Penman 5ed Appendix

CHAPTER 1
CHAPTER 2
A Summary of Formulas
Value of the firm =Value of debt+ Value of equity
Shareholders ' equity= Assets - Liabilities
Net income = Revenues - Expenses
Net revenue - Cost of goods sold = Gross margin
Gross margin - Operating expenses= Operating income
Operating income - Net interest expense= Income before taxes
Income before taxes - Income taxes = Income after taxes
(and before extraordinary items)
Income before extraordinary items+ Extraordinary items = Net income
Net income - Preferred dividends= Net income available to common
Cash from operations + Cash from investment + Cash from financing
=Change in cash
Ending equity = Beginning equity+ Total (comprehensive) income
- Net payout to shareholders
Comprehensive income = Net income+ Other comprehensive income
Intrinsic premium= Intrinsic value of equity - Book value of equity
Market premium= Market price of equity - Book value of equity
Value added for shareholders = Ending value - Beginning value+ Dividend
Stock return
1
= P
1
- P1- 1 + d1
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710 Appendix A Summary of Formulas
CHAPTER 3
CHAPTER 4
U l d
.
/ 1
Market value of equity +Net debt
n evere pnce sa es =
Sales
U 1 d
.
/
b. Market value of equity+ Net debt
n evere pnce e it = ------------
ebit
U I d
.
/
b. d Market value of equity+ Net debt
n evere pnce e 1t a= - - --- -----'----=-----
ebitda
.
/
Market value of equity+ Net debt
Enterpnse P B = - --------'---'-----
Book value of equity+ Net debt
T
.
1
. /E Price per share
rm mg P = -----"-----
Most recent annual EPS
II
. IE P1ice per share
Ro mg P = ---- ----'---------
Sum ofEPS for most recent four quarters
. Price per share
Foiward or leadmg P/E = ~
Forecast of next y e m ~ s EPS
. . d. d PIE Price per share + Annual DPS
D1v1dend-a JUSte = --'---------- -
EPS
Value of a bond= Present value of expected cash flows
VD= CF1 + CF2 + Cf3 + CF4 + . . . + CFr
0
PD Pi Pb Pb Pb
(PD is 1 + Required return for the bond)
Value of a project= Present value of expected cash flows
VP= CF1 + CF2 + CF3 + CF4 + ... + CFr
0
PP p ~ p ~ pj, p ~
(pp is I + Hurdle rate for the project)
Value of equity= Present value of expected dividends
VE= !!I_ + 3.l:_ + !!.l_ + + ...
0 2 3 4
PE PE PE PE
(PE is 1 +Required return for the equity)
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Value of equity = Present value of expected dividends + Present value of expected
terminal price
Page 112
CHAPTER 5
Appendix A Summary of Formulas 711
Perpetuity dividend model:
V
E c/1 d2 d3 dT ( dr+I ) T
0 =-+-2-+ - 3 + +--;-+ --- 1PE
PE PE PE p E PE - 1
Dividend growth model:
V
E di d2 d3 dr ( dr+I )1 T
o=-+-2- +-3 ++--;-+ PE
PE PE PE p E PE - g
Value of a perpetual dividend stream= V = di
PE - 1
d1
Value of a dividend growing at a constant rate= Vfj = ---'--
PE - g
Value of the firm= Present value of expected free cash flows
F C, - l1 C2 - 12 C3 - / 3 C4 - /4 + Cs - Is
Vo= ---+ ? + , + +
PF PJ:- Pf- Pf ~
(PF is 1 + Required return for the firm)
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Value of the equity= Present value of expected free cash flows minus value of net debt
V E = C1 - 11 + C2 - 12 + C3 - f 3 + ... + Cr - fr + CVr _ vo
0 2 3 T T 0
PF PF PF PF PF
If free cash flows after Tare forecasted to be a (constant) perpetuity,
CVr = Cr+1 - IT+1
PF - I
lf free cash flows are forecasted to grow at a constant rate after the hori zon,
CVr = (Cr+1 - 1r+
1
)
PF -g
Cash flow from operations = Reported cash flow from operations
+After-tax net interest payments
Cash investment in operations= Reported cash fl.ow from investing
- Net investment in interest-bearing
instruments
Earnings= Free cash flow - Net cash interest + Investment+ Accruals
Earnings= (C - l) - i +I+ Accruals
. E RE1 RE2 RE3
The value of common equity (V
0
) =Bo + - - + --+ -- +
PE ~ Pi
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712 Appendix A Summary of Fonnulas
CHAPTER 6
Residual earnings= Comprehensive earnings - (Required return for equity
x Beginning-of-period book value of equity)
RE
1
=Earn,- (PE- l)B1- 1
Residual earnings = (ROCE - Required return on equity)
x Beginning-of-period book value of common equity
Earn
1
- (PE- l)B1- 1 = [ROCE1 - (PE- 1 )]B,_1
Simple valuation model:
E RE I
Vo =Bo+--""--
PE - g
Case 1 valuation. RE is forecasted to be zero after some point:
RE1 RE2 RE
3
REr
vt = Bo + - - + - - + - - + + --
PE Pk Pi ~
Case 2 valuation. No growth:
VE = Bo + -- + -- + ... + --+ --- p7
RE1 RE2 REr ( REr +1 } .
0
PE Pi Pi PE - 1 E
Case 3 valuation. Growth is forecasted to continue at a constant rate:
VE = Bo + RE1 + RE2 + RE3 + . .. + REr + ( REr +I } pr
0
PE Pi Pi p ~ PE - g E
. E 1 [ ~ ~ LlliE4 l
Valueofeqmty= V
0
= -- Earn
1
+ - -+--+--+
P
-1 p p2 p3
E E E E
Normal forward P/E = - -----
Required return
1
.
1
.
/
(l + Required return)
Norma tra1 mg p, E = --------
Required return
Value of equity = Capitalized forward earnings
+ Extra value for abnormal cum-dividend earnings growth
v/ = Earn
1
+ - 1- [AEG
2
+ AEG
3
+ AEG
4
+ ]
PE - l p E - l p E Pi p ~
= _l_[ Earn + AEG
2
+ AEG
3
+ AEG
4
+ ]
p E - l
1
p E Pi p ~
Abnormal earnings growth
1
(AEG
1
) = Cum-dividend earn, - Normal earn
1
= [Earn1 + (PE- l )d,_1) - PEEarn1-1
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CHAPTER 7
CHAPTER 8
Abnormal earnings growth
1
(AEG
1
) = [G, - pE] x Earnings,_
1
Page 187
Value of equity (cum-dividend)= Capitalized current earnings
+ Extra value for abnormal cum-dividend abnormal
earnings growth
v. + d = ___Eg__[Eam + AEG
1
+ AEG
2
+ AEG
3
+ . . 1
0 0 p - 1 0 p 2 3
PE PE
PIE
PEG ratio=---------------
1-year-ahead percentage earnings growth
Value =Value based on what we know + Speculative value
Weighted-average expected return formula:
Value = Value based on book value and near-term forecasts
+ Value of speculative growth
E PE, PE2 .
Vo = Bo + -- + + Value of speculative growth
P P(P -1)
Earnings forecast,= (Book value,_
1
x Required return)+ Residual earnings,
1 [ AEG2]
vif = p _ l EPS
1
+ ~ +Value of speculative growth
Earnings forecast, = Normal earnings forecast,+ AEG,
- Forecast of earnings from prior year's dividends
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Free cash flow= Net dividends to shareholders+ Net payments to debtholders and
issuers
C - I=d+F
Treasurer's rule:
If C - 1 - i > d: Lend or buy down own debt
If C - I - i < d: Borrow or reduce lending
Free cash flow = Operating income - Change in net operating assets
C - I= 01 - ~ N O
Free cash flow = Change in net financial assets - Net financial income
+Net dividends
C - I= N F - NFI + d
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CHAPTER 9
Free cash flow = Net financial expenses - Change in net financial obligations
+Net dividends
C- 1= NFE - f1NFO + d
Net dividends= Free cash flow + Net financial income
- Change in net financial assets
d=C- l+NFI - ~ N F
Net dividends= Free cash flow - Net financial expenses
+ Change in net financial obligations
d = C - l - NFE + ~ N F O
Net operating assets (end)= Net operating assets (beginning)
+ Operating income - Free cash flow
Change in net operating assets = Operating income - Free cash flow
f1NOA
1
= 01
1
- ( C, - 1
1
)
Net financial assets (end)= Net financial assets (begin)
+Net financial income +Free cash flow
- Net dividends
Change in net financial assets= Net financial income+ Free cash flow
- Net dividends
f1NFA
1
= NFI, + ( C, - 1
1
) - d
1
Net financial obligations (end)= Net financial obligations (begin)
+Net financial expense - Free cash flow
+ Net dividends
Change in net financial obli gations= Net financial expense - Free cash flow
+Net dividends
Stocks and flows equation for common stockholders' equity:
CSE,= CSE
1
_
1
+Comprehensive earnings, - Net dividends
1
Dividends
Dividend payout = ---------
Comprehensive income
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Page 266
CHAPTER 10
Appendix A Swnmary of Fonnulas 715
. Dividends + Stock repurchases
Total payout ratLO =
. . Dividends
D1v1dends-to-book value = - ------ ------
Book value of CSE+ Dividends
Page 266
Page 266
1 b k 1
Dividends + Stock repurchases Page 266
Tota payout-to- oo va ue = --------------'---------
Book value of CSE+ Dividends+ Stock repurchases
. . Comprehensive income - Dividends
Retention ratio=--- --- --------
= I - Dividend payout ratio
Net investment rate
Growth rate of CSE
Net transactions with shareholders
Beginning book value of CSE
Change in CSE
Beginning CSE
Page 267
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Comprehensive income+ Net transactions with shareholders
Beginning CSE
Growth rate of CSE = ROCE +Net investment rate
Tax benefit of net debt= Net interest expense x Tax rate
After-tax net interest expense= Net interest expense x (1 - Tax rate)
Tax on operating income= Tax expense as reported
+(Net interest expense x Tax rate)
Effective tax rate for operations =
Tax on operating income
Operating income before tax, equity income, and extraordinary and dirty-surplus items
Residual operating income= Re01
1
= 01
1
- (p - l)NOAl-1
. 01 (after tax)
Operating profit margm (PM) = -----
Sales
01 (after tax) from sales
Sales PM =
Sales
M
01 (after tax) from other items
Other items P = - -"-----'--------
Sales
. . . Comprehensive income
Net (comprehensive) mcome profit margm = ---------
Sales
Expense
Expense ratio = -"---
Sales
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CHAPTER 11
CHAPTER 12
1 - Sales PM= Sum of expense ratios
0
. . . . Operating asset
peratmg asset compos1t10n rat10 = .
Total operating assets
0
.
1
. b'l' . . . Operating liability
peratmg ia 1 1ty compos1t10n ratio = -------='-----=--
Total operating liabilities
0
.
1
. b'l' l (OLLEV) Operating liabilities
peratmg 1a 1 1ty everage = --=---=----
Net operating assets
. . . . Net operating assets
Cap1tahzatton rat10 = = NOA/CSE
Common stockholders' equity
Financial leverage ratio
(FLEV)
Net financial obligations
----- ----- = NFO/CSE
Common stockholders' equity
Capitalization ratio - Financial leverage ratio = 1.0
Return on net operating assets (RNOA
1
) =
011
t/2 (NOA
1
+ NOAt-1)
NFI
Return on net financial assets (RNF A
1
) = l
1
12 (NFA
1
+ NFA
1
_
1
)
NFE
Net borrowing cost (NBC
1
) =
1
1
1
2
(NF0
1
+NF0
1
_
1
)
Free cash flow = Operating income - Change in net operating assets
C -1 = OI - .ilNOA
Free cash flow= Net financial expense - Change in net financial obligations
+ Net dividends
C - I= NFE - L'.lNFO + d
ROCE = ( NOA x RNOA) - (NFO x NBC)
CSE CSE
ROCE = RNOA + [ NFO x ( RNOA - NBC)]
CSE
= RNOA +(Financial leverage x Operating spread)
= RNOA + (FLEV x SPREAD)
ROCE = RNOA - [NFA x (RNOA - RNFA)]
CSE
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Page 368
Appendix A Summary of Fonnulns 717
Implicit interest on operating liabilities= Short-term borrowing rate (after tax)
x Operating liabilities Page 369
R
. (ROOA) OI +Implicit interest (after tax)
etum on operatmg assets = . Page 369
Operatmg assets
Return on net operating assets= Return on operating assets+ (Operating liability
leverage x Operating liability leverage spread)
RNOA = ROOA + (OLLEV x OLSPREAD)
OLSPREAD = ROOA - Short-term borrowing rate (after tax)
ROCE = ROCE before MI x MI sharing ratio
ROCE b
,, . . . (Ml) Comprehensive income before MI
eiore mmonty mterest = -------------
CSE+ MI
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Page 372
Page 372
Minority interest
sharing ratio
Comprehensive income/Comprehensive income before MI
-----'----------=------------ Page372
CSE/(CSE + MI)
ROCE =(PM x ATO) + [FLEV x (RNOA- NBC)]
PM= OI (after tax)/Sales
ATO = Sales/NOA
PM = Sales PM + Other items PM
Sales PM= Gross margin ratio - Expense ratios
1 Cash Accounts receivable Inventory PPE
--=--+ + + +--
A TO Sales Sales Sales Sales
Accounts payable Pension obligations
+- - - ...
