Transcript
C14.3 An SF2 forecast projects that new investment will earn at the required rate of
return. An SF3 forecast forecasts that new investment will earn at the same rate of return (RNOA) as the investments in the current period.
C14.4 If current core operating income is appropriately purged of transitory items the
forecast is a good forecast if: (1) Profitability of the net operating assets (RNOA) will be the same, and (2) There is no growth growth in net operating assets assets.. A forecast should adjust for growth. So a sound forecast based on current operating income (an SF2 forecast) is: Core OI , = Core OI0 + (Required return × ∆ NOA)
C14.5 The growth rate for sales is the same as the growth rate in residual operating
income when RNOA is constant, the required return is constant, and asset turnovers are constant. (if RNOA is constant and ATO is constant, profit margins (PM) must must also be constant.)
C14.6 A firm with high expected growth in sales is probably a firm that can grow residual
earnings. But sales have to be profitable: a firm might grow sales, but but with declining profit margins and increasing asset turnovers, that is, with rising expenses per dollar of sales and increasing investment to get a dollar of sales.
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must be greater than the required C14.7 This statement is generally correct. But RNOA must return on operations for it to be correct. See the calculation for the unlevered P/B in the chapter.
Simple Forecasting and Simple Valuation – Chapter 14 p. 143 143
Exercises Exercises E.14.1 E.14.1 Simple Simple Forecasting Forecasting and Valuation Valuation
(a) (a)
Resi Residu dual al ope opera rati ting ng inc incom omee (ReO (ReOI) I) is 91.4 = (12% - required return) × 4,572 So required return = 10%
(b)
Value of equity = CSE +
Re OI2004 0.10
= 3,329 +
91.4 0.10
= $4,243 million Also, Value of equity =
=
OI2004 0.10
- NFO
548.64 0.10
- 1,243
= $4,243 million
(c)
To get get the the resi residual dual earning earningss forec forecast, ast, we need need the the requir required ed retur return n for equity. equity. Using Using the value of the equity calculated in part (b), and the value of the net debt on the balance sheet, sheet, we can can calculate calculate the required required return return using using the "market "market leverage," leverage," as as in the formula 13.8 in Chapter 13.
Required return for equity
= 10.0% +
[
1,243 4,243 × (10.0% - 6.0%)
]
= 11.17%
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So the comprehensive earnings forecast for 2004 is Operating income Net financial financial expense expense Comprehensive
548.6
(4,572 × 12%)
74.6
(1,243 × 6%)
474.0
The residual earnings forecast is
RE
= 47 474.0 4.0 - (0.1117 117 × 3,329 ,329)) = 102.2 2.2
Simple Forecasting and Simple Valuation – Chapter 14 p. 145 145
E14.2 E14.2 SF2 and and SF3 SF3 Valuat Valuation: ion: Ben Ben & Jerry’ Jerry’ss
(a) Refer to reformulated reformulated statements statements for Ben & Jerry's Jerry's in the solution to Exercise 11.8 in Chapter 11.
The ReOI for 1996 can be calculated from the operating income (4.1) and NOA at the beginning of the year (74.8):
ReOI1986
= 4.1 - (0.10 × 74.8) = 3.38
SF2 valuation: The value of the equity is Value of equity
= CSE +
= 82.8 -
ReOI1996 0.10 3.38 0.10
= $49 million or 6.81 per share An SF3 valuation won't work: growth can't be applied to negative ReOI. More information needed: Generally we want information on future RNOA and growth in NOA: will increase in advertising affect PM, ATO and NOA? Strategy? Expansion plans? New products? Possible takeover target?
(b) One reason reason might be market market inefficie inefficiency: ncy: The stock is is overpriced. overpriced. Ben & Jerry's Jerry's is priced high high for a low low profitabili profitability ty firm. firm.
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1 Taking 18 as an efficient price, then the market sees much higher RNOA and/or 8 1 growth in NOA than currently. The 18 price is a premium premium of 6.62 6.62 per share share over 8 book value value (11.51 per per share). share). This implies implies a permanent permanent level of ReOI of of 4.76:
VOE
= 82.8 +
4.76
1 = 130.4 or 18 per share. share. 0.10 8
Can one forecast future RNOA and growth in NOA that will justify this level of residual operating profitability? If not, the the stock is overpriced.
