Business analysis & valuation : using financial statements [Third Asia Pacific ed.] 9780170425186, 0170425185

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Includes the latest regulations, practices and examples from the financial markets and research

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PALEPU HEALY WRIGHT BRADBURY COULTON

Industry insights from practitioners and other experts provide you with practical, reallife understanding of how the content translates to the workplace

Business Analysis and Valuation

Learn how to use financial statement data in various valuation tasks, building a solid understanding of the latest theoretical approaches so you can confidently apply them in your career

THIRD ASIA–PACIFIC EDITION

This book has all the tools for you to ace this subject. What’s stopping you?

U SING F I N ANC IAL S TATE M E N TS

BE AMBITIOUS

KRISHNA G. PALEPU PAUL M. HEALY SUE WRIGHT MICHAEL BRADBURY JEFF COULTON

Business Analysis and Valuation U SING F I N ANC IAL S TATE M E N TS

ISBN 978-0170425186

THIRD ASIA– PACIFIC EDITION 9

7 8 01 7 0 4 2 5 1 8 6

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Business Analysis and Valuation USING FINANC IAL STATEMENTS THIRD ASIA–PACIFIC EDITION Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

KRISHNA G. PALEPU PAUL M. HEALY SUE WRIGHT MICHAEL BRADBURY JEFF COULTON

Business Analysis and Valuation USING FINANC IAL STATEMENTS THIRD ASIA–PACIFIC EDITION Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Business Analysis and Valuation: Using Financial Statements

© 2021 Cengage Learning Australia Pty Limited

3rd Asia–Pacific Edition Krishna G. Palepu

Copyright Notice

Paul M. Healy

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National Library of Australia Cataloguing-in-Publication Data ISBN: 9780170425186

Adaptation of Business Analysis & Valuation: Using Financial

A catalogue record for this book is available from the National Library of

Statements, Fifth Edition by Krishna G. Palepu; Paul M. Healy,

Australia.

Cengage Learning 2013. ISBN: 9781111972288. Cengage Learning Australia This 3rd edition published in 2021

Level 7, 80 Dorcas Street South Melbourne, Victoria Australia 3205 Cengage Learning New Zealand Unit 4B Rosedale Office Park 331 Rosedale Road, Albany, North Shore 0632, NZ For learning solutions, visit cengage.com.au Printed in Singapore by 1010 Printing International Limited. 1 2 3 4 5 6 7 24 23 22 21 20

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

v

Brief contents PART 1 Framework 1 1 A framework for business analysis and valuation using financial statements

2

PART 2 Business analysis and valuation tools

15

2 Strategy analysis

16

3 Overview of accounting analysis

43

4 Implementing accounting analysis

69

5 Financial analysis

96

6 Prospective analysis: Forecasting

134

7 Prospective analysis: Valuation theory and concepts

157

8 Prospective analysis: Valuation implementation

181

PART 3 Business analysis and valuation applications

205

9 Equity security analysis

206

10 Credit analysis and distress prediction

226

11 Mergers and acquisitions

248

12 Communication and governance

272

PART 4 Further case studies

297

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

vi

Contents Guide to the text x Guide to the online resources xiii Preface xiv About the authors xviii Acknowledgements xix

PART 1 Framework 1 1

A framework for business analysis and valuation using financial statements

2

LO1 The role of financial reporting in capital markets 3 LO2 From business activities to financial statements 5 LO3 From financial statements to business analysis 8 Summary 11 Checking and applying your learning 12 Endnotes 13

PART 2 Business analysis and valuation tools

15

2

16

Strategy analysis

LO1 Industry evaluation 16 LO2 Applying industry evaluation 22 LO3 Competitive strategy evaluation 27 LO4 Corporate strategy evaluation 32 Summary 38 Checking and applying your learning 39 Case link 41 Endnotes 41

3

Overview of accounting analysis

43

LO1 The annual report 43 LO2 Factors influencing the financial statements 47 LO3 Steps in accounting analysis 52 Summary 63 Checking and applying your learning 63 Case link 67 Endnotes 67

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CONTENTS

4

Implementing accounting analysis

69

LO1 Recasting financial statements 69 LO2 Accounting adjustments: The process 70 LO3 Common adjustments 75 Summary 86 Checking and applying your learning 86 Case link 95 Endnotes 95

5

Financial analysis

96

LO1 Ratio analysis 96 LO2 Decomposing profitability: Traditional approach 102 LO3 Cash flow analysis 119 Summary 125 Checking and applying your learning 125 Case link 129 Endnotes 129 APPENDIX: Kathmandu financial statements ‘as reported’ and standardised 130

6

Prospective analysis: Forecasting

134

LO1 The overall structure of the forecast 135 LO2 Performance behaviour: A starting point 137 LO3 Other forecasting considerations 141 LO4 Making forecasts 143 L05 Sensitivity analysis 149 Summary 151 Checking and applying your learning 152 Case link 154 Endnotes 154 APPENDIX: The behaviour of components of ROE 155

7

Prospective analysis: Valuation theory and concepts

157

LO1 The discounted dividends valuation method 158 LO2 The discounted abnormal earnings valuation method 160 LO3 Valuation using price multiples 164 LO4 Shortcut forms of earnings-based valuation 170 LO5 The discounted cash flow model 172 LO6 Comparing valuation methods 173 Summary 177 Checking and applying your learning 177 Case link 179 Endnotes 179 APPENDIX: Reconciling the discounted dividends and discounted abnormal earnings models  180

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

vii

viii

CONTENTS

8

Prospective analysis: Valuation implementation

181

LO1 Computing a discount rate

181 186 LO3 Terminal values 188 Summary 198 Checking and applying your learning 198 Case link 200 Endnotes 200 LO2 Detailed forecasts of performance

PART 3 Business analysis and valuation applications

205

9

206

Equity security analysis

LO1 Investor objectives and investment vehicles 207 LO2 Equity security analysis and market efficiency 209 LO3 Approaches to fund management and securities analysis 211 LO4 The process of a comprehensive security analysis 213 LO5 Performance of security analysts and fund managers 218 Summary 222 Checking and applying your learning 222 Case link 223 Endnotes 223

10 Credit analysis and distress prediction

226

LO1 Suppliers of credit 227 LO2 The credit analysis process 230 LO3 Debt ratings 238 LO4 Predicting distress 239 Summary 243 Checking and applying your learning 243 Case link 246 Endnotes 246

11 Mergers and acquisitions

248

LO1 A guide to mergers and acquisitions 249 LO2 Acquisition pricing 255 LO3 Acquisition financing and form of payment 261 LO4 Acquisition outcome 266 Summary 269 Checking and applying your learning 270 Case link 271 Endnotes 271

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CONTENTS

12 Communication and governance

272

LO1 Governance overview 273 LO2 External information about financial reporting quality 276 LO3 Communication through financial reporting 278 LO4 Other ways to communicate with investors 282 LO5 Internal influences on financial reporting quality 285 LO6 Auditor analysis 288 Summary 293 Checking and applying your learning 294 Case link 295 Endnotes 295

PART 4 Further case studies Case 1 Qantas Case 2 Airlines: Depreciation differences Case 3 Recasting financial statements Case 4 Cochlear: Provisions and patent disputes Case 5 Accounting analysis: Cash flow reconciliation Case 6 Valuation ratios in the retail industry 2016 to 2018 Case 7 Dick Smith Case 8 Resinex Case 9 Foster’s–Southcorp merger

297 298 322 326 328 332 336 339 341 346

Index 349

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

ix

x

Guide to the text As you read this text you will find a number of features in every chapter to enhance your study of Business Analysis and Valuation and help you understand how the theory is applied in the real world. PART-OPENING FEATURES See the Chapter List outlining the chapters contained in each part for easy reference.

PART

2

Business analysis and valuation tools CHAPTER

2

CHAPTER 2

Strategy analysis

CHAPTER 3

Overview of accounting analysis

CHAPTER 4

Implementing accounting analysis

CHAPTER 5

Financial analysis

CHAPTER 6

Prospective analysis: Forecasting

CHAPTER 7 Prospective analysis: Valuation theory and Strategy analysis

concepts

CHAPTER 8

Prospective analysis: Valuation implementation

Strategy analysis is an important starting point when analysing financial statements. Strategy analysis allows the analyst to probe the economics of a firm at a qualitative level so that the subsequent quantitative accounting and financial analysis is informed by business reality. Strategy analysis also helps the analyst to identify the firm’s profit drivers and key risks. This in turn enables them to assess the sustainability of the firm’s current performance and make realistic forecasts of future performance. A firm’s value is determined by its ability to earn a BK-CLA-PALEPU_3E-200083-Chp02.indd 15 return on its capital in excess of the cost of capital. What determines whether or not a firm is able to accomplish this goal? While a firm’s cost of capital is determined by the capital markets, its profit potential is determined by its own strategic choices:

1 the choice of an industry or a set of industries in which the firm operates (industry choice) 2 the manner in which the firm intends to compete with other firms in its chosen industry or industries (competitive positioning) 3 the way in which the firm expects to create and exploit synergies across the range of businesses in which it operates (corporate strategy). Strategy analysis, therefore, involves evaluating the whole industry, as well as the firm’s competitive strategy and corporate strategy.1 In this chapter, we will briefly discuss these three steps and illustrate their application to Australasian companies, using Kathmandu Holdings Ltd and Wesfarmers to evaluate industry and corporate strategy, and the Apple iPhone for evaluation of CHAPTER 2 STRATEgy AnALySIS competitive strategy.

CHAPTER 2 STRATEgy AnALySIS

CHAPTER-OPENING FEATURES

39

07/07/20 3:39 PM

general, an industry’s average profit potential is influenced strategy, and recognise the key risks that the firm has by the degree of rivalry among existing competitors, the to39guard against. The analyst also has to evaluate the ease with which new firms can enter the industry, the sustainability of the firm’s strategy. Chapter learning objectives availability of substitute products, the power of buyers and Corporate social responsibility (CSR) is a new aspect of general, an industry’s average profit potential is influenced strategy, and recognise the key risks that the firm has by degree of chapter, rivalry among existing competitors, the to guard an against. The analyst the also has to evaluate the a firm’s competitive strategy. Although it initially incurs setBy the end of the this you should be able to: power of suppliers. To evaluate industry, analyst ease with which new firms can enter the industry, the sustainability of the firm’s strategy. understand the competitive forces in an industry that influence a firm’s profit potential to assess current strength of each of these(CSR) forces up availability ofhas substitute products, thethe power of buyers and Corporate social responsibility is a new aspect of costs, it can deliver direct economic benefits. In the short analyse industry in To evaluate a contemporary example the analyst the power of suppliers. an industry, a firm’s competitive strategy. Although it initially incurs setin an industry and make forecasts of any likely future run, the firm gains through increased sales and decreased has tounderstand assess theand current strength of each of these forces upadvantage costs, it can deliver direct economic benefits. In the short assess a firm’s potential source of competitive in an industrychanges. and make forecasts of any likely future run, the firm gains through increased sales and decreased expenses, and in the longer run it gains through increased understand and assess a firm’s corporate strategy. changes. expenses, and in the longer run it gains through increased Competitive strategy involves identifying returns and decreased risks. Competitive strategy evaluation involves identifyingevaluation returns and decreased risks. the basis on which the firm competes in its industry. Corporate strategy evaluation involves examining the basis on which the firm competes in its industry. Corporate strategy evaluation involves examining In general, there are two potential strategies that could whether a firm is able to create value by being in multiple provide a firm a competitive advantage: businesses at the samethat time. Cost savings or revenuewhether a firm is able to create value by being in multiple Inwith general, there arecost two potential strategies could leadership and differentiation. Cost leadership involves increases may be generated from specialised resources Industry evaluation provide a firm with a competitive advantage: cost businesses at the same time. Cost savings or revenue offering the same product or service that other firms offer that the firm has to exploit synergies across In analysing a firm’s profit potential, an analyst has to first assess the profit potential of each of the industries in but at a lower cost. Differentiation involves satisfying the businesses. For these resources to be valuable, leadership and differentiation. Cost leadership involves increases may be generated from specialised resources which the firm competes. There are systematic differences between the profitability of various industries, which a chosen dimension of customer need better than the they must be non-tradable, not easily imitated by can change over time as industries evolve. Figure 2.1 provides 10-year growth rates from 1996 to 2005 and 2006 competition,offering at an incremental cost that is less than competitionthat and non-divisible. Even when a firm has that the firm has to exploit synergies across same product service other offer to 2015 for Australian andthe New Zealand industry groups,or which reflect the changing naturefirms of those economies the price premium that customers are willing to pay. such resources, it must manage its multi-business during those periods. but atanalysis, a lower cost. involves satisfying To perform strategy the analyst has Differentiation to identify organisation so that the information and agency coststhe businesses. For these resources to be valuable, the firm’s intended strategy, assess whether the firm inside the organisation are lower than the market a chosen dimension of customer need better than the they must be non-tradable, not easily imitated by possesses the competencies required to execute the transaction costs. competition, at an incremental cost that is less than competition and non-divisible. Even when a firm has CHECKING AND APPLYING YOUR LEARNING the price premium that customers are willing to pay. such resources, it must manage its multi-business 1 Using the example of an organisation in the sharing a Location in the same geographic region economy,To perform assess the competitive forces in analysis, the Age of the firm strategy theb analyst has to identify organisation so that the information and agency costs industry. Do those forces explain why the organisation c Meeting the same customer need in a different way the firm’s intended strategy, assess whether the firm inside the organisation are lower than the market has succeeded? What is your assessment of its d Profit level or level of losses future profitability based on your predictions for the 4 What are the ways by which a firm can create barriers possesses the competencies required to execute the transaction costs. competitive forces in the industry?  LO1 to entry to deter competition in its business? What

Identify the key concepts that the chapter will cover with the NEW Learning Objectives at the start of each chapter.

LO1

LO2 LO3

LO4

LO1

LO1

BK-CLA-PALEPU_3E-200083-Chp02.indd 16

2

a Rate the leisure and hospitality industry and the mining industry as high, medium or low on the following dimensions of industry structure.  LO1

07/07/20 3:39 PM

factors determine whether these barriers are likely to be enduring?  LO3

5 Explain why you agree orLEARNING disagree with each of the CHECKING AND APPLYING YOUR

1

following statements.  LO3

Leisureexample and Using the of an organisation sharing a It is better toin be the a differentiator than a cost leader, hospitality Mining since you can then charge premium prices. industry industry economy, assess the competitive forces in the b It is more profitable to be in a high-technology than Rivalry a low-technology industry. Do those forces explain why the industry. organisation Threat of new entrants c The reason why industries with large investments Threat of substitute products has succeeded? What is your assessment itsis because it is costly to have high barriers toof entry Bargaining power of buyers raise capital. future profitability based on your predictions for the 4 6 Assess the expected source of competitive advantage Bargaining power of suppliers for firms in (potential LO1 or proven) growth industries such competitive forces in the industry?  b Use your ratings to explain why the mining industry as solar panel production, tertiary education or seafood has been able to earn higher returns than the leisure 2 a Rate the leisure and hospitality industry andorthe farming. Is it cost leadership differentiation or both? and hospitality industry.  LO1 How likely is this advantage to be sustained?  LO3 3 Explain why each of the following industry factors that as high, medium or low on the mining distinguish between firms may not be useful in 5 following dimensions of industry structure.  LO1 LO2 identifying a competitor. 

Leisure and hospitality industry BK-CLA-PALEPU_3E-200083-Chp02.indd 39

Mining industry

Rivalry

of new entrants Copyright 2021 Threat Cengage Learning. All Rights Reserved. May Threat of substitute products Bargaining power of buyers

Find the main heading covering each learning outcome quickly with NEW LO icons.

At the end of the chapter, test your comprehension of the learning objectives with the Checking and Applying Your Location Learning in the same geographic region questions.

a b Age of the firm c Meeting the same customer need in a different way d Profit level or level of losses What are the ways by which a firm can create barriers to entry to deter competition in its business? What factors determine whether these barriers are likely to be enduring?  LO3 Explain why you agree or disagree with each of the following statements.  LO3 a It is better to be a differentiator than a cost leader, since you can then charge premium prices. 07/07/20 3:39 PM b It is more profitable to be in a high-technology than a low-technology industry. not cbe The copied, orwith duplicated, in whole reasonscanned, why industries large investments have high barriers to entry is because it is costly to raise capital.

or in part. WCN 02-200-202

We see in Figure 5.6 that both Kathmandu and Super Retail Group reported increases in Weissee Figureclose 5.6tothat bothinKathmandu and Super Retail Group reported increases in NOPAT margin in 2018. Kathmandu ablein to retain 13 cents net operating profit for NOPAT inbelow 2018.12Kathmandu able oftorevenue. retain close to 13 cents in net operating profit for each dollar of revenue, and Super Retail margin Group just cents for eachisdollar Recall that in Figure 5.5 weeach defined NOPAT as net income plus net interest expense after tax. dollar of revenue, and Super Retail Group just below 12 cents for each dollar of revenue. NOPAT, calculated this way, can beRecall influenced unusual non-operating incomeas (expense) thatby inany Figure 5.5orwe defined NOPAT net income plus net interest expense after tax. items included in net income. We can calculate a ‘recurring’ NOPAT margin by eliminating these NOPAT, calculated this way, can be influenced by any unusual or non-operating income (expense) items, which we label ‘Other income’ in the standardised financial statement. In 2017 and 2018, items included in net income. We can calculate a ‘recurring’ NOPAT margin by eliminating these Kathmandu had no such items. This recurring NOPAT may be a better benchmark to use when items, which ‘Other in the standardised one is extrapolating current performance intowe thelabel future, since itincome’ reflects margins from the core financial statement. In 2017 and 2018, business activities of CHAPTER a firm. Kathmandu 5 FinAnCiAl AnAlysis had no such items. This123 recurring NOPAT may be a better benchmark to use when

GUIDE TO THE TEXT

xi

one is extrapolating current performance into the future, since it reflects margins from the core business activities of a firm.

Tax expense

Taxes are an important element of a firm’s total expenses. Through a wide variety of tax planning techniques, firms can attempt to reduce their tax expenses.9 There are two measures one can use Finally, as we will discuss in Chapter 7, free cash flow available to debt and equity and free cash Tax to evaluate a firm’s tax expense. Oneexpense is the ratio of tax expense to sales, and the other is the ratio flow available to equity are critical inputs into the cash-flow-based valuation ofare firms’ assets of tax expense to earnings before tax (also as and theelement average tax Thetotal firm’s tax note Through a wide variety of tax planning Taxes anknown important of arate). firm’s expenses. equity, respectively. CHAPTER 5 from FinAnCiAl AnAlysis 123 provides a detailed account oftechniques, why its average tax rate differs thereduce statutory tax tax rate. firms can attempt to their expenses.9 There are two measures one can use

FEATURES WITHIN CHAPTERS

to evaluate a firm’s tax expense. One is the ratio of tax expense to sales, and the other is the ratio

KEY ANALYSIS QUESTIONS

of tax expense to earnings before tax (also known as the average tax rate). The firm’s tax note KEY QUESTIONS Finally,ANALYSIS as we will discuss in Chapter 7, free cash flow available to debt and equity and free cash flow available to equity are critical provides inputs into theacash-flow-based valuation of detailed account offirms’ whyassets its and average

tax rate differs from the statutory tax rate.

Aequity, number of business questions will be useful to an analyst assessing the various elements of respectively.

The cash flow model in Figure 5.14 can also be usedoperating to assess a firm’s earnings quality, as discussed management: in Chapter 3. The reconciliation of a firm’s net income with its cash flow from operations facilitates this Are ANALYSIS the firm’s margins consistent with its stated competitive strategy? For example, a differentiation KEY QUESTIONS KEY ANALYSIS QUESTIONS exercise. Following are some of the questions an analyst can probe inusually this respect: strategy should lead to higher gross margins than a low-cost strategy. The cash flow model in Figure 5.14 can also be used to assess a firm’s earnings quality, as discussed the 3.firm’s margins changing? Why? What are underlying business causes – changes in Are there significant differences between a firm’s net income and its operating flow? it theflow inAre Chapter The reconciliation of a firm’scash income with Is cash from operations Anet number ofitsbusiness questionsfacilitates will bethisuseful to an analyst assessing the various elements of exercise. Followingchanges are some of the questions analyst can probe in this respect: competition, in input costsanor poor overhead management? possible to clearly identify the sources of this difference? Which accounting policies contribute tocost operating Are there significant differences between a firm’s net management: income and its operating cash flow? Is it Is the firm managing its overhead and administrative costs well? What are the business activities this difference? Are there any one-time events contributing thisidentify difference? possible toto clearly the sources of this difference? Which accounting policies contribute to driving these costs? activities necessary? Are the firm’s margins consistent with its stated competitive strategy? For example, a differentiation difference? Are thereAre any these one-time Is the relationship between cash flow and net income this changing over time? Why?events Is itcontributing becauseto this difference? Is the cash flow and net income over time? Why? influenced Is it because by one-time tax credits? Are therelationship firm’s taxbetween policies sustainable? Or ischanging the current tax rate strategy should usually lead to higher gross margins than a low-cost strategy. changes business conditions or because of changes in the firm’s accounting policies and of changes in business conditions or because of changes in inthe accounting policies and Doofthe firm’s taxfirm’s planning strategies lead to other business costs? For example, if the operations are Are the firm’s margins changing? Why? What are the underlying business causes – changes in estimates? estimates? located in tax havens, how does this affect the company’s profit margins and asset utilisation? Are What is the time lag between the recognition of revenues and expenses and the receipt and competition, changes in input costs orbusiness poor overhead the benefits of tax planning (reduced tax) greater than the increased costs? cost management? disbursement of cash flows?and Whatstrategies typesreceipt of uncertainties to be resolved in between? What is the time lag between the recognition of revenues and expenses the and need Are the changes in receivables, inventories Is andthe payables If not, is there firmnormal? managing its adequate overhead and administrative costs well? What are the business activities disbursement of cash flows? What types of uncertainties need to be resolved in between? explanation for the changes? driving these costs? Are these activities necessary? Are the changes in receivables, inventories and payables normal? If not, is there adequate Are the firm’s tax policies sustainable? Or is the current tax rate influenced by one-time tax credits? explanation for the changes? the firm’s tax planning strategies lead to other business costs? For example, if the operations are ANALYSIS OF KATHMANDU’SDo CASH FLOW located in tax havens, how does this affect the company’s profit margins and asset BK-CLA-PALEPU_3E-200083-Chp05.indd 109 07/07/20 6:22 PM utilisation? Are Kathmandu and Super Retail Group reported their Kathmandu borrowed to help fund the acquisition. After cash flows using the direct method for the cash the flow benefits taking the impact of the borrowing and loan tax) greater than the increased business costs? of into taxaccount planning strategies (reduced statement. Figure 5.14 recasts these statements using the

repayments, there was still a negative free cash flow to equity holders in 2018. In addition to borrowing, Kathmandu raised equity capital to help fund the acquisition. Despite Cash flow analysis presented in Figure 5.14 shows the negative free cash flow to equity, Kathmandu still Kathmandu borrowed to help fund the acquisition. After Kathmandu had operating cash inflow before working paid dividends in 2018. The firm’s consistently positive capital investments of $83.3 million in 2018, an increase on cash flows suggests that this capital raising and taking into account the impact ofoperating the borrowing and loan $70.7 million in 2017. In 2018, Kathmandu invested more dividend payments had not put them into a position of repayments, there was still a negative free cash flow to heavily in its operating working capital than in 2017. This led financial distress. The debt ratios in Figure 5.10 show that 109 toBK-CLA-PALEPU_3E-200083-Chp05.indd higher operating cash holders inflows before inaddition longKathmandu still has relatively low levels of gearing at the equity in investments 2018. In to borrowing, Kathmandu term assets of $83.3 million in 2018 compared with $70.7 end of the 2018 financial year. companies’ cash flow dynamics. raised equity capital to help fund the acquisition. Despite million in 2017. One of the ‘red flags’ about earnings quality that and Super Retail invested was discussed in Chapterstill 3 was the relation between Cash flow analysis presented in Figure 5.14 shows Both Kathmandu the negative freeGroup cash flow to equity, Kathmandu heavily in operating long-term assets in 2018. Kathmandu earnings and operating cash flows. In both 2017 and 2018, Kathmandu had operating cash inflow before working paid $82.4 million paid dividends in 2018. The firm’sKathmandu consistently positive to acquire Oboz, a US-based outdoor reported operating cash flows that exceeded footwear as well as investing millionsuggests in PPE. The that not only netcapital profit afterraising tax, but also EBIT. This indicates capital investments of $83.3 million in 2018, an increase on brand,operating cash$15 flows this and payment for this acquisition meant that free cash flow to that Kathmandu’s profits are not being driven by increasing $70.7 million in 2017. In 2018, Kathmandu invested more hadtonot into alevels position of debt and equitydividend in 2018 waspayments negative, in contrast 2017.put them higher relative of accruals.

KATHMANDU CASE

approach FLOW discussed above so that we can analyse the two ANALYSIS OF KATHMANDU’S CASH companies’ cash flow dynamics.

Link chapter concepts to real Kathmandu and Super Retail Group reported their cash flows using the direct method for the cash flow world examples with the NEW statement. Figure 5.14 recasts these statements using the approachboxes. discussed above so that we can analyse the two Kathmandu Case

KATHMANDU CASE

Critically analyse key concepts introduced in the chapter with Key Analysis Questions boxes.

07

BK-CLA-PALEPU_3E-200083-Chp05.indd 123

NEW Industry Insights from real professionals and researchers contextualise key chapter concepts. Apply your understanding with reflective activity questions.

meeting. The deal may not meet the approval of the relevant regulatory authorities. In Australia, these authorities can include the Australian Competition and Consumer Commission (ACCC), which administers the Competition and Consumer Act 2010, the Foreign Investment Review Board, and the Australian Takeovers Panel. The Takeovers Panel resolves disputes over takeovers. In addition, the Australian Securities and Investments Takeover Commission enforces takeover offersthecan berules unsuccessful within the Corporations Act 2001, which it also has the power to modify.

INDUSTRY INSIGHT

A PRACTITIONER ADVISES

CASE STUDY

Analyse and apply key chapter concepts in real world contexts with Case Study boxes.

CASE STUDY

heavily in its operating working capital than in 2017. This led financial distress. The debt ratios in Figure 5.10 show that to higher operating cash inflows before investments in longKathmandu still has relatively low levels of gearing at the term assets of $83.3 million in 2018 compared with $70.7 250 end ofPART the3 2018 financial BUSINESS ANALYSIS year. AND VALUATION APPLICATIONS 250 PART 3 BUSINESS ANALYSIS AND VALUATION APPLICATIONS million in 2017. One of the ‘red flags’ about earnings quality that Both Kathmandu and Super Retail Group invested was discussed PRIVATE EQUITY in Chapter 3 was the relation between Private equity buyouts have become a viable usInG alternative to What types of investor would be interested heavily in operating long-term in 2018. Kathmandu earnings and operating cash flows. In1 both 2017 and 2018, CHAPTER assets 1 A frAmeWork for BusIness AnAlysIs AnD vAluATIon fInAncIAl sTATemenTs 11in private PRIVATE EQUITY a trade sale or the appointment of a successor for owners equity buyouts? What time horizon would they need to paid $82.4 million to acquire Oboz, a US-based outdoor Kathmandu reported operating cash flows that exceeded BK-CLA-PALEPU_3E-200083-Chp05.indd 07/07/20 6:22 PM of123 Australian family and privately owned businesses. This is be interested in? Why? Private equity haveadvantages become a viable to 1 What types of investor would be interested in pri why privatenet investment havetax, become an also 2 buyouts What governance would a privatealternative equity footwear brand, as well as investing $15 million in PPE. Theone reason not only profitfirms after but EBIT. This indicates important group of players in the acquisition market. These bring to a family or private company? trade orbuyout the appointment of a successor for owners equity buyouts? What time horizon would they ne payment for this acquisition meant that free cash flow to firms offer that Kathmandu’s profits a are not sale being driven by increasing to buy the target firm with the cooperation of 3 How might the acquirer add sufficient value to the There are several ways in which financial statement analysis can add value, even when capital of either Australian family be interested in? Why? in these cases, and then take firm fully target toand justifyprivately a high buyoutowned premium?businesses. This is debt and equity in 2018 was negative, in contrast to 2017. management higher relative levels oftheaccruals. partly private. The purchase is largely financed withmany debt. applications whose markets are reasonably efficient. First,orfinancial statement analysis has one reason why private investment firms have become an 2 What governance advantages would a private eq focus is outside the capital market context – credit analysis, competitive benchmarking, and important group of players in the acquisition market. These buyout bring to a family or private company? analysis of mergers and acquisitions, to name a few. Second, markets become efficient precisely offer to the target firmShareholders with the cooperation 3 How might the acquirer add sufficient value to th Takeover offers can befirms unsuccessful for buy a number of reasons. may receive a of because some market participants rely on analytical such as those webid. discuss in this book highertools or more valuable alternative The acquirer fail to gain a controlling stake in an management in thesemay cases, and then take the firm either fully target to justify a high buyout premium? on-market decisions. bid. The conditions the takeover offergreater may not be met. The target shareholders to analyse information and make informed investment Thissetinforturn imposes partly purchaseatisanlargely financed with debt. may reject a proportional takeover bidprivate. or schemeThe of arrangement appropriate shareholder discipline on corporate managers to develop appropriate disclosure andorcommunication strategies.

for a number of reasons. Shareholders may re higher or more valuable alternative bid. The acquirer may fail to gain a controlling stak The conditions set for the takeover offer may not be met. The target share 07/07/20 6:22 PM may reject a proportional takeover bid or scheme of arrangement at an appropriate share Firms merge withalso or acquire other firms for many reasons. One significant reason is that business importantly, learning The real world is complex and keeps changing. You need combinations can create operating efficiencies that generate value for shareholders. New value meeting. The deal may not meet the approval of the relevant regulatory authorities. In Au a framework to be able to understand the real world. can be created by:about it will give you empathy for decision-makers, which these authorities can include the Australian Competition and Consumer Commission (A If you don’t have a framework to work with, then you 1 Taking advantage of economies of scale: Mergers are often justified as a means of providing will make youwith a better advisor. firms increased economies of scale. Economies of scale when actually can’t operationalise anything, even if reality is the two participating which administers thearise Competition and Consumer Act 2010, the Foreign Investment can perform a function have amore veryefficiently than two smaller firms. For example, different to what the textbook would say. If you don’t one large firmDecision-makers Board, and andM2the Australian Takeovers Panel. The Takeovers Panel resolves disputes over tak telecommunications Group merged in 2016 via a difficultcompanies job to do,Vocus and Communications if you have the framework in this textbook, then everything is scheme of arrangement to create the fourth largest telco in Australia and the third largest in In addition,and the Australian Securities and Investments Commission enforces the takeove understand where they’re comingatfrom, can from 2018. unexplainable and everything is just random, and you New Zealand.can Anticipated cost savings were projected $40 millionyou per annum Corporations 2001, which it also has the power to modify. understand the problems theywithin have andthe you for canacquisition help 2 Improving target management: Another common motivation is to Act improve

Australian financial analyst on the benefits of the framework Financial analysis is about on-market bid. Economic helping and non-economic of financial analysis: decision-makers, butmotivations

can’t make a forecast and you can’t plan ahead. This textbook provides such a framework, to give you a way of thinking about value, and to enable you to make a forecast and plan ahead. It provides order, and helps you to pull apart real-world complexity. This textbook gives you a way to think about how to communicate that complexity. But you can’t hold to it too tightly because the real world is different. The framework of the four steps of financial 3 statement analysis (business strategy analysis, accounting analysis, financial analysis and prospective analysis) in this textbook gives you a way of communicating the complexity of the real world.

target management. A firm is likely to be in a target if it has systematically them solve their problems a constructive way – that’sunderperformed in its industry. Historically poor performance could be due to bad luck, but it could also be actually understanding how to answer a question that due to poor investment and operating decisions from the firm’s managers, or from managers somebody has. And that’stheir going beyondpower just being a shareholders. South deliberately pursuing goals that increase personal but cost Africa’s Woolworths takeover oftoAustralian retailer David do Jones in 2014 service-provider, actually help someone what they was forecast to mergemuch with or acquire other firms for many reasons. One significant reason is that b improve David Jones’ value not only because Firms it would receive needed cash, but also need to do, better. because it brought international retail management expertise to the company. combinations can create operating efficiencies that generate value for shareholders. New Research shows that distressed firms are sought-after targets for takeovers, although Reflective activity: What techniques do you use inby: other can be created the completion rate is lower. The premium for a distressed target tends to be higher and 3 subject areas, orfirm in other youcash. undertake, shareholders of a distressed are lessactivities likely to bethat offered 1 Firms Taking advantage economies of scale: Mergers are often justified as a means of pro Combining resources or capacity: may decide that create to complementary help you to understand a complex situation, and toa mergerofwill value by represent combining complementary resources of the two partners. For example, may with increased economies of scale. Economies of scale aris two participating firms it in a simplified manner tothe enable decisions to be a firm

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SUMMARY Financial statements provide the most widely available data on an organisation’s economic activities; investors and other stakeholders rely on them to assess the plans and performance of organisations and corporate managers. Accrual accounting data in financial statements are noisy, and unsophisticated investors can assess an organisation’s performance only imprecisely. Financial analysts who understand managers’ disclosure strategies have an opportunity to create inside information from public

Economic and non-economic motivations

made? Some examples of complex one situations a perform a function more efficiently than two smaller firms. For ex largemight firmbecan strategy for a sports game, or planning an overseas trip on companies Vocus Communications and M2 Group merged in 20 telecommunications your own within a tight budget.

scheme of arrangement to create the fourth largest telco in Australia and the third lar New Zealand. Anticipated cost savings were projected at $40 million per annum from 2 Improving target management: Another common motivation for acquisition is to im target management. A firm is likely to be a target if it has systematically underper in its industry. Historically poor performance could be due to bad luck, but it could data, and they play a valuable role indue enabling outside to poor investment and operating decisions from the firm’s managers, or from ma parties to evaluate an organisation’s current and prospective deliberately pursuing goals that increase their personal power but cost shareholders performance. Africa’s Woolworths takeover of Australian retailer David Jones in 2014 was fore This chapter has outlined the framework for business improve David Jones’ value not only because it would receive much needed cash, b analysis using financial statements, which comprises four key because it brought steps: business strategy analysis, accounting analysis, financialinternational retail management expertise to the company. analysis and prospective analysis. The remaining chapters in Research shows that distressed firms are sought-after targets for takeovers, al this book describe these steps in greater and discuss rate is lower. The premium for a distressed target tends to be high thedetail completion how they can be used in a variety of business contexts. shareholders of a distressed firm are less likely to be offered cash.3 3 Combining complementary resources or capacity: Firms may decide that a merger wil value by combining complementary resources of the two partners. For example, a fir 30/07/20 6:57 PM

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Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202 BK-CLA-PALEPU_3E-200083-Chp11.indd 250

GUIDE TO THE TEXT

CHAPTER 9 EquITy SECuRITy ANAlySIS

END-OF-CHAPTER FEATURES

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f g

Whether its audit company is a ‘Big Four’ firm 10 Suzanne Ma is an analyst for an investment banking firm Whether there are analysts from major brokerage that offers both underwriting and brokerage services. firms following the company Suzanne sends you a highly favourable report on shares h Whether the shares are held mostly by retail or that her firm recently helped go public and for which institutional investors it currently makes the market. What are the potential What else would you consider useful to know?  LO4 advantages and disadvantages of relying on Suzanne’s 8 Biomedico Company’s shares have a market price of report in deciding whether to buy the shares?  LO5 11 Xiaoli states: ‘I can see how ratio analysis and valuation $40 and a book value of $44. If its cost of equity capital help me do fundamental analysis, but I don’t see the is 10% and its book value is expected to grow at 5% value of doing strategy analysis.’ Can you explain to her per year indefinitely, what is the market’s assessment how strategy analysis could be potentially useful?  LO1 of its steady state return on equity? If the share price 12 Obtain a copy of a security analyst’s report and evaluate increases to $60 and the market does not expect the 222 PART 3 BUSINESS ANALYSIS AND VALUATION APPLICATIONS CHAPTER 9 EquITy SECuRITy ANAlySIS 223 it against what you have learned in this chapter. Does firm’s growth rate to change, what is the revised steady the analyst indicate the basis on which they have state ROE? If, instead, the price increase was due to forecast earnings, and the basis on which they have an increase in the market’s assessments about longf Whether its audit company is a ‘Big Four’ firm 10 Suzanne Ma is an analyst for an investment banking firm SUMMARY LO5brokerage services. recommendation?  term book value growth grather than long-term Whether there are analystsROE, from major brokerage made athat offers both underwriting and firms following sends you a highly favourable report on shares Equity security analysis is the evaluation of a firm and its the degree of market efficiency. A largeAND bodywhat of evidence 222 PART 3 BUSINESS ANALYSIS VALUATION APPLICATIONS 13 Search Suzanne the financial press (Australian Financial Review, would the price revision imply forthe thecompany steady state h Whether the shares are held mostly by retail or that her firm recently helped go public and for which prospects from the perspective of a current or potential exists that supports a high degree of efficiency in active Wall Street Journal etc.) for the most recent summary growth rate?   LO1   LO2 institutional investors it currently makes the market. What are the potential investor in the firm’s shares. Security analysis is one share markets, but recent studies have reopened the debate What else you consider useful to know?  LO4 disadvantages of relying on Suzanne’s 9 There are two major types ofwould financial analysts: buy-side of fund advantages managerand performance (the ‘league table’). See component of a larger investment process that involves: on this issue. Biomedico Company’s shares have a market price of report in deciding whether to buy the shares?  LO5 1 establishing the objectives of the investor or fund In practice, a wide variety of approaches and to fund sell-side. Buy-side8 analysts work for investment if the funds that have recorded the highest returns in 11 Xiaoli states: ‘I can see how ratio analysis and valuation $40 and a book value of $44. If its cost of equity capital 2 forming expectations about the future returns and risks management and security analysis are employed. However, firms and that are to grow at 5% the most recent one-year period have help me do fundamental analysis, also but I don’t seethe the highest is 10% and its book value is expected of individual securities at the core of the analyses are the same steps outlined in make share recommendations SUMMARY doing strategy analysis.’ Can you explain to her about per year indefinitely, what within is the market’s 3 combining individual securities into portfolios to Chapters 2 to 8 of this book: business strategy analysis, only to the management available of funds that assessment returns value overoflonger periods. What does this imply how strategy analysis could be potentially useful?  LO1 of market its steady efficiency. state return onAequity? If body the share price maximise progress towards the investment objectives. analysis accounting analysis, financial of analysis andand prospective Equity security is the evaluation a firm its the degree of large of evidence LO3 firm. Sell-side analysts work for brokerage firms and market efficiency?  12 Obtain a copy of a security analyst’s report and evaluate increases to $60 and the market does not expect the Some security analysis is devoted primarily to assuring (forecasting and valuation). For the professional prospects from theanalysis perspective of a current or potential exists that supports high degree of efficiency in 14active In the last two decades, the amount money make thatgrowth areaused sell shares it against what you have learned in this of chapter. Doesinvested rate toto change, what is the revised steady that a firm possesses the proper risk profile and other analyst, the final product of the work is, of course, a recommendationsfirm’s investor in the firm’sforecast shares. Security analysis one sharefirms’ markets, recent studies have reopened theindebate the analyst indicate (i.e. the basis on which they have statebut ROE? If, instead, the price increase was due to desired characteristics prior to including it in an investor’s of the firm’s future earningsis and cash and passively managed in index funds) has increased toflows, the brokerage clients, which include individual forecast earnings, and the basis on which they have an increase in the market’s assessments about longportfolio. However, especially for manycomponent professional of a larger an estimate of the firm’s value. However, that final product on this issue. investment process that involves: dramatically relative to actively managed funds. What investors and managers of investment funds. made a recommendation?  LO5 term book value growth rather than long-term ROE, buy-side and sell-side security analysts, the analysis is less important than the understanding of the business 1 establishing theisobjectives of the investor or fund In practice, a wide variety of approaches to fund imply efficiency? IfReview, the trend What would be the differences tasks andimply for the steady statedoes13this Search the about financialmarket press (Australian Financial what would theinprice revision also directed towards identifying mispriced securities. In and its industry, which the analysis provides.a It is such 2 for forming expectations about the future risks management andtypes security analysis are employed. However, LO1analysts? LO2   Streetfunds Journaland etc.) away for the most summary rate?  of equilibrium, such activity will be rewarding those with understanding that positions thereturns analyst toand interpret new towardsWall index fromrecent actively managed motivations of thesegrowth two 9 of There two major are typesthe of financial buy-side in of fund manager performance (the ‘league table’). See the strongest comparative advantage. Those will securities information as it arrives and infer its implications. ofanalysts individual at theparticipants core theare analyses same analysts: steps outlined funds persists, what could this suggest about market b Many market believe that sell-side and sell-side. Buy-side analysts work for investment if the funds that have recorded the highest returns in be able to identify any mispricing at the lowest cost and Finally, the chapter summarises some key findings of 3 combining individual securities into portfolios to Chapters 2 to 8 of in this book: business strategy analysis, LO3 efficiency in the future?  analysts are too optimistic their recommendations firms and make share recommendations that are the most recent one-year period also have the highest exert pressure on the price to correct the mispricing. The the research on the performance of both sell-side and buymaximise progress towards the investment objectives. accounting financial analysis available only to the management fundsprospective within15 thatThere isreturns over longer periods. What this imply about types of effort that are productive in this domain depend on side security analysts. an increasing amount ofdoes financial and nonto buy shares and tooanalysis, slow to recommend sells.ofand firm. Sell-sideand analysts work for brokerage and market efficiency?  LO3 Some security analysis is devoted primarily to assuring analysis (forecasting valuation). For thefirms professional financial data available for firms and stock markets. What factors might explain this bias? 14 In the last two decades, the amount of money invested make recommendations that are used to sell shares CHECKING AND APPLYING YOUR LEARNING that a firm possesses the proper risk profile and other analyst, thesome final product of the work is, include of course, a There has also been increasing amounts of computing c On the other hand, researchers have found in passively managed (i.e. in index funds) has increased to the brokerage firms’ clients, which individual 1 What does market efficiency mean? How does market 5 Investment funds follow many different types of desired characteristicsinvestment prior tostrategies. including it in an investor’s forecast of the firm’s future earnings and funds. cash flows,power and and dramatically relative to actively managed funds. What investors andpessimistic managers of investment efficiency relate to the speed at which information is Income funds focus on shares ‘artificial intelligence’ used in financial that sell-side analysts can be in their does this imply about market efficiency? If the trend What would be the differences in tasks and However, especially for many reflected in share prices and to theportfolio. accuracy with which with high dividend yields;professional growth funds invest in shares anparticularly estimate aofearly the firm’s However, markets. How do you expect the role of the security forecasts, in thevalue. forecast period,that final product towards index funds and away from actively managed motivations of these two types of analysts? information is reflected in share prices?  LO2 are expected to have high capital appreciation; value buy-side and sell-side that security analysts, the analysis is in order to is less important than the understanding of the business analyst funds to change the next decade in market light of persists,over what could this suggest about gain the favour ofmarket managers. Why might b Many participants believe that sell-side 2 Despite many years of research, the evidence on funds follow shares that are considered to be undervalued; directed identifying securities. Inthis and its industry,analysts whicharethe It is such efficiency in the future?  LO3 too analysis optimistic inprovides. their recommendations market efficiency described in this also chapter appears towards and short fundsmispriced bet against shares they consider to occur?  LO3 the ongoing advances in artificial intelligence and is an increasing amount of financial and nonbuy shares and too slow to recommend sells. to be inconclusive. Some argue that this is becausesuch activity be overvalued. What types of for investors are likely equilibrium, will be rewarding those withto be understanding to that positions the analyst to interpretcomputing new15 Therepower?  LO5 financial data available for firms and stock markets. What factors might explain this bias? researchers have been unable to link company attracted to each of these types of funds? Why?  LO3 the strongest comparative advantage. Those analysts will information cas On it arrives its implications. There has also been increasing amounts of computing the other and hand, infer some researchers have found 6 Why don’t analysts follow smaller firms, or firms that fundamentals to share prices precisely. sell-side analysts can besome pessimistic their be able to identify anyare mispricing at the anddo these chapter summarises keyinfindings of power and ‘artificial intelligence’ used in financial making losses? Whatlowest practicalcost difficulties Comment.  LO2 CASE LINK Finally, the that particularly early in the forecast period, 3 Peter Low, a professor of finance and mathematics, firms present, and what might beThe interested in the research onforecasts, exert pressure on the price to correct theinvestors mispricing. the performance of both sell-side and buy- markets. How do you expect the role of the security to change over next decade in light of order to favour of managers. Concepts from this chapter areinused ingain thethe following case Why mightCase 10analyst Diligent (Part 1):theRevenue recognition states: ‘I have collected massive amounts of data on their valuations?  LO3 types of effort that are productive in this domain depend on side security analysts. the ongoing advances in artificial intelligence and this occur?  LO3 7 Biomedico Company went public three months markets and the companies listed on them, going in Part 4: ago. problems.

At the end of each chapter you will find several tools to help you to review, practise and extend your knowledge of the key learning objectives. Review your understanding of the key chapter topics with the Summary.

Find relevant case studies in Part 4 to extend on chapter concepts with the Case Link.

computing power?  LO5 You are a sophisticated investor who devotes time to back 50 years in some cases. The power of computer fundamental analysis as a way to identify future growth algorithms means that I can predict future share prices CASE LINK shares. Which of the following characteristics would you and the factors that lead to those changes. I can beat Whatnodoes efficiency mean? How does market 5 rates Investment funds follow many different types of Concepts this chapter arerating used in the following 10 439 Diligent (Part 1): of Revenue recognition on in deciding whether to follow company? any analyst’s fundamental analysis,1so there’s point marketfocus 1 this Investment-grade bonds havefrom received a credit by 2caseSee ASICCase Report ‘Snapshot the Australian hedge funds in Part 4:strategies. Income funds focus on shares problems. Itsspeed industry at which information is to it anymore.’ Do you agree? Why or why not?  LO2 relate toa the efficiency investment

CHECKING AND APPLYING YOUR LEARNING ENDNOTES

4

Moody’s of Baa or higher or a credit rating by Standard & Poor’s of

sector’ available at https://download.asic.gov.au/media/3278608/

What is the difference between fundamental and b The market capitalisation or above. We discuss these rating categories in morefunds detail ininvest in shares rep439-published-1july2015.pdf. reflected in share prices and to the accuracy withBBB which with high dividend yields; growth technical analysis? Can you think of any trading c The average number of shares traded per day ENDNOTES Chapter 10. 3 These figures are from Hedge Fund Research (HFR). LO2 information is reflected share prices?  that are to rates have high value strategies that use technical analysis? What are the d The in bid–ask spread for the shares 1 expected Investment-grade bonds havecapital received aappreciation; credit rating by 2 See ASIC Report 439 ‘Snapshot of the Australian hedge funds Moody’s of Baa or higher or a credit rating by Standard & Poor’s of sector’ available at https://download.asic.gov.au/media/3278608/ LO3 underlying assumptions made by these e of Whether the underwriter that brought 2 strategies?  Despite many years research, the evidence on the firm public funds follow shares that are considered to be undervalued; BBB or above. We discuss these rating categories in more detail in rep439-published-1july2015.pdf. is a highly regarded investment bank

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3

10. bet against shares they consider to 3 These figures are from Hedge Fund Research (HFR). market efficiency described in this chapter appears and shortChapter funds to be inconclusive. Some argue that this is because be overvalued. What types of investors are likely to be researchers have been unable to link company attracted to each of these types of funds? Why?  LO3 6 Why don’t analysts follow smaller firms, or firms that fundamentals to share prices precisely. BK-CLA-PALEPU_3E-200083-Chp09.indd 223 are making losses? What practical difficulties do these Comment.  LO2 BK-CLA-PALEPU_3E-200083-Chp09.indd 07/07/20 7:24 223PM Peter Low, a professor of finance and mathematics, firms present, and what investors might be interested in states: ‘I have collected massive amounts of data on their valuations?  LO3 7 Biomedico Company went public three months ago. markets and the companies listed on them, going You are a sophisticated investor who devotes time to back 50 years in some cases. The power of computer fundamental analysis as a way to identify future growth algorithms means that I can predict future share prices shares. Which of the following characteristics would you and the factors that lead to those changes. I can beat focus on in deciding whether to follow this company? any analyst’s fundamental analysis, so there’s no point a Its industry to it anymore.’ Do you agree? Why or why not?  LO2 298 PART 4 FURTHER CASE STUDIES What is the difference between fundamental and b The market capitalisation technical analysis? Can you think of any trading c The average number of shares traded per day strategies that use technical analysis? What are the d The bid–ask CASE 1spread for the shares PART underlying assumptions made by these strategies?  LO3 e Whether the underwriter that brought the firm public QANTAS is a highly regarded investment bank

Part 4 contains further APAC Case Studies to help you develop strong skills in applying the financial analysis framework to real-world situations. 4

4

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This case relates to Chapters 2, 3, 4, 5, 6, 7 and 8.

Part A Introduction Qantas is the largest operator within the Australian air transport industry.1 Various events and changes that have occurred within the industry over the past decade have resulted in high levels of both media and regulatory scrutiny for the company. Qantas offers a relatively generic product (passenger air transport) operating in a domestic market in which it is dominant, as well as in international markets where there is more competition. Within both of these markets, Qantas has worked hard to develop and maintain a competitive advantage to enhance profitability.

Background and history

Further case studies CASE 1

Qantas

CASE 2

Airlines: Depreciation differences

CASE 3

Recasting financial statements

CASE 4

Cochlear: Provisions and patent disputes

CASE 5

Accounting analysis: Cash flow reconciliation

CASE 6

Valuation ratios in the retail industry 2010 to 2013

CASE 7

Dick Smith

CASE 8

Resinex

CASE 9

Foster’s–Southcorp merger

Queensland and Northern Territory Aerial Services Limited (Qantas) was established in Queensland in 1920, and initially provided joy-riding and demonstration flights. Its operations were expanded in 1922 to include scheduled airmail services between the towns of Charleville and Cloncurry, subsidised by the Australian government. It was on this route that commercial passenger aircraft were first introduced to Australia in 1924. Qantas began overseas passenger services in 1935, with flights between Darwin and Singapore. Both the domestic and international operations of Qantas expanded significantly in the years leading up to World War II. As the international air transport industry expanded, so did the role of government in managing airline operations. This included involvement in negotiating air traffic rights, determining airfares between countries and in developing international standards for operations through organisations such as the International Civil Aviation Organisation. Such increasing involvement, along with a desire to see Australian control of this emerging mode of transport, led to the Australian Commonwealth government taking the decision to nationalise Qantas in 1947, by buying up all the shares in the company. Similar to many other international airlines, Qantas then developed as a wholly government-owned organisation, operating in a highly regulated and protected international industry.

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PART 4: FURTHER CASE STUDIES

CASE STUDY

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The domestic air transport industry was also highly regulated at this time. After acquiring Qantas, the government transferred the airline’s domestic operations to the newly formed, government-owned, Trans-Australia Airlines (TAA; later to become Australian Airlines). TAA, along with the privately owned Ansett Australia Ltd, operated under what became known as the ‘Two Airlines’ policy, with the objective of maintaining two economically viable operators for the domestic market. The policy sought 07/07/20 7:24 PM to ensure the provision of interstate services by regulating airline management matters such as timetables, fare levels and route structures.2 Thus the domestic air transport industry was also forced to operate in a highly regulated and protected environment. The most significant development in the air transport industry over the period 1950 to 1980 was the continually increasing capacity of aircraft. This saw a reduction in seat per kilometre costs, which was partially reflected in reduced airfares, fuelling consumer demand and contributing to rapid growth in the airline industry. Management and administrative practices also developed during this period in line with new technological developments. These addressed many aspects of airline operations, including computerised reservation systems, ticketing systems and ticket distribution procedures, as well as settlement of accounts for ticket sales. Organisations such as the International Air Transport Association developed to facilitate interairline relationships and the distribution of tickets through travel agencies. Although subsequent technological developments may have allowed further improvements in such procedures, the heavy regulation of the industry meant that there were too many impediments and too few economic incentives to review these operations. The 1980s saw the breakdown in government regulation of airfares internationally, foreshadowing major changes that were to come in the air transport industry, both in Australia and overseas. Though the industry is still regulated, the focus for regulators is on safety issues and ensuring viable route capacity rather than price setting. This change was realised through several key events, beginning

This case was adapted and updated by Sue Wright from an original work by Professor Peter Wells and Dr Anna Wright, University of Technology Sydney. This

case is intended solely as a basis for class discussion and is not intended to serve as an endorsement, source of primary data or illustration of effective or Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202 ineffective management.

xiii

Guide to the online resources FOR THE INSTRUCTOR Cengage is pleased to provide you with a selection of resources that will help you to prepare your lectures and assessments when you choose this textbook for your course. Log in or request an account to access instructor resources at cengage.com.au/instructors for Australia or cengage.co.nz/instructors for New Zealand. INSTRUCTOR SOLUTIONS MANUAL The Instructor Solutions Manual includes solutions for all end-of-chapter questions and Excel case solutions.

WORD-BASED TEST BANK This NEW bank of questions has been developed in conjunction with the text for creating quizzes, tests and exams for your students. Deliver these through your LMS and in your classroom.

POWERPOINT™ PRESENTATIONS Use the chapter-by-chapter PowerPoint slides to enhance your lecture presentations and handouts by reinforcing the key principles of your subject.

ARTWORK FROM THE TEXT These digital files of graphs and flowcharts from the text can be used in a variety of media. Add them into your course management system, use them within student handouts or copy them into lecture presentations.

EXCEL CALCULATOR SHEETS NEW Excel calculator sheets for use in conjunction with the data provided in the case studies.

ONLINE CASES Two additional NEW online-only cases discussing companies Diligent and Rubicon.

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Preface Among business students, demand is growing for a course that provides a framework to understand and use financial statements. Such a course is relevant across a wide range of business disciplines: accounting, of course, but also finance, marketing, management, and economics, because financial statements are the basis for a wide range of business analyses. Managers use them to monitor and judge their firms’ performance relative to competitors, to communicate with external investors, to help judge what financial policies they should pursue and to evaluate potential new businesses to acquire as part of their investment strategy. Securities analysts use financial statements to rate and value companies they recommend to clients. Bankers use them to decide whether to extend a loan to a client and to determine the loan’s terms. Investment bankers use them as a basis to value and analyse prospective buyouts, mergers and acquisitions. Consultants use them as a basis for competitive analysis for their clients. The purpose of this book is to provide a framework for understanding and using financial statements for business students and practitioners.

An Asia–Pacific edition As teachers or students of financial statement analysis, many of us have sought a quality textbook in this area that is contextualised for our region. Starting with the strong foundations provided by the highly successful US edition, the first Asia–Pacific edition addressed regional issues of terminology, institutional setting and accounting standards with a number of improvements. In particular, we rewrote Chapters 3 and 4 to streamline and better explain the process of accounting analysis, particularly in the context of International Financial Reporting Standards (IFRS). We used a DuPont-style ratio analysis in Chapter 5 to supplement operating vs. financial spread methodology. This provided a better method for diagnosing performance measurement. More focus was also placed on the elements of financial leverage and their impact on the firm’s performance, and ratio formulas were more precisely specified to answer relevant business questions. Our latest Asia–Pacific edition builds on these changes, revising all the material to ensure each chapter is relevant. We have included regionally recognised examples and case studies in the chapters, a new worked example throughout the book, and several new discussion questions and exercises at the end of each chapter. Additional references to recent research from Australasia as well as other regions are included in this edition, ensuring that the content continues to be informed by and consistent with the latest academic ideas and knowledge. All new Australasian firms and analyses are included as end-of-chapter case studies in this edition. This edition provides a further update of all chapters, to include the latest regulations, practices and examples from both the financial markets and research. Industry insights from practitioners and other experts have been added to each chapter to further bridge students’ learning to industry contexts. Finally, a new Asia–Pacific example has been integrated across the chapters. Kathmandu Limited, an outdoor equipment and clothing retailer, is used to illustrate the concepts and practice of financial analysis. The retail industry in the region remains competitive and subject to ongoing competitive challenges, yet is well known to students. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

PREFACE

Key features This book differs from other texts in business and financial analysis in a number of important ways. We introduce and develop a framework for business analysis and valuation using financial statement data. We then show how to apply this framework to a variety of decision contexts.

Framework for analysis We begin the book with a discussion of the role of accounting information and intermediaries in the economy, and how financial analysis can create value in well-functioning markets. We identify four key components of effective financial statement analysis: 1 business strategy analysis 2 accounting analysis 3 financial analysis 4 prospective analysis. The first of the components, business strategy analysis, involves developing an understanding of the business and competitive strategy of the firm being analysed. Incorporating business strategy into financial statement analysis is one of the distinctive features of this book. Traditionally, other financial statement analysis books have ignored this step. However, beginning a financial statement analysis with a company’s strategy provides an important foundation for the subsequent analysis. The strategy analysis section discusses contemporary tools for analysing a company’s industry, its competitive position and sustainability within an industry and the company’s corporate strategy. Accounting analysis involves examining how accounting rules and conventions represent a firm’s business economics and strategy in its financial statements and, if necessary, developing adjusted accounting measures of performance. In the accounting analysis section, we do not emphasise accounting rules. Instead, we develop general approaches to analysing assets, liabilities, equities, revenues and expenses. We believe this approach enables students to effectively evaluate a company’s accounting choices and accrual estimates, even if learners have only a basic knowledge of accounting rules and standards. The material is also designed to allow students to make accounting adjustments rather than merely identifying questionable accounting practices. Financial analysis involves analysing financial ratio and cash flow measures of the operating, financing and investing performance of a company relative to either key competitors or historical performance. Our distinctive approach focuses on using financial analysis to evaluate the effectiveness of a company’s strategy and to make sound financial forecasts. Finally, under prospective analysis, we show how to develop forecasted financial statements and how to use these to make estimates of a firm’s value. Our discussion of valuation includes traditional discounted cash flow models as well as techniques that link value directly to accounting numbers. In discussing accounting-based valuation models, we integrate the latest academic research with traditional approaches, such as earnings and book value multiples that are widely used in practice. While we cover all four components of business analysis and valuation in the book, we recognise that the extent of their use depends on the user’s decision context. For example, bankers are likely to use business strategy analysis, accounting analysis, financial analysis and the forecasting portion of prospective analysis. They are less likely to be interested in formally valuing a prospective client. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Applying the framework to decision contexts The next section of the book shows how our business analysis and valuation framework can be applied to the following decision contexts:

securities analysis credit analysis merger and acquisition analysis governance and communication analysis.

For each of these topics we present an overview to provide a foundation for the class discussions. Where possible, we discuss relevant institutional details and any academic research useful in applying the analysis concepts developed earlier in the book. For example, the chapter on credit analysis shows how banks and rating agencies use financial statement data to develop analysis for lending decisions and to rate public debt issues. This chapter also presents academic research on how to determine whether a company is financially distressed.

Case approach We have found that teaching a course in business analysis and valuation is significantly enhanced, both for teachers and students, by using cases as a pedagogical tool. Students want to develop ‘hands-on’ experience in business analysis and valuation so that they can apply the concepts in decision contexts similar to those they will encounter in the business world. Cases are a natural way to achieve this objective by presenting practical issues that might otherwise be ignored in a traditional classroom exercise. Our cases present Australasian-focused business analysis and valuation issues in specific decision contexts, and we find that this makes the material more interesting for students. Each chapter contains a link to one or more case studies at the end of the book or online. These case studies are either based on, or directly drawn from, real company situations and challenges. They are designed to show the reader how the material in this book is related to real life business situations that they might encounter, to extend their learning to more complex questions and scenarios, and to give them experience with problems that do not always have a single or neat solution. They would be useful for instructors to use for a major assessment task, or in some cases, in an examination that uses a case-study approach. Many of the cases in this edition are new, and so provide up-to-date and authentic examples for these uses. Because the cases are real or based on reality, they do not always neatly correspond to the content of an individual chapter. Although each chapter has a link to a case, we also indicate in each case the corresponding chapters that it draws on. So when you are using a case, it is advisable to check what parts of it are related to the chapter you are studying. You may be able to start a case when you are working through the first chapter that is mentioned, and to complete it later when the final chapter(s) have been covered. Or you might choose to wait until all of the chapters have been covered, and to use the case for revision and assimilation of material across several chapters.

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Using the book We designed the book so that it is flexible for courses in financial statement analysis for a variety of student audiences, from undergraduate students with Accounting or Finance majors through to post-graduate students in Masters programs in business, and even Executive Education Program participants. Depending upon the audience, the instructor can vary the manner in which the conceptual materials in the chapters, end-of-chapter questions and case examples are used.

Prerequisites To get the most out of the book, students should have completed basic courses in financial accounting, finance and either business strategy or business economics. The text provides a concise overview of some of these topics, primarily as background for preparing the cases. But it would probably be difficult for students with no prior knowledge in these fields to use the chapters as stand-alone coverage of them. We have integrated only a small amount of business strategy into each case and do not include any cases that focus exclusively on business strategy analysis. The extent of accounting knowledge required for the cases varies considerably. Some require only a basic understanding of accounting issues, whereas others require a more detailed knowledge at the level of a typical intermediate financial accounting course. However, we have found it possible to teach even these more complex cases to students without a strong accounting background by providing additional reading on the topic.

How to use the text and case materials The materials can be used in a variety of ways. If the book is used for students with prior working experience or for executives, the instructor can use almost a pure case approach, adding relevant lecture sections as needed. When teaching students with little work experience, a lecture class can be presented first, followed by an appropriate case. It is also possible to use the book primarily for a lecture course and include some of the cases as in-class illustrations of the concepts discussed in the book. Alternatively, lectures can be used as a follow-up to cases to more clearly lay out the conceptual issues raised in the case discussions. This may be appropriate when the book is used in undergraduate capstone subjects. In such a context, cases can be used in course projects that can be assigned to student teams.

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About the authors Krishna G. Palepu is the Ross Graham Walker Professor of Business Administration and Senior Associate Dean for International Development at the Harvard Business School, Harvard University. His current research and teaching activities focus on strategy and governance. Professor Palepu serves on a number of public company and non-profit Boards. He has been on the Editorial Boards of leading academic journals, and has served as a consultant to a wide variety of businesses. Professor Palepu is also a frequent commentator in the news media on issues related to emerging markets and corporate governance. Paul M. Healy is James R. Williston Professor of Business Administration, and Chair of the Accounting and Management Unit at Harvard Business School, Harvard University. Professor Healy joined Harvard Business School as a Professor of Business Administration in 1997. His primary teaching and research interests include corporate financial reporting, financial analysis, corporate governance and corporate finance. Professor Healy’s research includes studies of the role and performance of financial analysts, how firms’ disclosure strategies affect their costs of capital, the performance of merging firms after mergers and managers’ financial reporting decisions. His work has been published in leading journals in accounting and finance. In 1990, his article ‘The Effect of Bonus Schemes on Accounting Decisions’, published in Journal of Accounting and Economics, was awarded the AICPA/AAA Notable Contribution Award. His text Business Analysis & Valuation was awarded the AICPA/AAA’s Wildman Medal for contributions to the practice in 1997 and the AICPA/AAA Notable Contribution Award in 1998. Victor L. Bernard, who passed away 14 November 1995, was the Price Waterhouse Professor of Accounting and Director of the Paton Accounting Center at the University of Michigan. He was also the Director of Research for the American Accounting Association. Sue Wright is a Professor of Accounting and Head of Department at UTS Business School. Her research interests include corporate governance, financial reporting and valuation, and business education. Sue has taught financial statement analysis for over 20 years, and supervises many PhD and Masters students. She was awarded Fellow membership of the Accounting and Finance Association of Australia and New Zealand in 2014. Michael Bradbury is Professor of Accounting at Massey University, Albany, and FCA of the New Zealand Institute of Chartered Accountants. His research has examined issues in financial reporting and financial analysis. Michael became a life member of the Accounting and Finance Association of Australia and New Zealand in 2002 and received the Outstanding Contribution to Practice Award in 2001. Jeff Coulton is a Senior Lecturer in the UNSW Business School. Jeff’s research interests include earnings and audit quality, voluntary disclosure, executive remuneration and corporate governance. He has recently been involved in research with NASA on the technical and economic feasibility of off-earth mining. Jeff has been teaching financial statement analysis classes to undergraduate, postgraduate coursework and MBA students for over 10 years.

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Acknowledgements As with the previous Asia–Pacific editions of Business Analysis and Valuation, this third edition is the result of the combined efforts, energies and encouragement of each of the Australasian coauthors, as well as our colleagues, students, friends and family. Our colleagues in our various universities have provided much encouragement and support, and have materially contributed to the improvements evident in this third edition. We thank them for so willingly sharing their skill and experience, and for providing feedback and advice along the way. In particular, we thank those who have shared case material and examples, and other tips acquired from teaching business analysis and valuation in the Australasian context. Our sincere thanks go to various practitioner and academic colleagues whom we have consulted for industry insights. Their practical experience and research papers have made important contributions to our text. We also acknowledge all the students we have had the privilege of meeting in the courses we teach, and for their enthusiastic questions and astute observations as we have introduced them to various topics using the content and methods of this book. We are grateful to the many people at Cengage who have helped produce this book, for their vision, patience, support and encouragement. Finally, we thank our many friends and family members for their genuine interest in the progress of the manuscript, and their understanding of our passion for this subject matter. The authors and Cengage Learning would like to thank the following reviewers for their incisive and helpful feedback. Dr Charlene Chen Macquarie University Dr Anthony Ng Monash University Dr Warwick Anderson University of Canterbury Dr Bobae Choi University of Newcastle Dr Maria Prokofieva Victoria University Professor Millicent Chang University of Wollongong Dr Andreas Hellmann Macquarie University Dr Kuldeep Kumar Bond University Professor Sajid Anwar University of the Sunshine Coast Dr Lily Chen University of Auckland Professor Keith Duncan Bond University Dr Shyam Bhati University of Wollongong Dr Paskalis Glabadanidis University of Adelaide Business School Dr Stephen Kean University of Auckland Dr Hayley Ma University of Technology Sydney. Every effort has been made to trace and acknowledge copyright. However, if any infringement has occurred, the publishers tender their apologies and invite the copyright holders to contact them.

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

PART

1

Framework CHAPTER 1

A framework for business analysis and valuation using financial statements

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CHAPTER

1

A framework for business analysis and valuation using financial statements

Valuing an organisation is an important and regular analytical exercise performed by a wide variety of professional advisors and individual investors. Questions related to valuation include the following: A security analyst might want to know: ‘How well is the firm I am following performing? Did the firm meet my performance expectations? If not, why not? What is the value of the firm’s shares given my assessment of its current and future performance?’ A loan officer might ask: ‘What is the credit risk involved in lending money to this organisation? How well is the organisation managing its liquidity and solvency? What is the organisation’s business risk? What is the additional risk created by the organisation’s financing and dividend policies?’ A management consultant might enquire: ‘What is the structure of the industry in which the organisation is operating? What strategies are the various players in the industry pursuing? How have these factors affected the relative performance of different organisations in the industry?’ A corporate manager needs to know: ‘Are investors valuing my firm properly? Is our investor communication program helping them value it accurately?’ or ‘Is my firm a potential takeover target? How much value can we add if we acquire another firm? How can we finance the acquisition?’ An independent auditor should ask: ‘Are the accounting policies and accrual estimates in this organisation’s financial statements consistent with my understanding of this business and its recent performance? Do these financial reports communicate

the current status and significant risks of the business?’ An individual investor may want to know: ‘Which shares should I add to my portfolio of stocks? Are there any shares that I should sell? Given my expectations of the outlook for the economy and certain industries, is the current market price of any firm’s shares significantly higher or lower than my assessment of its value? Is the management and/or governance of any firm adding to or undermining its value?’ All of these people can use a systematic framework to analyse an organisation’s past, current and future economic activities. This framework is known as financial statement analysis. It is outlined in this initial chapter and then comprehensively discussed and illustrated in the following chapters of this book. The analysis draws on many sources of information to make it as current and accurate as possible. Because financial statements provide the most widely available data on any organisation’s economic activities, investors and other stakeholders primarily rely on financial reports to assess the plans and performance of organisations and corporate managers. To understand the contribution that financial statement analysis can make, it is important to understand the role of financial reporting in how capital markets function and the institutional forces that shape financial statements. In this chapter, we first present a brief description of these forces, followed by a discussion of the steps that an analyst must perform to extract information from financial statements and provide meaningful forecasts.

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CHAPTER 1 A framework for business analysis and valuation using financial statements

Chapter learning objectives By the end of this chapter, you should be able to: LO1

understand the role of capital markets in the economy and the potential for financial reporting to enhance capital market efficiency

LO2

remember the features of accounting that provide the potential for financial reports to inform external users

LO3

appreciate the importance of financial reports in financial statement analysis for business valuation.

LO1

 he role of financial reporting in capital T markets

A critical challenge for any economy is allocating savings to investment opportunities. Economies that do this well can benefit from innovation to create jobs and wealth at a rapid pace. In contrast, economies that manage this process poorly fail to fully support new business opportunities and do not maximise economic outcomes. Different models for channelling savings into business investments have prevailed in different countries through history. The prevailing model in many countries in the world today is the market model, in which capital markets play an important role in channelling financial resources from savers to business enterprises that need capital. Figure 1.1 provides a schematic representation of how capital markets typically work in a broad sense. Savings in any economy are widely distributed among households. Many aspiring entrepreneurs and existing companies would like to attract these savings to fund their business ideas. While both savers and those with business ideas want to connect, matching savings to business investment opportunities is complicated for at least three reasons. First, businesses typically have better information on the value of their investment opportunities than savers have. Second, communication from businesses to investors is not completely credible because investors know that businesses have an incentive to inflate the value of their ideas. Third, savers generally lack the financial sophistication needed to analyse and differentiate various business opportunities. These information and incentive problems lead to what economists call the ‘lemons’ problem, which can potentially break down the functioning of the capital market.1 It works like this. Savings Financial intermediaries

Information intermediaries Business ideas

FIGURE 1.1 Capital markets

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Consider a situation where half the business ideas are ‘good’ and the other half are ‘bad’. If investors cannot distinguish between the two types of business ideas, entrepreneurs with bad ideas will try to claim that their ideas are as valuable as the good ideas. Recognising this possibility, investors value both good and bad ideas at an average level. Unfortunately, this penalises good ideas, and entrepreneurs with good ideas find the terms on which they can get financing in the capital market to be unattractive. As these entrepreneurs leave the capital market, the proportion of bad ideas in that market increases. Over time, bad ideas outnumber good ideas and investors lose confidence in this market. The emergence of intermediaries can prevent such a market breakdown. There are several types of intermediaries in a sophisticated capital market system. Financial intermediaries, such as venture capital and private equity firms, banks, superannuation funds, managed funds and insurance companies, focus on aggregating funds from individual investors and distributing those funds to businesses seeking sources of capital. Information intermediaries, such as auditors and company audit committees, serve as credibility enhancers to provide an independent assessment of business ideas. Information analysers and advisors such as financial analysts, credit rating agencies and the financial press are another type of information intermediary that collect and analyse business information used to make business decisions. Transaction facilitators such as stock exchanges and brokerage houses play a crucial role in capital markets by providing a platform to facilitate buying and selling in markets. Finally, regulatory intermediaries such as the Australian Securities Exchange (ASX) and the Australian Securities and Investments Commission (ASIC) create appropriate regulatory policies to support the legal framework of the capital market system, while adjudicators such as the court system resolve disputes that arise between participants. In a well-functioning capital market, the market institutions described above add value by both helping investors distinguish good investment opportunities from bad ones and by directing funding to those business ideas deemed most promising. Financial reporting plays a critical role in the effective functioning of capital markets. Information intermediaries add value either by enhancing the credibility of financial reports (as auditors do) or by analysing the information in the financial statements (as analysts and the rating agencies do). Financial intermediaries rely on information in the financial statements to analyse investment opportunities, and supplement this information from other sources. It can surprise those who are new to business analysis to learn that financial reporting is an important source of information for valuation. It was also a surprise to many academics when this idea was presented in a seminal research paper published by Philip Brown and Ray Ball in 1968.2 At that time, accounting reporting was widely viewed as a backroom function necessary for compliance and stewardship, but not producing useful information. Ball and Brown (1968) empirically demonstrated that accounting information conveyed, at the end of the year, much of the same information as was known to the share market from all available sources during the year. What was not known affected the share price in the expected direction and in a timely fashion when it was announced in the accounting report. Ball and Brown (1968) relied on the hypothesis of market efficiency, which had been recently articulated by Eugene Fama in 1965.3 The efficient markets hypothesis states that asset prices reflect all available information. An implication of this hypothesis is that it is impossible for an investor to earn a riskless profit from trading on ‘new’ information. Paradoxically, the attempt by investors to earn a riskless profit leads to new information being incorporated into market prices, but also ensures that a riskless profit is not earned. Does this imply that financial statement and valuation analysis is useful for identifying the value of a firm’s shares, but not for identifying profitable trading opportunities from Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 1 A framework for business analysis and valuation using financial statements

mispriced shares? In practice this conclusion does not hold. Many investors have made profitable investments using financial reporting and the techniques discussed in this book, based on their superior skills, unique sources of information, interpretation of information or timing. In the following section, we discuss key aspects of the financial reporting system design that enable it to effectively play this vital role in the functioning of the capital markets.

LO2

 rom business activities to financial F statements

Corporate managers are responsible for acquiring physical and financial resources from the firm’s environment and using them to create value for the firm’s investors. When the firm earns a return on its investment in excess of the cost of capital, it creates value. Managers formulate business strategies to achieve this goal, and they implement them through business activities. A firm’s business activities are influenced by its economic environment and its own business strategy. The economic environment includes the firm’s industry, its input and output markets, and the regulations under which it operates. The firm’s business strategy determines how it positions itself in its environment to achieve a competitive advantage. As shown in Figure 1.2, a firm’s financial statements summarise the economic consequences of its business activities. The firm’s business activities in any time period are too numerous to be Business environment Labour markets Capital markets Product markets: Suppliers Customers Competitors Business regulations

Accounting environment Capital market structure Contracting and governance Accounting conventions and regulations Tax and financial accounting linkages Third-party auditing Legal system for accounting disputes

Business activities Operating activities Investment activities Financing activities

Accounting system Measure and report economic consequences of business activities.

Business strategy Scope of business: Degree of diversification Type of diversification Competitive positioning: Cost leadership Differentiation Key success factors and risks

Accounting strategy Choice of accounting policies Choice of accounting estimates Choice of reporting format Choice of supplementary disclosures

Financial statements Managers’ superior information on business activities Estimation errors Distortions from managers’ accounting choices

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reported individually. Further, some of the activities undertaken by the firm are proprietary, so disclosing them in detail could be detrimental to the firm’s competitive position. The accounting system provides a mechanism through which business activities are selected, measured and aggregated into financial statement data. Intermediaries using financial statement data to undertake business analysis have to be aware that financial reports are influenced both by the firm’s business activities and by its accounting system. A key aspect of financial statement analysis, therefore, involves understanding the influence of the accounting system on the quality of the financial statement data being used in the analysis. Some important features of the accounting systems are discussed in the following section.

Accounting system feature 1: Accrual accounting One of the fundamental features of corporate financial reports is that they are prepared using accrual rather than cash accounting. Accrual accounting distinguishes between recording costs and benefits associated with economic activities and actually paying and receiving cash. Profit is the primary periodic performance index. To compute profit, the effects of economic transactions are recorded on the basis of expected, not necessarily actual, cash receipts and payments. Expected cash receipts from the delivery of products or services are recognised as revenues, and expected cash outflows associated with these revenues are recognised as expenses. The need for accrual accounting arises from investors’ demand for financial reports on a periodic basis. Because firms undertake economic transactions continually, the arbitrary closing of accounting books at the end of a reporting period leads to a fundamental measurement problem. Accounting for only cash receipts and payments does not report the full economic consequence of the transactions undertaken in a given period. Accrual accounting is designed to provide more complete information about a firm’s periodic performance.

Accounting system feature 2: Accounting standards and auditing The use of accrual accounting lies at the centre of many important complexities in corporate financial reporting. Because accrual accounting deals with expectations of future cash consequences of current events, it is subjective and relies on a variety of assumptions. Who should be charged with the primary responsibility of making these assumptions? In the current system, the task of making the appropriate estimates and assumptions to prepare the financial statements is delegated to a firm’s managers because they have detailed knowledge of their firm’s business. This responsibility is known as ‘accounting discretion’. The accounting discretion granted to managers is potentially valuable because it allows them to reflect their detailed knowledge in reported financial statements. However, managers can use accounting discretion to distort financial statement numbers. One obvious incentive to do so is where management’s bonuses are based on accounting profits. The use of accounting numbers in contracts between the firm and outsiders provides another motivation for management distortion. Not all distortions are intended to misrepresent financial statement data. Managers may also unintentionally bias accounting estimates because of their lack of objectivity about their business. Whatever the reasons, the distortion of financial accounting numbers makes them less valuable to external users of financial statements. Therefore, the delegation of financial reporting decisions to corporate managers has both costs and benefits. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 1 A framework for business analysis and valuation using financial statements

A number of accounting practices, such as accounting standards and independent audits, have evolved to ensure that managers use their accounting flexibility to objectively reflect their knowledge of the firm’s business activities. Accounting standards are developed to improve the quality of financial reporting. They often improve the consistency of accounting by recording similar economic transactions in a like manner. This increases comparability both over time and across organisations. The demand for international comparability of financial reports has led to over 100 countries worldwide, including Australia and New Zealand, adopting or permitting use of the International Financial Reporting Standards (IFRS) promulgated by the International Accounting Standards Board (IASB). Increased consistency from accounting standards, however, comes at the expense of reduced flexibility for managers to reflect genuine business differences in their firm’s financial statements. Accounting standards work best for economic transactions whose accounting treatment is not predicated on managers’ proprietary information. When there is significant business judgement involved in assessing a transaction’s economic consequences, standards that prevent managers from using their superior business knowledge do not improve the quality of financial reporting. Further, if accounting standards are too rigid, they may induce managers to expend economic resources to restructure business transactions in order to achieve a desired accounting result.

Accounting system feature 3: Managers’ reporting strategy Because the mechanisms that limit managers’ accounting discretion add ‘noise’ to accounting data, it is not optimal to use accounting regulation to eliminate managerial flexibility completely. Furthermore, as accounting standards such as IFRS and the Generally Accepted Accounting Principles (GAAP) are revised to enable more widespread adoption or to reduce differences between regimes, the rigidity of accounting standards has become less of a concern. Accounting rules now often provide a broad set of alternatives managers can choose from. In practice, accounting systems leave considerable room for managers to influence financial statement data. A firm’s reporting strategy – that is, the manner in which managers use their accounting discretion – has an important influence on the firm’s financial statements. Accounting regulations usually prescribe minimum disclosure requirements, but they do not restrict managers from voluntarily providing additional disclosures. Corporate managers can choose accounting and disclosure policies that make it more or less difficult for external users of financial reports to understand the true economic picture of their businesses. A superior disclosure strategy will enable managers to communicate the underlying business reality to outside investors. One important constraint on a firm’s disclosure strategy is the competitive dynamics in product markets. Disclosing proprietary information about business strategies and their expected economic consequences may hurt the firm’s competitive position. Subject to this constraint, managers can use financial statements to provide information useful to investors in assessing their firm’s true economic performance. Reporting on corporate environmental and social effects under the heading of ‘sustainability’ is one example of a voluntary disclosure that has emerged in response to investor demand for new information. Managers can also use financial reporting strategies to manipulate investors’ perceptions. Using the discretion granted to them, managers can make it difficult for investors to identify poor performance on a timely basis. For example, managers can choose accounting policies and

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estimates to provide an optimistic assessment of the firm’s true performance. They can also make it costly for investors to understand a firm’s true performance by controlling the extent of information that is disclosed voluntarily. The extent to which financial statements reveal the underlying business reality varies across organisations and across time for a given organisation. This variation in accounting quality provides both an important opportunity and a challenge in doing business analysis. The process through which analysts can separate noise from information in financial statements, and gain valuable business insights from financial statement analysis, is discussed in the following section.

Accounting system feature 4: Auditing Auditing can be broadly defined as a verification of the integrity of the reported financial statements by someone independent of the preparer. This process ensures that managers use accounting rules and conventions consistently over time, and that their accounting estimates are reasonable. Therefore, auditing improves the quality of accounting data. Third-party auditing may also reduce the quality of financial reporting because it constrains the kinds of accounting rules and conventions that evolve over time. For example, the IASB considers the views of auditors in the standard-setting process. Auditors are likely to argue against accounting standards producing numbers that are difficult to audit, even if the proposed rules produce relevant information for investors. The legal environment in which accounting disputes between managers, auditors and investors are adjudicated can also have a significant effect on the quality of reported numbers. The threat of lawsuits and resulting penalties has the beneficial effect of improving the accuracy of disclosure. However, the potential for a significant legal liability may also discourage managers and auditors from supporting accounting proposals that require risky forecasts, such as forwardlooking disclosures.

LO3

 rom financial statements to F business analysis

Because managers’ insider knowledge is a source both of value and of distortion in accounting data, it is difficult for outside users of financial statements to separate true information from distortion and noise. Not being able to ‘undo’ accounting distortions completely, investors ‘discount’ a firm’s reported accounting performance. In doing so, they make a probabilistic assessment of the extent to which a firm’s reported numbers reflect its economic performance. As a result, investors can have only an imprecise assessment of an individual firm’s performance. Financial and information intermediaries can add value by improving investors’ understanding of a firm’s current performance and its future prospects. Effective financial statement analysis is valuable because it attempts to elicit managers’ inside information from public financial statement data. Because intermediaries do not have direct or complete access to this inside information, they rely on their knowledge of the firm’s industry and its competitive strategies to interpret financial statements. Successful intermediaries have at least as good an understanding of the industry economics as do the firm’s managers, as well

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CHAPTER 1 A framework for business analysis and valuation using financial statements

as a reasonably good understanding of the firm’s competitive strategy. Although outside analysts have an information disadvantage relative to the firm’s managers, they may be more objective in evaluating the economic consequences of the firm’s investment and operating decisions. Figure 1.3 provides a schematic overview of how business intermediaries use financial statements to accomplish four key steps: 1 business strategy analysis 2 accounting analysis 3 financial analysis 4 prospective analysis. Financial statements Managers’ superior information on business activities Noise from estimation errors Distortion from managers’ accounting choices Other public data Industry and firm data Outside financial statements

Business application context Credit analysis Securities analysis Mergers and acquisitions analysis Debt/dividend analysis Corporate communication strategy analysis General business analysis

ANALYSIS TOOLS Business strategy analysis Generate performance expectations through industry analysis and competitive strategy analysis.

Accounting analysis Evaluate accounting quality by assessing accounting policies and estimates.

Financial analysis Evaluate performance using ratios and cash flow analysis.

Prospective analysis Make forecasts and value business.

FIGURE 1.3 Analysis using financial statements

Analysis step 1: Business strategy analysis The purpose of business strategy analysis is to identify key profit drivers and business risks, and to assess the firm’s profit potential at a qualitative level. Business strategy analysis involves analysing the potential for profit and growth within a firm’s industry, and its strategy to create a sustainable competitive advantage. This qualitative analysis is an essential first step because it enables the analyst to frame the subsequent accounting and financial analysis better. For example, identifying the key success factors and key business risks allows the identification of key accounting policies. Assessment of a firm’s competitive strategy facilitates evaluating whether current profitability is sustainable. Finally, business analysis enables the analyst to make sound assumptions in forecasting a firm’s future performance. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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PART 1 FRAMEWORK

Analysis step 2: Accounting analysis The purpose of accounting analysis is to evaluate the degree to which a firm’s accounting captures the underlying business economics. By identifying places where there is accounting flexibility, and by evaluating the appropriateness of the firm’s accounting policies and estimates, analysts can assess the degree of distortion in a firm’s accounting numbers. Another important step in accounting analysis is to ‘undo’ any accounting distortions by recasting a firm’s accounting numbers to create unbiased accounting data. Sound accounting analysis improves the reliability of conclusions from financial analysis, the next step in a financial statement analysis.

Analysis step 3: Financial analysis The goal of financial analysis is to use financial data to evaluate the current and past performance of a firm and to assess its sustainability. There are two important skills related to financial analysis. First, the analysis should be systematic and efficient. Second, the analysis should allow the analyst to use financial data to explore business issues. Ratio analysis and cash flow analysis are the two most commonly used financial tools. Ratio analysis focuses on evaluating a firm’s product market performance and financial policies; cash flow analysis focuses on a firm’s liquidity and financial flexibility.

Analysis step 4: Prospective analysis Prospective analysis, which focuses on forecasting a firm’s future, is the final step in a business analysis. Two commonly used techniques in prospective analysis are financial statement forecasting and valuation. Both these tools allow the synthesis of the insights from business analysis, accounting analysis and financial analysis so that predictions can be made about a firm’s future.

Conclusion While the intrinsic value of a firm is a function of its future cash flow performance, it is also possible to assess a firm’s value based on its current book value of equity, and its future return on equity (ROE) and growth. Strategy analysis, accounting analysis and financial analysis, the first three steps in the framework discussed here, provide an excellent foundation for estimating a firm’s intrinsic value. Strategy analysis, in addition to enabling sound accounting and financial analysis, also helps in assessing potential changes in a firm’s competitive advantage and their implications for the firm’s future ROE and growth. Accounting analysis provides an unbiased estimate of a firm’s current book value and ROE. Financial analysis facilitates an in-depth understanding of what drives the firm’s current ROE. The predictions from a sound business analysis are useful to a variety of market participants and can be applied in various contexts. The exact nature of the analysis will depend on the context. The contexts that we will examine include securities analysis, credit evaluation, mergers and acquisitions, evaluation of debt and dividend policies, and the assessment of corporate communication strategies. The four analytical steps described above are useful in each of these contexts. Appropriate use of these tools, however, requires a familiarity with the economic theories and institutional factors relevant to the context. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 1 A framework for business analysis and valuation using financial statements

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A PRACTITIONER ADVISES Australian financial analyst on the benefits of the framework of financial analysis:

The real world is complex and keeps changing. You need a framework to be able to understand the real world. If you don’t have a framework to work with, then you actually can’t operationalise anything, even if reality is different to what the textbook would say. If you don’t have the framework in this textbook, then everything is unexplainable and everything is just random, and you can’t make a forecast and you can’t plan ahead. This textbook provides such a framework, to give you a way of thinking about value, and to enable you to make a forecast and plan ahead. It provides order, and helps you to pull apart real-world complexity. This textbook gives you a way to think about how to communicate that complexity. But you can’t hold to it too tightly because the real world is different. The framework of the four steps of financial statement analysis (business strategy analysis, accounting analysis, financial analysis and prospective analysis) in this textbook gives you a way of communicating the complexity of the real world.

Financial analysis is about helping decision-makers, but also importantly, learning about it will give you empathy for decision-makers, which will make you a better advisor. Decision-makers have a very difficult job to do, and if you can understand where they’re coming from, and you can understand the problems they have and you can help them solve their problems in a constructive way – that’s actually understanding how to answer a question that somebody has. And that’s going beyond just being a service-provider, to actually help someone do what they need to do, better. Reflective activity: What techniques do you use in other subject areas, or in other activities that you undertake, to help you to understand a complex situation, and to represent it in a simplified manner to enable decisions to be made? Some examples of complex situations might be a strategy for a sports game, or planning an overseas trip on your own within a tight budget.

SUMMARY Financial statements provide the most widely available data on an organisation’s economic activities; investors and other stakeholders rely on them to assess the plans and performance of organisations and corporate managers. Accrual accounting data in financial statements are noisy, and unsophisticated investors can assess an organisation’s performance only imprecisely. Financial analysts who understand managers’ disclosure strategies have an opportunity to create inside information from public

data, and they play a valuable role in enabling outside parties to evaluate an organisation’s current and prospective performance. This chapter has outlined the framework for business analysis using financial statements, which comprises four key steps: business strategy analysis, accounting analysis, financial analysis and prospective analysis. The remaining chapters in this book describe these steps in greater detail and discuss how they can be used in a variety of business contexts.

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INDUSTRY INSIGHT

There are several ways in which financial statement analysis can add value, even when capital markets are reasonably efficient. First, financial statement analysis has many applications whose focus is outside the capital market context – credit analysis, competitive benchmarking, and analysis of mergers and acquisitions, to name a few. Second, markets become efficient precisely because some market participants rely on analytical tools such as those we discuss in this book to analyse information and make informed investment decisions. This in turn imposes greater discipline on corporate managers to develop appropriate disclosure and communication strategies.

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PART 1 FRAMEWORK

CHECKING AND APPLYING YOUR LEARNING 1 Qian, who has just completed his first finance course, is unsure whether he should take a course in business analysis and valuation using financial statements because he believes that financial analysis adds little value, given the efficiency of capital markets. Explain to Qian when financial analysis can add value, even if capital markets are efficient.  LO1 2 Four steps for business analysis are discussed in this chapter (strategy analysis, accounting analysis, financial analysis and prospective analysis). For each of the following professional roles, explain which step is the most important and how accounting information is used in that step: a Auditor b Loan officer c Management consultant.  LO3 3 Explain voluntary disclosure of information in financial reports as a solution to the ‘lemons problem’ described in the chapter. Is it a full solution or a partial solution? Why?  LO1 4 Research demonstrates that managers usually report truthfully, rather than seeking to distort the firm’s performance and financial position. Explain why accounting analysis is still an important step in financial statement analysis.  LO2 5 Summarise the arguments for and against accounting reports providing useful information to outside investors.  LO2 6 Financial, information, transaction and regulatory intermediaries were described in this chapter as ‘adding value’ to a well-functioning capital market. Identify two intermediaries that operate in your country, and discuss how they add value.  LO1 7 Considering the arguments in the previous question, do you think that investors would be better off if ‘raw’ (unadjusted) accounting numbers were provided, in a system of reporting such as XBRL (eXtensible Business Reporting Language)? Why or why not?  LO2 8 Some scholars consider financial statement analysis to be a capstone subject for all business students. Below is a list of other business disciplines that use financial statement analysis. Indicate which of the four steps each one contributes to: – accounting – econometrics

– economics – finance – law – management – marketing – statistics. LO3  9 Read this scenario and respond to the questions that follow. Would you invest in this company? You open the annual financial report to shareholders for a large and well-known company. The first page, in large bold font, proclaims the company’s achievements for the year:

Asset growth of 79% in the past 12 months. Net profit up 14% on revenue increases of 4%. Dividend distribution has grown by 13%. You turn the pages. These achievements are also represented in upwardly sloping graphs, although the axes of the graphs are rather light coloured and difficult to read. There is a chart of share price growth, compared to the stock market average for the past five years. You turn to the section on the management team, and the board of directors. The photographs indicate to you that the management team is middle aged, and the board members are even older. Their smiles in the photographs are broad and friendly. Would you invest in this company? a For each section of the report described, present the case for investing in this company, and, if possible, also provide an alternative explanation for the presentation that does not encourage investment. b What else would you like to know about this company? i Would you find this information in the annual financial report? ii If not, where might you find it? 10 Find the latest annual report for the company Kathmandu Holdings Ltd. Describe its contents and your initial impressions of the company’s performance (without making any calculations). What other information would you like to know before you analyse this company’s financial statements and calculate its value? Where might you find that information?

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CHAPTER 1 A framework for business analysis and valuation using financial statements

ENDNOTES 1

2

G. Akerlof, ‘The market for “lemons”: ‘Quality uncertainty and the market mechanism’, Quarterly Journal of Economics (August 1970): 488–500. R. Ball & P. Brown, 'An empirical evaluation of accounting income numbers', Journal of Accounting Research, (1968): 159–178.

3

E. F. Fama, 'The behavior of stock-market prices', Journal of Business 38(1), (1965): 34–105.

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Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

PART

2

Business analysis and valuation tools CHAPTER 2

Strategy analysis

CHAPTER 3

Overview of accounting analysis

CHAPTER 4

Implementing accounting analysis

CHAPTER 5

Financial analysis

CHAPTER 6

Prospective analysis: Forecasting

CHAPTER 7

Prospective analysis: Valuation theory and concepts

CHAPTER 8

Prospective analysis: Valuation implementation

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CHAPTER

2

Strategy analysis

Strategy analysis is an important starting point when analysing financial statements. Strategy analysis allows the analyst to probe the economics of a firm at a qualitative level so that the subsequent quantitative accounting and financial analysis is informed by business reality. Strategy analysis also helps the analyst to identify the firm’s profit drivers and key risks. This in turn enables them to assess the sustainability of the firm’s current performance and make realistic forecasts of future performance. A firm’s value is determined by its ability to earn a return on its capital in excess of the cost of capital. What determines whether or not a firm is able to accomplish this goal? While a firm’s cost of capital is determined by the capital markets, its profit potential is determined by its own strategic choices:

1 the choice of an industry or a set of industries in which the firm operates (industry choice) 2 the manner in which the firm intends to compete with other firms in its chosen industry or industries (competitive positioning) 3 the way in which the firm expects to create and exploit synergies across the range of businesses in which it operates (corporate strategy). Strategy analysis, therefore, involves evaluating the whole industry, as well as the firm’s competitive strategy and corporate strategy.1 In this chapter, we will briefly discuss these three steps and illustrate their application to Australasian companies, using Kathmandu Holdings Ltd and Wesfarmers to evaluate industry and corporate strategy, and the Apple iPhone for evaluation of competitive strategy.

Chapter learning objectives By the end of this chapter, you should be able to: LO1

understand the competitive forces in an industry that influence a firm’s profit potential

LO2

analyse industry in a contemporary example

LO3

understand and assess a firm’s potential source of competitive advantage

LO4

understand and assess a firm’s corporate strategy.

LO1

Industry evaluation

In analysing a firm’s profit potential, an analyst has to first assess the profit potential of each of the industries in which the firm competes. There are systematic differences between the profitability of various industries, which can change over time as industries evolve. Figure 2.1 provides 10-year growth rates from 1996 to 2005 and 2006 to 2015 for Australian and New Zealand industry groups, which reflect the changing nature of those economies during those periods. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 2 Strategy analysis

FIGURE 2.1 Industry growth rates in Australia and New Zealand, 1996–2005 and 2006–15

Australian growth rates Industry

1996–2005

New Zealand growth rates

2006–15

1996–2005

2006–15

Agriculture, forestry and fishing

37.6

7.7

29.4

4.1

Mining

17.6

127.5

−6.5

57.8

Manufacturing

16.6

5.8

26.2

−6.6

Electricity, gas, water and waste services

12.5

123.1

12.9

14.6

Construction

77.0

88.9

62.8

27.3

Wholesale trade

45.2

40.9

36.6

21.6

Retail trade

48.3

38.2

40.6

36.6

Accommodation and food services

53.3

102.8

27.8

20.4

Transport, postal and warehousing

46.5

72.0

43.9

20.8

Information media and telecommunications

84.9

47.7

81.7

43.8

Financial and insurance services

49.3

0

37.5

36.2

Rental, hiring and real estate services

65.0

−28.6

40.3

21.4

Professional scientific and technical services

25.4

13.3

39.9

28.9

Administrative and support services

42.0

69.0

40.9

12.9

Education and training

21.5

−28.1

21

0.4

Healthcare and social assistance

48.8

44.9

38.5

32.7

Arts and recreation services

46.7

−7.1

46

−0.7

Note: Both positive and negative growth rates were experienced across sub-sectors of the financial and services industry, averaging at approximately 0% growth. Source: Stats NZ; ABS Cat. 8155.0 Australian Industry 2016-17, 1309.0 Australia at a glance 2008; IBISWorld. This work includes Stats NZ’s data which are licensed by Stats NZ for reuse under the Creative Commons Attribution 4.0 International licence; ABS data licensed under the Creative Commons Attribution 4.0 International licence.

Growth rates in Australia range from a low of –28.6% (negative growth) for rental, hiring and real estate services (2006–15) to a high of 127.5% for mining (2006–15). In New Zealand, growth over 10 years was lowest in manufacturing (2006–15) and highest in information media and telecommunications (1996–2005). It is interesting to note the similar growth patterns in agriculture, forestry and fishing; retail trade; information media and telecommunications; and arts and recreation – all industries that are subject to strong international influences. In contrast, growth patterns in electricity, gas, water and waste services; accommodation and food services; transport, postal and warehousing; administrative and support services; rental, hiring and real estate services; and education and training are more affected by country influences, particularly government funding and policies. For these industries, the extreme results in Australia over the period 2006–15 were not matched in New Zealand. A vast body of literature in industrial organisation discusses the influence of industry structure on profitability.2 Relying on this research, the strategy literature suggests that the average profitability of an industry is influenced by the ‘five forces’ shown in Figure 2.2.3 According to this framework, the intensity of competition determines the potential for creating abnormal profits by the firms in an industry. Whether or not the industry keeps the potential profits is determined by the relative bargaining power of the firms in the industry and their customers and suppliers. We will discuss each of these industry profit drivers in more detail. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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DEGREE OF ACTUAL AND POTENTIAL COMPETITION Rivalry among existing firms Industry growth Concentration Differentiation Switching costs Scale/learning economies Fixed-variable costs Excess capacity Exit barriers

Threat of new entrants Scale economies First-mover advantage Distribution access Relationships Legal barriers

Threat of substitute products Relative price and performance Buyers’ willingness to switch

INDUSTRY PROFITABILITY

BARGAINING POWER IN INPUT AND OUTPUT MARKETS Bargaining power of buyers Switching costs Differentiation Importance of product for costs and quality Number of buyers Volume per buyer

Bargaining power of suppliers Switching costs Differentiation Importance of product for costs and quality Number of suppliers Volume per supplier

FIGURE 2.2 Industry structure and profitability

Degree of potential competition At the most basic level, the profits in an industry are a function of the maximum price that customers are willing to pay for the industry’s product or service. One of the key determinants of the price is the degree to which there is competition among suppliers of the same or similar products. At one extreme, if  there is a state of perfect competition in the industry, microeconomic theory predicts that prices will be equal to marginal cost, and there will be few opportunities to earn supernormal profits. At  the other extreme, if the industry is dominated by a single firm, there will be potential to earn monopoly profits. In reality, the degree of competition in most industries is somewhere in between perfect competition and monopoly. There are three potential sources of competition in an industry: 1 rivalry between existing firms 2 threat of entry of new firms 3 threat of substitute products or services. We will discuss each of these potential competitive forces in the following paragraphs.

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CHAPTER 2 Strategy analysis

Competitive force 1: Rivalry among existing firms In most industries, the average level of profitability is primarily influenced by the nature of rivalry among existing firms in the industry. In some industries, firms compete aggressively, pushing prices close to (and sometimes below) the marginal cost. In other industries, firms do not compete aggressively on price. Instead, they find ways to coordinate their pricing, or compete on non-price dimensions such as innovation or brand image. Several factors determine the intensity of competition between existing players in an industry. Industry growth rate

If an industry is growing very rapidly, incumbent firms need not grab market share from each other to grow. In contrast, in stagnant industries the only way existing firms can grow is by taking share away from the other players. In this situation one can expect price wars among firms in the industry. Concentration and balance of competitors

The number of firms in an industry and their relative sizes determine the degree of concentration in an industry. The degree of concentration influences the extent to which firms in an industry can coordinate their pricing and other competitive moves; for example, if one firm dominates an industry (such as Transurban in Australian toll roads), it can set and enforce the rules of competition. Similarly, if  there are only two or three equal-sized players (such as Hoyts, Village and Event Cinemas in the cinema industry), they can implicitly cooperate with each other to avoid destructive price competition. If an industry is fragmented, such as with the production and distribution of food and beverage industries in Australasia, price competition is likely to be severe. Degree of differentiation and switching costs

The extent to which firms in an industry can avoid head-on competition depends on the extent to which they can differentiate their products and services. If the products in an industry are very similar, customers can readily switch from one competitor to another purely based on price. Switching costs also determine customers’ propensity to move from one product to another. When switching costs are low, there is a greater incentive for firms in an industry to engage in price competition. For example, petroleum has low switching costs and is extremely price competitive. When switching costs are high, early entrants to an industry (first movers) gain advantages from customers’ reluctance to change. In medical services, for example, switching costs, including lack of access to information, can be substantial, which reduces price competition. Scale/learning economies and the ratio of fixed to variable costs

If there is a steep learning curve or there are other types of scale economies in an industry, size becomes an important factor for firms in the industry. In such situations, there are incentives to engage in aggressive competition for market share. Similarly, if the ratio of fixed to variable costs is high, firms have an incentive to reduce prices to utilise installed capacity. Online streaming services are priced very competitively for this reason. Without government monopoly protection, utilities such as electricity, gas and water may also experience price wars.

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

Excess capacity and exit barriers

If capacity in an industry is larger than customer demand, there is a strong incentive for firms to cut prices to fill capacity. The problem of excess capacity is likely to be exacerbated if there are significant barriers for firms to exit the industry. Exit barriers are high when the assets are specialised or if there are regulations that make exit costly. The competitive dynamics of the farming sector demonstrates these forces at play.

Competitive force 2: Threat of new entrants The potential for earning abnormal profits will attract new entrants to an industry. The very threat of new firms entering an industry potentially constrains the pricing of existing firms within it. Therefore, the ease with which new firms can enter an industry is a key determinant of its profitability. Several factors determine the height of barriers to entry in an industry. Economies of scale

When there are large economies of scale, new entrants can either invest in a large capacity that might not be used initially, or enter with less than the optimal capacity. Either way, new entrants will suffer from an initial cost disadvantage in competing with existing firms. Economies of scale may arise from large investments in research and development or exploration (in the pharmaceutical or mining industries), in brand advertising (in the motor vehicle industry) or in physical plant and equipment (in the telecommunications industry). First-mover advantage

Early entrants in an industry may deter future entrants if there are first-mover advantages. For example, first movers may be able to set industry standards, or enter into exclusive arrangements with suppliers of cheap raw materials. They may also acquire scarce government licences to operate in regulated industries. Finally, if  there are learning economies, early firms will have an absolute cost advantage over new entrants. For example, network and communications development by ‘digital disrupters’ such as Airbnb, Uber, eBay and Coursera give first-mover advantages. Although their business models seem easy to copy, they have maintained their market advantage. Access to channels of distribution and relationships

Limited capacity in the existing distribution channels and high costs of developing new channels can act as powerful barriers to entry. For example, new consumer goods manufacturers find it difficult to obtain supermarket shelf space for their products. In Australia, chains of petrol suppliers, liquor suppliers and hardware shops (owned by large supermarket chains) make it difficult for smaller operators in these industries to gain or even keep a foothold. Existing relationships between firms and customers in an industry also make it difficult for new firms to enter an industry. Industry examples of this include auditing, car servicing and repairs, and any firm with a successful ‘loyalty program’ (such as airlines and credit card providers). Legal barriers

Legal barriers such as patents and copyrights can limit entry into research-intensive industries. Similarly, licensing regulations limit entry into higher education, medical services and banking industries.

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CHAPTER 2 Strategy analysis

Competitive force 3: Threat of substitute products The third dimension of competition in an industry is the threat of substitute products or services. Relevant substitutes are not necessarily those that have the same form as the existing products but can be those that perform the same function. For example, long day care and nanny/babysitting services may be substitutes for each other when it comes to child minding. Similarly, private transport (cars and bicycles) and public transport (trains and buses) substitute for each other for commuting. In some cases, the threat of substitution comes not from customers switching to another product but from their use of technologies that allow them to do without, or use less of, the existing products. For example, electric car technologies allow customers to reduce their consumption of fossil fuels such as petrol and diesel. Mobile phones reduce the need for a landline connection. The threat of substitutes depends on the relative price and performance of the competing products or services and on customers’ willingness to substitute. Customers’ perceptions of whether two products are substitutes depend to some extent on whether they perform the same function for a similar price. If two products perform an identical function, then it would be difficult for them to differ from each other in price. However, customers’ willingness to switch is often the critical factor in making this competitive dynamic work. For example, even when tap water and bottled water serve the same function, many customers may be unwilling to substitute the former for the latter, which enables bottlers to charge a price premium. Similarly, toll roads command a price premium even if they the actual road surface is no better than any other, because customers place a value on the time saved using a more direct route.

Degree of actual competition While the degree of competition in an industry determines whether there is potential to earn abnormal profits, the actual competition and actual profits are influenced by the industry’s bargaining power with its suppliers and customers. On the input side, firms enter into transactions with suppliers of labour, raw materials and components, and finances. On  the output side, firms either sell directly to the final customers or enter into contracts with intermediaries in the distribution chain. In all these transactions, the relative economic power of the two sides is important to the overall profitability of the industry firms.

Competitive force 4: Bargaining power of buyers Two factors determine the power of buyers: price sensitivity and relative bargaining power. Price sensitivity determines the extent to which buyers care to bargain on price; relative bargaining power determines the extent to which they will succeed in forcing the price down.4 Price sensitivity

Buyers are more price sensitive when the product is undifferentiated and there are few switching costs. The sensitivity of buyers to price also depends on the importance of the product to their own cost structure. When the product represents a large fraction of the buyers’ cost (e.g. fuel for taxi or ride-share drivers), buyers are likely to expend the resources necessary to shop for a lower-cost alternative. In contrast, if the product is a small fraction of the buyers’ cost (e.g. carry bags for a retailer), it may not pay to expend resources searching for

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

lower-cost alternatives. Further, the importance of the product to the buyers’ own product quality also determines whether or not price becomes the most important determinant of the buying decision. The enhanced employment opportunities expected from studying at a secondary college or university with the highest reputation may outweigh the importance of the associated costs, including fees, accommodation and transport. Relative bargaining power

Even if buyers are price sensitive, they may not be able to obtain low prices unless they have a strong bargaining position. Relative bargaining power in a transaction depends, ultimately, on the cost to each party of not doing business with the other party. The buyers’ bargaining power is determined by the number of buyers relative to the number of suppliers, volume of purchases by a single buyer, number of alternative products available to a buyer, buyers’ costs of switching from one product to another and the threat of backward integration by the buyers. For example, in the entertainment industry, promoters and ticket-sellers have considerable power over audience members because each entertainer is unique, and demand for tickets exceeds supply for popular events. Similarly, in the dairy industry, processors have considerable power over milk producers because of the large number of small suppliers and the small number of processors.

Competitive force 5: Bargaining power of suppliers The analysis of the relative power of suppliers is a mirror image of the analysis of the buyers’ power in an industry. Suppliers are powerful when there are only a few firms and few substitutes available to their customers. For example, large shopping centre owners such as Westfield are very powerful relative to small specialist retailers. In contrast, smaller shopping centre owners are not very powerful compared to large national retailers such as Myer or Woolworths, because those retailers may be the major drawcard for the whole shopping centre. Suppliers also have a lot of power over buyers when the suppliers’ product or service is critical to buyers’ business. For example, in franchise arrangements such as New Zealand Natural, Bakers Delight and Battery World, the franchisor determines many of the costs for the franchisee. Car manufacturers are powerful relative to car retailing dealerships because the dealerships usually concentrate on one manufacturer’s products. Suppliers also tend to be powerful when they pose a credible threat of forward integration. For example, in the book retailing industry, ‘bricks and mortar’ book shops struggle to add value for customers who can buy books online and have them delivered more cheaply.

LO2

Applying industry evaluation

Let us apply the above concepts of industry evaluation to the context of Kathmandu Holdings Limited and the Australasian Hiking and Outdoor Equipment Stores industry in 2018. Before we start to analyse Kathmandu, which is a New Zealand company that operates in both New Zealand and Australia, we need to know more about the company itself. Then we need to consider the economic settings in which it operates. We will examine both the world economy and the Australasian economy, focusing on their existing state and future prospects that might impact Kathmandu in the next few years. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

23

ABOUT KATHMANDU Kathmandu Holdings Limited is a designer, marketer, retailer and wholesaler of clothing, footwear and equipment for travel and adventure. It operates in New Zealand, Australia, United Kingdom and the US. It is domiciled and incorporated in New Zealand, with its head office in Christchurch. It employs approximately 2000 people, and has around 160 stores worldwide. Kathmandu opened its first store in 1987, as a small specialist outdoor retailer, manufacturing many of its own products. It has focused on good design, aiming to manufacture and sell products that are original, sustainable, engineered and adaptive. As the company grew, it was able

to do more in-house design and manufacturing as well as retailing. It began selling online in 2008. Kathmandu was acquired by a consortium of private equity funds in 2006, and was listed on the ASX and NZX in 2009 under the code KMD, with a new management team. It was subject to an unsuccessful takeover offer by New Zealand retailer Briscoe in 2015. In 2018, it purchased Oboz Footwear, a US-based outdoor footwear brand. Its share of sales, profits and assets in its four geographic locations are shown in Figure 2.3.

FIGURE 2.3 Kathmandu’s sales, profits and assets in its four segments

Segment

Revenue %

Profit %

Assets %

Australia

67

97

40

New Zealand

29

57

48

North America

3

5

21

Other

1

–59

–9

Total

100

100

100

Source: Kathmandu Holdings Ltd Annual Report 2018.

Economic evaluation The key economic factors to evaluate in order to understand the economic influences on Kathmandu’s operations in the next few years are economic growth and activity, which drive consumption and expenditure in the economy. We evaluate these in the following paragraphs, mindful that the economic outlook at the time of writing may look quite different in a few months or years. Prior to the outbreak of COVID-19 at the end of 2019, the world economy was relatively strong, and GDP growth in the major advanced economies was high. However, world trade was clearly affected by international political tensions and the prospect of increased national trade protection. These factors increased uncertainty, which led to increased volatility in all markets. In addition, many countries in South-East Asia and Australasia faced the risk of exposure to the Chinese economy, whose monotonic and high growth in recent years had slowed. China’s population is ageing and those in its growing middle class prefer to consume than to save. Chinese industry felt the impact of environmental restrictions, and, in turn, companies dealing with China experienced increased regulation. Australia’s and New Zealand’s terms of trade with China have weakened and were considered likely to remain weak. In Australia, economic activity was slowing, after 27 years without a recession. Four factors contributed to this slowdown: the housing market, wages growth, business and infrastructure Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

KATHMANDU CASE

CHAPTER 2 Strategy analysis

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investment, and climate events. The outlook for GDP growth is dependent on how these factors interact and how the impact of COVID-19 plays out in 2020 and beyond. The property market has fallen, and further falls are likely as bank lending has slowed. This has been driven by the regulator’s efforts to limit investor lending for housing, and by increased prudence in terms of loan-to-value ratios in the wake of the national banking enquiry. There is a risk of a downturn in both the housing market and the housing construction industry. Lower activity in the construction industry is a leading indicator of a decline in national economic activity overall. Low wages growth is expected to affect consumption as households reach the limit of their ability to run down savings or use debt to maintain their spending. High household indebtedness is a major risk factor. Although unemployment is low, underemployment is high, with an increase in part-time and casual/contract work. The participation rate among older workers who have reached the traditional retirement age is higher than expected, perhaps keeping measures of employment high but taking opportunities away from younger workers. The support for economic activity that has flowed from business investment and public sector spending on infrastructure in recent years has come to a natural conclusion. On the other hand, the slow down accompanying the end of the mining boom has finished affecting the economy. Unfavourable weather events have had catastrophic impacts on rural production and exports, and on rural communities and infrastructure. Taking these factors into account, it is likely that monetary policy in Australia will remain tight and the exchange rate is unlikely to improve. Inflation is not a risk to the economy. In New Zealand, similarly slow growth is expected from the trends in world economic growth and international trade. Its exchange rate is likely to weaken. In addition, as well as being directly impacted by the economic slowdown of its largest trade partner, Australia, there are other risk factors in New Zealand that Australia does not experience. New Zealand’s population growth and permanent migration numbers have both slowed, potentially undermining a demand-led recovery. This affects business activity, which already suffers from lower investment. As well, lower population growth affects housing construction activity, already experiencing a slowdown as the post-earthquake reconstruction work on the South Island finishes. New Zealand has relied on a strong tourism industry in recent years, but that is showing signs of weakening. And its economy will feel some of the effects of tighter credit from the Australian banks. However, there are several reasons to be more optimistic about the New Zealand economy than the Australian economy. First, the property market did not suffer from the same overheating as the Australian market, and was also protected from the inflationary impact of foreign investment by government prohibitions, with the consequence that corrections in housing prices have been minor. Second, New Zealand is experiencing some wages growth, and public funds are being directed at social support for low- and middle-income earners. These may help to compensate for the lack of population growth and lead to an improvement in overall demand. Third, demand for its key exports, particularly dairy and other agricultural products, are likely to remain strong and well-priced.

Industry evaluation Having analysed the economic conditions, we next analyse the potential for profit and growth in the specific industry or industries in which a company has chosen to operate. For Kathmandu, we Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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APPLYING INDUSTRY EVALUATION TO KATHMANDU Rivalry is high: As indicated earlier, in the absence of market growth, competition between firms for growth means that growth by one firm must be at the expense of the market share of its competitors. We have noted that the industries in which Kathmandu operates are not growing; hence, we find that they are characterised by price wars. One of Kathmandu’s major competitors is Super Retail Group, which owns Macpac, Rebel, BCF and Goldcross Cycles, among other brands.

Discount sales and special promotions are common in this industry, and online sales are a growing proportion of overall sales, which are likely to keep profit margins very tight for the foreseeable future. No one retailer has a majority share of the market. Threat of new entrants is high: There are no barriers to entry, such as legal barriers, economies of scale or access to channels of distribution. The profitability of the industry makes it attractive to overseas

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KATHMANDU CASE

have analysed the economic conditions in Australia and New Zealand, which are the locations where it derives over 95% of its sales revenue. We now analyse the industries in which Kathmandu operates. At the broadest level, Kathmandu operates in the general retail sector. That sector consists of many industries, including convenience stores, fuel retailing, motor vehicle dealers, pharmacies and fashion stores. Revenue growth in the general retail sector overall in Australia between 2012–17 was 1.1%, and is forecast to be 1.4% in 2017–22. To strategically analyse Kathmandu, so that we can forecast its future profit and growth potential, we will focus on the industry group or groups in which Kathmandu operates. Note that Kathmandu does not provide separate financial information on its industry segments in its 2018 annual report, stating that ‘The Group operates in one industry being outdoor clothing, footwear and equipment.’ Kathmandu has about a 50% share of this industry in terms of revenue. In general, the Hiking and Outdoor Equipment Stores industry has experienced tough conditions in recent years, which are likely to continue for the foreseeable future, for three main reasons. First, there has been low growth in retail generally, because of low wages growth in the economies of Australia and New Zealand. Second, consumers have increasingly spent their leisure time doing recreational activities that have not required hiking and outdoor equipment – think about the uptake of social media. Third, in a market that is not growing, there has been intensifying competition for market share from several directions, including specialist stores, department stores and online retailers. Individual industry descriptions are available for three categories in which Kathmandu operates: 1 Sport and camping equipment retailing: products in this industry are sourced from domestic and international suppliers, and include gym and fitness equipment, and camping equipment. 2 Clothing retailing in Australia: products in this industry are generally categorised by gender and by age, although for Kathmandu in the sports apparel market, these distinctions are less important. Their products are similar for both genders and across age groups. 3 Footwear retailing in Australia: like clothing, products in this industry are generally categorised by gender, a distinction that is less important for Kathmandu’s market.

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competitors as well as domestic firms expanding their product lines. Threat of substitute products is low: Kathmandu’s approach to high industry competition is to try to differentiate itself, as is evident in its motto in its 2018 annual report, p.6:

We are focused on answering the needs of our customers by designing original, sustainable, engineered and adaptive products. However, the success of this differentiation strategy depends on the extent to which their products cannot be imitated. The company’s challenge is to continue to provide original products, and to stay one step ahead of its competitors.

Thus, we consider the competition in the Hiking and Outdoor Equipment Stores industry to be quite high, and to provide limited opportunities for profitability and growth. The ability of Kathmandu to take advantage of the limited opportunities for profitability and growth depend in part on the two final competitive forces: Bargaining power of buyers is low: buyers may be price sensitive, and their purchases are discretionary, but they do not have sufficient bargaining power to determine prices in this industry. Bargaining power of suppliers is also low: the majority of Kathmandu’s products are their own brand, so they can control their cost of sales to a considerable extent.

So, in an industry that is highly competitive, Kathmandu’s advantageous position is due to its strategy of stocking own-brand products that are branded as original and sustainable.

Limitations of industry evaluation A potential limitation of the industry evaluation framework discussed in this chapter is the assumption that industries have clear boundaries. In reality, it is often difficult to demarcate industry boundaries clearly. For example, in analysing Kathmandu’s industry, should one focus on the specialist adventure wear industry, or the sub-industries of sport and camping equipment, clothing and footwear, or the retail industry as a whole? Should one consider only the Australian sales, which constitute about two-thirds of its revenue, or also New Zealand sales? Inappropriate industry definition will result in incomplete evaluation and inaccurate forecasts. While there are no simple solutions to this problem, the analyst’s choice of industry definition should be based on the purpose of the overall analysis, including likely changes to the company in the future, and the availability of industry information.

Selecting a competitor One of the biggest challenges of conducting a strategy analysis for a firm in a smaller economy such as Australia, New Zealand and many countries in Asia is finding a competitor for comparative purposes. The conventional approach is to identify a listed firm that is in the same country, in the same industry or with a similar range of activities, and about the same size. However, that sometimes produces no suitable matches. For example, it is challenging to find a suitable competitor for A2Milk. Suggestions such as Bega Cheese or Inghams Group are clearly operating in different markets, with different products and different drivers of revenue. Bellamy’s Australia and Freedom Food Group have a similar focus on healthy foods but each targets a different market. Sometimes the closest matching firm is a private company or part of a group of companies, which means that the full financial statements are not publicly available. Segment data may provide a limited comparison when available. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 2 Strategy analysis

If the conventional approach of identifying a firm in the same country, in the same industry or with a similar range of activities, and about the same size does not work, what does the analyst do when they are undertaking strategic, accounting, financial and prospective analysis? Typically, they will consider a range of factors, and the analyst develops a broader list of firms that are not in the same country or industry. The following is a list of factors that may be used to identify the most suitable competitor for a particular firm. Of course, not all analysts will agree which factors are important! Similar economic drivers that affect the business Comparable profile or type of customers Similar level of diversification across different industries Level or proportion of leverage (borrowing) Similar profile of employees or suppliers Similar regulations Similar needs related to location, such as weather or transportation

LO3

Competitive strategy evaluation

The profitability of a firm is influenced not only by its industry structure but also by the strategic choices it makes in positioning itself in the industry. While there are many ways to characterise a firm’s business strategy, research has traditionally identified two generic competitive strategies: cost leadership and differentiation. These two strategies will potentially allow a firm to build a sustainable competitive advantage.5 These strategies, shown in Figure 2.4, are broadly seen as mutually exclusive. Firms that straddle the two strategies are considered to be ‘stuck in the middle’ and are not expected to be very profitable. Such firms run the risk of not being able to attract price-conscious customers because their costs are too high; yet are also unable to provide adequate differentiation to attract premium price customers. Additional research has attempted to explain the certain exceptions to this rule, such as the Japanese automotive industry, which for many years offered both higher quality and lower cost than its competitors in the US and Europe. Generally, though, this ability to compete successfully from the ‘middle’ has been attributed to a focus on operational effectiveness – not strategy – that has allowed them to continuously push the ‘productivity frontier’ ahead of their competitors. Industries can only sustain this advantage if competitors cannot duplicate it; if they can copy this operational effectiveness competitors will eventually ‘catch up’.6

Sources of competitive advantage Cost leadership enables a firm to supply the same product or service offered by its competitors at a lower cost. In retailing, several national brands have succeeded by competing purely on a low-cost basis. Examples in Australia and New Zealand include Chemist Warehouse, Fantastic Furniture and The Warehouse, whose names, branding and slogans all emphasise value for money. Differentiation strategy involves providing a product or service with a distinctiveness that the customer values. As an example, the most prestigious private schools succeed on the basis of differentiation by emphasising their exceptional educational quality and reputation, compared to public schools. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Cost leadership Supply same product or service at a lower cost. Economies of scale and scope Efficient production Simpler product designs Lower input costs Low-cost distribution Little research and development or brand advertising Tight cost-control system

Differentiation Supply a unique product or service at a cost lower than the price premium customers will pay. Superior product quality Superior product variety Superior customer service More flexible delivery Investment in brand image Investment in research and development Control system focus on creativity and innovation

Competitive advantage • Match between firm’s core competencies and key success factors to execute strategy • Match between firm’s value chain and activities required to execute strategy • Sustainability of competitive advantage

FIGURE 2.4 Strategies for creating competitive advantage

Competitive strategy 1: Cost leadership Cost leadership is often the clearest way to achieve competitive advantage. In industries where the basic product or service is a commodity, cost leadership might be the only way to achieve superior performance. There are many ways to achieve cost leadership, including economies of scale and scope, economies of learning, efficient production, simpler product design, lower input costs and efficient organisational processes. If  a firm can achieve cost leadership, then it will be able to earn above-average profitability by merely charging the same price as its rivals. Conversely, a cost leader can force its competitors to cut prices and accept lower returns, or to exit the industry. For example, the entrance of low-cost grocery retailer chain Aldi to the UK in 1990 forced the incumbent supermarket chains such as Tesco and Sainsbury’s to change their strategy and focus more on competing through price. Firms that achieve cost leadership focus on tight cost controls. They make investments in efficient-scale plants, focus on product designs that reduce manufacturing costs, minimise overhead costs, make minimal investments in risky research and development, and avoid serving marginal customers. They have organisational structures and control systems that focus on cost control.