Sales Sales
Sales
Accounts receivable turnover = ----------
Accounts receivable (net)
Sales
PPE turnover= -------------
Property, plant, and equipment (net)
. . bl 365
Days m accounts rece1va e = -----------
Accounts receivable turnover
(sometimes called days sales outstanding)
The inventory turnover ratio is sometimes measured as:
Cost of goods sold
Inventory turnover =
Inventory
. . 365
Days 111 mventory = -------
Inventory turnover
. 365 x Accounts payable
Days 111 accounts payable = ---------
Purchases
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CHAPTER 13
The net borrowing cost is a weighted average of the costs for the different sources of net
financing:
(
FO After-tax interest on financial Gbligations (FO) J
NBC= --x ____________ __.o::_ __ -'----_:_
NFO FO
- ~ x After-tax interest on financial assets (FA)J
NFO FA
-( FA x Unrealized gains on FAJ
NFO FA
(
Preferred stock Preferred dividends J
+ x +
N FO Preferred stock
Page 380
OI = Core Ol from sales + Core other OI + UI
Page 396
Return on net operating assets= Core RNOA
+ Unusual items to net operating assets Page 404
RNOA = Core OJ + ~
NOA NOA
Page 404
R 0
Core 01 from sales Core other OT UI
N A= + +--
NOA NOA NOA
Page 404
( )
Core other 01 UI
RNOA = Core sales PM x ATO + + --
NOA NOA
where I
Core 01 from sales
Core sa es PM = -------
Sales
Page 406
Net borrowing cost = Core net borrowing cost + Unusual borrowing costs
Core net financial expenses Unusual financial expenses
NBC = + ---------'-----
NFO NFO
Page 406
Change in core sales Change due to Change due to Change due to
Change in
RNOA
profit margin at + change in asset + change in other + change in
previous asset turnover core income unusual items
turnover level
.6.RNOA1 = (.6.Core sales PM1 x ATOo) + (.6.AT0
1
x Core sales PM1)
+ .6.( Core other 01 J + . 6 . ~ J
NOA NOA
Page 408
CHAPTER 14
Sales PM
Sales - Variable cost - Fixed costs
Sales
Contribution margin
Sales
Fixed costs
Sales
C
.b . . .
1
Variable costs Contribution margin
ontn ut10n margm rat10 = - =
Sales Sales
0
Contribution margin Contribution margin ratio
LEV = = ---- ----"---
Operating income Profit margin
(Don't confuse OLEY with OLLEV!)
% Change in core OJ =OLEY x % Change in core sales
1
NOA = Sales x --
ATO
= x _l -J-
ATO
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Page 411
Resi dual operating income= Operating income - (Required return for operations
x Beginning net operating assets)
Re0I
1
= Ol, - (pF- l)NOA,_1 Page 439
Value of operations= Net operating assets
+Present value of expected residual operating income
VNOA = NOAo + ReOI1 + ReOb + ReOJ3 + . . . + ReOJ r + CYr
0 J 3 T T
PF PF- PF PF PF
Page 439
Value of common equity = Book value of common equity
+ Present value of expected residual operating income
VE= CSEo + ReOI1 + ReOI2 + ReOI
3
+ ... + ReOi r + CYr
0 2 3 T T
PF PF PF PF PF
Residual operating income= (RNOA - Required return for operations)
x Net operating assets
Re0J
1
= [RNOA,- (pF- l)]NOA,_1
Abnormal operating income growth, (AOIG)
=Cum-dividend operating income, - Normal operating income,
= [Operating income
1
+(PF- l)FCF,_1] - PF operating income
1
_
1
=[OJ,+ (PF- l)FCF,_1] - PFOI,_1
= [G, - PF] x OI1- 1
Page 440
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Page 443
Value of common equity= Capitali zed (Forward operating income+ Present
value of abnormal operating income growth)
- Net financ ial obli gations
V
E_ I [ol AOIG2 AOIG3 AOIG4 ] NFO
o--- 1+ + + + - 0
PF - 1 PF p} p}
Core ReOI
1
=Core 01
1
- (PF - 1) NOA1- 1
Page 445
Page 445
Cost of capital for operations= Weighted-average cost of equity and cost of net debt
(
Valueofequity . . J
= . x Equity cost of capital
Value of operations
(
Value of debt J
+ x Cost of debt capital
Value of operations
_ vg v ~
p F - VNOA . p E + ~ O . p D
0 0
After-tax cost of net debt (PD)= Nominal cost of net debt x (I - Tax rate)
Required return on equity= Required return for operations
+ (Market leverage x Required return spread)
VD
p E = p F + vE (p F - p D)
0
Earnings growth rate
1
= 01 growth rate
1
Page 447
Page 447
Page 449
+ [Earnings leverage
1
- i X (OI growth rate
1
- NFE growth rate
1
)]
ELEV=
NFE
Earnings
d IB
. Value of net operating assets
Unlevere P ratio = -----------
Net operating assets
v, NOA
_o __
NO Ao
Levered P/B ratio= Unlevered P/B ratio+ [Financial leverage
x (Unlevered P/B ratio - l)]
VE J!:NOA ( v,NOA )
_o_ =--o-+FLEV -
0
- -1
CSEo NOAo . NOAo
Value of operations 11,NOA
Forward enterprise PIE ratio = = _o __
Forward operating income 01
1
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CHAPTER 15
T
.
1
. . P' ' E . Value of operations + Free cash flow
rai mg enterprise / ratio == . .
Current operatrng mcome
V,NOA + FCFo
== 0
Ol a
Forward levered P/E ratio == -
0
- == -
0
-- + ELEV
1
_o __ - --
v;E v NOA ( vNOA 1 )
Eam 1 011 011 NBC1
. Earn1 011 NF00 [ 011 ]
Forward levered E/P rat10 == --- = NOA+ --E- NOA - NBC
1
Vo Vo Vo Vo
V,E +do
Trailing levered P/ E ratio == _a,,__ __
Eamo
Page 466
Page 466
Page 466
Page 466
- VaNOA + FCFo + ELEVo ( Vti'OA + FCFo
Ola Ola
- N ~ C o - l)
The no-growth forecast of operating income:
The no-growth valuation of operations:
NOA - ---2!.l_
Vo - PF - 1
The growth forecast of operating income:
01
1
== NOAo x Core RNOAo
Growth valuation:
Value of common equity:
E _CSE [Core RNOAo - (P F - l )]NOA0
V
0
- o + --------"---'-'----
PF - g
Value of operations:
v ~ o = NOAo + [Core RNOAo - (PF - J)]NOAo
PF - g
OAo x Core RNOAo - (g - I)
PF - g
Unlevered price-to-book ratio:
VNOA Core RNOAo - (g-1)
OAo PF - g
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Page 486
722 Appendix A Si;mmary of Formulas
CHAPTER 16
CHAPTER 18
Unlevered forward P/E ratio:
_ o - = -- 1 + -----"'-----'-
V, NOA 1 [ . G 2 - p F]
OI i Pp - 1 Pp- g
Weighted-average growth rate for ReOI = (0.7 x Current growth in ReOI)
+ (0.3 x 4%)
A simple valuation with short-term and long-term growth rates:
VoNOA = 011 X _ _ l_[ G2 - Giang]
PP - 1 PF - Giong
I S l
(c
1 PM
Required return for operations)
ReO = a es x ore sa es - ---'------_ _o__ __ _
ATO
+ Core other 01 + Unusual items
Quality diagnostics:
Net sales/Cash from sales
Net sales/Net accounts receivable
Net sales/ Allowance for sales returns and discounts
Net sales/Unearned revenue
Bad debt expense/ Actual credit losses
Bad debt reserves/ Accounts receivable (gross)
Bad debt expense/ Sales
Normalized 01
OI
where
Normali zed OI = Free cash flow + .6.Normalized NOA
= Free cash flow+ .6.Sales/Normal ATO
Adjusted ebitda
ebit
Depreciation
Capital expenditures
Cash flow from operations (CFO)
Operating income
CFO
Average NOA
Pension expense
Total operating expense
Page 486
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Page 610
CHAPTER 19
CHAPTER 20
Other posternployrnent expenses Page 61 O
Total operating expense
Operating tax expense Page 61 O
01 before taxes
Warranty expense/ Actual warranty claims
Warranty expense/Sales Page 611
R&D expense Page 615
Sales
Advertising expense
Sales
Reverse engineering the expected return:
Expocted oquity rntum = [ x ROCE
1
H [I - !: ) x (g - I)]
Page 615
Page 665
Expected return for operations
[
)x(g-1)]
C
. Current assets
urrent ratio = ---- --
Current liabilities
Q
. k ( 'd ) . Cash+ Sh01t-terrn investments+ Receivables
uic or ac1 test ratio=------ ----------
Current liabilities
C h
. Cash+ Short-te1111 investments
as ratio = -----------
Current liabilities
ti
. .
1
Cash+ Short-term investments+ Receivables
De ens1ve mterva = x 365
Cash flow to
capital expenditures
(Unlevered) cash flow from operations
Total debt ( cunent + long-term)
Debt to total
Total assets (liabilities+ total equity)
Total debt
Debt to equity = -----
Total equity
Page 665
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Page 685
Page 685
Page 685
Page 685
Page 686
Page 686
724 Appendix A Summary of Fonnulru
. Long- term debt
Long-term debt ratio = -----=-------
Long-term debt+ Total equity
Operating income
Interest coverage = (times interest earned)
Net interest expense
Unlevered cash flow from operations
Interest coverage= (cash basis)
Net cash interest
C d b
Unlevered cash flow from operations
FO to e t = ---------------
Total debt
Cash available for debt service = Free cash flow - Net dividends
= OI - b.NOA - Net dividends
Debt service requirement= Required interest and preferred dividend payments
+ Required net principal payments
+ Lease payments
Page 686
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Page 693
Page 693
Index
A
Abnormal accrual scores, 619
Abnormal earnings, 142
Abnormal earnings growth (AEG), 183,
187, 188, 393, 394
Abnormal earnings growth (AEG) model
advantages/disadvantages, 195
anchoring valuation to current
earnings, 189
basic equation, 187, 443
build your own analysis engine, 192- 193
buying earnings, 195
case I/case 2 valuations, 190- 191
converting forecasts to valuation,
191- 192
dividends, 196
earnings created by accounting, 196, 197
measuringAEG, 187-188
overview (fi gure), 186
paying too much for earnings growth,
180, 194
RE model, compared, 194, 195- 196
reverse engineering, 221- 222
share issues, 196
share repurchases, 196
simple valuation model, 188-189
steps in process, 186
value creation/strategy analysis, 195- 196
valuing equity, 443
Abnormal operating income growth (AOIG),
444,446
Abnormal operating income growth model,
444-445
Abnormal returns to quality analysis, 620
Accelerated depreciation, 570
Account-based valuation, 525- 526
Accounting
accrual. See Accrual accounting
aggressive, 592
big-bath, 592
casb,576
clean-surplus, 263
conservative. See Conservative
accounting
consolidation, 296
cookie-jar, 615
dirty-surplus, 263- 265
exercise date, 270
fair value, 40 I, 403, 6 12
"good" vs. "bad," 576
grant date, 270
historical cost, 46
liberal. See Liberal accounting
mark-to-market, 46, 442, 461-463
neutral. See Neutral accounting
pension, 418
tension, 53- 54, 597
Accounting adj ustments, 79
Accounting clinics
accrual accounting, 127
basic accounting principles, 52
business combinations, 297
equity investments, 297
income taxes, 307
marketable securities, 265
pensions, 401
stock compensation, 270
Accounting equation, 36
Accounting for projects, 557
Accounting manipulation, 594-617
assets, 599
balance sheet, 595-596, 599
core expenses, 602, 6 12-6 14
jL1stifiable manipulation, 617
li abilities, 599
off-balance-sheet operati ons, 616
sales, 602, 603-604
sensitive areas, 600
transaction manipulation, 614- 616
when li kely to occur, 601
Accounting methods
changing level of investment, 56 1
conservative accounting. See
Conservative accmmting
constant level of investment, 558- 561
forecast horizon, 5 7 5-5 7 8
GAAP, 554
liberal accounting. See Liberal accounting
neutral accounting. See Neutral
accounting
value added, 576
Accounting quality, 54- 55, 590- 639
abnormal returns to quality
analysis, 620
balance sheet, 320
cash fl ow statement, 354- 355
disclosure quality, 617- 618
earnings qual ity, 591
equity statement, 277
growth analysis, 4 18
"bard numbers" vs. "soft numbers," 603
manipulation. See Accounting
manipulation
prelude to quality analysis, 598- 600
quality scoring, 618-619
questions to ask, 593-594
red fl ags- accounting and financial
statement conditions, 60 I
red fl ags- institutional conditions, 60 I
speculation, 597- 598
Accounting rate of return, 14 7
Accounting relations
dividend driver equations, 245, 251
form, and, 34
free cash flow disposition equation,
244,251
free cash flow sources equation,
244, 251
net fi nancial asset driver equation,
245- 246, 251
net financial obligation driver equation,
246,25 1
net operating asset driver equation,
245, 251
Nike, 249
reformulated statements, 243-246
Accounting standards, 33
Accounting value added, 557, 579
Accounts receivable turnover, 3 77
Accrual accounting
balance sheet, 128
book value, 140- 176
creation of earnings, 163- 164
earnings, 178- 208
income statement, 128
Accruals
defined, 130
expense, 125
financial statements, 123, 128
manipulation, and, 608, 609
revenue, 125
timing, 125- 126
Accrued and estimated liabilities, 48
Accrued compensation, 127- 128
Accrued expense, 297, 320, 599
Acid test ratio, 685
Acquisitions, 93, 162, 527-528
Active bond investing, 696
Active investing, 210- 23 1. See also Analysis
of equity risk and return .
