1 Chapter Fifteen Link to previous chapter Chapter 14 developed simple forecasting schemes based on information in financial statements. LINKS Link to previous chapters Chapters 11 and 12 laid out the analysis of financial statements that uncovers drivers of profitability and growth. Full-Information Forecasting, Valuation, and Business Strategy Analysis This chapter This chapter shows how information outside the financial statements is utilized to make forecasts that improve upon the simple forecasts in Chapter 14. This chapter uses the financial statement analysis of Chapters 11 and 12 to develop a framework for full-information forecasting. How is knowledge of the business incorporated in forecasting? How is financial statement analysis utilized in forecasting? How are pro forma future financial statements prepared? How is pro forma analysis used in strategy decisions? Link to next chapter Chapter 16 begins an investigation of accounting issues that arise in forecasting and valuation. Link to Web page Learn how to develop spreadsheet financial models to convert forecasts to valuations visit the text Web site at The simple forecasting schemes in the last chapter embedded all the concepts needed for valuation. But they did not exploit all of the information that is necessary to make the analyst feel secure about a valuation. The simple schemes focused on operating income and growth in net assets employed in operations, but they relied on current measures. Full-information forecasting digs deeper. It forecasts the full set of factors that drive operating income and net operating assets and, from these forecasts, builds up a forecast of residual earnings and abnormal earnings growth from which a valuation can be made. Chapters 11 and 12 outlined the factors that drive profitability and growth enabling us to analyze current financial statements. But because those same factors drive future profitability and growth, the driver analysis of those chapters also gives us the framework for forecasting: The analyst forecasts the drivers future core profit
2 Chapter 15 Full-Information 547 The Analyst s Checklist After reading this chapter you should understand: How forecasting is a matter of financial statement analysis for the future. How financial statement drivers translate economic factors into a valuation. What a driver pattern is and what economic forces affect them. How to identify key drivers. How to conduct full-information pro forma analysis. The 13 steps in pro forma analysis. The seven steps involved in forecasting residual operating income and abnormal operating income growth. How mergers and acquisitions are evaluated. How buyouts are evaluated. The difference between dollar forecasting and pershare forecasting. How pro forma analysis is used as a tool in strategy analysis. After reading this chapter you should be able to: Develop pro forma income statements and balance sheets for the future. Get forecasts of future residual operating income, abnormal operating income growth, and free cash flow from pro forma financial statements. Get valuations from pro forma financial statements. Show how changes in forecasts for specific drivers change pro forma financial statements and valuations. Use pro forma analysis for sensitivity analysis. Calculate the effect of a proposed merger or acquisition on per-share value. Use pro forma analysis to evaluate strategy scenarios. margins, turnovers, and so on to develop forecasts. Financial statement analysis is an analysis of the present and past, to provide information for forecasts of the future. However, you will see in this chapter that forecasting is a matter of financial statement analysis of the future. Much of this chapter takes the analysis of Chapters 11 and 12 and rolls it over to the future. The drivers of profitability and growth are themselves driven by the real economic factors of the business. So knowing the business is an essential first step to discovering the information for full-information forecasting. You will see here how financial statement analysis provides the means of interpreting the many dimensions of business activity in a form that can be used for forecasting. Knowing the firm s strategy is also a prerequisite for forecasting, and you will also see how financial statement analysis interprets strategy. Moreover, you will see how the methods of forecasting are also the methods by which a manager evaluates alternative strategies. The chapter develops a formal scheme for forecasting. The scheme ensures that all relevant aspects of the business are incorporated and irrelevant aspects are ignored. It is comprehensive and orderly so that no element is lost. By forcing the analyst to forecast in an orderly manner, the scheme disciplines speculative tendencies. The simple forecasts of the last chapter are a starting point for full-information forecasting. They are based on current profitability and growth in net operating assets. Fullinformation forecasting asks how future profitability and growth will differ from current levels. If, through analysis of additional information, we forecast that indeed they will, then we will have improved on the simple forecasts and the simple valuations.
