Financial

Statement
Analysis

K R Subramanyam
John J Wild

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 11-2

Equity Analysis and Valuation

11
CHAPTER
 11-3

Earnings Persistence
Earnings persistence is a key to effective equity
analysis and valuation
Analyzing earnings persistence is a main
analysis objective
Attributes of earnings persistence include:
Stability
Predictability
Variability
Trend
Earnings management
Accounting methods
Analyze
 11-4

Earnings Persistence

Recasting and Adjusting

Two common methods to help assess earnings
persistence:
Recasting of income statement
Adjusting of income statement
Recasting and adjusting earnings
aids in determining the earning power.
 11-5

Earnings Persistence
Recasting and Adjusting
Information for Recasting and Adjusting
Income statement, including its subdivisions:
Income from continuing operations
Income from discontinued operations
Extraordinary gains and losses
Cumulative effect of changes in accounting principles
Other financial statements and notes
Managements Discussion and Analysis
Others: product-mix changes, technological innovations, work
stoppages, and raw material constraints
 11-6

Earnings Persistence
Recasting Earnings and Earnings Components
Aims at rearranging earnings components to provide a
meaningful classification and relevant format for analysis.
Components can be rearranged, subdivided, or tax effected, but
the total must reconcile to net income of each period.
Discretionary expenses, components like equity in income (loss)
of unconsolidated subsidiaries or affiliates should be segregated.
Components reported pretax must be removed along with their
tax effects if reclassified apart from income from continuing
operations.
 11-7

Earnings Persistence
Recasting Earnings and Earnings Components
Income tax disclosures enable one to separate
factors that either reduce or increase taxes such as:
Deductionstax credits, capital gains rates, tax-free income,
lower foreign tax rates
Additionsadditional foreign taxes, nontax-deductible
expenses, and state and local taxes (net of federal tax
benefit)
Immaterial items can be considered in a lump sum
labeled other.
 11-8

Earnings Persistence
Recasting Earnings and Earnings Components
Campbell Soup Company
Recast Income Statements ($ mil.)
Item Year 11 Year 10 Year 9 Year 8 Year 7 Year 6
13 Net sales $ 6,204.1 $ 6,205.8 $ 5,672.1 $ 4,868.9 $ 4,490.4 $ 4,286.8
19 Interest income 26.0 17.6 38.3 33.2 29.5 27.4
Total revenue $ 6,230.1 $ 6,223.4 $ 5,710.4 $ 4,902.1 $ 4,519.9 $ 4,314.2
Costs and expenses:
Cost of products sold (see Note 1 below) $ 3,727.1 $ 3,893.5 $ 3,651.8 $ 3,077.8 $ 2,897.8 $ 2,820.5
Marketing and selling expenses (see Note 2 below) 760.8 760.1 605.9 514.2 422.7 363.0
145 Advertising (see Note 2 below) 195.4 220.4 212.9 219.1 203.5 181.4
144 Repairs and maintenance (see Note 1 below) 173.9 180.6 173.9 155.6 148.8 144.0
16 Administrative expenses 306.7 290.7 252.1 232.6 213.9 195.9
17 Research and development expenses 56.3 53.7 47.7 46.9 44.8 42.2
102 Stock price related incentive programs (see Note 3 below)
15.4 (0.1) 17.4 (2.7) 8.5
20 Foreign exchange adjustment 0.8 3.3 19.3 16.6 4.8 0.7
104 Other, net (see Note 3 below) (3.3) (2.0) (1.4) (4.7) (0.4) (9.0)
162A Depreciation (see Note 1 below) 194.5 184.1 175.9 162.0 139.0 120.8
103 Amortization of intangible and other assets (see Note 3 below)
14.1 16.8 16.4 8.9 5.6 6.0
18 Interest expense 116.2 111.6 94.1 53.9 51.7 56.0
Total costs and expenses $ 5,557.9 $ 5,712.7 $ 5,266.0 $ 4,480.2 $ 4,132.2 $ 3,930.0
23 Earnings before equity in earnings of affiliates & min. interests
$ 672.2 $ 510.7 $ 444.4 $ 421.9 $ 387.7 $ 384.2
24 Equity in earnings of affiliates 2.4 13.5 10.4 6.3 15.1 4.3
25 Minority interests (7.2) (5.7) (5.3) (6.3) (4.7) (3.9)
26 Income before taxes $ 667.4 $ 518.5 $ 449.5 $ 421.9 $ 398.1 $ 384.6
Income taxes at statutory rate* (226.9) (176.3) (152.8) (143.5) (179.1) (176.9)
Income from continuing operations $ 440.5 $ 342.2 $ 296.7 $ 278.4 $ 219.0 $ 207.7
135 State taxes (net of federal tax benefit) (20.0) (6.6) (3.8) (11.8) (8.6) (8.0)
Investment tax credit 4.4 11.6
137 Nondeductible amortization of intangibles (4.0) (1.6) (1.2) (2.6) (1.4)
138 Foreign earnings not taxed or taxed at other than statutory rate
2.0 (2.2) (0.2) 3.2 11.1 15.2
139 Other: Tax effects (17.0) (2.2) (0.1) (3.7) 7.5 (4.7)
Alaska Native Corporation transaction 4.5
22 Divestitures, restructuring and unusual charges (339.1) (343.0) (40.6)
Tax effect of divest., restructuring & unusual charges (Note 4)
13.9 64.7 13.9
(Continued on next slide)
 11-9