Competitive strategy 2: Differentiation A firm following the differentiation strategy seeks to be unique in its industry along a chosen dimension that customers value highly. For differentiation to be successful, the firm has to accomplish three things. First, it needs to identify one or more attributes of a product or service that customers value. Second, it  has to position itself to meet the chosen customer need in a unique manner. Finally, the firm has to achieve differentiation at a cost that is lower than the price the customer is willing to pay for the differentiated product or service.

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CHAPTER 2 Strategy analysis

Drivers of differentiation include providing superior intrinsic value via product quality, product variety, bundled services or delivery timing. Differentiation can also be achieved by investing in signals of value such as brand image, product appearance or reputation. Differentiated strategies require investments in research and development, engineering skills and marketing capabilities. The organisational structures and control systems in firms with differentiation strategies need to foster creativity and innovation. For example, Nike and Adidas compete with other producers of sports shoes and apparel on the bases of their high-quality products. However, they also compete on their differentiated product images, which are created by extensive investments in commercials and product promotion. While successful firms choose between cost leadership and differentiation, they cannot completely ignore other dimensions. Firms that target differentiation still need to focus on costs so that the differentiation can be achieved at an acceptable cost. Similarly, cost leaders cannot compete without investing at least at a minimum level on key dimensions on which competitors might differentiate, such as quality and service.

Achieving competitive advantage The choice of competitive strategy does not automatically lead to achieving competitive advantage. To do this, the firm has to have the capabilities needed to implement and sustain the chosen strategy. Both cost leadership and differentiation strategy require that the firm commit to acquiring the core competencies needed, and to structure its value chain appropriately. Core competencies are the economic assets that the firm possesses, whereas the value chain is the set of activities that the firm performs to convert inputs into outputs. To evaluate whether a firm is likely to achieve its intended competitive advantage, the analyst should ask the following questions: What customer need is the firm focusing on? How does the firm distinguish its customer value proposition from the alternative propositions available to the customer from its competitors? Does the firm currently have the key capabilities and processes to deliver its value proposition?

Sustaining competitive advantage The uniqueness of a firm’s core competencies and its value chain, and the extent to which it is difficult for competitors to imitate them determines the sustainability of a firm’s competitive advantage.7 Few companies are able to sustain their competitive advantage over a long period, for a number of reasons. First, competitors often copy successful strategies. Firms can only prevent or delay this if they can access explicit barriers such as patents or other legal protections, or if there are implicit barriers such as customer switching costs or first-mover advantages. The second reason why firms lose their competitive advantage is changes in the environment. New technologies, changes in regulation and changes in customer requirements make current value propositions obsolete or enable the creation of new, substitute propositions that might be more attractive to customers. As industries and markets evolve, it is critical that a firm’s strategy evolves in response. The competitors who will win over time are the ones who are continually alert to the need to adapt to changing industry dynamics.

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To evaluate whether or not a firm is likely to sustain its competitive advantage, an analyst should ask the following questions: Are there any barriers to imitation in this firm’s strategy? Are there any changes that potentially affect this firm’s industry and its strategic position in that industry? What are they? In what ways are these changes likely to affect the competitive dynamics in this industry? What actions, if any, can this firm take to address these changes, and renew its competitive advantage? How likely is it to be able to renew itself successfully?

Corporate social responsibility When a business engages in corporate social responsibility (CSR), it conducts its operations in ways that enhance the economy, the society and the environment, instead of detracting from them. CSR initiatives support the reputation of the business, an increasingly significant intangible asset. This has recently been recognised as a key factor in a business’s competitive strategy, allowing it to differentiate itself from its competitors in a new way that investors, customers and employees value. Without question, CSR is valuable for society, but it is not without value to the business itself. It provides competitive advantages for employment, sales, design, investment, risk and return. Rather than the inherent conflict between profit and sustainability being an impediment to decision-making, firms can use this tension to drive more innovation and creativity. CSR can boost employee and customer morale, thus engendering loyalty and pride in its products and services. It can make a business an employer of choice, thus improving the quality of future employees. It can drive innovation by finding new ways to operate and new designs. Investors prefer to invest in businesses with a social responsibility agenda, as a key element that reduces future risks and drives improvements in the value of the business. CSR encourages companies to pay attention to their impact on the environment, thus reducing or mitigating the risk of future litigation, regulation and penalties. Management should focus on these risks under a corporate responsibility framework, which would drive CSR actions. CSR goes hand in hand with the business being responsible for itself and its owners, and is usually undertaken by businesses that have grown to the point where they can give back to the society in which they have operated. It is sometimes called being a good corporate citizen, or gaining a social licence to operate and profit from the structure of the economy and the society. The long-term financial interests of a business depend on its care of all stakeholders, not just owners. The ASX Corporate Governance Council noted in its Principles of Good Corporate Governance and Best Practice Recommendations that there is mounting anecdotal evidence suggesting a link between companies’ CSR activities and their long-term financial performance. The ASX Corporate Governance Council cites Orlitzky, Schmidt and Rynes who conducted a meta-analysis of 52 previous studies over a period of 30 years, and concluded that ‘Corporate virtue in the form of social and, to a lesser extent, environmental responsibility is rewarding in more ways than one’.8 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Applying competitive strategy evaluation

APPLE AND THE iPHONE When Apple disrupted the mobile phone market, this market was still relatively new. Prior to the launch of the first iPhone in 2007, the mobile phone industry had developed with five groups of main actors: network operators, mobile phone vendors, operating system (OS) providers, content providers and application developers. The network operator industry was concentrated and profitable, whereas the phone vendors were more fragmented, with increasingly similar products that included both expensive smartphones and more affordable basic phones. The network operators’ market concentration gave them more market power than the phone vendors, so that they were able to dictate the designs, features, interfaces and prices. Some OS providers were tied to phone vendors, whereas others were independent. From the mid-1990s, a number of vendors shared a common platform, Symbian, which had a 60% market share. Content providers were network operators who acted as content (software) aggregators, and app developers wrote the software. In January 2007, Steve Jobs announced to the annual Macworld Conference and Expo, ‘Today Apple is going to reinvent the phone’. The iPhone was launched in June of that year, combining the functions of a mobile music player, a mobile phone and an internet communications device. In 2008, Apple sold almost 14 million iPhones, compared to sales of Nokia smartphones (the then-market leader) of 60 million. Apple disrupted the mobile phone industry in three important ways: 1 Supply and profitability: – Initially, Apple distributed the iPhone in the US through its single-branded Apple Stores, avoiding

competition with other brands at the point of purchase. – It released one model per year, simplifying the choice for purchasers, and making each launch an anticipated and dramatic event, with significant media coverage. – It was (and is) priced at the high end of the market, adding to the brand image of a quality product. 2 Design and demand: – Its design was innovative: in 2007, it brought the touchscreen to the smartphone market. The touchscreen allowed it to remove the keyboard and stylus of its competitors, and to support fingertip movements to access content (although patenting these ‘touches’ has been the subject of various legal challenges). – Its square icon apps allowed customers to individualise their home screens, by first selecting and then organising their preferred apps. This option was not available from other providers. – It merged the iPod with the smartphone in 2007, the digital camera in 2010 and high-quality GPS in 2012, thus creating a ‘must have’ new product each time and eliminating the need for multiple devices. – It was easy to use: intuitive and appealing. 3 Market control: – It launched with an exclusive partnership with one US mobile network operator, AT&T, giving Apple (rather than the network operator) control over the development, branding and pricing of its smartphone. In addition, Apple had revenue-sharing

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CASE STUDY

In the contest for profits that flow from strong consumer demand and pricing power, a robust brand is essential. Reporting on the five most valuable brands in the world in 2018, Forbes magazine noted that they were all tech brands: Apple, Google, Microsoft, Facebook and Amazon. In just one year, the combined value of these brands increased by 20% to $586 billion. This was almost three times the Gross Domestic Product of New Zealand in the same year. Apple is at the top of the list, with a brand value of $182 billion. Because of the strength of its brand, Apple was able to sell 29 million iPhones in less than two months at the end of 2017, and earns 87% of the smartphone industry profits.9 Let us analyse Apple’s competitive strategy of differentiation in the context of the iPhone to understand how it is able to create this value.

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arrangements with AT&T. Over time, other network operators entered similar deals with Apple. – In the days before music streaming services, it was able to control the distribution of purchased music on an iPhone through its iTunes Store, and ensure that all users needed to open an iTunes account. – It allowed app development to be undertaken by ‘licensed’ freelance developers, who then distributed their apps through Apple. It thus avoided loss of control and potential risks of new apps, without diverting resources to their development. Because of this strategy, Apple has achieved significant differentiation from its competitors in the smartphone industry.

LO4

Since 2007, the iPhone has experienced high sales growth, at first in an expanding market, and more recently in what may be a declining market. In 2017, Apple sold 19% of all new smartphones around the world – a comparable percentage to its sales in 2007 when it launched. But this is not what drives its profits, so much as its ability to charge the highest price in the market for its product. It is an aspirational brand, and this is the focus of all aspects of its strategy. It tries to control access to all aspects of its product. Both of these factors keep demand high, almost regardless of the price. Source: Based on C. Giachetti, Smartphone Start-ups: Navigating the iPhone Revolution, Palgrave Macmillan, 2018.

Corporate strategy evaluation

So far in this chapter we have focused on the strategies at the individual business level. While some organisations focus on only one business, many operate in multiple businesses. In  2015, 58% of the top 200 companies in Australia operated in more than two business segments.10 This proportion is the same as a decade earlier.11 In recent years, there has been an attempt by some organisations to reduce the diversity of their operations and focus on a relatively few ‘core’ businesses. However, multi-business organisations continue to dominate economic activity in most countries in the world. When analysing a multi-business organisation, an analyst has to evaluate not only the industries and strategies of the individual business units but also the economic consequences – either positive or negative – of managing all the different businesses under one corporate umbrella. Some organisations have viewed this multi-business structure as a source of strength and embraced it, while others believe it is distracting and dilutes value, and have therefore moved to narrow their business focus. For examples of both perspectives, Wesfarmers was very successful in Australia for many years, creating significant value by managing a highly diversified set of businesses ranging from insurance, to home improvements, to fertilisers, while Southcorp was not successful in managing packaging, water-heaters and wine-making operations and was the subject of a takeover.

Sources of value creation at the corporate level Economists and strategy researchers have identified several factors that influence an organisation’s ability to create value through a broad corporate scope. Economic theory suggests that the optimal scope of activity of a firm depends on the relative transaction cost of performing a set of activities inside the firm versus using the market mechanism.12 Transaction cost economics implies that the multi-product firm is an efficient choice of organisational form when coordination among independent, focused firms is costly because of market transaction costs. Transaction costs can arise out of several sources. They may arise if the production process involves specialised assets such as human capital skills, proprietary technology or other Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 2 Strategy analysis

organisational know-how that is not easily available in the marketplace. Transaction costs also may arise from market imperfections such as information and incentive problems. If buyers and sellers cannot solve these problems through standard mechanisms such as enforceable contracts, it will be costly to conduct transactions through market mechanisms. For example, as discussed in Chapter 1, capital markets may not work well when there are significant information and incentive problems, making it difficult for entrepreneurs to raise capital from investors. Similarly, if buyers cannot ascertain the quality of products being sold because of lack of information, or cannot enforce warranties because of poor legal infrastructure, entrepreneurs will find it difficult to break into new markets. Finally, if employers cannot assess the quality of applicants for new positions, they will have to rely more on internal promotions rather than external recruiting to fill higher positions in an organisation. Emerging economies often suffer from these types of transaction costs because of poorly developed intermediation infrastructure.13 Even in many advanced economies, we can find examples of high transaction costs. For example, if  the venture capital industry is not highly developed, it is costly for new businesses in high technology industries to attract financing. Electronic commerce may be hampered by consumer concerns regarding the security of credit card information sent over the internet. Transactions inside an organisation may be less costly than market-based transactions for several reasons. First, communication costs inside an organisation are reduced because confidentiality can be protected and credibility can be assured through internal mechanisms. Second, the headquarters can play a critical role in reducing the costs of enforcing agreements between organisational subunits. Third, organisational subunits can share valuable non-tradable assets (such as organisational skills, systems and processes) or non-divisible assets (such as brand names, distribution channels and reputation). On the other hand, there are also forces that increase transaction costs inside organisations. Upper-level management may lack the expertise and skills necessary to manage businesses across several different industries. This lack of expertise reduces the possibility of actually realising economies of scope, even when there is potential for such economies. Firms can fix this problem by creating a decentralised organisation, hiring specialist managers to run each business unit and providing these managers with proper incentives. However, decentralisation will also potentially decrease goal congruence among sub-unit managers, which can also make it difficult to realise economies of scope. Whether or not a multi-business organisation creates more value than a comparable collection of focused organisations is, therefore, context dependent.14 Analysts should ask the following questions to assess whether an organisation’s corporate strategy has the potential to create value: Are there significant imperfections in the product, labour or financial markets in the industries (or countries) in which an organisation is operating? Is it likely that transaction costs in these markets are higher than the costs of similar activities inside a well-managed organisation? Does the organisation have special resources such as brand names, proprietary know-how, access to scarce distribution channels, and special organisational processes that have the potential to create economies of scope? Is there a good fit between the organisation’s specialised resources and the portfolio of businesses in which it is operating? Does the organisation allocate decision rights between the headquarters office and the business units optimally to realise all the potential economies of scope? Does the organisation have internal measurement, information and incentive systems to reduce agency costs and increase coordination across business units? Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Empirical evidence suggests that creating value through a multi-business corporate strategy is difficult in practice. Several researchers have documented that diversified companies trade at a discount in the share market relative to a comparable portfolio of focused companies.15 Studies also show that the acquisition of one company by another, especially when the two are in unrelated businesses, often fails to create value for the acquiring company.16 Finally, there is considerable evidence that value is created when multi-business companies increase corporate focus through divisional spin-offs and asset sales.17 There are several potential explanations for this diversification discount. First, managers’ decisions to diversify and expand are frequently driven by a desire to maximise the size of their company rather than to maximise shareholder value. Second, diversified companies often suffer from incentive misalignment problems, leading to sub-optimal investment decisions and poor operating performance. Third, capital markets find it difficult to monitor and value multi-business companies because of inadequate disclosure about the performance of individual business segments. In summary, while organisations can theoretically create value through innovative corporate strategies, there are many ways in which this potential fails to be realised in practice. Therefore, it pays to be sceptical when evaluating organisations’ corporate strategies.

Applying corporate strategy evaluation

CASE STUDY

Let us apply the concepts of corporate strategy to Wesfarmers, a diversified company that has grown over its 100-year history from a Western Australian farmers’ cooperative into one of Australia’s largest listed companies, with over 220 000 employees and a market capitalisation in excess of $24 billion. Its diverse business operations cover department stores, home improvement and office supplies; coal mining; chemicals, energy and fertilisers; and industrial and safety products.

WESFARMERS Wesfarmers’ diversification program began modestly in the 1950s with the formation of Kleenheat Gas, which pioneered the distribution of liquefied petroleum gas (LPG) and gas appliances to Western Australia’s rural areas. The company made more significant changes to operations and structure in the 1980s. In 1984, with the farmers’ cooperative as its majority shareholder, Wesfarmers Limited listed on the Australian Securities Exchange. In the same year, the company acquired fertiliser manufacturer and distributor CSBP & Farmers, in what was then Australia’s largest corporate takeover. Wesfarmers added to its energy industry investments by moving into coal mining through acquisitions and investments in the 1990s and 2000s. It followed a similar strategy with its insurance investments. It broadened its agricultural base for a decade in the 1990s; however, that business structure was eventually resold. In 1994, Wesfarmers completed its acquisition of Bunnings Limited,

establishing the company in hardware retailing and forest products. In April 2001, Wesfarmers completed the transition to a broadly based public company when shareholders overwhelmingly supported a proposal to simplify its complex ownership and control structure. In the same year, Wesfarmers added to its hardware division by acquiring Howard Smith’s BBC and Hardwarehouse businesses, including hardware and industrial and safety products businesses in New Zealand, which gave Wesfarmers its first significant presence outside Australia. Wesfarmers moved into rail transport in 2000, when, in a joint venture with Genesee & Wyoming Inc. of the US, it successfully bid for the Western Australian government’s rail freight business, leading to the creation of the Australian Railroad Group. Wesfarmers completed the sale of this business to Babcock & Brown and Queensland Rail in June 2006. In 2007, Wesfarmers entered yet another new

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CHAPTER 2 Strategy analysis

industry when it acquired Coles Group Limited, which it divided into three separate divisions for each of the major retailing brands. In recent years, however, Wesfarmers has divested itself of several of its investments. In 2014, it sold its insurance

35

businesses. In 2018, it sold its UK hardware business (discussed further in Chapter 11) and it also demerged from Coles. Source: Wesfarmers Ltd, http://www.wesfarmers.com.au/who-we-are/ourhistory

Why was Wesfarmers able to create value through a diversification strategy, when so many other companies had failed to do so? And did its subsequent divestitures represent a failure of its strategy, in the cases of Coles and Hardware House (UK)? Its strength had been its investment management approach to being a conglomerate. Its long-standing objective was simply: ‘to deliver a satisfactory return to shareholders’. It did not specify the industries through which it aimed to deliver that return. Through its size and the people that it employed and trained to run its diverse businesses, its business were managed without excessive interference from ‘head office’, apart from streamlined ‘back office’ functions such as accounting, human resource management and financing. Its conglomerate structure gave aspiring executives a pathway of promotions within Wesfarmers, so that it was able to benefit from retaining its top talent for longer than its competitors. The weakness of Wesfarmers’ strategy is that its board of directors and management makes decisions on an increasingly diverse range of industries across an increasingly wide geographic area. Its weaknesses have been more evident in softer economic conditions. And arguably its board and management were overconfident, a self-attribution bias that meant their judgement was not completely accurate. An interesting question to examine is whether there are systematic reasons to believe that a company such as Wesfarmers can succeed in pursuing a wide focus in the long run, because its business model – managing its investments like an investment manager – somehow allows it to manage this diversity in a fundamentally different manner from the way a traditional conglomerate would be able to. As Figure 2.5 shows, its share price since listing has steadily $45.00 $42.55

$40.00 $35.00 $30.00 $25.00 $20.00 $15.00 $10.00 $5.00 0

1989

1992

1995

1998

2001

2004

2007

2010

2013

2016

FIGURE 2.5 Wesfarmers share price since listing Source: ASX Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

2019

36

PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

increased, with the exception of the downturn in January 2009 that was a result of the Global Financial Crisis (GFC). It is clear that even through its more recent misadventures, its investors believe the answer to this question is ‘yes’.

Competitive strategy and corporate strategy evaluation

KATHMANDU CASE

Kathmandu follows a differentiation strategy. It is selling its image with every product. This is visually apparent in its annual report, which is populated with photographs of the rugged New Zealand outdoors: mountains, rocks, the ocean, green trees and grass, and adventurers in the midst of it all wearing Kathmandu gear. Everyone is smiling, everyone looks fit: even the board of directors and management team are decked out in sportswear or casual clothes. Its mission or purpose is explained using words like adventure, curiosity and confidence. Kathmandu has a clear competitive strategy, although it is one that could be easily imitated. A key factor in its continued success is going to be to keep ahead of customer needs and tastes, and to retain talented staff in the design and production phases. Kathmandu’s corporate strategy is vertical integration, spanning design, production and retailing. The key questions to answer are: Can it continue to deliver high-quality products at a competitive price, and can it sustain its market advantage? How will it expand its sales: by expanding the size of the adventure wear market or appropriating market share from its competitors? Kathmandu’s purchase of US-based outdoor footwear manufacturer Oboz in 2018 provides some answers to these questions. The US is a potential source of new market growth, and Kathmandu’s strategy is to tap into Oboz’s customer base to expand its international sales.

KATHMANDU TO VENTURE INTO THE US, PROFIT SURGES Kathmandu’s fleece jackets, thermals and hiking packs could be on the shelves of North American shops by October 2019 as the adventure wear retailer taps into the customer base of recently acquired US hiking boot manufacturer Oboz. Kathmandu, which acquired Oboz for $97 million in April, is in talks with the footwear company’s major customers, including Recreational Equipment Inc (REI) and Grassroots Outdoor Alliance, a group of independent outdoor specialty retailers, about stocking Kathmandu’s outdoor clothing, boots and accessories in the northern winter of 2019. It’s the first time Kathmandu has attempted to penetrate the intensely competitive North American outdoor market, which is dominated by leading global brands such as The North Face, Patagonia, and Backcountry. Kathmandu chief executive Xavier Simonet said many outdoor brands had been ‘over-distributed’ and North

American consumers were seeking more-authentic niche brands that offered a point of difference. ‘We are a brand with great values and the distribution needs to reflect the brand’s values, so authentic outdoor distribution is what we want,’ Mr Simonet told The Australian Financial Review after Kathmandu reported a 33 per cent increase in net profit to a record $NZ50.5 million ($46.4 million) for the 12 months ended July 2018. Mr Simonet said Kathmandu’s entry into the US would be ‘capital light’ and, while the company has appointed a vice-president of sales and marketing, there were no plans to open standalone Kathmandu stores. Kathmandu has a dedicated online store in the US but traffic to date has been low because of lack of brand awareness. ‘We need to show success through wholesale and online first and we’ll see how it goes,’ Mr Simonet said. ‘Oboz is giving us access to the authentic outdoor retailers in the US. That doesn’t mean we’ll get immediate

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CHAPTER 2 Strategy analysis

success but ... we’ll start talking to customers and presenting the range.’ It plans to extend the Oboz brand, which has been growing at about 40 per cent a year over the past four years, into new categories such as sandals to take advantage of its design and sourcing capabilities. ‘It’s a great company and a great brand and we need to strengthen and deepen the partnership with them,’ said Mr Simonet.

‘It’s going to accelerate our international growth and hopefully give us the capability and expertise and relationships in the US to start a healthy business there.’ Source: Sue Mitchell, The Australian Financial Review, 19 September 2018, https://www.afr.com/companies/retail/kathmandu-profit-surges-33pcto-nz505-m-20180917-h15i8o. The use of this work has been licensed by Copyright Agency except as permitted by the Copyright Act, you must not re-use this work without the permission of the copyright owner or

A good way to summarise at Kathmandu’s current position and upcoming challenges is with a simple SWOT analysis, as shown in Figure 2.6. FIGURE 2.6 Kathmandu SWOT analysis

Strengths

Opportunities

Growing profit

International expansion

Growing sales Clear brand identification Good market share Weaknesses

Threats

Strategy can be imitated

Online sales from competitors

Need for continual advertising and three major annual sales to support sales revenue

Failure to keep costs under control

Reliance on Australian market

37

Lack of wages growth in key markets

Losses in UK

Connecting strategy analysis to business analysis and valuation Strategy analysis is an important starting point for a structured business analysis because it allows the analyst to probe the economics of the firm at a qualitative level. The insights gained from strategy analysis can be useful in performing the remainder of the financial statement analysis. In accounting analysis, the analyst can examine whether a firm’s accounting policies and estimates are consistent with its stated strategy. For example, a firm’s choice of functional currency in accounting for its international operations should be consistent with the level of integration between domestic and international operations that the business strategy calls for. Similarly, a firm that mainly sells housing to low-income customers should have higher-than-average allowance for bad and doubtful debts. Strategy analysis is also useful in guiding financial analysis. For example, in a cross-sectional analysis, the analyst should expect firms with cost leadership strategy to have lower gross margins and higher asset turnover than firms that follow differentiated strategies. In a time-series analysis, the analyst should closely monitor any increases in expense ratios and asset turnover ratios for

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Copyright Agency.

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

INDUSTRY INSIGHT

low-cost firms, and any decreases in investments critical to differentiation for firms that follow a differentiation strategy. Business strategy analysis also helps in prospective analysis and valuation. First, it allows the analyst to assess whether, and for how long, differences between the firm’s performance and its industry’s (or industries’) performance are likely to persist. Second, strategy analysis facilitates forecasting investment outlays the firm has to make to maintain its competitive advantage.

A PRACTITIONER ADVISES Australian financial analyst on the usefulness of strategic analysis:

It’s about understanding. You need detail around what drives the business, what drives the industry, what matters. There may be 50 elements to consider, and you need to understand which 10 or 20 variables actually matter, and then to be able to explain that story. Partner with leading chartered accounting firm specialising in corporate finance and valuation on the benefits of engaging with the business being valued:

So, we do a lot of interviews with the client and their personnel. Even though we need to understand the economic environment and the industry, we don’t spend our time finding that out from the client. As a matter of fact, the client’s not that good at telling us what’s going on in the economy! But we’re quite good at doing that

ourselves, and we’re quite good at understanding the industry. What we need to find out directly from the company what its strategy is to deal with the industry competitive situation, which we can then do research on. So, we spend a lot of time interviewing, getting some of the qualitative information that you as a student might not have had access to in the work that you do. For example, if we do a valuation of Blackmores, we’d actually sit down with Blackmores’ management to understand some of the decisions they have made, to put some more meat around the bones of what they’ve said in public. Reflective activity: What is the value of undertaking a strategic analysis yourself, compared to outsourcing it in some way – whether that’s finding a commercially prepared economic and industry analysis, or getting an economist to write one for you? Are there any ways in which you can get additional insights into the thinking of the company’s management, assuming that you are unable to interview them directly?

SUMMARY Strategy analysis allows the analyst to identify the firm’s profit drivers and key risks, and to assess the sustainability of its performance. These are useful for making realistic forecasts of future performance. Whether a firm is able to earn a return on its capital in excess of its cost of capital is determined by three strategic choices: 1 industry choice: the industry or a set of industries in which the firm operates

2 competitive positioning: the manner in which the firm will compete with other firms in its chosen industry or industries 3 corporate strategy: the way in which the firm will create and exploit synergies across the range of businesses in which it operates. Strategy analysis involves analysing all three choices. Industry evaluation consists of identifying the economic factors that drive industry profitability. In

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CHAPTER 2 Strategy analysis

general, an industry’s average profit potential is influenced by the degree of rivalry among existing competitors, the ease with which new firms can enter the industry, the availability of substitute products, the power of buyers and the power of suppliers. To evaluate an industry, the analyst has to assess the current strength of each of these forces in an industry and make forecasts of any likely future changes. Competitive strategy evaluation involves identifying the basis on which the firm competes in its industry. In general, there are two potential strategies that could provide a firm with a competitive advantage: cost leadership and differentiation. Cost leadership involves offering the same product or service that other firms offer but at a lower cost. Differentiation involves satisfying a chosen dimension of customer need better than the competition, at an incremental cost that is less than the price premium that customers are willing to pay. To perform strategy analysis, the analyst has to identify the firm’s intended strategy, assess whether the firm possesses the competencies required to execute the

39

strategy, and recognise the key risks that the firm has to guard against. The analyst also has to evaluate the sustainability of the firm’s strategy. Corporate social responsibility (CSR) is a new aspect of a firm’s competitive strategy. Although it initially incurs setup costs, it can deliver direct economic benefits. In the short run, the firm gains through increased sales and decreased expenses, and in the longer run it gains through increased returns and decreased risks. Corporate strategy evaluation involves examining whether a firm is able to create value by being in multiple businesses at the same time. Cost savings or revenue increases may be generated from specialised resources that the firm has to exploit synergies across the businesses. For these resources to be valuable, they must be non-tradable, not easily imitated by competition and non-divisible. Even when a firm has such resources, it must manage its multi-business organisation so that the information and agency costs inside the organisation are lower than the market transaction costs.

CHECKING AND APPLYING YOUR LEARNING 1 Using the example of an organisation in the sharing economy, assess the competitive forces in the industry. Do those forces explain why the organisation has succeeded? What is your assessment of its future profitability based on your predictions for the competitive forces in the industry?  LO1 2 a Rate the leisure and hospitality industry and the mining industry as high, medium or low on the following dimensions of industry structure.  LO1 Leisure and hospitality industry

Mining industry

Rivalry Threat of new entrants Threat of substitute products Bargaining power of buyers Bargaining power of suppliers b Use your ratings to explain why the mining industry has been able to earn higher returns than the leisure and hospitality industry.  LO1 3 Explain why each of the following factors that distinguish between firms may not be useful in identifying a competitor.  LO2

a Location in the same geographic region b Age of the firm c Meeting the same customer need in a different way d Profit level or level of losses 4 What are the ways by which a firm can create barriers to entry to deter competition in its business? What factors determine whether these barriers are likely to be enduring?  LO3 5 Explain why you agree or disagree with each of the following statements.  LO3 a It is better to be a differentiator than a cost leader, since you can then charge premium prices. b It is more profitable to be in a high-technology than a low-technology industry. c The reason why industries with large investments have high barriers to entry is because it is costly to raise capital. 6 Assess the expected source of competitive advantage for firms in (potential or proven) growth industries such as solar panel production, tertiary education or seafood farming. Is it cost leadership or differentiation or both? How likely is this advantage to be sustained?  LO3

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

7 Explain the statement ‘Corporate virtue in the form of social and … environmental responsibility is rewarding in more ways than one’ (Orlitzky, Schmidt and Rynes, 2003). Identify how different forms of corporate virtue reward different groups of stakeholders.  LO3 8 Explain how outsourcing ‘non-core’ business functions can benefit a firm, by either reducing costs or improving revenues. Explain how the firm needs to maintain control of information and agency costs to gain these benefits.  LO4 9 A SWOT (Strengths, Weaknesses, Opportunities and Threats) evaluation is a useful way to summarise the various investigations and evaluations that have been described in this chapter, as was demonstrated for Kathmandu. Do opportunities and threats arise from factors beyond the control of the firm, or are they the result of poor management?  LO4 10 In undertaking a strategy analysis, what are the difficulties of comparing organisations that differ with respect to:  LO1 a reporting currency (A$, NZ$, US$, euro etc.) b degree of vertical integration c more than 50% of revenues coming from different geographical regions d competitive advantage e industry classification. 11 What sources of information would you use to conduct an industry evaluation of a firm in either Australia or New Zealand?  LO2 12 There are very few companies that are able to be both cost leaders and differentiators. Why? Can you think of a company that has been successful at both?  LO3 13 Extend the analysis of Apple and the iPhone in the chapter to speculate on its demise. What are the weaknesses in its competitive strategy?  LO3 14 Many consultants are advising diversified companies in emerging markets such as India or Vietnam to adopt corporate strategies proven to be of value in advanced economies like the US and the UK. What are the pros and cons of this advice?  LO4 15 Merger and acquisition activity is likely to bring advantages in terms of future profit potential from a strategic analysis perspective: reducing rivalry and bargaining power, for example. What are potential

disadvantages of such activity for future profit potential?  LO4 16 Read the Life Cykel case and answer the questions that follow   LO1 LO2 LO3 LO4 .

LIFE CYKEL Life Cykel is a growing start-up company now based in Byron Bay, Australia. It was co-founded in 2015 in Fremantle by Julian Mitchell and Ryan Creed, who had the original idea of using coffee grounds as a cheap and moist soil in which to grow gourmet oyster mushrooms. The young entrepreneurs crowd-funded $30 000, and personally cycled around Fremantle every day to collect the coffee ground waste from numerous cafés, taking them to their urban mushroom farm (a sea container) to mix with straw and mushroom spores. They then sold the mushrooms back to local restaurants, as well as selling mushrooms kits to individual customers. Not only commercially successful, they have also succeeded in recycling coffee grounds. In Fremantle alone, around 300 tonnes of coffee waste used to go to landfill each year. The used soil is now repurposed as garden fertiliser. And the oyster mushrooms are reportedly delicious! Life Cykel has since expanded into honey products, out of concern for the immunity of bees. The company employs 10 staff and has strategic partners around the world. Source: Lifecykel.com/pages/about-us; 'Recycled coffee grounds give rise to Fremantle mushroom farm' by Laura Gartry, 13 May 2016, ABC News.

Using this information, and any additional research that you can find, describe and analyse Life Cykel’s competitive strategy, using all of the approaches presented in this chapter. a Are they cost leaders or differentiators? b What customer need(s) have they focused on? c What risks did they take in their early days concerning capabilities and processes? d Is their strategy sustainable? e Are there any barriers to entry for potential competitors? f Identify possible changes that could affect their industry, and how their business would be affected. g What is their approach to CSR?

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CHAPTER 2 Strategy analysis

h What benefits have they gained from CSR, if applicable, in terms of employment, sales, design, investment, risk and return? i What costs have they incurred from CSR, if applicable? j Prepare a SWOT evaluation for Life Cykel.

41

strengths or weaknesses, using the following questions to guide your analysis: a Are the firm’s competitors found in the same industry, or are they found in a different industry but use the same underlying technology? One type of firm that defies classification in an industry is a ‘platform’ firm (also known as peer-to-peer marketplaces or shared economy businesses). Can you identify other firms whose competitors are identified on the basis of technology? b Is the firm’s competitive advantage best identified by its use of technology (or other inputs) or its product market (or other outputs)? c Can a firm choose different competitive approaches at the same time? For example, can its presence in different industries and sub-industries use a different competitive approach? Can it choose to be a differentiator in one area of operations (say, marketing) but a cost leader in another (say recruitment or sales)?  LO1 LO2 LO3 LO4

17 Using your own research, analyse the breakfast food industry in your country, using all of the tools introduced in this chapter: economic evaluation, industry evaluation and SWOT summary. Evaluate its prospects for future profitability and risks.  LO1 LO2 LO3 LO4 18 Non-conventional classification: The discussion of industry evaluation in Chapter 2 is based on a straightforward and conventional firm that operates in one industry and chooses the same strategic approach for all aspects of its operations. Find one or more firms in your country that defy these classifications, and consider whether their points of differentiation are

CASE LINK Concepts from this chapter are used in the following case in Part 4:

Case 1 Qantas – Part A

ENDNOTES 1

2

3 4

5

The discussion presented here is intended to provide a basic background in strategy analysis. For a more complete discussion of the strategy concepts, see, for example, Contemporary Strategy Analysis by R. M. Grant (Cambridge, MA: Blackwell Publishers, 1991); Economics of Strategy by D. Besanko, D. Dranove and M. Shanley (New York: John Wiley & Sons, 1996); Strategy and the Business Landscape by P. Ghemawat (Reading, MA: Addison Wesley Longman, 1999); and Corporate Strategy: Resources and the Scope of the Firm by D. J. Collis and C. Montgomery (Burr Ridge, IL: Irwin/ McGraw-Hill, 1997). For a summary of this research, see F. M. Scherer, Industrial Market Structure and Economic Performance, second edition (Chicago: Rand McNally College Publishing, 1980). See M. E. Porter, Competitive Strategy (New York: The Free Press, 1980). While the discussion here uses buyer to connote industrial buyers, the same concepts also apply to buyers of consumer products. Throughout this chapter we use the terms buyers and customers interchangeably. For a more detailed discussion of these two sources of competitive advantage, see M. E. Porter, Competitive Advantage: Creating and Sustaining Superior Performance (New York: The Free Press, 1985).

6

For a more detailed discussion of this theory, see M. E. Porter, ‘What is strategy,’ Harvard Business Review (November–December 1996). 7 See G. Hamel and C. K. Prahalad, Competing for the Future (Boston: Harvard Business School Press, 1994) for a more detailed discussion of the concept of core competencies and their critical role in corporate strategy. 8 From M. Orlitzky, F. L. Schmidt and S. L. Rynes, ‘Corporate social and financial performance: A meta-analysis’, Organization Studies 24(3) (2003): 403–441, p. 427. 9 K. Badenhausen, ‘The world’s most valuable brands 2018’, Forbes (23 May 2018), https://www.forbes.com/sites/ kurtbadenhausen/2018/05/23/the-worlds-most-valuable-brands2018/#48d4e773610c accessed 21 February 2020. 10 KPMG Financial Reporting Insights, 2016. 11 R. Chen, M. Dyball and S. Wright, ‘The ink between board composition and corporate diversification in Australia’, Corporate Governance: An International Review 17(2) (2009): 208–23. 12 The following works are seminal to transaction cost economics: R. Coase, ‘The nature of the firm,’ Economica 4 (1937): 386–405; O. Williamson, Markets and Hierarchies: Analysis and Antitrust Implications (New York: The Free Press, 1975); and D. Teece, ‘Toward an economic theory of the multi-product firm,’ Journal of Economic Behavior and Organization 3 (1982): 39–63.

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

13 For a more complete discussion of these issues, see T. Khanna and K. Palepu, ‘Building institutional infrastructure in emerging markets,’ Brown Journal of World Affairs (Winter/Spring 1998); and T. Khanna and K. Palepu, ‘Why focused strategies may be wrong for emerging markets,’ Harvard Business Review (July–August 1997). 14 For an empirical study which illustrates this point, see T. Khanna and K. Palepu, ‘Is group affiliation profitable in emerging markets? An analysis of diversified Indian business groups,’ Journal of Finance (April 2000): 867–891. 15 See L. Lang and R. Stulz, ‘Tobin’s q, diversification, and firm performance,’ Journal of Political Economy 102 (1994): 1248–80;

and Phillip Berger and Eli Ofek, ‘Diversification’s effect on firm value,’ Journal of Financial Economics 37 (1994): 39–65. 16 See P. Healy, K. Palepu and R. Ruback, ‘Which takeovers are profitable: Strategic or financial?’ Sloan Management Review 38 (Summer 1997): 45–57. 17 See K. Schipper and A. Smith, ‘Effects of recontracting on shareholder wealth: The case of voluntary spin-offs,’ Journal of Financial Economics 12 (December 1983): 437–467; and L. Lang, A. Poulsen and R. Stulz, ‘Asset sales, firm performance, and the agency costs of managerial discretion,’ Journal of Financial Economics 37 (January 1995): 3–37.

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CHAPTER

Overview of accounting analysis The purpose of accounting analysis is to evaluate the degree to which a firm’s accounting captures its underlying business reality.1 In this chapter, we describe the range and types of financial statements and the factors that influence them. We then describe the steps in the accounting analysis. By identifying

the appropriateness of the firm’s accounting policies, estimates and disclosures, analysts can assess the quality of financial statements. Sound accounting analysis improves the reliability of conclusions from financial analysis.

Chapter learning objectives By the end of this chapter, you should be able to: LO1

 describe the component statements of an annual report

LO2

 describe the factors that influence the financial statements

LO3

 apply the steps the accounting analysis.

LO1

3

The annual report

To evaluate the quality of financial statement data, the analyst needs to understand the range and types of financial statements. Annual reports of a firm typically comprise several financial statements, including: 1 2 3 4 5

a statement of financial position as at the end of the period a statement of profit or loss and other comprehensive income for the period a statement of changes in equity for the period a statement of cash flows for the period notes to the financial statements (such as notes on segment information, significant accounting policies and additional explanatory information) 6 an audit report 7 management commentary 8 extended external reports. Financial statements are structured representations, or models, of a firm’s financial position and financial performance. They reflect the financial results of transactions and other events by grouping them into broad classes of economic characteristics called elements. The statement of financial position, or balance sheet, is a summary of the levels of resources and obligations of the Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

firm at a point in time. The elements that directly relate to the measurement of financial position are assets, liabilities and equity. The following equation governs the structure of the statement of financial position: Assets = liabilities + equity The elements that directly relate to the measurement of performance are income and expenses. The following relations reflect the measurement in the firm’s performance: Comprehensive income = profit for the year + other comprehensive income Profit for the year = revenue – expenses ‘Clean surplus’ is a concept where all gains and losses go through income. In practice, this ideal can never be reached. Traditionally, some items avoid profit and are reported directly in equity. These items are labelled as ‘dirty surplus’. However, more recently standard setters have tried to limit the number of items that bypass profit for the year by developing the concept of ‘comprehensive income’. The International Accounting Standards Board (IASB) allows firms to create a single income statement with separate sections for profit or loss and for other comprehensive income. Alternatively, firms can present this in two statements, an income statement and a statement of comprehensive income. However, ownership type transactions (e.g. shares issued, dividends paid) must be reported separately from comprehensive income in a statement of changes in equity. The statement of comprehensive income is a statement that links revenue and expenses with the balance sheet elements. Because of this link, we can combine the balance sheet and income statement equations to form an expanded bookkeeping equation. Assets = liabilities + profit for the period + other comprehensive income + other equity where: Other equity = equity at the beginning of the period + contributions from and distributions to equity holders In the next chapter, we will use this expanded equation to adjust financial statements. Accompanying the financial statements is an extensive set of notes that provide further details on the items reported in the primary financial statements. These notes also include two important pieces of information for the analyst: accounting policies and segment information. The audit report reflects an independent opinion on whether the financial statements are fairly presented in accordance with generally accepted accounting standards. In Australia, New Zealand and elsewhere in the Asia–Pacific the accepted (or regulated) accounting standards are the International Financial Reporting Standards (IFRS). Managers often include a narrative discussion of performance with the financial statements. In some jurisdictions the term ‘management discussion and analysis’ is used. However, the IASB uses the term ‘management commentary’. Closely linked to ‘management commentary’ are segment reports. Most annual reports cover the financial statements of a group. These consolidated financial statements aggregate the parent and all its subsidiaries (less intra-group transactions). With this aggregation is a loss of information about sub-group operating segments. IFRS require the reporting of operating segment data. The link between operating segments and management commentary exists because operating segment data is extracted from reports that are regularly reviewed by the chief operating decision maker. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 3 Overview of accounting analysis

45

SEGMENT REPORT The consolidated financial statements provide aggregated information on the group’s activities. This aggregation can cover multiple industries and multiple jurisdictions. To enable analysts to more fully understand the business, segment reports can reveal which areas are profitable. For example, if the segment report shows a business operation is reporting losses, it could prompt a change in strategic direction. The following is part of Kathmandu’s segment report: 2.1 Segment information An operating segment is a component of an entity that engages in business activities which earns revenue and incurs

expenses and where the chief decision maker reviews the operating results on a regular basis and makes decisions on resource allocation. The Group is organised into four operating segments, depicting the four geographical regions the Group operates in. The New Zealand segment has been represented to exclude holding company balances. Other represents holding companies and consolidation eliminations. The Group operates in four geographical areas: New Zealand, Australia, North America and Rest of World. The North American segment was established during the financial year upon acquisition of Oboz Footwear LLC.

FIGURE 3.1 Segment report information from Kathmandu’s annual report

31 July 2018 Total segment sales

Australia NZ$’000

New Zealand NZ$’000

North America NZ$’000

Rest of World NZ$’000

Other NZ$’000

Total NZ$’000

335 876

143 167

16 785

6 932

–

502 760

Inter-segment sales

(2 193)

(190)

(666)

(2 274)

–

(5 323)

Sales from external customers

333 683

142 977

16 119

4 658

–

497 437

57 744

35 154

2 768

(685)

(5 220)

89 761

8 687

6 125

309

30

–

15 151

EBIT

49 057

29 029

2 459

(715)

(5 220)

74 610

Income tax expense

14 566

8 129

707

(225)

(158)

23 019

EBITDA Depreciation and software amortisation

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KATHMANDU CASE

The Kathmandu and the Brambles case boxes provide examples of operating segment reports. At this stage of the analysis, it is worth your while to simply scan the contents of the operating segment report to see what financial statement line items are reported. Chapter 5 describes the financial analysis in detail. Many of the ratios described in that chapter can be used on the data provided in the segment report. Often, firms also issue sustainability reports or social responsibility reports, or reports that use the frameworks of the International Integrated Reporting Council and the Global Reporting Initiative. Such reports go beyond the traditional financial statements and report strategic risk information on how environmental, social and governance matters impact the firm. It is becoming increasing common to label such reports as extended external reports (EER). Such reports can be part of management commentary, a separate section in the annual report or a separately published report. Kathmandu includes a two-page summary of ‘Our top 5 sustainability highlights’ in its annual report, but has a separate 90-page Sustainability Report. The importance of EER is highlighted by the fact that both the FRC in Australia and the XRB in New Zealand have posted position statements on this topic. We expect EER to become a major focus for financial reporting over the next decade.

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

31 July 2018

Australia NZ$’000

New Zealand NZ$’000

North America NZ$’000

Rest of World NZ$’000

Other NZ$’000

Total NZ$’000

Total segment assets

246 178

297 700

127 373

8 591

(65 225)

614 617

177 540

23 943

103 325

–

149 025

453 833

Additions to non-current assets

11 298

5 352

103 314

–

–

119 964

Total segment liabilities

82 916

59 060

27 975

21 227

3 057

194 235

Total assets includes: Non-current assets

BRAMBLES CASE

Source: Kathmandu Holdings Ltd Annual Report 2018, p.38.

SEGMENT REPORT Figure 3.2 shows part of Brambles segment report. It differs from the Kathmandu segment report because it not only reports geographical segments but it also reports segments based on sub-groups of the firm. In addition, it shows different financial statement line items. The reasons for these differences are that the accounting standard

(IFRS 8) requires segment reporting to be based around the internal reports to the chief decision maker. This reduces the comparability of segment reports but indicates how segments of the firm are managed. Such reports are relevant for analysts.

FIGURE 3.2 Segment information from the Brambles annual report

Note 2. Segment Information – continued Sales revenue By operating segment

Cash flow from operations1

2018 US$m

2017 US$m

2018 US$m

2017 US$m

CHEP Americas

2 195.3

2 073.5

219.1

218.9

CHEP EMEA

1 825.1

1 575.2

310.7

262.3

CHEP Asia Pacific

475.1

484.8

110.8

111.6

1 101.1

970.8

158.8

55.0

–

–

93.0

(56.3)

5 596.6

5 104.3

892.4

591.5

Americas

2 477.5

2 343.7

Europe

2 364.8

2 030.6

Australia

373.4

383.0

Other

380.9

347.0

Total

5 596.6

5 104.3

IFCO Corporate

2

Continuing operations By geographic origin

1 Cash flow from operations is cash flow generated after net capital expenditure but excluding significant items that are outside the ordinary course of business. 2 Cash flow from operations for the corporate segment in 2018 includes receipt of the US$150.0 million HFG loan (refer note 9).

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CHAPTER 3 Overview of accounting analysis

Operating profit3 By operating segment

2018 US$m

Significant items before tax4 2017 US$m

2018 US$m

47

Underlying profit4

2017 US$m

2018 US$m

2017 US$m

CHEP Americas

310.3

377.3

(40.3)

(17.8)

350.6

395.1

CHEP EMEA

452.0

375.1

(2.8)

(12.0)

454.8

387.1

CHEP Asia Pacific

111.4

110.9

(0.3)

(1.2)

111.7

112.1

IFCO

173.2

116.7

36.7

(0.9)

136.5

117.6

Corporate5

(60.9)

(208.6)

(4.0)

(154.2)

(56.9)

(54.4)

Continuing operations

986.0

771.4

(10.7)

(186.1)

996.7

957.5

3 Operating profit is segment revenue less segment expense and excludes net finance costs. 4 Underlying profit a non-statutory profit measure and represents profit from continuing operations before finance costs, tax and Significant items (refer note 4). It is presented to assist users of the financial statements to better understand Brambles’ business results. 5 Significant items for the corporate segment in 2017 included US$120.0 million relating to the impairment of the HFG. Source: Brambles Limited Annual Report 2018, pp. 60-61.

LO2

 actors influencing the financial F statements

In this section, we examine the factors that influence financial statements.

Transactions, events and conditions In the previous section, we noted that the financial statements are financial models of the firm’s business activities. If financial statements are to reflect the firm’s underlying business, they should reflect the transactions the firm undertakes. Accounting standards sometimes use the phrase ‘transactions, events and conditions’. Transactions refer to contracts made between the firm and external third parties. Transactions internal to the firm cannot change or create wealth. There is a saying ‘transferring money from one pocket to another does not create wealth’. Thus, the financial statements ought to reflect transactions that are external to the firm. The financial statements will also reflect events. An uninsured factory that has burnt to the ground is not a transaction, but the write-down in value is an event that needs to be recorded. Another example is borrowings in foreign currency, which are affected by changes in exchange rates. Finally, the accounting must also reflect conditions. A bottling plant working with corrosive materials will wear out faster than a similar plant bottling mineral water. Hence, the financial statements will also need to reflect the underlying conditions.

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Managers’ discretion While the basic elements of financial statements are simple, recording transactions and events often involves complex judgements and estimates. If revenue is recognised before cash is collected, how should potential defaults be estimated? Are the outlays associated with research and development activities, where payoffs are uncertain, assets or expenses? Should interest on a bank overdraft for working capital be capitalised (or added) to the cost of the purchasing manufacturing plant? Or, should interest be treated as an expense? Because managers have inside knowledge of the firm’s business, they are entrusted to make the appropriate judgements in portraying the myriad of business transactions using accrual accounting. Managers’ involvement in the financial statements is extensive. They are involved in: 1 the underlying transactions 2 choosing between acceptable alternative accounting methods 3 making assumptions and estimates 4 choosing the level of explanatory disclosures. The accounting discretion granted to managers allows them to enhance the information reported in financial statements. However, as profits are regarded as a measure of managers’ performance, managers have an incentive to use their accounting discretion to distort reported profits.2 The use of accounting numbers in contracts between the firm and outsiders provides further incentives for managers to manipulate accounting numbers. Earnings management distorts financial accounting data, making this data less valuable to external users of financial statements. In summary, delegating financial reporting decisions to managers has both costs and benefits. However, management does not have limitless discretion over accounting matters. Institutional factors affect financial statements and restrict managers’ discretion. These include accounting standards, audit, legal enforcement and governance.

Accounting standards: IFRS Before 2005, accounting standards around the world were mostly developed at a national level, often by the accounting profession. Since 2005, more than 100 countries have required or permitted reporting entities to adopt IFRS developed and issued by the IASB. The state of adoption by various countries in the Asia–Pacific is listed and regularly updated by the IASB.3 An objective of the IASB is: to develop, in the public interest, a single set of high quality, understandable, enforceable and globally accepted financial reporting standards based on clearly articulated principles. These standards should require high quality, transparent and comparable information in financial statements and other financial reporting to help investors, other participants in the various capital markets of the world and other users of financial information make economic decisions. Source: IFRS Foundation, ‘Preface to IFRS’, para 6, International Financial Reporting Standards 2013. © Copyright IFRS Foundation

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CHAPTER 3 Overview of accounting analysis

Clearly, one of the aims of IFRS is to increase comparability by accounting for ‘like economic transactions in a like manner’. This will make financial statements more comparable over time and across firms.4 Thus, accounting standards create a common accounting language. This ought to reduce the cost of analysis and limit managers’ ability to distort financial statements. The IASB tries to create accounting standards that are principles-based, rather than rulesbased. For example, to maintain uniformity the Financial Accounting Standards Board (FASB) in the US requires firms to expense all research and development, whereas the IASB requires research expenditure to be expensed, but allows recognition of intangible assets arising from development expenditure if specified conditions are met.5 Proponents of principles-based standards claim they reflect the economic substance of a transaction instead of its legal form. Proponents of the rules-based approach claim that their approach increases verifiability and uniformity of financial statement information. The IASB does not develop accounting standards in isolation. It seeks guidance from and is advised by regional interest groups. The main advisory groups are the national standard setters in jurisdictions that have adopted IFRS, such as the AASB in Australia and the NZASB in New Zealand. An important group in the Asia Oceania area is AOSSG (Asian-Oceanian StandardSetters Group). AOSSG was established at a meeting held in Beijing on 17 April 2009, with representatives from China, Japan, Korea, Malaysia, Singapore, Australia, New Zealand, Brunei, Hong Kong SAR, Indonesia and Macau SAR. It was agreed that accounting standard-setters in the region establish a platform to discuss problems and share experiences in the convergence process, to participate in the development of IFRS, and to contribute to a single set of high-quality global accounting standards.

Auditing The objective of external auditing is to arrive at an opinion as to whether the firm has presented their financial statements fairly. Auditing improves the credibility of accounting data by limiting the firm’s ability to manipulate financial statements, and ensures consistency of reporting over time. To ensure audit quality, many firms will engage a firm of internationally recognised auditors or an industry specialist. To be effective, the audit must be conducted by an expert who is independent of the preparer.

Legal environment Obviously, the quality of financial reporting is a joint product of the quality of accounting standards and the quality of enforcement of those standards. The IASB has no power to enforce IFRS. Different jurisdictions have different monitoring and enforcement mechanisms. In some countries, accounting standards are enforced by the profession. In other countries, accounting standards are legally enforceable. The legal environment in which accounting disputes between managers, auditors and investors are adjudicated can also have a significant effect on the quality of reported numbers. The threat of lawsuits and resulting penalties has the beneficial effect of improving the accuracy

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

of disclosure.6 The potential for significant legal liability may also discourage managers and auditors from making voluntary disclosures that require difficult estimates, such as forwardlooking disclosures. Such disclosures might turn out to be wrong and this could increase the manager’s personal liability. As regulations impose costs, it is simply not possible to completely eliminate managers’ influence over the accounting system. The net result is that information in corporate financial reports is noisy and biased, even in the presence of accounting regulation and external auditing. The objective of accounting analysis is to evaluate the degree to which a firm’s accounting captures its underlying business reality and to ‘undo’ any accounting distortions. When potential distortions are large, accounting analysis can add considerable value. For example, research indicates that firms criticised in the financial press for misleading financial reporting subsequently suffer an average share price drop of 8%.7 Furthermore, firms in the US subject to SEC investigation for earnings management show an average share price decline of 9% when the earnings management is first announced and continue to have poor share performance for up to two years. 8 These findings imply that analysts who are able to identify firms with misleading accounting are able to create value for investors. The findings also indicate that the share market ultimately sees through earnings management.

Governance In 2014, the ASX Corporate Governance Council used this quote from the HIH Royal Commission to define corporate governance: ‘… the framework of rules, relationships, systems and processes within and by which authority is exercised and controlled within corporations. It encompasses the mechanisms by which companies, and those in control, are held to account’.9 Good corporate governance is designed to promote investor confidence and is therefore important in accounting analysis. The ASX principles and recommendations acknowledge that governance practice is a matter for the board of directors based on a range of factors, such as size, complexity, history and corporate culture. It therefore does not prescribe governance practices. Like many other jurisdictions, it lays down principles and adopts a ‘comply or explain’ or ‘if not, why not’ approach. If the firm does not comply with a particular recommendation then it must explain why this is the case. It is common for the annual report to have a separate section on governance. For example, the Kathmandu 2018 Annual Report has four pages dedicated to corporate governance disclosures. These include the responsibilities of the board of directors, its charter, its committees and, of course, its explanation for departures from ASX and NZX guidelines. In the Kathmandu case ‘Comply or explain’, (Figure 3.3) the company notes that it does not maintain a separate nomination committee because of the small size of the board. In making a judgement on the quality of governance, an analyst would need to conclude whether the departure from the ASX guidelines and the stated explanation is reasonable.

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‘COMPLY OR EXPLAIN’ DEPARTURES FROM ASX RECOMMENDATIONS FIGURE 3.3 Kathmandu’s explanation for departure from NZX Corporate Governance Code 2017 and ASX Corporate Governance Principles and Recommendations (3rd Edition)

Reference

Recommendation

Departure

Explanation for departure

NZX Code 3.4

An issuer should establish a nomination committee to recommend director appointments to the Board

The Company has not maintained a separate nomination committee

Due to the size of the Board, the Board as a whole retains the responsibility for recommending new Director appointments. The Board considers that it is able to deal efficiently and effectively with the processes of appointment and reappointment of directors to the Board and considerations of Board composition and succession planning

Internal audit functions should be disclosed

The Company does not have an internal audit function

The Company considers that the external advisors it currently engages provide a sufficient system for evaluating and continually improving the effectiveness of risk management for the Company and delivers appropriate objective assurance on risk management

ASX Code 2.1

NZX Code 7.3 ASX Code 7.3

Source: Kathmandu Holdings Ltd Annual Report 2018, p.24.

This disclosure is a requirement of the ASX. If firms do not comply with governance guidelines, they must explain why. In this case, Kathmandu has not established a

separate nomination committee. The reason given is that the whole board has retained the responsibility that would otherwise be left to a separate sub-committee.

When analysing accounting, analysts often take particular interest in the function and composition of the audit committee. This committee oversees the financial reporting process and the communication with the firm’s external auditors. The following recommendations from the ASX Corporate governance principles and recommendations are relevant for accounting analysis: Recommendation 2.4 A majority of the board of a listed entity should be



independent directors. Recommendation 2.5 The chair of the board of a listed entity should be an independent director and, in particular, should not be the same person as the CEO of the entity. Recommendation 4.1 The board of a listed entity should have an audit committee which: (1) has at least three members, all of whom are nonexecutive directors and a majority of whom are independent directors; and (2) is chaired by an independent director, who is not the chair of the board; and it should disclose: (3) the charter of the committee; (4) the relevant qualifications and experience of the members of the committee; and (5) in relation to each reporting period, the number of times the committee met throughout the period and the individual attendances of the members at those meetings. Recommendation 4.2 The board of a listed entity should, before it approves the entity’s financial statements for a financial period, receive from its CEO and CFO a declaration that, in their opinion, the financial records of the entity have been properly maintained and that the financial

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CHAPTER 3 Overview of accounting analysis

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

statements comply with the appropriate accounting standards and give a true and fair view of the financial position and performance of the entity and that the opinion has been formed on the basis of a sound system of risk management and internal control which is operating effectively.10

LO3

Steps in accounting analysis

In this section, we discuss a series of steps that the analyst should follow to evaluate a firm’s accounting quality. Steps 1–3 are preliminary parts of the process. The subsequent steps follow the managers’ ability to affect the financial statements noted earlier in the chapter: (4) the underlying transactions, (5) choosing between acceptable alternative accounting policies and methods, (6) making assumptions and estimates, and (7) choosing the level of explanatory disclosures.

Step 1: What is the objective? The first step in almost any process is to identify the end goal. As an analyst, there are many reasons you could need to value a firm. Is the company preparing for an initial public offering? Is the objective to determine an independent valuation for a sale of a private company? Or its purchase? The analysis might be a forensic investigation of a firm’s recent decline in profitability, or to decide whether to extend credit. If you are an in-house analyst, the objective will be part of your day-to-day job. If you are a consultant, it will be necessary to understand and seek clarity on the client’s instructions and expectations. Whatever the objective of the analysis, who owns the firm will be an important factor. If the objective is valuation, who are you acting for? The majority shareholders? The minority shareholders? Is an independent valuation required? Ownership is also important for accounting analysis, because it can determine the quality of the financial statements. A closely held company has no need for high quality financial statements if each of the owners has access to ‘inside information’ on the way the firm is run.

Step 2: What information is available? The second step is to gather information. Do you have access to annual reports, interim reports, management reports and other reports (such as prospectuses, independent valuers or receiverships reports)? In consulting assignments, it is important to maintain a log of information and reports that have been used. (Often this log can extend to meetings held.) This is important because, to limit liability, the consultant’s report will state ‘… we have relied on the following documents…’. Also important is whether there are limitations or any restrictions placed on information that has been made available.

Step 3: Examine the audit report A useful preliminary step in assessing accounting quality is to read an expert’s opinion on the financial statements – the audit report. Recall, that the audit is an independent expert’s opinion on whether the financial statements are fairly presented in accordance with IFRS. The features to look for in the audit report are: Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 3 Overview of accounting analysis

53

AUDIT FEE ANALYSIS Auditor independence can be compromised if the firm pays the auditor large amounts of consulting income relative to other fees. The following footnote reports the fees earned by the auditor. Audit fees During the year the following fees were paid or payable for services provided by the auditor of the parent entity, its related practices and other network audit firms:

FIGURE 3.4 Kathmandu’s audit fees from its annual report 2018

2018

2017

NZ$’000

NZ$’000

175

133

Audit services – PricewaterhouseCoopers Statutory audit Half-year review

33

32

Other assurance services*

18

19

Total remuneration for audit services

226

184

* Other assurance services relate the preparation of revenue certificates, and banking compliance certificates and a treasury review in the previous year. Source: Kathmandu Holdings Ltd Annual Report 2018, p.67.

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KATHMANDU CASE

Who are the auditors? Are they industry experts? Generally, large audit firms are regarded as having superior training and expertise. How independent are the auditors? An auditor can never be completely independent, because the firm on which they are reporting pays the auditor. Large auditing firms are usually considered to be less economically dependent upon their clients. Other fees derived by the auditor can also compromise independence. A technique to analyse this is shown in the Kathmandu case ‘Audit fee analysis’ that follows. What is covered by the audit report? Not all of the annual report is audited. Often the audit only covers the financial statements. Management commentary is unlikely to have been audited. What is the date of the audit report? The date between balance date and when the audit report is signed is called the audit lag. Abnormal audit lags (either from prior years or from industry norms) may indicate that the firm has had audit problems that have taken time to resolve. What is the audit opinion? Is it a ‘clean’ (i.e. unqualified) opinion or have the auditors highlighted something in the audit report they consider is of fundamental importance to the understanding of the financial statements? Of particular relevance is whether the auditor’s report discloses there is material uncertainty about the firm’s ability to continue as a going concern. This does not mean the firm will go under, just that there is sufficient doubt. The Lachlan Star case ‘Going concern’ is an example of an audit report emphasising a material uncertainty regarding the firm continuing as a going concern. Since 2017, many jurisdictions have adopted international auditing standards and are required to report Key Audit Matters (KAMs). KAMs are those matters that the auditor considers most significant in the audit of the financial statements. The Kathmandu case ‘Audit fee analysis’ shows an extract from the auditor’s report on the inventory KAM. Another feature of modern audit reports is that they often discuss materiality: looking at what information is material or immaterial to the audit.

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LACHLAN STAR CASE

From this we can see other assurance fees are only a small part of the total fees received by the auditor (i.e. 18/266). This note also illustrates that there are various qualities of assurance. For example, the half-year statements have only been subject to a review and not a

full statutory audit. This review provides a moderate level of assurance – ‘it makes sense’. If the auditor provides an opinion, this is typically a more negative assurance along the lines of, ‘We have not found anything wrong’.

GOING CONCERN The extract from the audit report below highlights that the continuation of the firm as a going concern is a material uncertainty. It identifies note 1, in which the firm itself comments on the problem. Material uncertainty regarding continuation as a going concern Without qualifying our opinion, we draw attention to Note 1(a), which indicates that the consolidated entity incurred a net loss after tax of $263,346 during the year ended 30 June 2016, and, as of that date, had a net current asset

deficiency of $1,109,806. As a result, the consolidated entity is dependent on successfully raising additional funding. These conditions, along with other matters set forth in Note 1(a), indicate the existence of a material uncertainty that may cast significant doubt about the consolidated entity’s ability to continue as a going concern and therefore, the consolidated entity may be unable to realise its assets and discharge its liabilities in the normal course of business and at the amounts stated in the financial report. Lachlan Star Annual Report 2016

KATHMANDU CASE

In most cases, the firm is a going concern and the auditor issues a ‘clean’ audit report. While auditors issue an opinion on published financial statements, it is important to remember that the primary responsibility for the statements still rests with the firm’s board of directors. In the Kathmandu case ‘Going concern’, the audit report clearly states the responsibility of the directors.

GOING CONCERN The audit report outlines the relative responsibilities of the directors and the auditors in the preparation of the financial statements.

going concern basis of accounting unless the Directors either intend to liquidate the Group or to cease operations, or have no realistic alternative but to do so.

Responsibilities of the Directors for the consolidated financial statements

Auditor’s responsibilities for the audit of the consolidated financial statements

The Directors are responsible, on behalf of the Company, for the preparation and fair presentation of the consolidated financial statements in accordance with NZ IFRS and IFRS, and for such internal control as the Directors determine is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. In preparing the consolidated financial statements, the Directors are responsible for assessing the Group’s ability to continue as a going concern, disclosing, as applicable, matters related to going concern and using the

Our objectives are to obtain reasonable assurance about whether the consolidated financial statements, as a whole, are free from material misstatement, whether due to fraud or error, and to issue an auditor’s report that includes our opinion. Reasonable assurance is a high level of assurance, but is not a guarantee that an audit conducted in accordance with ISAs NZ and ISAs will always detect a material misstatement when it exists. Misstatements can arise from fraud or error and are considered material if, individually or in the aggregate, they could reasonably be expected to influence

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CHAPTER 3 Overview of accounting analysis

Source: Kathmandu Holdings Ltd Annual Report 2018, p.74. In note 4.3.4 the directors describe how they safeguard the firm’s going concern. 4.3.4 Capital risk management The Group’s capital includes contributed equity, reserves and retained earnings.

The Group’s objectives when managing capital are to safeguard the Group’s ability to continue as a going concern in order to provide returns for shareholders and benefits for other stakeholders and to maintain an optimal capital structure to reduce the cost of capital. In order to maintain or adjust the capital structure, the Group may adjust the amount of dividends paid to shareholders, return capital to shareholders, issue new shares or sell assets to reduce debt or draw down more debt. Source: Kathmandu Holdings Ltd Annual Report 2018, p.59.

KEY AUDIT MATTERS The following is an example of the auditor’s KAM in relation to inventory. It describes the nature of the matter (e.g. valuation and existence). It also describes the audit procedures to address the issue. Inventory valuation and existence At 31 July 2018, the Group held inventories of $111.9 million. Inventory valuation and existence was an audit focus area because of the number of stores/locations that inventory was held at, and the judgement applied in the valuation of inventory to incorporate inventory shrinkage. As described in note 3.1.1 of the financial statements, inventories are carried at the lower of cost and net realisable value on a weighted average basis. We performed a number of audit procedures over inventory existence and valuation. We

 Observed the stocktake process at selected store locations near period end and undertook our own test counts;  Attended the year end Oboz distribution centre count and performed independent test counts;  Validated all stores had been counted twice in the year by selecting a sample of locations not visited by us and inspected results of stock counts held and confirmed variances were correctly accounted for and approved by head office management; Source: Kathmandu Holdings Ltd Annual Report 2018, p.72. The inventory KAM also refers to the accompanying note 3.1.3. Thus, the analyst can triangulate the firm’s key accounting policies by referring to the audit report and the financial statements.

Step 4: Look for unusual transactions and events Sometimes unusual or non-recurring transactions and events can dominate the financial statements. These might include acquisitions, mergers, discontinued operations, major changes in management, potential lawsuits and major refinancing arrangements. Unfortunately, these will not be reported in one place and analysts must look through all parts of the annual report. Looking for business press commentary and continuous disclosure regime notices are useful to compile a list of events that ought to be disclosed in the annual report. The purpose is to consider if the major transactions make business sense or have been undertaken to achieve a certain accounting performance. The following list is not exhaustive but provides an indication of what to look for: Business combinations: IFRS requires footnotes on the impact of acquisitions on the financial statements. There is also likely to be a comment in the audit report on the valuation of goodwill. Some comment on the acquisition and how it has affected performance would be expected in management commentary. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

KATHMANDU CASE

the economic decisions of users taken on the basis of these consolidated financial statements.

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Disposals: For assets that meet certain criteria, IFRS 5 specifies the presentation and disclosure of assets held for sale. These are typically major asset sales and the accounting standard requires a split in the income statement between continuing and discontinued operations. Large asset impairment: Asset write-offs will arise as a result of unexpected changes in business circumstances. Profitability downturns are likely to trigger goodwill and intangible impairment. It is worthwhile considering whether managers have been slow or timely to incorporate changing business circumstances into accounting estimates.11 Unusual transactions: IFRS requires footnote disclosures for several items that might indicate unusual transactions, such as subsequent events, related party transactions, contingent liabilities and capital commitments. Management changes: Have there been changes in directors and senior management? If there have been changes in senior managers then sometimes the firm will take an ‘accounting bath’. That is, they will choose extremely conservative accounting by writing down and impairing assets. The bath (or lower profit) created by this accounting can be blamed on the old managers. This also creates ‘cookie jar reserves’. As accruals reverse over time, this accounting technique effectively transfers profit to the future. Auditor change: Auditor rotation is a change of auditor (mandatory in some jurisdictions) to keep a ‘fresh set of eyes’ and preserve the independence of the audit (which can be compromised through overfamiliarity). However, it may be the case that the client has chosen a new auditor because they want a certain accounting treatment not approved of by the old auditor. Such changes in auditor is termed ‘opinion shopping’. One-off transactions that profits: The give-away for this is a major jump in non-operating profit. For example, firms may undertake balance sheet transactions, such as asset sales or debt for equity swaps, to realise gains in periods when operating performance is poor.12 Off-balance sheet structures: While different structures and arrangements may have sound business logic, they also provide management with an opportunity to achieve certain accounting objectives. For example, Australian firms can adopt a deed of cross guarantee to relieve specified subsidiaries within a group from having to report financial statements. As well as accounting and auditing cost savings there are strategic reasons for adopting a non-disclosure policy, such as limiting product competition and other accounting disclosures (segment reporting).13 Such behaviour may suggest that the firm’s managers are willing to expend economic resources merely to achieve an accounting objective. Off-balance sheet structures may be difficult to observe – simply because the purpose is to keep items hidden off-balance sheet!

Step 5: Assess accounting policies In accounting analysis, the analyst tries to identify and evaluate the firm’s accounting policies, especially the methods used to measure critical factors and risks. For example, key success factors in the banking industry include interest and credit risk management. However, in the retail industry, inventory management is a key success factor. Traditionally, the accounting policies were found in a single place – ‘the statement of accounting policies’. Often this statement was ‘boiler-plate’ and generic to lots of firms regardless of the business model or industry. More recently, firms have been placing accounting policy notes along with relevant disclosures. Furthermore, the explanations tend to be firm-specific and more

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57

CRITICAL ACCOUNTING ESTIMATES The following describes the critical accounting estimate and assumptions (business combinations, goodwill, inventories and fair value of derivatives) made by the firm in producing the financial statements. Critical accounting estimates The Group makes estimates and assumptions concerning the future. The resulting accounting estimates will, by definition, seldom equal the related actual results. The estimates and assumptions that have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year are discussed below. Estimates and judgements are continually evaluated and are based on historical experience as adjusted for current market conditions and other factors, including expectations of future events that are believed to be reasonable under the circumstances. Further explanation as to estimates and assumptions made by the Group can be found in the following notes to the financial statements: FIGURE 3.5 Kathmandu estimations

Area of estimation

Section

Business combinations – purchase price allocation

5.1

Goodwill – assumptions underlying recoverable value

3.3

Inventory – estimates of obsolescence

3.1.1

Fair value of derivatives – assumptions underlying fair value

4.2

3.1.1 Inventory accounting policies Inventories are stated at the lower of cost and net realisable value. Cost is determined on a weighted average cost method and includes expenditure incurred in acquiring the inventories and bringing them to their existing location and condition. Net realisable value is the estimated selling price in the ordinary course of business, less applicable variable selling expenses. Inventory is considered in transit when the risk and rewards of ownership have transferred to the Group. The Group assesses the likely residual value of inventory. Stock provisions are recognised for inventory which is expected to sell for less than cost and also for the value of inventory likely to have been lost to the business through shrinkage between the date of the last applicable stocktake and balance sheet date. In recognising the provision for inventory, judgement has been applied by considering a range of factors including historical results, stock shrinkage trends and product lifecycle. Inventory is broken down into trading stock and goods in transit below: FIGURE 3.6 Kathmandu’s breakdown of trading stock and goods

2018 NZ$’000

2017 NZ$’000

Trading stock

89 802

76 678

Goods in transit

22 127

12 528

111 929

89 206

Source: Kathmandu Holdings Ltd Annual Report 2018, p.44.

Source: Kathmandu Holdings Ltd Annual Report 2018, p.37.

The next extract shows the relevant inventory note. Interestingly, the provision for obsolescence has almost doubled (from $337 970 in 2017 to $627 362 in 2018).

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KATHMANDU CASE

informative. This can be seen from the Kathmandu segment reporting note shown earlier in this chapter. The policy notes defines the firm’s definition of segment. Another source to identify key accounting policies is the disclosure of critical accounting estimates, which is required by IFRS. This is shown in the Kathmandu case ‘Critical accounting estimates’. This note identifies that business combinations, goodwill, inventory and fair value of derivatives are where management has made critical estimates.

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

ASX CASE

Once the analyst has identified the firm’s critical accounting policies – for example, inventories in the case of Kathmandu – how does the analyst know if the accounting policies are appropriate? Possible approaches are: Do the firm’s accounting policies compare to industry norms? If they are dissimilar, is it because the firm’s competitive strategy is different? For example, consider a firm that reports a significantly lower warranty allowance than the industry average. One explanation is that the firm competes on the basis of high quality and has invested considerable resources to reduce the rate of product failure. Or it could be that the firm is merely understating its warranty liabilities. Has the firm changed any of its policies? What is the justification? What is the impact of these changes? IAS 8 limits accounting policy changes to those changes in IFRS where the financial statement results are more relevant and reliable. IAS 8 requires firms to determine the amount of the adjustment arising from the initial application of IFRS. Any footnotes relating to changes in policy will be an important consideration in assessing the financial statement quality. Are there any prior period adjustments? IFRS allows changes in accounting policy to be retrospective. For example, a change from cost to market value for a non-current asset will not only affect the current year but also the depreciation charged in prior years. How does the accountant adjust prior years? The adjustment is to opening retained earnings. The best way see if this has occurred is to go to the retained earnings column in the Statement of Changes in Equity. An example of this is provided in the ASX case ‘Prior period adjustment’.

PRIOR PERIOD ADJUSTMENT When firms change their accounting method, the impact is often a cumulative effect of the impact on, first, this year’s income statement, and, second, a backlog adjustment related to prior years. For example, assume a firm has a $100 financial asset being amortised over five years. At the end of year 1, the asset book amount is $80 ($100–$20). At the end of year 2, the firm decides to change the method of accounting to fair

value. It estimates the fair value at year 2 is $90 and year 1 is $75. The prior period adjustment that relates to year 1 is to reduce the asset by $5 ($75 – $80) and reduce equity by $5. The adjustment that relates to year 2 is to increase the asset $15 ($90 – $75) and take $15 to income. The prior period adjustment is a direct adjustment against opening retained earnings, as illustrated in this case.

FIGURE 3.7  ASX consolidated statement of changes in equity

For the period ended

Note

Opening balance at 1 July 2018 Change in accounting policies Restated balance at 1 July 2018

10

Issued capital $m

Retained earnings $m

Restricted capital reserve $m

Asset revaluation reserve $m

Equity compensation reserve $m

Total equity $m

3 027.2

666.7

71.5

168.4

11.7

3 945.5

–

(84.9)

–

0.6

–

(84.3)

3 027.2

581.8

71.5

169.0

11.7

3 861.2

The ASX half-year report includes a change in accounting policy, which has been adjusted against components of equity (retained earnings, asset revaluation reserve). Further explanations of the accounting policy change can be found in footnote 10, as follows.

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CHAPTER 3 Overview of accounting analysis

10. Changes in accounting policies The Group has adopted AASB 9 Financial Instruments and AASB 15 Revenue from Contracts with Customers from 1 July 2018. This has resulted in changes in accounting policies and adjustments to the amounts recognised in the financial statements. In accordance with the transition provisions in AASB 9 (7.2.15) and (7.2.22) and AASB 15(C3)(b), the Group has adopted both standards retrospectively however comparative periods have not been restated. Any retrospective adjustments have been recognised in the opening balance sheet on 1 July 2018.

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The following tables show the adjustments recognised for each individual line item in the financial statements. Line items that were not affected by the changes have not been included. As a result, the sub-totals and totals disclosed cannot be recalculated from the numbers provided. © ASX Limited ABN 98 008 624 691 (ASX) 2020. All rights reserved. This material is reproduced with the permission of ASX. This material should not be reproduced, stored in a retrieval system or transmitted in any form whether in whole or in part without the prior written

Step 6: Assess accrual quality Financial statements can vary in quality. They range from simple tax accounts to full IFRS accrual accounting. Therefore, it is important to identify the basis on which the financial statements are prepared. One of the underlying features of financial statements is that they are prepared using the accrual basis of accounting. Accountants use accrual accounting to allocate current cash flow to past, current and future periods. For example, cash payments to purchase goods can be carried forward to the future (as inventory) until the goods are sold. Accrual accounting can also anticipate future cash flows. That is, revenues are recoded when the sales contract has been signed and not when the cash is received. Hence, accrual accounting requires accountants to make estimates and judgements in allocating cash flows to past, current and future periods. The evidence shows that accruals improve the ability of earnings to measure performance, as reflected in stock returns. Furthermore, this ability is greater when there is greater volatility in the firm’s working capital, when the firm’s operating cycle is longer, and when the performance measurement is shorter.14 The accruals will eventually reverse and ultimately profits and cash will converge. However, in the short term, new accruals can more than offset reversing accruals. Accruals are the link between income and cash flows: Income = operating cash flows + accruals While this is not the whole picture, it indicates the impact of accruals on income; that is, the potential impact of accounting discretion. If the financial statements are of IFRS quality, then they will show a reconciliation of net profit after tax with cash inflow from operations. An example of this particular note to the cash flow statement is provided in the Kathmandu case that follows. This reconciliation lists all the major accruals management has made. We can use this as a starting point to assess the accounting policies employed by the firm.

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permission of ASX.

KATHMANDU CASE

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

RECONCILIATION OF NET PROFIT AFTER TAXATION WITH CASH INFLOW FROM OPERATING ACTIVITIES The following reconciliation is from Kathmandu’s 2018 Annual Report: FIGURE 3.8 Kathmandu’s reconciliation of net profit after taxation with cash inflow from operating activities

Section

2018 NZ$’000

Profit after taxation

2017 NZ$’000 50 532

38 039

5 272

(1 249)

(13 873)

6 283

10 884

5 596

6 405

2 257

8 688

12 887

Movement in working capital: (Increase) / decrease in trade and other receivables (Increase) / decrease in inventories Increase / (decrease) in trade and other payables Increase / (decrease) in tax liability Add non cash items:

11 576

Depreciation

3.2

Amortisation of intangibles

3.3

Foreign currency translation of working capital balances

Loss on sale of property, plant and equipment

3 196 (816)

(1 944)

733

6.4

1 489

1 139

3.2

2 116

16 381 Cash inflow from operating activities

10 630

(431)

Increase / (decrease) in deferred taxation Employee share based remuneration

3 575

1 465 16 347

75 601

67 273

Source: Kathmandu Holdings Ltd Annual Report 2018, p.35.

All items in this reconciliation are accruals. From this, we can see that the movements in working capital (e.g. the increase or decrease in receivables, inventories and payables) and depreciation are the major contributions that distinguish cash flows from profits. The other non-cash items have not changed much between 2017 and 2018. One way of summarising this information is to calculate a profit to cash flow ratio. For example:

2018 50 532/75 601 = 0.668 2017 38 039/67 273 = 0.565 Whether these are reasonable will depend on prior history and industry factors (or what other retail firms are experiencing). Note, use care when interpreting this ratio if operating cash flows are small or negative.

In this step, we use operating cash flow as a benchmark to assess earnings or accrual quality. This is relevant because of the relation between cash flows, accruals and earnings. Another benchmark that analysis might use is the gap between reported income and tax income. Firms will often follow different accounting policies for financial reporting and tax accounting.15 However, the relation between book and tax accounting is likely to remain constant over time, unless there are significant changes in tax rules or accounting standards. Thus, an increase in reported income relative to tax income may indicate that financial reporting has become more aggressive. For example, warranty expenses are estimated on Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 3 Overview of accounting analysis

an accruals basis for financial reporting, but are recorded on a cash basis for tax reporting. Unless there is a significant change in the firm’s product quality, these two numbers should bear a consistent relation to each other. Therefore, a change in this relationship can indicate that product quality is changing, that financial reporting estimates are changing or that the tax basis has changed. Another way to assess accrual quality is to assess if the policies and estimates have been realistic in the past. For example, firms that depreciate non-current assets too slowly will be forced to take a large write-off later. A history of loss on sale may be, therefore, a sign of underdepreciation in early years. Similarly, if a firm makes substantial provisions for losses it might be creating ‘cookie jar’ reserves that it can realise in future years when profitability is not so good.

Step 7: Assess disclosure quality Financial disclosures can make it more or less easy for an analyst to assess the firm’s accounting quality.16 We have already discussed disclosures related to accounting policies; in this section we consider other disclosures. While accounting rules require a certain amount of minimum disclosure, managers have considerable choice in the matter. Disclosure quality, therefore, is an important dimension of a firm’s accounting quality. In assessing disclosure quality, an analyst could ask the following questions: Does the firm provide adequate disclosures to assess business strategy and its economic consequences? The firm’s strategy is typically reported as part of management commentary, such as the director’s review. This section is useful if it lays out the industry conditions, the firm’s competitive position and management’s plans for the future. However, some firms use this review to puff up the firm’s financial performance and gloss over any business difficulties. Does the firm adequately explain its current performance? Management commentary also should help analysts understand the reasons behind the firm’s performance. If accounting rules and conventions restrict the firm from reporting its key success factors appropriately, are additional disclosure provided? There has been a growing trend for firms to report alternative performance measures (APM).17 APM are non-GAAP measures of firm performance and may provide a view of ‘normalised earnings’ as seen through the ‘eyes of management’. These measures may have more predictive ability than comprehensive income, which includes gains and losses that may not recur. Thus, APM are useful when viewed alongside GAAP income. APM are more reliable if they are reconciled to GAAP income and the method of calculation is consistently applied. It is important to know that comparability of APM across firms and even within an industry can be very low. If a firm operates multiple business segments, what is the quality of segment disclosure? Some firms provide excellent discussion of their performance by product segments and geographic segments. Others firms lump many different businesses units into one broad segment. The level of competition in an industry and management’s willingness to share disaggregated performance data influences the quality of segment disclosure. Are there any related party disclosures? An important feature of financial statements is that they should reflect ‘arms-length’ transactions external to the firm. Related party transactions may lack the objectivity of the marketplace, and managers’ accounting estimates related to these transactions are likely to be more subjective and potentially self-serving.18 The Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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62

PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

stakeholders of the firm are entitled to know if there have been any transactions with related parties, such as major shareholders, directors and managers. If these transactions are not at fair or market value, then one party to the transaction has gained and the other has lost. At the extreme, wealth can be extracted from the firm and, ultimately, the shareholders. For example, the sale of land and buildings below market price to a majority shareholder reduces the wealth of minority shareholders. How forthcoming is the management with respect to bad news? A firm’s disclosure quality is most clearly revealed by the way management deals with bad news. Does it adequately explain the reasons for poor performance? Does the company clearly articulate its strategy to address the company’s performance problems? How good is the firm’s investor relations program? Is management accessible to analysts?

Step 8: Evaluate and conclude

INDUSTRY INSIGHT

The accounting analysis is a review of the information available, keeping in mind the objective of the analysis. We have described this review as a series of steps. In fact, steps 4–7 are more likely to be an iterative process rather than a strict sequential analysis. The analyst will go back and forth between and within financial statements, the annual report and other pieces of information. The process may indicate further information is required. However, collecting additional data is a cost-benefit activity. The accounting analysis should be a preliminary overview rather than an extensive investigation. Hence, even during the analysis phase (Chapter 5 and beyond) the analyst may uncover additional information. This accounting analysis will give the analyst an understanding of the available data. However, the main purpose is to come to a qualitative assessment of the information. The main features of this review will be considered during the analysis phase. The accounting analysis might suggest that the firm’s reported numbers need to be restated. While it is virtually impossible to undo the accounting without the help of outside information, often a reasonable attempt can be made in this direction. The next chapter covers this important step.

A PRACTITIONER ADVISES Partner with leading chartered accounting firm specialising in corporate finance and valuation, on how accountants use valuation skills in constructing financial statements: So, what can you use this skill of financial analysis and business valuation to do? The obvious thing is valuation. But it needs to be applied in context, and one of the main contexts is regulatory compliance. If you have studied accounting, then you will know that the accounting standards frequently have references to market value or fair value. And guess who determines those fair values? Someone like me.

Again, if you’ve done some tax subjects, you’ll realise that there are market values embedded throughout the various tax codes, and they all require valuation. So, there’s heaps of work in accounting report preparation for a valuation expert. Reflective activity: Financial analysis and business evaluation are relevant skills in a variety of career contexts, including as an expert advisor in legal disputes, a company investment advisor and providing banking assessment of corporate client credit-worthiness. How might you use financial analysis and business valuation skills in these contexts? What are some other contexts and career opportunities in which these skills would be relevant?

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CHAPTER 3 Overview of accounting analysis

63

SUMMARY Accounting analysis is an important step in analysing corporate financial reports. The purpose of accounting analysis is to evaluate the degree to which a firm’s accounting captures the underlying business reality. Sound accounting analysis improves the reliability of conclusions from financial analysis. There are eight key steps in accounting analysis. The preliminary steps include considering the objective of the analysis and determining what information is available. An important starting point is to examine the audit report,

which is the expert’s opinion of the financial statements. The analyst will then look for unusual transactions and events, assess whether the accounting policies are appropriate, assess the accrual quality and assess disclosure quality. Based on this analysis, the analyst will assess the quality of the financial statements. In this final stage, the analyst will consider whether to recast the financial statements. The next chapter discusses how to make some of the most common types of adjustments to recast the financial statements

CHECKING AND APPLYING YOUR LEARNING 1 Jing has looked at some statistics on the causes of company failure. The top six reasons are: i inadequate cash flow (18.8%) ii poor strategic management (18.3%) iii trading losses (14.3%) iv poor financial control, including record keeping (14.2%) v under-capitalisation (8.1%) vi poor economic conditions (5.9%). a For each of these causes of failure, which steps in the accounting analysis, if any, might ‘raise a red flag’ or give you forewarning? b Jing states: ‘As inadequate cash flow is the major causes of company failure, there is no need to look at earnings’. Do you agree? Why or why not?  LO2 2 Fiona argues: ‘The accounting standards that I like most are the ones that eliminate all management discretion in reporting – that way I get uniform numbers across all companies and don’t have to worry about doing accounting analysis.’ Do you agree? Why or why not?  LO3 3 The following questions relate to the Kathmandu case ‘Segment report’ included in the text. a Estimate the contribution of each segment. How much equity is tied up in each segment? Comment on the segment contributions. b Why are inter-segment sales deducted? c Segment reports are prepared ‘through the eyes of management’. That is, they must reflect the reports that are presented to the chief operating officer. Is reporting geographically the most appropriate basis? d The note to the segment report states: ‘The New Zealand segment has been represented to exclude

holding company balances. Other represents holding companies and consolidation eliminations’. What does this mean? You might like to refer to Note 5.2 in the 2018 Annual Report. e Which segment is more profitable? f If you could make one recommendation to Kathmandu to improve the segment report, what would it be? g The flexibility in financial reports can reflect management’s desire to inform users of financial statements or to their intent to distort information. How might management distort segment information and what would be their incentives?  LO2 4 Consider the following accounting changes: – a decrease in the estimated life of depreciable assets – a decrease in doubtful debts as a percentage of gross receivables – recognition of revenue from gold mining from when it was extracted rather than when gold is delivered – capitalisation of a higher proportion of interest to acquired property, plant and equipment. a If management reports truthfully, what economic events are likely to prompt the above accounting changes? b If potential earnings management had taken place, how would the above accounting changes impact the financial statements?  LO3 5 The conservatism principle arises because of concerns about management’s incentives to overstate the organisation’s performance. Joe Choi argues: ‘Conservative accounting is good accounting’. Do you agree? Why or why not?  LO2

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64

PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

6 Following on from the previous question, audit reports typically include three or four KAMs. What do you think are the top two KAMs in the following industries? – Commercial properties – Information technology – Energy  LO2 One way of thinking about accounting quality is to consider the incentives and consequences of accounting. Consider the following cases: 7 Assume that a public utility commission sets the electricity prices such that the following relation is maintained:

Revenues = operating expenses + depreciation + taxes + r × book where r is considered to be a ‘fair’ return on the investment base (book). Book is measured as the book amount of plant and working capital. IAS 16 ‘Property, plant and equipment’ allows firms the option to use the cost model or the revaluation model to measure property, plant and equipment. If an electric utility chooses the revaluation method, how will this affect the pricing equation? Other things being equal, would you expect a utility to use the cost or revaluation method? One condition of an efficient market is if information is rapidly and objectively impounded in stock prices. Sophie states that ‘as the market is efficient, then it does not matter if the value of property, plant and equipment is recognised in the financial statements or reported in the notes to the financial statements’. Evaluate Sophie’s statement.  LO3 8 What if the IASB decided to expense all R&D expenditure? Which firms might be adversely affected by such accounting standards? Would such an accounting standard make the financial statements of firms more comparable? Would it make the financial statements more relevant? What are your views on the relative merits of principles versus rules-based accounting standards?  LO3 9 IAS 23 requires companies to capitalise borrowing costs directly attributable to the acquisition, construction or production of an asset into the cost of an asset. Previously, accounting standards required all interest costs to be written off as an expense. Discuss which of these alternatives increases the comparability of accounting. Is interest a product cost or a period cost?  LO3

You might like to consider the acquisition of an identical asset in the following situations: – an all-equity company (i.e. a company with no debt) – a higher-risk company (i.e. a company with a higher borrowing rate) – the use of fair value accounting rather than cost accounting to establish the amount of the asset to be recognised in the balance sheet. 10 Obtain an annual report and review the corporate governance section. a Take the ASX Corporate Governance Council recommendations described in this chapter and score the firm’s governance to see if it meets ‘best practice’. The suggested scoring scale is 0= noncompliant, 1= compliant. If compliance exceeds requirement then score = 2. b Is non-compliance bad?  LO2 LO3 11 Find three annual reports and make a list of the KAMs reported in the audit report. From the following list, what do you think would be the top five KAMs reported in 2017? Why? – Asset impairment (not goodwill) – Biological assets – Capitalisation – Financial instruments – Going concern – Impairment of goodwill and intangibles – Inventory – Investment-related entities – IT-related – Provisions – Receivables – Revenue recognition – Taxation – Valuation of property plant, and equipment.  LO2 12 Obtain an annual report and go through the eight steps of the accounting analysis. Assume the objective of the analysis is to value a 10% shareholding in the firm.  LO3 13 In preparing the financial statements, management makes many judgements and estimates. Disclosures of the key judgements and estimates, required by IAS 1 ‘Presentation of financial statements’ can help investors to assess the impact of management judgements and estimates on financial position and performance. They are therefore an integral part of the accounting analysis.

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CHAPTER 3 Overview of accounting analysis



Figure 3.9 contains a summary of the critical accounting estimates from the 2018 financial statements of several retail firms: Kathmandu, Briscoe Group, Hallenstein Glassons, Michael Hill, Smith City, Super Retail Group and The Warehouse. Note that x = mentioned as a critical accounting estimate and 0 = not mentioned. Note also, this is a summary and the actual disclosures contained more details. a An analyst in the retail industry would need to be familiar with each type of critical accounting

65

estimate and how it might impact the financial statements. For each critical accounting estimate, provide a brief description of the transaction, event or condition and why it might be ‘critical’. b Discuss the economic-, industry- or firm-specific factors that might give rise to the variation in critical accounting estimates. c Do you think a critical accounting estimates might help to identify close competitors of Kathmandu (for the purposes of cross-sectional analysis)?  LO3

FIGURE 3.9 A summary of the critical accounting estimates from the 2018 financial statements of several retail firms

Kathmandu

Briscoe Group

Hallenstein Glassons

Michael Hill

Smith City

Super Retail Group

The Warehouse

KMD

BRG

HGL

MHL

SCY

SUL

WHS

Inventory

X

X

X

0

X

X

X

Financial instruments (including derivatives)

X

0

0

0

X

0

X

Employee benefits

0

0

0

X

X

X

0

Property, plant and equipment

0

0

X

X

0

0

0

Non-intangible asset impairment

0

0

0

X

0

X

0

Critical accounting estimates

Onerous contracts

0

0

0

0

X

X

0

Intangible assets

0

0

0

0

0

X

X

Make good provisions

0

0

0

X

0

X

0

Revaluation of investment property

0

0

X

0

0

0

0

Business combinations

X

0

0

0

0

0

0

Goodwill

X

0

0

0

0

0

0

Share-based payment transactions

0

0

0

X

0

0

0

Revaluation of land and buildings

0

0

X

0

0

0

0

Revenue recognition

0

0

0

X

0

0

0

Recovery deferred tax assets

0

0

0

X

0

0

0

Finance receivables

0

0

0

0

X

0

0

Unearned income on fixed instalment contracts

0

0

0

0

X

0

0

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

14 Most annual reports are consolidated financial statements that aggregate the financial statements of the parent and its subsidiaries. Segment reports are required by IFRS 8 ‘Operating segments’ to provide information of the major business components of the group. Reportable segments are those segments whose results are regularly reviewed by the firm’s chief operating decision maker. Hence, the reportable segments are unlikely to be comparable between firms. Figure 3.10 summarises the way in which segment information is reported in the 2018 financial statements from several retail firms. a Segment reports are generally either geographical or products and services. For each firm in the table, state whether the segment report is geographical or product based. b Why do you think some report geographically and some report on a product basis? c Some analysts suggest that segment reports can be useful for choosing comparisons across firms or comparison (cross-sectional) analysis. For each firm, state whether it would make a reasonable comparison firm and why. d The Kathmandu segment report has a ‘residual segment’ called ‘Other’. What type of data might be in this segment? Hint: review some of the other firms as they have more explicit descriptions.  LO3 FIGURE 3.10 Segment information reporting from several retail firms

Company

Segment report Australia New Zealand

Kathmandu (KMD)

North America Rest of World Other Homeware

Briscoe Group (BRG)

Sporting goods Eliminations/unallocated Glassons New Zealand Glassons Australia

Hallenstein Glassons (HGL)

Hallensteins

MH Australia Michael Hill (MHL)

MH New Zealand MH Canada Corporate and other Retail activities

Smith City (SCY)

Finance business Property activities Parent and abnormal items Auto

Super Retail Group (SUL)

Outdoor Sports Inter-segment eliminations and unallocated The Warehouse Warehouse Stationery

The Warehouse (WHS)

Noel Leeming Torpedo 7 Other group Inter-segment

15 A recent survey of 203 investors found that only 49% believed the auditor was independent of the firm and 29% believed the auditor was not independent. The fundamental problem is that auditors are paid by the firm that employs them. Auditor independence is also said to be stretched if the auditor undertakes non-audit services. Figure 3.11 lists the fees for audit and nonaudit services for several retail firms from their 2018 (including 2017 comparatives) financial statements. a Review the table of audit fees, as an analyst. What factors might increase or decrease your concern with regard to auditor independence? b What additional factors might mitigate your concerns about non-audit services and independence? c Juliana states, ‘We can solve all the problems about correct accounting if the auditors choose the accounting policies rather than management’. Do you agree? Why or why not?  LO3

Storm Property Parent

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CHAPTER 3 Overview of accounting analysis

67

FIGURE 3.11 Fees for audit and non-audit services for several retail firms

2018 Assurance and review

MHL

SCY

SUL

412

85

586

Statutory Half-year review Advisory/other

170

KMD

BRG

WHS

HGL

175

115

660

130

33

26

90

22

Revenue certificates

18

Cyber security audit

45

Taxation

461

Customs prudential review

19

Digital advertising advisory

50

Workshop facilitation

52

27

Treasury policy

53

2017 Assurance and review

343

84

492

Statutory Half-year review Advisory/other

7

133

104

579

32

26

90

126

24

Treasury review

19

Remuneration benchmarking

4

Risk appetite assurance

192

Taxation

180

Business review of subsidiary

20

50

Treasury policy

43

CASE LINK Concepts from this chapter are used in the following cases in Part 4:

Case 1 Qantas – Part B

Case 2 Airlines: Depreciation differences Case 7 Dick Smith Case 8 Resinex.

ENDNOTES 1

2

Accounting analysis is sometimes also called ‘quality of earnings analysis’. We prefer to use the term ‘accounting analysis’, as it encompasses the quality of accounting as a whole rather than focus on earnings. For a summary of management incentives see P. Healy and J. Wahlen, ‘A review of the earnings management literature and its implications for standard setting’, Accounting Horizons 13 (December 1999): 365–84; and T. Fields, T. Lys and L. Vincent, ‘Empirical research on accounting choice’, Journal of Accounting and Economics 31 (September 2001): 255–307.

3

When countries and firms describe themselves as having ‘adopted’ IFRS, some caution is necessary. The term ‘adoption’ can mean complete adoption or modified adaptation. See S. A. Zeff and C. W. Nobes, ‘Commentary: Has Australia (or any other jurisdiction) ‘adopted’ IFRS?’, Australian Accounting Review 20 (2010): 178–84. The terms ‘harmonisation’ or ‘convergence’ are also in use to express a move towards IFRS, without a commitment to fully adopt. Furthermore, for some countries, adoption may only be at the consolidated level for large listed companies. For others it might be applicable for smaller private

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companies. The IASB has also issued a set of accounting standards for Small and Medium Size Entities. Hence, reference to the IASB website is necessary. 4 It is not clear that uniformity of accounting can be achieved on an international scale. Capital, labour and product markets may differ such that transactions are not similar. IFRS may have local influences or interpretations, including accounting practices followed prior to IFRS adoption, different cultural arrangements, different regulatory monitoring and enforcement and different systems of business law. See R. Ball, ‘International Financial Reporting Standards (IFRS): Pros and cons for investors’, Accounting and Business Research 36 (2006): 5–27. 5 See B. Bennett, M. Bradbury and H. Prangnell, ‘Rules, principles and judgements in accounting standards’, Abacus, 42 (June 2006): 189–204 for a comparative analysis of FASB and IASB research and development standards. 6 For a description of international differences in managers’ legal liability and the information provided in prospectuses, see R. La Porta, F. Lopez-de-Silanes and A. Schliefer, ‘What works in securities laws?’, Journal of Finance 61 (2006): 1–32. 7 See G. Foster, ‘Briloff and the capital market’, Journal of Accounting Research 17(1) (Spring 1979): 262–74. 8 See P. Dechow, R. Sloan and A. Sweeney, ‘Causes and consequences of earnings manipulation: An analysis of firms subject to enforcement actions by the SEC’, Contemporary Accounting Research 13(1) (1996): 1–36, and M.D. Beneish, ‘Detecting GAAP violation: Implications for assessing earnings management among firms with extreme financial performance’, Journal of Accounting and Public Policy 16 (1997): 271–309. 9 Justice Owen in the HIH Royal Commission, The Failure of HIH Insurance Volume 1: A Corporate Collapse and Its Lessons, Commonwealth of Australia, (April 2003): p. xxxiv. 10 Research supports the view that independent and financially qualified audit committees, and those that are active (based on the number of meetings) reduce fraudulent reporting and other financial reporting irregularities. © Copyright 2020 ASX Corporate Governance Council. 11 For an empirical examination of asset write-offs, see J. Elliott and W. Shaw, ‘Write-offs as accounting procedures to manage perceptions’, Journal of Accounting Research 26 (1988): 91–119.

12 Examples of this type of behaviour are documented by J. Hand, ‘Did firms undertake debt-equity swaps for an accounting paper profit or true financial gain?’, The Accounting Review 64 (October 1989): 587–623; and E. Black, K. Sellers and T. Manley, ‘Earnings management using asset sales: An international study of countries allowing noncurrent asset revaluation’, Journal of Business Finance and Accounting 25 (November/December 1988): 1287–317. 13 See M. Bradbury, G. Dean and F.L. Clarke, ‘Incentives for non-disclosure by corporate groups’ Abacus 45(4) (November 2009): 410–54. 14 For further empirical evidence on this, see P. Dechow, ‘Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals’, Journal of Accounting and Economics 18 (July 1994): 3–42. 15 This is true, by and large, for many countries, including the US, UK, Australia and New Zealand. However, in other countries, such as Germany and Japan, tax accounting and financial reporting are closely tied. 16 Financial analysts pay close attention to managers’ disclosure strategies. The Association for Investment Management and Research publishes an annual report evaluating them for US organisations. For a discussion of these ratings, see M. Lang and R. Lundholm, ‘Cross-sectional determinants of analysts’ ratings of corporate disclosures’, Journal of Accounting Research 31 (Autumn 1993): 246–71. 17 J. Coulton, A. Ribeiro, Y. Shan, S. Taylor, ‘The rise and rise of non-GAAP disclosure’, published by Chartered Accountants Australia and New Zealand, (2016), accessed https://www. charteredaccountantsanz.com/-/media/d5177569324747908714e 5441ab06665.ashx 18 See M. Jian and T.J. Wong, ‘Propping through related party transactions’, Review of Accounting Studies 15 (2008): 70–105. Research shows that the market will discount firms that engage in related party transactions: see M. Kohlbeck and B.W. Mayhew, ‘Valuation of firms that disclose related party transactions’, Journal of Accounting and Public Policy 29 (2) (2010): 115–37.

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CHAPTER

Implementing accounting analysis In Chapter 3, we learned that accounting analysis will indicate if the firm’s accounting numbers need to be adjusted to increase comparisons or to ‘undo’ any accounting distortions. Firms use different formats and terminology to present financial statements. Recasting the financial statements using a standard template increases comparability between firms and consistency over time. Once the financial statements have been standardised, the analyst is ready to consider any adjustments. The analyst’s primary focus should be on those accounting estimates and methods that the firm uses to measure its key success factors and risks. If there are differences in key accounting estimates

and/or methods between firms, or for the same firm over time, the analyst’s job is to assess whether they reflect legitimate business differences (and therefore require no adjustment) or whether they reflect differences in managerial bias (and require adjustment). This chapter explains why recasting the firm’s financial statements into a standard template is useful. We then show how to adjust the financial statements. We use a worksheet approach to adjust both the balance sheet and the income statement. While illustrating the mechanical aspects of recasting and adjusting the reported financial statements, we also discuss the main distortions of which analysts will need to be aware.

Chapter learning objectives By the end of this chapter, you should be able to: LO1

 understand why recasting financial statements is necessary

LO2

 understand the process of making accounting adjustments

LO3

 demonstrate how adjustments are made for a variety of common accounting issues.

LO1

4

Recasting financial statements

Firms often use different formats and terminology to present their financial statements. For example, the balance sheet may be presented in a form that is consistent with the balance sheet equation, as presented in the last chapter, and the total of assets will equal the totals for liabilities and equity. Another firm may present working capital (current assets less current liabilities) plus non-current assets less non-current liabilities to equal equity. One firm may label its share capital as ‘common stock’; another may label inventories as ‘stock-in-trade’ or simply ‘stock’. One firm may present land and buildings on the face of the balance sheet under the heading ‘property, plant

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and equipment’; another may simply have the label ‘fixed assets’ on the face of the balance sheet with details in a footnote. Differences in financial statement format, classification and terminology make it difficult to compare performance across firms, and for the same firm over time. The first task in accounting analysis is, therefore, to recast the financial statements into a common format. This involves designing a standardised template for the balance sheet, income statement and cash flow statement that can be used for any firm. Although important, we do not dwell on the issue of recasting the financial statements into a particular standardised template. This is because most security analyst or investment banks have their own method of standardisation. Once the financials have been standardised, the analyst then considers whether accounting adjustments are needed to improve the analysis.

LO2

Accounting adjustments: The process

The analyst needs to decide if the financial statements need adjusting. As with recasting the financial statements, accounting adjustments are desirable to increase comparability between firms or consistency over time. The analyst might consider the financial statements need adjusting, because: the accounting policies adopted do not capture the firm’s economics firms use different accounting choices within GAAP managers have used their discretion to bias the firm’s financial statements. To make accounting adjustments, we use a worksheet approach based on the accounting equation: Assets = liabilities + equity The technique to capture the full impact of the adjustment is simply to ensure that equal adjustments are made to both sides of the equation. Hence, if an asset is considered to be overvalued, then an adjustment that reduces that asset value must result in either an increase in another asset, a reduction in a liability or a reduction in equity (or an adjustment to all three). The key point is that adjustments on both sides of the equation must be equal. To illustrate the adjustment process, we will use an example of removing deferred tax from the financial statements. Deferred tax represents temporary or timing differences between GAAP accounting and tax accounting. These differences should reverse over time. However, in firms that are growing, the new timing differences will more than offset the reversing timing differences. Analysts argue that the deferred tax asset or liability does not represent an amount owing to or from taxation authorities. Analysts often employ before-tax profit numbers (such as earnings before tax) and hence they might also argue that deferred tax should be excluded from the balance sheet. To illustrate this type of adjustment we will use information in the Kathmandu case, 'Illustration of accounting adjustments'.

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ILLUSTRATION OF ACCOUNTING ADJUSTMENTS Figure 4.1 shows Kathmandu’s 2018 financial statements related to deferred tax to use in the accounting adjustment illustration.

This is the liabilities and equity side of the statement of financial position. The relevant amount is the non-current deferred tax liability of $49 785 000.

FIGURE 4.1 Kathmandu’s 2018 financial statements related to deferred tax

FIGURE 4.2 Kathmandu taxation – statement of comprehensive income

Non-current liabilities

Section

2018 NZ$’000

2017 NZ$’000

Derivative financial instruments

4.2

62

265

Interest-bearing liabilities

4.1

39 500

10 431

Deferred tax

2.3

49 785

34 027

89 347

44 723

194 235

111 967

Total non-current liabilities

2018 NZ$’000

2017 NZ$’000

Current income tax charge

24 964

16 829

Deferred income tax charge / (credit)

(1 945)

106

Income tax charge reported in statement of comprehensive income

23 019

16 935

Source: Kathmandu Holdings Ltd Annual Report 2018, p.40.

Total liabilities

Figure 4.2 is a footnote disclosure that shows the deferred tax component in the income statement is a credit of $1 945 000.

Source: Kathmandu Holdings Ltd Annual Report 2018, p.33.

Using the information in the Kathmandu case, the accounting adjustment is to remove deferred tax liability and increase equity. Figure 4.3 is based on $ millions. FIGURE 4.3 Accounting adjustment removing deferred tax liability and increasing equity

Reported Deferred tax Adjusted

Assets

=

Liabilities

+

Equity

614

=

194

+

420

=

–50

+

+50

=

144

+

470

     614

The level of detail needed for the accounting adjustment is accommodated by increasing or reducing the number of columns. For example, if the deferred adjustment was to incorporate the income statement effect, we would insert an extra column in equity, as shown in Figure 4.4. FIGURE 4.4 Deferred adjustment incorporating the income statement effect

Assets

=

Liabilities

+

Equity Profit

Reported Asset impairment Adjusted

Other

614

=

194

+

51

369

0

=

–50

+

–2

+52

614

=

144

+

49

421

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In the equity column we have split equity into the current profit of $51 million and the balance of $369 million (other). We can see from the Kathmandu case the tax change would have been $24.964 million without the deferred tax. Hence, profit would be lower by $2 million. In the next section we use several examples to illustrate the use of this worksheet approach to make accounting adjustments.1

Why make accounting adjustments? Analysts make adjustments to financial statements because: 1 accounting standards may not reflect the economics of the firm 2 they want to adjust for accounting choices within GAAP 3 they want to remove management bias.

Accounting standards Financial statements will not always fully reflect the economics of the firm. First, the financial statements may have been prepared for tax purposes rather than as a means to measure performance. Tax rules are based on political and economic incentives rather than GAAP. For example, consider the purchase of an asset with a 10-year life. Under tax accounting, to provide regional development incentives, the asset might be depreciated over two years. However, under GAAP the asset would be depreciated over its useful life (10 years). Tax financial statements for unlisted firms that do not follow GAAP often do not have a clear separation between the owners and the business. For example, the owners have current accounts with the firm that, from an economic view, are either loans by the firm (asset balances) or borrowings (amounts owing). The accounting analysis is likely to have identified these issues. However, even if financial statements are prepared under GAAP, it is difficult for accounting rules to capture all of the subtleties arising from transactions, events and conditions that impact the firm. For example, the IASB’s framework states that it is not possible to define precisely when recognising an asset or liability provides useful information to users of financial statements at a cost that does not outweigh its benefits. The uncertainty in demonstrating that research expenditure leads to future benefits has led the IASB, in IAS 38 ‘Intangible assets’, to require the expensing of research expenditure.2 On the other hand, IAS 38 allows the capitalisation of development expenditure into an intangible asset, provided specified criteria are met. Hence, the research and development expenditure reflected in the financial statement of the firm will not reflect the underlying economics. First, the research component of the expenditure has been expensed and is not recorded as an asset. Second, even if all the cost of development expenditure was recorded as an intangible asset, it is unlikely that it would bear any relation to the value of the financial benefits from that asset. Another financial distortion arising from accounting practice that may not reflect the economics of the firm is the measurement attribute employed in the recording of assets. Many non-financial assets are recorded at historical cost or – for items such as property, plant and equipment – depreciated historical cost. In  many cases, depreciated historical cost may be a reasonable approximation of the fair (market) value of an asset. IAS  36 ‘Impairment of assets’ requires a loss to be recorded when an asset is impaired (i.e. when the fair value falls below book value). Similarly, IAS 2 ‘Inventories’ requires inventory to be recorded at the lower of cost or net

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CHAPTER 4 Implementing accounting analysis

realisable value. Hence, current accounting practice, if applied correctly, will mean that the book value of assets will not be overvalued. The accounting bias arising from GAAP is likely to result in undervalued assets. This is mitigated by the increasing use of fair value as a measurement base, especially for financial assets. IAS 16 ‘Property, plant and equipment’ allows firms to adopt either a cost model or a revaluation model. Therefore, an analyst may need to make adjustments to increase the comparability across firms. We have discussed two reasons why book amounts of assets may not represent economic values: uncertainty over the benefits and the conservative measurement bias of current accounting. Similar issues arise with reporting liabilities. For most liabilities, there is little ambiguity about whether an obligation has been incurred. For example, when a firm buys supplies on credit, it incurs an obligation to the supplier. However, for some transactions it is more difficult to decide whether there is any such obligation. For example, if a firm announces a plan to restructure its business by laying off employees, has it made a commitment that would justify recording a liability? Or, if a software firm receives cash from its customers for a fiveyear software licence, should the firm report the full cash inflow as revenues, or should some of it represent the ongoing commitment to the customer for servicing and supporting the licence agreement? For some liabilities, it is difficult to estimate the amount of the obligation. For example, a firm that is responsible for an environmental clean-up clearly has incurred an obligation, but the amount is highly uncertain.3 Similarly, firms that provide pension and post-retirement benefits for employees incur commitments that depend on uncertain future events, such as employee mortality rates and future inflation rate. The assumptions necessary to capture these uncertainties make valuation of the obligation subjective. Future warranty and insurance claim obligations fall into the same category: the commitment is clear but the amount depends on uncertain future events. In summary, accounting rules frequently specify when a commitment has been incurred and how to measure the amount of the commitment. However, accounting rules are imperfect – they cannot cover all contractual possibilities and reflect all of the complexities of a firm’s business relationships. Accounting standards require managers to make subjective estimates of future events to value the firm’s commitments. Thus, the analyst may decide an adjustment is necessary because an important obligation is omitted from the financial statements.

Accounting choices within GAAP Analysts will often want to compare the results of the firm with those of other firms (typically in the same industry) or compare the results of the same firm over time. If the target firm employs different accounting methods from those of the comparison firms, or if there has been a change in accounting policy, then the analyst must decide whether to make accounting adjustments to increase comparability and consistency.

Management bias Management has considerable input into, and discretion over, the financial reporting process. They select accounting policies (such as the choice of first-in, first-out (FIFO) or the weighted average method for cost inventory), make accounting estimates (such as provisions for doubtful

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debts and the useful lives of non-current assets) and select the level of disclosure (for instance, the reporting of segment data). Management has more information on business activities undertaken by the firm than financial statement users have. Managers can use this information asymmetry to make the financial statements more informative. Alternatively, managers can also impose bias on the financial results and position.4 Even though management discretion over financial reporting is not unlimited, analysts must understand the motivations for managers to act opportunistically and distort financial reports. These include:

to increase earnings to meet the consensus analysts’ earnings forecast to avoid reporting a loss or a decline in earnings to increase assets or income to meet a financial covenant in a debt agreement to increase or decrease earnings to reduce the volatility in reported earnings to increase earnings to ensure a higher bonus payout to decrease earnings, when earnings are above the amount at which no additional bonus compensation is earned.

Remember that accruals reverse over time. Thus, accruals that increase income this year – for example, recording sales in anticipation of contracts – will either reverse in the following accounting periods, if the anticipated contract arises, or will require further accruals, to maintain the illusion of revenue growth. In the previous chapter we looked at the divergence between cash from operations and net income as a measure of assessing accrual quality. Other opportunities for distorting financial statements can arise when major events occur. These include: a change of top management, when large write-offs can be blamed on the outgoing management and increase earnings in subsequent years a firm preparing for a public equity offering (when it is considered desirable to present the best picture to maximise the issue selling price) business combinations, when there is a motivation to increase or overstate assets and/or liabilities and offset with goodwill when the firm has become a potential political target, when earnings may be reduced because the industry is being threatened with price controls or loss of tax concessions. The previous examples make it clear that, depending on the circumstances, managers have incentives either to increase or decrease earnings and to increase or decrease assets and liabilities. Survey evidence from Dichev et al. (2013) indicates that chief financial officers believe that 60% of earnings management is income-increasing and 40% is income-decreasing. The incomedecreasing is consistent with using accruals to create cookie jar reserves in order to smooth earnings in the future.5 Furthermore, they find that the two most common red flags that point to potential misrepresentation are: (1) persistent deviations between earnings and the underlying cash flows, and (2) deviations from peer experience (e.g. what is standard for the industry). We do not wish to leave you with the impression that managers have unfettered ability to distort the accounting underlying financial statements. The accounting choices are restricted by accounting rules (e.g. IFRS or tax rules). These accounting rules are enforced, both publicly, through reviews by regulators such as ASIC and the Financial Markets Authority, and privately,

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CHAPTER 4 Implementing accounting analysis

via external auditing. Internal governance, such as the audit committee and internal audits, also constrain management’s accounting discretion.

LO3

Common adjustments

Adjustments for non-GAAP financial statements Analysts often make adjustments if they are analysing the financial statements of (unlisted) private companies.6 Financial statements must be adjusted to remove items that are unique to the current business, but do not impact business value on a continuing basis. The following are common adjustments:7 Excess cash is removed from the balance sheet (typically by adjusting shareholders’ funds, which assumes a notional distribution to the owners). Often the level of cash will be negotiated between buyer and seller and the valuation should reflect this negotiated outcome. Assets that are not part of the business operations will also be removed from the balance sheet (via shareholder funds). For example, the current owner may have a corporate jet on the books, which is used for personal purposes. Due diligence may indicate that uncollectable accounts receivable are over-or understated. Similarly, inventory may be understated to minimise taxation. This may require adjustments against current and past income. Intangible assets, such as patents, trademarks or deferred tax, may be written off against shareholders’ funds. This may be on the basis of the negotiation between buyer and seller but also because such adjustments are often incorporated into loan agreements. Shareholders’ current accounts (both debit and credit balances) are adjusted against shareholders’ funds. Often the owner/shareholder has a current account balance. Consideration must be given as to whether the current account balance is really a loan to, or borrowings from, the shareholders. In this circumstance, the analyst must also decide whether to make notional adjustments for interest received or paid, as if the loan or borrowing was an arm’slength commercial transaction. This adjustment ignores the legal priorities of debt and equity, but attempts to portray the substance of the arrangement. Similar to the above adjustment, consideration must be given to loans to or borrowings from affiliated firms. Balances to and from affiliated firms may exist only because of the close control of the firm by common owners. The adjustment, against shareholders’ funds, reflects this transaction as a disposition of corporate assets by the owner. To avoid the double taxation effect of a dividend distribution, it is common for small business to distribute taxable profit by way of salary to the owners. To approximate the underlying profit of the firm, owners’ salaries can be added back to reported earnings. Then a ‘normal’ salary for managing the firm should be charged. If the financial statements are to be used for forecasting future earnings, then it will also be relevant to transfer non-recurring items from operating income. For example, a one-time item of closing down a branch or costs incurred in a lawsuit might be transferred from operating income to special items.

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To illustrate, we will walk through an example that covers many of the above features. In Figure 4.5, the first row is the reported information from the financial statements of a private firm, prepared essentially for tax purposes. The analyst has decided to use six columns: two asset, two liability and two equity. Of course, the analyst could use more columns if they decide that more details are needed. For example, current assets could be split into components such as cash, receivables, inventory and other. The ‘trick’ with worksheet adjustments is to follow the accounting equation: assets = liabilities + equity. This reduces the amount of errors that can be made when making adjustments. Sometimes analysts make partial adjustments. For example, they might adjust only the profit. The weakness of this approach is that it completely ignores the impact on the balance sheet and other accounting ratios such as liquidity and leverage. Hence, we recommend that analysts make full adjustments. The analyst for Figure 4.5 has decided to make seven adjustments. Many of these adjustments are notional or ‘as if’ modifications. 1 Included in the non-current assets is an asset that is unnecessary for firm’s operations. This could be a corporate jet, a sailboat or a motor-racing car. The adjustment is to eliminate this asset from the balance sheet ($800 000) and adjust it against retained earnings. This is equivalent to selling the asset to the owners in lieu of a dividend. 2 Included in current assets is the owner’s current account receivable of $30 000. Like adjustment 1, this is a non-productive asset in terms of the firm’s operations. 3 Included in current liabilities is another current account of $500 000 payable to the owner. This amount has been sitting in the balance sheet for several years and the analyst has decided that it is ‘informal borrowing’ by the firm. The analyst has decided that as a standalone entity, the firm would need term borrowings of an equivalent amount. Hence the analyst transfers the owner’s current account to a non-current liability. 4 Adjustment 4 is to account for the notional interest expense that would have been payable if the $500 000 had been formal borrowing. The interest expense $25 000 is adjusted against owners’ equity. In some cases, the owner might be receiving interest on the loan, in which case the adjustment will be the difference between the market rate and the rate given to the owner. 5 To avoid paying company tax on profit and personal tax on the dividends from those profits, managers will often reduce the company profit to zero by paying out any profit as a salary. The analyst has determined that the salary extracted by the owner for the current year was $825  000. In adjustment 5 the $825  000 has been added back to profit and deducted from retained earnings. 6 Adjustment 6 is an extension of adjustment 5. Having added back the profit, the analyst now has to make an adjustment for a normal salary that would be paid to a manager to run the firm. The analyst determines this amount is $300 000 and reduces profit and owner’s equity accordingly. 7 The last step is to estimate the profit of the firm and notionally pay the appropriate amount of company tax. In this case the estimate was 30% of $500 000. Again, the other side of the adjustment is against overdraft.

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CHAPTER 4 Implementing accounting analysis

FIGURE 4.5 Worksheet adjustments to a private firm’s financial statements

($000)

Reported

Assets

Liabilities

+

Equity

Current assets

Non-current assets

=

Current liabilities

Non-current liabilities

Profit

Retained earnings

2 030

8 300

=

2 175

1 500

0

6 655

–800

=

–800

=

–30

1 2

=

–30

3

=

4

=

–500

500 –25

25

5

=

825

–825

6

=

–300

300

500 =

7 Adjusted

2 000

7 500

150 1 825

–150 2 000

350

5 325

Figure 4.6 reports the effect of the adjustments on three common ratios (which are discussed in more detail in Chapter 5). It should be obvious that accounting adjustment can significantly alter financial ratios, which are the tools that analysts use to interpret the firm’s underlying business. In this case, without the adjustments the analyst could not accurately assess profitability. FIGURE 4.6 The effect of the adjustments on three common ratios

Ratios

Reported

Adjusted

Current assets / current liabilities

0.933

1.096

Non-current liabilities / total assets

0.145

0.211

–

6.2%

Profit / equity

Adjusting for management bias Nelson, Elliot and Tarpley (2003) provide descriptive evidence of how managers attempt to manage earnings, based on a sample of 515 earnings-management attempts obtained from a survey of 253 experienced auditors.8 They also link their findings to SEC Accounting and Auditing Enforcement Releases to illustrate the extreme versions of specific approaches of earnings management identified by their participants.9 We rely on these results to illustrate the most common accounting distortions, the impact they have on financial statements and the appropriate accounting adjustments.