3 548 Part Three Forecasting and FINANCIAL STATEMENT ANALYSIS: FOCUSING THE LENS ON THE BUSINESS We have repetitively said that one cannot value a business without a thorough understanding of the business; knowing the business is a prerequisite to valuation and strategy analysis Step 1 of fundamental analysis. Before embarking on this chapter, look back to the section titled The Analysis of Business in Chapter 1, where the main factors that determine business success are discussed. The analyst must understand the business model and alternative, adaptive strategies available to the firm. She must understand the firm s product, its marketing and production methods, and its knowledge base. She must understand the competitive environment and have an appreciation of the firm s competitive advantage, if any, and its durability. She must understand the legal, regulatory, and political constraints on the firm. Understanding these many economic factors is a prerequisite to forecasting. But we need a way of translating these factors into measures that lead to a valuation. We must recognize the firm s product, the competition in the industry, the firm s ability to develop product innovations, and so on, but we must also interpret this knowledge in a way that leads to a valuation. Economic factors are often expressed in qualitative terms that are suggestive but do not immediately translate into concrete dollar numbers. We might recognize that a firm has market power, but what does this imply for its value? We might recognize that a firm is under threat of competition, but what does this imply for its value? How are growth opportunities valued? Accounting-based valuation models and the financial statement analysis of Chapters 11 and 12 provide the translation. Market power translates into higher margins; competition reduces them. The technology to produce sales is reflected in the asset turnover. And margins and turnovers are the drivers of profitability on which valuation is based. The structure of financial statement analysis is the means to interpret what we observe about business. It focuses the lens on the business. There is danger in relying on suggestive notions such as market power, competitive advantage, and breakthrough technology without a concrete analysis of what they mean. Investors can get carried away by enthusiasm for such ideas, leading to speculation in stock prices. Forecasting within a financial statement analysis framework disciplines investor exuberance and, indeed, investor pessimism. It brings both the bulls and the bears to a focus on the fundamentals. There are four points of focus for translating business activities into a valuation. 1. Focus on Residual Operating Income and Its Drivers The focus for the valuation of operations is on residual operating income (ReOI) for a P/B valuation or abnormal operating income growth (AOIG) for a P/E valuation. But AOIG is just the change in ReOI. So business activities are interpreted by their effect on ReOI. ReOI is driven by return on net operating assets (RNOA) and growth in net operating assets (NOA). RNOA is driven by four drivers: Core other OI RNOA = ( Core sales PM ATO) + + NOA Unusual items NOA Combining these RNOA drivers with growth in NOA, we can capture the drivers of residual operating income in one expression that contains five drivers: Required return for operations ReOI = Sales Core sales PM ATO + Core other OI + Unusual items (15.1)
4 Chapter 15 Full-Information 549 (It is often the case, however, that unusual items are expected to be zero.) The ATO is sales per dollar of net operating assets, so the ratio of the required return on operations to ATO here is a measure of operational efficiency in using net operating assets to generate sales relative to the required rate of return for those assets. We will refer to it as the turnover efficiency ratio, with a smaller ratio generating more ReOI. The RNOA drivers core profit margin, asset turnover, core other income, and unusual items are in this formula. And growth in NOA is embedded through its drivers: Since NOA is put in place to generate sales, NOA is driven by sales and 1/ATO, that is, by sales and the net operating assets required to generate a dollar of sales. Forecasting residual operating income involves forecasting these drivers so, with valuation in mind, observations about the business are translated into forecasts of the five drivers: 1. Sales 2. Core sales profit margin 3. Turnover efficiency 4. Core other operating income 5. Unusual items Sales is the primary driver because, without customers and sales, no value can be added in operations. Much of our knowledge of the business its products, its marketing, its R&D, its brand management, to name a few factors is applied to forecasting sales. And as every basic economics course teaches, dollar sales is sales price multiplied by quantity sold. Both price and quantity involve analysis of consumer tastes, the price elasticity of consumer demand, substitute products, the technology path, competitiveness of the industry, and government regulations, to name a few. But equation (15.1) tells us that sales generate positive ReOI only if they are turned into positive margins. And sales generate positive ReOI only if these margins are greater than the turnover efficiency ratio. As a first step in organizing your business knowledge, attach economic factors to ReOI drivers. What factors drive product prices and product quantities (and thus sales)? Among the answers will be competition, product substitutes, brand association, and patent protection. What factors drive margins? Among the answers will be the production technology, economies of scale and learning, and the competitiveness in labor and supplier markets. 2. Focus on Change A firm s current drivers are discovered through financial statement analysis. Forecasting involves future drivers, so focus on business activities that may change ReOI drivers from their current levels. The analysis of changes in drivers is a question of earnings sustainability, or more strictly, ReOI sustainability. Analyze change in three steps. Step A. Understand the Typical Driver Pattern for the Industry Figure 14.2 in the last chapter displays historical patterns that are starting points for forecasting. The displays are of typical mean-reversion behavior of ReOI, RNOA, and growth in NOA to long-run average levels. Similar displays can be made for each industry or product sector from the historical data. And similar displays can be developed for core profit margins, asset turnovers, and the other drivers of ReOI. These driver patterns are determined by two elements: 1. The current level of the driver relative to its typical (median) level for a comparison set of firms. 2. The rate of reversion to a long-run level.
5 550 Part Three Forecasting and Element 1 is established by the analysis of the current financial statements and element 2 is the subject of forecasting. The rate of reversion to a long-run level is sometimes referred to as the fade rate or persistence rate. Some analysts market their equity research as an analysis of fade rates. How long will a nontypical ReOI and nontypical ReOI drivers take to fade to the typical long-run level? How long will a nontypical level persist? Economic factors affect firms in similar ways within industries, so driver pattern diagrams are best developed by industry. Industry is usually defined by the product brought to market. There are standard classifications, like the Standard Industrial Classification (SIC) system, which classifies firms by nested four-digit industry codes. Within an industry firms tend to become more like each other over time, or they go out of existence. Thus analysts talk of ReOI and its drivers fading to levels that are typical for the industry. Firms may have temporary advantages, new ideas, or innovations that distinguish them from others, but the forces of competition and the ability of existing and new firms to imitate them drive out the temporary advantage. Correspondingly, if these competitive forces are muted, we expect to see more sustained driver patterns than for a strongly competitive industry. As fade rates are driven by competition, some analysts refer to the period over which a driver fades to a typical level as the competitive advantage period. Figure 15.1 gives historical patterns over five-year periods between 1964 and 1999 for the core RNOA driver for all NYSE and AMEX firms, along with patterns for core other income (relative to NOA) and items classified as unusual (also divided by NOA). 1 These figures, like those in the last chapter, track the drivers over five years from a base year (Year 0) for 10 groups of firms that differ in the amount of the drivers in the base year. They are referred to as fade diagrams. The top group contains firms with the highest 10 percent of the driver in the base year and the bottom group contains firms with the lowest 10 percent. As you would expect, unusual items (in Figure 15.1c) fade out quickly they are very transitory but core RNOA (in Figure 15.1a) and other core income (in Figure 15.1b) also fade toward central values, with high profitability (in the upper groups) declining and low profitability (in the lower groups) increasing. The diagrams indicate that the forces of competition are at play to drive core RNOA to common levels. Firms in the top 10 percent of core RNOA in the current year have a median 29 percent RNOA that fades to 18 percent five years later. But there are long-run differences between core RNOA that have to be forecast: Firms with higher core RNOA currently tend to have higher core RNOA later, but differences in core RNOA decrease over time. We will see in Part Four that the accounting partly explains these permanent differences. Driver patterns also can be established for change drivers that were analyzed in the analysis of growth in Chapter 12. Figure 15.2 gives historical patterns for sales growth rates, changes in core sales profit margins, and changes in asset turnovers. These patterns indicate the sustainability of increases or decreases in the drivers. Sales growth (in Figure 15.2a) is strongly mean reverting: Firms with large increases in sales tend to have lower increases in the future. And large increases or decreases in core sales profit margins (in Figure 15.2b) and asset turnovers (in Figure 15.2c) also tend to be temporary. Average changes in both drivers (represented by the fifth group from the top in Year 0) are close to zero, but all groups converge to this average over time. 1 As with Figure 14.2 in Chapter 14, the patterns in the figures here are averages of patterns from grouping firms on their drivers in 1964, 1969, 1974, 1979, 1984, 1989, and 1994, and tracking their subsequent path.
