VALUATION AND FORECASTS Chapter 15 CHAPTER 15 OBJECTIVES Understand the roles of valuation and forecasting in financial statement analysis. Describe and compute three measures related to corporate value. Discuss the advantages and disadvantages associated with statistical and judgmental forecasting techniques. CHAPTER 15 OBJECTIVES (CONT.) Prepare pro forma financial statements based on your forecasts of future events. Identify the primary factors that
affect financial statement forecasts of a company or industry. VALUATION AND FORECAST OBJECTIVES Valuation The determination of somethings worth (e.g., a business entity) Share price is one measure of an entitys value (on a per share basis) Analysts often need more specific information than share price to make decisions (e.g., the timing of cash flows) VALUATION AND FORECAST OBJECTIVES (CONT.) Financial forecasts Project an entitys financial
statements Reflect an analysts assumptions about the future Compiled on a pro forma (as if) basis VALUATION METHODS Investors assessment of the worth of an firms income VALUATION METHODS (CONT.) Price to earnings approach
Captured by the price to earnings ratio (P-E ratio) Reflects an investors expectations about the future performance of a company A high P-E ratio means the market expects earnings to increase A low P-E ratio signals an expected decline in earnings Computed as: market price per share of stock / earnings per share VALUATION METHODS (CONT.) Price to cash flow approach A derivative of the P-E ratio Substitutes cash flow from operations for earnings when questions about earnings quality exist Computed as: market price per share of stock / operating cash flows per
share VALUATION METHODS (CONT.) Price to equity approach Alternative to the P-E (and cash flow to earnings ratio) Compares market value of a share of stock to its book value at one point in time Computed as: market price per share of stock / book value per share of stock eSTUFFS PRICE-EARNINGS RATIOS Market Measures 2003 2002 High capitalization 185
874 Low capitalization 95 506 Average capitalization 140 690 High price to earnings (20.56) 38.00 Low price to earnings (10.56) 22.00 Average price to earnings (15.56) 30.00 2001 1,210 739 982 57.62 35.19 46.76 FORECASTING TECHNIQUES Statistical
methods Mathematical procedures used to help forecast financial statements FORECASTING TECHNIQUES (CONT.) Statistical methods are based on characteristics exhibited in previous data or industry conditions Trendgeneral tendency or direction of events Cyclical behaviorstate of the economy, ranging from prosperity to recession Seasonalitychanges in activity level within
one reporting period Randomnessunforeseen events that affect financial performance FORECASTING TECHNIQUES (CONT.) Four common statistical methods Time series analysisextrapolates past trends into the future Exponential smoothingsimilar to time series analysis, but places greater weight on the more recent disclosures Decompostionspecifically accounts for trend, seasonality, cyclicality, and randomness in projecting the future
Linear regressionuses one or more variables (e.g., time) to predict a financial statement result (e.g., revenue) FORECASTING TECHNIQUES (CONT.) Drawbacks to statistical forecasting All models are complex Their methods are based on assumptions that must be meet for the model to be valid Caution: only sophisticated analysts should use mathematical methods Benefit: all analysts should consider factors such time, trend, and cyclicality when forecasting financial statements
FORECASTING TECHNIQUES (CONT.) Judgmental methods Alternative to statistical methods Based on informed opinion Acknowledges that forecasting is as much art as science FORECASTING TECHNIQUES (CONT.) Incorporates knowledge about the Economy Industry Entity Entitys previous financial statements Competition
FORECASTING TECHNIQUES (CONT.) Other forecasting considerations Analysts often forecast a range of outcomes, rather than a single point estimate They can create a best, worst, and most likely forecast Earnings compilations Offer a point of comparison for an analysts EPS forecast Capture the range of analysts EPS forecasts
Published by the media (e.g., First Call/Thompson Financial) PRO FORMA FINANCIAL STATEMENTS Statement construction Requires many assumptions about future events Does not require a forecast of every line item on the financial statements PRO FORMA FINANCIAL STATEMENTS (CONT.) Financial statement sequence Income statement (Exhibit 15-3A) Balance sheet (Exhibit 15-3B) Statement of cash flows, including direct operating cash flows (Exhibit