Provisions Nelson et al. find the most common earnings-management approach (133 out of 515 cases) is to recognise too much or too little in provisions for the year.10 These include provisions relating to restructuring, inventories, bad debts, taxes and loan loss provisions. When an uncertain liability does not meet the criteria for recognition, the firm ought to disclose the liability in the notes as a contingent liability. The manager has discretion in deciding whether the obligation is probable and in estimating the amount of the obligation. The analyst may consider that the firm’s

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contingent liabilities are more certain than management asserts or may decide, because of the substantial risk involved, that more of the liability should be recognised. Thus, using footnote information on contingent liabilities, the analyst may undo the distortion by recognising more liability on the balance sheet. To illustrate, assume that at the end of the fiscal year (31 December 2017), New Products Limited (NPL) was a defendant in a $100 product liability case. NPL chose not to recognise a provision for potential damages because it considers having to make payments related to the lawsuit unlikely. However, over the next two years NPL paid out $50 in out-of-court settlements. In the annual report, it stated that there was no liability as there was no compulsion to make these payments. Assume an analyst estimates that at the end of 2017 the amount of payments to be made by NPL will be $100, which will be paid as $50 in 2018 and $50 in 2019, and NPL’s incremental borrowing rate is 5%. The analyst could make the following adjustments to recognise the liability: 1 Incorporate the present value of the obligation in the 2017 financial statements. The present value of $50 for two years discounted at 5% is $93. This increases current liabilities by $48 (the present value (PV) of $50 in 2018) and non-current liabilities by $45 (the PV of $50 in year 2019). The total amount is expensed in the income statement.11 2 Deferred tax is an accrual based on temporary differences between the book amounts and the tax amounts. Adjustment 1 has resulted in an additional liability of $93. Presumably, however, the firm’s tax basis has not changed. That is, NPL has estimated and recorded the tax it has to pay to the tax authorities, which will not change no matter how many adjustments the analyst makes. The tax adjustment is estimated by any additional temporary differences created by making adjustments at the statutory tax rate. In this case, it is $28 (= $93 × 0.30). As the underlying temporary difference is a liability, the tax adjustment is an asset. Often, as shown in Figure 4.7, the asset is shown as a contra against the deferred tax liability. We also report the impact of the adjustments on two important ratios: profit/total assets (return on assets) and debt/total assets. FIGURE 4.7 Tax adjustment for NPL and its impact on two ratios

2017

Assets

=

Liabilities Provisions

Reported

1 100

1…Provision

Ratios Return on assets Debt to assets

1 100

93

Reported

Adjusted

9.1%

3.2%

45.5%

51.4%

Equity Profit

Other

500

100

500

93

2…Deferred tax Adjusted

+ Other

–93 –28

–28

472

35

 500

3 In 2018, the analyst’s adjustments for 2017 have not been processed by NPL. Therefore, the first adjustment the analyst needs to make for 2018 is to account for all past adjustments. Let’s call this the backlog adjustment. This is done by ensuring the opening balances for the provision and the deferred tax are adjusted to the opening balance of retained earnings. Hence, opening retained earnings is reduced by $65 (–$93 + $28). 4 The analyst then eliminates the opening balances against current profit. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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5 The next step is to make whatever adjustment the analyst thinks is appropriate for the 2018 financial statements. We assume that the analyst wishes to create a provision for $48 (the expected $50 damages to be paid in 2019; discounted at 5%). 6 The last step is to create a deferred tax balance of $14 based on the new provision (=$48 × 0.3). The effect of these adjustments is as follows: FIGURE 4.8 The 2018 adjustments for NPL

2018

Assets

=

Liabilities Provisions

Reported

1 050

+

Profit

Other

500

50

500

3…Opening

93

–28

4…Reverse

–93

28

5…Provision

48

6…Deferred tax Adjusted Ratios Return on assets Debt to assets

 1 050

48

Reported

Adjusted

4.8%

7.7%

47.6%

50.9%

Equity

Other

–65 65 –48

–14

14

486

81

435

The effects of the opening (backlog) adjustment and its reversal (steps 3 and 4) transfers profit from 2017 to 2018. A shortcut to do these adjustments is to ignore the circled adjustments. The 2019 adjustments follow a similar pattern to 2018. 7 The opening balances are adjusted. 8 The opening firm’s balances are reversed. The analyst does not need to make any more adjustments because the firm’s accounting has caught up. FIGURE 4.9 The 2019 adjustments for NPL

2019

Assets

=

Liabilities Provisions

Reported

1 050

+

Equity

Other

Profit

Other

500

50

500

7…Opening

48

–14

8…Provision

–48

14

34

0

500

84

Adjusted Ratios Return on assets Debt to assets

1 050 Reported

Adjusted

4.8%

8.0%

47.6%

47.6%

–34  466

In practice, however, payments from the provision would not be made in equal instalments. Further provisions might also be necessary. Hence, the liability (present value of future payments) would be assessed each year. This would also have an impact on deferred taxes. Furthermore, discount rates can change over time. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

This example illustrates two main points. First, some adjustments are likely to have a cumulative effect over several years and will eventually reverse. A simple way to deal with this is to: 1 re-create the analyst’s adjustments in prior years (the backlog adjustment) by adjusting retained earnings 2 reverse them out to profit in the current year 3 create any new adjustments considered necessary. Second, by creating a provision, the analyst’s adjustment has transferred profit from 2017 to 2018 and 2019. This can be demonstrated by summing the profits for both methods over the three years. If the firm has a good year, managers may overestimate provisions, such as restructuring charges or inventory obsolescence, and defer earnings into the future. If analysts can identify and estimate the over-provision (and hindsight can be useful) they can use accounting analysis to adjust the financial statements to provide a more meaningful time-series analysis, which may be more useful for forecasting purposes. Another point worth making is that the analyst could simplify the adjustments by: (1) not present valuing the liabilities, and (2) ignoring the deferred tax. Analysts often ignore deferred tax because it is not payable to tax authorities. Hence, if an analyst eliminates deferred taxes, then it would be pointless, in this example, to put through the tax adjustments.

Asset impairment Nelson et al. find the second most common earnings-management approach relates to recognising too much (16 out of 515 cases) or too little (18 cases) asset impairment of property plant and equipment, investments and intangibles. When the fair value of an asset falls below the carrying amount, the ‘book’, the asset is impaired. IAS  36 requires a firm to recognise impairment as it occurs. However, the second-hand market for non-current assets is typically incomplete and illiquid. As  a result, the estimate of fair values for such assets is inherently subjective. This is particularly true for goodwill and other intangible assets. Therefore, managers can potentially use their discretion to delay report impairment. To illustrate, assume that after a series of minor acquisitions, in 2016 Morgan’s Orchard Limited acquired Kidd’s Gala Limited, which resulted in goodwill on consolidation of $200. Goodwill on consolidation arises when the cost of the acquisition exceeds the fair value of the net assets acquired. By June 2019, Morgan’s Orchard publicly admitted that it had paid too much for Kidd’s Gala. The firm also announced it would record a goodwill impairment in the December 2019 financial statements. Assume an analyst, based on market ‘rumblings’, decided that the December 2017 financial statements should have recorded a goodwill write-down and decides to make an impairment adjustment of $100. The effect of this adjustment is to reduce the asset (goodwill) and reduce profit (goodwill impairment expense): FIGURE 4.10 Asset impairment adjustment for Morgan’s Orchard in 2017

2017 Reported 1…Impairment Adjusted

Assets

=

Liabilities

Goodwill

Other

200

900

500

900

500

–100 100

+

Equity Profit

Other

100

500

–100 0

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CHAPTER 4 Implementing accounting analysis

Ratios Return on assets Debt to assets

Reported

Adjusted

9.1%

0.0%

45.5%

50.0%

First, note that the impairment of goodwill on consolidation does not attract a deferred tax adjustment. This only applies to goodwill on consolidation and would not be the case if it was a write-down of an intangible asset. Second, if the impairment was related to a depreciable asset, the analyst would also estimate the impact on depreciation and amortisation expense in future years. For 2018, the analyst would need to make an opening backlog adjustment to account for prior year adjustments. The effect of this adjustment is to reduce opening goodwill and opening retained earnings (other equity). FIGURE 4.11 Adjustment for Morgan’s Orchard in 2018

2018 Reported 2…Opening Adjusted Ratios Return on assets Debt to assets

Assets

=

Goodwill

Other

200

900

100

900

Reported

Adjusted

9.1%

10.1%

45.5%

50.0%

Liabilities

+

Equity Profit

Other

500

100

500

500

100

–100

–100    400

Note that no reversal of the opening adjustment is necessary as the analyst considers the current impairment of $100 is still appropriate. This opening (backlog) adjustment illustrates why such adjustments are necessary. Without it, the goodwill would be reported at $200, the unimpaired amount. We now look at the 2019 financial statements, where Morgan, as announced, impairs the goodwill ($150). FIGURE 4.12 Adjustment for Morgan’s Orchard in 2019

2019 Reported

Assets Goodwill

Other

50

900

3…Opening

–100

4…Reversal

100

Adjusted

=

+

Equity Profit

500

–50

Other 500 –100

100

50

900

Reported

Adjusted

Return on assets

–5.3%

5.3%

Debt to assets

52.6%

52.6%

Ratios

Liabilities

500

50

   400

The analyst makes the opening (backlog) adjustment and then, because the firm has made the impairment, the analyst makes a reversal adjustment. This example shows that the effect of the adjustment is to transfer profit from 2017 to 2019. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Timing of revenue recognition Another common earnings-management approach, according to the evidence in Nelson et al., relates to the timing of revenue recognition. During the 1990s and early 2000s the SEC considered that aggressive revenue recognition was one of the most popular forms of earnings management. An example of such a distortion is to enter into a sale agreement and segregate the goods in a separate location in the warehouse until the customer requests delivery. The revenue and cost of goods sold are recorded when the goods are segregated, rather than when they are delivered. Alternatively, the company may have a sale arrangement whereby the customer has the right to return all goods and does not have to pay for the goods until they have been sold by the customer. The company records sales as soon as the product is shipped. To illustrate, assume that in 2018 Impatient Imports Limited (IIL) installed a new accounting system that contained the following fault: during 2018, sales were recognised when goods left the depot; however, it was not until the client received the goods, which was sometimes up to a week later, that ownership passed to them. At the end of 2018, IIL changed auditors. In 2019, the new auditors uncovered the fault during interim testing. IIL has reported that it will restate its financial statements in the current year (2019). In 2018, the analyst has decided to make the following adjustments to the financial statements: 1 reduce sales revenue by $220. IIL develops software and as a result there is no change in cost of the software development regardless of sales volume 2 there is a minor impact on inventories related to these sales and the analyst considers an inventory reversal of $10 is appropriate 3 the deferred tax is effect is $69, calculated at the 0.30 rate of tax on the net change in assets (=(220 receivables + 10 inventory) × 0.3). FIGURE 4.13 Adjustment for IIL in 2018

2018

Assets

Reported

1 217

1 Receivables/revenue

–220

2 Inventories/cost of sales

=

Liabilities 569

Equity Revenue

Expenses

Other

1 430

–1 282

500

–220

10

10

3 Deferred tax

–69

Adjusted

Ratios

+

1 007

 500

Reported

Adjusted

Return on sales

10.3%

0.6%

Return on assets

12.2%

0.7%

Debt to assets

46.8%

49.7%

69 1 210

–1 203

500

In 2019, the analyst’s adjustments for 2018 would need to be reinstated. This is the backlog adjustment of $141 to equity (retained earnings). Then the 2018 adjustments need to be reversed in 2019. As we can see, the amounts going into the assets and liabilities columns are equal but in the opposite direction. There is no need to make any further adjustments as IIL has already made these.

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CHAPTER 4 Implementing accounting analysis

FIGURE 4.14 Adjustment for IIL, 2019

2019

Assets

=

Liabilities

+

Equity Revenue

Reported

1 480

Expenses

Other

–1 313

500

1 167

500

Opening

–210

–69

Reversal

210

69

210

–69

Adjusted

1 167

500

1 690

–1 382

Adjustments

Ratios

Reported

Adjusted

Return on sales

11.3%

18.1%

Return on assets

14.3%

26.4%

Debt to assets

42.8%

42.8%

–141  359

Expense capitalisation Capitalising and deferring too little or too much expenditure is another common earningsmanagement approach cited in Nelson et al. (2003). Under IFRS, this could relate to the discretion managers have in estimating development expenditure (under IAS 38 ‘Intangible assets’), interest (under IAS 23 ‘Borrowing costs’), or the expenditure required to get inventory (IAS 2 ‘Inventories’) and property, plant and equipment (IAS 16 ‘Property, plant and equipment’) to its ‘current location and condition’. Deferred expenditure is capitalised into the cost of the asset and affects income in the same period as the cost of the asset; that is, through depreciation, amortisation or cost of sales. Alternatively, accounting standards may require expenditure to be expensed because the potential future benefits cannot be measured with reliability. Consider the case of CSL Limited, an ASX-traded biotech company that researches, develops, manufactures and markets products to treat and prevent serious medical conditions. Consistent with IAS 38 ‘Intangible assets’, CSL’s accounting policy for R&D is to expense all costs incurred up to the point of regulatory approval. The issue arises: how should the analyst approach the omission of intangibles on the balance sheet? One approach is to capitalise intangibles and amortise them over their expected lives. However, this approach is not trouble-free. First, there is the problem of estimating how much expense to capitalise. Furthermore, often the ‘value’ of the intangible is not directly related to the expense. Second, analysts are sceptical of capitalised intangibles, especially when assessing solvency or the break-up value of the firm. A second approach is to leave the accounting as is, but to recognise that forecasts of non-current rates of return will have to reflect the inherent biases that arise from this accounting method. This highlights the fact that adjustments are only one tool available to the analyst. Making accounting adjustments to improve ratios is not a substitute for interpreting ratios and knowing their limitations. To illustrate, assume an analyst is reviewing the financial statements of Capital City Properties Limited (CCPL). In 2017, CCPL capitalised $50 of renovation expenses on a newly acquired property. The analyst notes that other firms in the industry expense all renovation expenses. To compare the company with its peers, the analysts decides to unwind the renovation expenses capitalised by CCPL We will also assume that the renovation expenses are being depreciated over five years.

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

In this worksheet we have added a column for the amount of the capitalised asset of $40, which is $50 depreciated by one year. The adjustments are: 1 undo the capitalised amount 2 make a deferred tax adjustment based on the difference between the book assets and the tax assets. We have reduced the book asset by $40 (assuming no change to the tax asset) resulting in a deferred tax asset of $12 ($40 × 0.3), which is offset against any deferred tax liabilities. FIGURE 4.15 Adjustment for CCPL in 2017

2017

Asset Capitalised

Other

40

1 100

Reported 1 Capitalisation

=

+

512

–40

Adjusted

Equity Profit

Other

128

500

–40

2 Deferred taxation 0

1 100

Reported

Adjusted

Return on assets

11.2%

9.1%

Debt to assets

44.9%

45.5%

Ratios

Liabilities

–12

12

500

100

500

In 2018, the opening adjustment to other equity (or retained earnings) of –$28 accounts for all prior year adjustments. The current year’s adjustment relates to the reversal of one more year’s depreciation and deferred tax on the depreciation. FIGURE 4.16 Adjustment for CCPL in 2018

2018

Asset

=

Capitalised

Other

Reported

30

1 072

Opening

–40

Depreciation

Ratios Return on assets Debt to assets

509

+

Equity Profit

Other

93

500

–12

10

–28 10

Deferred taxation Adjusted

Liabilities

0

1 072

Reported

Adjusted

8.4%

9.3%

46.2%

46.6%

3

–3

500

100

472

Note that CCPL has depreciated the capitalised amount from $40 to $30. The procedure for 2019 is the same as for 2018. Account for all prior year adjustments by adjusting retained earnings. Then reverse out the depreciation and the tax on the depreciation. This process will continue until 2021, at which stage the capitalised asset will have been fully depreciated and no further adjustments will be necessary.

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CHAPTER 4 Implementing accounting analysis

85

FIGURE 4.17 Adjustment for CCPL in 2019

2019

Asset

=

Capitalised

Other

Reported

20

1 079

Opening

–30

Depreciation

Ratios Return on assets Debt to assets

506

+

Equity Profit

Other

93

500

–9

10

–21 10

Deferred taxation Adjusted amounts

Liabilities

0

1 079

Reported

Adjusted

8.5%

9.3%

46.0%

46.3%

3

–3

500

100

 479

A PRACTITIONER ADVISES Partner with leading chartered accounting firm specialising in corporate finance and valuation on accounting adjustments: One of the data issues that valuers have is with the data itself. Imagine you’re valuing a business undertaking within a bigger company that’s going to be carved out and sold. You may not have any information that relates to that business undertaking, so you may have to reconstruct the entire set of financials. That’s typical of the work that you’re going to have to do in practice. Sometimes there are ‘normalisation’ adjustments that you have to make too. By that I mean adjusting the financials to their ‘normal’ state by taking out what you expect to be one-off events. So, for example, if you’re forecasting into the future and the company has just had a big stock write-off because it made a bad decision, is it likely to make a decision like that every year? The answer is probably not. So, you go through the earnings, and you pick out the items and the amounts that they probably wouldn’t have on an ongoing basis. You will spend some time teasing out those pieces of analysis. It could be an abnormal (item),

but it won’t always be flagged as an abnormal; it could just be part of the ordinary operating earnings. Or maybe the level is a lot higher than expected – say they’ve lost a major customer, which they won’t repeat every year. What you’re trying to do is get an understanding of what the future of the business is going to look like, so you’ve got to strip out the unusual events that happen from time to time, because you don’t expect them to happen all the time. Reflective activity: In what ways does financial analysis and business valuation involve more accounting knowledge and skills than you might have anticipated? What challenges could a student face when identifying accounting adjustments they should be make to published financial reports? How could you acquire and maintain this necessary expertise once you have finished your studies? (Hint: one way is to consider national or international professional accounting membership associations.)

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INDUSTRY INSIGHT

We noted earlier in this chapter that, in making adjustments, analysts need to consider the appropriate level of detail. In this case, making a column for the capitalised asset helps facilitate the adjustments. On the other hand, the analyst can reduce the level of detail by simply ignoring the deferred tax effects.

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SUMMARY To implement accounting analysis, the analyst will typically first recast the financial statements into a standardised format so that financial statement terminology and formatting are comparable between firms and over time. We do not present a standard template in this book because different analysts use their own customised template. Once the financial statements are standardised, the analyst can decide if accounting adjustments to the firm’s financial statements might improve the analysis. Adjustments to the financial statements will arise because accounting standards, although applied appropriately, may not reflect the firm’s economic reality. Adjustments can also arise if the analyst has a different point of view from that of management about the estimates and assumptions made in preparing the financial statements. The analyst may also make adjustments to increase their ability to compare across the firms being analysed. Once an analyst has identified the potential adjustments, they can use footnotes, cash flow statements and other information to make adjustments. We have illustrated the following process for adjustments: 1 Consider if a backlog opening adjustment is required. This adjustment accounts for the cumulative effect of all prior year adjustments the analyst makes. This adjustment is balanced against retained earnings. 2 Reverse out prior years’ adjustments (step 1) against income. This step is only necessary if the analyst wishes to make a new estimate. It is not necessary if

the adjustments are a continuation of the prior year adjustments. 3 Consider any new estimates to be made in the current year. Steps 1 and 2 have the effect of transferring profit from one year to the next. When implementing accounting analysis, it is worth remembering that the bulk of the analyst’s time and energy should be focused on evaluating and adjusting accounting policies and estimates that relate to the firm’s key strategic value drivers. Of course, this does not mean the analyst should ignore issues where management bias is suspected. However, making adjustments can be complex and time consuming. It helps if the analyst has a good knowledge of accounting. The analyst must first decide if such adjustments will be necessary. Adjustments might improve the ratios, but will they improve the interpretation? Having decided to make adjustments, the analyst must then decide the level of precision or detail required. For illustrative purposes we have made detailed adjustments in the examples in this chapter. However, in practice, it is important to recognise that many accounting adjustments can only be approximations, because much of the information necessary for making precise adjustments is not disclosed. Avoid worrying about being overly precise. By making rough estimates and assumptions, it is usually possible to make adjustments that improve the analysis. Accounting analysis ensures that the financial ratios used to evaluate a firm’s performance are more meaningful and form a better basis to interpret and forecast future results.

CHECKING AND APPLYING YOUR LEARNING 1 The asset (goodwill) impairment example, earlier in this chapter, assumes the analyst makes a $100 impairment adjustment in 2017 and the firm makes a $150 impairment adjustment in 2019. Show the impact of the adjustments if the analyst made an additional $50 impairment adjustment in 2018.  LO3 2 Take the same goodwill impairment example as in question 1, but assume the intangible asset is a series of patents and the analyst suspects that half of the patents are valueless because of new technology.  LO3 3 The provision example earlier in this chapter assumes the analyst makes a $93 provision adjustment in 2017 based on the present value of $50 paid in 2018 and $50 paid in 2019. The legal settlements paid equal the

amounts provided. Show the adjustments if the analyst in 2018 estimates that the legal settlement in 2019 will be $60. Assume that the settlements in 2019 amount to $70.  LO3 4 Cynical Cynthia suggests, ‘Accounting adjustments are a waste of time. Taking the provisions example, over the three years the total of reported and adjusted profits is the same–$200’. Do you agree with Cynthia? Why or why not?  LO3 5 Apps4U is a newly listed company established to acquire the business asset of Apps2U. At the end of the year (31 December 2019), it reported intangible assets equalling 50% of total assets. The intangible assets comprised acquired software, acquired patents, acquired

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CHAPTER 4 Implementing accounting analysis

brands and acquired goodwill. In accordance with international accounting standards, computer software and patents are amortised over useful life (which might be three to 15 years for software and five to 15 years or even longer for patents). However, brands and acquired goodwill are subject to an impairment test. As most of these intangibles were acquired from Apps2U, what incentives are there for management to use discretion in putting amounts on the relative acquisition values of software, patents, brands and goodwill? As an analyst how would you assess whether the intangibles reported by Apps4U are a reasonable reflection of the probable future benefits? What questions would you raise with the firm’s CFO about intangibles and any (or lack of any) impairment?  LO2 LO3 6 Obtain a recent copy of Kathmandu’s annual report and recast the financial statements into the following template. (Note, this is an actual template used by a financial intermediary as the basis to calculate further financial ratios.)  LO2

Balance sheet summary Period ending

31–Jul–19

31–Jul–18

31–Jul–17

Denomination

NZ$000

NZ$000

NZ$000

Cash and cash equivalent

8 146

3 537

Net trade receivables

8 251

240

Current inventories

111 929

89 206

Other current assets

32 458

6 044

160 784

99 027

63 514

61 026

390 319

279 014

Long-term Investments

n/a

n/a

Long-term deferred tax asset

n/a

n/a

0

0

453 833

340 040

614 617

439 067

104 833

67 179

Current assets

 

Property, plant and equipment Intangible assets

Other non-current assets Non-current assets

 

Total assets

 

Payables and accruals Current debt

FIGURE 4.18 Template to calculate further financial ratios

55

65

104 888

67 244

Long-term debt

39 562

10 696

Deferred tax liabilities

49 785

34 027

0

0

89 347

44 723

Total liabilities 

194 235

111 967

Paid-in capital

249 882

200 209

Retained earnings

173 217

149 893

n/a

n/a

–2 717

–23 002

Current liability

Financial profile Income statement summary

87

 

Period ending

31–Jul–19

31–Jul–18

31–Jul–17

Denomination

NZ$000

NZ$000

NZ$000

Year

Year

Year

497 437

445 348

47

28

497 484

445 376

90 091

70687

Other equity

–15 151

–13 826

Total equity

 

420 382

327 100

EBIT

79 940

56 861

Equity & liabilities

 

614 617

439 067

Interest expense

–1 389

–1 887

Cash flow summary

PBT

73 551

54 974

Period ending

31–Jul–19

31–Jul–18

31–Jul–17

–23 019

–16 935

Denomination

NZ$000

NZ$000

NZ$000

50 532

38 039

Year

Year

Year

Surplus from discontinued ops

0

0

Cash flow from operating activities

75 601

67 273

Minority interest earnings 

0

0

Cash flow from investing activities

–121 620

–13 275

50 532

38 039

50 402

–57 382

Basic EPS

239.2

188.8

4 383

–3 384

Diluted EPS

237.0

187.0

Reporting period Sales revenue

Interest received and investment revenue Total revenue from core operations  EBITDA Depreciation and amortisation

Income tax expense Surplus from continuing ops

Net income

 

Other non-current liabilities Non-current liabilities 

Minority interest

Reporting period

Cash flow from financing activities  Net change in cash

 

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

7 Simon Silk-Tongue has been the CEO of Variable Returns Limited (VRL) for five years. Simon is rather proud of his achievements in turning around VRL’s fortunes. He suggests that this would be good time to take the company public and has retained your company as advisors to the IPO. You also note that Simon’s employee share options expire in the next six months. Figure 4.19 shows the five-year summary of operations from the 2019 annual report. FIGURE 4.19 VRL five-year summary of operations

Assets

=

Liabilities

+

Equity Profit

Other

2019

1 320

468

128

724

2018

1 298

517

114

667

2017

1 283

561

110

612

2016

1 222

568

84

570

2015

1 135

563

22

550

The ratios are also presented in Figure 4.20. FIGURE 4.20 VRL ratios

ROA

LEV

EPS

DPS

2019

9.8%

35.5%

1.28

0.57

2018

8.8%

39.8%

1.14

0.55

2017

8.6%

43.7%

1.10

0.42

2016

6.9%

46.5%

0.84

0.00

2015

1.9%

49.6%

0.22

0.50

Where: • ROA is return on assets (profit/total assets) • LEV is leverage (debt/total assets) • EPS is earnings per share • DPS is dividends per share. The number of shares outstanding is 100. a Using the above information, forecast the ROA, EPS and DPS ratios of VRL for 2020. b After some historical detective work, you find out that Simon took over as CEO towards the end of 2015. At that time, Simon stated that the previous management had been running the company into the ground and immediately (i.e. in the 2015 financial statements) wrote off $25 goodwill impairment and created a provision for restructuring of $90. After doing some more digging, you question

why goodwill was impaired when clearly the profitability of VRL has not permanently declined? Restate the financial statement and the ROA, EPS and DPS ratios by adding back the goodwill impairment. You look back through the financial statements and summarise the footnote disclosures on the restructuring provision as shown in Figure 4.21. FIGURE 4.21 VRL summarised footnote disclosures

Opening

New

Reversal

Used

Closing

2015

0

90

0

0

90

2016

90

0

0

14

76

2017

76

0

0

0

76

2018

76

0

5

15

56

2019

56

0

56

0

0

Your concern is that the provision has not been used consistently over the years and several provision reversals have happened. Restate the financial statements and restate the ROA, EPS and DPS ratios by adding back the provision (ignore any goodwill adjustments). c Using the information in Figure 4.21, forecast the ROA, EPS and DPS ratios of VRL for 2020. d Compare your results in (c) with (a) and comment.  LO3 8 Bellamy Organics is an ASX-listed organic formula and food company. Anh Accountant is examining the inventory write-downs made by Bellamy in 2018 and 2017. She has scheduled the following information on profit margins and inventory levels: FIGURE 4.22 Bellamy Organics information on profit margins and inventory levels

2018

2017

2016

2015

328 704

240 182

244 583

125 302

Cost of sales

–199 830

–148 661

–132 855

–84 095

Gross margin

128 874

91 521

111 728

41 207

–5 973

–6 838

–657

–1 312

–61 705

–85 360

–56 177

–26 914

Revenue

Inventory provisions & writedowns Other expenses Profit before tax Taxation Profit after tax

61 196

–677

54894

12981

–18 380

–132

–16 566

–3 908

42 816

–809

38 328

9 073

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CHAPTER 4 Implementing accounting analysis

2018

2017

2016

2015

18 406

10 483

20 726

3 117

Finished goods

58 851

83 014

35 109

14 031

Goods in transit

13 196

0

11 917

0

Inventories

90 453

93 497

67 752

17 148

Total assets

280 812

156 641

143 501

72 170

Raw materials

The explanation Bellamy provided for the 2017 inventory situation was:

For our ‘Australian label’ product the market has now returned to normal trading after a build-up of inventory by China/Hong Kong resellers in 2H16 and 1H17 led to oversupply, causing discounting and channel instability. Production rates could not be immediately reduced for lower demand. The combined result was to increase inventory holdings and reduce cash. Source: Bellamy Australia Limited, 2017 Annual Report, p. 6.

a With the benefit of hindsight, comment on whether the 2017 provision for inventory is adequate. To do this you will need to make your own estimate of the provision. b Why is inventory obsolescence important in this industry? c Using your own estimate of the provision, what adjustments would you make to the 2017 financial statements? Show the impact on the following ratios: profit after tax to total assets, and gross margin to sales. d Using your own estimate of the provision, what adjustments would you make to the 2018 financial statements? Show the impact on the following ratios: profit after tax to total assets, and gross margin to sales.  LO3 9 The role of financial accountants is to allocate cash flows to future, present and past period income statements. The balance sheet represents the levels of items that will eventually become future income (revenues and expenses). In allocating cash flows to the past, accountants need to distinguish between changes in accounting estimates, changes in accounting policies, and changes due to errors (IAS 8 ‘Accounting policies, changes in accounting estimates and errors’). Changes in estimates must be corrected prospectively (i.e. in the current or future periods). However, changes in accounting policies and the correction of errors can be accounted for retrospectively (if practicable). Retrospective adjustment requires restating

89

comparative amounts for prior periods and an adjustment to opening retained earnings. This is similar to the adjustments an analyst would make to achieve time-series comparability. However, the analyst is not restricted by any accounting standards and can make whatever retrospective adjustments are necessary to achieve comparability. The chairman’s report in the 2018 Smiths City annual report states:

Group profits before tax fell from $2.0 million last year to a loss of $9.9 million. The result includes a number of one-off items including: the recognition of $4.9 million of provisions for onerous leases; a $1.5 million provision related to the Employment Court’s May ruling that Smiths City must recompense staff for pre-trading sales meetings; and a further $0.5 million of additional contractual provisions. Source: Smiths City Group, 2018 Annual report, p. 4.

Footnote 27 provides more information on the Employment Court issue:

27. Events subsequent to balance date The Directors have determined that a final dividend for the year will not be paid to ensure the cashflow is directed to the investment in the Group and in light of the current year result. In 2016 an improvement notice was issued by the Labour Inspectorate to Smiths City concerning payment of pre work meetings. This notice was issued by the Labour Inspectorate to Smiths City concerning payment of pre work meetings. This notice was challenged and successfully defended at that time. The Labour Inspectorate subsequently appealed and a hearing was held in December 2017. On 8 May 2018 the Employment Court decision was released overturning the original decision and demanding that the meetings be paid. The payment required bay pay extending back 6 years from the date of the improvement notice and includes also the periods between the original improvement notice date and the present time. The calculation is complex in term of data retrieval, review of staff contracted hours. The Group must complete the calculation by 8 August 2018. As at the date of signing, the Group has not completed the prior year calculation with data retrieval underway. Source: Smiths City Group, 2018 Annual report, p. 70.

Figure 4.23 shows is a summary of Smiths City’s financial statements from 2013 to 2018.

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

FIGURE 4.23 Summary of Smiths City’s financial statements 2013–18

($millions)

2018

2017

2016

2015

2014

2013

Operating revenue

251.9

227.4

221.9

221.4

220.6

222.5

2.8

9.4

12.2

8.2

9.9

13.6

–2.7

–1.8

–1.6

–1.4

–1.5

–2.8

0.1

7.6

10.6

6.8

8.4

10.8

Interest-finance business

–3.0

–3.4

–4.0

–4.2

–2.9

–7.0

Interest-retail business

–0.1

–0.2

–0.9

–1.8

–1.3

–1.4

‘Normalised’ profit

–3.0

4.0

5.7

0.8

4.2

2.4

Onerous leases

–4.9

Employment court ruling

–1.5

Holiday pay

–0.6

 

 

 

 

8.5

0.5

5.5

EBITDA Depreciation and amortisation Earnings before interest and tax (EBIT)

–0.6

Property sale

1.8

Insurance proceeds Restructuring

0.1

Non-continuing Profit before tax Tax Holiday pay

–1.4

–2.5

 

 

 

–1.9

 

 

–1.6

–9.9

2.0

3.1

9.3

4.7

6.3

2.6

0.2

2.5

–1.3

–0.6

–0.9

0.1

0.2

 

 

 

 

–7.2

2.4

5.6

8.0

4.1

5.4

0.5

0.5

–0.7

0.4

0.1

–0.1

Comprehensive income

–6.7

2.9

4.9

8.4

4.2

5.3

Capital

10.7

10.7

10.7

10.7

10.7

10.7

Opening retained earnings

43.5

43.3

36.3

29.9

27.8

30.2

Prior period adjustment

–0.5

–0.4

 

 

 

–6.0

Adjusted balance

43.0

42.9

36.3

29.9

27.8

24.2

Profit after tax

–7.2

2.4

5.6

8.0

4.1

5.4

Other reserves

 

3.2

0.2

–1.8

–1.8

–2.0

–1.8

Profit after tax Other comprehensive income

Dividends

–1.9

–1.8

 

Closing retained earnings

33.9

43.5

43.3

36.3

29.9

27.8

Other reserves

–0.3

–0.8

–1.3

2.6

2.4

1.9

44.3

53.4

52.7

49.6

43.0

40.4

135.4

132.9

136.1

149.7

151.7

148.2

Assets Deferred tax asset Liabilities Holiday pay provision

0.1

0.2

 

 

 

 

–90.6

–79.1

–83.4

–100.1

–108.7

–107.8

–0.6

–0.6

 

 

 

 

44.3

53.4

52.7

49.6

43.0

40.4

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CHAPTER 4 Implementing accounting analysis

The shaded items related to the holiday pay prior period adjustment that has been adjusted back to 2016. (Note the prior period adjustment in 2013 is unrelated and is an adjustment for unearned finance revenue.) In creating this table, the analyst has constructed ‘normalised profit’ measure, which is the profit before one-off items. Such measures are called non-GAAP earnings and can be reported by management or constructed by analysts. a What are onerous lease contracts and why do they relate to the future? b Why might Employment Court ruling be treated as a current year issue? c Footnote 27 states the Employment Court ruling on pay extends back six years. Regardless of how the firm treats the back pay, the analyst can make a ‘prior period adjustment’ to improve comparability. Make the adjustments to spread the employment court ruling over six years (the current year and the five prior years). d In addition to allocating cash flows to future, current and past periods, firms can try to improve comparability (predictability) by classifying items within comprehensive income. What are the various ways in which the Smith City statement of comprehensive income has grouped or classified items? e For each of the sub-totals in the statement of comprehensive income, calculate a measure of volatility. What is the ‘best’ subtotal for predication?  LO3 10 Zip Co Limited is a consumer finance company that issues credit at the point-of-sale and processes payments, both in-store and online. Its customer receivable balances are high-volume low-value advances to individual customers. Management have stated that they expect ‘the net debt write-offs will trend towards 3%’. Figure 4.24 shows extracts from the firm’s 2018 financial statements relating receivables and impairment (doubtful debt) provisions. FIGURE 4.24 Extracts from Zip Co’s financial statements

($000) Portfolio revenue

2018

2017

39 274

16 432

Cost of sales

30 157

17 996

Receivables

316 741

152 038

–6 636

–3 645

Unearned future income

($000)

91

2018

2017

–9 502

–4 562

300 603

143 831

4 562

1 222

Provisions recognised (cost of sales)

13 190

5 289

Receivable write-downs

–8 250

–1 949

Provision for doubtful debts Per balance sheet Opening balance

Closing balance

9 502

4 562

298 964

138 297

Past due under 30 days

9 950

7 727

Past due 31 days under 80 days

1 909

1 551

Past due 81 days under 180 days

5 918

4 463

316 741

152 038

Not past due

a Assess whether you think the provision for doubtful debts is over or understated and by how much. b AASB 9 (IFRS 9 ‘Financial instruments’) is applicable to annual reporting periods beginning on or after 1 January 2018. One of the new requirements of this standard was to impose an impairment estimation method based on ‘expected credit losses’. Describe the ‘expected credit loss’ method of impairment. What method did it replace and why? c Zip Co did not adopt the expected credit loss method early. However, it estimates that if it had adopted it earlier the provision for bad debts would be increased by $4.970 (million). If an analyst wished to adjust the financial statements for the new basis, what adjustments would be made in 2018? d Estimate a possible for expected credit provision for 2017. What adjustments should the analyst make?  LO3 11 This question is based on a real case. Home n General Limited (HGL) has decided to change its accounting policies. It owns properties that are leased in full or in part to third parties and earning rental income. The firm has previously been accounting for these as property, plant and equipment (IAS 16). It has decided that it is more appropriate to account for these as property investment companies at fair value under IAS 40. The table below summarises the financial statements before any corrections or adjustments have been made. a An analyst needs to understand the major accounting issue affecting the industry to which they have been assigned. This is possibly even more important if there has been an accounting change.

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

Figure 4.25 is a summary of alternative accounting methods. It summarises the measurement base, whether there is any depreciation, and where the gains and losses are reported. Fill in the missing cells, marked with '?'. FIGURE 4.25 Summary of alternative accounting methods

Valuation Depreciation

Gain

IAS 16

IAS 16

IAS 40

Historic cost

Fair value

Fair value

Model

Model

Model

Yes

?

?

None

OCI: revaluation reserve

2017

2016

Equity

67 990

58 473

55 877

Liabilities

23 781

26 671

22 751

91 771

85 144

78 628

45 346

38 047

39 617

9 210

9 210

8 455

Buildings

16 195

15 875

12 549

Other PPE

19 870

19 779

15 223

0

0

0

Deferred tax

590

1694

2291

Intangible assets

560

539

493

91 771

85 144

78 628

277 642

239 004

223 510

27 361

17 269

13 679

0

3298

0

3 517

893

–3375

30 878

21 460

10 304

Current assets Land

Investment property

?

b Figure 4.26 summarises the financial statements of Home n General before any corrections or adjustments have been made. Using this data, restate the reported financial statements for the following adjustments. •  Reclassification of land (at fair value) of $3.113m and buildings (at fair value) of $5.351m from property, plant and equipment to investment property. •  A major difference between asset revaluations under IAS 16 and IAS 41 is that in IAS 16 the revaluation changes go to the asset revaluation reserve, whereas under IAS 41, they go to income. There has been no change in fair value of property investments in 2018, 2017 or 2016. However, the impact on prior years is to reduce the asset revaluation reserve by $0.306m. •  Investment properties also change the way in which the firm intends to ‘recover the carrying amount’ it therefore changes deferred tax. In this case the adjustment is an increase in the deferred tax asset of $0.350m. c Are the above adjustments complete? What other adjustments might be made? d Why might Home n General have changed its accounting policy?  LO3 FIGURE 4.26 Home n General financial statements before corrections or adjustments

2018

2018

2017

2016

Financial performance Revenue Profit after tax Revaluation of land and building Other comprehensive income Comprehensive income

12 In 2003, Michael Hill made the following announcement to the stock exchange:

LISTED ISSUER ANNOUNCEMENT Listed Issuer Limited

Michael Hill New Zealand

Headline Corrected Unaudited Sales Revenue Figures Announced At

14 May 2003 2:25:37 PM

Category GENERAL (General Release by Issuer in relation to Activities) Material/Prescribed No Third Party

No

Attachments

No Attachments

Michael Hill International Limited has provided the Corrected unaudited Sales Revenue Figures for the nine months ended 31 March 2003. Total Group 2002/2003: NZ$168,004,000

Financial position Contributed capital

27 818

27 270

27 649

Commentary:

Retained earnings

22 363

16 615

17 826

Asset revaluation reserve

15 915

15 915

12 617

1 894

–1 327

–2 215

– This announcement corrects the Australian Company 2001/02 figures, which were released on 05 May 2003. In that announcement the 2001/02 Australian figures were stated as A$78,234. This should have been

Other reserves

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CHAPTER 4 Implementing accounting analysis

A$81,931 (NZ$99,916). This resulted in the previous statement recording an increase in Australian sales of 17.1% instead of 11.8%. In addition, this resulted in the previous statement recording an increase in total group sales of 7.1% instead of 4.1%. The company regrets the mistake made. – The strengthening of the NZ dollar has obviously impacted on the translation of the Australian sales figures into NZ dollars. – The sales for the Canadian company involve the sales for three stores that were open for a collective 14 months in total. –The full year after tax profit expectations remain in line with our announcement to the NZ Stock Exchange on 10 April 2003. Comment on the reasons given for the Australian sales revenue correction from A$78 234 to A$81 931.  LO3 13 Diligent: Revenue recognition problems On 7 August 2013, the business press reported:

‘Software company Diligent delivered yet another blow to investor confidence with its admission its financial accounts for the past three years and for the March quarter are inaccurate and unreliable. After this announcement Diligent shares fell to $5.80 from $8.20 in early June.’ Source: 'Diligent delivers blow to investor confidence', RNZ Business News, 7 August 2013. Copyright © 2013, Radio New Zealand.

In December 2007, Diligent Board Member Services listed on the NZX at $1 per share after raising $24m in an IPO. In October 2010, Diligent announced they had successfully completed a NZ$1.86 million share placement of three million ordinary shares at NZ$0.62 per share. Diligent has been consulting and hosting secure websites for mutual funds, banks and insurance companies since 1994. In 2000 it started developing Diligent Board books, an online software application that boards, management and administrative staff use to compile, review, update and archive board material during and after board meetings. As at November 2013, Diligent serves over 1950 registered users; over 85 boards; more than 270 sub-boards, meeting groups and committees; and over 60 corporations. In a statement to the New Zealand Stock Exchange (NZX), Diligent announced that it would restate its financial statements for the fiscal years ended 31 December

93

2010, 2011 and 2012 and the fiscal quarter ended 31 March 2013, and that its previously reported results for these periods should no longer be relied upon. The New Zealand-listed US-based governance software maker said it had mistakenly captured sales at the beginning of the month rather than when contracts were signed. Also, costs of software developed for the company’s own use were reported incorrectly. The statement to the NZX also stated that the errors were ‘material for the purpose of requiring a restatement in the company’s historical financial statements’. On 17 October 2013 Diligent announced:

‘To date, no new material adverse revenue recognition issues have been discovered during the restatement process. However, the restatement process is very complex and time consuming and involves reviewing the recognition of revenue for approximately 20 000 transactions over the period covered by the restatement.’ Diligent remains focused on completing the restatement process and announcing its restated financial statements and the preliminary half-year announcement as soon as possible. Diligent is working with its new US independent registered public accounting firm, Deloitte & Touche LLP to complete the reaudit of its historical financial statements and has also engaged additional external resources to assist with completing the restatement process. Alessandro Sodi, Diligent’s President & Chief Executive Officer, said ‘completing the restatement quickly is one of the highest priorities in the Company and the Board and management team are focused on the completion of both the restatement and reaudit.’ a What are the likely accounting adjustments that Diligent will have to make to restate its financial statements? b Comment on the following statement by the company:

‘The errors did not affect total revenues, the timing of cash flows received, or the overall cash flow and liquidity position of the company.’ 14 Rubicon: accounting change The following business news headline appeared on 17 December 2002:

GPG [Guiness Peat Group] directors oppose Rubicon accounting change. Two of Rubicon’s directors said today they voted against an accounting policy change that boosted the forestry and biotech company’s half-year result. Source: NZPA, 17 December 2002.

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

The background to this headline was that Rubicon was listed on the New Zealand Stock Exchange (NZX) and the ASX on 26 March 2001. Rubicon was formed out of the separation of the Fletcher Challenge Group, acquiring those businesses that Shell were unable to obtain when it bought Fletcher Challenge Energy. Rubicon’s forestry portfolio upon its formation is scheduled in Figure 4.27. Included in the initial portfolio was a shareholding in Fletcher Challenge Forest (FCF). Rubicon’s purpose was to create value for its shareholders by disposing of, restructuring or developing its initial portfolio of assets. In the 2002 financial statements, the largest value element in Rubicon’s portfolio was its investment in FCF of 432m shares (17.6%). Rubicon noted:

‘… we reduced through net earnings, the carrying value of our investment in FCF by $21.6 million, to $132.9 million, as our accounting policies require us to carry our listed investments at market value (as represented by the traded price on the NZSE at balance date). We adopted this accounting policy so that shareholders could be sure that the net asset backing numbers we publish for Rubicon effectively ‘mark to market’ at balance date those of our assets which are effectively traded in the equity market. Having said that, we strongly believe the value of our FCF shareholding to be well in excess of 27 cents per share – the market price used in our financial statements.’ Source: Rubicon Annual Report, 2002.

In the half-year accounts, Rubicon decided to change the accounting for its investment in FCF from mark-tomarket to equity accounting. The background to Rubicon and GPG was that in July 2002, GPG became Rubicon’s largest shareholder, acquiring a 19.9% interest. GPG also acquired a 2.2% shareholding in FCF. GPG describes itself as a ‘strategic investment holding company’. Its shares are listed on the London, Australian and New Zealand stock exchanges. At 31 December 2003, GPG had total assets of £613 213 million (which included £18.2 million investment in Rubicon and FCF) and equity of £368 165. Tony Gibbs and Gary Weiss of GPG opposed the decision to equity account Rubicon’s 17.6% interest in FCF. In a statement to the stock exchange the pair stated: ‘Neither Mr Gibbs nor Dr Weiss considers that the circumstances are such as to require Rubicon to alter its previously adopted accounting treatment and to account for Forests as an associate’. The GPG directors

believed that Rubicon avoided a much worse result by changing its accounting policies. The change to equity accounting meant that Rubicon included a share of FCF’s earnings in its income statement. Under the old policy, as an investment, changes in value flowed through the income statement. Subsequent action by Rubicon In the annual accounts, as at 31 March 2003, the chief executive officer noted that Rubicon had decided that in order to ‘extract value’ from its shareholding in FCF ‘… we would need to take a far more active role in its future direction’. One of the steps taken was to increase the shareholding to 19.9%. ‘At this level of ownership and Board representation we are required to equity account our investment in FCF (in accordance with the Financial Reporting Act).’ FIGURE 4.27 Rubicon’s forestry portfolio at commencement of business

Portfolio item A 17.6% ownership interest in FCF The Trees & Technology tree stock development business located in New Zealand A 31.67% interest in ArborGen – the world’s leading forestry biotechnology joint venture (in which Rubicon, International Paper and MeadWestvaco are equal partners) An interest in 50% of FTSA – a eucalyptus forest and timber/ plywood processing operation in Argentina A 3% interest in Genesis Research and Development Limited – a publicly listed New Zealand genomics company Cash of $13 million Source: Rubicon.

Comments on the accounting for FCF shareholding in Rubicon’s unaudited half-yearly report to 30 September 2002:

Consistent with the belief that we may be the owner of our FCF investment for a longer period of time and also with the strategic position we hold in the company, we have changed the way we account for our FCF investment. In our financial statements in the six-month period we moved from accounting for it as an investment at market value to treating it as an associate. This change, which has the agreement of our auditors, meets the accounting guidelines that require us to have ‘significant influence over the operating and financial policies’ of FCF (but not control them) in order to equity account the investment … This accounting change means that we now record Rubicon’s share of FCF’s earnings in our statement of

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CHAPTER 4 Implementing accounting analysis

95

Assume you are an analyst for the New Zealand Securities Commission (NZSC), which is investigating the accounting change. You have been asked to write a report on Rubicon’s change to the accounting for the investment in FCF. In your report you are required to describe the accounting alternatives that Rubicon has used to account for its investment in FCF and answer the following questions: a What is the impact on the financial statements? Is the change in accounting likely to affect the decisions of those that use Rubicon’s financial statements? b What are the possible motives of Rubicon and GPG with regard to the accounting change? c What is your opinion on the appropriateness of the accounting change?  LO3

financial performance. While this change has resulted in the recording of $8.3 million earnings relating to FCF in Rubicon’s results for the current six-month period, the per share carrying value of our FCF investment remains well below FCF’s own carrying value in its published financial statements. At 30 September 2002, the value at which we carried our FCF investment was 28.7 cents per FCF share, compared with FCF’s own net asset backing of 41 cents per share at 30 June 2002. The Directors are comfortable with the carrying value in Rubicon’s accounts, and are strongly of the opinion that FCF is worth well in excess of the 19 cents per share level at which its shares are currently trading. Source: Rubicon Ltd, Half-Yearly Report, September 2002.

CASE LINK Concepts from this chapter are used in the following cases in Part 4:



Case 1 Qantas – Part B Case 2 Airlines: Depreciation differences Case 3 Recasting financial statements Case 4 Cochlear: Provisions and patent disputes Case 5 Accounting analysis: Cash flow reconciliation Case 7 Dick Smith.

ENDNOTES 1

2

3

4

5

6

7

The worksheet approach is easily adapted to an electronic spreadsheet. If using a spreadsheet, a ‘check’ column for each row can be introduced that sums all the asset columns and deducts the sum of the liability columns. In this book we refer directly to IFRS. Some jurisdictions adopt a different numbering system for IFRS equivalent standards. For example, the Australian equivalent to IAS 38 is AASB 138. M.E. Barth and M. McNichols discuss ways for investors to estimate the value of environmental liabilities. See ‘Estimation and market valuation of environmental liabilities relating to superfund sites’, Journal of Accounting Research 32 (Supplement 1994). Studies that describe the motivations for managers to distort earnings include C.W. Mulford and E.E. Chomiskey, The Financial Numbers Game: Detecting Creative Accounting Practises, (New York: John Wiley, 2002); and P. Dechow and D. Skinner, ‘Earnings management: Reconciling the views of accounting academics, practitioners, and regulators’, Accounting Horizons (2000): 235–50. I.D. Dichev, J. R. Graham, C. R. Harvey and S. Rajgopal, ‘Earnings quality: Evidence from the field’, Journal of Accounting and Economics (2013): 1–33. M.E. Bradbury, ‘The effect of analysis’ adjustments in the context of loan assessment’, Accounting and Finance (1988) shows that such adjustments improve analysis (11 ratios) for predicting financial distress. In the past, one of the major adjustments made by analysts was to capitalise operating leases. See B. Bennett and M.E. Bradbury,

‘Capitalizing non-cancellable operating leases’, Journal of International Financial Management and Accounting (Summer 2003). However, the IASB has released a new accounting standard to capitalise almost all leases. This will remedy the non-comparability that exists in relation to the accounting and reporting of leases. 8 See M.W. Nelson, J.A. Elliot and R.L. Tarpley, ‘How are earnings managed? Examples from auditors’, Accounting Horizons (Supplement 2003). 9 The AAER illustrative cases are considered to be ‘extreme versions’ because they include accounting distortions where management have gone beyond the boundaries of flexibility within GAAP. Mulford and Comiskey (2002) refer to these cases as abusive earnings management because such cases might be seen to be abusive without considering whether they represent fraudulent financial reporting. 10 Nelson et al. (2003) use the term ‘reserves’ rather than ‘provisions’. However, under IFRS ‘reserves’ are used to describe amounts set aside in equity, whereas provisions are amounts set aside as liabilities. 11 For estimating present value, we assume the cash flows are made at the end of each year. It may be more realistic to assume the cash flows are made mid-year and discount accordingly. On the other hand, given the inherent inaccuracies of financial statement analysis, we recommend that analysts question the level of detail and effort made in making present value adjustments.

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CHAPTER

5

Financial analysis

The goal of financial analysis is to assess the performance of a firm in the context of its stated goals and strategy. There are two principal tools of financial analysis: ratio analysis and cash flow analysis. Ratio analysis involves assessing how various line items in a firm’s financial statements relate to one another. Cash flow analysis allows the analyst to examine the firm’s liquidity, and to assess the management of its operating, investment and financing cash flows.

Financial analysis is used in a variety of contexts. Ratio analysis provides the foundation for making forecasts of future performance. As we will discuss in later chapters, financial forecasting is useful in company valuation, credit evaluation, financial distress prediction, security analysis, mergers and acquisitions analysis, and corporate financial policy analysis.

Chapter learning objectives By the end of this chapter, you should be able to: LO1

understand the importance of assessing firm performance

LO2

analyse firm performance in a systematic and structured way

LO3

apply cash flow analysis to support your performance analysis.

LO1

Ratio analysis

The value of a firm is determined by its profitability and growth. As shown in Figure 5.1, the firm’s growth and profitability are influenced by its product market and financial market strategies. The product market strategy is implemented through the firm’s competitive strategy, operating policies and investment decisions. Financial market strategies are implemented through financing and dividend policies. The four levers managers can use to achieve their growth and profit targets are: 1 2 3 4

operating management investment management financing strategy dividend policies.

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CHAPTER 5 Financial analysis

Growth and profitability

Product market strategies

Financial market policies

Operating management

investment management

Financing decisions

Dividend policy

Managing revenue and expenses

Managing working capital and fixed assets

Managing liabilities and equity

Managing payout

FIGURE 5.1 Drivers of a firm’s profitability and growth

The objective of ratio analysis is to evaluate the effectiveness of the firm’s policies in each of these areas. Effective ratio analysis involves relating the financial numbers to the underlying business factors in as much detail as possible. While ratio analysis may not give an analyst all the answers regarding the firm’s performance, it will help the analyst frame questions for further probing. In ratio analysis, the analyst can: 1 compare ratios for a firm over several years (a time-series comparison) 2 compare ratios for the firm and other firms in the industry (cross-sectional comparison) 3 compare ratios to some absolute benchmark. In a time-series comparison, the analyst can hold firm-specific factors constant and examine the effectiveness of a firm’s strategy over time. For a cross-sectional comparison the analyst can examine the relative performance of a firm within its industry, holding industry-level factors constant. For most ratios, there are no absolute benchmarks. The exceptions are measures of rates of return, which can be compared to the cost of the capital associated with the relevant investment. For example, subject to distortions caused by accounting, the rate of ROE can be compared to the cost of equity capital. In the discussion to follow, we will illustrate these approaches using the example of Kathmandu Limited. We also need an example company to compare to Kathmandu. The difficulties in selecting a peer company were covered in Chapter 2, and we build upon that discussion here. Security analysts typically cover a number of firms within an industry, which allows them to compare firms that are, broadly speaking, doing similar things; that is, firms within an industry that are likely to be competing for the same customers, dealing with similar supply issues and making similar capital expenditure decisions. Recall that Kathmandu is a retailer operating in the following categories: sport and camping equipment retailing, clothing retailing and footwear retailing. Many of the competitor stores for Kathmandu are:

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

1 2 3 4

part of a group that incorporates other retail sectors privately owned, so we cannot obtain financial statement information independently owned or operated, so we cannot obtain financial statement information overseas owned, which makes comparisons far more complex.

Part of the skill of security analysts is being able to identify appropriate firms for comparison in cross-sectional analysis. This is particularly important if the analyst is making comparablebased valuation determinations. One way to identify peer companies is to use the Global Industry Classification Scheme (GICS), which is a widely used industry taxonomy. Kathmandu is classified as being in the Consumer Discretionary GICS Sector, which has a two-digit GICS code of 25, and the Retailing GICS Industry Group, four-digit GICS code 2550.1 Kathmandu is further classified as in the GICS Industry of Specialty Retailer, with the six-digit code 255040. When selecting a peer company or group, analysts will need to trade off the number of possible peers with the likelihood that those peer firms are doing similar things. That is, the number of companies declines as we move from broad, two-digit GICS code industry classifications to narrower classifications with four- and six-digit GICS codes. This can be demonstrated using 2018 data from financial services firm Morningstar. We examine the number of ASX-listed firms that, in 2018, reported total assets greater than $1 million and also total revenue greater than $1 million. FIGURE 5.2 ASX-listed firms with total assets and total revenue greater than $1 million in 2018

GICS classification Consumer discretionary (25)

Number of firms 125

Retailing (2550)

51

Specialty retailer (255040)

27

Even within the Specialty Retailer group, it can be difficult to find firms doing exactly the same thing as Kathmandu. We have chosen to compare Kathmandu with Super Retail Group Limited. Super Retail owns brands such as BCF, which sells outdoor recreation goods focusing on boating, camping and fishing; Macpac, which sells outdoor adventure products; Rebel, which sells sporting goods; and Supercheap Auto, which sells automotive parts and accessories. Much of the Super Retail Group portfolio competes with Kathmandu. The firms do differ in size: in 2018, Super Retail had total assets of just over $1.75 billion, while Kathmandu had total assets of $564 million. We will compare Kathmandu’s ratios for the financial year ending 31 July 2018 with its own ratios for the financial year ending 31 July 2017, and with the ratios for Super Retail Group, for the financial years ending 30 June 2018 and 30 June 2017.2 Both firms operate in the same industry, but one experienced increased revenue by over 10% and profits by over 30% in 2018 whereas the other experienced revenue growth of less than 5% and profits before abnormal items by 7% in the same year. We will explore the reasons for these different performances using ratio analysis. To help replicate the ratio calculations presented, we provide financial statements of both these companies as an appendix to this chapter. Two versions of these companies’ financials are presented in each appendix. The first version is the one reported by the two companies in their

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CHAPTER 5 Financial analysis

annual reports. The second set of financial statements is presented in the standardised format. These standardised financial statements put both companies’ financials in one standard format to facilitate direct comparison. We discuss the process of standardising these statements in the appendix to this chapter.

Properties of good ratios The ratios analysts use should be appropriately measured and calculated so that the analyst can draw meaningful conclusions from the financial analysis. While the exact form of ratios individual analysts use demonstrates their individual preferences, all ratios should follow a number of core principles. Those principles relate to the purpose of the ratios, the consistency of measurement units and the consistency of measurement scope.

Ratio purpose The construction and use of ratios presumes that the analyst has a particular goal or purpose. This purpose could be to understand the historical operating performance, to evaluate the firm’s strategy, to review its overall outcomes including extraordinary items, to evaluate management decisions or to help forecast future outcomes. The purpose of the analysis informs the construction of the ratio and is reflected in the specification of the ratio’s formula. While we set out particular ratio formulas in this book, individual analysts may choose to modify the basic formulas to suit their specific purpose. In addition, using a ratio suggests that there is some underlying relation between the item in the numerator and the item in the denominator. A well-formed ratio will have some economic logic linking the numerator and denominator in a (preferably linear) relation. It is also important that there is consistency when measuring the numerator and the denominator.

Consistency of measurement units: Stock versus flow The units used in a ratio should have consistency – particularly between the numerator and the denominator. Values that are measured at a point of time, like items from the balance sheet, are known as stock items, because they are measured in stock units. (The term ‘stock’ relates to the concept of inventory rather than the concept of a stock market.) These stock measures could come from opening or closing balance sheets or from other non-accounting sources (such as the number of subscribers to a telecommunications company). These stock measures are often measured in units of a country’s currency. On the other hand, items measured over a period of time use units of measure that are flows. This includes items coming from the income statement, the statement of cash flow or the statement of changes in equity. Flow measures – for example, units of currency per year – are the first difference of stock measures with respect to time. A ratio that measures different components in varying units risks measuring the desired concept with error. An example of this occurs with ratios that divide a flow measure by a stock measure. The dilemma is: which stock measure should be used – the one at the beginning or the one at the end of the relevant period? Furthermore, what if rapid growth has resulted in a significant change in the stock measure? One solution is to modify the nature of the stock measure to be measured over the relevant period. Often a simple average will overcome the problem if the change in the stock item has been even over the period. The risk of mismeasurement is greater for smaller firms; young, quickly growing firms; and firms in smaller capital markets. In our analysis below, we use average balance sheet (i.e. stock) measures in our ratios, unless indicated otherwise. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Consistency of measurement scope: Adjustments Another part of consistency is ensuring that the scopes of the numerator and the denominator are equivalent. For example, if the numerator is the profit for the entire business group, then the denominator should cover the same scope; that is, the entire group. Mismatching the ratio scope will lead to erroneous results. This is particularly challenging in situations where the analyst may be variously considering the consolidated group, the individual company or certain divisions of the company. It is also important to ensure that the financial statements of the firm being analysed do not include any data that will distort the analysis. Since the purpose of financial statement analysis is to better understand the performance of the firm as it relates to its strategy, the analyst needs to take care that any operations and events that are extraneous to that strategy do not distort the analyst’s picture of the firm. The major categories of such distortions include one-time write-offs of assets and results from discontinued operations, including the gain or loss on the disposal of such operations. In such circumstances, it is useful to look at the financial results of the core operations of the firm by adjusting the presented financial statements to exclude the impact of one-time effects. Analysts should also be cautious about using items or measures that may result in a zero or a small value. If these items are in the denominator of a ratio, an undefined ‘divide by zero error’ or a meaningless large value may result. Consider a ratio with equity in the denominator. A small percentage of firms will have zero or negative equity at any given time, while a ratio with a total asset measure is far less likely to be zero or negative. Also note that a ratio with negative values for both the numerator and the denominator will give a misleadingly positive result. When forming and interpreting ratios, take care to avoid these problems. If such a problem arises, the analyst could choose another ratio or use a measure with a similar interpretation that does not have the problem, or they could substitute a default value instead of a missing or nonsensical input item.

Measuring overall profitability The starting point for a systematic analysis of a firm’s performance is its ROE. This is also referred to as return on common shareholders’ equity (ROCE), because preference capital is excluded from equity to distinguish the return that is earned by the ordinary or common shareholders who are the residual claimants of the firm. For simplicity, the term ROE will be used. ROE is defined as: ROE =

Net income − Preferred dividends Average common shareholder’s equity

ROE is a comprehensive indicator of a firm’s performance because it provides an indication of how well managers are employing the funds invested by the firm’s shareholders to generate returns. In calculating ROE, the analyst gains an understanding of the return being generated by the business’s operations on the equity capital provided by (ordinary) shareholders. For this reason, the numerator, net income (or ‘profit for the year’ using the standardised income statement format), must be adjusted for payments (dividends) to preference shareholders. If the firm has not issued preference shares or other types of priority capital, then preferred dividends can be disregarded.

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RETURN ON EQUITY Figure 5.3 shows the ROE based on reported earnings for Kathmandu, Super Retail Group and a group of industry peers. These industry peers comprise the firms in the Specialty Retailer GICS grouping. FIGURE 5.3 Return on equity for Kathmandu, Super Retail Group and industry peers

Ratio Return on equity

Kathmandu

Super Retail Group

Other peers

2018

2017

2018

2017

2018

2017

13.5%

11.9%

16.4%

13.5%

16.5%

28.4%

Kathmandu’s ROE shows an increase from 11.9 to 13.5% between 2017 and 2018. These figures use the average value of shareholders’ equity in the denominator. This result is comparable to that achieved by many companies, based on historical trends, and it exceeds its expected ROE.4

Super Retail Group also reported an increase in ROE from 13.5 to 16.4%. This level of profitability is also above the firm’s expected level of ROE. The Specialty Retailer sector performed well in 2018, with an average ROE of 16.5%. We will examine the drivers behind these performances, as we deconstruct ROE.

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In most circumstances, the appropriate measure of net income to use in these performance ratio measures is, in the standardised income statement format, the net profit after tax for the year. This measure or return is used because the analyst is most interested in the total return performance that management, as a result of their decisions, has been able to earn for common shareholders. Of course, the return measure being used here is net of the costs of debt-holder provided capital such as interest payments, so no other adjustment for leverage is needed. In measuring the denominator, the careful analyst would average the (common) shareholders’ equity to ensure measurement unit consistency, and to compensate for any rapid growth or major changes in shareholders’ equity. A simple average of the opening and closing balances of shareholders’ equity will suffice in most circumstances. On average over long periods, large publicly traded firms in Australia have generated ROEs in the range of 10 to 12%. In the long run, the value of the firm’s equity is determined by the relationship between its ROE and its cost of equity capital.3 That is, those firms that are expected over the long run to generate ROEs in excess of the cost of equity capital should have market values in excess of book value, and vice versa. (We will return to this point in more detail in Chapters 7 and 8.) A comparison of ROE with the cost of capital is useful not only for analysing the value of the firm but also when considering the path of future profitability. Generating consistent supernormal profits will, in the absence of significant barriers to entry, attract competition. For that reason, competitive forces tend to drive ROEs towards a ‘normal’ level over time – the cost of equity capital. We can think of the cost of equity capital as establishing a benchmark for the ROE that would be observed in a long-run competitive equilibrium. Deviations from this level arise for two general reasons. One is the industry conditions and competitive strategy that cause a firm to generate supernormal (or subnormal) economic profits, at least over the short run. The second is distortions due to accounting.

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LO2

 ecomposing profitability: Traditional D approach

A firm’s overall profitability, as measured by its ROE, is affected by how profitably it employs assets and how big the firm’s asset base is relative to shareholders’ investment. This is shown in Figure 5.1 earlier in this chapter. To understand the effect of these two factors on firm performance, ROE can be decomposed into return on assets (ROA) and measures of financial leverage, as follows: ROE = ROA × leverage Profit or loss total assets × = total equity Total assets ROA is a critical measure of organisational performance, which tells us how much profit a firm is able to generate for each dollar of assets invested. The leverage measures (or equity multiplier) indicates how many dollars of assets the firm is able to deploy for each dollar of equity invested by its shareholders.5 Common Earnings Leverage (CEL) = CEL =

Net income to common Profit before leverage

Net income − Preferred dividends Net income + ((1 − Tax rate) × Interest expense) + Minority interest

Capital Structure Leverage (CSL) =

Average total assets Average common shareholders’ equity

The ROA itself can be decomposed as a product of two factors: ROA =

Profit or loss Revenue × Total assets Revenue

The ratio of profit or loss to revenue is called net profit margin or return on sales (ROS). The ratio of revenue to total assets is known as asset turnover. The profit margin indicates how much the company is able to keep as profits for each dollar of revenue that it makes. Asset turnover indicates how many dollars of revenue the firm is able to generate for each dollar of its assets. Figure 5.4 displays the three drivers of ROE for our specialty retailers: net profit margins, asset turnover and equity multipliers (leverage). In 2018, Kathmandu’s increase in ROE was driven by an increase in profit margin, which more than offset the decline in asset turnover. We can see this by the overall increase in ROA. A slight increase in leverage also contributed to the increase in ROE for 2018. Super Retail Group also recorded an increase in net profit margin and decline in asset turnover. Kathmandu’s profit margin is much higher than that of Super Retail Group and industry peers, while its asset turnover is lower. While Kathmandu recorded a higher ROA than Super Retail Group both years, its lower level of leverage meant that Super Retail Group had a higher overall level of ROE.

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CHAPTER 5 Financial analysis

FIGURE 5.4 Traditional decomposition of ROE

Kathmandu Ratio Net profit margin (ROS)

Super Retail Group

Other peers

2018

2017

2018

2017

2018

2017

10.2%

8.5%

4.9%

4.1%

5.8%

6.0%

× Asset turnover

0.94

1.00

1.55

1.58

1.54

1.87

= Return on assets

9.6%

8.6%

7.7%

6.4%

8.8%

11.2%

× Leverage (assets / equity)

1.41

1.39

2.14

2.10

1.87

2.53

13.5%

11.9%

16.4%

13.5%

16.5%

28.4%

= Return on equity

ROA =

Net income + ((1 − Tax rate) × Interest expense) + Minority interest Average total assets

Decomposing profitability: Alternative approach Even though the above approach is popularly used to decompose a firm’s ROE, it has several limitations. When computing ROA, the denominator includes the assets claimed by all providers of capital to the firm, but the numerator includes only the earnings available to equity holders. These assets themselves include both operating assets and financial assets such as cash and short-term investments. Further, net income includes income from operating activities as well as interest income and expenses, which are consequences of financing decisions. Often it is useful to distinguish between these two drivers of performance for at least three reasons: 1 As we will see in Chapters 6 through 8, valuing operating assets requires different tools from valuing investment assets and financing items. Specifically, financial statements include much detailed information about the financial and risk consequences of operating activities, which enables the analyst to take an informed approach to the analysis and valuation of such activities. In contrast, what comprises the investment assets and drives their profitability is often not easy to identify from the financial statements. This forces the analyst to use shortcut methods to rely on a firm’s own fair value disclosures to assess the value of such assets. 2 Operating, investment and financing activities contribute differently to a firm’s performance and value, and their relative importance may vary significantly across firm and time. Mixing operating with financing and investment assets may obfuscate the effect that these assets have on firms’ performance. An increase in financial leverage may not only have a direct positive effect on return on equity but also an indirect negative effect through increasing a firm’s financial risk and borrowing costs. The traditional decomposition of ROE does not make this explicit – while the equity multiplier reflects the direct effect of leverage, the net profit margin reflects the indirect effect. 3 Finally, the leverage ratios used above do not recognise the fact that a firm’s cash and shortterm investments are in essence ‘negative debt’ because they can be used to pay down the debt on the firm’s balance sheet.6 These issues are addressed by an alternative approach to decomposing ROE.7 The leverage ratio used in the traditional decomposition does not recognise the fact that some of a firm’s liabilities are in essence non-interest-bearing operating liabilities.

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Before discussing this alternative ROE decomposition approach, we need to define some terminology used in this section as well as in the rest of this chapter. We use the terms defined in Figure 5.5 to decompose ROE. The results for Kathmandu and Super Retail Group are shown in Figure 5.6. FIGURE 5.5 Definitions of accounting items used in ratio analysis

Item

Definition

Income statement items Net interest expense after taxa

(Interest expense – interest income) (1 – tax rate)

Net operating profit after tax (NOPAT)

Net operating income + net interest expense after tax

Balance sheet items Operating working capitalb

(Current assets – cash and marketable securities) – (current liabilities – shortterm debt and current portion of long-term debt)

Net long-term operating assetsb

Total long-term assets – non-interest-bearing long-term liabilities

Net operating assets

Operating working capital + net long-term operating assets

Net debt

Total interest-bearing liabilities – cash and marketable securities

b

Net assets

Operating working capital + net long-term assets

Net capitalb

Net debt + shareholders’ equity

b

a The calculation of net interest expense treats interest expense and interest income as absolute values, independent of how these figures are reported in the income statement. b The items in Figure 5.5 where the definition uses stock unit measures imply that they come from end-of-financial-period ‘point-of-time’ financial statements, but these can be measured as averages over time where that helps the accuracy of measurement of these items.

ROE =

NOPAT Net interest expense after tax − Equity Equity

Introducing ‘net operating assets’ into the numerator and denominator of the first term and ‘net debt’ into the numerator and denominator of the second term, gives us the following: =

Net operating assets Net interest expense after tax Net debt NOPAT − × × Net operating assets Equity Net debt Equity =

=

Net debt Net interest expense after tax Net debt NOPAT − × × 1+ Net operating assets Equity Net debt Equity

Net interest expense after tax Net debt NOPAT NOPAT + − × Net operating assets Net operating assets Net debt Equity

This helps us recognise the following identities: NOPAT divided by net operating assets could be considered a measure of operating ROA net debt divided by equity is a measure of net financial leverage net interest expense after tax divided by net debt gives a measure of the effective interest rate after tax. Finally, we recognise that the difference between the operating ROA and the effective interest rate after tax is a measure of the financial spread the firm faces:

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ROE = operating ROA + spread × net financial leverage Operating ROA is a measure of how profitably a firm is able to deploy its operating assets to generate operating profits. This would be a firm’s ROE if it were entirely financed with equity. Spread is the incremental economic effect from introducing debt into the capital structure. This economic effect of borrowing is positive, so long as the return on operating assets is greater than the cost of borrowing. Firms that do not earn adequate operating returns to pay their interest costs reduce their ROE by borrowing. Both the positive and negative effects are magnified by the extent to which a firm borrows relative to its equity base. The ratio of net debt to equity provides a measure of this net financial leverage. A firm’s spread multiplied by its net financial leverage, therefore, provides a measure of the financial leverage gain to the shareholders. Operating ROA can be further decomposed into NOPAT margin and operating asset turnover as follows: NOPAT Revenue × Operating ROA = Revenue Net operating assets

DECOMPOSING ROE Figure 5.6 shows how we can decompose the ROE of both Kathmandu and Super Retail Group by distinguishing between the operating and financing components. In the appendix to this chapter, we provide the as reported financial statements and the corresponding standardised financial statements that shows how we have approached the task of determining which line items in the financial statements should be considered as operating items and which accounts represent financing items. FIGURE 5.6 Distinguishing operating and financing components in ROE decomposition

Kathmandu Ratio Net operating profit margin × Net operating asset turnover = Return on net operating assets

Super Retail Group

2018

2017

2018

2017

10.3%

8.9%

5.4%

4.6%

1.23

1.31

2.19

2.17

12.7%

11.6%

11.9%

9.9%

Kathmandu

Super Retail Group

Ratio

2018

2017

2018

2017

After tax cost of net debt (net interest expense after tax/ net debt)

2.4%

6.4%

3.2%

3.1%

Spread (RNOA – after-tax cost of net debt)

10.3%

5.1%

8.7%

6.8%

× Financial leverage (net debt/equity)

0.08

0.07

0.52

0.53

= Financial leverage gain

0.8%

0.4%

4.5%

3.6%

13.5%

11.9%

16.4%

13.5%

ROE = return on operating assets + financial leverage gain

The ratios in this Figure 5.6 show that there can be differences between traditional ROA and operating ROA. Kathmandu’s operating ROA is about 3 percentage points higher than its traditional ROA in 2017 and 2018, while

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NOPAT margin is a measure of how profitable a firm’s sales are from an operating perspective. Operating asset turnover measures the extent to which a firm is able to use its operating assets to generate sales. Figure 5.6 presents the decomposition of ROE for Kathmandu and Super Retail Group. The ratios in this table, when compared to the traditional ratios presented in Figure 5.4, enable us to explore the reasons for their different performances in terms of whether they derive from operations or financing.

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Super Retail Group’s operating ROA is around 4 percentage points higher than its traditional ROA for those years. This difference is largely attributable to both companies’ operating liabilities, such as trade payables and deferred tax liabilities, as well as the classification of cash as part of net debt. Both of these factors reduce the amount of net operating assets relative to the amount of total assets. We can also see that the net operating asset turnover for both Kathmandu and Super Retail Group was higher than the asset turnover shown in Figure 5.2. Again, this can be explained by the difference between total assets and net operating assets. Kathmandu’s operating asset turnover and net operating profit margin are consistent with its strategy of focusing more on premium priced

goods relative to Super Retail Group. In particular, Super Retail Group’s sports brand Rebel tries to achieve a high turnover. Kathmandu and Super Retail Group are also both able to create value through their financing strategy. In 2018, the spread between Kathmandu’s returns on its net operating assets and its after-tax interest cost was 10.3%; however, its net debt as a percentage of its equity was only 8%. This led to Kathmandu’s ROE being 0.8 percent above its operating ROA. In contrast, in 2018 the operating ROA of Super Retail Group was 8.3 percentage points higher than its after-tax interest cost, but it had net debt at 52% of equity. This provided a larger financial leverage gain, with the ROE for Super Retail Group being 4.5% higher than the operating ROA.

The additional insights provided by the decomposition analysis show that, for at least some firms, it is important to adjust their simple ROA to take into account interest expense, interest income and financial assets. The appropriate benchmark for evaluating operating ROA is the weighted average cost of debt and equity capital, or WACC. In the long run, the value of the firm’s assets is determined by how its operating ROA compares to this norm. In addition, over the long run and in the absence of any barrier to competitive forces, operating ROA will tend to be pushed towards the weighted average cost of capital. Since the WACC is lower than the cost of equity capital, operating ROA tends to be pushed to a level lower than that to which ROE tends. The average operating ROA for large firms in Australia over long periods of time is in the range of 8 to 10%. Kathmandu’s operating ROAs in 2018 and 2018 were 12.7% and 11.5%, which are above this range. They exceed those of Super Retail Group in both years, and also exceed any reasonable estimates of its weighted average cost of capital.

Assessing operating management: Decomposing net profit margins A firm’s net profit margin (PM) or ROS shows the profitability of the firm’s operating activities. Further decomposition of a firm’s ROS allows an analyst to assess the efficiency of the firm’s operating management. A popular tool used in this analysis is the common-sized income statement, in which all the line items are expressed as a percentage of sales revenues. This type of analysis is also referred to as vertical analysis. Common-sized income statements make it possible to compare trends in income statement relationships over time for the firm, and trends across different firms in the industry. Income statement analysis allows the analyst to ask the following types of questions:

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1 Are the firm’s margins consistent with its stated competitive strategy? For example, a differentiation strategy should usually lead to higher gross margins than a low-cost strategy. 2 Are the firm’s margins changing? Why? What are the underlying business causes – changes in competition, changes in input costs or poor overhead cost management? 3 Is the firm managing its overhead and administrative costs well? What are the business activities driving these costs? Are these activities necessary? To illustrate how the income statement analysis can be used, common-sized income statements for Kathmandu and Super Retail Group are shown in Figure 5.7. The figure also shows some commonly used profitability ratios. We will use this information to investigate the drivers behind Kathmandu and Super Retail Group’s net income margins (ROS) in 2017 and 2018. FIGURE 5.7 Common-sized income statement and profitability ratios

Kathmandu Ratio

Super Retail Group

Other peers

2018

2017

2018

2017

2018

100%

100%

100%

100%

100%

Cost of sales

–36.6%

–38.0%

–55.1%

–55.3%

55.3%

Gross profit

63.4%

62.0%

44.9%

44.7%

44.7%

0.0%

0.0%

0.3%

0.1%

–2.7%

Selling expenses

–31.3%

–32.3%

–16.2%

–16.5%

Administrative and general expenses

–14.1%

–13.8%

–21.5%

–21.8%

Earnings before interest, tax, depreciation & amortisation

18.0%

15.9%

11.5%

11.2%

4.9%

Depreciation and amortisation

–3.0%

–3.1%

–3.0%

–2.9%

2.1%

EBIT

15.0%

12.8%

8.5%

8.4%

2.8%

0.0%

0.0%

0.0%

0.0%

0.1%

Line item as a percentage of sales Sales

Other income

Finance income Finance expenses

–0.2%

–0.5%

–0.7%

–0.7%

1.5%

Finance costs – net

–0.2%

–0.5%

–0.7%

–0.7%

1.4%

Profit before income tax

14.8%

12.3%

6.9%

5.7%

7.6%

Income tax expense

–4.6%

–3.8%

–1.9%

–1.6%

2.4%

Profit after income tax

10.2%

8.5%

5.0%

4.1%

2.6%

Gross profit margins The difference between a firm’s sales and cost of sales is gross profit. Gross profit margin is an indication of the extent to which revenues exceed direct costs associated with sales, and it is computed as: Gross profit margin =

Revenue − Cost of sales Revenue

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Gross margin is influenced by two factors: 1 the price premium that a firm’s products or services command in the marketplace 2 the efficiency of the firm’s procurement and production process. The price premium a firm’s products or services can command is influenced by the degree of competition and the extent to which its products are unique. The firm’s cost of sales can be low when it can purchase its inputs at a lower cost than its competitors and/or run its production processes more efficiently. This is generally the case when a firm has a low-cost strategy. Figure 5.7 indicates that Kathmandu’s gross margin in 2018 increased from 62 to 63.4%, which is above the company’s long-term target rate of 61 to 63%. This was driven by Kathmandu being able to sell more products at full price and increased average selling prices. Kathmandu’s gross margins remained well above those of Super Retail Group, which recorded only a slight increase in gross margin from 44.7 to 44.9% in 2018.

Selling, general and administrative expenses A firm’s selling, general and administrative (SG&A) expenses are influenced by the operating activities it has to undertake to implement its competitive strategy. As discussed in Chapter 2, firms with differentiation strategies have to undertake activities to achieve that differentiation. A firm competing on the basis of quality and rapid introduction of new products is likely to have higher R&D costs relative to a firm competing purely on a cost basis. Similarly, a firm that attempts to build a brand image, distribute its products through full-service retailers and provide significant customer service is likely to have higher selling and administration costs relative to a firm that sells through warehouse retailers or direct mail and does not provide much customer support. A firm’s SG&A expenses are also influenced by the efficiency with which it manages its overhead activities. The control of operating expenses is likely to be especially important for organisations competing on cost. However, even for differentiators, it is important to assess whether the cost of differentiation is commensurate with the price premium earned in the marketplace. Several ratios in Figure 5.7 allow us to evaluate how effectively Kathmandu and Super Retail Group managed their SG&A expenses. First, the ratio of SG&A expense to sales shows how much a firm is spending to generate each sales dollar. In 2018, Kathmandu’s SG&A expenses declined from 46.1 to 45.4% of sales. Given that Kathmandu describes itself as ‘a design-led, product-led, brand-led business with a customer-centric approach’, keeping marketing costs under control is an important part of their financial success.8 Super Retail Group also kept its SG&A expenses stable in 2018, where they declined from 38.3 to 37.7% of sales. The cost structures of Kathmandu and Super Retail Group are different. Whereas Kathmandu’s cost of sales is lower, its SG&A expenses are higher. The question is: when both these costs are netted out, which firm is performing better? Three ratios provide useful signals here: earnings before interest and tax margin (EBIT margin) ratio, EBITDA margin and NOPAT margin: EBIT margin = EBITDA margin =

Earnings before interest and tax (or EBIT) Revenue

Earnings before interest, tax, depreciation and amortisation Revenue NOPAT margin = NOPAT/Revenue

EBIT margin provides a comprehensive indication of the operating performance of a firm because it reflects all operating policies and eliminates the effects of debt policy. EBITDA margin provides similar Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 5 Financial analysis

information, except that it excludes depreciation and amortisation expense, a significant non-cash operating expense. Some analysts prefer to use EBITDA margin because they believe that it focuses on ‘cash’ operating items. While this is true to some extent, it can be potentially misleading for two reasons. EBITDA is not a strictly cash concept because sales, cost of sales and SG&A expenses often include non-cash items. Also, depreciation is a real operating expense, and it reflects to some extent the consumption of resources. Therefore, ignoring it can be misleading. As introduced earlier in this chapter, NOPAT margin is a measure of how profitable a firm’s sales are from an operating perspective. The numbers in Figure 5.7 show that some of Kathmandu’s higher gross margin compared with Super Retail Group is offset by higher SG&A costs. However, Kathmandu still shows a 5 to 7% higher EBITDA as a percentage of sales than Super Retail Group. Kathmandu’s EBITDA margin increased from 12.8 to 15% of revenue in 2018. The level of depreciation and amortisation for both Kathmandu and Super Retail Group remained steady and similar at around 3% of revenue. Retailing is typically more labour intensive than capital intensive so we do not expect to see large levels of depreciation. We see in Figure 5.6 that both Kathmandu and Super Retail Group reported increases in NOPAT margin in 2018. Kathmandu is able to retain close to 13 cents in net operating profit for each dollar of revenue, and Super Retail Group just below 12 cents for each dollar of revenue. Recall that in Figure 5.5 we defined NOPAT as net income plus net interest expense after tax. NOPAT, calculated this way, can be influenced by any unusual or non-operating income (expense) items included in net income. We can calculate a ‘recurring’ NOPAT margin by eliminating these items, which we label ‘Other income’ in the standardised financial statement. In 2017 and 2018, Kathmandu had no such items. This recurring NOPAT may be a better benchmark to use when one is extrapolating current performance into the future, since it reflects margins from the core business activities of a firm.

Tax expense Taxes are an important element of a firm’s total expenses. Through a wide variety of tax planning techniques, firms can attempt to reduce their tax expenses.9 There are two measures one can use to evaluate a firm’s tax expense. One is the ratio of tax expense to sales, and the other is the ratio of tax expense to earnings before tax (also known as the average tax rate). The firm’s tax note provides a detailed account of why its average tax rate differs from the statutory tax rate.

KEY ANALYSIS QUESTIONS A number of business questions will be useful to an analyst assessing the various elements of operating management: Are the firm’s margins consistent with its stated competitive strategy? For example, a differentiation strategy should usually lead to higher gross margins than a low-cost strategy. Are the firm’s margins changing? Why? What are the underlying business causes – changes in competition, changes in input costs or poor overhead cost management? Is the firm managing its overhead and administrative costs well? What are the business activities driving these costs? Are these activities necessary? Are the firm’s tax policies sustainable? Or is the current tax rate influenced by one-time tax credits? Do the firm’s tax planning strategies lead to other business costs? For example, if the operations are located in tax havens, how does this affect the company’s profit margins and asset utilisation? Are the benefits of tax planning strategies (reduced tax) greater than the increased business costs?

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Figure 5.7 shows that Kathmandu’s tax rate increased in 2018, and its tax rate as a percentage of revenue was higher than Super Retail Group’s in both 2017 and 2018. The primary reason for this is that Kathmandu’s pre-tax profit as a percentage of revenue was higher than that of Super Retail Group. If we calculate the average tax rate (income tax expense divided by profit before income tax) we find that Kathmandu’s tax rate rose from 30.8 to 31.3% from 2017 to 2018. At the same time, Super Retail Group shows an average tax rate moving down from 28.6 to 27.7%. These figures are close to the statutory corporate tax rate of 30% that applied in Australia (Super Retail Group) and 28% in New Zealand (Kathmandu). In summary, an examination of common-sized income statement ratios can illuminate strategic and/or operational differences among competitors. Both Kathmandu and Super Retail Group recorded increases in margins in 2018, but Kathmandu achieved a larger improvement in gross margins. Both firms recorded slight decreases in SG&A margins. Overall Kathmandu has a higher NOPAT and net profit margin than Super Retail Group. This is consistent with its positioning as a brand-led retailer, which provided it with more premium products than Super Retail Group.

Evaluating investment management: Decomposing asset turnover Asset turnover is the second driver of a firm’s return on equity. Since firms invest considerable resources in their assets, using them productively is critical to overall profitability. A detailed analysis of asset turnover allows the analyst to evaluate the effectiveness of a firm’s investment management. There are two primary areas of investment management are: 1 working capital management 2 management of long-term assets.

Working capital management Working capital is defined as the difference between a firm’s current assets and current liabilities. However, this definition does not distinguish between operating components (such as accounts receivable, inventory and accounts payable) and the financing components (such as cash, marketable securities and notes payable). An alternative measure that makes this distinction is operating working capital, as defined in Figure 5.5: Operating working capital = ( current assets – cash and marketable securities) – (current liabilities – short-term debt and current portion of long-term debt) In some cases, analysts will try to determine the ‘excess’ amount of cash and marketable securities to deduct from current assets. This involves assessing what the ‘normal’ or expected level of cash and marketable securities are for a firm. The components of operating working capital that analysts primarily focus on are accounts receivable, inventory and accounts payable. A certain amount of investment in working capital is necessary for the firm to run its normal operations. For example, a firm’s credit policies and distribution policies determine its optimal level of accounts receivable. The nature of the production process and the need for buffer stocks determine the optimal level of inventory. Finally, accounts payable is a routine source of financing for the firm’s working capital, and payment practices in an industry determine the normal level of accounts payable. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 5 Financial analysis

The following ratios are useful in analysing a firm’s working capital management: operating working capital as a percentage of sales, operating working capital turnover, accounts receivable turnover, inventory turnover and accounts payable turnover. The turnover ratios can also be expressed in the number of days of activity that the operating working capital (and its components) can support. The definitions of these ratios are given as follows. Operating working capital Operating working capital to sales ratio = Sales Sales Operating working capital

Operating working capital turnover

=

Accounts receivable turnover

=

Inventory turnover

=

Accounts payable turnover

=

Days receivables

=

Days inventory

=

Days payables

=

Sales Average accounts receivables Cost of goods sold Average inventory

Purchases Cost of goods sold or Average accounts payable Average accounts payable Average accounts receivable Average sales per day



Average inventory Average cost of goods sold per day



Average accounts payable Average purchases (or cost of goods sold) per day

Operating working capital turnover indicates how many dollars of sales a firm is able to generate for each dollar invested in its operating working capital. Accounts receivable turnover, inventory turnover and accounts payable turnover allow the analyst to examine how productively the three principal components of working capital are being used. Days receivables, days inventory and days payables are another way to evaluate the efficiency of a firm’s working capital management.10

Long-term assets management Another area of investment management concerns the utilisation of a firm’s long-term assets. It is useful to define a firm’s investment in long-term assets as follows: Net long-term assets = (total long-term assets – non-interest-bearing long-term liabilities) Long-term assets generally consist of net property, plant and equipment (PPE); intangible assets such as goodwill; and other assets. Non-interest-bearing long-term liabilities include items such as deferred taxes. We define net long-term assets and net working capital in such a way that their sum, net operating assets, is equal to the sum of net debt and shareholders’ equity, or net capital. This is consistent with the way we defined operating ROA earlier in the chapter. The efficiency with which a firm uses its net long-term assets is measured by the following two ratios: net long-term assets as a percentage of sales and net long-term asset turnover. Net long-term asset turnover is defined as:

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Net long-term asset turnover =

Sales Average net long-term assets

PPE is the most important long-term asset in a firm’s balance sheet. The efficiency with which a firm’s uses its PPE is measured either by the ratio of PPE to sales, or by the PPE turnover ratio: (PP&E) turnover =

Sales Average net property, plant, and equipment

KEY ANALYSIS QUESTIONS The ratios discussed in the two preceding sections allow the analyst to explore a number of business questions:

KATHMANDU CASE

How well does the firm manage its inventory? Does the firm use modern manufacturing techniques? Does it have good vendor and logistics management systems? If inventory ratios are changing, what is the underlying business reason? Are new products being planned? Is there a mismatch between the demand forecasts and actual sales? How well does the firm manage its credit policies? Are these policies consistent with its marketing strategy? Is the firm artificially increasing sales by loading the distribution channels? Is the firm taking advantage of trade credit? Is it relying too much on trade credit? If so, what are the implicit costs? Is the firm’s investment in plant and equipment consistent with its competitive strategy? Does the firm have a sound policy of acquisitions and divestitures?

ASSET MANAGEMENT Figure 5.8 shows asset management ratios for Kathmandu and Super Retail Group. Between 2017 and 2018, Kathmandu became less efficient in its working capital management, as can be seen from the increase in operating working capital as a percentage of revenue and the decrease in operating working capital turnover. Working capital management declined because of decreases in accounts receivable turnover and decreases in accounts payable turnover. The inventory turnover remained constant. Kathmandu’s non-current operating assets utilisation improved in 2018: both its net non-current asset turnover and its PPE turnover increased. Super Retail Group managed its inventories more efficiently than Kathmandu in both 2017 and 2018, as shown in the higher inventory turnover. This is explained in part by the results of Super Retail Group’s brand Rebel, which had a higher turnover than other parts of the Super Retail Group businesses. It is also consistent with Kathmandu adopting a more differentiated or premium position in the market.

A factor that allows Super Retail Group to make smaller investments in working capital than Kathmandu is the company’s much more effective collection of accounts receivable. In 2018, its accounts receivable turnover was more than double that of Kathmandu. FIGURE 5.8 Asset management ratios

Kathmandu

Super Retail Group

Other peers

Ratio

2018

2017

2018

2017

2018

Operating working capital / revenue

9.8%

7.7%

5.1%

6.9%

19.9%

Net non-current operating assets / revenue

71.3%

68.9%

40.6%

39.1%

45.5%

PPE / revenue

12.5%

13.8%

10.4%

10.2%

9.9%

Operating working capital turnover

10.2

12.9

19.7

14.6

5.0

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CHAPTER 5 Financial analysis

Ratio

Kathmandu

Super Retail Group

Other peers

2018

2017

2018

2017

2018

Net non-current operating assets turnover

1.4

1.5

2.5

2.6

2.2

PPE turnover

8.0

7.3

9.6

9.8

10.1

50.4

78.7

141.7

133.0

68.6

Days’ receivables

7.2

4.6

2.6

2.7

5.3

Inventories turnover

1.8

1.8

2.8

2.8

9.3

201.7

199.2

132.4

131.5

39.3

2.8

3.1

4.1

4.6

7.3

129.9

116.3

88.9

79.0

49.8

79.1

87.5

46.1

55.3

–5.2

Accounts receivables turnover

Days’ inventories Accounts payables turnover Days’ payable Cash conversion cycle (in days)

Super Retail Group’s non-current asset utilisation declined very slightly in 2018 with its PPE turnover moving from 9.8 to 9.6. Both Kathmandu and Super Retail Group have lower PPE turnover than their wider industry peers in the Specialty Retailer industry group, which has an average PPE turnover of 14.4. Super Retail Group also took longer to pay its suppliers than Kathmandu. The differences in the companies’ working capital becomes more visible when considering the average number of days it takes each company to collect cash from its customers from the moment it has paid its suppliers. This measure, which is also referred to as the cash conversion cycle, can be shown as:

Cash conversion cycle = days’ inventories + days’ receivable – days’ payable In 2018 Kathmandu had a cash conversion cycle of 79 days, while Super Retail Group had a cash conversion cycle of 46 days.

Evaluating financial management: Financial leverage Financial leverage enables a firm to have an asset base larger than its equity. The firm can augment its equity through borrowing and creating other liabilities like accounts payable, accrued liabilities and deferred taxes. Financial leverage increases a firm’s ROE so long as the cost of the liabilities is less than the return from investing these funds. In this respect it is important to distinguish between interest-bearing liabilities such as notes payable, other forms of short-term debt and long-term debt that carry an explicit interest charge, and other forms of liabilities. Some of these other forms of liability, such as accounts payable or deferred taxes, do not carry any interest charge at all. Other liabilities, such as capital lease obligations or salary-related obligations, carry an implicit interest charge. Finally, some firms carry large cash balances or investments in marketable securities. These balances reduce a firm’s net debt because conceptually the firm can pay down its debt using its cash and short-term investments. While financial leverage can potentially benefit a firm’s shareholders, it can also increase their risk. Unlike equity, liabilities have predefined payment terms, and the firm faces risk of financial distress if it fails to meet these commitments. There are a number of ratios to evaluate the degree of risk arising from a firm’s financial leverage.

Current liabilities and short-term liquidity The following ratios are useful in evaluating the risk related to a firm’s current liabilities: Current ratio = Quick ratio =

113

Current assets Current liabilities Cash + Short-term investment + Accounts receivable Current liabilities

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Cash ratio = Operating cash flow ratio =

Cash + Marketable securities Current liabilities Cash flow from operations Average current liabilities

KATHMANDU CASE

All the above ratios attempt to measure the firm’s ability to repay its current liabilities. The first three compare a firm’s current liabilities with the short-term assets the firm can use to repay those liabilities. The fourth ratio focuses on the ability of the firm’s operations to generate the resources needed to repay its current liabilities. Since both current assets and current liabilities have comparable duration, the current ratio is a key index of a firm’s short-term liquidity. Analysts view a current ratio of more than one to be an indication that the firm can cover its current liabilities from the cash realised from its current assets. However, such a rule of thumb does not take into account the timing of the cash payments and receipts. For example, the firm can face a short-term liquidity problem even with a current ratio exceeding one when some of its current assets, such as inventory, are not easy to liquidate. The quick ratio and cash ratio capture the firm’s ability to cover its current liabilities from liquid assets. The quick ratio assumes that the firm’s accounts receivable are liquid. This is true in industries where the credit-worthiness of the customers is beyond dispute, or when receivables can be collected quickly. When these conditions do not prevail, cash ratio, which considers only cash and marketable securities, is a better indication of a firm’s ability to cover its current liabilities in an emergency. Operating cash flow is another measure of the firm’s ability to cover its current liabilities from cash generated from operations of the firm.

LIQUIDITY RATIOS The liquidity ratios for Kathmandu and Super Retail Group and industry peers are shown in Figure 5.9. Both firms had current ratios well in excess of one, but below the industry average of 2.0. The quick ratio for both firms was significantly below the industry average, especially for Super Retail Group. This indicates that inventory comprises a large percentage of current assets for these firms. Kathmandu’s liquidity ratios improved over 2018, with the exception of the operating cash flow ratio, while Super Retail Group experienced a decline in each of the liquidity ratios shown in Figure 5.9. Analysts would pay attention to the trend in liquidity over time.

FIGURE 5.9 Liquidity ratios

Kathmandu

Super Retail Group

Other peers

Ratio

2018

2017

2018

2017

2018

Current ratio

1.53

1.47

1.38

1.68

2.07

Quick ratio

0.42

0.15

0.09

0.12

1.22

Cash ratio

0.08

0.05

0.04

0.06

0.47

Operating cash flow ratio

0.72

1.00

0.72

0.73

0.18

Debt and long-term solvency A firm’s financial leverage is also influenced by its debt financing policy. There are several potential benefits from debt financing. First, debt is typically cheaper than equity because the firm promises predefined payment terms to debt holders. Second, in most countries, interest on debt financing is tax deductible whereas dividends to shareholders are not. Third, debt financing can impose discipline on the firm’s management and motivate it to reduce wasteful expenditures. Fourth, Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 5 Financial analysis

it is often easier for management to communicate their proprietary information on the firm’s strategies and prospects to private lenders than to public capital markets. Such communication can potentially reduce a firm’s cost of capital. For all these reasons, it is optimal for firms to use at least some debt in their capital structure. Too much reliance on debt financing, however, is potentially costly to the firm’s shareholders. The firm will face financial distress if it defaults on the interest and principal payments. Debt holders also impose covenants on the firm, restricting the firm’s operating, investment and financing decisions. The optimal capital structure for a firm is determined primarily by its business risk. A firm’s cash flows are highly predictable when there is little competition or there is little threat of technological changes. Such firms have low business risk and hence they can rely heavily on debt financing. In contrast, if a firm’s operating cash flows are highly volatile and its capital expenditure needs are unpredictable, it may have to rely primarily on equity financing. Managers’ attitudes towards risk and financial flexibility also often determine a firm’s debt policies. There are a number of ratios that help the analyst in this area. To evaluate the mix of debt and equity in a firm’s capital structure, the following ratios are useful: Liabilities-to-equity ratio = Debt-to-equity ratio = Net-debt-to-equity ratio =

Total liabilities Shareholders’ equity

Short-term debt + Long-term debt Shareholders’ equity

Short-term debt + Long-term debt − Cash and marketable securities Shareholders’ equity

Short-term debt + Long-term debt Debt-to-capital ratio = Short-term debt + Long-term debt + Shareholders’ equity Net-debt-to-net-capital ratio = Interest bearing liabilities − Cash and marketable securities Interest-bearing liabilities − Cash and marketable securities + Shareholders’ equity The first ratio restates one of the three primary ratios underlying ROE, the assets-to-equity ratio (it is the assets-to-equity ratio minus 1). The second ratio provides an indication of how many dollars of debt financing the firm is using for each dollar invested by its shareholders. The third ratio uses net debt, which is total debt minus cash and marketable securities, as the measure of a firm’s borrowings. The fourth and fifth ratios measure debt as a proportion of total capital. In calculating all the above ratios, it is important to include all interest-bearing obligations, whether the interest charge is explicit or implicit. Recall that examples of line items that carry an implicit interest charge include capital lease obligations and pension obligations. Analysts sometimes include any potential off-balance-sheet obligations that a firm may have, such as non-cancellable operating leases, in the definition of a firm’s debt. The ease with which a firm can meet its interest payments is an indication of the degree of risk associated with its debt policy. The interest coverage ratio provides a measure of this construct: Interest coverage (earning basis) =

Net income + Interest expense + Tax expense Interest expense

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Interest coverage (cash flow basis) =

Cash flow from operations + Interest expense + Tax paid Interest expense

One can also calculate coverage ratios that measure a firm’s ability to repay all fixed financial obligations, such as interest payments, lease payments and debt repayments, by appropriately redefining the numerator and denominator in the above ratios. In doing so it is important to remember that, while some fixed charge payments (such as interest and lease rentals) are paid with pre-tax dollars, others (such as debt repayments) are made with after-tax dollars. The earnings-based coverage ratio indicates the dollars of earnings available for each dollar of required interest payment; and the cash-flow-based coverage ratio indicates the dollars of cash generated by operations for each dollar of required interest payment. In both these ratios, the denominator is the interest expense. In the numerator, we add tax back because tax is computed only after interest expense is deducted. A coverage ratio of one implies that the firm is barely covering its interest expense through its operating activities, which is a very risky situation. The larger the coverage ratio, the greater the cushion the firm has to meet interest obligations.

KEY ANALYSIS QUESTIONS Some of the business questions to ask when the analyst is examining a firm’s debt policies are: Does the firm have enough debt? Is it exploiting the potential benefits of debt–interest tax shields, management discipline and easier communication? Does the firm have too much debt given its business risk? What type of debt covenant restrictions does the firm face? Is it bearing the costs of too much debt, risking potential financial distress and reduced business flexibility? What is the firm doing with the borrowed funds? Investing in working capital? Investing in fixed assets? Are these investments profitable? Is the company borrowing money to pay dividends? If so, what is their justification?

We show debt and coverage ratios for Kathmandu and Super Retail Group in Figure 5.10. Kathmandu has a much lower rate of borrowing than Super Retail Group, particularly at the end of the 2017 financial year. Kathmandu notes in its 2018 annual report that the level of debt at the end of July each year (which is the end of the financial year) is typically at the low point of the debt cycle. As a result of its substantially lower debt levels, Kathmandu had much higher interest coverage ratios than Super Retail Group. FIGURE 5.10 Debt and coverage ratios

Kathmandu

Super Retail Group

Other peers

Ratio

2018

2017

2018

2017

2018

Liabilities to equity

0.46

0.34

1.21

1.07

1.07

Debt to equity

0.15

0.03

0.55

0.53

0.47

Debt to capital

0.13

0.03

0.35

0.35

0.20

Interest coverage (earnings-based)

67.46

27.70

12.29

12.12

50.46

Interest coverage (cash-flow-based)

46.19

38.86

19.44

16.01

58.75

Note: liquidity and solvency ratios use closing balance sheet data.

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CHAPTER 5 Financial analysis

117

Ratios of disaggregated and non-financial data

METRICS In its investor presentations of its half-yearly and annual results, Kathmandu provides information on metrics that investors are likely to consider important when evaluating Kathmandu’s performance. Figure 5.11 shows the 2018 full-year results, which highlights both same store sales growth and provides information on in-store versus online growth rates.

FIGURE 5.11 Kathmandu’s 2018 full-year results presentation slide 16 Australia

New Zealand

6.9% 7.5%

6.9%

3.6%

2.6%

–0.1% –1.1% –0.1%

–2.7% GROUP - Actual Rates

GROUP - Constant Rates

6.4% 4.4%

5.5%

4.2%

–1.4%

FY14–FY17

4.4%

1.6%

0.4%

–2.7%

–2.4%

–1.9% FY18

Source: Adapted from Kathmandu’s 2018 full-year results, slide 16

Putting it all together: Assessing sustainable growth rate Analysts often use the concept of sustainable growth as a way to evaluate a firm’s ratios in a comprehensive manner. A firm’s sustainable growth rate is defined as: Sustainable growth rate = ROE × (1 – dividend payout ratio)

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KATHMANDU CASE

So far, we have discussed how to compute ratios using information in the financial statements. Analysts often probe the above ratios further by using disaggregated financial and physical data. This could include information in the performance overview provided by management in the annual report, or in the additional disclosures in the notes to the financial statements. For example, for a multi-business company, one could analyse the information by individual business segments. Such an analysis can reveal potential differences in the performance of each business unit, allowing the analyst to pinpoint areas where a company’s strategy is working and where it is not. It is also possible to probe financial ratios further by computing ratios of physical data pertaining to a company’s operations. The appropriate physical data to look at vary from industry to industry. As an example, in retailing, one could compute productivity statistics such as sales per store, sales per square metre, customer transactions per store and amount of sale per customer transactions. In the hotel industry, room occupancy rates provide important information, while in the mobile telephone industry, acquisition cost per new subscriber and subscriber retention rate are important. These disaggregated ratios are particularly useful for young firms and industries such as new technology-based firms, where accounting data may not fully capture the business economics because of conservative accounting rules.

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We have already discussed the analysis of ROE in the previous four sections. The dividend payout ratio is defined as: Dividend payout ratio =

Cash dividends paid Net income

A firm’s dividend payout ratio is a measure of its dividend policy. Firms pay dividends for several reasons. Dividends are a way for the firm to return any cash generated in excess of its operating and investment needs to its shareholders. When there are information asymmetries between a firm’s managers and its shareholders, dividend payments can serve as a signal to shareholders about managers’ expectations of the firm’s future prospects. Firms may also pay dividends to attract a certain type of shareholder base. Sustainable growth rate is the rate at which a firm can grow while keeping its profitability and financial policies unchanged. A firm’s return on equity and its dividend payout policy determine the pool of funds available for growth. Of course, the firm can grow at a rate different from its sustainable growth rate if its profitability, payout policy or financial leverage change. Therefore, the sustainable growth rate provides a benchmark against which a firm’s growth plans can be evaluated. Figure 5.12 shows how a firm’s sustainable growth rate can be linked to many of the ratios discussed in this chapter. These links allow an analyst to examine the drivers of a firm’s current sustainable growth rate. If the firm intends to grow at a higher rate than its sustainable growth rate, one could assess which of the ratios are likely to change in the process. SUSTAINABLE GROWTH RATE Dividend payout ROE

Financial

Operating ROA

leverage effect

Net operating

Operating asset

profit margin

turnover

Gross profit margin SG&A/Sales R&D/Sales Effective tax rate on operating profits

Spread

Operating working capital turnover

Net effective interest rate

Operating long-term asset turnover

Interest income/Cash and marketable securities

Receivables turnover Inventory turnover Payables turnover

Interest expense/Total debt

Net financial leverage

Debt/Equity Cash and marketable securities/Equity Interest coverage • earnings basis • cash basis

FIGURE 5.12 Sustainable growth rate framework for financial ratio analysis

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CHAPTER 5 Financial analysis

KEY ANALYSIS QUESTIONS Analysis of sustainable growth can lead an analyst to ask the following types of business questions: How quickly can the firm grow its business by keeping its profitability and financial policies unchanged? If it intends growing faster, where is the growth rate going to come from? Is management expecting profitability to increase? Or asset productivity to improve? Are these expectations realistic? Is the firm planning for these changes? Is the firm planning to increase its financial leverage or cut dividends? What is the likely impact of these financial policy changes?

Figure 5.13 shows the sustainable growth rate and its components for Kathmandu and Super Retail Group. In both 2017 and 2018, Kathmandu had a lower ROE but also a lower dividend payout ratio than Super Retail Group. Together this led to a higher sustainable growth rate for Kathmandu. The sustainable growth rate in 2018 was higher than it had been during the previous five years. This has been driven by the increase in ROE since 2015. The dividend payout ratio has varied during this time. The dividend policy for Kathmandu seems to be driven more on a per-share basis rather than paying out a constant proportion of profits. For 2015 to 2018, Kathmandu paid dividends of $0.08, $0.11, $0.13 and $0.15 per share, respectively. The increasing sustainable growth rate suggests that Kathmandu could increase its dividend payout ratio while maintaining a plausible sustainable growth rate. FIGURE 5.13 Sustainable growth rate

Kathmandu

Super Retail Group

Other peers

Ratio

2018

2017

2018

2017

2018

ROE

13.5%

11.9%

16.4%

13.5%

16.5%

Dividend payout ratio

53.8%

63.6%

72.0%

84.4%

76.8%*

6.2%

4.3%

4.6%

2.1%

3.8%

Sustainable growth rate *Excludes firms with losses

Super Retail Group also showed an increase in its sustainable growth rate, which was a function of both an increase in ROE and a decrease in dividend payout ratio. Both Kathmandu and Super Retail Group showed higher sustainable growth rates than their industry peers in 2018. Australian firms have, on average, higher dividend payout ratios than comparable overseas firms. This is due in part to the taxation treatment of dividends in Australia, which is one of the only OECD countries with a full dividend imputation system.11

LO3

Cash flow analysis

The ratio analysis discussion in the previous section focused on analysing a firm’s income statement (net profit margin analysis) or its balance sheet (asset turnover and financial leverage). The analyst can gain further insights into the firm’s operating, investing and financing policies by examining its cash flows. Cash flow analysis also provides an indication of the quality of the Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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information in the firm’s income statement and balance sheet. As before, we will illustrate the concepts discussed in this section using Kathmandu’s and Super Retail Group’s cash flows.

Cash flow statements Under IAS 7 ‘Statement of cash flows’, companies are required to include a statement of cash flows in their financial statements. In the reported cash flow statement, firms classify their cash flows into three categories: cash flow from operations, cash flow related to investments and cash flow related to financing activities. Cash flow from operations is the cash generated by the firm from the sale of goods and services after paying for the cost of inputs and operations. Cash flow related to investment activities shows the cash paid for capital expenditures, inter-corporate investments, acquisitions and cash received from the sales of long-term assets. Cash flow related to financing activities shows the cash raised from (or paid to) the firm’s shareholders and debt holders. Firms can use two cash flow statement formats: the direct format and the indirect format. The key difference between the two formats is the way they report cash flow from operating activities. In the direct cash flow format, operating cash receipts and disbursements are reported directly. In the indirect format, firms derive their operating cash flows by making adjustments to net income. Statements of cash flow have been required by Australian and New Zealand companies since 1993. Between 1993 and 2007, companies in these jurisdictions were required under AASB1026, AASB107 and FRS10 to report cash flow from operating activities using the direct method, with reconciliation to operating profit. This continues to be the case for New Zealand companies reporting under IFRS since 2005. However, since 2007 Australian companies have had the choice of reporting cash flow from operating activities using either the direct or the indirect method, a choice that is consistent with IAS and with reporting practices in the UK and the US. Recall from Chapter 3 that net income differs from operating cash flows because revenues and expenses are measured on an accrual basis. There are two types of accruals embedded in net income. First, there are current accruals like credit sales and unpaid expenses. Current accruals result in changes in a firm’s current assets (such as accounts receivable, inventory and prepaid expenses) and current liabilities (such as accounts payable and accrued liabilities). The second type of accruals included in the income statement is non-current accruals such as depreciation, deferred taxes and equity income from unconsolidated subsidiaries. To derive cash flow from operations from net income, adjustments have to be made for both these types of accruals. In addition, adjustments must be made for non-operating gains included in net income, such as profits from asset sales.

Analysing cash flow information Cash flow analysis can be used to address a variety of questions regarding the dynamics of a firm’s cash flow: How strong is the firm’s internal cash flow generation? Is the cash flow from operations positive or negative? If it is negative, why? Is it because the firm is growing? Is it because its operations are unprofitable? Or is it having difficulty managing its working capital properly? Does the firm have the ability to meet its short-term financial obligations, such as interest payments, from its operating cash flow? Can it continue to meet these obligations without reducing its operating flexibility? Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 5 Financial analysis

How much cash did the firm invest in growth? Are these investments consistent with its business strategy? Did the firm use internal cash flow to finance growth, or did it rely on external financing? Did the company pay dividends from internal free cash flow, or did it have to rely on external financing? If the company had to fund its dividends from external sources, is the company’s dividend policy sustainable? What type of external financing does the firm rely on? Equity, short-term debt or long-term debt? Is the financing consistent with the firm’s overall business risk? Does the firm have excess cash flow after making capital investments? Is it a long-term trend? What plans does management have to deploy the free cash flow? While the information in reported cash flow statements can be used to answer the above questions directly in the case of some firms, it may not be easy to do so always for a number of reasons. First, even though IAS 7 provides broad guidelines on the format of a cash flow statement, there is still significant variation across firms in the way cash flow data are disclosed. Therefore, to facilitate a systematic analysis and comparison across firms, analysts often recast the information in the cash flow statement using their own cash flow model. Second, firms include interest expense and interest income in computing their cash flow from operating activities. However, these two items are not strictly related to a firm’s operations. Interest expense is a function of financial leverage, and interest income is derived from financial assets rather than operating assets. Therefore, it is useful to restate the cash flow statement to take this into account. Analysts use a number of different approaches to restate the cash flow data. One such model is shown in Figure 5.14. This presents cash flow from operations in two stages. The first step computes cash flow from operations before operating working capital investments. In computing this cash flow, the model excludes interest expense and interest income. To compute this number starting with a firm’s net income, an analyst adds back three types of items: 1 after-tax net interest expense, because this is a financing item that will be considered later 2 non-operating gains or losses typically arising out of asset disposals or asset write-offs, because these items are investment-related and will be considered later 3 long-term operating accruals such as depreciation and deferred taxes, because these are noncash operating charges. Several factors affect a firm’s ability to generate positive cash flow from operations. Healthy firms that are in a steady state should generate more cash from their customers than they spend on operating expenses. In contrast, growing firms – especially those investing cash in research and development, advertising and marketing or building a firm to sustain future growth – may experience negative operating cash flow. A firm’s working capital management also affects whether it generates a positive cash flow from operations. Cash flow from operations before working capital can also be calculated, to establish the extent to which the firm relied on or added to working capital in its operations. Firms in the growing stage typically use cash flow for operating working capital items such as funding customers (accounts receivable) and purchasing inventories (net of accounts payable financing from suppliers). Net investments in working capital are a function of firms’ credit policies (accounts receivable), payment policies (payables, prepaid expenses and accrued liabilities) and expected growth in sales (inventories). Thus, in interpreting firms’ cash flow from operations after working capital, it is important to keep in mind their growth strategy, industry characteristics and credit policies.

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

The cash flow analysis model next focuses on cash flows related to long-term investments. These investments take the form of capital expenditures, inter-corporate investments, and mergers and acquisitions. Any positive operating cash flow after making operating working capital investments allows the firm to pursue long-term growth opportunities. If the firm’s operating cash flows after working capital investments are not sufficient to finance its long-term investments, it has to rely on external financing to fund its growth. Such firms have less flexibility to pursue long-term investments than those that can fund their growth internally. There are both costs and benefits from being able to fund growth internally. The cost is that managers can use the internally generated free cash flow to fund unprofitable investments. Such wasteful capital expenditures are less likely if managers are forced to rely on external capital suppliers. However, reliance on external capital markets may make it difficult for managers to undertake long-term risky investments if it is not easy to communicate the benefits from such investments to the capital markets. Any excess cash flow after these long-term investments is free cash flow that is available for both debt holders and equity holders. Cash transactions involving debt holders include interest payments and principal payments as well as new borrowing. Cash flow after payments to debt holders is free cash flow available to equity holders. Cash transactions involving shareholders include dividend payments and share repurchases, as well as issues of new equity. Firms with negative free cash flow have to borrow additional funds to meet their interest and debt repayment obligations, or cut some of their investments in working capital or long-term investments or issue additional equity. Managers of firms in this situation are often reluctant to cut dividends for fear that it will be viewed negatively by investors. However, it must be recognised that if firms pay dividends despite negative free cash flow to equity holders, they are borrowing money to pay dividends. While this may be feasible in the short term, it is not prudent for a firm to pay dividends to equity holders unless it has a positive free cash flow on a sustained basis. In contrast, firms with large positive free cash flow to debt and equity run the risk of wasting that money on unproductive investments to pursue growth for its own sake. An analyst, therefore, should carefully examine the investment plans of such firms. The model in Figure 5.14 suggests that the analyst should focus on a number of cash flow measures: 1 cash flow from operations before investment in working capital and interest payments, to examine whether or not the firm is able to generate a cash surplus from its operations 2 cash flow from operations after investment in working capital, to assess how the firm’s working capital is being managed and whether or not it has the flexibility to invest in long-term assets for future growth 3 free cash flow available to debt and equity holders, to assess a firm’s ability to meet its interest and principal payments 4 free cash flow available to equity holders, to assess the firm’s financial ability to sustain its dividend policy and to identify potential agency problems from excess free cash flow. These measures have to be evaluated in the context of the firm’s business, its growth strategy and its financial policies. Further, changes in these measures from year to year provide valuable information on the stability of the cash flow dynamics of the firm.

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CHAPTER 5 Financial analysis

123

Finally, as we will discuss in Chapter 7, free cash flow available to debt and equity and free cash flow available to equity are critical inputs into the cash-flow-based valuation of firms’ assets and equity, respectively.

KEY ANALYSIS QUESTIONS

ANALYSIS OF KATHMANDU’S CASH FLOW Kathmandu and Super Retail Group reported their cash flows using the direct method for the cash flow statement. Figure 5.14 recasts these statements using the approach discussed above so that we can analyse the two companies’ cash flow dynamics. Cash flow analysis presented in Figure 5.14 shows Kathmandu had operating cash inflow before working capital investments of $83.3 million in 2018, an increase on $70.7 million in 2017. In 2018, Kathmandu invested more heavily in its operating working capital than in 2017. This led to higher operating cash inflows before investments in longterm assets of $83.3 million in 2018 compared with $70.7 million in 2017. Both Kathmandu and Super Retail Group invested heavily in operating long-term assets in 2018. Kathmandu paid $82.4 million to acquire Oboz, a US-based outdoor footwear brand, as well as investing $15 million in PPE. The payment for this acquisition meant that free cash flow to debt and equity in 2018 was negative, in contrast to 2017.

Kathmandu borrowed to help fund the acquisition. After taking into account the impact of the borrowing and loan repayments, there was still a negative free cash flow to equity holders in 2018. In addition to borrowing, Kathmandu raised equity capital to help fund the acquisition. Despite the negative free cash flow to equity, Kathmandu still paid dividends in 2018. The firm’s consistently positive operating cash flows suggests that this capital raising and dividend payments had not put them into a position of financial distress. The debt ratios in Figure 5.10 show that Kathmandu still has relatively low levels of gearing at the end of the 2018 financial year. One of the ‘red flags’ about earnings quality that was discussed in Chapter 3 was the relation between earnings and operating cash flows. In both 2017 and 2018, Kathmandu reported operating cash flows that exceeded not only net profit after tax, but also EBIT. This indicates that Kathmandu’s profits are not being driven by increasing higher relative levels of accruals.

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KATHMANDU CASE

The cash flow model in Figure 5.14 can also be used to assess a firm’s earnings quality, as discussed in Chapter 3. The reconciliation of a firm’s net income with its cash flow from operations facilitates this exercise. Following are some of the questions an analyst can probe in this respect: Are there significant differences between a firm’s net income and its operating cash flow? Is it possible to clearly identify the sources of this difference? Which accounting policies contribute to this difference? Are there any one-time events contributing to this difference? Is the relationship between cash flow and net income changing over time? Why? Is it because of changes in business conditions or because of changes in the firm’s accounting policies and estimates? What is the time lag between the recognition of revenues and expenses and the receipt and disbursement of cash flows? What types of uncertainties need to be resolved in between? Are the changes in receivables, inventories and payables normal? If not, is there adequate explanation for the changes?

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

FIGURE 5.14 Cash flow analysis

Kathmandu Line item (in A$ or NZ$000)

2018

2017

2018

2017

75 601

67 273

308 400

234 500

226

30

19 000

19 200

75 375

67 243

289 400

215 300

728

1405

12 718

12 014

76 103

68 648

302 118

227 314

–121 620

–13 275

–241 200

–101 200

–45 517

55 373

60 918

126 114

–728

–1405

–12 718

–12 014

Net debt (repayment) or issuance

28 908

–33 203

39 000

–25 000

Free cash flow available to equity

Cash flow from operations Net (investments in) or liquidation of operating working capital Operating cash flow before working capital After-tax net interest expense (income) Operating cash flow before investment in long-term assets Net (investments in) or liquidation of operating long-term assets Free cash flow available to debt and equity After-tax net interest expense (income)

–17 337

20 765

87 200

89 100

Dividend payments

27 208

24 179

91 700

84 800

Net stock (repurchase) or issuance

48 702

0

0

0

226

30

–100

0

4 383

–3 384

–4 600

4 300

Effect of foreign currency Net increase (decrease) in cash balance

INDUSTRY INSIGHT

Super Retail Group

A PRACTITIONER ADVISES Australian financial analyst on the future of financial analysis:

More and more, technology will replace the hardcore analytics. As things like artificial intelligence and machine learning grows, technology will be able to put numbers into a spreadsheet, and to perform other quantitative and qualitative analysis. Analytics is going to become more and more technology related, and so it’s going to be a job for a data scientist who can build you your data model, rather than an analyst. The same will be true for a model of the economy, or a model of a business or industry. Technology will replace a lot of that. But the application of those frameworks, the application of those models, the application of those technologies, will only be as useful as the person who can look at that universe and put the right analytical framework over the top, look at the results and then explain them to somebody. So, there will always be a place for a very

good analyst, but the quality of that analyst won’t be in the nitty-gritty work that they do, it’ll be how they interpret the results and then go ‘this is what you do with it’. These days, most research houses and most banks don’t get their people to model specifically; they’ve got tools that let you put in a couple of variables and it does all the modelling for you. And so you’re not being paid anymore for the financial model you’ve built. What you’re being paid for is using that financial model to understand an issue, to give your opinion on something, and then to say what you do with that. It’s the bit that, to be frank, AI or machine learning won’t ever be able to replace. Because what humans can do, imperfectly but still better than a computer, is understand that the world is not the same dayto-day and is always changing, and that there is an irrationality of humanity that doesn’t match the rationality of the frameworks. I can bring up Wall Street or Yahoo Finance or Google Finance on my phone to get a financial model. I

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CHAPTER 5 Financial analysis

can bring up a newspaper article and there will be some framework underlying it that’s been used to analyse an idea. But you don’t pick up the newspaper for the news story–you pick it up for the opinion piece. In the same way, for financial analysis, you don’t pick up a research note that tells you what the results say–you pick up one that tells you ‘There’s a recommendation change because I think the world has changed’. Maybe the analyst looked at an issue–how many cars have been

125

sold, or what the weather was like–linked that to the real world, and then worked out that that you need to make a decision because of it. Reflective activity: What if technology does replace the role of the financial analyst? What other roles (that use these skills) would you argue are not likely to be replaced by a robot? Or, in a future dystopia, what is wrong with all financial analysis being automated?