6 Chapter 15 Full-Information 551 FIGURE 15.1 Driver Patterns for Core RNOA, Core Other Income, and Unusual Operating Items, NYSE and AMEX Firms, The patterns trace the median drivers over five years for 10 groups formed for different levels of the drivers in Year 0. Firms in the upper groups have high drivers in the current year (Year 0) and firms in the lower groups have low drivers in the current year. Source: D. Nissim and S. Penman, Ratio Analysis and Equity Valuation: from Research to Practice, Review of Accounting Studies, March 2001, pp Based on Standard & Poor s COMPUSTAT data. (a) Core RNOA. Firms with high core RNOA currently (in the upper groups) tend to have declining profitability in the future; firms with low core RNOA (in the lower groups) tend to have increasing profitability in the future. Core RNOA 35% 30% 25% 20% 15% 10% 5% 0% 5% 10% Year relative to current year (Year 0) (b) Core other income/noa. High core other income (for firms in the upper groups) tends to decline subsequently as a percentage of net operating assets; low core other operating income (for firms in the lower groups) tends to increase. 6% 5% 4% Other items/noa 3% 2% 1% 0% 1% 2% Year relative to current year (Year 0) (continued )
7 552 Part Three Forecasting and FIGURE 15.1 (concluded) (c) Unusual operating items/noa. Unusual items tend to disappear very quickly as expected for a transitory item. 8% 6% 4% Unusual items/noa 2% 0% 2% 4% 6% Year relative to current year (Year 0) The contrarian stock screening strategy (in Chapter 3) shorts stocks with high growth in sales and profits and buys stocks with low growth. The contrarians have these change patterns in mind but believe that the market does not. They believe that the market gets too excited with high sales and profit growth and thinks growth will continue rather than fade; and they believe the market does not understand that drops in sales and profits are often temporary. Step B. Modify the Typical Driver Pattern for Forecasts for the Economy and the Industry Historical industry patterns are a good starting point if the future is likely to be similar to the past. But indications may be to the contrary. Government or trade statistics may forecast a change in the direction for the (global) economy or for the specific industry. Forecasts of recession or a slowdown of GDP growth may signal a change from the past. Shifts in industrywide demand for the product may be indicated by changing demographics or changing consumer tastes. Knowing the business requires a knowledge of industry trends and a knowledge of the susceptibility of the industry to macroeconomic changes. Historical driver patterns, adjusted if need be for macroeconomic and industry forecasts, modify the simple forecasts of the last chapter; forecasts based on current levels of the drivers are modified to incorporate typical fade rates. Step C. Forecast How the Firm s Drivers Will Be Different from the Typical Pattern Understanding typical drivers for an industry disciplines speculative tendencies. But firms have idiosyncratic features that yield drivers that are predictably different from industry
8 Chapter 15 Full-Information 553 FIGURE 15.2 Driver Patterns for Sales Growth Rates, Changes in Core Sales Profit Margins, and Changes in Asset Turnovers, NYSE and AMEX Firms, (a) Sales growth rates. Sales growth tends to fade quickly: Firms with high sales growth currently (in the upper groups) have lower sales growth subsequently; firms with low current sales growth (in the lower groups) have higher sales growth subsequently. 50% 40% Source: D. Nissim and S. Penman, Ratio Analysis and Equity Valuation: from Research to Practice, Review of Accounting Studies, March 2001, pp Based on Standard & Poor s COMPUSTAT data. Sales growth rate 30% 20% 10% 0% 10% 20% 30% Year relative to current year (Year 0) (b) Changes in core sales profit margins. Changes in core sales profit margins tend to fade quickly toward common levels close to zero. 6% 4% Change in core sales profit margin 2% 0% 2% 4% 6% 8% Year relative to current year (Year 0) (continued )
9 554 Part Three Forecasting and FIGURE 15.2 (concluded) (c) Changes in asset turnovers. Changes in asset turnovers tend to revert toward common levels; large increases in asset turnovers (in the upper groups) are temporary, as are large decreases in asset turnovers (in the lower groups) Change in ATO Year relative to current year (Year 0) patterns. So full-information forecasting is completed by asking how the firm s future drivers will be different from the typical pattern for the industry. The main factor in determining fade rates is competition and firms reactions to it. Competition causes abnormal RNOA to fade, and the ability of the firm to counter the forces of competition sustains RNOA higher than the industry average. Firms both create the forces of competition and counter those forces. Among the ways that they challenge other firms (with examples of specific firms or industries) are: Product price reductions (Wal-Mart, Home Depot, and other discount retailers). Product innovations (software developers, pharmaceutical companies). Product delivery innovations (Dell Computer (Dell, Inc.), electronic commerce). Lower production costs (clothing manufacturers moving production to countries with low labor costs). Imitation of successful firms (PC cloners copying IBM; imitating Dell s inventory and distribution system). Entering industries where firms are earning abnormal profits (software, biotechnology). Among ways that firms counter competitive forces (with examples of specific firms or industries) are: Brand creation and maintenance; franchising (Coca-Cola, McDonald s). Creating proprietary knowledge that receives patent protection (pharmaceutical firms).