Active investor, 4, 5
Activity ratios, 3 77
725
726 index
Adaptation option, 659
Adjusted ebitda, 607
Adjusted multiples, 79
Advancing payments of receivables, 354
Advertising expense, 354, 399
AEG, 183, 187, 188, 393, 394
AEG model. See Abnormal earnings growth
(AEG) model
After-tax net interest payments, 120
Aggressive accounting, 592
Airlines, 516- 517
Alpha, 5
Alpha technologies, 5
Altman, Edward, 690
Amazon.com, I 0, 50
America Online (AOL), 10, 30, 6 11
Ameri ca West Holdings, 415
Amortization, 573, 575, 606- 608
AMR, 607
Analysis of business, 14-17
financial statements. See Financial
statements
lens of the business, 506- 515
mastering the details, 16- 17
strategy and valuation, 15
sustainabi lity of competitive
advantage, 17
Analysis of credit risk and return,
680- 708
active bond investing, 696
credit scoring, 688- 692
fi nancial statement analysis, 682- 687
forecast ing and credit analysis, 687- 696
full -information forecasting, 692- 695
liquidity planning, 696- 697
logit analysis, 690- 691
pro forma analysis, 692- 694
ratio analysis, 684-687
reformulated financial statements,
682-683
required return/expected return,
695- 696
suppliers of credit, 681- 682
value-at-risk profiles, 694- 695
z-score analysis, 690
Analysis of equity ri sk and return,
642- 678
adaptation option, 659
asset pricing models, 649- 65 1
discounting for ri sk, 660- 661
distribution of returns, 644- 648
diversification, 648- 649
downside risk, 647
expected return, 643-644, 664- 670
financing risk, 653- 654
finessing the required return problem, 667
fundamental determinants of equity
risk, 65 1
fundamental risk, 651- 654
growth option, 660
growth-return profile, 666- 667
growth ri sk, 654
inferring expected returns, 664- 670
liquidity risk, 664
market inefficiency risk, 661-664
operating risk, 653
pairs trading, 668
price ri sk, 66 1- 664
required return, 643, 644
ri sk classes, 668
risky growth, 668- 670
uncertain times, 670
upside potential, 64 7
value-at-ri sk profi ling. See Value-at-risk
profiling
Analysis of growth and sustainable earnings,
392-433
accounting quality watch, 41 8
cautionary notes, 394
changes in financing, 409
core borrowing cost, 406-407
core operating income. See core
operating income
core operating profitability, 404-406
growth, defini tion of, 393- 395
growth in shareholders' equity, 409-41 l
growth through profitability, 407-408
operating leverage, 408-409
P/ B-P/E relationship, 41 1-416
P/B ratio and growth, 416
P/E ratio and sustainable earnings, 416
Analysis of profitability, 364- 39 1
borrowing cost drivers, 380- 38 1
build your own analysis engine, 38 l
DuPont model, 3 74
financial leverage. See Financial
leverage (FLEV)
first-l evel breakdown, 366- 373
key drivers, 379
methodology, 373
OLLEV, 368-370
overview (figure), 366
profit margin- asset turnover tradeoff,
374, 375
profit margin drivers, 376, 378
ROA, 371, 372
ROCE. See Return on common equity
(ROCE)
second-level breakdown, 373- 376
third-level breakdown, 376- 381
turnover drivers, 376- 378
Analysis spreadsheet. See Build Your Own
Analysts' forecasts, 490
Anm1ity, I 13
AOlG, 444, 446
AOL Time Warner, 15, 93
Apple, Inc., 19,331 - 333
Application exercise questions. See
individual company names
Arbitrage pricing theory (APT), I 07
Arthur Andersen, 53
Articulation, 42, 56
Asset-based companies, 84
Asset-based valuation, 82- 84
Asset impairment, 399
Asset pricing models, 96, I 06, 649- 65 l
Asset sales, 403, 418
Asset turnover (ATO), 373- 377, 512,
605- 606
Asset turnover (ATO) drivers, 3 76- 3 78
Asset turnover (ATO) forecast, 522- 523
Asset turnover (ATO) risk, 653
Asset utilization ratios, 3 77
Assets
accounting quality watch, 320
current, 684- 685
defined, 34
enterprise, 293
financial, 236
IFRS, 33, 54
manipulation, and, 599
measurement, 4 7-48
NFA,237,241,242,293, 300
NOA. See Net operating assets (NOA)
operating, 23 7, 241
At the money, 268
AT0,373-377,512,605- 606
ATO forecast, 522- 523
AT&T, 608, 613
Audit quality, 593
Automobile manufacturers, 295, 304, 516.
See also individual company names
B
"Bad accounting," 576
Bad debt expense, 40 I , 604
Balance sheet, 34- 36
accounting equation, 36
accruals, investments, 127- 128
accrued expenses, 297
cash, 294-295
common-size, 316
credit analysis, 682-683
debt investments, 296
deferred revenue, 297
deferred tax assets and liabilities, 297
dividends payable, 297
Kimberly-Clark, 58
leases, 297
long-term equity investments, 296
manipulation, 595- 596, 599
measurement, 46, 4 7-48
minority interest, 298
Nike, 35
other items, 297- 298
preferred stock, 297
ratio analysis, 319
reformulated, 241- 242, 293- 303,
682- 683
short-term equity invest ments, 296
short-term notes payabl e, 296- 297
short-term notes receivable, 296
stock statement, 42
strategi c, 30 1- 303
typical presentation, 294
Balance sheet equation, 36
Balance sheet line items, 610- 612
Balance sheet ratios, 319
Bank loan, 682. See also Analysis of credit
risk and return
Bank of America, 604
Banking income for the future, 592
Bankruptcy, 691
Banks, 295, 682
Barriers to entry, 155
Basic earnings per share, 40, 272
Bausch & Lomb, 625
Bear Stearns, 8
Beaver, William, 688
Behavioral finance, 663
Beta. 5, I 07, 642
Beta bashing, 97
Beta risk, 5
Beta technologies, 5, 106- 108
Beverage industry, 516
Big-bath accounting, 592
Bleedback, 398, 399
Bond arbitrage, 696
Bond ratings, 681 , 688
Bond valuation, 89- 90
Book
how to use, 21
overview, 2 1- 22
Book leverage, 450
Book rat e of return, 14 7
Book value
anchor, as, 142
anchoring principle, 145
BPS, 147
P/B ratio. See Price-to-book (P/B) ratio
simple valuation model, 150- 151
Book value growth rate, 148, 149
Book value method, 274
Book value of equity. 20, 44
Book value per share (BPS), 44, 147
Borden, Inc., 613
Borrowing cost drivers, 380- 381
Borrowing cost risk, 653, 654
Borrowing income from the future , 592
Borrowings, 48
"Bottom-line" numbers, 73
Bottom-up tax allocation, 308
Brand management firm, 515
Breakup value, 84
Bubble. See Market bubble
Buffett, Warren, 8, 274, 285, 490, 498,
649,650
Build Your Own
act ive investing, 222
AEG model, 192- 193
balance sheet, 321
business activities, 248- 250
Kimberly-Clark, 384
profitability analysis, 381
RE model , 157- 159
statement of shareholder '
equity, 276
Build Your Own Anal ysis Product
(BYOAP), 21 , 34, 525
Burlington Northern Santa Fe, 498
Burroughs, 7
Business, knowledge of. See Analysis
of business
Business activities
cash conservation equation, 238
cash flows, 236- 242
free cash flow, 238, 239
reformulated statements, 240- 242
stocks and flows, 242- 243
treasurer's rule, 238
Business combinations, 297
Business concept, 15
Business condition, 515
Business debt. See Analysis of credit risk
and return
Business model , 15
Business ri sk, 651
Business strategy, 15
Business strategy analysis, 530- 53 1
Buy-side analyst , 13
Buy-side fundamental investor, 212
Buyouts, 528
BYOAP, 34, 525
c
Cadbury Schweppes, 613
Capacity swap, 614
Capital asset pricing model (CAPM), 96,
106- 107, 649- 651
Capi tal expenditures, 115
Capital gain, 46
Capital lease, 297, 684
Capital market, 11
Capitalization, 598
Capitali zation policy, 355
Capitalization ratio, 319
Captive finance subsidiaries, 295
Carrying value (operating
liabilities), 611
Case I valuation, 152- 154, 190
Case 2 valuation, 153, 154, 191
Case 3 valuation, 154-155
Cases. See Kimberl y-Clark Corporation;
Mini cases
Index 727
Cash, 294- 295
Cash accounting, 576
Cash and cash equivalents, 47, 82, 300
Cash available for debt service, 693
Cash conservation equation, 238
Cash dividends, 262
Cash flow from investing act iviti es, 121
Cash flow from operat ions. 120-122, 238,
353- 355
accounting quality watch, 354- 355
advancing payments of receivables, 354
advertisi ng expense, 354
capitalization poli cy, 355
cash flow and noncash charges, 354
delaying payments, 354
mismatching, 355
noncash transactions, 354
R&D expense, 354
structured finance, 354
total cash flow from projects, I 15
Cash flow hedge, 264
Cash flow in investment activities, 237
Cash flow ratio, 685
Cash flow statement. See Statement of
cash flows
Cash flow to capital expenditures, 685
Cash flows
business activities, 236- 242
to claimants and within the firm, 23 7
financing, 40
firm/ claimants (capital market), 236
free. See Free cash flow
investing, 40
operating activities, 345
tying it together, 246- 248
Cash from operations, 40
Cash investment , I 15, 23 7
Cash ratio, 685
Caterpillar, Inc., 354
Cell analysis of P/ B-P/ E relationship,
412-41 5
Cellular phone industry, 516
Centerless corporation, 13
Cerner Corporation, 627-628
CFO, 14
CFO to debt, 686
Chain letter, 7, 8
Challenging other firms, 512- 513
Change, 507- 514
Changes in esti mates, 418
Changes in financing, 409
Channel stuffing, 593, 614
Cherry picking, 403, 418
Chief financial officer (CFO), 14
Choices vs. conditions, 515
Chubb Corporation
reformulated financial statements,
338- 34 1
valuing operations and investments,
477-478
728 Index
Cisco Systems
challenging the market price, 229- 230
competitive advantage, 394
conditional shipments, 609
equity statement, 67
gain followed by loss, 442
growth-return profile, 677
impaired inventory, 613- 614
inventory buildup, 606
P/ E ratio, 9
sensitivity analysis, 500-502
Citicorp, 613
Citigroup, 8, 93, 173- 174
Claim, 10
Clean-surplus accounting, 263, 278
Clinics. See Accounting clinics
Coca-Cola Company
advertising costs, 398
analysts' forecasts and valuation,
174, 208
book value, 84
brand asset, 84
brand management firm, 515
cash flows, 133
challenging the stock price, 490
convert forecast to valuation, 134
core profit margins, 514
DCF valuation, 11 7, 138- 139
free cash flow, 583- 584
Nifty Fifty stocks, 7
profitability analysis, 388- 389
residual operating income, 540, 584
share issues, 616, 617
simple valuation, 490, 496
subsidiaries, 683
Collateral, 682
Collateralized debt obligations, 681
Commercial banks, 682
Commercial paper holders, 681
Commercial real estate industry, 5 16
Commitments, 48
Common dividends payable, 262
Common shareholders' equity (CSE),
241 ,242,246- 248,298
Common-size analysis, 3 15- 316
Common-size balance sheet, 316
Common-size income statement, 315- 316
Common stock outstanding, 36, 56
Company of averages, 515
Competitive advantage, 17, 91, 532
Competitive advantage period, 508
Competitive forces, 513
Competitiveness, 16
Composition ratios, 319
Comprehensive income, 41 , 260, 262, 524
Comprehensive income reporting, 265
Comprehensive operating income, 397
Comprehensive tax allocation, 406
Comps, 76
Computer industry, 516
Conservative accounting
accounting practices, 571
changing level of investment, 561, 563