SUMMARY This chapter presents two key tools of financial analysis: ratio analysis and cash flow analysis. Both these tools allow the analyst to examine a firm’s performance and its financial condition, given its strategy and goals. Ratio analysis involves assessing the firm’s income statement and balance sheet data. Cash flow analysis relies on the firm’s cash flow statement. We applied these tools to Kathmandu and Super Retail Group in order to compare the two firms’ performances. The starting point for ratio analysis is the firm’s ROE. The next step is to evaluate the three drivers of ROE, which are net profit margin, asset turnover and financial leverage. Net profit margin reflects a firm’s operating management; asset turnover reflects its investment management; and financial leverage reflects its financing policies. Each of these areas can be further probed by examining a number of ratios. For example, common-sized income statement analysis allows a detailed examination of a firm’s net margins. Similarly, turnover of key working capital accounts, like accounts receivable, inventory and accounts payable, and turnover of the firm’s fixed assets, allow further examination of a firm’s asset utilisation. Finally, shortterm liquidity ratios, debt policy ratios and coverage ratios provide a means of examining a firm’s financial leverage. A firm’s sustainable growth rate – the rate at which it can grow without altering its operating, investment and financing policies – is determined by its ROE and its

dividend policy. The concept of sustainable growth provides a way to integrate the different elements of ratio analysis and to evaluate whether or not a firm’s growth strategy is sustainable. If a firm’s plans call for growth at a rate above its current sustainable rate, then the analyst can examine which of the firm’s ratios is likely to change in the future. Cash flow analysis supplements ratio analysis in examining a firm’s operating activities, investment management and financial risks. Firms are required to report a cash flow statement summarising their operating, investment and financing cash flows. However, analysts often use a standard format to recast cash flow data because the way firms report cash flow data can vary widely. We discussed one such cash flow model. This model allows the analyst to assess whether a firm’s operations generate cash flow before investments in operating working capital, and how much cash is being invested in the firm’s working capital. It also enables the analyst to calculate the firm’s free cash flow after making long-term investments, which is an indication of the firm’s ability to meet its debt and dividend payments. Finally, the cash flow analysis shows how the firm is financing itself, and whether its financing patterns are too risky. The insights gained from analysing a firm’s financial ratios and its cash flows are valuable in forecasting the firm’s future prospects.

CHECKING AND APPLYING YOUR LEARNING 1 Which of the following types of firms do you expect to have particularly high or low asset turnover? Explain why, providing an example for each instance.  LO2

a b c d

A mining company An airline An electricity supplier A software sales and service company

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

2 Which of the following types of firms do you expect to have high or low sales margins? Why? a A mining company b An airline c An electricity supplier  LO2 d A software sales and service company 3 Which ratios have benchmarks or expected levels that apply across all industries and countries? Which ratios have benchmarks or expected levels that are different between industries? Which ratios are best benchmarked across historic performance of the individual firm?  LO2 4 Katya, an accounting undergraduate student, asks you to explain the difference between EBIT, EBITDA and NOPAT performance ratios. Illustrate two scenarios, one when the ratios differ very little, and one when the ratios differ significantly. What is the key point for Katya to understand?  LO1 5 What are the reasons a firm may have lower cash from operations than working capital from operations? What are the possible interpretations of these reasons?  LO3 6 ABC Company recognises revenue at the point of shipment. Management decides to increase sales for the current quarter by filling all customer orders. Explain what impact this decision will have on: a days receivable for the current quarter b days receivable for the next quarter c sales growth for the current quarter d sales growth for the next quarter e return on sales for the current quarter f return on sales for the next quarter.  LO2 7 What ratios would you use to evaluate operating leverage for a firm? How would you decide if leverage was used successfully or not?  LO2 8 What ratios would you use to evaluate working capital management for a firm? How would you decide if working capital was well managed or not?  LO2 9 In 2019, Woolworths Group had a return on equity of 25.6%, whereas its supermarket industry competitor Coles Group Ltd earned 43.4%. use the decomposed ROE framework to provide possible reasons for this difference based on Figure 5.15.  LO2

Return on sales

Coles

2019

2018

2019

2018

Asset turnover

2.56

2.45

3.45

3.12*

Leverage

2.17

2.24

3.38

3.86*

* not calculated for average total assets and average equity due to the unavailability of 2017 comparison figures

10 Joe Investor asserts: ‘A company cannot grow faster than its sustainable growth rate.’ True or false? Explain why.  LO2 11 In the year just ended, Epping Eyewear has sales of $5 000 000 and incurred a cost of goods sold equal to $4 500 000. The firm’s operating expenses were $130 000 and its increase in retained earnings was $68 000 for the year. There are currently 100 000 ordinary shares outstanding and the firm pays a $1.63 dividend per share. The firm has $1 000 000 in interestbearing debt on which it pays 4% interest.  LO2 a Assuming that the firm’s profit is taxed at 30%, construct the firm’s income statement. b Calculate the firm’s operating profit margin and net profit margin. c Compute the interest coverage ratio. What does this ratio tell you about Epping’s ability to pay its interest expense? 12 The balance sheet and income statement for Cavanagh Enterprises are shown in Figures 5.16 and 5.17.  LO1 FIGURE 5.16 Balance sheet for Cavanagh Enterprises

202X Balance sheet

$ 000

Current assets C  ash and marketable securities Accounts receivable Inventories

500 6 000 9 500

Total current assets

16 000

Net property plant and equipment

17 000

Total assets

33 000

Current liabilities

FIGURE 5.15 Woolworths and Coles ROE, 2019

Woolworths

Woolworths

Coles

Accounts payable

7 200

Short-term debt

6 800

2019

2018

2019

2018

Total current liabilities

14 000

4.6%

3.1%

3.7%

4.0%

Non-current liabilities

7 000

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CHAPTER 5 Financial analysis

202X Balance sheet

$ 000

Total liabilities

21 000

Total equity

12 000

Total liabilities and equity

33 000

202X Revenue Cost of goods sold Gross profit

$ 000 30 000 (20 000) 10 000

(2 697)

Interest paid

(1 899)

Interest received Net cash from operating activities

P  roceeds from the sale of plant, rental machines and other property Payments for software Purchases of marketable debt securities Proceeds from marketable debt securities Net cash used in investing activities

Interest expense

(900)

Cash flow from financing activities

Tax

(330)

Net profit

770

a State all balance sheet items as a percentage of total assets (this is known as a common size balance sheet). b State all income statement items as a percentage of revenue (this is known as a common size income statement). c Use the common size financial statements to answer the following questions: i What proportion of Cavanagh’s assets has the firm financed using short-term debt? What proportion uses long-term debt? ii What percentage of Cavanagh’s revenue does the firm have left after paying all of its expenses, including tax? iii Describe the relative importance of Cavanagh’s major expense categories: cost of goods sold, operating expenses and interest expense. 13 Figure 5.18 shows the Doobae company’s statement of cash flows for the most recent year.  LO3 FIGURE 5.18 Summary of Doobae’s statement of cash flows for the most recent year

Cash flow from operating activities Receipts from customers Payments to suppliers and employees Dividends received

$ million 502 226 (490 799) 80

979 7 890

Cash flow from investing activities

(8 000)

Operating expenses

$ million

Income tax paid

P  ayments for plant, rental machines and other property

FIGURE 5.17 Income statement for Cavanagh Enterprises

Income statement

Cash flow from operating activities

127

(5 616) 1 617 (565) (1 500) 1 600 (4 464)

Proceeds from borrowing

1 205

Proceeds from issues of shares

1 899

Repayment of borrowings

(2 500)

Dividends paid

(3 050)

Net cash used in financing activities Net increase (decrease) in cash

(2 446) 980

a Calculate the operating cash flow after adjusting after-tax net interest. The statutory tax rate is 30%. b Calculate the free cash flow available for payments to debt and equity holders. c Calculate the free cash flow available to equity holders. 14 Using one or more of the techniques described in this chapter, identify a suitable comparison company for:   LO1

a Transurban Group b A2 Milk Company c Michael Hill International d Wesfarmers e Pacific Smiles Group. 15 Case: Bert’s Bikes and Toby’s Tyres  LO2 Bert’s Bikes and Toby’s Tyres are two small retail outlets operating in the Adelaide suburb of Baylands. Both were set up as small listed companies by two brothers 20 years ago, and have operated more or less successfully since. Recently, the brothers have both realised that the markets for bicycles and tyres in their area have changed, for better and for worse.

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The market for bicycles has been affected by technological changes in bike design and renewed interest from those who follow international bike races such as the Tour de France and Giro Italia. However, many sales are made online, and Bert wonders if the ability of a small suburban shop to keep up with trends and reach its potential market has declined. The market for tyres has similarly been impacted by technology, and is also facing increased competition as tyres are increasingly available from discount outlets. A small suburban shop faces the challenge of keeping sufficient stock across the full range, without incurring disproportionate storage costs. Given growing environmental and climate concerns, Toby wonders if specialising in motor vehicle accessories has any longterm future. Evaluate the performance of the two companies using the information provided in Figures 5.19, 5.20 and 5.21. Note that all sales are made electronically, and both businesses expect accounts to be settled via the relevant banks within 45 days. The directors of Bert’s Bikes intend to recommend a dividend of $87 000, and the directors of Toby’s Tyres intend to recommend a dividend of $241 500. FIGURE 5.19 Bert’s Bikes and Toby’s Tyres basic comparison

Bert’s Bikes

Toby’s Tyres

$1

$2

Par value of shares Share price EPS

$2.23

$4.50

29 cents

98.6 cents

Toby’s Tyres values its land and buildings at fair value, and made an upwards fair value adjustment of $300 000 last year. Bert’s Bikes values its land and buildings at historic cost. FIGURE 5.20 Bert’s Bikes and Toby’s Tyres balance sheets

Toby’s Tyres

$000

$000

$000

%

$000

%

990

39.6

1090

27.25

50

2.0

200

5.0

180

7.2

150

3.75

Total non-current assets

1220

48.8

1440

36.0

Total assets

2500

100.0

4000

100.0

350

14.0

700

17.5

50

2.0

200

5.0

Non-current assets Plant, property and equipment Intangible assets Other financial assets

Current liabilities Accounts payable Line-of-credit Short-term loans

200

8.0

250

6.25

Other financial liabilities

50

2.0

50

1.25

Total current liabilities

650

26.0

1200

30.0

Borrowings

500

20.0

1250

31.25

Provisions

100

4.0

50

1.25

Total non-current liabilities

600

24.0

1300

32.5

Total liabilities

1250

50.0

2500

62.5

Net assets

1250

50.0

1500

37.5

600

24.0

700

17.5

–

–

400

10.0

Non-current liabilities

Equity Contributed equity Reserves Retained earnings Total equity

650

26.0

400

10.0

1 250

50.0

1 500

37.5

Bert’s Bikes

%

Current assets Cash and cash equivalents

140

5.6

90

Accounts receivable

460

18.4

1220

30.5

Inventories

680

27.2

1250

31.25

1280

51.2

2560

64.0

Total current assets

Toby’s Tyres

FIGURE 5.21 Bert’s Bikes and Toby’s Tyres income statement

Bert’s Bikes %

Bert’s Bikes

2.25

Toby’s Tyres

$000

%

$000

%

Revenue from sales

5 000

100.0

7 500

100.0

Cost of sales

4 050

81.0

5 900

78.7

950

19.0

1 600

21.3

400

8.0

700

9.3

Gross profit Less expenses Selling

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CHAPTER 5 Financial analysis

Bert’s Bikes

Toby’s Tyres

$000

%

$000

%

General and administration

200

4.0

200

2.7

Total expenses

600

12.0

900

12.0

Earnings before interest and tax

350

7.0

700

9.3

60

1.2

125

1.6

Profit before income tax

290

5.8

575

7.7

Less tax at 40%

116

2.3

230

7.7

Profit for the period

174

3.5

345

4.6

Less interest

129

16 Using the financial statements from the most recent annual report for Kathmandu or Super Retail Group, update the calculation of ratios found in this chapter. Compare the ratios to the ones calculated in this chapter, and comment on the four key aspects of its financial performance: profitability, operating management, investment management and financial management. Using the sustainable growth rate calculated in this chapter, how indicative of Kathmandu or Super Retail’s growth to date has that ratio been?

CASE LINK Concepts from this chapter are used in the following cases in Part 4:



Case 1 Qantas – Part C Case 2 Airlines: Depreciation differences Case 5 Accounting analysis: Cash flow reconciliation Case 6 Valuation ratios in the retail industry 2016 to 2018.

ENDNOTES 1 2

3

4

5

6

For more detail on the GICS scheme, see https://www.msci.com/gics. Note that Australia and New Zealand are among those countries in which dividends are given equal tax treatment with interest paid on debt financing. Australia introduced a Dividend Imputation Tax in 1987, New Zealand in 1989. Under dividend imputation, some or all of the tax paid by a company may be attributed, or imputed, to the shareholders by way of a tax credit to offset the income tax payable on a dividend distribution. In computing return on equity, one can either use the beginning equity, the ending equity, or an average of the two. Conceptually, the average equity is appropriate, particularly for rapidly growing companies. However, for most companies this computational choice makes little difference so long as the analyst is consistent. Therefore, in practice most analysts use ending balances for simplicity. In this chapter, we have used average balances of the stock variables as far as possible. We discuss in greater detail in Chapter 8 how to estimate a firm’s cost of equity capital. For now, taking the equity beta for both Kathmandu and Super Retail Group to be 0.8 (the beta for the retailing industry at 30 June 2018), and the yield on long-term government bonds as approximately 3%; if one assumes a risk premium of 6%, the two firms’ costs of equity are 8.4% Lower assumed risk premium will, of course, lead to lower estimates of equity capital. Leverage can be defined in a number of ways, including: assets/ equity, debt/equity, debt/assets. For the ROE equation to hold, assets/equity is the appropriate measure of leverage. Strictly speaking, part of a cash balance is needed to run the firm’s

operations, so only the excess cash balance should be viewed as negative debt. However, firms do not provide information on excess cash, so we subtract all cash balance in our definitions and computations. An alternative possibility is to subtract only shortterm investments and ignore the cash balance completely. 7 See D. Nissim and S. Penman, ‘Ratio analysis and valuation: From research to practice,’ Review of Accounting Studies 6 (2001): 109–54, for a more detailed description of this approach. 8 From Kathmandu’s 2018 full-result analyst conference call – available at https://finance.yahoo.com/news/edited-transcript-kmdnz-earnings-042721878.html. 9 See M. Scholes and M. Wolfson, Taxes and Business Strategy (Englewood Cliffs, NJ: Prentice-Hall, 1992). 10 There are a number of issues related to the calculation of these ratios in practice. First, in calculating all the turnover ratios, the assets used in the calculations can either be beginning-of-the-year values, year-end values or an average of the beginning and ending balances in a year. Where possible we have used average balance values in our calculations. Second, strictly speaking, one should use credit sales to calculate accounts receivable turnover and days receivables. But since it is usually difficult to obtain data on credit sales, total sales are used instead. Similarly, in calculating accounts payable turnover or days payables, cost of goods sold is substituted for purchases for data availability reasons. 11 J. J. Coulton, C. M. S. Ruddock and S. L. Taylor, ‘The Informativeness of Dividends and Associated Tax Credits’, Journal of Business Finance & Accounting 41(9) (2014): 1309–36. [The specific reference is in footnote 2 of that paper.]

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APPENDIX: KATHMANDU FINANCIAL STATEMENTS ‘AS REPORTED’ AND STANDARDISED FIGURE 5.22 Kathmandu ‘as reported’ income statement

FIGURE 5.23 Kathmandu condensed income statement

For the year ended 31 July (all amounts in NZ$’000) 2018

445 348

497 437

Cost of sales

–169 165

–181 961

Gross profit

276 183

315 476

–143 740

–155 677

–61 613

–70 038

Other income Selling expenses Administrative and general expenses Earnings before interest, tax, depreciation & amortisation Depreciation and amortisation

70 830

89 761

–15 151

57 004

74 610

28

47

Finance expenses

–2 058

–1 106

Finance costs – net

–2 030

–1 059

Profit before income tax

54 974

73 551

–16 935

–23 019

38 039

50 532

Finance income

Income tax expense Profit after income tax Other comprehensive income Movement in cash flow hedge reserve

209

Movement in foreign currency translation reserve

209

10 518

OCI, net of tax

418

19 338

38 457

69 870

Total comprehensive income attributable to shareholders

445 348

497 437

38 039

50 532

1 405

728

39 444

51 260

Interest expense

2 058

1 106

(Interest income)

28

47

2 030

1 059

69%

69%

1405

728

Operating profit Net profit after tax + Net interest expense after tax = Net operating profit after tax Calculating net interest expense after tax

Net interest expense × (1 – tax expense / pre-tax profit)

–13 826

EBIT

2018

Revenues

2017 Sales

2017

8 820

= net interest expense after tax

Source: Kathmandu Holdings Ltd Annual Report 2018, p.31.

FIGURE 5.24 Kathmandu as reported balance sheet

As at 31 July (all amounts in NZ$’000) 2017

2018

Cash and cash equivalents

3 537

8 146

Trade and other receivables

6 284

13 453

89 206

111 929

ASSETS Current assets

Inventories Derivative financial instruments

Source: Kathmandu Holdings Ltd Annual Report 2018, p.31.

5 076

Other financial assets Total current assets

22 180 99 027

160 784

Non-current assets Property plant and equipment

61 026

63 514

279 014

390 319

Total non-current assets

340 040

453 833

TOTAL ASSETS

439 067

614 617

Intangible assets Derivative financial instruments Deferred tax

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CHAPTER 5 Financial analysis

As at 31 July (all amounts in NZ$’000) 2017

2018

LIABILITIES Current liabilities Trade and other payables

56 735

72 770

Derivative financial instruments

7 034

156

Current tax liabilities

3 475

9 968

Other financial liabilities Total current liabilities

21 994 67 244

104 888

Non-current liabilities Derivative financial instruments

131

2017

2018

(Other Long-term Liabilities)

265

62

NET LONG TERM ASSETS

305 748

403 986

TOTAL OPERATING ASSETS

333 994

473 730

Short-term debt

0

21 994

Long-term debt

10 431

39 500

Less cash

3 537

8 146

Net debt

6 894

53 348

Plus shareholders equity

327 100

420 382

Net capital

333 994

473 730

NET DEBT

265

62

Interest-bearing liabilities

10 431

39 500

Source: Kathmandu Holdings Ltd Annual Report 2018, p.33.

Deferred tax

34 027

49 785

FIGURE 5.26 Kathmandu as reported statement of cash flows

Total non-current liabilities

44 723

89 347

1 411 967

194 235

327 100

420 382

Contributed equity – ordinary shares

200 209

249 882

Reserves

–23 002

–2 717

Retained earnings

149 893

173 217

Interest received

TOTAL EQUITY

327 100

420 382

Payments to suppliers and employees

TOTAL LIABILITIES NET ASSETS EQUITY

For the year ended 31 July (all amounts in NZ$’000) 2017

2018

444 100

502 703

OPERATING ACTIVITIES

Source: Kathmandu Holdings Ltd Annual Report 2018, p.33.

Other Current Assets

Income tax paid Net cash flow from operating activities

2017

2018

6 284

13 453

89 206

111 929

0

27 256

Acquisition of subsidiaries

Purchase of PPE Purchase of intangibles

56 735

72 770

Investments in other financial assets

(Other Current Liabilities)

10 509

10 124

Net cash flow from investing activities

NET OPERATING WORKING CAPITAL

28 246

69 744

FINANCING ACTIVITIES

360 122

406 508

14 571

18 710

2 162

2 087

67 273

75 601

Long-term Tangible Assets

61 026

63 514

Long-term Intangible Assets

279 014

390 319

0

0

34 027

49 785

1 11 419

14 300

1 857

2 394 82 746 22 180

–13 275

–121 620

90 330

148 815

0

48 702

24 179

27 208

Repayment of loan advances

123 533

119 907

Net cash flow from financing activities

–57 382

50 402

Proceeds of loan advances

Plus NET LONG TERM ASSETS

(Net Deferred Taxes Payable)

47

INVESTING ACTIVITIES

(Accounts Payable)

Other Long-term Assets

156 28

Proceeds from sale of PPE

NET WORKING CAPITAL Inventory

Income tax received

Interest paid

FIGURE 5.25 Kathmandu ‘condensed’ balance sheet

Trade Receivables

Receipts from customers

Proceeds from share issues Dividends paid

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For the year ended 31 July (all amounts in NZ$’000)

FIGURE 5.28 Super Retail Group condensed income statement

2017

2018

Net increase/decrease in cash held

–3 384

4 383

Revenues

Opening cash and cash equivalents

6 891

3 537

Operating profit

30

226

3 537

8 146

Effect of foreign exchange rates Closing cash and cash equivalents

Source: Kathmandu Holdings Ltd Annual Report 2018, p.34.

As at 30 June Operating revenue

2018 2 570 400 000

1 400 000

8 500 000

2 467 200 000

2 578 900 000

—

—

–2 190 300 000

–2 282 800 000

EBITDA

276 900 000

296 100 000

Depreciation

–52 200 000

–55 100 000

Amortisation

–18 600 000

–22 200 000

Depreciation and amortisation

–70 800 000

–77 300 000

EBIT

206 100 000

218 800 000

Interest revenue

100 000

100 000

Interest expense

–17 000 000

–17 800 000

Net interest expense

–16 900 000

Pre-tax profit

Total revenue excluding interest Operating expenses

2 467 200 000

2 578 900 000

100 500 000

127 300 000

+ Net interest expense after tax

12 014 006

12 718 299

= Net operating profit after tax

112 514 006

140 018 299

17 000 000

17 800 000

Interest expense

2 465 800 000

Other revenue

2018

Calculating net interest expense after tax

FIGURE 5.27 Super Retail Group income statement

2017

Net profit after tax

2017

(Interest income) Net interest expense × (1 – tax expense / pre-tax profit) = net interest expense after tax

100 000

100 000

16 900 000

17 700 000

71%

72%

12 014 006

12 718 299

Source: Super Retail Group 2018 Annual Report

FIGURE 5.29 Super Retail Group balance sheet

As at 30 June 2017

2018

CA – Cash

19 900 000

15 200 000

CA – Receivables

19 300 000

17 100 000

23 300 000

6 700 000

481 500 000

545 500 000

CA – Investments

0

6 800 000

–17 700 000

CA – NCA held sale

0

0

189 200 000

201 100 000

Total current assets

Tax expense

–54 700 000

–56 600 000

Net profit after tax before abnormals

134 500 000

144 500 000

Abnormals

–48 500 000

–25 000 000

Abnormals tax

14 500 000

7 800 000

Net abnormals

–34 000 000

–17 200 000

Reported NPAT after abnormals

100 500 000

127 300 000

Source: Super Retail Group 2018 Annual Report

CA – Prepaid expenses CA – Inventories

CA – Other

0

0

544 000 000

591 300 000

NCA – Receivables

0

0

NCA – Inventories

0

0

NCA – Investments

0

9 300 000

NCA – PPE

264 500 000

270 400 000

NCA – Intangibles (ExGW)

302 500 000

365 700 000

NCA – Goodwill

447 600 000

525 900 000

NCA – Future tax benefit

0

0

NCA – Other

0

0

Total NCA

1 014 600 000

1 171 300 000

Total Assets

1 558 600 000

1 762 600 000

253 700 000

342 300 000

CL – Account payable

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CHAPTER 5 Financial analysis

As at 30 June

2017

2018

1 135 300 000

1 222 100 000

2017

2018

2 600 000

3 000 000

66 900 000

82 100 000

Short-term debt

2 600 000

3 000 000

CL – NCL held sale

0

0

Long-term debt

398 000 000

435 100 000

CL – Other

0

0

Less cash

19 900 000

15 200 000

323 200 000

427 400 000

NCL – Account payable

44 200 000

49 100 000

Net debt

380 700 000

422 900 000

NCL – Long-term debt

398 000 000

435 100 000

Plus shareholders equity

754 600 000

799 200 000

38 600 000

51 800 000

1 135 300 000

1 222 100 000

0

0

Total NCL

480 800 000

536 000 000

Total liabilities

804 000 000

963 400 000

Share capital

542 300 000

542 300 000

3 500 000

10 300 000

210 700 000

247 300 000

Other equity

0

0

Convertible equity

0

0

Se held sale

0

0

Interest paid

–1 900 000

–700 000

754 600 000

799 200 000

CL – Short-term debt CL – Provisions

Total curr. liabilities

NCL – provisions NCL – other

Reserves Retained earnings

Outside equity Total equity

Source: Super Retail Group 2018 Annual Report

2018

19 300 000

17 100 000

481 500 000

545 500 000

Other current assets

23 300 000

13 500 000

(Accounts payable)

297 900 000

391 400 000

66 900 000

82 100 000

159 300 000

102 600 000

Inventory

(Other current liabilities) NET OPERATING WORKING CAPITAL

NET CAPITAL

Source: Super Retail Group 2018 Annual Report

FIGURE 5.31 Super Retail Group cash flow statement

2017

2018

Receipts from customers

2 733 700 000

2 850 100 000

Payments to suppliers and employees

–2 203 100 000

–2 268 600 000

Dividends received

0

0

Interest received

0

0

0

0

–53 700 000

–43 800 000

–242 400 000

–229 300 000

234 500 000

308 400 000

–102 100 000

–107 100 000

900 000

0

Investments purchased

0

–300 000

Proceeds from sale of investments

0

0

Payments for purchase of Subsidiaries

0

–133 800 000

–101 200 000

–241 200 000

Proceeds from borrowings

930 000 000

994 500 000

Repayment of borrowings

–955 000 000

–955 500 000

Dividends paid

–84 800 000

–91 700 000

Other financing cashflows

–19 200 000

–19 100 000

–129 000 000

–71 800 000

4 300 000

–4 600 000

Tax paid Other operating cashflows Net operating cashflows Proceeds from sale of PPE

NET WORKING CAPITAL Trade receivables

NET DEBT

Payment for purchase of PPE

FIGURE 5.30 Super Retail Group condensed balance sheet

2017

TOTAL OPERATING ASSETS

133

Plus NET LONG-TERM ASSETS Long-term tangible assets

264 500 000

279 700 000

Long-term intangible assets

750 100 000

891 600 000

Other long-term assets

0

0

(Net deferred taxes payable)

0

0

(Other long-term liabilities)

38 600 000

51 800 000

NET LONG-TERM ASSETS

976 000 000

1 119 500 000

Net investing cashflows

Net financing cashflows Net Increase in cash Cash at beginning of period

15 600 000

19 900 000

Exchange rate adj

0

–100 000

Other cash adjustments

0

0

19 900 000

15 200 000

Cash at end of period

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CHAPTER

6

Prospective analysis: Forecasting

Most financial statement analysis tasks are undertaken with a forward-looking decision in mind – and much of the time it is useful to summarise the view developed in the analysis with an explicit forecast. Managers need forecasts to formulate business plans and to provide performance targets; analysts need forecasts to help communicate their views about the firm’s prospects to investors; and bankers and debt market participants need forecasts to assess the likelihood of loan repayment. There are many scenarios (including but not limited to security analysis) where the forecast is usefully summarised in the form of an estimate of the firm’s value. This estimate can be viewed as an attempt to best reflect in a single summary statistic the manager’s or analyst’s view of the firm’s prospects. Prospective analysis includes two tasks – forecasting and valuation – that together represent approaches to explicitly summarising the analyst’s forward-

looking views. In this chapter, we focus on forecasting. Forecasting is not so much a separate analysis as it is a way of summarising what has been learned through business strategy analysis, accounting analysis and financial analysis. However, there are certain techniques and knowledge that can help a manager or analyst to structure the best possible forecast, conditional on what has been learned in the previous steps. Below we summarise an approach to structuring the forecast, offer information to help you begin, explore the relationship between the other analytical steps and forecasting, and give detailed steps to forecast earnings, balance sheet data and cash flows. The key concepts discussed in this chapter are again illustrated for Kathmandu Limited; however, note that these were prepared before Kathmandu's purchase of Rip Curl in late 2019, and before the advent of COVID-19 in 2019/20.

Chapter learning objectives By the end of this chapter, you should be able to: LO1

understand the purpose of the forecast you are preparing

LO2

recall the extent to which key financial ratios exhibit mean-reverting behaviour over time

LO3

use macroeconomic, industry and firm-specific factors in making your forecasts

LO4

use a structured and comprehensive approach to creating your forecast financial statements

LO5

understand the importance of ‘what if’ analysis for key forecasting items, and evaluate the impact of changes to your key driver forecasts.

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CHAPTER 6 Prospective analysis: Forecasting

LO1

The overall structure of the forecast

The best way to forecast future performance is to do it comprehensively – producing not only an earnings forecast but also a forecast of the balance sheet and cash flows. A comprehensive approach is useful, and indeed highly recommended, even if the analyst is primarily interested in a single facet of performance, because it guards against unrealistic implicit assumptions. For example, if an analyst forecasts growth in sales and earnings for several years without explicitly considering the required increases in working capital and long-term assets, and the associated financing of the working capital and assets, the forecast could contain unreasonable assumptions about asset turnover, leverage or equity capital infusions. A comprehensive approach involves many forecasts, but in most cases they are all linked to the behaviour of a few key drivers. The drivers vary according to the type of business involved, but for most businesses outside the financial services sector, the sales forecast is nearly always one of the key drivers, while profit margin is another. When asset turnover is expected to remain stable – often a realistic assumption – working capital accounts and investment in non-current assets should track the growth in sales closely. Most major expenses also track sales, subject to expected shifts in profit margins. By linking forecasts of such amounts to the sales forecast, we can avoid internal inconsistencies and unrealistic implicit assumptions. In some contexts, the manager or analyst is interested ultimately in a forecast of cash flows, not earnings per se. Nevertheless, in practice even forecasts of cash flows tend to be grounded in practice on forecasts of accounting numbers, including sales, earnings, assets and liabilities. Of course, it would be possible in principle to move directly to forecasts of cash flows – inflows from customers, outflows to suppliers and employees, and so forth – and in some businesses this is a convenient way to proceed. In most cases, however, the growth prospects, profitability, and investment and financing needs of the firm are more readily framed in terms of accrual-based sales, operating earnings, assets and liabilities. These amounts can then be converted to cash flow measures by adjusting for the effects of non-cash expenses and expenditures on working capital and plant, property and equipment.

A practical framework for forecasting The most practical approach to forecasting a company’s financial statements is to focus on projecting ‘condensed’ financial statements, as used in the ratio analysis in Chapter 5, rather than attempting to project detailed financial statements at the level that the company reports. Forecasting condensed financial statements involves a relatively small set of assumptions about the future of the firm, so the analyst will have more ability to think about each of the assumptions carefully. A detailed line-item forecast is likely to be very tedious, and an analyst may not have a good basis to make all the assumptions necessary for such a forecast. Further, for most purposes, condensed financial statements are all that an analyst needs needed for analysis and decisionmaking. We therefore approach the task of financial forecasting with this framework. Recall that the condensed income statement used in Chapter 5 consists of the following elements: sales, net operating profits after tax (NOPAT), net interest expense after tax, and net income. The condensed balance sheet consists of net working capital, net long-term assets, net debt and equity. Also recall that we start with a balance sheet at the beginning of the forecasting period. Assumptions about how we use the beginning balance sheet and run the firm’s operations

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will lead to the income statement for the forecasting period; and assumptions about investment in working capital and long-term assets, and how we finance these assets, results in a balance sheet at the end of the forecasting period. In Chapter 5 we learned how to decompose return on equity in order to separately analyse the consequences on profitability of management’s: 1 operating decisions 2 non-operating investments 3 financing decisions. To make full use of the information generated through the return on equity decomposition, the forecasting task should follow the same process, forecasting operating items first, then nonoperating investments and finally forecasting financing items. To forecast the condensed income statement, one needs to begin with an assumption about the next period’s sales. Beyond that, assumptions about NOPAT margin, interest rate on beginning debt, and tax rate are all that are needed to prepare the condensed income statement for the period. To forecast the condensed balance sheet for the end of the period, or the equivalent, the beginning of the next period, we need to make the following additional assumptions: 1 the ratio of net working capital to sales: to estimate the level of working capital needed to support those sales 2 the ratio of net operating long-term assets to the following year’s sales: to calculate the expected level of net operating long-term assets 3 the ratio of net debt to capital: to estimate the levels of debt and equity needed to finance the estimated amount of assets in the balance sheet. Once we have the condensed income statement and balance sheet, it is relatively straightforward to compute the condensed cash flow statement, including cash flow from operations before working capital investments, cash flow from operations after working capital investments, free cash flow available to debt and equity, and free cash flow available to equity. We will discuss how best to make the necessary assumptions to forecast the condensed income statement, balance sheet and cash flow statements.

Information for forecasting The analytical tools that we discussed in earlier chapters – strategy, accounting and financial analysis – can lead analysts to make informed decisions about expected performance, especially in the short and medium term. Specifically, the primary goal of financial analysis is to understand the historical relationship between a firm’s financial performance and economic factors identified in the strategy and accounting analysis, such as the firm’s macroeconomic environment, industry and strategy, and accounting decisions. Forecasting can be seen as performing a reverse financial analysis, primarily addressing the question of the effect of anticipated changes in relevant economic factors on the firm’s future performance and financial position, conditional on the historical relationships identified in the financial analysis. Thus, much of the information generated in the strategic, accounting and financial analysis is of use when going through the forecasting process. Recent research shows that analysts can significantly improve large-sample forecasts of profitability when a firm’s profitability is decomposed into market, industry and idiosyncratic (firm-specific) components. Jackson et al. (2018) decompose return on net operating assets (RNOA) and show that each of the market, industry and firm-specific components have different levels of persistence and different mean-reverting properties.1 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 6 Prospective analysis: Forecasting

LO2

Performance behaviour: A starting point

Every forecast has, at least implicitly, an initial point of reference – some notion of how a particular amount, such as sales or earnings, would be expected to behave in the absence of detailed information. For example, as we begin to contemplate profitability for Kathmandu Limited in the fiscal year 2019, we could use 2018 performance as a point of reference. Another potential point of reference might be 2018 performance adjusted for recent trends. A third possibility that might seem reasonable – but one that generally turns out not to be very useful – is the average performance over several prior years. By the time one has completed a business strategy analysis, an accounting analysis and a detailed financial analysis, the resulting forecast may differ significantly from the original point of reference. Nevertheless, a starting point will help anchor the detailed analysis, as it is useful to know how certain key financial statistics behave ‘on average’ for all firms. In the case of some key statistics, such as earnings, a point of reference based only on prior behaviour of the number is more powerful than one might expect. Research demonstrates that some such estimates for earnings are almost as accurate as the forecasts of professional security analysts, who have access to a rich information set. (We will return to this point in more detail.) Therefore, the point of reference is often not only a good starting point but may also be close to the amount forecast after detailed analysis. Significant departures from it can be justified only in cases where the firm’s situation is demonstrably unusual. Reasonable adjustments for forecasts of key accounting numbers can be based on the evidence summarised in the coming section. Such evidence may also be useful for checking the reasonableness of a completed forecast.

Sales growth behaviour Sales growth rates tend to be ‘mean-reverting’: firms with above-average or below-average rates of sales growth tend to revert over time to a ‘normal’ level (historically in the range of 5 to 10%) within three to 10 years. Figure 6.1 documents this effect for 2000–18 for all non-mining firms trading on the ASX covered by the Morningstar Fundamentals database. All firms are ranked in terms of their sales growth in 2000 (year 1) and formed into five portfolios based on the relative ranking of their sales growth in that year. Firms in portfolio 1 are in the top 20% of rankings in terms of their sales growth in 2000, those in portfolio 2 fall into the next 20%, while those in portfolio 5 are in the bottom 20% when ranked by sales growth. The sales growth rates of firms  in  each of these five portfolios are traced from 2000 through the subsequent five years (years 2 to 6). The same experiment is repeated using 2005, 2010 and 2015 as the base year (year 1). The results are averaged over these windows and the resulting sales growth rates of each of the five portfolios for years 1 to 6 are plotted in Figure 6.1. The behaviour of sales growth for both US and European firms shows a similar pattern. The figure shows that the group of firms with the highest growth initially – sales growth rates of a little over 50% – experienced a decline to about 10% growth rate within three years. Those with the lowest initial sales growth rates, negative 21%, improved immediately to a positive sales growth rate in year 2 and showed positive growth through to year 6. One explanation for the pattern of sales growth seen in Figure 6.1 is that, as industries and companies mature, their growth rate slows down due to demand saturation and intra-industry competition. Therefore, even when a firm is growing rapidly at present, it is generally unrealistic to assume that the current high growth will persist indefinitely. Of course, how quickly a firm’s growth rate reverts Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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60% 50% 40% 30% 20% 10% 0 –10% –20% –30% 1

2

3

4

5

6

Years since portfolio formation Top quintile of sales growth in year of portfolio formation

Second quintile of sales growth in year of portfolio formation

Fourth quintile of sales growth in year of portfolio formation

Bottom quintile of sales growth in year of portfolio formation

Third quintile of sales growth in year of portfolio formation

FIGURE 6.1 Behaviour of sales growth for Australian firms over time, 2000–18

to the average depends on the characteristics of its industry and its own competitive position within an industry.

Earnings behaviour Earnings have been shown on average to follow a process that can be approximated by a ‘random walk’ or ‘random walk with drift’. This implies that the prior year’s earnings are a good point of reference for considering future earnings potential. Even a simple random walk forecast – one that predicts next year’s earnings will be equal to last year’s earnings – is surprisingly useful. One study observes that professional analysts’ year-ahead forecasts are only 22% more accurate, on average, than a simple random walk forecast.2 Thus a final earnings forecast will usually not differ dramatically from a random walk benchmark. In addition, it is reasonable to adjust this simple point of reference for the earnings changes of the most recent half-year (or quarter); that is, changes relative to the comparable months of the prior year after controlling for the long-run trend in the series. Although the average level of earnings over several prior years is not useful, long-term trends in earnings tend to be sustained on average, and so they are also worthy of consideration. If halfyearly (or quarterly) data are also included, then some consideration should usually be given to any departures from the long-run trend that occurred in the most recent sub-period. For most firms, these recent changes tend to be partially repeated in subsequent sub-periods.3

Return on equity behaviour Given that prior earnings is a useful benchmark for future earnings, one might expect the same to be true of rates of return on investment such as ROE. That, however, is not the case, for two reasons. First, even though the average firm tends to sustain the current earnings level, this is not Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 6 Prospective analysis: Forecasting

true of firms with unusual levels of ROE. Firms with abnormally high ROE tend to experience earnings declines, while those with low ROE tend to experience increases.4 Second, firms with higher ROEs tend to expand their investment bases more quickly than others, which causes the denominator of ROE to increase. Of course, if firms could earn returns on the new investments that match the returns on the old ones, then the level of ROE would be maintained. However, firms have difficulty continuing to generate those impressive ROEs. Firms with higher ROEs tend to find that, as time goes by, their earnings growth does not keep pace with growth in their investment base, and ROE ultimately falls. The resulting behaviour of ROE and other measures of return on investment is characterised as ‘mean-reverting’, a pattern similar to that observed for sales growth rates earlier. Firms with aboveaverage or below-average rates of return tend to revert over time to a ‘normal’ level, historically around 10% for Australian firms, within no more than 10 years.5 Figure 6.2 documents this effect for Australian firms for 2000 to 2018. All firms are ranked in terms of their ROE in 2000 (year 1) and formed into five portfolios in a similar fashion to the sales growth analysis above. Firms in portfolio 1 have the top 20% ROE rankings in 2000, those in portfolio 2 fall into the next 20%, and those in portfolio 5 have the bottom 20%. The average ROE of firms in each of these five portfolios is then traced through five subsequent years (years 2 to 6). The same experiment is repeated each year with 2005, 2010 and 2015 as base years. Figure 6.2 plots the average ROE of each of the portfolios in years 1 to 6 averaged across these three experiments. Again, the behaviour of ROE for European firms shows a similar pattern. 30% 25% 20% 15% 10% 5% 0 –5%

1

2

1

2

3

4

5

6

3

4

5

6

–10% –15% –20% Years since portfolio formation Top quintile of ROE in year of portfolio formation

Second quintile of portfolio formation

Fourth quintile of ROE in year of portfolio formation

Bottom quintile of sales growth in year of portfolio formation

Third quintile of ROE in year of portfolio formation

FIGURE 6.2 Behaviour of ROE for Australian firms over time, 2000–18

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Though the five portfolios start out in year 1 with a wide range of average ROEs (–70 to +30%), by year 6 the pattern of mean-reversion is clear. The most profitable group of firms initially – with average ROEs of 30% – experience a decline to below 15% within five years. Those with the lowest initial ROEs (–30%) experience a dramatic increase in ROE in the first three years, and become, on average, profitable by year 5. The pattern in Figure 6.2 is not a coincidence; it is exactly what the economics of competition would predict. The tendency of high ROEs to fall is a reflection of high profitability attracting competition; the tendency of low ROEs to rise reflects the mobility of capital away from unproductive ventures towards more profitable ones. Research demonstrates that the pattern of ROE mean-reversion is not just an Australian phenomenon. In a study from 1997 to 2008 of firms in 49 countries in Australasia and South-East Asia, including Australia, New Zealand, Japan, China, Taiwan, Korea, Hong Kong, Malaysia, Thailand, India, Singapore, Indonesia and the Philippines, researchers have examined the pattern of change in ROE. They have found that the pattern of mean-reversion in earnings persists across many of these countries, with mean-reversion being faster in countries with more competitive product and capital markets, and with less efficient governments.6 The same pattern has also been documented for US firms as well as those in Europe. Despite the general tendencies documented in Figure 6.2, there are some firms whose ROEs may remain above or below normal levels for long periods of time. In some cases, the phenomenon reflects the strength of a sustainable competitive advantage, such as a natural monopoly or a protected national industry, but in other cases it is purely an artefact of conservative accounting methods. A good example of the latter phenomenon is pharmaceutical firms in the US whose major economic asset, the intangible value of research and development, is not recorded on the balance sheet and is therefore excluded from the denominator of ROE. For those firms, one could reasonably expect high ROEs – in excess of 20% – over the long run, even in the face of strong competitive forces.

The behaviour of components of ROE The behaviour of rates of return on equity can be analysed further by looking at the behaviour of its key components. Recall from Chapter 5 that ROEs and profit margins are linked as follows: ROE = operating ROA + (operating ROA – net interest rate after tax) × net financial leverage = NOPAT margin × operating asset turnover + spread × net financial leverage The time-series behaviours of the primary components of ROE for Australian companies for 2000 to 2018 are shown in a series of figures in the appendix to this chapter. We can draw the following conclusions from these figures: Operating asset turnover tends to be rather stable, in part because it is largely a function of the technology of the industry. The only exception to this is the set of firms with very high asset turnover, which tends to decline somewhat over time before stabilising. Net financial leverage also tends to be stable, simply because management policies on capital structure are not often changed. NOPAT margin and spread stand out as the most variable component of ROE. If the forces of competition drive abnormal ROEs towards more normal levels, the change is most likely to arrive in the form of changes in profit margins. The change in NOPAT margin will drive

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CHAPTER 6 Prospective analysis: Forecasting

changes in the spread, since the cost of borrowing is likely to remain stable because leverage tends to be stable. To summarise, profit margins and ROEs tend to be driven by competition to ‘normal’ levels over time. What constitutes normal varies widely according to the technology employed within an industry and the corporate strategy pursued by the firm, both of which influence turnover and leverage.7 In a fully competitive equilibrium, profit margins should remain high for firms that must operate with a low turnover, and vice versa. The above discussion of rates of return and margins implies that a reasonable point of departure for forecasting such statistics should consider more than just the most recent observation. One should also consider whether that rate or margin is above or below a normal level. If so, then, absent detailed information to the contrary, one would expect some movement over time to that norm. Of course, this central tendency might be overcome in some cases – for example, where the firm has erected barriers to competition that can protect margins, even for extended periods. The lesson from the evidence, however, is that such cases are unusual. In contrast to rates of return and margins, it is reasonable to assume that asset turnover, financial leverage and the net interest rate remain relatively constant over time. Unless there is an explicit change in technology or financial policy being contemplated for future periods, a reasonable point of reference for assumptions for these variables is the current period level. The only exceptions to this appear to be firms with either very high asset turnovers that experience some decline in this ratio before stabilising, or those firms with very low (usually negative) net debt to capital that appear to increase leverage before stabilising. In addition, firms with very high levels of leverage tend to survive at a lower rate than more conservatively financed firms, driving down averages over time. As we proceed with the steps involved in producing a detailed forecast, the reader will note that we draw on the above knowledge of the behaviour of accounting numbers to some extent. However, it is important to keep in mind that knowledge of average behaviour will not fit all firms well. The art of financial statements analysis requires not only knowing what the ‘normal’ patterns are but also having expertise in identifying those firms that will not follow the norm.

LO3

Other forecasting considerations

In general, the mean-reverting behaviour of sales growth and return on equity that is demonstrated by the broader market should hold true for individual companies over time. The starting point for any forecast should therefore be the time-series behaviour of the various measures of firm performance, as discussed. However, there are several other factors that the analyst should consider in making forecasts. These include an understanding of the implications of the three levels of analysis that precede prospective analysis – strategy, accounting and financial performance – and of macroeconomic considerations.

Strategy, accounting and financial analysis and forecasting We use the example of Kathmandu Limited to illustrate the strategic analysis that informs the forecast as well as the mechanics of forecasting. A projection of the future performance of

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Kathmandu for the year 2019 must be grounded ultimately in an understanding of questions such as these: From business strategy analysis: What are the characteristics of the industry in which the firm operates? Are there significant barriers to entry that are likely to deter future competition? If so, how long are they expected to last? What are the industry’s growth prospects? How are they likely to affect future competition? And, does the company in question have a clear strategy that positions it for future success? From accounting analysis: The accounting analysis discussed in Chapters 3 and 4 provides the analyst with an understanding of how a company’s accounting affects its reported financial performance. Are assets overstated, requiring a future write-down? Does the firm have offbalance sheet assets, such as R&D, that overstate reported rates of return? If so, what are the implications for future accounting statements? From financial analysis: What are the sources of a firm’s poor or strong recent performance?  Is  this performance sustainable? Are there any discernible patterns in the firm’s past performance? If so, are there any reasons why this trend is likely to continue or to change? These insights assist the analyst in answering questions of whether and for how long the firm will be able to maintain any competitive advantage and current performance levels, which are critical to forecasting. The answers to these questions determine the speed with which the firm’s performance follows the general mean-reverting trends discussed above.

Macroeconomic factors and forecasting For many firms, their financial performance is sensitive to the economic cycle, and the analyst should consider macroeconomic conditions when making forecasts. Of course, the impact of changing macroeconomic conditions on financial performance cannot be forecast with a high degree of certainty. Consequently, it is advisable to focus on the firm’s particular strategy and competitive position and assume that the impact of changes in the business cycle will even out in the long run. Australia was not as badly affected by the GFC as other advanced economies in the world from 2007 to 2009. However, by 2013 the Australian economy was experiencing a period of slower growth, particularly in states that were not supported by mining activity. Australia’s GDP growth remained between 2 and 3.5% from 2014 to 2018. Forecasts of GDP for 2019 and 2020 by the Reserve Bank of Australia, as well as other forecasters, were trending down.8 In general, employment growth was weak and consumer confidence was low, both of which may negatively impact demand for consumer discretionary products such as those produced and sold by Kathmandu. During 2018, retail industry growth in Australia was forecast to be 1.5% for 2019, and around 1% for 2020–23. Clothing retailing experienced a difficult and changing operating environment over 2013–18. The clothing retailing industry was expected to grow at 0.5% for 2019, and just above 2% for 2020–23. The sport and camping equipment retailing industry in Australia grew in the 2013–18 period, notwithstanding the difficult conditions for retailing more generally. As described in Chapter 2, there has also been strong competition from a range of external vendors, including online-only vendors. Research firm IBISWorld predicts sports and camping equipment retailing growth to be in between 1% and 2% for 2019–23 in Australia, and close to zero or negative in New Zealand for 2019–21, before turning positive in 2022.9 Figure 6.3 shows Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 6 Prospective analysis: Forecasting

the actual and projected growth rates for the main countries and industries that Kathmandu operates in. FIGURE 6.3 Realised and expected economic and industry growth rates

Actual

Forecast

2016

2017

2018

2019

2020

2021

2022

2023

Australian GDP growth

2.6%

2.3%

3.0%

3.1%

2.9%

2.7%

2.6%

2.6%

New Zealand GDP growth

3.6%

3.7%

3.1%

2.6%

2.6%

3.1%

2.5%

2.5%

Australia clothing retail revenue growth

7.2%

0.2%

0.8%

0.9%

0.4%

2.1%

2.1%

2.4%

–6.2%

11.1%

–3.0%

2.5%

1.9%

4.8%

1.4%

1.1%

2.5%

–0.7%

1.1%

1.7%

2.5%

1.8%

1.5%

1.3%

–12.6%

2.1%

3.5%

0.3%

–1.5%

–0.8%

3.5%

3.1%

New Zealand clothing retail revenue growth Australian sporting and camping equipment revenue growth New Zealand sporting and camping equipment revenue growth

Source: IMF, RBA, RBNZ, IBISWorld

LO4

Making forecasts

The first step in forecasting is to use the preceding strategic, accounting and financial analysis, as well as macroeconomic factors, to develop forecasting assumptions for six key financial metrics of the financial statements. These key metrics can be used to produce full or condensed forecast financial statements, and as inputs to valuation models, as will be explained in Chapter 8. The six key financial metrics are: 1 sales growth rate 2 NOPAT margin 3 beginning net operating working capital to sales ratio 4 beginning net operating long-term assets to sales ratio 5 beginning net debt to capital ratio 6 after-tax cost of debt. Developing forecasts for each of these key financial metrics is explained in the following section. Figure 6.4 shows the forecasting assumptions we have made for Kathmandu for the years 2019 to 2023. We use as our base the condensed financial statements detailed in Chapter 5. We have chosen a five-year forecasting period because we believe that the firm should reach a relatively steady state of performance by then (discussed in further detail in Chapter 8). We discuss the forecasting assumptions below.

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FORECASTING ASSUMPTIONS FIGURE 6.4 Forecasting assumptions for Kathmandu

Actual 2016

2017

Forecasts 2018

2019

2020

2021

2022

2023

Sales growth

4.0%

4.6%

11.7%

9.2%

8.8%

8.5%

6.4%

3.7%

Net operating profit margin

8.5%

8.9%

10.3%

10%

9%

8.50%

8.50%

8.50%

Start-of-year operating working capital / sales

20.0%

9.1%

5.7%

13%

10%

10%

10%

10%

Start-of-year net operating long-term assets / sales

72.3%

68.7%

81.2%

80%

78%

76%

74%

72%

After tax cost of debt Start-of-year debt to capital ratio

4.7%

6.4%

2.4%

2.3%

2.5%

2.50%

3%

3%

18.1%

10.6%

2.1%

11.3%

10%

12%

13%

15%

The short-term forecasts for Kathmandu take the company’s recent performance as its point of reference, because the company’s current strategic positioning, existing financials and other company-specific metrics will continue to affect its performance in the short term. This is generally a valid approach for an established company such as Kathmandu as we can make a few assumptions. First, recent performance is a useful point of reference when the company’s management gives no indication of

any major restructurings or changes to its operating and financing policies in the short term. One issue in forecasting Kathmandu’s 2019 and beyond sales growth is estimating the impact of the Oboz acquisition that took place on 4 April 2018. In 2018, Kathmandu’s overall sales growth was 11.7%, and the same store sales growth was 4.4%. The Oboz acquisition contributed $15 million to sales (over the three months that Oboz was part of the Kathmandu group). We will look at this issue in more detail later in the chapter.

Developing a sales growth forecast A good starting point for developing a forecast of short-term revenue growth is management’s outlook. Managers often provide guidance about future revenue and margins in the management discussion section of the annual report, but also in annual and interim financial results presentations, as well as at analyst conferences and in press releases. The analyst’s task is to challenge the assumptions underlying management’s expectations, using information about macroeconomic, industry and firm-specific factors. A key determinant of a retailer’s revenue is the store count. Kathmandu had increased its store count from 91 in 2010 to 166 in 2018, with the Australian store numbers going from 55 to 118. In the 2018 full-year investor presentation, Kathmandu stated that the Australasian store rollout was nearly finished, and that physical store numbers would be balanced with online acceleration. Based on this information, our forecasts assume that Kathmandu will add a net two stores in 2019 and 2020, and one store in each year of 2021–23. The revenue from these stores is more difficult to predict than the number of stores. The sales growth for the physical stores is assumed to decline steadily from 4% in 2019 to 2% in 2023 to become more consistent with expected industry growth and macroeconomic demand factors. Kathmandu discloses the proportion of sales that come from their online channels. From this, we can calculate that the 2018 growth in online sales was 40% in 2018 (and around 14–15% in Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 6 Prospective analysis: Forecasting

2016 and 2017), and while online sales are expected to grow at a faster pace than physical store sales, we do not believe it is reasonable to assume that a rate at or near 40% is sustainable. Recall that (overall) sales growth tends to mean-revert rapidly. We forecast that online sales growth will be 30% in 2019 and decline to a 5% growth level in 2023. This implies that the online proportion of Kathmandu overall sales increases steadily towards 15% by 2022. These forecasts assume that the online sales are not cannibalising the in-store sales. Finally, we assume that the Oboz sales will grow by 15% in 2019, and that the growth rate in Oboz sales will steadily decline to 3.5% by 2023. Figure 6.5 shows the forecasts of the number of stores, and sales growth rates for the different sales channels for Kathmandu. FIGURE 6.5 Expected growth in Kathmandu stores and online sales

Actual 2017

2018

2019

2020

2021

2022

2023

2

2

3

2

2

1

1

1

162

164

167

169

171

172

173

174

Net number of stores added Number of stores at year end Average number of stores Store sales growth (%) Online sales growth rate Online sales (as % of total sales)

Forecasts

2016

161

163

165.5

168

170

171.5

172.5

173.5

1.6%

6.9%

4.4%

4.0%

3.5%

3.0%

2.5%

2.0%

15.7%

13.7%

40.0%

30%

20%

15%

10%

5%

6.9%

7.5%

9.4%

11%

13%

14%

15%

15%

–

–

–

15%

12%

9%

6%

3.5%

Oboz revenue growth rate

The preceding forecasts assume that in the short term, Kathmandu is able to maintain the growth in its revenues at a rate higher than that expected for the retail sector generally, and also the expected growth in both the sporting and camping equipment sector and the clothing sector. Figure 6.6 shows the consequences of these assumptions for Kathmandu’s revenue over the 2019–23 window. By the end of the forecasting window, our overall revenue growth forecasts are close to the long-term growth forecasts for Australian and New Zealand GDP measures. FIGURE 6.6 Expected revenue growth for Kathmandu

Actual

Forecasts

2016

2017

2018

2019

2020

2021

2022

2023

Revenue excluding online sales & Oboz

396227

411 947

436 273

460 577

482 372

501 228

516 754

530 145

Revenue per store ($000)

2 461

2 527

Oboz revenue ($000) Online revenue Total revenue ($000) Implied revenue growth rate

2 636

2 742

2 837

2 923

2 996

3 056

15 900

18 285

20 479

22 322

23 662

24 490

29 366

33 401

46 759

60 787

72 944

83 886

92 274

96 888

425 593

445 348

497 437

539 649

575 796

607 436

632 690

651 522

4.6%

11.7%

8.5%

6.7%

5.5%

4.2%

3.0%

Developing a NOPAT margin forecast Kathmandu increased its NOPAT margin from 8.5% in 2016 to 10.3% in 2018. Management has claimed that this was in part due to reducing discounting and improving its product mix. Its margins are higher than its close peers and the retailing industry more generally. The competition

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in the industries that Kathmandu operates in is unlikely to decrease, so we view it as unlikely that the profit margins will keep increasing year on year. In fact, management state that they try to keep gross margins around 63% of sales. Kathmandu continues to expand internationally, which requires additional investments and some of that investment will be reflected immediately as expenses in the income statement. It is difficult to forecast the impact of Oboz on NOPAT margins given that the acquisition only took place in April 2018, and it is not clear yet clear how the Oboz business will perform. It will be easier to make these forecasts after Kathmandu has an additional year or two of data to draw upon. The rate of income tax will also impact on NOPAT margins (which are an after-tax measure). At June 2018 there was the possibility of a reduction in the Australian corporate tax rate, which would increase the NOPAT margins to the extent that any tax reductions were not passed on to customers as lower costs. We forecast that Kathmandu’s NOPAT margin will be 10% in 2019, and this will decline by 50 basis points each year until 2023, at which point our NOPAT margin forecast is 8.0%.

Developing a net operating working capital to sales forecast Kathmandu’s start-of-year net operating working capital consists of inventory, receivables, trade payables, and other current assets and liabilities. Recall that we classified Kathmandu’s cash as part of net debt in Chapter 5. Net operating working capital relative to sales has varied from 20% in 2016 down to 9.1% in 2017, and further declined to 5.7% in 2018. The decline in 2018 was driven by a relatively low inventory balance at the end of FY2017. The higher levels of inventory at the end of 2018 reflect the additional inventory acquired in the Oboz acquisition. This, in turn, will be reflected in the ratio of start-of-year working capital in 2019 to 2023 (forecast) sales. The 2018 end-of-year balance sheet is the same as the start-of-year 2019 balance sheet, so we know the balance sheet components of these turnover ratios and do not need to forecast them. The 2019 sales figure is a forecast. This also applies to the 2019 long-term assets to sales forecast figure. Without detailed information, we consider it reasonable to assume that during the forecasting period that the net operating working capital requirements relative to sales reverts to 10%, being close to the four-year average from 2015 to 2019. This assumes that Kathmandu’s overall level of store productivity remains relatively constant in the next few years.

Developing a net non-current operating assets to sales forecast The forecasts of net non-current operating assets relative to sales are closely linked with the previously described forecasts of Kathmandu’s store productivity. Specifically, under an assumption that the investment in net non-current operating assets per store will remain constant in the next few years, store productivity and net non-current operating assets to revenue will follow the same trend. For 2016 to 2017, average net non-current operating assets per average number of stores was around NZ$1 870 000. The Oboz acquisition in 2018 led to a large increase in intangible assets from NZ$279m to $390m. This is reflected in the start-of-year 2019 net non-current operating asset figure.

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CHAPTER 6 Prospective analysis: Forecasting

147

Net non-current operating assets/sales declined from just under 70% in 2016 and 2017 to just over 60% in 2018. The Oboz acquisition leads to an increase in the ratio to 75% in 2019, but we forecast that this number will steadily decline back towards 70%. The implied increase in net non-current operating assets per store reflects additional investment in the online channels and international distribution. In its 2018 full-year result analyst conference call, Kathmandu indicated that it expected to spend around $20m each year for capital expenditure overall, but that the mix would change with a greater focus on IT projects (possibly up to $4–5m for 2019–21). Our forecasts of net noncurrent operating assets are consistent with that level of capital expenditure less depreciation and amortisation of $10–15m each year over the forecasting window.

Developing a capital structure forecast

FROM ASSUMPTIONS TO FORECASTS The analysis of Kathmandu’s performance in Chapter 5 and the preceding discussions about general market behaviour and Kathmandu’s strategic positioning lead to the conclusion that in the near and medium term it is likely that the company can, at least temporarily, earn substantial abnormal profits. These forecast assumptions are shown in Figure 6.4. Having made the set of key assumptions detailed above, it is a straightforward task to derive the forecasted income statements and beginning balance sheets for years 2019 through 2023, as shown in Figure 6.7. Recall that the balance sheet at the beginning of fiscal 2019 is the same as the balance sheet reported by the company for the year ending 31 July 2018.

We have chosen a five-year forecasting period because we believe that the firm should reach such a steady state of performance by the end of that period, such that a few simplifying assumptions about its subsequent performance are sufficient to estimate firm value (which we discuss further in Chapter 8). Under these forecasts, Kathmandu’s sales will grow to NZ$651m in 2023, about 31% higher than the level in 2018. By the end of 2023 the firm will have net operating assets of $536m, and shareholders’ equity of $456m. Consistent with market-wide patterns of mean-reversion in returns, Kathmandu’s return on average equity will decline from 13.5% in 2018 to 11% in 2023, and return on net operating assets will show a similar pattern.

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KATHMANDU CASE

As we discussed previously, we would typically expect a company’s capital structure to remain constant over the forecast period, simply because management policies on capital structure are slow to change. However, the start-of-year debt to capital ratio for Kathmandu did vary over the 2016–19 period. It has ranged from 18.1% at the start of 2016, down to a low of 2.1% at the end of 2017 (start of year for 2018), and back up to 11.3% at the start of 2019. Kathmandu paid down a larger portion of debt than usual in 2017, and also had a lower closing balance of cash and cash equivalents in 2017 than 2016. Both of these factors are reflected in the start-of-year 2018 debt to capital ratio. We expect that the debt to capital ratio will gradually increase back to 15%, in line with the longer-term average for Kathmandu. In 2018, the after-tax cost of debt is low. This is due in part to the reduction in interest-bearing liabilities during the year, but also the relatively low borrowing costs in the market. Our forecasts reflect a gradual increase in the after-tax cost of debt, consistent with the market expectations of an increase in borrowing costs of the 2019–23 period.

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FIGURE 6.7 Pro forma balance sheet and income statement

Actual Beginning balance sheet ($000s)

Forecasts

2016

2017

2018

2019

2020

2021

2022

2023

2024

84 987

40 642

28 246

69 744

57 580

60 744

63 269

65 152

67 092

Beg. long-term operating assets

297 642

307 841

305 748

403 986

420 331

431 279

442 883

456 066

469 641

= Net operating assets

382 629

348 483

333 994

473 730

477 911

492 023

506 152

521 218

536 732

69 315

36 800

6 894

53 348

57 349.3

59 043

65 800

78 183

80 510

Shareholders’ equity

313 314

311 683

327 100

420 382

420 561

432 980

440 352

443 035

456 223

Net capital

382 629

348 483

333 994

473 730

477 911

492 023

506 152

521 218

536 732

425 593

445 348

497 437

539 649

575 796

607 436

632 690

651 522

670 916

36 040

39 444

51 260

53 965

51 822

51 632

53 779

52 122

2 519

1 405

728

1 227

1 434

1 476

1 974

2 736

33 521

38 039

50 532

52 738

50 388

50 156

51 805

49 385

Beg. operating working capital

Net debt

Income statement ($000s) Sales Net operating profit after tax Interest expense after tax Net income

Cash flow forecasts Once we have forecasted income statements and balance sheets, we can derive cash flows for the years 2019 through 2023. Note that we need to forecast the beginning balance sheet for 2024 to compute the cash flows for 2023. This balance sheet is shown in Figure 6.7. In it, we assume that the sales growth and the balance sheet ratios remain the same in 2024 as in 2023. Based on this, we project a beginning balance sheet for 2024 and compute the cash flows for 2023. Cash flow to capital is calculated as NOPAT minus increases in net working capital and net long-term assets. As Figure 6.8 shows, the free cash flow to all providers of capital increases from –$88.5m in 2018 to just under $50m in 2019, but then steadily declines to $36m in 2023. We observe a similar pattern for free cash flow to equity, which we calculate as net income, less the change in net operating assets, plus change in net debt. Free cash flow to equity is –$42m in 2018, increases to $52.5m in 2019 and then declines to just over $36m in 2023. FIGURE 6.8 Cash flow forecasts

Actual

Free cash flow to equity ($000s) Net income – change in working capital (during the year) – change in long-term assets + change in debt Free cash flow to equity

2016

Forecast

2017

2018

2019

2020

2021

2022

2023

33 521

38 039

–44 345

–12 396

50 532

52 738

50 388

50 156

51 805

49 385

41 498

–12 164

3 164

2 525

1 883

1 939

10 199

–2 093

98 238

16 345

10 948

11 604

13 183

13 575

–32 515

–29 906

464 54

4 001

1 693

6 757

12 383

2 327

35 152

22 622

–42 750

52 559

37 969

42 784

49 122

36 198

(Continued)

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CHAPTER 6 Prospective analysis: Forecasting

FIGURE 6.8 Cash flow forecasts (Continued)

Actual

Free cash flow to capital ($000s)

Forecast

2016

2017

2018

2019

2020

2021

2022

2023

36 040

39 444

51 260

53 965

51 822

51 632

53 779

52 122

–44 345

–12 396

41 498

–12 164

31 64

2 525

1 883

1 939

– change in long-term assets

10 199

–2 093

98 238

16 345

10 948

11 604

13 183

13 575

Free cash flow to capital

70 186

53 933

–88 476

49 784

37 709

37 503

38 713

36 607

NOPAT – change in working capital (during the year)

LO5

Sensitivity analysis

The projections discussed thus far represent nothing more than an estimation of a most likely scenario for Kathmandu. Managers and analysts are typically interested in a broader range of possibilities. An analyst estimating the value of Kathmandu would typically consider the sensitivity of projections to the key assumptions about sales growth, profit margins and asset utilisation. What if Kathmandu is unable to maintain its NOPAT margin in the face of increased competition? What if it is unable to improve its efficiency in the use of its long-term assets? What if the sales of Oboz Footwear are lower than anticipated, or that Kathmandu’s online sales come at the expense of those from the physical stores? It is wise to also generate projections based on a variety of assumptions to determine the sensitivity of the forecasts to these assumptions. There is no limit to the number of possible scenarios we could consider. One systematic approach to sensitivity analysis is to start with the key assumptions underlying a set of forecasts, and then examine the sensitivity of those forecasts to the assumptions with greatest uncertainty in a given situation. For example, if a company has experienced a variable pattern of gross margins in the past, it is important to make projections using a range of margins. Alternatively, if a company has announced a significant change in its expansion strategy, asset utilisation assumptions might be more uncertain. In determining where to invest your time in performing sensitivity analysis, it is therefore important to consider historical patterns of performance, changes in industry conditions and changes in a company’s competitive strategy.

Seasonality and interim forecasts Thus far we have concerned ourselves with annual forecasts. However, in practice, in Australia and other countries that have half-yearly reporting, forecasting is very much a half-yearly game. In the US, where companies report on a quarterly basis, forecasting is a quarterly exercise. Forecasting for sub-periods raises a new set of questions. How important is seasonality? What is a useful point of departure – the most recent quarter’s or half-year’s performance? The comparable period of the prior year? Some combination of the two? How should sub-period data be used to produce an annual forecast? Does the item-by-item approach to forecasting used for annual data apply equally well to sub-period data? Full consideration of these questions lies outside the scope of this chapter, but we can begin to answer some of them. Seasonality is a more important phenomenon in sales and earning behaviour than one might guess. It is present for more than just the retail sector firms that benefit from holiday sales. Seasonality also results from weather-related phenomena; for example, for tourist services, Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

electric and gas utilities, and construction firms; and for new product introduction patterns such as for the fashion industry; as well as for other factors. Analysis of the time-series behaviour of earnings suggests that at least some seasonality is present in nearly every major industry. The implication for forecasting is that one cannot focus only on performance of the most recent quarter or half-year as a starting point. In fact, the evidence suggests that, in forecasting earnings, if one had to choose only one sub-period’s performance as a point of departure, it would be the comparable sub-period of the prior year, not the most recent one. Note how this finding is consistent with the reports of analysts or the financial press; when they discuss a subperiod earnings announcement, it is nearly always evaluated relative to the performance of the comparable sub-period of the prior year, not the most recent quarter or half-year. Research has produced models that forecast sales, earnings or EPS based solely on prior quarters’ observations. These models are not used by many analysts since analysts have access to much more information than such simple models contain. However, the models are useful to help those unfamiliar with the behaviour of earnings data to understand how it tends to evolve over time. Such an understanding can provide useful general background, a point of departure in forecasting that can be adjusted to reflect details not revealed in the history of earnings, or a ‘reasonableness’ check on a detailed forecast. One model of the earnings process that fits well across a variety of industries is the so-called Foster model.10 Using Qt to denote earnings (or EPS) for quarter t, and E(Qt) as its expected value, the Foster model predicts that: E(Qt) = Qt–4 + δ + φ (Qt–1 – Qt–5) Foster shows that a model of the same form also works well with quarterly sales data. The form of the Foster model confirms the importance of seasonality because it shows that the starting point for a forecast for quarter t is the earnings four quarters ago, Qt–4. It states that, when constrained to using only prior earnings data, a reasonable forecast of earnings for quarter t includes the following elements: the earnings of the comparable quarter of the prior year (Qt–4) a long-run trend in year-to-year quarterly earnings increases (δ) a fraction (φ) of the year-to-year increase in quarterly earnings experienced most recently (Qt–1 – Qt–5). We can easily estimate the parameters δ and φ for a given firm with a simple linear regression model available in most spreadsheet software.11 For most firms the parameter δ tends to be in the range of 0.25 to 0.50, indicating that 25 to 50% of an increase in quarterly earnings tends to persist in the form of another increase in the subsequent quarter. The parameter φ reflects, in part, the average year-to-year change in quarterly earnings over past years, and it varies considerably from firm to firm. Research indicates that the Foster model produces one-quarter-ahead forecasts that vary from actual results by $0.30 to $0.35 per share, on average. Such a degree of accuracy stacks up surprisingly well against that of security analysts, who obviously have access to much more information than that used in the model. As one would expect, most of the evidence concludes analysts’ predictions are more accurate, but the models are a reasonable approximation in most circumstances. While it would certainly be unwise to rely completely on such a mechanistic model, an understanding of the typical earnings behaviour reflected by the model is useful.

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A PRACTITIONER ADVISES Australian financial analyst on the challenge of forecasting:

The first thing about forecasting is that you’ll always be wrong. And you can take an accounting/audit mentality and want everything to be precisely correct. That will only ever be true in history, based on the assumptions you make around the numbers you put in place. Once you accept that you’ll be wrong with your forecast, you realise that what you want to be is acceptably wrong. So, what matters more to my mind around forecasts isn’t so much the numbers that you pick – although you want to make sure you’re sensible about that – and it’s not so much the end result – although again, you want to be sensible about it. You don’t always want to follow the crowd. What you want to do is to be able to explain to somebody why you got the forecast that you had. That’s what you get paid for. That’s what people are looking for. Because when the world changes, the number you get at the back end will be different to what you forecast at the start. However, if your story is correct, then you should be theoretically moving in the right direction. And then it’s about all the things that you need to understand to make a forecast make sense and have a story around that forecast. So that’s where you need

to be detailed. You need to be detailed around what things will drive the business, and what things will drive the industry. Australian investment banker and instructor on the challenge of forecasting:

Obviously, forecasting is the hardest part. The way we do it in the workplace is to work with different scenarios – to create best- and worst-case scenarios and then determine the outcomes under each one. Because at the end of the day, no one really can forecast what the future will be. It’s more about making some assumptions and then seeing what outcomes you get, and then determining how you will mitigate any risks. I tell students that they need to focus on the conclusions that they draw, and which path they will recommend using those kinds of assumptions, rather than the actual numbers that they forecast. Reflective activity: Why is forecasting ‘obviously’ considered to be the hardest part of a business valuation? What does it mean to follow the crowd, and why should the analyst not want to do this? If the crowd is right, isn’t that the safest and most sensible thing to do?

SUMMARY Forecasting represents the first step of prospective analysis and serves to summarise the forward-looking view that emanates from business strategy analysis, accounting analysis and financial analysis. Although not every financial statement analysis is accompanied by such an explicit summary of the future, forecasting is still a key tool for managers, consultants, security analysts, investment and commercial bankers, and other credit analysts, among others. The best approach to forecasting future performance is to do it comprehensively – producing not only an earnings forecast but also a forecast of cash flows and the balance sheet. Such a comprehensive approach guards against internal inconsistencies and unrealistic implicit assumptions. The approach described here involves a

condensed line-by-line analysis, so as to recognise that different items on the income statement and balance sheet are influenced by different drivers. Nevertheless, it remains the case that a few key projections – such as sales growth and profit margin – usually drive most of the projected numbers. The forecasting process should be embedded in an understanding of how various financial statistics tend to behave on average, and what might cause a firm to deviate from that average. Absent detailed information to the contrary, one would expect sales and earnings numbers to persist at their current levels, adjusted for overall trends of recent years. However, rates of return on investment (ROEs) tend, over several years, to move from abnormal to normal levels – close to the cost of equity capital – as the forces

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CHAPTER 6 Prospective analysis: Forecasting

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

of competition come into play. Profit margins also tend to shift to normal levels, but for this statistic ‘normal’ varies widely across firms and industries, depending on the levels of asset turnover and leverage. Some firms are capable of creating barriers to entry that enable them to fight these tendencies towards normal returns, even for many years, but such firms are unusual. Forecasting should be preceded by a comprehensive business strategy, accounting and financial analysis. It is important to understand the dynamics of the industry in which the firm operates and its competitive positioning within that industry. Therefore, while general market trends provide a useful benchmark, it is critical that the analyst incorporates the views developed about the firm’s prospects to guide the forecasting process.

For some purposes, including short-term planning and security analysis, forecasts for sub-periods are desirable. One important feature of sub-period data is seasonality; at least some seasonality exists in the sales and earnings data of nearly every industry. An understanding of a firm’s intrayear peaks and valleys is a necessary ingredient of a good forecast of performance. Forecasts provide the input for estimating a firm’s value, which can be viewed as the best attempt to reflect in a single summary statistic the manager’s or analyst’s view of the firm’s prospects. The process of converting a forecast into a value estimate is labelled valuation and is discussed in the next chapter.

CHECKING AND APPLYING YOUR LEARNING 1 Many students of financial statement analysis, like new analysts, produce overly optimistic forecasts for a firm. Some managers are also optimistic in their forecasts. What would you see as evidence of such over-optimism in their forecasts, and what possible explanations are there for such behaviour?  LO2 2 Ali Baba, an analyst with Smart Beta Inc., claims: ‘It is not worth my time to develop detailed forecasts of sales growth, profit margins, etcetera, to make earnings projections. I can be almost as accurate, at virtually no cost, using the random walk model to forecast earnings’. What is the random walk model? Do you agree or disagree with Ali Baba’s forecast strategy? Why or why not?  LO1 3 Imagine you are a financial analyst preparing investment advice for your clients. a Consider the various sections of an annual financial report. Which section(s) do you think would be of most value to you when it is publicly released? b What other sources of data would be useful to you if you are reporting on firms in the following industries: – building and construction – extractive industries (i.e. mining) – hospitals and medical services – software as a service – airlines.  LO3 4 Which of the following types of businesses do you expect to show very little degree of seasonality in sub-period earnings? Explain why earnings might be constant throughout the year for those selected.

5

6

7

8

– A car mechanic – A juice manufacturer – A university – A property valuer – A dentist  LO2 Which of the following types of businesses do you expect to show a high degree of seasonality in quarterly earnings? Explain why. – A telecommunications company – A consulting company – A software as a service company – A car manufacturer – A grocery retailer  LO2 An analyst forecasts that next year’s net operating profit after tax will be the same as this year’s net operating profit after tax. Under what conditions is this a good forecast?  LO2 CSL is one of the largest biotechnology firms in Australasia, and over an extended period of time it consistently earned higher ROEs than the biotech industry as a whole. As a biotechnology analyst, what factors would you consider to be important in making projections of future ROEs for CSL? In particular, what factors would lead you to expect CSL to continue to be a superior performer in its industry, and what factors would lead you to expect CSL’s future performance to revert to that of the industry as a whole?  LO3 What factors are likely to drive a firm’s outlays for new capital (such as plant, property and equipment) and for working capital (such as receivables and inventory)?

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CHAPTER 6 Prospective analysis: Forecasting

What ratios would you use to help generate forecasts of these outlays?  LO1   LO3 9 How would the following events (reported this year) affect your forecasts of a firm’s future net income? a An asset write-down b A merger or acquisition c The sale of a major division d The initiation of dividend payments  LO3   LO5 10 Consider the following two earnings forecasting models: Model 1:

Qantas (in $millions)

Net book value of PPE

1

1 Et(EPSt+1) = ∑ EPSt 5 t+1 E(EPSt+1) is the expected forecast of earnings per share for year t+1, given information available at t. Model 1 is usually called a random walk model for earnings, whereas Model 2 is called a mean-reverting model. Figure 6.9 shows earnings per share for Woolworths Limited for the fiscal years ending June 2014 to June 2018. FIGURE 6.9 Woolworths earnings per share, 2014–18

Fiscal year

2014

2015

2016

2017

2018

EPS

$1.97

$1.71

–$0.98

$1.19

$1.33

a What would be the forecast for earnings per share in FY2019 for each model? b Actual earnings per share for Woolworths in FY2019 were $2.06. Given this information, what would be the FY2020 forecast for earnings per share for each model? Why do the two models generate quite different forecasts? Which do you think would better describe earnings per share patterns? Why?   LO4 11 JB Hi-Fi is a leading Australian retailer of consumer electronics and home entertainment goods. Use the data in Figure 6.10 for 2018 and 2019 to forecast revenue, cost of sales, and end-of-year inventory for 2020. Assume that JB Hi-Fi’s revenue growth rate, gross profit margin and inventory turnover will be the same as 2019.   LO4 FIGURE 6.10 JB Hi-Fi summary data, 2018–19

2018 5 384

5 568

891

886

27 534 –14 683

12 253

12 851

1 276

1 401 1 942

Assume that Qantas uses straight-line depreciation for its planes and that it expects its planes to have zero residual value. a Estimate the depreciation expense to average net book value of PPE for 2018. b What does your answer to the previous question imply about the expected useful life of Qantas’ planes? c Assume that the expected useful life of the planes does not change. Also assume that Qantas spends $2 000m on planes in 2019, and makes this purchase on the first day of the 2019 FY so there is a full year of depreciation on those planes. Forecast the 2019 depreciation expense for Qantas. This will include the depreciation of the planes held at the end of 2018, and the additional depreciation from the 2019 purchases. d Forecast the 2019 closing balance of PPE, both at cost and at net book value.  LO4 13 Bunnings is one of Australia and New Zealand’s leading retailers of home improvement and outdoor living products. Bunnings stores are owned by Wesfarmers Limited. The following table provides summary data for Bunnings. FIGURE 6.12 Bunnings summary data, 2018–19

Number of stores

Cost of sales

25 940 –13 687

1 334

Revenues

7 095

2018

Depreciation expense

2019

6 854

2017

Net cash payments for PPE

Bunnings ($m)

Revenue Ending inventory

FIGURE 6.11 Qantas’ PPE, 2017–18

Accumulated depreciation

Model 2:

JB Hi-Fi ($m)

12 Qantas is Australia’s largest airline. Running an airline is capital intensive with large expenditure on planes. Airlines do not keep their planes for the same length of time, and this difference is reflected in their respective depreciation policies. Figure 6.11 relates to Qantas’ PPE for 2017 and 2018. Assume that all of the PPE is for aircraft and engines.

PPE, at cost

Et(EPSt+1) = EPSt

153

2018

2019

12 544

13 166

369

374

Bunnings assets 5 025 5 118 Note that Wesfarmers segment data does not show ­Bunnings closing inventory levels.

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a Calculate the average revenue generated per store for Bunnings in 2018 and 2019. b Calculate average assets per store for Bunnings in both 2018 and 2019. Assume that Bunnings will add an additional 10 stores in 2020.

c Project 2020 revenues assuming that each new store will be open for half of the year. Assume that all of the revenue growth comes from opening new stores. d Project 2020 revenues assuming that the 10 new stores will open, and that same store revenue growth will be 5%.  LO4

CASE LINK Concepts from this chapter are used in the following case in Part 4:

Case 1 Qantas – Part D.

ENDNOTES 1

2 3

4

5

6

7

See A. B. Jackson, M. A. Plumlee and B. R. Rountree, ‘Decomposing the market, industry and firm components of profitability: Implications for forecasts for profitability’, Review of Accounting Studies 23 (2018): 1071–95. See P. O’Brien, ‘Analysts’ forecasts as earnings expectations’, Journal of Accounting and Economics (January 1988): 53–83. See G. Foster, ‘Quarterly accounting data: Time-series properties and predictive ability results’, Accounting Review (January 1977): 1–21. See R. Freeman, J. Ohlson and S. Penman, ‘Book rate-of-return and prediction of earnings changes: An empirical investigation’, Journal of Accounting Research (Autumn 1982): 639–53. See S. H. Penman, ‘An evaluation of accounting rate-of-return’, Journal of Accounting, Auditing, and Finance (Spring 1991): 233–56; E. Fama and K. French, ‘Size and book-to-market factors in earnings and returns’, Journal of Finance (March 1995): 131–56; and V. Bernard, ‘Accounting-based valuation methods: Evidence on the market-to-book anomaly and implications for financial statements analysis’, University of Michigan, working paper (1994). Ignoring the effects of accounting artefacts, ROEs should be driven in a competitive equilibrium to a level approximating the cost of equity capital. P. Healy, G. Serafeim, S. Srinivasan and G. Yu, ‘Market competition, government efficiency, and profitability around the world,’ HBS Working Paper, No. 12–010 (2011). A ‘normal’ profit margin is that which, when multiplied by the turnover achievable within an industry and with a viable corporate strategy, yields a return on investment that just covers the cost of capital. However, as mentioned above, accounting artefacts can

cause returns on investment to deviate from the cost of capital for long periods, even in a competitive equilibrium. 8 The RBA forecasts for 2019 and 2020 GDP are available from https://www.rba.gov.au/publications/smp/2018/nov/economicoutlook.html. 9 From IBISWorld forecast for sports and camping retail growth 2019–24, https://www.ibisworld.com.au/industry-trends/marketresearch-reports/retail-trade/other-store-based-retailing/sportcamping-equipment-retailing.html, accessed 29 March 2020. 10 See Foster, op. cit. A somewhat more accurate model is furnished by Brown and Rozeff, but it requires interactive statistical techniques for estimation; see L. D. Brown and M. Rozeff, ‘Univariate time-series models of quarterly accounting earnings per share’, Journal of Accounting Research (Spring 1979): 179–89. 11 To estimate the model, we write in terms of realised earnings (as opposed to expected earnings) and move Qt–4 to the left side: Qt – Qt–4 = δ + φ(Qt–1 – Qt–5) + et

We now have a regression where (Qt – Qt–4) is the dependent variable, and its lagged value (Qt–1 – Qt–5) is the independent variable. Thus, to estimate the equation, prior earnings data must first be expressed in terms of year-to-year changes; the change for one quarter is then regressed against the change for the most recent quarter. The intercept provides an estimate of δ, and the slope is an estimate of φ. The equation is typically estimated using 24 to 40 quarters of prior earnings data.

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155

APPENDIX: THE BEHAVIOUR OF COMPONENTS OF ROE In Figure 6.4 we showed that ROEs tend to be meanreverting. In this appendix we show the behaviour of the key components of ROE – NOPAT margin, operating asset turnover and net financial leverage. These ratios are

computed using the same portfolio approach described in this chapter, based on the data for all Australian firms for the time period 2000 to 2018. We have excluded mining firms in our analysis.

0.2 0.15 0.1 0.05 0 –0.05 –0.1 –0.15 1

2

3

4

5

6

Years relative to portfolio formation Top quintile of profit margin in year of portfolio formation

Second quintile of profit margin in year of portfolio formation

Fourth quintile of profit margin in year of portfolio formation

Bottom quintile of profit margin in year of portfolio formation

Third quintile of profit margin in year of portfolio formation

FIGURE 6.13 Behaviour of NOPAT margins for Australian firms, 2000–18 6 5 4 3 2 1 0 1

2

3

4

5

6

Year relative to portfolio formation Top quintile of asset turnover in year of portfolio formation

Second quintile of asset turnover in year of portfolio formation

Fourth quintile of asset turnover in year of portfolio formatio

Bottom quintile of asset turnover in year of portfolio formation

Third quintile of asset turnover in year of portfolio formation

FIGURE 6.14 Behaviour of operating asset turnover for Australian firms, 2000–18

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2 1.5 1 0.5 0 –0.5 –1 1

2

3

4

5

6

Years relative to portfolio formation Top quintile of financial leverage in year of portfolio formation Fourth quintile of financial leverage in year of portfolio formation

Second quintile of financial leverage in year of portfolio formation

Third quintile of financial leverage in year of portfolio formation

Bottom quintile of financial leverage in year of portfolio formation

FIGURE 6.15 Behaviour of net financial leverage for Australian firms, 2000–18

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CHAPTER

Prospective analysis: Valuation theory and concepts The previous chapter introduced forecasting, the first stage of prospective analysis. In this and the following chapter we describe the second and final stage of prospective analysis: valuation. This chapter focuses on valuation theory and concepts, and the following chapter discusses implementation issues. Valuation is the process of converting a forecast into an estimate of the value of the firm or some component of the firm. At some level, nearly every business decision involves valuation, at least implicitly. Within the firm, capital budgeting involves considering how a potential project will affect firm value. Strategic planning focuses on how value is influenced by larger sets of actions. Outside the firm, security analysts conduct valuation to support their buy/sell decisions, and potential acquirers, often with the assistance of their investment bankers, estimate the value of target firms and the synergies they might offer. Valuation is necessary to price an initial public offering and to inform parties to sales, estate settlements and divisions of property involving ongoing business concerns. Even credit analysts, who typically do not explicitly estimate firm value, must at least implicitly consider the value of the firm’s equity ‘cushion’ if they are to maintain a complete view of the risk associated with lending activity. In practice, analysts employ a variety of valuation approaches. For example, in evaluating the fairness of a takeover bid, investment bankers commonly use five to 10 different valuation methods. The methods used include: Discounted dividends: this approach expresses the value of the firm’s equity as the present value of forecasted future dividends. Discounted cash flow (DCF) analysis: this approach involves producing detailed, multiple-year forecasts of cash flows. The forecasts are then discounted at the firm’s estimated cost of capital to arrive at an estimated present value.

7

Discounted abnormal earnings: under this approach the value of the firm’s equity is expressed as the sum of its book value of equity and discounted forecasts of abnormal earnings. Valuation based on price multiples: under this approach a current measure of performance or single forecast of performance is converted into a value by applying some price multiple for other presumably comparable firms. For example, firm value can be estimated by applying a price-to-earnings ratio to a forecast of the firm’s earnings for the coming year. Other commonly used multiples include price-to-book ratios and price-to-sales ratios. These methods are developed throughout this chapter. All of the above approaches can be structured in two ways. The first is to directly value the equity of the firm, since this is usually the variable the analyst is directly interested in estimating. The second is to value the assets of the firm – that is, the claims of equity and net debt – and then to deduct the value of net debt to arrive at the final equity estimate. Theoretically, both approaches should generate the same values. However, as we will see in the following chapter, there are implementation issues in reconciling the approaches. In this chapter, we illustrate valuation using an all-equity firm to simplify the discussion. Where appropriate we discuss the theoretical issues in valuing the firm’s assets. From a theoretical perspective, shareholder value is the present value of future dividend payoffs. This definition can be implemented by forecasting and discounting future dividends directly. Alternatively, it can be framed by recasting dividends in terms of earnings and book values, or in terms of free cash flows to shareholders. We examine these methods throughout the chapter and discuss their pros and cons. Valuation using multiples is also discussed. Multiples are a popular method of valuation because,

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unlike the discounted dividend, discounted abnormal earnings and discounted cash flow methods, they do not require analysts to make multi-year forecasts. However, identifying comparable firms is a serious challenge in implementing the multiples approach. This chapter discusses how the discounted abnormal earnings valuation approach can be recast to generate

firm-specific estimates of two popular multiples: valueto-book and value-earnings ratios (or price-to-book and price-earnings ratios). Value-to-book multiples are shown to be a function of future abnormal ROEs, book value growth and the firm’s cost of equity. Value-earnings multiples are driven by the same factors and also the current ROE.

Chapter learning objectives By the end of this chapter, you should be able to: LO1

understand how to define value for shareholders

LO2

understand that earnings-based valuation methods should reconcile with dividends-based valuation methods

LO3

remember the benefits and potential pitfalls of using multiples as valuation metrics

LO4

apply ‘short cut’ forms of valuation and understand their benefits and limitations

LO5

apply the discounted cash flow model to company valuation and understand its equivalence to the discounted dividends model

LO6

evaluate the differences between the dividends, cash flows and earnings-based valuation models.

LO1

 he discounted dividends valuation T method

How should shareholders think about the value of their equity claims on a firm? Finance theory holds that the value of any financial claim is simply the present value of the cash payoffs that its claimholders receive. Since shareholders receive cash payoffs from a company in the form of dividends, the value of their equity is the present value (PV) of future dividends (including any liquidating dividend). Equity value = PV of expected future dividends If we denote re as the cost of equity capital (the relevant discount rate), the equity value is as follows: Equity value =

Dividend1 (1 + re)

+

Dividend2 (1 + re)

2

+

Dividend3 (1 + re)3

+…

Notice that the valuation formula views a firm as existing indefinitely. But in reality, firms can go bankrupt or get taken over. In these situations, shareholders effectively receive a terminating dividend on their shares. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 7 Prospective analysis: Valuation theory and concepts

In practice, analysts tend to produce detailed forecasts for a finite near-term period, referred to as the forecast horizon, and make simplifying assumptions about firm performance after the forecast horizon. Using a forecast horizon of three years, equity value can be written as follows: Equity value =

Dividend1 (1 + re)

+

Dividend2 (1 + re)2

+

Dividend3 (1 + re)3

+ PV of dividends beyond year 3 If a firm had a constant dividend growth rate (gd) indefinitely, its value would simplify to the following formula: Equity value =

Dividend1 (re − gd )

To better understand how the discounted dividend approach works, consider the following example. At the beginning of year 1, Down Under Company raises $60 million of equity and uses the proceeds to buy a fixed asset. Operating profits before depreciation (all received in cash) and dividends for the company are expected to be $40 million in year 1, $50 million in year 2 and $60 million in year 3, at which point the company terminates (having a terminal value of zero). The firm pays no taxes. If the cost of equity capital for this firm is 10%, the value of the firm’s equity is computed as shown in Figure 7.1. FIGURE 7.1 Calculation of Down Under Company’s equity

Year

Dividend

PV factor

PV of dividend

(a)

(b)

(a) × (b)

1

$40m

0.9091

$36.4m

2

50

0.8264

41.3

3

     60

0.7513

       45.1

Equity value

$122.8m

The valuation formula in Figure 7.1 is called the dividend discount model. It forms the basis for most of the popular theoretical approaches for share valuation. Despite its theoretical importance, the dividend discount model is not commonly used in practice. This is because equity value is created primarily through the operating and investment operating activities of a firm. Dividend payments tend to be a by-product of such activities, and their timing and amount depends strongly on the firm’s investment opportunities. Within a period of five to 10 years, which tends to be the focus of most prospective analyses, dividends may therefore reveal very little about the firm’s equity value. For example, high-growth start-up firms tend not to pay out dividends until later into their life cycle, but they nonetheless have value when they start their operations. Predicting long-run dividends for these firms is virtually impossible. Because the first stage of the prospective analysis, as discussed in Chapter 6, typically produces comprehensive, detailed forecasts for the near term but unavoidably makes simplifying assumptions for the longer term, useful valuation models value near-term profitability and growth directly rather than indirectly through long-run dividends. The remainder of the chapter discusses how this model can be recast to generate the discounted abnormal earnings, discounted cash flow and price multiple models of value.

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LO2

 he discounted abnormal earnings T valuation method

As discussed in Chapter 3, there is a link between dividends and earnings. If all transactions that affect equity, other than capital transactions, flow through the income statement,1 the expected book value of equity for existing shareholders at the end of year 1 (BVE1) is simply the book value at the beginning of the year (BVE 0) plus expected net income or loss in year 1 (NI1) less expected dividends paid in year 1 (Dividend1).2 This relation can be rewritten as follows: Dividend1 = Net income1 + BVE 0 - BVE1 By substituting this identity for dividends into the dividend discount formula and rearranging the terms, equity value can be rewritten as follows:3 Equity value = Book value of equity + PV of expected future abnormal earnings Abnormal earnings are calculated as net income adjusted for a capital charge. The capital charge is computed as the discount rate multiplied by the beginning book value of equity. Abnormal earnings therefore adjust net income to reflect the fact that accountants do not recognise any opportunity cost for equity funds used. Thus, the discounted abnormal earnings valuation formula is: Equity value = BVE 0 + +

Net income1 - re × BVE 0 (1 + re) Net income - re × BVE2 (1 + re)3

+

Net income2 - re × BVE1 (1 + re)2

+ PV of abnormal earnings beyond year 3

As noted earlier, equity values can also be estimated by valuing the firm’s assets and then deducting its net debt. Under the earnings-based approach, this implies that the value of the assets is: NOPAT1 − WACC × BVA0 NOPAT2 − WACC × BVA1 + (1 + WACC ) (1 + WACC )2 NOPAT3 − WACC × BVA2 + + PV of abnormal NOPAT beyond year 3 (1 + WACC )3

Asset value = BVA0 +

Book value of assets (BVA) is the book value of the firm’s assets, NOPAT is net operating profit (before interest) after tax, and WACC is the firm’s weighted average cost of debt and equity. From this asset value the analyst can deduct the market value of net debt to generate an estimate of the value of equity. The earnings-based formulation (also known as the residual income model) has intuitive appeal. It implies that if a firm can earn only a normal rate of return on its book value, then investors should be willing to pay no more than book value for the shares. Investors should pay more or less than book value if earnings are above or below this normal level. The deviation of firm’s market value from book value depends on its ability to generate ‘abnormal earnings’. The formulation also implies that a firm’s equity value reflects the cost of its existing net assets (i.e. its book equity) plus the net present value of future growth options (represented by cumulative abnormal earnings).

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CHAPTER 7 Prospective analysis: Valuation theory and concepts

To illustrate the earnings-based valuation approach, let’s return to the Down Under Company example. Since the company is an all-equity firm, the value of the firm’s equity and its assets (debt plus equity) are the same. If the company depreciates its fixed assets using the straight-line method, its beginning book equity, earnings, abnormal earnings and valuation will be as shown in Figure 7.2. FIGURE 7.2 Down Under Company’s depreciated fixed assets using the straight-line method

Beginning book value of equity

Net income

Abnormal earnings

PV factor

PV of abnormal earnings

(a)

(b)

(c) = re × (a)

(e)

(d) × (e)

1

$60m

$20m

$14m

0.909

$12.7m

2

40

30

26

0.826

21.5

3

      20

     40

      38

0.751

       28.6

Year

Cumulative PV of abnormal earnings in years 1–3 PV of abnormal earnings beyond year 3

62.8 0.0

+ Beginning book value of equity

       60.0

= Equity value

$122.8m

This share valuation of $122.8 million is identical to the value estimated using the discounted cash flows method and the discounted dividends method. This should not be surprising, since we have used the same underlying assumptions to forecast profits and cash flows.

KEY ANALYSIS QUESTIONS Valuing equity under the discounted abnormal earnings method requires the analyst to answer the following questions: What are expected future net income and book values of equity over a finite forecast horizon (usually five to 10 years) given the firm’s industry competitiveness and positioning? What is the expected future abnormal net income beyond the final year of the forecast horizon (called the ‘terminal year’) based on some simplifying assumption? If abnormal returns are expected to persist, what are the barriers to entry that deter competition? What is the firm’s cost of equity capital? This is used to compute the present value of abnormal earnings.

Research shows that abnormal earnings estimates of value outperform traditional multiples, such as price-earnings ratios, price-to-book ratios and dividend yields, for predicting future share movements.4 Firms with high abnormal earnings model estimates of value relative to current price show positive abnormal future share returns, whereas firms with low estimated value-to-price ratios have negative abnormal share performance.

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Accounting methods and discounted abnormal earnings It may seem odd that firm value can be expressed as a function of accounting numbers. After all, accounting methods per se should have no influence on firm value, except as those choices influence the analyst’s view of future real performance. Yet the valuation approach used here is based on numbers – earnings and book value – that vary with accounting method choices and accrual estimates. How then can the valuation approach deliver accurate estimates? Accounting choices that affect current net income also affect its book value, and therefore they affect the capital charge used to estimate future abnormal earnings. In addition, the selfcorrecting nature of double-entry bookkeeping – that all ‘distortions’ of accounting must ultimately reverse – means estimated values based on the discounted abnormal earnings method will not be affected by the choice of accounting methods or by accrual estimates. Reusing our example from earlier, assume that Down Under Company’s managers choose to be conservative and expense some unusual costs that could have been capitalised as inventory at year 1, causing earnings and ending book value to be lower by $10 million. This inventory is then sold in year 2. For the time being, let’s say the accounting choice has no influence on the analyst’s view of the firm’s real performance. The managers’ choice reduces abnormal earnings in year 1 and book value at the beginning of year 2 by $10 million. However, future earnings will be higher, for two reasons. First, future earnings will be higher by $10 million when the inventory is sold in year 2 at a lower cost of sales. Second, the benchmark for normal earnings, based on book value of equity, will be lower by $10 million. The $10 million decline in abnormal earnings in year 1 is perfectly offset, on a present value basis, by the $11 million higher abnormal earnings in year 2. As a result, the value of Down Under Company under conservative reporting is identical to the value under the earlier accounting method – $122.8 million. FIGURE 7.3 Down Under’s value using conservative reporting

Beginning book value

Earnings

Abnormal earnings

PV factor

PV of abnormal earnings

(a)

(b)

(c) = re × (a)

(e)

(d) × (e)

1

$60m

$10m

$4m

0.9091

$3.6m

2

30

40

37m

0.8264

30.6

3

     20

     40

38m

0.7513

   28.6

Year

Cumulative PV of abnormal earnings

62.8

PV of abnormal earnings beyond year 3

0.0

+ Beginning book value of equity

       60.0

= Equity value

$122.8m

Provided the analyst is aware of biases in accounting data as a result of managers using aggressive or conservative accounting choices, abnormal earnings-based valuations are unaffected by the variation in accounting decisions. This implies that strategic and accounting analyses are critical precursors to abnormal earnings valuation. The strategic and accounting analysis tools help the analyst to identify whether abnormal earnings arise from sustainable competitive advantage or

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CHAPTER 7 Prospective analysis: Valuation theory and concepts

163

UPDATED FORECASTS During the first week following the publication of the financial statements for the fiscal year ending in July 2018, several analysts updated their forecasts for Kathmandu’s 2019 and 2020 revenue and earnings. Analysts’ average expectations are shown in Figure 7.4. FIGURE 7.4 Analysts’ average expectations for Kathmandu, 2019–20

(NZ$) Revenue Earnings per share Earnings (using end-of-year FY 2018 number of shares)

2018 actual

2019 forecast

2020 forecast

$497m

$545m

$580m

$0.24

$0.26

$0.28

$54.1m

$58.6m

$63.1m

Note: analysts’ AUD forecasts have been translated to NZD amounts.

The forecasts above are not sufficient to estimate the value of Kathmandu’s equity. We will need to forecast Kathmandu’s ending operating working capital, net non-current assets, debt and group equity under the simplifying assumption that the future growth in these items follows revenue growth. 1 Assume that Kathmandu’s cost of equity capital is 8%. From there we will need to calculate: a dividends in 2019 and 2020 b abnormal earnings in 2019 and 2020 c free cash flows to equity in 2019 and 2020. To estimate Kathmandu’s equity value, we need to make assumptions about what will happen to Kathmandu’s earnings, dividends, equity, debt and assets after 2020. In the next chapter, we will discuss several assumptions that the analyst can make. For now, we make the somewhat unrealistic but convenient assumption that in 2021 Kathmandu liquidates all its assets at their book values, uses the proceeds to pay off debt, and pays out the remainder to its equity holders. 2 What does this assumption imply about: a the book value of Kathmandu’s assets and liabilities at the end of 2021?

b Kathmandu’s profit or loss in 2021? c Kathmandu’s final dividend payment in 2021? d Kathmandu’s free cash flow to equity holders in 2021? 3 We will then need to estimate Kathmandu’s equity value at the end of fiscal 2018 using: a the discounted dividends model and the discounted cash flow model b the discounted abnormal earnings model. The solution to this demonstration case is as follows: Expected revenue growth in 2019 and 2020 is 9.7% (47/497) and 6.4% (35/545), respectively. The values of the four balance sheet items at the end of 2018 are known. Based on the expected revenue growth rates, the expected values at the end of 2019 and 2020 are shown in Figure 7.5. FIGURE 7.5 Kathmandu expected values at the end of 2019 and 2020

(NZ$m)

2018A

2019F

2020F

69.7

76.5

81.4

404.0

443.0

471.5

53.3

58.5

62.3

Equity

420.4

461.0

490.6

Operating assets

473.7

519.5

552.8

Operating working capital Net long-term operating assets Net debt

A = actual, F = forecast The calculations are as follows: 1 Dividends2019 = Equity2018 + Earnings2019 – Equity2019 = 420.4 + 58.6 – 461.0 = 18.0 Dividends2020 = Equity2019 + Earnings2020 – Equity2020 = 461.0 + 63.1 – 490.6 = 33.5 2 Abnormal earnings2019 = Earnings2019 – re × Equity2018 = 58.6 – 8% × 420.4 = 25.0 Abnormal earnings2020 = Earnings2020 – re × Equity2019 = 63.1 – 8% × 461.0 = 26.2 3 FCF to equity2019 = Earnings2019 – ∆Operatingassets2019 + ∆Netdebt2019 = 58.6 – (519.5 – 473.7) + (58.5 – 53.3) = 18.0

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KATHMANDU CASE

from unsustainable accounting manipulations. For example, consider the implications of failing to understand the reasons for a decline in earnings from a change in inventory policy for Down Under Company. If the analyst mistakenly interpreted the decline as indicating that the firm was having difficulty moving its inventory, rather than that it had used conservative accounting, she might reduce expectations of future earnings. The estimated value of the firm would then be lower than that reported in our example.

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

FCF to Equity2020 = Earnings2020 – ∆Operatingassets2020 + ∆Netdebt2020 = 62.3 – (552.8 – 519.5) + (62.3 – 58.5) = 33.5 Note that free cash flow to equity is equal to the dividends paid out to equity holders. Further calculations: 1 Kathmandu’s assets and liabilities will have book values of zero at the end of 2021. 2 Kathmandu’s profit or loss will be zero in 2021 as all assets will have been sold at their book values (so profit on sale = 0). Dividends2021 = Equity2020 + Earnings2021 – Equity2021 = 490.6 + 0 – 0 = 490.6 3 FCF to Equity2021 = Earnings2021 – ∆Operatingassets2021 + ∆Netdebt2021 = 0 – (0 – 552.8) + (0 – 62.3) = 490.6 4 Abnormal earnings2021 = Earnings2021 – re × Equity2020 = 0 – 8% × 490.6 = –39.2 For the final calculations 1 Note that Kathmandu’s dividends are exactly equal to free cash flow to equity holders. Using the discounted dividend (or discounted cash flow) model, Kathmandu’s equity value is calculated as follows in Figure 7.6. FIGURE 7.6 Calculating Kathmandu’s equity value using the discounted dividend model

2019

2020

2020

Dividend

18.0

33.5

490.6

PV factor (8% discount rate)

0.93

0.86

0.79

PV of dividends

16.7

28.7

389.5

Sum of PV of dividends = value of equity

LO3

434.8

2 Using the abnormal earnings valuation model, Kathmandu’s equity value is calculated as follows FIGURE 7.7 Calculating Kathmandu’s equity value using the abnormal earnings valuation model

2019

2020

2020

Earnings

58.6

63.1

0

Normal (or required) earnings

33.6

36.9

39.2

Abnormal earnings

25.0

26.2

–39.2

Present value factor

0.93

0.86

0.79

Present value of abnormal earnings

23.1

22.5

–31.2

Sum of present value of abnormal earnings

14.4

+ Book value of equity at start of 2019

420.4

= Value of equity

434.8

Number of shares

225.3

Value per share

$1.93

At the end of 2018, Kathmandu had 225.3m shares on issue. The equity value of $434.8m corresponds with an estimate of NZ$1.93 per share. On 1 August, 2018, one day after Kathmandu’s annual earnings announcement, the company’s closing share price was $3.08. Our estimate of equity value per share is substantially lower than the actual share price because we made very conservative assumptions about Kathmandu’s performance after 2020. In the next chapter we will discuss methods to arrive at more realistic (less conservative) equity value estimates.

Valuation using price multiples

Many analysts prefer to create valuations based on price multiples because the model is simple to apply. Unlike the discounted abnormal earnings, discounted dividend and discounted cash flow methods, multiple-based valuations do not require detailed multiple-year forecasts about a variety of parameters, including growth, profitability and cost of capital. Valuation using multiples involves the following steps: 1 Select a measure of performance or value (such as earnings, sales, cash flows, book value of equity or book value of assets) as the basis for multiple calculations. 2 Calculate price multiples for comparable firms using the measure of performance or value. 3 Apply the comparable firm multiple to the performance or value measure of the firm being analysed. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 7 Prospective analysis: Valuation theory and concepts

With this approach, the analyst relies on the market to undertake the difficult task of considering the short- and long-term prospects for growth and profitability and their implications for the values of the comparable firms. Then the analyst assumes that the pricing of those other firms is applicable to the firm at hand. On the surface, using multiples seems straightforward. Unfortunately, in practice it is not as simple as it would appear. Identifying ‘comparable’ firms is often quite difficult. Analysts also need to choose how they will calculate the multiples. Finally, explaining why multiples vary across firms, and how applicable another firm’s multiple is to the one at hand, requires a sound understanding of the determinants of each multiple.

Selecting comparable firms Ideally, analysts who use price multiples for a comparable firm analysis will find firms with similar operating and financial characteristics. Firms within the same industry are the most obvious candidates. But within narrowly defined industries, it is often difficult to find multiples for similar firms. Many firms operate in multiple industries, making it difficult to identify representative benchmarks. In addition, firms within the same industry frequently have different strategies, growth opportunities and profitability, creating more problems with comparisons. One way of dealing with these issues is to average across all firms in the industry. The analyst implicitly hopes that the various sources of non-comparability cancel each other out, so that the firm being valued is comparable to a ‘typical’ industry member. Another approach is to focus on only those firms within the industry that are most similar. Consider using multiples to value Kathmandu. Financial databases classify Kathmandu in the specialty retail industry. Its competitors from the same industry include Super Retail Group and footwear retailer Accent Group. There were a number of other firms that did not compete in the same markets as Kathmandu, such as JB Hi-Fi and Automotive Holdings Group. Figure 7.8 shows that the median price-earnings (PE) ratio for the 27 firms in the specialty retailer industry was 11.8 and the median price-to-book (PB) was 1.9. However, it is not clear whether these multiples are useful benchmarks for valuing Kathmandu. Not all of these competitors follow a similar strategy or financing policy, and some of them operate on a different scale, in terms of both revenue and geographic reach. In addition, not all competitors exhibit similar growth rates as Kathmandu. Figure 7.8 shows similar multiples for the broader GICS industry classifications that Kathmandu is classified in. FIGURE 7.8 Selected valuation multiples by industry grouping

Number of firms

Median price-book

Median price-earnings

125

1.79

11.1

Retailing

51

1.93

11.2

Specialty retail

27

1.93

11.8

Consumer discretionary

Note: multiples are calculated at 2018 for firms with assets and revenues both above $1million. Source: Morningstar Datanalysis

Another problem arises when comparing firms from different countries. Within each country, a variety of factors could influence price multiples. We know the price-earnings ratio is affected by risk, growth and earnings. Therefore, international differences that affect these components will influence international price-earnings ratios. For example, the cost of equity, which is inversely Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

related to the price-earnings multiple, is affected by the risk-free interest rate. Consequently, international differences in risk-free interest rates lead to international differences in priceearnings multiples. In addition, differences in accounting standards may lead to systematic international differences in earnings and book amounts, which are common denominators in price multiples. The most obvious way around the problem of different international price multiples is to choose multiples from a single country. However, the number of available peer firms will depend on the size of the equity market. Choosing an appropriate set of comparable firms relies heavily on the analyst’s skill and judgement. Furthermore, in the current case we know the price multiples for Kathmandu. This would not be the case if the analyst were valuing a private firm. In choosing a multiple, the analyst must have a thorough understanding of the determinants of multiples such as price-to-book and price-earnings. However, research shows that industry appears to be a good basis for comparable selection and a good rule of thumb is that the industry has at least six observations.5 However, getting six comparable firms in thin markets is not always possible.

Multiples for firms with poor performance Price multiples can be affected when measures such as earnings (used as the denominator in a P/E ratio) or cash flow reflects current poor performance. For example, one of Kathmandu’s competitors, AuMake International, reported losses in 2018, making the price-earnings ratio negative. Since negative price-earnings ratios have no sensible interpretation, they are often excluded from the estimation of the average price-earnings ratio. Note that we presented the median price-earnings ratio in Figure 7.8, which is an alternative way of dealing with the potential influence of outlier observations on average values. What are analysts’ other options for handling the problems for multiples created by transitory shocks to the denominator? One option is to simply exclude firms with large transitory effects from the set of comparable firms. As an alternative to excluding some firms from the industry comparison group, if the poor performance is due to a transitory shock such as a write-off or special item, the effect can be excluded when computing the multiple. For this reason, some analysts prefer to use operating earnings. Finally, the analyst can use a denominator that is a forecast of future performance rather than a past measure. Multiples based on forecasts are termed leading multiples, whereas those based on historical data are called trailing multiples. Leading multiples are less likely to include one-time gains and losses in the denominator, simply because such items are difficult to anticipate.

Adjusting multiples for leverage Price multiples should be calculated in a way that preserves consistency between the numerator and denominator. Consistency is an issue for those ratios where the denominator reflects performance before servicing debt. Examples include the price-to-sales multiple and any multiple of operating earnings or operating cash flows. When calculating these multiples, the numerator should include not just the market value of equity but the value of debt as well.

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CHAPTER 7 Prospective analysis: Valuation theory and concepts

Determinants of value-to-book and value-earnings multiples Even across relatively closely related firms, price multiples can vary considerably. Careful analysis of this variation requires consideration of factors that may explain why one firm’s multiples should be higher than those of benchmark firms. We therefore return to the abnormal earnings valuation method and show how it provides insights into differences in value-to-book and valueto-earnings multiples across firms. If the abnormal earnings formula is scaled by book value, the left-hand side becomes the equity value-to-book ratio as opposed to the equity value itself. The right-hand side variables are now earnings deflated by book value, or our old friend ROE, discussed in Chapter 5.6 The valuation formula becomes:

ROE 1 − re (ROE 2 − re )(1 + gbve1 ) + (1 + re ) (1 + re )2 (ROE 3 − re )(1 + gbve 1 )(1 + gbve 2 )    + + (1 + re )3

Equity value-to-book ratio = 1 +

where gbvet = growth in book value of equity (BVE) from year t - 1 to year t or BVEt - BVEt-1 BVEt-1

The formulation implies that a firm’s equity value-to-book ratio is a function of three factors: its future abnormal ROEs, its growth in book value of equity and its cost of equity capital. Abnormal ROE is defined as ROE less the cost of equity capital (ROE - re ). Firms with positive abnormal ROE are able to invest their net assets to create value for shareholders and have price-to-book ratios greater than one. Firms that are unable to generate returns greater than the cost of capital have ratios below one. The magnitude of a firm’s value-to-book multiple also depends on the amount of growth in book value. Firms can grow their equity base by issuing new equity or by reinvesting profits. If this new equity is invested in positive value projects for shareholders - that is, projects with ROEs that exceed the cost of capital - the firm will boost its equity value-to-book multiple. Of course, for firms with ROEs that are less than the cost of capital, equity growth further lowers the multiple. The valuation task can now be framed in terms of two key questions about the firm’s ‘value drivers’: 1 How much greater (or smaller) than normal will the firm’s ROE be? 2 How quickly will the firm’s investment base (book value) grow? If desired, the equation can be rewritten so that future ROEs are expressed as the product of their components: profit margins, sales turnover and leverage. This approach permits us to build directly on projections of the same accounting numbers used in financial analysis (see Chapter 9) without the need to convert projections of those numbers into cash flows. Yet in the end, the estimate of value should be the same as that from the dividend discount model.7 It is also possible to structure the multiple valuation as the debt plus equity value-to-book assets ratio by scaling the abnormal NOPAT formula by book value of net operating assets. The valuation formula then becomes Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Debt plus equity value-to-book ratio = 1 +

ROA1 − WACC (ROA2 − WACC )(1 + gbva ) + (1+WACC ) (1 + WACC )2 (ROA3 − WACC )(1 + gbva1 )(1 + gbva2 ) + + ⋅⋅⋅ (1 + WACC )3

where ROA = operating return on assets = NOPAT/(operating working capital + net long-term assets) WACC = weighted average cost of debt and equity gbvat = growth in BVA from year t-1 to year t or

BVAt − BVAt −1 BVAt −1 The value of a firm’s debt and equity to net operating assets multiple therefore depends on its ability to generate asset returns that exceed its WACC and on its ability to grow its asset base. The value of equity under this approach is then the estimated multiple times the current BVA less the market value of debt. Returning to the Down Under Company example, the implied equity value-to-book multiple is estimated in Figure 7.9. FIGURE 7.9 Down Under’s implied equity value-to-book multiple

Year 1

Year 2

Year 3

Beginning book value of equity

$60m

$40m

$20m

Net income

$20m

$30m

$40m

ROE - Cost of equity capital = Abnormal ROE × (1 + cumulative book value of equity growth)

0.33

0.75

2.00

     0.10

     0.10

      0.10

0.23

0.65

1.90

     1.00

     0.67

      0.33

0.23

0.43

0.63

= PV factor

 0.9091

 0.8264

0.75513

= PV of abnormal ROE scaled by book value growth

0.212%

0.358%

0.476%

= Abnormal ROE scaled by book value growth

Cumulative PV of abnormal ROE scaled by book value growth

1.046

+ 1.00

1.000

= Equity value-to-book multiple

2.046

The equity value-to-book multiple for Down Under is therefore 2.046 and the implied equity value is $122.8 ($60 times 2.046), once again identical to the dividend discount model as well as the DCF model value. Recall that Down Under is an all-equity firm, so that the abnormal ROE and abnormal ROA structures for valuing the firm are the same.

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CHAPTER 7 Prospective analysis: Valuation theory and concepts

The equity value-to-book formulation can also be used to construct the equity value-earnings multiple as follows: Equity value-to-earnings multiple = Equity value-to-book multiple × =

Equity value-to-book multiple

Book value of equity Earnings

ROE

In other words, the same factors that drive a firm’s equity value-to-book multiple (i.e. priceto-book multiple) also explain its equity value-earnings multiple (i.e. price-earnings multiple). The key difference between the two multiples is that the price-earnings multiple is affected by the firm’s current level of ROE performance (relative to expected future levels of performance), whereas the price-to-book multiple is not. Firms with low current ROEs therefore can have very high price-earnings multiples and vice versa. If a firm has a zero or negative ROE, its PE multiple is not defined. Price-earnings multiples are therefore more volatile than price-to-book multiples. These issues are illustrated in the discussion of Figure 7.10 FIGURE 7.10 Selected PB, PE and ROE figures for the specialty retailing industry for 2018

Price-book

Price-earnings

Return on equity

Kathmandu

1.66

13.05

12.0%

Super Retail Group

2.00

11.07

18.2%

Briscoe Group Australasia

3.68

15.16

24.7%

PAS Group

0.34

16.13

2.1%

Premier Investments

2.04

24.29

8.5%

Specialty retailing average

3.06

13.47

19.2%

Note: average figures exclude firms with negative earnings. Source: Morningstar

Figure 7.10 reports 2018 price multiples data for a subset of firms in the specialty retailing sector (GICS = 255040). The first row reports data from Kathmandu, while the last row reports the average ratios for the search. These can be used as benchmarks for the other firms reported in the table. Note that negative price-earnings have been excluded. Super Retail Group and Premier Investments both have price-book ratios that are slightly above that of Kathmandu. Kathmandu has a higher price-earnings multiple than Super Retail, indicating that investors believe that the growth in its ROE will be higher than that of Super Retail. Premier Investments has the highest price-earnings multiple in the table, and a low current ROE. Investors expect future ROE to be higher than current ROE. PAS Group has a price-earnings ratios just above that of the industry average, but a low current ROE. Investors do not expect that low level of ROE to increase as fast as that of Premier Investments. Briscoe Group Australasia has a very high current ROE, which is reflected in the high price-book multiple. The above-industry average price-earnings suggests that investors believe that it can maintain that high level of ROE in the future.

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KEY ANALYSIS QUESTIONS To value a firm using multiples, an analyst has to assess the quality of the variable used as the multiple basis, and to determine the appropriate peer firms to include in the benchmark multiple. Analysts are therefore likely to be interested in answering the following questions: What is the expected future growth in the variable to be used as the basis for the multiple? For example, if the variable is earnings, has the firm made conservative or aggressive accounting choices that are likely to unwind in the coming years? If the multiple is book value, how sustainable is the firm’s growth and ROE? What are the dynamics of the firm’s industry and product market? Is it a market leader in a high-growth industry, or is it in a mature industry with fewer growth prospects? How is the firm’s future performance likely to be affected by competition or potential new entry in the industry? Which are the most suitable peer companies to include in the benchmark multiple computation? Have these firms had comparable growth (earnings or book values), profitability and quality of earnings as the firm being analysed? Do they have the same risk characteristics?

LO4

 hortcut forms of earnings-based S valuation

The discounted abnormal earnings valuation formula can be simplified by making assumptions about the relation between a firm’s current and future abnormal earnings. Similarly, the equity value-to-book formula can be simplified by making assumptions about long-term ROEs and growth.

Relation between current and future abnormal earnings Several assumptions about the relation between current and future net income are popular for simplifying the abnormal earnings model. First, abnormal earnings are assumed to follow a random walk. The random walk model for abnormal earnings implies that an analyst’s best guess about future expected abnormal earnings is current abnormal earnings. The model assumes that past shocks to abnormal earnings persist forever, but that future shocks are random or unpredictable. The random walk model can be written as follows: Forecasted AE1 = AE 0 Forecasted AE1 is the forecast of next year’s abnormal earnings and AE 0 is current period abnormal earnings. Under the model, forecasted abnormal earnings for two years ahead are simply abnormal earnings in year 1, or once again current abnormal earnings. In other words, the best guess of abnormal earnings in any future year is just current abnormal earnings.8 How does the above assumption about future abnormal earnings simplify the discounted abnormal earnings valuation model? If abnormal earnings follow a random walk, all future forecasts of abnormal earnings are simply current abnormal earnings. It is then possible to rewrite value as follows: Equity value = BVE 0 +

AE 0 re

The equity value is the book value of equity at the end of the year plus current abnormal earnings divided by the cost of capital. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 7 Prospective analysis: Valuation theory and concepts

In reality, of course, shocks to abnormal earnings are unlikely to persist forever. Firms that have positive shocks are likely to attract competitors that will reduce opportunities for future abnormal performance. Firms with negative abnormal earnings shocks are likely to fail or to be acquired by other firms that can manage their resources more effectively. The persistence of abnormal performance will therefore depend on strategic factors such as barriers to entry and switching costs, discussed in Chapter 2. To reflect this, analysts frequently assume that current shocks to abnormal earnings decay over time. Under this assumption, abnormal earnings are said to follow an autoregressive model. Forecasted abnormal earnings are then: Forecasted AE1 = βAE 0 β is a parameter that captures the speed at which abnormal earnings decay over time. If there is no decay, β is 1 and abnormal earnings follow a random walk. If β is 0, abnormal earnings decay completely within one year. Estimates of β using actual company data indicate that, for a typical Australian consumer staples firm, β is approximately 0.6. However, it varies by industry and is smaller for firms with large accruals and one-time accounting charges.9 The autoregressive model implies that equity values can again be written as a function of current abnormal earnings and book values:10 Equity value = BVE 0 +

βAE 0 1 + re − β

This formulation implies that equity values are simply the sum of current book value plus current abnormal earnings weighted by the cost of equity capital and persistence in abnormal earnings.

ROE and growth simplifications It is also possible to make simplifications about long-term ROEs and equity growth to reduce forecast horizons for estimating the equity value-to-book multiple. Firms’ long-term ROEs are affected by such factors as barriers to entry in their industries, change in production or delivery technologies, and quality of management. As discussed in Chapter 6, these factors tend to force abnormal ROEs to decay over time. One way to model this decay is to assume that ROEs follow a mean-reverting process. Forecasted ROE in one period’s time then takes the following form: Forecasted ROE 1 = ROE 0 + β( ROE 0 − ROE ) ROE is the steady state ROE (either the firm’s cost of capital or the long-term industry ROE) and β is a ‘speed of adjustment factor’ that reflects how quickly it takes the ROE to revert to its steady state.11 Growth rates are affected by several factors. First, the size of the firm is important. Small firms can sustain very high growth rates for an extended period, whereas large firms find it more difficult to do so. Second, firms with high rates of growth are likely to attract competitors, which reduces their growth rates. The long-term patterns in ROE and book equity growth rates imply that for most companies there is limited value in making forecasts for valuation beyond a relatively short horizon; that is, three to five years. Powerful economic forces tend to lead firms with superior or inferior performance early in the forecast horizon to revert to a level that is comparable to that of other

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firms in the industry or the economy. For a firm in steady state – that is, expected to have a stable ROE and book equity growth rate (gbve) – the value-to-book multiple formula simplifies to the following: Equity value-to-book multiple = 1 +

ROE 0 − re re − gbve

Consistent with this simplified model, there is a strong relation between price-to-book ratios and current ROEs. Using the 2018 data in the consumer specialty retail sector (GICS = 254040), for firms with positive price-earnings multiples, the correlation between the two variables is 0.89. Of course, analysts can make a variety of simplifying assumptions about a firm’s ROE and growth. For example, they can assume that they decay slowly or rapidly to the cost of capital and the growth rate for the economy. They can assume that the rates decay to the industry or economy average ROEs and book value growth rates. The valuation formula can easily be modified to accommodate these assumptions.

