Download CHAPTER SIXTEEN

Chapter 17 - Creating Accounting Value and Economic Value
CHAPTER SEVENTEEN
Creating Accounting Value and Economic Value
Stephen H. Penman
The web page for Chapter 17 runs under the following headings:
What this Chapter is Doing
Metrics that Indicate the Hidden Reserves Created by Conservative Accounting and
the Release of Hidden Reserves
A Spreadsheet Program for Analyzing the Effects of Accounting Methods
Accounting Issues in Forecasting: Starbucks Corporation
Equivalences: Residual earnings and Discounted Cash Flow Approaches to Valuation
Readers’ Corner
What this Chapter is Doing
Conservative accounting that features so much in this chapter is an accounting policy that keeps the balance
sheet low, such that we always expect book value to be below market value. If LIFO inventory methods are
consistently applied, then the balance sheet number for inventory will always be low (provided inventory costs
are rising). Expensing R&D permanently results in (R&D) assets being omitted from the balance sheet,
permanently.
Conservative accounting is a feature of GAAP. Chapter 17 shows how conservative accounting affects numbers
like ROCE, earnings, earnings growth, residual earnings growth. But most importantly, it shows how
conservative accounting is handled in valuation, for conservative accounting affects accounting value added but
not economic value added. It also deals with liberal accounting, the opposite of conservative accounting,
although this is not common, except in the relative sense of a particular accounting being less conservative than
otherwise. Boxes 17.2 and 17.3 provide good summaries.
Focus on the valuations under conservative accounting. The chapter shows how the accounting does not affect
the valuation, provided that steady state is forecasted. But conservative accounting does affect P/B ratios and
P/E ratios, as the chapter demonstrates. Table 17.6 provides a summary.
17-1
Chapter 17 - Creating Accounting Value and Economic Value
Metrics that Indicate the Hidden Reserves Created by Conservative Accounting and the Release of
Hidden Reserves
Table 17.7 shows how conservative accounting creates hidden reserves and how these hidden reserves can be
liquidated, inflating earnings, if investment slows. This is not a concern for valuation if slowing of investment
is forecasted within the forecast horizon (as the example there demonstrates). But one must be aware of
earnings that are temporarily inflated by a liquidation of hidden reserves.
A paper by Penman and Zhang, “ Accounting Conservatism, the Quality of Earnings, and Stock Returns,”
published in The Accounting Review in April, 2002 develops metrics – C scores -- that estimate the amount of
hidden reserves developed by the accounting for inventories, advertising and promotion, and R&D. It also
develops diagnostics to estimate the amount of hidden reserves released into earnings in any period by the
slowing of investment. The paper can be downloaded at:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=201048
A Spreadsheet Program for Analyzing the Effects of Accounting Methods
(Thanks to Mengcherng Deng for developing the spreadsheets.)
The following programs show how changes in accounting methods for book values change profitability,
growth, residual earnings, and P/B and P/E ratios. Make sure you understand Tables 17.1 – 17.5 in the text
before proceeding.
17-2
Chapter 17 - Creating Accounting Value and Economic Value
Here are definitions of the variables:




