ContentsList of Cases xxiiiList of Accounting Clinics xxivChapter1Introduction to Investing and Valuation 2Investment Styles andFundamental Analysis 3Bubble, Bubble 6How Bubbles Work 7Analysts During theBubble 8Fundamental Analysis Anchors Investors 8TheSetting: Investors, Firms, Securities, andCapital Markets 8TheBusiness ofAnalysis: TheProfessionalAnalyst 12Investing in Firms: TheOutside Analyst 12Investing within Firms: TheInside Analyst 13The Analysis ofBusiness 14Strategy andValuation 14Mastering (heDetails 15TheKeyQuestion: Sustainability a/CompetitiveAdvantage 17Financial Statements: TheLensontheBusiness 17Choosing aValuation Technology [7Guiding Principles 18Anchoring Palue in theFinancial Statements 20How toUseThisBook 21An Outline of theBook 21TheWeb Connection 22Key Concepts 22AContinuing Case: Kimberly-Clark Corporation 23Concept Questions 27Exercises 29Minicase 31Chapter2Introductionto the FinancialStatements 32TheAnalyst's Checklist 33TheFormof theFinancial Statements 33TheBalance Sheet 34TheIncome Statement 34xvlTheCash Flow Statement 38The Statement of Stockholders .Equiry 39The Footnotes andSupplementary Informationto Financial Statements 40TheArticulation a/the Financial Statements:How theStatements Tell a Story 40Measurement intheFinancial Statements 41ThePrice-to-Book Ratio 42Measurement in theBalance Sheet 44Measurement in theIncome Statement 44ThePrice-Earnings Ratio 49TheReliability Criterion: Doni MixWhatYou Know withSpeculation 49Tension inAccounting 51Summary 52TheWeb Connection 53KeyConcepts 53TheAnalyst's Toolkit 54AContinuing Case: Kimbeny-Ctark Corporation 55Concept Questions 60Exercises 61Minicase 66PART ONEFINANCIAL STATEMENTSAND VALUATION 72Chapter3HowFinancialStatements AreUsed inValnation 74TheAnalyst's Checklist 75Multiple Analysis 76TheMethod o/Comparables 76Screening onMultiples 79Asset-Based Valuation 82Fundamental Analysis 84TheProcess ofFundamental Analysis 85Financial Statement Analysis, ProFonnaAnalysis, andFundamental Analysis 86TheArchitecture of Fundamental Analysis:TheValuation Model 88Terminal Investments andGoing-ConcernInvestments 89Valuation Models for Terminal Investments 90Valuation ModelsforGoing-ConcernInvestments 92Criteriafor a Practical Valuation Model 92What Generates ifllue? 93Valuation Models andAssetPricing Models 97Summary 97TheWeb Connection 98Key Concepts 98TheAnalyst's Toolkit 99AContinuing Case: Kimberly-ClarkCorporation 100Concept Questions 101Exercises 101Minicases 105AppendixTheRequired Return andAssetPricingModels 110Chapter4CashAccounting, AccrualAccounting, andDisconnted CashFlowVaination 114TheAnalyst's Checklist 115TheDividend Discount Model 116TheDiscounted Cash Flow Model 118Free Cash FlowandValue Added 121Simple Valuation Models 123TheStatement of Cash Flows 124TheCash FlowStatement underIFRS 126Forecasting Free Cash Flows 127Cash Flow, Earnings, andAccrual Accounting 128Earnings andCash Flows 128Accruals, Investments, andtheBalanceSheet 132Summary 135TheWeb Connection 136Key Concepts 136TheAnalyst's Toolkit 137AContinuing Case: Kimberly-ClarkCorporation 137Concept Questions 138Exercises 139Minicases 144Chapter5AccrualAccounting andValuation:PricingBookValues 148TheAnalyst's Checklist 149TheConcept Behind thePrice-to-Book Ratio 149Beware of Paying Too Much for Earnings 150Contento; xviiPrototype Valuations 150Valuing a Project 150Valuing a Savings Account 151TheNormal Price-to-Book Ratio 152AModel forAnchoring Value onBookValue 153Residual Earnings Drivers andvalueCreation 156ASimple Demonstration andaSimplevaluation Model 158Applying theModel to Equities 160TheForecast Horizon andtheContinuing ValueCalculation 161Target Prices 164Converting Analysts' ForecaststoaValuation 165Applying theModel toProjects andStrategies 166Features of theResidual EarningsModel 168BookValue Captures Value andResidualEarnings Captures Value AddedtoBookValue 169Protectionfrom Paying Too Much for EarningsGenerated byInvestment 170ProtectionfromPaying Too Much for EarningsCreated bytheAccounting 171Capturing Value Nolan theBalance Sheet-forAllAccountingMethods 172Residual EarningsAre NotAffected byDividends, Share Issues, orShareRepurchases 172What theResidual Earnings Model Misses 173Reverse Engineering theModel forActiveInvesting 173Reverse Engineering theS&P500 176UsingAnalysts' Forecasts inReverseEngineering 176Implied Earnings Forecasts andEarningsGrowth Rates 177Separating Speculation from What We Know: ValueBuilding Blocks 177TheWeb Connection ISOSummary 180KeyConcepts 18iTheAnalyst's Toolkit 181AContinuing Case: Kimberly-ClarkCorporation IS2Concept Questions IS3Exercises 183Minicases 189xvlii COnlcr.:.>Chapter 6AccrualAccounting andValuation: PricingEarnings 192TheAnalyst's Checklist 193TheConcept Behind thePrice-Earnings Ratio 193Beware ofPaying Too Much for EarningsGrowth 194From Price-to-Beck: Valuation to PIEValuation 194Prototype Valuation 195TheNormal Forward PIERatio 197TheNormal Trailing PIERatio 198ApoorPIEModel 199AModel forAnchoring Value onEarnings 199MeasuringAbnormal Earnings Growth 201A Simple Demonstration anda SimpleValuation Model 202AnchoringValuation onCurrent Earnings 203Applying theModel toEquities 204ConvertingAnalysts'Forecasts toaValuation 205Features oftheAbnormal Earnings Growth Model 206BuyEarnings 207Abnormal Earnings Growth Valuation andResidual Earnings Valuation 207Abnormal Earnings Growth Is NotAffected byDividends, Share Issues, or ShareRepurchases 209AccountingMethods andValuation 209Reverse Engineering theModel forActive Investing 211Reverse Engineering theS&P500 212UsingAnalysts'Forecasts in ReverseEngineering 212Implied Earnings Forecasts andEarningGrowth Rates 213Separating Speculation fromWhatWe Know: ValueBuilding Blocks 213PIE Screening 214Screening on Earnings Yield 214Screening onPEGRatios 216Summary 217TheWeb Connection 218KeyConcepts 218TheAnalyst's Toolkit 218AContinuing Case: Kimberly-Clark Corporation 219Concept Questions 220Exercises 220Minicases 226PART TWOTHEA..'lALYSIS OFFINANCIALSTATEMENTS 230Chapter 7Viewing the Bnsiness Throngh the FinancialStatements 232TheAnalyst's Checklist 233Business Activities: TheCash Flows 234TheReformulated Cash FlowStatement 238TheReformulated Balance Sheet 239Business Activities: All Stocks andFlows 240TheReformulated IncomeStatemenl 241Accounting Relations thatGovern ReformulatedStatements 241TheSources of Free Cash FlowandtheDisposition ofFree Cash Flow242TheDrivers of Dividends 242TheDrivers a/Net OperatingAssetsandNetIndebtedness 243Tying It Together forShareholders:WhatGenerates Value? 244Stocks andFlows Ratios: Business Profitability 246Summary 248TheWeb Connection 249Key Concepts 249TheAnalyst's Toolkit 250AContinuing Case: Kimberly-ClarkCorporation 250Concept Questions 251Exercises 252Chapter 8TheAnalysis of the Statement ofShareholders' Eqnity 256TheAnalyst's Checklist 257Reformulating theStatement of Owners' Equity 257Introducing Hike 258Refonnulation Procedures 258Dirty-Surplus Accounting 262Comprehensive Income ReportingWIder u.s.GMP andlFRS 263Ratio Analysis 264Payout andRetention Ratios 264Shareholder Profitability 265Growth Ratios 265Hidden DirtySurplus 266Issueof Shares inOperations 266Issuea/SharesinFinancingActivities 270Handling DilutedEarnings per Share 270Share Transactions inInefficien1r,.Markets 272TheEyeof theShareholder 274Accounting Quality Watch 275TheWeb Connection 275Summary 276KeyConcepts 276TheAnalyst's Toolkit 277A Continuing Case: Kimberly-Clark Corporation 278Concept Questions 278Exercises 279Minicase 285Chapter 9TheAnalysis of the BalanceSheet andIncomeStatement 290TheAnalyst's Checklist 291Reformulation of theBalance Sheet 291IssuesinRefonnulating Balance Sheets 292Strategic Balance Sheets 299Reformulation of theIncome Statement 301Tax Allocation 302Issues in ReformulatingIncome Statements 306Value AddedtoStrategic Balance Sheets 309Comparative Analysis of theBalance SheetandIncome Statement 312Common-Size Analysis 312TrendAnalysis 314Ratio Analysis 316Summary 318TheWeb Connection 320KeyConcepts 320TheAnalyst's Toolkit 321AContinuing Case: Kimberly-ClarkCorporation 322Concept Questions 323Exercises 323Minicases 332Chapter 10TheAnalysis oftheCashFlowStatement 340TheAnalyst's Checklist 341TheCalculation of FreeCashFlow 341GAAP Statement of CashFlows andReformulatedCashFlow Statements 343Reclassifying Cash Transactions 344Tying It Together 349Cash Flow from Operations 350Content; xixSummary 353TheWeb Connection 353KeyConcepts 354TheAnalyst's Toolkit 354AContinuing Case: Kimberly-ClarkCorporation 354Concept Questions 355Exercises 355Minicase 360Chapter 11TheAnalysis of Profitability 362TheAnalyst's Checklist 363TheAnalysis ofRetumonCommon Equity 363First-Level Breakdown: Distinguishing FinancingandOperating Activities andtheEffect ofLeverage 364Financial Leverage 364Operating Liability Leverage 366Summing Financial Leverage andOperatingLiability Leverage Effects onShareholderProfitability 368Return onNetOperatingAssetsandReturnonAssets 369Financial Leverage andDebt-to-EquityRatios 371Second-Level Breakdown: Driversof Operating Profitability 371Third-Level Breakdown 374Profit Margin Drivers 374Turnover Drivers 374Borrowing CostDrivers 377TheWeb Connection 379Summary 379KeyConcepts 379TheAnalyst's Toolkit 380AContinuing Case: Kimbeny-Ctark Corporation 380Concept Questions 381Exercises 382Minicase 390Chapter 12TheAnalysis of Growthand SnslainableEarnings 392TheAnalyst's Checklist 393WhatIs Growth? 393Cutting totheCore: Sustainable Earnings 394CoreOperating Income 395IssuesinIdentifying Core OperatingIncome 398xx COnfCTI(SCore Operating Profitability 405Core Borrowing Cost 407Analysis of Growth 407Growth Through Profitobdity 407Operating Leverage 409Analysis of Changes inFinancing 410Analysis of Growth inSharehoiders'Equity 411Growth, Sustainable Earnings, andtheEvaluationof P'B Ratios andPIE Ratios 412How Price-to-Book Ratios andTrailing PIERatios Articulate 412Trailing Price-Earnings Ratios andGrowth 415Trailing Price-Earnings Ratios andTransitoryEarnings 416PIE Ratios andtheAnalysis of SustoinoaieEarnings 417Summary 418TheWeb Connection 419Key Concepts 419TheAnalyst's Toolkit 420AContinuing Case: Kimberly-Clark Corporation 420Concept Questions 421Exercises 422Minicases 428PART THREEFORECASTINGANDVALUATIONANALYSIS 438Chapter13TheValue of Operatiousaud the Evaluatiouof Enterprise Price-to-Book Ratios andPrice-Earnings Ratios 440TheAnalyst's Checklist 441AModification to Residual Earnings Forecasting:Residua! Operating Income 442TheDrivers of Residual Operating Income 445AModification toAbnormal Earnings GrowthForecasting: Abnormal Growth inOperatingIncome 447Abnormal Growlh inOperating Income andthe"Dividend "fromOperatingActivities 447TheCostof Capital andValuation 449The Cost of Capitalfor Operations 450The Cost of Capitalfor Debt 451Operating Risk, Financing Risk, andtheCost of Equity Capital 452Financing RiskandReturn andtheValuationof Equity 453Leverage andResidual Earnings Valuation 453Leverage andAbnormal Earnings GrowrhValuation 455Leverage Creates Earnings Growth 460Debt and Taxes 463Mark-to-Market Accounting: ATool for IncorporatingtheCostof StockOptions inValuation 