Overview of Financial Reporting, Financial Statement Analysis, and Valuation 1

Size: px

Start display at page:

Download "Overview of Financial Reporting, Financial Statement Analysis, and Valuation 1"

Grant Kennedy
5 years ago
Views:

1 CONTENTS Preface About the Authors iv xvii Chapter 1 Overview of Financial Reporting, Financial Statement Analysis, and Valuation 1 Overview of Financial Statement Analysis 2 Step 1: Identify the Industry Economic Characteristics 5 Tools for Studying Industry Economics 7 Value Chain Analysis 7 Porter's Five Forces Classification Framework 10 Economic Attributes Framework 13 Step 2: Identify the Company Strategies 15 Framework for Strategy Analysis 15 Application of Strategy Framework to PepsiCo's Beverage Division 16 Step 3: Assess the Quality of the Financial Statements 17 Accounting Principles 18 Balance Sheet Measuring Financial Position 19 Income Statement-Measuring Operating Performance 27 Statement of Cash Flows 33 Important Information with the Financial Statements 36 Summary of Financial Statements, Notes, MD&A, and Managers' and Auditors' Attestations 40 Step 4: Analyze Profitability and Risk 41 Tools of Profitability and Risk Analysis 42 Step 5: Prepare Forecasted Financial Statements 51 Step 6: Value the Firm 51 Role of Financial Statement Analysis in an Efficient Capital Market 52 The Association between Earnings and Share Prices 53 Sources of Financial Statement Information 55 Summary 56 Appendix 1.1 Preparing a Term Project 57 Questions and Exercises 62 Problems and Cases 64 Integrative Case 1.1 Starbucks 72 Case 1.2 Nike: Somewhere between a Swoosh and a Slam Dunk 85 Chapter 2 Asset and Liability Valuation and Income Recognition 96 XX Introduction to the Mixed Attribute Accounting Model 97 Asset and Liability Valuation 101 Historical Value: Acquisition Cost 103 Historical Value: Adjusted Acquisition Cost 104 Historical Value: Initial Present Value 105 Current Values: Fair Value 106

2 Current Values: Fair Value Based on Current Replacement Cost 108 Current Values: Fair Value Based on Net Realizable Value 109 Summary of U.S. GAAP and IFRS Valuations 110 Income Recognition 111 Approach 1 : Economic Value Changes Recognized on the Balance Sheet and Income Statement When Realized 114 Approach 3: Economic Value Changes Recognized on the Balance Sheet and the Income Statement When They Occur 115 Approach 2: Economic Value Changes Recognized on the Balance Sheet When They Occur but Recognized on the Income Statement When Realized 117 Summary of Asset and Liability Valuation and Income Recognition 120 Income Taxes 121 Overview of Financial Reporting of Income Taxes 122 Measuring Income Tax Expense: A Bit More to the Story (to Be Technically Correct) 127 Reporting Income Taxes in the Financial Statements 130 PepsiCo's Reporting of Income Taxes 130 Framework for Analyzing the Effects of Transactions on the Financial Statements 132 Overview of the Analytical Framework 133 Summary of the Analytical Framework 138 Summary 138 Questions and Exercises 139 Problems and Cases 140 Integrative Case 2.1 Starbucks 150 Chapter 3 Income Flows versus Cash Flows: Understanding the Statement of Cash Flows 153 Understanding the Relations among Net Income, Balance Sheets, and Cash Flows 155 The Relations among Cash Flows from Operating, Investing, and Financing Activities 156 The Relation between Cash Balances and Net Cash Flows 164 The Operating Section of the Statement of Cash Flows 165 The Relation between Net Income and Cash Flow from Operations 179 Aside: Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA) 182 Preparing the Statement of Cash Flows 183 Algebraic Formulation 184 Classifying Changes in Balance Sheet Accounts 186 Illustration of the Preparation Procedure 191 Using the Statement of Cash Flows to Assess Earnings Quality 194 Summary 202 Questions and Exercises 202 Problems and Cases 205 Integrative Case 3.1 Starbucks 222 Case 3.2 Prime Contractors 224 Case 3.3 W. T. Grant Company 226 xxi

