AFSA Lecture 5

Important Exam Information

• Exam time was adjusted because of room capacity constraints
• The new exam time is April 23, 2025, from 18:30 to 20:30
• The old exam time was April 23, 2025, from 13:30 to 15:30

Group Assignment Update

• Boeing has been replaced with Airbus for the assignment
• Use Airbus's investor relations website for information
• This includes financial statements, quarterly reports, reports of the board of directors, and press releases with material information

Mock Exam Details

• The mock exam is based on a previous real exam
• It is available on Canvas under "Self-Exercise"
• Solutions for self-checking will be uploaded next Thursday
• Taking the mock exam will help you avoid self-deception when practicing and give you a realistic sense of the exam setup
• You can use the mock exam to get used to the exam format, check your understanding of the course material, and practice time management

Today's Lecture Topics

• Chapter 6: Forecasting
• Chapter 7: Valuation
• Chapter 8: Practical implementation of valuation models
• Valuation approaches
• Discount rates
• Terminal values
• Other practical issues

Last Week's Key Concepts

• The Return on Equity, ROE, is calculated as Net Income / Average Equity or ROA × Equity Multiplier (EM)
• Alternative formula for ROE is ROS × ATO × EM
• Balance sheet and income statement reformulation
• Assets side consists of: Net operating assets (NOA), Investment assets (IA), and Business assets (BA)
• Liabilities+Equity side consists of: Financial obligations (FO), Equity and Net capital
• Income statement calculations consists of: Net Operating Revenue, Net Operating Profit After Tax (NOPAT), Net Investment Profit After Tax (NIPAT), Interest Expense After Tax (IEAT)
• Net income calculation is NOPAT + NIPAT - IEAT
• Decomposition of ROE: ROBA + Spread × Leverage

Prospective Analysis Overview

• Move to a forward-looking perspective using accounting/financial analysis
• Part 1: Forecasting
• Part 2: Valuation

Forecasting Fundamentals

• Accurate forecasting to gauge a company's future performance is essential, it is the first step prior to implementing valuation analysis
• Prospective Analysis depends on:
• Business Strategy Analysis
• Accounting Analysis
• Financial Analysis
• Understanding of certain techniques and historical knowledge are necessary to create a forecast that is based on acquired knowledge from each step

Comprehensive Forecasting Strategies

• The optimal way to forecast future performance is comprehensively by forecasting earnings along with the balance sheet, including cash flows where applicable
• Comprehensive forecasting is is useful, even when only interested in one number
• Forecasting the balance sheet prevents and guards potentially unrealistic assumptions
• Example of an implicit assumption is forecasting high sales and earnings without considering the required investment in assets
• Comprehensive forecasting relies on a few key drivers such as sales forecast, profit margins, and asset turnover
• By linking balance sheet amounts to sales, you avoid inconsistencies and unrealistic assumption, such as changes in working capital linked to revenue changes

Condensed Financial Statements

• Previous classes covered over turning financial statements into "condensed" statements
• Forecasting = projecting these "condensed” statements into the future
• Condensed statements require a relatively small set of assumptions
• Condensed statements help identify operating, investing, and financing activities, and assets/liabilities
• Forecasting condensed statements helps to forecast the net profit and equity
• Net profit and equity are key inputs for the valuation model

Condensed Balance Sheet Components

• Operating working capital (OWC) + Net non-current operating assets (NNCOA) = Net operating assets (NOA) + Investment assets (IA) = Business assets (BA)
• Financial obligations [Debt] (FO) + Common shareholders' equity + Minority interest = Net capital
• Forecasting steps incude: OWC, NNCOA, IA, FO, and minority interest, to get forecasts of equity

Condensed Income Statement Contents

• The summarized income statement has Sales, Net operating profit (NOP), Marginal tax rate, Tax, and Earnings of discontinued operations.
• It also has Net operating profit after tax (NOPAT), Net investment income, and Tax.
• Net investment income after tax (NIPAT) is also part of the comprehensive statement
• In addition, Interest expense, Tax, Interest expense after tax (IEAT) are included
• Statements also contains Minority interest in earnings, which are used in calculating Net income (to common shareholders)
• NOPAT+NIPAT-IEAT-Minority interest = Income after Minority interest for common shareholders
• To get the forecast of Net Income you need to forecast the following: NOPAT, NIPAT, IEAT, and Minority interest.

