FullInformation Forecasting, Valuation, and Business Strategy Analysis

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Chapter 15

• Full-Information Forecasting, Valuation, and
  Business Strategy Analysis

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Full-Information Forecasting, Valuation, and
Business Strategy Analysis
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What you will learn from this chapter

• What types of economic factors have to be
  considered for forecasting
• How financial statement drivers translate
  economic factors into valuation
• How particular drivers typically change over time
• How to do pro forma analysis
• The 15 steps involved in forecasting residual
  operating income and abnormal operating income
  growth
• How to convert pro forma financial statements to
  a valuation
• How pro forma analysis is used as a tool in
  strategy analysis
• The difference between dollar forecasting and
  per-share forecasting
• How mergers and acquisitions are evaluated

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A ReminderThe Steps of Fundamental Analysis
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Review of Chapter 1Knowing the BusinessKnow
the Firms Products

• Type of products
• Consumer demand for the product
• Price elasticity of demand for the product
• Substitutes for the product. Is it
  differentiated? On price? On quality?
• Brand name association of the product
• Patent protection for the product

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Knowing the BusinessKnow the Technology

• Production process
• Marketing process
• Distribution channels
• Supplier network
• Cost structure
• Economies of scale

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Knowing the BusinessKnow Industry Competition

• Concentration in the industry, the number of
  firms and their sizes
• Barriers to entry in the industry and the
  likelihood of new entrants and substitute
  products
• The firms position in the industry. Is it the
  first mover or a follower in the industry? Does
  it have a cost advantage?
• Competitiveness of suppliers. Do suppliers have
  market power? Do labor unions have power?
• Capacity in the industry? Is there excess
  capacity or under capacity?
• Relationships and alliances with other firms

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Knowing the Business Know the Political, Legal
and Regulatory Environment

• The firms political influence
• Legal constraints on the firm including antitrust
  law, consumer law, labor law and environmental
  law
• Regulatory constraints on the firm including
  product and price regulations
• Taxation of the business

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Financial Statement AnalysisThe Lens on the
Business
Economic Factors
The Filter of Financial Statement Analysis
Economic Factors Interpreted as ReOI Drivers
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Four Points of Focus

• 1. Focus on Residual Operating Income and its
  Drivers
• 2. Focus on Change
• 3. Focus on Key Drivers
• 4. Focus on Choice versus Conditions

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Focus on Residual Operating Income (ReOI)

• Two drivers
• 1.
• 2.
• The two drivers can be captured in one expression
  for ReOI
• To add ReOI (and AOIG and value) grow sales and
  increase Core Sales PM relative to Turnover
  Efficiency Ratio

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Focus on Change

• Establish Typical Driver Pattern for Industry
• Modify Typical Driver Pattern for Forecasted
  Changes for the Industry and the Economy
• Discover How a Firms Driver Pattern will be
  Different from the Typical Pattern
• Remember

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Driver Patterns Core RNOA

• (All NYSE and AMEX firms, 1965 96)
• The rate of convergence towards common
• level is referred to as the Fade Rate
• What economic factors drive fade rates?

Core RNOA
Year Ahead
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Driver Patterns Core Other Income/NOA
Core Other Income / NOA
Year Ahead
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Driver Patterns Unusual Items/NOA
Unusual Items / NOA
Year Ahead
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Driver Change PatternsSales Growth Rates
Sales Growth Rate
Year Ahead
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Driver Change PatternsChange in Core Sales PM
Change in Core Sales PM
Year Ahead
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Driver Change PatternsChange in ATO
Change in ATO
Year Ahead
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Forecasting How a Firms Drivers will be
Different from the Typical Pattern

• The tension between the forces of competition and
  the firms responses to those forces challenge
  and counter challenge
• Firms challenge other firms
• Product price reduction
• Product innovation
• Lower production costs
• Imitation of successful firms
• Entering industries where firms are earning
  abnormal profits
• Firms counter challenge
• Brand creation
• Patent protection
• Managing consumer expectations
• Alliances and agreements with competitors,
  suppliers and firms with related technology
• Exploiting first-mover advantages
• Mergers
• Creating superior production and marketing
  technologies
• Creating economies of scale that are difficult to
  replicate
• Creating a technological standard that consumers
  and other firms must tie into

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Focus on Key Drivers

• Some firms have one or two drivers that are key
  to driving ReOI. Analysts focus on these key
  drivers

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Driver History for a Brand Name Company
Coca-Cola

• Coke targets economic profit (similar to ReOI)
  to create shareholder value. It reported the
  following in its 10-K
• This is a Growth Pattern, not a Fade Pattern
• Forces of competition create fade patterns
• Challenges to competition create growth patterns

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Full Information Forecasting

• Forecast all economic factors and the full set of
  ReOI drivers
• Express forecasts in a set of pro forma financial
  statements
• An Example with PPE Inc. follows

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PPE Inc. The Initializing Balance Sheet, Year 0
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The Initializing Income Statement and Cash Flow
Statement
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Forecasting for PPE Inc.