3 Chapter 4 Profitability Analysis 246 Overview of Profitability Analysis 248 Earnings Per Share (EPS) 249 Calculating EPS 250 Criticisms of EPS 252 Common-Size Analysis 253 Percentage Change Analysis 254 Alternative Definitions of Profits 255 Comprehensive Income 255 Operating Income, EBIT, EBITDA, and Other Profit Measures 256 Segment Profitability 256 Pro Forma, Adjusted, or Street Earnings 257 Rate of Return on Assets (ROA) 259 Two Comments on the Calculation of ROA 264 Disaggregating ROA 266 Economic and Strategic Factors in the Interpretation of ROA 267 Analyzing the Profit Margin for ROA 276 Analyzing Total Assets Turnover 285 Supplementing ROA in Profitability Analysis 290 Rate of Return on Common Shareholders' Equity (ROCE) 295 Benchmarks for ROCE 297 Relating ROA to ROCE 299 Disaggregating ROCE 301 Interpreting Financial Statement Ratios 304 Comparisons with Earlier Periods 305 Comparisons with Other Firms 306 Summary 307 Questions and Exercises 308 Problems and Cases 310 Integrative Case 4.1 Starbucks 330 Case 4.2 Profitability and Risk Analysis of Wal-Mart Stores 334 xxii Chapter 5 Risk Analysis 345 Disclosures Regarding Risk and Risk Management 346 Firm-Specific Risks 346 Commodity Prices 347 Financial Statement Analysis of Risk 350 Analyzing Financial Flexibility: Alternative Approaches to Disaggregate ROCE 352 Summary of Financial Flexibility 361 Analyzing Short-Term Liquidity Risk 361 Current Ratio 363 Quick Ratio 364 Operating Cash Flow to Current Liabilities Ratio 365 Working Capital Turnover Ratios 365 Revenues to Cash Ratio 368 Days Revenues Held in Cash 369 Summary of Short-Term Liquidity Risk 370

4 Analyzing Long-Term Solvency Risk 370 Debt Ratios 371 Interest Coverage Ratios 372 Operating Cash Flow to Total Liabilities Ratio 373 Summary of Long-Term Solvency Risk 374 Analyzing Credit Risk Circumstances Leading to Need for the Loan Credit History Cash Flows Collateral Capacity for Debt Contingencies Character of Management Communication Conditions or Covenants 380 Summary of Credit Risk Analysis 380 Analyzing Bankruptcy Risk 380 The Bankruptcy Process 380 Models of Bankruptcy Prediction 381 Synthesis of Bankruptcy Prediction Research 388 Market Equity Beta Risk 391 Financial Reporting Manipulation Risk 393 Motivations for Earnings Manipulation 393 Empirical Research on Earnings Manipulation 393 Application of Beneish's Model to Sunbeam Corporation 396 Summary of Earnings Manipulation Risk 398 Summary 398 Questions and Exercises 399 Problems and Cases 401 Integrative Case 5.1 Starbucks 411 Case 5.2 Massachusetts Stove Company Bank Lending Decision 412 Case 5.3 Fly-by-Night International Group: Can This Company Be Saved? 418 Case 5.4 Millennial Technologies: Apocalypse Now 428 Chapter 6 Financing Activities 439 Equity Financing 440 Investments by Shareholders: Common Equity Issuance 441 Distributions to Shareholders: Dividends 444 Distributions to Shareholders: Share Repurchases 448 Equity Issued as Compensation: Stock Options 449 Fair Value Method and Required Disclosures 449 Alternative Share-Based Compensation: Restricted Stock and RSUs 454 Alternative Share-Based Compensation: Cash-Settled Share-Based Plans 455 Net Income, Retained Earnings, Accumulated Other Comprehensive Income, and Reserves 456 Summary and Interpretation of Equity 459 xxiii

5 Debt Financing 459 Principles of Liability Recognition 460 Principles of Liability Valuation 460 Application of Criteria for Liability Recognition 461 Contingent Obligations 463 Financing with Long-Term Debt 464 Financial Reporting of Long-Term Debt 467 Measuring Fair Value 468 Reducing Debt 471 Accounting for Troubled Debt 471 Additional Issues in Liability Recognition and Debt Financing 474 Hybrid Securities 474 Off-Balance-Sheet Financing Arrangements 478 Leases 484 Operating Lease Method 485 Capital Lease Method 486 Choosing the Accounting Method 488 Converting Operating Leases to Capital Leases 490 Impact of Accounting for Operating Leases as Capital Leases 493 Summary 493 Questions and Exercises 493 Problems and Cases 499 Integrative Case 6.1 Starbucks 509 Case 6.2 Case 6.3 Oracle Corporation: Share-Based Compensation Effects/Statement of Shareholders' Equity 510 Long-Term Solvency Risk: Southwest and Lufthansa Airlines 513 Chapter 7 Investing Activities 522 Investments in Long-Lived Operating Assets 524 Are the Acquisition Costs "Assets"? 525 What Choices Are Managers Making to Allocate Acquisition Costs to the Periods Benefited? 537 What Is the Relationship between the Book Values and Market Values of Long-Lived Assets? 541 When Will the Long-Lived Assets Be Replaced? 548 Summary 549 Investments in Securities 549 Percentage of Ownership 550 Minority, Passive Investments 550 Minority, Active Investments 561 Majority, Active Investments 564 Consolidation of Unconsolidated Subsidiaries and Affiliates 581 Joint Ventures: Proportionate Consolidation of Unconsolidated Subsidiaries and Affiliates 585 Primary Beneficiary of a Variable-Interest Entity 585 Income Tax Consequences of Investments in Securities 589 xxiv