Investment expense rate () is the percentage of investment that is expensed rather than booked to the
balance sheet.
Investment turnover (t1 and t2) is the amount of sales (as a percentage of investment) that the investment
produces. In the program, investment produces sales for two years (as in the tables in the text), so
investment turnover for two years has to be specified. As the only expense is the depreciation on the
investment, this turnover is the element that determines the “real” profitability. The examples in the text
deal only with investments that do not add value. To observe effects for value-added investments,
increase these investment turnovers. We denote investment turnover as t1 and t2 for year 1 and year 2,
respectively.
Depreciation rate (d) is the depreciation rate for year 1. Depreciation expense is equal to depreciation
rate times the beginning balance of net operating asset, on top of direct investment expense.
Investment growth rate (g) is the annual growth rate for investments.
With the assumptions described in the textbook, we can show that
(1  g )(t1  1  g )  t2
(1  g  1  d )(1   )
Given that, you can easily see how return of net operating assets is affected by accounting methods. For
instance, RNOA can be induced by higher investment turnover, but reduced by lower investment expense rate
and depreciation rate. Most importantly, since
RNOAt 1  g
Enterprise P/B 
, it is now clear that enterprise P/B ratio is a function of accounting methods too.
rg
To see how this program works, click on a panel to get into Excel and change the assumptions in the green
area, the spreadsheet will calculate enterprise P/B ratio automatically. The different cases here have the same
ingredients, but different targets of the analysis.
RNOA t+1  g 
17-3
Chapter 17 - Creating Accounting Value and Economic Value
Case 1: To show that RNOA and P/B is a funtion of Investment turnover,
investment expense ratio, and depreciation rate.
Required rate of return
10% <-change your assumption here
Investment expense rate
10% <-change your assumption here
Investment turnover (Year 1)
60% <-change your assumption here
Investment turnover (Year 2)
55% <-change your assumption here
Depreciation rate (Year 1)
50% <-change your assumption here
Investment growth rate
5% <-change your assumption here
Target P/B
1.11
Target RNOA
10.6%
2004
Sales
From
From
From
From
investments in 2004
investments in 2005
investments in 2006
investments in 2007
Operating expenses (depreciation)
From investments in 2004
From investments in 2005
From investments in 2006
From investments in 2007
From investments in 2008
Operating income
Net Operating Asset (NOA)
From investments in 2004
From investments in 2005
From investments in 2006
From investments in 2007
From investments in 2008
Investment
Free cash flow
40.0
2006
240.0
220.0
252.0
240.0
472.0
180.0
42.0
180.0
189.0
44.1
2007
231.0
264.6
495.6
189.0
198.5
46.3
2008
242.6
277.8
520.4
40.0
222.0
413.1
433.8
198.5
208.4
48.6
455.4
(40.0)
18.0
58.9
61.8
64.9
360.0
180.0
378.0
189.0
396.9
198.5
416.7
360.0
558.0
585.9
615.2
208.4
437.6
646.0
400.0
(400.0)
420.0
(180.0)
441.0
31.0
463.1
32.6
486.2
34.2
5.0
7.5
0.7
55.0
(18.0)
N/A
10.6
12.5
0.8
5.0
3.1
N/A
127.2
21.1
N/A
10.6
12.5
0.8
5.0
3.3
5.0
10.3
0.2
-99.3
10.6
12.5
0.8
5.0
3.4
5.0
10.3
0.2
5.0
620.0
62.0
1.11
24.4
10.5
10%
651.0
65.1
1.11
11.6
10.5
10%
683.6
68.4
1.11
11.6
10.5
10%
717.7
71.8
1.11
11.6
10.5
10%
RNOA (%)
Profit margin (%)
Asset turnover
Growth in NOA (%)
ReOI
Growth in ReOI (%)
Growth in cum-dividend OI (%)
AOIG (0.10)
Growth in AOIG (%)
Value of firm
Premium over book value
P/B
Trailing P/E
Forward P/E
Equity Return
2005
400.0
1.11
22.2
17-4
Chapter 17 - Creating Accounting Value and Economic Value
Case 2:To show that given any return on investment, we can find the rate of investment
expense (the amount of conservatism) that produces target RNOA and P/B ratio.
Required rate of return
10%
<-change your assumption here
Investment turnover (Year 1)
60%
<-change your assumption here
Investment turnover (Year 2)
55%
<-change your assumption here
Depreciation rate (Year 1)
50%
<-change your assumption here
Investment growth rate
5%
<-change your assumption here
Target RNOA
10.6%
<-change your assumption here
Target P/B
1.11
Investment expense rate
10.00%
2004
Sales
From
From
From
From
investments in 2004
investments in 2005
investments in 2006
investments in 2007
Operating expenses (depreciation)
From investments in 2004
From investments in 2005
From investments in 2006
From investments in 2007
From investments in 2008
Operating income
Net Operating Asset (NOA)
From investments in 2004
From investments in 2005
From investments in 2006
From investments in 2007
From investments in 2008
Investment
Free cash flow
40.0
2006
240.0
220.0
252.0
240.0
472.0
180.0
42.0
180.0
189.0
44.1
2007
231.0
264.6
495.6
189.0
198.5
46.3
2008
242.6
277.8
520.4
40.0
222.0
413.1
433.8
198.5
208.4
48.6
455.4
(40.0)
18.0
58.9
61.8
64.9
360.0
180.0
378.0
189.0
396.9
198.5
416.7
360.0
558.0
585.9
615.2
208.4
437.6
646.0
400.0
(400.0)
420.0
(180.0)
441.0
31.0
463.1
32.6
486.2
34.2
5.0
7.5
0.7
55.0
(18.0)
N/A
10.6
12.5
0.8
5.0
3.1
N/A
127.2
21.1
N/A
10.6
12.5
0.8
5.0
3.3
5.0
10.3
0.2
-99.3
10.6
12.5
0.8
5.0
3.4
5.0
10.3
0.2
5.0
620.0
62.0
1.11
24.4
10.5
10%
651.0
65.1
1.11
11.6
10.5
10%
683.6
68.3
1.11
11.6
10.5
10%
717.7
71.8
1.11
11.6
10.5
10%
RNOA (%)
Profit margin (%)
Asset turnover
Growth in NOA (%)
ReOI
Growth in ReOI (%)
Growth in cum-dividend OI (%)
AOIG (0.10)
Growth in AOIG (%)
Value of firm
Premium over book value
P/B
Trailing P/E
Forward P/E
Equity Return
2005
400.0
1.11
22.2
17-5
Chapter 17 - Creating Accounting Value and Economic Value
Case 3:To show that given any investment expense rate, we can find the ratio of
investment turnover (year 1) that yields the target RNOA and P/B ratio.
Required rate of return
10% <-change your assumption here
Investment expense rate
10% <-change your assumption here
Investment turnover (Year 2)
55% <-change your assumption here
Depreciation rate (Year 1)
50% <-change your assumption here
Investment growth rate
5% <-change your assumption here
Target RNOA
10.6% <-change your assumption here
Target P/B
1.11
Investment turnover (Year 1)
60.0%
2004
Sales
From
From
From
From
investments in 2004
investments in 2005
investments in 2006
investments in 2007
Operating expenses (depreciation)
From investments in 2004
From investments in 2005
From investments in 2006
From investments in 2007
From investments in 2008
Operating income
Net Operating Asset (NOA)
From investments in 2004
From investments in 2005
From investments in 2006
From investments in 2007
From investments in 2008
Investment
Free cash flow
40.0
2006
240.0
220.0
252.0
240.0
472.0
180.0
42.0
180.0
189.0
44.1
2007
231.0
264.6
495.6
189.0
198.5
46.3
2008
242.6
277.8
520.4
40.0
222.0
413.1
433.8
198.5
208.4
48.6
455.4
(40.0)
18.0
58.9
61.8
64.9
360.0
180.0
378.0
189.0
396.9
198.5
416.7
360.0
558.0
585.9
615.2
208.4
437.6
646.0
400.0
(400.0)
420.0
(180.0)
441.0
31.0
463.1
32.5
486.2
34.2
5.0
7.5
0.7
55.0
(18.0)
N/A
10.6
12.5
0.8
5.0
3.1
N/A
127.2
21.1
N/A
10.6
12.5
0.8
5.0
3.3
5.0
10.3
0.2
-99.3
10.6
12.5
0.8
5.0
3.4
5.0
10.3
0.2
5.0
619.9
61.9
1.11
24.4
10.5
10%
650.9
65.0
1.11
11.6
10.5
10%
683.5
68.3
1.11
11.6
10.5
10%
717.7
71.7
1.11
11.6
10.5
10%
RNOA (%)
Profit margin (%)
Asset turnover
Growth in NOA (%)
ReOI
Growth in ReOI (%)
Growth in cum-dividend OI (%)
AOIG (0.10)
Growth in AOIG (%)
Value of firm
Premium over book value
P/B
Trailing P/E
Forward P/E
Equity Return
2005
399.9
1.11
22.2
17-6
Chapter 17 - Creating Accounting Value and Economic Value
Case 4: To show that we can find the depreciation rate that produces target RNOA
and P/B ratio. Notice that future RNOA increases as depreciation rate accelerates.
Required rate of return
10% <-change your assumption here
Investment expense rate
10% <-change your assumption here
Investment turnover (Year 1)
60% <-change your assumption here
Investment turnover (Year 2)
55% <-change your assumption here
Investment growth rate
5% <-change your assumption here
Target RNOA
10.6% <-change your assumption here
Target P/B
1.11
Depreciation rate (Year 1)
50.0%
2004
Sales
From investments in 2004
From investments in 2005
From investments in 2006
From investments in 2007
Operating expenses (depreciation)
From investments in 2004
From investments in 2005
From investments in 2006
From investments in 2007
From investments in 2008
Operating income
Net Operating Asset (NOA)
From investments in 2004
From investments in 2005
From investments in 2006
From investments in 2007
From investments in 2008
Investment
Free cash flow
40.0
2006
240.0
220.0
252.0
240.0
472.0
179.9
42.0
180.1
188.9
44.1
2007
231.0
264.6
495.6
189.1
198.4
46.3
2008
242.6
277.8
520.4
40.0
221.9
413.1
433.8
198.5
208.3
48.6
455.4
(40.0)
18.1
58.9
61.8
64.9
360.0
180.1
378.0
189.1
396.9
198.5
416.7
360.0
558.1
586.0
615.3
208.4
437.6
646.0
400.0
(400.0)
420.0
(180.0)
441.0
31.0
463.1
32.6
486.2
34.2
5.0
7.5
0.7
55.0
(17.9)
N/A
10.6
12.5
0.8
5.0
3.1
N/A
126.5
21.0
N/A
10.6
12.5
0.8
5.0
3.3
5.0
10.3
0.2
-99.3
10.6
12.5
0.8
5.0
3.4
5.0
10.3