464Enterprise Multiples 466Elite/prise Price-to-Book Ratios 467Enterprise Price-Earnings Ratios 468Summary 472TheWeb Connection 472Key Concepts 473TheAnalyst's Toolkit 473AContinuing Case: Kimberly-Clark Corporation 474Concept Questions 476Exercises 477Minicase 483Chapter14Anchoring ontheFinancial Statements:SimpleForecastiug aud SimpleValuation 486TheAnalyst's Checklist 487Simple Forecasts andSimple Valuationsfrom Financial Statements 488Forecostingfrom BookValues:SFl Forecasts 488Forecaslingfrom Earnings andBookValues:SF2 Forecasts 490Forecastingfrom Accounting Rates of Return:SF3 Forecasts 493Simple Forecasting: Adding Information toFinancialStatement Information 498Weighed-Average Forecasts afProfitabilityandGrowth 499Growth inSalesasaSimple Forecastof Growlh 499TheApplicability of Simple Valuations 500Simple Valuations withShort-TermandLong-Term Growth Rates 503Simple Valuation as anAnalysis Tool 503Reverse Engineering 503Enhanced StockScreening 505Sensitivity Analysis 505Summary 506TheWeb Connection 507Key Concepts 508TheAnalyst's Toolkit 508AContinuing Case: Kimberly-Clark Corporation 508Concept Questions 509Exercises 510Minicases 516Chapter15Full-Information Forecasting, Valuation, andBusiuess StrategyAnalysis 522TheAnalyst's Checklist 523Financial Statement Analysis: Focusing theLensonthe Business 5241.Focus onResidual Operating Income andItsDrivers 5242, Focus onChange 5253, Focus onKey Drivers 5314. Focus onChoices versus Conditions 534Full-Information Forecasting andProFormaAnalysis 535AForecasting Template 538Features of'Accounting-Based Valuation 543Value Generated in ShareTransactions 545Mergers andAcquisitions 545Share Repurchases andBuyouts 546Financial Statement Indicators andRedFlags 547Business StrategyAnalysis andProFormaAnalysis 547Unarticulated Strategy 549Scenario Analysis 550TheWeb Connection 550Summary 550Key Concepts 551TheAnalyst's Toolkit 552AContinuing Case: Kimberly-Clark Corporation 552Concept Questions 553Exercises 554Minicases 561PART FOURACCOUNTINGANALYSISANDVALUATION 568Chapter 16CreatingAccounting Value andEconomic Valne 570TheAnalyst's Checklist 571Value Creation andtheCreation ofResiduaiEarnings 571Accounting Methods, Price-to-Book Ratios,Price-Earnings Ratios, andtheValuationof Going Concerns 574Accounting Methods with a Constant LevelofInvestment 574Ccnrcncs xxiAccounting Methods with a Changing Levelof Investment 577AnException: LIFOAccounting 581Hidden Reserves andtheCreationofEarnings 582Conservative andLiberal Accountingin Practice 586UFOversus FIFO 587Research andDevelopment inthePharmaceuticals Industry 588Expensing Goodwill andResearchandDevelopment Expenditures 589LiberalAccounting: Breweries andHotels 590Profitability inthe1990s 590Economic-value-Added Measures 591Accounting Methods andthe ForecastHorizon 591The Quality of Cash Accounting andDiscountedCash FlowAnalysis 592Summary 594TheWeb Connection 594KeyConcepts 595TheAnalyst's Toolkit 595ConceptQuestions 596Exercises 596Minicase 601Chapter 17Aualysis of the Qualityof FiuaneialStatements 606TheAnalyst's Checklist 607'What IsAccounting Quality? 607Accounting Quality Watch 608FiveQuestions About Accounting Quality 609CuttingThrough theAccounting:Detecting Income Shifting 610Separating What We KnowfromSpeculation 613Prelude toa QualityAnalysis 614Quality Diagnostics 616Diagnostics toDetect Manipulated Sales 619Diagnostics toDetect Manipulation of CoreExpenses 621Diagnostics toDetect Manipulation of UnusualItems 627Detecting Transaction Manipulation 629Core Revenue Timing 629Core Revenue Structuring 629Core Expense Timing 630ReleasingHidden Reserves 630xxii ContentsOtherCore Income Timing 631Unusual Income Timing 631Organizational Manipulation: Off-Balance-SheetOperations 631Justifiable Manipulation? 632Disclosure Quality 632Quality Scoring 633Abnormal Returns toQuality Analysis 635Summary 636TheWeb Connection 636KeyConcepts 636TheAnalyst's Toolkit 637Concept Questions 638Exercises 639Minicases 648PART FIVETHE ANALYSIS OF RISKANDRETURN 656Chapter18The Analysisof Equity Risk and Return 658TheAnalyst's Checklist 659TheRequired Return andtheExpected Return 659TheNature of Risk 660TheDistribution of Returns 660Diversification andRisk 664AssetPricing Models 665Fundamental Risk 667Return on Common Equity Risk 669Growth Risk 670Value-at-Risk Profiling 670Adaptation Options andGrowthOptions 675Strategy andRisk 676Discountingfor Risk 676Fundamental Betas 677PriceRisk 678Market Inefficiency Risk 678Liquidity Risk 681Inferring Expected Returns from Market Prices 681Finessing theRequired Return Problem 683Evaluating Implied Expected Returns withvalue-at-Risk: Profiles 683Enhanced Screening andPairs Trading 683Relative Value Analysis: Evaluating Firms withinRiskClasses 683Conservative andOptimistic ForecastingandtheMargin of Safety 685Beware of PayingforRiskyGrowth 686Expected Returns in Uncertain Times 686Summary 687TheWeb Connection 687KeyConcepts 687TheAnalyst's Toolkit 688Concept Questions 688Exercises 689Chapter 19The Analysis of Credit Riskand Return 696TheAnalyst's Checklist 697TheSuppliers of Credit 697Financial Statement Analysis forCreditEvaluation 698ReformulatedFinancial Statements 698Short-Term Liquidity Ratios 700Long-Term Solvency Ratios 702Operating Ratios 703Forecasting andCredit Analysis 703Prelude to Forecasting: TheInterpretiveBackground 703Ratio Analysis andCredit-Scoring 704Full-Information Forecasting 708RequiredReturn, Expected Return, andActiveDebtInvesting 711Liquidity Planning andFinancialStrategy 712TheWeb Connection 713Summary 713Key Concepts 713TheAnalyst's Toolkit 714Concept Questions 714Exercises 715Minicase 719AppendixASnmmary of Formulas 723Index 740List of CasesCritiqueofanEquityAnalysis:America Online Inc. 31Reviewing theFinancial Statements of Nike, Inc. 66AnArbitrage Opportunity? Cordant Technologies andHowmet International J05Nifty Stocks? Returns to Stock Screening 106Attempting Asset-Based Valuations: WeyerhaeuserCompany 107Discounted Cash FlowValuation: Coca-Cola CompanyandHome Depot, Inc. 144Forecasting from Traded Price-to-Book Ratios:Cisco Systems, Inc. 189Analysts' Forecasts andValuation: PepsiCo andCoca-Cola 190Kimberly-Clark: BuyItaPaper? 190Forecasting from Traded Price-Earnings Ratios:Cisco Systems, Inc. 226Analysts' Forecasts andValuation: PepsiCo andCoca-Cola 227Reverse Engineering Google: How DoI UnderstandtheMarket's Expectations? 227Analysis of theEquity Statement, Hidden Losses,andOff-Balance-Sheet Liabilities: MicrosoftCorporation 285Financial Statement Analysis: Procter &Gamble I 332Understanding theBusiness Through ReformulatedFinancial Statements: Chubb Corporation 336Analysis of CashFlows: Dell, Inc. 360Financial Statement Analysis: Procter &Gamble11 390Financial Statement Analysis: Procter &Gamble 1Il 428AQuestion of Growth: Microsoft Corporation 429Analysis of Sustainable Growth: International BusinessMachines 432Valuing theOperations andtheInvestments of aProperty andCasualty Insurer: ChubbCorporation 483Simple Forecasting andValuation: Procter &Gamble IV 516Simple Valuation andReverse Engineering forCiscoSystems, Inc. 516FullForecasting andValuation: Procter &GambleV 561AComprehensive Valuation to Challenge theStockPrice of Dell,Inc. 561TheBattle forMaytag: An Analysis of aTakeover 565Advertising, Low Quality Accounting, andValuation:E*Trade 601AQuality Analysis: Xerox Corporation 648AQuality Analysis: Lucent Technologies 652Analysis of Default Risk: Fruitof theLoom 719xxiiifirms, gointoanewlineof business, spinoffa division orrestructure, or indeed acquire ordisinvest inanassetofanyform. Inall cases financial statements mustbeanalyzed tomakea sound decision.In market economies, mostfirms areorganized to make money (or"create value") fortheirowners. Sofinancial statements areprepared primarily with shareholders' investmentinmind: Thestatements areformally presented toshareholders at annual meetings andthemainnumbers theyreport are earnings (for the owners) in the income statement and thebookvalue of owners' equity in the balance sheet But much of the financial statementanalysis for investors is relevant to otherparties. Theshareholder is concerned withprof-itability. Butgovernmental regulators, suppliers, thefirms' competitors, andemployees areconcerned with profitability also. Shareholders and bondholders are concerned withtheriskiness of the business, but so are suppliers and employees. Andsecurities litigation,which involves expert witnesses, usually dealswithcompensation for lossof profits-orlossof value-to investors. Thus muchof the financial statement analysis in this bookisrelevant totheseusersaswell.Investors typically invest ina fum bybuying equity shares or thefirm's debt. Theirpri-maryconcern is theamount topay-the value of theshares or thedebt. Theanalysis of in-formation that focuses onvaluation is calledvaluationanalysis, fundamental analysis,or,when securities likestocks andbonds areinvolved, securityanalysis. Thisbookdevel-ops theprinciples of fundamental analysis. Andit shows howfinancial statement analysisis usedin fundamental analysis.In thischapter weset thestage.Millions of shares of business firms aretraded every dayontheworld's stockmarkets. Theinvestors whobuyandsell theseshares askthemselves: Am I trading at the rightprice?Whataretheshares really worth? Theyattempt toanswer these questions while adiscordantbackground chorus-the printed press, "talking heads" on television financialnetworks,andInternet cbatrooms-c-voices opinions about whatthepriceshould be.Theyturnto in-vestment advisers who provide an almost endless streamof information andrecommenda-tionsto sort out.Theyhearclaims thatsomeshares areoverpriced, some underpriced, andtheyhear theories that stockmarkets can be caught up in the fadsand fashions-evenmania-that aresaidtodrive sharepricesaway fromtheirappropriate values.Intheabsence of anyclearindication of whatstocksareworth, investors copeindiffer-ent ways. Some-intuitiveinvestors-rely on their owninstincts. 