Financial Statement Analysis/Analyst Report Project
Your task is to write an analyst’s report for your firm with your final work product including both a price target and a buy/sell/hold recommendation. Your recommendation should be supported by careful analyses of the financial statements, other macroeconomic and industry information, firm news and management opinion, and a carefully-applied valuation framework.
What you will turn in:
At a minimum, your final report will consist of the following items:
1. A reformulated Income Statement and Balance Sheet where you indentify net operating assets and operating income—including NOA, NNO and NOPAT. These are the statements upon which your valuation work depends. (This is what you’ve done for Exhibits 13.1 & 14.1)
2. Parsimonious forecasts of sales and operating earnings for 5 years.
3. An executive summary where you state your opinion on whether your firm is a buy, sell or hold and the basic set of facts—including your valuation work—upon which your decision rests. The executive summary should be no more than 1 or 2 paragraphs and not more than a single page of text.
4. Your valuation model and methodologies. Use Excel but be sure to make it clear as to the inputs you are using. In other words, make sure I can tell what went into the model and don’t just present your estimate of V0.
a. Please be explicit about your calculations of residual income, your estimate of the firm’s required cost of equity capital and your treatment of the horizon (terminal value) issue.
5. Executive summary, including:
a. Brief summary of the company’s value-producing operations, the industry in which it operates and chief competitors.
b. Chief valuation challenges (if any) of the GAAP financial statements and how reformulation focused your analyses on the creation of value (operations).
i. Other issues important to your valuation or recommendation. This is open to whatever YOU think might be important to your clients (us) in explaining your work and recommendation.
ii. Relative valuation
iii. Other analysts’ opinions and why you differ from their analysis.
Putting it All together:
• Continue gathering/analyzing data for your firm. At a minimum, you should have defined for your firm:
o Operating and non-operating assets and liabilities
o Net operating assets (NOA)
o Net operating profit after tax (NOPAT)
o Return on assets (ROA) and the disaggregation of ROA into margin and turnover and the further disaggregation into operating and non-operating return.
o Return on net operating assets (RNOA) and the disaggregation into net operating profit margin (NOPM) and net operating asset turnover (NOAT)
o Return on equity (ROE)
Ideally you would have these ratios for a minimum of three years and preferably 5 years to evaluate trends.
• Gather industry data for your firm. Start here: http://www.ibisworld.com.silk.library.umass.edu:2048/launch.aspx?
o Key ratios and industry averages are published on finance websites or here: http://www.library.umass.edu/. Go to research databases, then business, and then look for the D&B Key Industry Ratios. There is a lot of information here. While you are in the business databases section, check out the other resources that might be useful to you.
Inputs to the models—forecasting:
a. Forecasting is an art not a science. The idea is that we would like to develop a “full information” forecast for our firm’s prospects to generate future earnings and cash flows. Forecasting is not a “guess” in the sense that the word guess connotes some sort of random, uninformed estimate of the future. There should be nothing random about your earnings and cash flow forecasts.
b. Where do we start? One place I like to start is with a “naïve” forecast. That is, one that is better than a pure guess but does not incorporate all of the available information about the firm. You can then take this naïve forecast and adjust it for other firm-specific information or information about the economy or the state of the world.
Some Naïve forecasts:
1. Last year’s earnings may be my best first expectation of this year’s earnings.
2. Last year’s earnings multiplied by (1+g) where g is a reasonable short-term growth rate.
3. An average of past year’s earnings may work better if your firm has experienced one or more atypical years. For example, your firm is normally very profitable but has posted large operating losses the past few years for some reason. If you think the firm will return to “normal” earnings at some point in the near future then using an average of past years may give you a place to start.
4. Use ratios (RNOA, Turnover, Margin, etc.) to establish industry-specific or firm-specific ROAs and then use the assets in place to back into ‘normal’ earnings.
a. Using the methodology in the book—and the PowerPoint slides as a guide—use the “parsimonious method” to forecast sales and operating earnings of the next 5 years.
a. You will essentially be making two forecasts of growth here: one for the horizon period and one for the terminal period. Recall our discussion on the regression tendencies of growth rates.
