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CHAPTER FOURTEEN

Simple Forecasting and Simple Valuation

Concept Questions

C141 Book values give a good forecast when they are reviewed at their fair value:

applying the required return to book value gives a good forecast of earnings from the net

assets. So, for a bond measured at market value, one gets a good forecast of the expected

name from the bond by applying the expected return on the bond to the book value. But

net operating assets are seldom carried at their fair value; indeed many operating assets lite

knowledge assets! are not on the balance sheet.

C14! "es, this is correct. #he following two valuations are equivalent using a $%&

required return for operations!:

'alue of (perations%) *(+%%.$%

-e($

'alue of (perations% )%.$%

(

compare valuations $/.0 and $/.0a in the chapter!.

f there is no growth in residual operating, abnormal operating income growth must be

1ero. #he valuation here is for the case of abnormal operating income growth of 1ero an

S20 valaution!.

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C14" +n S20 forecast pro3ects that new investment will earn at the required rate of

return. +n S24 forecast forecasts that new investment will earn at the same rate of return

-*(+! as the investments in the current period.

C144 f current core operating income is appropriately purged of transitory items the

forecast is a good forecast if:

$! 5rofitability of the net operating assets -*(+! will be the same, and

0! #here is no growth in net operating assets.

+ forecast should ad3ust for growth. So a sound forecast based on current operating

income an S20 forecast! is:

6ore ( , ) 6ore (% -equired return 7 *(+!

C14# #he growth rate for sales is the same as the growth rate in residual operating

income when -*(+ is constant, the required return is constant, and asset turnovers are

constant. if -*(+ is constant and +#( is constant, profit margins 58! must also be

constant.!

C14$ + firm with high expected growth in sales is probably a firm that can grow residual

earnings. But sales have to be profitable: a firm might grow sales, but with declining profit

margins and increasing asset turnovers, that is, with rising expenses per dollar of sales and

increasing investment to get a dollar of sales.

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C14% #his statement is generally correct. But -*(+ must be greater than the required

return on operations for it to be correct. See the calculation for the unlevered 59B in the

chapter.

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Exercises

E141 Simple Forecasting and Valuation

a! -esidual operating income -e(! is

$./ ) $0& required return! 7 /,

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So the comprehensive earnings forecast for 0%%/ is

(perating income

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E14! SF! and SF" Valuation& 'en ( )err*+s

a! -efer to reformulated statements for Ben F GerryHs in the solution to >xercise $$.A in

6hapter $$.

#he -e( for $@ can be calculated from the operating income /.$! and *(+

at the beginning of the year =/.A!:

-e($A@ ) /.$ %.$% 7 =/.A!

) 4.4A

S20 valuation:

#he value of the equity is

'alue of equity ) 6S> %.$%

-e($@

) A0.A $%.%

4A.4

) ?/ million or @.A$ per share

+n S24 valuation wonHt work: growth canHt be applied to negative -e(.

8ore information needed:

Ienerally we want information on future -*(+ and growth in *(+: will increase

in advertising affect 58, +#( and *(+J

StrategyJ >xpansion plansJ *ew productsJ 5ossible takeover targetJ

b! (ne reason might be market inefficiency: #he stock is overpriced. Ben F GerryHs is

priced high for a low profitability firm.

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#aking $AA

$as an efficient price, then the market sees much higher -*(+ and9or

growth in *(+ than currently. #he $AA

$price is a premium of @.@0 per share over

book value $$.

(' ) A0.A $%.%=@./

) $4%./ or $AA

$per share.

6an one forecast future -*(+ and growth in *(+ that will 3ustify this level of

residual operating profitabilityJ f not, the stock is overpriced.

#oo excited about ice creamJ 6ool itK

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E14" Simple Forecasting and Sensiti,it* Anal*sis& Ree-o. /nternational

a! nlevered 59B )*(+

nterest8inorityof'alueLebt*et>quityofice5r ++

)$4

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d! Sales growth would contribute nothing to the valuation with a 4./0& profit

margin, -*(+ would be 4./0& 7 0.< ) $%.$&, equal to the required return on

operations. -eebok would be worth book value.

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E144 /dle Capacit* and Value

a! +#( )$%

40) 0.%

+ccounts receivable turnover )%.$

40 ) 40.%

nventory turnover )4./

40) =./

5lant turnover )=.$%

40) 4.%

-*(+ ) 58 7 +#(

)

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+ccounts receivable 0.% turnover unchanged!

nventory A.@ turnover unchanged!

5lant $%.= turnover increases to @.%!

*(+ 0$.4

#otal +#( )4.0$

@/

) 4.%

-*(+ )

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E14# Value and 0rot2 in Sales& 3al5art Stores

a!

Mith constant margins and turnovers, growth will be determined by growth in sales.

-*(+ ) 58 7 +#( ) 4.@

$ ) '*(+

$ *2( ) A.= A.% ) ?A$.= billion

b!

6alculate the implied growth rate using reverse engineering. +s margins and

turnovers are constant, the implied growth in -e( is the implied growth in

sales.

5*(+

$ ) 0%% A ) ?0%A billion

0%A ) 0. g$$.$

=/.$

g ) $.% .& growth rate!

D+gain, sales growth rate is -e( growth rate in this caseE

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Sales0%%% ) +#( 7 *(+

) /.@@ 7 ?0. billion

) $4.44/ billion

>xpected Sales0%%/ ) $4.44/ 7 $.%/ ) ?0%4.0

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E14$ Preparing a Valuation 0rid& CocaCola

a!

#o prepare the valuation grid, apply alternative scenarios to the following

valuation formula, and then divide by the 0,0=$ million shares outstanding:

'alue of equity ) =,4$$ g$.$%

$A@,$$!$%.%-*(+

Mhere g is growth in *(+ or, with a constant asset turnover, growth in sales.