10 Chapter 15 Full-Information 555 Managing consumer expectations (beer and wine marketing). Forming alliances and agreements with competitors, suppliers, and firms with related technology (airline alliances, telecom alliances). Exploiting first-mover advantages (Wal-Mart, Amazon.com, Internet portal pioneers). Mergers (banking, financial services). Creating superior production and marketing technologies (Dell Computer (Dell, Inc.)). Staying ahead on technological knowledge and production learning curve (Intel). Creating economies of scale that are difficult to replicate (telecom networks, banking networks). Creating a proprietary technological standard or a network that consumers and other firms must lock into (Microsoft). Government protection (agriculture). Understanding the tension between the forces of competition and the counterforces is crucial to forecasting fade rates. Many actions of firms that challenge and counter competition create temporary advantages, but these advantages often disappear over time. Product innovation draws customers but ultimately is imitated if there is no patent protection. Success draws imitators unless there are natural or government-enforced barriers to entry. These factors yield decreasing returns (to use economists language). Firms strive to maintain returns or generate increasing returns. A firm that can create a technological standard (like Microsoft with Windows) will enjoy sustained or even growing ReOI as customers are locked in. So will a pharmaceutical firm with patents for products in strong demand (Genentech). So will a firm that has created consumer demand through a strong brand name (Coca-Cola). Government policy attempts to balance the forces of competition against the forces to counter them. So government policy must be understood. Is the government disposed to free trade and competition? To protection? To political favoritism? What is the antitrust (monopolies) law? What are the trade laws and international trade treaties? The driver pattern diagrams indicate not only that high profitability tends to decline but also that low profitability tends to increase. Firms on the latter trajectory include those that are entering an industry or establishing new products. These often have low initial profitability that gradually improves. The forecasting challenge is to assess the likely success of new products or innovations. Firms that fade up rather than down also include those whose core income is temporarily depressed because of product transition, competitive challenge, or a labor strike. The forecasting challenge is to assess the extent to which the low profitability is indeed temporary (so will recover) or is permanent. The diagrams here are based on actual data; the patterns therefore are for firms which survived to each future year. Forecasting survival and recovery is important for these low-profitability firms: The forces of competition drive out firms that cannot sustain ReOI in the long run. Chapter 19 deals with bankruptcy prediction. Fading (up or down) is a typical pattern, but many other driver patterns are possible. A not uncommon pattern is continuing high RNOA, without any fading, along with growth in ReOI because of growth in net operating assets. These are firms that counter competition successfully. Coca-Cola is a good example of a firm that has grown ReOI through brand management. See Box Focus on Key Drivers For some firms, particular drivers are more important than others. A number of drivers might change slightly, but one or two drivers might change significantly. Drivers that
11 The Coca-Cola Company: The Driver History for a Brand-Name Company 15.1 The Coca-Cola Company manufactures concentrates and syrups and ships them to its bottlers for distribution in soft drinks. By keeping its cola formula secret, by careful quality control, and by maintenance and promotion of its brand, Coke has consistently increased its sales and profits. Coke s management says in its 10-K Discussion and Analysis that our mission is to create share-owner value over time. In doing so they focus on improving what they call economic profit, which is similar to residual operating income. Below are the economic profit figures that Coke has reported in its 10-Ks from 1990 to 1997, along with its drivers and stock prices Net revenues ($ millions) 10,261 11,599 13,119 14,030 16,264 18,127 18,673 18,868 Return on capital 1 (%) Sales profit margin (%) Asset turnover Economic profit ($ millions) 920 1,073 1,300 1,549 1,896 2,291 2,718 3,325 Growth in economic profit (%) Stock price per share Coke defines return on capital in a similar way to RNOA. See Box 14.3 in Chapter 14. Coke s stock price increased almost 5.6 times over the period, matched by increasing economic profit (ReOI). The economic profit has been driven by increasing sales and margins. This is a growth pattern, not a fade pattern. Can growth at this rate be maintained? require particular focus are key drivers. For Coca-Cola (in Box 15.1) sales and margins are key drivers. A simple forecast might suffice for a non key driver, but key drivers require thorough investigation of the factors that determine them. In retailing, profit margins are often fairly constant, so forecasting focuses on sales and ATO where there is more uncertainty. Because sales and ATO are driven by sales per square foot, the retail analyst cuts through to this number first. Box 15.2 identifies key economic factors for selected industries and the ReOI drivers associated with them. It also gives an analysis of key drivers for airlines. Analysts sometimes identify firms by value types according to their key drivers. So Coca-Cola is a brand management firm where value is driven by exploiting a brand. A firm where profit margins and asset turnovers quickly revert to typical levels is called a company of averages. A firm where value comes from growing sales and net operating assets is called a growth firm. A firm that has large fixed costs to be covered and where most of sales go to the bottom line after fixed costs are covered like telecoms is referred to as being sales driven. (This firm has increasing ATO as sales increase.) A firm whose product is not yet clearly defined like a start-up research biotech is a speculative type. These names are helpful to bring focus but are often oversimplifications; be careful not to presume too much by typing a firm. 4. Focus on Choices versus Conditions Economic factors and ReOI drivers can change in two ways. They are determined either by a change in the environment the firm is in or by choices made by management. Government 556
