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					                                CHAPTER SIXTEEN
                  Creating Accounting Value and Economic Value

                                      Stephen H. Penman

The web page for this chapter 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 16 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
16.2 and 16.3 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 16.6
provides a summary.
Metrics that Indicate the Hidden Reserves Created by Conservative Accounting and the
Release of Hidden Reserves

Table 16.7 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

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
16.1 – 16.5 in the text before proceeding.

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
        RNOA t+1  g                               .
                          (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                 ,
                            rg

it is now clear that enterprise P/B ratio is a function of accounting methods too. 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.
      1: To show that RNOA and P/B is a investment, we can find the rate
Case 2:To show that given any return on funtion of Investment turnover, of investment
expense (the amount of conservatism) that rate.
investment expense ratio, and depreciation produces target RNOA and P/B ratio.
   Required rate of return             10% <-change your assumption here
                                      10%
               expense (Year
   Investment turnover rate 1)         10% <-change your assumption here
                                      60%
                              1)
   Investment turnover (Year 2)        60% <-change your assumption here
                                      55%
   Investment turnover (Year
   Depreciation rate (Year 1) 2)       55% <-change your assumption here
                                      50%
   Depreciation rate (Year
   Investment growth rate 1)           50% <-change your assumption here
                                        5%
   Investment growth rate
   Target RNOA                          5% <-change your assumption here
                                    10.6%
   Target P/B                          1.11
                                      1.11
   Target RNOA
   Investment expense rate           10.6%
                                   10.00%

                                      2004
                                      2004       2005
                                                  2005    2006
                                                           2006      2007
                                                                      2007     2008
                                                                                 2008
Sales
Sales
   From investments in 2004
   From investments in 2004                     240.0
                                                 240.0    220.0
                                                           220.0
   From investments in 2005
   From investments in 2005                               252.0
                                                           252.0    231.0
                                                                     231.0
   From investments in 2006
   From investments in 2006                                         264.6
                                                                     264.6     242.6
                                                                                 242.6
   From investments in 2007
   From investments in 2007                                                    277.8
                                                                                 277.8
                                                240.0
                                                 240.0    472.0
                                                           472.0    495.6
                                                                     495.6     520.4
                                                                                 520.4

Operating expenses (depreciation)
Operating expenses (depreciation)
  From investments in 2004
  From investments in 2004            40.0
                                      40.0      180.0
                                                 180.0    180.0
                                                           180.0
  From investments in 2005
  From investments in 2005                       42.0
                                                  42.0    189.0
                                                           189.0    189.0
                                                                     189.0
  From investments in 2006
  From investments in 2006                                 44.1
                                                            44.1    198.5
                                                                     198.5     198.5
                                                                                 198.5
  From investments in 2007
  From investments in 2007                                           46.3
                                                                      46.3     208.4
                                                                                 208.4
  From investments in 2008
  From investments in 2008                                                      48.6
                                                                                   48.6
                                      40.0
                                      40.0      222.0
                                                 222.0    413.1
                                                           413.1    433.8
                                                                     433.8     455.4
                                                                                 455.4

Operating income
Operating income                      (40.0)
                                     (40.0)      18.0
                                                  18.0     58.9
                                                            58.9     61.8
                                                                      61.8      64.9
                                                                                   64.9

Net Operating Asset (NOA)
Net Operating Asset (NOA)
   From investments in 2004
   From investments in 2004          360.0
                                     360.0      180.0
                                                 180.0
   From investments in 2005
   From investments in 2005                     378.0
                                                 378.0    189.0
                                                           189.0
   From investments in 2006
   From investments in 2006                               396.9
                                                           396.9    198.5
                                                                     198.5
   From investments in 2007
   From investments in 2007                                         416.7
                                                                     416.7     208.4
                                                                                 208.4
   From investments in 2008
   From investments in 2008                                                    437.6
                                                                                 437.6
                                     360.0
                                     360.0      558.0
                                                 558.0    585.9
                                                           585.9    615.2
                                                                     615.2     646.0
                                                                                 646.0