So, for example, if the -*(+ in $@ was indicative of the future -*(+ rather

than the $= -*(+!, the value of the equity would, with a sales growth rate of

=.

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Nere is a valuation grid that gives some range of -*(+ and growth in Sales.

'alues one per share.

-*(+

Irowth inSales 4%& 44& 4@& 4& /0&

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#he market value of the firm is =% x 0,/=$ million ) ?$=0,=% million.

So the premium is ?$=0,=% =,4$$ ) ?$@

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E14% A Simple Valuation 'ased on A-normal Operating /ncome 0rot2&

Coca Cola

Box $/.4 applies an S24 valuation to 6oke using the residual operating income method.

Mith constant -*(+ and constant +#(, residual operating income is forecasted to grow at

the sales growth rate of =.

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) ?$/0,$% million

#his is close to the valuation of operations in Box $/.4, allowing for rounding error.

*ote: a simpler way to get +(I0

+(I0) -e($ $.%=*6(8> $,

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Re=ormulated 'alance S2eets

$ $A $= $@

(perating assets $4,4A/ $$,%4= A,=@0 =,$

(perating liabilities 4,$4@! 0,=%/! 0,%/%! $,

8inority interest $$@ A ==

6S> A,=/% =,%A

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The Set-up: Anal!ing the Reformulated Financial Statements

Common Si>e /ncome Statements

(perating 5rofit 8argin +nalysis!

$ $A $= $@

Sales ?4%,0$ ?0/,$

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6ommentary:

Iross margins, core operating profit margins from sales, and expense ratios are

fairly constant, and look like a good basis for forecasting.

+ note on 5ricetoSales ratios:

#he case refers to NLQs pricetosales 59S! ratio. n recent years analysts have given

considerable attention to 59S ratio particularly in cases of negative earnings!. Nome Lepot

had a 59S ratio of 4.4 in $. #his is considerably above the historical median for all firms

about $.%! and above that for retailers %.A!. Now should an analyst interpret a 59S ratioJ

Gust as the 59> ratio is interpreted as an indication of earnings growth, so the 59S ratio is

often interpreted as an indication of sales growth. So, a 59S ratio of 4.4 builds in an

expectation of considerable sales growth. But we have to be careful. Sales are important to

valuation and growth in sales adds value, all else constant. But there is also the question of

the profitability of sales, the expected profit margins from sales. So, as

59S ) 59> x >9S

) 59> x 58

one should modify the 59S ratio for the 58. But then, of course, one is really looking at the

59> ratio: the ability to grow earnings through growth in sales and increasing profit

margins.

*ote, also that 59S ratios should be unlevered because sales come from assets, not equity.

See chapter 0.

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Turno,er Anal*sis

8a3or Balance Sheet tems+s a 5ercentage of Sales

$ $A $= $@

-eceivables $.=

& 0.%

& $.A

& $.

&nventories $4.$ $4.$ $0.< $0.=5roperty, plant and equipment 0/.4 0/.= 0'! %.$@/ %.$@< %.$$$ %.$$'!

%.4$/ %.4%= %.00 %.0/

Peverage ratios are calculated from average balance sheet amounts.!

6ommentary:

#urnovers are also reasonably constant. #ypically Nome Lepot requires investment of 4$

cents of net operating assets to generate a dollar of sales and maintains an operating

liability level of about %.4.

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Trend Anal*sis

$ $A $=

ncome statement:

Sales growth rate 0

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Balance Sheet:

$ $A $=

(perating asset growth 0$.4& 0@.%& 0$.=&

(perating liability growth $@.%& 40. growth 04.$& $.0& $./&

6ommentary:+gain, NL has regular growth, corresponding to the growth in sales. Mith constant

+#(, the *(+ growth rate must equal the sales growth rate; the two rates are similar.

Free Cas2 Flo Anal*sis

$ $A $=

(perating income (! $,

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Anal*sis o= Residual Operating

/ncome and its

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Question A: Simple Forecasts

Me are restricting ourselves to information in the financial statements. So work with S2$,

S20, and S24 forecasts. +n S2$ forecast wonHt work; with a 59B ratio of $/.% and an

unlevered 59B of $0.$!, the balance sheet is certainly imperfect. So move on to S20 and

S24 forecasts.

#he SF! forecast of operating income:

(0%%% ) 6ore ($ %.$% x *(+$!) $,@$A %.$% x

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#he aftertax borrowing cost is estimated from past reformulated statements.

Some of the interest expense is capitali1ed in construction of stores, and

analysts are probably! anticipating this.

#he SF" eps forecast

(0%%% ) $,=A4*2>0%%% ) /5S ?$.$A

#hese forecasts are under analystsH consensus forecast of ?$.4A per share in

(ctober $. By (ctober, analysts were using more information than that in

the $ financial statements. *ote, however, that analysts were forecasting

$.0/ per share in 8arch $, 3ust after the $ financial statements were

published. So at that time they did not see much a lot than was indicated in the

statements. -evisions afterwards! came later as they obtained more

information.

Question ": Simple #aluations

SF! 'aluation:

>$' ) 6S>$$%.%

-e0%%%

&'

) A,=/% $%.%

@A

) $

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D2orecasted -e(0%%%is $,=$/ O %.$% x $%,0/A! ) @AE

SF"'aluation:

>

$' ) 6S>$g$.$%

-e( 0%%%

) A,=/% g$%.$

=

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$00,0%% ) A,=/% g$%.$

=

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'alue ) A,=/% rate!growth$$%.$

0/A,$%!$%.%-*(+

+

'alue per share ) $,/=