LO5

The discounted cash flow model

The value of an asset or investment is the present value of the net payoffs that the asset generates. The discounted cash flow valuation model clearly reflects this basic principle of finance. The model defines the value of a firm’s business assets as the present value of the cashflows generated by those assets (cash from operations, or CFO) minus the investments made in new operating assets. It is derived from the dividend discount model, and is based on the insight that dividends can be recast as free cash flows;12 that is: Dividends = Operating cash flow - capital outlays + net cash flows from debt owners As discussed in Chapter 5, operating cash flows to equity holders are simply net income plus depreciation less changes in working capital accruals. Capital outlays are capital expenditures less asset sales. Finally, net cash flows from debt owners are issues of new debt less retirements less the after-tax cost of interest. By rearranging these terms, the free cash flows to equity can be written as follows: Dividends = Free cash flows to equity = NI − ∆BVA + ∆BVND where NI is net income, ΔBVA is the change in book value of operating net assets (including changes in working capital plus capital expenditures less depreciation expense), and ΔBVND is the change in book value of net debt (interest-bearing debt less excess cash). The dividend discount model can therefore be written as the present value of free cash flows to equity. Under this formulation, firm value is estimated as follows: Equity value = PV of free cash flows to equity claim holders =

Net income1 − ∆BVA1 + ∆BVND1 (1 + re )

+ +

Net income2 − ∆BVA2 + ∆BVND 2 (1 + re )2 Net income3 − ∆BVA3 + ∆BVND3 (1 + re )3

+ PV of free cash flows to equity beyond year 3 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 7 Prospective analysis: Valuation theory and concepts

Alternatively, the free cash flow formulation can be structured by estimating the value of claims to net debt and equity and then deducting the market value of net debt. This approach is more widely used in practice because it does not require explicit forecasts of changes in debt balances.13 The value of debt plus equity is then: Debt plus equity value = PV of free cash flows to net debt and equity claim holders =

NOPAT1 − ΔBVA1 (1 + WACC)

+

NOPAT2 − ΔBVA2 (1 + WACC)

2

+

NOPAT3 − ΔBVA3 (1 + WACC)3

+ PV of free cash flows to debt and equity beyond year 3 Valuation under the discounted cash flow method therefore involves the following steps: 1 Forecast free cash flows available to equity holders, or to debt and equity holders, over a finite forecast horizon – usually five to 10 years. 2 Forecast free cash flows beyond the terminal year based on some simplifying assumption. 3 Discount free cash flows to equity holders (debt plus equity holders) at the cost of equity (weighted average cost of capital). The discounted amount represents the estimated value of free cash flows available to equity (debt and equity holders as a group). Returning to the Down Under Company example, there is no debt, so that the free cash flows to owners are simply the operating profits before depreciation. Since Down Under is an all-equity firm, its WACC is the cost of equity (10%) and the present value of the free cash flows is as follows: FIGURE 7.11 Present value of Down Under’s free cash flows

Year

Net income

Change in book value of assets

Change in book value of debt

Free cash flows to equity

PV factor

PV of free cash flows

(a)

(b)

(c)

(d) = (a) – (b) + (c)

(e)

(d) × (e)

1

$20m

–$20m

$0

$40m

0.909

$36.4m

2

30

–20

0

50

0.826

41.3

3

40

–20

0

60

0.751

45.1

Equity value

$122.8m

Note that the value of Down Under’s equity is exactly the same as that estimated using the discounted abnormal earnings method. This should not be surprising. Both methods are derived from the dividend discount model. Note also that, in estimating value under the two approaches, we have used the same underlying assumptions to forecast earnings and cash flows.

LO6

Comparing valuation methods

We have discussed three methods of valuation derived from the dividend discount model: discounted dividends, discounted abnormal earnings (or abnormal ROEs) and discounted cash flows. What are the pluses and minuses of these approaches? Since the methods are all derived from the same underlying model, no one version can be considered superior to the others. As long as analysts make the same assumptions about firm fundamentals, value estimates under all four methods will be identical. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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However, it is worth noting several important differences between the models: they focus the analyst’s task on different issues they require different levels of structure for valuation analysis they have different implications for estimating terminal values.

Focus on different issues The methods frame the valuation task differently and can in practice focus the analyst’s attention on different issues. The earnings-based approaches frame the issues in terms of accounting data such as earnings and book values. Analysts spend considerable time analysing historical income statements and balance sheets, and their primary forecasts are typically for these variables. Defining values in terms of ROEs has the added advantage that it focuses analysts’ attention on ROE, the same key measure of performance that is decomposed in a standard financial analysis. Further, because ROEs control for firm scale, it is likely to be easier for analysts to evaluate the reasonableness of their forecasts by benchmarking them with ROEs of other firms in the industry and the economy. This type of benchmarking is more challenging for free cash flows and abnormal earnings.

Differences in required structure The methods differ in the amount of analysis and structure required for valuation. The discounted abnormal earnings and ROE methods require analysts to construct both pro forma income statements and balance sheets to forecast future earnings and book values. In contrast, the discounted cash flow method requires analysts to forecast income statements and changes in working capital and long-term assets to generate free cash flows. Finally, the discounted dividend method requires analysts to forecast dividends. The discounted abnormal earnings, ROE and free cash flow models all require more structure for analysis than the discounted dividend approach. They therefore help analysts to avoid structural inconsistencies in their forecasts of future dividends by specifically allowing for firms’ future performance and investment opportunities. Similarly, the discounted abnormal earnings/ROE method requires more structure and work than the discounted cash flow method to build full pro forma balance sheets. This permits analysts to avoid inconsistencies in the firm’s financial structure.

Differences in terminal value implications A third difference between the methods is in the effort required for estimating terminal values. Terminal value estimates for the abnormal earnings and ROE methods tend to represent a much smaller fraction of total value than under the discounted cash flow or dividend methods. On the surface, this would appear to mitigate concerns about the aspect of valuation that leaves the analyst most uncomfortable. Is this apparent advantage real? As will be explained, the answer turns on how well value is already reflected in the accountant’s book value. The abnormal earnings valuation does not eliminate the discounted cash flow terminal value problem, but it does reframe it. Discounted cash flow terminal values include the present value of all expected cash flows beyond the forecast horizon. Under abnormal earnings valuation, that value is broken into two parts: the present values of normal earnings and abnormal earnings Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 7 Prospective analysis: Valuation theory and concepts

beyond the terminal year. The terminal value in the abnormal earnings technique includes only the abnormal earnings. The present value of normal earnings is already reflected in the original book value of equity or growth in book value of equity over the forecast horizon. The abnormal earnings approach, then, recognises that current book value and earnings over the forecast horizon already reflect many of the cash flows expected to arrive after the forecast horizon. The approach builds directly on accrual accounting. For example, under accrual accounting book equity can be thought of as the minimum recoverable future benefits attributable to the firm’s net assets. In addition, revenues are typically realised when earned, not when cash is received. The discounted cash flow approach, on the other hand, ‘unravels’ all of the accruals, spreads the resulting cash flows over longer horizons, and then reconstructs its own ‘accruals’ in the form of discounted expectations of future cash flows. The essential difference between the two approaches is that abnormal earnings valuation recognises that the accrual process may already have performed a portion of the valuation task, whereas the discounted cash flow approach ultimately moves back to the primitive cash flows underlying the accruals. The usefulness of the accounting-based perspective thus hinges on how well the accrual process reflects future cash flows. The approach is most convenient when the accrual process is ‘unbiased’, so that earnings can be abnormal only as the result of economic rents and not as a product of accounting itself.14 The forecast horizon then extends to the point where the firm is expected to approach a competitive equilibrium and earn only normal earnings on its projects. Subsequent abnormal earnings would be zero, and the terminal value at that point would be zero. In this extreme case, all of the firm’s value is reflected in the book value and earnings projected over the forecast horizon. Of course, accounting rarely works so well. For example, in most countries research and development costs are expensed and book values fail to reflect any research and development assets. As a result, firms that spend heavily on research and development – such as pharmaceuticals – tend on average to generate abnormally high earnings even in the face of stiff competition. Purely as an artefact of research and development accounting, abnormal earnings would be expected to remain positive indefinitely for such firms, and the terminal value could represent a substantial fraction of total value. If desired, the analyst can alter the accounting approach used by the firm in their own projections. ‘Better’ accounting would be viewed as that which reflects a larger fraction of the firm’s value in book values and earnings over the forecast horizon.15 This same view underlies analysts’ attempts to ‘normalise’ earnings; the adjusted numbers are intended to provide better indications of value, even though they reflect performance only over a short horizon. Research has focused on the performance of earnings-based valuation relative to discounted cash flow and discounted dividend methods. The findings indicate that over relatively short forecast horizons – 10 years or less – valuation estimates using the abnormal earnings approach generate more precise estimates of value than either the discounted dividend or discounted cash flow models. This advantage for the earnings-based approach persists for firms with conservative or aggressive accounting, indicating that accrual accounting does a reasonably good job of reflecting future cash flows.16 Research also indicates that abnormal earnings estimates of value outperform traditional multiples, such as price-earnings ratios, price-to-book ratios and dividend yields, for predicting future share price movements. Firms that have high abnormal earnings model estimates of value relative to price show positive abnormal future share returns, while firms with low estimated value-to-price ratios have negative abnormal share price performance.17

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KEY ANALYSIS QUESTIONS

INDUSTRY INSIGHT

The above discussion on the trade-offs between different methods of valuing a company raises several questions for analysts about how to compare methods and to consider which is likely to be most reliable for their analysis: What are the key performance parameters that the analyst forecasts? Is more attention given to forecasting accounting variables, such as earnings and book values, or to forecasting cash flow variables? Has the analyst linked forecasted income statements and balance sheets? If not, is there any inconsistency between the two statements, or in the implications of the assumptions for future performance? If so, what is the source of this inconsistency and does it affect discounted earnings-based and discounted cash flow methods similarly? How well does the firm’s accounting capture its underlying assets and obligations? Does it do a good enough job that we can rely on book values as the basis for long-term forecasts? Alternatively, does the firm rely heavily on off-balance-sheet assets, such as R&D, which make book values a poor indicator of long-term performance? Has the analyst made very different assumptions about long-term performance in the terminal value computations under the different valuation methods? If so, which set of assumptions is more plausible given the firm’s industry and its competitive positioning?

A PRACTITIONER ADVISES Partner with leading chartered accounting firm specialising in corporate finance and valuation on alternative valuation methods: The most common method used in practice is probably the multiples method. It is arguably also the simplest method that students look at – take one number, multiply it by another, you get the answer – that’s pretty simple mathematics! So why is it the most common compared to all the other ones? Well, remember that valuation is an argument. In a multiples valuation there are only two inputs – the number and the multiple. In other methods, how many inputs do you have? In a dividends account model, it’s relatively easy: you need the dividend, the dividend growth and the cost of capital – that’s three. In a discounted cash flow model, how many inputs? Usually there’s about six items, going over five years, so that’s roughly 30 inputs, plus a cost of capital, that’s 31. So instead of two or three arguments, you’ve got 31 arguments – which one would you rather have? And of course, there are errors – when you’ve got 31 inputs, a small error in every one can actually produce a

big error in the answer. So, people just don’t want to argue that many points, which is why multiples are probably the most used in practice, even though theoretically they are the weakest. What’s the next most popular? Discounted cash flows is the next. The reason it’s the most used is because it’s the most-often seen. Anyone picked up a broker report? The most common valuations in there are a few multiples and a discounted cash flow. The beauty about discounted cash flow is that you don’t have to be that disciplined about the growth assumptions you make – you can effectively say ‘this company’s going to grow forever’. Australian investment banker and instructor: The difference between investment banking and the classroom is that in fact we use more multiples in the workplace, rather than discounted models. One advantage of my time in the classroom was to demonstrate that it is a good idea to use different valuation methods and to look at it from different angles, including accounting-based approaches. Partner with leading chartered accounting firm specialising in corporate finance and valuation on using different methods:

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CHAPTER 7 Prospective analysis: Valuation theory and concepts

The way to reduce the chance of error in valuation is to do the valuation from multiple perspectives. So, you might use a discounted cash flow model, a dividend discount model, you might even use the residual income method, and then you would compare the answers. If you use the residual income method, and the discounted cash flow method, you should get the same answer, but in practice you usually won’t. Understanding what drives the difference is actually really important to

177

getting the valuation right. You should definitely try to triangulate between multiple valuation methods. Reflective activity: Does it surprise you to learn that expert practitioners most often report values based on the simplest valuation methods? When do you think that they would support these valuations using more complex methods? What is meant by triangulation between multiple methods?

SUMMARY Valuation is the process by which forecasts of performance are converted into estimates of price. A variety of valuation techniques are employed in practice and there is no single method that clearly dominates others. In fact, since each technique involves different advantages and disadvantages, it can be advantageous to consider several approaches simultaneously. For shareholders, a share’s value is the present value of future dividends. This chapter described three valuation techniques directly based on this dividend discount definition of value: discounted dividends, discounted abnormal earnings/ROEs and discounted free cash flows. The discounted dividend method attempts to forecast dividends directly. The abnormal earnings approach expresses the value of a firm’s equity as book value plus discounted expectations of future abnormal earnings. Finally, the discounted cash flow method represents a firm’s equity value by expected future free cash flows discounted at the cost of capital. Although these three methods were derived from the same dividend discount model, they frame the valuation task differently. In practice, they focus the analyst’s

attention on different issues and require different levels of structure in developing forecasts of the underlying primitive, future dividends. Price multiple valuation methods were also discussed. Under these approaches, analysts estimate ratios of current price to historical or forecasted measures of performance for comparable firms. The benchmarks are then used to value the performance of the firm being analysed. Multiples have traditionally been popular, primarily because they do not require analysts to make multi-year forecasts of performance. However, it can be difficult to identify comparable firms to use as benchmarks. Even across highly related firms, there are differences in performance that are likely to affect their multiples. The chapter discussed the relation between two popular multiples, value-to-book and value-earnings ratios and the discounted abnormal earnings valuation. The resulting formulations indicate that value-to-book multiples are a function of future abnormal ROEs, book value growth and the firm’s cost of equity. The value-earnings multiple is a function of the same factors and also the current ROE.

CHECKING AND APPLYING YOUR LEARNING 1 Should the present value of a share depend on how long the investor plans to own that share? Explain why.  LO1 2 How can a company with a high ROE have a low P/E ratio?  LO4 3 What types of companies have: a a high P/E and a low market-to-book ratio? b a high P/E ratio and a high market-to-book ratio?

c a low P/E and a high market-to-book ratio? d a low P/E and a low market-to-book ratio?  LO3 4 Janet Stringer argues: ‘The DCF valuation method has increased managers’ focus on short-term rather than long-term performance, since the discounting process places much heavier weight on short-term cash flows than long-term ones.’ Comment.  LO5

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5 Several studies have undertaken regression analysis on the determinants of P/E ratios. Generally, such studies support the conceptual models presented in this chapter. Some analysts advocate the use of these models to actually value companies. For example, regress P/E ratios on expected growth, ROE and other variables and then use the coefficients from that regression and data from the target company to be valued to estimate the P/E ratio. What do you think are the advantages and disadvantages of this approach, relative to an ‘expert’s judgement’ on the appropriate P/E?  LO3 6 What is the interpretation of a price-to-book ratio = 1? Is this likely? Why or why not? Why would the price-to-book ratio > 1? Why would it be < 1?  LO3 7 Consider the following three companies: i Company A is expected to pay a dividend of $5 forever. ii Company B is expected to pay a dividend of $2 next year, and after that the annual dividend is expected to grow by 3% each year. iii Company C is expected to pay a dividend of $3 next year and this dividend will grow at 5% for three years. After year 4 the dividends will grow at 2% forever. Assume the cost of equity for each of these companies is 8%. Which company has the highest present value? Does your answer change if the appropriate cost of equity is 10%?  LO1 8 a Explain why a firm valuation arrived at using discounted dividends should be the same as the same firm’s valuation using a discounted free cash flow to equity model.  LO2 b Explain why terminal values in earnings-based valuation model are significantly less than those in DCF valuation models.  LO6 9 a Can a firm have negative residual income (i.e. abnormal earnings)? What does this mean? b Suppose you are valuing a growing firm and you forecast that it will have negative abnormal earnings for the next five years. Can you use the abnormal earnings valuation approach when abnormal earnings are negative?  LO2 10 A firm’s earnings and dividends per share are both expected to grow indefinitely by 4% per year. If next year’s dividend is $8 per share, and the appropriate cost of equity capital is 9%, what should the firm’s share price be?  LO4

11 The Earnings Factory a According to many analysts, The Earnings Factory is a ‘darling’ of the ASX. Its current market price is $15 per share and its book value is $5 per share. Analysts forecast that the firm’s book value will grow by 10% per year indefinitely and the cost of equity is 15%. Given these facts, what is the market’s expectation of the firm’s long-term average ROE? b Given the information in question 3a, what will be The Earnings Factory’s share price if the market revises its expectations of long-term average ROE to 20%? c Analysts reassess The Earnings Factory’s future performance as follows: growth in book value increases to 12% per year, but the ROE of the incremental book value is only 15%. What is the impact on the market-to-book ratio?  LO4 12 Free cash flows used in DCF valuations discussed in the chapter are defined as follows: FCF to debt and equity = Earnings before interest and taxes × (1 – tax rate) + depreciation and deferred taxes – capital expenditures –/+ Increase/decrease in working capital FCF to equity = Net income + depreciation and deferred taxes – capital expenditures –/+ increase/decrease in working capital –/+ increase/decrease in debt Which of the following items affect free cash flows to debt and equity holders? Which affect free cash flows to equity alone? Explain why and how. An increase in accounts receivable A decrease in gross margins An increase in property, plant and equipment An increase in inventory Interest expense An increase in prepaid expenses An increase in notes payable to the bank  LO5 13 The Singapore Sapphires Company is valued at $40 per share. Analysts expect that it will generate free cash flows to equity of $8 per share for the foreseeable future. What is the firm’s implied cost of equity capital?  LO4

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CHAPTER 7 Prospective analysis: Valuation theory and concepts

14 The following table presents price multiples for Qantas. The current multiple is for 30 June 2019 and descriptive statistics over the period 2000–19. Discuss why there is more variation in the time-series of the price-to-earnings ratio than the price-to-net tangible assets ratio.  LO3 FIGURE 7.12 Price multiples for Qantas

  At 30 June 2019

Price-earnings (P/E)

Price-net tangible Assets (P/NTA)

Price-operating cash Flows (P/CFO)

9.82

3.78

2.97

For the period 2000–19 Average

12.64

1.66

3.27

Minimum

4.59

0.46

1.33

10.32

1.22

3.14

Median

179

Price-earnings (P/E)

Price-net tangible Assets (P/NTA)

Price-operating cash Flows (P/CFO)

Maximum

29.22

4.00

6.29

Standard deviation

6.41

1.07

1.13

 

15 Question 8 asked about the time-series of multiple ratios. Do you think the price-to-book ratio would exhibit more variation than the price-to-book ratio in a cross-sectional analysis (i.e. an analysis that compared Qantas to other airlines)? Why or why not? Undertake such an analysis to confirm your expectations.  LO3 16 Explain what we mean by ‘residual income’ and ‘residual operating income’. How do these concepts differ from the concepts of free cash flow to equity and free cash flow to capital, respectively?   LO2

CASE LINK Concepts from this chapter are used in the following cases in Part 4:

Case 1 Qantas – Part D Case 6: Valuation ratios in the retail industry 2010 to 2013

ENDNOTES 1

2

3 4 5

6

7

The incorporation of all non-capital equity transactions into income is called clean surplus accounting. It is analogous to the term ‘comprehensive income’, as used in IAS 1 ‘Presentation of financial statements’. Changes in book value also include new capital contributions. However, the dividend discount model assumes that new capital is issued at fair value. As a result, any incremental book value from capital issues is exactly offset by the discounted value of future dividends to new shareholders. Capital transactions therefore do not affect firm valuation. The appendix to this chapter provides a simple proof of the earnings-based valuation formula. C. Lee, J. Meyers and B. Swaminathan, ‘What is the intrinsic value of the Dow?’ Journal of Finance 54 (1999): 165–201. See A. Alford, ‘The effect of the set of comparable firms on the accuracy of the price-earnings valuation method’, Journal of Accounting Research 30(1) (1992): 94–108; and C.S.A. Cheng and R. McNamara, ‘The valuation accuracy of the price-earnings and price-book benchmark valuation methods’, Review of Quantitative Finance and Accounting 15 (2000): 349–70. There is an important difference between the way ROE is defined in the value-to-book formulation and the way it is defined in Chapter 9. The valuation formula defines ROE as return on beginning equity, whereas in our ratio discussion we used return on ending or return on average equity. It may seem surprising that one can estimate value with no explicit attention to two of the cash flow streams considered in DCF analysis: investments in working capital and capital expenditures. The

 8  9

10

11

accounting-based technique recognises that these investments cannot possibly contribute to value without affecting abnormal earnings, and that therefore only their earnings impacts need be considered. For example, the benefit of an increase in inventory turnover surfaces in terms of its impact on ROE (and thus abnormal earnings), without the need to consider explicitly the cash flow impacts involved. It is also possible to include a drift term in the model, allowing earnings to grow by a constant amount, or at a constant rate each period. See P. M. Dechow, A. P. Hutton and R. G. Sloan, ‘An empirical assessment of the residual income valuation model’, Journal of Accounting and Economics 23 (January 1999). This formulation is a variant of a model proposed by J. Ohlson, ‘Earnings, book values, and dividends in security valuation’, Contemporary Accounting Research 11, (Spring 1995). In his forecasts of future abnormal earnings, Ohlson includes a variable that reflects relevant information other than current abnormal earnings. This variable then also appears in the share valuation formula. Empirical research by P. M. Dechow, A. P. Hutton and R. G. Sloan, ‘An empirical assessment of the residual income valuation model’, Journal of Accounting and Economics 23 (January 1999), indicates that financial analysts’ forecasts of abnormal earnings do reflect considerable information other than current abnormal earnings, and that this information is useful for valuation. This specification is similar to the model for dividends developed by J. Lintner, ‘Distribution of incomes of corporations among dividends, retained earnings, and taxes’, American Economic Review 46 (May 1956): 97–113.

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

12 In practice, firms do not have to pay out all of their free cash flows as dividends; they can retain surplus cash in the business. The conditions under which a firm’s dividend decision affects its value are discussed by M. H. Miller and F. Modigliani in ‘Dividend policy, growth and the valuation of shares’, Journal of Business 34 (October 1961): 411–33. 13 A good forecast, however, would be grounded in an understanding of these changes as well as all other key elements of the firm’s financial picture. The changes in financing cash flows are particularly critical for firms that anticipate changing their capital structure. 14 Unbiased accounting is that which, in a competitive equilibrium, produces an expected ROE equal to the cost of capital. The actual ROE thus reveals the presence of economic rents. Market-value accounting is a special case of unbiased accounting that produces an expected ROE equal to the cost of capital, even when the firm is not in a competitive equilibrium. That is, market-value accounting reflects the present value of future economic rents in book value, driving the expected ROEs to a normal level. For a discussion of

unbiased and biased accounting, see G. Feltham and J. Ohlson, ‘Valuation and clean surplus accounting for operating and financial activities’, Contemporary Accounting Research 11(2) (Spring 1995): 689–731. 15 In B. Stewart’s book on EVA valuation, The Quest for Value (New York: HarperBusiness, 1999), he recommends a number of accounting adjustments, including the capitalisation of research and development. 16 S. Penman and T. Sougiannis, ‘A comparison of dividend, cash flow, and earnings approaches to equity valuation’, Contemporary Accounting Research (Fall 1998): 343–83, compares the valuation methods using actual realisations of earnings, cash flows and dividends to estimate prices. J. Francis, P. Olsson and D. Oswald, ‘Comparing accuracy and explainability of dividend, free cash flow and abnormal earnings equity valuation models’, Journal of Accounting Research 38 (Spring 2000): 45–70, estimates values using Value Line forecasts. 17 C. Lee, J. Meyers and B. Swaminathan, op. cit., pp. 1693–741.

APPENDIX: RECONCILING THE DISCOUNTED DIVIDENDS AND DISCOUNTED ABNORMAL EARNINGS MODELS To derive the discounted abnormal earnings model from the dividend discount model, consider the following two-period valuation:

Equity value =

Dividend1 (1 + re)

+

Dividend2 (1 + re)2

With clean surplus accounting, dividends can be expressed as a function of NI and the BVE:

Dividendt = NIt + BVEt – 1 − BVEt Substituting this expression into the dividend discount model yields the following:

Equity value = This can be rewritten as follows:

Equity value =

NI1 + BVE 0 - BVE1 (1 + re)

+

NI2 + BVE1 - BVE2 (1 + re)2

NI 1 − re BVE 0 + BVE 0 (1 + re ) − BVE 1 NI 2 − re BVE + BVE 1 (1 + re ) − BVE 2 + (1 + re ) (1 + re )2 NI − r BVE 0 NI 2 − re BVE 1 BVE 2 + = BVE 0 + 1 e − (1 + re ) (1 + re )2 (1 + re )2

The value of equity is therefore the current book value plus the present value of future abnormal earnings. As the forecast horizon expands, the final term (the present value of liquidating book value) becomes inconsequential.

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CHAPTER

Prospective analysis: Valuation implementation To move from the valuation theory discussed in the previous chapter to the actual task of valuing a firm, we have to deal with a number of issues. We have to make forecasts of financial performance and state them in terms of abnormal earnings and book values, or free cash flows, over the life of the firm. The first part of this chapter provides guidance on calculating the discount rates used to value cash flows and earnings. The forecasting task itself is divided into two components: 1 detailed forecasts over a finite number of years, known as the ‘forecast horizon’ 2 a forecast of ‘terminal value’, which represents a summary of performance beyond the forecast horizon.

Continuing with our Kathmandu example, this chapter builds on the forecasts developed in Chapter 6 and provides guidance on estimating the value of a firm’s equity by computing a terminal value, calculating cost of equity and synthesising the different pieces of the analytical process to estimate the value of equity. We focus on valuing equity directly since this is typically the analyst’s primary objective. However, as discussed in the Chapter 7 and 8 appendices, we recognise that a similar approach can be used to value a firm’s assets (both debt and equity).

Chapter learning objectives By the end of this chapter, you should be able to: LO1

 understand how to estimate discount rates

LO2

 create a structured and systematic performance forecast

LO3

 understand the way in which terminal value assumptions affect overall valuations.

LO1

8

Computing a discount rate

To value a firm’s equity, the analyst discounts cash flows available to equity holders, abnormal earnings or abnormal ROE. The appropriate discount rate to value equity is the cost of equity.

Estimating the cost of equity Estimating the cost of equity (re) can be difficult, and a full discussion of the topic lies beyond the scope of this chapter. At any rate, even an extended discussion would not supply answers to all the questions an analyst might raise on this topic because the field of finance is in a state of flux over

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what constitutes an appropriate measure of the cost of equity. However, one common approach is to use the capital asset pricing model.

The capital asset pricing model The capital asset pricing model (CAPM) expresses the cost of equity as the sum of a required return on riskless assets plus a premium for beta or systematic risk: Cost of equity = Riskless rate of return + beta risk × market risk premium or re = rf + β[E(rm) – rf] where rf is the riskless rate, [E(rm) – rf] is the risk premium expected for the market as a whole, expressed as the excess of the expected return on the market index over the riskless rate, and β is the systematic risk of the equity. To compute re, one must estimate three parameters: the riskless rate r f , the market risk premium [E(rm) – r f] and systematic risk β. To estimate the required return on riskless assets (r f), analysts often use the rate on intermediate-term treasury notes or bonds, based on the observation that it is cash flows beyond the short term that are being discounted.1 The systematic or beta risk of a share reflects the sensitivity of its cash flows and earnings, and hence share price, to economy-wide market movements.2 A firm whose performance increases or decreases at the same rate as changes in the economy as a whole will have a beta of 1. Firms whose performance is highly sensitive to economy-wide changes, such as luxury goods producers, capital goods manufacturers and construction firms, will have beta risks that exceed 1. Firms whose earnings and cash flows are less sensitive to economic changes, such as regulated utilities or supermarkets, will have betas that are lower than 1. International financial services firms, such as Standard & Poor’s, DataStream and Morningstar, provide estimates of beta for publicly listed companies that are based on the historical relation between the firm’s share returns and the returns on the market index. These estimates, which are also reported on standard online financial sites such as Google Finance, provide a useful way to assess publicly traded firms’ beta risks.3 For firms that are not publicly traded, analysts can use betas for publicly traded firms in the same industries as an indicator of their likely beta risks. Finally, the market risk premium is the amount that investors demand as additional return for bearing beta risk. It is the excess of the expected return on the market index over the riskless rate. In the US, the evidence points to a market risk premium of about 4.4%, although there is no true consensus among analysts. Using Australian evidence, we use a market risk premium of 6% in our calculation of Kathmandu’s cost of equity, consistent with Australian estimations of the risk premium at between 5 and 8%.4 Although the above CAPM is often used to estimate the cost of capital, the evidence indicates that the model is incomplete. Assuming shares are priced competitively, share returns should be expected just to compensate investors for the cost of their capital. Thus long-run average returns should be close to the cost of capital and should (according to the CAPM) vary across shares according to their systematic risk. However, factors beyond just systematic risk seem to play some role in explaining variation in long-run average returns. The most important such factor is labelled the ‘size effect’: smaller firms (as measured by market capitalisation) tend to generate higher returns in subsequent periods. Why this is so is unclear. It could mean either that smaller firms are riskier than indicated by the CAPM or that they are underpriced at the point their market capitalisation is measured, or some combination of the two.5 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 8 Prospective analysis: Valuation implementation

An example of the variation across size quintiles of average share returns for Australian firms from 1991 to 2000 is shown in Figure 8.1. The figure shows that, historically, investors in firms in the top quintile of the size distribution have realised returns of between 0.5 and 1.5% per month (or 0.1 to 1.0% above the risk-free rate). In contrast, firms in the smallest quintile have realised significantly higher returns, ranging from 2.5 to 3.7% per month (or 2.1 to 3.4% above the risk-free rate). Note, however, that if we use returns based on firm size as an indicator of the cost of capital, we are implicitly assuming that large size is indicative of lower risk; yet finance theorists have not developed a well-accepted explanation for why that should be the case. FIGURE 8.1 Australian share returns, risk premiums, firm size and book-to-market, 1991–2000

Quintiles

Market capitalisation (A$m)

Size/BM

Low BM

2

3

4

High BM

All

(Small) 1

4.0

4.6

4.5

4.4

4

4.2

2

11.7

12.2

12.1

12.0

12.4

12.1

3

32.6

34.7

34.1

34.9

32

33.6

4

127.5

131.8

128.9

136.1

127.6

130.9

3 801.1

2 721

1 987.2

1 479.7

1 234.9

2 518.5

957.6

800

560.8

283.5

87.7

(Big) 5 All Quintiles

Raw returns (% per month)

Size/BM

Low BM

2

3

4

High BM

(Small) 1

2.5

3.7

2.8

2.8

3.1

0.6

2

0.5

1.7

1.0

1.0

1.5

1

3

0.1

0.2

1.7

1.2

1.4

1.3**

4

–0.2

1.0

1.1

1.4

2.2

2.4*

0.5

1.2

1.4

1.0

1.5

1.0***

Size/BM

Low BM

2

3

4

High BM

(Small) 1

2.1

3.2

2.4

2.4

2.7

(Big) 5 Quintiles

High-low

Risk premium (% per month)

2

0.1

1.3

0.5

0.5

1.1

3

–0.3

–0.2

1.2

0.8

1.0

4

–0.7

0.6

0.7

1.0

1.8

0.1

0.8

1.0

0.6

1.1

(Big) 5 * 1% significance of difference. ** 5% significance of difference. *** 10% significance of difference.

Source: Clive Gaunt, ‘Size and book-to-market effects and the Fama French three factor asset pricing model: evidence from the Australian stock market’, in Accounting and Finance, Wiley-Blackwell (2004), pp. 27–44

Using a larger sample size and including more recent data, other research shown in Figure 8.2 does not find clear evidence of the size effect in Australia, but does show a ‘value effect’ for the smallest and largest portfolios. The ‘value’ anomaly relates to the empirical finding for some samples that a portfolio of firms with a low ratio of the market value to book value of equity (or high book-to-market) outperforms a portfolio of firms with a high market-to-book value. Firms with a low market-to-book value are known as ‘value’ firms. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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FIGURE 8.2 Australian share returns, size, and book-to-market ratios (1983–2013)

Characteristics of portfolios formed on sorts based on size and book-to market Book-to-market Low

2

3

4

High

Market capitalisation ($m) Small

17

17

17

15

11

2

93

98

98

97

94

3

286

290

286

292

272

4

1016

1061

1075

1040

996

Large

7570

8912

1150

8374

6673

Monthly excess returns of portfolios formed by doubles sorts based on size and book-to-market

t-statistic

Excess return Low

2

3

4

High

H–L

High

H–L

Low

2

3

4

0.57

1.06

–1.03

0.14

0.13

0.92

1.87*

3.52*** 1.68*

Size and book-to-market portfolios Small

–0.50

0.06

0.05

0.34

2

–0.12

0.31

0.19

0.32

0.44

0.56

–0.27

0.85

0.67

1.20

1.67*

3

–0.08

0.32

0.42

0.38

0.30

0.38

–0.19

0.99

1.49

1.41

1.00

1.20

4

0.39

0.52

0.35

0.65

0.39

0.00

1.10

1.82*

1.20

2.63***

1.42

–0.01

Large

0.13

0.44

0.69

0.69

1.11

0.98

0.35

1.73*

2.48**

2.34***

2.91*** 2.49**

***, **, and * denote statistical significance at the 1%, 5% and 10% levels, respectively. Source: M. Chiah, D. Chai, A. Zhong and S. Li, ‘A Better Model? An Empirical Investigation of the Fama–French Five-factor Model in Australia’, International Review of Finance 16:4 (2016), pp. 595–638, Tables 3 and 4.

One method for estimating the cost of capital estimates combines the CAPM and the ‘size effect’. This approach calls for adjusting the CAPM-based cost of capital for the difference between the average return on the market index used in the CAPM (the Standard and Poor’s 500 in the US or the S&P ASX 200 in Australia) and the average return on firms of a size comparable to the firm being evaluated. The resulting cost of capital is: Cost of equity = Risk rate of return + beta risk × market risk premium + size premium or re = r f + β[E(rm) – r f] + rsize In light of the continuing debate on how to measure the cost of capital, it is not surprising that managers and analysts often consider a range of estimates. In addition to the question about whether the historical risk premium of 5 to 8% is valid today, there is debate over whether beta is a relevant measure of risk, and whether other metrics such as size should be reflected in cost of capital estimates. Since these debates are still unresolved, it is prudent for analysts to use a range of risk premium estimates in computing a firm’s cost of capital.

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185

ESTIMATING KATHMANDU’S COST OF CAPITAL To estimate the cost of capital for Kathmandu in 2018, we first look at the firm’s equity beta at that time. Beta measures provided by the Securities Institute Research Centre of Australia (SIRCA) estimated Kathmandu’s beta at –0.19 in September 2018 and 0.19 in December 2018.6 The beta for all of the firms in the Consumer Discretionary (GICS 25) classification was 0.99 in September 2018

and 1.1 in December 2018. SIRCA had its own retailing industry classification and the beta estimate for that group was 0.81 in September 2018 and 0.96 in December 2018. These beta estimates are shown in Figure 8.3. Also shown is the beta estimates for the Super Retail Group. These estimates are consistently higher than the industry averages.

FIGURE 8.3 Beta estimates from SIRCA Limited

 

 

  Kathmandu

Super Retail

Consumer discretionary

SIRCA

(GICS 25)

Retailing

June 2018

–0.11

1.55

0.98

0.81

September 2018

–0.19

1.47

0.99

0.81

December 2018

0.19

1.80

1.10

0.96

Source: SIRCA Ltd

Extremely high or low betas tend not to persist, especially when compared with industry averages.7 The yield on the 10-year Australian government bond at 1 August 2018 was 2.75%. Using a conservative risk premium for equity of 6%, we calculate Kathmandu’s cost

of equity to be 7.01%. Clearly this estimate is only a starting point, and the analyst can change the estimate by changing the assumed market risk premium or by adjusting for the size effect.

Adjusting cost of equity for changes in leverage The cost of equity changes as a function of a firm’s leverage. As leverage increases, debt and equity become riskier and therefore more costly. To see this, recall from Chapter 5 that the ROE can be decomposed in the following manner:

ROE = Return on net operating assets + (return on net operating assets – after tax interest rate) × net debt/equity

The above equation shows that if net debt equals equity, a 2% increase in return on net operating assets (RNOA) after an economy-wide recovery will increase ROE by 4%, all else being equal. In contrast, if net debt is two times equity, the same increase in RNOA will increase ROE by 6%. If an analyst is contemplating changing capital structure during the forecasting time period, either relative to the historical capital structure of the firm or over time, it is important to reestimate the cost of debt and equity to take these changes into account. We describe a four-step approach to this adjustment, but caution that it is not straightforward. It requires estimating the changes in the costs of debt and equity that are likely to arise from changing the firm’s capital structure. Analysts can estimate the change in the cost of debt by examining the cost of debt for firms in the same or comparable industries that have the revised capital structure.

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To estimate the change in the cost of equity, analysts can compute the beta of the firm’s assets – that is, the weighted average beta risk of its debt and equity – and then re-leverage the firm using its new capital structure. The first step in this process is to infer the old and revised debt betas using the CAPM and, given information on the former, revised costs of debt, the risk premium and the risk-free rate. To compute the revised cost of debt, the analyst can estimate how the revised capital structure would change its debt rating (as discussed in Chapter 10). Higher or lower rated debt would increase or decrease the firm’s cost of debt. The second step is to estimate the firm’s asset beta under the current (or old) capital structure, using the current betas for debt and equity, and the weightings of debt and equity in its market value: Asset beta risk = Equity beta riskold × %equityold + debt beta riskold × %debtold × (1 − tax rate) The asset beta risk represents the extent to which the cash flows generated by the firm’s assets fluctuate with economic cycles. The %equityold and %debtold are the share of the firm’s enterprise market or fair value currently financed by equity and debt, respectively, with an adjustment for the differential tax treatment of debt financing costs (1 − tax rate). We are then in a position to infer the revised equity beta under the new capital structure. To do so, we assume that the firm’s asset beta is unchanged by the change in capital structure. Since we know the asset beta, the revised debt beta and the new capital structure, we can solve for the new equity beta as follows: Equity beta risk new = {Asset beta risk – [(debt beta risk new × %debtnew)(1 − tax rate))]} /(%equitynew) Finally, we can use the CAPM and the revised equity beta to compute the new cost of equity under the revised capital structure. Given the complexity of this process, we recommend you use it only when there are likely to be significant changes in a firm’s capital structure.

LO2

Detailed forecasts of performance

The key to sound forecasts is that the underlying assumptions are grounded in a firm’s business reality. Strategy analysis provides a critical understanding of a firm’s value proposition and whether current performance is likely to be sustainable in the future. Accounting analysis and ratio analysis provide a deep understanding of a firm’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 rather than as a discrete exercise not connected to the rest of the analysis. Since valuation involves forecasting over a long horizon, it is not practical to forecast all the line items in a firm’s financial statements. Instead, the analyst has to focus on the key elements of a firm’s performance. Specifically, we forecast Kathmandu’s condensed income statement, beginning balance sheet and free cash flows for a period of five years starting in fiscal year 2019 (year beginning July 2018). We will use these same forecasting assumptions and financial forecasts, which are repeated here in Figures 8.4 and 8.5, as a starting point to value Kathmandu as of 1 August 2018. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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MAKING PERFORMANCE FORECASTS TO VALUE KATHMANDU FIGURE 8.4 Forecasting assumptions for Kathmandu

Actual Sales growth rate Net operating profit margin

Forecasts

2016

2017

2018

2019

2020

2021

2022

2023

4.0%

4.6%

11.7%

8.5%

6.7%

5.5%

4.2%

3.0%

8.5%

8.9%

10.3%

10%

9%

8.5%

8.5%

8.0%

Start of year operating working capital / Sales

20.0%

9.1%

5.7%

13%

10%

10%

10%

10%

Start of year net operating long-term assets / Sales

69.9%

69.1%

61.5%

75%

73%

71%

70%

70%

After tax cost of debt Start of year debt to capital ratio

4.7%

6.4%

2.4%

2.3%

2.5%

2.50%

3.0%

3.5%

18.1%

10.6%

2.1%

11.3%

12%

12%

13%

15%

FIGURE 8.5 Forecast financial statements for Kathmandu

Forecasts 2019

2020

2021

2022

2023

69 744

57 580

60 744

63 269

65 152

Beginning long-term operating assets

403 986

420 331

431 279

442 883

456 066

= Net operating assets

473 730

477 911

492 023

506 152

521 218

53 348

57 349.3

59 043

65 800

78 183

Shareholders’ equity

420 382

420 561

432 980

440 352

443 035

Net capital

473 730

477 911

492 023

506 152

521 218

539 649

575 796

607 436

632 690

651 522

53 965

51 822

51 632

53 779

52 122

1 227

1 434

1 476

1 974

2 736

52 738

50 388

50 156

51 805

49 385

Beginning balance sheet ($000s) Beginning operating working capital

Net debt

Income statement ($000s) Sales Net operating profit after tax Interest expense after tax Net income

FIGURE 8.6 Forecast financial statements for Kathmandu

ROE (%) Abnormal earnings ($000s) Abnormal ROE (%) [assuming cost of equity of 7%] Return on net operating assets (%) Book value of equity growth rate (%)

2019

2020

2021

2022

2023

12.5%

11.8%

11.5%

11.7%

11.0%

23 311

20 949

19 847

20 980

18 373

5.5%

4.8%

4.5%

4.7%

4.0%

11.3%

10.7%

10.3%

10.5%

9.9%

35%

29%

3%

5%

2%

Book value of net operating assets growth

41.8%

0.9%

3.0%

2.9%

3.0%

Net income

52 738

50 388

50 156

51 805

49 385

–12 164

3 164

2 525

1 883

1 939

– change in working capital (during the year)

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

– change in long-term assets + change in debt Free cash flow to equity

2019

2020

2021

2022

2023

16 345

10 948

4 001

1 693

11 604

13 183

13 575

6 757

12 383

2 327

52 559

37 969

42 784

49 122

36 198

53 965

51 822

51 632

53 779

52 122

–12 164

3 164

2 525

1 883

1 939

Free cash flow to capital NOPAT – change in working capital (during the year) – change in long-term assets

16 345

10 948

11 604

13 183

13 575

Free cash flow to capital

49 784

37 709

37 503

38 713

36 607

As discussed in Chapter 7, under the different approaches to valuation, the key forecasts required to convert the financial forecasts into estimates of value are: abnormal earnings: net income less ‘normal’ or required income, which is shareholders’ equity at the beginning of the year times the cost of equity capital. The cost of equity is the shareholders’ required rate of return. abnormal ROE: the difference between ROE and cost of equity, adjusted for growth in book value. free cash flows to equity: net income for the year less any increase in operating working capital and net long-term assets plus any increase in net debt over the course of the year. In order to generate the forecasts of abnormal earnings and abnormal ROE, we need to establish an estimated cost of equity for the firm. We will take

LO3

Kathmandu’s cost of equity as 7%, as calculated earlier in the chapter. Figure 8.5 shows Kathmandu’s performance forecasts for these three financial statement variables for the five-year period 2019 to 2023. As discussed earlier, to derive cash flows in 2023, we need to make assumptions about sales growth rate and balance sheet ratios in 2024. The cash flow forecasts shown in Figure 8.6 are based on the assumption that the sales growth from 2024 is 3% (as explained in Chapter 6), and beginning balance sheet ratios in 2024 remain the same as in 2023. We discuss the sensitivity of these assumptions and the terminal value assumption later in the chapter. Kathmandu’s projected abnormal ROE decreases slightly over the forecast horizon, from 5.5% in 2019 to 4.0% in 2023. Abnormal operating ROA also shows a similar trend.

Terminal values

Explicit forecasts of the various elements of a firm’s performance generally extend for a period of five to 10 years. The final year of this forecast period is labelled the terminal year. We will discuss how to select an appropriate terminal year later in this section. Terminal value is then the present value of either abnormal earnings or free cash flows occurring beyond the terminal year. Since this involves forecasting performance over the remainder of the firm’s life, the analyst must adopt some assumption that simplifies the process of forecasting. A key question is whether it is reasonable to assume a continuation of the terminal year performance or whether some other pattern is expected. Clearly, sales growth that continues to be significantly greater than the average growth rate of the economy over a long horizon is unrealistic. That rate would be likely to outstrip inflation in the dollar and the real growth rate of the world economy. Over many years, it would imply that the

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CHAPTER 8 Prospective analysis: Valuation implementation

firm would grow to a size greater than all other firms in the world combined. But what is a suitable alternative assumption? Should we expect the firm’s sales growth to ultimately settle down to the rate of inflation? Or to a higher rate, such as the nominal GDP growth rate? And, perhaps equally important, will a firm that earns abnormal profits continue to do so by maintaining its profit margins on a growing, or even existing, base of sales? To answer these questions, we must consider how much longer the rate of growth in industry sales can outstrip overall economic growth, and how long a firm’s competitive advantage can be sustained. Clearly, looking six to 11 years, or more, into the future, any forecast is likely to be subject to considerable error. Next, we discuss a variety of alternative approaches to the task of calculating a terminal value.

Terminal values with the competitive equilibrium assumption Fortunately, in many if not most situations, how we deal with the seemingly imponderable questions about long-range growth in sales simply does not matter very much! In fact, under plausible economic assumptions, there is no practical need to consider sales growth beyond the terminal year. Such growth may be irrelevant, so far as the firm’s current value is concerned. How can long-range growth in sales not matter? The reasoning revolves around the forces of competition. One impact of competition is that it tends to constrain a firm’s ability to consistently identify growth opportunities that generate supernormal profits. The other dimension is that competition tends to impact on is a firm’s margins. Ultimately, we would expect high profits to attract enough competition to drive down a firm’s margins, and therefore its returns, to a normal level. At this point, the firm will earn its cost of capital, with no abnormal returns or terminal value. (Recall the evidence in Chapter 6 concerning the reversion of ROEs to normal levels over horizons of five to 10 years.) Certainly, at some point a firm may maintain a competitive advantage that permits it to achieve returns in excess of the cost of capital. When that advantage is protected with patents or a strong brand name, the firm may even be able to maintain it for many years, perhaps indefinitely. With hindsight, we know that some such firms – like Apple or Coca-Cola, or, in Australia, BHP or Wesfarmers – were able not only to maintain their competitive edge but also to expand it across dramatically increasing investment bases. However, with a few exceptions, it is reasonable to assume that the terminal value of the firm will be zero under the competitive equilibrium assumption, obviating the need to make assumptions about long-term growth rates.

Competitive equilibrium assumption only on incremental sales An alternative version of the competitive equilibrium assumption is to assume that a firm will continue to earn abnormal earnings forever on the sales it had in the terminal year, but there will be no abnormal earnings on any incremental sales beyond that level. If we invoke the competitive equilibrium assumption on incremental sales beyond the terminal year, then it does not matter what sales growth rate we use beyond that year, and we may as well simplify our arithmetic by treating sales as if they will be constant at the terminal year level. Then ROE, net income and free cash flow to equity will all remain constant at the terminal year level. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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For example, by treating Kathmandu as if its competitive advantage can be maintained only on the nominal sales level achieved in the year 2023, we would be assuming that in real terms its competitive advantage will shrink. In this scenario, it is simple to estimate the terminal value by dividing the 2023 level of abnormal earnings, abnormal ROEs or free cash flows by the appropriate discount rate. As one would expect, terminal values in this scenario would be higher than those with no abnormal returns on all sales in the years 2024 and beyond. This is entirely because we would be assuming that Kathmandu could retain its superior performance on its existing base of sales indefinitely.

Terminal value with persistent abnormal performance and growth Each of the approaches described above appeals in some way to the competitive equilibrium assumption. However, there are circumstances where the analyst is willing to assume that the firm may defy competitive forces and earn abnormal rates of return on new projects for many years. If the analyst believes supernormal profitability can be extended to larger markets for many years, it can be accommodated within the context of a valuation analysis. One possibility is to project earnings and cash flows over a longer horizon until the competitive equilibrium assumption can reasonably be invoked. In the case of Kathmandu, for example, we could assume that the supernormal profitability will continue for five years beyond 2023 (for a total forecasting horizon of 10 years from the beginning of the forecasting period), but after that period the firm’s ROE will equal its cost of equity. Another possibility is to project growth in abnormal earnings or cash flows at some constant rate. For instance, one could expect Kathmandu to maintain its advantage on a sales base that remains constant in real terms, implying that sales grow beyond the year 2023 at the expected long-run inflation rate of between 2 and 3%. Beyond our terminal year, 2023, as the sales growth rate remains constant at 3%, abnormal earnings, free cash flows and book value of equity also grow at this same constant rate. This is simply because we held all other performance ratios constant in this period. As a result, abnormal operating ROA and abnormal ROE remain constant at the same level as in the terminal year. This approach is more aggressive than the preceding assumptions about terminal value, but it may be more realistic. After all, there is no obvious reason why the real size of the investment base on which Kathmandu earns abnormal returns should depend on inflation rates. The approach, however, still relies to some extent on the competitive equilibrium assumption. The assumption is now invoked to suggest that supernormal profitability can be extended only to an investment base that remains constant in real terms. In rare situations, if the firm has established a market dominance that the analyst believes is immune to the threat of competition, the terminal value can be based on both positive real sales growth and abnormal profits. When we assume that the abnormal performance persists at the same level as in the terminal year, projecting abnormal earnings and free cash flows is a simple matter of growing them at the assumed sales growth rate. Since the rate of growth in abnormal earnings and cash flows is constant, starting in the year after the terminal year, it is also straightforward to discount those flows. The present value of the flow stream is the flow at the end of the first year divided by the difference between the discount rate and steady-state growth rate, provided that the discount rate exceeds the growth rate. There is nothing about this valuation method that requires reliance

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CHAPTER 8 Prospective analysis: Valuation implementation

on the competitive equilibrium assumption, so it could be used with any sales growth rate less than the discount rate. The question is not whether the arithmetic is available to handle such an approach, but rather how realistic it is.

Terminal value based on a price multiple A popular approach to terminal value calculation is to apply a multiple to abnormal earnings, cash flows or book values of the terminal period. This approach is not as ad hoc as it may first appear. Note that, under the assumption of no sales growth, abnormal earnings or cash flows beyond the terminal year remain constant. Capitalising these flows in perpetuity by dividing by the cost of capital is equivalent to multiplying them by the inverse of the cost of capital. For example, in the case of Kathmandu, capitalising free cash flows to equity at 7.01% is equivalent to assuming a terminal cash flow multiple of 14.26 (= 1/0.0701). Thus, applying a multiple in this range is similar to discounting all free cash flows beyond 2023 while invoking the competitive equilibrium assumption on incremental sales. The mistake to avoid here is to capitalise the future abnormal earnings or cash flows using an overly high multiple. The earnings or cash flow multiples may be high currently because the market anticipates abnormally profitable growth. However, once that growth is realised, the priceearnings multiple should fall to a normal level. It is that normal price-earnings ratio, applicable to a stable firm or one that can grow only through making investments that generate the cost of capital (i.e. zero net present value projects), that should be used in the terminal value calculation. Thus, we should use multiples in the range of 10 to 12 – close to the reciprocal of the cost of equity. Higher multiples are justifiable only when there are still abnormally profitable growth opportunities beyond the terminal year. A similar logic applies to estimating terminal values using book value multiples.

Selecting the terminal year A critical question posed by the above discussion is how long to make the detailed forecast horizon. When the competitive equilibrium assumption is used, the answer is whatever time is required for the firm’s returns on incremental investment projects to reach that equilibrium – an issue that turns on the sustainability of the firm’s competitive advantage. As indicated in Chapter 6, historical evidence indicates that most firms should expect ROEs to revert to normal levels within five to 10 years. But for the typical firm, we can justify ending the forecast horizon even earlier as the return on incremental investment can be normal even while the return on total investment (and therefore ROE) remains abnormal. Thus, a five- to 10-year forecast horizon should be more than sufficient for most firms. Exceptions would include firms so well insulated from competition, because of a powerful brand name or a natural monopoly, that they can extend their investment base to new markets for many years and still expect to generate supernormal returns.

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ESTIMATES OF KATHMANDU’S TERMINAL VALUE Choosing the terminal year In the case of Kathmandu, the terminal year used is five years beyond the current one. Beyond that point, we believe that the industry will be settled, and the firm’s performance will have reached a steady state. Figure 8.6 shows that the ROE is forecasted to decrease slightly over these five years, from 12.5% in 2019 to 11.0% in 2023. At this level the firm will earn an abnormal return on equity of close to 4%, since its cost of equity is estimated to be 7.01%.

Terminal value of equity under varying assumptions Figure 8.7 shows Kathmandu’s terminal value of equity under the various theoretical approaches we discussed previously. Scenario 1 in this table shows the terminal value if we assume that Kathmandu’s sales growth will increase to the expected rate of population growth of 3% beyond fiscal year 2023, and that it will continue to earn the same level of abnormal returns as in 2023. (That is, we assume that all the other forecasting assumptions will be the same as in 2023.) This scenario essentially summarises Kathmandu’s performance in perpetuity under the assumption that the firm will maintain its abnormal returns and leads to a terminal value of $335.6 million. We calculate this as follows:

Terminal valueabnormal Earnings =

1.03 × Abnormal earnings2023 (0.071 – 0.03) × (1.071)5

Scenario 2 assumes that Kathmandu is able to maintain its abnormal returns on a base of sales that is growing in real terms. Scenario 2 calculates the terminal value assuming that Kathmandu will maintain its margin on sales that are growing at the long-run expected rate of inflation, assumed to be 2.1%, decreasing the terminal value to $271.6 million. Scenario 3 shows the terminal value if we assume that the firm’s competitive advantage can be maintained only on the nominal sales level achieved in 2023. As a result, sales growth beyond the terminal year is assumed to be zero, which is equivalent to assuming that incremental sales do not produce any abnormal returns. The terminal value under this scenario drops to $186.4 million. The final scenario invokes the competitive equilibrium assumption; that is, margins will be eroded such that the firm will have no abnormal returns irrespective of the rate of sales growth, leading to no terminal value. For the sake of illustration, the expected sales growth of 3% is maintained, with margins lowered to a calculated 5.187% to eliminate any competitive advantage for Kathmandu.

FIGURE 8.7 Terminal values for Kathmandu under various assumptions

Terminal sales growth

Terminal NOPAT margin

Abnormal earnings value beyond the forecast horizon ($000s)

Scenario

Approach

Scenario

1

Persistent abnormal earnings performance

Sales growth and margins based on detailed analysis and forecast

3.0%

8.0%

335 583

2

Abnormal returns on constant sales (real terms)

Sales grow at the rate of inflation, margins maintained

2.1%

8.0%

271 676

3

Abnormal returns on constant sales (nominal terms)

Essentially zero sales growth, margins maintained

0.0%

8.0%

186 376

4

Competitive equilibrium

Margins reduced so no abnormal earnings

3.0%

5.19%

0

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COMPUTING EQUITY VALUE FOR KATHMANDU Figure 8.8 shows the estimated value of Kathmandu’s equity, using the abnormal earnings and free cash flows to equity. These values are computed using the financial forecasts in Figure 8.6 and the terminal value forecasts using the persistent abnormal performance scenarios

are presented in Figure 8.7. Scenario 1 represents the most likely outcome, as a result of the assumptions made for the forecasts. The range of valuations using the four assumptions described above is from $2.24 to $3.73 per share.

FIGURE 8.8 Valuation for Kathmandu using various scenarios

(in NZ$000s)

Beginning book value

Value from forecast period (2019–23)

Value beyond forecast horizon (terminal value)

Total equity value

Value per share

Scenario 1 – Persistent abnormal performance Abnormal earnings

420 382

85 194

335 583

841 159

$ 3.73

Abnormal ROE

473 730

85 194

335 583

841 159

$ 3.73

N/A

180 300

660 859

841 159

$ 3.73

85 194

271 676

777 252

$ 3.45

Free cash flow to equity

Scenario 2 – Abnormal returns on constant sales (real terms) Abnormal earnings

420 382

Abnormal ROE

420 382

85 194

271 676

777 252

$ 3.45

N/A

183 142

594 110

777 252

$ 3.45

Free cash flow to equity

Scenario 2 – Abnormal returns on constant sales (nominal terms) Abnormal earnings

420382

85 194

186 376

691 952

$ 3.07

Abnormal ROE

420382

85 194

186 376

691 952

$ 3.07

N/A

189 774

502 178

691 952

$ 3.07

Abnormal earnings

420382

85 194

1

505 577

$ 2.24

Abnormal ROE

420382

85 194

1

505 577

$ 2.24

N/A

180 300

325 277

505 577

$ 2.24

Free cash flow to equity Scenario 4 – Competitive equilibrium

Free cash flow to equity

We then show in Figure 8.9 a complete free cash flow to equity and residual earnings valuation for Kathmandu using the assumptions in Scenario 1. FIGURE 8.9 Equity valuation using free cash flows and abnormal earnings for Kathmandu

Assuming cost of equity = 7.01% DCF method Free cash flow to equity ($000) * discount factor (for common equity) = Present value of free cash flow to equity

1

2

3

4

5

2019

2020

2021

2022

2023

2024

52 559

37 969

42 784

49 021

36 103

37 186

0.934

0.873

0.816

0.763

0.713

49 116

33 157

34 915

37 384

25 729

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PART 2 BUSINESS ANALYSIS AND VALUATION TOOLS

Assuming cost of equity = 7.01% DCF method

1

2

3

4

5

2019

2020

2021

2022

2023

PV of FCF to Equity (years 1–5)

180 300

+ PV of FCF to equity beyond year 5

660 859

= Value of the equity

841 159

Number of shares outstanding (000s)

225 315

Estimated value per share

$ 3.73

2024

Discounted residual income model Net income to common shareholders

52 738

50 388

50 156

51 805

49 397

– charge for equity capital

29 469

29 481

30 352

30 869

31 064

= Residual income

23 269

20 907

19 804

20 936

18 333

0.934

0.873

0.816

0.763

0.713

21 745

18 257

16 161

15 966

13 065

* Discount factor (for common equity) = Present value of residual income PV of residual income (years 1–5)

85 194

+ PV of residual income beyond year 5

335 583

+ Start of year shareholders’ equity

420 382

= Estimated value of the equity

841 159

Number of shares outstanding

225 315

Estimated value per share

$ 3.73

18 883

Value estimates using the abnormal returns method, the abnormal earnings method and the free cash flow method result should be the same, as claimed in Chapter 7. Note also that Kathmandu’s terminal value represents a significantly larger fraction of the total value of equity under the free cash flow method relative to the other methods. As discussed, this is due to the fact that the abnormal earnings and ROE methods rely on a firm’s book value of equity, so the terminal value forecasts are for incremental value over book value. In contrast, the free cash flow approach ignores the book value, implying that the terminal value forecasts represent total value during this period. The primary calculations in the above estimates treat all flows as if they arrive at the end of the year. In reality, they will typically arrive throughout the year. If we choose to assume for the sake of simplicity that cash flows will arrive at mid-year, then we should adjust our value estimates upward by the amount

()

r   1 × 2  where r is the discount rate. This would increase the equity value estimates to a range of $2.32 to $3.86.

Value estimates versus market values As the discussion above shows, valuation involves a substantial number of assumptions by analysts. Therefore, the estimates of value will vary from one analyst to the other. The only way Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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195

KATHMANDU’S VALUE ESTIMATES VERSUS MARKET VALUES In the case of Kathmandu, our estimated value of the firm’s equity is NZ$3.73. On 31 July 2018, Kathmandu’s closing price on the New Zealand Stock Exchange was $3.27. Although our assumptions were realistic for Kathmandu at that time, the retail market in Australia and New Zealand was difficult. The market price is consistent with investors taking a more conservative view about Kathmandu’s capacity to generate positive abnormal earnings in the future.

This is an example of differences in the two sets of assumptions underlying the analyst’s valuation and the market value. Such differences may be related to growth rates, NOPAT margins, asset turnover or discount rates (primarily due to differences in assumed equity risk premium or capital structure). One could run different scenarios regarding each of these variables and test the sensitivity of the estimated value to these assumptions.

Sensitivity analysis The broad range of estimated equity values shown in Figure 8.8 demonstrates that changes in assumptions can significantly affect an analyst’s equity valuation for a company. The market’s valuation of Kathmandu falls closest to our Scenario 3 valuation, indicating that the market may have expected Kathmandu to be able to continue to generate abnormal returns beyond the forecast horizon on constant sales in nominal terms. However, in Chapter 6, we recognised that the company’s future could play out in multiple ways. The differences between these scenario values were driven primarily by long-term differences in sales growth and margins, performance

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KATHMANDU CASE

to ensure that one’s estimates are reliable is to make sure that the assumptions are grounded in the economics of the business being valued. It is also useful to check the assumptions against the time-series trends for performance ratios discussed in Chapter 6. While it is legitimate for an analyst to make assumptions that differ markedly from these trends in any given case, it is important for the analyst to be able to articulate the business and strategy reasons for making such assumptions. When a company being valued is publicly traded, it is possible to compare one’s own estimated value with the market value of a company. When an estimated value differs substantially from a company’s market value, it is useful for the analyst to understand why such differences arise. An analyst can do this by reframing the valuation exercise to figure out the valuation assumptions they need to arrive at the observed share price. They can then examine whether the market’s assumptions are more or less valid relative to their own assumptions. As we discuss in the next chapter, such an analysis can be invaluable in using valuation to make buy or sell decisions in the security analysis context.

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measures that are strongly affected by competition. For the retail industry in Australia, market share and competition will be the determining factors for value in the future. Recall also that Kathmandu made a relatively large acquisition of the Oboz Footwear business in the second half of the 2018 financial year. At the end of the 2018 financial year, it is too early for us to be able to determine the impact of this on both sales growth and sustainable margins.

Other practical issues in valuation The above discussion provides a blueprint for valuing a firm. In practice, the analyst has to deal with a number of other issues that affect valuations. We discuss below three frequently encountered complications – accounting distortions, negative book values and excess cash.

Dealing with accounting distortions We know from the discussion in Chapter 7 that accounting methods per se should have no influence on firm value, despite the fact that abnormal returns and earnings valuation approaches used here are based on numbers that vary with accounting method choices. Because accounting choices must affect both earnings and book value, and because of the self-correcting nature of double-entry bookkeeping (all ‘distortions’ of accounting must ultimately reverse), estimated values will not be affected by accounting choices, as long as the analyst recognises the accounting distortions.8 When a firm uses ‘biased’ accounting – either conservative or aggressive – the analyst needs to recognise the bias to ensure that their value estimates are not biased. If a thorough analysis is not performed, a firm’s accounting choices can influence analysts’ perceptions of the real performance of the firm and hence the forecasts of future performance. Accounting choice would affect expectations of future earnings and cash flows, and distort the valuation, regardless of whether the valuation is based on DCF or on discounted abnormal earnings. For example, if a firm overstates current revenue growth through aggressive revenue recognition, failure to appreciate the effect is likely to lead the analyst to overstate future revenues, affecting both earnings and cash flow forecasts. An analyst who encounters biased accounting has two choices – either to adjust current earnings and book values to eliminate managers’ accounting biases, or to recognise these biases and adjust future forecasts accordingly. Whereas both approaches lead to the same estimated firm value, the choice will have an important impact on what fraction of the firm’s value is captured within the forecast horizon and what remains in the terminal value. Holding forecasting horizon and future growth opportunities constant, higher accounting quality allows a higher fraction of a firm’s value to be captured by the current book value and the abnormal earnings within the forecasting horizon. Accounting can be of low quality either because it is unreliable or because it is extremely conservative. If accounting reliability is a concern, the analyst has to expend resources on ‘accounting adjustments’. If accounting is conservative, the analyst is forced to increase the forecasting horizon to capture a given fraction of a firm’s value or to rely on relatively more uncertain terminal values estimates for a large fraction of the estimated value.

Dealing with negative book values A number of firms have negative earnings and negative values of book equity. For example, firms in the start-up phase can have negative equity, as can those in high technology industries.

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CHAPTER 8 Prospective analysis: Valuation implementation

These firms incur large investments whose payoff is uncertain. Accountants may write off these investments as a matter of conservatism, leading to negative book equity. Examples of firms in this situation include high-risk technology firms, such as biotechnology firms; internet and telecommunication firms; and mining and exploration firms. A second category of firms with negative book equity are those that are performing poorly, resulting in cumulative losses exceeding the original investment by the shareholders. Negative book value of equity makes it difficult to use the accounting-based approach to value a firm’s equity. There are several possible ways to get around this problem. The first approach is to value the firm’s assets (using, for example, abnormal operating ROA or abnormal NOPAT) rather than equity. Then, based on an estimate of the value of the firm’s debt, one can estimate the equity value. Another alternative is to ‘undo’ accountants’ conservatism by capitalising the investment expenditures written off. This is possible if the analyst is able to establish that these expenditures are value creating. A third alternative, feasible for publicly traded firms, is to start from the observed share price and work backwards. Using reasonable estimates of cost of equity and steady-state growth rate, the analyst can calculate the average long-term level of abnormal earnings needed to justify the observed share price. Then the analytical task can be framed in terms of examining the feasibility of achieving this abnormal earnings ‘target’. Australian research on this issue separates firms with negative earnings into three categories: those facing high distress risk, those with future growth options and those who have used high accounting conservatism. It finds that liquidation value is most useful for companies facing high distress risk, whereas the level of investment intensity is more heavily weighted by investors assessing firms with growth options. For companies exhibiting high accounting conservatism, unrecorded accounting reserves have more influence on equity values.9 It is important to note that the value of firms with negative book equity often consists of a significant option value. For example, the value of mining firms is not only driven by the expected earnings from their current sites but also by the payoff from options embedded in their exploratory efforts. Similarly, the value of troubled companies is driven to some extent by the ‘abandonment option’ – shareholders with limited liability can put the firm to debt holders and creditors. One can use the options theory framework to estimate the value of these ‘real options’.

Dealing with excess cash and excess cash flow Firms with excess cash balances, or large free cash flows, also pose a valuation challenge. In our projections in Figure 8.3, we implicitly assumed that cash beyond the level required to finance a firm’s operations will be paid out to the firm’s shareholders. Excess cash flows are assumed to be paid out to shareholders in the form of either dividends or share repurchases. Notice that these cash flows are already incorporated into the valuation process when they are earned, so there is no need to take them into account when they are paid out. Both the accounting-based valuation and the discounted cash flow valuation assume a dividend payout that can potentially vary from period to period. This dividend policy assumption is required so long as one wishes to assume a constant level of financial leverage and stable equity risk used to compute the cost of equity in the valuation calculations. Firms rarely have such a variable dividend policy in practice. However, this in itself does not make the valuation approaches invalid, so long as a firm’s dividend policy does not affect its value. That is, the valuation approaches assume that the well-known Modigliani–Miller theorem regarding the irrelevance of dividends holds.10

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INDUSTRY INSIGHT

A firm’s dividend policy can affect its value if managers do not invest free cash flows optimally. For example, if a firm’s managers use excess cash to undertake value-destroying acquisitions, then our approach overestimates the firm’s value. Firms that suffer from such ‘agency’ costs are likely to have ineffective corporate governance (discussed in Chapter 12). One approach an analyst can use to reflect these types of concerns in a valuation is to first estimate the firm value according to the approach described earlier and then adjust the estimated value for whatever agency costs the firm’s managers may impose on its investors.

A PRACTITIONER ADVISES Partner with leading chartered accounting firm specialising in corporate finance and valuation on other activities that are important when using valuation models: In my experience, 70 to 80% of the time on a valuation is spent finding out the numbers (that are presented to you in your textbook or in the question that’s been given to you). Only about 20% of the time is spent doing the analysis, and probably only about 10% or 20% is spent actually writing the report.

Remember that valuation is not a fact–it’s an opinion. And the most important aspect of an opinion is its justification. So effective valuation is more about how you present the evidence, rather than just the numerical answer. And sometimes, particularly when it is used in disputatious matters, the arguments that you present are even more important than the number. Because even if the number is exactly right but the arguments are poor, it’s not a helpful report. Reflective activity: Why do you think that this practitioner considers it not helpful to have an accurate valuation without good arguments to support it? Would an investor care if they are not provided with a comprehensive report to back a valuation, as long as the valuer has a record of being very accurate?

SUMMARY This chapter illustrates how to apply the valuation theory discussed in Chapter 7. The chapter explains the set of business and financial assumptions one needs to make to conduct the valuation exercise. It also illustrates the mechanics of making detailed valuation forecasts and terminal values of earnings, free cash flows and accounting

rates of return. We discuss how to compute cost of equity. Using a detailed example, we show how a firm’s equity value can be computed using earnings, cash flows and rates of return. Finally, we offer ways to deal with some commonly encountered practical issues, including accounting distortions, negative book values and excess cash balances.

CHECKING AND APPLYING YOUR LEARNING A spreadsheet containing Kathmandu’s actual and forecasted financial statements as well as the valuation described in this chapter is available on the companion website of this book. Use it to answer the following questions. 1 a How will the forecasts in Figure 8.5 change if Kathmandu were to maintain a sales growth rate of

10% per year from 2019 to 2023 (and all the other assumptions are kept unchanged)? b  How would this assumed change in sales growth affect the equity value estimates shown in Figure 8.5?  LO1 2 Recalculate the forecasts in Figure 8.5 assuming that the NOPAT profit margin is held steady for the first two

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CHAPTER 8 Prospective analysis: Valuation implementation

years of the forecast and then declines by 0.1 percentage points per year thereafter (keeping all the other assumptions unchanged).  LO2 3 Recalculate the forecasts in Figure 8.5 assuming that the ratio of net operating working capital to sales is 6% and the ratio of net long-term assets to sales is 60% for all the years from fiscal 2019 to fiscal 2023. Keep all the other assumptions unchanged.   Calculate Kathmandu’s cash payouts to its shareholders in the years 2019–23 that are implicitly assumed in the projections in Figure 8.5. a How will the abnormal earnings calculations in Figure 8.5 change if the cost of equity assumption is changed to 10%? b What would be the total equity value (as calculated for scenarios in Figure 8.8 using abnormal earnings) if the sales growth in years 2024 and beyond is 3% and the firm is able to generate its abnormal returns at the same level as in fiscal 2023 forever (keeping all the other assumptions in the table unchanged)?  LO1 4 Calculate the proportion of terminal values to total estimated values of equity under the abnormal earnings method and the discounted cash flow method for the Scenario 2 results shown in Figure 8.7. Why are these proportions different?  LO2 5 Assume that Kathmandu changes its capital structure so that its market value weight of debt to capital increases to 40%, and its after-tax interest rate on debt at this new leverage level is 4%. What will be the cost of equity at this new debt level? What will be the weighted average cost of capital?  LO3 6 Adrielle says she is uncomfortable making the assumption that Kathmandu’s dividend payout amount will vary from year to year. If she makes a constant dividend payout assumption, what changes does she have to make in her other valuation assumptions to make them internally consistent with each other?  LO2 7 Figure 8.10 show total assets, book value and market value of equity, equity beta and analysts’ consensus earnings forecasts for CSL, Woolworths and Xero.   CSL is one of Australia’s leading biopharmaceutical companies, Woolworths is one of the two largest grocery retailers, and Xero provides online accounting software.



199

 As part of the following calculation, assume that the Australian government 10-year bond is yielding 2.75% and the equity risk premium is 5.0%.

FIGURE 8.10 Total assets, book value and market value of equity, equity beta and analysts’ consensus earnings forecasts for CSL, Woolworths and Xero

  

CSL

Woolworths

Xero

17 559

23 491

929

7 488

10 669

338

97 425

41 826

6 829

Equity beta

1.15

0.56

2.32

Analyst forecast of next year’s earnings ($m)

3076

1826

14

Total assets ($m) Shareholders’ equity ($m) Book value Market value

a Compute the CAPM estimate of cost of equity capital for each firm. b Calculate ‘normal’ or required earnings for each firm. c Calculate abnormal (i.e. residual) earnings for each firm. d What do the different amounts of abnormal earnings imply for each firm? Do they help explain the differences in market value of equity of the three firms?  LO1 LO2 8 Assume you expect a company’s net income to remain stable at $2000 for all future years, and you expect all earnings to be distributed to stockholders at the end of each year, so that common equity also remains stable for all future years (this also assumes a clean surplus). Also, assume the company’s β = 1.2, the market risk premium is 6% and the 10-year yield on risk-free government bonds is 3%. Finally, assume the company has 1000 ordinary shares outstanding. a Use the CAPM to estimate the company’s equity cost of capital. b Compute the expected net distributions to stockholders (dividends) for each future year.  LO3 9 Use the same facts as in Question 8, but assume you expect the company’s income to be $2000 in the coming year and to grow at the rate of 5% in every subsequent year into infinity. Also, assume that the company’s common equity as of the end of the most recent fiscal year is $12 000, and the investment needed to support the growth in net income causes shareholders’ equity to increase by 5% each year. Assume the company is an all-equity firm; that is, all

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financing comes from stockholders and none comes from debtholders. In this case, the company’s balance sheet has net operating assets (NOA) of $12 000, shareholders’ equity of $12 000, and zero net financial obligations (zero net debt). a Compute dividends (or free cash flow to equity holders) for the coming year and the rate of growth in dividends for every year thereafter. b Use the dividend discount (i.e. free cash flow to equity investors) valuation model to estimate the company’s current stock price.  LO2 LO3 10 Use the same facts as in Question 9, except the 5% income growth rate (and beginning of year common equity to support it) is only expected for years 2 and 3. Then growth is expected to be zero and all income is expected to be distributed to shareholders for all future years.

a Compute the dividend payment for the next three years, and then dividends for all future years. b Use the dividend discount (i.e. free cash flow to equity investors) valuation model to estimate the company’s current stock price.  LO2 LO3 11 Use the same facts as Question 8, except derive the value of the company and the price per common share using the earnings-based valuation model. a Compute residual income (i.e. abnormal earnings) for the next three years, and verify that residual income is growing at a constant rate. What is that rate of growth? b Use the residual income (abnormal earnings) model to derive the value of the firm and the price per common share. Compare your answer to the answer you got using the free cash flow to equity investors (dividend discount model) in Question 4. LO2 LO3

CASE LINK Concepts from this chapter are used in the following cases in Part 4:

Case 1 Qantas – Part E Case 6 Valuation ratios in the retail industry 2016 to 2018.

ENDNOTES 1

2

3

See T. Copeland, T. Koller and J. Murrin, Valuation: Measuring and Managing the Value of Companies, 2nd edition (New York: John Wiley & Sons, 1994). Theory calls for the use of a short-term rate, but if that rate is used here, a difficult practical question arises: how does one reflect the premium required for expected inflation over long horizons? While the premium could, in principle, be treated as a portion of the term [E(rm – rf ], it is probably easier to use an intermediate- or long-term riskless rate that presumably reflects expected inflation. One way to estimate systematic risk is to regress the firm’s share returns over some recent time period against the returns on the market index. The slope coefficient represents an estimate of b. More fundamentally, systematic risk depends on how sensitive the firm’s operating profits are to shifts in economy-wide activity and the firm’s degree of leverage. Financial analysis that assesses these operating and financial risks should be useful in arriving at reasonable estimates of β. See W. Beaver, P. Kettler and M. Scholes, ‘The association between market determined and accounting determined risk measures’, Accounting Review 45(4) (1970), who develop a model for estimating beta using financial statement data. These betas are typically estimated by regressing five years of daily firm stock returns on the return on a market index, such as the Standard & Poor’s 500. These estimates can be heavily influenced by extremely positive or negative firm-specific news (and stock returns) during the five-year estimation period, generating betas that are implausibly high or low. Since it uses a more complex estimation approach, Value Line betas are less likely to be subject to these biases and are used throughout this book.

4

5

6

7

8

Australian research provides arguments for market risk premiums between 6% (T. Brailsford, J. Handley and K. Maheswaran, ‘The historical equity risk premium in Australia: Post-GFC and 128 years of data’, Accounting and Finance 52 (1) (2012): 237–247) and 8% (N. Hathaway, ‘Australian Market Risk Premium’, Capital Research Pty Ltd, January 2005). We have chosen the more conservative approach in this instance. Recent US evidence is provided in J. R. Graham, and R. C. Harvey, ‘The Equity Risk Premium in 2018’ (27 March 2018). Available at SSRN: https://ssrn.com/ abstract=3151162 or http://dx.doi.org/10.2139/ssrn.3151162 . See J. Lewellen and S. Nagel, ‘The conditional CAPM does not explain asset-pricing anomalies’, Journal of Financial Economics 82 (2006): 289–314, which addresses issues with use of the CAPM. SIRCA calculate their beta estimates by estimating an OLS regression model using 48 monthly observations of the firm’s stock returns and the market returns. R. D. Brooks, R. W. Faff and M. D. McKenzie, ‘Time-varying beta risk of Australian industry portfolios: A comparison of modelling techniques’, Australian Journal of Management 23(1) (June 1998): 1–22, doi: 10.1177/031289629802300101. Valuation based on discounted abnormal earnings does require one property of the forecasts: that they be consistent with ‘clean surplus accounting’. Such accounting requires the following relation: End-of-period book value = Beginning book value + earnings – dividends ± capital contributions/withdrawals



 Clean surplus accounting rules out situations where some gain or loss is excluded from earnings but is still used to adjust the book

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CHAPTER 8 Prospective analysis: Valuation implementation

9

value of equity. For example, under US GAAP, gains and losses on foreign currency translations are handled this way. In applying the valuation technique described here, the analyst would need to deviate from GAAP in producing forecasts and treat such gains/ losses as a part of earnings. However, the technique does not require that clean surplus accounting has been applied in the past – so the existing book value, based on US GAAP or any other set of principles, can still serve as the starting point. All the analyst needs to do is apply clean surplus accounting in the forecasts. That much is not only easy but is usually the natural thing to do anyway. H. Wu, Valuing Currently Unprofitable Companies in Australia: The Impact of Distress, Investment Intensity and Accounting

201

Conservatism (2012), Working paper, Research School of Accounting and Business Information System, Australian National University (2014). 10 Modigliani and Miller proposed that in a perfect world with no taxes or bankruptcy costs, the dividend policy of a firm would not affect firm value. 11 These weights are likely to change over the forecast horizon, depending on assumptions about dividend payments, and changes to debt and equity. This is another reason why the use of WACC is not an accurate method for discounting future earnings or cash flows to obtain asset value.

APPENDIX: ESTIMATING KATHMANDU’S OVERALL ASSET VALUE Our primary focus in this chapter has been on valuing Kathmandu’s equity. But it can also be useful for the analyst to value the firm’s assets. As we discussed in Chapter 7, under the different approaches to valuation, the key forecasts required to convert the financial forecasts shown in Figures 8.5 and 8.6 into estimates of asset value are the following: abnormal NOPAT: NOPAT less total net capital at the beginning of the year times the weighted average cost of capital abnormal operating ROA: the difference between operating ROA and the weighted average cost of capital free cash flows to capital: NOPAT less the increase in operating working capital, less the increase in new long-term assets. In the same way that we used the cost of equity to discount Kathmandu’s forecasted equity performance and value its equity, we need to come up with a cost of all capital provided, termed the weighted average cost of capital (WACC), to discount the forecasts of asset performance and value its assets. As discussed in Chapter 7, WACC is used to discount the abnormal earnings or free cash flows to all investors in the firm. WACC is the average cost to a firm of obtaining capital from both debt and equity sources. It is, literally, the weighted after-tax cost of debt financing (i.e. the return required by providers of debt to the firm on an after-tax basis) and the weighted return required by equity providers, where the weights are the percentages of debt and equity (at their fair or market values) to the enterprise market value. To estimate the WACC for Kathmandu, we start with the assumption that its after-tax cost of debt is 4.5%, based on the average ratio of the net interest expense after tax to beginning net debt for the three years 2016–18. (We

discuss this in more detail in Chapter 10.) As discussed in the chapter, Kathmandu’s cost of equity is estimated at 7.01%, reflecting the firm’s assumed equity beta of 0.70, the 10-year Treasury bond yield of 2.75%, and a risk premium of 6%. Kathmandu’s estimated equity value seen in our Scenario 1 estimate in Figure 8.8 (which is the most realistic forecast) was NZ$841.1 million; its net book debt was $53.3 million. Based on these numbers we estimate the ‘market value’ weights of debt and equity in the firm’s capital structure as 6% and 94%, respectively, for 2019.11 Given these weightings and the costs of equity and debt, Kathmandu’s WACC for 2019 is estimated at 6.86%, as shown in Figure 8.11. As our forecast proceeds, the relative weights of debt and equity capital vary, hence we recalculate a new WACC for each period/year. The proportion of equity in the capital structure varies from 75 to 70% over the forecast horizon, and the WACC varies from 7.95 to 7.74% over the same period. FIGURE 8.11 Kathmandu’s weighted average cost of capital for 2019

Cost of funds

×

Market weighting

=

Weighted cost

Debt

4.5%

6.0%

0.27%

Equity

7.01%

94%

6.59%

Capital

6.86%

Now that we have estimated Kathmandu’s WACC, we can forecast the variables needed to compute an overall asset value for the firm. Figure 8.12 shows forecasts for the three financial statement variables – abnormal NOPAT, abnormal operating ROA and free cash flow to capital – for the five-year period 2019 to 2023.

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To derive cash flows in 2023, we need to make assumptions about the sales growth rate and balance sheet ratios in 2024. The cash flow forecasts shown in Figure 8.12 are based on the assumption that the sales growth and beginning balance sheet ratios will track those shown in Scenario 1 above, which assumes a sales growth rate of 3.0% with other beginning balance sheet ratios remaining the same as in 2023. To complete our analysis, Figure 8.13 shows the estimated value of Kathmandu’s assets using the three methods

discussed in Chapter 7 for Scenario 1 (persistent abnormal performance) shown in the body of the chapter. To compute this value, Kathmandu’s performance forecasts in Figure 8.12 and its terminal value forecast for Scenario 1 are discounted at the weighted average cost of capital of 6.86%. These discounted forecasts are then summed and combined with beginning book value of net operating assets (except in the free cash flows to equity calculation, which does not depend on beginning book value) to arrive at a total estimated value of Kathmandu’s assets under Scenario 1 of $864.9 million.11

FIGURE 8.12 Asset valuation performance forecasts for Kathmandu

Free cash flow to capital NOPAT – change in working capital (during the year)

2019

2020

2021

2022

2023

53 965

51 822

51 632

53 779

52 134

–12 164

3 164

2 525

1 898

1 955

– change in long-term assets

16 345

10 948

11 604

13 286

13 685

Free cash flow to capital

49 784

37 709

37 503

38 594

36 494

NOPAT

53 965

51 822

51 632

53 779

52 134

less required operating profit after tax

32 499

32 786

33 754

34 724

35 765

21 466

19 036

17 878

19 055

16 368

Abnormal NOPAT

[WACC × start-of-year net operating assets] = abnormal NOPAT Abnormal RNOA RNOA [using average NOA]

11.3%

10.7%

10.3%

10.5%

9.9%

less WACC

6.86%

6.86%

6.86%

6.86%

6.86%

= abnormal RNOA

4.5%

3.8%

3.5%

3.6%

3.0%

Book value of net operating assets growth rate

0.9%

3.0%

2.9%

3.0%

3.0%

FIGURE 8.13 Kathmandu asset valuation using Scenario 1 assumptions

2019

2020

2021

2022

2023

NOPAT

53 965

51 822

51 632

53 779

52 134

– charge for all capital (WACC)

32 499

32 786

33 754

34 724

35 765

= Residual operating income

21 466

19 036

17 878

19 055

16 368

* Discount factor (for assets)

0.936

0.876

0.820

0.767

0.718

20 088

16 670

14 651

14 613

11 747

2024

Discounted residual operating income model

= Present value of residual operating income PV of residual operating income (years 1–5)

77 768

+ PV of residual operating income beyond year 5

313 429

+ Start of year net operating assets

473 730

= Estimated value of the assets

864 927

16 859

(Continued)

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FIGURE 8.13 Kathmandu asset valuation using scenario 1 assumptions (Continued)

2019

2020

2021

2022

2023

2024

FCF to capital

49784

37709

37503

38594

36494

37588

* Discount factor (for assets)

0.936

0.876

0.820

0.767

0.718

= Present value of FCF to assets

46588

33023

30734

29598

26190

 

 

 

 

Discounted free cash flow to assets model

PV of FCF to assets (years 1–5)

166132

+ PV of FCF to assets beyond year 5

698795

= Estimated value of the assets

864927

Finally, by deducting the book value of debt ($53.3 million), the analyst can generate the implied value of the equity under Scenario 1. This implied equity valuation of $811m is close to that reported in Figure 8.9 of $841m in this chapter, when we valued equity directly. The example of Kathmandu shows that asset-based approach to valuation–that is, valuing net operating assets first, and then deriving equity value–does not always produce the same equity value estimate as the equity-based

 

approach. One reason is that the after-tax cost of debt used in the calculation of WACC may differ from the average coupon rate that Kathmandu pays on its debt. Another reason is that the book value of debt is an approximation of the market value of debt. The typical accounting rules for interest-bearing liabilities suggest that the book value of debt should, on average, be a reasonable approximation of the market value of debt, but it will not be a precise measure.

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PART

3

Business analysis and valuation applications CHAPTER 9

Equity security analysis

CHAPTER 10 Credit analysis and distress prediction CHAPTER 11 Mergers and acquisitions CHAPTER 12 Communication and governance

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CHAPTER

9

Equity security analysis

Equity security analysis involves evaluating a firm and its prospects from the perspective of a current or potential investor in the firm’s shares. Security analysis is one step in a larger investment process that involves: establishing the objectives of the investor forming expectations about the future returns and risks of individual securities combining individual securities into portfolios to maximise the chances of achieving the investment objectives. Security analysis is the foundation for the second step of forecasting future returns and assessing risk. Analysts often conduct security analysis to try to identify mispriced securities in the hope of generating returns that more than compensate the investor for risk. Many analysts also use security analysis to gain an appreciation of how a security would affect the risk of a given portfolio and whether it fits the profile that the portfolio is designed to maintain. Security analysis is undertaken by individual investors, by analysts at brokerage houses and investment banks (sell-side analysts) and by analysts who work at the direction of funds managers for various institutions (buy-side analysts). The institutions employing buy-side analysts include managed funds, superannuation funds, insurance companies, universities and others.

Security analysts deal with a variety of questions: A sell-side analyst asks: Is the industry I am covering attractive and, if so, why? Do firms within the industry adopt different competitive strategies? What are the implications of industry characteristics and firmspecific strategies for my earnings forecasts? Given my expectations for the firm, do these shares appear to be mispriced? Should I recommend these shares as a buy, a sell or a hold? A buy-side analyst for a ‘value fund’ asks: Do these shares possess the characteristics we seek in our fund? That is, do they have a relatively low ratio of price-to-earnings, low price-to-book value and other fundamental indicators? Do its prospects for earnings improvement suggest good potential for high future returns on the shares? An individual investor asks: Does this firm present the risk profile that suits my investment objectives? Does it help diversify the risk of my portfolio? Is the firm’s dividend payout policy consistent with my preferences for cash payout and imputation tax credits? As the above questions underscore, there is more to security analysis than simply estimating the value of shares. Nevertheless, for most sell-side and buy-side analysts, the key goal remains to identify mispriced shares.

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CHAPTER 9 Equity security analysis

Chapter learning objectives By the end of this chapter, you should be able to: LO1

understand the usefulness of financial analysis tools in equity security analysis

LO2

evaluate the role of market efficiency theories in assessing whether equity securities are likely to be mispriced

LO3

understand the difference between passive and active funds management, as well as understand how to evaluate the performance of fund managers, and the complexities in doing so

LO4

remember the steps in undertaking a comprehensive security analysis

LO5

understand the ways in which we can assess the performance of security analysts.

LO1

I nvestor objectives and investment vehicles

The investment objectives of individual savers are highly idiosyncratic. Every saver is influenced by such factors as income, age, wealth, risk appetite and tax status. For example, savers with many years until retirement are likely to prefer a larger share of their portfolio be invested in equities, which offer a higher expected return than that of fixed income (or debt) securities, and have higher short-term variability. Investors in high tax brackets are likely to prefer a large share of their portfolio in shares that pay fully franked dividends or that generate tax-deferred capital gains rather than in shares that pay unfranked dividends or in interest-bearing securities. Managed funds (or unit trusts, as they are called in some countries) have become popular investment vehicles for savers to achieve their investment objectives. A managed fund is a pooled investment. Investors combine their money with other investors, and this pool of funds is handled by a fund manager. Managed funds sell shares in professionally managed portfolios that invest in specific types of equities or fixed income securities. They provide a low-cost way for savers to invest in a portfolio of securities that reflects their particular appetite for risk. The major classes of managed funds include: 1 cash or money market funds that invest in treasury notes and bills, certificates of deposit (CDs) and bank bills 2 bond or fixed interest funds that invest in debt instruments 3 equity funds that invest in equity securities 4 balanced funds, or multi-asset funds, that hold cash, money market, bond and equity securities 5 property funds and infrastructure funds that invest in commercial real estate or large infrastructure assets. Within the bond and equities classes of funds, however, there are wide ranges of fund types. For example, bond funds include:

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PART 3 BUSINESS ANALYSIS AND VALUATION APPLICATIONS

corporate bond funds that invest in investment-grade rated corporate debt instruments1 high-yield funds that invest in non-investment-grade rated corporate debt mortgage funds that invest in mortgage-backed securities. Equity funds include: income funds that invest in shares that are expected to generate dividend income growth funds that invest in shares expected to generate long-term capital gains income and growth funds that invest in shares that provide a balance of dividend income and capital gains value funds that invest in equities that are considered to be undervalued based on fundamental characteristics such as the price-to-book ratio short funds that sell short equity securities that are considered to be overvalued index funds that invest in shares that track a particular market index. In Australia, many funds track indices such as: – the S&P/ASX 20 Index, 100 Index or 300 Index – the S&P/ASX Small Ordinaries Index or All Ordinaries Index – specialist indices such as the S&P/ASX Emerging Companies Index – various accumulation indices size-based funds that invest based on the market capitalisation of the company, such as largecap and small-cap funds sector funds that invest in shares in a particular industry segment, such as the technology sector regional funds that invest in equities from a particular country or geographic region, such as Japan, Europe, North America or the Asia–Pacific region ethical funds that employ a range of strategies to suit different definitions of ethical investing, ranging from avoiding investments in certain industries (such as tobacco sales or uranium mining) to ‘deep green’ funds that invest only in firms that are positive for the environment, such as those developing renewable energy sources. As these tend to be small companies in terms of capitalisation, the portfolios of ethical share funds often have a small company bias. In many developed economies, the proportion of funds managed professionally rather than by individuals has been increasing. Since the 1990s, hedge funds have gained increased prominence and the assets controlled by these funds have grown significantly. According to a 2015 report published by ASIC, single-manager hedge funds had $83.7 billion under management, which represented 3.5% of all Australian managed fund assets.2 Assets on a global basis have gone from $39 billion at year‐end 1990 to $1.93 trillion as of the second quarter of 2008. 3 Hedge funds are intended to profit in both rising and falling markets, usually by taking a more aggressive investment approach than other managed funds. While generally open only to institutional investors and certain qualified wealthy individuals, hedge funds are becoming an increasingly important force in the market. Hedge funds employ a variety of investment strategies including: market neutral funds that typically invest equal amounts of money in purchasing undervalued securities and shorting overvalued ones to neutralise market risk short-selling funds that short-sell the securities of companies that they believe are overvalued special situations funds that invest in undervalued securities in anticipation of an increase in value resulting from a favourable turn of events.

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CHAPTER 9 Equity security analysis

Regardless of the strategy employed, for many funds, their most critical tasks is the fundamental analysis of companies. This chapter focuses on applying the tools we have developed in Part 2 of the book to analyse equity securities.

LO2

 quity security analysis and market E efficiency

How security analysts should invest their time depends on how quickly and efficiently information flows through markets and becomes reflected in security prices. In an extreme scenario, publicly available information would be reflected in security prices fully and immediately upon its release. This is essentially the condition in the strong-form version of the efficient markets hypothesis. This hypothesis states that security prices reflect all publicly available information, as if such information could be digested without cost and translated immediately into demands for buys or sells without regard to frictions imposed by transaction costs. Under such conditions, it would be impossible to identify mispriced securities on the basis of public information. In a world of efficient markets, the expected return on any equity security should be just sufficient to compensate investors for the unavoidable risk the security involves. Unavoidable risk is that risk which cannot be ‘diversified away’ simply by holding a portfolio of many securities. Given efficient markets, the investor’s strategy shifts away from the search for mispriced securities and focuses instead on maintaining a well-diversified portfolio. Aside from this, the investor must arrive at the desired balance between risky securities and very low-risk short-term government bonds.4 The desired balance depends on how much risk the investor is willing to bear for a given increase in expected returns. The above discussion implies that investors who accept that share prices already reflect available information have no need for analysis involving a search for mispriced securities. If all investors adopted this attitude, of course, no such analysis would be conducted, mispricing would go uncorrected and markets would no longer be efficient!5 This is why the efficient markets hypothesis cannot represent an equilibrium in a strict sense. In equilibrium there must be just enough mispricing to provide incentives for investing resources in security analysis. The existence of some mispricing, even in equilibrium, does not imply that it is sensible for just anyone to engage in security analysis. Instead, it suggests that securities analysis is subject to the same laws of supply and demand faced in all other competitive industries: it will be rewarding only for those with the strongest comparative advantage. How many analysts are in that category depends on a number of factors, including the liquidity of a company’s shares and investor interest in the company.6 For example, many sell-side professional analysts will follow a company such as Rio Tinto, a firm with highly liquid shares and considerable international interest. Many other buy-side analysts track the firm on their own account without issuing any formal reports to outsiders. For the smaller publicly traded companies in Australia, there is typically no formal following by analysts, and would-be investors and their advisors are left to form their own opinions on the shares.

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Market efficiency and the role of financial statement analysis The degree of market efficiency that arises from competition among analysts and other market agents is an empirical issue addressed by a large body of research spanning the last five decades. Such research has important implications for the role of financial statements in security analysis. Consider, for example, the implications of an extremely efficient market, where information is fully integrated into prices within minutes of its revelation. In such a market, agents could profit from digesting financial statement information in two ways. First, the information would be useful to the select few who receive newly announced financial data, interpret it quickly and trade on it within seconds, or minutes. Second, and probably more important, the information would be useful to gain an understanding of the firm to place the analyst in a better position to interpret future news, from financial statements as well as other sources, as it arrives. On the other hand, if securities prices fail to reflect financial statement data fully, even days or months after its public revelation, market agents could profit from such data by creating trading strategies designed to exploit any systematic ways in which the publicly available data are ignored or discounted in the price-setting process.

Market efficiency and managers’ financial reporting strategies The degree to which markets are efficient also has implications for managers’ approaches to communicating with their investment communities. The issue becomes most important when the firm pursues an unusual strategy, or when the usual interpretation of financial statements would be misleading in the firm’s context. In such a case, the communication avenues managers can successfully pursue depend not only on management’s credibility but also on the degree of understanding present in the investment community. We will return to the issue of management communications in more detail in Chapter 12.

Evidence of market efficiency There is an abundance of evidence consistent with a high degree of efficiency in securities markets.7 In fact, during the 1960s and 1970s, the evidence was so one-sided that the efficient markets hypothesis gained widespread acceptance within the academic community and had a major impact on the practising community as well. Evidence pointing to very efficient securities markets comes in several forms: When information is announced publicly, the markets react very quickly. Prices in large, actively traded firms respond within seconds to information announcements. It is difficult to identify specific funds or analysts who have consistently generated abnormally high returns. A number of studies suggest that share prices reflect a rather sophisticated level of fundamental analysis. While a large body of evidence consistent with efficiency exists, recent years have witnessed a re-examination of the once widely accepted thinking. A sampling of the research includes the following: Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 9 Equity security analysis

211

MARKET EFFICIENCY AND THE NOBEL PRIZE The 2013 Nobel Memorial Prize in Economic Sciences captured this debate. It was jointly awarded to Professors Eugene Fama, Lars Peter Hansen and Robert Shiller ‘for their empirical analysis of asset prices’. Fama found that it is nearly impossible to predict short-term changes in stock prices, and that new information is incorporated quickly into share values. In the 1980s, Shiller showed that stock prices fluctuate more than the underlying fundamentals like dividend yield and that the ratio of prices to dividends tends to fall when it is high, and to increase when it is low (and

that this pattern extends to bonds and other asset classes). Hansen provided statistical methodologies such as the Generalised Method of Moments that have helped test asset pricing theories.11 In the last two decades there has a rapid growth in research focusing on behavioural finance models that recognise that cognitive biases can affect investor behaviour. As part of this, many studies examine the role of investor sentiment and its effect on stock returns.12

The controversy over the efficiency of securities markets is unlikely to be resolved soon. Most researchers accept the two following lessons. First, securities markets not only reflect publicly available information but they also anticipate much of it before it is released. The open question is: what fraction of the response is left to be integrated into the price at the end of the day of the public release? Second, even in most studies that suggest inefficiency, the degree of mispricing is relatively small for shares in large or actively traded firms. Even if some of the evidence is currently difficult to align with the efficient markets hypothesis, this benchmark remains a useful (at a minimum) for thinking about the behaviour of security prices. The hypothesis will continue to play that role unless it can be replaced by a more complete theory. Some researchers are developing theories that encompass the existence of market agents who are forced to trade for unpredictable ‘liquidity’ reasons, and prices that differ from so-called ‘fundamental values’, even in equilibrium.13

LO3

 pproaches to fund management and A securities analysis

Fund managers use a wide variety of approaches to manage funds. One important approach is the extent to which investments are actively or passively managed. Another variation is

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CASE STUDY

On the issue of the speed of share price response to news, a number of studies suggest that, even though prices react quickly, the initial reaction tends to be incomplete.8 Many studies point to trading strategies that could have been used to outperform market averages.9 Related evidence – still subject to ongoing debate about its proper interpretation – suggests that, even though market prices reflect some relatively sophisticated analyses, prices still do not fully reflect all the information that could be garnered from publicly available financial statements.10

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PART 3 BUSINESS ANALYSIS AND VALUATION APPLICATIONS

whether a quantitative or a traditional fundamental approach is used. Security analysts also vary considerably in terms of whether they produce formal or informal valuations of the organisation.

Active versus passive management Active portfolio management relies heavily on security analysis to identify mispriced securities. The passive portfolio manager holds a portfolio that matches a particular index or sector. This avoids the costs of security analysis and turnover. Combined approaches are also possible. For example, one may actively manage 20% of a fund balance while passively managing the remainder. The widespread growth of passively managed or index funds around the world over the past 30 years serves as testimony to the growing belief that it is difficult to consistently earn returns superior to broad market indices such as the ASX 200 in Australia.

Quantitative versus traditional fundamental analysis Actively managed funds must depend on some form of security analysis. Some funds employ technical analysis, which attempts to predict share price movements using market indicators (prior share price movements, volume etc.). In contrast, fundamental analysis attempts to evaluate the current market price relative to projections of the firm’s future earnings and cash flow generating potential. Fundamental analysis involves all the steps described in the previous chapters of this book: business strategy analysis, accounting analysis, financial analysis and prospective analysis (forecasting and valuation). In recent years, some analysts have supplemented traditional fundamental analysis, which involves a substantial amount of subjective judgement, with more quantitative approaches. The quantitative approaches themselves are quite varied. Some involve simply ‘screening’ shares using firm-specific factors, such as trends in analysts’ earnings revisions, price-earnings ratios, priceto-book ratios and so on. Whether such approaches are useful depends on the degree of market efficiency relative to the screens. Quantitative approaches can also involve implementing some formal model to predict future share returns. Securities analysts can use long-standing statistical techniques such as regression analysis, or more recent computer-intensive techniques such as neural network analysis. Again, the success of these approaches depends on the degree of market efficiency and whether the analysis can exploit information in ways not otherwise available to market agents as a group. Quantitative approaches play a more important role in security analysis today than they did a decade or two ago. However, by and large, analysts still rely primarily on the kind of fundamental analysis involving complex human judgements. The different approaches to investing are also described in terms of ‘top-down’ versus ‘bottomup’ approaches. A top-down approach focuses on how macroeconomic factors drive the markets and ultimately stock prices, and will also examine the performance of sectors and industries. Screens can be set on factors including economic growth indicators, monetary policy, inflation and bond prices. The bottom-up approach is what we have described as fundamental analysis above. There has also been a dramatic increase in the extent of high-frequency trading where investors use ‘fast, sophisticated computers and computer algorithms to submit and cancel orders rapidly (and frequently) and to trade securities’. High-frequency trading has grown from less than 10% of trading volume in US equity markets in the early 2000s to around 50% by the end of Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 9 Equity security analysis

2012.14 Consistent with this, research has shown that prices and trading volume respond to the dissemination of insider trading activity over Dow Jones Newswire around 20–30 seconds after its initial release on the SEC Website through a subscriber feed to the EDGAR Public Dissemination System.15 Increasing amounts of information and how quickly it is incorporated into prices results in more competitive environment, but also creates opportunities for analysts who are good at identifying important information from a mass of data.

Formal versus informal valuation Full-scale, formal valuations based on the methods described in Chapter 7 have become more common in recent years. However, less formal approaches are also possible. For example, an analyst can compare a long-term earnings projection with the consensus forecast to generate a buy or sell recommendation. Alternatively, an analyst may recommend a firm because the earnings forecast appears relatively high when compared to the current price. Another possible approach that might be labelled ‘marginalist’ involves no attempt to value the firm. The analyst simply assumes that if they have unearthed favourable or unfavourable information not to recognised by others, the shares should be bought or sold. Unlike many security analysts, investment bankers produce formal valuations as a matter of course. Investment bankers estimate values to values to help bring a private firm to the public market, to evaluate a merger or buyout proposal, to issue a fairness opinion16 or to make a periodic managerial review, and they must document their valuation in a way that can readily be communicated to management and, if necessary, to the courts.

LO4

 he process of a comprehensive T security analysis

Given the variety of approaches practised in security analysis, it is impossible to summarise all of them here. Instead, we briefly outline the steps to include in a comprehensive security analysis. The amount of attention focused on any given step varies among analysts.

Selecting candidates for analysis No analyst can effectively investigate more than a small fraction of the securities on a major exchange, and therefore we must employ an approach to narrow the focus. Investment banks often organise sell-side analysts by industry or sector, to limit the number of firms they follow. However, a fund manager or an investment firm as a whole usually has the freedom to focus on any firm or sector. Research shows that security analysts prefer to cover larger firms, those with better future prospects, and those with more liquid securities.17 Analysts also prefer to cover firms with high levels of holdings by institutional investors.18 As noted earlier, some funds specialise in investing in shares with certain risk profiles or characteristics (such as growth shares, ‘value’ shares, technology shares and cyclical shares). Managers of these types of funds focus the energies of their analysts on identifying shares that Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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fit their fund objective. In  addition, individual investors who seek a well-diversified portfolio without holding many shares also need information about the nature of a firm’s risks, and how they fit with the risk profile of their overall portfolio. An alternative approach to share selection is to screen firms based on some potential mispricing followed by a detailed analysis of only those shares that meet the specified criteria. For example, one fund managed by a large insurance company screens shares based on recent ‘earnings momentum’, as reflected in revisions in the earnings projections of sell-side and buyside analysts. Upward revisions trigger investigations for possible purchase. The fund operates on the belief that earnings momentum is a positive signal of future price movements. Another fund complements the earnings momentum screen with one based on recent short-term share price movements, hoping to identify earnings revisions not yet reflected in share prices. Increasingly, some asset managers have marketed ‘smart beta’ funds that use alternative index construction. They consider factors such as size, value, volatility and momentum. They use both passive and active management techniques; passive in the sense that the funds follow an index, but active in that they consider other factors.

KEY ANALYSIS QUESTIONS Depending on whether fund managers follow a strategy of targeting shares with specific types of characteristics, or of screening shares that appear to be mispriced, the following questions are likely to be useful: What is the risk profile of a firm? How volatile is its earnings stream and share price? What are the most likely bad outcomes in the future? What is the upside potential? How closely linked are the firm’s risks to the health of the overall economy? Are the risks largely diversifiable or are they systematic? Does the firm possess the characteristics of a growth share? What is the expected pattern of sales and earnings growth for the coming years? Is the firm reinvesting most or all of its earnings? Does the firm match the characteristics desired by ‘income funds’? Is it a mature or maturing company, prepared to ‘harvest’ profits and distribute them in the form of high dividends? Is the firm a candidate for a ‘value fund’? Does it offer measures of earnings, cash flow and book value that are high relative to the price? What specific screening rules can be implemented to identify misvalued shares?

Inferring market expectations If the security analysis is conducted with a view towards identifying mispriced shares, it must ultimately involve a comparison of the analyst’s expectations with those of ‘the market’. One possibility is to view the observed share price as the reflection of market expectations and to compare the analyst’s own estimate of value with that price. However, a share price is only a ‘summary statistic’ – a quick and simple snapshot of the data about a firm. It is useful to have a more detailed idea of the market’s expectations about a firm’s future performance, expressed in terms of sales, earnings and other measures. For example, assume that an analyst has developed new insights about a firm’s near-term sales. Whether those insights represent new information

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INFERRING ANALYSTS’ EXPECTATIONS Consider the 2018 valuation of one of Australia’s two largest grocery retailers, Woolworths Limited. The grocery retailing industry has been subject to increasing competition in the last decade, with new entrants including Aldi and Costco. Woolworths had reported profits and ROE figures of close to 20% or above since 2001. In 2016, it reported a net loss of over $2 billion, driven by a write-down of its home hardware group, Masters. Woolworths had invested in Masters in an attempt to match Bunnings (one of Australia’s best performing retail operations for a number of years). The following analysis focuses on information available in 2018, and illustrates how market prices can be analysed to extract information on market perceptions or expectations of future performance. The company’s 2018 results showed a rise in earnings per share (after abnormal items) from $1.19 to $1.32, which

was released to the ASX on 20 August 2018. During the week prior to this announcement, Woolworths’ share price fell from $29.80 to around $29.50. By the end of August 2018, Woolworths’ share price had declined to $28.30 The company had experienced sales growth averaging around 7% in the prior decade, but in 2015 growth was close to zero, and in 2016 sales declined by 4% (in part due to the divestment of Masters). Analysts had differing opinions about Woolworths’ future prospects, with some describing the market’s expectations as too high, and others seeing some improvement ahead. How do consensus forecasts by analysts reconcile with the market valuations of Woolworths? What are the market’s implicit assumptions about the short-term and long-term earnings growth for the company? By altering the amounts for key value drivers and arriving at combinations

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CASE STUDY

for the share market, and whether they indicate that a ‘buy’ recommendation is appropriate, can be easily determined if the analyst knows the market consensus sales forecast. Around the world, a number of agencies summarise analysts’ forecasts of earnings, sales and, increasingly, cash flows. Forecasts for the next year or two are commonly available, and for many firms a ‘long-run’ earnings growth projection is also available – typically for three to five years. Some financial information providers in the US provide continuous online updates to such data, so if an analyst revises a forecast, that revision can be made known to fund managers and other analysts within seconds. As useful as analysts’ forecasts of sales and earnings are, they do not represent a complete description of expectations about future performance, and there is no guarantee that consensus analyst forecasts are the same as those reflected in market prices. Further, financial analysts typically forecast performance for only a few years so it is helpful to understand what types of long-term forecasts are reflected in share prices. Armed with the model in Chapters 7 and 8 that expresses price as a function of future cash flows or earnings, an analyst can draw some educated inferences about the expectations embedded in share prices. Analysts often provide target prices, which are usually 12-month-ahead share price expectations. These target prices have been found to be systematically optimistic; recent research shows that the implied share returns based on these target prices exceed the actual returns by an average of 15%, and at the end of the 12-month forecast horizon, only 38% of target prices are met.19 However, that final quantitative products from analysts’ reports are often less important than the understanding of the business and its industry that the analysis provides. This understanding enables the analyst to interpret new information as it arrives and to infer its implications. Much of the day-to-day work of security analysts involves obtaining information by communicating with clients, management teams and other professionals.20

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that generate an estimated value equal to the observed market prices, the analyst can infer what the market might have been expecting for Woolworths at the end of September 2018. Woolworths had an equity beta of 0.83 in 2018 (according to SIRCA, which estimates a 48-month rolling OLS regression). At that time, it was reasonable to assume long-term government bond rates of 2.2% and a market risk premium of 5.5%, from which Woolworths’ cost of equity capital could have been estimated to be 6.7%. At these values, it is quickly apparent that the market agreed with the analysts’ earnings forecasts. For example, assuming longterm growth of 3%, the market value of Woolworths using

analysts’ earnings forecasts would be $28.62. This was close to the share price of Woolworths of $28.30 at the end of August 2018. For many firms, the difference between the assumed terminal year growth rate and the cost of capital is a key driver of value, as it determines the capitalisation ‘factor’ for terminal year abnormal earnings or free cash flows. Critical questions for arriving at the market valuation Woolworths are: 1 Will earnings improve more or less quickly than anticipated by analysts? 2 What is the growth rate beyond 2021? Figure 9.1 shows these calculations.

FIGURE 9.1 Computing the value of Woolworths

Average dividend payout ratio over last 10 years

47%

Assumed cost of equity capital

6.7%

Assumed perpetual growth rate

3.0%

*

Beginning of year book value of equity per share

2019

2020

2021

2022

$8.29

$9.01

$9.75

$10.53

I/B/E/S Consensus forecast earnings per share

$1.35

$1.41

$1.47

$1.51

Forecast residual earnings

$0.80

$0.81

$0.82

$0.81

PV factor

0.938

0.879

0.824

PV of residual earnings

$0.75

$0.71

$0.67

Sum of PV of residual earnings to 2021

$2.13

Terminal value of residual earnings PV of terminal value of residual earnings Beginning of year book value

$22.09 $18.20 $8.29

Equity value per share

$28.62

Cost of equity capital

6.7%

Risk-free rate

2.1%

Equity risk premium

5.5%

Woolworths beta

0.83 * Assuming the 10-year average dividend payout rate continues

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CHAPTER 9 Equity security analysis

Security analysis need not involve such a detailed attempt to infer market expectations. However, whether the analysis is made explicit or not, a good analyst understands what economic scenarios could plausibly be reflected in the observed price.

KEY ANALYSIS QUESTIONS By using the discounted abnormal earnings/ROE valuation model, analysts can infer the market’s expectations for a firm’s future performance. This permits analysts to ask whether the market is over or undervaluing a company. Typical questions that analysts might ask from this analysis include the following: What are the market’s assumptions about long-term ROE and growth? For example, is the market forecasting that the company can grow its earnings without a corresponding level of expansion in its asset base (and hence equity)? If so, how long can this persist? How do changes in the cost of capital affect the market’s assessment of the firm’s future performance? If the market’s expectations seem to be unexpectedly high or low, has the market reassessed the company’s risk? If so, is this change plausible? In developing expectations about a firm’s future performance using the financial analysis tools discussed throughout this book, the analyst is likely to ask the following types of questions: How profitable is the firm? In light of industry conditions, the firm’s corporate strategy and its barriers to competition, how sustainable is that rate of profitability? What are the opportunities for growth for this firm? How risky is this firm? How vulnerable are operations to general economic downturns? How highly leveraged is the firm? What does the riskiness of the firm imply about its cost of capital? How do answers to the above questions compare to the expectations embedded in the observed share price?

The final product of security analysis For financial analysts, the final product of security analysis is a recommendation to buy, sell or hold the shares (or some more refined ranking). The recommendation is supported by a set of forecasts and a report summarising the foundation for the recommendation. Analysts’ reports often delve into significant detail and include an assessment of a firm’s business as well as a lineby-line income statement, balance sheet and cash flow forecasts for one or more years. In making a recommendation to buy or sell a firm’s shares, the analyst has to consider the investment time horizon required to capitalise on the recommendation. Are anticipated improvements in performance likely to be confirmed in the near term, allowing investors to capitalise quickly on the recommendation? Or do expected performance improvements reflect long-term fundamentals that will take several years to play out? Longer investment horizons increase the risk that the company’s performance will be affected by changes in economic conditions that an analyst cannot anticipate, reducing the value of the recommendation. Consequently, thorough analysis requires not merely the ability to recognise whether a share is misvalued, but also the ability to anticipate when a price correction is likely to take place. Because there are additional investment risks from following recommendations that require long-term commitments, security analysts tend to focus on making recommendations that are likely to pay off in the short term. This might explain why so few analysts recommended selling

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dot-com and technology shares during the late 1990s when their prices would have been difficult to justify on the basis of long-term fundamentals. However, research on security analysts has found that it is often difficult to reconcile an analysts’ stock recommendations with the same analysts’ earnings forecasts. That is, analysts do not seem to use their own earnings forecasts in the context of an earnings-based valuation model when generating their recommendations. Analysts’ stock recommendations are consistent with the use of a price-earnings to growth (PEG) model.21 This also explains why analysts recommended the now defunct One-Tel’s shares at their peak, even though the kind of analysis performed in this chapter would have shown that the future growth and ROE performance implied by this price would be extremely difficult to achieve. It also implies that taking advantage of long-term fundamental analysis can often require access to patient, long-term capital.

LO5

 erformance of security analysts and P fund managers

There has been extensive research on the performance of security analysts and fund managers during the last three decades. A few of the key findings are summarised in the following section.

Performance of security analysts Research shows that analysts generally add value in the capital market, and do so by bringing prices in line with the expectations that the forecasts embody. Analysts’ earnings forecasts in the short-term are more accurate than those produced by time-series models that use past earnings to predict future earnings.22 Of course, this should not be too surprising, since analysts can update their earnings forecasts between quarters to incorporate new firm and economy information, whereas time-series models cannot. Recent studies show that a simple random walk forecast of earnings per share is at least as accurate as analysts forecasts for longer-term (two- to three-year) forecasts. Forecast accuracy appears to be a characteristic influenced by firm-level attributes such as the riskiness of investments, firm size and temporary shocks.23 Buy-side analysts have been shown to make more optimistic and less accurate forecasts than do sell-side analysts, and the difference can be partly explained by buy-side firms retaining less accurate and more optimistic analysts for longer.24 Share prices tend to respond positively to upward revisions in analysts’ earnings forecasts and recommendations, and negatively to downward revisions. Trading activity and liquidity all change around analysts’ forecast revisions.25 Further, US research indicates that sell-side analysts exhibit persistence in their stock-picking ability. Analysts whose recommendation revisions earn the highest returns in the past continue to outperform in the future.26 However, the market reaction is incomplete, and a trading strategy taking long (or short) positions in recommendation upgrades (or downgrades) conditional on analysts’ prior performance is unprofitable.27 Even in the Australian environment, which is characterised by relatively thin analyst coverage and a regime of continuous disclosure of value-relevant information to the investment community, recent evidence has confirmed the US finding that the forecasts for firms with higher analyst followings are more accurate.28 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 9 Equity security analysis

Several factors seem to be important in explaining analysts’ earnings forecast accuracy. Studies of differences in earnings forecast accuracy across analysts find that analysts who are more accurate tend to specialise by industry and work for large well-funded firms that employ other analysts who follow the same industry.29 Recent research also shows that in the month prior to the earnings announcement, the consensus analyst forecast, which is the average of individual analysts’ forecasts at a point in time, is more accurate than any individual forecast that contributes to the consensus, probably because the consensus diversifies away individual analysts’ idiosyncratic errors.30 Although analysts perform a valuable function in the capital market, research shows that their forecasts and recommendations tend to be biased. Early evidence on bias indicated that analyst earnings forecasts tended to be optimistic and that their recommendations were almost exclusively for buys.31 Several factors potentially explain this finding. First, security analysts at brokerage houses are typically compensated on the basis of the trading volume that their reports generate. Given the costs of short-selling and the restrictions on short-selling by many institutions, brokerage analysts have incentives to issue optimistic reports that encourage investors to buy shares rather than to issue negative reports that create selling pressure.32 Second, research shows that analysts who issue optimistically biased forecasts generate higher trading volumes, which (before 2003 in the US) is rewarded. Other studies also show that analysts who work for lead underwriters make more optimistic long-term earnings forecasts and recommendations for firms raising equity capital than unaffiliated analysts.33 Recent research has started to examine the role played by social and professional networks in influencing the accuracy and bias of information supplied to investors. Examples such as shared educational backgrounds serve as an information pathway between managers and analysts, and those analysts with close ties to management have less biased forecast and more profitable recommendations (at least before the Regulation Fair Disclosure (Reg FD) era in the US, discussed below).34 Evidence indicates that during the late 1990s there was a marked decline in analyst optimism for forecasts of near-term earnings.35 In addition, studies also show that the level of optimism in analyst forecasts is higher as the start of the forecasting ‘year’, and systematically declines up until the time of the earnings announcement, at which point the consensus forecasts are slightly pessimistic.36 One explanation offered for this change is that during this time analysts relied heavily on private discussions with top management to make their earnings forecasts. Management allegedly used these personal connections to manage analysts’ short-term expectations downwards over the course of a year so that the firm could subsequently report earnings that beat analysts’ expectations. In the US, concerns about this practice were addressed in October 2000, when the SEC approved Reg FD, which prohibits management from making selective disclosures of non-public information. Studies show that this regulatory intervention has led to greater independence from management by analysts and an increased effort in independent information discovery.37 In Australia, the government has prohibited private briefings with management since the introduction of the continuous disclosure regime in 1994, which requires any listed company to publicly disclose any information that is not generally available and that would have a marked effect on its price. There has also been a general decline in sell-side analysts’ optimistic recommendations during the past few years. Many large investment banks now require analysts to use a forced curve to rate shares, leading to a greater number of the lowest ratings.38 Factors that underlie this change include a sharp rise in trading by hedge funds, which actively seek shares to short-sell. In contrast, Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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traditional money management firms are typically restricted from short-selling, and are more interested in analysts’ buy recommendations than their sells.

Performance of fund managers

CASE STUDY

Measuring whether managed and superannuation fund managers earn superior returns is a difficult task for several reasons. First, there is no agreement about how to estimate benchmark performance for a fund. Studies have used a number of approaches – some have used the CAPM as a benchmark, while others have used multi-factor pricing models. For studies using the CAPM, there are questions about what type of market index to use. For example, should it be an equalor value-weighted index, an exchange-related index or a broader market index? Second, many of the traditional measures of fund performance abstract from market-wide performance, which understates fund abnormal performance if fund managers can time the market by reducing portfolio risk prior to market declines and increasing risks before a market run-up. Third, the overall volatility of share returns stretches the limits of statistical power needed to measure fund performance. Finally, tests of fund performance are likely to be highly sensitive to the time period examined. Value or momentum investing could therefore appear to be profitable depending on when the tests are conducted. Perhaps because of these challenges, there is no consistent evidence that active management of managed funds generates superior returns for investors. While some studies find evidence of positive abnormal returns for the industry, others conclude that returns are generally negative.39 Of course, even if managed fund managers on average can only generate ‘normal’ returns for investors, it is still possible for the best managers to show consistently strong performance. Some studies do in fact document that funds earning positive abnormal returns in one period continue to outperform in subsequent periods.40 However, more recent evidence suggests that these findings are caused by general momentum in share returns, or are offset by high fund expenses from management fees and/or trading costs. Momentum strategies have also shown to experience infrequent and persistent strings of negative returns.41 Researchers have also examined which, if any, investment strategies are most successful. However, no clear consensus appears; several studies have found that momentum and high turnover strategies generate superior returns, while others conclude that value strategies are better.42 Finally, recent research has examined whether fund managers tend to buy and sell shares in many of the same firms at the same time. There is evidence of such ‘herding’ behaviour, particularly by momentum fund managers.43 This could arise because managers have access to common information, because they are affected by similar cognitive biases, or because they

LEAGUE TABLES Each year business publications like the Wall Street Journal and the Australian Financial Review publish ‘league tables’ of fund manager performance. These tables typically show that the funds or managers who were the best performers over a one-year period are not the best performers over a longer period (such as five- or eight-year windows). Some examples include ‘Appalling performance by mutual

funds run by stock pickers’, The Wall Street Journal, 16 September 2016; ‘What investors should know about yearly performance rankings’, The Wall Street Journal, 6 January 2019; and ‘Active fund managers failing investors, survey shows’, Australian Financial Review, 13 September 2018. This final article shows that most Australian active fund managers failed to beat their benchmarks in 2018.

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A PRACTITIONER ADVISES A partner with a leading chartered accounting firm specialising in corporate finance and valuation on the contrasting valuation use of valuation methods by sell-side and buy-side analysts:

In practice, investment research houses like people to buy. They’re known as sell-side analysts, which means that they prefer a slightly rosier view of the future. And a rosier view of the growth assumptions in their models is best supported by a discounted cash flow analysis, because it’s a little easier make optimistic projections to get a higher valuation. On the other hand, residual income techniques are often used by buy-side analysts. And with residual income, what happens to returns over time? They tend to come back to the cost of capital. So, it’s a very disciplined method of valuation, because you have to be explicit about the sources of growth and ask some very uncomfortable questions about the business prospects. Most people don’t like to believe that they’re going to come back to the average. It’s the biases in people’s thinking processes which means that that this technique, excellent as it is, is not often used in practice. A practitioner discusses the current practice of institutional investors regarding performance evaluation of funds managers:

While a track record is an important aspect of the overall analysis, it represents what an individual or

group of individuals has done in the past, and we’re much more interested in ascertaining what its likely to do in the future. [However], we don’t ignore the past results of an investment strategy. We review quantitative data over rolling periods that are consistent with our view of the manager’s investment time horizon, typically between one and five years. Source: The Science and Art of Manager Selection, Manager Research at Barclays, white paper, p. 12.