Earnings Persistence
Recasting Earnings and Earnings Components
Campbell Soup Company
Recast Income Statements ($ mil.)
Item Year 11 Year 10 Year 9 Year 8 Year 7 Year 6
Gain on sale of businesses in (Yr 8) and sub. in Yr 7 3.1 9.7
Loss on sale of exercise equipment subsidiary, net of tax (1.7)
LIFO liquidation gain (see Note 1 below) 1.7 2.8 1.4
Income before cumulative effect of accounting change$ 401.5 $ 4.4 $ 13.1 $ 241.6 $ 247.3 $ 223.2
153A Cumulative effect of accounting change for income taxes 32.5
28 Net income as reported $ 401.5 $ 4.4 $ 13.1 $ 274.1 $ 247.3 $ 223.2
14 (Note 1) Cost of products sold $ 4,095.5 $ 4,258.2 $ 4,001.6 $ 3,392.8 $ 3,180.5 $ 3,082.8
144 Less: Repair and maintenance expenses (173.9) (180.6) (173.9) (155.6) (148.8) (144.0)
162A Less: Depreciation(a) (194.5) (184.1) (175.9) (162.0) (139.0) (120.0)
153A Plus: LIFO liquidation gain(b) 2.6 5.1 2.6
$ 3,727.1 $ 3,893.5 $ 3,651.8 $ 3,077.8 $ 2,897.8 $ 2,821.4
15 (Note 2) Marketing and selling expenses $ 956.2 $ 980.5 $ 818.8 $ 733.3 $ 626.2 $ 544.4
145 Less: Advertising (195.4) (20.4) (212.9) (219.1) (203.5) (181.4)
$ 760.8 $ 960.1 $ 605.9 $ 514.2 $ 422.7 $ 363.0
21 (Note 3) Other expenses (income) $ 26.2 $ 14.7 $ 32.4 $ (3.2) $ (9.5) $ 5.5
102 Less: Stock pricerelated incentive programs (15.4) 0.1 (17.4) 2.7 (8.5)
103 Less: Amortization of intangible and other assets (14.1) (16.8) (16.4) (8.9) (5.6) (6.0)
Less: Gain on sale of businesses (Yr 8) and sub. (Yr 7) 4.7 14.7
104 Other, net $ (3.3) $ (2.0) $ (1.4) $ (4.7) $ (0.4) $ (9.0)
(Note 4) Tax effect of divest, restruc., & unusual charges $ 115.3(c) $ 116.6(d) $ 13.9
136 Nondeductible divestitures, restructuring, and unusual charges
(101.4)(e) (51.9)(f)
$ 13.9 $ 64.7 $ 13.9

