comparison for an analyst’s Offer a point of comparison for an analyst’s EPS forecastEPS forecast

Capture the range of analysts’ EPS forecastsCapture the range of analysts’ EPS forecasts Published by the media (e.g., First Published by the media (e.g., First

Call/Thompson Financial)Call/Thompson Financial)

PRO FORMA FINANCIAL PRO FORMA FINANCIAL STATEMENTSSTATEMENTS

Statement constructionStatement construction Requires many assumptions about Requires many assumptions about

future eventsfuture events Does not require a forecast of every Does not require a forecast of every

line item on the financial statementsline item on the financial statements

PRO FORMA FINANCIAL PRO FORMA FINANCIAL STATEMENTS (CONT.)STATEMENTS (CONT.)

Financial statement sequence Financial statement sequence Income statement (Exhibit 15-3A)Income statement (Exhibit 15-3A) Balance sheet (Exhibit 15-3B)Balance sheet (Exhibit 15-3B) Statement of cash flows, including Statement of cash flows, including

direct operating cash flows (Exhibit direct operating cash flows (Exhibit 15-3C and 15-3D)15-3C and 15-3D)

2002 PRO FORMA 2002 PRO FORMA FINANCIAL STATEMENTSFINANCIAL STATEMENTS

Income Statements 2002 2001 2000Sales revenue $1,440 $1,200 $1,000Cost of goods sold 792 660 600 Gross profit 648 540 400 Selling, general, and administrative expenses 504 485 335 Income from continuing operations 144 55 65 Financial expenses 20 20 10 Pretax income 124 35 55 Income tax expense 50 14 22 Net income 74$ 21$ 33$ Earnings per share- $1.06 $0.42 $0.79

2002 PRO FORMA 2002 PRO FORMA FINANCIAL STATEMENTS FINANCIAL STATEMENTS (CONT.)(CONT.)

Balance Sheets 2002 2001 2000Assets

Current assets:Cash $144 $45 $30Accounts receivable, net 168 140 120 Inventory 293 250 200 Prepaid expenses - 5 10 Total current assets 605 440 360 Property, plant and equipment:Equipment, net 460 380 400 Intangible Assets: 210 15 20 Total assets $1,275 $835 $780


Cash flows from investing activities: 2002 2001 2000

Purchase of equipment (200) (100) (500) Acquisition of intangibles (200) - (25)

Net cash provided (used) by investing activities(400) (100) (525) Cash flows from financing activities:Issue notes payable - 100 120 Issue common stock 300 80 420 Pay cash dividend - (2) (8)

Net cash provided (used) by financing activities300$ 178$ 532$

Net change in cash $99 $15 $30Cash, end of the year $144 $45 $30


Statement of Cash Flows 2002 2001 2000Cash, beginning of the year $45 $30 ---Cash flows from operating activities:Net income $74 $21 $33Depreciation and amortization expenses 125 125 105 Changes in current accounts:Accounts receivable (28) (20) (120) Inventory (43) (50) (200) Prepaid expenses 5 5 (10) Accounts payable 60 (110) 160 Accrued liabilities 6 (29) 50 Taxes payable - (5) 5 Net cash provided (used) by operating activities199 (63) 23

2002 PRO FORMA 2002 PRO FORMA FINANCIAL STATEMENTS FINANCIAL STATEMENTS (CONT.)(CONT.)Cash flows from investing activities: 2,002 2,001 2,000

Purchase of equipment (200) (100) (500) Acquisition of intangibles (200) - (25) Net cash provided (used) by investing activities(400) (100) (525) Cash flows from financing activities:Issue notes payable - 100 120 Issue common stock 300 80 420 Pay cash dividend - (2) (8) Net cash provided (used) by financing activities300$ 178$ 532$

Net change in cash $99 $15 $30Cash, end of the year $144 $45 $30

VALUATION AND FORECAST OF THE VALUATION AND FORECAST OF THE PC INDUSTRYPC INDUSTRY

Market valuations Market valuations Confirm analytical evidence Confirm analytical evidence

presented in previous chapters presented in previous chapters that direct PC sellers, Dell and that direct PC sellers, Dell and Gateway, have outperformed Gateway, have outperformed indirect sellers, Apple and Compaqindirect sellers, Apple and Compaq

VALUATION AND FORECAST OF THE VALUATION AND FORECAST OF THE PC INDUSTRYPC INDUSTRY (CONT.) (CONT.)