Investment
Investment                             400.0
                                      400.0      420.0
                                                  420.0   441.0
                                                           441.0    463.1
                                                                     463.1     486.2
                                                                                 486.2
Free cash flow
Free cash flow                       (400.0)
                                    (400.0)    (180.0)
                                                (180.0)    31.0
                                                            31.0     32.6
                                                                      32.6      34.2
                                                                                   34.2

RNOA (%)
RNOA (%)                                           5.0
                                                    5.0    10.6
                                                            10.6      10.6
                                                                        10.6    10.6
                                                                                   10.6
Profit margin (%)
Profit margin (%)                                  7.5
                                                    7.5    12.5
                                                            12.5      12.5
                                                                        12.5    12.5
                                                                                   12.5
Asset turnover
Asset turnover                                     0.7
                                                    0.7     0.8
                                                             0.8        0.8
                                                                         0.8     0.80.8
Growth in NOA (%)
Growth in NOA (%)                                 55.0
                                                   55.0     5.0
                                                             5.0        5.0
                                                                         5.0     5.05.0
ReOI
ReOI                                            (18.0)
                                                 (18.0)     3.1
                                                             3.1        3.3
                                                                         3.3     3.43.4
Growth in ReOI (%)
Growth in ReOI (%)                                N/A
                                                   N/A      N/A
                                                             N/A        5.0
                                                                         5.0     5.05.0
Growth in cum-dividend OI (%)
Growth in cum-dividend OI (%)                             127.2
                                                           127.2      10.3
                                                                        10.3    10.3
                                                                                   10.3
AOIG (0.10)
AOIG (0.10)                                                21.1
                                                            21.1        0.2
                                                                         0.2     0.20.2
Growth in AOIG (%)
Growth in AOIG (%)                                          N/A
                                                             N/A     -99.3
                                                                       -99.3     5.05.0

Value of firm
Value of firm                        400.0
                                     400.0      620.0
                                                 620.0    651.0
                                                           651.0    683.6
                                                                     683.6     717.7
                                                                                  717.7
Premium over book value
Premium over book value                          62.0
                                                  62.0     65.1
                                                            65.1     68.4
                                                                      68.3      71.8
                                                                                   71.8
P/B
P/B                                   1.11
                                      1.11       1.11
                                                  1.11     1.11
                                                            1.11     1.11
                                                                      1.11      1.11
                                                                                   1.11
Trailing P/E
Trailing P/E                                     24.4
                                                  24.4     11.6
                                                            11.6     11.6
                                                                      11.6      11.6
                                                                                   11.6
Forward P/E
Forward P/E                           22.2
                                      22.2       10.5
                                                  10.5     10.5
                                                            10.5     10.5
                                                                      10.5      10.5
                                                                                   10.5
Equity Return
Equity Return                                    10%
                                                  10%      10%
                                                            10%      10%
                                                                      10%       10%10%
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       2005      2006      2007     2008
Sales
   From investments in 2004                     240.0     220.0
   From investments in 2005                               252.0     231.0
   From investments in 2006                                         264.6     242.6
   From investments in 2007                                                   277.8
                                                240.0     472.0     495.6     520.4

Operating expenses (depreciation)
  From investments in 2004             40.0     180.0     180.0
  From investments in 2005                       42.0     189.0     189.0
  From investments in 2006                                 44.1     198.5     198.5
  From investments in 2007                                           46.3     208.4
  From investments in 2008                                                     48.6
                                       40.0     222.0     413.1     433.8     455.4

Operating income                     (40.0)      18.0      58.9       61.8        64.9

Net Operating Asset (NOA)
   From investments in 2004           360.0     180.0
   From investments in 2005                     378.0     189.0
   From investments in 2006                               396.9     198.5
   From investments in 2007                                         416.7     208.4
   From investments in 2008                                                   437.6
                                      360.0     558.0     585.9     615.2     646.0

Investment                            400.0      420.0    441.0     463.1     486.2
Free cash flow                      (400.0)    (180.0)     31.0      32.5      34.2