This institutional investor compares performance against indices and peers, and analyses risk statistics. It takes into account historical performance and asset growth, and reviews historical holdings, styles and exposures. Reflective activity: These industry sources express contrasting views about the use of rigorous methods by analysts at brokerage houses and investment banks (sellside analysts). One view is that they are sales-people whose motivation is turnover, and the other view is that they are continuously monitored quantitative experts who are tasked with predicting the future. Combine these views, and create a short video to inform prospective sell-side analysts as to the skills and knowledge that they will need.

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INDUSTRY INSIGHT

have incentives to follow the crowd.44 For example, consider the rationale of a fund manager who holds a firm’s shares but who, through long-term fundamental analysis, estimates that they are misvalued. If the manager changes the fund’s holdings accordingly and the share price returns to its intrinsic value in the next quarter, the fund will show superior relative portfolio performance and will attract new capital. However, if the shares continue to be misvalued for several quarters, the informed fund manager will underperform the benchmark and capital will flow to other funds. In contrast, a risk-averse manager who simply follows the crowd will not be rewarded for detecting the misvaluation, but neither will this manager be blamed for a poor investment decision when the share price ultimately corrects, since other funds made the same mistake.

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SUMMARY Equity security analysis is the evaluation of a firm and its prospects from the perspective of a current or potential investor in the firm’s shares. Security analysis is one component of a larger investment process that involves: 1 establishing the objectives of the investor or fund 2 forming expectations about the future returns and risks of individual securities 3 combining individual securities into portfolios to maximise progress towards the investment objectives. Some security analysis is devoted primarily to assuring that a firm possesses the proper risk profile and other desired characteristics prior to including it in an investor’s portfolio. However, especially for many professional buy-side and sell-side security analysts, the analysis is also directed towards identifying mispriced securities. In equilibrium, such activity will be rewarding for those with the strongest comparative advantage. Those analysts will be able to identify any mispricing at the lowest cost and exert pressure on the price to correct the mispricing. The types of effort that are productive in this domain depend on

the degree of market efficiency. A large body of evidence exists that supports a high degree of efficiency in active share markets, but recent studies have reopened the debate on this issue. In practice, a wide variety of approaches to fund management and security analysis are employed. However, at the core of the analyses are the same steps outlined in Chapters 2 to 8 of this book: business strategy analysis, accounting analysis, financial analysis and prospective analysis (forecasting and valuation). For the professional analyst, the final product of the work is, of course, a forecast of the firm’s future earnings and cash flows, and an estimate of the firm’s value. However, that final product is less important than the understanding of the business and its industry, which the analysis provides. It is such understanding that positions the analyst to interpret new information as it arrives and infer its implications. Finally, the chapter summarises some key findings of the research on the performance of both sell-side and buyside security analysts.

CHECKING AND APPLYING YOUR LEARNING 1 What does market efficiency mean? How does market efficiency relate to the speed at which information is reflected in share prices and to the accuracy with which information is reflected in share prices?  LO2 2 Despite many years of research, the evidence on market efficiency described in this chapter appears to be inconclusive. Some argue that this is because researchers have been unable to link company fundamentals to share prices precisely. Comment.  LO2 3 Peter Low, a professor of finance and mathematics, states: ‘I have collected massive amounts of data on markets and the companies listed on them, going back 50 years in some cases. The power of computer algorithms means that I can predict future share prices and the factors that lead to those changes. I can beat any analyst’s fundamental analysis, so there’s no point to it anymore.’ Do you agree? Why or why not?  LO2 4 What is the difference between fundamental and technical analysis? Can you think of any trading strategies that use technical analysis? What are the underlying assumptions made by these strategies?  LO3

5 Investment funds follow many different types of investment strategies. Income funds focus on shares with high dividend yields; growth funds invest in shares that are expected to have high capital appreciation; value funds follow shares that are considered to be undervalued; and short funds bet against shares they consider to be overvalued. What types of investors are likely to be attracted to each of these types of funds? Why?  LO3 6 Why don’t analysts follow smaller firms, or firms that are making losses? What practical difficulties do these firms present, and what investors might be interested in their valuations?  LO3 7 Biomedico Company went public three months ago. You are a sophisticated investor who devotes time to fundamental analysis as a way to identify future growth shares. Which of the following characteristics would you focus on in deciding whether to follow this company? a Its industry b The market capitalisation c The average number of shares traded per day d The bid–ask spread for the shares e Whether the underwriter that brought the firm public is a highly regarded investment bank

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CHAPTER 9 Equity security analysis

f Whether its audit company is a ‘Big Four’ firm g Whether there are analysts from major brokerage firms following the company h Whether the shares are held mostly by retail or institutional investors What else would you consider useful to know?  LO4 8 Biomedico Company’s shares have a market price of $40 and a book value of $44. If its cost of equity capital is 10% and its book value is expected to grow at 5% per year indefinitely, what is the market’s assessment of its steady state return on equity? If the share price increases to $60 and the market does not expect the firm’s growth rate to change, what is the revised steady state ROE? If, instead, the price increase was due to an increase in the market’s assessments about longterm book value growth rather than long-term ROE, what would the price revision imply for the steady state growth rate?   LO1   LO2 9 There are two major types of financial analysts: buy-side and sell-side. Buy-side analysts work for investment firms and make share recommendations that are available only to the management of funds within that firm. Sell-side analysts work for brokerage firms and make recommendations that are used to sell shares to the brokerage firms’ clients, which include individual investors and managers of investment funds. a What would be the differences in tasks and motivations of these two types of analysts? b Many market participants believe that sell-side analysts are too optimistic in their recommendations to buy shares and too slow to recommend sells. What factors might explain this bias? c On the other hand, some researchers have found that sell-side analysts can be pessimistic in their forecasts, particularly early in the forecast period, in order to gain the favour of managers. Why might this occur?  LO3

223

10 Suzanne Ma is an analyst for an investment banking firm that offers both underwriting and brokerage services. Suzanne sends you a highly favourable report on shares that her firm recently helped go public and for which it currently makes the market. What are the potential advantages and disadvantages of relying on Suzanne’s report in deciding whether to buy the shares?  LO5 11 Xiaoli states: ‘I can see how ratio analysis and valuation help me do fundamental analysis, but I don’t see the value of doing strategy analysis.’ Can you explain to her how strategy analysis could be potentially useful?  LO1 12 Obtain a copy of a security analyst’s report and evaluate it against what you have learned in this chapter. Does the analyst indicate the basis on which they have forecast earnings, and the basis on which they have made a recommendation?  LO5 13 Search the financial press (Australian Financial Review, Wall Street Journal etc.) for the most recent summary of fund manager performance (the ‘league table’). See if the funds that have recorded the highest returns in the most recent one-year period also have the highest returns over longer periods. What does this imply about market efficiency?  LO3 14 In the last two decades, the amount of money invested in passively managed (i.e. in index funds) has increased dramatically relative to actively managed funds. What does this imply about market efficiency? If the trend towards index funds and away from actively managed funds persists, what could this suggest about market efficiency in the future?  LO3 15 There is an increasing amount of financial and nonfinancial data available for firms and stock markets. There has also been increasing amounts of computing power and ‘artificial intelligence’ used in financial markets. How do you expect the role of the security analyst to change over the next decade in light of the ongoing advances in artificial intelligence and computing power?  LO5

CASE LINK Concepts from this chapter are used in the following case in Part 4:

Case 10 Diligent (Part 1): Revenue recognition problems.

ENDNOTES 1

Investment-grade rates bonds have received a credit rating by Moody’s of Baa or higher or a credit rating by Standard & Poor’s of BBB or above. We discuss these rating categories in more detail in Chapter 10.

2

3

See ASIC Report 439 ‘Snapshot of the Australian hedge funds sector’ available at https://download.asic.gov.au/media/3278608/ rep439-published-1july2015.pdf. These figures are from Hedge Fund Research (HFR).

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 4 Government bonds are often described as the ‘risk-free security’ as it is very rare for governments to default on their bonds. However, default on government securities, known as sovereign default, does occur; for example, in June 2015, Greece defaulted on a $1.7 billion payment to the International Monetary Fund.  5 P. Healy and K. Palepu, ‘The fall of Enron’, Journal of Economic Perspectives 17(2) (Spring 2003): 3–26, discuss how weak money manager incentives and a lack of proper long-term analysis contributed to the share price run-up and subsequent collapse of Enron. A similar discussion on factors affecting the rise and fall of dot-com shares is provided in ‘The role of capital market intermediaries in the dot-com crash of 2000’, Harvard Business School Case 9 (2001): 101–10.  6 See S. Kothari, E. So and R. Verdi, ‘Analysts’ forecasts and asset pricing: A survey’, Annual Review of Financial Economics 8 (2016): 197–219; and M. Bradshaw, Y. Ertimur and P. O’Brien, ‘Financial analysts and their contribution to well-functioning capital markets’, Foundations and Trends in Accounting 11 (2017): 119–91.  7 Reviews of evidence on market efficiency are provided by E. Fama, ‘Market efficiency, long-term returns, and behavioural finance’, Journal of Financial Economics (September 1998): 283–306; E. Fama, ‘Two pillars of asset pricing’, American Economic Review 104 (2014): 1467–85; and C. Lee, ‘Market efficiency in accounting research’, Journal of Accounting and Economics 31 (September 2001): 233–53.  8 Early research on the post-earning announcement drift (PEAD) includes V. Bernard and J. Thomas, ‘Evidence that stock prices do not fully reflect the implications of current earnings for future earnings’, Journal of Accounting and Economics 13 (December 1990): 305–41. For a more recent summary of the PEAD and other ‘anomalies’ see S. Richardson, I. Tuna and P. Wysocki, ‘Accounting anomalies and fundamental analysis: a review of recent research advances’, Journal of Accounting and Economics 50 (2010): 410–54.  9 For example, the superior returns earned by pursuing a ‘value stock’ strategy is discussed in J. Piotroski, ‘Value investing: The use of historical financial statement information to separate winners from losers’, Journal of Accounting Research 38 (2000): 1–41; and C. Asness, T. Moskowitz and L. Pedersen, ‘Value and momentum everywhere’, Journal of Finance 68 (2013): 929–85. 10 For example, see S. Richardson, R. Sloan, M. Soliman and I. Tuna, ‘Accrual reliability, earnings persistence and stock prices’, Journal of Accounting and Economics 39 (September 2005): 437–485; and R. Ball, J. Gerakos, J. Linnainmaa and V. Nikolaev, ‘Accruals, cash flows, and operating profitability in the cross-section of stock returns’, Journal of Financial Economics 121 (July 2016): 28–45. 11 See https://www.nobelprize.org/prizes/economic-sciences/2013/ advanced-information/ for details of the prize and a scientific background paper covering the work of Fama, Hansen and Shiller as well as R. Shiller, ‘Speculative asset prices’, American Economic Review 104 (2014): 1486–517. 12 For an overview of research in behavioural finance, see R. Thaler, Advances in Behavioral Finance Vol II (New York: Russell Sage Foundation, 2005); R. Thaler, ‘Behavioral economics: Past, present, and future’, American Economic Review (2016): 1577–1600; and D. Hirshliefer, ‘Behavioral finance’, Annual Review of Financial Economics 7 (2015): 133–59. For investor sentiment, see M. Baker and J. Wurgler, ‘Investor sentiment and the cross-section of stock returns’, Journal of Finance 61 (August 2006): 1645–80; and D. Huan, F. Jiang, J. Tu and G. Zhou, ‘Investor sentiment aligned: A

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powerful predictor of stock returns’, Review of Financial Studies 28 (March 2015): 791–837. A. Schleifer, ‘Do demand curves for stocks slope down’, Journal of Finance and Quantitative Analysis 34 (March 1986): 579–90, argues that stocks show positive abnormal returns immediately after entering the S&P 500 Index as a result of increased demand from index funds. While extensive research exists on the idea that trading as a result of investor preference creates short-term price pressure in spin-off transactions, J. Abarbanell, B. Bushee and J. Raedy, in ‘Institutional investor preferences and price pressure: The case of corporate spin-offs’, Journal of Business 76 (2003): 233–61, find that this trading is not associated with abnormal price movements for parents or subsidiaries around the spin-off. M. Goldstein, P. Jumar and F. Craves, ‘Computerized high frequency trading’, Financial Review 49 (2014): 177–202. J. Rogers, D. Skinner and S. Zechman, ‘Run EDGAR run: SEC dissemination in a high-frequency world’, Journal of Accounting Research 55 (May 2017): 459–505. A fairness opinion is a report put together by qualified analysts or advisers providing key decision-makers with an evaluation of and facts about a merger or acquisition. R. Bhushan, ‘Firm characteristics and analyst following’, Journal of Accounting and Economics 11 (1989): 255–274, shows that analysts prefer larger firms; M. McNichols and P. O’Brien, ‘Self-selection and analyst coverage’, Journal of Accounting Research 35 (1997): 167–99 looks at future prospects; while D. Roulstone, ‘Analyst following and market liquidity’, Contemporary Accounting Research 20 (2003): 552–78 shows that analysts prefer firms with more liquid securities. See S. Rock, S. Sedo and M. Willenborg, ‘Analyst following and count-data econometrics’, Journal of Accounting and Economics 30 (2000): 351–73. M. Bradshaw, L. Brown and K. Huang, ‘Do sell-side analysts exhibit differential target price forecasting ability?’ Review of Accounting Studies 18 (2013): 930–55. M. Bradshaw, Y. Ertimur and P. O’Brien, ‘Financial analysts and their contribution to well-functioning capital markets’, Foundations and Trends in Accounting 11 (2017): 119–191. See M. Bradshaw, ‘How to analysts use their earnings forecasts in generating stock recommendations?’ Accounting Review 79 (January 2004): 25–50. Time-series model forecasts of future annual earnings are the most recent annual earnings (with or without some form of annual growth), and forecasts of future quarterly earnings are a function of growth in earnings for the latest quarter relative to both the last quarter and the same quarter one year ago. A random walk model of earnings (where next year’s earnings are assumed to be the same as current year earnings) was used as the benchmark when evaluating the accuracy of analysts’ forecasts in M. Bradshaw, M. Drake, J. Myers and L. Myers, ‘A re-examination of analysts’ superiority over time-series forecasts of annual earnings’, Review of Accounting Studies 17 (December 2012): 944–68. S. Kothori, E. So and R. Verdi, ‘Analysts’ forecasts and asset pricing: A survey’, Annual Review of Financial Economics 8 (2016): 197–219. B. Groysberg, P. Healy and C. Chapman, ‘Buy-side vs. sell-side analysts’ earnings forecasts’, Financial Analysts Journal 64 (2008): 25–39. See P. Asquith, M. Mikhail and A. Au, ‘Information content of equity analyst reports’, Journal of Financial Economics 75

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34 35 36

(2005): 245–282; and R. Frankel, S. Kothari and J. Weber, ‘Determinants of the informativeness of analyst research’, Journal of Accounting and Economics 41 (2006): 29–54. See M. Mikhail, B. Walther and R. Willis, ‘Do security analysts exhibit persistent differences in stock picking ability?’ Journal of Financial Economics 74 (October 2004): 67–91. See M. Mikhail, B. Walther and R. Willis, ‘Do security analysts exhibit persistent differences in stock picking ability?’, Journal of Financial Economics 74 (October 2004): 67–91. See X. Chen, ‘Australian evidence on the accuracy of analysts’ expectations: The value of consensus and timeliness prior to the earnings announcement’, Accounting Research Journal 23(1) (2010): 94–116. See M. Clement, ‘Analyst forecast accuracy: Do ability, resources, and portfolio complexity matter?’, Journal of Accounting and Economics 27 (1999): 285–304; J. Jacob, T. Lys and M. Neale, ‘Experience in forecasting performance of security analysts’, Journal of Accounting and Economics 28 (1999): 51–82; and S. Gilson, P. Healy, C. Noe and K. Palepu, ‘Analyst specialization and conglomerate stock breakups’, Journal of Accounting Research 39 (December 2001): 565–73. See S. Ramnath, S. Rock and P. Shane, ‘Value line and I/B/E/S earnings forecasts’, International Journal of Forecasting 21 (2005): 185–98, for US evidence; and X. Chen, op. cit., for Australian evidence. See L. Brown, G. Foster and E. Noreen, ‘Security analyst multi-year earnings forecasts and the capital market’, Studies in Accounting Research, 23, (Sarasota, FL: American Accounting Association, 1985). M. McNichols and P. O’Brien, in ‘Self-selection and analyst coverage’, Journal of Accounting Research, Supplement (1997): 167–208, find that analyst bias arises primarily because analysts issue recommendations on firms for which they have favourable information and withhold recommending firms with unfavourable information. See B. Groysberg, P. Healy and D. Maber, ‘What drives sell-side analyst compensation at high-status investment banks?’, Journal of Accounting Research 49 (2011): 969–1000. See H. Mehran and R. Stulz, ‘The economics of conflicts of interest in financial institutions’, Journal of Financial Economics 85(2) (2007): 267–96; and L. Brown, A. Call, M. Clement and N. Sharp, ‘Inside the “Black Box” of sell-side financial analysts’, Journal of Accounting Research 53 (2015): 1–47. L. Cohen, A. Frazzini, and C. Malloy ‘Sell-side school ties’, The Journal of Finance 65 (2010) 1409–37. See D. Matsumoto, ‘Management’s incentives to avoid negative earnings surprises’, Accounting Review, 77 (July 2002): 483–515. See S. Richardson, I. Tuna and P. Wysocki, ‘The walk-down to beatable analyst forecasts: The role of equity issuance and insider trading incentives’, Contemporary Accounting Research 21 (2004): 885–924'; B. Ke and Y. Yu, ‘The effect of issuing biased earnings forecasts on analysts’ access to management and survival’, Journal of Accounting Research 44 (2006): 965–99; and M. Bradshaw, L.

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Lee and K. Peterson, ‘The interactive role of difficulty and incentives in explaining the annual earnings forecast walkdown’, Accounting Review 91 (2016): 995–1021. See P. Mohanram and S. Sunder, ‘How has regulation FD affected the functioning of financial analysts?’, Contemporary Accounting Research, 23(2) (2006): 491–525; and B. Ke, K. Petroni and Y. Yu, ‘The effect of Regulation FD on transient institutional investors’ trading behavior’, Journal of Accounting Research 46 (2008): 853–83. B. Barber, R. Lehavy, M. McNichols and B. Trueman, ‘Buy, holds, and sells: The distribution of investment banks’ stock ratings and the implications for the profitability of Analysts’ recommendations’, Journal of Accounting and Economics 41 (April 2006): 87–117. For example, evidence of superior fund performance is reported by M. Grinblatt and S. Titman, ‘Mutual fund performance: An analysis of quarterly holdings’, Journal of Business 62 (1994); and by D. Hendricks, J. Patel and R. Zeckhauser, ‘Hot hands in mutual funds: Short-run persistence of relative performance’, Journal of Finance 48 (1993): 93–130. In contrast, negative fund performance is shown by M. Jensen, ‘The performance of mutual funds in the period 1945–64’, Journal of Finance 23 (May 1968): 389–416; and B. Malkiel, ‘Returns from investing in equity mutual funds from 1971 to 1991’, Journal of Finance 50 (June 1995): 549–73. See M. Carhart, ‘On persistence in mutual fund performance’, Journal of Finance 52 (March 1997): 57–82; and P. Barroso and P. Santa-Clara, ‘Momentum has its moments’, Journal of Financial Economics 116 (April 2015): 111–20. M. Grinblatt and S. Titman, ‘The persistence of mutual fund performance’, Journal of Finance 47 (December 1992): 1977–86; and D. Hendricks, J. Patel and R. Zeckhauser, op. cit., find evidence of persistence in managed fund returns. However, M. Carhart, ‘On persistence in mutual fund performance’, Journal of Finance 52 (March 1997): 57–83, shows that much of this is attributable to momentum in share returns and to fund expenses; K. Daniel and T. Mosowitz, ‘Momentum crashes’, Journal of Financial Economics 122 (November 2016) show how momentum strategies can experience persistent negative returns. See N. Brown, K Wei and R. Wermers, ‘Analyst recommendations, mutual fund herding, and overreaction in stock prices’, Management Science 60 (January 2014). For example, J. Lakonishok, A. Shleifer and R. Vishny, op. cit., find that value funds show superior performance, whereas M. Grinblatt, S. Titman and R. Wermers, op. cit., find that momentum investing is profitable. M. Brinbaltt, S. Titman and R. Wermers, ‘Momentum investment strategies, portfolio performance and herding: A study of mutual fund behavior’, American Economic Review 85 (1995): 1088–105; and H. Jiang and M. Verardo, ‘Does herding behaviour reveal skill? An analysis of mutual fund performance’, Journal of Finance 73 (October 2018): 2229–69 show a negative relation between herding and skill.

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10

Credit analysis and distress prediction

Credit analysis is the evaluation of a firm from the perspective of a holder or potential holder of its debt, such as trade payables, loans and listed debt securities. A key element of credit analysis is predicting the likelihood that firm will receive timely repayment of interest and principal. At the extreme, it involves predicting the likelihood the firm will face financial distress. Credit analysis is involved in a wide variety of decision contexts: A commercial banker asks: Should we extend a loan to this firm? If so, how should it be structured? How should it be priced? If the loan is granted, the banker will ask: Are we providing the services, including credit, that this firm needs? Is the firm in compliance with the loan terms? If not, do we need to restructure the loan, and if so, how? Is the situation serious enough to call for accelerating the loan repayment? A potential supplier asks: Should I sell products or services to this firm? The associated credit may only be extended for a short period, but the amount is large. How can I have some assurance that collection risks are manageable? A pension fund manager, insurance company or other investor asks: Are these debt securities a sound investment? What is the probability that the firm will face distress and default on the debt? Does the yield provide adequate compensation for the default risk involved? An investor contemplating purchase of debt securities in default asks: How likely is it that this firm can be turned around? In light of the high yield on this debt

relative to its current price, can I accept the risk that the debt will not be repaid in full? Although credit analysis is typically viewed from the perspective of the financier, it is obviously important to the borrower as well: A manager of a small firm asks: What are our options for credit financing? Would the firm qualify for bank financing? If so, what type of financing would be possible? How costly would it be? Would the terms of the financing constrain our flexibility? A manager of a large firm asks: What are our options for credit financing? Is the firm strong enough to raise funds in the public market? If so, what is our debt rating likely to be? What required yield would that rating imply? Finally, there are third parties – those other than borrowers and lenders – who are interested in the general issue of how likely it is that a firm will avoid financial distress: The auditor asks: Is the firm a going concern? Actual or potential employees ask: How confident can I be that this firm will be able to offer employment over the long term? A potential customer asks: What assurance is there that this firm will survive to provide warranty services, replacement parts, product updates and other services? A competitor asks: Will this firm survive the current industry shakeout? What are the implications of potential financial distress at this firm for my pricing and market share?

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CHAPTER 10 Credit analysis and distress prediction

Chapter learning objectives By the end of this chapter, you should be able to: LO1

understand who are the major suppliers of credit

LO2

understand the steps in the credit analysis process

LO3

understand the meaning of debt ratings and the factors that drive them

LO4

apply models to predict financial distress.

LO1

Suppliers of credit

The major suppliers in the market for credit are described below.

Commercial banks Commercial banks are important players in the market for credit. These banks provide a range of client services and usually have intimate knowledge of the client and its operations. They, therefore, have a comparative advantage in extending credit in settings where: 1 knowledge gained through close contact with management reduces the perceived riskiness of the credit 2 credit risk can be contained through careful monitoring of the firm. Because it is important to maintain public confidence in the banking sector, governments regulate banks and constrain their exposure to credit risk. One constraint on bank lending operations is that the overall credit risk of the bank needs to be relatively low, so that its loan portfolio is acceptable to regulators. Banks also tend to shield themselves from the risk of shifts in interest rates by avoiding fixed-rate loans with long maturities. As banks’ capital mostly comes from short-term deposits, long-term loans leave banks exposed to increases in interest rates, unless the risk can be hedged with derivatives. Thus, banks are less likely to play a role when a firm requires a very long-term commitment to financing. However, in some cases banks might help place the firm’s debt with an insurance company, a pension fund or a group of private investors.

Other financial institutions Banks face competition in the commercial lending market from a variety of sources. Finance companies compete with banks in the market for asset-based lending (i.e. the secured financing of specific assets such as receivables, inventory or equipment). Insurance companies are involved in a variety of lending activities. As life insurance companies face long-term obligations, they often seek investments of long duration (such as long-term bonds or loans to support large, longterm commercial real estate and development projects). Investment bankers are prepared to place

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debt securities with private investors or in the public markets. Various government agencies are another source of credit.

Listed debt markets Some firms have the size, strength and credibility necessary to bypass the banking sector and seek financing directly from investors, either through sales of commercial paper or by issuing bonds – these debt issues are traded on a listed debt market.1 Debt issues are assigned debt ratings by the ratings agencies Fitch, Moody’s or Standard & Poor’s. These three agencies are the largest in most Asia–Pacific jurisdictions. As a broad generalisation, a firm’s debt rating is an indicator of the likelihood that the firm will meet its interest and principal obligations in a timely manner. The debt rating influences the yield that must be offered to sell the debt instruments. The higher the debt rating, the lower the likelihood of default and the lower the required yield. After the debt issue, the rating agencies continue to monitor the firm’s financial condition. Changes in the rating are associated with fluctuation in the price of the securities. Banks often provide financing in tandem with a listed debt issue or other source of financing. In highly levered transactions, such as leveraged buyouts, banks commonly provide financing along with listed debt that has a lower priority for payment in case of bankruptcy. The bank’s ‘senior financing’ would typically be scheduled for earlier retirement than the listed debt, and it would carry a lower yield. For smaller or start-up firms, banks often provide credit in conjunction with equity financing from venture capitalists. Note that in the case of both the leveraged buyout and the start-up company, the bank helps provide the cash needed to make the deal happen, but it does so in a way that shields it from risks that would be unacceptably high in the banking sector.

Sellers who provide financing Other sectors of the market for credit are manufacturers and other suppliers of goods and services. As a matter of course, such firms tend to finance their customers’ purchases on an unsecured basis for periods of 30 to 60 days. Suppliers will, on occasion, also agree to provide more extended financing, usually with the support of a secured note. A supplier may be willing to grant such a loan if they expect the creditor will survive a cash shortage and remain an important customer in the future. However, the customer would typically seek such an arrangement only if bank financing were unavailable because it could constrain flexibility in selecting among and/or negotiating with suppliers.

The credit mix The suppliers of credit, noted above, are not equally important in every country. One source of cross-country difference is the extent to which national bankruptcy laws protect suppliers of credit. There are two stylised classifications of bankruptcy laws. The first provides extensive creditor protection in the case of financial distress. Under this classification, laws offer creditors a right to repossess collateral and enforce other contractual rights when the borrower is in default. These laws increase the probability of recovery of lenders but decrease the probability of the borrower surviving financial distress. The second type of bankruptcy legislation is oriented towards keeping the financially distressed company as a going concern by shielding the company from creditors. These laws typically impose court-administered bankruptcy procedures and a Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 10 Credit analysis and distress prediction

stay on the assets of the borrower, such that creditors cannot repossess collateral during the period in which the lenders’ obligations are being restructured. Short-term lending, multiplebank lending and supplier financing are more likely where the legal rights of banks are weakly protected; particularly where there are difficulties in repossessing collateral. Listed debt markets are not equally developed in all parts of the world. Figure 10.1 shows the size of bond markets relative to equity markets in 21 exchanges throughout the Asia–Pacific region. The low correlation between the size of the debt market and the size of the equity market (as shown by the variation in percentages in the last column) illustrates that debt and equity markets have developed independently. Even within debt markets there are substantial differences. For example, in Japan the listed debt market is almost 100% public debt, whereas in the Colombo Stock Exchange private and public debt is around 50:50%. FIGURE 10.1 The importance of debt and equity markets in Asia–Pacific, 2018

Equity, domestic market capitalisation (USD millions)

Debt vs equity (%)

Value of bonds listed Private

Public

Australian Securities Exchange

1 262 800

BSE Limited

2 088 431

3 378

1 687

0.2%

398 019

478

0

0.1%

Bursa Malaysia

38

0

0

0.2%

Colombo Stock Exchange

Chittagong Stock Exchange

15 575

1 450

1 590

19.5%

Dhaka Stock Exchange

39 762

34

0

0.1%

Hanoi Stock Exchange

8 308

–

124 345

–

Ho Chi Minh Stock Exchange Hong Kong Exchanges and Clearing Indonesia Stock Exchange

3 819 215 486 766

– 170 201

396 538

116.4%

Japan Exchange Group

5 296 811

2 417

8 155 252

154.0%

Korea Exchange

1 413 717

374 619

1 172 339

109.4%

National Stock Exchange of India

2 056 337

25 166

253 812

13.6%

86 133

13 250

28 293

48.2%

1 345 096

3 789 687

131.0%

NZX Limited Philippine Stock Exchange

258 156

Shanghai Stock Exchange

3 919 420

Shenzhen Stock Exchange

2 405 460

Singapore Exchange Taipei Exchange

687 257 92 478

104 479

183 298

311.2%

Taiwan Stock Exchange

959 220

0

186 007

19.4%

The Stock Exchange of Thailand

500 741

11 696

198 336

41.9%

*Where cells are blank, this exchange does not deal in those securities. Source: Adapted from the World Federation of Exchanges (2018), http://www.world-exchanges.org

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At a firm level, the mix of fixed and floating debt will have an important effect on the credit risk of the firms. The interest rate on debt can either be fixed or floating. If the rate is fixed, then when interest rates change, the fair value of the borrowing changes; that is, the cash flows are fixed but the discount rate changes. On the other hand, if the rate is floating then the cash flows will change with a change in interest rates. Ideally, if interest rates are low and are expected to rise then, as a borrower, you would prefer to have fixed rates. However, this is a speculative strategy. A hedging strategy is to match the fixed and floating rate borrowings with the nature of income generated. If a firm has all fixed-rate income then it would prefer fixed interest borrowing. In practice, firms have a mixture of fixed and floating income and therefore would prefer a mixture of fixed and floating debt. The relative amounts of fixed and floating debt will change over time due to the relative cost of either type of debt, debt repayment and changes in the mix of income. Firms can fine-tune the fixed and floating rate debt with financial derivatives such as swaps.

LO2

The credit analysis process

At first blush, credit analysis may appear less difficult than the valuation task discussed in previous chapters. After all, a potential creditor ultimately cares only about whether the firm is strong enough to pay its debts at the scheduled times. The firm’s exact value, its upside potential or its distance from the threshold of credit-worthiness may not appear so important. Viewed in that way, credit analysis may seem more like a ‘zero-one’ decision: either the credit is extended, or it is not. However, credit analysis involves more than just establishing credit-worthiness. First, credit-worthiness lies within a range, and when pricing and structuring a loan, it is important to understand where a firm lies within this range. Moreover, if the creditor is a bank or other financial institution and expects to continue its relationship with the borrower, the borrower’s upside potential is important, even if its downside risk remains the primary consideration in credit analysis. A firm that offers growth potential also offers opportunities for future incomegenerating financial services. Given this broader view of credit analysis, it should not be surprising that it involves most of the same issues already discussed in the earlier chapters on business strategy analysis, accounting analysis, financial analysis and prospective analysis. Perhaps the greatest difference is that credit analysis rarely involves any explicit attempt to estimate the value of the firm’s equity. However, the determinants of that value are relevant in credit analysis because a larger equity cushion translates into lower risk for the creditor. We describe the credit analysis process as a series of steps. While these steps are presented in a particular order, they are interdependent. Thus, you may need to re-think an analysis at an earlier step depending on the results of an analysis at a later step.

Step 1: Analyse the potential borrower’s financial status Even before negotiations over the amount and terms of credit to be extended begin, the analyst will review the potential borrower’s financial status. This will provide a better understanding of the client’s business. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 10 Credit analysis and distress prediction

231

KEY ANALYSIS QUESTIONS Analysing the financial status of the borrower involves all the steps discussed in our chapters on business strategy analysis, accounting analysis and financial analysis. For example: Business strategy analysis: How does this business work? Why is it valuable? What is its strategy for sustaining or enhancing that value? How well qualified is the management to carry out that strategy effectively? Is the viability of the business highly dependent on the talents of the existing management team? Accounting analysis: How well do the firm’s financial statements reflect its underlying economic reality? Are there reasons to believe that the firm’s performance is stronger or weaker than reported profitability would suggest? Are there sizeable off-balance-sheet liabilities (such as operating leases) that would affect the potential borrower’s ability to repay the loan? Financial analysis: Is the firm’s level of profitability unusually high or low? What are the sources of any unusual degree of profitability? How sustainable are they? What risks are associated with the operating profit stream? How highly levered is the firm? What is the firm’s cash flow picture? What are its major sources and uses of cash? Is cash required to finance expected growth? How great are cash flows expected to be relative to the debt service required?

We would use the ratios described in Chapter 5 in this analysis. The emphasis, however, is on: how the firm has met its existing service obligations the firm’s current level of debt the firm’s debt policies its debt capacity. However, the financial analysis should produce more than an assessment of the risk of nonpayment. It should also identify the nature of the significant risks. At many commercial banks it is standard operating procedure to summarise the analysis of the firm by listing the key risks that could lead to default and factors to control those risks if the bank makes the loan. The bank can then use that information to structure detailed loan terms that will to trigger default when problems arise, at a stage early enough to permit corrective action. The following Kathmandu box shows extracts of footnote disclosures from the financial statements that will help the analyst assess credit risk.

EXPOSURE TO CREDIT RISK The following information from Kathmandu’s 2018 Annual Report illustrates various aspects related to credit analysis.

4.1.2 Cash flow and fair value interest rate risk Interest rate risk is the risk that fluctuations in interest rates impact the Group’s financial performance. Risk

Exposure arising from

Monitoring

Management

Interest rate risk

Interestbearing liabilities at floating rates

Cash flow forecasting

Interest rate swaps

Refer to section 4.2 for notional principal amounts and valuations of interest rate swaps outstanding at balance sheet date. A sensitivity analysis of interest rate risk on the Group’s financial assets and liabilities is provided in the table below. At the reporting date the interest rate profile of the Group’s banking facilities was (carrying amount):

Sensitivity analysis

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2018 NZ$’000

interest rates. The financial statements also provide information on the sensitivity on interest rate risk. We can see from the following extract that a plus or minus 1% change in interest rates has $40,000 increase or decrease in profit.

2017 NZ$’000

Total secured loans

39,500

10,431

less Principal covered by interest rate swaps

(37,587)

(37,724)

Net Principal subject to floating interest rates1

1,913

(27,293)

Summarised sensitivity analysis The following table summarises the sensitivity of the Group’s financial assets and financial liabilities to interest rate risk. A sensitivity of 1% (2017: 1%) has been selected for interest rate risk. The 1% is based on reasonably possible changes over a financial year, using the observed range of historical data for the preceding fiveyear period. Amounts are shown net of income tax. All variables other than applicable interest rates are held constant. The impact on equity is presented exclusive of the impact on retained earnings.

1. Debt levels fluctuate throughout the year and as at 31 July, are at a cyclical low. Forecast debt levels are expected to remain in excess of the interest rate swaps for a significant majority of the year. Interest rate swaps have the economic effect of converting borrowings from floating to fixed rates. The cash flow hedge (gain)/ loss on interest rate swaps at balance sheet date was $117,340 (2017: $330,041). Source: Kathmandu Holdings Limited, Annual Report 2018, p. 52

This note describes the exposure to interest rate risk, and how it is monitored and managed. The interest rate swaps convert borrowings ($39.5 m) from floating to fixed such that only a little over $1.9 m is subject to floating

31 July 2018 Derivative financial instruments (asset) / liability

Carrying amount $’000

–1% Profit $’000

Equity $’000

+1% Profit $’000

Equity $’000

(4 858)

(376)

323

376

(312)

8 146

(59)

–

59

–

(59)

–

59

–

395

–

(395)

–

395

–

(395)

–

(40)

323

Financial assets Cash Financial liabilities Borrowings Total increase / (decrease)

39 500

40

(312)

Source: Kathmandu Holdings Limited, Annual Report 2018, p. 53

Step 2: Consider the purpose for extending credit Once the credit analyst has an understanding of the customer’s business, the next step is to find out why they need credit. There is an important difference between refinancing an existing loan and extending new credit to acquire working capital, a new machine, a building or to fund a project.

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CHAPTER 10 Credit analysis and distress prediction

Refinancing is typically an easier option. If the customer is an existing client then a prior history of the client’s ability to manage debt will be available. However, this does not mean that the analyst should overlook Step 1. If the loan is for refinancing for a new customer, then the analysis in Step 1 takes on more importance. Extending credit to acquire new assets or fund a project is more difficult than refinancing existing loans because it impacts both sides of the balance sheet and can seriously alter the firm’s income and cash flow streams. Hence, it can fundamentally change the ratios estimated in Step 1. The purpose for the loan will also shift the focus of the analysis. For example, if credit is needed to support seasonal fluctuations in inventory, a short-term loan is most appropriate and the emphasis would be on the ability of the firm to convert the inventory into cash on a timely basis. In contrast, a term loan to support plant and equipment must be made with confidence in the firm’s long-run earnings prospects. Understanding the purpose of extending credit is important not just to help decide whether a loan should be granted, but also to structure the terms of the agreement. The loan agreement will need to include the amount of credit, the nature of that credit, the term and ability to repay, security required, loan covenants and pricing.

Step 3: Nature of credit There are two ways to lend (or borrow): closed-end and open-end credit. A fixed-term mortgage that is repaid through specified monthly payments is a good example of a closed-end loan. Open-end credit provides the borrower with a pre-approved credit limit that available over a specified period. The borrower is allowed to draw down, repay and redraw loans during the term of the facility. The borrower makes payments based only on the amount withdrawn, plus interest. A credit card is a good example of open-ended credit. Some open-ended facilities (especially corporate bank loan revolving credit facilities) will require a fee for any money that is undrawn. A revolving facility is a series of loans. Each loan is borrowed for a set period of time, typically one, three or six months. At the end of this period, the loan is technically repayable. Repayment of a revolving loan is achieved either by scheduled reductions in the total amount of the facility over time, or by all outstanding loans being repaid on the date of termination. A revolving loan made to refinance the previous loan, which matures on the same date, is known as a ‘rollover loan’. The conditions to be satisfied for drawing a rollover loan are typically less onerous than for other loans.

Step 4: Term and ability to repay Implicit in the above discussion is a forward-looking view of the firm’s ability to service the loan. Good credit analysis should also be supported by financial forecasts. Clearly, financial forecasting will be more important if the client wants credit to invest in new assets, businesses and projects rather than to refinance an existing loan. The basis for such forecasts usually comes from the firm’s management, but, not surprisingly, lenders do not accept such forecasts without question. Analysts will often have access to financial forecasts of the firm that are not available to the general public. However, many firms report a maturity profile of their liabilities. This is a useful tool to supplement ratio analysis when assessing liquidity risk. The following Kathmandu case illustrates the maturity profile of liabilities. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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LIABILITY MATURITY PROFILE In 2018, Kathmandu’s notes to the financial statements reported the following maturity profile.

liabilities into relevant maturity groupings based on the remaining period at the balance sheet date to the contractual maturity date. The amounts disclosed in the table are the contractual undiscounted cash flows, so will not always reconcile with the amounts disclosed on the balance sheet.

Keeping it simple The table below analyses the Groups’ financial liabilities and net-settled derivative financial

Group 2018

Less than 1 year

Between 1 and 2 years

Between 2 and 5 years

Over 5 years

NZ$’000

NZ$’000

NZ$’000

NZ$’000

Trade and other payables

72 770

–

–

–

Other financial liabilities

21 994

–

–

–

1 116

40 619

–

–

95 880

40 619

–

–

Borrowings

Source: Kathmandu Holdings Limited, Annual Report 2018, p. 54

The above table highlights when the cash requirements related to borrowings are due. It may indicate when refinancing needs to take place. Ideally, this table should be compared to the timing of the firm’s operating cash flows. Kathmandu’s debt profile is relatively simple. A large part of its debt financing comes from trade creditors.

Firms with substantial long-term assets will have longterm debt that is due over several years. Note that Kathmandu has no debt due beyond two years. While the profile is simple, the short-term nature of principal repayments means the credit analysts must actively monitor Kathmandu’s ability to repay.

In forecasting, a variety of scenarios should be considered – including not just a ‘best guess’ but also a ‘pessimistic’ scenario. Ideally, the firm should be strong enough to repay the loan even in the latter scenario. Ironically, it is not necessarily a decline in sales that presents the greatest risk to the lender. If managers can respond quickly to a sales decline, it should be accompanied by a liquidation of receivables and inventory, which enhances cash flow for a given level of earnings. The nightmare scenario is one where managers are surprised by a downturn in demand and are forced to liquidate inventory at substantially reduced prices. The worst case is where a sale has been made but the customer defaults on payment. If borrowers are struggling to service borrowings the lender must consider whether to ‘call in the loan’ or whether to reconsider the structure of a loan. Rather than take an immediate loss on the loan, the lender might receive the principal if the loan is extended or the amortisation pattern changed. Often a bank will grant a loan with the expectation that it will be continually renewed, thus becoming a permanent part of the firm’s financial structure. (Such a loan is labelled an ‘evergreen’.) In that case, the loan will still be written as if it is due within the short term, and the bank must make sure it has a viable exit strategy. However, the firm would be expected to service the loan by simply covering interest payments.

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CHAPTER 10 Credit analysis and distress prediction

Step 5: Security Much bank lending is done on a secured basis, especially for smaller or highly leveraged companies. The amount that a bank will lend on given security depends on a variety of factors. A significant factor is the liquidity of the security that the loan is borrowed against, so the bank can recoup if the firm becomes financially distressed; that is, the extent to which creditor protection laws permit banks to quickly repossess collateral in the event of default. The following are some rules of thumb often applied in commercial lending to various categories of security: 1 Receivables: Accounts receivable are usually considered the most desirable form of security because they are the most liquid. Some banks allow loans of 50 to 80% of the balance of nondelinquent accounts. However, the percentage applied is lower when: a the borrower has many small accounts that would be costly to collect if the situation arose b the borrower has a few very large accounts, such that problems with a single customer could have serious effects c the customer’s financial health is closely related to that of the borrower, so that collectability is endangered just when the borrower is in default. On the latter score, banks often refuse to accept receivables from associated companies as effective security. 2 Inventory: The desirability of inventory as security varies widely. The best-case scenario is inventory consisting of a common commodity that can easily be sold to other parties if the borrower defaults. Specialised inventory that appeals to only a limited set of buyers, or  inventory that is costly to store or transport, are less desirable. A bank may have a policy of lending up to 60% on raw materials, 50% on finished goods and 20% on work in progress. 3 Machinery and equipment: Machinery and equipment are less desirable as collateral. It is likely to be used, and it must be stored, insured and marketed. Keeping the costs of these activities in mind, banks typically will lend only up to 50% of the estimated value of such assets in a forced sale such as an auction. 4 Real estate: The value of real estate as collateral varies considerably. Banks will often lend up to 80% of the appraised value of readily saleable real estate. On the other hand, a factory designed for a unique purpose would be much less desirable. When security is required to make a loan viable, a commercial lender will estimate the amounts they could lend on each of the assets available as security. Unless the amount exceeds the required loan balance, the loan would not be provided. Even when a loan is not secured initially, a bank can require a ‘negative pledge’. This is a pledge that the firm will not use assets as security for any other creditor. In that case, if the borrower begins to experience difficulty and defaults on the loan, and if there are no other creditors in the picture, the bank can demand that the loan become secured if it is to remain outstanding. Liquidity risk is lower if the company has lines of credit that it can draw down on if cash flow dries up unexpectedly or when there is an element of variability in short-term cash flows. As the following Kathmandu box illustrates, financial statements often include disclosures on how the firm manages liquidity.

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LIQUIDITY RISK The following extract from Kathmandu’s 2018 financial statements describes the Group’s liquidity risk.

4.1.3 Liquidity risk Liquidity risk is the risk that the Group will not be able to meet its financial obligations as they fall due. Risk Liquidity risk

Exposure arising from Interestbearing and other liabilities

Monitoring

Management

Forecast and actual cash flows

Active working capital management and flexibility in funding arrangements

The Group has borrowing facilities of NZD $140,729,053 / AUD $129,330,000 (2017; NZD 116,772,823 / AUD $110,000,000 AUD) and operated well within this facility. This includes short term bank overdraft requirements and at balance sheet date no bank accounts were in overdraft. Source: Kathmandu Holdings Limited, Annual Report 2018, p. 53

Another aspect of security is deciding which parts of the firm will assume responsibility for the borrowing. Often, lenders deal with firms that have multiple subsidiaries. Credit is extended to the ‘borrowing group’, which may be a subset of the ‘economic group’ on which the financial statements report. The subsidiaries to be included in the borrowing group is a trade-off between including those subsidiaries that have the cash flows to repay the loan and the assets to be used as collateral and excluding subsidiaries that represent high risk. Also important is establishing mechanisms (loan covenants and guarantees) to ensure that assets are not switched in or out of the borrowing group to alter the risk after credit has been granted. 2

Step 6: Loan covenants Loan covenants outline the mutual expectations of the borrower and lender by specifying actions the borrower will and will not take. Some covenants require certain actions, such as regularly providing financial statements; others preclude certain actions, such as undertaking an acquisition without the permission of the lender; still others require maintaining certain financial ratios. Violating a covenant represents an event of default that could cause immediate acceleration of the debt payment, but in most cases the lender uses the default as an opportunity to re-examine the situation and either waive the violation or renegotiate the loan. Loan covenants must strike a balance between protecting the interests of the lender and providing the flexibility management needs to run the business. The covenants represent a mechanism to ensure that the business will remain as strong as the two parties anticipated at the time the loan was granted. Thus, required financial ratios are typically based on the levels that existed at that time, perhaps allowing for some deterioration but often with some expected improvement over time.

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CHAPTER 10 Credit analysis and distress prediction

The particular covenants included in the agreement should contain the significant risks identified in the financial analysis, or should at least provide early warning that such risks are surfacing. Some commonly used financial covenants include: Maintenance of minimum net worth: This covenant assures that the firm will maintain an ‘equity cushion’ to protect the lender. Covenants typically require a level of net worth rather than a particular level of income. In the final analysis, the lender may not care whether that net worth is maintained by generating income, cutting dividends or issuing new equity. Tying the covenant to net worth offers the firm the flexibility to use any of these avenues to avoid default. Minimum coverage ratio: Especially in the case of a long-term loan, such as a term loan, the lender will require an interest cover to be maintained. The traditional interest cover is the ratio of earnings before interest and tax to interest expense. More recent covenants include the cash flow coverage ratio. Maintaining some minimum coverage helps assure that the ability of the firm to generate cash internally is strong enough to justify the long-term nature of the loan. Maximum ratio of total liabilities to net worth: This ratio constrains the risk of high leverage and prevents growth without either retaining earnings or infusing equity. Minimum net working capital balance or current ratio: Constraints on this ratio force a firm to maintain its liquidity by using cash generated from operations to retire current liabilities (as opposed to acquiring long-lived assets). Maximum ratio of capital expenditures to earnings before depreciation: Constraints on this ratio help prevent the firm from investing in growth (including the illiquid assets necessary to support growth) unless such growth can be financed internally, with some margin remaining for debt service. In addition to such financial covenants, loans sometimes place restrictions on other borrowing activity, pledging of assets to other lenders, selling of substantial parts of assets, engaging in mergers or acquisitions, and payment of dividends. Covenants are included not only in private lending agreements but also in listed debt agreements. However, listed debt agreements tend to have less restrictive covenants for two reasons. First, negotiations resulting from a violation of listed debt covenants are costly (possibly involving not just the trustee but also bondholders), and so they are written to be triggered only in serious circumstances. Second, listed debt is usually issued by stronger, more creditworthy firms. (The primary exception would be high-yield debt issued in conjunction with leveraged buyouts.) For firms with strong debt ratings, fewer covenants will be used – only those necessary to limit dramatic changes in the firm’s operations, such as a major merger or acquisition. Restrictions on dividend payouts arise through national laws, as well as debt contracts. In some countries, dividends are restricted by the amount of profit earned, either current or past profits that have not yet been appropriated. In other countries, legislation requires solvency and net asset testing before dividends can be paid. Traditional types of accounting-based covenants, while still persisting, have declined relative to new measures that use cash flows and earnings before interest, tax and amortisation.3

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Step 7: Pricing A detailed discussion of loan pricing falls outside the scope of this text. The essence of pricing is to assure that the yield on the loan is sufficient to cover: 1 the lender’s cost of borrowed funds 2 the lender’s costs of administering and servicing the loan 3 a premium for exposure to default risk 4 a normal return on the equity capital necessary to support the lending operation. The price is often stated in terms of a deviation from a bank’s prime rate – the rate charged to stronger borrowers. For example, a loan might be granted at prime plus 2%. An alternative base is LIBOR, or the London Interbank Offer Rate, the rate at which large banks from various nations lend large blocks of funds to each other. Banks compete actively for commercial lending business, and it is rare that a yield includes more than 2 percentage points to cover the cost of default risk. If the spread to cover default risk is, say, 1%, and the bank recovers only 50% of amounts due on loans that turn out bad, then the bank can afford only 2% of their loans to fall into that category. This underscores how important it is for banks to conduct a thorough analysis and to contain the riskiness of their loan portfolio.

LO3

Debt ratings

The meaning of debt ratings In the case of listed debt, the investors are distanced from the issuer. To a large extent, they will depend on professional debt analysts, including debt rating agencies, to assess the riskiness of the debt and monitor the firm’s ongoing activities. Debt ratings are an independent opinion on the ability of a firm, state or government to meet its financial obligations in full and on time. The three major debt rating agencies in the Asia–Pacific region are Fitch, Moody’s and Standard & Poor’s. Each agency applies its own methodology and rating scale. Moody’s uses letter grades from ‘Aaa’ to ‘C’ to express its opinion on the level of credit risk. Aaa rated obligations are judged to be of the highest quality; that is, they represent the lowest level of credit risk. Proceeding downward, the ratings are Aa, A, Baa, Ba, B, Caa, Ca and C; where C indicates the lowest related obligations and are typically in default. Moody’s also append numerical modifiers 1, 2 and 3 to each generic rating classification, with 1 indicating it is at the higher end, 2 the mid-range and 3 the lower end. Figure 10.2 shows the distribution of Australian organisations rated by Moody’s. Out of 190 organisations that have debt ratings, only 78 are corporates. The non-corporate organisations are typically public sector entities that issue debt securities or other non-public firms that have a credit rating to reduce the cost of conducting foreign business. Most of the corporate firms are finance companies. For example, Toyota Finance Australia Limited (which provides finance to buy Toyota cars) has an Aa3 rating. Very few listed firms obtain debt ratings. Some of the more well-known Australian firms with ratings are: Telstra Corporation (A2), Wesfarmers (A3) and Boral (Baa2).

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CHAPTER 10 Credit analysis and distress prediction

90 80 70 60

Non-corporate Corporate

50 40 30 20 10 0

Aaa

Aa

A

Baa

Ba

B

Caa

FIGURE 10.2 Moody’s distribution of debt ratings for Australian organisations Source: Moody's

Factors that drive debt ratings While debt ratings can be viewed as subjective, research demonstrates that some of the variation in debt ratings can be explained as a function of selected financial statement ratios. Some debt rating agencies rely heavily on quantitative models. Insurance companies, banks and other lenders also commonly use such models to assist them to evaluate the riskiness of debt issues for which a public rating is not available. Several researchers have estimated quantitative models used for debt ratings. Using a sample of 392 debt ratings from Australian corporates over the period 1995 to 2002, Gray, Mirkovic and Ragunathan (2006) find that interest cover and leverage ratios have the most pronounced effect on credit ratings, while profitability and industry concentrations are also important. In a US study by Kaplan and Urwitz, the two most important factors explaining debt ratings are not financial ratios at all – rather, they are firm size (large firms tend to get better ratings than small ones) and debt subordination. The other factors explaining debt ratings were similar to Australian data: leverage, ROA and interest cover.5 The Gray-Mirkovic-Ragunathan model correctly assigns credit ratings to 61.5% of their sample firms. The main weakness of the model is that it struggles to distinguish between adjacent categories (e.g. AAA/AA or AA/A–). They suggest that rating agencies incorporate factors other than financial ratios the analysis. These are likely to include the types of strategic, accounting and prospective analyses discussed throughout this book. Given that debt ratings can be explained reasonably well in terms of a handful of financial ratios, one might question whether ratings convey any news to investors – anything that could not already have been garnered from publicly available financial data. The answer to the question is yes, at least in the case of debt rating downgrades. That is, downgrades are greeted with drops in both bond and share prices.6 To be sure, the capital markets anticipate much of the information reflected in rating changes. But that is not surprising, given that the changes often represent reactions to recent known events and that the rating agencies typically indicate in advance that they are considering a change.

LO4

Predicting distress

The key task in credit analysis is assessing the probability that a firm will face financial distress and fail to repay a loan. A related analysis, relevant once a firm begins to face distress, involves considering whether it can be turned around. In this section, we look at how we can predict these states. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Predicting distress is a complex, difficult and subjective task that involves all of the steps of analysis discussed throughout this book: business strategy analysis, accounting analysis, financial analysis and prospective analysis. Purely quantitative models based on simple ratios can rarely serve as substitutes for in-depth analysis. However, research on ratio models does offer some insight into which financial indicators are most useful. Moreover, there are some settings where extensive credit checks are too costly to justify, and where quantitative distress prediction models are useful. Several distress prediction models have been developed over the years.7 They are similar to the debt rating models, but instead of predicting ratings they predict whether a firm will face some state of distress within one year, typically defined as bankruptcy. One such model, the Altman Z-score, weights five variables to compute a bankruptcy score.8 For public companies the model is as follows:9 Z = 1.2(X1) + 1.4(X2) + 3.3(X3) + 0.6(X4) + 1.0(X5) where: X1 = net working capital/total assets X2 = retained earnings/total assets X3 = EBIT/total assets X4 = market value of equity/book value of total liabilities X5 = sales/total assets The model predicts bankruptcy when Z < 1.81. The range between 1.81 and 2.67 is labelled the ‘grey area’. Such models have some ability to distinguish between failing and surviving firms. However, the real test is if the model can be used to predict outcomes on new (out-of-sample) data. Altman (1968) reports that, when the model was applied to a holdout sample containing 33 failed and 33 non-failed firms (the same proportion used to estimate the model), it correctly predicted the outcome in 63 of 66 cases. However, it seems likely that if we apply the model to a holdout sample where the proportion of failed and non-failed firms was not forced to be the same as that used to estimate the model, the performance of the model would degrade substantially. Several attempts have been made to produce financial distress prediction models using nonUS data.10 Ferner and Hamilton (1987) constructed a New Zealand version of the Altman model; that is, using the same variables but recalibrating the coefficients. The Ferner-Hamilton model is: Z = 0.86 – 3.55(X1) + 0.5(X2) + 8.77(X3) + 0.95(X4) – 0.99(X5) According to Ferner and Hamilton, the Z-score that minimises total classification errors is −0.04. As an example, Figure 10.3 presents calculations of the Ferner-Hamilton model for Fletcher Building at two points in time. The financial statement data is taken from the firm’s half-yearly financial statements. On 8 February 2018 Fletcher Building requested a trading halt of its shares and capital notes on the NZX and ASX exchanges. The halt was sought because the firm was reviewing its key projects, and although the review was not yet completed, the Board expected further material losses. On 21 February, the firm announced an operating earnings loss of $322m for the six months to 13 December 2017, down from a $310m profit for the first half of FY17. We can make some interesting observations about Figure 10.3. First, it is common for financial distress models to be compared in cross-section; that is, against other firms, rather than in than in time-series. Nevertheless, it is interesting to note that the Z-score almost halved in 2017; Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 10 Credit analysis and distress prediction

Dec 2017 Factor Intercept Net working capital/assets

Coefficient

Ratio

0.86 –3.55

Dec 2016 Score

Ratio

0.86 –0.05

Score 0.86

0.18

0.21

0.04

Retained earnings/total assets

0.50

0.07

0.04

0.14

0.00

EBIT/total assets

8.77

–0.04

–0.35

0.04

–0.01

Market value of equity/book value of total liabilities

0.95

1.07

1.02

1.70

1.72

–0.99

0.61

–0.61

0.60

–0.37

Sales/total assets Z-score

1.13

2.24

FIGURE 10.3 Ferner-Hamilton model applied to Fletcher Building

indicating the model captured the ‘direction of travel’. The half-yearly report did not provide a figure for ‘retained earnings’, so we used the ‘total reserves’ figure. The model seems quite robust to this adjustment. Third, the market (value of equity) to book (value of liabilities) ratio is the variable that has the most influence on the Z-score, and in this case the largest influence on the decline in Z-score; that is, the market seems to have anticipated financial difficulty. If we used the market price at 21 February in the model, the Z-score drops to 0.92. Fourth, it is worthwhile examining each ratio so see if it ‘behaves appropriately’. The net working capital to total assets ratio (0.18) positively contributes to the total Z-score. However, this is a result of multiplying to negative numbers! If we replace the –0.05 with a small positive ratio (0.01) the Z-score is 0.75. The important point is: do not blindly apply Z-score models without checking for reasonableness. Financial ratios can differ over time, between different industries and across different accounting methods. Simple distress prediction models like the Altman and the Ferner-Hamilton model tend to be sample-specific and cannot serve as a replacement for in-depth analysis of the kind discussed throughout this book. However, they do provide a useful reminder of the power of financial statement data to summarise important dimensions of the firm’s performance. In addition, they can be useful to screen large numbers of firms before undertaking more indepth analysis of corporate strategy, management expertise, market position and financial ratio performance. In screening data, the ranking of ‘Z-scores’ is likely to be more important than the specific cut-off values.11 The above default prediction approaches are sometimes called ‘kitchen sink’ methods because the researchers have just thrown a bunch of variables into the model; that is, there is no theoretical basis. In contrast, Merton (1974) presents an approach where corporate bonds (and stocks) are derivatives of the firm’s assets. More specifically, the model for default prediction and corporate bond pricing views the firm’s equity as a call option on its assets, because the equity holders have the residual interest in the firm after all obligations have been paid. The model for default predication requires specifying three parameters related to the firm’s assets: values, volatility and expected return. Tanthanongsakkun and Treepongkaruna (2008) find the Merton model to be more effective than the Gray-Mirkovic-Ragunathan model. This is, not surprising because the Merton (1974) variables use market measures that capture a wider range of ‘news’ than the financial statements themselves. This was potentially quite significant because they measured the market variables three months after balance date (the assumed date of the release of the annual report). In addition, they theoretically added two other variables: firm size and book-to-market. 12 Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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A PRACTITIONER ADVISES Partner with leading chartered accounting firm specialising in corporate finance and valuation on valuing start-ups:

Do you know what the odds are for a small company becoming a large listed company? It’s unlikely that a little company will survive even 10 years. And only about one in 10 of those that survive 10 years becomes a listed company. And only one in more than 10 000 of those listed companies becomes a Google. When you multiply it out, that’s a pretty small chance! So, although everyone thinks they’re going to be the next Google, the odds are they won’t be. It’s harder to value early-stage companies than more mature-stage companies. The analyst is trying to reconcile between a person who thinks they’re the next Google and his/her own awareness that they probably aren’t. No one thanks you if the price goes down to something approaching zero. Which is why its such difficult and risky work for a valuer. Leading Australian researcher on predicting financial distress:

All models, by construction, over-simplify the factors that can lead to financial distress across a range of companies, and miss the cause of the next individual failure, because its inherently unpredictable. Increasingly, qualitative factors such as corporate culture and fraud are key predictors of distress. Research is turning more to textual analysis for insights. Online publisher of expert views on international affairs:

The ‘Big Three’ global credit rating agencies – Standard and Poor’s, Moody’s and Fitch Ratings – control nearly

95% of the credit ratings market. They have been extensively criticised for misusing their market power. They have been accused of exacerbating the global financial crisis and the eurozone’s sovereign debt crisis, misleading investors and distorting financial markets. The current system of credit ratings is an ‘issuerpays’ model, whereby the issuer pays the rating agencies for the initial rating, as well as ongoing ratings, which the public can access free of charge. The model prior to the 1970s was a ‘subscriber-pays’ model, in which investors paid for the ratings. The issuer-pays model is more successful because issuers are more willing to pay than investors. Proponents of each approach accuse the other of conflicts of interest, and the Big Three argue that the real issue is one of transparency. One expert argues that investors should stop giving the ratings of the Big Three so much weight. ‘The reason why ... [crises] can happen is largely that very blind investors bought bonds relying on ratings and [didn’t do] their own homework about what the real credit risk was in the bonds.’ Source: The Credit Rating Controversy, Council on Foreign Relations, 19 February, 2015, cfr.org.

Reflective activity: What do these three industry sources indicate about the need for detailed business analysis by various market participants to fully understand the risks involved in entrepreneurship and investment? Consider how the following may help: improved financial literacy for investors, enhanced corporate disclosure of future projects including expected payoffs and risks, greater competition in the market for credit ratings, and/or stronger penalties for corporate fraud. Can you think of any other solutions?

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CHAPTER 10 Credit analysis and distress prediction

243

SUMMARY Credit analysis is the evaluation of a firm from the perspective of a holder or potential holder of its debt. Credit analysis is important to a wide variety of economic agents – not just bankers and other financial intermediaries but also public debt analysts, industrial companies, service companies and others. At the heart of credit analysis lie the same techniques described in previous chapters: business strategy analysis, accounting analysis, financial analysis and portions of prospective analysis. The purpose of the analysis is not just to assess the likelihood that a potential borrower will fail to repay the loan. It is also important to identify the nature of the key risks involved, and how the loan might be structured to mitigate or control those risks. A well-structured loan provides the lender with a viable ‘exit strategy’, even in the case of default. A key to this structure is properly designed accounting-based covenants. Fundamentally, the issues involved in analysing listed debt are no different from those used to evaluate bank

loans or other private debt. Institutionally, however, the contexts are different. Investors in listed debt are usually not close to the borrower and must rely on other agents, including debt rating agencies and other analysts, to assess credit-worthiness. Debt ratings, which depend heavily on firm size and financial measures of performance, have an important influence on the market yields that must be offered to issue debt. The key task in credit analysis is the assessment of the probability that principal and interest will be paid in full and on time. Default is the ‘lower-tail’ outcome of this assessment. The task is complex, difficult and, to some extent, subjective. A small number of key financial ratios can help predict financial distress with some accuracy. The most important financial indicators for this purpose are profitability, volatility of profits and leverage. However, the models cannot replace the in-depth forms of analysis discussed in this book.

CHECKING AND APPLYING YOUR LEARNING 1 What are the critical performance dimensions that should be considered in credit analysis for: a a retailer? b a financial services company? What ratios would you suggest looking at for each of these dimensions?  LO2 2 Why would a company pay to have its debt rated by Fitch, Moody’s or Standard & Poor’s? Why might a firm decide not to have its debt rated?  LO3 3 Some have argued that the market for original-issue junk bonds developed in the late 1970s as a result of a failure in the rating process. Proponents of this argument suggest that rating agencies rated companies too harshly at the low end of the rating scale, denying investment-grade status to some deserving companies. What are proponents of this argument effectively assuming were the incentives of rating agencies? What economic forces could give rise to this incentive?  LO3 4 Many debt agreements require borrowers to obtain the permission of the lender before undertaking a major acquisition or asset sale. Why would the lender want to include this type of restriction?  LO2 5 Betty Li, the CFO of a company applying for a new loan, states: ‘I will never agree to a debt covenant that restricts my ability to pay dividends to my shareholders because it reduces shareholder wealth.’ Do you agree with this argument?  LO2

6 Wollongong Construction Company follows the percentage-of-completion method for reporting longterm contract revenues. Percentage-of-completion is based on the cost of materials shipped to the project site as a percentage of total expected material costs. Wollongong’s major debt agreement includes restrictions on net worth, interest coverage and minimum working capital requirements. A leading analyst claims that ‘the company is buying its way out of these covenants by spending cash and buying materials, even when they are not needed’. Explain how this may be possible.  LO2 7 Can Wollongong improve its Altman Z-score by behaving as the analyst claims in Question 6? Is this change consistent with economic reality?  LO4 8 A banker asserts: ‘I avoid lending to companies with negative cash from operations because they are too risky’. Is this a sensible lending policy?  LO2 9 A leading retailer finds itself in a financial bind. It doesn’t have sufficient cash flow from operations to finance its growth, and it is close to violating the maximum ­ debt-to-assets ratio allowed by its covenants. The marketing director suggests: ‘We can raise cash for our growth by selling the existing stores and leasing them back. This source of financing is cheap, since it avoids violating either the debt-to-assets or interest coverage ratios in our covenants.’ Do you agree with this analysis?

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PART 3 BUSINESS ANALYSIS AND VALUATION APPLICATIONS

Why or why not? As the firm’s banker, how would you view this arrangement?  LO2 10 Applying Altman Z-score models to out-of-sample data reduces the accuracy of the model. This suggests that such models are context specific. Do you think the Altman Z-score model would be useful in predicting financial distress among a set of Singaporean banks during the Asian crisis? Why or why not?  LO4

Consolidated

11 Would the Altman Z-score model (and its variants) be suitable for predicting distress among private firms? Why or why not?  LO4 12 Figure 10.4 shows the liability maturity analysis of Wesfarmers for 2018. Compare this to the similar table for 2019. Has the liquidity risk improved or not? Why?  LO2

5 years

Total contractual cash flows

Carrying amount (assets)/ liabilities

$m

$m

$m

Year ended 30 June 2018 Non-derivatives Trade and other payables

6 455

46

39

1

10

–

–

–

6 551

6 551

–

316

845

500

500

1026

1131–

–

4 318

4 124

19

13

37

75

51

43

31

–

269

–

6 474

375

921

576

561

1 069

1 162

–

1 1138

1 0675

Hedge interest rate swaps (net settled)

–

(1)

(1)

(2)

(1)

–

–

–

(5)

(5)

Hedged commodity swaps

(1)

(1)

(7)

(13)

(6)

–

–

–

(28)

(28)

Cross-currency interest rate swaps (gross settled)

(3)

(3)

–

(41)

(42)

(1 070)

(1 162)

–

(2 321)

(348)

–outflow

4

11

43

86

86

931

786

–

1947

–

Net cross-currency interest rate swaps

1

8

43

45

44

(139)

(376)

–

(374)

(348)

(1 142)

(959)

(959)

(448)

–

–

–

–

(3 508)

(120)

–

–

–

–

3 393

–

Loans and borrowings before swaps Expected future interest payments on loans and borrowings Total non-derivatives Derivatives

–(inflow)

Hedge forward exchange contracts (gross settled) –(inflow) –outflow

1 110

Net forward exchange contracts

(32)

(32)

(27)

(24)

–

–

–

–

(115)

(120)

Total derivatives

(32)

(26)

8

6

37

(139)

(376)

–

(522)

(501)

Source: Wesfarmers, Annual Report 2019, p. 122

FIGURE 10.4 Liability maturity analysis of Wesfarmers for 2018

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CHAPTER 10 Credit analysis and distress prediction

13 Consider the following group of companies: A B

D

C

Company A owns 100% of Company B Company B owns 100% of Company C Company B owns 75% of a Joint Venture in D. A and B have executed a deed of cross guarantee. BIGbank has a borrowing arrangement to cover the financing needs of A, B and C. a What companies are in the economic group? Income statement

06/10

Operating revenue

245

b What companies are in the borrowing group? c What companies are in the closed group? A senior credit analyst at BIGbank has suggested that rather than secure the borrowings over A, B and C, it need only finance company C, because A and B are only holding companies and have no manufacturing plant or inventory. d What do you think of this idea?  LO2 14 Mesoblast Limited is an Australian-based regenerative medicine company, founded in 2004. It provides treatments for inflammatory ailments, cardiovascular disease and back pain. You have downloaded the following data for 2010, 2015, 2018 and 2019.

06/15

06/19

06/18

0

20 483 000

22 967 122

Other revenue

5 500

18 800 000

16 924 638

0

Total revenue

5 500

39 283 000

39 891 760

22 819 050

–15 372 896

–149 432 000

–123 593 559

–145 457 008

–153 285

–1 955 000

–3 585 441

–3 050 049

–15 520 681

–112 104 000

–87 287 241

–125 688 007

739 786

–7 264 000

–1 979 434

–15 127 620

Pre-tax profit

–14 780 895

–119 368 000

–89 266 675

–140 815 628

Tax expense

0

0

83 056 419

12 769 143

NPAT

–14 780 895

–119 368 000

–6 210 255

–128 046 485

NPAT after abnormals

–14 780 895

–119 368 000

–47 747 260

–128 046 485

Operating expenses Dep. & amort. EBIT Net interest expense

Balance sheet CA – cash CA – receivables

06/10

06/15

32 049 327

22 819 050

06/18

144 142 000

06/19

51 093 221

71 903 607

1 375 679

5 172 000

68 145 041

5 789 248

93 284

10 139 000

17 510 485

11 458 719

33 518 290

159 453 000

136 748 748

89 151 575

5 334 241

2 995 000

3 140 305

3 303 864

NCA – PPE

223 695

5 727 000

1 466 648

1 177 812

NCA – intangibles

438 544

2 723 000

609 055 608

639 773 278

NCA – goodwill

0

175 069 000

181 914 490

191 719 663

NCA – other

0

671 958 000

4 547 422

4 739 769

CA – prepaid expenses Current assets NCA – investments

Non-current assets Total assets CL – accounts payable CL – short-term debt

5 996 480

858 472 000

800 124 475

840 714 387

39 514 770

1 017 925 000

936 873 224

929 865 963

1 595 510

36 774 000

25 600 054

18 622 558

0

0

0

19 972 907

CL – provisions

0

6 720 000

6 875 930

10 357 906

CL – other

0

19 537 000

0

14 259 232

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246

PART 3 BUSINESS ANALYSIS AND VALUATION APPLICATIONS

Income statement Current liabilities

06/10

06/15

06/18

06/19

1 595 510

63 031 000

32 475 984

63 212 605

NCL – long-term debt

0

0

80 363 956

95 934 692

NCL – provisions

0

316 232 000

85 286 158

84 775 417

NCL – other

0

29 303 000

0

0

Non-current liabilities

0

345 535 000

165 650 115

180 710 109

Total liabilities

1 595 510

408 566 000

198 126 099

243 922 714

Share capital

87 949 316

737 260 000

1 203 465 025

1 298 167 688

Reserves

5 595 764

170 252 000

49 680 692

57 946 670

Retained earnings

–55 625 820

–298 153 000

–514 398 592

–670 171 110

Total equity

37 919 260

609 359 000

738 747 124

685 943 248

Cash flows

06/10

06/15

06/18

06/19

Net operating cashflows

–9 657 662

–121 709 000

–101 491 002

–82 404 106

Net investing cashflows

–343 448

–5 612 000

–1 560 005

–1 425 923

Net financing cashflows

25 537 082

59 413 000

92 833 175

102 107 514

06/10

06/15

06/18

06/19

1.85

3.76

1.48

1.48

Market cap

286 529 028

1 253 951 461

709 126 687

730 311 156

Net debt

–32 049 327

–144 142 000

29 270 734

44 003 992

Enterprise value

254 479 701

1 109 809 461

738 397 422

774 315 149

Price/book value

7.56

2.06

0.96

1.06

Price data Year-end share price

FIGURE 10.5 Mesoblast Ltd Source: Mesoblast Ltd.

a Compute the Altman Z-score value for Mesoblast for all four years. (You might like to do this on a spreadsheet.) Using the data provided, calculate: i interest cover ii operating expenses to cash iii operating expenses to cash flow iv current liabilities to cash v term liabilities to cash.

b Using the data provided, choose and calculate another five ratios. c Using the analysis in parts (a) and (b) discuss the most important factors that a signalling financial distress. d Do you think the Altman Z-score works well for firms like Mesoblast? Why?   LO4

CASE LINK Concepts from this chapter are used in the following case in Part 4:

Case 8 Resinex

ENDNOTES 1

People can use the term ‘public debt’ to mean debt listed on market exchanges or to refer to government debt, which may or may not be listed. We distinguish between these terms referring to listed debt and public (government) debt.

2

‘Closed groups’ are also different from the borrowing group and the economic group. ASIC exempts subsidiary companies for the filing requirements if they enter into a deed of cross guarantee (see M. Bradbury, G. Dean and F. L. Clarke, ‘Incentives for non-disclosure by

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CHAPTER 10 Credit analysis and distress prediction

3

4 5

6

7

8 9

corporate groups’, Abacus 45(4) (2009): 429–54). The companies within the economic group that management nominates to participate in the deed are defined as the ‘closed group’. The deed requires mutual guarantees among closed-group companies of each other’s debts if a shortfall arises on liquidation of any company in the closed group. P. Taylor, ‘What do we know about the role of financial reporting in debt contracting and debt covenants?’ Accounting and Business Research 43(4) (2013): 386–417 is a review of the accounting research on debt contracting and accounting. Data extracted from the Moody’s website in mid-May 2019. From S. Gray, A. Mirkovic and V. Ragunathan, ‘The determinants of credit ratings: Australian evidence’, Australian Journal of Management (December 2006): 333–54. See R. Holthausen and R. Leftwich, ‘The effect of bond rating changes on common stock prices’, Journal of Financial Economics (September 1986): 57–90; and J. Hand, R. Holthausen and R. Leftwich, ‘The effect of bond rating announcements on bond and stock prices’, Journal of Finance (June 1992): 733–52. See E. Altman, ‘Financial ratios, discriminant analysis, and the prediction of corporate bankruptcy’, Journal of Finance (September 1968): 589–609; E. Altman, Corporate Financial Distress (New York: John Wiley, 1993); W. Beaver, ‘Financial ratios as predictors of distress’, Journal of Accounting Research, supplement (1966): 71– 111; J. Ohlson, ‘Financial ratios and the probabilistic prediction of bankruptcy’, Journal of Accounting Research (Spring 1980): 109–31; and M. Zmijewski, ‘Predicting corporate bankruptcy: An empirical comparison of the extant financial distress models’, working paper, SUNY at Buffalo (1983). See E. Altman, Corporate Financial Distress (New York: John Wiley, 1993). The Altman model does not work for private firms that have no market price (i.e. where ratio X4 cannot be calculated). Altman

247

produces a model for private companies replacing X4 with the ratio of book value of equity to book value of total liabilities. For research into financial distress models specifically built for private firms in Australasia, see R. McNamara, N. Cocks and D. Hamilton, ‘Predicting private company failure’, Accounting and Finance 28(2) (1988): 53–64; and M. Bradbury, ‘Empirical evidence on predicting small business loan default’, Accounting Forum (June 1992): 95–118. 10 See H. Y. Izan, ‘Corporate distress in Australia’, Journal of Banking & Finance (June 1984): 303–20; and C. D. Castagna and Z. P. Matolcsy, ‘The prediction of corporate failure: Testing the Australian experience’, Australian Journal of Management, 6(1) (June 1986): 23–50, for distress prediction model using Australian data. See M. Anstis, M. Nash and M. Bradbury, ‘Testing corporate failure model prediction accuracy’, Australian Journal of Management (December 1989): 211–22; and G. Ferner and R. T. Hamilton, ‘A note on the predictability of financial distress in New Zealand companies’, Accounting and Finance 27(1) (1987): 55–64, for models using New Zealand data. 11 The Z-score model has also been used to assess the usefulness of methods of accounting. For example, W. Stent, M. E. Bradbury and J. Hooks, ‘IFRS in New Zealand: Effects on financial statements and selected ratios’, Pacific Accounting Review (22)2 (2010): 92–107, use the Z-score to assess the impact of adoption of international accounting standards. Thus, the ability prediction of corporate financial distress can be viewed as a measure of the quality of accounting. 12 R. C. Merton, ‘On the pricing of corporate debt: The risk structure of interest rates’, Journal of Finance 29(2) (1974): 449–70; and S. Tahthnongsakkum and S. Treepongkaruna, ‘Explaining credit ratings of Australian companies – An application of the Merton model’, Australian Journal of Management (December) 2008: 261–76.

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CHAPTER

11

Mergers and acquisitions

Mergers and acquisitions are important investment activities that should improve overall economic efficiency as assets are transferred to a more profitable use or user. However, mergers and acquisitions cannot always be explained in such rational economic terms. Across the economy, they occur in waves, possibly boosted by investor sentiment as well as investment opportunities. While target shareholders usually gain from these transactions, acquiring shareholders tend to lose, raising questions about whether mergers and acquisitions create value, and why acquirers pay such high premiums.1 Analysts can examine a number of questions using financial analysis for mergers and acquisitions: Securities analysts can ask: At what price does a proposed acquisition create value for the acquiring firm’s shareholders? Risk arbitrageurs can ask: What is the likelihood that a hostile takeover offer will ultimately succeed, and are there other potential acquirers likely to enter the bidding? Acquiring management can ask: Does this target fit our business strategy? If so, what is it worth to us, and how can we make a successful offer?

Target management can ask: Is the acquirer’s offer reasonable for our shareholders? Are there other potential acquirers that would value our company more highly than the current bidder? Investment bankers can ask: How can we identify potential targets that are likely to be a good match for our clients? And how should we value target firms when we are asked to issue fairness opinions? In this chapter, we focus primarily on using financial statement data and analysis directed at evaluating whether a merger creates value for the acquiring firm’s shareholders. However, our discussion can also be applied to these other merger contexts. The topic of whether acquisitions create value for acquirers focuses on evaluating the: 1 motivations for acquisitions 2 types of acquisitions 3 pricing of offers 4 forms of payment 5 likelihood that an offer will be successful. Throughout the chapter, the expansion and contraction of the Wesfarmers subsidiary Bunnings Warehouse via mergers and acquisitions will be used to illustrate how financial analysis can be used in a merger context.

Chapter learning objectives By the end of this chapter, you should be able to: LO1

distinguish different types of mergers and acquisitions, and the motives to pursue them

LO2

adjust valuation models for unique features of mergers that enhance or detract from the value of the merged firm

LO3

interpret the impact that the merger will have on the acquirer’s capital structure and control, and the impact that its announcement will have on the market

LO4

evaluate the likelihood that the merger will not succeed because of competing offers, anti-takeover measures or lack of regulatory approval.

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CHAPTER 11 Mergers and acquisitions

LO1

A guide to mergers and acquisitions

This section describes the different ways in which previously separate organisations can be combined into a single organisation, and the different types of motivations for doing so.

Types of acquisitions Mergers and acquisitions can be classified in several different ways, highlighting the variety of arrangements that can be used to combine two or more business organisations into a joint or connected organisation.2 In Australia, the terms ‘acquisition’ and ‘takeover’ are synonymous, and refer to acquiring control of a publicly listed company. Sometimes ‘merger’ is also used synonymously, but the term ‘merger’ is more of a commercial description than a legal one, and tends to involve companies of equal size. Some common classifications of takeovers and their relative importance in Australia are: A hostile versus a friendly takeover: A hostile takeover is one that is opposed by the target’s management. In 2018, of the 56 public announcements of a merger or acquisition in Australia, 67% were initially classified as hostile. However, because management opinion changed during the process, only 32% finally proceeded without the support of the target board, implying that 35% obtained management support during the process. That support is important: if a deal is classified as hostile, it only has a 50% chance of succeeding, compared to 72% for all deals overall. A scheme of arrangement, a takeover bid and a trust scheme: Under a takeover offer, all target shareholders receive an offer to acquire their shares at an offer price, which is determined by the acquirer. A scheme of arrangement is a shareholder- and court-approved statutory arrangement between a company and its shareholders to reorganise the company’s share capital, so that the majority or all of the shares are transferred to the acquirer in return for consideration that is paid to the target shareholders. It can only be used for a friendly acquisition. Schemes of arrangement are the most common in Australia. Trust schemes are similar to schemes of arrangement, but can only be used for trusts and do not require court approval. Under both schemes of arrangement and trust schemes, the entity is delisted from the securities exchange. An on-market takeover offer versus an off-market takeover offer: As the names imply, an onmarket offer is implemented through a broker at the securities exchange, whereas an offmarket offer is implemented by contacting each shareholder individually. Off-market offers, both friendly and hostile, are the most common in Australia, because the acquirer is able to include conditions. A cross-border merger or acquisition: A cross-border takeover occurs between firms that are registered in different countries. It involves increased legal complexity and the transaction may be subject to special approval in one or both jurisdictions. A private equity takeover: A private company offers to buy the target firm, with or without the support of the target management, and then take the firm private by repurchasing its shares. The buyout group finances much of the acquisition with debt capital, leaving the target as a highly leveraged private company. In 2018, 18% of Australian takeovers involved private equity.

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249

CASE STUDY

250

PART 3 BUSINESS ANALYSIS AND VALUATION APPLICATIONS

PRIVATE EQUITY Private equity buyouts have become a viable alternative to a trade sale or the appointment of a successor for owners of Australian family and privately owned businesses. This is one reason why private investment firms have become an important group of players in the acquisition market. These firms offer to buy the target firm with the cooperation of management in these cases, and then take the firm either fully or partly private. The purchase is largely financed with debt.

1 What types of investor would be interested in private equity buyouts? What time horizon would they need to be interested in? Why? 2 What governance advantages would a private equity buyout bring to a family or private company? 3 How might the acquirer add sufficient value to the target to justify a high buyout premium?

Takeover offers can be unsuccessful for a number of reasons. Shareholders may receive a higher or more valuable alternative bid. The acquirer may fail to gain a controlling stake in an on-market bid. The conditions set for the takeover offer may not be met. The target shareholders may reject a proportional takeover bid or scheme of arrangement at an appropriate shareholder meeting. The deal may not meet the approval of the relevant regulatory authorities. In Australia, these authorities can include the Australian Competition and Consumer Commission (ACCC), which administers the Competition and Consumer Act 2010, the Foreign Investment Review Board, and the Australian Takeovers Panel. The Takeovers Panel resolves disputes over takeovers. In addition, the Australian Securities and Investments Commission enforces the takeover rules within the Corporations Act 2001, which it also has the power to modify.

Economic and non-economic motivations Firms merge with or acquire other firms for many reasons. One significant reason is that business combinations can create operating efficiencies that generate value for shareholders. New value can be created by: 1 Taking advantage of economies of scale: Mergers are often justified as a means of providing the two participating firms with increased economies of scale. Economies of scale arise when one large firm can perform a function more efficiently than two smaller firms. For example, telecommunications companies Vocus Communications and M2 Group merged in 2016 via a scheme of arrangement to create the fourth largest telco in Australia and the third largest in New Zealand. Anticipated cost savings were projected at $40 million per annum from 2018. 2 Improving target management: Another common motivation for acquisition is to improve target management. A firm is likely to be a target if it has systematically underperformed in its industry. Historically poor performance could be due to bad luck, but it could also be due to poor investment and operating decisions from the firm’s managers, or from managers deliberately pursuing goals that increase their personal power but cost shareholders. South Africa’s Woolworths takeover of Australian retailer David Jones in 2014 was forecast to improve David Jones’ value not only because it would receive much needed cash, but also because it brought international retail management expertise to the company. Research shows that distressed firms are sought-after targets for takeovers, although the completion rate is lower. The premium for a distressed target tends to be higher and shareholders of a distressed firm are less likely to be offered cash.3 3 Combining complementary resources or capacity: Firms may decide that a merger will create value by combining complementary resources of the two partners. For example, a firm may Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 11 Mergers and acquisitions

4

5

6

7 8

pursue a merger to acquire new technology or intellectual property, or a firm with a strong research and development unit could benefit from merging with a firm that has a strong distribution unit. A firm could benefit from a merger with another that has strong product sales in a different part of the market, or a different customer base that the acquirer is unable to reach. For example, Foster’s Group acquired Southcorp in 2005, combining Foster’s portfolio of leading beer and international wine brands with Southcorp’s premium Australian brand wines. Capturing tax benefits: Potential tax benefits from acquisitions include the tax shield from increasing leverage for the target firm (subject to thin capitalisation rules in Australia) and, in some jurisdictions, increased capital allowance deductions. If a firm does not expect to earn sufficient profits to fully utilise operating loss carryforward benefits, it may decide to buy another firm that is earning profits. The operating losses and loss carryforwards of the acquirer can then be offset against the target’s taxable profit. In Australia, this benefit only applies to 100% acquisitions. Capital gains tax relief where a shareholder receives new shares (or trust units) rather than cash in a takeover or merger has been available in Australia since 2000. This is known as ‘scrip for scrip’ rollover, and the capital gains tax is deferred until the new shares are sold. Providing low-cost financing to a financially constrained target: If capital markets are imperfect, perhaps because of information asymmetries between management and outside investors, firms can face capital constraints. Information problems can be especially severe for newly formed, high-growth firms. It can be difficult for outside investors to value these firms, since they have short track records, and their financial statements provide little insight into the value of their growth opportunities. Further, since they typically have to rely on external funds to finance their growth, capital market constraints for high-growth firms are likely to affect their ability to undertake profitable new projects. Public capital markets are therefore likely to be costly sources of funds for these types of firms. An acquirer that understands the business and is willing to provide a steady source of finance may therefore be able to add value.4 Creating value through restructuring and break-ups: Financial investors, such as leveraged buyout firms, often pursue acquisitions to create value by significantly restructuring or even breaking up the firm. The investors expect that the break-up value will be larger than the aggregate worth of the entire firm. Often, a financial investor will acquire a firm with a view to unlocking value from various components of the firm’s asset base. Penetrating new geographies: Cross-border acquisitions are pursued by firms to expand product markets, to capitalise on new technologies, and to capture labour cost advantages that they presumably could not achieve through joint ventures or supplier contracts. Increasing product-market rents: Firms have incentives to merge in order to increase productmarket rents. By merging and becoming the dominant firm in an industry, two smaller firms can benefit from the scale economies of a horizontal integration. The resulting consolidated industry can allow firms to collude to restrict their output and raise prices, thereby increasing their profits. Two firms that transact at different stages of an industry, such as the supplier of raw materials and the manufacturer, or the retailer and the transportation firm, can also increase their product-market rents via vertical integration.

While product-market rents make sense for firms as a motive for merging, the two partners are unlikely to announce their intentions when they explain the merger to their investors, since

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most countries have anti-trust laws that regulate mergers between two firms in the same industry. In Australia, merger behaviour is regulated by s. 50 of the Trade Practices Act 1974. The US has three major anti-trust statutes: the Sherman Act of 1890, the Clayton Act of 1914 and the Hart Scott Rodino Act of 1976. In 2019, the proposed $15 billion merger of telecom providers TPG Telecom Limited and Vodafone Hutchison Australia Pty Ltd raised significant anti-competitive concerns for the ACCC. This opposition was notable because the parties did not compete in the same markets and neither party was the market leader. Instead, ACCC opposed the merger because of potential competition between the parties. Given TPG’s ‘proven track record of disrupting established markets,’ the ACCC alleged that there was a ‘real chance’ that TPG would enter the market for mobile network services absent the merger.  Although acquirers generally initiate mergers and acquisitions, target-initiated deals are not uncommon. A company may seek to be taken over because of its economic weakness, financial constraints or a general economic shock from which it cannot recover. In these circumstances, information asymmetry between target and acquirer drives down the takeover premium.5 While many of the motivations for acquisitions are likely to create new economic value for shareholders, some are not. Some relate to the managers’ own preferences and beliefs, or their lack of ability. Of course, managers will never announce that they are not buying a firm for economically rational reasons. Their public explanation may be to justify the merger using one of the value-based motivations discussed above, or they may argue that they are buying the target at a bargain price. Non-economic reasons for mergers include: Increase in managerial power and prestige: Some acquiring managers may want to control a larger firm with more assets, a larger market base or more employees in order to increase their own power and prestige, and their own financial rewards. Use a cash surplus: Firms that are flush with cash but have few new profitable investment opportunities are particularly prone to using their surplus cash to make acquisitions. Shareholders of these firms may prefer that managers pay out any surplus or ‘free’ cash flows as dividends, or use the funds to repurchase their firm’s shares. However, this would expose the lack of profitable investments available and, by implication, the performance of the managers. Overconfidence: A CEO or a board of directors may be overconfident, based on success with a previous target, which may have been due to ability or just to good luck. Such overconfidence is associated with lower abnormal stock returns and higher premiums.6 Diversification: Another motivation for mergers that is valued by managers but not shareholders is diversification. Acquirers seek to dampen their earnings volatility by buying firms in unrelated industries. However, diversification as a motive for acquisitions has been widely discredited. Modern finance theorists point out that, in a well-functioning capital market, investors can diversify for themselves and do not need managers to diversify on their behalf. In addition, diversification has been criticised for leading firms to lose sight of their major competitive strengths and to expand into businesses where they do not have expertise.7 The international literature has largely supported the view that diversification mergers are sub-optimal, finding evidence for a ‘diversification discount’, or lower abnormal returns at the time of the merger announcement for more diversifying mergers compared to less diversifying

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mergers. This wealth reduction is explained as managers overpaying the target shareholders of firms that are outside the bidding firm’s industry. However, in Australia, there is less evidence of a diversification discount, with recent research finding no systematic difference between diversifying and non-diversifying mergers.8

KEY ANALYSIS QUESTIONS In evaluating a proposed merger, analysts are interested in determining whether it is likely to create new wealth for acquiring and target shareholders, or whether it is motivated by non-economic goals and beliefs. Key questions for financial analysis are likely to include:

BUNNINGS WAREHOUSE The Bunnings story Bunnings Group, trading as Bunnings Warehouse, is a retail hardware chain operating in Australia and New Zealand. The company began in Perth as a sawmilling company, founded by English immigrants Arthur and Robert Bunning in 1887. It refocused to be a building products supplier, expanding its product range and then taking over existing hardware stores and chains. The chain was purchased by Wesfarmers in 1994. In 2019, it had 295 stores and over 30 000 employees, while in 2016 a Sydney Morning Herald article estimated its market share of the Australian retail hardware sector at

around 20%. Its competitors include chains such as Home Timber & Hardware and Mitre 10, as well as numerous independent retailers.

Motivation for Bunnings' takeover of BBC Hardware Let’s examine one of Bunnings’ takeovers in detail to consider the motives behind its expansion. What economic motives are mentioned in the excerpts that follow to explain the reasons for the takeover? And were there non-economic motives as well?

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CASE STUDY

What are the motivations for the acquisition and the anticipated benefits disclosed by acquirers or targets? What are the industries of the target and acquirer? Are the firms related horizontally or vertically? How close are the business relations between them? If the businesses are unrelated, is the acquirer cash-rich and potentially reluctant to return free cash flows to shareholders? What are the key operational strengths of the target and the acquirer? Are these strengths complementary? What is the pre-merger performance of the two firms? Performance metrics are likely to include ROE, gross margins, general and administrative expenses to sales, and working capital management ratios. Based on these measures, is the target a poor performer in its industry, implying that there are opportunities for improved management? Is the acquirer in a declining industry and searching for new directions? Is the acquisition a friendly one, supported by target management, or is it hostile? Has the performance of a hostile management been poor? Will the transaction go through despite the opposition of target management who will want to preserve their jobs? Will the hostile acquirer have sufficient access to information to mitigate the risk of overpayment? What is the tax position of both firms? What are the average and marginal current tax rates for the target and the acquirer? Does the acquirer have operating loss carryforwards and the target taxable profits?

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Remember that Wesfarmers might have had more underlying motives for the bid than those announced publicly. It might not have publicised its non-economic motives in order to avoid shareholder opposition. It might have been pursuing growth for the benefits that it would provide to managers, to spend surplus cash balances from the sale of another operating division, or to increase its geographic diversification in order to reduce risk.

Bunnings makes bid for BBC group June 13 2001 Perth based Wesfarmers Ltd, which owns Bunnings has announced a $2.2 billion takeover offer for Howard Smith Ltd, the BBC Hardware group. Wesfarmers said it would offer $12 in cash and two of its shares for every five Howard Smith shares. Wesfarmers managing director Michael Chaney said Howard Smith’s BBC Hardware and Hardwarehouse business was an attractive fit with its Bunnings operations. ‘By combining Bunnings and BBC Hardware, we will create an Australian owned hardware retailer with combined Australian hardware sales of $2.4 billion, performing at international benchmark levels and with significant potential for growth in the $19 billion Australian hardware market,’ he said. ‘Total hardware sales in Australia and New Zealand for the expanded group will be approximately $3 billion.’ Mr Chaney said if Howard Smith accepted the bid, the combined group would have a market share of 13 per cent in Australia, which would leave it just behind market leader Mitre 10. Mr Chaney said the group would roll out the large warehouse style hardware stores used by both Hardwarehouse and Bunnings. He said the combined businesses would reap synergies and savings of $40 million in the first year. Source: Central Western Daily, 13 June 2001. The use of this work has been licensed by Copyright Agency except as permitted by the Copyright Act, you must not re-use this work without the permission of the copyright owner or Copyright Agency.

A Bunnings press release at the time of the takeover announcement stated:

As noted by market analysts, Bunnings has a significantly better performance record than Howard Smith’s hardware division as measured by sales and margins. Based on results to 30 June 2000, the average sales per Bunnings Warehouse store is approximately 60% higher than the corresponding average for BBC Hardware’s Hardwarehouse stores. On a whole of business basis, Bunnings’ earnings before interest and tax (EBIT) margins are about 50% higher than BBC Hardware’s. Bunnings has developed a highly successful operating model that in recent years has consistently achieved results comparable with international benchmark levels. Wesfarmers believes that it can substantially improve the operating performance of BBC Hardware by utilising its management expertise and operating approach. Bunnings and BBC Hardware are highly complementary with limited geographic overlap. In total, the combined hardware business will have more than 270 stores throughout Australia and New Zealand, of which 107 will be larger format warehouse stores. In order to bring Howard Smith’s Hardwarehouse stores up to Bunnings’ standards, Wesfarmers intends to make a further investment in existing warehouse stores and staff. Wesfarmers also intends to utilise the best of both management teams and to maintain the Hardwarehouse brand for warehouse stores in NSW and New Zealand. In other States, Bunnings Warehouse branding will be adopted for warehouse stores. Given the limited warehouse stores overlap, Wesfarmers expects limited store closures. As part of the integration, Wesfarmers intends to conduct a detailed review of BBC Hardware’s stores and operations. Based on public information, and subject to detailed review, current expectations are that there may be closures of up to nine Hardwarehouse stores over the next 12 months. Source: Wesfarmers Limited News, 13 June 2001.

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CHAPTER 11 Mergers and acquisitions

LO2

Acquisition pricing

A well-thought-out economic motivation for a merger or acquisition is a necessary but not sufficient condition for the acquisition to create value for acquiring shareholders. The acquirer must be careful to avoid overpaying for the target. Overpayment makes the transaction highly desirable and profitable for target shareholders, but it diminishes the value of the deal to acquiring shareholders. Even in hindsight, it is difficult to assess whether a merger or acquisition target was acquired at too high a price, as subsequent events may change its value considerably from what was foreseeable at the time of the offer. A novel approach to determining whether paying the winning premium in a close merger contest pays off in the end was developed by a team of researchers. They compared the three-year post-merger stock returns of similar bidders, both winners and losers, finding that losers outperform winners by 24%. Indeed, winning can mean losing!9 With this warning in mind, the following methods can be a useful guide to assessing whether the acquiring firm is overpaying for its target.

Analysing premium offered to target shareholders One popular way to assess whether the acquirer is overpaying for a target is to compare the premium offered to target shareholders to premiums offered in similar transactions. If the acquirer offers a relatively high premium, the analyst may reasonably conclude that the transaction is less likely to create value for acquiring shareholders. Premiums differ significantly for friendly and hostile acquisitions, with the evidence showing that hostile acquirers are more likely to overpay for a target. In Australia, average premiums for friendly acquisitions are in the 0–10% range, whereas for hostile acquisitions they average between 10 and 20%.10 In the US, premiums tend to be about 30% higher for hostile deals than for friendly offers.11 Cumulative abnormal returns to target shareholders in Australia are 6 to 8% higher for hostile than for non-hostile offers, for several reasons.12 First, a friendly acquirer has access to the internal records of the target, improving valuation accuracy and making it less likely that the acquirer will be surprised by hidden liabilities or problems once it has completed the deal. In contrast, a hostile acquirer does not have this advantage in valuing the target during negotiations, and is more likely to overpay. Second, the delays that typically accompany a hostile acquisition often provide opportunities for competing bidders to make an offer for the target, leading to a bidding war that raises the premium paid by the successful bidder. Comparing a target’s premium to values for similar types of transactions is straightforward, but has several practical problems. First, it is not obvious how to define a comparable transaction. Figure 11.1 shows the value of mergers and acquisitions completed and announced each quarter in Australia between 2002 and 2018. As can be seen, mergers and acquisitions activity was robust in 2018, with the highest value of deals completed since the GFC. Around $35 billion in deals were completed in the December quarter and potential deals worth a further $50 billion were announced. A second problem in using premiums offered to target shareholders to assess whether an acquirer overpaid is that measured premiums can be misleading if investors anticipate an offer. The share price run-up for the target in this situation will tend to make estimates of the premium appear relatively low. Australian research demonstrates aggressive trading in target firms prior

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Quarterly

$b

60 40 20 0 2002

2006

2010

2014

2018

2014

2018

By completion date

$b

60

Pending* Completed

40 20 0 2002

2006

2010

By announcement date *Includes transactions announced in the past 15 months but not yet completed Source: Reserve Bank of Australia, Statement on Monetary Policy 2019, Graph 3.24, p.54.

FIGURE 11.1 Mergers and acquisitions by listed Australian entities

to the announcement date of the takeover.13 This limitation can be partially offset by using target share prices one month prior to the acquisition offer as the basis for calculating premiums. However, in some cases offers may have been anticipated for longer than one month. Finally, using target premiums to assess whether an acquirer overpaid ignores the value of the target to the acquirer after the acquisition. This value can be viewed as: Value of target after acquisition = Value as independent organisation + value of merger benefits The value of the target before acquisition is the present value of the free cash flows for the target if it were to remain an independent entity. This is likely to be somewhat different from the firm’s share price prior to any merger announcement, since the pre-takeover price is a probabilityweighted average of the value of the firm as an independent unit and its value in the event of a takeover. The benefits of the merger include such effects as improvements in target operating performance from economies of scale, improved management and tax benefits, as well as any spillover benefits to the acquirer from the acquisition. Clearly, acquirers will be willing to pay higher premiums for targets that are expected to generate higher merger benefits. Therefore, examining the premium alone cannot determine whether the acquisition creates value for acquiring shareholders.

Analysing value of the target to the acquirer A second and more reliable way of assessing whether the acquirer has overpaid for the target is to compare the offer price to the estimated value of the target to the acquirer. This latter value can be computed using the valuation techniques discussed in Chapters 7 and 8. The most Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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FACEBOOK AND MYSPACE In 2005, Facebook had a serious competitor in the social networking industry: Myspace. In fact, it was more than a competitor: at the time it was the world’s hottest internet firm. It's little wonder that in that year News Corp was willing to pay $580 million for it. The wisdom of this decision was confirmed in 2006, when Google signed a $900 million deal to sell ads on Myspace, and again in 2007 when it was valued at $12 billion on the strength of its market power of 300 million registered users. But then Facebook overtook Myspace in terms of popularity. By 2009, Facebook had more users and of course the advertising revenue followed them. In 2011, Myspace was sold for just $35 million. In turn, Facebook received (and rejected) takeover offers ranging from $75 million to $2 billion. Instead, it accepted investments of small shareholdings that indicated its value

was between $15 billion and $50 billion. In 2012, Facebook held an IPO, going public at a share price of $38, which valued the company at $104 billion. 1 What do you consider to be News Corp’s motive for the 2005 takeover of Myspace? 2 Why do you think that bidders, investors and ultimately shareholders were not discouraged by News Corp’s experience and were willing to invest substantially in Facebook? 3 This case indicates that the value of a social networking company was between $35 million and $104 billion in this seven-year period. If, as a financial analyst, you were asked to value a social networking company, what method would you use, and what factors would you incorporate into your research and your valuation?

Earnings multiples To estimate the value of a target to an acquirer using earnings multiples, we first forecast earnings for the target and then decide on an appropriate earnings multiple, as follows: Step 1: Forecasting earnings. Earnings forecasts start by forecasting next year’s profit for the target, assuming no acquisition. Historical sales growth rates, gross margins and average tax rates are useful to build a pro forma profit model. Once we have forecasted the profit for the target as an independent firm, we can adjust the pro forma model for any improvements in earnings performance that we expect from the acquisition. Performance improvements can be modelled on numerous dimensions, including: higher operating margins through economies of scale in purchasing, or increased market power reductions in expenses as a result of consolidating research and development staff, sales forces and/or administration lower average tax rates from taking advantage of operating tax loss carryforwards. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CASE STUDY

popular methods of valuation used for mergers and acquisitions have been earnings multiples and discounted cash flows, for which we provided comprehensive discussion earlier. These are also discussed in detail below. A more recent valuation approach used in mergers and acquisitions is enterprise value (EV)/ EBITDA, which is an economic measure of the market value of a firm, such as you would pay to acquire the operating assets of a firm and pay out all of its other equity and debt holders. It includes the market value of all types of equity and debts that require repayment, less the liquidation value of assets such as cash and associated companies. Whichever valuation approach is used, we recommend first computing the value of the target as an independent firm. This provides a way of checking whether the valuation assumptions are reasonable, since for publicly listed targets we can compare our estimate with pre-merger market prices. It also provides a useful benchmark for thinking about how the target’s performance, and hence its value, is likely to change once it is acquired.

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Step 2: Determining the price-earnings multiple. How do we determine the earnings multiple to be applied to our earnings forecasts? If the target firm is listed, it may be tempting to use the pre-acquisition price-earnings multiple to value post-merger earnings. However, there are several limitations to this approach. First, for many targets, earnings growth expectations are likely to change after a merger, so the pre-merger price-earnings multiple will not be relevant for the postmerger firm. Post-merger earnings should be valued by using a multiple that is relevant for firms with comparable growth and risk characteristics, as discussed in Chapter 7. A second problem is that pre-merger price-earnings multiples are unavailable if the target is unlisted. Once again, we need to identify which types of listed firms are likely to provide good comparisons. In addition, since the earnings being valued are the projected earnings for the next 12 months or the next full financial year, the appropriate benchmark should be a forward price-earnings ratio. Finally, if a pre-merger price-earnings multiple is appropriate for valuing post-merger earnings, we need to be careful to ensure that the multiple is calculated before any acquisition announcement, since the price will increase in anticipation of the premium to be paid to target shareholders. Figure 11.2 summarises how price-earnings multiples are used to value a target firm before an acquisition (assuming it will remain an independent entity), and to estimate the value of a target to a potential acquirer: FIGURE 11.2 Summary of price-earnings valuation for targets

Value of target as an independent firm

Target earnings forecast for the next year, assuming no change in ownership, multiplied by its pre-merger forward P/E multiple.

Value of target to potential acquirer

Target revised earnings forecast for the next year, incorporating the effect of any operational changes made by the acquirer, multiplied by its post-merger forward P/E multiple.

Limitations of price-earnings valuation As explained in Chapter 7, there are serious limitations to using earnings multiples for valuation. In addition to these, the method has two more limitations specific to merger valuations: 1 P/E multiples assume that merger performance improvements come either from an immediate increase in earnings or from an increase in earnings growth (and hence an increase in the post-merger P/E ratio). In reality, improvements and savings can come in many forms: gradual increases in earnings from implementing new operating policies, eliminating overinvestment, managing working capital better or paying out excess cash to shareholders. These types of improvements are not naturally reflected in P/E multiples. 2 P/E models do not easily incorporate any spillover benefits from an acquisition for the acquirer, since they focus on valuing the earnings of the target.

Discounted abnormal earnings or cash flows As discussed in Chapters 7 and 8, we can also value a company using the discounted abnormal earnings and discounted free cash flow methods. These require us to first forecast the abnormal earnings or free cash flows for the firm and then discount them at the cost of capital, as follows. Step 1: Forecast abnormal earnings/free cash flows. A pro forma model of expected future profit and cash flows for the firm provides the basis for forecasting abnormal earnings/free cash flows. As a starting point, we should construct the model under the assumption that the target remains an independent firm. The model should reflect the best estimates of future sales growth; cost structures; working capital needs; investment, research and development needs; and cash Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 11 Mergers and acquisitions

requirements for known debt retirements, all developed from a financial analysis of the target. The abnormal earnings method requires that we forecast abnormal earnings or net operating profit after tax (NOPAT) for as long as the firm expects new investment projects to earn more than their cost of capital. Under the free cash flow approach, the pro forma model will forecast free cash flows to either the firm or to equity, typically for a period of five to 10 years. Once we have a model of the abnormal earnings or free cash flows, we can incorporate any improvements in earnings/free cash flows that we expect from the acquisition. These will include the cost savings, cash received from asset sales, benefits from eliminating overinvestment, improved working capital management and excess cash paid out to shareholders. Step 2: Compute the discount rate. If we are valuing the target’s post-acquisition abnormal NOPAT or cash flows to the firm, the appropriate discount rate is the weighted average cost of capital for the target, using its expected post-acquisition capital structure. Alternatively, if the target equity cash flows are being valued directly or if we are valuing abnormal earnings, the appropriate discount rate is the target’s post-acquisition cost of equity rather than its weighted average cost of capital (WACC). Two common mistakes are to use the acquirer’s cost of capital or the target’s pre-acquisition cost of capital to value the post-merger abnormal earnings/cash flows from the target. Computing the target’s post-acquisition cost of capital can be complicated if the acquirer plans to make a change to the target’s capital structure after the acquisition, since the target’s costs of debt and equity will change. As discussed in Chapter 8, this involves estimating the asset beta for the target, calculating the new equity and debt betas under the modified capital structure, and finally computing the revised cost of equity capital or WACC. As a practical matter, the effect of these changes on the WACC is likely to be quite small unless the revision in leverage has a significant effect on the target’s interest tax shields or its likelihood of financial distress. Figure 11.3 summarises how the discounted abnormal earnings/cash flow methods can be used to value a target before an acquisition (assuming that it will remain an independent entity) and to estimate the value of a target firm to a potential acquirer. FIGURE 11.3 Summary of discounted abnormal earnings/cash flow valuation for targets

Value of target as an independent firm

a Present value of abnormal earnings/free cash flows to target equity assuming no acquisition, discounted at pre-merger cost of equity. b Present value of abnormal NOPAT/free cash flows to target debt and equity assuming no acquisition, discounted at pre-merger WACC, less value of debt.

Value of target to potential acquirer

a Present value of abnormal earnings/free cash flows to target equity, including benefits from merger, discounted at post-merger cost of equity. b Present value of abnormal NOPAT/free cash flows to target, including benefits from merger, discounted at post-merger WACC, less value of debt.

Step 3: Analyse sensitivity. Once we have estimated the expected value of a target, we will want to examine the sensitivity of our estimate to changes in the model assumptions. For example, answering the following questions can help the analyst assess the risks associated with an acquisition: What happens to the value of the target if it takes longer than expected for the benefits of the acquisition to materialise? What happens to the value of the target if the acquisition prompts its primary competitors to respond by also making an acquisition? Will potential changes in industry dynamics affect the firm’s plans and estimates? Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Common mistakes Common mistakes in valuing a target include: applying the acquirer’s cost of capital in the target’s valuation equation applying the acquirer’s growth rate in revenues to the target’s sales level applying the acquirer’s price-earnings ratio to the target’s earnings to value the target. Although these seem like easy mistakes to avoid, they can become embedded in a takeover valuation without being identified because of the speed and complexity of the takeover being considered. Here are some scenarios that show how good motivations can lead to faulty analysis. A bank evaluates its competitive advantage to be its lower offshore borrowing rate, which enables it to benefit from a higher interest margin between its borrowing and lending rates. The bank’s CEO proposes acquiring another bank, which has a higher cost of funds, to extend its competitive advantage to its capital structure and improve the overall profitability of the combined bank. A shirt retailer proposes to merge with a jeans retailer, offering shareholders in the jeans retailer a 40% premium over the current market price of $15 per share ($21 per share). The $6 premium is justified on the basis of price-earnings analysis: the shirt retailer has a priceearnings ratio of 12, and management forecast that the jeans retailer will generate long-term earnings of $2.50 per share. Therefore, they reason that the jeans retailer is worth $30 per share, making the current offer of $21 per share seem like a bargain price at which to expand their operations. In each case, the acquirer is making the mistake of applying pricing metrics relevant to the acquirer prior to the merger to either the target or the post-merger firm, without considering how the merger will change the balance of capital structure, cost of funding, risks and revenue sources.

KEY ANALYSIS QUESTIONS To analyse the pricing of an acquisition, the analyst is interested in assessing the value of the acquisition benefits to be generated by the acquirer relative to the price paid to target shareholders. Analysts are therefore likely to be interested in answers to the following questions: What is the premium that the acquirer paid for the target’s shares? What does this premium imply for the acquirer in terms of future performance improvements to justify the premium? What are the likely performance improvements that management expects to generate from the acquisition? For example, are there likely to be increases in the revenues for the merged firm from new products, increased prices or better distribution of existing products? Alternatively, are there cost savings as a result of taking advantage of economies of scale, improved efficiency or a lower cost of capital for the target? What is the value of any performance improvements? Values can be estimated using multiples or discounted abnormal earnings/cash flow methods.

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BUNNINGS WAREHOUSE: PRICING It is always challenging for a bidder to make an offer that is attractive to target shareholders, when market speculation about such an offer has already bid up the target’s price. This is all the more so in the case of Bunnings and BBC, when market speculation led to a pre-emptive counter offer from Howard Smith to buy back Howard Smith shares, and when in the midst of this valuation activity, BBC’s CEO resigned. These are explained in the excerpts below. Wesfarmers’ offer was part cash and part shares in the newly merged company, an approach that required Howard Smith shareholders to share in the risks as well as the returns of the newly merged company.

Howard Smith buy-back On 16 May 2001, Howard Smith announced that it intended to initiate an off-market share buy-back. The buy-back was structured as a tender offer at prices between $8.50 and $9.70 per share, with the ultimate price being the lowest possible price in that range to purchase the amount of capital Howard Smith determined to buy back. This price range, set by the directors of Howard Smith, followed a volume weighted average share price in the month prior to announcement of the buy-back details of $8.85. The maximum aggregate cash sum to be returned to Howard Smith shareholders under the buy-back was $250 million and would have been subject to capital gains tax. Wesfarmers released the following on 13 June 2001.

LO3

Wesfarmers Limited today announced a takeover offer for all of the issued shares in Howard Smith Limited. Wesfarmers’ offer will be $12.00 cash and two Wesfarmers shares for every five Howard Smith shares (the “Offer”). Over the last few weeks, Howard Smith’s share price has been affected by the buy-back proposed by Howard Smith in mid May 2001 and widespread speculation of an offer from Wesfarmers following the sudden resignation of BBC Hardware’s chief executive on 30 May 2001. Based on Wesfarmers’ closing share price on 12 June 2001, the Offer values each Howard Smith share at $11.14 and represents:  a premium of 26% to the $8.85 pre buy-back announcement price referred to above;  a premium of 22% over the mid-point of the buy-back tender price range of $9.10; and  a premium of 14% over the closing price of Howard Smith shares on 12 June 2001. By comparison, Wesfarmers’ offer should provide capital gains tax rollover relief on that portion of the Offer represented by Wesfarmers shares. Source: Wesfarmers Limited News, 13 June 2001

 cquisition financing and form A of payment

Even if an acquisition is undertaken to create new economic value and is priced judiciously, it may still destroy shareholder value if it is inappropriately financed. Several financing options are available to acquirers, including issuing shares or warrants to target shareholders or acquiring target shares using surplus cash or proceeds from new debt. The trade-offs between these options from the standpoint of target shareholders usually hinge on their tax and transaction cost implications. For acquirers, they can affect the firm’s capital structure and provide new information to investors. As we will discuss, the financing preferences of target and acquiring shareholders can diverge. Financing arrangements can therefore increase or reduce the attractiveness of an acquisition from the standpoint of acquiring shareholders. As a result, a complete analysis of an acquisition will include an examination of the implications of the financing arrangements for the acquirer. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Effect of form of payment on acquiring shareholders From the perspective of the acquirer, the form of payment is essentially a financing decision. As discussed in Chapter 10, in the long term, firms choose whether to use debt or equity financing to balance the tax and incentive benefits of debt against the risk of financial distress. For acquiring shareholders, the costs and benefits of different financing alternatives therefore usually depend on three factors: 1 how the offer affects their firm’s capital structure 2 any information effects associated with different forms of financing 3 control issues arising from the form of payment. In Australia in 2018, most successful bids were funded by cash (60%), debt (14%) or a combination of cash and debt (19%), leaving only 7% funded by other means such as equity raisings.

Capital structure effects from the form of financing In acquisitions, where debt financing or surplus cash are the primary form of consideration for target shares, the acquisition increases the net financial leverage of the acquirer. This increase in leverage may be part of the acquisition strategy, since one way an acquirer can add value to an inefficient firm is to lower its taxes by increasing interest tax shields. However, in many acquisitions an increase in post-acquisition leverage is a side effect of the method of financing and not part of a deliberate tax-reduction strategy. Demands by target shareholders for consideration in cash could potentially reduce shareholder value for the acquirer by increasing the risk of financial distress. To assess whether an acquisition leads an acquirer to have too much leverage, financial analysts can assess the acquirer’s financial risk following the proposed acquisition by: analysing the business risks and the volatility of the combined post-acquisition cash flows against the level of debt in the new capital structure, and the implications for possible financial distress. assessing the pro forma financial risks for the acquirer under the proposed financing plan. Popular measures of financial risk include debt-to-equity and interest coverage ratios, as well as projections of cash flows available to meet debt repayments. The ratios can be compared to similar performance metrics for the acquiring and target firms’ industries to determine whether post-merger ratios indicate that the firm’s probability of financial distress has increased significantly. examining whether there are important off-balance-sheet liabilities for the target and/or acquirer that are not included in the pro forma ratio and cash flow analysis of post-acquisition financial risk. dvetermining whether the pro forma assets for the acquirer are largely intangible and therefore sensitive to financial distress. Measures of intangible assets include such ratios as market-tobook equity and tangible assets to the market value of equity.

Information problems and the form of financing In the short term, information asymmetries between managers and external investors can make managers reluctant to raise equity to finance new projects. Managers’ reluctance arises from their fear that investors will interpret the decision as an indication that the firm’s shares are overvalued. In the short term, this effect can lead managers to deviate from the firm’s

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long-term optimal mix of debt and equity. As a result, acquirers are likely to prefer to use internal funds or debt to finance an acquisition, since investors are less likely to interpret these forms of consideration negatively.14 The information effects imply that firms forced to use equity financing are likely to face a share price decline when investors learn of the method of financing.15 From the viewpoint of financial analysts, the financing announcement may, therefore, provide valuable news about the acquiring managers’ views of their own company’s value prior to the acquisition. On the other hand, it should have no implications for analysing whether the acquisition creates value for acquiring shareholders, since the news reflected in the financing announcement is about the pre-acquisition value of the acquirer and not about the post-acquisition value of the target to the acquirer. A second information problem arises if the acquiring management does not have good information about the target. Equity financing then provides a way for acquiring shareholders to share the information risks with target shareholders. If the acquirer finds out after the acquisition that the value of the target is less than previously anticipated, the accompanying decline in the acquirer’s equity price will be partially borne by target shareholders who now hold the acquirer’s shares. In contrast, if the target’s shares were acquired in a cash offer, any post-acquisition loss would be fully borne by the acquirer’s shareholders. Looking at a takeover from the perspective of the target, recent research finds that equity financing is prevalent when the target knows more about the bidder, and is therefore less concerned about the value of the shares being offered as consideration.16 The risk-sharing benefits from using equity financing appear to be widely recognised for acquisitions of private companies, where public information on the target is largely unavailable.17 In practice, it appears to be considered less important for acquisitions of large public corporations.

Control and the form of payment There is a significant difference between the use of cash and shares in terms of their impact on the voting control of the combined firm post-acquisition. Financing an acquisition with cash allows the acquirer to retain the structure and composition of its equity ownership. On the other hand, depending on the size of the target firm relative to the acquirer, an acquisition financed with shares could have a significant impact on the ownership and control of the firm post-acquisition. This could be particularly relevant to a family-controlled acquirer. Therefore, the effects of control need to be balanced against the other costs and benefits when determining the form of payment.

Effects of form of payment on target shareholders The key payment considerations for target shareholders are the tax and transaction cost implications of the acquirer’s offer.

Tax effects of different forms of consideration Target shareholders care about the after-tax value of any offer they receive for their shares. In Australia, as in the US, whenever target shareholders receive cash for their shares, they are required to pay capital gains tax on the difference between the takeover offer price and their original purchase price. Alternatively, if they receive shares in the acquirer as consideration and the acquisition is undertaken as a tax-free reorganisation, they can defer any taxes on the capital gain until they sell the new shares. In Australia this is known as ‘scrip for scrip’ rollover. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Such laws appear to cause target shareholders to prefer a share offer to a cash one. This is certainly likely to be the case for a target founder who still has a significant stake in the company. If  the company’s share price has appreciated over its life, the founder will face a substantial capital gains tax on a cash offer and will therefore probably prefer to receive shares in the acquiring firm. However, cash and share offers can be tax-neutral for some groups of shareholders. For example, consider the tax implications for risk arbitrageurs, who take a short-term position in a company that is a takeover candidate in the hope that other bidders will emerge and increase the takeover price. They have no intention of holding shares in the acquirer once the takeover is completed, so they will pay ordinary income tax on any short-term trading gain. Cash and share offers therefore have identical after-tax values for risk arbitrageurs. Similarly, tax-exempt institutions are likely to be indifferent as to whether an offer is in cash or shares.

Transaction costs and the form of financing Transaction costs are another factor related to the form of financing that can be relevant to target shareholders. Transaction costs are incurred when target shareholders sell any shares received as consideration for their shares in the target. These costs will not apply to target shareholders if the bidder offers them cash. Transaction costs are unlikely to be significant for investors who intend to hold the acquirer’s shares following a share acquisition. However, they may be relevant for investors who intend to sell, such as risk arbitrageurs.

KEY ANALYSIS QUESTIONS For an analyst focused on the acquiring firm, it is important to assess how the method of financing affects the acquirer’s capital structure and its risks of financial distress by asking the following questions:

CASE STUDY

What is the leverage for the newly created firm? How does this compare to leverage for comparable firms in the industry? What are the projected future cash flows for the merged firm? Are these sufficient to meet the firm’s debt commitments? How much of a cushion does the firm have if future cash flows are lower than expected? Is the firm’s debt level so high that it is likely to impair its ability to finance profitable future investments if future cash flows are below expectations?

BUNNINGS WAREHOUSE ACQUISITION OF HOMEBASE IN THE UK Bunnings’ expansion of its hardware chain continued after its successful acquisition of BBC Hardware. In 2016, it bought a UK-based retail chain, Homebase, after extensive market research. Its plan was to continue to operate Homebase and also to open a small number of Bunnings warehouses to test the proven Australian format on the UK market. However, by 2018, it was clear that this takeover was not as successful as Bunnings’ past ventures, leading to a massive loss of value, an embarrassing loss of reputation and a stalled strategy of expansion.

How had Bunnings (Wesfarmers) financed these expansions? Wesfarmers is in the business of diversified investments and divestments, so expansions in one part of the conglomerate can be financed by a contraction or withdrawal from another. Also, they undertook a $3 billion refinancing in 2008 followed by a $4.6 billion equity raising in 2009. In contrast to many companies that are reluctant to return capital to investors, Wesfarmers provided capital returns in both 2013 and 2014.

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Note that the initial cost of a merger or takeover is not the only consideration when a company divests itself at a later point. There may be ongoing contractual commitments to unwind. In the case of Bunnings UK, in order for Wesfarmers to exit with no further losses than its initial investment, it had to find a ‘buyer’ to take over its lease liabilities for the premises that it had intended to operate from.