constant level of investment, 558,
560,561
defined, 52, 557
earnings growth/value, 570
economic-value-added measures, 575
forecast horizon, 575- 576
Forte vs. Hilton, 574
goodwill, 574
hidden reserves, 567
liberal accounting, and, 570
LIFO, 565, 571
profitability in the 1990s, 574
R&D (Glaxo Wellcome), 573
R&D (pharmaceuticals industry),
572- 573
summary of accounting effects, 565
Consolidation accounting, 296
Constant growth dividend model, I 13
Constant growth model, I 13
Constant growth valuation model, I 13
Contingencies, 48
Contingent claims, 10
Contingent equity claims, 272
Contingent liabilities, 320, 683
Continuing case. See Kimberly-Clark
Corporation
Continuing value, 116, 152- 156, 190- I 9 I
Contrarian investor, 80
Contrarian stock screening strategy,
80, 508
Contribution margin, 409
Contribution margin ratio, 409
Controlling interest, 48
Convertible bonds, 274, 277
Convertible preferred stock, 274
Convertible securities, 274
Converting analysts' forecasts to valuation
AEGmodel, 191- 192
Kimberly-Clark, 202
RE valuation, 156- 157
Cookie-jar accounting, 615
Cordant Technologies, 104
Core borrowing cost, 406-407
Core business strategy, 398
Core earnings, 396
Core expense timing, 615
Core expenses, 602, 612- 614
Core operating income, 396-404
advertising expense, 399
changes in estimates, 40 I
deferred revenue, 397- 398
equity investments, unrealized
gains/losses, 40 I
eye to the future, 445
fair value accounting, unrealized
gains/losses, 401-403
General Mills, 405
income taxes, 403
merger charges, 399
other income, 403
pension expense, 400-401
R&D expense, 399
realized gains and losses, 40 l
reformulation, 397
restructuring charges, 399
Core operating profitability, 404-406
Core other income/NOA, 510
Core revenue structuring, 614
Core revenue timing, 614
Core RNOA, 506, 509
Core sales profit margin, 406, 51 1, 523
Corporate bonds, 681. See also Analysis
of credit risk and return
Corporate claims, I 0
Cost of capital, 86, I 06, 467, 643
Cost of capital and valuation, 445-450
Cost of capital for debt, 90, 44 7-448
Cost of capital for operations, 116,
446-447, 448
Cost of capital for the firm, I 16, 44 7, 448
Cost of idle capacity, 532
Crane, Burton, I 05
Credit analysis, 682. See also Analysis
of credit ri sk and return
Credit analyst, 13
Credit default swaps, 681
Credit facilities, 295
Credit risk, 680- 681
Credit scoring, 682, 688- 692
Credit scoring models, 690
Cross-sectional analysis, 314
CSE,241,242, 246- 248,298
Cum-dividend earnings, 182, 188
Cum-dividend price, 79, 98
Currency gai ns and losses, 396
Current assets, 684- 685
CwTent liabilities, 685
Current ratio, 685
D
Days in accounts payable, 3 78
Days in accounts receivable, 3 77
Days in inventory, 3 77
Days sales outstanding, 3 77
DCF analysis. See Discounted cash fl ow
(DCF) analysis
Debt
generating value, 46 1
taxes, and, 459-460
unconsolidated subsidiaries, of, 683
Debt arbitrage, 696
Debt capacity, 687
Debt-equity ratio, 373
Debt financing activities, 95
Debt financing fl ows, 236
Debt financing irrelevance, 95
Debt investments, 296
Debt securities, 4 7
Debt service requirement, 693
Debt to equity, 686
Debt to total assets, 686
Debtholders, I I
Default, 681
Default analysis, 682. See also Analysis
of credit risk and return
Default planning, 696
Default point, 694
Default premium, 680
Default ri sk, 680, 681
Default scenari o, 692
Default strategy, 696
Defensive interval, 685
Defensive investor, 4
Deferment of revenue recognition, 163
Deferred charges, 599
Deferred revenue, 125, 297, 320, 397- 399,
418, 599
Deferred tax, 610, 683
Deferred tax assets and li abilities,
297,320
Delaying payments, 354
Dell, Inc.
abnormal earnings growth, 187
balance sheet, 298
challengi ng the stock price,
542- 548
cost of capital for operations, 448
method ofcomparables, 76-77, 102
operating liability leverage, 370
put options/hidden losses, 273
reformulated income statement,
312, 313
reformulation of equity statement with
hidden losses, 286
residual operating income, 475
reverse engineering growth
rates, 226
sources of value creation, 313- 314
stock repurchase program, 304
stock repurchases and value, I 03
strategic balance sheet, 30 I, 302
successful operation, 4
valuation, I 70
Delta Air Lines, 403
Demutualization of insurance
companies, 149
Depreciation, 125, 354, 606- 608
Derivatives, 264, 396, 683
Details, 16
Digital Equipment, 7
Diluted earnings per share, 40
Diluted EPS, 272- 274
Dilution, 268
Direct method cash flow statement, 34 7
Dirty-surplus accounting, 41 , 263- 265
comprehensive income reporting, 265
defined, 263
financing income (expense) items, 264
foreign currency gains/losses, 264
gains and losses on derivatives, 264
operating income items, 264
operating or financing income
items, 264
unrealized gains and losses on securities,
263- 264
Dirty-surplus items, 264
Disclosure, lack of, 308
Disclosure quality, 594, 617- 618
Discount, 44
Discount rate, 86
Discounted cash flow (DCF) analysis,
11 4- 119
Coca-Cola, 11 7, 138-139
forecast horizon, 576-578
free cash flow and value added, 11 7-119
free cash flow problem, 128
mismeasurement, and, 127
speculation, and, 119
when it works best, 120
Discounting for risk, 660- 661
Discriminant analysis, 690
Distribution of returns, 644- 648
Diversifiable risk, 648
Diversification, 648-649
Dividend
AEG model, and, 196- 197
drivers, 244-245
homemade, 94
residual earnings, and, 165
valuation model , and, 93- 95
Dividend-adjusted PIE, 79, 184
Dividend conundrum, 114
Dividend discount model, 111-114
Dividend driver equations, 245, 25 1
Dividend irrelevance concept, 94
Dividend payout ratio, 266
Dividends payable, 262, 277, 297, 320
Dividends-to-book value, 266
Dodd, David, 211
Dollar sales, 507
Downside risk, 64 7
Driver pattern, 507
Driver pattern diagrams, 510-512
Drivers
borrowing cost, 380- 381
dividends, 244- 245

net operating assets/net indebtedness,
245- 246
profit margin, 376, 378
ReOl,506
residual earnings, 148
Index 729
RNOA, 373, 506
ROCE, 366, 367, 407
turnover, 376-378
value, 148, 364
DuPont model, 374
Dutch tulip bubble, 7
Earnings
E
anchoring principle, 185
cum-dividend, 182, 188
equation, 126
ex-dividend, 182
forward, 181
normal, 182, 188
normalizing, 396
PIE ratio. See Price-earnings (P/E) ratio
sustainable, 396
transitory, 396
Earnings and cash flows, 124- 127
Earnings before interest and taxes (ebit), 39
Earni ngs created by accounting
AEG method, 196, 197
RE method, 163- 164
Earnings growth created by leverage,
457-458
Earnings leverage (ELEV), 458, 466
Earnings management, 592, 598. See also
Accounting manipulation
Earnings per share (EPS), 40
Earnings qual ity, 591
Eastman Kodak, 7, 399, 613, 632
Ebit, 39
Ebitda, 50
Economic factors, 17, 506, 508, 516
Economic profit, 91, 439, 576
Economic profit models, 161
Economic value added, 439, 557, 576
Economic-value-added measures, 575
Economic value-added models, 161
EDGAR, 65
Effective cost of debt, 447
Effective tax rate, 305
Electronic Data Systems (EDS), 273,
607, 627
ELEV, 458, 466
Employee stock options. See Stock options
End-of-chapter exercises. See individual
company names
Ending equity, 40
Enron, 53, 354, 611
Enterprise assets, 293
Enterprise income, 303, 309
Enterprise multiples, 79
levered vs. unlevered measures, 467
P/B ratio, 463-465
PIE ratio, 465-466
730 Index
Enterprise P/B multiplier, 486, 493
Enterprise P/ B ratio, 79, 463, 486
Enterprise P/E multiplier, 486, 493
Enterprise P/E ratio, 465, 466
Enterprise risk, 447
Enterprise valuation model, 445
Enterprise value, 12, 44, 440
Environmental liabilities, 611
EPS,40
Equations (formulas), 709- 723
Equity analyst, 13
Equity financing activities, 92- 95
Equity investing. See Analysis of equity risk
and return
Equity investments, 4 7-48, 296, 297, 40 I
Equity investments in subsidiaries, 296
Equity method, 48, 296
Equity securities, 442
Equity statement. See Statement of
shareholders' equity
Equity valuation, 11
Estimated liabilities, 6 11
Estimates, 40 I, 418
Estimating the expected return, 664
ETF, 218
E*Trade, 586-589
Ex-dividend earnings, 182
Ex-dividend price, 79
Excess profit, 142
Exchange traded fund (ETF), 218
Exercise date accounting, 2 70
Expected payoff, 642
Expected return, 643- 644, 664- 670
Expedia, Inc., 476
Expenditure timing, 593
Expense, 38
accrued, 297
financial , 243
hidden dirty-surplus, 268
IFRS, 54
matching principle, 49
net financial, 243
operating, 243
pension, 400-401
Expense accruals, 125
Expense ratios, 3 18
Expense ri sk, 653
Extensible business reporting language
(XBRL), 54
Extraordinary items, 308
Eye of the shareholder, 275- 276
F-scores, 618
Fade diagrams, 507
Fade pattern, 220
Fade rate, 507, 5 13
Fair value, 46, 47, 48
F
Fair value accounting, 53, 401-403, 6 12
Fair value hedge, 264
Fairfield, Patricia, 628
Fannie Mae, 8
FASB. See Financial Accounting Standards
Board (FASB)
Fashion clothing industry, 5 16
Fat-tai led distributi on, 647
Favorable financial leverage, 36 7
Favorable gearing, 367
Favorable operating liabi lity leverage, 369
Fed model, 197-199
Finance subsidiaries, 295
Financial Accounting Standards Board
(FASB)
accounting standards, 33
FASB Statement 11, 264
FASB Statement 115, 47, 263,
264,296
FASB Statement 123R, 269
FASB Statement 159, 40 I
IFRS, harmoni zation with, 33
Financial analysis, 244
Financial analyst
CFO, 14
credit analyst, 13
defined, 23
equity analyst, 13
forecasts, 490
good times/bad ti mes, 490
identifying firms by value types, 5 15
inside analyst, 13- 14
knowing what they are saying, 25
market bubble, 7
maxim (speculation), 20
outside analyst, 12- 13
Financial asset buildup, 525
Financial assets, 236, 354
Financial expense, 243
Financial leverage (FLEV), 366- 368
calculation of, 3 19, 366
capitalization ratio, and, 319
debt-equity ratio, 373
defined, 366
favorable, 367
General Mills, 369
minority interests, and, 372
negative, 3 70
Nike, 370
RNOA, and, 368
ROCE, and, 366, 367
U.S. firms ( 1963- 2010), 459
Financial leverage (FLEV) risk, 653
Financial liabilities, 237
Financial obligations, 23 7
Financial planning, 342, 696
Financial rati os. See Ratio analysis
Financial statement analysis
change, 507- 514
choices vs. conditions, 5 15
common-size analysis, 3 15- 316
credit evaluation, 682-687
cross-sectional analysis, 3 14
defined, 2
growth analysis, 364. See also Analysis
of growth and sustainable earni ngs
key drivers, 514- 515
lens of the busi ness, 505- 5 l 5
Procter & Gamble, 334- 338, 391,
425-426
profitability analysis, 364, 365. See also
Analysis of profitabili ty
residual operating income, 506- 507
time-seri es analysis, 314
trend analysis, 316- 317
Financial statement analysis engine.