• The forecasts
• Sales are forecasted to grow at 5
• Forecasted Core PM is 7.85
• Forecasted ATO is 1.762
• (1/ATO 56.75 cents for each dollar of sales)
• With these three items we can value the firm.
• Cost of capital for operations 11.34
• Cost of capital for debt 10.00

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PPE Inc. The Pro Forma for Operating Activities
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A Short-Cut Calculation of ReOI

• For PPE Inc., Year 3

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A Short-Cut Calculation of AOIG

• Abnormal OI Growth
• For PPP Inc., Year 3

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PPE Inc. The ReOI Valuation from the Pro Forma
(0.96 per share on 100 million shares)

• Features of the pro forma
• 1. Future RNOA is the same as currently
• Core PM the same
• ATO the same
• 2. Growth rate is constant

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PPE Inc.The AOIG Valuation from the Pro Forma
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PPE Inc.The Free Cash Flow Valuation from the
Pro Forma
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Filling out the Pro Forma Financial Statements

• Dividend forecast Payout will be 40 of Earnings
• Borrowing cost forecast Same as present (10)

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Full-Information ForecastingNike
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Full-Information ForecastingNike (Cont.)
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A Forecasting Template

• Forecast sales
• Forecast ATO and calculate NOA
• NOAsales/ATO
• Revise sales forecast for asset constraints
• Forecast Core PM and calculate Core OI
• Core OI Sales x Core PM
• Forecast Other Core OI and total Core OI
• Core OI Core OI from sales Other Core OI
• Forecast unusual operating items
• Calculate ReOI and AOIG
• OIt Core OIt UIt
• ReOIt OIt - (?F-1) NOAt-1
• AOIGt?ReOIt
• Calculate Free Cash Flow

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A Forecasting Template (cont)

• Forecast net dividend payout
• Calculate financial expenses (or income)
• Calculate net financing position
• Calculate comprehensive net income
• Calculate common stockholders equity
• Adjust the valuation for stock option overhang
  (Chapter 13)
• Adjust for any value for minority interests
• Steps 1-6 and step 9 and 10 require forecasting
• All other steps are calculations from forecasted
  amounts using accounting relations
• Only steps 1-7 are necessary for valuation
  (without stock options)

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Forecasting ReOI and AOIG from Their Drivers
(4) Forecast PM Gross Margin - Expense Ratios
Apply PM Core OI Sales x PM
(1) Sales Forecast
Core OI
Other OI
(5) Forecast Other OI
UI
(6) Forecast Unusual Items
(3) Revise Sales Forecast
OI
(2) Forecast ATO
(7) Match OI and NOA
ReOI
NOA
ATO
Apply ATO NOA Sales / ATO
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Checking Pro Forma Analysis

• Make sure CSE reconciliations in Step 13 agree
• Check common size analysis against industry
  norms. Are differences reasonable?
• Watch for financial asset build up. What will
  the firm do with the build-up?

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Features of the OI Valuation Approach

• 1.- It is efficient forecast five factors
• Sales
• Core PM
• ATO
• Other Core OI
• Unusual Items
• 2.- Focuses in the part of the business that adds
• value the operations
• 3.- Dividends are irrelevant
• 4.- Financing is irrelevant
• 5.- Zero NPV (zero ReOI) investments dont
• affect the valuation
• 6.- Value-generating investments are
• identified
• 7.- Avoids problems of the discount rate
• changing as leverage changes

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Mergers and Acquisitions Involving Share Issues

• Mergers and Acquisitions often involve share
  issues
• Residual earnings valuation cannot be done by
  forecasting per-share amounts if shares
  outstanding are likely to change
• Always carry out residual earnings valuations on
  a dollar basis, then divide by current shares
  outstanding
• Abnormal Earnings Growth (AEG) valuation can be
  carried out by forecasting per-share earnings and
  dividends
• However, must then work on a levered basis
  (requiring changes in the cost of equity capital)
• Best to work with operations on a dollar basis

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Valuation with an Anticipated Acquisition
Dealing with Value Received in the Exchange Ratio
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Financial Statement Indicators

• 1.- Current RNOA different from the past
• 2.- Components of RNOA different from the
• past
• Analyze the determinants of the current ?RNOA
• ? in Core PM is particularly important
• 3.- RNOA different from industry mean
• RNOAs tend to revert towards industry averages

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Financial Statement Indicators (cont)

• 4.- Components of RNOA different from industry
  mean
• PM components
• Cost of sales/Sales
• Advertising/Sales
• G A expenses/Sales
• R D /Sales
• ATO components
• Inventories/Sales
• Accounts receivables/Sales
• Doubtful debts/Sales
• PPE/Sales
• 5.- Changes in RNOA components different from
  industry
• mean
• 6.- Changes in capital expenditures different
  from a
• industry mean

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Indicators Outside Financial Statements

• Firm specific indicators
• Non-working assets
• Order backlog
• Per-unit sales prices
• RD success
• Firms investment plans
• Change in labor force
• Management discussion and analysis
• Insider trading
• Contingent liabilities (see footnotes)

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Red Flag Indicators

• Slow sales growth
• Declines in order backlog
• Increasing Accounts Receivable/Sales
• Increasing Inventory/Sales
• Deterioration in Gross margin/Sales
• Increasing Selling and Administrative Expenses/
  Sales
• Low effective tax rates
• Large non-recurring items
• Increases in dilutive securities executive stock
  options
• Build up of financial assets

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Business Strategy and Pro Forma Analysis

• The same apparatus serves strategy analysis
• Five steps of fundamental analysis are the five
  steps of strategy analysis
• Focus
• maximize RNOA relative to required return
• grow NOA
• Pro forma financial statement analysis
  articulates strategy
• Beware of unarticulated strategy fads