RNOA (%)                                           5.0     10.6       10.6        10.6
Profit margin (%)                                  7.5     12.5       12.5        12.5
Asset turnover                                     0.7      0.8        0.8         0.8
Growth in NOA (%)                                 55.0      5.0        5.0         5.0
ReOI                                            (18.0)      3.1        3.3         3.4
Growth in ReOI (%)                                 N/A      N/A        5.0         5.0
Growth in cum-dividend OI (%)                             127.2       10.3        10.3
AOIG (0.10)                                                21.1        0.2         0.2
Growth in AOIG (%)                                          N/A      -99.3         5.0

Value of firm                         399.9     619.9     650.9     683.5     717.7
Premium over book value                          61.9      65.0      68.3      71.7
P/B                                    1.11      1.11      1.11      1.11      1.11
Trailing P/E                                     24.4      11.6      11.6      11.6
Forward P/E                            22.2      10.5      10.5      10.5      10.5
Equity Return                                    10%       10%       10%       10%
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       2005       2006       2007     2008
Sales
   From investments in 2004                      240.0       220.0
   From investments in 2005                                  252.0     231.0
   From investments in 2006                                            264.6    242.6
   From investments in 2007                                                     277.8
                                                 240.0       472.0     495.6    520.4

Operating expenses (depreciation)
  From investments in 2004             40.0      179.9       180.1
  From investments in 2005                        42.0       188.9     189.1
  From investments in 2006                                    44.1     198.4    198.5
  From investments in 2007                                              46.3    208.3
  From investments in 2008                                                       48.6
                                       40.0      221.9       413.1     433.8    455.4

Operating income                      (40.0)      18.1        58.9      61.8     64.9

Net Operating Asset (NOA)
   From investments in 2004           360.0      180.1
   From investments in 2005                      378.0       189.1
   From investments in 2006                                  396.9     198.5
   From investments in 2007                                            416.7    208.4
   From investments in 2008                                                     437.6
                                      360.0      558.1       586.0     615.3    646.0

Investment                             400.0      420.0      441.0     463.1    486.2
Free cash flow                       (400.0)    (180.0)       31.0      32.6     34.2

RNOA (%)                                            5.0       10.6       10.6    10.6
Profit margin (%)                                   7.5       12.5       12.5    12.5
Asset turnover                                      0.7        0.8        0.8     0.8
Growth in NOA (%)                                  55.0        5.0        5.0     5.0
ReOI                                             (17.9)        3.1        3.3     3.4
Growth in ReOI (%)                                 N/A         N/A        5.0     5.0
Growth in cum-dividend OI (%)                                126.5       10.3    10.3
AOIG (0.10)                                                   21.0        0.2     0.2
Growth in AOIG (%)                                             N/A      -99.3     5.0

Value of firm                         400.0      620.0       651.0     683.6    717.7
Premium over book value                           61.9        65.0      68.3     71.7
P/B                                    1.11       1.11        1.11      1.11     1.11
Trailing P/E                                      24.4        11.6      11.6     11.6
Forward P/E                            22.2       10.5        10.5      10.5     10.5
Equity Return                                     10%         10%       10%      10%
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      2005    2006    2007    2008
Sales
   From investments in 2004                    240.0    220.0
   From investments in 2005                             252.0   231.0
   From investments in 2006                                     264.6   242.6
   From investments in 2007                                             277.8
                                               240.0    472.0   495.6   520.4

Operating expenses (depreciation)
  From investments in 2004            40.0     180.0    180.0
  From investments in 2005                      42.0    189.0   189.0
  From investments in 2006                               44.1   198.5   198.5
  From investments in 2007                                       46.3   208.4
  From investments in 2008                                               48.6
                                      40.0     222.0    413.1   433.8   455.4

Operating income                     (40.0)     18.0     58.9    61.8    64.9

Net Operating Asset (NOA)
   From investments in 2004          360.0     180.0
   From investments in 2005                    378.0    189.0
   From investments in 2006                             396.9   198.5
   From investments in 2007                                     416.8   208.4
   From investments in 2008                                             437.6
                                     360.0     558.0    585.9   615.2   646.0

Investment                            400.0     420.0   441.0   463.1   486.2
Free cash flow                      (400.0)   (180.0)    31.0    32.5    34.2