Too excited about ice cream? Cool it!
Simple Forecasting and Simple Valuation – Chapter 14 p. 147 147
E14.3 Simple Forecasting Forecasting and and Sensitivity Sensitivity Analysis: Analysis: Reebok International International (a)
Unlevered P/B
=
=
Pr ice of Equity + Net Debt + Value of Minority Interest NOA 2,401 + 720 + 210 1,135
= 2.93
(b) (b)
Marke Markett pric pricee of opera operati tions ons = $1,1 $1,135 35 mil milli lion on × 2.93 2.93 = $ 3,331 3,331 mil milli lion. on. Value of operations = 1,135 +
(0.146 − 0.101) × 1,135 1.101 − 9
For a market price of $3,331 million for the operations, g = 1.078, or a 7.8% annual growth rate in net operating assets
If asset turnovers were also constant, thus growth rate would translate into a sales growth rate.
(c) (c)
RNO RNOA wou woulld fal falll to to 3.5 3.5% % × 2.9 2.95 5 = 10.33 0.33% %. So, value of operations with this RNOA would be: Value of operations
= 1,135 +
(0.1033 − 0.101) × 1,135 1.101 − 1.078
= $1,248.5 million Unlevered P/B
=
$1,248.5 1,135.0
= 1.1
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(d) (d)
Sales Sales gro growt wth h woul would d contr contrib ibut utee nothi nothing ng to to the the valu valuat atio ion n with with a 3.4 3.42% 2% pro profi fitt margin, RNOA would be 3.42% × 2.95 = 10.1%, equal to the required return on operations. Reebok would be worth book value.
Simple Forecasting and Simple Valuation – Chapter 14 p. 149 149
E14.4 E14.4 Idle Idle Capa Capacit city y and and Value Value
(a)
ATO
=
32 10
Accounts re receivable tu turnover
Inventory turnover
=
= 2.0
= 32 4.3
32 1.0
= 32.0
= 7.4 32
Plant turnover
=
RNOA
= PM × ATO
10.7
= 3.0
= 5.6% × 2.0 = 11.2%
(b) Value of operations
= 16.0 +
(0.112 − 0.10) × 16.0 0.10
= $17.92 million (an SF2 valuation)
(c) The net operating asset section of the balance sheet will change to reflect the increased investment in accounts receivable and inventory (in millions of dollars):
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Accounts receivable
2.0 (turnover unchanged)
Inventory
8.6 (turnover unchanged)
Plant
10.7 (t (turnover increases to 6.0)
NOA
21.3
Total ATO
=
64 21.3
= 3.0 RNOA
= 5.6% × 3.0 = 16.8%
Value of operations
= 21.3 +
(0.168 − 0.10) × 21.3 0.10
= $35.78 million
The value has come by using the idle components (with no additional investment in plant) with with just a little little additional additional investment investment in in accounts receivable receivable and inventory. The driver that picks this up is the the Plant Turnover: Turnover: This increases from 3.0 to 6.0. And other drivers, except sales growth, remain the same. same.
Simple Forecasting and Simple Valuation – Chapter 14 p. 151 151
E14.5 E14.5 Value Value and Growt Growth h in Sales: Sales: Wal-Ma Wal-Mart rt Stores Stores
(a) With constant margins and turnovers, growth will be determined by growth in sales.
RNOA = PM × ATO
= 3.65% × 4.66 = 17.0%
Fore Foreca cast st of ReOI ReOI for for 200 2000 0
= (0. (0.17 17 - 0.11 0.11)) × 29. 29.9 9 = 1.7 1.794 94
Forecasted growth in ReOI
= 8% per year
NOA
V 1999
= 29.9 +
1.794 1.11 − 1.08
= $89.7 billion
E
V 1999
NOA
= V 1999 - NFO = 89.7 - 8.0 = $81.7 billion
(b) Calculate the implied growth rate using reverse engineering. As margins and turnovers are constant, the implied growth in ReOI is the implied growth in sales. NOA
P 1999
= 200 + 8 = $208 billion 1.794
208
= 29.9 +
g
= 1. 1.099 (9.9% growth rate)
1.11 − g
[Again, sales growth rate is ReOI growth rate in this case]
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Sales2000
= ATO × NOA
= 4.66 × $29.9 billion = 139.334 billion Expected Sales2004
= 139.334 × 1.0994 = $203.258 billion
Simple Forecasting and Simple Valuation – Chapter 14 p. 153 153
E14.6 E14.6 Prepari Preparing ng a Valuatio Valuation n Grid: Grid: Coca-Co Coca-Cola la
(a) To prepare the valuation grid, apply alternative scenarios to the following valuation formula, and then divide by the 2,271 million shares outstanding: Value of equity = 7,311 +
RNOA − 0.10) × 11,186 1.10 - g
Where g is growth in NOA or, with a constant asset turnover, growth in sales.