See Build Your Own
Financial statement analysis of the future,
505, 533
Financial statement indicators, 529
Financial statement information, 481
Financial statements
articulation, 42
balance sheet. See Balance sheet
cash flow statement. See Statement
of cash flows
content, 32
cues to future problems, 529
footnotes, 41
footnotes/supplementary information,
41-42
form, 32
how they fit together, 43
income statement. See Income statement
lens of the business, 17
misclassificati ons, 278
omission, 278
red flag indicators, 529
reformulated. See Reformulated
statements
statement of shareholders' equity.
See Statement of shareholders' equity
Financing activities, 12, 236
Financing assets, 241
Financing bubble (2006- 2007), 53
Financing cash flows, 40
Financing income, 243
Financing risk, 449-450, 65 1, 653- 654
Finite-horizon forecast, 91
Firm
strategy, 5 15
value types, 515
Firm risk, 44 7
First-in, first-out (FIFO)
LIFO, compared, 571- 572
manipulation, and, 61 5
measurement, 4 7
Fixed asset turnover, 3 77
Fixed-charge coverage, 686
Fixed-charge coverage (cash basis), 686
Fixed costs, 408
Fixed-income investing, 696
Flanigan's Enterprises, Inc. , 152, 153
FLEV See Financial leverage (FLEV)
Flows, 42
Footnotes, 41
Forces of competition, 17, 508, 5 13, 5 14
Ford Motor Company
inventory accounting, P/ B, and P/E
ratios, 582
PEG ratio, 200
problems, 4
strategic cash, 304
Forecast horizon, 575- 578
Forecasted asset turnover, 522- 523
Forecasting template, 520- 525
Forecasts and forecasting, 434-435
convert forecast to valuation.
See Convert forecasts to valuation
free cash fl ow, 123-124
fundamental analysis, 87
how forecasts developed, 85
observabilty, 91
pro formal analysis, 87
speculative nature, 20
valuation technology, 18
Foreign currency gai ns/losses, 264
Formulas, 709- 723
Forte PLC, 574
Forward earnings, 181
Forward earnings valuation, 4 12
Forward earnings yield, 467
Forward enterprise PIE ratio, 486
Forward PIE, 79, 467
Forward share purchase agreement,
273,279
Freddie Mac, 8
Free cash flow
calculation of, 343- 345
cash conservation equation, 238
DCF model, 117- 119
defi ned, 11 5
"dividend" from operating activities to
financi ng activities, 247
forecasting, 123- 124
General Electric, 239
Microsoft, 239
negative, 118, 238, 239
net operating assets/net indebtedness, 246
positive, 238, 239
sources/disposition, 244
Free cash flow disposition equation,
244,25 1
Free cash flow hypothesis, 526
Free cash flow sources equati on, 244, 251
Fruit of the Loom, 704- 707
Full-information forecasting, 5 15- 526
account-based valuation, 525- 526
credit analysis, 692- 695
defined, 533
forecasting template, 520- 525
Nike, 521- 522
Fundamental analysis
defined, 23, 84
speculation, 191, 213, 48 1
steps in process, 85- 86
tenets, 19, 449
valuation model. See Valuation model
Fundamental bond arbitrage, 696
Fundamental investor, 4, 5, 210
Fundamental ri sk, 5, 65 1- 654
Fundamental screening, 80, 81
Fundamental value, 98
G
GAAP. See Generally accepted accounti ng
principles (GAAP)
GAAP appl ication quality, 593
GAAP quality, 593
Gap, lnc., 398
Garbage in, garbage out, 212
Gateway, Inc., 604, 605, 629- 630
Gearing, 366. See also Leverage
Genentech Inc., 66- 67
General Elechic
acquisitions, 162
building blocks for valuation, 226
continuing val ue, 152- 154
free cash flow and financing
activities, 359
growth, 395
PIE ratio, 205
reformulated cash flow statement, 240
sales ( 1998), I 0
smoothing earnings, 6 17
valuation, I 71
General Mills
accounting rel ations, 65- 66
balance sheet ratios, 3 19
common-size balance sheet, 316
conunon-size income statement, 315
core operating income, 405
cum-dividend earnings, 205
DCM valuation, 135
enterprise multiples, 475
Index 731
financi al leverage, 369
forecasting and valuation, 539
forecasting from core income, 424
joint ventures, 404
net borrowing cost, 319, 380
operating liabi lity leverage, 371
pension plan, 404
pricing multiples, I 02
reformtilated income statement, 312, 314
residual operating income, 4 75
RNOA, 3 18, 408
second-/third-level breakdown, 378, 379
simple valuation, 496
strategic balance sheet, 301 -302, 303
unusual items, 405
WACC, 448
General Motors Corporation
LIFO inventories, 6 15
lower book values, 574, 575
manipulation, 607, 615
missing numbers (financial statements), 67
problems, 4
return on equity, 171
sales ( 1998), I 0
strategic cash, 304
Generally accepted accounting principles
(GAAP)
accounting methods, 554
advertising expense, 354
assets, 4 7-48
balance sheet items, 47-48
cash flow statement, 345- 352
common shareholders, property
ri ghts, 276
comprehensive income reporting, 265
converti ble bonds, 277
dirty-surplus accounting, 264
dividends payable, 277
grant date accounting, 277
interest that finances construction, 399
leaving assets off balance sheet, 509
liabilities, 48
LIFO reserve, 566
losses from exercise of stock
options, 462
matching principle, 49
noncontrolling interests, 260
preferred stock, 260, 277
R&D expense, 354
stock option credits to equity, 277
warrants/options, 277
Glamour stock, 80
Glaxo Wellcome, 573
Global Crossing, 614
Going-concern investment, 88, 89, 9 1
Goldman Sachs, 274, 285
"Good accounting," 576
732 Index
Goodwill , 47, 320, 573-574
Google, Inc.
challenging the market price,
218- 221
converting forecasts to valuation,
191- 192, 193
dominant first-mover position, 394
expected return, 226- 227, 678
no-growth valuation, 218, 219
Gordon growth model, 113
Government policy, 513
Graham, Be1tj amin, 51 , 21 1- 213,
230,304
Grant date accounting, 270, 277
Greenspan, A Ian, 7, 197, 198
Greenspan model , 197-199
Gross margin, 36, 39
Gross profit, 39, 59
Gross receivables, 599
Growth
defined, 393- 394
payi ng too much for, 155- 156
warnings about, 394-395
Growth analysis, 364. See also Analysis of
growth and sustainable earnings
Growth firm, 393, 395, 418, 515
Growth forecast, 484-486
Growth in book value, 148, 149
Growth in sales, 489
Growth investment, 128
Growth opportunities, 91
Growth option, 660
Growth rate of CSE, 267
Growth ratios, 267
Growth-ren1rn profile, 666- 667
Growth ri sk, 654
Growth stock, 80, 180
Guarantees of third-party debt, 684
H
"Hard numbers" vs. "soft numbers," 603
Held-to-maturity debt investments, 320
Held-to-maturity equity investments, 320
Hewlett-Packard, 76-78
Hidden dirty surplus, 268- 275
diluted EPS, 272- 274
issue of shares in financing acti vities, 272
issue of shares in operations, 268- 271
share transactions in inefficient markets,
274-275
Hidden dirty-surplus expense, 268, 279
Hidden reserves, 566-570, 615
Hilton Hotel s, 574
Historical cost accounting, 46, 56
Home Depot
delaying payments, 354
projected price of stock, 227
simple forecasting, 498-499
valuation grid and reverse
engineering, 499
Homemade di vidend, 94
Horizon Financial Corp., 415
Horizon premium, 152
Hotel and resort firms, 5 l 7
Household International, 286- 287
Howmet International, 104
HSBC Finance Corporation, 286- 287
Hurdle rate, 90, 106, 664
IAS 9, 401
fASB, 33
IBM
analysis of sustainable growth, 429-433
asset sales, 403
cost of capital for operations, 448
enterprise multiples, 475
Nift y Fifty stocks, 7
pension expense, 400, 40 l
residual earnings/abnormal earnings
growth, 205
restructuring charges, 399
share repurchases and financial
leverage, 456
simple valuation and reverse engineering,
497-498
Idle capacity, 532
IFRS. See Internati onal financial reporting
standards (IFRS)
Impairment of plant assets, 163
Imperfect measurements, 575
Implied earnings growth rate, 219
Impl ied expected return, 214
Implied expected returns, 660- 661
Implied residual earnings growth rate, 214
Jn the money, 268
Incentive option, 269
Income before taxes, 39
Income shifting, 163- 164, 594- 614.