Estimate of your firm’s weighted average cost of capital (WACC):
Compute your WACC for use in valuation
1. Compute your firm-specific return on equity capital using your firm-specific Beta and a market risk premium of 4% (you are free to use a different market risk premium if you think it is warranted and can defend your decision. I provide a simple estimate because we have other “fish to fry.”) Use the expected return on the 10-year Treasury for your risk-free rate.
2. Compute your cost of debt capital by computing the average borrowing rate. To get this rate, divide your interest expense by average interest-bearing debt. Next, using your tax footnote, get your firm’s statutory tax rate (this is the same way you computed the tax shield earlier) compute your firm’s return of debt capital:
Rd = Average borrowing rate x (1-tax rate)
3. Use the market values of debt (usually in the debt 10-k footnote) and the market value of equity (from yahoo finance or similar), apply the formula on page 03-13 to compute your firm’s weighted average cost of capital. This cost of capital will be used in your valuation work from this point forward in place of the arbitrary one we were using before.
• Forecast sales—and sales growth—for at least 5 years into the future.
• Use existing relationships for NOPM and NOAT to generate forecasts of NOPAT and NOA.
(firm and time subscripts omitted)
NOPM = NOPAT/SALES E(NOPAT) = E(SALES) x NOPM
NOAT = SALES/NOA E(NOA) = E(SALES)/NOAT
• You may have to get creative with what is the “normal” NOPM or NOAT for your firm. The base years you have may have unusual relationships—relationships that cannot persist into the future. Perhaps and industry average or an average of a few peer firms would work better in this case.
• Lastly, you’ll need to forecast a “terminal growth rate.” This is the growth rate you expect applies to operating profits in the very long term. Since we know growth rates tend to regress to the industry mean and industry mean growth rates regress to the growth in the economy, these long term growth rates will be very modest—in the low single digits.
2. Estimate the WACC (rw)
is the risk premium on the market (I gave you 4%) and
is the risk-free rate (as a proxy for we use the return on the 10-year treasury).
? We’ll estimate firm value (V0) using two different models. Remember that after you estimate total firm vale, you need to back out the market value of the debt (we use the book value of debt as a reliable proxy) to get the value of the equity. Then to get the estimated share price, you’ll need to divide by total shares outstanding. (Basic or fully diluted? What makes sense?)
V0 = MVd + MVe
where V0 is firm value and MVd and MVe are the market values of debt and equity, respectively.
a. FCFF or Free Cash Flows to the Firm is a measure of economic income computed as cash available to investors from operations after net investments in productive assets.
i. Measuring FCFF:
FCFFt = NOPATt – Increase in NOAt
ii. The Valuation Model:
b. Residual Income Model (RIM)
i. It is somewhat displeasing that for many firms, discounting FCFF gives us a fairly distorted estimate of value—or no estimate of value where operating or free cash flows are negative.
ii. The RIM values firms by explicitly including book value in the process. In other words, the very assets that we expect will create value are central to the analysis.
iii. The Model:
And Clean Surplus Implies
Where Divt is net owner transactions and Et is accounting earnings.
In effect, the model forces a charge to be recognized for the assets under management’s stewardship (this is the bv x r term.) Notice that no value is created unless residual earnings are created. In other words, management must do better with your invested funds than you could have done or they have failed to add value. This common sense is now impounded into our valuation work.
c. Valuation with the RIM:
i. What metric should we be using for our earnings input? GAAP Income? Income from continuing operations? Comprehensive Income? Something else? Recall our focus on operations.
Adapting the model above to focus on operations, we calculate residual operating income (ROPI)
Now you can plug ROPI in for RI in the model above. And NOPAT replaces E and NOA replaces bv (book value):
ii. Notice that you will have to reformulate the income statement a bit to arrive at operating income. NOPAT is a net income number that the firm derives from its core operations. Therefore, it should not include interest on or income from any financial assets or financial obligations.
? Notice also that you have to compute a beginning-of-the-period NOA for each period in your forecast horizon using the relation above—or from your parsimonious forecasts.
? For your firm, how much of NOPAT is reinvested in new NOA?
a. Do your forecasts of NOA from the parsimonious method make sense?
b. Can you get this relationship from past financials and then adjust it for new information from management and what you have learned about the industry?
iii. Create a table similar to the one at the top of page 14-5 (very similar to the one we used for FCFF valuation).
iv. Compute an estimate of the value of your firm using a minimum 4-5 year horizon.