So, for example, if the RNOA in 1996 was indicative of the future RNOA (rather than the 1997 RNOA), the value of the equity would, with a sales growth rate of 7.5%, be Value of equity = 7,311 +
(0.367 − 0.10) × 11,186 1.10 − 1.075
= $126,777 million (or $51.31 per share)
The $51.31 per share contrasts with the $56.20 per share calculated in the text with 1997 RNOA.
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Here is a valuation grid that gives some range of RNOA and growth in Sales. Values one per share.
RNOA
Growth in Sales
30%
33%
36%
39%
42%
5%
21.07
23.78
26.50
29.21
31.93
6%
25.59
28.99
32.38
35.78
39.17
7%
33.14
37.67
42.19
46.72
51.25
8%
48.23
55.02
61.81
69.00
75.39
9%
93.50
107.08
120.66
134.24
147.82
Growth in sales is used rather than growth in NOA for the case of constant ATO. The grid can be expanded for changing ATO and, indeed, changing forecasts of profit margins. margins.
Cotie's per-share price at the end of 1997 was $70. This corresponds (in the grid) to an expected RNOA of 39% with growth in sales of 8% per year.
(b) This question requires a matched matched pairs analyses. For a given RNOA, RNOA, the required growth rate in NOA (plus one) is given by g=
(Premium x 1.10) - [(RNOA - 0.10) × 11,186] Premium
Simple Forecasting and Simple Valuation – Chapter 14 p. 155 155
The market value of the firm is 70 x 2,471 million = $172,970 million. So the premium is $172,970 - 7,311 = $165,659 million So, g=
(165,659 × 1.10) − [(RNOA − 0.10) × 11,186] 165,659
Thus, for an RNOA of 39%, g = 1.0804 or 8.04%. The matched pairs for the RNOA in the valuation grid are:
Matched Pairs Price = $70 RNOA
Growth in NOA
30%
8.65%
33%
8.45%
36%
8.24%
39%
8.04%
42%
7.84%
Coke needs considerable growth to justify a $70 price, even at an expected RNOA of 42%.
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E14.7. A Simple Valuation Based on Abnormal Operating Income Growth: Coca Cola
Box 14.3 applies an SF3 valuation to Coke using the residual operating income method. With constant RNOA and constant ATO, residual operating income is forecasted to grow at the sales growth rate of 7.5%. As the growth rate in residual operating income is always to the abnormal operating income growth rate, we can apply the SF3 AOIG valuation with this growth rate. The formula is in equation 14.4 of the chapter:
V 0 NOA
AOIG2 OI 1 1 1+ = OI 1 × ρ F − 1 ρ F − g
The inputs: Year 0 is 1997; Year 1 is 1998; Year 2 in 1999 OI1 = NOA0 × RNOA1
(RNOA is expected to stay at the same level as in 1997)
= 11,186 × 0.394 = 4,407 AOIG2 = OI2 + (FCF1× 0.10) – (1.10 × 4,407 NOA1 = NOA0 × 1.075 = 12,025 OI2
(NOA growing at the sales growth rate)
= 12,025 × 0.394 = 4,738
FCF1 = OI1 - ∆ NOA1 = 4,407 – 839 = 3,568 AOIG2 = 4,738 + (3,568 × 0.10) – (1.10 × 4,407) = 247.1
Value of operations
247.1 4 , 407 1 + = $ 4,407 × 0.10 1.10 − 1.075 1
= $4,407 × 32.43
Simple Forecasting and Simple Valuation – Chapter 14 p. 157 157
= $142,910 million This is close to the valuation of operations in Box 14.3, allowing for rounding error. Note: a simpler simpler way way to get AOIG2 AOIG2 = ReOI1 × 1.075 = 3,288.7 × 0.075 = 247.0 This works because AOIG is always just the growth in residual operating income. The exercise can also be worked using growth rates and model 14.4a: V 0 N OA
= OI 1 ×
G2 − ρ F 1 + ρ − g ρ F − 1 F 1
As G2 (cum-FCF OI growth rate in Year 2) = 15.61, then V 0 NOA
= 4,407 ×
1 + 1.1561 − 1.10 0.10 1.10 − 1.075 1
= 142,910 million
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E14.8. A simple Valuation with Short-term and Long-term Growth Rates: Cisco Systems