0.2
5.0
620.0
61.9
1.11
24.4
10.5
10%
651.0
65.0
1.11
11.6
10.5
10%
683.6
68.3
1.11
11.6
10.5
10%
717.7
71.7
1.11
11.6
10.5
10%
RNOA (%)
Profit margin (%)
Asset turnover
Growth in NOA (%)
ReOI
Growth in ReOI (%)
Growth in cum-dividend OI (%)
AOIG (0.10)
Growth in AOIG (%)
Value of firm
Premium over book value
P/B
Trailing P/E
Forward P/E
Equity Return
2005
400.0
1.11
22.2
17-7
Chapter 17 - Creating Accounting Value and Economic Value
Case 5: To show that we can find the investment growth rate that produces
target RNOA and P/B ratio.
Required rate of return
10% <-change your assumption here
Investment expense rate
10% <-change your assumption here
Investment turnover (Year 1)
60% <-change your assumption here
Investment turnover (Year 2)
55% <-change your assumption here
Depreciation rate (Year 1)
50% <-change your assumption here
Target RNOA
10.6% <-change your assumption here
Target P/B
1.11
Investment growth rate
5%
2004
Sales
From
From
From
From
investments in 2004
investments in 2005
investments in 2006
investments in 2007
Operating expenses (depreciation)
From investments in 2004
From investments in 2005
From investments in 2006
From investments in 2007
From investments in 2008
Operating income
Net Operating Asset (NOA)
From investments in 2004
From investments in 2005
From investments in 2006
From investments in 2007
From investments in 2008
Investment
Free cash flow
40.0
2006
240.0
220.0
252.0
240.0
472.0
180.0
42.0
180.0
189.0
44.1
2007
231.0
264.6
495.6
189.0
198.5
46.3
2008
242.6
277.8
520.4
40.0
222.0
413.1
433.8
198.5
208.4
48.6
455.4
(40.0)
18.0
58.9
61.8
64.9
360.0
180.0
378.0
189.0
396.9
198.5
416.8
360.0
558.0
585.9
615.2
208.4
437.6
646.0
400.0
(400.0)
420.0
(180.0)
441.0
31.0
463.1
32.5
486.2
34.2
5.0
7.5
0.7
55.0
(18.0)
N/A
10.6
12.5
0.8
5.0
3.1
N/A
127.2
21.1
N/A
10.6
12.5
0.8
5.0
3.3
5.0
10.3
0.2
-99.3
10.6
12.5
0.8
5.0
3.4
5.0
10.3
0.2
5.0
620.0
62.0
1.11
24.4
10.5
10%
651.0
65.1
1.11
11.6
10.5
10%
683.6
68.4
1.11
11.6
10.5
10%
717.7
71.8
1.11
11.6
10.5
10%
RNOA (%)
Profit margin (%)
Asset turnover
Growth in NOA (%)
ReOI
Growth in ReOI (%)
Growth in cum-dividend OI (%)
AOIG (0.10)
Growth in AOIG (%)
Value of firm
Premium over book value
P/B
Trailing P/E
Forward P/E
Equity Return
2005
400.0
1.11
22.2
17-8
Chapter 17 - Creating Accounting Value and Economic Value
Accounting Issues in Forecasting: Starbucks Corporation
Case 6:To show that given any required rate of return, we can find the combination of
investment expense rate and investment growth rate that yields target RNOA and P/B.
Required rate of return
8% <-change your assumption here
Investment turnover (Year 1)
60% <-change your assumption here
Investment turnover (Year 2)
55% <-change your assumption here
Depreciation Rate
50% <-change your assumption here
Target RNOA
10.6% <-change your assumption here
Target P/B
1.11 <-change your assumption here
Investment expense rate
2%
Investment growth rate
-15%
2004
Sales
From
From
From
From
investments in 2004
investments in 2005
investments in 2006
investments in 2007
Operating expenses (depreciation)
From investments in 2004
From investments in 2005
From investments in 2006
From investments in 2007
From investments in 2008
Operating income
Net Operating Asset (NOA)
From investments in 2004
From investments in 2005
From investments in 2006
From investments in 2007
From investments in 2008
Investment
Free cash flow
8.6
2006
240.0
220.0
203.4
240.0
423.4
195.7
7.3
195.7
165.9
6.2
2007
186.5
172.5
358.9
165.9
140.6
5.2
2008
158.1
146.2
304.3
8.6
203.0
367.8
311.7
140.6
119.2
4.4
264.3
(8.6)
37.0
55.7
47.2
40.0
391.4
195.7
331.8
165.9
281.2
140.6
238.4
391.4
527.5
447.1
379.0
119.2
202.1
321.3
400.0
(400.0)
339.1
(99.1)
287.4
136.0
243.6
115.3
206.5
97.7
9.5
15.4
0.6
34.7682
5.7
N/A
10.6
13.1
0.8
-15.2
13.5
136.7
29.0
7.8
N/A
10.6
13.1
0.8
-15.2
11.4
-15.2
4.3
-2.1
-126.4
10.6
13.1
0.8
-15.2
9.7
-15.2
4.3
-1.7
N/A
585.5
58.0
1.11
13.1
10.5
8%
496.3
49.2
1.11
11.4
10.5
8%
420.7
41.7
1.11
11.4
10.5
8%
356.6
35.3
1.11
11.4
10.5
8%
RNOA (%)
Profit margin (%)
Asset turnover
Growth in NOA (%)
ReOI
Growth in ReOI (%)
Growth in cum-dividend OI (%)
AOIG (0.10)
Growth in AOIG (%)
Value of firm
Premium over book value
P/B
Trailing P/E
Forward P/E
Equity Return
2005
450.4
1.15
12.2
17-9
Chapter 17 - Creating Accounting Value and Economic Value
Chapter 17 makes the point that a valuation has integrity if the relevant information is reflected in forecasts
within the forecast horizon, such that periods beyond the horizon can be summarized in a steady-state
continuing value calculation. Accounting methods determine how quickly information is reflected in the
accounting system and thus how quickly information will show up in forecasted earnings. Accordingly,
accounting methods determine the length of the forecast horizon at which a steady-state continuing value can
be calculated. For example, if a firm is expected to invest heavily in R&D – which is expensed directly to
income under GAAP – losses might be expected for a number of years, so the forecast horizon will have to be
long to capture the returns to R&D.
The following material appeared in the first addition of the text.
The Issue Restated
If the future earnings that are forecasted are of low quality, valuations also will be low quality. Forecasted
earnings and residual earnings are of good quality if they capture the value generated by a business. As
earnings are determined by accounting rules, forecast quality is a matter of accounting principle. If the analyst
forecasts earnings but the rules to measure earnings miss some aspect of value, the earnings forecast will be of
questionable quality. As analysts typically forecast GAAP earnings, we have a particular interest in how well
GAAP captures value.
Chapter 16 draws the conclusion that the accounting methods a firm uses should not affect its valuation. Nor
should they affect the value calculated from forecasting residual earnings. But there was an important proviso:
residual earnings must be forecasted to a point in the future where the firm is expected to be in “steady state.”
That is, one must forecast to a forecast horizon where long-run growth in residual earnings can be ascertained
so that an appropriate continuing value can be calculated. If one’s forecast horizon is shorter than that for the
steady-state forecast, value is not fully captured. So, for example, forecasting residual earnings for just one
year ahead often does not yield a high-quality valuation.
A continuing value is merely a device for summarizing residual earnings beyond a forecast horizon. So value
can be captured by forecasting for longer and longer periods into the future. But the analyst prefers to work
with short forecasting horizons for, as she forecasts further out into the future, she becomes less certain about
her forecasts and less certain about her valuation. Accounting plays an important role in determining the length
of the forecast horizon that captures value, so we can think of the quality of the forecasted accounting in terms
of how long a forecast horizon is typically required to capture value. If the accounting delivers a perfect
balance sheet (where value equals book value), no forecasting is required at all, so the accounting can be seen
as high quality. Thus, as financial assets and liabilities are typically close to market value on the balance sheet
(because of use of the effective interest method and mark-to-market accounting), no forecasting is necessary for
financing items. So the accounting for financial items is deemed to be good accounting. But not so for
operating aspects of the business. Residual earnings must be forecasted and the quality issue is how far in the
future must those earnings be forecasted. Or, put another way, for a given forecast horizon of, say, five years,
how well does the accounting capture value?
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Chapter 17 - Creating Accounting Value and Economic Value
GAAP ultimately recognizes value in the income statement (in most cases) if the forecast period is long
enough, provided that the earnings are comprehensive. But you can think of situations where the accounting is
remiss for shorter forecast periods. The appreciated value of land is not recognized in GAAP earnings until
sold, so forecasting earnings over five years before the land is expected to be sold will not capture the earnings
from the land. (Marking the land to market on the current balance sheet would solve the problem.) R&D
expenditures are expensed under GAAP so one could forecast losses over five years where considerable R&D
expenditures are expected, but the revenues from the R&D are not expected until later. The valuation from a
five-year forecast would be a poor valuation indeed. Focusing on GAAP, the question is: if we base our
valuation on an analyst's forecast of GAAP earnings for the next five years (say), will we get a good-quality
valuation? Well, the analyst might be a poor forecaster, but that's another issue. But if we accept the analyst as
a good forecaster, would we accept that value is captured by earnings forecasted over five years?