P-E ratios indicate that P-E ratios indicate that Dell was more highly valued than the Dell was more highly valued than the

other PC firms by 1998 (Exhibits 154-other PC firms by 1998 (Exhibits 154-A to 15-4D)A to 15-4D)

Gateway’s market value increased Gateway’s market value increased during the period examinedduring the period examined

The market values of Apple and The market values of Apple and Compaq declined due to poor Compaq declined due to poor operating performance operating performance

PC IndustryHigh Price Earnings Ratios

1993-1998

010

2030

405060

7080

90100

1993 1994 1995 1996 1997 1998

P/E

Rat

ios

Apple Compaq Dell Gateway

PC IndustryLow Price Earnings Ratios

1993-1998

0

5

10

15

20

25

30

35

40

1993 1994 1995 1996 1997 1998

P/E

Rat

ios


Apple ComputerP E Ratio Range

1993-1998

0102030405060708090

100

1993 1994 1995 1996 1997 1998

P/E

Rat

ios

Low High


Market to book value ratios Market to book value ratios reinforce conclusions drawn from reinforce conclusions drawn from P-E ratios (Exhibits 15-5A and 15-P-E ratios (Exhibits 15-5A and 15-5B)5B)


Industry forecastsIndustry forecasts Dell and Gateway’s stable growth Dell and Gateway’s stable growth

patterns enable analysts to predict patterns enable analysts to predict future performance with some degree future performance with some degree of certainty (Exhibit 15-6A)of certainty (Exhibit 15-6A)

The erratic nature of Apple and The erratic nature of Apple and Compaq’s results make forecasting Compaq’s results make forecasting more difficult (Exhibit 15-6B)more difficult (Exhibit 15-6B)

Dell and GatewayInventory Trends

(in thousands of dollars)

050

100150

200250

300350

400450

500

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Inve

ntor

y ($

)

Dell Gateway Linear (Dell) Linear (Gateway)

Apple and CompaqInventory Trends


-1000

-500

0

500

1000

1500

2000

2500

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Inve

ntor

y ($

)

Apple Compaq Linear (Compaq) Linear (Apple)

Dell and GatewayRevenue Trends


0

2000

4000

6000

8000

10000

12000

14000

16000

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Rev

enue

s ($

)

Dell Gateway Linear (Dell) Linear (Gateway)

Apple and CompaqRevenue Trends


0

5000

10000

15000

20000

25000

30000

35000

40000

45000

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Rev

enue

($)

Apple Compaq Linear (Compaq) Linear (Apple)

PC IndustryCompound Annual Revenue Growth Rates

1993-1998

-10%

0%

10%

20%

30%

40%

50%


Com

pund

Gro

wth

(%

)


Apple’s operating activities will Apple’s operating activities will determine the direction of the company determine the direction of the company

Optimistic perspective: the company’s Optimistic perspective: the company’s financial statements will improve iffinancial statements will improve if Technical innovations separate the company Technical innovations separate the company

from its Wintel competitorsfrom its Wintel competitors Product development creates sustainable Product development creates sustainable

earningsearnings Market share improvesMarket share improves Consumers pay a premium for Apple’s value Consumers pay a premium for Apple’s value

added productsadded products


Pessimistic view: the company recent Pessimistic view: the company recent financial decline will continue becausefinancial decline will continue because The market increasingly views PCs as The market increasingly views PCs as

commoditiescommodities Apple’s intellectual activities are too costlyApple’s intellectual activities are too costly Its competitors quickly mimic Apple’s Its competitors quickly mimic Apple’s

technical innovationstechnical innovations Market share continues to slideMarket share continues to slide Revenues cannot support operating costs Revenues cannot support operating costs Cash cannot be generated by further Cash cannot be generated by further

inventory reductions inventory reductions

Documents

VALUATION AND FORECASTS Chapter 15. CHAPTER 15 OBJECTIVES Understand the roles of valuation and forecasting in financial statement analysis. Understand