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 havedriven thepricetotheappropriate pointThese investment styles aresimple anddon't require mucheffort. Butbothtypes of in-vestors run risksbeyond thoseinherent inthe firms they buy:Paying toomuch or sellingfor toolittle damages investment returns. Theintuitive investor hastheproblem of the in-tuitive bridge builder: Onemaybe pleased withone'sintuition but, before building getsunderway, it might paytocheckthat intuition against thecalculations prescribed bymod-em engineering. Not doing so might leadto disaster. Thepassive investor is in danger ifstocks aremispriced. It is tempting totrust, as amatter of faith, thatthemarket isefficient,andmuch economic theory saysit should be. But it is goodpractice to check. Bothtypesof investors runtheriskof trading withsomeone who has"donehishomework," someonewhohasanalyzed theinformation thoroughly.Chapter 1 Introduction!O Inue.Hing andVallUltion 3INVESTMENT STYLES ANDFUNDAMENTAL ANALYSISHowarebusiness analysisandfinancialstatementanalysisconnected?What is theroleof theprofessionalanalyst?ction to Valuationtheprimary information that firms publish aboutthemselves, and __,_,,_ Net income available to commonMost of these subtotalsappear on De11S income statement. (Dell reported no extraordi-nary items.) Names of line itemscan differamongcompanies. Grossmarginis alsoreferred to as gross profit andoperating income before tax is sometimes referred to asChapter 2 lntrodllcrionlO Fli'landa!37EXHIBIT 2.1 Financial Statements for Dell (continued)ConsolidatedStatement of CashFlows(in millions)Fiscal Year EndedFebruary 1, 2008 February 2, 2007February 3, 2006Cashflows fromoperating activities:NetincomeS2,947 $ 2,583 $ 3,602Adjustments to reconcile net income to net cashprovided byoperating activitiesDepredation andamortization607 471 394Stock-based compensation329 36817In-process research anddevelopment charges83Excess taxbenefits from stock-based compensation(12) (3D)Tax benefits from employee stockplans224Effects of exchange ratechangeson monetary assetsand liabilities denominated inforeign currencies3037 (3)Other133 61 157Changes in:Operating working capital(519)397 (53)NonCurrent assets andliabilities351132 413Net cash providedby operating activities3,949 3,969 4,751Cashflows frominvestingactivitiesInvestmentsPurchases(2,394)(8,343) (6,796)Maturities andsales3,679 10,320 11,692Capital expenditures(831) (896)(747)Acquisition of business, net of cashreceived(2,217) (113)Proceeds from saleof building40Net cash(used in) provided by investing activities(1.763) 1,0034,149Cashflows form financing activitiesRepurchase of common stock(4,004) (3,026) (7,249)Issuance of common stockunderemployee plans136 314 1,051Excess taxbenefits from stock-based compensation12 80(Repayment) issuance of commercial paper. net(100)100Repayments of borrowings(165)(63) (81)Proceeds from borrowings665255Other(8)

Net cash used infinancingactivities(4,120)(2,551) (6,252)Effect of exchange ratechanges oncashandcashequivalents-----.ill 71-ill)Net(decrease) increase incashand cash equivalents(1,732)2,4922,575Cash andcashequivalents at beginning of year9,5467,054 4,479Cash and Cash equivalents at endof year$ 7,764 $ 9,546 $ 7,054earnings interest andtaxes (ebit), forexample. Items included incertain categoriescan alsodiffer. Interest income is sometimes given as a separate categoryfrominterest Although necessary to calculate net income to common shareholders, preferreddividends areill thestatement of shareholders' equity.38 Chapter 2 )ntrooucnOn WIhe Financial SrarementsEXHIBIT 2.1 Financial Statements for Dell (concluded)ConsolidatedStatement of Stockholders' Equity {inmillions)Common StockAccumulatedandCapital inOtherExcess of Par Value Treasury StockRetained ComprehensiveIssued Shares Amount Shares Amount Earnings Income TotalBalances atFebruary2, 2007 3,307 $10,107 606 $(21,033) $15,282 $(28) $4,328Netincome 2,947 2,947Impact of adoption ofSFA$ 155 29 (23) 6Change in net unrealizedgainon investments,net of taxes 56 56Foreign currency translationadjustments 17 17Change innet unrealizedloss onderivative lnstru-ments, net of taxes (38)Totalcomprehensive income 2,988Impact ofadoption of FIN 48 (3) (59) (62)Stock issuances underemployee plans 13 153 153Repurchases 179 (4,004) (4,004)Stock-based compensationexpense under SFAS 123(R) 329 329Tax benefit from employeestock plans 3 3Balance atFebruary 1, 2008 3,320 $10,589 785 'HlS,037) $18,199 $(16) $3,735Net income isgivenona dollarbasisandona per-share basis.Earnings pershare (EPS)is always earnings (afterpreferred dividends) forthe common shareholder (called ordinaryshareholders in the UnitedKingdom andothercountries), so thenumerator is net incomeavailable tocommon. Basic earnings pershare ($1.33 forDell in2008)isnet income avail-able to commonshareholdersdivided by the weighted-averageof common shares out-standing duringthe year;a weighted average is used to accommodate changes in sharesoutstanding fromshareissuesandrepurchases. Diluted earnings pershare ($1.31 for DeB)is basedon totalcommon sharesthat would be outstanding if holders of contingent claimson shares(likeconvertible bondsandstockoptions) were toexercise theiroptions andholdcommon shares.TheCash Flow StatementThe cash flowstatement-s-Dell's Consolidated Statement of CashFlows in the exhibit-describes howthe finn generated andusedcashduring the period. Cashflows are dividedinto three types in the statement: cash flows fromoperating activities, cash flows frominvesting activities,andcash flows fromfinancing activities. Recall that this is cashgener-ated fromthe threeactivities of the fumdepicted in Figure l.l in Chapter 1. Cashfromoperations is cash generatedfrom sellingproducts, net of cash used up indoing so.Chapter 2 Jnrroduaion ro[he FiMr:ciol SW!Cmefll.l 39 flowsare cashspent on purchasingassetsless cash receivedfrom sellingassets. Fmancmg cashflows arethecashtransactions withdebtandequity claimants thataredepicted in1.1.TheSum of thecashflows from thethreeactivities explains theincrease or decrease mthefinn'scash(at thebottomof thestatement):Cashfrom operations +Cashfrom investment (2.3)+Cashfrom financing = Change incash. generated $3,949 million in cashfrom operations in fiscal 2008, spenta netSI,763milliona?investments, and disburseda net $4,120 millionto claimants, leavinga netdecreasemof $1,934 million. The line items in Dell's statement give the specificsources of cashIneachcategory. Some,of course, involve cashoutflows ratherthan cashinflows, andoutflows are inparentheses. Delltrades aroundtheworldandso holds cashindifferent Thusthechangeincashin u.s. dollarequivalents isalsoexplained bya III exchange ratesoverthe year:The U.S. dollarequivalent of cashin othercur-rencresIncreased by $152 million over the year, so the overalldecrease in cash (in U.S.dollars) was $1,782million.TheStatement of Stockholders' EquityThe statement of shareholders' equity-c-DellsConsolidated Statement of Stockholders'inthe withbeginning-of-period equity andendswithend-of-periodequity, thusexplaining howthe equity changed overthe period. Forpurposes of analysisthechange in equityis bestexplained as follows: 'Ending equity= Beginning equity +Comprehensive income (2.4)-NetpayouttoshareholdersThis isto as the stocks andflowsequationfor equitybecauseit explainshowof (at the beginning and end of the period) changedwithflows of equityduring the periodOwners' equityincreases from value added inbusiness activities(comprehensive income) and decreases if thereis a net payout to owners. DellS reportedcomprehensive mcome for 2008was$2,988million. Net payout is amounts paidtoshare-holders lessamounts received from share issues. As cashcan be paid out in dividends orshare:epurchas.es, netis stock repurchases plus dividends minus proceeds fromshareIssues. Withno dividend, theseitemsnet to a net payout for Del!ofS3,85lmillion(a sharerepurchase of$4,004 million net of a shareissueof$153 million). statement doesnot quite reconcile beginning and ending equity asequation 2.4prescribes. You seeotheritemsinDell'sequity statement. Asit turnsout theseare misclassiftcations dueto badaccounting prescribed byaccounting rules.Wewill dealwiththisissuewhenweanalyze the equitystatement in depth in Chapter 8-You'll noticethat comprehensiveincomeincludesnet incomeof $2,947 millionre-portedin thestatem:nt?lus someadditionalincome reported inthe equitystate-ment mcome in the equitystatement is known as dirty surplusaccounting,for It doesnot givea cleanincome number in the income statement. Thetotalof dirtysurplusincome items($41 millionfor Dell)is calledothercomprehensive incomeandthe.totalof net(intheincome statement) andothercomprehensive income (inthe equity statement) IS comprehensive income:Comprehensive income = Net income +Othercomprehensive income (2.5)Afewfirms reportothercomprehensive income below net income in theincome statementandsomereport it in a separate "OtherComprehensive Income Statement."40 Chapter2 IIl!nxlllC!ionto rhe Firu:mcial $wtcmcnt.lChapter 2 intToo"etionto ,heFinancial Stmeme,u; 41MEASUREMENT INTHE FINANCIAL STATEMENTSTo recap, the balancesheet reportsthe stockof shareholder valuein the firmand the in-comestatement reportsthe flow, or change, inshareholder valueovera period. Using thelanguage of valuation, the balance sheet givesthe shareholders' net worth and the incomestatement gives thevalueaddedto theirnet worthfromrunning thebusiness. However, weowners' frommillion to $3,735 million overthe year byearning$2,988 million mIts busmess actrvmes andpayingout a net $3,851million to its ownersthoseo.ther itemsin theequitystatement). The income statement indicates thatthenetincome portion of the increase in equityfrombusiness activities($2,947 million) camefrom revenue fromselling products andfinancing revenueof$61 133 million lessincurred in generating therevenue of$57,693million, plusand'othermcome of $387million, lesstaxesof $880million.AndsoDell began its fiscaJ 2009yearwiththestocks inplaceinthe2008 balance sheet toaccumulatecashandwealth fo.r shareholders. Fundamental analysis involves forecastingthataccumulation. Asweproceed withtheanalysis insubsequent chapters wewill seehow theaccounting relations wehavelaidout areimportant in developing forecasting tools. SeeBox2.1forasummary. Besureyouhave Figure 2.1 firmly inmind. Understand how thestatementsfit together; how reporting tracks theevolution of shareholders' equity,of equrty valuemthebalance sheetwithvalue added in earnings from busi-nessacuvrtres. Andunderstand theaccounting equations thatgovern eachstatement.Cash FlowStatementCash from operationsCashfrom investingCashfrom financingJt Netchangein cashr-.. Beginning Balancesheey' BalanceSheet 0/Statement ofCashShareholders' Equity+Otherassets+OtherassetsTotal assetsTotal assets-Liabilities Investment and-LiablliliesOwners' equitydisinvestment byownersNetincome andother {w.;;',i I", ,"",)

11

&1i::tt,

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liabilities and Stockholders' EquityDecember 31 2002 2003YearEndedDecember312004(483.9) (484,1) (629.9)124.8 107.0 1133(73.9) (55.6) (58.1)1,770.4 1,643.6 1,627.429.8 50.6 58.61,80o.z 1,694.2 1,686.0(11.4)$1,800.2 $1,694.2 $1,674.63.58 3.24 3.15.06 .10 .11--..ill)3.64 3.34 3.243.55 3.23 3.13.06 .10 .11(.02)s 3.61 $ 3.33 3.22(Continued)$15,083.2 $14,026.3 $13,231.510,014.7 9,231.9 8,537.75,068.5 4,794.4 4,693.82,510.9 2,3503 2,251.8 73.72,506.4 2,331.6 2,3683(158.4) (105.5)17.9 18.0 15.7 2,203.4 2,0763 2,202.1Net salesCostof products soldGrossprofitMarketing, research, andgeneral expensesOther (income) expense, netOperating profitNonoperatingexpenseInterest incomeInterest expenseIncome before incometaxes, equityinterests, discontinuedoperationsand cumulativeeffect of accountingchange(Millions of dollars, except pershare amounts)ConsolidatedIncomeStatementChapter 2 ImrodllC!lon rotheFinancial Sultements 57Provision forincome taxesShare of net lncome of equitycompaniesMinority owners share ofsubsidiaries net incomeIncome fromcontinuingoperationsIncome from discontinued operations,net of income taxesIncome before cumulative effectofaccounting changeCumulative effectof accountingchange, net of income taxesNet incomePershare basisBasicContinuing operationsDiscontinued operationsCumulative effect of accounting changeNet incomeDilutedContinuing cceretonsDiscontinued operationsCumulative effect of eccountoqchangeNet incomeEXHIBIT 2.2(Continued)1,214.7 864.3 S1,086.6983.2 857.9 844.5265.5 283.5 277.51,431.6 1,374.7 1,325.2448.0 367.2 4043194.2 171.1