The authorities who prescribe GAAP accounting trade off relevance for reliability: they eschew subjective
estimates (that may be relevant for valuation) in favor of "hard" (reliable) numbers based on market
transactions. In the U.S., GAAP typically does not allow appreciations in the value of land (or other
operational assets) to be recognized unless the land is sold, because of uncertainty about whether the value will
ultimately be realized. GAAP requires R&D investments to be expensed because of the uncertainty about
whether payoffs to the R&D will be realized. Indeed the driving principle for recognizing value under GAAP
is the realization principle: value is not added until assets or products are sold. These rules arise from a
concern with quality. The restrictions on estimates reduce the opportunities for manipulation, improving
quality in one sense, but mean that estimated value may not be recognized within a reasonable time frame,
reducing quality. There is a tension in financial reporting that requires a balancing of the need to capture value
against the need to maintain credibility. You will see in the next chapter how the estimates that are allowed do
indeed introduce quality concerns. We now see how the estimates not allowed also give concerns. To the
extent that accountants don't make the estimates, analysts must.
As we recognize from Chapter 17, forecasted residual earnings can be constructed to be higher or lower
through conservative or liberal accounting, but this in itself is not a concern if steady state is forecasted. What
is of concern is whether steady state can be forecasted within a (reasonable) forecast period. Continuing values
capture the steady state, so this issue is the same as asking whether residual earnings forecasted at the forecast
horizon is, with an anticipation of growth, a good indicator of long-run residual earnings so that a continuing
value calculation can be made.
Residual operating income (and continuing values) are driven by return on net operating assets (RNOA) and
growth in net operating assets (NOA). In the first three subsections here we examine how the accounting
affects the quality of forecasted RNOA. In the last subsection we show how growth forecasts also affect the
quality of residual income forecasts. The figure below guides you through the analysis. Use this figure as a
summary.
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Chapter 17 - Creating Accounting Value and Economic Value
Forecast Quality Issues
Quality of RNOA Forecasts
The Effect of Growth Forecasts on the Quality
of Forecasted Residual Operating Income
Sales Forecast Quality: Revenue Recognition
 Sales growth forecasts
 Assets held for sale
 Equity investments
 Hidden assets
 Long-term contracts
Steady-state Diagnostic: Sales/NOA
Profit Margin Quality: Expense Matching
 Research and development
 Advertising and promotion
 Start-up costs
 Strategic losses
 Amortization
 Compensation expense
Steady-state Diagnostic: Expense/ Sales
We illustrate the quality problem with Starbucks Corporation. In 1998 Starbucks had the largest chain of
coffee shops in the U.S., many stores in Asia, and was beginning an expansion into Europe. It was a favored
stock, selling at nearly 6.6 times book value and a P/E of 52. The following is based on its financial reports
from 1993 to 1997.
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Chapter 17 - Creating Accounting Value and Economic Value
Starbucks Corporation. Summary of residual operating income drivers, 1993 – 97.
Sales ($ thousands)
Operating income ($ thousands)
As a % of sales:
Gross margin
Store operating expenses
Other operating expenses
Depreciation and amortization
General and administrative
expenses
Taxes on core income
Core profit margin (%)
Asset turnover
Core RNOA (%)
1993
1994
1995
1996
1997
176,541
7,253
284,923
15,051
465,213
24,406
696,481
31,081
966,946
53,252
54.4
32.1
3.0
3.8
8.4
55.3
32.7
3.1
4.4
7.0
54.6
32.0
3.0
4.8
6.2
51.8
30.3
2.8
5.2
5.3
55.3
32.0
2.9
5.4
5.9
2.8
2.9
3.4
3.7
3.5
4.4
1.89
8.3
5.3
2.00
10.6
5.2
1.74
9.0
4.5
1.84
8.3
5.6
1.95
10.9
Net operating assets ($ thousands)
93,589
191,416
342,648
412,958
578,237
Growth in NOA (%)
--104.5
80.5
20.6
40.0
Growth in sales (%)
61.4
63.3
49.7
38.8
______________________________________________________________________________
Let's roll back the clock to the end of 1992 and suppose that the actual numbers here are as forecasts for 1993 to
1997. The CAPM operating cost of capital for Starbucks at the time (with a beta about 0.9) was about 11%.
We could calculate forecasted residual operating income (ReOI) up to 1997 and our problem would be to
calculate a continuing value at the end of 1997. Starbucks had few unusual items so core RNOA is close to
RNOA. Taking our forecasts of RNOA in 1997 as indicative of long-run RNOA (after 1997), we might set the
continuing value equal to zero: the 1997 RNOA of 10.9% is roughly equal to the calculated cost of capital.
We would reinforce this calculation by noting that the RNOA from 1993 to 1997 are no more than the cost of
capital, core profit margins are no more than the 5.6% in 1997, and asset turnover (ATO) is fairly constant.
This seems like a business that earns regularly at or below its cost of capital. We would forecast growth in
NOA from opening more and more stores, but this would not change our continuing value calculation: growth
in NOA grows residual operating income only if RNOA is greater than the cost of capital. (Of course, we
would treat the estimate of the cost of capital with some reservation.)
A continuing value measures the premium at the forecast horizon. Our forecasts would set this to zero in 1997.
But the market's levered P/B ratio in early 1998 was 6.6 and the unlevered P/B was 6.4. And the levered P/E
was 52 with an unlevered P/E of 62. Clearly the market priced Starbucks as if it saw a higher RNOA after
1997 and saw 1997 and prior earnings as low quality indicators of subsequent earnings. Is the accounting
missing something? Is the accounting not revealing Starbucks' potential profitability? Or has the market
misjudged the potential profitability of the firm? One might be impressed by the sales growth, the earnings
growth, and the net operating asset growth. And one might like the coffee. Starbuck’s was a glamour stock at
the time. But it seems from the reported margins, turnovers, and RNOA that Starbucks is not able to generate
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Chapter 17 - Creating Accounting Value and Economic Value
much value over its required return. We are even more concerned when we realize that, because Starbucks
expenses advertising, the accounting is conservative: conservative accounting should induce a higher RNOA.
But let's check the accounting further.
We have couched the Starbucks' quality question as a question of forecast quality and the quality of continuing
values. But, rather than rolling back the clock to 1992, place yourself at the beginning of 1998 and think about
forecasting future RNOA on the basis of the 1993-97 numbers. Then the GAAP quality question is one of the
quality of current and past earnings.
Below we discuss a number of aspects of GAAP that raise quality questions and address them to Starbucks'
accounting.
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Chapter 17 - Creating Accounting Value and Economic Value
Recognition of Revenues: the Realization Principle Defers Value Recognition
Revenue is value coming into the business, value generated by taking goods and services to the
market. With its insistence on reliable evidence, GAAP accounting typically recognizes revenues
only when products and services are sold. Estimating revenues that are likely to be earned in the
future is not allowed. The accounting authorities feel (justifiably) that, if firms were allowed to
book forecasted revenues, the license would be used for abuse.
Booking revenues at sale is called the realization principle. Forecasted earnings for the next five
years, say, are based on revenues that will be realized within five years. If these revenues
(perhaps extrapolated with a growth rate) are a good indication of the ability to earn revenues
after the five years, the forecast is of good quality. If not, the value analyst must adjust the
forecast or extend the forecast horizon to capture "long-run" sales. Below are the issues to be
considered.
The quality of forecasted sales growth rates. The continuing value at the end of a forecast period
requires a forecasted growth rate for residual operating income. One element is forecasted sales
growth. Is the forecasted growth rate for the next five years a good indicator of the permanent
growth rate? Starbucks' sales growth from 1993 to 1997 was quite phenomenal, accompanied,
with reasonably constant asset turnover, with large growth in net operating assets from new store
openings. Could this be continued? In 1998 Starbucks began its foray into Europe with the
acquisition of the Seattle Coffee Company, a UK firm. But one might doubt its ability to grow
sales at the rates for 1993-97. Considerations are