12 Key Drivers 15.2 SELECTED INDUSTRIES Industry Key Economic Factors Key ReOI Drivers Automobiles Model design and production efficiency Sales and margins Beverages Brand management and product innovation Sales Cellular phones Population covered (POP) and churn rates Sales and ATO Commercial real estate Square footage and occupancy rates Sales and ATO Computers Technology path and competition Sales and margins Fashion clothing Brand management and design Sales, advertising/sales Internet commerce Hits per hour Sales and ATO Nonfashion clothing Production efficiency Margins Pharmaceuticals Research and development Sales Retail Retail space and sales per square foot Sales and ATO AIRLINES Airlines typically operate with a given fleet and a given gate allocation at airports, at least in the short run. Thus with a fixed number of flights their costs are mainly fixed costs, and profitability is driven largely by revenues. Below are statistics for the 10 largest carriers in the United States for 1994 to U.S. Industry Statistics 1994 Change 1995 Change 1996 Change Revenue miles seat (RMS) (thousands) 499, % 512, % 546, % Available seat miles (ASM) (thousands) 752, % 762, % 784, % Load factor 66.38% 3.14% 67.22% 1.27% 69.71% 3.70% Yield (cent per RMS) % % % Revenues ($ millions) Passenger 62, % 65, % 71, % Cargo and other 7, % 7, % 7, % Total 69, % 73, % 79, % Costs ($ millions) Labor 24, % 24, % 25, % Fuel 8, % 8, % 10, % Commissions 6, % 6, % 6, % Rentals and landing fees 7, % 7, % 7, % Maintenance 3, % 2, % 3, % Depreciation and amortization 3, % 3, % 3, % Other 14, % 15, % 15, % Total costs 67, % 68, % 72, % Commission rate 10.2% 2.86% 9.6% 5.88% 8.8% 8.33% Fuel price/gallon ($) % % % Average compensation ($ millions) 58, % 59, % 61, % Labor productivity 1 1, % 1, % 1, % Unit labor cost/asm % % % Note: Industry includes Alaska, America West, American, Continental, Delta, Northwest, Southwest, TWA, United, and US Airways. 1 Thousands of available seat miles per employee. (continued) 557
13 Key Drivers (concluded) 15.2 The size of the fleet and gate allocation defines what the industry calls available seat miles (ASM). A load factor determines revenue miles seat (RMS) and ticket prices determine the dollar yield per RMS. This yield, along with RMS, drives revenues so, for a given ASM, load factors and yields are the key drivers for airlines. The analyst cuts to these key factors but is also sensitive to any changes in available seat miles with new routes and new gate allocations. Other drivers such as labor productivity, labor costs, commission rates to travel agents, and fuel costs per mile (given in the table above) are also monitored. HOTELS AND RESORTS Hotel and resort firms, like Hilton, Marriott, and Starwood run large fixed-cost facilities with added (fixed and variable) labor costs. Occupancy rates are an important driver but these depend on the price charged for a room. A composite driver revenue per available room captures both, so leads the set of factors that drive profitability. These factors are: Revenue per available room (REVPAR) at existing properties, calculated as the product of the occupancy rate and the average daily rate charged (ADR). Construction of new hotels and disposition of underperforming hotels. New contracts to manage or franchise hotels. Enhancements in technology to streamline operations and reduce costs. Starwood Hotels and Resorts (which manages Westin, Sheraton, W, and St Regis hotels, among others) reported the following REVPAR for the years : Worldwide (138 hotels with approximately 49,000 rooms) REVPAR $ $ $ $ ADR $ $ $ $ Occupancy 68.5 % 64.7 % 63.5 % 65.1 % North America (93 hotels with approximately 36,000 rooms) REVPAR $ $ $ $ ADR $ $ $ $ Occupancy 70.3 % 66.7 % 64.8 % 65.9 % International (45 hotels with approximately 13,000 rooms) REVPAR $ $ $ $ ADR $ $ $ $ Occupancy 63.5 % 59.0 % 59.3 % 62.8 % Stock price, end of year $ $ $ $ You see that the stock price tracks REVPAR. Occupancy rates dropped after September 11, 2001 and, in the international operations, after the SARS outbreak in regulations and tax rates are determined outside the firm (although the firm might try to influence regulations). Product price is often set by the market. The degree of competition in the industry is often outside management s control. These are business conditions under which the firm must operate. But other factors are the result of strategic choices made by management. Management chooses the product. Management chooses the location and form of the production process. They choose product quality. They decide on the R&D program. They make alliances with other firms. These choices, taken as a whole, amount to the firm s strategy. Understanding both business conditions and the firm s strategy is a prerequisite for sound forecasting and valuation. When forecasting, the analyst asks how business 558