4,537.2 3,918.7 4,092.12,298.0 2,733.7 2,844.01,621.7 1,614.4 1,390.08403 880.5 854.2368.4 2983 255.5722.9 567.9 553.5710.8 710.8 710.8348.6 406.9 419.0(5,047.5) (3,818.1) (3,350.6)(1,226.0) (1,565.4) (2,157.7)11,865.9 11,059.2 10,054.0(223) (27.1) 6,629.5 6,766.3 5,6503$17,018.0 $16,779.9 $15,639.6AssetsKIMBERLY-CLARK CORPORATION ANDSUBSIDIARIESConsolidatedBalance Sheet2004 2003 2002(Millions of dollars)Current liabiiitiesDebtpayable within oneyearTrade accounts payableOtherpeveblesAccrued expensesAccrued income taxesDividends payableTotal current liabilitiesLong-term debtNoncurrent employee benefit and otherobligationsDeferred income taxesMinority owners interests insubsidiariesPreferred securities of subsidiaryStockholders' equityPreferred stock-ereparvahe-euthoreec20.0million shares, noneissuedCommon parvalue-authorized1.2billion shares; issued 568.6million shares atDecember 31, 2004and2003Additional paid-in capitalCommon stock heldintreasury, at cost-85.7million and67.0million shares atDecember 31, 2004and2003Accumulated othercomprehensive income (loss)Retained earningsUnearned compensation on restricted stockTotalstockholders' equityCurrent assetsCashandcashequivalents I 594.0 290.6 s 494.5Accounts receivable, net 2,038.3 1,955.1 2,005.9Inventories 1,670.9 1,563.4 1,430.1Deferred income taxes 278.2 281.4 191.3Othercurrent assets 205.9Totalcurrent assets 4,961.9 4,438.1 4,327.7Property, plant, and equipmentnet 7,990.5 8,263.4 7,619.4Investments inequitycompanies 444.4 427.7 571.2Goodwill 2,702.9 2,649.1 2,254.9Other assets

1,001.6

$17,018.0 $16,779.9 $15,639.6EXHIBIT 2.2FinancialStatementsfor Kimberly-ClarkCorporationfor YearEnding December3l,200456 Chapter 2 /mTooucdon 10rhc Financial 59

I!I

Ng00.EXHIBIT 2.2(Concluded)2004 2003 2002(Millions of dollars)YearEndedDecember31Consolidated Cash Flow StatementContinuing operations:OperatingactivitiesIncome from continuing operations $1,770.4 $1,643.6 $1.627.4Depreciation andamortization 800.3 745.3 704.4Deferred income tax(benefit) provision (19.4) (50.8) 189.0Net losses onassetdispositions 45.5 35.0 37.7Equity companies earnings inexcess of (30.1) (9.6) (8.2)dividends paidMinority owners share ofsubsidiaries net income 73.9 55.5 58.1Decrease (increase) inoperating working capital 133.0 118.2 (197.8)Postretirement benefits (54.4) (59.9) (118.5)Other-22 49.4Cash provided byoperations 2,726.2 2552.2 2,341.5InvestingactivitiesCapital spending (535.0) (872.9) (861.3)Acquisitions of businesses, netofcash acquired (258.5) (410.8)Investments inmarketable securities (11.5) 110.8) (9.0)Proceeds from sales of investments 38.0 29.4 44.9Net increase intime deposits (22.9) (149.0) (36.9)Proceeds from dispositions of property 30.7 7.6 4.8Other Cash used forinvesting (495.4) (1.260.1) (1,2873)Financing activitiesCash dividends paid (767.9) (671.9) (612.7)Net decrease inshort-term debt (54.7) (424.2) (423.9)Proceeds from issuance oflone-term debt 38.7 540.8 823.1Repayments of long-term debt (199.0) (481.6) (154.6)Proceeds from preferred securities ofsubsidiary 125.0Proceeds from exercise ofstock options 290.0 31.0 68.9Acquisitions of common stock forthe treasury (1.598.0) (546.7) (680.7)Other Cash used forfinancing (2.174.9) (1,570.9) (1,014.8)Effect ofexchange ratechanges oncash andcash 4.1 18.6 14.7equivalentsCashprovidedby (usedfor) continuingoperations 60.0 (260.2) 54.1Discontinued operations:Cash provided bydiscontinued operations 30.0 56.3 75.9Cash payment from NeenahPaper. Inc. 213.4Cash provided bydiscontinued operations 243.4 56.3

Increase{decrease) incashand cashequivalents 303.4 (203.9) 130.0Cash andcash equivalents, beginning of year 290.6 494.5 364.5Cash andcash equivalents, endof year s594.0 $ 290.5 $ 494.558 Chapter2 introduction10 lhe SwrcmentsEXHIBIT 2.2(Continued)60 Chapter2 IlHrodllCuonEOFinMcialTHE FORM AND CONTENT OF KIMBERLY-CLARK'SFINANCIAL STATEMENTSGothrough the firm's fourstatements andshow thateachof theaccounting relations inthischapter-2.1 to 2.5-are obeyed in 2004. Be sureto identify comprehensive income andnet payout to shareholders. Satisfy yourselfthat the cashflow statement reconciles to theopening andclosingcashbalances, as in Figure 2.1, andhowthe income statement recon-ciles to the shareholders' equitystatement, as alsoshown in Figure 2.1. Canyou"tell thestory"of what the financial statements, as a whole, aredepicting?Lookat Kimberley-Clark's balance sheetandtickoffthoseassetsandliabilities thatyouthink are reported closeto their fair value. On what basis are the remainingitemsmea-sured?Fromyour investigation of the firmin theChapter I case, whatassetsdo youcon-jecturearemissing fromthebalance sheet?Whatitemsinthe income statement involve themostmismatching of revenues toexpenses?MARKET VALUES ANDMARKET MULTIPLESYou sawinthe Chapter I casethatKMB traded at $64.81 in March2005,justafterits2004annual report waspublished. Using this number andothersfromthe statements, calculatethe total marketvalueof the equity. Forthis youwill needto identify shares outstanding;remember thatsharesoutstanding arenot thesameas shares issued. Calculate thepremiumor discount at which KMBtrades relative to bookvalue. Alsocalculate the price-to-bookratio(PIS) and the price-earnings ratio(PIE). Canyouprovide someexplanation for thesize of theseratios?Usingthevalueequation (2.6)andinformation inthefinancial statements, make thebestcalculation you can for the valueof the finn (enterprise value). K:\1Btraded at $62 pershare 12months priorto March 2005 andpaida dividend of$1.60 pershareoverthe year.Whatwasthe rateof returnon thestockfor theyear?Chapter2 Inrroduc(ioll W lheFinancial 61C2.12. Why is the matching principle important?C2.13. Whydo fundamentalanalysts want accountants to followthe reliability criterionwhen preparing financial reports?Exercises Drill ExercisesE2.1. Applying Accounting Relations: Balance Sheet, Income Statement,and EquityStatement (Easy)Thefollowing questions pertain tothe samefirm.a. The balancesheet reports$400million in total assetsand $250million insharehold-ers' equityat theendof a fiscal period. What arethe firm's liabilities?b. The incomestatement reports$30 million in net incomeand $175 millionin totalexpenses for theperiod. Whatarethe finn's revenues?c. Theshareholders' equity statement hasa beginning balance fortheperiodof$230mil-lion andthe firmhada net payout to shareholders of$12million. What is the finn'scomprehensive income fortheyear? Howmuchincome is reported intheequitystate.mentratherthantheincome statement?d. Therewere no share issuesor stockrepurchases duringthe year. How muchdid thefirm payindividends?E2.2. Applying Accounting Relations:Cash Flow Statement (Easy)Afirmreported $J30 million increase in cashovera year. It alsoreported $400million incashflow fromoperations, anda net $75 million paidout to claimants in financing activi-ties. Howmuchdidthe 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. Cashbalances in theaccount earninterest at a 5 percentrateperannum.Preparing anIncome Statement andStatementof Shareholders' Equity (Medium)From thefollowing information fortheyear2009,prepare anincome statement andastate-mentof shareholders' equity, underGAAP rules, fora company withshareholders' equityat thebeginning of2009 of $3,270million. Amounts areinmillions.This statement is effectivelyastatement ofowner's equityfor the account. It showsyour starting balance, adds your earningsfor the year, and subtractsyour dividend (thewithdrawal), to yielda closingbalance.a.Prepare an income statement, balancesheet,and cashflow statement for thisaccountfor 2009.b. Ratherthanwithdrawing $5 fromtheaccount, suppose youleft it in theaccount. Whatwould yourfinancial statements for 2009thenlooklike?c. If, before theendof theyear, youinstructed yourbankto invest theearnings of$5 in amutual fund(andtherewerenowithdrawals), whatwould thefinal financial statementslooklike?ConceptQuestionsC2.1. Changes inshareholders' equityaredetermined by totalearnings minusnet payoutto shareholders, but the change inshareholders' equityis not equal to net income(inthe income statement) minus netpayout toshareholders. Why?C2.2. Dividends arethe onlywayto paycashout toshareholders. Trueor False?C2.3. Explain the difference between net income andnet 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) andshareholdervalueadded.C2.7. Givesome examples in which thereis poor matching of revenues and expenses.C2.8. Price-to-book ratiosare determined byhowaccountants measure bookvalues. Canyou think of accountingreasonsfor whyprice-to-bookratios were high in the1990s? Whatotherfactors mightexplain thehighPIB ratios?C2.9. Why are dividends not anexpense 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 patent rightan appropriate expense in measuring valueaddedin operations?E2.4.Balance, January 1, 2009Earnings at an interest rateof 5%p.aWithdrawalsBalance, December 31, 2009$1005-.)100Show thatat leastoneof these numbers must bewrong because it doesnotobeyaccountingrelations.18,1845,31912,4425045051,385Fiscal 2007$ 672.5947.51,088.1593.6182.7(82.6)1,219.4434.6784.819,0426,21613,6521,1335301,385Fiscal 2008RevenuesCosts and expensesCost ofsalesResearch and developmentMarketing, general, and administrativeCollaboration profit sharingSpecial chargesOther expense-net interest incomeIncome before taxIncome taxNet incomeTotal assetsTotal stockholders' equityTotal revenuesCommon share issuesCommon dividendsCommon stock repurchasesChapter 2 introouclion totheFinoncia! Sratcment; 63ApplicationsFinding Financial Statement Information on the Internet (Easy)TheSecurities andExchange Commission (SEC) maintains theEDGAR database of com-pany filings withthecommission. Explore theSEC'SEDGAR site:htlp:l!www.sec.gov/edgar.shtml.Lookat the"Descriptions of SECForms" pagetofamiliarize yourself withthetypes of fil-ingsthat firms make. Thenclickon"Search for Company Filings" for thefilings of firmsyouareinterested in. FormsIO-K (annual reports) and10-Q (quarterly reports) will beofprimary interest.Accessing the database directly on the SECsite gives youthe full text of each filing.A number of servicesdeliver the material in small,digestible pieces so youdon't haveto scroll through the entirefiling in search of a particular item. These services alsofor-matthefiling in a form that canbedownloaded intoa spreadsheet program. Access thesesitesthrough linksonthebook's Web page.Using Accounting Relations: General Mills. Inc. (Medium)Thefollowing numbers appeared intheannual report of General Mills, Inc., theconsumerfoods manufacturer, for thefiscal yearending May 2008 (inmillions of dollars):Thefirm hasnopreferred stock.Forfiscal 2008, calculatea. Total liabilities at yearend.b. Comprehensive income for theyear.Real WorldConnectionSeeExercises E1.5, E2.9,E3.9,E4.9, E6.8,EIO.9, EI3.5,E14.8, and E15.10 forthemate-rial onGeneral Mills.E2.8,E2,9.E2.10. Using Accounting Relations: Genentech Inc. (Medium)Consider the