the total size of the market
competition that might reduce price and volume
the ability to develop other product lines
Assets held for sale. Firms sometimes have valuable assets whose earnings are not reported in
the income statement until sold. So forecasts of earnings may not reflect their value. Land and
property held for speculation are an example. These assets gain value if their market prices
increase, but they are held at cost on the balance sheet, subject to impairment, with no gain
reported in the income statement. To value them, add the present value of their anticipated gain
or loss over the forecast period to the valuation. Or, if their current price is considered an
"efficient" one, recognize their current book value at market value rather than cost.
Starbucks leases most of its stores so does not have much property for resale. It does own
manufacturing facilities. Are these on land that can be sold and has appreciated?
Equity investments. If a holding in another firm is greater than 20%, earnings from the
investment will appear in future statements under the equity method or through consolidation of
accounts. But, if the investment is less than 20%, there could be quality problems. In many
countries these investments are held at cost, and in the U.S. they are held at cost if classified as
not available-for-sale ("held-to-maturity"). If so, only dividends are recognized in the income
statement and dividends, as we have seen, are a poor indicator of value. A solution is to
recognize their market value as their value, like the land.
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Chapter 17 - Creating Accounting Value and Economic Value
Since 1994 U.S. GAAP has required all securities "available-for-sale" or in trading portfolios to
be recorded on the balance sheet at market value. This solves the problem if the market price is a
sound valuation, an "efficient" price. If investments are carried at cost in a "held-to-maturity"
category, and if market prices are available, add the market value to the valuation of other net
operating assets. In both cases exclude the book value of the equities and forecasts of dividends
from the ReOI valuation of the other assets, then add the market value of the equities. But be
careful: using market prices to calculate values is dangerous if one is trying to establish values
independent of prices. If you doubt the efficiency of market prices of equities (and why else
would you be doing a valuation!), analyze the financial statements of the investee firms to
uncover the value in the earnings they generate. This of course has to be done if market prices
are unavailable.
Starbucks' investments in unconsolidated joint ventures with Dryers Grand Ice Cream, PepsiCola Company and SAZABY (in Japan) are accounted for under the equity method, so this issue
does not arise.
Hidden assets that can generate additional revenue streams. A firm might have assets or
potential assets that can produce revenues in the long run over those forecasted. It might have
customer lists that generate revenues for its products but which also can be sold to other firms. It
might be positioned to develop products that tie into its existing products. It might have
distribution channels which can be used to market other products or which can be sold to other
vendors. And it might have contacts -- alliances with other firms or political clout -- that provide
opportunities to generate value.
The value of these opportunities are difficult to quantify. The opportunities can be seen as
options, often called real options to distinguish them from financial options like options on
stocks. As part of its investment strategy, a firm might place itself in a position where it could
benefit from technological change, shifts in consumer demand, or political developments.
Should these occur, it capitalizes on the opportunity. By committing to a strategy, it has
effectively bought itself an option to be exercised should events be favorable. Techniques are
available to value these real options in a similar way to financial options. These techniques are
complicated and are fraught with measurement problems1. Ultimately value from the
opportunities must show up in financial statements, they must produce earnings, so the potential
revenue streams can, in principle, be forecasted (with considerable uncertainty) and valued using
the techniques in this book: what sales are likely to be delivered, at what margins and with what
investment in net operating assets? Indeed, as part of their strategy analysis, firms should be
identifying these opportunities and estimating their value with the techniques. They should be
tracking the value and protecting and enhancing it. But being unarticulated, these strategies and
the opportunities they present, are not easily modeled with pro forma analysis.
Brand names can produce additional revenue streams. The Starbucks name is well known.
Could it be used to market other drinks? A line of coffee makers? Specialty clothes? A chain of
restaurants? Is Starbucks the next McDonalds that generates value from franchising under its
name? What turnovers and profit margins might these opportunities yield?
1
See the special issue on real options in, The Quarterly Review of Economics and Finance, 1998.
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Chapter 17 - Creating Accounting Value and Economic Value
Long-term contracting. Firms engaging in long-term construction (of ships and planes, for
example) sometimes do not recognize revenue until a project is finished. The accounting is
called the completed contract method (for recognizing revenue). If the project takes years,
revenue recognition is deferred for a considerable time. Firms may, under strict conditions,
recognize revenue gradually over the life of a project using the percentage-of-completion
accounting method. If so, the deferral of revenue is less of an issue.
For long-term contractors, discover whether the firm is using the completed contract method or
the percentage-of-completion method. If the former, watch for revenues not recognized. If the
latter, watch for manipulation, for the percentage of a completion method requires estimates of
total revenues and costs for the project.
The quality of forecasted revenue is a matter of assessing whether there are additional sales not
anticipated by the forecast. But it is important to appreciate that additional sales do not
necessarily mean higher RNOA. Remember, RNOA = PM x ATO so, if more sales require more
net operating assets such that ATO is the same, and if PM remains the same, then RNOA will be
unaffected. Thus Starbucks' RNOA for 1993-97 might be a good forecast of subsequent RNOA
and thus good quality, even if sales are not a good indicator of subsequent sales. Starbucks may
open numerous stores in Europe and Asia, increasing sales and net operating assets, but unless
ATO increases, RNOA will not change given it earns the same profit margins on coffee sales.
Sales per store is an important driver for Starbucks, not just stores and not just sales.
So it is that ATO is a useful diagnostic for assessing the quality of sales:
Diagnostic: Sales/NOA
Are forecasted ATO's a good indicator of long-run ATO or will the firm increase or decrease
sales per dollar invested? Is there idle capacity such that Starbucks can make more sales with the
same NOA?
The quality of RNOA is determined by the quality of the profit margin as well as the ATO, so we
now turn to the profit margin.
Mismatch of Expenses with Revenues Can Obscure Core Profitability
Revenue is value coming in, expense is value going out. We are concerned about net value
added, the value added per dollar of sales. Profit margins measure this net value from sales.
Profit margins may not be a good indicator of subsequent margins because of real factors. So,
for example, Starbucks can increase its profit margins with an increase in sales if its costs -- rents
in store operating expenses and depreciation -- are fixed and there is idle capacity. Sales per
store is a driver of margins as well as ATO. But margins can be affected by the accounting also.
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Chapter 17 - Creating Accounting Value and Economic Value
The profit margin calculation ideally subtracts from revenues the expenses necessary to earn the
revenues. If revenues and expenses are appropriately matched, margins are a reliable measure of
the profitability of revenues. Applying expenses to revenues to reveal profitability is the
matching principle (as described in Chapters 2 and 4). So cost of goods sold is just what it says,
the cost of the goods actually sold to get proper matching, not the total expenditure on inventory.
If total inventory costs were expensed, there would be a mismatching of revenues and expenses
and gross margins would not be a good measure of profits from selling goods. So, any costs for
goods not sold are "capitalized" in the balance sheet (in inventories) until they are sold (at which
point they are "amortized" to cost of goods sold).
But GAAP accounting doesn't always do this matching so well. Ideally all costs should be
"capitalized" and amortized to expense only as the revenues for which they are incurred are
booked. Typically this is so, at least in principle. Plant costs are capitalized in the balance sheet
and expensed against revenue (ideally) as the plant is used up in generating the revenue.
Purchased goodwill is capitalized in the balance sheet and (ideally) expensed as its value
declines. And, also to accomplish matching, operating liabilities are recognized for expenses
necessary to generate revenues of the current period but which will be paid later, like accrued
expenses and pensions. But there are exceptions and indeed GAAP, in pursuit of reliable
numbers, requires imperfect matching in some cases. Here are the main problem areas.
Expensing of R&D. With the exception of certain software development costs, GAAP charges
all R&D spending directly to the income statement. The accounting does not distinguish highquality R&D from low-quality R&D so the investment is not recognized in the balance sheet.
Nor are expenses matched to revenues in the income statement. If revenues that the R&D
generates do not flow until after a forecast horizon, earnings forecasts will be of low quality.
Indeed, some firms incur losses from investing in R&D for several years even though the R&D
is very valuable.
We are familiar with this problem from the simulation of ratios for pharmaceutical firms with
R&D programs in Chapter 17. Once revenues flow from R&D and a steady-state is reached,
R&D firms are relatively easy to value. But prior to steady state, RNOA is low and, for startups,
is often negative. The diagnostic to track is:
Diagnostic: R&D/ Sales
If the analyst forecasts a change in this ratio -- because more or less sales are likely to flow from
a dollar investment in R&D – the earnings are of low quality. If no change in forecasted, the
ratio is in steady state and the earnings are of sound quality.
Forecasting long-run profitability when R&D yields a low RNOA is a tricky matter. Will the
R&D be successful and, if so, what will be the revenues it will generate? Again, this is an issue
of knowing the business. To value the R&D of a start-up biotechnology firm, one has to be a
biochemist to understand whether the R&D will pay off. And one has to know the drug market.
But one still needs to do financial analysis. Knowing the technology and knowing the market are
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Chapter 17 - Creating Accounting Value and Economic Value
necessary but the valuation issue is ultimately one of translating this knowledge into forecasts of
the long-run residual earnings that will be generated.
Advertising and Promotion. Advertising and promotion costs can be incurred to deliver current
sales and also future sales. But the accounting typically treats all advertising as an expense when
incurred and applies it against current sales.
The solution involves a marketing analysis. Will the forecasted advertising produce more sales
in subsequent years? The diagnostic to track is:
Diagnostic: Advertising Expense/ Sales
Start-up costs. Start-up costs for product and facilities development are usually expensed even
though they are needed to generate long-term revenue.
Strategic losses. Firms may, as a matter of strategy, decide to go into markets where they know
they will have to incur losses for a time before they are established and draw customers.
Publishing and media ventures, fashion ventures, and new retailers require time to develop name
recognition, establish a quality reputation or to drive out competitors. The losses forecasted for
the near term may be investments in long-term operations. When Amazon.com began trading,
their management insisted that the business model required continuing losses and it would be a
number of years before profits were likely. Needless to say, such a firm is difficult to value.
Amortization. Expensing an investment immediately is really a very rapid (immediate)
amortization. A firm may capitalize an investment but, as a matter of policy, choose high or low
amortization rates. This can distort the matching of expenses to revenues.
Purchased intangibles are a case in point, and a particular area to watch is amortized goodwill. If
a firm has made a recent acquisition using the purchase (rather than pooling) method, it can
choose to amortize over one to forty years in the U.S. If the amortization is done over five years,
a five-year forecast of earnings will be low quality because subsequent years will not bear the
charge. Indeed, there is a question if amortization is warranted at all if the value of the
investment does not decline. In the U.K., firms may amortize goodwill only if it is judged to be
impaired. This notionally deals with the problem but, as impairment is a matter of judgment, it
opens up the accounts to manipulation.
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Chapter 17 - Creating Accounting Value and Economic Value
This points to a solution: back out any amortized goodwill from a forecast and add it back to
current book value. Then ask if current goodwill is a good carrying value or should be written
down. That is, continually mark goodwill to market. One must, however, have considerable
faith in one's ability to judge impairment. One guiding rule is to write goodwill off such that the