RNOA (%)                                          5.0    10.6    10.6    10.6
Profit margin (%)                                 7.5    12.5    12.5    12.5
Asset turnover                                    0.7     0.8     0.8     0.8
Growth in NOA (%)                                55.0     5.0     5.0     5.0
ReOI                                           (18.0)     3.1     3.3     3.4
Growth in ReOI (%)                                N/A     N/A     5.0     5.0
Growth in cum-dividend OI (%)                           127.2    10.3    10.3
AOIG (0.10)                                              21.1     0.2     0.2
Growth in AOIG (%)                                        N/A   -99.3     5.0

Value of firm                        400.0     620.0    651.0   683.6   717.7
Premium over book value                         62.0     65.1    68.4    71.8
P/B                                   1.11      1.11     1.11    1.11    1.11
Trailing P/E                                    24.4     11.6    11.6    11.6
Forward P/E                           22.2      10.5     10.5    10.5    10.5
Equity Return                                   10%      10%     10%     10%
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       2005     2006      2007     2008
Sales
   From investments in 2004                     240.0    220.0
   From investments in 2005                              203.4     186.5
   From investments in 2006                                        172.5     158.1
   From investments in 2007                                                  146.2
                                                240.0    423.4     358.9     304.3

Operating expenses (depreciation)
  From investments in 2004             8.6      195.7    195.7
  From investments in 2005                        7.3    165.9     165.9
  From investments in 2006                                 6.2     140.6     140.6
  From investments in 2007                                           5.2     119.2
  From investments in 2008                                                     4.4
                                       8.6      203.0    367.8     311.7     264.3

Operating income                      (8.6)      37.0     55.7       47.2     40.0

Net Operating Asset (NOA)
   From investments in 2004          391.4      195.7
   From investments in 2005                     331.8    165.9
   From investments in 2006                              281.2     140.6
   From investments in 2007                                        238.4     119.2
   From investments in 2008                                                  202.1
                                     391.4      527.5    447.1     379.0     321.3

Investment                            400.0     339.1    287.4     243.6     206.5
Free cash flow                      (400.0)     (99.1)   136.0     115.3      97.7

RNOA (%)                                           9.5    10.6       10.6     10.6
Profit margin (%)                                15.4     13.1       13.1     13.1
Asset turnover                                     0.6     0.8        0.8      0.8
Growth in NOA (%)                             34.7682    -15.2      -15.2    -15.2
ReOI                                              5.7     13.5       11.4      9.7
Growth in ReOI (%)                                N/A    136.7      -15.2    -15.2
Growth in cum-dividend OI (%)                             29.0        4.3      4.3
AOIG (0.10)                                                7.8       -2.1     -1.7
Growth in AOIG (%)                                        N/A      -126.4      N/A

Value of firm                        450.4      585.5    496.3     420.7     356.6
Premium over book value                          58.0     49.2      41.7      35.3
P/B                                   1.15       1.11     1.11      1.11      1.11
Trailing P/E                                     13.1     11.4      11.4      11.4
Forward P/E                           12.2       10.5     10.5      10.5      10.5
Equity Return                                     8%       8%        8%        8%
Accounting Issues in Forecasting: Starbucks Corporation

Chapter 14 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?
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 16, 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.
                                   Forecast Quality Issues


                                                 The Effect of Growth Forecasts on the Quality
Quality of RNOA Forecasts
                                                     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.
Starbucks Corporation. Summary of residual operating income drivers, 1993 – 97.


                                       1993         1994        1995         1996        1997

Sales ($ thousands)                   176,541     284,923      465,213     696,481     966,946
Operating income ($ thousands)          7,253      15,051       24,406      31,081      53,252
As a % of sales:
 Gross margin                          54.4         55.3        54.6        51.8         55.3
 Store operating expenses              32.1         32.7        32.0        30.3         32.0
 Other operating expenses               3.0          3.1         3.0         2.8          2.9
 Depreciation and amortization          3.8          4.4         4.8         5.2          5.4
 General and administrative             8.4          7.0         6.2         5.3          5.9
    expenses
 Taxes on core income                   2.8          2.9         3.4          3.7          3.5

Core profit margin (%)                  4.4          5.3         5.2          4.5         5.6
Asset turnover                          1.89         2.00        1.74         1.84        1.95
Core RNOA (%)                           8.3         10.6         9.0          8.3        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 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.