See also Accounting manipulation
Income statement, 36-40
accruals, 128
conunon-size, 315- 316
di vidends, 124
equity analysis, 683
extraordinary items, 308
groupings, 39
investment, 124
Kimberl y-Clark, 59
lack of disclosure, 308
matching principl e, 124
measurement, 46, 49- 50
Nike, 36
ratio analysis, 318
reformulation, 303-3 14, 683
residual income from operations,
312- 314
strategic balance sheets, and, 3 12
tax all ocation, 304- 308
typical presentation, 305
Income statement ratios, 318
Index fund, 21 8
Index investing, 5, 23
Indirect method cash flow statement, 34 7
Inferring expected ren1rns, 664- 670
Information, 6
Initial public offering (JPO), 78, 60 I
Inside analyst, 13- 14
Insider-trading screen, 8 l
Ins ta I lment purchase of plant assets, 35 l
Insurance companies, demutual ization, 149
Intangible assets, 47, 82, 599
Intel Corp., 403, 442, 632
Intellectual capital model , 530
lnre/ligen/ lnvesto1: The (Graham), 73
Interest coverage (cash basis), 686
Interest coverage (times interest
earned) , 686
Interest income, 308
Interest payments, 350
Interest rates, 199
International Accounting Standards Board
(JASB), 33
International financial reporting standards
(IFRS), 33
balance sheet/development not
research, 164
cash flow statement, 122- 123
common shareholders, property
ri ghts, 276
comparati ve income statements, 54
deferred tax assets and liabilities, 54
expenses, 54
leaving assets off balance sheet, 509
noncontrolling interests, 260
other comprehensive income, 265
revaluation of assets, 54
terminology, 265
Internet commerce industry, 516
Intrinsic P/ E ratio, 50
Intrinsic premium, 44
Intrinsic price-to-book ratio, 44
Intrinsic value, 4, 211, 212
Intuitive investor, 3, 4, 23
Inventory, 4 7, 599
Inventory turnover, 3 77
Inventory write-down, 163, 164
Investing
acti ve, 210- 231 , 642- 678
active bond, 696
basic precept, 141
fixed-income, 696
game against other investors, 212
index, 5, 23
momentum, 8
periodic payoffs, 88
relative value, 668
Investing activities, 12, 95, 23 7
Investing cash flows, 40
Investment decision, 86
Investment hori zon, 89
Investments, 126
J nvestments available for sale, 4 7
Investments held for active trading, 4 7
Investments held to maturity, 47
Investor
active, 4, 5
defensive, 4
fundamental , 4, 5
intuitive, 3, 4
passive, 3, 5
!PO, 78, 601
J. C. Penny, 283- 284
John Hancock Financial Services, 149
Johnson & Johnson, 7
K
Kessler, Jeffrey, 78
Key drivers, 379, 514- 515, 516- 517
Kimberly-Clark Corporation, 24- 27
accounting relations, 69- 70, 256
active investing, 223- 224
asset-based valuation, I 00
balance sheet, 58
build your own analysis engine, 384
cash flow statement, 60, 131
cash flows and earnings, 134
change in profitability, 41 9-420
comparables, 99- 100
comprehensive income, 62, 324
converting forecasts to valuation, 202
cost of capital for operations, 4 70
DCF valuation, 131
defined benefit pension plan, 420
enterpri se P/ B and P/E ratios, 471
fi nancial statements, 58- 62
forecast to valuation, 167
good buying opportunity, 175- 176
implied EPS growth rates, 228
market values/market multiples, 62- 63
operating activities, 252
operating segments, 69
option overhand, 4 70
organization optimization initiative, 420
proforma analysis, 534
profitability measures, 388
questions to ask, 25
ratio analysis, 281
recommendations and estimates (Mar/ I 1 ) ,
26-27
reformulated balance sheet, 324
reformulated equity statement, 280- 281
reformulated income statement, 324
reverse engineering, 224, 494
sensitivity analysis, 384, 494, 534
simple valuation, 494
sources of business information, 24-25
statement of comprehensive income, 62
statement of stockholders' equity, 61
stock repurchase, 4 70
treasurer's rul e, 252
KMB. See Kimberly-Clark Corporation
Knowledge base, 16
Knowledge corporation, 13
Krispy Kreme, 614
L
Lack of disclosure, 308
Last-in, first-out (LIFO)
conservative accounting method, 565
FIFO, compared, 571-572
LIFO cost of goods sold, 566
LIFO dipping, 615
LIFO inventory, 566
LIFO liquidation profits, 569
LIFO reserves, 566, 568
measurement, 4 7
tax/financial reports, 565
Last-twelve-months (LTM), 77n
LBO, 528
Leading P/E, 79
Lease, 297, 351 , 684
Lease obligations, 320
Lease receivables, 599
Lehman Brothers, 8, 78, 684
Lenovo, 78
Leverage, 366
AEG valuation, 45 1-456
book, 450
cautionary warning, 457-458
earnings growth, 456-459
ELEV, 458, 466
FLEV See Financial leverage (FLEV)
levered P/B ratio, 464
market, 450
OLEY, 408-409
OLLEV, 319, 368-370, 37 1
residual earnings valuation, 450-451
ROCE, and, 370- 371
Leverage adjustments, 79
Leverage risk, 651
Leveraged buyout (LBO), 528
Index 733
levered cash flow from operations, 122
Levered forward PIE, 466
Levered P/B ratio, 464
Levered PIE ratio, 465
Levin, Gerald, 15
Liabilities
contingent, 683
current, 685
defined, 34
estimated, 611
financial , 23 7
manipulation, and, 599
market value, 82
measurement, 48
off-balance-sheet, 61 1
operating, 24 l, 298
Liberal accounting
accounting practices, 571
breweries and hotels, 574
conservative accounting, and, 570
defined, 557
Forte vs. Hilton, 574
LIFO. See last-in, fi rst-out (LIFO)
LIFO cost of goods sold, 566
LIFO dipping, 615
LIFO inventory, 566
LIFO liquidation profits, 569
LIFO reserves, 566, 568
Line items, 606- 610
Liquidating hidden reserves, 566
Liquidation of financial assets, 410
liquidity analysis, 342
Liquidity discount, 94, 664
Liquidity fl.ow measures, 685
Liquidity planning, 696-697
Liquidity ratios, 684-686
Liquidity risk, 664
Liquidity stock measures, 685
Logit analysis, 690- 691
Long-term debt ratio, 686
l ong-term debt securities, 4 7
Long-term equity investments, 296
Long-term marketable securities, 683
Long-term solvency ratios, 686- 687
Long-term tangible assets, 47
LTM, 7711
Lucent Technologies, 349, 637- 639
M
M-scores, 61 8
Maintenance capi tal expenditure, 128
Management, 16
Management buyout, 528
Management choices, 515
Manipulation. See Accounting manipulation
Margin of safety, 667
734 Index
Marginal tax rate, 305
Mark-to-market accounting, 46, 442,
461-463,575, 612
Marked to market, 46
Marked-to-market equity investments
avai lable for sale, 320
Market bubble, 6- 9
Dutch tulip bubble, 7
financial analysts, 8
financing bubble (2006- 2007), 53
how bubbles work, 7- 8
mark-to-market accounting, 612
suspect analysi s, 9
technology bubble ( 1997-2000), 53
Market capitali zation, 44
Market inefficiency ri sk, 661 - 664
Market leverage, 450
Market P/E ratio, 50
Market power, 506
Market premium, 44
Market risk premium, 107
Market-to-book ratio, 44
Market value a d d e ~ 46
Market value method, 274
Marketable securiti es, 4 7, 236
Matching principl e, 46, 49, 124
Maytag Corporation
credit scoring, 70 1-703
forward PIE ratio, 207
takeover, 549- 550
McDonald's Corporation, 7
Mean reversion, 507
Mechanical schemes, 218
Merck & Co., 398
Merger charges, 399
Mergers and acquisitions, 93, 162,
527- 528
Merrill Lynch, 8
Method of comparables, 76- 78
Metropolitan Life Insurance, 149
Microsoft Corporation
accounting qua! ity, 609
competitive advantage, 394
deferred revenue, 398
equity investments, 403
free cash flow, 239
gai n followed by loss, 442
growth analysis, 426-428
hidden leases, 288-291
loss on conversion of preferred stock, 285
off-balance-sheet liabilities, 288- 291
reformation/ cash flow statement,
360- 36 1
revenues, 13 7
sales ( 1998), I 0
SEC investigation, 625- 626
stock repurchases, 460
treasurer's rule, 255- 256
valuation, 206
MicroStrategy, 604
Miller, Merton, 94
Minicases
America Online (AOL), 30
Chubb Corporation, 338- 341, 477-478
Cisco Systems, 229- 230, 500- 502.
See also Cisco Systems
Citigroup, 173- 174
Coca-Cola, 138- 139, 174- 175, 208.
See also Coca-Cola Company
Cordant Technologies and Howmet
International , I 04
E*Trade, 585- 588
Fruit of the Loom, 704- 707
Google, 230- 231, 678
I BM, 429-433
KMB. See Kimberly-Clark Corporation
Lucent Technol ogies, 637- 639
Maytag, 549- 550
Microsoft, 288- 291 , 426-428. See also
Microsoft Corporation
Nifty Fi fty stocks, 105
PepsiCo, 174, 208
Procter & Gamble. See Procter & Gamble
Tyco International , 173
Xerox, 633- 636
Minimum true value, 51
Minority interest, 4 7-48, 260, 262, 298,
372,524
Minority interest shari ng ratio, 3 72
Misclassifications, 278
M&M dividend proposition, 94
Modig li an i, Franco, 94
Molodovsky, Nicholas, 414
Molodovsky effect , 414
Momentum investing, 8, 162
Momentum screen, 81
Moody's bond ratings, 688
Moral hazard problem of debt, 687
Multex, 25
Multi factor pricing models, 107
Multiperiod project evaluation, 159
Multiple, 76
Multiple analysi s
method of com parables, 76- 78
screening on multiples, 79- 82
Multiple comparison analysis, 76
Multiple discriminant analysis, 690
Multiple screening, 79-82
Murdoch, Rupert, 617
N
Negative denominators, 78
Negative financial leverage, 3 70
Negative free cash flow, 11 8, 238, 239
Neglected-stock screen, 81
Net assets, 36
Net borrowing cost, 319, 380, 406
Net borrowing cost (NBC) risk, 653
Net cash interest, 350
Net debt, I 16
Net debt financing flow, 236
Net dividend, 262
Net dividends to shareholders, 236, 247
Net financial asset dri ver equation,
245- 246,25 1
Net financial assets (NFA), 237, 241, 242,
293, 300
Net financial expense (NFE), 243, 246, 303
Net financial income (NFI), 243
Net financial obligation driver equation,
246,251
Net financial obligations (NFO) , 237, 242,
293, 524
Net income, 36, 38, 39, 120
Net income available to common
shareholders, 40
Net (comprehensive) income profit
margin, 318
Net interest payments, 120
Net investment rate, 267
Net operating asset driver equation,
245,25 1
Net operating assets (NOA), 242,
293,300
basic equation, 24 1
forecasting template, 522
manipulation of core expenses,
604- 605
Net operating profit after tax (NOPAT),
303, 309
Net payout, 41
Net present value (NPV), 90- 91
Net profit, 38
Net receivables, 599
Net sales, 603
Netflix, 227
Neutral accounting
changing level of investment, 56 1, 562
constant level of investment, 558, 559
defined, 557
forecast horizon, 5 7 6
News Corporation, 617
NFO, 237, 242, 293, 524
Nifty Fifty stocks, 7, I 05
Nike
abnormal earnings growth, 187, 191 , 192
AOTG, 446
arti culating accounting relations, 249
balance sheet, 35, 299, 300, 30 I
balance sheet ratios, 319
BYOAP, 312
cash flow/cash used, 119
change in cash, 34 7
common equity, 411
common-size balance sheet, 3 16
common-size income statement, 3 15
comprehensive income, 265
continuing value, 154- 155
convert forecast to val uat ion, 156- 157
cum-dividend earnings growth, 204-205
earnings potenti al , 164
equity financing, 39
financial leverage, 3 70
full-information foreca sting, 521- 522
growth, 395
growth-return profile, 666, 667
income statement, 36, 125, 310, 3 11
interest paid, 120
UFO vs. FIFO, 571 - 572
market fo recast/growth rate, 226
noncash transactions, 352
operating income growt h forecasts, 540
operations, 39
P/E-P/B relationship, 415
P/E valuation, 180
pro forma analysis and valuat ion, 540
profitability (2000- 2008), 380
ratio analysis (equity statement) , 286
reformulated balance sheet, 300
reformulated income statement, 311
reformulated statement of shareholders'
equity, 260, 26 1- 262, 27 1, 309
residual operating income, 439, 475, 514
RNOA, 318, 408
ROCE, 147, 267
second-/third-level breakdown, 378, 379
SF2 valuation, 485
SF3 valuation, 487
statement of cash flows, 37, 12 1,
348, 353
statement of shareholders' equity, 38
stock repurchase program, 304
stock returns, 68
strategic balance sheet, 30 I
strategy, 39
taxes on net interest payments, 351
trend analysis, 317
two- stage growth valuation, 489
valuation grid, 491
value-at-ri sk profile, 6 77
WACC,448
Nikkei225 index,6
No-growth forecast, 483-484
No-growth valuation, 218
NOA, 193, 241 , 242, 300, 522, 604- 605.
