Tài chính doanh nghiệp - Chapter 6: The role of financial information in valuation and credit risk assessment

The Role of Financial Information in Valuation and Credit Risk AssessmentRevsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 6Learning objectivesThe basic steps in business valuation using free cash flows and abnormal earnings.Why current earnings are considered more useful than current cash flows for assessing future cash flows.The expanding use of fair value measurements in financial statements.What factors contribute to variation in price-earnings multiples.6-*Learning objectives:concludedWhat factors influence earnings quality.How stock returns relate to “good news” and “bad news” about earnings.The importance of credit risk assessment in lending decisions, and how credit ratings are determined.How to forecast a company’s financial statements.6-*Business valuation:OverviewStep 1:Forecast future amounts of the financial attribute that ultimatelydetermines how much a company is worth.Determine the risk or uncertainty associated with the forecastedfuture amounts.Determine the discounted present value of the expected futureamounts using a discount rate that reflects the risk from Step 2.There are three steps involved in valuing a company: Free cash flows Accounting earnings Balance sheet book values6-*Step 2:Step 3:Business valuation:Discounted free cash flow approachThis approach says the value per share (P0) of a company’s common stock is given by: CFt is the future free cash flow (per share) available to common equity holders at period t. r is the discount rate appropriate for the risk and uncertainty of the forecasted free cash flows. is the discount factor for forecasted cash flows in period t. E0 is investors’ expectations (at time 0) about future free cash flows.6-*Business valuation:DCF illustration6-*Goodwill and other Intangible Assets6-*Two-step process for determining goodwill impairmentIs the fair value of the reporting unit higher than the carrying amount including goodwill?Step 2 - determine the implied fair value in the same manner as the amount of goodwill recognized in a business combination. An impairment loss is recognized equal to the excessGoodwill is not impaired so no Step 2Step 1 – Compare the fair value of a reporting unit with its carrying amount including goodwillNoYesEarnings or cash flow?The traditional approach to stock valuation relies on forecasted free cash flows.Why then do many analysts and investors pay such close attention to accrual earnings?According to the FASB, it’s because accrual earnings is more helpful in forecasting a company’s future cash flows6-*The role of earnings in valuationAccrual earnings takes a long-horizon view that smoothes out the “lumpiness” in year-to-year cash flows.6-*2. Stock returns correlate better with accrual earnings than with realized operating cash flows.1. Current earnings are a better forecast of future cash flows than are current cash flows.Research evidence shows that:Linkage between stock price and accrual earningsThe role of earnings in valuation:Zero growth exampleTo appreciate the link between earnings and future cash flows, let’s take another look at the free cash flow valuation model:The zero growth assumption means that expected future earnings, and thus expected future free cash flows, form a perpetuity so that:orEstimated share priceImplied price earning ratio (P/E) or earnings multiple6-*Abnormal earnings approach to valuationWhat matters most to investors is:The amount of money they turn over to management.The profit management is able to earn on that money.Abnormal earnings is:What management does with the moneyExpected returnWhat investors entrust to management6-*Abnormal earnings approach to valuationManagement does worse than expected:$200$150 - $50 of abnormal earningsManagement does better than expected:$200$300+ $100 of abnormal earningsSuppose investors contribute $2,000 of capital expecting a 10% rate of return.6-*Corporate valuation:Abnormal earnings valuation approachWhat management accomplishedWhat shareholders expectedWhat shareholders have invested in the firmExpectations operatorCost of equity capital6-*Abnormal earnings:Price premium and discount[1]$20$15$5$5 premiumInvestors willingly pay a premium over BV for companies that earn positive AE[2]$10$15- $5$5 discountFirms that earn negative AE sell at discount to BV6-*Abnormal earnings valuation:Illustration6-*Abnormal earnings valuation:Illustration6-*Abnormal earnings valuation:Illustration6-*Abnormal earnings and ROCEROCE combines information about earnings and equity book value:ROCE =EarningsEquity book valueRelationship between ROCE performance and market-to-book (M/B) ratios for 48 restaurant companiesCompanies with ROCEs that consistently exceed the industry average have shares that sell for a premium relative to book value.Figure 6.26-*Abnormal earnings approach:SummaryA company’s future earnings are determined by:the resources (net assets) available to management;the rate of return (profitability) earned on those net assets.The abnormal earnings valuation model makes explicit the role of:Income statement and balance sheet information;Cost of capital6-*If a firm can earn a return above its cost of capital, then it will generate positive abnormal earnings.Firms that earn less than their cost of capital generate negative abnormal earnings.Firms expected to generate positive abnormal earnings sell at a premium to equity book value.Those expected to generate negative abnormal earnings sell at a discount to equity book value.Fair Value AccountingBased on Exit Prices (i.e., what the assets could be sold for).Level 1: Quoted prices for identical assetsLevel 2: Observable prices for similar assets.Level 3: Unobservable prices (mark-to-model)Used by Enron, now not AcceptableSee SFAS 157 and ASC Topic 820, “Fair Value Measures and Disclosures”6-*Global Vantage PointIASB and FASB concluded a joint convergence project on fair value measurement and disclosure. The aim was to ensure that both U.S. GAAP and IFRS reflect a shared view about fundamental principles such as what fair value means and how best to measure it.The IASB issued IFRS 13 “Fair Value Measurement” in May 2011 (effective for fiscal years that begin after January 1, 2013) that fundamentally agrees with U.S. GAAP as far as exit price, the three-level measurement hierarchy, and most disclosure requirements.6-*Earnings and stock prices:Evidence on value relevanceIf investors use accrual earnings to price stocks, then earnings differences across firms should explain differences in stock prices.Stock price and actual EPS for 48 restaurant companiesFigure 6.3Regression Result:Stock priceEarnings per shareStock price at $0 EPSEarnings multiple (should be statistically positive)The test:Random error6-*Earnings and stock prices:Sources of variation in P/E multiplesComponents of EarningsStock prices (and thus P/E multiples) are influenced by:6-*Earnings and stock prices:Earnings components and P/EDifferences in earnings components mix produces differences in P/E6-*Earnings and stock prices:Earnings qualityThe notion of earnings quality is multifaceted, and there is no consensus on how best to measure it.Most observers agree that earnings are high quality when they are sustainable over time.Unsustainable earnings might arise from:Debt retirementCorporate restructuringsTemporary reductions in advertising or R&D spendingCertain accounting methods used for routine, on-going transactionsInherent subjectivity of accounting estimates.Research evidence shows that earnings quality matters to investors.6-*Earnings surprises:Typical behavior of stock returnsStock returns and quarterly earnings “surprises”Figure 6.56-*Credit risk assessment:Traditional lending productsShort-termLoans Seasonal lines of credit Special purpose loans (temporary needs) Secured or unsecuredLong-termLoans Mature in more than 1 year Purchase fixed assets or another company, refinance debt, etc. Often securedRevolvingLoans Like a seasonal credit line Interest rate usually “floats”Public Debt Bonds, debentures, notes Sinking fund and call provisions Covenants6-*Credit analysis:Evaluating the borrower’s ability to repayUnderstandthe businessStep 1: Business model and strategy Key risks and success factors Industry competitionEvaluateaccounting qualityStep 2: Spot potential distortions Adjust reported numbers as neededEvaluate current profitability and healthStep 3: Examine ratios and trends Look for changes in profitability, financial conditions, or industry position.Prepare “pro forma”cash flow forecastsStep 4: Develop financial statement forecasts Assess financial flexibilityDue diligenceStep 5: Kick the tiresComprehensive risk assessmentStep 6: Likely impact on ability to pay Assess loss if borrower defaults Set loan terms6-*The Credit Rating ProcessInvestor’s belief about credit risk influence the price paid – and thus the amount borrowedThree agencies (Moody’s, Standard & Poor’s, and Fitch) assess and grade the creditworthiness of companies and public entities that sell debt to investors. Credit ratings are letter-based grades (AAA, BBB) that express the rating agency’s opinion about default risk.6-*Based On:6-*Standard & Poor’s Ratings6-*Appendix A:Valuing a business opportunity:By the Cup Franchise6-*Appendix A:Valuing a business opportunity:Free cash flow approachWhat the business is worth6-*Appendix A:Valuing a business opportunity:Abnormal earnings approach6-*Appendix A:Valuing a business opportunity:Abnormal earnings approach6-*SummaryThis chapter provides a framework for understanding equity valuation and credit analysis.The framework illustrates how accounting numbers are used in business valuation and credit risk assessment.You have also seen how financial reports help investors and lenders assess the “amounts, timing, and uncertainty of prospective net cash flows”.Knowing which numbers are used, why they are used, and how they are used is crucial to understanding the decision-usefulness of accounting information. 6-*