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.

        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,
Pepsi-Cola 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?

        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.


1
    See the special issue on real options in, The Quarterly Review of Economics and Finance, 1998.
        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.

        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
high-quality 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 16. 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 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.

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 16. Conservative and liberal accounting disturb the
matching. But we also saw in Chapter 16 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 16. But what if, in
the Chapter 16 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.

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 8 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 8. 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).


Starbucks Corporation. Adjustments to operating income for stock issues to employees (in
thousand of dollars except share and per-share items)


                                                     1993           1994           1995           1996         1997
Employee Stock Option Plan
  Shares issued                                      1,407           774            946           1,177        1,382
  Weighted-average share price                       20.38          25.16          16.44          23.87        34.81
  Weighted-average exercise price                     8.59           9.25           3.34           6.78        9.92

   Loss (before tax)                                 16,591         12,311        12,390         20,128       34,409
   Tax benefit                                        5,243          3,719         4,754          6,808        9,626
   Implicit wages expense (after tax)                11,348          8,592         7,636         13,320       24,783

Employee Stock Purchase Plan
  Proceeds of share issues                                                          263           1,735        2,313
  Implicit wages expense                                                             46            306          408

Total implicit wages expense                         11,348         8,592          7,782         13,626       25,191

Restated comprehensive operating income             (4,095)         6,459         16,624         17,455       28,061
Restated RNOA (%)                                     -4.7           4.5            6.2           4.6          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:

       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.

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 16.7 in Chapter 16. 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.


Equivalences: Residual earnings and Discounted Cash Flow Approaches to Valuation

Table 16.14 in Chapter 16 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

                                                     C  I T 1  T
                       V0E     t C t  I t    T 1
                              T

                                  F                    gCF  /  F  NFOo .
                                                                                    Case 3 (A.1a)
                             t 1                    F          

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:

                                                     C  I T 1  T
                       V0E     t C t  I t    T 1
                              T

                                  F                    1  /  F  NFOo .
                                                                                    Case 2 (A.1b)
                             t 1                        F      
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:

                                      C1  I1      6.57
                          V0NOA                             103.63
                                    F  g(CF) 1.1134  1.05

which is the same valuation as in Chapter 15, allowing for rounding error.
PPE Inc.: Pro Forma Cash Flow Statement and Case 3 Discounted Cash Flow Valuation

Forecast, year t                           0       1        2        3         4      5

Free cash flow

          OI                             9.80    10.29    10.81    11.35     11.92   12.51
          NOA                           4.52     3.72     3.91     4.10      4.31    4.52
                                         5.28     6.57     6.90     7.25      7.61    7.99


Financing flows

          Dividends                      5.28     3.81     4.10     4.40      4.73    5.08
          Debt                           0.00     2.76     2.80     2.85      2.88    2.91
                                         5.28     6.57     6.90     7.25      7.61    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     5.0


PV of free cash flow to year 4                    5.90     5.57     5.25      4.95


Total PV of free cash flow              21.67


Continuing value (g = 1.05)1                                                126.03


PV of continuing value                  82.01


Value of operations V0NOA             103.68

1
    CV = 7.99/(1.1134 1.05) = 126.03
        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 Wal-
Mart 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     t d t   T 1                  / E
                                                     E  g
                                     E
                                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.)