6 Foreign Currency Translation 589 Functional Currency Concept 590 Translation Methodology Foreign Currency is Functional Currency 592 Translation Methodology U.S. Dollar Is Functional Currency 595 Foreign Currency Translation and Income Taxes 599 Interpreting the Effects of Exchange Rate Changes on Operating Results 599 Summary 600 Questions and Exercises 601 Problems and Cases 603 Integrative Case 7.1 Starbucks 618 Case 7.2 Disney Acquisition of Marvel Entertainment 627 Chapter 8 Operating Activities 630 Accomplishments (Revenue Recognition) 632 Criteria for Revenue Recognition 632 Application of Revenue Recognition Criteria 635 Revenue Recognition at the Time of Sale (Delivery) 638 Delaying Revenue Recognition When Substantial Performance Remains 640 Income Recognition under Long-Term Contracts 641 Revenue Recognition When Cash Collectability Is Uncertain 646 Investment in Working Capital: Accounts Receivable and Deferred Revenues 649 Efforts (Expense Recognition) 649 Criteria for Expense Recognition 649 Cost of Sales 650 Conversion from LIFO to FIFO 653 Reporting Changes in the Fair Market Value of Inventory 655 Accounting Quality: Cost of Sales and Inventory 655 Investment in Working Capital: Inventory and Accounts Payable 657 SG&A (Selling, General, and Administrative) Costs 657 Operating Profit 661 Income Taxes 661 Review of Income Tax Accounting 661 Required Income Tax Disclosures 662 Assessing a Firm's Tax Position 669 Analyzing PepsiCo's Income Tax Disclosures 670 Summary of Income Taxes 672 Pensions and Other Postretirement Benefits 672 The Economics of Pension Accounting in a Defined Benefit Plan 673 Other Postretirement Benefits 682 Signals about Earnings Persistence 682 PepsiCo's Pensions and Other Postemployment Benefits 683 Derivative Instruments 684 Nature and Use of Derivative Instruments 685 Accounting for Derivatives 687 Illustrations of Accounting for Derivatives 689 Summary of Derivative Examples 697 xxv

7 Disclosures Related to Derivative Instruments 697 PepsiCo's Derivatives Disclosures 698 Accounting Quality Issues and Derivatives 698 Summary 699 Questions and Exercises 699 Problems and Cases 702 Integrative Case 8.1 Starbucks 712 Case 8.2 Arizona Land Development Company 713 Case 8.3 Coca-Cola Pensions 728 xxvi Chapter 9 Accounting Quality 729 Accounting Quality 730 High Quality Reflects Economic Information Content 731 High Quality Leads to Earnings Persistence over Time 734 Specific Events and Conditions That Affect Earnings Quality 735 Discontinued Operations 736 Extraordinary Gains and Losses 738 Changes in Accounting Principles 741 Other Comprehensive Income Items 745 Impairment Losses on Long-Lived Assets 747 Restructuring and Other Charges 747 Changes in Estimates 750 Gains and Losses from Peripheral Activities 750 Summary of Accounting Data Adjustments 752 Restated Financial Statement Data 752 Accounting Classification Differences 753 Financial Reporting Worldwide 755 Earnings Management 757 Incentives to Practice Earnings Management 757 Disincentives to Practice Earnings Management 758 Boundaries of Earnings Management 758 Summary 759 Questions and Exercises 759 Problems and Cases 760 Integrative Case 9.1 Starbucks 769 Case 9.2 Citi: A Very Bad Year 773 Chapter 10 Forecasting Financial Statements 783 Introduction to Forecasting 784 Preparing Financial Statement Forecasts 786 General Forecasting Principles 786 Seven-Step Forecasting Game Plan 787 Practical Tips for Implementing the Seven-Step Forecasting Game Plan 788 Using FSAP to Prepare Forecasted Financial Statements 791 Step 1: Projecting Sales and Other Revenues 792 Projecting Revenues from Sales 792 Projecting Sales Revenues for PepsiCo 793