following excerpts from Genentech's 2004 income statement andcashflowstatement. From the2004income statement (inmillions):$4.4581401,2304503,34868076(200)s 2,3001,750(90)4,3401,3804D090015019,140SalesCommon dividends paidSelling expensesResearch and development costsCost ofgoods soldShare issuesUnrealized gain onsecurities available for saleIncome taxesRevenuesTotal expenses, including taxesOther comprehensive incomeTotal assets, end ofyearTotal liabilities, end ofyearDividends toshareholdersShare issuesShare repurchasesShareholders' equity, beginning ofyearE2.5.E2.6.Alsocalculate comprehensive income andnetpayout. Income taxes arenegative. How canthisbe?Classifying AccountingItems (Easy)Indicate where inthefinancial statements thefollowing appear underGAAP:a. Investment ina certificate of deposit maturing in 120 days.b. Expenses for baddebts.c. Allowances for baddebts.d. Research anddevelopment expenditures.e. Arestructuring charge.f. Alease of anassetforitsentire productive life.g. Unrealized gainonshares held for trading purposes.h. Unrealized gainonshares available forsale.i. Unearned revenue.j. Preferred stockissued.k. Preferred dividends paid.1. Stock option compensation expense.Violationsof the MatchingPrinciple (Easy)Generally accepted accounting principles (GAAP) notionally follow thematching princi-ple. However, there are exceptions. Explain why thefollowing accounting rules, requiredunderGAAP, violate thematching principle.a. Expenditures onresearch anddevelopment intonewdrugs areexpensed intheincomestatement as theyareincurred.b. Advertising andpromotion costsfora newproduct areexpensed as incurred.c. Film production costsareexpensed priortotherelease of films to theaters.E2.7. Using AccountingRelationsto Check Errors (Hard)Achiefexecutive reported thefollowing numbers forfiscal year2009 toanannual meetingof shareholders (inmillions):62 Chapter 2 lmroducdon to{ h ~ FilUlnciaJ Statements64 Chapter 2 lmrooucrioll to( h ~ Financial SratCmc,lt5e. Calculate cashflows from financing activities reported for2004.E2.11. Find the Missing Numbers intheEquity Statement: Cisco Systems, Inc. (Easy)Attheendof its2007 fiscal year, Cisco Systems, Inc., theproducer ofrouters andother hard-ware and software for the telecommunicationsindustry, reported shareholders' equity of$31,931 million. At theendof thefirst nine months of fiscal 2008, thefirmreported $32,304million inequity along with$6,526 million of comprehensive income fortheperiod.a. What wasthenet transactions withshareholders inthefirstninemonths of2008?b. Cisco paidno dividends andshareissues amounted to $2,869 million. Whatwastheamount of shares repurchased during thefirstnine months of2008?$780million$605million$760million$920 million$790millionFirst quarter, 2001Second quarter,2001Third quarter,2001Fourth quarter, 2001First quarter, 2002Chapter2 IntrOOllcriolllQ (he Financial SWtcmCIlt5 65Real World ConnectionExercise 14.12 andMinicases 5.l, 6.1,and14.2 dealwith Cisco Systems.Find the Missing Numbers in Financial Statements: General MotorsCorporation (Medium)General Motors endedits 2007 year with shareholders' equityof -$37,094million atDecember 31 (yes, negativeequity'). Six months later, at June 30, 2008, it reported-$56,990 million inequity afterpaying a dividend of$283 million toshareholders. Therewere noothertransactions withshareholders.a. What wascomprehensive income forthesixmonths?b. Theincome statement reported a lossof S18,722million forthesixmonths. What was"othercomprehensive income"?c.Total expense andotherlosses intheincome statement, including taxes, were $60,895million. What wasrevenue for thesixmonths?d. Thefirm reported S148,883 million of total assetsat theendof 2007 andS136,046 atJune30,2008. Whatwere total liabilities at thesetwodates?e. How cana finnhave negative equity?Real World ConnectionExercises 4.10and5.16alsocover General Motors.Mismatching at WoridCom (Hard)DUring thefour fiscal quarters of2001 andthefirstquarter of2002,WorldCom incorrectlycapitalizedaccesschargesto local networks as assets (as explainedin Box 2.3). Theamount of costs capitalized were as follows:Suppose WoridComamortized these capitalized costs straight-line overfive years(20quarters). Calculate theamount of theoverstatement of income before tax foreachofthefive quarters.Calculating Stock Returns: Nlke, Inc. (Easy)Theshares of Nike, Inc., tradedat $55pershareat thebeginning of fiscal year2008 andclosed at $67pershareat theendof theyear. Nikepaida dividend of 87.5centspershareduring theyear. What was thereturn toholding Nike's shares during 2008?Real World ConnectionNikeis covered extensively inthisbook, bothintextmaterial andexercises. Seeexercises6.7,8.13, 13.17, 13.18, 15.11, 15.13, 18.5, and19.4 andminicase 2.1inthischapter.E2.13.E2,12,E2,14.353,221(73,585)(14,927)34,722329,470(13,577)1,83912,3405,115784,8162003$1,398.4372.2(362,740)(120,703)(75,695)335,542$1,195,8382004$451.6270.1$3,422.89,403.41,377.96,782.2Current assetsTotal assetsLong-term liabilitiesStockholders' equityFrom the2004 cashflow statement (inthousands);d. Calculate thelong-term assets andshort-term liabilities that were reported.Thefollowing were alsoreported inthe2004statements (in millions):Cash flows fromoperating activitiesNet incomeAdjustments to reconcile netincome to netcash provided byoperating activities:Depreciation and amortizationDeferred income taxesDeferred revenuelitigation-related and other long-term liabilitiesTax benefit from employee stock optionsGain onsales of securities available forsale and otherLoss onsales of securities available for saleWrite-down of securities available for saleLoss onfixedasset dispositionsChanges inassets and liabilities:Receivables and other current assetsInventoriesInvestments intrading securitiesAccounts payable and other current liabilitiesNet cash providedby operatingactivitiesCash used ininvesting activities (inthecash flowstatement)Cash and cash equivalents (inthebalance sheet)66 Chapter 2 InrrodtlC!ion to! h ~ Financiol Sr.o.temcn1SChapter 2 /nrrod"criollcofhe Finonciol Swtements 67NIKE,INC.Consolidated Statementsof IncomeYearEnded May31$14.954.98,367.96,587.04,477.836.8~2,141.6~$ 1392.0~$ 2.64s 0.59(Con/iT/ued)$16.325.99,165.47,160.55,028.767.20.92,199.9~$1,491.5~$ 2.93~2,502.9619.52008 2007 2006(inmillions, except per-share data)$18,627.010,239.68,387.45,953.777.1(7.91$1883.4$ 3.80$ 3.74s 0.875RevenuesCostofsalesGross marginSeiling andadministrative expenseInterest income, net(Notes 1, 6, and7)Other (expense) income, net(Notes 15and 16)Income beforeincometaxesIncome taxes (Note 8)Net incomeBasic earnings percommon share (Notes 1and11)Diluted earnings percommon share (Notes 1and11)Dividends declared percommon shareF. Explain thedifference between basicearnings per shareanddiluted earnings pershare.G.Explain why someinventory costsare in cost of goodssoldandsomeare in inventoryonthebalance sheet.H. Nike spent $2,308 million on advertising andpromotion during 2008. Where is this costincluded in thefinancial statements? Does thistreatment satisfy thematching principle?1. Accounts receivablefor 2008 of $2,795millionis net of $78.4 million(reportedinfootnotes). Howis thiscalculation made?1. Whyaredeferred income taxesbothan assetand a liability?K. Whatis "goodwill" and howis it accounted for?Whydid it change in 2008but not in20077Whyarecommitments andcontingencies listedon thebalance sheet, yet the amount iszero?Explain whythereis a difference between net income andcashprovided byoperations.WhatitemsinNike'sbalancesheetwould yousaywere closeto fairmarket value?Nike'sshares tradedat $62afterthe 2008 report wasfiled. Calculate the PIE ratioandthe PIB ratioat this price. Howdo theseratios compare withhistorical PIE and PIBratios inFigures 2.2 and2.3?Real WorldConnectionFOllow Nikethrough Chapters 5-15 andontheBYOAP feature onthebook's Web site. SeealsoExercises 2.14, 6.7, 8.13, 13.17, 13.18, 15.11, 15.13, 18.5,and 19.4.EXHIBIT 2.3FinancialStatementsfor Nike,Inc. forYearEndingMay3112008L.M.;}N.'t o.iM2.1Reviewing the Financial Statementsof Nike, Inc.Nike, Inc., is a leading manufacturer andmarketer ofsportandfashion footwear. Incorporatedin 1968 andheadquartered inBeaverton, Oregon, itsbrand name hasbecome almost univer-sal, delivering salesof over$18.5 billion by2008 andmaking it the largest sellerof athleticfootwear andapparel intheworld, withoperations in 180countries. Nike's top-selling productcategories arerunning, basketball, andcross-training shoes, butitalsomarkets shoesdesignedfortennis, golf,soccer, baseball, football, bicycling, volleyball, wrestling, cheerleading, skate-boarding, hiking, andoutdoor activity. Many of itsproducts aresoldas leisurewear.Inthe 1990sNike wasa hot stock,trading at a PIE ratioof35 anda PIB ratioof5.1 inmid-1999. By2008,its PIE ratiohadfallen to 16andits PIB ratioto3.8, but itsstockpriceactually increased duringthebursting of thebubble, from$20in 2000to$40in 2004.We will spend considerable time in the bookanalyzing and valuing Nike. The BuildYour OwnAnalysisProduct (BYOAP) on the Web site tracks Nikefrom1996to 2006.The 2008 financial statements (and comparative 2007 and 2006statements)that followintroduce youtothefirm.You alsocanfindthesefinancial statements inNike'slO-Kreportfor 2008on the SEC'sEDGAR Web site, whichis accessible through theaddress giveninExercise 2.8, or through linkson the book's Web site. Browse theentire 10-Kas anexam-ple of what a typical lO-K looks like. Lookat the footnotes referred to in the statementsbelow. Readthemanagement's discussion of the business and get a senseof the businessmodel. Lookalsoat thefirm's Web siteat www.nike.com.Examine thefinancial statements inExhibit 2.3andusethemtotestyourbasicknowledgeof accounting. The questions thatfollow willhelpyoufocus On thepertinent features.A. Usingthe numbers in the financial statements, showthatthe following accounting rela-tions holdinNike's2008statements:Shareholders' equity'" Assets -LiabilitiesNet income> Revenue -ExpensesCashfromoperations +Cashfrominvestment +Cashfromfinancing +Effectof exchange rate> Change incashandcashequivalentsB. What are the componentsof other comprehensiveincomefor 2008? Showthat thefollowing accounting relation holds:Comprehensive income> Net income +Othercomprehensive incomeC. Calculate the net payout to shareholders in 2008fromthe Statement of Shareholders'Equity.D. Explain howrevenue is recognized.E. Calculate the following for 2008: gross margin, effective tax rate, ebit, ebitda, and thesalesgrowth rate.Minicases 6.3 30.5 255.3177.7 100.8 43.41,287.6 1,040.3 952.21,761.9 1,303.4 1,286.988.0 109.0 85.53,321.5 2,584.0 2,623.3441.1 409.9 410.7854.5 668.7 550.10.3 0.3 0.3Chapter2 Jncroduction 10 theFinancial S I ( l ( ~ I l l C l l l , 69EXHIBIT 2.3 ConsolidatedStatements of CashFlows(Continued) YearEndedMay312008 2007 2006(in millions)Cashprovided(used) by operations:NetincomeS1,883.4 S1,491.5 s1,392.0Income charges not affecting cash:Depreciation303.6 269.7 282.0Deferred income taxes(300.6) 34.1 (26.0)Stock-based compensation (Notes 1and 10) 141.0 147.7 11.8Gain on divestitures (Note 15)(60.6)Amortization and other17.9 05 (2.9)Income taxbenefit from exercise of stock options54.2Changes incertain working capital componentsandotherassetsand liabilities excluding theimpact of acquisition anddivestitures:Increase inaccounts receivable(118.3) (39.6) (85.1)Increase ininventories(249.8) (495) (200.3)Increase inprepaid expenses andothercurrent assets(11.2) (60.8) (37.2)Increase inaccounts peyabe, accrued liabilitiesandincome taxespayable330.9 85.1~Cashprovidedby operations1,936.3 1,878.7 1,667.9Cashprovided(used) byinvestingactivities:Purchases of short-term investments(1,865.6) (2,133.8) (2,619.7)Maturit;'es of short-term investments2,246.0 2,516.2 1,709.8Additions to property, plant, andequipment(449.2) (313.5) (333.7)Disposals of property, plant, andequipment1.9 28.3 1.6Increase inotherassets, net of otherliabilities(21.8) (43) (34.5)Acquisition of subsidiary, net of cashacquired(Note 15)(571.1)Proceeds from divestitures (Note 15)246.0Cash(used) providedby investingactivities~ )~(1,276.5)Cashprovided(used) byfinancingactivities:Proceeds from issuance of long-term debt41.8Reductions inlong-term debt including currentportion(35.2) (255.7) (6.0)Increase (decrease) innotespayable63.7 52.6 (18.2)Proceeds from exercise of stock options andotherstock issuances343.3 322.9 225.3Excess taxbenefits from share-based paymentarrangements63.0 55.8Repurchase of common stock(1,248.0) (985.2) (761.1)Dividends-EXHIBIT 2.3(Continued)EXHIBIT 2.3