forecasted residual income from (the share of) profits forecasted for the subsidiary is always
zero. If the forecast of residual income from the investment is zero, the carrying value of the
investment must be its value. This may require writing goodwill up.
Alternatively one can stick with historical cost accounting, estimate the life of residual earnings
from the book values purchased, and amortize over that life.
With these points in mind, let's return to Starbucks. Starbucks' expense ratios for 1993-97 look
stable and predictable. So, are its profit margins a good indicator of its long-run ability to get
profits from sales? Starbucks has a small amount of R&D but significant advertising costs.
Footnotes reveal that store operating expenses, which are in the order of 32% of sales fairly
consistently, include advertising, store opening costs and store remodeling costs, as required by
GAAP. These depress profit margins but may pay off later with higher sales. The reports do not
give the detail on these costs (disclosure quality!) but if the amount each year that produced sales
after 1997 were just 2% of sales (and so were capitalized in the balance sheet), profit margins
would be higher by 2% and RNOA (with an adjusted turnover for increased net operating assets
with the capitalization of the costs) would be 14.4%, 12.3%, 11.8%, and 14.5% for 1994-97.
(The profit margins and RNOA for 1994-97 would be lower than these numbers if any of the
costs capitalized for future sales produced sales before 1998: the costs would have to be
amortized to match the sales.)
Starbucks new joint ventures generated $5.9 million in losses from 1994-97 (which were
included in other operating expenses). Over the same period it contributed $34.8 million in
capital to these ventures in anticipation of profit. The losses might be seen as strategic, start-up
losses. One would have to analyze the ventures.
Mismatching of revenues and expenses is not always a problem. Proper matching is what we
called neutral accounting in Chapter 17. Conservative and liberal accounting disturb the
matching. But we also saw in Chapter 17 that this is no problem if there is a steady-state
relationship between revenues and expenditures. The accounting induces a change in PM, ATO
and RNOA, but the change is permanent, as in the panel examples in Chapter 17. But what if, in
the Chapter 17 panel examples, the R&D expenditure forecasted over the four years did not pay
off until later? The forecasted RNOA for these four years will be depressed by the expensing of
the R&D and will not be at the same level of subsequent RNOA that incorporates the revenues
from R&D. A steady-state relationship between revenues and expenses will be deferred to a
more distant future and the RNOA for the first four years will be low quality.
Profit margins are constant if expense ratios are constant and profit margins are predictably
growing if expense ratios are predictably decreasing. So the diagnostic for the quality of
forecasted expenses is:
Diagnostic: Expense/sales.
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Chapter 17 - Creating Accounting Value and Economic Value
The R&D/Sales and Advertising/Sales ratios earlier are examples. If expense to sales ratios
forecasted for Starbucks for years after 1998 are forecasted to be the same as those for 1997,
there is no quality problem. But if one forecasts more (or less) revenues per dollar outlays on
advertising, start-up costs and R&D further down the line, the forecasted earnings are low
quality. Put another way, one asks: Is advertising, R&D, etc. at the level to sustain sales or is
more or less needed in the future per dollar of sales?
Missing Accounting: Hidden Dirty Surplus Omits Value
Forecasts will be low quality, and some aspect of value will be missed, if earnings forecasted are
not comprehensive. We saw in Chapter 9 that GAAP does not recognize the value effects when
services are paid with stock issues or shares are issued (usually in exchange for convertible
securities) at less than market price. This is a significant issue with stock compensation but
potentially any service could be paid for with stock. The issue is not a matter of delayed
recognition. It's a matter of non-recognition. We might forecast strong GAAP earnings but will
overvalue the firm if we don't reduce the forecast for the value loss anticipated in these share
transactions. Remember, we have to be careful that the employees will not run away with the
company.
Starbucks issues stock options to its employees under an Employee Stock Option Plan. In
addition it instituted an Employee Stock Purchase Plan in 1995 permitting eligible employees to
apply 10% of their base earnings to purchase up to $25,000 of Starbucks' common stock at a
15% discount from market price. The panel below calculates the implicit additional wages
expense from the employee stock plans. The implicit wages paid in the option plan are
calculated as laid out in Chapter 9. Proceeds from share issues under the stock purchase plan are
in the statement of shareholders' equity and, as these are 85% of market price, the implicit wage
cost (market price-issue price) is easily calculated (there is no tax benefit reported).
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Chapter 17 - Creating Accounting Value and Economic Value
Starbucks Corporation. Adjustments to operating income for stock issues to employees (in
thousand of dollars except share and per-share items)
Employee Stock Option Plan
Shares issued
Weighted-average share price
Weighted-average exercise price
Loss (before tax)
Tax benefit
Implicit wages expense (after tax)
1993
1994
1995
1996
1997
1,407
20.38
8.59
774
25.16
9.25
946
16.44
3.34
1,177
23.87
6.78
1,382
34.81
9.92
16,591
5,243
11,348
12,311
3,719
8,592
12,390
4,754
7,636
20,128
6,808
13,320
34,409
9,626
24,783
263
46
1,735
306
2,313
408
Employee Stock Purchase Plan
Proceeds of share issues
Implicit wages expense
Total implicit wages expense
11,348
8,592
7,782
13,626
25,191
Restated comprehensive operating income
Restated RNOA (%)
(4,095)
-4.7
6,459
4.5
16,624
6.2
17,455
4.6
28,061
5.7
______________________________________________________________________________
Note: The tax benefit from issue of shares in the option plan is given in the statement of shareholders' equity.
The effect on operating income and RNOA of these quasi-payments to employees is substantial.
Reported RNOA is low quality.
In 1996 Starbucks' convertible debt with a book value of $79 million was converted into
5,359,769 shares of common stock. At an average 1996 price per share of $23.87 this resulted in
a loss of $48.9 million (the market price of share issued minus the book value of the bonds).
This is a financing activity, so will not affect RNOA. But the conversion is a loss to
stockholders that is not recognized in reported income.
Forecasted losses from these share transactions must be recognized to produce a quality forecast.
But there is a problem. The loss depends on the forecasted price of the share when options and
conversion rights will be exercised. But that price depends on the value of the firm and to get the
value of the firm we need the forecasted loss! The circularity is hard to break. But here are
some suggestions for accounting for employee stock options:
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Chapter 17 - Creating Accounting Value and Economic Value
1. Extrapolate from past losses. Calculate current and past losses from share issues to
employees (as we have just done for Starbucks). If they are regular (as a percentage
of sales), extrapolate to the future.
2. Forecast future prices from current prices. Forecast stock prices at expected exercise
dates by extrapolating from the current stock market price to the future price at the
cost of capital and reduce the future price for any expected dividends. This assumes
that the market price is efficient and is expected to grow, cum-dividend, at the cost of
capital. Deduct expected losses (forecasted price minus exercise price) from
forecasted operating income.
3. A liability calculation: calculate the current market price minus exercise price for all
options currently outstanding and in the money. This options overhang is the amount
of loss that would be incurred if all outstanding options were exercised at today's
price. Discounting for the probability the options will not be exercised and for
anticipated tax benefits on exercise yields the contingent liability for outstanding
options. Reduce the valuation by the amount of the contingent liability. The
calculation is correct if the market is efficient and if future option grants are expected
to be granted at the money in a fair game.
4. Forecast future prices from an initial calculated value. Value the equity today by
using forecasts of operating income before stock compensation. Then forecast future
stock prices at forecasted exercise dates by extrapolating from the calculated value at
the cost of capital, adjusting for expected dividends. Calculate the future losses and
reduce today's value by the present value of the forecasted losses. This method
assumes the market will be efficient in the future when options are exercised, but not
necessarily so currently. But because the initial calculation of today's value is too
high, it also overestimates the loss. Fudge it down?
5. A normal RNOA calculation. Forecast future market prices at expected exercise
dates as expected future book value plus a premium based on a normal RNOA for the
industry, where the normal RNOA is calculated with normal cash-equivalent
compensation expense for employees in the industry.
Calculation 1 relies on the past as indicative of normal compensation expense. Calculations 2
and 3 are appropriate if the analyst is comfortable with market efficiency. But this goes against
the grain of fundamental analysis. Management may grant options to themselves when their
inside information indicates stock prices are low and exercise when stock prices are high: they
may play the swings in prices away from fundamentals. Calculations 4 and 5 attempt to measure
without reference to market prices, albeit imperfectly.
17-23
Chapter 17 - Creating Accounting Value and Economic Value
Growth and Accounting Quality
RNOA quality is affected by accounting principles. But it is also affected by growth in net
operating assets (NOA). Cast back to the panel examples in Chapter 16 and compare Panels B
and D. Both panels apply conservative accounting but in Panel D there is growth in NOA. And
RNOA in Panel D is lower than in Panel B, 10.6% compared to 11.1%: growth in NOA reduces
RNOA if there is conservative accounting. Both panels deal with the same investments that
don't add value. Which RNOA is the quality one?
Well, if growth in NOA after 2004 is forecasted at the same rate as 2002-2004, both RNOA are
quality RNOA. In both cases RNOA forecasted for 2002-2004 is a good indicator of subsequent
RNOA and a continuing value can be calculated with this RNOA and the relevant growth rate.
But, if growth in RNOA is forecasted to change after 2004, the conservative accounting in Panel
D will induce a change in RNOA. Thus the RNOA for 2002 to 2004 will not be a good indicator
of subsequent RNOA.
Indeed, this is the situation in table 17.7 in Chapter 17. The forecasted leveling off of NOA after
2004 increases forecasted RNOA to 11.1%, the no-growth rate. Hidden reserves are liquidated,
as we saw. We would be wrong in calculating a continuing value at 2004 based on the 10.6%
RNOA from 2002 to 2004. The continuing value must be based on the zero long-term growth
rate rather than 5% rate prior to 2004. But it must also be based on the higher RNOA induced by
a change in growth in NOA because conservative accounting is used.
In the end, it's a question of the quality of forecasted residual earnings used in continuing values.
Residual earnings are driven by RNOA and growth in NOA but growth in NOA will affect
RNOA if the accounting is conservative or liberal. Full pro forma analysis (of the type in the
panels in Chapter 16) models the evolution of the firm, it RNOA, its growth in NOA and the
interaction between the two.
In the case of Starbucks, we probably would calculate that the firm could not keep up the high
NOA growth rate from 1993 to 1997. Would we expect a decline in the growth rate to generate a
higher RNOA? Well, somewhat. Starbucks expenses store opening expenditures and
advertising so the accounting is conservative. An extended pro forma after 1997 that anticipated
any changes in advertising/sales and store-opening-costs/sales ratios will anticipate changes in
RNOA from 1997 levels.
17-24
Chapter 17 - Creating Accounting Value and Economic Value
Equivalences: Residual earnings and Discounted Cash Flow Approaches to Valuation
Table 17.14 in Chapter 17 indicates that the forecasting horizon for Starbucks is likely to be
longer if one uses discounted cash flow (DCF) analysis (cash accounting for the future) rather
than accrual accounting, returning to the issue raised in Chapter 4: Starbuck’s free cash flows are
negative. If one extended the forecast horizon for DCF analysis far enough, one would
eventually forecast steady state, and an equivalent valuation to an accrual accounting valuation
would result.
Here we lay out the situations where DCF valuation and residual earnings valuation are
equivalent and where they are not. The material here is somewhat technical but is worth
mastering if you wish to be comfortable in choosing a valuation technology.
As stated Chapter 4, the discounted cash flow (DCF) valuation model is
T
 C  I T 1  T
 /  F  NFO o .
V0E    F t C t  I t    T 1
t 1
  F  gCF 
Case 3 (A.1a)
To be compact, we use the summation notation to indicate summed forecasts of discounted cash
flows to the forecast horizon, T. This calculation will give the correct valuation if free cash flow
is forecasted to grow at the rate g(CF) after T and if net financial obligations (NFO) are at market
value. We indicate the anticipated growth rate as g(CF), "growth in free cash flow," to
distinguish it from growth in residual operating earnings (ReOI). This calculation is called Case
3 because, like Case 3 of the ReOI valuation, it involves growth in the continuing value. Case 2
applies when there is no growth in free cash flow anticipated after the horizon and accordingly
the continuing free cash flow is capitalized at the rate, F  1:
T
 C  I T 1  T
 /  F  NFO o .
V0E    F t C t  I t    T 1