*Statutory federal tax rate is 34% in Year 8 through Year 11, 45% in Year 7, and 46% in Year 6.
This amount is not disclosed for Year 6.
(a)We assume most depreciation is included in cost of products sold.
(b)LIFO liquidation gain before tax. For example, for Year 8 this is $2.58 million, computed as $1.7/(1 - 0.34).
(c)$339.1 (22) x 0.34 = $115.3.
(d)$343.0 (22) x 0.34 = $116.6
(e)$179.4 (26) x 0.565 (136) = $101.4.
(f)$106.5 (26) x 0.487 (136) = $51.9.
 11-10

Earnings Persistence
Adjusting Earnings and Earnings Components
Adjusting aims to assign earnings components
to the periods in which they best belong.
Uses data from recast income statements and
other available information.
 11-11

Earnings Persistence
Adjusting Earnings and Earnings Components
Specific (Typical) Adjusting Procedures
Assign extraordinary and unusual items (net of tax) to applicable
years
Tax benefit of operating loss carryforwards normally moved to
the loss year
Costs or benefits from lawsuit settlements moved to relevant
prior years
Gains and losses from disposals of discontinued operations can
relate to one or more prior years.
Changes in accounting principles or estimates yield adjustments
to all years under analysis to a comparable basisredistribute
cumulative effect to the relevant prior years
Normally include items that increase or decrease equity
 11-12

Earnings Persistence
Adjusting Earnings and Earnings Components
Specific (Typical) Adjusting Procedures
If a component should be excluded from the period it is
reported:
Shift it (net of tax) to the operating results of one or more prior
periods or
Spread (average) it over earnings for the period under analysis.
Spread the component over prior periods earnings only
when it cannot be identified with a specific period.
While spreading helps in determining earning power, it is
not helpful in determining earnings trends.
Moving gains/ losses to other periods does not remedy the
misstatements of prior years results.
 11-13

Earnings Persistence
 11-14

Earnings Persistence

Determinants of Earnings Persistence

Earnings persistence determined by many factors

including:
Earnings trends
Variability
Earnings Management
Management Incentives

Note: assess earnings persistence

over both the business cycle and the long run.
 11-15

Earnings Persistence

Determinants of Earnings Persistence

Earnings trends can be assessed by:

Statistical methods
Trend statements
Uses earnings numbers taken from the recasting
and adjusting procedures
 11-16

Earnings Persistence

Determinants of Earnings Persistence

Earnings management
Changes in accounting methods or assumptions
Offsetting extraordinary or unusual gains and losses
Big baths
Write-downs
Timing revenue and
expense recognition
 11-17

Earnings Persistence

Determinants of Earnings Persistence

Management incentives affecting persistence

include:
Personal objectives and interests
Companies in distress
Prosperous companiespreserving hard-earned
reputations
Compensation plans
Accounting-based incentives and constraints
Analysts targets
 11-18

Earnings Persistence
Persistent and Transitory Items in Earnings
Recasting and adjusting earnings for equity valuation
rely on separating stable, persistent earnings
components from random, transitory components.
Assessing persistence is important in determining earning
power.
Earnings forecasting also relies on persistence.
A crucial part is to assess the persistence of the gain and
loss components of earnings.
 11-19

Earnings Persistence
Analyzing and Interpreting Transitory Items
Purpose of analyzing and interpreting extraordinary
items:
Determine whether an item is transitory.
Assessing whether an item is unusual, nonoperating, or
nonrecurring.
Determine adjustments that are necessary given
assessment of persistence.
 11-20