(Concluded) 0Consolidated Statements of Shareholders' Equity(inmillions, except per share data)AccumulatedCommonStockCapital in OtherClass A ClassBExcess of Comprehensive RetainedShares Amount Shares Amount Stated Value Income (loss) Earnings Total..Balance at May 31, 2007 117.6 $0.1 384.1 $2,7 $1,960.0 $177.4 $4,885.2 $7,025.4-----Stockoptionsexercised 9.1 372.2 372.2Conversion toClass 8 common stock (20.8) 20,8Repurchaseof Class B commonstock (20.6) (12.3) (1,235.7) (1,248.0)Dividends oncommonstock($0.875per share) (432.8) (432.8)Issuanceofshares toemployees 1.0 39.2 39.2Stock-basedcompensation(Notes1 and10): 141.0 141.0Forfeitureof shares fromemployees (0.1) (2.3) (1.1) (3.4)Comprehensive income(Note 13):Net income 1,883.4 1,883.4Other comprehensiveincome:Foreigncurrency translationandother (net of taxexpenseof $101.6) 211.9 211.9Realizedforeign currencytranslationgainduetodivestiture (Note 15) (46.3) (46.3)Net loss oncash flow hedges(netof taxbenefit of $67.7) (175.8) (175.8)Net loss onnet investment hedges(net of taxbenefit of $25.1) (43.5) (43.5)Reclassificationtonet incomeofpreviously deferred losses relatedtohedge derivatives (net of taxbenefit of $49.6) ..J...27.7-------.!lUComprehensive income 74.0 1,883.4 1,957.4Adoptionof FIN 48(Notes1 and8) (15.6) (15.6)Adoptionof EITF06-2 Sabbaticals(netof taxbenefit of $6.2) (Note 1) (10.1) (10.1)------ ----- --'-Balance at May31, 2008 96.81Q:.!394.3 $2.7. $2.497.8 $251.4 $$,073.3 E.825.3Tho notosill thesofinonc;al stalOmenlS'ofer 10 (oolnot .. ;n the IOK 'OpOrl. . , . '. " :,""', 'W'EI" "''''Ui\'j;,'>t?''''stt''''tUi's"j "'j"Ot:1 ll'FJ",[i1"$U'"5ff8@?i1ittWti\rj'iN'W'Wt '1;)'fl.IIi ..,....1.l.K ... -;."" khiiii ""-".'" 7",:""'" ...,. , ,",." rlii' ' . " . .... ..... :," .. " \'\'}f,!Chapter 3 How Finaru:ial StatementS AreUsed in Va]:um"on 75After reading this chapter you should beable to:Carry out a multiple comparison analysis.Developasimple ormultiplescreen using astockscreener;Calculate anarray. of price multiples for a firm.Calculate unlevered price multiples.Calculate trailing andforwardPIE ratios.Calculate a dividend-adjustedPIE ratio.Apply asset-based valuation techniques.Calculate thebreakup value of a firm.Value a bond.Value a project.Calculate thevalue added fromproject selection.Showthat abond purchasedat apriceto yield itsrequired return generates novalue.Calculate theloss toexisting shareholders from issuingshares at less than market value.Generate "homemade dividends."Simplevaluations usea limitedamount of information. Thechapterbeginswithmulti-ple analysis that uses just a fewnumbers in the financial statements-sales, earnings, orbook values, for example-and appliespricing multiples to thesenumbers. Asset-basedvaluation techniquesare then introduced. These techniquesattempt to value equities bysumming themarket valueofthe firms'assets, netofliabilities.We willseethatasset-basedvaluation, though seemingly simple, is a doubtful exercise for mostfirms.Simplemethodsrun the risk of ignoring relevantinformation. A full-fledgedfunda-mental analysis identifies all the relevant information andextracts the implications of thatinformation for valuing the finn. The chapterconcludes witha broad outlineof funda-mental analysistechnologiesthat accomplishthis. It leads you throughthe five stepsinvolved and shows howfinancial statements arc incorporated in the process. It stressesthe importance of adopting a valuation modelthat capturesvaluecreatedin the firmandshowshowthat valuation modelprovides the architecture for fundamental analysis. Thechapter distinguishesvaluationmodelsfor terminal investments fromthose for going-concerninvestments (likebusiness firms), andit showshowvaluing goingconcernsraisesparticularproblems.After reading this chapter you should understand:What a valuation technology looks like.What a valuationmodel isandhow it differs from anasset pricing model.How a valuationmodel provides the architecture forfundamental analysis.Thepractical stepsinvolvedin fundamental analysis.How the financial statements are involvedin funda-mental analysis.How oneconverts a forecast toa valuation.Thedifferencebetweenvaluingterminal investmentsandgoingconcerninvestments{likebusinessfirms}.What business activities generate value.The dividend irrelevance concept.Whyfinancing transactions do not generate value,except inparticular circumstances.Why thefocus ofvalue creationis ontheinvesting andoperating activities ofa firm.How the method of comparables works (ordoes notwork).How asset-based valuation works(ordoes not work).Howmultiplescreeningstrategies work (or do notwork).How fundamental analysis differs from screening.What isinvolved incontrarian investing.Howis avaluationmodelconstructed?Howisfundamentalanalysiscarriedout?Howdoesfundamentalanalysisutilizethefinancialstatements?--.Howarefundamentalscreens usedininvesting?-=: Don,Inc., lQ-Kfiling, 2008.EXHIBIT 4.3Operating andInvesting Portionofthe 2008 CashFlowStatement forDell,Inc.Typically, longforecast horizons arerequired to recognizecashinflowsfrom investments, particularly wheninvestments aregrowing.Continu-ingvalues have a highweightinthevaluation.Analystsforecast eamings, not freecashflow; adjustingearningsfore-caststo freecashflow forecasts re-quires further forecastoq ofaccruals.Forecast horizons:Notaligned withwhatpeopleforecast:WHEN iTWORKSBESTWhen the investment patternproduces positive constantfreecash flowor free cash flowgrowingat aconstant rate;a "cashcow"business.DCF applies whenequityinvestments are terminal or theinvestor needs to "cashout," as inleverage buyout situationsand private equity investments: wherethe ability to generatecashislrroortant.Free cash flowdoes not measure valueadded intheshortrun;value gained isnotmatched withvalue given up.Free cash flowfails torecognize valuegenerated that does notinvolve cash flows.Investment istreated asa loss ofvalue.Freecashflow is partly a liquidationcon-cept; firms increase free cashflowbycut-ting back oninvestments.Suspectconcept:ADVANTAGESEasy concept: Cashflows are "real"and easyto thinkabout: they arenotaffectedby accountingrules.Familiarity: Cash flowvaluationis astraightforwardapplication of familiar present valuetechniques.124126'lnlo=1payment'3 ~ givenassupplcmcmol OOlJ 10tn. ;(:Il."",nlorcoshflows, but interest receiplS lISoolly ;"c nol.Int.'o 203Theexhibit alsoforecasts abnormal earnings growth (AEO), in orderto apply the ab-normal earnings growth model. Abnormal earnings growth eachyearis cum-dividend earn-ingslessnormal earnings. Calculations aredescribed at thebottomof theexhibit usingboththeequation 6.3and6.3amethods. You see thatAEG is growing at 3 percent afterYear 1.So,theAEGforYear 2 canbe capitalized withthisgrowth rate:E I [ 6 0.071] .Vo:::: - 12.3 + :::: 133.71 million0.10 1.10-1.03(Allow for rounding errors.) Thisis a simple valuation model where growth at a constantratebegins after the forward year. The forward PIE ratiois 133.71/12.36"" 10.82, higherthan the normal PIE of 10. Youwill notice at the bottom of the exhibit that the cum-dividend earnings growth rate is 10.57 percent, higherthanthe required returnof 10 per-cent,andaccordingly thePIE ratiois greaterthan thenormal PIE. You alsowillnoticethatthecum-dividend earnings growth rateis considerably higher thanthe 3 percent ratefore-castedfor (ex-dividend) eamings.' Andyou will notice that the REmodel andtheAEOmodel give us thesamevaluation.Anchoring Valuationon Current EarningsThe valuation in this example pricesforward earnings so, strictly speaking, it anchors onforecasted earnings ratherthanthecurrentearnings in thefinancial statements. Thevaluecanalsobe calculated byanchoring oncurrent(trailing) earnings: Capitalize currentearn-ings, and then add the valueof forecasted AEG from Year1onward. That is, shift theapplication of themodel oneperiod backin time.So,for theexample inExhibit 6.2,E UO[ 0.069 ]Vo +do =133.71+ 9.09 =- 12.00+ =142.80million0.10 UO- 1.03Thevalue obtained is thecum-dividend value(price plusdividend) appropriate forvaluingcurrent earnings. Thetrailing PIE is$142.80/$12.00 "" 11.90, higherthanthe normal trail-ingPIE of II(for a required returnof 10percent). The$12.00 hereis earnings forYear 0andthe$0.069 is forecastedAEO forYear I, whichis expected togrowat a 3percent rate.Thecapitalization rateis 1.10/0.10, the normaltrailing PIE, ratherthan 1/0.10, thenormalforward PIE. Theformal model forthecalculation isE PE [ AEG, AEG, AEG, ]Vo+do=,,--Earn,+--+--+--+...PE-l PE p} piClearly, withnoABO afterthecurrent year, thetrailing PIE is normaLAnchoring valuation on current earningsanchorson actual earnings in the financialstatements ratherthana forecast of earnings. However, thereis a goodreason toapply themodel to forward earnings ratherthancurrentearnings. As wewilJsee when we come toanalyze financial statements, currentearnings oftencontain nonsustainable components-unusual events and one-timecharges, for example-that do not bear on the future. Byfocusing on forward earnings and using current earnings as a base for the forecast, we2Strictly. cum-dividend earnings foranyyearaheadareearnings forthat year plus earnings from alldividends paid andreinvested fromYear 1upto that year. So, forYear 3, cum-dividend earnings arethe $13.11EP5 forthat year, plus theYear Zdividend invested foroneyear, plus the earnings from thereinvested Year 1dividend. However, asdividends earnat the required return andearnings at therequired return aresubtracted inthe AEG calculation, it makes nodifference to thevaluation-andiscertainly simpler-ifwe justinclude the earnings on the prior year's dividends incum-dividend earnings.204 Part One Financial SEa!emems and ValuationAnchor on What You Know and Avoid Speculation 6.2Converting Analysts'Forecasts