See Net operating assets (NOA)
oncash transactions, 350- 35 l , 352, 354
Noncontrolling interest, 39, 48, 58, 59, 260,
262, 298
Nondiversifiable risk, 648
Nonfashion clothing industry, 516
Nonqualifying option, 269
1
0PAT, 303, 309
Normal accounting, 558. See also
Neutral accoLinting
Normal distributi on, 645, 646
Normal earnings, 182, 188
Normal earnings growth, 182, 20 I
Normal P/B ratio, 144- 145
Normal return, I 06
Normal trailing P/E, 184
Normalized 01, 605
Normali zing earnings, 396
Novartis, 226
NPV, 90-91
0
Off-balance-sheet financing, 684, 698
Off-balance-sheet liabiliti es, 611
Off-balance-sheet operations, 616
Off-balance-sheet partnerships, 684
Ohlson, James, 69 1
Ohl son-Juettner model, 187. See also
Abnormal earnings growth (AEG)
model
OLEY, 408-409, 653
OLLEV, 319, 368- 370, 371
OLSPREAD, 369
Omission, 273, 278
Omitted borrowing costs, 277
Omitted (off-balance-sheet) liabiliti es, 277
One- stop residual operating income
calculation, 506
Online trading firms, 586- 587
Operating act iviti es, 12, 95, 242, 250, 252
Operating asset compositi on ratio, 319
Operating assets, 23 7, 241
Operating cash, 294
Operating expense, 243
Operating income, 39, 243, 245, 246, 303,
309, 396,397
Operating lease, 297, 684
Operating leverage (OLEV) , 408-409, 653
Operating liabiliti es, 241 , 298
Operating liability composition ratio, 319
Operating liability leverage (OLLEV) , 3 19,
368- 370,37 1
Operating liability leverage (OLLEV)
ri sk, 653
Operating li ability leverage spread
(OLSPREAD), 369
Operating profit margin, 318, 373
Operating rati os, 687
Operating revenue, 243
Operating ri sk, 447, 449, 651 , 653
Operating spread (SPREAD), 367
Option overhang, 27 1
Options. See Stock options
Oracle Corporation
balance sheet, 298
betas/market risk premium, I 03
Order backlog, 529
Other assets, 297
index 735
Other comprehensive income, 41, 260,
262, 265
Other core income timing, 616
Other intangible assets, 4 7
Other items profit margin, 3 18
Other li abilities, 297, 320
Other operating items profit margin, 3 76
Out line of the book, 2 1- 22
Outside analyst, 12- 13
Overvaluing earnings, 141 - 142
Overvaluing growth, 155- 156
Owner's equity, 11
p
P/B-P/E relationship, 411-416
P/B ratio. See Price-to- book (P/B) ratio
P/B screen, 81
P/CFO screen, 81
P/d screen, 81
P/E ratio. See Price-earni ngs (P/E) ratio
PIE screen, 8 1
PIE-to-earnings-growth (PEG) ratio,
199- 200
P/ E (ttm) , 79
PIS rat io, 83
Pairs trading, 668
Parsimony, 92
Parsons, Richard, 15
Passive investor, 3, 5, 23, 210, 218
Paying too much
earnings, 141- 142
earnings growth, 180
growth, 155- 156
RE valuation, 162- 163, 163- 164
Payoff, 11
Payout, 266
Payout and retention ratios, 266-267
PCAOB, 593
PEG ratio, 199- 200
Pension accounting, 418
Pension expense, 125, 400-40 I
accounting clinic, 40 I
actuarial gains and losses, 400
amorti zation of prior service cost, 400
amorti zation of transition asset, 400
expected return on plan assets, 400, 402
IBM, 400, 401
interest cost, 400
service cost, 400
Pension funds, 616
Pension liabilities, 320, 599
PepsiCo
accruals and investments, 136
anal ysis of income statement, 328
analysts' forecasts and valuation,
174, 208
736 Index
Perpetuity, 1 13
Persistence rate, 507
Persistent earnings, 396
Pharmaceuticals industry, 516, 572- 573
Polaroid, 7
Ponzi scheme, 7
Positive free cash flow, 238, 239
Positive-NPV investment, 91
PPE turnover, 377
Preferred dividends, 277
Preferred stock, 260, 277, 297, 320
Premium
default, 680, 698
hori zon, 152
intrinsic, 44
market, 44
market risk, 107
ri sk, 96, 106, 661
unrecorded goodwill, as, 44
Prepaid expenses, 599
Present value formula, 90
Price, 141
Price/earni ngs before unusual items, 79
Price-earnings (P/E) ratio, 50- 51
accounting method, 564, 565
conservative accounting (changing level
of investment), 561
conservative accounting (constant level
of investment), 558
di vidend-adjusted P/E, 79
earnings growth, 179
enterprise, 465-466
enterprise PIE multiplier, 486, 493
Fed model, 197- 199
forward P/ E, 79, 467
interest rates, 199
intrinsic, 50
levered vs. unlevered measures, 467
market, 50
Molodovsky effect, 414
normal forward PfE, 183- 184
normal trailing P/E, 184
P/B ratio, and, 411-416
PEG ratio, 199- 200
poor P/E model, 185
rolling P/E, 79
S&P 500, 183
sustainable earnings, 416
trailing P/E, 79, 414, 467
underlying concept, 179
valuation (Nike), 180- 181
Price multiples, 80
Price of credit, 681
Price ri sk, 5, 661-664
Price screen, 8 1
Price-to-book (P/B) ratio, 44-45
accounting method, 558
cautionary note, 141- 142
conservative accounting (changi ng level
of investment), 561, 564
conservative accounting (constant level
of investment), 558
enterprise P/B, 79, 463-465
enterprise P/ B multiplier, 486, 493
expected earnings, and, 141
growth, 416
levered/unlevered ratios (1963- 2010), 465
levered vs. unlevered measures, 46 7
normal, 144- 145
PIE ratio, and, 411-41 6
residual earnings, and, 146, 164
ROCE/growth in book value, and,
149, 150
simple valuation model, 150- 15 1
underlying concept, 140, 141
Price-to-book value (P/B) screen, 81
Price-to-cash flow (P/CFO) screen, 81
Price-to-dividend (P/d) screen, 81
Price-to-earnings (P/ E) screen, 81
Price-to-ebitda, 83
Price-to-sales (P/S) ratio, 83
Pro forma analysis, 86, 515- 526
account-based valuat ion, 525- 526
AOIG, 519
business strategy analysis, 530- 531
default prediction, 692- 694
sample statements, 518, 520
scenario analysis, 531
testing proforma statements, 524-525
Pro forma default prediction, 692- 694
Pro forma earnings, 50
Pro forma ReOI, 526
Pro forma statement, 86- 87
Procter & Gamble
analysis of cash flows, 362-363
financial statement analysis, 334- 338,
391, 425-426
foll forecasting and evaluation, 542
market price premiu111, 103
simple forecasti ng and valuation, 500
Products, 16
Professional anal yst. See Financial analyst
Profit margin, 376
Profit margin drivers, 3 76, 3 78
Profit margin ratios, 3 18
Profit margin risk, 653
Profitability, 141 , 467
Profitability analysis, 364, 365. See also
Analysis of profitability
Project valuation, 142- 143, 159
Project valuation model , 90
Property, plant, and equi pment (PPE), 47,
128, 599
Public Company Accounting Oversight
Board (PCAOB), 593
Public debt market investors, 68 1
Purchases, 3 78
Pure equi ty firm, 449
Put option, 273
Put warrant, 273
Pyra111id scheme, 7
Pyramiding !PO 111arket, 78
Q
Q-scores, 619
Qua! ity diagnostics, 600- 6 14
Qual ity issues. See Accounting quality
Quality scoring, 618- 619
Quick ratio, 685
Qwest Co111munications, 53, 614
R
Rainforest Cafe, 41 5
Rate of ren1rn in the long run, 509
Rate of return on book value, 141
Ratio analysis, 266- 267, 318- 3 19,
376- 378
balance sheet ratios, 3 19
composition ratios, 319
expense ratios, 3 18
financial leverage, 3 19
growth ratios, 267
income state111ent ratios, 3 18
liquidity ratios, 684- 686
OLLEV,31 9
operating ratios, 687
payout and retention rat ios, 266-267
profit margin ratios, 3 18
shareholder profitability, 267
solvency ratios, 686- 687
statement of shareholders' equity,
266- 267
turnover ratios, 376- 378
R&D expenditures, 354, 399, 572- 573
R&D partnerships, 616
RE valuation. See Residual earnings model
Real-world connections. See individual
company names
Realnetworks, lnc. , 328
Receivable al lowances, 320
Receivables, 47
Red fl ag indicators, 529, 601
Redeemable preferred stock, 260, 279
Reebok
LIFO VS. FlFO, 571- 572
ROCE, 410
stock repurchase, 453-454
stock warrants, 272
Reformul ated balance sheet, 241- 242
Reformulated cash flow statement, 240, 683
Reformul ated comprehensive income
statement, 306
Reformulated income statement, 683
Reformul ated operating income, 397
Reformulated statement of shareholders'
equity, 259
Reformulated statements
accounting relations, 243- 246
articulation, 24 7
balance sheet, 241- 242, 293- 303
cash flow statement, 240
credit evaluation, 682-684
General Electric, 239, 240
income statement, 303-3 14
Microsoft, 239, 240
statement of shareholders' equity,
259-263
Regina Company, 628-629
Relative val ue investing, 668
Reliability criterion, 51 , 52
Reliability principle, 597
ReOl , 312,439-442, 506
ReOI sustainability, 507
Repurchase agreement, 684
Required return, 86, 106- 108, 212,
643,644
Research and development expenditures,
354,399,572- 573
Residual earnings, 142, 147, 148, 393,
394,441
Residual earnings drivers, 148
Residual earnings model
AEG model, compared, 194, 195- 196
all accounting methods, 164
anchoring valuation to book value,
145- 146
basic equation, 143
build your own analysis engine,
157- 159
defined, 166
dividends, and, 165
earnings created by accounting,
163- 164
Google, 2 18- 221
imperfect balance sheet, 164
paying too much for earnings created by
accounting, 163-164
paying too much for earnings growth,
162- 163
share issues, and, 165
share repurchases, and, 165
simple valuation model , 150- 151
speculation, and, 162
value added to book value, 16 1- 162
variations/strategic planning
products, 161
Residual income, 142
Residual income from operations,
3 12- 314
Residual net financial expense, 439
Residual net financial income, 439
Residual operating income (ReOI), 3 12,
439-442,506
Residual operating income drivers, 442
Residual operating income model, 440
Restructuring charges, 163, 399, 4 18, 592
Retailers, 295, 516
Retention, 266- 267, 279
Retention ratio, 267
Return, 11
Return on assets (ROA), 3 71, 372
Ren1rn on conunon equity (ROCE), 653
alternative names, 147
calculation of, 147, 365
drivers, 366, 367, 407
leverage, and, 370- 371
median ROCE ( 1963- 2010), 150
Nike, 267
P/B ratio, and, 150
premium/ discount, 147- 148
residual earnings, and, 148
Rentrn on equity (ROE), 147. See also
Ren1rn on common equity (ROCE)
Return on net financial assets (RNFA),
318,368
Return on net operating assets (R OA),
298, 318
changein, 408
core, 404, 506, 509
drivers, 3 73, 506
equation, 369, 406
General Mills, 405
low quality, 404
median, 372
operating risk, 653
Return on operating assets (ROOA), 369
Returns to screening on PIE and P/B
( 1963- 2006), 81
Revenue
deferred, 297, 397- 399
operating, 243
recognition of, 49
unearned, 297, 397- 399
Revenue accruals, 125
Revenue recognition principle, 46, 49
Revenue timing, 593
Reversal property of accounting, 591
Reverse engineering, 214
AEG model, 221- 222
challenging the market price, 491-492
Cicso Systems, 500- 502
defined, 223
estimati ng expected return, 664-665
Google, 230- 231
Kimberly-Clark, 224, 494
S&P 500 index, 215-218
Risk. See also Analysis of equity ri sk
and return
ATO, 653
beta, 5
credit, 680- 681. See also Analysis of
credit risk and return
diversifiable, 648
downside, 647
Index 737
expense, 653
financing, 449-450, 651, 653-654
FLEV, 653
fundamental, 5, 651-654
growth, 654
liquidity, 664
market inefficiency, 66 1- 664
NBC, 653, 654
nondiversifiable, 648
OLLEV, 653
operating, 447, 449, 65 1, 653
price, 5, 661- 664
profit margin, 653
recession/financial crisis, 218
scenario A, 662
scenari o B, 663
Risk classes, 668
Risk-free ren1rn, 106- 107
Risk premium, 96, I 06, 661
Risk protection mechanisms, 655
Risky growth, 668- 670
RNFA, 318, 368
RNOA. See Return on net operating assets
(RNOA)
ROA, 371, 372
ROCE. See Return on common equity
(ROCE)
Rocky Shoes & Boots, Inc., 415
ROE, 147. See also Return on common
equi ty (ROCE)
Rolling PIE, 79
ROOA, 369
s
S-scores, 619, 620
Sales, 507, 531, 602, 603- 604
Sales driven firm, 515
Sales forecast, 520- 521, 523
Sales growth rates, 51 l
Sales of receivables with recourse, 684
Sales profit margin, 318, 376
Saving income for the future, 592, 62 l
Savings account valuation, 143- 144,
181- 182
Scenario, 53 l
Scenario A risk, 662
Scenario analysis, 531
Scenario B ri sk, 663
Scenario planning, 660