Earnings Persistence
Analyzing and Interpreting Transitory Items
Determining persistence
(transitory nature) of items:
Nonrecurring operating gains and losses
Usually included in current operating income
Nonrecurring non-operating gains and losses
Omitted from operating earnings of a single year
Part of the long-term performance of a company
 11-21

Earnings Persistence
Analyzing and Interpreting Transitory Items
Adjustments to Extraordinary Items Reflecting
Persistence:
Effects of transitory items on company resources.
Effects of recorded transitory items and the likelihood of future
events causing transitory items.
Effect of transitory items on evaluation of management.
 11-22

Earnings Based Equity Valuation

Relation between Stock Prices and Accounting Data

Equity value (Vt)

Book value (BVt)
Residual Income, RIt = (NIt k * BVt-1)
Cost of equity capital (k)

Key Question: Does the potential manipulation of

accounting data influence the accuracy of accounting-
based estimates, or forecasts, of company value?
 11-23

Earnings Based Equity Valuation

Fundamental Valuation Multiples

Price-to-Book (PB) Ratio

Market Value of Equity
Book Value of Equity
 11-24

Earnings Based Equity Valuation

Fundamental Valuation Multiples
Price-to-Book (PB) expressed in accounting data
Vt ROCEt 1 k ROCEt 2 k BVt 1 ROCEt 3 k BVt 2
1 ...
BVt 1 k 1 k 2
BV t 1 k 3
BV t

Note:
ROCE and growth in book value increase PB increases
Cost (risk) of equity capital increases PB decreases
Present value of future abnormal earnings is positive (negative)
PB is greater (less) than 1.0
 11-25

Earnings Based Equity Valuation

Fundamental Valuation Multiples
Price-to-Earnings (PE) Ratio

Market Value of Equity

Net Income
 11-26

Earnings Based Equity Valuation

Fundamental Valuation Multiples
PE ratio can be written as a function of short-term (STG) and
long-term growth (LTG) of earning per share (eps) as follows:

Where k is the cost of equity capital, STG (LTG) is the expected short-
term (long-term) % change in eps relative to expected normal growth
(STG>LTG and LTG>k)
Note:
The PE ratio is inversely related to k
The PE ratio is positively related to the expected growth in eps
relative to normal growth.
 11-27

Earnings Based Equity Valuation

Fundamental Valuation Multiples
PEG ratio
If LTG=0 (long-term growth in eps relative to normal
growth is expected to remain constant)

This yields the popular PEG ratio.

Example: If PE=20 and k=10%,
proponents of this screening device
recommend stock purchase (sale) if
the expected eps growth is greater
(less) than 20%.
 11-28

Earnings Based Equity Valuation

Illustration of Earnings-Based Valuation

Christy Co. book value of equity at January 1, Year 1, is $50,000

Christy has a 15% cost of equity capital (k)
Forecasts of Christys accounting data follow:

Year 1 Year 2 Year 3 Year 4 Year 5

Sales $ 100,000 $ 113,000 $127,690 $ 144,290 $144,290
Operating expenses 77,500 90,000 103,500 118,000 119,040
Depreciation 10,000 11,300 12,770 14,430 14,430
Net income $ 12,500 $ 11,700 $ 11,420 $ 11,860 $ 10,820
Dividends 6,000 4,355 3,120 11,860 10,820

Year 6 and beyond = Both accounting data and dividends

approximate Year 5 levels
 11-29

Earnings Based Equity Valuation

Illustration of Earnings-Based Valuation

Christys forecasted book value at January 1, Year 1 is

$58,594computed as:

This implies Christy stock should sell at a PB ratio of 1.17

($58,594/$50,000) at January 1, Year 1
 11-30

Earnings Based Equity Valuation

Illustration of Earnings-Based Valuation
Three additional observations:
Expected ROCE = 15% (Christys cost of capital) for Year 5 and
beyond. Since ROCE equals the cost of capital for Year 5 and
beyond, these years results do not change the value of Christy
(i.e. abnormal earnings equal zero for those years). Anticipated
effects of competition are implicit in future profitability estimates.
Since PE ratios are based on both current and future earnings, a
PE ratio for Christy as of January 1, Year 1, cannot be calculated
since prior years data are unavailable. PE ratio at January 1, Year
2 is computed as:
 11-31