toa ValuationIn Chapter 5 we converted analysts' forecasts for Nike toa valuation usingresidual earn-ings methods. Herewedo the samefor Google, Inc., the supplier of Web-based software,A Case 2 valuationis demonstrated usingDell, lnc., with a required rate of return ofII percent. TheEPSandDPSup to2005are thesameas thoseinChapter 5 where weval-uedthe firmusingresidual earnings methods with a continuing valuebasedon a forecastthat residual earnings after2005 would growat 6.5percent. The EPSfor2006here is thatwhich would result from this growth rate. Dellpays nodividends, so cum-dividend earn-ingsarethe sameas earnings.Case2 differs fromCase1because AEGis expected tocontinue togrowafterthefore-cast horizon, so the valuation adds a continuing valuethat incorporates thisgrowth. Withthe forecasted AEGfor 2006expected togrowat a rateof 6.5percent after 2006, thecon-tinuing valueforDellat theendof2005 is0.873pershare.Adding thepresent value of thiscontinuing valueat theend of 200I to thetotalpresent valueof AEG upto theendof2005($-0.062) andthe forward earnings for 2001(50.84) yields $1354 of earnings to becapi-talized, resulting in a valueofS123 I per share.Thisis thesamevaluecalculated withresidual earnings methods inChapter 5.Andit isalso the sameas the valueusingforecasted changes in residual earnings in equation 6.1.Indeed, youcansee that theAEGfor Dell herealways equals thechange in residual earn-ingsgiven above in equation 6.1.As bothareanchored on forward earnings, thetwo valu-ationsmust bethesame.Go to Box 6.3for a formal demonstration that t.RE:::: AEG.effectively focuson the sustainable portionof currentearnings that cangrow. Indeed, thefinancial statement analysis of PartTwo of the bookaims to identifysustainable earningsthat area soundanchorfor forecasting forward earnings.The Webpage for this chapterprovides a spreadsheet to help you develop abnormalearnings growth pro formas.APPLYING THE MODEL TOEQUITIESTheexample inExhibit 6.2issimilartoour prototype savings account example, exceptthatthis firm has someabnormal earnings growthwhereas the savings account had none.Thefirmis simplebecause AEGis forecasted to growat a constantrateimmediately after thefirst yearahead. Model6.2requires infinite forecasting horizons, so, to valueequities, weneedcontinuing values to truncate the forecast horizon. Inthesimpleexample, this occursjust oneyearahead.Thereare twotypesof continuing valuecalculations. Case I applieswhenoneexpectssubsequent abnormal earnings growth at the forecast horizon to be zero. Case 2 applieswhenoneexpects moreabnormal earnings growth afterthe forecast horizon.CaseI is illustrated usingGeneral Electric Company witha required returnofl0 percent.TheEPSandDPSnumbers inCase1areGE'sactual numbers for2000-2004, thesamenum-hersusedtovalueGEusingresidual earnings methods inthelastchapter. Asin thelastchap-ter,wetreatthenumbers asforecasts andvalueGE'sshares at theendof1999.Recall thatweattempted tovalueGEusingdiscounted cashflow techniques inChapter 4 but ranintodiffi-culties. However, wefound wecouldvalueit withresidual earnings methods. TheAEGval-uation hereproduces thesame$13.07 persharevalueastheREvaluation inChapter 5.TheCase 1valuation is basedona forecast thatAEGwill bezeroafter2004.Whiletheanalyst forecasts positive AEGfor2004, henotesthattheaverage AEGisclosetozeroover2001-2004andsoforecasts zeroAEGsubsequently. ZeroAEGimplies, of course, thatcum-dividend earnings areexpected togrowafter2004at therequired rateof return.justlikethesavings account. The totalAEGover2001-2004, discounted to the endof 2000, is SO.Ql7pershare.Addedtoforward earnings for 2000of Sl.29 yields $1.307, whichwhen capital-izedat the 10percentrate,yields thevaluation of$13.07pershare.Nowgo toBox6.2.CASE1ForecastYearGeneral ElectricC,.(GE)1999 2000 2001 2002 2003 2004Inthis case, abnormalDP5 0.57 0.66 0.73 0.77 0.82earnings growth isEP5 1.29 1.38 1.42 1.50 1.60expected tobezeroDPS reinvested (0.10x DPSr_1) 0.057 0.066 0.073 0.077after 2004. RequiredCum-dividend earningsrate ofreturn is(EPS +DPS reinvested) 1.437 1.486 1.573 1.67710percent.Normal earnings (1.10 x EPSr_1) 1.419 1.518 1.562 1.650Abnormal earnings growth (AEG) 0.018 -0.032 0.011 0.027Discount rate(1.l0t) 1.100 1.210 1.331 1.464Present value of AEG 0.016 -0.026 0.008 0.018Total PVofAEG 0.017Total earnings to becapitalized 1.307Capitalization rate 0.10Value pershare (1.307) 13.07 ..0.10Noto' Allowro, rounding error.!.,!'.Fundamentalistprinciples (inChapter 1)emphasize that weshould separate what we know from speculation andanchoronwhat weknow. This isparticularly important when valuinggrowth, for growth isspeculative.!n Chapter 4, we pointed out that discountedcashflow(DCF) analysis often putsa lotofthevalue into thecontinuingvalue.Thisis problematic forthecontinuing value isthemostuncertain part of a valuation, dealing asit does with thelongterm. For General Electric(GE) inChapter 4, more than 100percent ofthevaluation isinthecontinuing value. We wouldmuch prefer a valuation method where thevalue comes fromthepresent ("what weknow") or thenear-term future (whatweknow with some confidence): We suggested thatearningsmight supply some level of comfort.Indeed, for General Electric inCase 1,thecontinuing valueat the forecast horizon, 2004, iszero, comparedwithmorethan100percent inthe OCF valuation. We valuedGEwithfive years of forecasts. Wemay have some uncertainty aboutthese forecasts-and would prefer a valuation based ononeor twoyears offorecasted earnings-but probably feelmorecomfortable with this valuation thanone that speculatesabout a large continuing value.The difference betweenDCF valuation andthe valuationhereis, of course, the accounting: Cashaccountingversusaccrual accounting. Accrual accounting brings the futureforward intime, leaving less valuein a continuing value.Theresidualearnings valuation for GE inChapter 5 alsoused accrual accounting, buttheCase 2 valuation there hasa nonzero continuing value(in equation 5.5). Is it then thecasethat AEGvaluationgivesus a moresecurevaluationthan an RE valuation? It does look like it, but infact no.Theresidualearnings valuationgives the same valuation as theAEGvaluationfor the sameforecast horizon. Forecastingthat RE will bea constant at theforecast horizon ina Case 2residual earnings valuationis the same as forecasting thatAEG =0, for it isalways thecase that AEG =change inRE.By forecasting that REwill be positive but constant. wearejustforecasting that there will bevalue missing from thebal-ance sheet. But therewill benoadded value for qrowth. SeeBox 6.3.If expectedAEG=0, then the PIE is normal, asdemon-strated with thesavings account. Soforecasting that GEwillhave zero AEG in2005 isequivalent toforecasting thatitsPIEwill benormal. (By 2008,GE'sPIE was approximately normal.See Exercise E6.1 0.)Proceed nowto thevaluation ofDell, Inc. You will seethatthereis now a continuing value containing a qrowth specula-tion. Inthis case, wedonot escape some speculation aboutthelong run. But weseparate thatspeculation (in thecontin-uing value) from what wearemore confident about (in near-term forecasts).205206 Part One Fi'nancial Statemel1ts and Valll(ldonCASE2Dell, Inc.Inthiscase, abnormalearnings areexpectedtogrow at a 6.5per-ccnt rateafter 2005.Required rateofreturnis 11 percent.2000DPSEPSDPS reinvested (0.11 x DPSH)Cum-dividend earningsNormal earnings (1.11xEPSt_1)Abnormal earnings growthDiscount rate (1.11 'lPresent value of AEGTotal PV of AEGContinuing value (CV)PVof CVTotal earnings to becapitalizedCapitalization rate(1.354)Value pershare --0.11The continuing value calculation:CV 0.0393 0.8731.11-1.065Present value ofCV =0.873= 0.5761.5181Note:Allow forrounding emns.20010.00.840.84-0.0620.5761.3540.11..Forecast Year TABLE 6.12002 2004 2005 2006ConvertingAnalysts'2003Forecasts toa0.0 0.0 0.0 0.0 0.0 Valuation: Google,0.48 0.82 1.03 1.18 1.35 10c0.00 0.00 0.00 0.00 0.00 Analysts forecast EPS0.48 0.82 1.03 1.18 1.349 two years ahead0.932 0.533 0.910 1.143 1.310 (S19.61 for2008 and-0.452 0.287 0.120 0.037 0.039 $24.01 for2009) and1.110 1.232 1.368 1.518 also give a five-year-0.408 0.233 0.088 0.025 EPS growth rate of28percent. Forecasts0.873 for 2010-2012 applythis consensus growthrate tothe2009estimate. Google paysnodividends. Requiredrate ofreturn is12percent, reflectingGoogle's high beta.Chapter 6 AccrudAccounting and Valuotion: Pricing Earnings 2072007A200aE 2009E 2010E 2011E 2012EDPSJ1!L0.0 0.0 0.0 0.0EPS 19.61 24.01 30.73 39.34 50.35DPS reinvested (0.12 x DPSt_l) 0.0 0.0 0.0 0.0Cum-dividend earnings 24.01 30.73 39.34 50.35Normal earnings (1.12 xEPSt_l)21.96 26.89 34.42 44.06Abnormal earnings growth (AEG) 2.05 3.84 4.92 6.29Discount rate (1.12f)1.12 1.254 1.405 1.574Present value of AEG1.830 3.061 3.502 3.996Total PV of AEG 12.39Continuing value (CV)81.77PVofCV 51.95Total earnings to becapitalized 83.95Capitalization rate 0.12( 8395)$699.58..J Value pershare 0.12The continuing value calculation:CV" 6.29x 1.04"81.771.12-1.0481.77Present value of CV=1.574 =51.95Note:Allow forroundingorrors.particularly Web search, whoserevenues come largely fromonlineadvertising. In Table6.1, analysts'consensus EPSforecasts for 2008and2009areentered, alongwithforecastsfor 2010-2012fromapplying theirintermediate-term (five-year) consensus growth ratetothe 2009estimate.The calculationsinthe table showthat analystsare forecastingabnormal earningsgrowthafterthe forward year,2008.Analysts do notprovide forecasts morethanfiveyearsahead, so thecontinuing valuehere is basedon a 4percentlong-termgrowthrate,thetyp-ical GDPgrowth rate. Bydoingso, weare refusing to speculate; we arerelying on a his-toricalaverage ("whatweknow"). Thecalculated valueis $699.58 pershare.Google tradedat $520at the time, so thisvalueis wellinexcessof themarket's valuation. Whatcouldbe'Wrong? Analysts' five-year growthratesaretypically optimistic, moreso(probably) forthishot stock.Alternatively, the marketpriceis cheap. Or, couldit be the case that the long-termgrowthrateof 4percenthereis toooptimistic? We will returntotheseissueswhenwereverse engineer themarketpriceat theendof the chapter.FEATURES OF THE ABNORMAL EARNINGS GROWTH MODELBox6.4liststhe advantages anddisadvantages of theabnormal earnings growthmodel. Compare it to similarsummaries for the dividend discount model (in Chapter 4),the discountedcash flowmodel (in Chapter4),and the residual earningsmodel (inChapter5).We haveemphasized that AEGvaluation, likethe residual earnings valuation, protectsus frompaying toomuch for earnings growth. Inthis sectionwewill discuss someotherfeatures of themodel.Buy EarningsTheabnormal earnings growth modeladopts theperspective of "buying earnings." It em-bodiesthe ideathat thevalueof a fumis basedon whatit canearn. As earnings representvalue to be addedfromsellingproducts and services in markets, the modelanticipatesthe valueto be addedfromtrading with customers, after matching revenuesfromthosecustomers withthevalues given up, in expenses, togenerate therevenue.TheAEGmodel embraces the language of the analyst community. PIEratiosaremoreoftenreferredto thanPro ratios. Analysts talkofearnings andearning growth, not