? Remember to use the WACC (this is rw above) you computed for the valuations using FCFF and to adjust enterprise value for NNO.
v. Next, perform some sensitivity analyses surrounding your measurement of g (the terminal growth rate). Choose alternative measures of g and see how it impacts your estimate of value.
vi. Incorporate your ROPI valuation work into your presentation and executive summary. This is the ‘state of the art’ in valuation methods so it should be a prominent part of your presentation.
4. Begin putting it all together
• You should be looking for news on your firm, management reports including the MD&A, as well as forecasts for the economy to help inform your forecasts.
i. Remember, we are not trying to “make the model work” at this point. We think the model will work if we use the right inputs. If we get a valuation that is very different from current price that is OK. It means we can give our clients some advice about the action to take (Buy, Sell Hold). In fact, if we compute a price that is very close to share price, we haven’t uncovered “value.”
ii. Of course, notwithstanding i above, we need to make sure our model is not giving us nonsense. If it appears it is, we need to check for errors in execution of the valuation techniques.
• Sensitivity Analysis
We have been using different estimates of the risk premium, g (the long-term or perpetual growth rate) as well as our forecasts of earnings and dividends which include implicit assumptions about short-term growth.
Sensitivity analysis is the systematic testing of our assumptions and estimates so that we can construct a probability distribution around our point estimate of value. Suppose your ROPI or FCFF model yield estimates that your firm should trade at $65.79 per share. We don’t really think that $65.79 is an exact computation of value since we know our inputs are noisy and our model imperfect. What we mean is that we think the value is around $65 per share. Sensitivity analysis simply examines how sensitive our estimate of value is when we make changes to r, g and our forecasts.
It would be nice if we continued to get numbers that were close to $65 as it would increase our confidence that the point estimate is a good one.
i. For your firm, try at least three different estimates for r and/or g and/or short-term sales growth in combination to see how it changes your valuation. You may find that your estimate of value is very sensitive to some assumptions and estimates.
5. Begin assembling your presentation.
• If you haven’t already started, you should be thinking about the structure and format of your presentation.
i. Avoid trying to make the model work. There is no extra credit because your model was within pennies of the actual stock price. It is more fun in fact to find a security that is under- (or over-) priced by the market
ii. Brevity is key—you only have 10-15 minutes.
iii. Start with the punch line—is the stock a buy, sell or hold?
iv. Every other statement should relate to your conclusion.
v. Avoid the book report trap. No one cares what the CEO’s boat’s name is.
vi. Report on weaknesses as well as strengths. Avoid being a cheerleader. You are an unbiased analyst—report the good the bad and the ugly.
6. If you find you have extra time and want to explore relative valuation, see Module 15 and the notes below.
Relative Valuation (OPTIONAL)
In relative valuation, the value of an asset is compared to the values assessed by the market for similar or comparable assets. To do relative valuation we need to identify comparable assets and obtain market values for these assets. Next, we convert these market values into standardized values, since the absolute prices cannot be compared.
This process of standardizing creates price multiples.
We compare the standardized value or multiple for the asset being analyzed to
the standardized values for comparable asset, controlling for any
differences between the firms that might affect the multiple, to judge
whether the asset is under- (or over-) valued.
Prices can be standardized using a common variable such as earnings,
cash flows, book value or revenues.
• Earnings Multiples
– Price/Earnings Ratio (PE) and variants (PEG and Relative PE)
For our purposes, because of time constraints, I only want you to compute the PE ratio for your firm and for (at a minimum) your comparison firm. This will give you one more piece of information about whether you think your firm is over or under valued. Firms in similar industries with similar growth prospects should have similar PE ratios (which can also be thought of the capitalization rate being applied by the market to earnings).
Some Helpful Relations:
Assets=Liabilities + Owners’ Equity
Owners’ Equity=Common Equity + Preferred Equity
OI=Net Income—Net Financial Income
Net Assets=Book Value=Assets—Liabilities=Shareholders’ Equity
Net Operating Assets=Net Assets—non-operating assets
Analyst Project Report of KEURIG GREEN MOUNTAIN, Inc.