Pro forma Cisco as follows: 2003
Eps 0.54 Dps Reinvested dividends
2004
0.61 0.00 0.00
Cum-dividend earnings
0.61
Cum-div growth rate (G2) Long-term growth (Glong)
12.96% 4.0%
Applying the two-stage growth formula: NOA V 2002
= OI 1 ×
G2 − Glong ρ F − 1 ρ F − Glong
= 0.54 ×
1
1.1296 − 1.04 0.09 1.09 − 1.04 1
= 0.54 × 19.9 = $10.75 per share (The forward P/E is 19.9). This valuation is less than than the market price of $15. The market is pricing Cisco at a forward P/E of 15/0.54 = 27.8. So the market implicitly is seeing longterm growth in excess of 4% (if the required return is 9%) if one takes analysts forecasts for 2003 and 2004 as sound estimates.
Simple Forecasting and Simple Valuation – Chapter 14 p. 159 159
E14.9. Using Short-term and Long-term Growth Rates to Value Reebok
Pro forma Reebok as follows:
Operating income ($million) Net operating operating assets assets (NOA) (NOA) (growing at 7%) Free cash flow (OI - ∆ NOA) Reinvested free cash flow (at 10.1%) Cum-FCF operating income
1996
1997
1998
1,135
187 1,214
200 1,299
108
Cum-FCF OI growth rate (G2) 210.9/187
115 10.9 210.9 12.78%
The formula for a two-stage growth valuation is: NOA
V 1996
= OI 1 ×
G2 − Glong ρ F − 1 ρ F − Glong 1
A valuation grid is prepared by setting G2 = 1.1278 and calculating V NOA for different longterm growth rates, Glong. The forward enterprise P/E (which multiplies OI1 of $187 million in the formula) is included below. Per-share value is based on the 55.84 million shares outstanding (Box 13.5 in Chapter 13). Glong
Forward P/E
VNOA
NFO
VE
Value per share
1%
12.82
$2,397
720
1,677
30.03
2%
13.18
2,464
720
1,744
31.23
3%
13.64
2,550
720
1,830
32.77
4%
14.25
2,665
720
1,918
34.36
6%
16.37
3,061
720
2,342
41.94
8%
22.64
4,214
720
3,494
62.58
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Reebok was trading at about $42 at the time. So, Given analysts’ forecasts for 1997 and 1998, the market was implicitly forecasting ling-run growth at 6% and so gave Reebok a forward enterprise P/E of 16.4. This is a bit high for a perpetual growth rate.
Simple Forecasting and Simple Valuation – Chapter 14 p. 161 161
Minicases Minicases M14.1 Simple Forecasting, Forecasting, Valuation, and Sensitivity Sensitivity Analysis: Home Depot Introduction Introduction
This case applies simple forecasting to the valuation of Home Depot, Inc. at the end of 1999. At the time this firm traded traded at very high multiples multiples that conjecture overvaluation. Simple valuation methods give us perspective on this conjecture. They allow the analyst to test forecasting scenarios --through sensitivity analysis-- and to examine the implied forecasts in the market price. Students will see simple simple forecasting in action in this case. And they will see see the limitations of simple forecasting-- and the need to search for further information to develop the full-information forecasting of the next chapter. Simple forecasting and valuation is based on the information in the current and past financial statements. So, before forecasting, summarize the statements in a form that elicits the information in the statements that will help with forecasting:
•
Reformulate financial statements to separate the operating activities from the financial activities.
•
Identify core (sustainable) income in the reformulated income statements
•
Examine the regularity of the profitability by preparing comparative common size income statements over the years. Common size statements yield an analysis of profit margins. margins.