14 Chapter 15 Full-Information 559 conditions might change and how management s strategy might change perhaps in reaction to changes in business conditions. But strategy, as a matter of choice, is itself the subject of valuation analysis. FULL-INFORMATION FORECASTING AND PRO FORMA ANALYSIS Full-information forecasting builds up pro forma future financial statements from forecasts of drivers. This is done in an orderly way to ensure that no element is overlooked. The forecasting scheme follows a straightforward outline. Sales forecasting is the starting point. Then forecasted profit margins are applied to sales to yield forecasts of operating income. And forecasted ATO applied to sales yields the forecast of NOA to complete the ReOI calculation. We will demonstrate the scheme with PPE Inc., the merchandising company for which we developed simple forecasts in the last chapter. Here are the relevant numbers in PPE s Year 0 statements (in millions of dollars): Sales Operating income 9.80 Net operating assets These numbers indicate a sales PM of 7.85 percent and an ATO of Suppose we forecast from a marketing analysis that sales for PPE Inc. will increase at a rate of 5 percent per year. Suppose also that we forecast that core profit margins will be the same in the future as they are currently (7.85 percent) and that there will be no other operating income or unusual items. To produce sales, an investment of net operating assets (more property, plant, and equipment) of 56 3/4 cents for each dollar of sales will have to be in place at the beginning of each year. This is just the inverse of the forecasted ATO, so the forecasted ATO is Based on these forecasts, we can develop the pro forma of Exhibit Sales, as you see, are growing at the predicted 5 percent rate. Applying the forecasted PM to forecasted sales each year yields operating income: OI = Sales PM. Applying the forecasted ATO to sales yields the forecast of net operating assets at the beginning of the year: NOA = Sales/ATO. So we produce the ingredients of residual operating income, OI and NOA. (Allow for some rounding errors when proofing these calculations.) The forecasted ReOI is given at the bottom of Exhibit This is growing at a rate of 5 percent per year. So, with PPE s required return for operations of percent, the value of the equity is V ReOI1 = CSE + ( ρ g) E = = $ million and the intrinsic levered P/B ratio is The value of the operations is $ million and the unlevered P/B is On 100 million shares outstanding, the per-share value is $0.96. F
15 560 Part Three Forecasting and EXHIBIT 15.1 PPE INC. Pro Forma Financial Statements, Operating Activities (in millions of dollars) (Required return for operations is 11.34%.) Year 1 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Income Statement Sales Core operating expenses Core operating income Financial income (expense) (0.70) Earnings 9.10 Balance Sheet Net operating assets Net financial assets (7.00) (7.70) Common stockholders equity (100 million shares outstanding) Cash Flow Statement OI NOA Free cash flow (C 1) RNOA (%) Profit margin (%) Asset turnover Growth in NOA (%) Residual OI (0.1134) Growth in ReOI (%) Abnormal OI Growth (AOIG) Growth in AOIG (%) Allow for rounding errors. The drivers of ReOI are given in the pro forma. The RNOA in all years is the same as that forecasted for Year 1 because its drivers, PM and ATO, are forecasted to stay the same: This is a firm with constant profitability but growing investment in NOA. But the forecast and the valuation implied differ from an SF3 forecast because ATO and growth in NOA are predicted to be different from current levels. Moreover, growth is not assumed but is forecasted by forecasting sales and the technology for producing sales that is captured by the ATO. The pro forma in Exhibit 15.1 also forecasts abnormal operating income growth (AOIG). By recognizing that AOIG is the change in ReOI, the analysis avoids forecasting cum-dividend operating income and the free cash flow needed to calculate it. As AOIG is forecasted to grow at 5 percent per year, the AOIG equity valuation is 1 V CSE = = $ million or 0.96 per share (allow for rounding error.) That is, the equity value is the value of the operations less the value of the net financial obligations.
16 Chapter 15 Full-Information 561 The forecasted OI and NOA are also the drivers of free cash flow (C I = OI NOA), so the cash flow forecast in the pro forma falls out immediately. 2 These free cash flow forecasts can, in this case, be used to value the firm using discounted cash flow analysis. As the free cash flows are forecasted to grow at 5 percent per year after Year 1, the value of the equity is V E 0 Free cash flow = ρ g E NFO = = $ million 1 0 or $0.96 per share (allow for rounding error). This is a simple scenario, of course, but it highlights the ingredients in forecasting. The change in asset turnover and growth in net operating assets from current levels might be accompanied by changes in profit margins, but always the three forecasts sales, PM, and ATO along with any other operating income and unusual items, will determine the RNOA and growth in NOA, which produce residual operating income and abnormal operating income growth. You might put the PPE example into your spreadsheet program and see how the valuation changes with different predictions of the drivers. The pro forma financial statements are not complete, but we can fill out the rest of the pro forma with just two further forecasts, one for net dividends and one for borrowing costs. The pro forma has free cash flow forecasts and so, if we forecast dividends and borrowing costs, we can forecast net financial obligations and expenses and fill out the income statement and balance sheet: NFO t = NFO t 1 (C I) t + NFE t + d t and NFE t = (ρ D 1)NFO t 1 Suppose borrowing costs are 10 percent here. Let s set the future dividend at 40 percent of net income (a 40 percent payout ratio). The pro forma rolls out as in Exhibit Interest expense in the income statement is always 10 percent of net financial obligations in place at the beginning of the period and the change in net financial obligations is always determined by the treasurer s rule: Sell debt to cover the deficiency of free cash flow over interest and dividends. In this case there is a surplus, as indicated by the debt financing flows in the forecasted cash flow statement. This has been applied to buying bonds, first the firm s own bonds until Year 3 and then others bonds after Year 3, to yield net financial assets rather than obligations. With both NOA and NFO forecasted, we have forecasted common stockholders equity: CSE = NOA NFO. 2 With these forecasts of free cash flow, one can forecast AOIG. The pro forma is developed as follows: Year 1 Year 2 Year 3 Year 4 Year 5 OI Free cash flow Reinvested FCF Cum-dividend OI Normal OI AEG (for OI) By forecasting AOIG as the change in ReOI, the forecasting is more efficient, for one avoids these calculations.