8 Step 2: Projecting Operating Expenses 800 Projecting Cost of Goods Sold 801 Projecting Selling, General, and Administrative Expenses 802 Projecting Other Operating Expenses 803 Projecting Nonrecurring Operating Gains and Losses 804 Step 3: Projecting Operating Assets and Liabilities on the Balance Sheet 804 Projecting Cash 807 Operating Asset and Liability Forecasting Techniques 811 Projecting Marketable Securities 812 Projecting Accounts Receivable 813 Projecting Inventories 814 Projecting Prepaid Expenses and Other Current Assets 814 Projecting Investments in Noncontrolled Affiliates 815 Projecting Property, Plant, and Equipment 815 Projecting Amortizable Intangible Assets 818 Projecting Goodwill and Nonamortizable Intangible Assets 818 Projecting Other Noncurrent Assets 819 Projecting Assets That Vary as a Percentage of Total Assets 819 Projecting Accounts Payable 820 Projecting Other Current Accrued Liabilities 820 Projecting Current Liabilities: Income Taxes Payable 821 Projecting Other Noncurrent Liabilities 821 Projecting Deferred Income Taxes 822 Step 4: Projecting Financial Assets, Financial Leverage, Common Equity Capital, and Financial Income Items 822 Projecting Financial Assets 823 Projecting Short-Term Debt and Long-Term Debt 823 Projecting Interest Expense 824 Projecting Interest Income 825 Projecting Bottling Equity Income 826 Projecting Preferred Stock and Minority Interest 827 Projecting Common Stock and Capital in Excess of Par Value 827 Projecting Treasury Stock 827 Projecting Accumulated Other Comprehensive Loss 829 Step 5: Projecting Nonrecurring Items, Provisions for Income Tax, and Changes in Retained Earnings 829 Projecting Nonrecurring Items 830 Projecting Provisions for Income Taxes 830 Net Income 830 Retained Earnings 831 Step 6: Balancing the Balance Sheet 832 Balancing PepsiCo's Balance Sheets 832 Closing the Loop: Solving for Co-determined Variables 834 Step 7: Projecting the Statement of Cash Flows 835 Tips for Forecasting Statements of Cash Flows 835 Specific Steps for Forecasting Implied Statements of Cash Flows 836 Shortcut Approaches to Forecasting 840 Projected Sales and Income Approach 841 Projected Total Assets Approach 841 Analyzing Projected Financial Statements 843 xxvii

9 Sensitivity Analysis and Reactions to Announcements 846 Summary 847 Questions and Exercises 848 Problems and Cases 849 Integrative Case 10.1 Starbucks 862 Case 10.2 Massachusetts Stove Company: Analyzing Strategic Options 875 Chapter 11 Risk-Adjusted Expected Rates of Return and the Dividends Valuation Approach 884 Introduction and Overview 884 Equivalence among Dividends, Cash Flows, and Earnings Valuation 887 Risk-Adjusted Expected Rates of Return 888 Cost of Common Equity Capital 889 Adjusting Market Equity Beta to Reflect a New Capital Structure 894 Evaluating the Use of the CAPM to Measure the Cost of Equity Capital 895 Cost of Debt Capital 896 Cost of Preferred Equity Capital 897 Computing the Weighted Average Cost of Capital 897 Rationale for Dividends-Based Valuation 901 Dividends-Based Valuation Concepts 902 The Dividends Valuation Model 905 Implementing the Dividends Valuation Model 907 Measuring Dividends 907 Selecting a Forecast Horizon 909 Continuing Value of Future Dividends 911 Using the Dividends Valuation Model to Value PepsiCo 915 Sensitivity Analysis and Investment Decision Making 918 Evaluation of the Dividends Valuation Method 920 Summary 921 Questions and Exercises 921 Problems and Cases 922 Integrative Case 11.1 Starbucks 926 Chapter 12 Valuation: Cash-Flow-Based Approaches 928 Introduction and Overview 928 Rationale for Cash-Flow-Based Valuation 930 Free-Cash-Flows-Based Valuation Concepts 931 Risk, Discount Rates, and the Cost of Capital 932 Free Cash Flows Valuation Examples for a Single-Asset Firm 933 Cash Flows to the Investor versus Cash Flows to the Firm 935 Nominal versus Real Cash Flows 937 Pretax versus After-Tax Free Cash Flows 938 Selecting a Forecast Horizon 938 Computing Continuing Value of Future Free Cash Flows 939 xxviii