In for $705m, out for £1: Wesfarmers abandons UK Bunnings disaster By Patrick Hatch, May 25, 2018 Bunnings is leaving the UK. The conglomerate’s managing director, Rob Scott, said executives would take responsibility for destroying more than $1.7 billion of shareholder value through the offshore foray by taking ‘significant’ pay cuts. The company said that it would sell the British hardware business, consisting of about 240 Homebase stores and 24 pilot Bunnings outlets, to the restructuring firm Hilco Capital. It will book a loss of between £200 million to £230 million ($350 million to $400 million) in its 2018 full-year results from the exit. Wesfarmers had hoped to replicate the success of its earnings powerhouse hardware

chain in the UK and Ireland, but instead ran up heavy losses after misreading the market and alienating Homebase’s existing customers. The company paid $705 million for Homebase in 2016, but wrote down the value of the venture by $1 billion in February 2018. Wesfarmers won’t be recouping any of its losses from the sale, with Hilco buying the business for the nominal figure of £1 ($1.60). But Hilco will take over property leases with liabilities of about $1.8 billion, which Wesfarmers could have had to bear if it decided to simply close the business down. Argo Investments managing director Jason Beddow, whose fund is Wesfarmers’ 11th biggest shareholder with about $240 million worth of stock, said he was happy with the outcome as it avoided potentially billions more in losses. ‘If they’ve got out of it for less than it was going to cost to turn it around, it’s probably not a bad option,’ Mr Beddow said. Source: Patrick Hatch, The Sydney Morning Herald, 25 May 2018. The use of this work has been licensed by Copyright Agency except as permitted by the Copyright Act, you must not re-use this work without the permission of the copyright owner or Copyright Agency.

BUNNINGS ANALYSIS Consider the Bunnings Warehouse case study presented in this chapter: 1 Why do you think that Bunnings was prepared to offer a $2.29 premium (26%) to Howard Smith to acquire all of its shares? What would it gain that it could not have obtained by a gradual expansion of its stores? What were the potential risks of this action? 2 How do you think that Wesfarmers CEO at the time, Michael Chaney, might have explained a 26% premium for the purchase of Howard Smith to his board of directors?

3 What valuation approach do you think that Wesfarmers might have used to value BBC Hardware (Howard Smith) and Homebase UK? Would they have used an earnings multiple based on Bunnings’ margins and factors, or would they have used a discounted abnormal earnings or cash flow model? For each method, explain the reasons why it might be useful in these specific cases.

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LO4

Acquisition outcome

The final question of interest to the analyst evaluating a potential acquisition is whether it will indeed be completed. If an acquisition has a clear value-based motive, the target is priced appropriately, and its proposed financing does not create unnecessary financial risks for the acquirer, it may still fail. As has been mentioned previously, a bid may fail because there is opposition from entrenched target management or because the transaction fails to receive necessary regulatory approval. So, the financial analyst has to consider whether target managers are entrenched and likely to oppose an offer in order to protect their jobs, as well as the political and regulatory environment in which the target and the acquirer operate. In addition, a bid may fail because the target receives a higher competing bid. Typically, there is more than one bidder for a target. In such cases, to evaluate the likelihood that an offer will be accepted, the financial analyst has to understand whether there are potential competing bidders who could pay an even higher premium to target shareholders. Research supports the predictions of economic theory that, on average, it is the target firm’s shareholders who gain when there is more than one bidder, because the offer price gets pushed up to the point at which there are no gains to the winning bidder.18

Other potential acquirers If there are other potential bidders for a target, especially ones who place a higher value on the target, there is a strong possibility that the bidder in question will be unsuccessful. Target management and shareholders have an incentive to delay accepting an initial offer to give potential competitors time to submit a bid. From the perspective of the initial bidder, this means that the offer could potentially reduce shareholder value by the cost of making the offer, which includes substantial investment banking and legal fees. In practice, a losing bidder can usually recoup these losses and sometimes even make healthy profits from selling any shares it has accumulated in the target to the successful acquirer.

KEY ANALYSIS QUESTIONS The financial analyst can determine whether there are other potential acquirers for a target and how they value the target by asking the following questions: Who are the acquirer’s major competitors? Could any of these firms provide an even better fit for the target? Are there other firms that could also implement the initial bidder’s acquisition strategy? For example, if this strategy relies on developing benefits from complementary assets, look for potential bidders who also have assets complementary to the target. If the goal of the acquisition is to replace inefficient management, what other firms in the target’s industry could provide management expertise?

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Target management entrenchment If target managers are entrenched and fearful for their jobs, it is likely that they will oppose a bidder’s offer. Some firms have implemented ‘golden parachutes’ for top managers to counteract their concerns about job security at the time of an offer. Golden parachutes provide top managers of a target firm with attractive compensation rewards should the firm get taken over. However, many firms do not have such schemes, and opposition to an offer from entrenched management is a very real possibility. More generally, there are a variety of structural impediments known as takeover defence mechanisms that provide a disincentive to acquiring firms. Some of the most widely adopted include poison pills, staggered boards, super-majority rules, dual-class recapitalisations, fair-price provisions and ESOP plans. While the existence of takeover defences for a target indicates that its management is likely to fight a bidding firm’s offer, defences do not typically prevent an acquisition. Instead, they tend to cause delays, which increase the likelihood other firms will make competing offers, including offers solicited by target management from friendly parties known as ‘white knights’. Takeover defences therefore increase the likelihood that the bidder in question will be outbid for the target, or that it will have to increase its offer significantly to win a bidding contest. One counterbalance to the power of a takeover defence is the ability of a powerful bidding CEO to make a 'take it or leave it' offer. In Australia, where very few companies combine the roles of CEO and Chair, there is evidence that firms with powerful chairs pay lower bid premiums, and are less likely to revise their initial offer price.19

KEY ANALYSIS QUESTIONS To assess whether the target firm’s management is entrenched and therefore likely to oppose an acquisition, analysts can ask the following questions: Does the target firm have takeover defences designed to protect management? Has the target been a poor performer relative to other firms in its industry? If so, is management’s job security likely to be threatened by a takeover, leading it to oppose any offers. Is there a golden parachute plan in place for target management? Golden parachutes provide attractive compensation for management in the event of a takeover to deter opposition to a takeover for job security reasons.

Anti-competitive issues Regulators such as the Federal Trade Commission in the US, the European Competition Commission in Europe and the ACCC in Australia assess the effects of an acquisition on the competitive dynamics of the industry in which the firms operate. The objective is to ensure that no single firm, through mergers and acquisitions, creates a dominant position that can impede effective competition in specific geographies or product markets. It was the likely effect on local market competition for the supply of petrol, diesel and automotive LPG that led the ACCC to oppose the takeover of Mobil Oil Australia’s retail assets by Caltex Australia Limited in 2009. The ACCC also expressed concerns for the potential of ‘coordination’ in determining petrol

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prices between the major fuel retailers if the number of independent suppliers were reduced.20 Researchers confirm that the mention of the words ‘entry barriers’ in an application to the ACCC in Australia make it more likely to be opposed by the regulator.21 In addition, political concerns around firms that have an impact on the national and economic security of a country come under the scrutiny of local lawmakers, whose opposition can often derail cross-border acquisition efforts. A proposed merger between the Australian Securities Exchange and Singapore Exchange in April 2011 was blocked by the Foreign Investment Review Board, who gave the Treasurer Mr Wayne Swan ‘unambiguous and unanimous advice … that the proposed transaction was contrary to the national interest’.22 Mr Swan more candidly summed up his own opposition with the comment, ‘Becoming a junior partner to a smaller regional exchange through this deal would risk us losing many of our financial sector jobs. So let’s be clear. This is not a merger, it’s a takeover that would see Australia’s financial sector become a subsidiary to a competitor in Asia’.23

KEY ANALYSIS QUESTIONS To assess whether the regulators and/or government are likely to oppose an acquisition, analysts can ask the following questions:

INDUSTRY INSIGHT

What proportion of industry sales do the two firms control? Is this likely to be of concern to regulators in countries in which the firms operate? Are the combined firms likely to be able to reduce regulatory opposition by selling certain business units? Is the target firm or the industry in which it operates of strategic importance or in the national interest of the country in which it is located? Is the ownership structure of the acquirer likely to create political opposition to the deal?

A PRACTITIONER ADVISES Leading Australian researcher on mergers and acquisitions on motivation for mergers:

Some acquisitions serve the interest of the directors, rather than the shareholders. Management motives are, at best, dubious. Some directors want to sell their firm at a discount, or at least at a lower premium, in return for a future board seat with the acquiring firm. And there’s more takeovers coming from unlisted vehicles, which might be private equity, rather than from listed firms. The motivation is not synergy when the acquisition is by an investment vehicle. It’s simply a financing arrangement.

In Australia more deals are being done as schemes rather than takeover bids. And the average premiums in schemes are about half of those in the takeover bids. So, the target shareholders are still benefitting, but not as much as before. Leading Australian researcher on mergers and acquisitions on acquisition pricing:

Bidder statements don’t indicate what valuation models are used. The only insights are in the independent expert reports, which seem to use a template. Most of them apply simple multiple-based methods – at most they might do a DCF. We don’t find any evidence of valuations being used to confirm what management wants to be told on the bidding side, but we do see it

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on the target side, where an expert’s report will rubber stamp the viewpoint of the directors. Leading Australian researcher on mergers and acquisitions on acquisition outcome:

The winners are still the target shareholders. Acquiring shareholders don’t benefit from acquisitions on average. The returns are at best, zero. They’re usually slightly negative; sometimes they’re really negative. Consistently, we find that the success of Australian acquisitions is determined by what the target board says. So, if the target board recommends ‘accept’, almost all of the shareholders will agree. This is different to

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the US, because we don’t have proxy advisors saying ‘This is a bad deal’. Most US acquisitions use a tender offer where there’s prior negotiation. Here, most of our acquisitions involve a direct offer to the shareholders, so you need the board on side. Reflective activity: There are some indications in this chapter that merger activity is not only related to calculations using the tools of financial analysis and business valuation presented in this book. Some mergers may be motivated by non-economic motives, or may not be given regulatory approval. How is this view of mergers and acquisitions further informed by the insights from this researcher?

SUMMARY This chapter summarises how financial statement analysis can be used by financial analysts to evaluate whether an acquisition creates value for an acquiring firm’s shareholders. Obviously, much of this discussion is also likely to be relevant to other merger participants, including target and acquiring management and their investment banks. For the external analyst, the first task is to identify the acquirer’s motivation. We present a number of motives. Some of these are economically based and consistent with maximising acquirer value, including acquisitions to take advantage of economies of scale, improve target management, combine complementary resources, capture tax benefits, provide low-cost financing to financially constrained targets and increase product-market rents. These motives will indicate additional factors to include in the analyst’s valuation model. Other strategies are non-economically based, and appear to benefit managers more than shareholders. For example, some unprofitable acquisitions are made because managers are reluctant to return free cash flows to shareholders, or because managers want to lower the firm’s earnings volatility by diversifying into unrelated businesses. These are also helpful for the valuation model, perhaps causing the analyst to lower managerial estimates of future cash flows from the merger. The financial analyst’s second task is to assess whether the acquirer is offering a reasonable price for the target. Even if the acquirer’s motivation is based on increasing shareholder value, it can overpay for the target. Target

shareholders will then be well rewarded, but at the expense of acquiring shareholders. We show how the ratio analysis, forecasting and valuation techniques discussed earlier in the book can all be used to assess the worth of the target to the acquirer. We also show how to adjust the valuation of the existing target or acquirer for factors that are unique to the merger, such as enhanced revenues or cost savings, or a lower cost of capital due to changes in capital structure. The method of financing an offer is also relevant to a financial analyst’s review of an acquisition proposal. If a proposed acquisition is financed with surplus cash or new debt, it increases the acquirer’s financial risk. Financial analysts can use ratio analysis of the acquirer’s post-acquisition balance sheet and pro forma estimates of cash flow volatility and interest coverage to assess whether demands by target shareholders for consideration in cash led the acquirer to increase its risk of financial distress. Alternatively, if a proposed acquisition is financed with equity, the analyst needs to consider the changes to control as well as to capital structure, and to interpret the information signals that such a change conveys to the market. Finally, the financial analyst is interested in assessing whether a merger is likely to be completed once the initial offer is made, and at what price. This requires the analyst to determine whether there are other potential bidders, whether target management is entrenched and likely to oppose a bidder’s offer, and whether the deal could fail because of regulatory intervention.

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CHECKING AND APPLYING YOUR LEARNING 1 Using the list of economic motivations for mergers and acquisitions in this chapter, classify potential motives into: a those that improve management b those that increase revenues c those that reduce costs In each case, explain how this benefit occurs.  LO1 2 Consider the list of motivations for mergers and acquisitions in this chapter. Which one(s) would be more relevant in a growing industry, and which one(s) would be more relevant in a mature non-growing industry?  LO1 3 What is a hostile bid? What tactics can be used by the target in such a situation? What tactics can be used by the bidder?  LO1 4 You have been hired by GS Investment Bank to work in the mergers department. The analysis required for all potential acquisitions includes examining the target for any off-balance-sheet assets or liabilities that have to be factored into the valuation. Prepare a checklist for your examination.  LO2 5 What is meant by the value of a potential takeover target as an ‘independent’ firm? When can a financial analyst can just use the current market valuation as the starting point for the valuation? When can’t they? What is the difference between these two valuations, if any?  LO2 6 Explain the difficulties in practice of assessing whether an acquirer is overpaying for its target.  LO2 7 The difference between the value of a target as an independent firm and the value of a target to a potential acquirer is known as the ‘control premium’. How might you value this difference, and why is the acquirer willing to pay for it?  LO2 8 A leading oil exploration company decides to acquire an internet company at a 50% premium. The acquirer argues that this move creates value for its own shareholders because it can use its excess cash flows from the oil business to help finance growth in the new internet segment. Evaluate the economic merits of this claim.  LO3 9 Develop a list of anti-takeover mechanisms a potential takeover target could adopt, and explain situations in which each of them could be or could not be in the target shareholders’ interests.  LO4

10 Research shows that Australian diversifying mergers do not attract a ‘diversification discount’ that has been identified in research elsewhere. Can you think of potential reasons for this? Is the same likely to be true in other small economies such as New Zealand?  LO4 11 Search the news media and the mergers regulatory body in your country for a recent merger offer, whether it was successful or unsuccessful. a What was the motivation for the merger? b What was the payment offered for the target and how was the offer received by the target’s board of directors? c How did the acquirer finance, or intend to finance, the merger? d What was the outcome of the merger offer? Was there any regulatory or political intervention? e What has been the profit and share price performance of the firm(s) involved since these events?   LO1 LO2 LO3 LO4 12 Under current accounting standards, acquirers are required to capitalise goodwill and report any subsequent declines in value as an impairment charge. As an analyst who is valuing a takeover target with such a goodwill impairment charge, what performance metrics would you use to judge whether goodwill is likely to be impaired?  LO3 13 Van Nguyen, CFO of a new listed firm in the telecommunications industry, is keen to acquire one of its competitors, Teletom, for $18.00 per share, a 20% premium over its current market price. Van justifies the premium using price-earnings analysis: ‘Our priceearnings ratio is 25, and using forecast earnings of Teletom of $1.00 per share, I value Teletom at $25.00, which is well above our offer price’. Do you agree with Van’s analysis? Explain your reasoning carefully.  LO2 14 Since the year 2000, there has been a noticeable increase in cross-border mergers and acquisitions. What factors could explain this increase in mergers between firms in different countries? What special issues and risks should an analyst be aware of when valuing a cross-border acquisition?  LO1 15 Which of the following industries might be subject to close scrutiny for reasons related to market competition, if a merger were planned in: a Australia, b New Zealand and c Singapore.

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i Banking industry ii Supermarket industry iii Mobile network industry

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iv Early childhood education sector v Health insurance industry  LO1

CASE LINK Concepts from this chapter are used in the following case in Part 4:

Case 9 Foster’s–Southcorp.

ENDNOTES 1 In a review of studies of merger returns, M. Jensen and Richard R. Ruback ‘The market for corporate control: The scientific evidence’, Journal of Financial Economics 11 (April 1983): 5–50, conclude that target shareholders earn positive returns from takeovers, but that acquiring shareholders only break even. 2 For more detailed information on Australian takeovers, see Allen’s Takeovers Handbook, https://www.allens.com.au/pubs/pdf/ma/ takeovers-handbook.pdf. 3 M. Bugeja, ‘The impact of target firm financial distress in Australian takeovers’, Accounting & Finance 55(2) (2015): 361–96. 4 K. Palepu, ‘Predicting takeover targets: A methodological and empirical analysis’, Journal of Accounting and Economics 8 (March 1986): 3–36. 5 R. Masulis and S. Simsir, ‘Deal initiation in mergers and acquisitions’, Journal of Financial and Quantitative Analysis 53(6) (2018): 2389–430. 6 A. Kind and T. Twardawski, ‘Board overconfidence in mergers and acquisitions: A self-attribution bias’, Academy of Management Journal (2016). 7 Chapter 2 discusses the pros and cons of corporate diversification and evidence on its implications for firm performance. 8 M. Nankervis and H. Singh, ‘The diversification discount and takeovers: Some Australian evidence’, International Journal of Managerial Finance 8(1) (2012): 36–57. 9 U. Malmendier, E. Moretti and F. Peters, ‘Winning by losing: Evidence on the long-run effects of mergers’, Review of Financial Studies (31(8) (1 August 2018): 3212–64. 10 Pitcher Partners report. 11 See P. Healy, K. Palepu and R. Ruback, ‘Which mergers are profitable – strategic or financial?’, Sloan Management Review 38(4) (Summer 1997): 45–58. 12 K. Maheswaran and S. Pinder, ‘Australian evidence on the determinants and impact of takeover resistance’, Accounting and Finance 45 (2005): 613–33.

13 M. Bugeja, V. Patel and T. Walter, ‘The microstructure of Australian takeover announcements’, Australian Journal of Management 40(1): pp 161–88. 14 See S. Myers and N. Majluf, ‘Corporate financing and investment decisions when firms have information that investors do not’, Journal of Financial Economics (June 1984): 187–221. 15 For evidence see N. Travlos, ‘Corporate takeover bids, methods of payments, and bidding firms’ stock returns’, Journal of Finance 42 (1987): 943–63. 16 B. E. Eckbo, T. Makaew and K. S. Thorburn, ‘Are stock-financed takeovers opportunistic?’ Journal of Financial Economics 128(3) (2018): 443–65. 17 See S. Datar, R. Frankel and M. Wolfson, ‘Earnouts: The effects of adverse selection and agency costs on acquisition techniques’, Journal of Law, Economics, and Organization 17 (2001): 201–38. 18 M. Jensen and R. Ruback, ‘The market for corporate control: the scientific evidence’, Journal of Financial Economics 11 (April 1983): 5–50. 19 S. Ghannam, Z. Matolcsy, H., Spiropoulos and N. Thai, ‘The influence of powerful non-executive chairs in mergers and acquisitions’, Journal of Contemporary Accounting and Economics 15(1) (April 2019): 887–104. 20 http://www.accc.gov.au/media-release/accc-to-oppose-theacquisition-of-mobil-retail-assets-by-caltex, viewed 4 February 2014. 21 R. Breunig, F. Menezes and K. Tan, ‘An empirical investigation of the mergers decision process in Australia’, Economic Record 88(283) (2012): 459–75. 22 Reuters, ‘Australia’s government on Friday said it had decided to block Singapore Exchange Ltd’s $7.8 billion bid for Australia’s ASX Ltd’, 8 April 2011. 23 ‘How the ASX-SGX merger failed’, The Sydney Morning Herald (21 April 2011), accessed 22 March 2020 http://www.smh.com.au/ business/how-the-asxsgx-merger-failed-20110421-1dqb2.html.

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12

Communication and governance

Two important aspects of analysing and valuing a company are reading and assessing its communications with its investors, and evaluating its governance. Communications can reveal much more than is reported in financial statements, but are these communications credible? You can assess the company’s credibility by observing and considering its governance structures and noting the assessments and actions of other agents and market participants. Corporate governance has become an increasingly important issue in capital markets throughout the world following financial market meltdowns in the Asian and US markets in the early 2000s, the GFC in 2008 and the European debt crisis of 2010–11. These market collapses exposed problems of accounting misstatements and lack of corporate transparency, as well as governance problems and conflicts of interest among the intermediaries charged with monitoring management and corporate disclosures. The market crashes have also raised questions about improving the quality of governance by information and financial intermediaries. Financial regulators have attempted to increase accountability and financial competence for audit committees and external auditors, who are charged with reviewing the financial reporting and disclosure process. In Australia, the need for further reforms have been given additional prominence by the deliberations and findings of the 2017–19 Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. This Royal Commission uncovered evidence and admissions of a long list of behaviours that are not consistent with a well-governed and socially responsible financial sector: money laundering for drug syndicates, charges to customers for no service, improper foreign exchange trading and ignoring statutory

reporting responsibilities. Hauntingly, at least some of the problems exposed by the GFC remain unaddressed by large and powerful financial intermediaries. This chapter discusses how managers can use many of the financial analysis tools presented in Chapters 2–8 to develop a coherent disclosure strategy, and by corporate board members and external auditors to improve the quality of their work. The following types of questions are dealt with: Directors ask: Is the firm’s corporate governance policy being implemented throughout the organisation? Are the key drivers that motivate employees and management consistent with this policy? Are governance issues raised at the board level? Are whistle-blowers protected? Audit committee members ask: What are the firm’s key business risks? Are they reflected appropriately in the financial statements? How is management communicating on important risks that cannot be reflected in the financial statements? Is information on the firm’s performance presented to the board consistent with that provided to investors in the financial report and disclosures? Managers ask: Is our current communication strategy effective in helping investors understand the organisation’s business strategy and expected future performance, thereby ensuring that our share price is not seriously over- or undervalued? External auditors ask: What are the client organisation’s key business risks, and how are they reflected in the financial statements? Where should we focus our audit tests? Is our assessment of the firm’s performance consistent with that of external investors and analysts? If not, are we overlooking something, or is management misrepresenting the organisation’s true performance in disclosures?

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CHAPTER 12 Communication and governance

Throughout this book, we have focused primarily on showing how financial statement data can help analysts and outside investors to make a variety of decisions. In this chapter, we change our emphasis and focus primarily on management and governance agents. Of course,

understanding the management communication process and corporate governance is also important for security analysts and investors. The approach taken here, however, is more germane to insiders, as most of the analyses we discuss are not available to outsiders.

Chapter learning objectives By the end of this chapter, you should be able to: LO1

 explain the external supply and demand influences on financial reporting quality

LO2

 understand the information environment for investors

LO3

 understand the role of financial reporting in communicating with investors

LO4

 understand alternative ways in which managers can communicate

LO5

 understand the internal influences on financial reporting quality

LO6

 apply the tools presented in this book to the audit function.

LO1

273

Governance overview

As we discuss throughout this book, outside investors require access to reliable information on firm performance, both to value their debt and equity claims and to monitor the performance of management. Investors expect managers to provide information on their company’s performance and future plans when they agree to provide capital to the firm. However, left to their own devices, managers are likely to paint a rosy picture of the organisation’s performance in their disclosures, generally for the following three reasons. 1 Most managers are genuinely positive about their firms’ prospects, leading them to unwittingly emphasise the positive and downplay the negative. 2 Business disclosures play an important role in mitigating ‘agency’ problems between managers and investors.1 Investors use these disclosures to judge whether managers have run the firm in investors’ best interests or have abused their authority and control over its resources. Reporting consistently poor earnings or earnings that fall short of market expectations increases the likelihood that top management will be replaced, either by the board of directors or by an acquirer who takes over the firm to improve its management.2 Of course, managers are aware of this and have incentives to show positive performance. 3 Managers are also likely to make optimistic disclosures prior to issuing new equity. Recent evidence indicates that entrepreneurs tend to take their firms public after disclosure of strong reported, but frequently unsustainable, earnings performance. Also, seasoned equity offerings typically follow strong, but unsustainable, share and earnings performance. The strong earnings performance prior to IPOs and seasoned offerings appears to be at least partially due

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to the management of earnings through accrual adjustments or transactions timing.3 Rational outside investors recognise management’s incentives to manage earnings and to downplay any bad news prior to a new issue. They respond by discounting the value of existing shares, demanding a hefty discount on new shares issued, and in extreme cases refusing to purchase the new shares. This raises the cost of capital and potentially leaves some of the best new ventures and projects unfunded.4 Financial and information intermediaries help reduce agency and information problems that face outside investors by evaluating the quality of management representations in the firm’s disclosures, providing their own analysis of organisation and management performance and making investment decisions on investors’ behalf. As shown in Figure 12.1, these intermediaries include internal governance agents, assurance professionals, information analysers and professional investors. The importance of these intermediaries is underscored by high fees they receive from investors and entrepreneurs. Information demand side

Professional Retail investors

$$

investors (managed funds, investment banks, venture capitalists)

Investment advice

Information analysers (financial analysts, rating agencies)

Credible financial statements Business & financial information

Internal governance

Managers

agents (board, audit committee, internal auditors)

Assurance professionals (external auditors)

Information supply side

Standard-setters and capital market regulators (e.g. accounting standards-setters, financial regulators, stock exchanges)

FIGURE 12.1 The intermediation chain between managers and investors

Internal governance agents, such as corporate boards, are responsible for monitoring a firm’s management. Their functions include reviewing business strategy, evaluating and rewarding top management and assuring the flow of credible information to external parties. Assurance professionals, such as external auditors, enhance the credibility of management’s financial information. Information analysers, such as financial analysts and ratings agencies, gather and analyse information to provide performance forecasts and investment recommendations to

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CHAPTER 12 Communication and governance

both professional and retail individual investors. Finally, professional investors (such as banks, managed funds and venture capital firms) make investment decisions on behalf of their large number of dispersed (individual) investors. They are therefore responsible for valuing and selecting investment opportunities in the economy. In this framework, management, internal governance agents and assurance professionals supply the information; while individual and professional investors and information analysers make up the demand side. Both the supply and demand sides are governed by a variety of regulatory institutions. These include government and financial regulators as well as private sector bodies, such as the accounting and finance profession and stock exchanges. For example, the Sarbanes-Oxley Act (2002) in the US attempts to increase accountability and financial competence for audit committees and external auditors, who are charged with reviewing the financial reporting and disclosure process, and to increase accountability for the CEO and CFO, who are required to certify the validity of both financial statements and internal controls. The US also has the Dodd-Frank Act (2010), which attempts to protect investors by increasing the transparency and accountability of credit rating agencies and to improve the financial security of large financial institutions. In Australia, the Corporations Act (2001) and the Australian Securities Exchange (ASX) listing regulations aim to have similar effects on financial controls and oversight. Since 2005, Section 295A of the Corporations Act requires a signed declaration from both the CEO and CFO of listed companies that the accounts are in compliance with accounting standards and give a ‘true and fair’ view. The ASX has produced a guide called the ‘ASX Corporate Governance Council Principles and Recommendations’ (CGCP&R), consisting of eight principles for recommended practice. ASX Listing Rule 4.10.3 requires listed companies to comply with CGCP&R, which is monitored and enforced by the ASX. The fourth edition of the CGCP&R, released in 2019, includes the following eight principles: 1 2 3 4 5 6 7 8

Lay solid foundations for management and oversight Structure the board to be effective and add value Instil a culture of acting lawfully, ethically and responsibly Safeguard the integrity of corporate reports Make timely and balanced disclosures Respect the rights of security holders Recognise and manage risk Remunerate fairly and responsibly

Source: ASX Corporate Governance Council, ‘Corporate Governance Principles and

Recommendations’, Fourth Edition, 2019. © Copyright 2020 ASX Corporate Governance Council.

In New Zealand, the New Zealand Stock Exchange (NZX) has issued a Corporate Governance Code under NZX Listing Rule 3.8.1 (a) and (b) against which all listed companies must report, on a comply or explain basis. This is mirrored by the Financial Markets Authority’s ‘Corporate Governance in New Zealand Principles and Guidelines’ for non-listed companies. Both guides specify eight principles: Code of Ethical Behaviour, Board Composition and Performance, Board Committees, Reporting and Disclosure, Remuneration, Risk Management, Auditors, and Shareholder Rights and Relations. These examples demonstrate that the level and quality of information and residual information and agency problems in capital markets are determined by the organisational design of these

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intermediaries and regulatory institutions. They are also influenced by a variety of economic, legal, historical, cultural and institutional factors. Future research may provide insights on how to improve the functioning of capital markets through changes in organisational design. Key organisational design questions include: What are the optimal incentive schemes to reward top managers? What should be the composition and charter of corporate boards? Should auditors assure that financial reports comply with the relevant accounting standards or represent a firm’s underlying economics? Should there be detailed accounting standards or a few broad accounting principles? What should the organisational form and business scope of auditors and analysts be? What incentive schemes should be used for professional investors to align their interests with individual investors? While it is interesting to speculate on how to improve the functioning of capital markets through changes in organisational design, that issue goes beyond the scope of this chapter. Instead, we discuss how the financial analysis tools developed in Chapters 2 to 8 can be used to improve the performance of information intermediaries. We have already discussed applying financial analysis tools to equity and credit analysts and to professional investors in Chapters 9 and 10. In the remainder of this chapter, we discuss how managers can use these tools to develop strategies to communicate effectively with investors, and how directors and audit committees can use them to oversee management and the audit process, and how audit professionals can apply them in their analyses.

LO2

 External information about financial reporting quality

Some managers argue that communication problems are not worth worrying about. They maintain that as long as managers make investment and operating decisions that enhance shareholder value, investors will value their performance and the firm’s shares accordingly. While this is true in the long run, since all information is eventually public, it may not hold in the short or even medium term. If investors do not have access to the same information as management, they will probably find it difficult to value new and innovative investments. In an efficient capital market, they may not consistently over or undervalue these new investments, but their valuations will tend to be inaccurate. This can make share values (prices) more volatile, leading management to consider their organisations to be either seriously over or undervalued at various times. Does it matter if a firm’s shares are over or undervalued for a period? Most managers would prefer to not have their shares undervalued, since it makes it more costly to raise finance. They may worry that undervaluation increases the chance of a takeover by a hostile acquirer, with an accompanying reduction in their job security. The financial crisis of 2008 demonstrated the importance of investor confidence to effectively operate financial markets and the risk of financial distress for firms that lose that confidence. Managers of firms that are overvalued may also be concerned about the market’s assessment, since they may be held accountable for failing to disclose information relevant to investors.5 They may therefore not wish to see their shares seriously overvalued, even though overvaluation provides opportunities to issue new equity at favourable rates. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

CHAPTER 12 Communication and governance

As discussed in Chapter 9, in the US managers may be legally liable for failing to disclose value-relevant information to investors under Reg FD intervention. Australia and New Zealand have continuous disclosure regimes (CDR), where listed firms must continually inform the market of all value-relevant information. In Australia, firms must announce their news to both ASIC and ASX, with the ASX then making all public announcements. Should they provide incidental information to other parties, such as security analysts, firms must ensure that the same information is disseminated through the CDR within 24 hours.

A word of caution As noted above, it is natural for many managers to believe that the capital market has undervalued their firm. This frequently occurs because it is difficult for managers to be realistic about their company’s future performance. After all, it is part of their job to sell the company to new employees, customers, suppliers and investors. In addition, forecasting the organisation’s future performance objectively requires them to judge their own capabilities as managers. Therefore, many managers may argue that investors are uninformed and that their firm is undervalued. Only some can back that up with solid evidence. If management decides that the firm does face a genuine information problem, it will need to consider whether and how to redress the problem. Is the issue serious enough that it is worth taking action to alter investors’ perceptions? Or is the problem likely to resolve itself quickly? Does the firm have plans to raise new equity or to use equity to acquire another company? Is management’s job security threatened? As we will discuss, management has a wide range of options in this situation.

KEY ANALYSIS QUESTIONS We recommend that before jumping to the conclusion that their firms are undervalued, managers analyse their organisations’ performance and compare their own forecasts of future performance with those of analysts, using the following approach: Is there a significant difference between internal management forecasts of future earnings and cash flows and those of outside analysts? Do any differences between managers’ and analysts’ forecasts arise because of different expectations about economy-wide performance? Managers may understand their own businesses better than analysts, but they may not be any better at forecasting macroeconomic conditions. Can managers identify any factors that may explain a difference between analysts’ and managers’ forecasts of future performance? For example, are analysts unaware of positive new R&D results, or do they have different information about customer responses to new products and marketing campaigns? These types of differences could indicate that the firm faces an information problem.

Sources of information and communication Before discussing the best ways to communicate information to investors, it is useful to think about the information set or environment that is available to different interested groups. Starting with the financial statements themselves, a great deal of information is gathered and reported in the four main financial statements:6 a balance sheet as at the end of the period, an Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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income statement for a period, a statement of changes in equity for a period, and a statement of cash flows for a period. These statements are supplemented through the significant note disclosures required by the accounting standards, which summarise significant accounting policies and provide other explanatory information, including reports on corporate governance and sustainability. Management has the opportunity to use the firm’s financial statements to communicate more than the minimum level of disclosure, and this can provide strategic benefits for the firm. These financial statements are most often included in an annual report, which includes a directors’ report and management commentary on the operations of the business, highlighting key performance measures, goals and strategies. While some of this information is required by regulation, most of it is provided voluntarily by the firm’s management. Another major source of information about a company comes from the organisation’s public announcements. These include major (value-relevant) announcements to stock exchanges, press releases, online announcements, emails, media interviews, social media communications and other public news stories about the firm. The latter items in this category may be considered voluntary disclosures. Employees and other insiders are also a source of information in the marketplace, as their private information can leak into the market through informed share market trading. A third source of information is other organisations in competition with the studied firm; opponents are often very well informed on market conditions, opportunities and the general economy. As there are a number of information sources, some regulated and some voluntary, managers must seek the combination of information signals that maximises the firm’s ability to communicate effectively with its interested parties.

LO3

 Communication through financial reporting

Financial reports are the most popular format for management communication. In this section, we discuss the role of financial reporting as a means of investor communication, the institutions that make accounting information credible, and when this communication is likely to be ineffective.

Accounting as a means of management communication As we discussed in Chapters 3 and 4, financial reports are an important medium for management to communicate with external investors. Reports explain to investors how their money has been invested, summarise the performance of those investments and discuss how the firm’s current performance fits within its overall philosophy and strategy. Accounting reports not only provide a record of past transactions but also reflect management estimates and forecasts of the future. For example, they include estimates of bad debts, forecasts of the lives of tangible assets and implicit forecasts that outlays will generate future cash flow benefits that exceed their cost. Since management is likely to be in a position to make more accurate forecasts of these future events than external investors, financial reports are a potentially

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useful way of communicating with investors. However, as discussed above, investors are likely to be sceptical of reports prepared by management. A body of research known as ‘impressions management’ validates investor scepticism of the content of annual reports. This research has identified four types of improperly designed graphs that frequently appear in annual reports. The four designs tend to: 1 2 3 4

exaggerate increasing trends mask declining trends show items in reverse chronological order omit negative values.

This literature was initiated by Vivien Beattie and Michael Jones with a report on UK company reporting in 1992, and has been followed by a number of similar studies in other countries.7 These authors have analysed the use and abuse of graphs in external financial reporting, finding that managers are selective in their use of graphs, and not compliant with the principles of graph construction. To date, there has been no regulation of financial graphs by standard setters, nor any explicit oversight by auditors, that would reduce this type of potential distortion in the communication process.8

Factors that increase the credibility of accounting communication Although there is no overarching regulation of all aspects of communication using financial reporting, there are a number of mechanisms that can mitigate conflicts of interest in financial reporting and increase the credibility of accounting information that is communicated to shareholders. These include accounting standards, auditing, monitoring of management by financial analysts, and management reputation.

Accounting standards and auditing Accounting standards and financial regulators9 provide guidelines for managers on how to make accounting decisions and provide outside investors with a way to interpret these decisions. Uniform accounting standards attempt to reduce managers’ ability to record similar economic transactions in different ways, either over time or across organisations. Compliance with these standards is monitored by internal auditors and enforced by external auditors. Internal auditors provide oversight for business practices and risks, both operational and financial, throughout the year. External auditors verify the processes and outcomes of financial reporting at the end of the year, including assurance that managers’ estimates are reasonable. Auditors therefore reduce the likelihood of earnings management.

Monitoring by financial analysts Financial intermediaries such as analysts also limit management’s ability to manage earnings. Financial analysts specialise in developing firm- and industry-specific knowledge, enabling them to assess the quality of a firm’s reported numbers and to make any necessary adjustments. Analysts evaluate the appropriateness of management’s forecasts implicit in accounting method choices and reported accruals. This requires a thorough understanding of the firm’s business and the relevant accounting rules used to prepare its financial reports. Superior analysts adjust reported

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accrual numbers, if necessary, to reflect economic reality, perhaps by using the information in the cash flow statement and the footnote disclosures. Analysts’ business and technical expertise as well as their legal liability and incentives differ from those of auditors. Consequently, analyst reports can provide information to investors on whether the firm’s accounting decisions are appropriate or whether managers are overstating the firm’s economic performance to protect their jobs.10

Management reputation A third factor that can counteract external investors’ natural scepticism about financial reporting is management reputation. Managers who expect to have an ongoing relation with external investors and financial intermediaries may be able to build a track record for unbiased financial reporting. By making accounting estimates and judgements that are supported by subsequent performance, managers can demonstrate their competence and reliability to investors and analysts. As a result, managers’ future judgements and accounting estimates are more likely to be viewed as credible sources of information.

Limitations of financial reporting for investor communication While accounting standards, auditing, monitoring of management by financial analysts, and management concerns about its reputation increase the credibility and informativeness of financial reports, these mechanisms are far from perfect. Consequently, there are times when financial reporting breaks down as a means for management to communicate with external investors. These breakdowns can arise when: 1 there are no accounting rules to guide practice or the existing rules do not distinguish between poor and successful performers 2 auditors and analysts do not have the expertise to judge new products or business opportunities 3 management faces credibility problems.

Accounting rule limitations Despite the rapid increase in the number of new accounting standards, accounting rules frequently do not distinguish between good and poor performers. For example, current accounting rules do not permit managers to show on their balance sheets in a timely fashion the benefits of investments in quality improvements, human resource development programs, research and development (with the exception of software and some other development costs) and customer service. Some of the problems with accounting standards arise because it takes time for standard setters to develop appropriate standards for many new types of economic transactions. Other difficulties arise because although standard setters seek compromise and the public interest, it is widely acknowledged that standard-setting is a political process in which the public interest is hard to identify. Accounting standards are finalised and adopted after compromises between different interest groups (such as auditors, investors, corporate managers and regulators). These interest groups often have opposing preferences for the way in which a particular standard is written, and convey self-interested points of view and promote private interests in their comment letters and lobbying.11, 12

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Auditor and analyst limitations While auditors and analysts have access to proprietary information, they do not understand the organisation’s business the way managers do. The divergence between manager and auditor/ analyst business assessments is likely to be most severe for firms with distinctive business strategies, or organisations that operate in emerging industries. In addition, auditors’ decisions in these circumstances are likely to be dominated by concerns about legal liability, hampering management’s ability to use financial reports to communicate effectively with investors. Finally, the conflicts of interest auditors and analysts can face make their analysis imperfect. Conflicts can potentially induce auditors to side with management to retain the audit, or to enable the audit firm to sell profitable non-audit services to the client. They can also arise for analysts who provide favourable ratings and research on companies to support investment banking services, or to increase trading volume among less-informed investors.

Limited management credibility When is management likely to face credibility problems with investors? There is very little evidence on this question. However, managers of new organisations, firms with volatile earnings or in financial distress, firms facing takeover offers, and organisations with poor track records in communicating with investors should expect to find it difficult to be seen as credible reporters. Where managers have short expected horizons in a business, such as when they approach retirement, there may be a decrease in the likely credibility management brings to an organisation. If management has a credibility problem, financial reports are likely to be viewed with considerable scepticism. Investors will see financial reporting estimates that increase income as evidence that management is padding earnings. This makes it very difficult for management to use financial reports to communicate positive news about future performance.

KEY ANALYSIS QUESTIONS For management interested in understanding how effectively the firm’s financial reports help it communicate with outside investors, the following questions are likely to provide a useful starting point: What are the key business risks that have to be managed effectively? What processes and controls are in place to manage these risks? How are the organisation’s key business risks reflected in the financial statements? For example, credit risks are reflected in the bad debt allowance, and product quality risks are reflected in allowances for product returns and the method of revenue recognition. For these types of risks, what message is the firm sending about the management of these risks through its estimates or choices of accounting methods? Has the firm been unable to deliver on the forecasts underlying these choices? Alternatively, does the market seem to be ignoring the message underlying the firm’s financial reporting choices, indicating a lack of credibility? How does the organisation communicate about key risks that cannot be reflected in accounting estimates or methods? For example, if technological innovation risk is critical for a company, it is unable to reflect how well it is managing this risk through research and development in its financial statements. But investors will still have questions about this business issue.

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LO4

 Other ways to communicate with investors

Given the limitations of accounting standards, auditing and monitoring by financial analysts, as well as the reporting credibility problems faced by management, firms that wish to communicate effectively with external investors are often forced to use alternative media. Three alternative ways managers can communicate with external investors and analysts are: 1 meeting with analysts to publicise the organisation 2 expanding voluntary disclosure 3 using financing policies to signal management expectations. These forms of communication are typically not mutually exclusive.

Analyst meetings One popular way for managers to help mitigate communication problems is to meet regularly with financial analysts who follow the firm. At these meetings, management will field questions about the firm’s current financial performance and discuss its future business plans. In addition to holding analyst meetings, many organisations appoint a director of public relations, who provides further regular contact with analysts seeking more information on the firm. In the 1990s, conference calls became a popular forum for management to communicate with financial analysts. Research evidence finds that firms were more likely to host calls if they were in industries where financial statement data failed to capture key business fundamentals on a timely basis.13 In addition, conference calls themselves appear to provide new information to analysts about a firm’s performance and future prospects.14 While firms continue to meet with analysts, the nature of these interactions has been changed by the introduction of new regulations. As discussed previously, these regulations now require that if firms provide material non-public information to security analysts or professional investors, they must simultaneously (or promptly thereafter) disclose that same information to the public. This has reduced the information that managers are willing to disclose in conference calls and private meetings, making these forums less effective for resolving information problems.

Voluntary disclosure Another way for managers to improve the credibility of their financial reporting is through voluntary disclosure. Accounting rules usually prescribe minimum disclosure requirements, but they do not restrict managers from voluntarily providing additional information. These could include articulating the company’s long-term strategy, specifying non-financial leading indicators that are useful in judging the effectiveness of the strategy implementation, and explaining how the leading indicators relate to future profits, and to forecasts of future performance. Voluntary disclosures can be reported in the firm’s annual report, in brochures created to describe the firm to investors, in management meetings with analysts or  in investor relations responses to information requests. Research into voluntary disclosures finds that firms make disclosures to reduce information risk and to boost stock price if these are likely to be sustainable in the future. They are more Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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likely to provide high levels of disclosure if they have strong earnings performance, issue securities, have more analysts following and have less dispersion in analyst forecasts. In addition, firms with high levels of disclosure have good outcomes on every dimension: a lower cost of capital, a lower bid–ask spread, and increases in share returns, institutional ownership, analyst following and share liquidity. Research examining the market response to management earnings forecasts finds that bad news forecasts are always informative but that good news forecasts are informative only when supported by verifiable forward-looking statements. Finally, research shows that environmental disclosures are positively associated with environmental performance. The initial environmental disclosure is associated with a reduction in the cost of equity and new capital raisings. 15 One constraint on expanded disclosure is the competitive dynamics in product markets. Disclosing proprietary information on strategies and their expected economic consequences may hurt the firm’s competitive position. Managers face a trade-off between providing information that is useful to investors in assessing the firm’s economic performance, and withholding information to maximise the firm’s product market advantage. A second constraint in providing voluntary disclosure is management’s legal liability. Forecasts and voluntary disclosures can potentially be used by dissatisfied shareholders to bring civil action against management for providing misleading information. This seems ironic, since voluntary disclosures should provide investors with additional information. Unfortunately, it can be difficult for courts to decide whether managers’ disclosures were good-faith estimates of uncertain future events that later did not materialise, or whether management manipulated the market. Consequently, many corporate legal departments recommend against management providing much voluntary disclosure. Finally, management credibility can limit the firm’s incentives to provide voluntary disclosures. If management faces a credibility problem in financial reporting, any voluntary disclosures it provides are also likely to be viewed sceptically. In particular, investors may be concerned about what management is not telling them, particularly since such disclosures are not audited.

Selected financial policies Managers can also use financing policies to communicate effectively with external investors. Financial policies that are useful in this respect include dividend payouts, share buy-backs (repurchases), financing choices and hedging strategies. One important difference between this type of communication and additional disclosure is that the firm does not provide potentially proprietary information to competitors. The signal therefore indicates to competitors that a firm’s management is bullish on its future, but it does not provide any details.

Dividend payout policies The firm’s dividend decisions, with regard to proportion or amount of cash payout to shareholders, can provide information to investors on managers’ assessments of the firm’s future prospects. This arises because dividend payouts tend to be ‘sticky’, in  the sense that managers are reluctant to cut dividends. Thus, managers will only increase dividends when they are confident that they will be able to sustain the increased rate in future years. Consequently, investors interpret dividend increases as signals of managers’ confidence in the quality of current and future earnings.16

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Share buy-backs (repurchases) Managers may be able to use share buy-backs (repurchases) to communicate with external investors.17 A share buy-back can occur when the firm buys back its own shares either through a purchase on the open market, through a tender offer or through a negotiated purchase with a large shareholder. Of course, a share buy-back, particularly via a tender offer, is an expensive way for management to communicate with outside investors. The company typically pays a hefty premium to acquire their shares in tender offer repurchases, potentially diluting the value of the shares that are not tendered or not accepted for tender. In addition, the fees to investment banks and lawyers, and share solicitation fees, are not trivial. Given these costs, it is not surprising that research findings indicate that share buy-backs (repurchases) are effective signals to investors about the level and risk of future earnings performance.18 Research findings also suggest that firms that use share buy-backs to communicate with investors have accounting assets that reflect less of firm value and have high general information asymmetry.19 On the other hand, the positive price reaction usually associated with a share buy-back announcement has been associated with holding in-the-money options and earnings management effects, suggesting that the announcement might be part of a strategy to maximise the option payoffs.20

Financing choices Organisations that have problems communicating with external investors may be able to use financing choices to reduce these issues. For example, a firm that is unwilling to provide proprietary information to help dispersed public investors value it may be willing to provide such information to a knowledgeable private investor – which can become a large shareholder/creditor – or a bank that agrees to provide the company with a significant new loan. An organisation with credibility problems in financial reporting can sell shares or issue debt to an informed private investor such as a large customer who has superior information about the quality of its product or service. Such changes in financing and ownership can mitigate communication problems in two ways. First, the terms of the new financing arrangement and the credibility of the new lender or shareholder can provide investors with information to reassess the value of the firm. Second, the accompanying increased concentration of ownership and the role of large block holders in corporate governance can have a positive effect on valuation. If investors are concerned about management’s incentives to increase shareholder value, the presence of a new block shareholder or significant creditor on the board can be reassuring. This type of monitoring arises in leveraged buyouts, in start-ups backed by venture capital firms and in firms with equity partnership investments. In Japanese and German corporations, it may also arise because large banks own both debt and equity and have close working relationships with firms’ managers. Of course, in the extreme, management can decide that the best option for a firm is to no longer operate as a public company. This can be accomplished by a management buyout, where a buyout group (including management) leverages its own investment (using bank or public debt finance), buys the firm and takes it private. The buyout group hopes to run the firm for several years and then take the company public again, hopefully with a track record of improved performance that enables investors to value the firm more effectively.

Hedging An important source of mispricing arises if investors are unable to distinguish between unexpected changes in reported earnings due to management performance and transitory shocks that are

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beyond managers’ control (such as foreign currency translation gains and losses). Managers can counteract these effects by hedging such ‘accounting’ risks. Even though hedging is costly, it may be valuable if it reduces information problems that potentially lead to misvaluation.

KEY ANALYSIS QUESTIONS For management considering whether to use financing policies to communicate more effectively with investors, the following questions are likely to provide a useful starting point for analysis: Have they considered other, potentially less costly, actions, such as expanded disclosure or accounting communication? If not, would these alternatives provide lower cost ways to communicate? Alternatively, have they considered that if management is concerned about providing proprietary information to competitors, or has low credibility, these alternatives may not be effective? Does the firm have sufficient free cash flow to be able to implement a share repurchase program or to increase dividends? If so, these may be feasible options. If the firm has excess cash available today but expects to be constrained in the future, a share buy-back may be more effective. Alternatively, if management expects to have some excess cash available each year, a dividend increase may be in order. Is the firm cash constrained and unable to increase disclosure for proprietary reasons? If so, management may want to consider changing the mix of owners as a way of indicating to investors that another informed outsider is bullish on the company. Of course, another possibility is for management itself to increase its stake in the company.

LO5

 Internal influences on financial reporting quality

As explained earlier in this chapter, internal governance agents, such as corporate boards and audit committees, are responsible for monitoring a firm’s management. Their functions include reviewing business strategy, evaluating and rewarding top management, and assuring the flow of credible information to external parties.

Corporate board The structure and role of the corporate board as a corporate governance structure can be important in providing credible communication about the firm. In order to have a well-functioning corporate board that monitors the decisions of the firm and its management, the ASX Corporate Governance Council Principles and Recommendations (CGCP&R) recommends that the board has a majority of independent directors and is chaired by an independent director.21 A board structured this way should be able to monitor and influence management, and ensure the board’s credibility with market participants. Independent directors with broad experience and reputation bring credibility to the board and firm. Subcommittees of directors should also oversee the nomination, remuneration and audit functions of the firm.

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SUPPORTING CASE

On occasion, we gain insight into how directors act behind the closed doors of the boardroom, when their disagreements and disputes spill over into the public domain. A recent example of this in Australia is Getswift, a logistics software company whose announcements to the stock market were being investigated by the ASIC in 2019 as being potentially misleading.

GETSWIFT From public announcements and other media releases related to a company’s operations, we can speculate about the pressures it faces to maximise its value and not undermine future opportunities for corporate partnerships when it is experiencing operating difficulties. Getswift is a company that has had more than its fair share of publicity for a variety of reasons, and so invites our speculation about its corporate governance. Founded by former AFL player Joel Macdonald in 2015, Getswift operates in the information technology sector. It offers delivery management software that allows customers to dispatch, manage and track their inventory movements in real time. In 2017, it made statements to the market about customer contracts with Fruitbox, the Commonwealth Bank and Amazon that it subsequently revealed were overstated: fewer than half of the contracts it had been publicising actually generated any revenue. The Australian Securities Investment Corporation considered this to be misleading the market, and as a consequence, Getswift faced both a shareholder class action and ASIC legal action. These legal actions had followed a share capital raising of $75 million from investors, and unsurprisingly both new and old shareholders alike were alarmed at the potential consequences: the stock price crashed from $2.92 to 98c, valuing the company at just $30 million. Should the value have been higher? The company’s cash holdings were

$74 million and it held no debt. It appears that the market substantially underpriced its net asset value because it saw that Getswift’s cash was less than its recent capital raising. Its shareholders did not trust its management to even maintain the value of the recent cash injection. Imagine the boardroom discussions at the time: continued corporate survival depended on restoring the share price, but how could that happen? Does the company avoid further legal actions by pulling back from its buoyant approach of trying to convince the market that good times are just around the corner, or does it continue the fine line of talking up the market with hints of good news at the risk of further trouble? Apparently, both views were expressed in the boardroom, because in April 2019 three Getswift directors resigned with immediate effect. Their written statement included the following: ‘We have different views as to the manner in which the company engages with its board’. We can get insight into whether the remaining directors were the ones who preferred a safe approach or a buoyant approach to shareholder relations by what happened next. In 2019, its share price increased suddenly by 20%, due to a strategic partnership in Kuwait that it had announced on Bloomberg but not on the ASX. ASIC reacted by suspending it from trading. Source: 'GetSwift trio exits' by Liz Main, Australian Financial Review, 27 April 2019, p.24; 'Embattled GetSwift suspended from ASX', by Lucas Baird, Australian Financial Review, 29 May 2019, p.20

Audit committee reviews Audit committees are responsible for overseeing the work of the auditor, for ensuring that the financial statements are properly prepared, and for reviewing the internal controls at the company. Audit committees, which are mandated by many stock exchanges, typically comprise three to four outside directors who meet regularly before or after their full board meetings. In recent years, the requirements for audit committees have been strengthened and formalised. In Australia, the ASX’s corporate governance recommendations require listed organisations

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either to explicitly disclose information on their corporate governance activities or to provide a public announcement justifying why they did not follow the guidelines in any area of corporate governance.22 Similar recommendations were introduced by the New Zealand Stock Exchange in 2001. Among other things, these guidelines define best practice for structuring and running an audit committee, including the perceived independence of its members. A well-formed audit committee should take formal responsibility for appointing, overseeing and negotiating fees with external auditors. Audit committee members should be independent directors with no consulting or other potentially compromising relation to management. It is recommended that at least one member of the committee have financial expertise, such as being a qualified accountant, while the rest of the committee must at least be financially literate. Some members of the committee should bring an understanding of the business/industry in which the firm operates. Ideally, the audit committee is expected to be independent of management and to take an active role in reviewing the propriety of the firm’s financial statements. Committee members are expected to question management and the auditors about the quality of the firm’s financial reporting, the scope and findings of the external audit and the quality of internal controls. In reality, however, the audit committee has to rely extensively on information from management as well as internal and external auditors. Given the ground that it has to cover, its limited available time and the technical nature of accounting standards, audit committees are not in a position to catch management fraud or auditors’ failures on a timely basis. Recent research supports this idea, that the audit committee’s role is one of oversight not monitoring, and has questioned the extent to which the audit committee can substantively engage in the audit process.23 How then can the audit committee add value? We believe that many of the financial analysis tools discussed in this book can provide a useful way for audit committees to approach their tasks. Many of the applications of the financial analysis steps discussed for auditors also apply for audit committees. In its scrutiny of financial statements, the committee should use the 80–20 rule, devoting most of its time (80%) to assessing the effectiveness of those few policies and decisions (20%) that have the most impact on investors’ perceptions of the company’s critical performance indicators. This should not require any additional work for committee members, since they should already have a good understanding of the organisation’s key success factors and risks from discussions of the full board. Audit committee members should also have sufficient financial background to identify where in the financial statements the key risks are reflected. Their discussions with management and external auditors should focus on these risks. How well are they being managed? How are the auditors planning their work to focus on these areas? What evidence have they gathered to judge the adequacy of key financial statement estimates? The audit committee also receives regular reviews of company performance from management as part of their regular board duties. Committee members should be especially proactive in requesting information that helps them evaluate how the firm is managing its key risks, since this information can also help them judge the quality of the financial statements. Audit committee members need to ask: Is information on company performance we are receiving in our regular board meetings consistent with the picture portrayed in the financial statements? If not, what is missing? Are additional disclosures required to ensure that investors are well informed about the firm’s operations and performance? Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Finally, audit committees need to focus on capital market expectations, not just statutory financial reports. In today’s capital markets, the game begins when companies set expectations via analyst meetings, press releases and other forms of investor communications. Indeed, the pressure to manage earnings is often a direct consequence of unrealistic market expectations, either deliberately created by management or sustained by their inaction. Thus, it is also important for audit committees to oversee the firm’s investor relations strategy and ensure that management sets realistic expectations for both the short and long term.

KEY ANALYSIS QUESTIONS The following questions are likely to provide a useful starting point for audit committees in their discussions with management and auditors over the firm’s financial statements: How are the key business risks facing the organisation reflected in its financial statements? How are these risks being managed? How are the firm’s key risks reflected in the financial statements – what are the key accounting policies and estimates? What was the basis for the external auditor’s assessment of these items? Is information on the key value drivers and firm performance presented to the full board consistent with the picture of the firm reflected in the financial statements and management commentary? What expectations are management creating in the capital market? Are these likely to create undue pressure to manage earnings?

LO6

 Auditor analysis

With regard to regulating the scope and opinion of the auditor, countries use two different approaches. In the first, used in the US, the audit can be seen to verify the process by which the accounts have been prepared and whether the firm has followed the appropriate accounting rules. The second approach, used in a number of countries, is that the audit not only checks the rules and processes but also considers whether the outputs of those rules and processes provide a reasonable and useful view of the financial situation of the firm. Using the first approach in the US, the auditor is responsible for providing investors with assurance that the financial statements are prepared in accordance with GAAP. This requires the auditor to evaluate whether transactions are recorded in a way that is consistent with the regulator’s rules and whether management estimates reflected in the financial statements are reasonable. The results of the audit are disclosed in the audit report, which is part of the financial statements. If the firm’s financial statements conform to GAAP, the auditor issues an unqualified report. However, if the financials do not conform to GAAP, the auditor is required to issue a qualified or an adverse report that provides information to investors on the discrepancies. Finally, if the auditor is uncertain about whether the firm can survive during the coming year, a going concern report is issued, highlighting the firm’s survival risks. The second, broader definition of an audit is used in countries that have adopted the UK system, such as Australia, New Zealand, Singapore, Hong Kong and India, where a broader review of the organisation is undertaken. In these situations, the auditor is required not only to assess whether the financial statements are prepared in accordance with the prevailing GAAP, but also

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to judge whether they fairly reflect the client’s underlying economic performance. Auditors are often asked if the financial statements provide a ‘true and fair’ view of the organisation. This additional assurance requires more judgement on the part of the auditor but also increases the value of the audit to outside investors. The key procedures involved in a typical audit include: 1 understanding the client’s business and industry to identify key risks for the audit 2 evaluating the organisation’s internal control system to assess whether it is likely to produce reliable information 3 performing preliminary analytic procedures to identify unusual events and possible errors 4 collecting specific evidence on controls, transactions and account balance details to form the basis for the auditor’s opinion. In most cases, client management is willing to respond to issues raised by the audit to ensure that the company receives an unqualified audit opinion. Once the audit is completed, the auditor presents a summary of audit scope and findings to the audit committee of the firm’s board of directors. It is worth noting that in both systems, the audit is not intended to detect fraud. Of course, in some cases, it may do so, but that is not its purpose. Detecting fraud is the domain of the internal audit.

Challenges facing the audit industry To understand the current problems facing the audit industry,24 it is necessary to consider several historical events that created pressures on audit firms to cut costs and seek alternative revenue sources. The first of these was a concern over a potential oligopoly being formed by the large audit firms, with regulators pressuring the major firms to compete aggressively with each other for clients. The second event was a shift in legal standards, which enabled investors of companies with accounting problems to seek legal redress against the auditor without having to show that they had specifically relied on questionable accounting information in making their investment decisions. Instead, they could assert that they had relied on the stock price itself, which had been affected by the misleading disclosures. This change, along with increasing litigiousness (at least in the US), dramatically increased the lawsuit risk for auditors. Audit firms then lobbied for mechanical accounting and auditing standards and developed standard operating procedures to reduce the variability in audits. This approach reduced the cost of audits and provided a defence in the case of litigation. However, it also meant that auditors were more likely to view their role narrowly, rather than as matters of broader business judgement. Unfortunately, while mechanical standards make auditing easier, they do not necessarily increase corporate transparency.25 Audit firms also decided that one way to compete with each other was by aggressively pursuing a high-volume (low-profit) strategy. Audit partners became responsible for attracting new audit clients and retaining existing clients. This made it difficult for partners to be effective watchdogs. The large audit firms also responded to challenges to their core business by developing new higher-margin, higher-growth consulting services. This diversification strategy deflected top management energy and partner talent from the audit side of the business to the more profitable consulting part. The Enron debacle in 2001 dramatically illustrated many of the problems facing the industry. The use of mechanical, standardised audits encouraged Enron’s auditors, Arthur Andersen, to

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take a narrow perspective on their role as financial report watchdogs. Even though they may have believed that Enron’s reports met GAAP, they failed to ask big-picture questions about their client’s strategy, the core risks and the company’s overall transparency. Mechanical standards also made it easier for Enron’s unscrupulous managers to meet the letter of GAAP (although in the end they did not even do that), but to evade their spirit, concealing important obligations and overstating profits. Finally, the pressure on Arthur Andersen to retain their clients and to grow their firms’ consulting businesses reduced their independence, leading them to approve questionable accounting decisions and to work closely with management to meet Enron’s financial reporting objectives. These problems prompted regulatory changes to correct the structural problems in the audit industry. As discussed earlier in this chapter, regulatory and corporate governance initiatives have clarified the audit function and its separation from the role of management. Examples include: restricting audit firms from providing certain types of consulting services to their clients initiating or requiring an audit committee of the board of directors to become more active in appointing and reviewing the audit having the CEO and CFO sign off that the financials fairly represent the financial performance of the company.

Role of financial analysis tools for auditing How can the financial analysis tools discussed in this book be used by audit professionals? The four steps in financial analysis are strategy analysis, accounting analysis, financial analysis and prospective analysis. We discuss how each of these is relevant to the audit.

Strategy analysis One of the fundamental challenges facing auditors is how to narrow the scope of their work. Large corporations undertake millions of transactions each year. It is not possible for any audit to review all of these, so the auditor has to decide where to focus attention and time. Strategy analysis can help identify those few key areas of the business that are critical to the organisation’s survival and future success. These are the areas that investors want to understand so that they can evaluate the firm’s value proposition and how well it is managing key success factors. They are also likely to be areas worth further testing and analysis by the auditor to assess their impact on the financial statements. For example, the key success factors for a firm that pursues a strategy of targeted acquisitions are the skills and ability to manage acquisitions. The key success factor for a financial services business is managing loan risks, and the key risk for a high technology product firm is managing its product innovation. Strategy analysis is critical to the first stage of the audit, understanding the client’s business, industry and risks. It is important that the auditor develop the expertise to be able to identify the one or two key risks facing their clients.

Accounting analysis For the auditor, accounting analysis involves two steps. First, the auditor must understand how the key success factors and risks are reflected in the financial statements. For a firm making acquisitions, these are reflected in the valuation of goodwill. If it fails to manage its acquisitions successfully, it will have to take a write-down of goodwill. For financial services companies, the

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key success factors and risks are reflected in loan loss reserves. If a firm fails to manage its loan process properly, it will begin making loans to high-risk clients, leading to higher future default rates and requiring higher loan loss estimates. In contrast, for a high technology product firm, accounting rules restrict the way its key success factor, product innovation, can be accounted for. For example, accounting standards such as IAS 38/AASB138 only allow (most) R&D outlays to be expensed in the year in which they are incurred.26 While such limits simplify the audit, unintended consequences are that the financial statements are not a very timely source of information on the company’s innovation, and the auditor’s service is less valuable. Managers of a high technology product firm will have to use other ways of providing credible information to investors on its product innovation. The second step in accounting analysis is for the auditor to evaluate management judgement as reflected in the key financial statements items. For example, for a financial services company where loan loss reserves are critical, the auditor will need to design tests and collect evidence to evaluate management’s forecasts of future loan losses implicit in the reserve. The auditor must assess whether these forecasts are reasonable given the company’s historical performance, the current economic climate, and the credit review and collection process in place in the organisation. For a firm where goodwill valuations are critical, the auditor must judge whether the current performance of acquired companies meets forecasts made by management at the time of the acquisition and reflected in the price paid for the target.

Financial analysis Auditors use financial ratio analysis as part of their analytic review. Financial ratios help auditors judge whether there are any unusual performance changes for their client, either relative to past performance or relative to their competitors. Auditors should investigate such changes further to ensure management can explain the reasons for the change, and to determine what additional tests are required to satisfy that the reported changes in performance are justified. For example, financial ratio analysis of WorldCom’s financial performance should have revealed a significant decline in the company’s cost structure that was not matched by any of its competitors. Such analysis should have been a red flag for the auditor that prompted a detailed examination of WorldCom’s costs and capitalisation policies, and might have led the auditor to detect the massive fraudulent change in capitalisation of network costs at WorldCom. Careful ratio analysis can also reveal whether clients are facing business problems that may induce management to conceal losses or keep key obligations off the balance sheet. Such information should alert auditors to the likely need for extra care and additional detailed tests to reach a conclusion on the client’s financial statements.

Prospective analysis Auditors use prospective analysis to assess whether management’s estimates and forecasts are consistent with the firm’s economic position. Auditors typically do not concern themselves with the stock market’s valuation of their client. Yet there is valuable information for auditors in the market’s valuation. The market’s perception of a client’s future performance provides a useful benchmark to affirm or refute the auditor’s assessment of the client’s prospects. If the auditor reaches a different conclusion about a client from that of the market, it is worth exploring reasons for the differences. Is the client failing to publicly disclose some critical information that is known to the auditor? Or is the auditor too optimistic or pessimistic?

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If the auditor concludes that the market is overly optimistic about a client, is additional disclosure required to help investors get a more realistic view of the company’s prospects? Are management’s estimates and forecasts in the financial statements realistic, or do they seek to avoid disappointing the market? Alternatively, if the auditors decide that the market is overly pessimistic about their client’s prospects, what additional information, if any, can be disclosed to increase transparency? Is the company too conservative in its financial statement estimates and forecasts?

KEY ANALYSIS QUESTIONS The following questions are likely to provide a useful starting point for auditors when analysing a client’s financial statements:

INDUSTRY INSIGHT

What are the key business risks facing the organisation? How well are these risks managed? What are the key accounting policies and estimates that reflect the firm’s key risks? What tests and evidence are required to evaluate management judgement that is reflected in these accounting decisions? Do key ratios indicate any unusual changes in client performance? What tests and evidence are required to understand the causes of such changes? Has firm performance deteriorated, creating pressure on management to manage earnings or record off-balance-sheet transactions? If so, what additional tests and evidence are required to provide assurance that the financial statements are consistent with accounting standards and, for Australian/NZ/UK system auditors, fairly represent the firm’s financial position? How is the market assessing the client’s prospects? If differently from the auditor, what is the reason for the difference? If the market is overly optimistic or pessimistic, are there implications for client disclosure or accounting estimates?

A PRACTITIONER ADVISES Leading Australian researcher on how auditing can be improved: A major challenge facing the auditing industry is the perception by market participants that accounting firms provide low-quality services. Regulators have blamed this on accounting firms having compromised independence due to their close relationships with client management and also receiving lucrative contracts for consulting services with their clients. Their solutions to increasing independence include mandatory rotation of audit firms and audit partners, and even calls to split the big four accounting firms. However, there is limited academic support for these initiatives. What the literature does indicate is that auditors struggle to fully understand a business when its staff have limited preparation time, insufficient industry knowledge and issues with management transparency.

The audit committee predominantly functions to monitor the financial reporting decisions of management and to oversee the external audit function. Academic research shows that audit committees are more effective when individual audit committee members have accounting expertise, a strong social and professional standing, and fewer social connections with management. Expert views on how board governance can be improved, from The Conversation website: There is a popular notion that women are not risk takers and their mere presence on a board will reduce risky strategies and behaviours. However, research shows that women who choose to follow a career path leading to a directorship are not ‘typical’ women in terms of risk aversion. Female directors are likely to be less risk-averse than the ‘typical’ woman – otherwise they would not have chosen this career path. So, while diversity on boards brings other benefits – better

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performance, better overall board attendance, different committee duties – it does not reduce risk. Source: Adapted from Renee Adams, ‘Risky Business: why we shouldn’t stereotype female board directors’, The Conversation, 3 December 2014. Are Australian executives rewarded for achieving sustainability targets as well as financial targets? The majority of leading Australian companies have either a board sub-committee or senior management committee responsible for sustainability issues. And a substantial majority also mention some aspect of sustainability performance when describing their remuneration policy. Source: Adapted from Alice Klettner, ‘Beyond the bottom line: how to reward executives for sustainable practice’, The Conversation, 14 May 2012 Big investors have begun to pressure the companies in their portfolios to report on climate risks. In 2017, one of the world’s largest investors, BlackRock, voted in favour of a shareholder resolutions calling on oil giant ExxonMobil to increase its climate change reporting. Source: Adapted from Rosemary Sainty, ‘The G20’s new guidelines will help investors tackle climate change’, The Conversation, 7 July 2017

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This was followed up by BlackRock in 2020 by a decision to ‘exit investments that “present a high sustainability-related risk”’. It is establishing 75 new exchange-traded funds to allow clients to avoid investment in companies that may be adding to climate change. But perhaps the largest change is BlackRock’s apparent willingness to use its considerable shareholder power to demand climate action. It has voted against (or withholding votes from) directors at 2700 companies where it felt that companies and boards were not producing effective sustainability disclosures or implementing frameworks for managing these issues. Source: Adapted from Edward Helmore, ‘Activists cheer BlackRock’s landmark climate move but call for vigilance’, The Guardian, Australia edition, 15 January 2020 Reflective activity: What do these industry insights indicate about internal and external influences on financial reporting? How do management communicate effectively with investors, and is it always with words, or can it also be with actions? Give examples from this industry insight

SUMMARY This chapter discussed how many of the financial analysis tools developed in Chapters 2–8 can be used by managers to develop a coherent disclosure strategy, and by corporate board members and external auditors to improve the quality of their work. By communicating effectively with investors, management can potentially reduce information problems for outside investors, lowering the likelihood that the shares will be mispriced or unnecessarily volatile. This can be important for firms that wish to raise new capital or avoid takeovers, or whose management is concerned that its true job performance is not reflected in the firm’s share price. The typical way for organisations to communicate with investors is through financial reporting. Accounting standards and auditing make the reporting process a way for managers to not only provide information about the firm’s current performance, but also to indicate, through accounting estimates, where they believe the firm is headed

in the future. However, financial reports are not always able to convey the types of forward-looking information that investors need. Accounting standards often do not permit firms to capitalise outlays, such as internally generated intangible assets and elements of R&D expenditure, that provide significant future benefits to the firm. A second way in which management can communicate with investors is through non-accounting means. We discussed several such mechanisms, including meeting with financial analysts to explain the firm’s strategy, current performance and outlook; disclosing additional information, both quantitative and qualitative, to provide investors with similar information as management’s; and using financial policies (such as share buy-backs, dividend increases and hedging) to help signal management’s optimism about the firm’s future performance. In this chapter, we have stressed the importance of communicating effectively with investors. But organisations

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also have to communicate with other stakeholders, including employees, customers, suppliers and regulatory bodies. Many of the same principles discussed here can also be applied to management communication with these other stakeholders. Finally, we examined the capital market role of internal governance agents, such as the corporate board and audit committees. We also considered the role of the auditor in improving financial reporting quality. All have recently faced considerable public scrutiny following a spate of financial

reporting meltdowns. Much has been done to improve the governance and independence of these intermediaries. We focus on how the financial analysis tools developed in the book can be used to improve the quality of audit work. The tools of strategy analysis, accounting analysis, financial analysis and prospective analysis can help auditors (and audit committee members) to identify the key issues in the financial statements to focus on and provide common sense ways of assessing whether there are potential reporting problems that merit additional testing and analysis.

CHECKING AND APPLYING YOUR LEARNING 1 Explain how external influences on financial reporting quality can determine the extent to which a new manager’s optimism in reporting has inflated actual reported results. What comparisons might they need to make, and what additional information would they need? How would this influence reporting by the new manager in the future?  LO1 2 Apart from the mandated financial statements, management has a number of ways of communicating with investors. List those ways using the internet.  LO2 3 What are the factors that increase the credibility of accounting communication? In what situations does that credibility breakdown?  LO3 4 What is one important difference between analyst meetings and voluntary disclosures on the one hand, and financial policies on the other? Which do you think is more credible, and why?  LO4 5 Explain how internal influences on financial reporting quality can check the extent to which managers’ optimism in reporting might otherwise inflate reported results. What processes occur that limit managerial discretion?  LO5 6 There are two approaches to auditing: one that verifies that accounting rules have been followed (processfocused) and another that verifies that the financial statements reflect the firm’s underlying performance (output-focused). Discuss how each method might or might not incorporate elements of the other. Does a process-focused approach also consider the underlying performance in applying accounting rules? Does an output-focused approach also develop rules for applying judgement?  LO6 7 Two years after a successful public offering, the CEO of a biotechnology company is concerned about stock market uncertainty surrounding the potential of new

drugs in the development pipeline. In his discussion with you, the CEO notes that, even though they have recently made significant progress in their internal R&D efforts, the share price has performed poorly. What options does he have to help convince investors of the value of the new products? Which of these options are likely to be feasible?  LO2 8 Why might the CEO of the biotechnology firm discussed in Question 7 be concerned about the firm being undervalued? Would the CEO be equally concerned if the shares were overvalued? Do you believe that the CEO would attempt to correct the market’s perception in this overvaluation case? How would you react to company concern about market under- or overvaluation if you were the firm’s auditor? Or if you were a member of the audit committee?  LO2 9 Management frequently objects to disclosing additional information on the grounds that it is proprietary. In particular, many corporate managers expressed strong opposition to increased accounting disclosures on: a executive share-based compensation b business segment performance.  What are the potential proprietary costs from expanded disclosures in each of these areas? If you conclude that proprietary costs are relatively low for either, what alternative explanations do you have for management’s opposition?  LO3 10 a What are likely to be the long-term critical success factors for the following types of firms? A high technology company such as Microsoft A large low-cost retailer such as Kmart b How useful is financial accounting data for evaluating how well these two companies are managing their critical success factors? What other types of information would be useful in your

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evaluation? What are the costs and benefits to these companies from disclosing this type of information to investors?  LO4 11 Under a management buyout, the top management of a firm offers to buy the company from its shareholders, usually at a premium over its current share price. The management team puts up its own capital to finance the acquisition, with additional financing typically

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coming from private buyout firms and private debt. If management is interested in making such an offer for its firm in the near future, what are its financial reporting incentives? How do these differ from the incentives of management that are not interested in a buyout? How would you respond to a proposed management buyout if you were the firm’s auditor? What if you were a member of the audit committee?  LO6

CASE LINK Concepts from this chapter are used in the following case in Part 4:

Case 11 Diligent (Part 2): Governance issues.

ENDNOTES 1

2

3

4

M. Jensen and W. Meckling, ‘Theory of the firm: managerial behavior, agency costs, and capital structure’, Journal of Financial Economics 3 (October 1976): 305–60, analysed agency problems between managers and outside investors. Subsequent work by B. Holmstrom and others examined how contracts between managers and outside investors could mitigate the agency problem. The seminal work on this question is K. J. Murphy and J. L. Zimmerman, ‘Financial performance surrounding CEO turnover’, Journal of Accounting and Economics 16 (January/April/July 1993): 273–315, who find a strong relation between CEO turnover and earnings-based performance. K. A. Farrell and D.A. Whidbee (2003) ‘Impact of firm performance expectations on CEO turnover and replacement decisions’, Journal of Accounting and Economics 36(1–3), 165–96 and S.M. Puffer and J.B. Weintrop (1991) ‘Corporate performance and CEO turnover: The role of performance expectations’, Administrative Science Quarterly: 1–19 find that it is the deviation from expected earnings that drives the CEO turnover decision. There has been a debate in the literature over reporting biases prior to IPOs. The traditional view of aggressive reporting using accruals was established by S. Teoh, I. Welch and T. Wong, ‘Earnings management and the long-run market performance of initial public offerings’, Journal of Finance 63 (December 1998): 1935–74, and S. Teoh, I. Welch and T. Wong, ‘Earnings management and the underperformance of seasoned equity offerings’, Journal of Financial Economics, 50 (October 1998): 63–99. Subsequent research has both challenged this view (R. Ball and L. Shivakumar, ‘Earnings quality at initial public offerings’, Journal of Accounting and Economics 45(2–3), (2008): 324–49) and supported ‘real’ rather than ‘accrual’ earnings management (D.A. Cohen and P. Zarowin, ‘Accrual-based and real earnings management activities around seasoned equity offerings’, Journal of Accounting and Economics 50(1), (2010): 2–19. This market imperfection is often referred to as a ‘lemons’ or ‘information’ problem. It was first discussed by G. Akerlof in relation to the used car market (see ‘The market for “Lemons”: Quality uncertainty and the market mechanism’, Quarterly Journal of Economics 90 (1970): 629–50). Akerlof recognised that the seller of a used car knew more about the car’s value than the buyer. This meant that the buyer was likely to end up overpaying, since the seller

5

6 7

would accept any offer that exceeded the car’s true value and reject any lower offer. Car buyers recognised this problem and would respond by only making low-ball offers for used cars, leading sellers with high-quality cars to exit the market. As a result, only the lowest quality cars (the ‘lemons’) would remain in the market. Akerlof pointed out that qualified independent mechanics could correct this market breakdown by providing buyers with reliable information on a used car’s true value. D. J. Skinner, ‘Earnings disclosures and stockholder lawsuits’, Journal of Accounting and Economics (November 1997): 249–83, finds that firms with bad earnings news tend to pre-disclose this information, perhaps to reduce the cost of litigation that inevitably follows bad news quarters. J.R. Graham, C.R. Harvey and S. Rajgopal, ‘The economic implications of corporate financial reporting’, Journal of Accounting and Economics 40(1–3)(2005): (2005): 3–73, conducted a survey and interviews with evidence supporting the importance to managers of carefully managing their market disclosures. Details of the financial statements and their content are also discussed in Chapter 3. V. Beattie and M. J. Jones, 'The use and abuse of graphs in annual reports: a theoretical framework and an empirical study', Accounting and Business Research 22(88), (1992): pp. 291–303; 'A comparative study of the use of financial graphs in the corporate annual reports of major U.S. and U.K. companies', Journal of International Financial Management and Accounting 8(1), (1997): pp. 33–68; 'Australian financial graphs: an empirical study', Abacus 35(1), (1999); 'Changing graph use in corporate annual reports: a time-series analysis', Contemporary Accounting Research 17(2), (2000): pp. 23–26 ; ‘A six-country comparison of the use of graphs in annual reports’, The International Journal of Accounting 36(2) (May 2001): pp. 195–222. J. K. Courtis, 'Corporate Annual Report Graphical Communication in Hong Kong: Effective or Misleading?', Journal of Business Communication 34(3) (1997): pp. 269–284. C. Frownfelter and C. Fulkerson, ‘Linking the incidence and quality of graphics in annual reports to corporate performance: An international comparison’, Advances in Accounting Information Systems 6, (1998): pp. 129–151. C. Frownfelter-Lohrke and C. Fulkerson, ‘The incidence and quality of graphics in annual reports: an international comparison’, Journal of Business Communication 38, (2001): pp. 337–357. P. J. Steinbart, ‘The auditor’s responsibility for the

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 8

 9

10

11

12

13

14

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accuracy of graphs in annual reports: some evidence of the need for additional guidance’, Accounting Horizons (1989): pp. 60–70. P. Mather, A. Ramsay, and A. Serry, 'The use and representational faithfulness of graphs in annual reports: Australian evidence', Australian Accounting Review 6(12), (1996): pp. 56–63. D. Burgess, et al., 'Does graph design matter to CPAs and financial statement readers?', Journal of Business & Economics Research 6.5 (2008): p. 111. J. R. Johnson, R. R. Rice, and R. A. Roemmich, 'Pictures that Lie: The Abuse of Graphs in Annual Reports', Management Accounting (October 1980): pp 50–56. Beattie and Jones, ‘The use and abuse of graphs in annual reports: Theoretical framework and empirical study Accounting and Business Research 1 (88), September 1992. Examples include accounting standard setters such as the International Accounting Standards Board (IASB), Australian Accounting Standards Board (AASB) in Australia, Financial Reporting Standards Board (FRSB) in New Zealand, and Financial Accounting Standards Board (FASB) in the US. Financial regulators include Australian Securities and Investments Commission (ASIC) in Australia, Securities Commission in New Zealand and the Securities Exchange Commission (SEC) in the US. For example, G. Foster, ‘Briloff and the capital market’, Journal of Accounting Research 17(1) (Spring 1979): 262–74, finds firms that are criticised for their accounting by Abraham J. Briloff on average suffer an 8% decline in their share price. K. Handley E. Evans & S. Wright, ‘Understanding participation in accounting standard-setting: The case of AASB ED 192 Revised Differential Reporting Framework’, Accounting and Finance (29 May 2019), https://doi.org/10.1111/acfi.12490. However, recent research has identified how the political and technical aspects of standard-setting were separated in the development of a particular standard. J.J. Young, ‘Separating the political and technical: Accounting standard‐setting and purification’, Contemporary Accounting Research 31(3): 713–47. See S. Tasker, ‘Bridging the information gap: Quarterly conference calls as a medium for voluntary disclosure’, Review of Accounting Studies, 3(1–2) (1998): 137–67. See R. Frankel, M. Johnson and D. Skinner, ‘An empirical examination of conference calls as a voluntary disclosure medium’, Journal of Accounting Research 37(1) (Spring 1999): 133–50, and M.D. Kimbrough, ‘The effect of conference calls on analyst and market underreaction to earnings announcements’, Accounting Review 80(1) (2005): 189–219. Research on voluntary disclosure includes M. Lang and R. Lundholm, ‘Cross-sectional determinants of analysts’ ratings of corporate disclosures’, Journal of Accounting Research 31 (Autumn 1993): 246– 71; Lang and Lundholm, ‘Corporate disclosure policy and analysts’, Accounting Review 71 (October 1996): 467–92; M. Welker, ‘Disclosure policy, information asymmetry and liquidity in equity markets’, Contemporary Accounting Research (Spring 1995); C. Botosan, ‘The impact of annual report disclosure level on investor base and the cost of capital’, Accounting Review (July 1997): 323–50; P. Healy, A. Hutton and K. Palepu, ‘Stock performance and intermediation changes surrounding sustained increases in disclosure’, Contemporary Accounting Research 16(3) (Fall 1999): 485–521; and A. P. Hutton, G. S. Miller and D. J. Skinner, ‘The role of supplementary statements with management earnings forecasts’, Journal of Accounting Research 41(5) (2003): 867–90; J.R. Graham, C.R. Harvey and S. Rajgopal, The economic implications of corporate financial reporting’, Journal of Accounting and Economics, 40(1–3) (2005): 3–73; P. M. Clarkson,

16

17

18

19

20

21

22

23

24

25

26

Y. Li, G. D. Richardson and F. P. Vasvari, ‘Revisiting the relation between environmental performance and environmental disclosure: An empirical analysis’, Accounting, Organisations and Society, 33 (4–5), 303–327; and D. S. Dhaliwal, O. Z. Li, A. Tsang and Y. G. Yang, ‘Voluntary nonfinancial disclosure and the cost of equity capital: The initiation of corporate social responsibility reporting’, Accounting Review 86(1) (2011): 59–100. Findings by P. Healy and K. Palepu, ‘Earnings information conveyed by dividend initiations and omissions’, Journal of Financial Economics, 21 (1988): 149–75, indicate that investors interpret announcements of dividend initiations and omissions as managers’ forecasts of future earnings performance. The rules governing the ability and way that share buy-backs occur differ from country to country. For example, in Australia the shares bought back (through various means) must be cancelled. On the other hand, in the US the arrangement is known as stock repurchases, and firms can hold the repurchased securities (in themselves) as treasury stock (which can later be resold). See L. Dann, R. Masulis and D. Mayers, ‘Repurchase tender offers and earnings information’, Journal of Accounting and Economics (September 1991): 217–52; and M. Hertzel and P. Jain, ‘Earnings and risk changes around stock repurchases’, Journal of Accounting and Economics (September 1991): 253–76. See M. Barth and R. Kasznik, ‘Share repurchases and intangible assets’, Journal of Accounting and Economics 28 (December 1999): 211–41. B. Balachandran, K. Chalmers and J. Haman, ‘On-market share buybacks, exercisable share options and earnings management’, Accounting and Finance, 48(1) (2008): 25–49. The definition of an ‘independent director’ used in ASX CGCP&R is one who is a non-executive director not involved with the management of the firm, and who does not have any business or other interests that could be seen to interfere with their independent judgement with regard to matters relating to the firm. The types of issues covered by the corporate governance guidelines include: the role and function of management and the board of directors; structure of the board; promotion of ethical and responsible decision-making; ensuring quality financial reporting, including a true and fair view opinion and a audit committee; disclosure quality; risk management; shareholder rights; benchmarking performance; remuneration; and rights of other stakeholders. N. M. Brennan and C. E. Kirwan, ‘Audit committees: practices, practitioners and praxis of governance’, Accounting Auditing and Accountability, 28(4) (2015): 466–93. See P. Healy and K. Palepu, ‘The fall of Enron’, Journal of Economic Perspectives 17 (Spring 2003): 3–26; and P. Healy and K. Palepu, ‘How the quest for efficiency undermined the market’, Harvard Business Review 81 (July 2003). For example, M. Nelson, J. Eliott and R. Tarpley, ‘Evidence from auditors about managers’ and auditors’ earnings management decisions’, Accounting Review 77 (2002 supplement): 175–202, show that mechanical accounting rules for structured finance transactions lead to more earnings management. Under the IAS and similar standards, R&D activity is broken into two components: the research phase and the development phase. All of the costs of the research phase must be expensed as incurred. In the development phase, some costs can be capitalised if they meet a series of requirements, but in most cases they too will need to be expensed as incurred. See IAS 38 and AASB 138.

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PART

4

Further case studies CASE 1 Qantas CASE 2

Airlines: Depreciation differences

CASE 3

Recasting financial statements

CASE 4

Cochlear: Provisions and patent disputes

CASE 5

Accounting analysis: Cash flow reconciliation

CASE 6 Valuation ratios in the retail industry 2010 to

2013

CASE 7

Dick Smith

CASE 8 Resinex CASE 9

Foster’s–Southcorp merger

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CASE STUDY

298

PART 4 FURTHER CASE STUDIES

CASE 1

QANTAS

This case relates to Chapters 2, 3, 4, 5, 6, 7 and 8.

Part A Introduction Qantas is the largest operator within the Australian air transport industry.1 Various events and changes that have occurred within the industry over the past decade have resulted in high levels of both media and regulatory scrutiny for the company. Qantas offers a relatively generic product (passenger air transport) operating in a domestic market in which it is dominant, as well as in international markets where there is more competition. Within both of these markets, Qantas has worked hard to develop and maintain a competitive advantage to enhance profitability.

Background and history Queensland and Northern Territory Aerial Services Limited (Qantas) was established in Queensland in 1920, and initially provided joy-riding and demonstration flights. Its operations were expanded in 1922 to include scheduled airmail services between the towns of Charleville and Cloncurry, subsidised by the Australian government. It was on this route that commercial passenger aircraft were first introduced to Australia in 1924. Qantas began overseas passenger services in 1935, with flights between Darwin and Singapore. Both the domestic and international operations of Qantas expanded significantly in the years leading up to World War II. As the international air transport industry expanded, so did the role of government in managing airline operations. This included involvement in negotiating air traffic rights, determining airfares between countries and in developing international standards for operations through organisations such as the International Civil Aviation Organisation. Such increasing involvement, along with a desire to see Australian control of this emerging mode of transport, led to the Australian Commonwealth government taking the decision to nationalise Qantas in 1947, by buying up all the shares in the company. Similar to many other international airlines, Qantas then developed as a wholly government-owned organisation, operating in a highly regulated and protected international industry.

The domestic air transport industry was also highly regulated at this time. After acquiring Qantas, the government transferred the airline’s domestic operations to the newly formed, government-owned, Trans-Australia Airlines (TAA; later to become Australian Airlines). TAA, along with the privately owned Ansett Australia Ltd, operated under what became known as the ‘Two Airlines’ policy, with the objective of maintaining two economically viable operators for the domestic market. The policy sought to ensure the provision of interstate services by regulating airline management matters such as timetables, fare levels and route structures.2 Thus the domestic air transport industry was also forced to operate in a highly regulated and protected environment. The most significant development in the air transport industry over the period 1950 to 1980 was the continually increasing capacity of aircraft. This saw a reduction in seat per kilometre costs, which was partially reflected in reduced airfares, fuelling consumer demand and contributing to rapid growth in the airline industry. Management and administrative practices also developed during this period in line with new technological developments. These addressed many aspects of airline operations, including computerised reservation systems, ticketing systems and ticket distribution procedures, as well as settlement of accounts for ticket sales. Organisations such as the International Air Transport Association developed to facilitate interairline relationships and the distribution of tickets through travel agencies. Although subsequent technological developments may have allowed further improvements in such procedures, the heavy regulation of the industry meant that there were too many impediments and too few economic incentives to review these operations. The 1980s saw the breakdown in government regulation of airfares internationally, foreshadowing major changes that were to come in the air transport industry, both in Australia and overseas. Though the industry is still regulated, the focus for regulators is on safety issues and ensuring viable route capacity rather than price setting. This change was realised through several key events, beginning

This case was adapted and updated by Sue Wright from an original work by Professor Peter Wells and Dr Anna Wright, University of Technology Sydney. This case is intended solely as a basis for class discussion and is not intended to serve as an endorsement, source of primary data or illustration of effective or ineffective management.

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in 1991 with the Australian government announcing its intention to privatise Qantas (49%) and Australian Airlines (100%). In 1992, the government removed the barrier between the provision of international and domestic air transport in Australia, allowing Qantas to re-enter the domestic air transport industry. Qantas re-entered the market by buying Australian Airlines in September 1992 and merging the operations of the two airlines under the single Qantas brand in October 1993. At the same time, the Australian government decided to fully privatise Qantas, through the sale of 25% of the airline to British Airways in March 1993 followed by a public share offer in June 1995. On 31 July 1995, the privatisation was completed and Qantas shares were listed on the Australian Securities Exchange. Under Australian law, Qantas must be at least 51% Australian owned, thus the level of foreign ownership is constantly monitored by the federal government.3 In 1999, Qantas, along with American Airlines, British Airways, Canadian Airlines and Cathay Pacific, launched the global airline alliance oneworld. This alliance, which has now grown to 13 member airlines, along with some 30 affiliated airlines, aims to provide smoother service and a wider range of network destinations to passengers. At the same time, the operational synergies of the member airlines can keep costs down. oneworld competes with two other major airline alliances, Star Alliance and SkyTeam, with the three alliances combined flying 61% of all passengers worldwide. On 14 September 2001, there was a further shakeup in the Australian airline industry with the collapse of Ansett Australia. Ansett had been Qantas’ main domestic competitor, and its sudden collapse led to Qantas temporarily holding nearly 90% market share. The remainder was held by budget airline Virgin Blue, launched only one year earlier. Qantas was able to capitalise on these events, expanding its fleet by obtaining new aircraft just three months after Ansett’s demise. This short delivery timeframe was made possible through the downturn in the global air passenger industry, due to the terrorist attacks in the US, which took place just three days before Ansett suspended all its flights. However, Virgin also saw an opportunity, and expanded its domestic operations such that Qantas’ market share fell back down to 60%. In turn, Qantas launched Jetstar Airways, a wholly owned subsidiary, in 2003 to target the low-cost market. Qantas thus runs a two-brand strategy in which the Qantas brand targets the premium full-service market. Under this strategy, the Qantas group accounts for approximately 60% of the domestic market.4

299

Qantas’ main business remains the transportation of passengers, both internationally and domestically. In addition to the aforementioned Qantas and Jetstar brands, Qantas also operates the subsidiary Qantaslink, serving regional markets, and Jetconnect, a trans-Tasman service linking Auckland and Wellington with Brisbane, Sydney and Melbourne. Qantas also runs Network Aviation, an air charter carrier bought by Qantas in 2011, fulfilling flyin fly-out contracts with mining companies in Western Australia. In 2017–18, the Qantas group carried 55.27 million passengers5 and, excluding codeshares, served 65 domestic and 27 international destinations.

Industry analysis Passenger air transport accounted for 86.25% of Qantas’ operating revenues in 2017–18, which can be separated into international and domestic passenger operations.6 The separate analyses reflect differences in the market for air transport across the segments, together with availability of both industry and firm-specific information.

International air transport International air transportation between Australia and foreign destinations is provided by Qantas and a number of overseas airlines. Access for Australian airlines to overseas markets is typically conditional upon reciprocal access for carriers from that country to the Australian market, so the extent of competition on particular routes will vary considerably. Because of Australia’s geographical isolation, the overwhelming majority of international passenger traffic arrives and departs by air. A detailed breakdown of international passenger travel movements to Australia is shown in the graphs provided in Figures C1.1, C1.2, C1.3 and C1.4. These show that international passenger movements to Australia increased strongly over the period 2009–19, with both domestic and international visitors almost doubling over this 10-year period. Throughout this period the majority of passengers have been short term (96.6% in 2013). However, there have been a number of shifts in the balance between Australian residents and overseas visitors in the number of arrivals and departures. In 1982, Australian residents accounted for 56.7% of short-term arrivals and departures. This decreased to a low of 40% in 1996, but then rebounded to be 54% in 2019. A number of factors have contributed to these changes.

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CASE STUDY

Case 1 QANTAS

PART 4 FURTHER CASE STUDIES

FIGURE C1.1 Short-term visitor arrivals, Australia – June 1979 to June 2019

Short-term visitor arrivals 9 8 7 Sydney Olympics Millions

6 5 GFC

SARS

4 Brisbane Expo 3

2001 11 Sept. attacks Asian financial crisis

2 1

0 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 Source: Based on ABS Cat. Nos 3401, licensed under the Creative Commons Attribution 4.0 International licence.

FIGURE C1.2 Short-term resident returns, Australia – June 1979 to June 2019 12 Short-term resident returns 10

8

Millions

CASE STUDY

300

6

GFC

4

SARS

2

2002 Bali bombings Early 1990s recession

2001 11 Sept. attacks

1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 Source: Based on ABS Cat. Nos 3401, licensed under the Creative Commons Attribution 4.0 International licence.

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Case 1 QANTAS

301

CASE STUDY

FIGURE C1.3 Visitor arrivals – original, seasonally adjusted and trend estimates 1 150 Original

Seasonally adjusted

Trend

1 050 950

Thousands

850 750 650 550 450 350 Nov-09

Nov-10

Nov-11

Nov-12

Nov-13

Nov-14

Nov-15

Nov-16

Nov-17

Nov-18

Nov-19

Source: Based on ABS Cat. Nos 3401, licensed under the Creative Commons Attribution 4.0 International licence.

FIGURE C1.4 Resident returns – original, seasonally adjusted and trend estimates 1 400 Original

Seasonally adjusted

Trend

1 300 1 200 1 100

Thousands

1 000 900 800 700 600 500 400 Nov-09

Nov-10

Nov-11

Nov-12

Nov-13

Nov-14

Nov-15

Nov-16

Nov-17

Nov-18

Nov-19

Source: Based on ABS Cat. Nos 3401, licensed under the Creative Commons Attribution 4.0 International licence.

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PART 4 FURTHER CASE STUDIES

Major reasons for the increase in the number of overseas passengers in the earlier years were the promotion of Australia as a tourism destination, increasing affluence in major inbound tourism markets, an increase in the number of carriers servicing the market and the relative decline in the value of the Australian dollar. Passenger numbers increased in the lead-up to the Sydney Olympics in 2000, but were flat again in 2002–03 because of security concerns following the 2001 terrorist attacks in the US and health concerns from the outbreak of SARS. The effects of the GFC in 2008–09 caused another downturn, but from 2009 to 2019, overseas passenger numbers grew strongly. In 2020, health concerns about COVID-19 have almost shut down the industry, at the time of writing. Over the period 1990–2018, Qantas’ international passenger numbers increased from 4.232m to 14.82m,7 at an average annual increase of 5.36%. Note that although Qantas’ growth rate was slightly higher than the overall growth rate of 5.1% for international passenger transport in Australia, there was still a decline in Qantas’ share of this market from almost 50% in 1990 to 34.3% in 2001 and then 26% in 20188. This decline in market share is consistent with trends around the world where traditional airlines, often referred to as ‘legacy carriers’, have struggled to compete with new airlines. It comes alongside a significant change in the makeup of international airlines operating services to and from Australia over this period. Traditional airlines such as Lufthansa no longer fly to Australia, while new-age airlines have emerged in the Australian market, including Emirates, Virgin Australia and Air Asia. Passengers who travel to and from Australia visit a wide array of destinations.9 In 2018, the most visited country was New Zealand, and it was also country with the most visitors to Australia, accounting for 15.0% and 13.2% of the respective markets. When we compare Figure C1.5 with Figure C1.6, we can see that the majority of the passengers travelling the routes between Australia and the UK, Japan and China are overseas residents. This is a problem for Qantas as airlines based in these countries may be the first choice for these passengers. Furthermore, a significant proportion of these customers are price-sensitive tourists. On the other hand, routes to and from destinations such as Fiji, Indonesia, Thailand and the US serve a larger proportion of Australians travelling overseas. This is reflective of the pull factor of these destinations to Australian tourists. While such tourists may consider flying with Qantas because it is a ‘national brand’, such travellers also tend to be highly price sensitive.

FIGURE C1.5 Short-term movement: arrivals of overseas visitors – country of residence

2016–17

2017–18

38 900

44 500

Oceania and Antarctica Fiji New Caledonia

50 000

52 800

1 352 900

1 371 300

51 700

49 500

1 538 900

1 569 600

Austria

18 500

19 300

Denmark

28 700

29 400

France

129 000

134 300

Germany

208 200

208 200

Ireland

56 500

57 800

Netherlands

53 400

58 100

Norway

21 400

23 300

Sweden

46 400

45 700

Switzerland

54 900

56 600

New Zealand Papua New Guinea Total North-west Europe

UK, Channel Islands & Isle of Man

726 500

742 700

1 383 700

1 417 400

Italy

40 400

43 300

Spain

77 600

74 600

Total

220 100

225 600

14 100

14 800

Total Southern and Eastern Europe

North Africa and the Middle East Israel United Arab Emirates

43 800

43 800

123 400

126 300

Indonesia

199 600

203 800

Malaysia

405 600

393 600

Philippines

124 500

131 200

Singapore

432 000

432 700

Thailand

95 000

99 200

1 367 400

1 395 900

1 259 100

142 1500

Hong Kong (SAR of China)

259 400

298 600

Japan

428 700

442 300

Total South-east Asia

Total North-east Asia China (excludes SARs and Taiwan)

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Korea

288 700

304 400

North Africa and the Middle East

Taiwan

169 300

197 900

Lebanon

2 416 100

2 678 900

Total Southern and Central Asia

51 000

Turkey Total

India

280 200

335 000

South-east Asia

Total

365 300

443 500

Indonesia

Americas Canada

163 700

172 900

United States of America

759 400

787 600

1 059 200

1 124 300

South Africa

54 700

58 200

Total

83 800

90 100

Total

8 557 600

9 071 800

Total Sub-Saharan Africa

Note: totals for each region include other countries in that region. Source: ABS Cat. No. 3401.05. Licensed under the Creative Commons Attribution 4.0 International licence.

FIGURE C1.6 Short-term movement: departures of Australian residents – country of intended stay

303

57 000

24 200

31 400

236 900

259 300

1 223 100

1 210 700

Malaysia

267 200

268 000

Philippines

230 800

231 200

Singapore

404 400

407 700

Thailand

558 300

581 100

Vietnam

269 600

314 400

3 051 400

3 111 600

China (excludes SARs and Taiwan)

505 700

571 900

Hong Kong (SAR of China)

218 600

235 400

Total North-east Asia

Japan

380 800

438 000

Korea

74 400

73 000

Taiwan

62 000

64 100

1 249 400

1 392 800

343 200

383 300

85 100

99 100

543 900

617 300

163 400

178 200

Total

2016–17

2017–18

353 400

340 200

22 000

20 400

1 411 600

1 417 600

101 100

101 300

55 700

60 200

2 034 200

2 035 000

France

136 900

140 700

Germany

106 700

112 300

Total

160 300

165 200

Ireland

75 400

80 600

Total

1 029 7200

1 075 9300

Netherlands

34 800

34 500

610 800

643 900

Oceania and Antarctica Fiji New Caledonia New Zealand Papua New Guinea Vanuatu Total

India

North-west Europe

UK, Channel Islands & Isle of Man Total

Sri Lanka Total Americas Canada United States of America

1 086 300

1 083 300

Total

1 379 200

1 397 000

89 300

87 700

Sub-Saharan Africa South Africa

Note: totals for each region include other countries in that region. Source: ABS Cat. No. 3401.09. Licensed under the Creative Commons Attribution 4.0 International licence.

1 083 600

1 145 100

Southern and Eastern Europe Greece

Southern and Central Asia

89 700

112 900

Italy

208 200

237 900

Spain

85 100

88 900

Total

558 400

636 400

In summary, over the years from 1982 to 2018 there was a considerable increase in the market for international passenger transport, averaging growth of 6.08% p.a. However, the rate of customer growth for Qantas was substantially less, reducing its market share, which stood at 26% in 2018. Continuing economic problems in Europe saw a decline in inbound tourism to Australia. This was

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Case 1 QANTAS

CASE STUDY

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PART 4 FURTHER CASE STUDIES

somewhat offset through a rise in the volume of travel by Australians, and the falling Australian dollar; however, it was by increasingly price-sensitive consumers and on routes with more intense competition.

Domestic air transport The domestic airline sector comprises interstate and intrastate operations. Generally, interstate traffic is the most significant, and falls within core operations for Qantas.

Intrastate traffic is a relatively minor part of Qantas’ overall business, and is undertaken by Qantaslink. Over the last 30 years, the emergence of so-called ‘low-cost airlines’ has reshaped domestic air transport. While this same situation has arisen internationally, it is especially significant in the Australian domestic market. Figure C1.7 shows domestic air transport from 1982 to 2018, during which time passenger numbers have increased from 11.006m to 60.765m, an average annual growth rate of 4.73%.

FIGURE C1.7 Domestic air passengers

Year ending 30 June

Passengers

Revenue passenger kms (000s)

Available seat kms (000s)

Load factor

1982

11 005 755

9 885 094

14 489 544

68.2

1983

10 240 633

9 312 482

13 277 017

70.1

1984

10 869 906

9 966 406

13 733 586

72.6

1985

11 801 504

10 861 807

15 017 626

72.3

1986

12 345 414

11 661 837

16 097 715

72.4

1987

13 074 500

12 753 939

17 305 489

73.7

1988

14 320 503

13 920 102

17 982 972

77.4

1989

10 482 659

10 454 105

14 095 385

74.2

1990

12 894 575

13 040 762

18 217 987

71.6

1991

16 741 291

17 695 857

23 722 965

74.6

1992

17 706 392

18 277 055

23 712 953

77.1

1993

19 081 262

19 937 391

25 766 610

77.4

1994

21 302 395

22 674 829

29 660 827

76.4

1995

22 789 674

24 625 409

33 129 880

74.3

1996

23 678 307

26 191 426

35 639 503

73.5

1997

23 375 317

26 357 065

35 402 866

74.4

1998

23 574 788

26 774 140

35 466 723

75.5

1999

24 392 360

27 852 666

36 119 215

77.1

2000

25 660 355

29 600 791

38 231 527

77.4

2001

26 152 254

30 409 469

39 739 357

76.5

2002

25 808 422

30 564 721

38 639 928

79.1

2003

28 948 568

34 642 820

43 202 197

80.2

2004

33 132 831

40 098 642

50 842 828

78.9

2005

35 894 944

43 339 350

55 059 124

78.7

2006

38 423 752

46 932 694

59 388 290

79.0

2007

40 918 870

50 315 387

62 201 115

80.9

2008

44 134 065

54 131 498

68 603 166

78.9

2009

44 357 443

54 078 809

66 956 086

80.8

2010

47 284 941

57 622 592

72 054 404

80.0

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2011

47 325 174

59 288 822

74 263 421

79.8

2012

49 456 632

62 472 597

79 727 018

78.4

2013

57 124 778

67 185 405 516

87 558 884 236

76.7

2014

57 715 710

68 079 352 606

89 542 357 435

76.0

2015

57 217 177

67 429 357 461

88 278 923 775

76.4

2016

58 406 349

68 834 142 712

88 880 652 331

77.4

2017

59 256 681

69 469 949 999

88 645 961 529

78.4

2018

60 764 755

70 868 453 059

88 527 555 098

80.1

Source: Australian Domestic Aviation Activity Annual Publications, Department of Infrastructure, Transport, Regional Development and Communications. Licensed under the Creative Commons Attribution 3.0 Australia licence.

In the early years, the domestic passenger transport industry operated as a duopoly, comprising two longestablished ‘legacy’ carriers, Australian Airlines and Ansett Airlines, with Ansett being the larger of the two. The position of these two airlines was challenged in the early 1990s by a third carrier, Compass Airlines. Compass Airlines offered heavily discounted airfares, which could have significantly expanded the market for domestic air travel, taking a large proportion of the market for itself. However, Compass Airlines had difficulties in distributing its product and constraining costs, leading to financial collapse in just over one year of operations. Though Compass itself was unsuccessful in creating a low-cost domestic air travel market, it was a precursor of things to come. The balance between Australian Airlines and Ansett Airlines shifted significantly in 1993 when Qantas acquired the operations of Australian Airlines. This precipitated an increase in ‘Available Seat Kilometres’ (ASK), as Qantas’ international aircraft fleet became available for domestic services. At the same time the integration of Qantas’ fare structures and timetables enabled Qantas to significantly strengthen its competitive position. As a consequence, over the period from 1994 to 1999, while overall domestic passenger numbers grew at 4.4% annually, for Qantas the growth rate was 7.3%, leading to a significant increase in market share from an estimated 45% in 1991 to 54% in 2001. This demonstrates the value of being able to offer integrated domestic and international travel, one of Qantas’ traditional strengths. Since the market for domestic air transport in Australia remained relatively profitable at this time, it once again attracted new entrants. In June 2000, Impulse Airlines commenced operations, closely followed by Virgin Blue in August of the same year. Previously operating in the regional market, Impulse expanded its capacity by buying Boeing 717 (100-seat) aircraft and offered heavily discounted flights on the Sydney–Melbourne route. Meanwhile, Virgin focused initially

on the eastern seaboard (Brisbane–Sydney–Melbourne). Virgin was able to introduce more intense competition through the larger capacity of its Boeing 737 aircraft and more frequent flights. The impact of these new entrants on the market was a period of heavy airfare discounting, seeing prices on the Sydney–Melbourne route falling to just $99. This four-way price battle was not sustainable, and on the 2 May 2001 Impulse Airlines announced the sale of its operations to Qantas, after having earlier reported financial distress. A major problem for Impulse was the limited capacity of its aircraft and the inability to achieve economies of scale. At the other end of the scale, Ansett Airlines, the traditional rival of Qantas, had been experiencing declining market share and profitability throughout the 1990s. In common with many legacy carriers, it had relatively high costs, and it was the least able of the three remaining airlines to sustain the airfare discounting. This culminated in the appointment of an administrator to Ansett on 13 September 2001. While under administration, attempts were made to re-establish the airline on a greatly reduced basis. This involved the development of a cost structure that more closely resembled that of Virgin, and probably best approximated ‘industry best practice’. However, these efforts were unsuccessful and Ansett ceased all flights on 4 February 2002. With the demise of Ansett, Qantas’ share of the domestic airline market increased to an estimated 80–85%. This was easily achieved due to the fact that Virgin was only just starting up its operations. However, as Virgin’s business took off, it was able to add new aircraft to expand its market share. It also expanded its services internationally, and it has established important international partnerships such as with Singapore Airlines. At the same time, Qantas struggled with the issues facing many legacy airlines around the world, such as staff costs and conditions, alongside outdated administrative structures and procedures. In 2019, Qantas’s market share had reduced to 63% with Virgin’s reaching 27%.

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The most important routes for domestic air transport are shown in Figure C1.8. The figure reveals that domestic air traffic is concentrated along the eastern seaboard of Australia, with just four routes accounting for 33.48% of all domestic air travel (Melbourne–Sydney 15.22%, Brisbane– Sydney 7.88%, Brisbane–Melbourne 5.85%, and Gold Coast–Sydney 4.53%). A consequence of this concentration is that it facilitates targeted entry into the market by new participants. Most recently, this has been by Tiger Airways, a subsidiary of Singapore Airlines, although in 2013 Virgin Australia acquired a 60% share of Tiger Australia. FIGURE C1.8 Domestic air passengers between city pairs – 2017–18

Ranking

City pair

Passengers

% of domestic market

1

Melbourne

Sydney

9 250 822

15.22

2

Brisbane

Sydney

4 788 059

7.88

3

Brisbane

Melbourne

3 556 885

5.85

4

Gold Coast

Sydney

2 751 593

4.53

5

Adelaide

Melbourne

2 487 319

4.09

6

Melbourne

Perth

2 057 845

3.39

7

Gold Coast

Melbourne

2 045 631

3.37

8

Adelaide

Sydney

1 908 584

3.14

9

Perth

Sydney

1 719 947

2.83

10

Hobart

Melbourne

1 638 627

2.70

11

Brisbane

Cairns

1 362 514

2.24

12

Canberra

Melbourne

1 150 476

1.89

13

Cairns

Sydney

1 135 079

1.87

14

Brisbane

Townsville

976 920

1.61

15

Brisbane

Perth

976 100

1.61

16

Canberra

Sydney

951 976

1.57

17

Launceston

Melbourne

945 695

1.56

18

Adelaide

Brisbane

856 844

1.41

19

Cairns

Melbourne

850 342

1.40

20

Brisbane

Mackay

717 341

1.18

 

Other

18 636 156

30.67

 

Total

60 764 755

 

Source: Australian Domestic Aviation Activity Annual Publications, Department of Infrastructure, Transport, Regional Development and Communications. Licensed under the Creative Commons Attribution 3.0 Australia licence.

In summary, the domestic market has experienced steady growth over the last 37 years (4.73% p.a.), and

this will in all likelihood continue. Linking of domestic and international operations has contributed to Qantas’ dominant position in the domestic market. However, this advantage is likely to be eroded with the expansion of Virgin’s operations internationally and its relationship with Singapore Airlines. While there are now only two major operators remaining in the domestic market, limiting potential competition, it must be recognised that Virgin operates with a much lower cost structure than Qantas. This means that any benefits it gains from an erosion of Qantas’ market share should be sustainable. Qantas is therefore likely to increasingly experience the effects of competition in the domestic airline market.

Summary Historically, there is evidence of substantial growth in the two major industry markets in which Qantas operates: international and domestic passenger transport. However, both segments are subject to volatility and intense competition, dependent on economic conditions and major world events. Such examples include the GFC and health concerns from SARS and COVID-19. Qantas is the dominant carrier in the Australian airline market; however, increased competition in both the domestic and international passenger transport markets have negatively impacted its position. In the domestic market, Virgin has significantly expanded its operations both domestically and internationally, limiting growth for Qantas and creating downward pressure on prices and yield. Internationally, competitive pressures are building through an increase in capacity to Asian and European markets, particularly from Singapore Airlines and Emirates. This puts pressure on margins, which can constrain growth. The overall outlook for passenger numbers for Qantas is therefore limited by increased competition, both domestically and internationally, with likely increased pressure on prices.

Strategy analysis The financial performance of a company depends in part on the industry environment. As discussed, the airline industry has experienced modest growth in recent decades, while also dealing with an increase in competition in the international and domestic passenger markets. Airlines are also sensitive to economic conditions, and must have firm strategies in place to respond to these factors. In the case of airlines, their strategies can be divided into revenue

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strategies and cost strategies. Revenue strategies deal with issues relating to maximising the level of operation, through maximising yield and capacity utilisation. Cost strategies seek to minimise the cost of providing capacity.

Revenue strategies Qantas’ core business is transporting air passengers. In the financial year ending 30 June 2018, passenger revenue made up 86.25% of all Qantas revenue, and Figure C1.9 highlights that the increase in Qantas’ overall revenue has followed the increase in passenger revenue. Figure C1.10 further shows the relative importance of the domestic

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market to Qantas, with 65%10 of Qantas’ passengers travelling domestically. This figure also reveals the impact of the failure of Ansett Airlines, with a marked increase in domestic passenger numbers for Qantas in 2001–02. There is also a marked decline in passenger numbers from 2008 to 2010, which coincided with the GFC, highlighting the sensitivity of airline operations to economic conditions. Between 2010 and 2019 passenger numbers recovered, largely as a consequence of an increase in the number of Australians travelling overseas. COVID-19 has seen all airlines severely affected in 2020, and it remains to be seen how long it will take them to recover.

FIGURE C1.9 Qantas revenue by segment, 2005–18 20 000

15 000

$ Millions

10 000

5 000

0

–5 000 2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Qantas Domestic

Qantas International

Jetstar Group

Qantas Freight

Corporate

Jetset Travelworld Group

Eliminations

Consolidated

2016

2017

2018

Qantas Loyalty

Note 1: In 2013, the Qantas Segment as restructured as two separate operating segments – Qantas Domestic and Qantas International. Hence the figure of Qantas Domestic from 2005 to 2012 is the aggregate of Qantas Domestic and Qantas International. Note 2: From 2005 to 2008, Qantas Holidays and Qantas Catering segments is reported under Jetset Travelworld Group. Note 3: As a result of merger of Jetset Travelworld Group with Stella Travel Services, Jetset Travelworld Group is no longer an opeating segment from FY 2012. Note 4: In 2018, the Qantas Freight segment was consolidated into the Qantas International segment. Source: Qantas Airways Ltd

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A major factor in the decline was the increased competition on major routes that Qantas operates, in particular the route between Australia and the US. Figure C1.11 shows that Qantas has achieved some increase in efficiency, however, with capacity utilisation rising to around 83.2%.11 This is relatively high by international standards and is likely approaching the limit of what is practically achievable. Given the relatively fixed cost nature of airline operations, this will have a significant impact on overall firm performance.

FIGURE C1.10 Qantas passenger numbers by sector, 2000–13* 60 000 000 50 000 000 40 000 000 30 000 000 20 000 000 10 000 000 0 2000 2002 2004 2006 2008 2010 2012 Total

International

Domestic

*Later updates are unavailable Source: Qantas Airways Ltd

FIGURE C1.11 Qantas capacity utilisation, 2005–18 84.00% 82.00% 80.00% 78.00% 76.00% 74.00% 72.00% 2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

Source: Qantas Airways Ltd

Historically, a key revenue strategy to maximise yield that traditional airlines such as Qantas have pursued is to segment the market by the client’s price elasticity of demand. A feature of the market for air transport is that it comprises travellers who are relatively price inelastic, such as business customers who have to travel at certain times, and leisure travellers, who are price elastic. To take advantage of this, airlines have broken the market up into separate segments. This has involved offering a range

of airfares from premium through to heavily discounted tickets, varying the conditions attached to each type of airfare in an effort to discriminate between the different types of traveller. For example, heavily discounted airfares typically have conditions such as being non-exchangeable and non-refundable, having minimum stay requirements and requiring purchase in advance of travel, and, in general, these characteristics appeal to tourists but do not work for the typical business traveller. The significance of

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this strategy from a yield maximisation perspective is highlighted in Figure C1.12, which provides evidence of a wide spread in the price of Qantas airfares for travel between Sydney and London. FIGURE C1.12 Sydney–London return airfares

Category First

Price $16 261

Business

$9 661

Premium economy

$5 048

Economy

$2 100 Source: Qantas Airways Ltd

Additionally, for leisure travellers there will be changes in the level of demand throughout the year. Reflecting the increased demand in school holidays for instance, seasonality is incorporated into the airfare structure, as shown in Figure C1.13, which highlights a 49% increase in the price of travel between Sydney and Los Angeles from low to high season. Thus, Qantas can achieve much greater revenue yield during peak times of travel. However, the effectiveness of both of these strategies to maximise revenue is diminishing, which is a problem for Qantas. Many airlines, including new low-cost airlines, are adopting much flatter fare structures and fewer fare restrictions. This is reflected in the restricted growth in revenue yield, and suggests that Qantas’ revenue performance will continue to come under increased pressure in future periods. FIGURE C1.13 Price of Sydney–Los Angeles economy return airfares

Season

Dates

High season

• 20 Jun – 20 Jul

Price $1813

• 12 Dec – 16 Jan Shoulder

• 17 Jan – 31 Jan

$1589

• 1 Apr – 19 Jun • 1 Jul – 13 Oct • 25 Nov – 11 Dec Low season

• 1 Feb – 31 Mar

$1219

• 14 Oct – 24 Nov Source: Qantas Airways Ltd

The Qantas brand name is also an integral part of the revenue strategy of Qantas, positioning itself as a premium product for which a premium price is charged. A key aspect of the brand is an enviable safety record; however, this marketable public perception is increasingly

309

being challenged. For example, an incident in November 2010 in which a Qantas A380 suffered an uncontained engine failure, forcing it to make an emergency landing, led to the grounding of the entire A380 fleet. There have also been concerns about the impact of outsourcing and scheduling of maintenance, and comments made in the period surrounding the grounding of the entire Qantas fleet in November 2011 have also undermined the brand name. In combination, these factors may have significantly eroded brand value. The other key aspect of the brand is the positioning of Qantas as the ‘Australian’ airline. This is achieved through the nature of promotional programs, including sponsorship of such sporting teams as the Wallabies, the Australian rugby team. Such nationalistic marketing of Qantas may be useful to the domestic market; however, it would have little impact upon passengers originating outside Australia. This contributed to the establishment of a ‘low-cost’ international operation, Jetstar, to serve the Asian tourist market, a brand that Qantas is continuing to expand. Such a strategy suggests that there is little value in the Qantas brand name in Asian markets, and that Qantas must lower its cost structure for its operations there to enable it to engage in more aggressive price-based competition. Qantas is also concerned with maximising capacity utilisation. The most apparent strategy for attracting customer preference is the Qantas loyalty program. This includes not only the frequent flyer program operated by Qantas itself,12 but also the programs offered in conjunction with credit card and other companies. At 30 June 2018, Qantas had 12.3m members of its frequent flyer program and over 400 program partners, clearly highlighting the reach of this program within Australia. To mitigate some of the costs of operating this scheme, and to enhance revenues, Qantas has progressively increased charges to program partners. Nonetheless, this remains an effective strategy for ensuring product loyalty and should continue to constrain customer leakage to competitors, particularly for high-yield business travellers, where airfares are typically paid for by businesses but points accrued to the traveller personally. An important component of Qantas’ frequent flyer strategy is its membership of the oneworld alliance. From a passenger perspective, this alliance allows frequent flyer points to be earned and redeemed beyond Qantas’ own routes. From Qantas’ perspective, it ensures preferential access to passengers travelling on member airlines from

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other parts of the world. Further facilitating the transfer of passengers between alliance members is the integration of airline schedules and sharing of terminal facilities, which both reduce connection times for passengers. Qantas’s international strategy continues to develop as it seeks greater customer satisfaction. In 2018, Qantas changed its Asian hub from Dubai to Singapore, and introduced the direct Perth–London route. It has plans to introduce a non-stop flight from the east coast of Australia to London and New York.

Cost strategies In the financial statements for the year ended 30 June 2018 Qantas reported total expenses (excluding interest costs) of $15 487m, equivalent to 90.78%13 of total revenues. Figure C1.14 shows that the most significant costs identified were staff costs, variable aircraft operating expenses and fuel costs. Together these represented over 71.85% of Qantas’ expenses14 and as such comprise the prime focus of Qantas’ cost strategies. Success in constraining these expenses will result in material improvements in overall performance.

FIGURE 1.14 Qantas operating expenses (%) 2018

2017

Manpower and staff

Bonuses and redundancies

Fuel

Lease non-aircraft rentals

Lease non-aircraft rentals

Commissions and marketing

Capacity hire

Other

Aircraft operating

Depreciation Computer

Source: Qantas Airways Ltd

Staff and variable aircraft operating costs combined totalled $7896m, representing 50.98% of total expenses for Qantas in 2018. While these are two of the three most significant expenses for Qantas, there is relatively limited scope for developing advantages over competitors in this area. However, Qantas does have an advantage over domestic competitors and some smaller international competitors in buying power, through the size of the fleet it operates. The Qantas group’s fleet comprised 307 aircraft at 30 June 2018,15 with an average age of just 11.116 years. Qantas’ variety of aircraft in its fleet also allows it to

make optimal use of the routes it operates by assigning appropriate aircraft to each flight.17 This is demonstrated by the substitution of 747 and 767 aircraft domestically in place of 737 aircraft at times of peak demand. In the international market, however, there is little significant difference between Qantas and its major competitors. All use broadly similar aircraft and therefore face much the same aircraft operating costs. Technological developments have resulted in significant improvements in efficiency over the past 20 years. These include flight performance, through lighter aircraft weight

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and longer flying distance, contributing to improved fuel efficiency. Qantas’ international flights comprise many long-distance routes, which has necessitated the constant updating of the Qantas long-range fleet, made up of both 747 and A380 aircraft. This not only ensures that Qantas owns a modern, fuel-efficient fleet, but has also contains the costs of repairs and maintenance, and assists Qantas in holding on to its safety record. Qantas is currently undergoing a program of upgrading the long-range fleet, phasing out 747-400s to be replaced by A380s. Qantas has also upgraded its domestic fleet, replacing ageing 737s with the acquisition of 46 Boeing 737-800 aircraft. These together with 767 and A330 aircraft now provide most domestic capacity. These types of aircraft are also being used by Virgin; therefore, there should be relatively similar aircraft operating costs across the two companies, though Qantas’ staff costs remain substantially higher. Qantas continues to upgrade its fleet, bringing the Boeing 787 aircraft (the Dreamliner) into service. Qantas was one of the first airlines to buy this aircraft, and initial reports suggest that it will offer significant advantages over other models in terms of range and efficiency. This may provide some benefits for Qantas in the near future, particularly in relation to routes to the US, where destinations beyond Los Angeles may be successfully targeted. Staff costs are the largest expense category for Qantas in 2018, amounting to $4300m, or 27.77% of total expenses. Many of Qantas’ administrative procedures and work practices have their origins in the period when the majority of the international airlines were publicly owned and regulated. These include costly labour-intensive pre-internet global distribution systems that charge sector-booking fees. Consequently, staff and remuneration levels are greater than those of low-cost airlines, which utilise the internet as their means of distribution. Accordingly, this is the area where there is the greatest potential for Qantas to reduce costs. Within Qantas, the strategies to reduce staff costs include redundancies, constraining remuneration and improving work practices. As far back as 2001 Qantas announced almost 3500 staff redundancies, in excess of 10% of its overall workforce. Included in these redundancies were 25% of senior and middle management, indicating particular attention being devoted to positions considered administrative. However, the success in managing staff levels must be questioned with Qantas having more staff in 201818 than it had in 2001. Qantas has also limited wage increases for existing staff, introduced lower wage levels

311

for new employees, often employed through Jetstar, and increased its use of casual labour. Nevertheless, pay rates for Virgin flight and cabin crew can be up to 35% less than those for Qantas staff, while for ground handling and airport check-in staff pay rates can be up to 18% less. Qantas therefore needs to work hard to reduce its wage rates to levels comparable to those of its competitors. Outdated work practices have also been a problem for Qantas. The company has sought to address this with strategies such as relocating data processing functions to Fiji and employing flight crews from Manila and Auckland, where labour costs are lower. They also outsource heavy engineering to a contract labour firm that was able to sign a single union agreement with the relatively moderate Australian Licensed Aircraft Engineers Union. Additionally, Qantas has employed contractors for baggage handling. Whether Qantas has achieved the desired outcome in this area is difficult to determine. It is notable that staff costs have increased 11.8% since 2013. Qantas has significantly contained selling and marketing expenses. They were the third-largest expense for Qantas in 2002, amounting to $1158m and representing 11.0% of total expenses. In 2018, they were $724m and represented just 5.28% of total expenses. This is a significant saving and it has been facilitated through changes in technology. In this regard, Qantas is simply following the model of low-cost airlines and aggressively using technology to market and distribute tickets. Features of this technology are ease of customer access, including no special equipment requirements, and a relatively simple interface into a single airline reservation system. There is also the use of electronic tickets, which have provided an estimated cost saving of around $10 per ticket. Importantly, these changes offered the advantages of direct cost savings. A consequence of the distribution of tickets via the internet, though, is that where a strong relationship once existed between Qantas and travel agents, meaning that travellers were directed to Qantas, this relationship has now effectively been lost. A remaining issue for Qantas is whether or not it continues to be able to use technological solutions to reduce costs more broadly across the organisation. In summary, in response to an increasingly competitive environment Qantas has sought to reduce its costs. However, the success of these strategies is yet to be fully apparent. Perhaps indicating an inability to reduce its cost structure within its current institutional constraints, Qantas has continued to work to extend the operation of its budget carrier Jetstar.