•
Analyze asset turnovers to complement the analysis of margins.
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•
Prepare a trend analysis to observe any trends that might be extrapolated to the future
The Set-up for Forecasting: Reformulated Financial Statements
Reformulated Income Statements
Sales Cost of Merchandise Gross Profit Core operating expenses General and administrative Core operating income from sales Tax reported Tax on financing Tax on unusual items
1,040 3 ---
1999
1998
1997
1996
30,219 21,614 8,605
24,156 17,375 6,781
19,535 14,101 5,434
15,470 11,184 4,286
5,429
4,368
3,584
2,836
515
413
324
270
2,661
2,000
1,526
1,180
1,043
738 (1) 41
778
597 (4) ---
593
464 (6) ---
458
Core operating income from sales (after tax) Non- recurring recurring charge Currency translations Tax for non-recurring charge
1,618
1,222
933
---
(104)
---
(33) ---
(30) 41
8 ---
5
Operating income after tax
1,585
1,129
941
727
Interest expense Interest Income Tax (39%)
(37) 30 (7) 3
(4)
(42) 44 2 (1)
1
(16) 25 9 (4)
5
722
(4) 20 16 6
Simple Forecasting and Simple Valuation – Chapter 14 p. 163 163
10
COMPREHENSIVE INCOME
1,581
1,130
946
(The 1996 income stat statement ement was not given in the case. This has been added for further further comparisons.)
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737
Reformulated Balance Sheets
1999
1998
1997
1996
Operating assets
13,384
11,037
8,762
7,199
Operating liabilities
(3,136)
(2,704)
(2,040)
(1,567)
NOA
10,248
8,333
6,722
5,632
(81)
(192)
(580)
(155)
Financial assets Financial liabilities
1,580
1,311
1,249
722
NFO
1,499
1,119
669
567
9
116
98
77
CSE
8,740
7,098
5,955
4,988
Average NOA
9,291
7,528
6,177
4,951
Average NFO
1,309
894
618
530
Average equity before minority minority interest
7,982
6,634
5,559
4,421
Minority interest
As a balance sheet is not available for 1995, average amounts are approximated. Financial assets are the sum of cash and cash equivalents, short-term investments, longterm investments (debt) and long-term notes receivable, minus part of cash for operating cash.
Simple Forecasting and Simple Valuation – Chapter 14 p. 165 165
The Set-up: Analyzing the Reformulated Financial Statements Common Size Income Statements (Operating Profit Margin Analysis)
1999
1998
1997
1996
$30,219
$24,156
$19,535
$15,470
28.5%
28.1%
27.8%
27.7%
18.0
18.1
18.3
18.3
General and administrative
1.7
1.7
1.7
1.7
Core operating income from sales
8.8
8.3
7.8
7.6
Taxes on core operating income
3.5
3.2
3.0
3.0
Core operating income after tax
5.4
5.1
4.8
4.6
Operating income after unusual items
5.2
4.7
4.8
4.7
Comprehensive income
5.2
4.7
4.8
4.8
Sales Gross profit Selling and operating expenses
These percentages gave expense ratios (for expense items) and profit margins (for income items).
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Commentary: Gross margins, core operating profit margins from sales, and expense ratios are fairly constant, and look like a good basis for forecasting. A note on Price-to-Sales ratios: The case refers to HD’s price-to-sales (P/S) ratio. In recent years analysts have given considerable attention to P/S ratio (particularly in cases of negative earnings). Home Depot had a P/S ratio of 3.3 in 1999. This is considerably above the historical median for all firms (about 1.0) and above that for retailers (0.8). How should an analyst interpret a P/S ratio? Just as the P/E ratio is interpreted as an indication of earnings growth, so the P/S ratio is often interpreted as an indication of sales growth. So, a P/S ratio of 3.3 builds in an expectation of considerable sales growth. But we have to be careful. Sales are important to valuation and growth in sales adds value, all else constant. But there is also the question of the profitability of sales, the expected profit margins from sales. So, as
P/S = P/E x E/S = P/E x PM one should modify the P/S ratio for the PM. But then, of course, one is really looking at the P/E ratio: the ability to grow earnings through growth in sales and increasing profit margins. Note, also that P/S ratios should be unlevered because sales come from assets, not equity. See chapter 2.