Restated in terms of discounted "dividends," Case 3 of the ReOI model is:

                                             O I  g  1NO A T    T
               V0E     t C t  I t    T 1
                       T

                                                                    /  F  NFOo .
                                                                                      Case 3 (A.2a)
                                                   F  g
                          F
                     t 1                                          

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. We valued this firm with a one-year horizon
but, as we forecasted ReOI to grow at a constant rate after one year, we get the same value with
any horizon. Let's set a four-year horizon and value PPE's operations using the original 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                                                                35.49

PV of continuing value                     23.09

NOAo                                       74.42

Value of operations V0NOA            103.64




            2.25
1
    CV           35.49
           .0634




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
                                                          Re OI T 1  T
                        V0E    1 C  I t   NOA T 
                               T
                                                                       /  F  NFOo
                                                            F  g 
                                   F
                              t 1               
                                              NOA
The continuing value here is the forecast of VT , given by the forecasted NOA at T plus a premium based on
subsequent Re OI growing at the rate, g.
The valuation of 103.64, is the same as in Chapter 15 with a shorter horizon (allowing for
rounding error): extending the horizon always gives the same valuation once the long-run
profitability has been forecasted. 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:


PPE Inc.: Valuation Using Cash Flow Version of ReOI Model with Four-Year Horizon

Forecast, year t                              0           1          2           3          4           5

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                   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                 103.64

1          12.51  .05 x 90.46
    TV                           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:

                                                                  OI 
                                       V0E     t C  I t   T 1  /  T  NFOo
                                              T

                                                  F                 1 F                     Case 2 (A.2b)
                                             t 1                 F    
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:

                               V0E     t C  I t  N O A T /  T  NFO o
                                      T

                                         F                           F                        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

 Case 1                  Zero (SF1)                     VTNOA  N O A T

 Case 2                Constant (SF2)                             O I T 1
                                                        VTNOA 
                                                                   F 1

 Case 3          Growing at a constant rate                       OI T 1  g  1NOA T
                                                        VTNOA 
                                                                           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
                    DCF Model : V0NOA     t C t  I t    T 1
                                         T
                                                                            
                                             F                    gCF  /  F                  (A.1a)
                                        t 1                    F          

                                                            OI  g  1NOA T        T
              Re OI Model : V0NOA     t C t  I t    T 1
                                     T
                                                                                      / F         (A.2a)
                                         F                       F  g             
                                    t 1                                            
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 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.
PPE Inc.: Operating Activities Pro Forma with Anticipated Value-Neutral Investment in Year 2

Forecast year, t                        0          1           2           3           4         5        6         7
Income Statement
  Sales                                         131.15      137.70      232.67       239.91    247.49   255.48   263.85
  Core operating expenses                       120.86      126.89      215.65       222.32    229.31   236.67   244.38
  Core operating income                          10.29       10.81       17.02        17.59     18.18    18.81    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                                             10.29        10.81      17.02        17.59     18.18    18.81    19.47
  NOA                                            3.72        53.90       4.10         4.31      4.52     4.75     4.99
Free cash flow (C-I)                              6.57       (43.09)     12.92        13.28     13.66    14.06    14.48

ReOI Drivers
 RNOA (%)                                        .1383       .1383       .1289       .1292     .1294    .1297     .1300
 Profit margin (%)                                7.85        7.85        7.32        7.33      7.35     7.36      7.38
 Asset turnover                                  1.762       1.762       1.762       1.762     1.762    1.762     1.762
Growth in NOA (%)                                 5.00       68.97        3.11        3.16      3.22     3.28      3.33

Residual OI (0.1134)                              1.85        1.95        2.05        2.15      2.25     2.37     2.49
Growth in ReOI (%)                                 5.0         5.0         5.0         5.0       5.0      5.0      5.0

Free Cash Flow Growth Drivers
Growth in free cash flow (%)                      24.4       (655.9)       ---        2.80      2.87     2.92     2.98
  Growth in OI (%)                                5.05         5.0       57.45        3.33      3.39     3.44     3.49
  Growth in NOA (%)                               5.00        68.97       3.11        3.16      3.22     3.28     3.33
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 C T 1  I T 1 
 OI T 1  N O 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 N O A T in
the terminal value of the ReOI model (in A.2a) is, in this case, a forecast of NOA T 1 , and
OI T 1  g  1 NOA T is equal to O I T 1  N O A 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.
        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
       Economics 29: 125-149.

Beaver, W., and S. Ryan. 2000. Biases and lags in book value and their effects on the ability of
       the book-to-market ratio to predict book return on equity. Journal of Accounting
       Research 38 (Spring): 127-148.

				
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