17 562 Part Three Forecasting and EXHIBIT 15.2 PPE INC. Pro Forma Financial Statements, All Activities (in millions of dollars) Year 1 Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Income Statement Sales Core operating expenses Core operating income Financial income (expense) (0.70) (0.77) (0.57) (0.35) (0.10) 0.18 Earnings Balance Sheet Net operating assets Net financial assets (7.00) (7.70) (5.71) (3.47) (0.97) Common stockholders equity (100 million shares outstanding) Cash Flow Statement OI NOA Free cash flow (C I) Dividends (payout: 40%) Debt financing Total financing flows Allow for rounding errors. The forecasting scheme can get into more detail, and that added detail will add further line items to the pro forma statements. Rather than forecasting profit margins, the detailed forecast predicts gross margins and expense ratios for each component of the margin and so builds up further line items for the forecasted income statement. And rather than forecasting the (total) asset turnover, the detailed forecast predicts individual asset and liability turnovers and so builds up the line items for the forecasted balance sheets. The forecaster decides what level of detail is necessary to improve a forecast, keeping in mind the cost of researching for more information. Box 15.3 builds up a detailed forecast for Nike A Forecasting Template We can pull all this forecasting together as a series of steps that can be built into a spreadsheet program. Step 1. Forecast Sales The sales forecast is the starting point and usually involves the most investigation. Simple extrapolations with sales growth rates are a way to get going but a complete analysis involves a thorough understanding of the business. The following issues have to be considered: 1. The firm s strategy. What lines of business is the firm likely to be in? Are new products likely? What is the product quality strategy? At what point in the product life cycle is the firm? What is the firm s acquisition and takeover strategy?
18 Full-Information Forecasting: Nike, Inc After reformulating Nike s financial statements for 2004, an analyst prepares a forecast in order to value Nike s shares. With a thorough knowledge of the business, its customers and the outlook for athletic and fashion footwear, he first prepares a sales forecast. Then, understanding the production process and the components of cost of goods sold, he forecasts how much gross margin will be earned from sales. Adding forecasts of expense ratios particularly the all-important driver, the advertising-tosales ratio he finalizes his pro forma income statements with a forecast of operating income. His forecasted balance sheet models accounts receivable, inventory, PPE, and other net operating assets based on his assessment of turnover ratios for these items. He arrives at the following forecasts: Income statement forecasts: 1. Sales for 2005 will be $13,500 million, followed by $14,600 for For , sales are expected to grow at a rate of 9 percent per year. 2. The gross margin of 42.9 percent in 2004 is expected to increase to 44.5 percent in 2005 and 2006 as benefits of off-shore manufacturing are reaped, but decline to 42 percent in 2007 and subsequently to 41 percent as labor costs increase and more costly, high-end shoes are brought to market. 3. Advertising, standing at percent of sales in 2004, will increase to 11.6 percent of sales to maintain the ambitious sales growth. The recruitment of visible sports stars to promote the brand will also add to advertising costs. 4. Other before-tax expenses are expected to be 19.6 percent of sales, the same level as in The effective tax rate on operating income will be 34.6 percent. 6. No unusual items are expected or their expected value is zero. Balance sheet forecasts: 1. To maintain sales, the carrying value of inventory will be cents per dollar of sales (an inventory turnover ratio of 8.08). 2. Receivables will be 16.5 cents per dollar of sales (a turnover ratio of 6.06). 3. PPE will fall to 12.8 cents per dollar of sales in 2005 and 2006, from the 13.1 cents in 2004, because of more sales from existing plant. However, with new production facilities coming on line at higher construction costs to support sales growth, PPE will increase to 13.9 cents on a dollar of sales (a turnover ratio of 7.19). 4. The holdings of all other net operating assets, dominated by operating liabilities, will be 6.0 percent of sales. 5. A contingent liability for the option overhang of $452 million is recognized (as calculated in Chapter 13). These forecasts result in the following pro forma and the valuation it implies (in millions of dollars): 2004A 2005E 2006E 2007E 2008E 2009E Income Statement Sales 12,253 13,500 14,600 15,914 17,346 18,907 Cost of sales 7,001 7,492 8,103 9,230 10,234 11,155 Gross margin 5,252 6,008 6,497 6,684 7,112 7,752 Advertising 1,378 1,566 1,694 1,846 2,012 2,193 Operating expenses 2,400 2,646 2,862 3,119 3,400 3,706 Operating income before tax 1,474 1,796 1,941 1,719 1,700 1,853 Tax at 34.6% Operating income after tax 961 1,175 1,269 1,124 1,112 1,212 Core profit margin 7.84% 8.69% 8.69% 7.06% 6.41% 6.41% (continued) 2. The market for the products. How will consumer behavior change? What is the elasticity of demand for products? Are substitute products emerging? 3. The firm s marketing plan. Are new markets opening? What is the pricing plan? What is the promotion and advertising plan? Does the firm have the ability to develop and maintain brand names? 563