Simple Forecasting and Simple Valuation – Chapter 14 p. 167 167
Turnover Analysis
Major Balance Sheet Items As a Percentage of Sales 1999
1998
1997
1996
Receivables Inventories Property, plant and equipment
1.7 % 13.1 24.3
2.0 % 13.1 24.7
1.8 % 12.5 25.3
1.9 % 12.7 24.9
Operating assets
40.4
41.0
40.9
41.0
9.7
9.8
9.2
9.1
30.7
31.1
31.6
32.0
Operating liabilities 1 Total asset turnover inverse : ATO
(Calculations are based on average balance sheet amounts)
Leverage Ratios
Financial Leverage (FLEV)
0.164
0.165
0.111
0.115
Operating liability leverage (OLLEV)
0.314
0.307
0.292
0.294
(Leverage ratios are calculated from average balance sheet amounts.) Commentary: Turnovers are also reasonably constant. Typically Home Depot requires requires investment of 31 cents of net operating assets to generate a dollar of sales and maintains an operating liability level of about 0.3.
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Trend Analysis
1999
1998
1997
Income statement: Sales growth rate
25.1%
23.7%
26.3%
Cost of sales growth rate
24.3
23.2
26.1
Gross profit growth rate
26.1
24.8
26.8
Operating expense growth
24.3
21.9
26.4
General and administrative Growth
24.7
27.5
20.0
Tax expense growth
34.1
31.2
29.5
Core operating income growth
32.4
31.0
29.2
Comprehensive income growth
39.9
19.5
28.4
Commentary: Growth rates in most items are fairly constant and consistent with the growth in sales. But these growth rates are high! Will they persist?
Simple Forecasting and Simple Valuation – Chapter 14 p. 169 169
Balance Sheet:
Operating asset growth
1999 21.3%
1998 26.0%
1997 21.7%
Operating liability growth
16.0%
32.5%
30.2%
NOA growth growth
23.0%
24.0%
19.4%
CSE growth
23.1%
19.2%
19.4%
Commentary: Again, HD has regular growth, corresponding to the growth in sales. With constant ATO, the NOA growth rate must equal the sales growth rate; the two rates are similar.
Free Cash Flow Analysis
1999
1998
1997
Operating income (OI)
1,585
1,129
941
Change in NOA (∆ NOA)
1,915
1,611
1,090
Free cash flow (OI - ∆ NOA)
(330)
(482)
(149)
HD is generating negative free cash flow.
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Analysis of Residual Operating Income and its Drivers
RNOA Core RNOA Core profit margin Asset turnover Growth in NOA ReOI(10%) (millions) Core ReOI (millions) Growth in core ReOI ReOI is based on average NOA Price per share, 1999 Shares outstanding Market value of equity Levered P/B ratio Unlevered P/B ratio
1999 17.06% 17.4% 5.4% 3.26 23.0% $656 $689 46.9%
1998 15.0% 16.2% 5.1% 3.22 24.0% $376 $469 48.9%
1997 15.2% 15.1% 4.8% 3.16 19.4% $323 $315 38.8%
1996 14.8% 14.6% 4.6% 3.13 -$232 $227 ---
$83 1,475million $122,200 million 14.0 (based on January, 1999 book values) 12.1 (based on January, 1999 book values)
Simple Forecasting and Simple Valuation – Chapter 14 p. 171 171
Question A: Simple Forecasts
We are restricting ourselves to information in the financial statements. So work with SF1, SF2, and SF3 forecasts. An SF1 forecast won't work; with a P/B ratio of 14.0 (and an unlevered P/B of 12.1), the balance sheet is certainly imperfect. So move on to SF2 and SF3 forecasts.
The SF2 forecast of operating income: OI2000
= Core OI1999 + (0.10 x ∆ NOA1999) = 1,618 + (0.10 x 957) = $1,714 million
[The ∆ in NOA is the ending NOA in 1999 over the average NOA. Core OI is used as a base for forecasting, rather than full OI, as unusual items (in full OI) do not forecast the future] The SF3 forecast of operating income: OI2000
= Core RNOA1999 × NOA (beginning of 2000) = 0.174 × 10,248 10,248 = $1,783 million
The SF2 eps forecast: OI2000 NFE2000 Earnings2000 EPS
= = =
1,714 45 1,669 $1.13 (on 1,475 million shares)
Note: Net Net financial financial expenses expenses are forecast forecasted ed as follows follows NFF2000
= NFO1999 × After-tax Borrowing Cost
= 1,499 × 3.0% = 45
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The after-tax borrowing cost is estimated from past reformulated statements. Some of the interest expense is capitalized in construction of stores, and analysts are (probably) anticipating this.
