BAB 11 (Subramanyam)

EQUITY ANAYSIS & VALUATION

Earning Persistence

Earnings persistence is a key to effective equity analysis and

valuation

Analyzing earnings persistence is a main analysis objective

Attributes of earnings persistence include:

Stability

Predictability

Variability

Trend

Earnings management

Accounting methods

Two common methods to help assess earnings persistence:

Recasting of income statement

Adjusting of income statement

Recasting and adjusting earnings

aids in determining the earning power.

Information for Recasting and Adjusting

Income statement, including its subdivisions:

Income from continuing operations

Income from discontinued operations

Extraordinary gains and losses

Cumulative effect of changes in accounting

principles

Other financial statements and notes

Managements Discussion and Analysis

Others: product-mix changes, technological innovations,

work stoppages, and raw material constraints

Recasting Earnings and Earnings Components

Aims at rearranging earnings components to provide a

meaningful classification and relevant format for analysis.

Components can be rearranged, subdivided, or tax

effected, but the total must reconcile to net income of
each period.

Discretionary expenses, components like equity in

income (loss) of unconsolidated subsidiaries or affiliates
should be segregated.

Components reported pretax must be removed along

with their tax effects if reclassified apart from income
from continuing operations.

Income tax disclosures enable one to separate factors

that either reduce or increase taxes such as:

Deductionstax credits, capital gains rates, taxfree income, lower foreign tax rates

Additionsadditional foreign taxes, nontaxdeductible expenses, and state and local taxes
(net of federal tax benefit)

Immaterial items can be considered in a lump sum

labeled other.

Adjusting Earnings and Earnings Components

Adjusting aims to assign earnings components to the periods

in which they best belong.

Uses data from recast income statements and other available

information.

Specific (Typical) Adjusting Procedures

Assign extraordinary and unusual items (net of tax) to

applicable years

Tax benefit of operating loss carryforwards normally

moved to the loss year

Costs or benefits from lawsuit settlements moved to

relevant prior years

Gains and losses from disposals of discontinued

operations can relate to one or more prior years.

Changes in accounting principles or estimates yield

adjustments to all years under analysis to a comparable
basisredistribute cumulative effect to the relevant
prior years

Normally include items that increase or decrease equity

Specific (Typical) Adjusting Procedures

If a component should be excluded from the period it is

reported:

Shift it (net of tax) to the operating results of one

or more prior periods or

Spread (average) it over earnings for the period

under analysis.

Spread the component over prior periods earnings only

when it cannot be identified with a specific period.

While spreading helps in determining earning power, it

is not helpful in determining earnings trends.

Moving gains/ losses to other periods does not remedy

the misstatements of prior years results.

Determinants of Earnings Persistence

Earnings persistence determined by many factors including:

Earnings trends

Variability

Earnings Management

Management Incentives

Note: assess earnings persistence over both the business cycle and
the long run.

Earnings trends can be assessed by:

Statistical methods

Trend statements

Uses earnings numbers taken from the recasting and

adjusting procedures

Earnings management

Changes in accounting methods or assumptions

Offsetting extraordinary or unusual gains and losses

Big baths

Write-downs

Timing revenue and

expense recognition

Management incentives affecting persistence include:

Personal objectives and interests

Companies in distress

Prosperous companiespreserving hard-earned

reputations

Compensation plans

Accounting-based incentives and constraints

Analysts targets

Persistent and Transitory Items in Earnings

Recasting and adjusting earnings for equity valuation rely on
separating stable, persistent earnings components from
random, transitory components.

Assessing persistence is important in determining

earning power.

Earnings forecasting also relies on persistence.

A crucial part is to assess the persistence of the gain and loss

components of earnings.
Analyzing and Interpreting Transitory Items

Purpose of analyzing and interpreting extraordinary items:

Determine whether an item is transitory.

Assessing whether an item is unusual,

nonoperating, or nonrecurring.

Determine adjustments that are necessary given

assessment of persistence.

Determining persistence
(transitory nature) of items:

Nonrecurring operating gains and losses

Usually included in current operating income

Nonrecurring non-operating gains and losses

Omitted from operating earnings of a single year

Part of the long-term performance of a company

Adjustments to Extraordinary Items Reflecting Persistence:

Effects of transitory items on company resources.

Effects of recorded transitory items and the

likelihood of future events causing transitory
items.

Effect of transitory items on evaluation of management.

Relation between Stock Prices and Accounting Data

Equity value (Vt)

Book value (BVt)

Residual Income, RIt = (NIt k * BVt-1)

Cost of equity capital (k)

Fundamental Valuation Multiples

Price-to-Book (PB) expressed in accounting data

Note:

ROCE and growth in book value increase PB increases

Cost (risk) of equity capital increases PB decreases

Present value of future abnormal earnings is positive

(negative) PB is greater (less) than 1.0

PE ratio can be written as a function of short-term (STG) and

long-term growth (LTG) of earning per share (eps) as follows:

Earning Power

Factors in selecting a time horizon for measuring earning

power:

One-year is often too short to reliably measure earning

power

Many investing and financing activities are long term

Better to measure earning power by using average (or

cumulative) earnings over several years

An extended period is less subject to distortions,

irregularities, and other transitory effects

Preferred time horizon in measuring earning

power is typically 4 to 7 years

djusting Earnings per Share

Earning power is measured using all earnings

components.

The issue is to what year we assign these items when

computing earning power.

Earnings Forecasting

Elements Impacting Earnings Forecasts

Current and past evidence

Forecasts reasonableness.

Continuity and momentum of company performance

Industry prospects

Company's financial condition

Management

Management qualityresourcefulness

Asset managementoperating skills

Economic and competitive factors

Key Indicators such as capital expenditures, order

backlogs, and demand trends

Interim Reports for Monitoring and Revising Earnings

Estimates

Limitations in interim reporting related to difficulties in

assigning earnings components to periods of under one year
in length:

Period-end accounting adjustments

Seasonality in business activities

Integral reporting method

SEC interim reporting requirements

Analysis implications of interim Reports

Available Interim Reports

Quarterly reports (Form 10-Q)

Reports on current developments (Form 8-K)

Disclosure of separate fourth-quarter results

Details of year-end adjustments

Interim reports filed with the SEC such as:

Comparative interim and year-to-date income statement

Comparative balance sheets

Year-to-date statement of cash flows

Pro forma information on business combinations

Disclosure of accounting changes

Managements narrative analysis of operating results

Reports of a change in auditor