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Prospective Analysis: Valuation Theory and Concepts




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October November December




Price Volume
Prospective Analysis: Valuation Theory and Concepts




a. In late 1990, approximately 23 million shares were outstanding.
11-54




Schneider and Square D
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Prospective Analysis: Valuation Theory and Concepts




11-55 Part 2 Business Analysis and Valuation Tools




EXHIBIT 6
Valuation Data for Square D

.........................................................................................................................

Square D equity beta 0.95
Moody™s corporate bond average yield in February 1991 for major
Schneider and Square D




ratings:
Aaa 8.83%
Aa 9.16%
A 9.38%
Ba 10.07%
Prime rate in February 1991 8.8%
Treasury bills rates in February 1991 (3 months) 6.0%
Government 30-year treasuries rates in February 1991 8.25%
Square D commercial paper rating in February 1991 (on a scale
from P3 to P1, P1 being the best rating) P1
Square D corporate bonds rating in February 1991 Aa3
US federal statutory tax rate in 1990 34.0%
State income tax rate, net of federal bene¬t in 1990 3.6%
.........................................................................................................................
12
12 Prospective Analysis: Valuation Implementation
chapter




T o move from the valuation theory discussed in the previous chapter to
the actual task of valuing a company, one has to deal with a number of issues. First, the
analyst needs to make forecasts of ¬nancial performance stated in terms of dividends,
earnings, and book values, or free cash ¬‚ows over the life of the ¬rm. As a practical mat-
Business Analysis and 2
Valuation Tools


ter, the forecasting task is often divided into two subcomponents”detailed forecasts
over a ¬nite number of years and a forecast of “terminal value,” which represents a sum-
mary forecast of performance beyond the period of detailed forecasts. Second, the ana-
lyst needs to estimate the cost of capital to discount these forecasts. We discuss these
issues in this chapter, and provide guidance on how to deal with them.


DETAILED FORECASTS OF PERFORMANCE
The horizon over which detailed forecasts are to be made is itself a choice variable. We
will discuss later in this chapter how the analyst might make this choice. Once it is made,
the next step is to consider the set of assumptions regarding a ¬rm™s performance that
are needed to arrive at the forecasts. We described in Chapter 10 the general framework
of ¬nancial forecasting. Since valuation involves forecasting over a long time horizon,
it is not practical to forecast all the line items in a company™s ¬nancial statements. In-
stead, the analyst has to focus on the key elements of a ¬rm™s performance.
The key to sound forecasts, of course, is that the underlying assumptions are
grounded in a company™s business reality. Strategy analysis provides a critical under-
standing of a company™s value proposition, and whether or not current performance is
likely to be sustainable in future. Accounting analysis and ratio analysis provide a deep
understanding of a company™s current performance, and whether the ratios themselves
are reliable indicators of performance. It is, therefore, important to see the valuation
forecasts as a continuation of the earlier steps in business analysis rather than as a dis-
creet and unconnected exercise from the rest of the analysis.
A common practice for generating valuation forecasts is to begin with assumptions
about the following six key performance drivers of a company in each time period: (1)
the sales growth rate over the prior year, (2) the ratio of net operating pro¬t after tax to
sales, (3) the ratio of after-tax net interest expense to net debt, (4) the ratio of net oper-
ating working capital to sales, (5) the ratio of net operating long-term assets to sales, and
(6) the ratio of net debt to net capital. All the balance sheet items in these ratios are


12-1




461
462 Prospective Analysis: Valuation Implementation




12-2
Prospective Analysis: Valuation Implementation




beginning-of-period balances, and all the income statement items are for a given time
period.1 Together, these six assumptions are suf¬cient to forecast a company™s income
statement, balance sheet, cash ¬‚ows, and return on equity.2 To forecast abnormal net op-
erating pro¬t after tax and abnormal earnings, we also need to estimate the ¬rm™s cost
of capital.
We discussed in Chapter 9 the de¬nition of the items used in the above ratios”net
operating pro¬t after tax (NOPAT), after-tax interest expense, net operating working
capital, net operating long-term assets, net debt, and net capital. These are recapped in
Table 12-1.

Table 12-1 Definitions of Financial Items Used in Valuation Forecasts

Variable De¬nition
.....................................................................................................................................................

Net operating pro¬t after tax
Net income + Net Interest Expense — (1 “ Tax rate)
(NOPAT)
(Interest expense “ Interest income) — (1 “ Tax rate)
After-tax net interest expense
Net operating working capital (Current assets “ Excess cash and short-term investments) “ ( Current
liabilities “ Interest-bearing current liabilities) where excess cash is the
cash on the balance sheet less cash needed for supporting operations
Net operating long-term assets (Long-term assets “ Non-interest-bearing long-term liabilities)
Net debt All interest-bearing liabilities “ Excess cash
Net debt + Shareholders™ equity
Net capital
Net operating working capital + Net operating long-term assets
Operating assets
.....................................................................................................................................................