19 Full-Information Forecasting: Nike, Inc. (concluded) A 2005E 2006E 2007E 2008E 2009E Balance Sheet Accounts receivable 2,120 2,228 2,409 2,626 2,862 3,120 Inventory 1,634 1,671 1,807 1,970 2,147 2,341 PPE 1,587 1,728 1,869 2,212 2,411 2,628 Other NOA (790) (810) (876) (955) (1,041) (1,134) Net operating assets 4,551 4,817 5,209 5,853 6,379 6,955 Asset turnover (ATO) Operating income 1,175 1,269 1,124 1,112 1,212 Change in NOA Free cash Flow RNOA (on beginning NOA) 25.82% 26.34% 21.58% 19.00% 19.00% ReOI (8.6% required return) Present Value (PV) of ReOI Total PV to ,851 Continuing Value (CV)* 12,809 19,349 Enterprise value 20,211 Net financial assets ,500 Option overhang 452 Value of common equity 20,048 Value per share on million shares: $ *CV = = 19, The analyst feels comfortable forecasting five years ahead, but is unsure about the long-term growth rate. Understanding that Nike is an exceptional firm with long-run prospects, he sets the long-term growth rate at 5 percent, above the average GDP growth rate, but has his reservations. With that growth rate, the value comes to $76.20 per share, a little above the market price of $75 per share. With concerns that interest rates are rising so the required return for operations may well increase the analyst decides to place a weak sell recommendation on the stock. With this Nike model in a spreadsheet program, the analyst is ready to adjust the pro forma and the valuation when new information arrives. When Nike announced actual results for 2005, operating income, after tax, was $1,209 million, considerably above his forecast. He revised his forecast for subsequent years and recalculated the value at $82 per share. The market price, he noted, increased to $87 per share. The analyst can also change the numbers to see how sensitive his valuation is to different scenarios about the future. He has a tool for sensitivity analysis. He also has a tool for risk analysis. See Chapter 18. Step 2. Forecast Asset Turnover and Calculate Net Operating Assets The forecasted asset turnover, applied to sales, yields the NOA: NOA = Sales/ATO. Forecasting overall ATO involves forecasting its elements: receivables turnover, inventory turnover, PPE turnover, and so on. Accordingly the forecaster develops line items on forecasted balance sheets for receivables, inventories, PPE, and so on, that total to NOA. The ATO forecast asks what assets need to be put in place to generate the forecasted sales. This of course requires a knowledge of the production technology: What plants need 564
20 Chapter 15 Full-Information 565 to be built and what level of inventories and receivables need to be carried to maintain the forecasted sales? It also requires a forecast of costs: How much will plants cost to build? In the Americas, in Asia, in Europe? For PPE Inc. we forecasted that the amount of assets to be put in place will be proportional to sales. But this is probably unrealistic. Because plants do not always run at the same level of capacity, even without changes in technology the ATO will change if more sales can be generated with existing plants or if a forecasted drop in demand produces idle capacity. The ATO forecast captures the cost (in value lost) of idle capacity and the value gained by producing sales with existing capacity. If full capacity is reached, new plants will have to be built, but they may result in idle capacity to begin with. The Nike forecast in Box 15.3 involves both an increase in PPE turnover as capacity is used and a decrease as new plants come online. Step 3. Revise Sales Forecasts Capacity constraints limit sales. Forecasted ATO yields forecasted net operating assets, but if the assets cannot be put in place to produce the sales, the sales forecast must be revised. Step 4. Forecast Core Sales Profit Margins Core OI from sales = Sales Core sales PM, so next forecast core sales PM. This involves forecasting all its components, gross margins, and expense ratios. This also requires a good knowledge of the business. What will be production costs? Is there a learning curve in production? Will technological innovations reduce costs? Will there be changes in labor costs or material prices? What will be the advertising budget? How much of each dollar of sales will be spent on R&D? For firms with operating leverage, profit margins and expense ratios, like ATO, may not be proportional to sales. Variable costs might increase as a constant percentage of sales, but if some costs are fixed over a range of forecasted sales, margins will increase as sales increase over that range. Of course, as sales continue to increase all costs become variable as additional fixed costs are incurred to support the sales, but these fixed costs increase in lumps rather than continuously. Step 5. Forecast Other Operating Income The share of income in subsidiaries is the main item here and requires going to the subsidiaries and forecasting their earnings. Step 6. Forecast Unusual Operating Items These often can t be forecasted (they are forecasted to be zero). But if you can forecast a restructuring or a special charge, this is subtracted from core operating income to get total operating income. Step 7. Calculate ReOI and AOIG With the operating income and net operating asset forecasts and the operating cost of capital, calculate residual operating income: OI t = (ρ F 1)NOA t 1. Remember the shortcut: Required return for operations ReOI = Sales Core sales PM Core other OI + UI ATO + Abnormal operating growth is the change in ReOI over the previous period. The valuation can now be done. In the PPE example we forecasted that the cost of capital was to remain constant, but we could use different rates in each period if the cost of capital were forecasted to change.