residualearnings andresidual earnings growth. So, converting ananalyst's forecast toa valuation ismoredirect with this model thanwiththe residual earnings model. (Thelanguage of the(Wall) street does not recognizehowdividends affect growth, however; analysts talk ofex-dividend earnings growth rates, not cum-dividend rates.)Abnormal Earnings Growth Valuationand Residual Earnings ValuationOnthe otherhand,theAEGmodel does not giveas muchinsightintothe valuecreationas the residual earnings model. Firms investin assetsand addvaluebyemploying theseassets in operations. The residual earnings(RE) mode! explicitly recognizes the invest-ment in assets, then recognizes that valueis addedonlyif that return is greater that therequired return.The residual earningsmodel is a better lens on the business of generat-ing value, the cycle of investment and return on investment. Accordingly, we have notproposed theAEGmodel as a modelforstrategy analysis(as wedidwiththe REmodel),for strategy analysis involves investment. The central questionin strategyanalysisiswhether the investmentwill add value. Whenwe come to analysisin Part Twoof thebook, wewill focus on the REmodel, for it provides more insightintovaluegenerationwithin a business.AccountingMethods andValuationThe residual earnings model accommodates different accounting principles. As wesawinChapter 5, thisis because bookvalues andearnings work together. Firms may create higherfutureearnings by the accountingthey choose, but to do so theymust writedown bookAbnormal Earnings Growth Is Not Affected by Dividends,ShareIssues, or ShareRepurchasesWe sawin Chapter 5 that residual earnings valuation is not sensitive toexpected dividendpayout or shareissuesand sharerepurchases. This is also the case withthe AEGmodel.With respect to dividends, you canprove this to yourselfusing the simpleexample inExhibit 6.2. Rather thanpaying a dividend, reinvest thedividends inthe firm at the 10per-centrate. Subsequent earnings within thefirmwill increase bytheamount ofthe reinvesteddividends. Cum-dividend earnings-the amount of earnings earnedin the firmplus thatearnedby reinvesting the dividends outsidethe firm-willbe exactly the sameas if theshareholder reinvested thedividends ina personal account (asintheexhibit). AEG will notchange, norwill thevaluation. (You alsosawthis with thesavings account)Thissimulatesthe earnings for an investor whoreceives the dividend but usesthe cashto buythestock,whichis priced to yielda 10percent required return. He effectively undoes the dividend,withnoeffect on value. Thesamelogic appliesif thepayouts in Exhibit 6.2are from stockrepurchases ratherthandividends.Requires anunderstanding of how accrual accounting works.Requires an appreciationof the conceptof cum-dividendearnings and abnormal earningsgrowth.As thevaluederives completely fromforecasts that arecapitalized at the requiredreturn. thevaluationis sensitive to the estimate used for the requiredreturn. Residual earnings valuationsderive partly from book value thatdoes notinvolve a required return.Theresidualearningsmodel provides better insight into the analysis of value creation andthedrivers of growth (in Part Two ofthebook).Does not give an insightinto the drivers of earningsgrowth. particularly balance sheetitems;therefore, it is notsuited tostrategy analysis.Relies onearnings numbers thatcart besuspect. Should beimplemented along with anearningsquality analysis. (Chapter 17).Forecasthorizons aretypically shorter thanthosefor DCFanalysis andmore value is typicallyrecoqoized intheimmediate future. There isless reliance oncontinuing values.Protects frompaying toomuch for growth.Investors think interms offuture earnings andearnings growth; investors buy earnings. Focusesdirectly onthemost common mUltiple used, the PIE ratio.Embeds theproperties of accrual accounting bywhichrevenues arematched with expenses tomeasure value added from selling products.Can beused under a variety ofaccounting principles (Chapter 16).Analysts forecast earnings andearnings growth.Application tostrategy:Protection:Uses accrual accounting:Use inanalysis:Sensitive totherequiredreturn estimate:Versatility:Aligned with whatpeople forecast:Forecast horizon:Suspect accounting:ADVANTAGESEasy tounderstand:DISADVANTAGESAccounting complexity:Concept complexity:You can also seetheequivalence bycomparing the AEG forDell intheCase 2valuation with thechanges inRE intheDellvaluation at thefront of this chapter.So, forecastingthat therewill be noabnormal earningsgrowth isthesame asforecasting that residual earnings willnot change.Or,asabnormal earnings growth of zero meansthat(cum-dividend) earnings aregrowing at therequired rateof return, forecastingthis normalgrowthrate isthesame asforecasting that residual earnings will not change. Corre-spondingly, forecasting cum-dividend earnings growth abovenormal isthesame asforecasting growth inresidual earnings.Accordingly, oneset of forecasts gives usboth valuations, asthe Case2 valuationfor Dell and the equivalentvaluationbasedon changesin residual earningsat the front of thischapter demonstrate.The rearrangement oftheinputs leads to thedifferent an-chors anddifferent definitions ofadding value totheanchors.Yet the underlyingconcepts are similar. AEGvaluationen-forces the point that a firm cannot addvalue fromgrowingearningsunless it growsearnings at a rategreater than therequired rate of return. Only then does itincrease itsPIE ratio.But thatisthesame assaying thatthefirm must grow residualearnings to increase itsPIBratio. Thatis. added value comesfrominvestingto earnareturngreaterthanthe requiredreturn, and that addedvaluehas its manifestationin bothgrowth inresidual earnings andgrowth incum-dividend earn-ings over a normal growth rate.In onesense, theAEG valuation ismore convenient for onedoes not have to worry about book values. However, the REmodel gives usmore insight into thevalue creation (that pro-duces growth) sois more useful when wecome toanalysis inPart Two ofthebook.2 3 4Residual earnings 2.360 2.431 2.504 2.579 2.656Change inresidualearnings 0.071 0.073 0.075 0.077Abnormal earningsgrowth 0.071 0.073 0.075 0.077AEGt "" Earnl- Earnl_1 1)(81_1 '"[Esm, -(Pc -1)8H ] - [EarnC_1 -(Pc -1)8c_2]'"REr- REt_1So, abnormal earnings growth isalways equal to thechangein residual earnings. You canseethis by comparing thechanges inresidualearnings with theAEGfor the prototypefirm inExhibit 6.2:The AEG model andtheRE model look different butarereallyquite similar. Both require forecasts ofearnings and dividends,although theRE model adds theextra mechanical stepofcal-culating book value forecasts from these forecasts.Structurally, thetwomodels aresimilar. TheRE starts withbookvalue as an anchor and thenaddsvaluebychargingforecastedearnings by the requiredreturnapplied to bookvalue. The AEGmodel starts with capitalized earnings as ananchorand thenaddsvaluebychargingforecasted(cum-dividend) earnings bythe required return appliedtopriorearnings, rather than book value.This structural difference isjust a different arrangement ofthe inputs. Alittle algebraunderscores the point. Abnormalearnings growth can bewritten ina different form:AEGr"" IEarn( +(PE -l)dl_d -PEEarnl_1"" Earnr- Earnr_1 -(Pf-1){Earnt_1 -dl_l)Using the stocks andflows equationforaccountingfor thebook value of equity (Chapter2), 81_1"" 81_2 +- soEarnt_l -dl_1 ""8:_18r_2. Tnus,208209values. Whenthe higherearnings are combined withthe lower bookvalues (ina residualearnings valuation), valueis unaffected.TheAEGmodel, at first glance, looksas ifit mightnot havethisfeature. Amanager cancreate higher futureearnings by writing downbook values, and the AEGmodel valuesfuture earnings without carrying bookvalues as a correcting mechanism. We do not wantto payfor growth that does not add value, and accounting methods can creategrowth inearnings that we do not want to payfor. As it happens, the AEGmodel, likethe residualearnings model, provides protection against paying for growth that is createdby account-ing. Box6.5explains.(6.5)Exhibit 6.2presented pro forma earnings andearningsgrowthforvaluing the equity of a prototypefirm. Supposethemanager of this firm hasdecided tocreate more earningsfor Year 1 bywritingdowninventory by$8 in Year O. Thisaccounting adjustment changes theaccounting numbers, butit should not affect thevalue. Here isthe revised pro forma:CreatingEarningswith Accounting: ModifyingExhibit6.2for a Write-DownForecast Year0 3 4 5Earnings 4.00 20.36 12.73 13.11 1351 13.91Dividends 9.09 9.36 9.64 9.93 10.23 10.54Book value 92.00 103.00 106.09 109.27 112.55 115.92Earnings onreinvesteddividends 0.936 0.964 0.993 1.023Cumdividendearnings 13.667 14.077 14.499 14.934Normalearnings 22.396 14.004 14.424 14.857Abnormalearningsgrowth (8.729) 0.073 0.075 0.077Abnormaiearningsgrowth rate 3% 3%EFFECT ONVALUATIONAs a result of the$8 write-down, the $12 reported for Year 0earnings is now$4(andthe bookvalueis $92insteadof$100). Correspondingly, Year 1 forward earnings increase by$8 to$20.36because cost ofgoods soldis lower by$8. Cum-dividendearningsfor Year 2 are not affectedbut, becausethoseearningsare nowcomparedtonormal earningsof$22.396, on the highbase of $20.36 for Year 1, abnormalearnings growth fer Year 2 is(adecline of) -$8.729. Subse-quent years areunaffected. The AEG valuation at the end ofYear 0 isV,f = _'_[20.36 _ 8.729 + 0.073 I 1'" 133.71o 0.10 1.10 1.10 1.03/1.10JThis is the same as the value before the accountingchange. WhileforwardYear 1 earningshaveincreased, thehigher earnings of $20.36 meanhighernormalearnings forYear 2 andconsequently lower earnings growth of -$8.729.The neteffectis to leave thevalue unchanged.EFFECT ONPIE RATIOSWhilevaluationsare not affectedbyaccountingmethods,PIEratios certainly are. The forward PIEfor this firm isnow$133.71/$20.36'" 6.57, down from 10.82. The trailing(dividend-adjusted) PIEis now($133.71 + $9.09}/$4.00=35.70, upfrom11.90. Shifting income from current earningsto forwardearningsincreases the trailingPIE;there is nowmore anticipated earnings growth next year andthePIE pricesgrowth. However, shifting income tothefuture decreases theforwardPIE-there isnow lessanticipatedgrowthafter theforward year, andthevalue oftheearnings (inthenumerator)does notchange.A LESSONFOR THE ANALYSTThere is alesson here. The diligent analyst distinguishesgrowth .that comes from accounting from growth'thatcomesfromreal businessfactors. If growthis inducedbythe ac-counting, hechanges the PIEratio, but hedoes not changethevaluation. Applying theAEG model (orindeed theresidualearningsmodel) protectshimfrommakingthe mistake ofpricing earnings thatareduetoaccounting methods.Weopened this chapter with the caveat that wedo notwant topayfor growththat doesnot add value. We donotwant to pay for earnings growth from added investmentthat earns only therequiredreturn. But wealso donotwantto pay for growth thatis createdbyaccountingmethods.Using the residual earnings model or theabnormal earningsgrowth model protects usfromboth dangers.Chapter 6 Accrua1Accollnting tmd Valuation:Pricing Earnings 211Make sureyoureadthe sectiontitled''A Lessonfor theAnalyst" in Box6.5.The trail-fig PIE indicate