1
t 1
F


Case 2 (A.1b)
To compare DCF and ReOI valuation techniques we will work with PPE Inc., the example in
Chapters 14 and 15 where we introduced ReOI valuation. The panel below reproduces the pro
forma cash flow statement for PPE Inc. and calculates the value of the operations using DCF
valuation with a four-year forecast horizon. The forecasted operating income (OI) and change in
net operating assets (NOA) from which the free cash flow is calculated are taken directly from
earlier panels for PPE in Chapter 15. The value of the operations, 103.68, is the same as that
calculated using the ReOI model in Chapter 15 and the value of the equity, after subtracting net
financial obligations, is the same value of 103.68  7.7 = 95.98. The free cash flow is forecasted
to grow indefinitely after Year 4 at 5% a year and this is incorporated in the continuing value.
Indeed, the free cash flow is predicted to grow at 5% from Year 1 onwards, so we can value the
firm with a horizon of one year:
17-25
Chapter 17 - Creating Accounting Value and Economic Value
V0NOA 
C1  I1
6.57

 103.63
F  g(CF) 1.1134  1.05
which is the same valuation as in Chapter 15, allowing for rounding error.
17-26
Chapter 17 - Creating Accounting Value and Economic Value
PPE Inc.: Pro Forma Cash Flow Statement and Case 3 Discounted Cash Flow Valuation
Forecast, year t
0
1
2
3
4
5
9.80
4.52
5.28
10.29
3.72
6.57
10.81
3.91
6.90
11.35
4.10
7.25
11.92
4.31
7.61
12.51
4.52
7.99
5.28
0.00
5.28
3.81
2.76
6.57
4.10
2.80
6.90
4.40
2.85
7.25
4.73
2.88
7.61
5.08
2.91
7.99
Discount rate (0.1134)
1.1134
1.2397
1.3802
1.5368
Growth in free cash flow (%)
24.4
5.0
5.0
5.0
5.57
5.25
4.95
Free cash flow
OI
NOA
Financing flows
Dividends
Debt
PV of free cash flow to year 4
Total PV of free cash flow
5.90
21.67
Continuing value (g = 1.05)1
PV of continuing value
Value of operations V0NOA 
1
126.03
82.01
103.68
CV = 7.99/(1.1134 1.05) = 126.03
17-27
5.0
Chapter 17 - Creating Accounting Value and Economic Value
The DCF analysis here gives the same calculation as the ReOI calculation with the same forecast
horizon. So, can they be used interchangeably? If so, what was all the fuss in Chapter 4 and in
this chapter where we criticized the DCF approach? Does accrual accounting versus cash
accounting for the future make any difference? Why doesn't the DCF model work for the WalMart case in Chapter 4 and Starbucks in this chapter? Well, the DCF model works for PPE, Inc.
only because it's a special case. We'll show this shortly, but to make a comparison of the two
models it is helpful to restate the ReOI model in a form that refers to cash flows.
Equivalent Valuation Methods
In the appendix to Chapter 5 we pointed out that residual earnings valuation can be done in
different ways that yield equivalent valuations. And so can the ReOI valuation. The residual
earnings model, we saw, can be stated as the dividend discount model with a continuing value
appropriate for Cases 1, 2 and 3. For Case 3 the restatement is:
t
 NI  g  1 C S E T  T
V0T    Et d t   T 1
 / E
E  g
t 1


where g is the anticipated growth in residual earnings after the horizon. The terminal value
supplies the expected value of the equity at the horizon, VTE . One thinks of the current value,
V0E , as the present value of the terminal value, cum dividend. In the same way the ReOI model
can be stated in terms of discounted dividends plus a horizon value. But the dividends are not
the cash paid to shareholders. The dividends from operating activities are the cash that the
operations pay off to the financing activities. That is, they are the free cash flow from operations
that are invested in financial assets or reduce financial obligations. (And they can be negative if
more cash is required for operations.)
17-28
Chapter 17 - Creating Accounting Value and Economic Value
Restated in terms of discounted "dividends," Case 3 of the ReOI model is:
T
 OI  g  1NO A T
V0E    F t C t  I t    T 1
F  g
t 1

 T
 /  F  NFO o .

Case 3 (A.2a)
where g is now the anticipated growth in ReOI after the horizon. The terminal value is the
expected value of the operations at T, VTNOA . One thinks of the current value of the operations,
V0NOA , as the present value of their terminal value cum-dividend. Clearly the form of the
restated residual earnings and ReOI models is the same but the restated ReOI model forecasts
free cash flows rather than dividends, operating income at the horizon rather than net income,
and NOA at the horizon rather than CSE to reflect that we are dealing with the value of the
operations, not the equity. Then, in both cases, the value of the net debt is subtracted from the
value of the operations to yield the equity value.
We refer to the restated ReOI model as the cash flow version of the ReOI model.2 The cash flow
version of the ReOI model always gives the same valuation as the original ReOI model. We can
proof the equivalency for PPE Inc., now with a required return for operations of 11.34%. Let's
set a four-year horizon and value PPE's operations using the ReOI model:
PPE Inc.: Valuation Using ReOI Model with Four-Year Horizon
Forecast, year t
0
1
2
3
4
5
ReOI
1.85
1.95
2.05
2.15
2.25
Discount rate (1.1134t)
1.1134
1.2397
1.3802
1.5368
PV of ReOI
1.67
1.57
1.49
1.40
Total PV of ReOI
6.13
Continuing Value (g = 1.05)1
PV of continuing value
35.49
23.09
2
If you are wondering why we call it an ReOI model (given that ReOI is not in the formula), remember it's
equivalent to the ReOI model calculation. And the model can be restated as
T

Re OI T 1  T
V0E    F1 C  I t   NOA T 
 /  F  NFO o


g
t 1
F


The continuing value here is the forecast of VTNOA , given by the forecasted NOA at T plus a premium based on
subsequent Re OI growing at the rate, g.
17-29
Chapter 17 - Creating Accounting Value and Economic Value
NOAo
74.42
Value of operations V0NOA 
1
CV 
103.64
2.25
 35.49
.0634
You can show that this value is the same at valuing the firm with a one-year forecasts horizon:
V = NOA 
= 74.42 
= 103.64
Re OI 1
F  g
1.85
1.1134  1.05
(allow for rounding error)
Now let's value the operations using the cash flow version of the ReOI model with the four-year
horizon. Using the forecasts of free cash flows and terminal operating income and net operating
assets in the pro forma, the valuation is as follows:
17-30
Chapter 17 - Creating Accounting Value and Economic Value
PPE Inc.: Valuation Using Cash Flow Version of ReOI Model with Four-Year Horizon
Forecast, year t
0
1
2
3
4
Free cash flow
6.57
6.90
7.25
7.61
Discount rate (1.1134t)
1.1134
1.2397
1.3802
1.5368
PV of free cash flow
5.90
5.57
5.25
4.95
Total PV of free cash flow
5
21.67
Terminal OIT+1
12.51
Terminal NOAT
90.46
Terminal value (g = 1.05)1
125.98
PV of terminal value
81.97
Value of operations V0NOA 
1
TV 
103.64
12 .51  .05 x 90 .46 
 125 .98
.0634
The valuation of the operations here is the same as the ReOI model valuation. And the valuation
is also the same as that for the DCF model.
Case 2 of the cash flow version of the ReOI model sets g = 1 (in A.2a) to recognize that ReOI
will be constant after the horizon:
T
 OI 
V0E    F t C  I t   T 1  /  TF  NFO o
t 1
 F  1
Case 2 (A.2b)
This gives the same valuation as Case 2 for the ReOI model and you see it has the same form as
the restated Case 2 of the RE model in the appendix to Chapter 5. Here the horizon value is
calculated simply by capitalizing the forecasted operating income for T+1. This terminal value
is the same as the valuation with an SF2 forecast (see Chapter 14) but with the valuation done at
the horizon rather than at time 0. Here ReOI is expected to be constant after the future horizon
whereas, with an SF2 forecast, it's expected to be constant for all future years after the current
one. Case 1 of the cash flow version of the ReOI model (where ReOI is expected to be zero after
the horizon) is:
17-31
Chapter 17 - Creating Accounting Value and Economic Value
V0E    F t C  I t  NOA T /  TF  NFOo
T
Case 1 (A.2c)
t 1
This gives the same valuation as Case 1 of the ReOI model; it is the same form as Case 1 of the
RE model in the appendix to Chapter 5. Here the NOA at the horizon are expected to earn at the
cost of capital so their forecasted book value is indeed the expected value of the operations at
that date. So the terminal value is the same calculation as that for the SF1 forecast. The
accompanying box summarizes the terminal value and the forecasts involved.
Forecasts and Terminal Valuations for the Cash Flow Version of the ReOI Model
Case
Forecast of ReOI at Horizon
Terminal Valuation
VTNOA  NO A T
Case 1
Zero (SF1)
Case 2
Constant (SF2)
Case 3
Growing at a constant rate
VTNOA 
O I T 1
 F 1
VTNOA 
O I T 1  g  1NO A T
F  g
Are the DCF and Residual Earnings Techniques Equivalent?
Having expressed the ReOI model in terms of discounted cash flows, we can compare it with the
DCF model directly. Placing their Case 3 versions beside each other,
 C  I T 1  T
 / F
   F t C t  I t    T 1