To illustrate the mechanics of forecasting, we show an example in Table 12-2. The
example is for Sigma Inc., with sales of $1,000 million in 1998 and net assets of $715
million ($275 million net operating working capital, and $440 million long-term oper-
ating assets) at the end of 1998. The table shows Sigma™s actual balance sheet at the be-
ginning of 1999, forecasts of summary income statements for 1999 to 2003, and
forecasts of beginning balance sheets for 2000 to 2004.
The forecasted ¬nancial statements are based on the following assumptions:
(1) Sales will grow each year at a rate of 10 percent from 1999 to 2003. Sales in 2004
will grow at 3.5 percent in 2004. (This assumption will be discussed and altered later.)
Sales growth forecast is based on the past pattern of sales for the company, expected
growth in industry sales, and the company™s strategic position within the industry;
(2) The ratio of NOPAT to sales will be 14 percent in 1999, and will decline by 1 percent-
age point each year to 10 percent in 2003. The initial level of assumed NOPAT re¬‚ects the
company™s strategy and its past operating performance. The decline in NOPAT margins re-
¬‚ects the expected increase in competitive forces in this time period;
463
Prospective Analysis: Valuation Implementation




12-3 Part 2 Business Analysis and Valuation Tools




(3) The ratio of after-tax net interest expense to net debt is 5 percent. This is based on
the expected interest rates given the company™s capital structure policy (which will be
discussed later) and forecasted tax rate;
(4) The ratio of net operating working capital (at the beginning of the year) to sales (dur-
ing the year) is 25 percent. Net working capital includes an operating cash balance of 1
percent of sales;
(5) The ratio of net long-term assets (at the beginning of the year) to sales (during the
year) is 40 percent. This assumption re¬‚ects the pattern of asset turnover in the past, ex-
pected depreciation and amortization policies, expected capital expenditures, and ex-
pected increases in deferred tax liability; and
(6) Net debt is assumed to be 40 percent of net capital, based on the company™s business
risk and ¬nancing strategy. Net debt includes any cash and marketable securities bal-
ances that are not required to support operations.


Table 12-2 Forecasts for Valuation of Sigma Inc. from 1999 to 2003

1999 2000 2001 2002 2003 2004
($ millions)
.................................................................................................................................................
Income Statement
Sales $1,100 $1,210 $1,331 $1,464 $1,611 $1,667
Net operating pro¬t
after tax (NOPAT) 121 121 120 117 113
After-tax net interest
expense 14 16 17 19 21
Net income $107 $105 $103 $98 $92
Balance Sheet (at the beginning of the year)
Net operating working
capital $275 $303 $333 $366 $ 403 $417
Net long-term assets 440 484 532 586 644 667
Total net assets $715 $787 $865 $952 $1,047 $1,083
Net debt 286 315 346 381 419 433
Shareholders™ equity 429 472 519 571 628 650
Total net capital $715 $787 $865 $952 $1,047 $1,083
.................................................................................................................................................
Note: The 1999 balance sheet shows the actual balances at the beginning of the year; the balance sheets for the rest
of the years are forecasts of the beginning-of-year balances. Income statements for each year show the forecasted
amounts during that year. To forecast the balance sheet for the beginning of 2004, it is assumed that there will be 3.5
percent sales growth in 2004. The 2004 beginning balance sheet forecasts will change under different growth rate as-
sumptions beyond 2003, as discussed later.



Table 12-3 shows the performance forecasts implied by the ¬nancial statement fore-
casts in Table 12-2. Six performance forecasts, which can be used as input into the val-
uation exercise, are shown: abnormal operating ROA, abnormal ROE, abnormal NOPAT,
abnormal earnings, free cash ¬‚ows to debt and equity holders, and free cash ¬‚ows to
464 Prospective Analysis: Valuation Implementation




12-4
Prospective Analysis: Valuation Implementation




equity holders implied by the forecasted income statement and balance sheet. The fol-
lowing de¬nitions are used in the calculations:
(1) Abnormal operating ROA is the difference between operating ROA and the weighted
average cost of debt and equity (WACC), where operating ROA is the ratio of NOPAT dur-
ing the year to net assets at the beginning of the year;
(2) Abnormal ROE is the difference between ROE and cost of equity, where ROE is the
ratio of net income to beginning-of-year equity;

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