The SF3 eps forecast OI2000 = NFE2000
1,783 =
45 1,738
EPS
$1.18
These forecasts are under analysts' consensus forecast of $1.38 per share in October 1999. By October, analysts were using more information than that in the 1999 financial state statements. ments. Note, however, that analysts analysts were forecasting 1.24 per share in March 1999, just after the 1999 financial statements were published. published. So at that that time they they did not see much a lot than than was indicate indicated d in the statements. Revisions (afterwards) came later as they obtained more information.
Question B: Simple Valuations
SF2 Valuation: E V1999
Re OI 2000
=
CSE1999 +
=
8,740 +
=
15,630 (or $10.60 per share)
0.10
689 0.10
Simple Forecasting and Simple Valuation – Chapter 14 p. 173 173
[Forecasted ReOI2000 is 1,714 – (0.10 x 10,248) = 689]
SF3 Valuation: E V1999
=
CSE1999 +
=
8,740 +
ReOI 2000 1.10 - g 758
1.10 − g
[Forecasted ReOI2000 is 1,783 - (0.10 × 10,248) = 758] Then we have a problem: what should the growth rate, g, be?
• •
Use the past growth in NOA?: 23% Use past sales growth rate and assume a constant ATO?: 25%
These rates are too high to be maintained perpetually.
Question C
Clearly, the main focus for the analysis must be on the growth rate. Growth rates in the order of 23% must come down, but to what level? Home Depot has fairly fairly consistent margins, profitability and growth. These are features that make a firm suitable for simple valuation. But growth is not on its long-run long-run path. The analyst needs information as to the long run growth prospects. In addition, he needs to be concerned about how the profitability is likely to fade in the future.
Question D
The implicit growth forecast from the market is obtained by solving for g in the SF3 valuation. For a market market valuation of $122,200 million ($83 per share),
p. 174 Solutions Solutions Manual Manual to accompany accompany Financia Financiall Statement Statement Analysis Analysis and Security Security Valuation Valuation
758
122,200
= 8,740 +
So, g
= 1.093 .093 (a gr growth ra rate of of 9.3% 9.3% per per yea year)
1.10 − g
[One could test sensitivity of this calculation to different estimates of the required return] Is this growth growth rate justified? The key is forecasting the sales growth rate because ATO is reasonably reasonably constant. To forecast retail sales growth, analysts distinguish (1)
growth in in sa same-store sa sales
(2)
growth fr from st store op openings
HD was achieving 10% increase in same-store sales during 1999.
Question E
The valuation grid gives the value per share that different forecasts of RNOA and growth in NOA imply.
RNOA
Growth in Sales
15%
16%
17%
18%
19%
20%
21%
2%
10.27
11.14
12.00
12.87
13.74
14.61
15.48
4%
11.72
12.87
14.03
15.19
16.35
17.51
18.67
6%
14.61
16.35
18.08
19.82
21.56
23.29
25.03
8%
23.29
26.77
30.24
33.72
37.19
40.66
44.13
9%
40.66
47.61
54.56
61.51
68.5
75.40
82.35
Simple Forecasting and Simple Valuation – Chapter 14 p. 175 175
Value = 8,740 +
( RNOA − 0.10) × 10,248
Value per share
1.10 − (1 + growth rate)
=
Value 1,475
This grid gives a sense of what is required to justify the market price of $83. If Home Depot increases its RNOA to 21%, it would still have to generate a growth in NOA (driven by sales growth) of 9% a year. Lower profitability or growth yields a lower value than the current $83 price. This valuation grid can be supplemented with a matched forecast pairs analysis (see text).
HD is currently generating very high growth. The question is, for how long can it keep such growth up. Forecasting declining growth rates follows in the next chapter.