10 Measuring Periodic Free Cash Flows 943 A Framework for Free Cash Flows 943 Free Cash Flows Measurement 945 Cash-Flow-Based Valuation Models 954 Valuation Models for Free Cash Flows for Common Equity Shareholders 955 Valuation Models for Free Cash Flows for All Debt and Equity Capital Stakeholders 956 Free Cash Flows Valuation of PepsiCo 957 PepsiCo Discount Rates 958 Computing Free Cash Flows for PepsiCo 959 PepsiCo's Free Cash Flows to All Debt and Equity Capital Stakeholders 959 PepsiCo's Free Cash Flows to Common Equity 962 Valuation of PepsiCo Using Free Cash Flows to Common Equity Shareholders 963 Valuation of PepsiCo Using Free Cash Flows to All Debt and Equity Capital Stakeholders 964 Sensitivity Analysis and Investment Decision Making 967 Evaluation of the Free Cash Flows Valuation Method 971 Summary 971 Questions and Exercises 971 Problems and Cases 972 Integrative Case 12.1 Starbucks 988 Case 12.2 Holmes Corporation: LBO Valuation 990 Chapter 13 Valuation: Earnings-Based Approaches 1004 Introduction and Overview 1004 Rationale for Earnings-Based Valuation 1007 Earnings-Based Valuation: Practical Advantages and Concerns 1009 Theoretical and Conceptual Foundations for Residual Income Valuation 1011 Intuition for Residual Income Measurement and Valuation 1013 Illustrations of Residual Income Measurement and Valuation 1014 Residual Income Valuation Model with Finite Horizon Earnings Forecasts and Continuing Value Computation 1017 Coaching Tip: Avoid This Crucial But Common Mistake 1019 Valuation of Pepsico Using the Residual Income Model 1019 Discount Rates for Residual Income 1020 Pepsico's Book Value of Equity and Residual Income 1020 Discounting Pepsico's Residual Income to Present Value 1022 Computing Pepsico's Common Equity Share Value 1022 Sensitivity Analysis and Investment Decision Making 1025 Residual Income Model Implementation Issues 1025 Dirty Surplus Accounting 1025 Common Stock Transactions 1027 Consistency in Residual Income, Dividends, and Free Cash Flow Value Estimates 1029 xxix

11 Summary Comments on Valuation Questions and Exercises Problems and Cases Integrative Case 12.1 Starbucks Chapter 14 Valuation: Market-Based Approaches Introduction and Overview Market Multiples of Accounting Numbers Market-to-Book and Value-to-Book Ratios A Theoretical Model of the Value-to-Book Ratio 1045 The Value-to-Book Model with Finite Horizon Earnings Forecasts and Continuing Value Computation 1049 Application of the Value-to-Book-Model to PepsiCo Reasons Why VB Ratios and MB Ratios May Differ From Empirical Data on MB Ratios 1056 Empirical Research Results on the Predictive Power of MB Ratios Price-Earnings and Value-Earnings Ratios 1059 A Model for the Value-Earnings Ratio 1059 Price-Earnings Ratios 1060 Summary of Value-Earnings and Price-Earnings Ratios 1071 Using Market Multiples of Comparable Firms 1072 Price Differentials 1072 Computing PDIFF for PepsiCo 1074 Reverse Engineering 1075 Reverse-Engineering PepsiCo's Stock Price 1076 The Relevance of Academic Research for the Work of the Security Analyst 1077 Creating Relevant Academic Research Results 1078 What Does "Capital Market Efficiency" Really Mean? 1079 Striking Evidence on the Degree of Market Efficiency and Inefficiency with Respect to Earnings 1080 Striking Evidence on the Use of Valuation Models to Form Portfolios 1082 Summary 1084 Questions and Exercises 1084 Problems and Cases 1086 Integrative Case 14.1 Starbucks 1094 Appendix A Appendix B Appendix C Appendix D Index Financial Statements and Notes for PepsiCo, Inc. and Subsidiaries Management's Discussion and Analysis for PepsiCo, Inc. and Subsidiaries Financial Statement Analysis Package (FSAP) Financial Statement Ratios: Descriptive Statistics by Industry and by Year XXX

DANA HOLDING CORPORATION Quarterly Financial Information and Reconciliations of Non-GAAP Financial Measures

DANA HOLDING CORPORATION Quarterly Financial Information and Reconciliations of Non-GAAP Financial Measures Quarterly Financial Information and Reconciliations of Non-GAAP Financial Measures Non-GAAP Financial Measures Adjusted EBITDA is a non-gaap financial measure which we have defined as earnings from continuing