g
CF
t 1
 F

T
NOA
0
DCF Model : V
 OI  g  1NOA T
   F t C t  I t    T 1
F  g
t 1

T
NOA
0
Re OI Model : V
(A.1a)
 T
 / F


(A.2a)
Clearly the two approaches give the same valuation for the same horizon if the two terminal
values here are the same. Indeed the two approaches gave us the same valuation in the PPE case.
But let's modify the forecasts for PPE Inc. a little. In discussing the features of the ReOI model
in Chapter 15 we demonstrated that an anticipated investment of 50 million at the end of Year 2
would not affect the current valuation if it was forecasted to earn at the cost of capital. The pro
17-32
Chapter 17 - Creating Accounting Value and Economic Value
forma with this anticipated investment is laid out below with the forecast horizon extended to
seven years.
You can see that the 50 million investment has been added to the net operating assets for Year 2.
The ATO on this investment is predicted to be the same as that for existing investments, 1.762.
But the forecasted profit margin on the sales from the investment is 6.44%, so the expected
RNOA is 11.34%, the cost of capital.3 The overall RNOA and profit margins in the pro forma
after Year 2 are based on total operating income, net operating assets and sales from the existing
investments and the new investment and, are weighted averages of those on the existing and new
investments. The drivers yield the same total ReOI and growth in ReOI as before and thus the
new investment does not affect the valuation.
But look now at the free cash flow forecast. Whereas the firm can be valued using the ReOI
model with a forecast horizon of one year, this is not the case for the DCF valuation. Free cash
flows are not growing at a constant rate. Indeed free cash flows are predicted to be negative in
Year 2 (due to the cash investment) and this is rewarded with higher free cash flow later. But the
free cash flow is not forecasted to grow at a constant rate after Year 2. The forecast horizon will
have to be quite long for forecasted free cash flow to settle down to a steady state with constant
growth.
3
To keep it simple we assume that any depreciation is replaced with further investment at the cost of capital.
17-33
Chapter 17 - Creating Accounting Value and Economic Value
PPE Inc.: Operating Activities Pro Forma with Anticipated Value-Neutral Investment in Year 2
Forecast year, t
Income Statement
Sales
Core operating expenses
Core operating income
0
1
2
3
4
5
6
7
131.15
120.86
10.29
137.70
126.89
10.81
232.67
215.65
17.02
239.91
222.32
17.59
247.49
229.31
18.18
255.48
236.67
18.81
263.85
244.38
19.47
Balance Sheet
Net operating assets
78.15
132.05
136.16
140.46
144.99
149.73
154.72
Cash Flow Statement
OI
NOA
Free cash flow (C-I)
10.29
3.72
6.57
10.81
53.90
(43.09)
17.02
4.10
12.92
17.59
4.31
13.28
18.18
4.52
13.66
18.81
4.75
14.06
19.47
4.99
14.48
ReOI Drivers
RNOA (%)
Profit margin (%)
Asset turnover
Growth in NOA (%)
.1383
7.85
1.762
5.00
.1383
7.85
1.762
68.97
.1289
7.32
1.762
3.11
.1292
7.33
1.762
3.16
.1294
7.35
1.762
3.22
.1297
7.36
1.762
3.28
.1300
7.38
1.762
3.33
Residual OI (0.1134)
Growth in ReOI (%)
1.85
5.0
1.95
5.0
2.05
5.0
2.15
5.0
2.25
5.0
2.37
5.0
2.49
5.0
Free Cash Flow Growth Drivers
Growth in free cash flow (%)
Growth in OI (%)
Growth in NOA (%)
24.4
5.05
5.00
(655.9)
5.0
68.97
--57.45
3.11
2.80
3.33
3.16
2.87
3.39
3.22
2.92
3.44
3.28
2.98
3.49
3.33
17-34
When Will DCF Analysis Work?
We have seen DCF analysis work for the same horizon as the ReOI model for PPE Inc. What
are the situations where this occurs? Well, look back at the terminal values for Case 3 of the two
models that are compared in expressions (A.1a) and (A.2a).
As CT 1  I T 1 
OI T 1  NO A T 1 , free cash flow will grow at a constant rate if OI and NOA grow at the same
rate. And this occurs when the net operating assets generate operating income at a constant rate,
that is, when RNOA is expected to be constant: OI is generated from NOA so, for OI to grow at
the same rate as NOA, the rate of return on NOA must be constant. But when this is so, any
forecasted growth in ReOI, g, is due only to growth in NOA. The forecast of g  1 NOA T in
the terminal value of the ReOI model (in A.2a) is, in this case, a forecast of NOAT 1 , and
OIT 1  g  1 NOAT is equal to OI T 1  NOA T which is the same as C T 1  I T 1 . So the
anticipated growth in free cash flow, g(CF), equals the anticipated growth in ReOI, g. Under
these conditions the two methods are equivalent and the DCF calculation gives the correct
valuation. This was the case in the original PPE pro forma. But not so for the pro forma
modified for new investment.
Comparing the Case 2 version of the ReOI model (in A.2b) with Case 2 of the DCF model (in
A.1b), it is clear that the two models give the same valuation when C  I T 1  OI T 1 , and
perpetually so. That is, the valuations are the same when one forecasts no growth in NOA and
constant RNOA after the horizon.
The distinguishing feature of the modified pro forma was the negative free cash flow in Year 2.
But the determining feature for the horizon point is the changing RNOA that the new investment
induced. The changing RNOA results in operating income changing at a different rate from
NOA and this yields non-constant growth in free cash flow. Indeed you can see at the bottom of
the pro forma with the investment in Year 2 that, not only is RNOA changing each year, but
forecasted OI and NOA are also growing at different rates. ReOI on the other hand is forecasted
to grow at a constant rate.
If forecasted free cash flow is positive, DCF analysis will work if we forecast RNOA to be
constant so that any growth in ReOI comes from growth in NOA alone. This of course is the
case of an SF3 "simple" forecast (in Chapter 14) but with the forecast applying at the horizon
rather than currently. ReOI valuation will work more generally where growth comes from
profitability as well as growth in NOA. If one wants to forecast cash flows, one is advised to use
the terminal value in (A.2a) rather than that in (A.1a). But this of course effectively transforms
the calculation to the ReOI model and, given one must forecast OI and NOA to forecast free cash
flows, one might just as well use the ReOI model.
Chapter 17 - Creating Accounting Value and Economic Value
Both DCF analysis and ReOI analysis will work well if forecast horizons are very long. But the
further one forecasts into the future the less certain one typically is about the forecast. The ReOI
model has the feature that in most cases more of the value is captured by the current net
operating assets and forecasts over the first few years. Thus it is less susceptible to errors in
prediction for later years, particularly in forecasting long-term growth rates. DCF analysis, on
the other hand, places much more weight on the terminal value. In the extreme, if free cash
flows are forecasted to be negative in the initial years, over 100% if the valuation comes from
forecasts for the "long run."
In some cases, future cash flows can be in the very distant future. Consider employee pension
payments; these often are cash flows well into the future. Accrual accounting accounts for them
in the present. DCF analysis has difficulty in capturing value from investments in subsidiaries.
The cash flows from the investments are the dividends they pay, but dividends (if any) do not
usually capture value. Accrual accounting captures value through the equity method.
Under the right conditions DCF analysis can be used interchangeably with ReOI analysis. But
one might just as well use the ReOI approach with more general applicability. And the ReOI
model has the right mentality. The DCF approach is conceptually flawed because one wants to
get at the source of the value generation in the operating activities, not the "dividends" from the
operating activities. One wants to "account for the future" in terms of operating income and net
operating assets and, having done this, one does not want to "back out the accruals" to get to the
cash flows. Cash is king, yes, because investors ultimately want cash. But the valuation
problem is one of forecasting what the ultimate cash will be and cash generated in the short term
may not be a good indicator of this. Indeed negative free cash flows are often generated to beget
the ultimate cash.
Readers’ Corner
The properties of conservative accounting and its effects of P/B and P/E ratios are modeled and
discussed in the following papers:
Feltham, J., and J. Ohlson. 1995. Valuation and clean surplus accounting for operating and
financial activities.” Contemporary Accounting Research 11 (2): 689-731.
Zhang, X. 2000. Conservative accounting and equity valuation. Journal of Accounting and
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Chapter 17 - Creating Accounting Value and Economic Value
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