Short-term and Long-term Growth Rates
One can also get a sense of the appropriate valuation – and develop a valuation grid – using the two-stage growth model in the chapter. This forecasts operating income for two years, based on current current operating operating income with with a growth growth rate, rate, and then then adds a long-ter long-term m growth growth rate: NOA V 2002
= OI 1 ×
G2 − Glong ρ F − 1 ρ F − Glong 1
The following pro forma uses the SF3 forecast for OI1 and then forecasts cum-FCF operating income for year 2 by maintaining the SF3 forecast of growth in NOA of 23% with RNOA at the same level as currently:
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1999
2000
Net operating operating assets assets (NOA) (NOA) 10,248 Operating income Free cash flow (OI – ΔNOA) Reinvested FCF (at 10%) Cum-FCF OI
12,605 1,783 (574)
2002
2,193 (12,605 × 0.174) (57) 2,136
Cum-FCF growth rate (G2) 2,136/1,783
19.8%
With this two-year ahead growth rate, G2, one can now develop a valuation grid for different long-term growth rates, Glong, using the the formula. For example, if the long-term growth rate is 5%, then V NOA = $52,776.8 million. If the long-term growth rate is 8.3%, V NOA is approximately equal to the current market price of the operations. So, given that the forecast for 2000 and 2001 are reasonable, the market is expecting very large long-term growth to be sustained. Near-term Near-term and Long-t Long-term erm Growth Growth Rates Rates (The following was supplied by Professor Kenton Yee)
Home Depot has been delivering growth in residual operating income of over 40% in the years up to 1999. One can imagine their keeping up this growth rate for some years, but the growth growth rate rate tapering tapering off in the long long term. term. A model forecasts forecasts different different growth growth rates rates for the near term and long term follows:
Simple Forecasting and Simple Valuation – Chapter 14 p. 177 177
4 5 g near g far g near 1 − g far ρ ρ ×coreRe P 1999 =CSE 1999 + core Re OI 2000 + ρ − g far ρ − g near 5
where g near is annual RE growth during next 5 years; g far is annual RE perpetuity growth after 5 years; ``g'' always always refers refers to 1 PLU PLUS S the the grow growth th rate; rate;
and
mean mean reversion reversion suggests suggests g far << g near if the latter is large. A valuation grid can be developed using this model:
r h o= c se= RE co cor eO eOI ( 9 9) 9) = sh ar es=
1 .1 8 7 40 689 1 47 5
g _ n ear \ g _ far 1 .3 .3 5 1 .4 .4 1.4 1.45 1.5
1 $ 23 2 3 .4 .43 $ 26 2 6 .6 .6 2 $30. $30. 28 $34.4 $34.46 6
RE co cor eOI (0 ( 00) = g _ ne near *R * R E co cor eO eOI ( 9 9) 9)
1 . 02 $ 27 2 7 .0 .01 $ 3 0. 0. 9 1 $35. $35 . 40 $40 $40.52
1 . 04 1 . 06 1 . 07 $ 3 2. 2. 9 7 $ 44 44. 8 9 $ 56 5 6 .8 .8 1 $ 3 8. 8. 06 $ 52 5 2 .3 .3 6 $ 6 6. 6. 6 66 6 $43. $43.92 92 $60.9 $60.96 6 $78.00 $50.61 $50.61 $ 7 0. 8 0 $ 9 0. 0. 9 99 9
1 . 08 $80.66 $ 9 5. 5. 2 26 6
$112.08 $131.37
This valuation grid indicates that the current (1999) price of $83 per share makes sense if one can forecast short-term growth of 45 - 50% and long-term growth of about 6 – 7 %.
The bottom line on this case
Home Depot can't be valued using simple valuations. But the analysis with simple forecasts and simple valuations gives us considerable understanding of the critical valuation issues. HD has regular profitability--margins and turnovers-- and this helps us in forecasting. The simple analysis instructs the analyst to focus on sales growth.
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How will this be different in the future? Given that profitability is fairly regular, this is where the analyst should focus her efforts. Of course, she must also be sensitive sensitive to declining margins that may ensue from pursuit of sales growth. But, if the sensitivity analysis in the valuation grid indicates that the combination of growth in sales and RNOA implied by a price of $83 is very unlikely, the analyst may reach the conclusion that the stock is overpriced, and issue a SELL, without going into further forecasting analysis.
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Simple Forecasting and Simple Valuation – Chapter 14 p. 181 181