Approach to Computing Ratios

• Financial ratios use average balance sheet values between years t and t-1
• OATO = Sales / Average NOA
• Simplify forecasting by using the beginning values for balance sheet values
• Ex: OATO = Sales / Beginning NOA
• Therefore ratio analysis uses average balance sheet values and forecasting models use beginning balance sheet values

Steps for Forecasting Condensed Statements

• For years 2025-2034:
• 1. Start with the condensed balance of 2024
• 2. Project sales growth for 2025-2034
• 3. Assume NOPAT margin changes (operating return on sales)
• 4. Operating items
  • Operating working capital to revenue (Sales / OWC)
  • Net operating non-current assets to revenue (Sales / NNCOA)
• 5. Investment items
  • Ratio of investment assets to revenue (Sales / IA)
  • Return on investment assets (NIPAT / IA)
• 6. Financing items
  • Ratio of debt to capital (DEBT / EQUITY)
• Gives us equity
  • Interest rate after tax (IEAT)
• Gives us net income

Framework of Assumptions

• Focus on Sales growth, NOPAT margin, Operating working capital turnover, Net non-current operating asset turnover, and Investment assets turnover
• Then find the Return on investment, Debt / Equity, and Interest rate after tax,
• And the Cost of equity and Terminal growth rate
• Assuming constant rates for items 3 through 8 is generally sufficient

Forecasted Condensed BS and IS

• Beginning net capital = Beginning operating working capital (OWC) + Beginning net non-current operating assets (NNCOA) + Beginning investment assets (IA)
• Equity = Beginning net capital - Beginning financial obligations - Beginning non-controlling interest
• Statements also provides information on sales, NOPAT, NIPAT, IEAT and Net income
• The 2024 condensed statement items are needed

Regular Performance

Measurements

• Past performance helps understanding key measures (sales or earnings)
• The time series can provide insights into trends for future performance
• Past periods provide benchmarks

Key Statistics

• A point of departure based on prior behavior is more powerful than you might expect
• Earnings are "persistent"
• Future earnings are derived from past earnings, the formula is: EARNt+1 = a + b × EARN₁ + e, where b>0

Performance Behavior: Sales Growth

• Sales growth: Mean reverting (6-10% in long-run), sales growth slows due to demand saturation and industry competition

Performance Behavior: Earnings

• Earnings: Follow a random walk with drift, or a random walk
• Long-term trends are often sustained on average

Performance Behavior: ROE

• ROE: Dependent on both earnings and the asset base
• ROE reverts to the mean and is generally in the 8-12% in long-run range
• Persistently high levels of ROE are often due to sustainable competitive advantage, or conservatism within accounting
• ROE components:
  • Operating asset turnover (OATO): Stable over time
  • Financial leverage: Stable over time
  • NOPAT margins and spread: more variable – competitive forces drive down abnormal ROE through NOPAT margins and spread

Valuation Overview

• These are the common valuation methods:
  • Discounted dividends
  • Discounted cash flows (DCF)
  • Discounted abnormal earnings
  • Discounted abnormal earnings growth
  • Valuation based on multiples
• Focus on discounted abnormal earnings and the other methods will be discussed and are not necessarily used in the course

Shareholder Value

• Shareholders care about receiving a return on investment
• Through a regular dividend, or through the ability to liquidate the investment at a higher price

Discounted Dividends Model (DDM)

• Equity share value is the present value of expected future dividends
• V = Dividends₁/(1+re) + Dividends2/(1+re)² + Dividends3/(1 + re)3 +: Where re is the discount rate
• For Dividends growing at a constant rate of g:
• V = Dividends₁/(re - g)

Discounted Dividend Model

Advantages:

• Easy to apply , dividends are what shareholders get
• Dividends yield are fairly predictable

Disadvantages:

• Not directly related to value creation
• Some companies do not pay dividends and or dividends are more relevant in some countries
• Can cause issues with the valuation model when there is a horizon forecast

Discounted Abnormal Earnings

• Known as the Residual Income valuation model; the model is correlated with shareholder value and does not rely on future dividend information
• Clean surplus relation:
• BVE₁ = BVE + Earnings₁ – Dividends₁
• Clean Surplus suggests all changes in owners equity, with exceptions to share issues and repurchases, and that there is significant flow through the income statement
• It can be rewritten as:
• Dividends₁ = Earnings₁ + BVE – BVE₁ = E₁ + Bo - B₁
• From this we can replace dividends in the DDM
• V = (E₁ + Bo - B1) / (1 + re) + (E2 + B1 - B2) / (1 + re)² + (E3 + B2 - B3) / (1 + re)3 + ... or:
• Earnings₁ – reBVEo /(1 + re) + Earnings2 – reBVE1 /(1 + re)^2 +

Discounted Abnormal Earnings: Equation Explanation

• Introduction of zero sum equation:

  • 0 = Bo - (1+re)Bo / (1+re)

• This zero-sum equation, we get:

  • 0 = (E1 - reBo) /(1 + re) + (E2 - reB1) /(1 + re)² +...