Screening on multiples, 79- 82
Seasonal screen, 81
Securities and Exchange Commission
(SEC), 593
accounting standards, 33
annual filings, 33
EDGAR, 65
international accounting standards, 54
investigation of Microsoft, 625-626
738 Index
Securi ties available for sale, 263- 264
Securities held to maturity, 263, 264
Securitization, 696
Securiti zed debt obligations, 681
Security analysis, 3. See also Fundamental
analysis
Sell -side analyst, 13
Sell-side investment banker, 212
Sellers, Mark, 227
Selling, general, and admini strati ve expenses
(SG&A), 308, 418
Sensitivity analysis, 381, 491. See also
What-if questions
Cisco Systems, 500- 502
Kimberly-Clark, 494
Seven steps to valuation, 520- 523, 524
Share appreciation, 403
Share issues
acquisitions, 93
efficient markets, 92
ineffi cient markets, 92- 93
RE model, 165
residual earnings, 165
Share repurchases, 93
AEG model, 196
RE model , 165
stock options, 275
value generation, 528
why done?, 460
Share transactions, 526- 528
buyouts, 528
mergers and acquisitions, 527- 528
Shared Medical Systems, 609
Shareholder, 275-276
Shareholder profitability, 267, 370. See also
Return on common equity (ROCE)
Shareholder value added, 46, 56
Shareholder value-added models, 161
Shareholders, I 1
Shareholders' equity, 11
Shell, 616
Shell game, 616
Shifting income to the future, 163- 164
Short-term equi ty investments, 296
Short-term investments, 47
Short-term liquidity ratios, 684- 686
Short-term notes payable, 296- 297
Short-term notes receivable, 296
Short-term payables, 48
Shortcut residual operating income
calcul ati on equation, 506, 524
SIC, 508
Signaling effect, 92
Simple forecast, 482
Simple forecasting and simple valuation,
480- 502
analysts' forecasts, 490
Coca-Cola, 490
definitions, 482
enterprise P/B mult iplier, 486, 493
enterprise PIE multi plier, 486, 493
growth forecast, 484-486
growth in sales, 489
Nike, 485, 487, 489
no-growth forecast, 483-484
overview (formulas), 487
reverse engineering, 491-492
sensitivity analysis, 491
simple no-growth valuation, 485, 493
simplicity, 480
two-stage growth forecasting, 488-489
valuation grid, 491
weighted-average forecasts, 488
Simple no-growth valuation, 485, 493
Simpli city, 480
SIVs, 684
Skewed distribution, 647
Small-stocks screen, 81
"Soft numbers" vs. "hard numbers," 603
Solvency flow measures, 686
Solvency ratios, 686- 687
Solvency stock measures, 686
Sources and uses of cash equation, 238
South Seas Bubble, 7
S&P 500 index
boom and bust, 226
challenging the level/analysts' forecasts,
205- 206
expected/annual year-ahead returns, 217
expected return, 228
impli ed growth rates/year-ahead
returns, 216
market portfolio, 648
P/B and implied residual earnings, 216
PIE ratio, 183
reverse engineering, 215- 21 8
reverse engineering growth forecasts, 22 7
statistical drawi ngs, 646- 649
S&P Market Insight, 25
Special investment vehicles (SI Vs), 684
Special-purpose entities, 616, 684
Speculation
accounting quality, and, 597- 598
bubble. See Market bubble
DCF valuation, 1 19
equity risk premium, 449
fundamental analysis, 191, 213, 481
Internet stocks ( 1996- 2000), 10
market price, 213-222
RE model, 161
WACC, 449
Specul ative firm, 515
Speculative mania, 10
SPREAD, 367
Spread between lending and borrowing
rates, 38 1
Spreadsheet engine. See Build Your Own
Standard & Poor's 500. See S&P 500 index
Standard & Poor's bond ratings, 688
Standard deviati on of returns, 645, 648
Standard Industrial Classificati on (SIC), 508
Standard retention ratio, 267
Starbucks Corporation
core operating income, 423
free cash fl ow, 11 8, 576- 577
opening new stores, 398
profitability analysis, 389- 390
reformulation, 328-33 1, 389-390
reformulation of equity statement,
284- 285
reverse engineering, 497
stock options, 284- 285
Starwood Hotels and Resorts, 517
Statement of cash flows, 40, 119- 124,
342- 363
accounting qual ity watch, 354- 355
cash and cash equivalents, 346
cash fl ow from operations, 353- 355
direct method, 34 7
equity analysis, 683
financial assets, 346, 349
forecasti ng free cash flows, 123- 124
free cash flow, 123- 124, 343- 345
GAAP statement, 345- 352
IFRS, 122- 123
indirect method, 34 7
Kimberly-Clark, 60
net cash interest, 350
Nike, 37
noncash transactions, 350- 35 1, 352
reclassifying cash transactions, 346- 35 1
reformul ated, 240, 346, 353, 683
tax on net interest, 350, 351
Statement of fi nancial position.
See Balance sheet
Statement of income. See Income statement
Statement of shareholders' equity, 40-41 ,
258- 29I
build your own analysis engine, 276
dirty-surpl us account ing, 263-265
hidden dirty surplus, 268-275
Kimberly-Clark, 61
Nike, 38
ratio analysis, 266- 267
reformulated, 259-263
Statistical concepts, 644- 648
Statutory tax rate, 306
Steady-state condition, 155
Stock
contrarian, 80
glamour, 80
growth, 80
preferred, 260, 277, 320
treasury, 36
value, 80
Stock market bubble. See Market bubble
Stock option credits to equity, 277
Stock opt ions
cal I option, 268
exercise date, 268
exerc ise date accounting, 270
grant date, 268
hidden losses, 273, 277
lapse elate, 268
loss from exercising, 269
mark-to-market accounting, 461-463
option overhang, 27 1
vesting elate, 268
Stock repurchases. See Share repurchases
Stock return, 46
Stock return performance, 644, 645
Stock screening, 79-82
Stock warrants, 272
Stocl<l1olders' equity, 34
Stocks, 42
Stocks and flows, 242- 243
Stocks and flows equation, 40
Strategic balance sheet, 30 1- 303
Strategic cash, 304
Strategic choi ce, 515
Strategic plan, 533
Strategic planning products, 161
Strategic position, 532
Strategic thinking, 53 1
Strategy analysis, 13, 196, 530- 531
Strategy evaluation, 160
Structured finance, 354
Structured finance vehicles, 684
Sun Trust Bank, 474-475
Sunbeam Corporation, 606, 609, 630- 631
Suppl ementary information, 41-42
Sustainable competiti ve advantage, 220
Sustainable earnings, 396-407. See also
Analysis of growth and sustainable
earnings
Sustainable income, 445
Synergies, 93
Synthetic lease, 684
Systematic risk, 648
T
Take-or-pay agreement, 684
Takeover, 93, 162, 527- 528
'Taking a big bath," 592
Tax allocation, 304- 308, 406
Tax benefit, 279, 305
Tax expense, 610
Tax on net interest, 350, 35 1, 354
Tax shield, 305
Technical screening, 80, 81
Technological advantage, 91, 532
Technology bubble ( 1997- 2000), 53
Telecommunications Inc. (TC!), 608
Teleservicing firms, 78
I 0-K report, 33
I 0-Q report, 33
Tension in accounting, 53- 54, 597
Terminal investment, 88, 89, 91 - 93
Terminal value, 112
Textbook
how to use, 21
overview, 21 - 22
The Gap, 398
"The market," I 07
"The market portfolio," I 07
Thinking, 530
Third-party agreement, 684
Thomson One, 25
Three-stop shopping, 80
Throughput agreement, 684
Time-series analysi s, 314
Too- si mpl e techniques, 19
Top-down tax allocation, 308
Toro Company, 206
Total comprehensive income, 265
Total payout ratio, 266
Total payout-to-book value, 266
Toys "R" Us, 70 I, 702
Trading securities, 263
Trailing earnings valuation, 412
Trai I ing enterprise PIE, 466
Trailing P/E, 79, 184, 414, 467
Transaction manipul ation, 614- 616
Transaction qualit y, 593
Transaction structuring, 594
Transitory earnings, 396
Translation gains and losses, 264, 277
Treasurer's rul e, 238, 239
Treasury stock, 36, 56
Trend analysis, 316- 317
TRW, Inc. , 354
Turner Broadcasting System, 350
Turnover dri vers, 376-378
Turnover efficiency ratio, 506
Turnover ratios, 376- 378
Two-stage growth forecasting, 488-489
Two-stop shopping, 80
Tyco International
acquisition spree, 162
earnings, book value ( 1997- 2005), 173
Type I default prediction error, 692
Type IT default prediction error, 692
u
UAL Corporation, 415
Unarticulated strategy, 530-53 1
Uncertain times, 670
Underlying earnings, 396
Unearned revenue, 125, 297, 320, 397- 399
Unfunded pension liabilities, 684
Unlevered cash flow from operations, 122
Unlevered measures, 79
Un levered P/B ratio, 463
Unlevered P/E ratio, 465
Unl evered price/ebit, 79
Unlevered price/ebitda, 79
Unlevered price/sales ratio, 79
Unlevered value, 79
Unpaid claim reserves, 599
Index 739
Unrealized gains and losses on securities,
263- 264
Unrealized gains/ losses on securities, 277
Unrecorded goodwill, 44
Unsystematic ri sk, 648
Unusual income timing, 616
Unusual items, 396, 397, 405
Unusual operating items/NOA, 510
Upside potential , 64 7
US Airways Group, 415
V/P ratio, 158
Validation, 91
Valuation
v
account-based, 525- 526
act ive investing, 210- 23 I
AEG. See Abnormal earnings growth
(AEG) model
anticipated acquisition, of, 527
asset-based, 82- 84
book val ue, and, 142
breakup, 84
case I, 152- 154, 190
case 2, 153, 154, 191
case 3, 154- 155
convert forecast to, 156- 157
cost of capital , 445-450
fallacies/mi sconceptions, 211-213, 570
no-growth, 218
project, of, 142- 153, 159
RE. See Residual earnings model
savi ngs account, of, 143- 144, 181- 182
seven steps, 520- 523
simplicity, 480
strategy, of, 160
Valuation analysis, 3, 232. See also
Fundamental analysis
Valuation fallacies, 570
Valuation grid, 491
Valuation model , 87, 212
debt financing activities, 95
defi ned, 98
equity financing activities, 92- 95
finite forecast horizon, 91
garbage in, garbage out, 212
going-concern invesh11ent, 88, 89, 93
investing and operating activi ties, 95- 96
parsimony, 92
required return/ asset pricing model , 96- 97
terminal investment, 88- 93
validation, 91
740 Index
Valuation model for the firm, 445
Valuation technology
asset-based valuation, 82- 84
choosing, 18- 21
DCF analysis. See Discounted cash ftow
(DCF) analysis
dividend discounting, 111- 114
earnings growth analysis. See Abnormal
earnings growth (AEG) model
method of comparables, 76- 78
multiple screening, 79- 82
overview, 18
residual earnings analysis. See Residual
earnings model
Value, 20, 51
continuing, 116, 152- 156
debt, and, 46 1
enterprise, 12, 23, 440
intrinsic, 4, 23, 211, 212
terminal, 112
unlevered, 79
Value added, 86
Value-added measures, 161
Value-at-risk (VaR), 695
Value at-ri sk profiling, 654- 661
adaptation option, 659
discounting for risk, 660- 661
growth option, 660
implied expected returns, 660- 661
probability of default, 694- 695
profiles for two firms, 657, 658
ri sk classes, 668
strategy and risk, 660
Value-based management, 13, 23
Value conservation principle, 557, 579
Value created, 98
Value driver, 364
Value driver models, 161
Value drivers, 148
Value equation, 44
Value generated, 98
Value of a perpetuity, 112, 113
Value of a perpetuity with growth, 113
Value of operations, 439
Value of the equity, I 0, 23
Value of the firm, 12, 23, 114, 11 5, 440
Value reporting, 53
Value stock, 80
Value-to-price (V/P) ratio, 158
Value types, 515
VaR, 695
Variable costs, 408
Vitesse Semi conductor Corp., 625
w
WACC, l 16n, 447, 448, 650
Wages payable, 125
Wall Street Journal shareholder scorecard,
644,645
Wal mart
cash flows, 118, 136
sales ( 1998), I 0
Warrant, 272, 277
Warranty liabilities, 599
Weighted-average cost of capital (WACC),
116n, 447,448, 650
Weighted-average expected return
formula, 214
Weighted-average forecasts, 488
Weighted-average return formula, 665
Westcorp, 415
Westinghouse, 350
What-if questions. See also
Sensitivity analysis
General Mills, 369, 371, 379
Nike,370, 379
Whirlpool Corporation, 298, 412, 415
Wilde, Oscar, 4
Working capital, 684
Working capital flow, 691
Working cash, 294
WorldCom
acquisition spree, 162
mismatching, 68
overstatement of income, 50
poor financi al reporti ng practices, 53
x
XBRL, 54, 55
Xerox Corporation
minicase, 633- 636
Nifty Fifty stocks, 7
poor financial reporti ng practices, 53
red flag indicators, 604
y
Yahoo! , 10
Yield-to-maturity, 695
z
z-score analysis, 690
ZeroAEG, 190
Zero-NPV investment, 91

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