15-3C and 15-3D) 2002 PRO FORMA FINANCIAL STATEMENTS Income Statements 2002 2001 2000 Sales revenue $1,440 $1,200 $1,000 Cost of goods sold 792 660 600 Gross profit 648 540 400 Selling, general, and administrative expenses 504 485 335 Income from continuing operations 144
55 65 Financial expenses 20 20 10 Pretax income 124 35 55 Income tax expense 50 14 22 Net income $ 74 $ 21 $ 33 Earnings per share$1.06 $0.42 $0.79 2002 PRO FORMA FINANCIAL STATEMENTS
460 210 380 15 400 20 Assets Current assets: Cash Accounts receivable, net Inventory Prepaid expenses Total current assets Property, plant and equipment: Equipment, net Intangible Assets: 2002 PRO FORMA FINANCIAL STATEMENTS (CONT.) 2002
Cash flows from investing activities: Purchase of equipment (200) Acquisition of intangibles (200) Net cash provided (used) by investing activities (400) Cash flows from financing activities: Issue notes payable Issue common stock 300 Pay cash dividend - Net cash provided (used) by financing activities $ 300 $ Net change in cash Cash, end of the year $99 $144 2001 2000
2002 PRO FORMA FINANCIAL STATEMENTS (CONT.) Statement of Cash Flows 2002 Cash, beginning of the year $45 Cash flows from operating activities: Net income $74 Depreciation and amortization expenses 125 Changes in current accounts: Accounts receivable (28) Inventory (43) Prepaid expenses 5 Accounts payable 60 Accrued liabilities 6 Taxes payable
23 2002 PRO FORMA FINANCIAL STATEMENTS (CONT.) 2,002 2,001 2,000 Cash flows from investing activities: Purchase of equipment (200) (100) (500) Acquisition of intangibles (200) (25) Net cash provided (used) by investing activities (400) (100) (525) Cash flows from financing activities: Issue notes payable 100 120 Issue common stock
300 80 420 Pay cash dividend (2) (8) Net cash provided (used) by financing activities $ 300 $ 178 $ 532 Net change in cash Cash, end of the year $99 $144 $15 $45 $30 $30 VALUATION AND FORECAST OF THE PC INDUSTRY Market
valuations Confirm analytical evidence presented in previous chapters that direct PC sellers, Dell and Gateway, have outperformed indirect sellers, Apple and Compaq VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.) P-E ratios indicate that Dell was more highly valued than the other PC firms by 1998 (Exhibits 154-A to 15-4D) Gateways market value increased during the period examined The market values of Apple and Compaq declined due to poor operating performance P/E Ratios PC Industry
1997 Gateway 1998 PC Industry Low Price Earnings Ratios 1993-1998 40 35 P/E Ratios 30 25 20 15 10 5 0 1993 1994 Apple
1995 Compaq 1996 Dell 1997 1998 Gateway P/E Ratios Apple Computer P E Ratio Range 1993-1998 100 90 80 70 60 50 40 30
20 10 0 1993 1994 1995 Low 1996 High 1997 1998 VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.) Market to book value ratios reinforce conclusions drawn from P-E ratios (Exhibits 15-5A and 155B)
VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.) Industry forecasts Dell and Gateways stable growth patterns enable analysts to predict future performance with some degree of certainty (Exhibit 15-6A) The erratic nature of Apple and Compaqs results make forecasting more difficult (Exhibit 15-6B) Inventory ($) Dell and Gateway Inventory Trends (in thousands of dollars) 500 450 400 350 300
1997 1998 Linear (Dell) 1999 2000 2001 Linear (Gateway) Apple and Compaq Revenue Trends (in thousands of dollars) 45000 40000 Revenue ($) 35000 30000 25000
20000 15000 10000 5000 0 1992 1993 Apple 1994 1995 Compaq 1996 1997 1998 Linear (Compaq)
1999 2000 Linear (Apple) 2001 PC Industry Compound Annual Revenue Growth Rates 1993-1998 50% Compund Growth (%) 40% 30% 20% 10% 0% Apple -10% Compaq
Dell Gateway VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.) Apples operating activities will determine the direction of the company Optimistic perspective: the companys financial statements will improve if Technical innovations separate the company from its Wintel competitors Product development creates sustainable earnings Market share improves Consumers pay a premium for Apples value
added products VALUATION AND FORECAST OF THE PC INDUSTRY (CONT.) Pessimistic view: the company recent financial decline will continue because The market increasingly views PCs as commodities Apples intellectual activities are too costly Its competitors quickly mimic Apples technical innovations Market share continues to slide Revenues cannot support operating costs Cash cannot be generated by further
Equip for Equality is providing this information under a subcontract with the DBTAC - Great Lakes ADA Center, University of Illinois at Chicago, U.S. Department of Education, National Institute on Disability of Rehabilitation and Research Award No. #H133A110029.
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