Earnings Based Equity Valuation

Illustration of Earnings-Based Valuation

Valuation estimates assume dividend payments occur at the end

of each year. A more realistic assumption is that, on average,
these cash outflows occur midway through the year. To adjust
valuation estimates for mid-year discounting, multiply the PV of
future abnormal earnings by (1 + k/2). For Christy Company the
adjusted valuation estimate equals $59,239. This is computed as
$50,000 + (1 + [.15/2]) x $8,594.
 11-32

Earning Power and Forecasting for Valuation

Earning Power
Earning power is the earnings level expected to persist
into the foreseeable future
Accounting-based valuation models capitalize earning power
Many financial analyses directed at determining earning power
Measurement of Earning Power reflects:
Earnings and all its components
Stability and persistence of earnings
and its components
Sustainable trends in earnings and its
components
 11-33

Earning Power and Forecasting for Valuation

Earning Power
Factors in selecting a time horizon for measuring earning
power:
One-year is often too short to reliably measure earning power
Many investing and financing activities are long term
Better to measure earning power by using average (or cumulative)
earnings over several years
An extended period is less subject to distortions, irregularities, and
other transitory effects
Preferred time horizon in measuring earning
power is typically 4 to 7 years
 11-34

Earning Power and Forecasting for Valuation

Earning Power
Adjusting Earnings per Share
Earning power is measured using all earnings components.
The issue is to what year we assign these items when computing
earning power.

Our earnings analysis might be limited to a short time

horizon. We adjust short time series of earnings for
items that better relate to other periods. If this is done
on a per share basis, every item must be adjusted for
its tax effect using the companys effective tax rate
unless the applicable tax rate is specified. All items
must also be divided by the number of shares used in
computing EPS.
 11-35

Earning Power and Forecasting for

Valuation
 11-36

Earning Power and Forecasting for Valuation

Earnings Forecasting
Done by analyzing earnings components and considering all
available information, both quantitative and qualitative.
Forecasting benefits from disaggregation.
Disaggregation involves using data by product lines or segments
Especially useful when segments differ by risk, profitability, or growth.
Difference between forecasting and extrapolation.

Divisional earnings for TechCom, Inc., reveal how different divisional

performance can be masked by aggregate results:
 11-37

Earning Power and Forecasting for Valuation

Earnings Forecasting
Elements Impacting Earnings Forecasts
Current and past evidence
Forecasts reasonableness.
Continuity and momentum of company performance
Industry prospects
Company's financial condition
Management
Management qualityresourcefulness
Asset managementoperating skills
Economic and competitive factors
Key Indicators such as capital expenditures, order backlogs,
and demand trends
 11-38

Earning Power and Forecasting for Valuation

Interim Reports for Monitoring and Revising Earnings Estimates

Limitations in interim reporting related to difficulties in

assigning earnings components to periods of under one
year in length:
Period-end accounting adjustments
Seasonality in business activities
Integral reporting method
SEC interim reporting requirements
Analysis implications of interim Reports
 11-39

Earning Power and Forecasting for Valuation

Interim Reports for Monitoring and Revising Earnings Estimates

Available Interim Reports
Quarterly reports (Form 10-Q)
Reports on current developments (Form 8-K)
Disclosure of separate fourth-quarter results
Details of year-end adjustments
Interim reports filed with the SEC such as:
Comparative interim and year-to-date income statement
Comparative balance sheets
Year-to-date statement of cash flows
Pro forma information on business combinations
Disclosure of accounting changes
Managements narrative analysis of operating results
Reports of a change in auditor