• Infinite application can result in:

  • V = (Earnings₁ – reBVEo) /(1 + re) + (Earnings2 – reBVE1) /(1 + re)^2 + (Earnings3 – reBVE2) /(1 + re)^3 Summation notation: = BVE + (Earningsť - reBVEt-1) /(1+re)t

• Transformed to DDM to current book value BVE, Future value of earnings and Future equity values

Discounted Abnormal Earnings Valuation

• The Equity model does not depend on dividend forecasts
• Depends on earning forecasts (net income estimate)
• Earnings are directly accountable to all shareholders (post-tax and interest payments) over a set period
  • Connection with operation and capital activity through accounting principles

Additional Benefits

• Need for financial forecasts
  • Using the equity of previous balance sheets
• Used to understand valuation for current assets and equity investments

Model

 V = BVE +  (Earningsť - reBVEt-1) /(1+re)t

• Abnormal returns are returns - the normal levels of returns that can be expected and what equity will generate at the start of the period
  • discount is Earning₁-rex BVE /(1re)

Valuation: Additional Elements

AE valuation will give more details on equity if earnings are deemed expected at the start

If PV of all the AE >0 the valuation is exactly in alignment with BV equity.

Accounting Issues can effect valuations

Analyst must recognize accounting changes on equity estimates

AE values depend on BV equity estimates and balance sheets

Accounting has a self rectifying/reversing attribute

Emphasis on the importance of a preceding AE valuation

Accounting in R&D has to be viewed carefully as it can undstate BVE which inturn effects expectations on forwards expectations.

Analyst need to factor consequences with accounting principles to estimate equity.

Accounting Treament Example

Analysis needs to consider consequences of years 1 due to effects on under/over stating exp vs revenues over a 10 year span

Consequence for bv and expenses by 10m

Analyse for AEP.

AE less by 10, and the years after can be estimated as BVi/E/AE

AE + or - is to find the normal estimates of the overall valuation.

MKT- to BOOK and Unusual Revenue Statistics

In practice the the estimated stock estimates can be very different depending on which BV is viewed with Analyst/investors.

MTB ratios and historical data helps guide valuation for the MKT estimates

What influences them? Current data creates a forward look compared to financial conservatism and backwards outlook.

Rewriting BVs is important to getting correct analysis for MBF calculations moving forwards..

BVE Equations and Valuations.

We can weigh each estimate to find value vs growth. More importantly is getting returns vs rates in BV.

Multiples

Alternative Method

What estimates can be used for ratios. Earnings value Mkt to book

Estimates. Comparables to industry averages will get the right estimates of interest Valuations Estimates require NO forecast information. Disadvantage Whats comparable Efficiency

Uniqueness

With multiple valuation may will effect treatments moving forwards

PE overstated and earnings under.

BV or MTB also are subject estimates and conservative methods can cause large disparity

Chapter 7 3+4

BV formula. Can be simplified and is in steady growth with ratios.

Rewritten to the following

Equity= Equity value/ rate with growth

Given the previous we now can estimate as follows. Mkt to book share is 5$ with 15percent return expected/ with 10pc growth the LT value expect is 25 percent earnings.

Rate valuation and is solvable.

Estimations

P = 1 + % 0.2% We now expect to see an EQ adjustment ROE in 33pc.

Self Study

Files on canvas provide additional insight.

Self Study Files on canvas provide additional valuations

The data can be presented with charts to properly follow steps to estimates.

Next next will continue with more examples on valuations. Chapter 8 Will address more valuations insights

Condensed Balance are at the forefront for the valuation.

Valuation approaches

Valuation is possible with multiple methods given the analysis that’s already been performed.

Primary form and discount rates.

NOpat Interest exp estimates Mkt value Capital rates

Also estimate the Equities and the cost valuation.

Equity valuation is best estimates using different methods.

Estimates require the right data/analyst skills

Equity value is also best and also has the greatest need for accuracy because of CAP estimates.

Government insights in data is extremely important and there should be a long term look (10 Year Bonds look)

Also mkt prem is a huge factor that needs to evaluated and is subject to a 5 pc increase.

Enteprise Valuation :

It has an abnormal focus on valuation to replace forecasts earnings with estimates VBV = NOPAT/ wacc. Can be applied

Income gets a substitute with NOPAT and interest

Both items require interest

NP and NOP are before tax profits that are given to debt and holders to estimate valuation

What needs attention are EQ as the results for estimations.

After all is said and done the data subtracted will be valued as debt. WAC are also important to review.. WACC and EQ valuation