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Summary Historically Qantas has been dominant in both the international and domestic air transport markets. However, there is increasing competition both domestically from Virgin and internationally from several airlines. This constrains Qantas’ ability to apply revenue-maximising strategies, and also limits the firm’s capacity utilisation. This suggests that Qantas will face increasing revenue pressure in the future. On the other hand, Qantas must also continue to find ways to reduce its expenses, especially in the area of staff costs. However, institutional constraints may limit the potential for cost reduction, necessitating further expansion of Qantas’ low-cost brand, Jetstar. Any impact on overall costs from this relatively new operation may take time to emerge.

QUESTIONS Use the analysis presented in this case, and any recent material available to you. 1 Analyse the competitive forces facing Qantas, using the ‘five forces’ framework from the strategy literature. Evaluate Qantas’ prospects for profitability and growth in the next five years. 2 Identify the limitations of this analysis. What other factors do and could affect Qantas’ competitive environment? 3 Discuss Qantas’ competitive strategy since 2000. Is it successful, and is it sustainable? 4 What is Qantas’ competitive advantage, if any? Apply a SWOT evaluation to it. 5 What has been Qantas’ corporate strategy across its domestic and international divisions since 2000? How has that strategy changed in response to market changes? Have any changes been initiated by Qantas? 6 Prepare an executive summary of recommendations to the Qantas executive, based on your analysis. Identify three key changes to its structure and/or operations.

Part B Accounting analysis The financial statements represent a window on the activities of the firm, and accounting analysis is concerned with determining the quality of information provided by such a view. This requires consideration of a number of factors, including what has influenced the managers’ accounting policy choice, noise from accounting policy choice, and forecast errors.

Motivations for managing the financial reporting and disclosures For Qantas, a clear example of a profit announcement being affected by non-financial circumstances was the 1993 financial result. This featured large write-offs and abnormal items, and was identified in the media as an ‘earnings bath’. The circumstances of the announcement were that Gary Pemberton and James Strong had both recently been appointed as Chairman and CEO, respectively, and the firm was in the lead-up to its IPO and ASX listing. Management were looking to signal to potential investors that hard decisions had been made, and would continue to be made, to reform what had previously been a public sector organisation in order to ensure its profitability. In a similar vein, it is notable the 2000 profit announcement was the final full year of tenure for both Pemberton and Strong, and Qantas reported a record profit of $762.8m, an increase of 15.1% on 1999. Conversely, the 2001 profit announcement was the first annual profit announcement to be made by the new management team of Margaret Jackson (chairman) and Geoff Dixon (chief executive), and Qantas announced a profit decline of 19.7%. However, the extent to which this decline can be attributed to deliberate financial reporting decisions of new management is difficult to determine, as this period coincided with the increase in competition through the commencement of operations by both Impulse Airlines and Virgin Blue. In the half-year ended 31 December 2001 there was also further incentive for Qantas to reduce reported income. At the same time as Qantas was due to make its profit announcement, it was engaged in negotiations with unions in an attempt to limit wage and salary increases, which was an integral component of Qantas’ strategy for reducing its cost structure. Consequently, whether Qantas could afford to pay substantial increases was central to the negotiations. Furthermore, with the financial collapse of Ansett, and Qantas assuming a dominant market position, Qantas was under close supervision by the ACCC. This reinforced the motivation not to report a strong profit performance in the period. In November 2008, Alan Joyce was appointed CEO, and this was again accompanied by a major fall in operating profitability (–84%). However, it must be noted that there was also a significant change in operating conditions, thus the decline is not entirely attributable to the change of management. Rather, the departure of the former CEO

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Geoff Dixon could be described as opportunistic. This was further seen in the lack of a rebound in earnings over subsequent years. In 2011, there was a period of protracted industrial dispute followed by the grounding of the entire Qantas fleet, and the threat of lockout of employees by management. During this time, Qantas incurred significant financial losses. In such a circumstance there is a clear incentive for management to minimise profitability in order to constrain union wage demands, enhance the possibility of receiving government support, and to accelerate the recognition of expenses. Despite having remained profitable during the GFC, the 2011–12 financial year saw Qantas post a $245 million loss, its first loss since full privatisation in 1995. Continued growth in the industry and cost reduction strategies have enabled Qantas to turn this poor result into a small profit of $560 million in 2015, and to increase that result to $980 million in 2018. Noise from accounting policy choice and forecast error Having considered the environment within which financial reporting occurs, we must shift our attention to evaluating the accounting policies adopted and their application. This involves identifying changes in accounting policies and key accounting policies and then considering whether these accounting practices are overly ‘aggressive’ in recognising income. This involves comparing Qantas with other firms in the same industry. It is unlikely, however, that firms will actively engage in earnings management through accounting policy choice, as the nature and impact of accounting policy changes are mandated disclosures. Rather, earnings management is more likely to be achieved by applying accounting policies (i.e. accruals) and this requires more quantitative analysis. There were no changes in accounting policy in the Qantas Financial Report for the year ended 30 June 2018. From 2019, there will be changes caused by applying the new accounting standards AASB 15 Revenue from Contracts with Customers and AASB 16 Leases. Revenue recognition practices are disclosed in note 29(F). Passenger and freight revenues are recognised when passengers or freight are uplifted. This practice would be expected to generate significant unearned revenues in the balance sheet, and consistent with expectation these totalled $3939m (23.1% of total revenues) at 30 June 2018. This was a slight increase from 2017 when the balance was $3685m (22.9% of total revenues). As tickets are prepurchased and are commonly non-refundable, this is a

313

relatively conservative practice. However, it is standard in the airline industry. The most significant expense category for Qantas is staff costs, representing $4300m in 2018. The accounting practices applied to employee benefits are disclosed in Note 29(N) and are consistent with AASB119. Staff redundancy expenses of $43m (Note 1) were recognised in the income statement and this is consistent with the stated objectives of reducing the size of its workforce. This was a reduction on the previous year’s value of $48m. Nevertheless, at balance date the provision amounted to $183m (Note 16), indicating that these plans had yet to be fully realised. Finally, superannuation commitments are disclosed in Note 23. This highlights plan assets at fair value of– $ 2468m, and leaving a deficit of $4644m. Problematically, the balance sheet (Notes 13 and 16) recognise net superannuation prepayments less liabilities of $292m, therefore actuarial losses of $690m19 are unrecognised. This was up from $557m in 2017. As expected of a company with property, plant and equipment recorded at $12851m, the depreciation expense is significant. The basis for determining depreciation is outlined in Note 29(I). Aircraft and engines are the most significant depreciable asset amounting to $10749m20 or 83.6% of total assets at 30 June 2018. These are depreciated over a period of 2.5–20 years with a residual value of 0–10%. This compares to a depreciation period of 15–20 years and a 5–10% residual value at Singapore Airlines.21 Therefore, this accounting practice at Qantas may be less conservative than practices employed by other firms in the airline industry, but at the same time allows Qantas considerable flexibility in this aspect of its accounting policy. At 30 June 2018, the value of outstanding operating lease commitments was $1288m, of which $1179m related to non-cancellable operating leases. Although this was a decrease on the previous year at $1364m, it was down significantly from 2016, when the figure was $1468m, with $1366m non-cancellable. Qantas is also exposed to significant interest rate, foreign currency and fuel price risks. Interest rate risks arise from the high value of non-current assets and the necessary debt (or lease) funding. From the notes to the financial statements, it is apparent that Qantas actively manages these risks. At 30 June 2018, the value of financial instruments was net assets of $527m, an increase from $18m in 2017.22 There are material gains and losses recognised in comprehensive income that are consistent

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CASE STUDY

Case 1 QANTAS

PART 4 FURTHER CASE STUDIES

with these being accounted for as cash flow hedges, and are considered effective instruments. In addition to qualitatively reviewing the adopted accounting policies, quantitative analysis of the resulting financial information is also important. This may involve consideration of income, cash flow, accruals and revenue or expense items, either separately or together. Presented in Figure C1.15 is NOPAT and cash flow from operations (CFOPS) for the period 2010–18. This highlights operating profit after tax at a peak of $1182.3m in 2016

after dramatically declining to –$120.8m in 2012, with a slight rebound to $136.9m in 2013. Over this same period, cash flow from operations was less volatile, but still recorded substantial variations, peaking at $3413m in 2018 after a low of –$2643m in 2014 followed by a modest increase to $1227m in 2016. These changes correspond with the changes in the industry environment described earlier. The reasonably close association between NOPAT and CFOPS suggests that earnings are of a relatively ‘high’ quality.

FIGURE C1.15 Operating profit and cash flow from operations, 2005–18 4000 3000 2000 1000 0 –1000 –2000 –3000 –4000 –5000 2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

Operating Profit

Cash Flow from Operations

Source: Qantas Airways Ltd

FIGURE C1.16 Fuel expense, 2005–18 5000 4500 4000 3500 3000 2500 2000 1500 1000 500 2018

2016

2017

2014

2015

2013

2012

2011

2009

2010

2008

2006

2007

0 2005

A limited analysis of components of income, and consideration of how this might be impacted by accruals, is possible and for demonstration purposes fuel expense is reviewed here. Fuel expense has been selected as it is one of the more economically significant expenses, with variations materially impacting income. It is also potentially subject to manipulation through decisions on the valuation of inventories and the realisation of hedge contract gains or losses. Fuel expenses for the years 2005–18 are presented in Figure C1.16, which clearly shows a significant variation in expenses. However, this can be due to changes in fuel prices, exchange rates and level of operation. The impacts of these factors are shown in Figure C1.17, which displays fuel expense adjusted for the level of operation, measured by ASK and fuel prices expressed in Australian dollars. There is a clear correspondence between the two, suggesting that the major causes of variation in fuel expense are both the level of business activity and fuel prices.

$m

CASE STUDY

314

Fuel Expense Source: Qantas Airways Ltd

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FIGURE C1.17 Comparison of fuel expense and fuel price, 2000–13*

315

3 Update the accounting analysis in Part B for the most recent Qantas annual report available to you, and reevaluate Qantas’s accounting policies for the current year.

140

0.035

120

0.03

100

0.025

Part C Financial analysis

80

0.02

Profitability and turnover

60

0.015

40

0.01

20

0.005

The primary objective of financial analysis and ratio analysis is to summarise information contained in the financial statements to gain a greater understanding of the activities of the firm, and to more accurately forecast activities in future periods. This requires evaluating current firm performance to understand both the factors that contribute to the firm’s performance, and the relationships between key items in the financial statements.

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

0

Fuel Expense/ASK

Fuel Price (AUD)

Profitability

*Later updates are unavailable Source: Qantas Airways Ltd

Summary When compared to some competitors, Qantas’ accounting policies might be considered aggressive. In other areas, however, Qantas is simply following industry standard practices. It must also be recognised, though, that in some cases accounting practices may be universally aggressive in the airline industry. Nevertheless, the association between NOPAT and CFOPS provides some comfort that the financial statements are accurately reflecting Qantas’ performance. Concerns remain in regards to the accounting practices adopted for financial instruments and hedges and the potential for these to materially distort reported performance. Accordingly, these accounting practices and the related note disclosures should be subject to careful scrutiny.

QUESTIONS Use the analysis presented in this case, and any recent material available to you. 1 Select one accounting policy that was analysed in this case, and make an adjustment to the account of 10% of the recorded figure in either direction. Follow through the effect of this adjustment to the financial statements. 2 Apart from the accounting policies identified in Part B, what are likely to be policies that should be closely watched by auditors and analysts for a company in the airline industry? Why have you chosen each of them?

Over the period 2010–18, ROE rose from 1.98% in 2010 to 26.14% in 2018, having collapsed to –64.47%% in 2014 and risen back to 30.68% in 2016. These changes in ROE reflected changes in the return on assets (ROA) from 1.48% in 2010 to 6.36% in 2018. Profit margins for Qantas over this same period showed a similar pattern. These ratios highlight that Qantas operates in an increasingly volatile economic environment with intense competition. The end result has been much volatility in performance and a progressive overall improvement in profitability. As a consequence of the improving performance, leverage as reflected in the debt to assets ratio decreased from 28.6% in 2010 to 26.5% in 2018. Over the period 2010–18 total revenues increased from $13772m to $17060m, an average annual increase of 2.41%. The major component of this is passenger revenues, accounting for approximately 85% of total revenues. Accordingly, this is the major driver of revenue growth. Passenger numbers increased by 3.26% p.a. over the period 2010–18, resulting from an increase of 2.3% in domestic passengers and 4.69% in international passengers. This level of growth has declined over the period, as indicated by an annual growth rate in passenger numbers of just 1.32% domestically since 2016, and 2.83% overall. Over the period 2010–18, expenses increased from $13519m to $15487m, an average annual increase of 1.52% p.a. This compares favourably with an increase in revenues of 2.41% p.a. Consequently, whereas expenses represented 98.16% of revenues in 2010, that proportion had reduced

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PART 4 FURTHER CASE STUDIES

to 90.78% in 2018. This trend is also seen in changes in the ratio of expenses to ASK, which decreased from 0.108 in 2010 to 0.102 in 2018 at a rate of 0.63% p.a. The most significant expense for Qantas is staff. In 2018 this expense was $4300m, equivalent to 25.2% of revenues. It is notable that staff expenses were slightly lower at 24.72% of revenues in 2010. However, as a consequence of falling revenue growth and increases in staff expenses per employee of 3.41% p.a., previous gains have been lost. While staff expenses have been the focus of much management attention, they have not yet made significant improvements and this is of ongoing concern. Of the remaining expenses only fuel, aircraft operating variable expenses and other expenditures are over 10%. It is difficult to evaluate these expenses with the limited information available, and it is not obvious how these costs would differ significantly between Qantas and its competitors. Fuel expense tracks the price of jet fuel, for which the biggest factor is world oil prices. Aircraft operating variable expenses have historically represented approximately 19% of revenues. This increased to 21.1% in 2018 and was attributed to increases in airport charges and costs associated with increased security. Neither of these situations can be expected to change in the foreseeable future, hence there is no reason to adjust these in estimating expenses in future periods. Marketing expenses declined by 81.1% to 2018 and this likely reflects changes in the pattern of ticket distribution, in particular disintermediation in the travel market through the use of the internet and reduced commissions.

Asset turnover The other major driver of ROA is asset turnover. Asset turnover, measured by revenues/average assets, has changed considerably over the period 2010–18, increasing from 0.69 in 2010 to 0.95 in 2018. Decomposition of assets into categories provides insights into the causes of these variations. Note that Qantas included unearned revenues of $3939m in current operating liabilities in 2018, which has affected several of its performance measures. Current assets have fallen over this period, from $5832m in 2010 to $3712m in 2018, whereas current liabilities have increased from $6241m in 2010 to $7596m in 2018, causing the current ratio to fall dramatically from 0.9345 in 2010 to 0.4887 in 2018. Operating working capital to sales is negative, reflecting that current liabilities are higher than current assets. It has increased over the period, reflecting

the composition of current liabilities. Non-current assets are decomposed into property, plant and equipment (PPE) and other. PPE turnover has been above 1.0 over the period being analysed, from a low of 1.12 in 2010 to 1.36 in 2018. Changes in the ratio of book value to cost of aircraft over the period 2005–18 highlights the ageing of the Qantas fleet. In 2018, this ratio stood at 47%. As the 747 fleet reaches the end of its operational life, Qantas is phasing these aircraft out, replacing them with new A380s. Qantas is also beginning to phase out use of its ageing 737-400 aircraft. This is identified in capital expenditure commitments reported in Note 10, which notes $12478m in commitments, an increase over that in the previous three years ($10090m, $11623m and $11385m in 2015, 2016 and 2017, respectively).

Liquidity and leverage Short-term liquidity The short-term liquidity of Qantas is captured by the ratios that relate current assets to current liabilities, or components thereof, and includes the current, quick and cash ratios. Over the period 2005–18 changes in these ratios are consistent with Qantas generating significant operating cash flows. For Qantas, as noted above, in 2018 unearned revenues of $3939m were included in current operating liabilities, representing 73% of such liabilities. Accordingly, short-term liquidity ratios at historically low levels are of less concern.

Debt servicing Over the years leading up to 2018, Qantas generated significant cash flows from operating activities and the realisation of assets. This was directed towards repaying financial obligations, and was reflected in the following ratios in 2018: 1 debt to assets of 23.3% (25.6% in 2010) 2 interest coverage (earnings) of 3.47 3 interest coverage (cash flow) of 14.05. In combination, these ratios suggest that while Qantas has increased its use of debt, it is comfortably servicing its debt and is unlikely to experience financial distress.

Dividend payout and sustainability Between 2010 and 2015, Qantas did not pay a dividend, in recognition of its marginal profitability. Since that time, it has paid 7c per share (2016, 2017) and 10c per share (2018), signalling a more buoyant future. Sustainable growth reflects this positive outlook, overall increasing over the period from 1.98 to 21.66%, although declining from 2012 to 2014.

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317

Conclusion

QUESTIONS

Relatively stable relations can be observed across the financial statements, which facilitate more accurate forecasting. However, we must remember that when forecasting future returns, we need to consider the following major issues: 1 whether labour cost savings can be achieved and maintained 2 what the impact of increased competition will be on revenue yields 3 what the impact of aircraft acquisitions will be on the financial statements.

Use the analysis presented in this case, and any recent material available to you. 1 Evaluate Qantas’ financial performance and financial position at the end of 2018. 2 Update the analysis in this case for the most recent Qantas annual report available to you, and re-evaluate Qantas’ more recent financial performance and financial position. 3 Prepare a shareholder information presentation to present to current and potential shareholders with a succinct set of useful information about Qantas’ most recent report. Include the good news highlights, and explain plausible reasons for any bad news.

FIGURE C1.18 Financial analysis, 2010–18

2010

2011

2012

2013

2014

2015

2016

2017

2018

Profitability ratios Return on equity (ROE)

0.0198

0.0410

–0.0405

0.0010

–0.6447

0.1774

0.3068

0.2509

0.2614

Return on operating assets

0.0148

0.0227

0.0003

0.0103

–0.1409

0.0462

0.0717

0.0600

0.0636

Profit margin

0.0214

0.0311

0.0004

0.0134

–0.1721

0.0509

0.0758

0.0633

0.0669

Assets turnover

0.6893

0.7307

0.7481

0.7686

0.8184

0.9077

0.9464

0.9470

0.9513

Operating working capital to sales

–0.2537

–0.2359

–0.2504

–0.1961

–0.2856

–0.2882

–0.3154

–0.3311

–0.3033

Operating working capital turnover

–3.9416

–4.2397

–3.9939

–5.0984

–3.5018

–3.4699

–3.1709

–3.0207

–3.2973

Net long-term asset turnover

1.2030

1.2575

1.2491

1.2570

1.3317

1.4788

1.4788

1.3865

1.4153

PPE turnover

1.1165

1.1383

1.1316

1.1372

1.2621

1.4910

1.4474

1.3430

1.3591

Current ratio

0.9345

0.9047

0.7671

0.8234

0.6554

0.6759

0.4920

0.4396

0.4887

Quick ratio

0.8834

0.8451

0.7142

0.7662

0.6133

0.6328

0.4442

0.3901

0.4425

Cash ratio

0.5935

0.5607

0.4774

0.4441

0.3988

0.3893

0.2817

0.2502

0.2230

Operating cash flow ratio

0.2094

0.2858

0.2543

0.2224

0.1421

0.2742

0.4011

0.3811

0.4493

Interest coverage (earnings)

1.2109

1.5738

0.6106

0.9831

–4.9790

1.9484

3.2324

3.2340

3.4739

Interest coverage (cash flow)

5.8633

6.6000

6.3641

5.7500

8.6993

6.2120

9.5352

11.1106

14.0522

Dividend payout ratio

0.0000

0.0000

0.0000

0.0000

0.0000

0.0000

0.1302

0.1489

0.1714

Sustainable growth rate

0.0198

0.0410

–0.0405

0.0010

–0.6447

0.1774

0.2669

0.2135

0.2166

Working capital management ratios

Long-term asset management ratios

Liquidity ratios

Debt and long-term solvency ratios

Dividend ratios

Source: Qantas, Annual Reports, 2010–18

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Part D Forecasting Forecasting future periods Forecasting is the process of taking information about the firm obtained from strategy, accounting and financial analysis and using it to make predictions about the firm’s performance in the future. Importantly, it should recognise the opportunities and constraints on future performance imposed by the economic environment, and the strategies the firm is employing. Forecasting is not limited to profit but also includes the balance sheet and free cash flows to ensure consistency. Given the nature of forecasting, and the inherent uncertainty of future events, forecasting focuses its attention only on the major components of the financial statements.

Forecast profit and loss The major determinant of firm performance is the level of firm activity, and hence the initial focus is on revenue. For Qantas, passenger revenues represent over 85% of total revenues. Consequently, a major factor in Qantas’ revenue, and revenue growth, is the level of activity in the industry. The long-term growth rate for international passengers is 5.36% p.a., and for domestic passengers 4.73% p.a. Once the industry has recovered from the downturn caused by COVID-19, growth can be expected to continue at these rates, while still remaining sensitive to general economic conditions and the level of competition. With increased competition, both the domestic and international yields will come under pressure, and it is unlikely that there will be substantial revenue growth. Revenue increased at an average of 2.41% p.a. over the period 2010–18. However, this fell to an average of just 1.91% between 2015 and 2018. Taking into account all of these factors, revenue is forecast to grow at 2% p.a. Freight revenues have fluctuated only slightly in recent periods and 2% p.a. growth is included in the forecasts. Other revenues are forecast to increase at the same rate as passenger revenues; however, these are not expected to have a significant impact on the forecasts due to the relatively minor size of these revenue streams for Qantas’ overall revenue. The most significant expense category is staff costs, which represented 25.2% of total revenues in 2018. There have been minor variations in this proportion over recent years, but over the longer term it has remained around this level, notwithstanding efforts by management to reduce this cost. On this basis, staff expenses are forecast at 25.0% of total revenues, although sensitivity analysis should be undertaken over the range 24 to 26%.

Variable aircraft operating costs represented 21.1% of total revenues in 2018, above the 2010 rate of 19.4%. On the basis that this likely reflects long-term contracts and fixed operating requirements, this can be forecast to stay at 21% of total revenues. Depreciation and amortisation are forecast to be slightly lower as the fleet is being rationalised. Fuel expenses have been volatile in recent years, with an overall downward trend. Currently they are below 20% of total revenue, whereas previously it was a higher percentage. Although a weakening of the AUD may see fuel expenses rise, they are forecast to remain at 20% of total revenues. Given the uncertainty of exchange rates and fuel prices, sensitivity is undertaken for fuel expenses ranging from 19 to 21%. To the extent that hedge positions were entered at historic rates, reported fuel expense may not reach this forecast position immediately, but can be expected to approximate spot prices over time. All remaining expenses represent less than 10% of total revenues and can be forecast to remain at present levels. Interest is calculated at 3% of financial obligations and tax is calculated at the present marginal corporate tax rate of 30%.

Forecast balance sheet Changes in the level of business activity flow through to the balance sheet as changes in the level of net operating assets required, and changes in the financing of the firm’s operations. Historically, Qantas’s current assets have fallen from 42% of sales in 2010 to around 22% over several recent years, making 22% a reasonable forecast. Current liabilities have been increasing due to their accounting treatment; however, in recent years they have stabilised at around 45% of total revenues. Therefore, they can be forecast to continue at this level. Forecasting of non-current operating assets is problematic due to Qantas’ program of aircraft acquisition. As a consequence of these acquisitions, PPE turnover has increased to 1.36 in 2018 from 1.14 in 2013. As acquisitions continue, PPE turnover has been forecast to remain at a similar level. Reflecting the possibility for error, the sensitivity of forecasts to variations in turnover between 1.25 and 1.45 are considered. Other non-current operating assets are forecast at 10% of total revenues and all non-current operating liabilities are forecast at 35% of total revenues, with the exception of deferred tax, which is forecast to remain stable. Cash is calculated as the balancing item in the statement of financial position. Dividends are forecast to continue at 10c per share, or $175m (17.5% of NOPAT).

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QUESTIONS

QUESTIONS

Use the analysis and suggested forecasts presented in this case, and any recent material available to you. 1 Prepare forecast financial statements for Qantas in 2019, based on the most likely forecasts. 2 Choosing the least favourable forecast for each item for which a range of possible forecasts are given, prepare a ‘worst-case’ forecast financial statements for Qantas in 2019. What level of borrowing or equity raising is required in this scenario? 3 Choosing the most favourable forecast for each item for which a range of possible forecasts are given, prepare a ‘best-case’ forecast financial statements for Qantas in 2019. What level of borrowing or equity raising is required in this scenario? 4 Update the forecast assumptions for the most recent Qantas annual report available to you. Prepare the forecast financial statements for Qantas for the following year. 5 How confident do you feel about any of these forecasts, and why?

1 Based on the above forecast financial performance and assumptions, calculate the value of Qantas’ shares at the end of 2018 using the abnormal earnings model. 2 Extension: Using your own forecasts for Qantas for the current year (calculated in Part D, Question 4), update this analysis.

Part E Valuation The valuation model that will be the primary focus of this case is the abnormal earnings model. Valuations will also be undertaken using alternative models, and the results compared. When applying the abnormal earnings model, the firm’s cost of equity capital and an estimate of return growth at the end of the forecast period is required in addition to the forecast financial information. In the first instance, Qantas’ cost of equity capital has been estimated at 4.0%. However, estimates of the cost of capital will be subject to considerable imprecision, arising through uncertainty in relation to: 1 future risk-free returns 2 market risk premiums 3 firm risk (β). Accordingly, the sensitivity of the valuation to changes in the cost of equity capital should be considered, and sensitivity analysis undertaken with costs of equity capital of between 3.0 and 5.0%. For the abnormal earnings model, the level of abnormal earnings at the end of the forecast period is assumed to be zero. This is consistent with competition in the market eliminating abnormal earnings and the observation that ROE is mean-reverting.

Alternative valuation For alternative valuation models, different forecasting assumptions are used. In the case of firm valuations, rather than equity valuations, the weighted average cost of capital is necessary and has been estimated initially at 3.5%. Similarly, different terminal value growth rate assumptions are necessary. For the (naïve) dividend discount model, the terminal value growth rate has been estimated initially as 2%. For the discounted free cash flow model, a terminal growth rate of 0% is initially assumed.

QUESTIONS 1 Based on the above forecast financial performance and assumptions, calculate the value of Qantas’ shares at the end of 2018 using dividend discount model and discounted free cash flow model. 2 If your values do not coincide, rework these two models to reconcile its valuation in 2018 with that of the abnormal earnings model. 3 Extension: Using your own forecasts for Qantas for the current year (calculated in Part D, Question 4), update this analysis.

Part F Sensitivity Variations in the assumptions made in forecasting future financial performance will result in the estimates of Qantas share price using the abnormal earnings model varying across a wide range.

QUESTIONS 1 Based on the range of forecast financial performance and assumptions given the forecasts section, recalculate the value of Qantas’ shares at the end of 2018 using abnormal earnings model in Figure C1.19. 2 Extension: Using your own forecasts for Qantas for the current year, update this analysis using sensitivity ranges appropriate to the current year.

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PART 4 FURTHER CASE STUDIES

Conclusion

For example, Qantas may be unable to limit staff costs or fuel costs may increase significantly. This suggests ongoing analysis to determine material changes in these areas is necessary to ensure accuracy of forecasts.

Caution should always be exercised when undertaking valuations. Price movements outside this range may be expected if the forecasting assumptions are not realised. FIGURE C1.19 Abnormal earnings model valuation of Qantas ($m)

2018

2019

2020

2021

2022

2023

Actual

Forecast

Forecast

Forecast

Forecast

Forecast

Net profit Shareholders’ funds Abnormal earnings Forecast Valuation Cost of capital Terminal growth rate Book value Abnormal earnings

Forecast Terminal

Market value Shares Share price ($) FIGURE C1.20 Dividend discount model valuation of Qantas ($m)

2018

2019

2020

2021

2022

2023

Actual

Forecast

Forecast

Forecast

Forecast

Forecast

Dividend Shares DPS

Valuation Cost of capital Terminal growth rate Dividend forecast Terminal value Share price ($)

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321

FIGURE C1.21 Discounted cash flow model valuation of Qantas ($m)

2018

2019

2020

2021

2022

2023

Actual

Forecast

Forecast

Forecast

Forecast

Forecast

NOPAT NOA Change NOA FCF Interest Change debt Free cash flow FCF (equity) Valuation Cost of capital (firm) Terminal growth rate FCF

Forecast Terminal

Firm value Equity value Shares Share price ($)

Endnotes 1 2 3

4

5 6 7 8 9

As at 6 February 2014, the market capitalisation of Qantas was $2339m compared with Virgin Australia at $1117m. For example, under the ‘Two Airlines’ policy both domestic airlines operated the same schedules. This policy is under much media scrutiny at the time of writing, after Qantas launched a campaign to petition the federal government to amend the Qantas Sale Act in November 2013, claiming that the restriction creates an ‘unfair playing field in Australian aviation’, in relation to Virgin becoming 80% foreign owned, http://www. qantasnewsroom.com.au/media-releases/fair-go-4-qantas. Qantas Data Book 2018, available from: https://investor.qantas. com/FormBuilder/_Resource/_module/doLLG5ufYkCyEPjF1tpgyw/ file/data-book/2018qantasdatabook.pdf, p. 46. Qantas Annual Report 2018. Qantas derived only 6% of total revenues from freight activities in 2012–13, which is hence immaterial to this analysis. Qantas Data Book 2018, p. 60. Ibid., p. 46. Figures C1.5 and C1.6 list the main destinations from which overseas visitors travel to Australia, and to which Australians travel overseas, grouped into global regions.

8 10 11 12 13 14 15 16 17

18 19 20 21 22

Later to be renamed Virgin Australia. Qantas Data Book 2018, p. 46. Ibid., p. 60. Formerly known as Qantas Frequent Flyer, the program was renamed Qantas Loyalty in 2013. Qantas Annual Report 2018, p. 52. Qantas’ expense figures used here exclude interest costs. Qantas Data Book 2018, p. 47. Ibid., p. 40. Diversity of fleet needs to be balanced against the economies arising from the operation of a limited range of aircraft, and this is reflected in the still relatively limited number of aircraft types in the Qantas core fleet. One airline which has taken this to the extreme is Ryanair, which operates a fleet of 275 Boeing 737-800 aircraft. 30 248 full-time employees, Qantas Data Book, p. 24. Net defined benefit asset – Note 13, plus long service leave – Note 16. Qantas Annual Report 2018, p. 66. Ibid., p. 114. Ibid., p. 76.

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CASE STUDY

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322

PART 4 FURTHER CASE STUDIES

CASE 2

AIRLINES: DEPRECIATION DIFFERENCES

This case relates to Chapters 3, 4 and 5.

FIGURE C2.1 Comparison of airline accounting policies on aircraft, engine and spares

BACKGROUND

Air China Limited

Heath Karton has just begun a career as an analyst and has been assigned to the airline sector. Heath’s first task has been to input various airline financial statements into his firm’s standard format, which is identical to the one used in this book. In doing this task, Heath is surprised at the variation in presentation, classification and accounting policies. He claims: ‘Even the balance dates are different’. In particular, Heath is considering the differences in depreciation policies for aircraft, engines and spares as shown in Figure C2.1. Heath wonders if underlying economic or technical reasons explain why depreciation rates and residual values differ between airlines. ‘If there are no underlying differences’, Heath argues ‘then comparability is compromised. Furthermore, the range depreciation rates within each class of assets, the estimation of salvage value and the method of allocation (straight-line or diminishing value) would seem to provide management with considerable discretion.’

Depreciation is calculated on the straight-line basis to write off the cost of each item of PPE to its residual value over its estimated useful life. The estimated useful lives and residual values used for this purpose are as follows:

QUESTIONS 1 Estimate the depreciation expense to asset cost ratio using the information in Figure C2.2. Does the variation in this ratio support the variation in accounting indicated by the written accounting policies? 2 What possible underlying differences might account for the differences in depreciation accounting policy choices? 3 How would you go about investigating whether the accounting choices were ‘opportunistic’? 4 To increase comparability, Heath thinks he might use either the average or most conservative ‘expense to asset ratio’ and restate the depreciation for each airline. Without going into detailed restatement procedures, what general impact would this restatement have on return on assets (i.e. the ratio of earnings before interest (EBIT) and tax to total assets)? 5 On the other hand, Heath thinks he might just as well estimate return on assets using EBITDA (earnings before interest, tax depreciation and amortisation). Do you agree with this approach?

Estimated useful life

Residual value

Depreciation rate

Aircraft and flight equipment Core parts of airframe and engine

15 to 30 years

5%

3.17–6.33%

Overhaul of airframe and cabin refurbishment

5 to 12 years

Nil

8.33–20%

Overhaul of engine

2 to 15 years

Nil

6.67–50%

Rotable

3 to 20 years

Nil–5%

4.75–33.33%

Source: Air China, Annual Report, 2011, 2012

Air New Zealand Limited Depreciation of the aircraft fleet is calculated to write down the cost of these assets on a straight-line basis to an estimated residual value over their economic lives. The aircraft and related engines, simulators and spares are being depreciated on a straight-line basis as follows: Airframe

10–22 years

Engines

5–17 years

Engine overhauls

Period to next overhaul

The residual values of aircraft are reviewed annually by reference to external projected values. Source: Air New Zealand, Annual Report, 2012, 2013

Korean Air Lines Co., Limited Depreciation is recognised in profit or loss on a straight-line basis over the estimated useful lives of each part of an item of property, aircraft and equipment, since this most closely reflects the expected pattern of consumption of the future economic benefits embodied in the asset. Leased assets are depreciated over the shorter of the lease term and their useful lives unless it is reasonably certain that the Group will obtain ownership by the end of the lease term. Land is not depreciated. The estimated useful lives for the current and comparative periods are as follows:

Michael Bradbury prepared this case. This case is intended solely as a basis for class discussion and is not intended to serve as an endorsement, source of primary data or illustration of effective or ineffective management.

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Useful lives (years) Aircraft and leased aircraft Fuselage, etc. Overhaul

6 ~ 15

(i) (ii) (iii)

2.8 ~ 10.2 (iv)

Engine and leased engine Engine

15

Overhaul

2.8 ~ 8.8

Aircraft parts

15

Depreciation methods, useful lives and residual values are reviewed at each financial year-end and adjusted, if appropriate. Such adjustments are made as changes in accounting estimates. Source: Korean Air Lines Co., Limited, Annual Report, 2011, 2012

Malaysian Airline System Berhad Depreciation of aircraft, PPE The cost of aircraft, aircraft modifications/retrofits, spare engines, property and equipment are depreciated on a straight-line basis over the assets’ useful lives up to its residual value. Management reviews the residual values, useful lives and depreciation method at the end of each financial year and ensures consistency with previous estimates and patterns of consumption of the economic benefits that embodies the items in these assets. Changes in useful lives and residual values of these assets may result in revision of future depreciation charges. Aircraft, PPE and depreciation All aircraft, PPE are initially recorded at cost. Subsequent costs are included in the asset’s carrying amount or recognised as a separate asset, as appropriate, only when it is probable that future economic benefits associated with the item will flow to the Group and the cost of the item can be measured reliably. The cost of PPE comprises its purchase price and any incidental costs directly attributable to bringing the asset to working condition for its intended use. The cost of aircraft owned is stated after taking into account the manufacturers’ credit. The costs of spare engines acquired on an exchange basis are stated at amount paid and the fair value of the item traded-in. Heavy maintenance expenditure for aircraft and engine overhauls are capitalised at cost. All other repairs and maintenance are charged to profit or loss during the financial period in which they are incurred. Subsequent to recognition, aircraft, PPE are stated at cost less accumulated depreciation and any accumulated impairment losses. Depreciation of aircraft, aircraft modifications/retrofits, spare engines, property and equipment is provided for on a straight-line basis to write off the cost of each asset up to its residual value over the estimated useful life at the following annual rates:

(v) (vi) (vii) (viii) (ix)

323

Narrow-body aircraft are depreciated over a period of 10 to 18 years. Wide-body aircraft are depreciated over a period of 20 years. Aircraft modifications/retrofits are depreciated over 7 years or the remaining lease period of the aircraft to which they relate, whichever is the shorter. Spare engines are depreciated over their estimated useful commercial lives, which range from 7 to 20 years, having regard to their planned withdrawal from services. Maintenance and overhaul costs incurred on aircraft and spare engines owned by the Group are depreciated over the average expected life between major overhauls. Repairable and rotable aircraft spares are depreciated over 7 to 20 years or the remaining lease period of the aircraft to which they relate, whichever is the shorter. Leasehold land and buildings are depreciated over periods ranging from 5 to 40 years. Operating plant and equipment, office furniture and equipment and motor vehicles are depreciated over periods ranging from 2 to 10 years. Progress payments represent aircraft, PPE under construction. They are stated at cost and are not depreciated until the respective assets are ready for their intended use.

The residual values, useful lives and depreciation method are reviewed at each financial year end to ensure that the amount, method and period of depreciation are consistent with previous estimates and the expected pattern of consumption of the future economic benefits embodied in the items of aircraft, PPE. An asset is derecognised upon disposal, replacement or when no future economic benefits are expected from its use or disposal. The difference between the net disposal proceeds, if any, and the net carrying amount is recognised in the profit or loss. Source: Malaysian Airline System Berhad, Annual Report, 2011, 2012

Qantas Airways Limited Depreciation is provided on a straight-line basis on all items of PPE except for freehold land, which is not depreciated. The depreciation rates of owned assets are calculated to allocate the cost or valuation of an asset, less any estimated residual value, over the asset’s estimated useful life to the Qantas group. Assets are depreciated from the date of acquisition or, with respect to internally constructed assets, from the time an asset is completed and available for use. The costs of improvements to assets are depreciated over the remaining useful life of the asset or the estimated useful life of the improvement, whichever is the shorter. Assets under finance lease are depreciated over the term of the relevant lease or, where it is likely the Qantas group will obtain ownership of the asset, the life of the asset. The principal asset depreciation periods and estimated residual value percentages are:

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CASE STUDY

Case 2 AIRLINES: DEPRECIATION DIFFERENCES

CASE STUDY

324

PART 4 FURTHER CASE STUDIES

Years

Residual value (%)

Passenger aircraft and engines

2.5–20

0–10

Freighter aircraft and engines

2.5–20

0–20

Aircraft spare parts

15–20

0–20

Air New Zealand Limited $M 30 June

Source: Qantas Airways Limited, Annual Report, 2012, 2013

Cost Carrying amount Depreciation

3 822

–1 444

–1 216

2 488

2 606

319

270

5

Spares Cost

Aircraft, spares and spare engines

Accumulated depreciation

The Group depreciates its new passenger aircraft, spares and spare engines over 15 years to 10% residual values. The Group depreciates its new freighter aircraft over 15 years to 20% residual values. For used freighter aircraft, the Group depreciates them over the remaining life (15 years less age of aircraft) to 20% residual values. Major inspection costs relating to landing gear overhauls, heavy maintenance visits and engine overhauls (including inspection costs provided under power-by-hour maintenance agreements) are capitalised and depreciated over the average expected life between major overhauls, estimated to be 4 to 10 years. Training aircraft are depreciated over 5 to 15 years to 10 to 20% residual values. Flight simulators are depreciated over 5 to 10 years to nil residual values.

Carrying amount

FIGURE C2.2 Selected financial statement items

3 932

Impairment

Singapore Airlines Limited

Source: Singapore Airlines Limited, Annual Report, 2012, 2013

2012

Aircraft, spare engines and simulators Accumulated depreciation

Useful lives and residual values are reviewed annually and reassessed having regard to commercial and technological developments, the estimated useful life of assets to the Qantas group and the long-term fleet plan.

2013

263

264

–147

–136

116

128

19

15

Depreciation EBIT Total assets

310

158

5 612

5 459

Source: Air New Zealand Limited, Annual Report, 2012, 2013

KOREAN AIR LINES CO., LIMITED Won’M 31 December

2012

2011

Cost

18 012 976

14 002 516 5 808 238

Aircraft and engines Accumulated depreciation

 7 365 521

Air China Limited

Carrying amount

10 647 455

8 194 278

RMB’M

Depreciation

1 385 303

1 206 344

Cost

228 899

219 870

159 995

Accumulated depreciation

120 670

110 863

108 229

109 007

31 December

2012

2011

Aircraft and flight equipment Cost

180 584

Accumulated depreciation Carrying amount Depreciation Impairment EBIT Total assets

Aircraft parts

71 505

 64 364

Carrying amount

 109 079

 95 631

Depreciation

9 587

8 690

EBIT Total assets

581

2237

8 209

6 259

187 591

175 850

12 162

11 317

835 769

80 878

20 678 036

20 333 503

Source: Korean Air Lines Co., Limited, Annual Report, 2011, 2012

Source: Air China, Annual Report, 2011, 2012

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Malaysian Airline System Berhad

NBA

RM’000

Depreciation

31 December

2012

2011

EBIT Total assets

Aircraft Cost Accumulated depreciation Carrying amount Depreciation

9 843 458

4 370 619

921 017

555 142

8 922 441

3 815 477

289 583

163 343

Impairment

224 089

Aircraft spare engines Cost

387 079

365 540

Accumulated depreciation

158 175

111 095

Carrying amount

228 904

254 445

47 080

14 188

–189 542

–2 353 420

17 291 118

12 499 476

Depreciation EBIT Total assets

Source: Malaysian Airline System Berhad, Annual Report, 2011, 2012

Qantas Airways Limited $M 30 June

2013

2012

Aircraft and engines Cost

18 486

18 799

7 411

7 521

11 075

11 278

1 175

1 123

Cost

885

875

Accumulated depreciation

468

433

Accumulated Carrying amount Depreciation Aircraft spare parts

325

417

442

61

54

204

–173

20 200

21 178

Source: Qantas Airways Limited, Annual Report, 2012, 2013

Singapore Airlines Limited $M 31-Mar

2013

2012

19 144

19 229

8 598

8 205

10 546

11 024

1 446

1 433

9.2

14.3

Cost

198

305

Accumulated

123

211

Carrying amount

75

94

Depreciation

19

9

Cost

612

615

Accumulated depreciation

357

349

NBA

255

266

28

27

462

471

22 428

22 043

Aircraft Cost Accumulated depreciation Carrying amount Depreciation Impairment Aircraft spare engines

Aircraft spares

Depreciation EBIT Total assets

Source: Singapore Airlines Limited, Annual Report, 2012, 2013

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CASE STUDY

Case 2 AIRLINES: DEPRECIATION DIFFERENCES

CASE STUDY

326

PART 4 FURTHER CASE STUDIES

CASE 3

RECASTING FINANCIAL STATEMENTS

This case relates to Chapter 4.

C. Ash Flo Investment – background You have just joined a small boutique investment firm – C. Ash Flo Investment Limited, in your first job as a new graduate. Ash, your boss and founder of the firm, has asked you to standardise the financial statements of Smith City Group Limited. This task has gone well so far. You only have the cash flow statement to complete. You note the operating cash flows have two interest paids, as shown in Figure C3.1; one for finance business and two for bank and other. Your first reaction was to aggregate these into one amount. You were just about to do this when you had a second thought – is interest paid an operating expense? Or should it be part of financing cash flows? You ask Ash how you should treat the interest paid. His response is unhelpful: ‘It’s your problem. When you have completed the task, write me a brief memo and tell me what you have done and why. We will then develop a policy for future standardisation of the cash flow statement’. To inform your opinion, you decide to look at how other firms treat interest paid in the cash flow statement. You then have further thoughts: is the treatment of interest paid differently between retail firms and finance firms or banks? You collect the cash flow statements of ANZ Bank (Figure C3.2) and two other retail firms – Kathmandu (Figure C3.3) and Super Retail Group (Figure C3.4). A quick look at other cash flow statements has left you a little confused. Your next thought is perhaps you should look at what the accounting standards require.

FIGURE C3.1 Operating cash flow of Smith City Group, 2018

Statement of cash flows for the year ended 20 April 2018 Note

2018

2017

198.8

211.9

Interest received – finance business

4.8

5.8

Interest received – other

0.1

0.2

203.7

217.9

(201.4)

(207.3)

Income tax paid

(0.6)

(0.2)

Interest paid – finance business

(3.0)

(3.4)

Interest paid – bank and other

(0.1)

(0.2)

(205.1)

(211.1)

(1.4)

6.8

Cash flows from operating activities Cash was provided from: Receipts from customers

Total cash flows from operating activities Cash was applied to: Payments to suppliers and employees

Total cash flows applied to operating activities Net cash inflow/(outflow) from operating activities

Source: Smiths City Group, Annual Report, 2018, p. 41

FIGURE C3.2 Operating cash flow of ANZ Bank, 2018

Cash flow statement

QUESTIONS 1 Write a memo to Ash on your views of the appropriate treatment of interest paid in the statement of cash flows. 2 Is diversity in accounting a good thing? What are the advantages or disadvantages?

Note

Year to 20/09/2017

Year to 20/09/2016

NZ$M

NZ$M

Cash flows from operating activities Interest received Dividends received Net funds management and insurance income

6 223

6 443

5

2

344

332

Michael Bradbury prepared this case. This case is intended solely as a basis for class discussion and is not intended to serve as an endorsement, source of primary data or illustration of effective or ineffective management.

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Fees and other income received

569

642

Interest paid

(3 100)

(3 416)

Operating expenses paid

(1 374)

(1 495)

Income taxes paid

(605)

(648)

Cash flows from operating profits before changes in operating assets and liabilities

2 062

1 860

Source: ANZ, Annual Report, 2018, p. 53.

Consolidated cash flows for the year ended 31 July 2018 Section

2018 NZ$’000

2017 NZ$’000

Cash flows from operating activities

2 850.1

2 733.7

Payments to suppliers and employees (inclusive of goods and services tax)

(2 268.6)

(2 203.1)

(218.5)

(231.0)

–related parties

(10.8)

(11.4)

Income taxes paid

(43.8)

(53.7)

308.4

234.5

(107.1)

(102.1)

–

0.9

Rental payments –external

19

Cash flows from investing activities Payments for PPE and computer software Proceeds from sale of PPE

Cash was provided from: Receipts from customers

502 703

444 100

156

–

47

28

502 906

444 128

Income tax received Interest received

Payments for acquisitions of investments in associates/joint ventures

23(b)

(0.3)

–

Acquisition of subsidiary, net of cash acquired

23(a)

(133.8)

–

(241.2)

(101.2)

Proceeds from borrowings

994.5

930.0

Repayment of borrowings

(955.5)

(955.0)

Finance lease payments

(2.7)

(0.9)

Borrowing costs paid

(0.3)

(1.3)

(16.2)

(17.1)

0.1

0.1

(91.7)

(84.8)

Net cash (outflow) from financing activities

(71.8)

(129.0)

Net increase / (decrease) in cash and cash equivalents

(4.6)

4.3

Net cash (outflow) from investing activities Cash flows from financing activities

Cash was applied to: Payments to suppliers and employees Income tax paid

406 508

360 122

18 710

14 571

2 087

2 162

427 305

376 855

75 601

67 273

Interest paid

Net cash inflow from operating activities

Source: Kathmandu Holdings Ltd Annual Report 2018, p. 34.

FIGURE C3.4 Operating cash flow of Super Retail Group, 2018

Consolidated statement of cash flows for the year ended 31 June 2018 Notes Cash flows from operating activities

Receipts from customers (inclusive of goods and services tax)

Net cash inflow from operating activities

FIGURE C3.3 Operating cash flow of Kathmandu, 2018

327

2018 NZ$’000

2017 NZ$’000

Interest paid Interest received Dividends paid to Company’s shareholders

21

Source: Super Retail Group, Annual Report, 2018, p.77.

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CASE STUDY

Case 3 RECASTING FINANCIAL STATEMENTS

CASE STUDY

328

PART 4 FURTHER CASE STUDIES

CASE 4

COCHLEAR: PROVISIONS AND PATENT DISPUTES

This case relates to Chapters 3 and 4.

Introduction The following article appeared on 5 November 2018:

Cochlear cops $465 million hit in American patent judgement Hearing aid Cochlear has copped a spray from an American court as it suffered a major reversal in a patent dispute that will mean the company will now have to lodge a $US335 million ($465 million) bond to secure the right to appeal the judgment. Cochlear told the ASX on Monday morning it intended to fight the judgment, which awarded $US268 million in damages to the Alfred E. Mann Foundation for Scientific Research (AMF) and Advanced Bionics (AB). The judgment found Cochlear had wilfully infringed on patents. In response to the latest development on the longrunning case, investors hammered the company at the market opening driving its share price down almost 4 per cent. With its shares trading at $172.99 at that time the company had about $380 million wiped from its market capitalisation on Monday. The stock recovered slightly over the morning before sinking again to be 3.76 per cent down by mid-afternoon. Source: Cloe Latimer, The Sydney Morning Herald, 5 November 2018. The use of this work has been licensed by Copyright Agency except as permitted by the Copyright Act, you must not re-use this work without the permission of the copyright owner or Copyright Agency.

Background Cochlear (ASX: COH), was formed in 1981, with finance from the Australian government to commercialise the hearing implants pioneered by Dr Graeme Clark. It is a publicly held company based in Australia, and the world’s largest cochlear implant maker, followed by its rival Advanced Bionics. The two are cutthroat competitors in the multibillion-dollar global market for hearing implants. In 2011, there were reports of the Nucleus model CI500 implants shutting down. Cochlear funded a complete recall of the model, although less than 1% of implants were

affected and the failures posed no health risks. Cochlear spent $101.1 million on the recall. By 2013, Cochlear was recovering from the effects of the recall when it was hit with claims of patent infringement. The patent dispute that burst forth in 2018 was a longrunning disagreement. In 2013, the annual report mentions the dispute all though no provision was created (see Figure C4.1). In 2014, a patent dispute provision was created for $21.3 million, as shown in Figure C4.2. This provision has remained unchanged in the financial statements over the period 2014 to 2018 as shown in the summary financial statements in Figure C4.3. We now come to the events of 5 November 2018, which hammered the share price of Cochlear (Figure C4.4). This longrunning dispute has raised the following points of interest: The series of court cases and appeals began in January 2014. A jury found Cochlear had ‘wilfully’ infringed on four counts patents owned by AMF and AB. This resulted in a US$131 claim for damages against Cochlear. In April 2015, the previous judgement was overturned. The judge held that three of the four claims were invalid and dismissed full damages. The fourth claim was considered valid but not ‘wilful’. In late 2016, the US Court of Appeals decided two out of the four patent claims were valid, with the decision of damages to be decided by the district court. At the district court, AMF and AB argued for additional damages due to Cochlear’s ‘wilfulness’. The court having considered the ‘high level of culpability of Cochlear’s conduct, in the exercise of its discretion, that doubling the [jury-awarded] damages is sufficiently punitive for Cochlear’s egregious conduct in this case’. Cochlear insists that it has strong grounds for appeal and that it would now have to lodge US$335 million insurance bond with the court. Furthermore, Cochlear said that the patent at the centre of the case had since expired. Thus, any judgement made by the court will not impact Cochlear’s future business in the US. An independent commentator said this latest appeal could take years to resolve.

Michael Bradbury prepared this case. This case is intended solely as a basis for discussion and is not intended to serve as an endorsement, source of primary data, or illustrating of effective or ineffective management.

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

QUESTIONS 1 In looking at Figure C4.3, what factors might cause an analyst to recast or adjust to the summary financial statements? 2 What is the relationship between provisions, onerous contracts, contingent liabilities and other types of liabilities? 3 The definition of provision in Figure C4.2 uses the term ‘probable’. How would you interpret ‘probable’? What percentage would you ascribe to the term? Is there any research on how this term is interpreted? (Hint: look for ‘uncertainty expressions’.) 4 Considering the features in this case, in making a provision for a legal claim what factors would influence the amount of that provision? What factors ought to influence changes to the amount of provisions in each year? 5 How would you interpret the market reaction on 5 November? FIGURE C4.1 Extract from Cochlear 2013 Annual Report

Patent infringement complaints During the year ended 30 June 2008, the Company was served with a complaint for patent infringement by the Alfred E. Mann Foundation for Scientific Research (Mann Foundation). The complaint, filed in the US District Court of California, alleges that two patents have been infringed. The Company believes the Mann Foundation’s allegations are without merit and is vigorously defending the complaint. At the date of this report, the litigation process is ongoing. No provision has been established against settlement because the probability of a significant outflow is considered unlikely. Source: Cochlear 2013 Annual Report, p. 94

FIGURE C4.2 Extracts from Cochlear 2014 Annual Report

Directors report Infringement litigation Cochlear operates in an industry that has substantial intellectual property and patents, designs and trademarks protecting that intellectual property. Cochlear is exposed to the risk that it will be litigated against for claims of infringement. This could result

in Cochlear paying royalties to be able to continue to manufacture product, or injunctions preventing Cochlear selling products it had developed. In F14, a provision of USD 20 million ($22.5 million) was expensed in relation to a patent infringement lawsuit by AMF and AB in the US. The directors are of the opinion that the facts and the law do not support the jury’s findings and Cochlear has applied to overturn the verdict in post-trial motions filed with the District Court. The directors will appeal any significant adverse Judgment to the United States Court of Appeals for the Federal Circuit. Source: Cochlear 2014 Annual Report, p. 28

Footnote A provision is recognised in the balance sheet when Cochlear has a present legal or constructive obligation as a result of a past event that can be estimated reliably, and it is probable that an outflow of economic benefits will be required to settle the obligation. Provisions are determined by discounting the expected future cash flows at a pre-tax rate that reflects current market assessments of the time value of money and the risk specific to the liability. The unwinding of the discount rate is recognised as a finance expense. Source: Cochlear 2014 Annual Report, p. 85

Patent dispute On 24 January 2014, a jury verdict in the patent infringement lawsuit by the Alfred E. Mann Foundation for Scientific Research and AB LLC in the United States District Court in Los Angeles, California was reached. The jury found direct, contributory and wilful, but not induced infringement against Cochlear Limited and its USA subsidiary Cochlear Americas and awarded damages of USD 131.2 million against Cochlear. No judgment has been entered based on the verdict as important issues still remain to be decided by the Judge. These decisions may negate some of the findings of the jury and could alter the damages awarded by the jury. The directors have obtained external advice and are of the opinion that the facts and the law do not support the jury’s findings and Cochlear has applied to overturn the verdict in post-trial motions filed with the District Court. A Judgment is pending and the timing for entry of the Judgment is uncertain. The directors will appeal any significant adverse Judgment to the United States Court of Appeals for the Federal Circuit.

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329

CASE STUDY

Case 4 COCHLEAR: PROVISIONS AND PATENT DISPUTES

CASE STUDY

330

PART 4 FURTHER CASE STUDIES

If an appeal is necessary, Cochlear will provide non-cash security to stay the execution of the Judgment against Cochlear. Providing this security will avoid the requirement for Cochlear to pay the Judgment amount prior to the outcome of the appeal. A provision of USD 20 million ($22.5 million) was expensed in the half-year ended 31 December 2013 in relation to this dispute. No additional amount has been provided since the half-year accounts. For the purpose of determining this provision, Cochlear considered its

independent damages expert’s assessment prepared for the trial to estimate the liability that could result from the dispute. The nature of the above legal process is such that final future outcomes are uncertain. The directors have made judgements and assumptions relating to their best estimate of the outcome of this litigation and actual outcomes may differ from the estimated liability. Source: Cochlear 2014 Annual Report, p. 86

FIGURE C4.3 Summary of annual report information for Cochlear, 2013 to 2018

2013 $000

2014 $000

2015 $000

2016 $000

2017 $000

2018 $m

Summary of statement of financial performance Revenue

752 721

804 936

925 630

1 130 552

1 253 838

1 363.7

Cost of sales

208 072

248 285

275 320

333 593

358 373

361.2

Gross profit

544 649

556 651

650 310

796 959

895 465

1 002.5

Patent dispute provision

N/R

22 545

0

N/R

N/R

N/R

6 223

9 977

10 105

8 338

6 775

7.9

Other expenses

365 789

407 015

443 722

534 355

579 865

654.1

Profit before tax

172 637

117 114

196 483

254 266

308 825

340.5

40 074

23 405

50 463

65 345

85 209

94.7

Net profit

132 563

93 709

146 020

188 921

223 616

245.8

Other comprehensive income

(18 411)

19 806

(2 920)

6 904

(1 608)

(24.4)

Comprehensive income

114 152

113 515

143 100

195 825

222 008

221.4

Net finance expense

Income tax

Summary of statement of financial position Current provisions

63 224

26 492

26 652

33 675

24 992

24.5

Other current liabilities

128 606

143 086

376 632

217 425

321 623

263.2

Non-current provisions

35 356

44 603

43 394

44 027

54 711

54.4

Other non-current liabilities

180 402

245 650

66 992

213 679

191 386

204.0

Total liabilities

407 588

459 831

513 670

508 806

592 712

546.1

Equity

356 913

329 205

355 386

448 557

543 647

610.8

Total liabilities and equity

764 501

789 036

869 056

957 363

1 136 359

1 156.9

17 914

21 551

25 573

36 604

41 125

39.8

7 487

4 465

5 012

4 401

3 205

4.9

36 586

21 607

15 918

13 020

12 488

11.1

2 143

2 139

2 210

2 344

1 552

1.8

0

21 333

21 333

21 333

21 333

21.3

Footnote disclosures Provisions Warranties Legal and insurance Product recall Lease make good Patent dispute

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Employee benefits

331

34 450 98 580

71 095

70 046

77 702

79 703

78.9

Current

63 224

26 492

26 652

33 675

24 992

24.5

Non-current

35 356

44 603

43 394

44 027

54 711

54.4

Total provision

98 580

71 095

70 046

77 702

79 703

78.9

Note: N/R = not reported.

FIGURE C4.4 Unadjusted stock price performance of Cochlear, 2015 to 2019 250

200

150

100

50

2015

2016

2017

2018

2019 Source: ASX

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CASE STUDY

Case 4 COCHLEAR: PROVISIONS AND PATENT DISPUTES

CASE STUDY

332

PART 4 FURTHER CASE STUDIES

CASE 5

ACCOUNTING ANALYSIS: CASH FLOW RECONCILIATION

This case relates to Chapters 3, 4 and 5.

BACKGROUND Samantha Hopper has just begun a career as an analyst and has been assigned to the retail sector. As part of the accounting analysis, to familiarise herself with the firms she has been assigned, Samantha decides to review the cash flow reconciliation statements of seven retail firms. Figures C5.1 to C5.7 record the profit to cash flow reconciliation reported in their 2018 financial statements.

QUESTIONS 1 The Warehouse Group cash flow reconciliation has three sub-headings: non-cash items, non-operating items and change in working capital items. What are these items and why do they appear in this reconciliation? 2 Recast each of the reconciliations into a common format. 3 Chapter 3 suggests that the profit to operating cash ratio is a useful way to summarise this table. A more complete analysis is to take each item in the table and express it as a percentage of operating cash flow. This is similar to calculating what is known as a common size statement. The idea behind common size statements is to make different firm’s financial statements comparable by scaling by size. For example, each item in the balance sheet is scaled (divided by) total assets. For the income statement the divisor is revenue. In this question the divisor will be operating cash flow. Undertake this analysis and answer the following: a Comment on the percentages for Smith City. b Often this type of analysis highlights areas where the analyst should delve a little deeper to get a better understanding of the transactions, events and conditions that have affected the financial statements (especially the accruals). For the percentages you have just calculated, list the line items that you would investigate further and why. 4 Because of the possibility of negative and small operating cash flow numbers, analysts will sometime calculate per cent of cash flow reconciliation items in relation to revenue. Repeat Question 3, scaling items by revenue. In addition, state whether you prefer scaling by operating cash flows or revenue.

5 Some analysts argue that this reconciliation is a measure of accounting quality (and therefore an essential part of accounting analysis). Do you agree with this statement? Why or why not? 6 One of Samantha’s colleagues has said ‘analysing cash flow statements is a waste of time. I can construct a simple measure of operating cash flow by adding back depreciation and amortisation. That is why, I just use EBITDA rather than profit for all my analysis.’ Do you agree with Samantha’s colleague? Why? FIGURE C5.1 Profit to operating cash flow reconciliations for Briscoe Group

Period ended 28 January 2018

Period ended 29 January 2017

$000

$000

Reconciliation of net cash flows from operating activities to reported net profit Reported net profit attributable to shareholders

61 325

59 420

6 233

5 988

Adjustment for fixed increase leases / inducements

29

277

Bad debts and movement in doubtful debts

110

98

(157)

227

632

637

Items not involving cash flows Depreciation and amortisation expense

Inventory adjustments Executive share option expense Loss (gain) on disposal of assets

116

(1 627)

6 963

5 600

Decrease (increase) in trade and other receivables

(288)

(323)

Decrease (increase) in inventories

4 594

1 046

696

(526)

Impact of changes in working capital items

Increase (decrease) in taxation payable

Michael Bradbury prepared this case. This case is intended solely as a basis for class discussion and is not intended to serve as an endorsement, source of primary data or illustration of effective or ineffective management. Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Increase (decrease) in trade payables

(41)

Increase (decrease) in other payables and accruals

21 112

(3 721)

(345)

1 240

20 964

Movement in working capital:

69 528

85 984

(Increase) / decrease in trade and other receivables

Source: Briscoe Group, 2018 Annual Report, p. 18

FIGURE C5.2 Profit to operating cash flow reconciliations for Hallenstein Glasson Holdings

Reconciliation of profit after taxation to cash flows from operating activities

Net profit after taxation

2018

2017

$’000

$’000

27 361

17 269

Add/(deduct) items classified as investing or financing activities

(Increase) / decrease in inventories

5 272

(1 249)

(13 873)

6 283

10 884

5 596

6 405

2 257

8 688

12 887

Depreciation

3.2

11 576

10 630

Amortisation of intangibles

3.3

3 575

3 196

(431)

(816)

(1 944)

733

1 489

1 139

Foreign currency translation of working capital balances

35

Depreciation and amortisation

2.2

7 908

7 565

Employee share-based remuneration

6.4

Deferred taxation

6.2

(215)

(688)

Loss on sale of PPE

3.2

–

(254)

124

129

Add/(deduct) non cash items

Increase / (decrease) in deferred taxation

Cash inflow from operating activities

Add/(deduct) movements in working capital items

2 116

1 465

16 381

16 347

75 601

67 273

Source: Kathmandu Holdings, 2018 Annual Report, p. 35

Taxation payable

195

1 518

Trade and other receivables and prepayments

599

427

Trade and other payables and employee benefits

(787)

3 798

Inventories

(354)

(604)

35 312

29 195

Source: Hallenstein Glasson Holdings, 2018 Annual Report, p. 25

FIGURE C5.3 Profit to operating cash flow reconciliations for Kathmandu

Reconciliation of net profit after taxation with cash inflow from operating activities

38 039

Add non cash items:

481

Net cash flows from operating activities

50 532

Increase / (decrease) in trade and other payables

2.2

Share option expense

2017 NZ$’000

Increase / (decrease) in tax liability Note

Revaluation of financial instruments

2018 NZ$’000

Profit after taxation

Net cash inflows from operating activities

Loss on sale of plant and equipment

Section

333

FIGURE C5.4 Profit to operating cash flow reconciliations for Michael Hill International

NOTE 10 Cash flow information NOTES

2018

2017

$000

$000

Reconciliation of profit after income tax to net cash inflow from operating activities Profit for the year

4 610

32 647

17 565

17 415

2 597

2 601

Adjustment for Depreciation

5(b)

Amortisation

5(b)

Impairment – PPE Impairment – other assets

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11 029 563

CASE STUDY

Case 5 ACCOUNTING ANALYSIS: CASH FLOW RECONCILIATION

CASE STUDY

334

PART 4 FURTHER CASE STUDIES

Non-cash employee benefits expense – share-based payments

484

371

Other non-cash expenses

(78)

897

Net loss on sale of non-current assets

450

1 166

Net exchange differences

966

(908)

(Increase) / decrease in trade and other receivables

(1 348)

(579)

(Increase) / decrease in inventories

12 169

(6 073)

(Increase) / decrease in deferred tax assets

(3 968)

6 043

(Increase) / decrease in other current assets

273

1 085

(Increase) / decrease in other non current assets

(826)

118

(Decrease) / increase in trade and other payables

2 258

3 050

(Decrease) / increase in current tax liabilities

3 665

(26 110)

(Decrease) / increase in provisions

2 030

830

(Decrease) / increase in deferred revenue

2 454

7 199

54 893

39 752

Change in operating assets and liabilities:

Net cash inflow from operating activities

FIGURE C5.5 Profit to operating cash flow reconciliations for Smith City Group

Note

2018

2017

($m)

($m)

Reconciliation of net profit with cash flows from operating activities

4.1

Add Increase (Deduct Decrease) Accounts Payable and Provisions

3.9

(0.6)

Movements in Working Capital

5.8

3.0

NET CASH INFLOW/ (OUTFLOW) FROM OPERATING ACTIVITIES

(1.4)

6.8

Source: Smith City Group, 2018 Annual Report, p. 42

FIGURE C5.6 Profit to operating cash flow reconciliations for Super Retail Group

19. Reconciliation of profit from ordinary activities after income tax to net cash inflow from operating activities

Profit from ordinary activities after related income tax Depreciation and amortisation Impairment charge Net gain on sale of non-current assets Non-cash employee benefits expense/share based payments Gain on divestment

13 14

(9.9)

2.0

2.7

1.8

(7.2)

3.8

(4.2)

(0.5)

Add/(Deduct) Movements in Working Capital

2018

2017

$m

$m

128.3

101.8

77.3

70.8

2.4

45.0

–

(0.6)

1.1

2.0

(6.9)

–

1.0

–

Profit for the period attributable to non-controlling interests

(1.0)

(1.3)

Net finance costs

17.7

16.9

19.6

0.1

– decrease / (increase) in net current tax liability

7.3

(4.7)

– (increase) / decrease in inventories

(37.0)

20.4

– increase / (decrease) in payables

94.0

(2.7)

– increase / (decrease) in provisions

7.0

(4.1)

(2.4)

(9.1)

308.4

234.5

Change in operating assets and liabilities, net of effects from the purchase of controlled entities – decrease in receivables

Profit before taxation

Add Decrease (Deduct Increase) Receivables

6.1

Equity accounting loss

Source: Michael Hill International, 2018 Annual Report, p. 74

Add depreciation; amortisation and impairment

Add Decrease (Deduct Increase) Inventories

– increase / (decrease) in deferred tax liability Net cash inflow from operating activities

Source: Super Retail Group, 2018 Annual Report, p. 107

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FIGURE C5.7 Profit to operating cash flow reconciliations for The Warehouse

Reconciliation of operating cash flows

Loss/(Gain) on sale of property, plant and equipment Loss on business disposal and related costs

For the 52-week period ended 29 July 2018 NOTE Net profit

(52 weeks)

(52 weeks)

397

(9 979)

1 421

946

Supplementary dividend tax credit 4.2

2018

2017

Total investing and financing adjustments

$000

$000

Changes in assets and liabilities

23 120

20 731

Trade and other receivables

Non-cash items

Finance business receivables

Depreciation and amortisation expense 2.2

Inventories

335

327

378

2 145

(8 655)

(3 715)

4 248

3 305

6 210

(36 566)

9 895

59 630

60 191

Trade and other payables

11 522

7 557

9.2

25 622

40 061

Provisions

18 768

(6 811)

Share based payment expense 3.3

353

1 283

Income tax

11 347

(7 027)

Interest capitalisation

467

524

4 661

14 072

(2 694)

–

107 914

128 088

(5 826)

(555)

436

436

77 988

101 940

Intangible asset impairment

Suppliers contributions Movement in deferred tax

4.3

Movement in de-designated derivative hedges Total non-cash items

Total changes in assets and liabilities Net cash flows from operating activities

Source: The Warehouse Group, 2018 Annual Report p. 76

Items classified as investing or financing activities

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CASE STUDY

Case 5 ACCOUNTING ANALYSIS: CASH FLOW RECONCILIATION

CASE STUDY

336

PART 4 FURTHER CASE STUDIES

CASE 6

VALUATION RATIOS IN THE RETAIL INDUSTRY 2016 TO 2018

This case relates to Chapters 5, 7 and 8.

Jessica Waters, a 25-year-old student, was recently quoted as saying, ‘I don’t buy more than I used to, but I buy differently …’ and in those simple words she eloquently summed up the quandary facing Australia’s retailers’.1

Introduction Over the decade leading up to the GFC (mid-2007), Australia’s retailers enjoyed year after year of growth without the need for real innovation. In the current climate, complacent retailers find themselves in a constricting market, unprepared for the changes demanded by a tough new world. Australian consumers are spending less with retailers. Much of the commentary by big retail has focused on the impact of online shopping and the threat to local industry from overseas e-tailers. Several major retailers have moved into omni-channel businesses. However, retail sales indices show that online sales represented just 8% of Australia’s $267.4 billion retailing industry,2 with less than half of these sales from overseas. Hence, there is no single ‘silver bullet’ solution facing retail Australia. With this background, the following text summarises the strategies of four unidentified retail firms. Figure C6.1 presents financial ratios for the same firms over the period 2016 to 2018.

The firms Company A Company A operates in three segments: Auto & Cycle Retailing, Leisure Retailing and Sports Retailing. The Auto & Cycle Retailing segment is engaged in retail and distribution of motor vehicle spare parts and bicycle accessories, tools and equipment. The Leisure Retailing segment is engaged in retail and distribution of boating, camping, fishing, outdoor equipment and apparel. The sports retailing segment is engaged in the retail and distribution of sporting equipment and apparel. In 2016 and 2017 it acquired additional retail interests. It operates approximately

585 stores. The management commentary includes the following comments:

‘… solid sales growth in all divisions ... Underlying costs of business increasing due to investment in multichannel capability, investment in store service level and increase in occupancy costs … Dividend increase to 38 cps.’

Company B Company B operates in two segments: investments and retail. The investments segment is managed and operated through the company. The retail segment operates through a number of retail fashion chains within Australia and New Zealand and via a joint venture entity in South Africa. The company offers casual wear, women’s wear and nonapparel products. It owns various brands and offers its products through the internet. As of 28 July 2017, it had seven brands trading from more than 1000 stores. The management commentary includes the following remarks:

‘… setting aside one-off accounting reclassification gains, company B achieved an increase in sales and profit despite the challenging operating environment … the Board has decided to increase dividends to 38 cents per share …’

Company C Company C operates in two divisions: the Rental division and the Credit management division. The Rental division offers a range of audio-visual products, kitchen and laundry appliances, computers, furniture and fitness equipment. The Credit management division includes receivables management, debt recovery, credit information services, debt purchasing, equipment finance and personal loans. The company operates 90 outlets. The management commentary includes the following comments:

‘… the backdrop to this year’s report is that many customers … have encountered tough economic conditions, with consumer and business confidence at low levels. Company C is not immune from these conditions but another record year from our core consumer rental division coupled with a strong base of recurring revenue streams and significant cash flows underscores our resilience and strength …’

Michael Bradbury prepared this case. This case is intended solely as a basis for class discussion and is not intended to serve as an endorsement, source of primary data or illustration of effective or ineffective management.

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Company D Company D operates through two segments. The retail segment comprises businesses that retail locally manufactured and imported household furniture. The retail segment also includes the manufacturing operations. The property segment purchases and develops sites for use by the company and leases surplus requirements to external tenants. As of 30 June 2018, it operated 136 retail stores. The management commentary includes the following comments:

‘… the gross margin for the Group varies by brand and has been affected by product discounting and the clearance of excessive inventory. Trading conditions are expected to remain challenging in financial year 2019 due to increasing competition in key markets, lower exchange rates, continued economic weakness and continued subdued consumer confidence.’

Company B

2018

2017

2016

Profit ratios

 

 

 

Return on equity

5.6%

3.4%

6.7%

Return on assets

5.1%

3.3%

6.2%

Leverage

 

 

Total debt / total assets Efficiency ratios

 

9.0

EBIT / interest expense

0.0

10.6    

12.8  

*

0.6  

Gross margin

7.7

6.9  

Total asset turnover Margin ratios

0.6  

*

11.8%

14.0%

EBIT margin

12.3%

7.5%

11.0%

Net margin

8.2%

4.6%

9.1%

Working capital management

FIGURE C6.1 Financial comparison of four retail firms over the period 2011 to 2013

337

 

 

 

Current ratio

5.4

1.7

4.3

Quick ratio

4.4

1.4

3.5

Inventory turnover

9.9

10.4

10.4

Company A

2018

2017

2016

Receivable turnover

84.0

75.3

85.9

Profit ratios

 

 

 

Payable turnover

39.7

40.4

37.0

Return on equity

14.5%

16.8%

19.4%

Growth rates

Return on assets

8.5%

10.2%

11.8%

Sales

(4.4%)

(0.3%)

3.3%

Net income

68.4%

(49.1%)

(3.8%)

Leverage

 

 

 

Total debt / total assets

32.5

36.0

24.6

EBIT / interest expense

6.6

6.4

8.2

Efficiency ratios

 

Total asset turnover Margin ratios

  *

 

Gross margin

  1.2

 

1.9  

*

43.6%

45.2%

EBIT margin

8.6%

8.6%

8.1%

Net margin

5.1%

5.0%

5.1%

Working capital management

 

 

 

Current ratio

1.7

2.2

2.3

Quick ratio

0.2

0.3

0.3

Inventory turnover

2.5

2.5

–

Receivable turnover

68.6

80.2

68.6

6.5

8.4

7.5

Payable turnover Growth rates

 

 

 

Sales

22.1%

51.4%

16.5%

Net income

23.0%

50.2%

46.1%

* Figure deliberately missing – see Question 1 below.

 

 

 

* Figure deliberately missing – see Question 1.

Company C

2018

2017

2016

Profit ratios

 

 

 

Return on equity

19.0%

Return on assets Leverage

23.7%

14.7%  

24.9%

17.0%  

15.8%  

Total debt / total assets

15.7

9.1

27.5

EBIT / interest expense

23.6

26.3

53.5

Efficiency ratios

 

Total asset turnover Margin ratios

  *

 

Gross margin

  1.0

 

1.0  

*

30.7%

27.4%

EBIT margin

21.0%

22.2%

20.9%

Net margin

13.8%

14.8%

14.0%

Working capital management

 

 

 

Current ratio

1.8

1.7

1.3

Quick ratio

1.6

1.7

1.2

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CASE STUDY

Case 6 VALUATION RATIOS IN THE RETAIL INDUSTRY 2016 to 2018

CASE STUDY

338

PART 4 FURTHER CASE STUDIES

Inventory turnover

–

–

–

Receivable turnover

4.1

4.4

–

Payable turnover

6.9

6.0

–

Growth rates

 

 

1 Match these ratios with each firm. What is the reasoning for your selection? Firm

Total asset turnover 2018

Gross margin 2018

2.5

28.2%

 

Sales

8.0%

19.2%

8.6%

1.4

44.5%

Net income

0.6%

26.4%

13.0%

0.9

29.6%

0.6

12.5%

* Figure deliberately missing – see Question 1.

Company D

2018

2017

2016

Profit ratios

 

 

 

2 Match the following price-earnings multiple with each firm. What is the reasoning for your selection?

Return on equity

12.4%

20.0%

20.3%

Return on assets

8.2%

13.0%

12.5%

Leverage

 

  19.0

15.4

15.2

EBIT / interest expense

17.2

28.2

23.2

 

 

Total asset turnover Margin ratios

*  

EBIT margin Net margin

2.6

2.7  

3 Match the following price-to-book multiple with each firm. What is the reasoning for your selection?

4.2%

7.0%

6.5%

0.6

4.5%

1.9

 

4.7%  

Price-to-book 2018

2.0 2.0

Quick ratio

0.5

0.4

0.4

Inventory turnover

4.2

3.9

3.7

Receivable turnover

54.0

49.0

42.5

Payable turnover

26.2

20.3

18.9

 

Firm

  1.7

Net income

22.9

29.6%

2.0

Growth rates

15.0

30.3%

Current ratio

Sales

11.1

* 3.0%

Working capital management

10.8

 

 

Gross margin

Price-earnings 2018

 

Total debt / total assets Efficiency ratios

Firm

 

 

3.2

Endnotes 1 2

(0.1%)

2.1%

4.2%

(35.6%)

7.8%

5.1%

See P. Singline and D. Ansett, ‘Walking with retail dinosaurs’, The Melbourne Review (May 2012). Australian Bureau of Statistics (ABS), Retail Turnover excluding cafes, restaurants and takeaway food services for 2017 calendar year and Australia Post, ‘Inside Australian Online Shopping’ Paper, based on delivery data from January 2016 and December 2017.

* Figure deliberately missing – see Question 1.

QUESTIONS One way to think about the differences between various retail activities is to consider two ratios: asset turnover and gross margin.

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339

CASE 7

DICK SMITH

This case relates to Chapters 3 and 4.

Dick Smith – accounting analysis Dick Smith Electronics (DSH) was an Australian business that operated consumer electronics retail stores and an online consumer electronics business throughout Australia and New Zealand. It was owned by Woolworths Limited from 1982. In January 2012, Woolworths announced that it had decided to accelerate the restructure of Dick Smith with a view to divesting the business as a going concern in a staged and managed process. On 26 November 2012, Woolworths sold the Dick Smith business to private equity firm Anchorage Capital. A prospectus was lodged on 14 November 2013 and shares commenced trading on the ASX in December 2013. In January 2016, Dick Smith was placed into voluntary administration. One of the accounting issued faced by Dick Smith was its accounting for its stock rebates, also known as inventory rebates or supplier rebates. On or about 30 November 2015, DSH announced a $60 million write-down in the value of its inventory. A rebate is a reduction, refund or a return on what has already been paid. They are common in the retailing industry. Rebates can be obtained for sales or marketing; for example, where a manufacturer contributes towards the retailer’s promotional costs of a new product. Other types of rebates relate to volume: where a manufacturer offers discount if the retailer purchases a specified volume of stock. Dick Smith obtained volume and price rebates, as well as rebates directly attributable to marketing and advertising expenses. At the time Dick Smith was operating, no specific accounting rule governed rebates.1 However, there was some guidance as to the appropriate accounting treatment for rebates in the accounting standards. AASB102 Inventories states that ‘the cost of inventories shall comprise all costs of purchase, costs of conversion and other costs incurred in bringing the inventories to their present location and condition’ [paragraph 10]. Paragraph 11 states: ‘Trade discounts, rebates and other similar items are deducted in determining the costs of purchase’ [emphasis added]. The international accounting standard setting body (the IASB) addressed the issue of accounting for rebates in the

International Financial Reporting Interpretations Committee (IFRIC) November 2004 update. The IFRIC considered three related questions on applying IAS 2 inventories', referred to it by the Urgent Issues Group (UIG) of the Australian Accounting Standards Board:

(a) whether discounts received for prompt settlement of invoices should be deducted from the cost of inventories or recognised as financing income. (b) whether all other rebates should be deducted from the cost of inventories. The alternative would be to treat some rebates as revenue or a reduction in promotional expenses. (c) whether volume rebates should be recognised only when threshold volumes are achieved, or proportionately where achievement is assessed as probable. On (a), the IFRIC tentatively agreed that settlement discounts should be deducted from the cost of inventories. Because the requirements under IFRSs were sufficiently clear, the IFRIC tentatively agreed that the matter should not be added to the agenda. On (b), the IFRIC tentatively agreed that IAS 2 requires only those rebates and discounts that have been received as a reduction in the purchase price of inventories to be taken into consideration in the measurement of the cost of the inventories. Rebates that specifically and genuinely refund selling expenses would not be deducted from the costs of inventories. Because the requirements under IFRSs were sufficiently clear, the IFRIC tentatively agreed that the matter should not be added to the agenda. On (c), the IFRIC tentatively agreed that there was insufficient evidence of diversity in practice to warrant the matter being added to the agenda. Source: Copyright © 2020 IFRS® Foundation. Used with permission of the IFRS Foundation. All rights reserved.

Once the inventory is sold, the net effect of the decision to classify the rebates as marketing or inventory related on net income is zero. However, the classification decision affects the assessment of gross profitability; that is, the level of cost of sales relative to sales revenue.

Jeff Coulton prepared this case. This case is intended solely as a basis for class discussion and is not intended to serve as an endorsement, source of primary data or illustration of effective or ineffective management.

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CASE STUDY

Case 7 DICK SMITH

CASE STUDY

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PART 4 FURTHER CASE STUDIES

For accounting purposes, Dick Smith treated at least some of these rebates as a reduction in marketing costs – this had the effect of increasing profit in the period the rebate was booked. The alternative accounting treatment was to book the rebates as a reduction in inventory costs. If the inventory ‘associated’ with the rebate is not sold by balance date (financial year end) then the decision to classify the rebate as marketing-related affects net income. A reduction in marketing costs is reflected in income immediately, whereas a reduction in inventory costs is reflected in net income in the financial period in which the inventory is sold. This gives rise to two potential accounting issues. First, there would need to be a specific, incremental, identifiable cost incurred by an entity in selling a supplier’s products for the rebate to be correctly recorded as a reduction in marketing expenses. Otherwise the rebate should be treated as a reduction in the cost of inventory (consistent with AASB102 Inventories). The second issue is recording the rebate as a reduction in the cost of sales (i.e. reducing an expense) prior to the inventory being sold. The correct treatment would be to include the rebate as a reduction in the cost of the inventory in the balance sheet. The rebate should be reflected in the income statement in the financial period in which they were actually sold, as a reduction in the cost of sales account. It has been claimed that Dick Smith classified some of its volume-based rebates as marketing rebates.

FIGURE C7.1 Dick Smith income statement and balance sheet 2017

Income statement  

Balance sheet

 

Cash

200

Revenue

1 000

Inventories

500

Cost of sales

(600)

Total Assets

700

Gross profit

400 Total liabilities

300

Net assets

400

  Marketing and sales costs

(100)

Profit before income tax

300

 

Equity

 

Issued capital

240

Income tax expense

(50)

Retained earnings

160

Net profit for the year

250

Total equity

400

Assume the following events occur. They are not ‘cumulative events' for the purposes of this illustration. Ignore any tax effects here. a Dick Smith purchases a TV for $100, and the TV is not sold by the end of June. b Dick Smith purchases a TV for $100, and the TV is sold for $150 by the end of June. c Dick Smith purchases a TV for $100, and receives a rebate for $30. The TV is not sold. The O&A rebate relates to marketing. d Dick Smith purchases a TV for $100, and receives a rebate for $30. The TV is not sold. The rebate relates to inventory, not marketing. e Dick Smith purchases a TV for $100, and receives a rebate for $30. The TV is sold for $150. The rebate relates to marketing. f Dick Smith purchases a TV for $100, and receives a rebate for $30. The TV is sold for $150. The rebate relates to inventory, not marketing.

QUESTIONS 1 Briefly (in three to four lines) explain how stock rebates work in a retail setting. 2 Rebates are common in the retailing industry. Can you find evidence of how an Australian or New Zealand company other than Dick Smith or Target treats its rebates from an accounting perspective? This will involve a small amount of research. Try Google, but limit it to news search. 3 If you were an auditor, what evidence would you look for to determine whether a rebate was classified as a reduction in marketing costs, or a reduction in inventory costs? 4 Several example scenarios in relation to rebates are provided below. Show the accounting impact of these transactions. That is, show how would the income statement and balance sheet look after each of these transactions. They are not cumulative. Assume that a company has the following income statement and balance sheet at the start of June 2017.

1 June 2017

Endnote 1

Woolworths Limited, ASX Announcement, 21 January 2012.

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CASE 8

RESINEX

This case relates to Chapters 3 and 10.

The 20X1 audit of Resinex Corporation The 20X1 audit of Resinex Corporation account balances has been completed. Ken Brinkly, the audit partner, is concerned with one outstanding issue: the assessment of Resinex as a going concern. Hank Bergerman, an audit manager who has been seconded to work in New Zealand from an affiliated audit firm in the US, suggests ‘Why don’t we try assessing going concern using the Altman Z-score?’ ‘I have heard of the Altman Z-score, but is it suitable in New Zealand?’ questions Ken. ‘If it is, perhaps we can make it part of the firm’s general procedures to assess going concern. To do this we will need to convince the rest of the partnership. First, we will need an assessment of advantages and disadvantages of the Z-score model to assess going concern in New Zealand. Second, can we demonstrate the application of an Altman Z-score with an assessment of Resinex?’ ‘I can do that,’ Hank replies. Ken says, ‘Have it on my desk by Monday morning’.

QUESTIONS Assume you are Hank Bergerman. You have been asked to write a brief memo to the audit partners on the following matters: 1 Comment on the general use of the Altman Z-score model to determine whether a company is a going concern in New Zealand. 2 In a second memo, assess whether Resinex Corporation Limited is a going concern. To do this, you might like to use the Ferner-Hamilton model described in Chapter 10. On the following pages, detailed information is provided to complete this case. The background section provides some initial details on Resinex Corporation. Figure C8.1 presents the 20X1 financial statements of Resinex. At the end of this case, we also provide extracts from the New Zealand professional requirements dealing with ‘going concern’.

Background Resinex Corporation Limited had its origins in the Kauri Deposit Survey Company (KDSC), which was incorporated to investigate the commercial viability of extracting resins and waxes from peat deposits for worldwide use in a diverse range of high-demand products, including polishes, adhesives, printing inks and cosmetics. The positive results of the field surveys, product evaluation and market testing were finalised in January 20X0. KDSC (an unlisted company with more than 200 shareholders) then decided to establish a commercial venture. The company changed its name to Resinex Corporation Limited and increased its authorised capital. A share issue of 100 000 shares was placed with Dodd G. Securities, a merchant bank and subsequently manager and underwriter of an 11 million ordinary shares private offering dated 26 July 20X0.

The offering The issuing prospectus noted that:

Extraction feasibility and product development has been conducted by consulting engineers and scientists of international repute … The market was assessed by a senior executive, who over the course of two extensive overseas study tours has identified major blenders, distributors and end-users of resins and waxes and negotiated agency agreements in the UK, Germany, Spain, Italy, Japan and the US. Resinex’s output will represent 1% of world resin exports, while the target market share for Resinex wax is 4%. Site establishment is well-advanced, with plant commissioning scheduled for late 20X1. Projected output in the first full year is 1875 tonnes, rising to 5000 tonnes per annum within four years and progressing to 15 000 tonnes per annum by 20X8. Stage one is estimated to cost $9 million, covering site development, plant engineering, fabrication, erection and commissioning and product development. These capital requirements will be financed by this share issue of $5.5 million and borrowing of $3.5 million. Stage Two, scheduled for commencement in

Michael Bradbury prepared this case. This case is intended solely as a basis for class discussion and is not intended to serve as an endorsement, source of primary data or illustration of effective or ineffective management.

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20X5/6 and due to be fully operational in 20X8, is estimated to cost $13 million. TR&Co have prepared a report assessing the present value of the project at $8.7 million*. This valuation is based on projected future cash flows from the project and given the nature of the venture incorporates a requirement for a return on funds of 20% in real terms (i.e. after inflation). Prior to the issue of this prospectus, there has been a revaluation of the assets of Resinex to equate to the valuation of TR&Co. *The TR&Co report was included in the prospectus report.

Interest paid Other expenses Operating loss Extraordinary items Net development expenditure Bank Short-term deposits Accounts receivable Work in progress

The company has a resource right located in the far north of New Zealand. The 1450 ha of peat to be worked by Resinex over a period of about 30 years offers an estimated 600 000 tons of resins and waxes.

Investment

A drainage system will be used to dry peat to a level where it can be handled by earthmoving equipment. The field peat is then milled, screened and air-dried to a moisture content of about 50% before going into the extraction plant. The resins and waxes are extracted from the peat by contact with a flow of hot solvent. The end-product are obtained by a fractional crystallisation process and are then packed for export to world markets. The peat is treated with steam and water to recover the solvent for reuse and the extracted peat is returned to its source and developed as grassland.

17 880

695 450

428 142

704 082

450 522

194 148

319 799

–

55 361

194 148

375 160

–

16 154

600 000

4 537 110

1 687

73 411

35 451

–

637 138

4 626 675

50 000

50 000

PPE

3

9 135 281

818 310

Intangibles

4

9 037 449

8 843,301

18 859 868

14 338 286

9 700 000

9 700 000

314 458

314 458

4 136 759

4 136 759

(141 209)

(141 209)

14 010 008

14 010 008

107 682

0

1 418 848

328 278

1 526 530

328 278

3,323,330

0

18 859 868

14 338 286

Total assets Capital

The process

6

Share premium Asset revaluation

7

Retained earnings Shareholders’ funds Bank Accounts payable Current liabilities Term debt Total funds

5

Part 1 Particular accounting policies

Current share price The current share price (as at 14 January 20X2) is 90 cents, although over the last month it has traded between 95 to 109 cents per share. FIGURE C8.1  Resinex Corporation statement of financial performance for the year ended 30 September 20X1

Notes

20X1

20X0 $

$

509 934

130 723

Revenue Expenditure Depreciation

2

Current assets

The resource

Interest

4

147

8 485

4 500

A) Extraction project Expenditure incurred to research financial viability and to obtain the company’s coal mining licence is capitalised. At 13 June 20X0, the amounts incurred were revalued based on the discounted expected future net cash flows from the project. The value is to be amortised over the life of the project on a production basis. The revaluation was based on revenue and cost forecasts including tax legislation applicable at that date.

B) Foreign currency Liabilities denominated in foreign currencies have been translated into New Zealand dollars at the rates of exchange ruling at balance date.

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All gains or losses incurred to date of commencement of plant production are capitalised to fixed assets.

policy of capitalising all costs associated with the project until the plant commences production.

C) Property, plant and equipment (PPE)

D) Preliminary expenses

PPE is stated at cost. Mobile equipment used in the extraction operation has been depreciated on a straight-line basis over their useful life ranging from three to five years. No depreciation will be charged on other fixed assets until used in production. During the period borrowing costs of $111 202 and associated unrealised foreign exchange losses of $123 330 have been capitalised to fixed assets in accordance with International Accounting Standard 23 and the Company’s

Represent the cost of flotation of the company and are to be amortised over a period of five years commencing with the year ending 30/9/20X2.

Changes in accounting policies There have been no changes in accounting policies. All policies have been applied on bases consistent with those used in previous years.

Part 2 Work in progress Work in progress is stated at cost, and represents 4 000 cubic metres of peat excavated to balance date.

Part 3 PPE FIGURE C8.2 PPE

Cost a) Site development

Net book value

Net book value

20X1

20X0

395 823

–

395 823

352 219

8 109 661

817

8 108 844

99 973

64 305

–

64 305

9 435

586 078

19 769

566 309

56 683

$9 155 867

$20 586

$9 135 281

$818 310

b) Extraction plant c) Buildings d) Mobile equipment

Part 4 Intangible assets – project development account Expenditure relating to the development and research into the financial viability of the project has been capitalised. The project was revalued to $8.7 million in June 20X0. This value was obtained from an independent valuation prepared by TR&Co and dated 5 June 20X0. A coal mining licence has been issued for a period of 33 years commencing 12 July 1999, which allows the Company to extract peat in an area covering 1450 hectares in the Opoe and Rangaunu Survey Districts.

20X1

–

670 370

Development expenditure 30/9/20X1

194 148

–

8 598 938

1 563,241

0

7 136 759

$8 598 938

$8 700 000

–

381 748

8 598 938

8 318 252

–

86 538

8 598 938

8 404 790

Project revaluation (Note 11) Less expenditure transferred to fixed assets Development expenditure 13/6/20X0 to 30/9/20X1 Preliminary expenses

20X0

Development expenditure account 8 404 790

Development expenditure 13/6/20X0

Total development expenditure

FIGURE C8.3 Resinex’s intangible assets

Opening balance

Accumulated depreciation

892 871

Total intangible assets

438 511

438 511

$9 037 449

$8 843,301

Since balance date, the Directors have reviewed the basis of valuation of the project. This review has converted all

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variables and assumptions used in the valuation including the rate of taxation, the currency exchange rates and a recent assessment of the marketing of the resins and waxes. The Directors are of the opinion that the independent valuation prepared by TR&Co as adjusted for development expenditure incurred since that valuation is still valid.

Part 5 Term liabilities Regional development concessional loans $200 000 The company has received a government development loan. It is interest free and no principal repayments required until September 20X3. Repayments of $3333 monthly plus interest are then required. It is secured by a second debenture over specified plant and mobile equipment.

Offshore loan $3 123 330 Debenture loan facility of NS$4 million equivalent with draw down commencing July 20X1. Interest-only payments, at current bank rate, until December 20X3 with NZ$1 million dollars due followed by a similar principal payment. December 20X3 and the balance December 20X5. Secured by a first debenture over the company.

Part 6 Movement in number of shares FIGURE 8.4 Resinex’s movement in shares

At 30 September

19 400 000

994 000

Issue for cash at $3.10 per share

–

100 000

Issue under option agreements and cancellation of management contracts

–

106 000

Balance at 12 June 20X0

–

1 200 000

Share split from 1 share to 2 shares

–

2 400 000

Bonus issue of 5 ordinary shares for each 2 held

–

6 000 000

Issue for cash

–

11 000 000

19 400 000

19 400 000

At 30 September

Part 7 Asset revaluation reserve FIGURE 8.5 Resinex’s asset revaluation reserve

4 136 759

–

Revaluation of the project up to the value specified by TR&Co in the valuation dated 5 June 20X0 (Note 4)

Opening balance

–

7 136 759

Less amount applied to 5 for 2 bonus issue

–

3,000 000

$4 136 759

$4 136 759

Closing balance

Part 8 Capital commitments At balance date, commitments have been made for site works and engineering for $931 218 (20X0: $306 509).

Part 9 Events subsequent to balance date Since balance date, shareholders were advised of the participation of Leyla Growth Limited in our company. The issue of 4 850 000 shares at a premium of 30c has raised $3 880 000. This association brings financial backing and expertise in the establishment phase of the company. The capital from this issue will meet increased construction costs, provide greater flexibility and finance the proposed early plant expansion to meet anticipated market demand for waxes and resins. It will also provide capital for Resinex’s current peat excavation.

Extracts from professional requirements dealing with ‘going concern’ Below is information from the ‘New Zealand Equivalent to the IASB Conceptual Framework for Financial Reporting 2010’. Going concern is an important assumption underlying the preparation of general-purpose financial statements. The ‘statement of concepts’ says:

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Financial reports are normally prepared on the assumption that the entity will continue in existence for the foreseeable future. Hence, it is assumed that the entity has neither the intention nor the need to enter liquidation or to cease trading. If such an intention or need exists, the financial statements may have to be prepared on a different basis. If so, the financial statements describe the basis used.

The auditor’s responsibilities are to obtain sufficient appropriate audit evidence regarding, and conclude on, the appropriateness of management’s use of the going concern basis of accounting in the preparation of the financial statements, and to conclude, based on the audit evidence obtained, whether a material uncertainty exists about the entity’s ability to continue as a going concern. These responsibilities exist even if the financial reporting framework used in the preparation of the financial statements does not include an explicit requirement for management to make a specific assessment of the entity’s ability to continue as a going concern.

Source: IASB Conceptual framework for financial reporting, par 4.1.

Some financial reporting frameworks contain an explicit requirement for management to make a specific assessment of the entity’s ability to continue as a going concern, and standards regarding matters to be considered and disclosures to be made in connection with going concern. For example, IAS 1 ‘Presentation of financial statements’ (paragraphs 25–26), requires management to make an assessment of an entity’s ability to continue as a going concern. ‘International Auditing Standard 570 (revised), Going Concern’ places a specific obligation upon auditors to assess whether the client is a going concern.

345

Source: IAASB, International Standard on Auditing (ISA) 570 (revised), Going Concern.

Take this information into account as you assess Resinex.

Endnote 1

IFRS 15 was released in 2018, providing additional guidance for the accounting treatment for rebates.

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CASE 9

FOSTER’S–SOUTHCORP MERGER

This case relates to Chapter 11.

Part A Motivations Foster’s and Southcorp were major beverage producers in Australia. Southcorp was a major Australian wine producer with a strong international presence. The firm owned leading brand rankings in Australia and strong rankings internationally. Foster’s was an Australian-based, international multi-beverage company with a total portfolio of beer, wine, spirits, cider and non-alcohol beverages. On 13 January 2005, Foster’s Group Limited announced the purchase of an 18.8% interest in Southcorp Limited from Southcorp’s largest shareholder, Reline Investments Pty Ltd, an investment vehicle belonging to the Oatley family, for $4.17 per share in cash, valuing the stake at $584 million. In spite of amicable discussions between board representatives of Foster’s and Southcorp, no agreement was reached. On 17 January, Foster’s announced that it intended to launch a conditional off-market takeover offer for the shares in Southcorp that it did not already own at a price of $4.17 per share in cash. The sale price agreed with the Oatley family was extended to all Southcorp shareholders and valued 100% of the shares in Southcorp at $3.1 billion. The context of this takeover lay in the growth of the Australian wine industry since the 1980s, fuelled by a new exporting opportunity to the UK and the devaluation of the Australian dollar in the mid-1980s. The new exporting opportunity to the UK arose because of the relaxation of liquor licensing laws in that country allowing wine to be sold in supermarkets. The introduction of new technologies to combat high labour costs was made possible by several mergers between wine producers, resulting in an industry concentration of about 50% of annual sales in the top three producers by 1998. Further devaluation and wine quality improvements consolidated this growth, which in turn saw drives for further economies of scale and marketing alliances with liquor retailers. These economies could only be achieved by further mergers. Foster’s gave several reasons for its pursuit of a merger with Southcorp. Foster’s promoted the takeover

as ‘a unique opportunity to create a pre-eminent global wine company, with an unrivalled collection of premium wine brands furthering Foster’s global wine leadership strategy’.1 It would retain Australian ownership and control of Southcorp’s iconic wine brands in the hands of the logical acquirer, and protect and strengthen Australia’s position in the global wine industry. There were opportunities for greater scale in key geographies and price segments for wine particularly in the US, the UK and Australia. The merger would create an enhanced platform for growth and deliver long-term benefits to shareholders, employees, customers and consumers of the combined company. They said that their decision to proceed with the transaction was made in the context of increasingly favourable industry trends, and greater confidence in the outlook for the North American wine market and new world wine markets generally.

We are confident that the proven track record of management teams in our Australian wine and beer businesses will enable us to integrate the two organisations, capture synergy benefits and retain the best elements of the two companies, while maintaining the momentum of our existing businesses. In doing so, we will adopt a measured, inclusive and partnership approach to integrating both organisations. Source: Trevor O’Hoy, President and CEO, Foster’s Group Limited, www. fosters.com.au/mediacentre/CB834B2977C0499093CD335492DF94E9. htm, accessed 13 November 2008

Financially, synergy benefits were expected to result from reducing cost structures and maximising revenue benefits. The acquisition was expected to be earnings per share accretive by year 2. It was expected to generate double-digit returns by year 3, and was not expected to dilute cash flow generation capabilities.

Part B Foster’s pricing of Southcorp Foster’s considered that Southcorp’s share price had traded above its fundamental value for a considerable period before the takeover offer, because it was expected to become a takeover target. The firm believed that this was exacerbated by industry consolidations. At $4.17

Sue Wright developed this case. This case is intended solely as a basis for class discussion and is not intended to serve as an endorsement, source of primary data or illustration of effective or ineffective management.

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per share, Foster’s argued that target shareholders were getting a 51% premium on the average of Southcorp broker valuations of $2.76 per share. Foster’s further argued that the offer represented a 33% premium to the volume weighted average price (VWAP) for the month prior to the recapitalisation, and a 25% premium to the VWAP for the month prior to the most recent industry consolidations. It used price multiples to show value: the one-year forward enterprise value (EV) to earnings before interest, tax, depreciation and amortisation (EBITDA) based on consensus broker estimates was 14.9, representing a 48% premium to the average one-year forward EV/EBITDA trading multiple for comparable companies. Southcorp directors were not pleased with the offer of $4.17. They steadfastly rejected the Foster’s offer. While the Southcorp share price had been only $3.14 at the end of its previous financial year, it had risen to over $3.50 prior to the price run-up associated with the takeover speculation, and immediately prior to the takeover offer it had traded above $4.17. Southcorp directors countered with an unusual step in this takeover battle, proposing a merger with Foster’s wine business as an alternative to the Foster’s $3.1 billion takeover bid. They also released an independent report valuing Southcorp shares at $4.57 to $4.80 – well above the Foster’s bid of $4.17. Following these announcements, Southcorp shares traded 13c higher at $4.44. Foster’s was up 4c at $5.30. However, Southcorp continued to resist the takeover. The board took another unusual step, restoring dividend payments that had been suspended in 2003. A 3c-per-share dividend was declared in February, on the strength of cash flows that had grown by 35% and a fall in net debt by $390 million from the level of $842 million 18 months before. The 3c unfranked dividend was paid on 31 March. Southcorp chairman Brian Finn told shareholders in a letter that the turnaround was clear evidence that they should ignore Foster’s Group’s $4.17-a-share bid, as Southcorp was back in town. ‘These results further underline why your board believes you should reject Foster’s Group’s unsolicited bid for your shares as inadequate and opportunistic,’ Mr Finn said. The market seemed to agree, with Southcorp shares closing 1 cent higher at $4.41 – 24¢ above the bid.2

Part C Foster’s financing of Southcorp The consideration for the acquisition of Southcorp shares was cash. Were all of the offers accepted at the original

347

offer price, including all options, the total outlay by Foster’s would have been approximately $3.122 billion. The cash consideration plus the funds to satisfy all other expenses incurred by Foster’s was to be derived from: existing cash balances of Foster’s and other members of the Foster’s Group, which as at 31 December 2004 were in excess of $1 billion a share acquisition and refinancing facility with members of the Foster’s Group (underwritten) up to a limit of $2700 million. In response to the unfranked dividend declared by Southcorp, Foster’s adjusted its offer price downward by 3 cents per share to $4.14. The proposed acquisition was approved by the ACCC in March, following the fulfilment and waiver of equivalent regulatory conditions with respect to the US and Canada. By April, Foster’s and Southcorp had agreed to a revised takeover offer, and Foster’s interest in Southcorp grew from 30% to over 95% by June, at which point it proceeded to compulsory acquisition of the remaining shares. Foster’s then proceeded with its financing arrangements, first refinancing its $2.7 billion bridge facility put in place to fund the acquisition of Southcorp. The new facility was a £525 million syndicated multi-currency revolving facility, split between one, three and five-year tranches that Foster’s could draw in pound sterling, US dollars, Australian dollars and euros. In June, the bank debt market was approached for a £425 million facility that was oversubscribed by more than two times by a bank group comprising leading Australian and international banks. Foster’s elected to take an additional £100 million of oversubscriptions. Interestingly, the lowering of Foster’s credit rating by S&P two days before commitments were due had no impact on the volume received from the banks and very competitive pricing was achieved. Foster’s completed the second and third stages of its refinancing of the A$2.7 billion bridge facility, with a US$300 million syndicated multi-currency revolving facility with a seven-year term, which Foster’s could draw in US dollars, Australian dollars, sterling and euros, and a US dollardenominated note issued (pursuant to Rule 144A under the US Securities Act) in two tranches: US$700 million of 10year notes with a coupon of 5.125%; and US$300 million of 30-year notes with a coupon of 5.875%. Pete Scott, Chief Financial Officer, said:

Foster’s is very pleased to have completed the permanent refinancing of the acquisition of Southcorp

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within three weeks of closing the takeover offer on 3 June. We have effectively 100% debt financed the transaction as planned and structured the refinancing to spread the maturities over 1 to 30 years and achieved the foreign currency mix required to match the cash flows acquired. We are now focused entirely on integration. Source: Pete Scott, www.fosters.com.au/mediacentre/365ACDD84F5247 479133D0DA4B993CFD.htm, accessed 12 June 2009

Part D The outcome of Foster’s offer for Southcorp Southcorp’s directors initially opposed the takeover offer by Foster’s but eventually agreed to it, and from that point the takeover proceeded smoothly. There were no counteroffers from other potential bidders, and the takeover was completed within six months of the original offer. With the benefit of hindsight, in July 2008 Foster’s admitted frankly that it had paid too much for Southcorp. Foster’s itself was the target of a successful takeover offer in 2011. A long-expected offer for Foster’s came in June 2011, one month after it had demergered its wine division, in a move designed by its board to strengthen the company’s struggling balance sheet and profitability. But the damage had been done, and encumbered by poor acquisitions and an increasingly competitive retail market, Foster’s was unable to escape the outcome that it had delivered to Southcorp six years earlier. CEO Trevor O’Hoy had resigned in 2008 after Foster’s expansion into the wine industry had proved to be unprofitable. The demerger of its wine and beer businesses was orchestrated by Chairman David Crawford, creating Treasury Wine Estates and enabling Foster’s to focus on brewing. SABMiller, an international brewer originally from South Africa, made the offer of $4.90 per share to the Foster’s board in June 2011. That offer was rejected as being too low, but SABMiller took the opportunity provided by Foster’s falling share price as a result of its poor financial performance and poor sales growth to try again at the same price. In August, SABMiller declared a hostile offer, appealing directly to shareholders to accept its $11 billion bid for their company. The board of Foster’s agreed to a bid at the final price of $5.40 per share in September. By November,

the takeover was approved by the federal Treasurer Wayne Swan, and by December the transaction was complete. Foster’s was delisted from the ASX on 20 December 2011.

QUESTIONS Part A Motivations 1 Evaluate the given reasons for the Foster’s-Southcorp merger against market conditions at the time. 2 What were the risks for Foster’s in pursuing a merger with Southcorp? What were the opportunities? Part B Foster’s pricing of Southcorp 3 Summarise the actions taken by Southcorp directors to resist the takeover. Using both economic and noneconomic motives, provide two explanations for their resistance. 4 The price of Southcorp rose throughout this period. To what extent do you see this increase as a response to an expected higher premium from a likely successful takeover, or as a response to information revealed about the value of Southcorp? 5 If you were an analyst during this period, how would you separate out the value of Southcorp as a standalone firm, from the increases due to the takeover bids? How would Fosters’ management determine the value of Southcorp to them, first as a standalone firm, and then post-merger? Part C Foster’s financing of Southcorp 6 Looking at the relevant financial statements of Foster’s before and after the acquisition of Southcorp, determine the change in leverage. How does their leverage ratio compare to that of a competitor, such as Lion (Lion Nathan)? Part D The outcome of Foster’s offer for Southcorp 7 Analyse the reasons for Fosters’ eventual failure and subsequent takeover. How could this have been prevented by different actions regarding Southcorp, if at all? How much of this was foreseen in 2005?

Endnotes 1 www.fosters.com.au/mediacentre/CB834B2977C0499093CD3 35492DF94E9.htm, accessed 13 November 2008. 2 www.fosters.com.au/mediacentre/docs/050202-Southcorp_ Bidders_Statement.pdf; www.theage.com.au/news/Business/ Southcorp-proposes-Fosters-merger/2005/03/08/1110160822830. html, accessed 13 November 2008.

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Index A AASB 49 abnormal earnings 160–1, 162, 170–1, 175, 189–90 abnormal earnings valuations 162–3 abnormal growth, persistent 190–1 abnormal performance, persistent 190–1 abnormal profits 17, 20–1, 189 abnormal returns 220 absolute benchmarks 97 accountability 276 accounting 101, 141–2, 175, 196 as communication 278–9 methods 56–7, 70, 162–3 accounting adjustments 70–5 common 75–85 accounting analysis 9–10, 43–62, 69–85, 142–3, 162–3, 290–1, 312–15, 332–5 cash flow reconciliation 332–5 evaluate and conclude 62 objective 50, 62 preliminaries 52–5 as review 62 steps 52–62 Accounting and Auditing Enforcement Releases 77 accounting bias 73 accounting choices 56–7, 70, 73, 162–3 accounting discretion 6, 70 accounting environment 5 accounting equation 44, 70, 76 accounting flexibility 10 accounting numbers 135, 162 manipulation 48 accounting policies 44, 56–7, 73 accounting reporting 4 accounting rules 73–5, 291 limitations 280 accounting standards 6–8, 44, 47–9, 72–3, 83, 279, 291 see also generally accepted accounting standards; International Financial Reporting Standards accounting strategy 5 accounting systems 5–8 IIL example 82–3 accrual accounting 6, 48, 59, 135, 175 quality assessment – accruals and disclosure 59–62 accruals 74, 171 quality 60–1 accuracy 8, 49–50, 150, 218–19, 278–9 acquisition financing 261–5 acquisition pricing 255–61 acquisitions 10, 55, 249–69

by listed Australian entities 256 target (acquisition) value analysis 256–61 types 198, 249–50 value-destroying 198 see also mergers activities 23, 60, 62, 103, 159 see also business activities actual competition 21–2 actual profits 21 adjudicators 4 adjustment factor 171 adjustments 58, 70–83, 100, 166, 185–6, 196 detail 71, 76, 85 equal adjustments both equation sides 70 administration expenses 108–9 see also selling, general and administrative (SG&A) expenses advantage 10 see also competitive advantage; firstmover advantage advertising 29 advisors 4 after-tax cost of debt 143, 147 ageing population 23 agency costs 198 agency issues 273–6 aggregation 4, 44–5 airlines 298–325 alternative decomposition methods 103–6 alternative performance measures (APM) 61 alternative products 21–2 alternative valuation methods 176–7 amortisation 83, 237 analysis 38, 120–5, 149–51, 255–6, 288–93 approaches 211–13 candidate selection 213–14 derived from activities 5–8 derived from statements 8–11 determining objective 52 fundamental 212–13 iterative versus strict sequential 62 quality-driven opportunity/challenge 8 steps 9–10 systematic and efficient 10 also under specific analyses analyst meetings 282 analysts 29–30, 61–2, 213, 218–19, 221, 279–80 goals/purpose 99 limitations 281 annual reports 43–7, 50, 144 anti-competitive issues 267–8 anti-trust laws 252 AOSSG (Asian-Oceanian Standard-Setters Group) 49

Apple 31–2 Asia–Pacific 48, 229, 238 assessment 4, 56–7, 59–61, 106–9, 231 of sustainable growth rate 10, 117–19 asset beta 186 asset impairment 56, 80–1 asset prices 4 asset turnover 37–8, 102, 110–13, 135 assets 23, 29, 33, 44, 70, 72, 74–5, 135–6, 143 long-term management 111–13 assumption 6, 9, 26, 57, 59–61, 73, 135–6, 144, 147–8, 151, 159, 165, 170, 172, 186–8, 195, 197–8, 257 ASX 200 212 audit committee reviews 286–8 audit reports 44, 52–5 fee analysis 53–4 auditing 6–8, 49, 75, 279, 289, 292–3 challenges 289–90 auditor analysis 288–93 auditors 4, 56 limitations 281 Australian Competition and Consumer Commission (ACCC) 250, 252, 267–8 Australian Securities and Investments Commission (ASIC) 4, 250 Australian Securities Exchange (ASX) 4, 30, 58–9, 275 Australian Takeovers Panel 250 autoaggressive model 171 average 73–4, 99, 101, 106, 137, 163, 185 average return 184 average tax rate 109–10

B backlog adjustment 80–1 bad debts 37 balance sheet see statement of financial position bankruptcy 228–9 bankruptcy law 228 banks 4, 213–14, 227, 235, 275, 284 bargaining power 17–18, 21–2, 26 buyer–seller competitive forces 22 before-tax profit numbers 70 beginning net debt to capital ratio 143 beginning net operating long-term assets to sales ratio 143 benchmark 60, 97, 101, 106, 109, 138, 162, 165, 167, 169, 220, 258, 291 benefits see costs and benefits beta risk 182, 184, 186 bias 6, 35, 50, 70, 73–5, 77, 196, 219, 221 see also distortion

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INDEX

bond funds 207–8 bonds 182, 207, 229 book value 10, 72–3, 101, 160, 162–3, 167–9, 191, 194, 196 market value derived from 160 negative 196–8 bookkeeping equation, expanded 44 book-to-market ratio 183–4 borrowings 27, 47, 72, 83, 123, 147, 230, 234–5 borrower’s financial status 230–2 bottom-up approach 212 Brambles 46–7 brand awareness 36 brand image 19, 29, 31–2, 108 brand names 33, 189, 191 break-up value 83, 251 brokerage houses 4 bull market (bullish) 283 Bunnings Warehouse 253–4, 261, 264–6 business 3, 6, 30 combinations 55, 57 multiple 32 opportunities for new see investment opportunities owners–business separation 72 see also firms business activities economic consequences of see financial statements financial models see financial statements financial statements derived from 5–8 business analysis 37–8 from financial statements to 8–11 business analysis and valuation 3–11, 16–38, 43–62, 69–85, 96–125, 135–51, 158–63, 181–98, 207–21, 227–42, 249– 69, 273–93 activities–financials–analysis pathway 5–11 business economics 10 business enterprises 3 business environment 5 business intermediaries 9 business investment 23–4 business strategy/analysis 5, 9, 38, 142 buyers/buying 4, 21–2, 26 see also sellers/selling buyouts 228, 250–1, 284 buy-side analysts 209, 214, 218, 221

C capacity capacity-based price reductions 20 combining 250–1 excess 20 capital 3–5, 33, 48, 59, 100–1, 135–6, 143, 184, 249 constraints 251

capital allowance 251 capital asset pricing model (CAPM) 182–5, 220 CAPM–size effect combination 184 critique 182 capital charge 160, 162 capital gains 251 capital markets 3–5, 33, 276, 288 imperfect 33, 251 capital structure 147, 185–6, 260, 262 capitalisation 34, 48, 72, 83–5, 162, 182–3, 197, 208, 251 CCPL example 83–5 case studies 31–2, 34–6, 54, 211, 257, 261, 298–348 also under specific worked example cash 60, 75, 197–8, 250 cash accounting 6 cash flow 6, 59, 99, 135, 148–9, 161, 172–3, 182, 186, 188, 190–1, 235, 256, 258–61, 278, 332–5 excess 197–8 cash flow analysis 10, 119–24 cash flow reconciliation 332–5 cash flow statements 120 cash from operations (CFO) 172 cash payments 6, 158 cash receipts 6 cash surplus 252 central tendency 141 certainty 142 certificates of deposit (CDs) 207 change 19, 29, 58, 182 citizenship (corporate) 30 ‘clean surplus’ 44 climate events 24 commercial banks 227 common shareholders 100–1 common-sized income statements 106–7, 110 communication 3, 33, 215, 273–9 issues 276 sources 277–8 through financial reporting 278–81 see also governance communication strategies 10, 210 company audit committees 4 comparability 7, 46–7, 49, 70, 255 comparative advantage 209 comparison 27, 58, 99, 101, 138–40, 165, 171–2, 255–7 of firms/peers 26, 83–4, 97–8, 165–6 of valuation methods 173–7 competition 6, 17–21, 26, 101, 108, 145–6, 175, 227–8, 267 degrees of actual and competitive 18–22 forces 19–22 Competition and Consumer Act 2010 250 competitive advantage 5, 10, 27–30, 38, 142, 189, 190–1, 260

competitive dynamics 7, 283 competitive equilibrium assumption 175, 189–91 competitive strategy 4, 28–9, 36–7, 96, 108, 275 competitive strategy evaluation 27–32 competitors 19, 26–7, 29, 278 compliance 4, 275 ‘comply or explain’ 50–1 comprehensive income 44 conclusions 99 condensed financial statements 135–6, 143 conditions 21, 35, 47–8, 72, 101, 142, 250, 278 conference calls 282 confidence 4, 276, 283 confidentiality 33 conflict 30 conflicts of interest 279–81 conglomerates 35 conservatism 197 consistency 7–8, 49, 99–101, 166 consumer demand 20 consumption 23–4 contingent liabilities 78 continuous disclosure regimes (CDR) 277 contract 6, 21, 48 contributions 44 convention 8 core competencies 29 corporate boards 285–6 corporate finance/reports 6, 176–7 corporate governance see governance Corporate Governance Council 30 Corporate Governance Council Principles and Recommendations’ (CGCP&R) 275, 285 corporate social responsibility (CSR) 30 corporate strategy 33–4 corporate strategy evaluation 32–7 corporations 32–4 corporate citizenship 30 see also firms Corporations Act 2001 250, 275 corrective action 217, 231 cost 6, 21, 28–9, 32–3, 72–3, 83, 106, 108, 143, 147, 160, 171, 198, 209, 310–11 cost disadvantage 20 cost inventory 73–4 cost leadership 27–9 cost leadership strategy 37–8 cost model 73 cost of capital 5, 101, 163, 184–5, 191, 259, 274 cost of debt 185 cost of equity 181–6, 190 adjusting for changes in leverage 185–6 cost of sales 83 cost-benefit activities 62 costs and benefits 6, 48

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court system 4 COVID-19 23–4 creativity 29–30 credibility 3–4, 33, 49, 210, 274–5, 282 factors increasing 279–80 limited 281 credit extending 232–3 nature 233 terms/ability to pay 233–4 credit analysis 227–39 credit evaluation 10 credit mix 228–30 credit rating agencies 4, 239, 242 credit risk/management 56, 227, 230–2 credit suppliers 227–30 credit-worthiness 230 critical products 22 cross-border merger/acquisition 249, 251 cross-sectional comparison 97–8 cumulative abnormal earnings 160 currency 47, 99, 285 current abnormal earnings 170–1 current accounts 75 current liabilities 113–14 current net income 162 customers 21, 27 willingness to pay/switch/substitute 18–19, 21, 28

D data 6–8, 10, 26, 44, 49, 85, 138, 213 unbiased 10 data collection 62 data ratios 117 databases 165 debt 10, 37, 73–4, 103, 106, 114–16, 136, 143, 147, 185, 230–1, 257 debt agreements 237 debt instruments 207 debt markets 228–9 debt ratings 238–9 drivers 239 meaning 238–9 debt to capital ratio 147 decay 171–2 decentralisation 33 decision making 4, 11, 22, 35, 48, 136, 250, 279 decomposition 103, 105–13, 136, 185 alternative/traditional methods 102–6 deferred tax 70–1, 78–9, 81, 84 demand 20, 144, 275 denominators 99, 101, 104, 139, 166 equivalent scope with numerators 100 see also numerators depreciated historical cost 72–3 depreciation 72, 83–4, 147, 161, 322–5 derivatives 227, 230

Dick Smith 339–40 differentiation 3, 19, 26–9, 38, 108 drivers 29 ‘dirty surplus’ 44 disadvantage 20 disaggregated data ratios 117 disclosure 6, 61–2, 74, 103, 218, 231–3, 273, 278, 287, 291 accuracy of 8, 49–50 continuous disclosure regime 219 forward-looking 50 voluntary 7–8, 278, 282–3 discontinued operations 55, 100 discount rate computing 78, 181–6, 194, 259 discounted abnormal earnings 162–3, 196, 258–61 discounted abnormal earnings valuation formula/method 160–4, 170 discounted cash flow model/method 161, 172–3 discounted dividends valuation method 158–9, 161 disposal (operations) 100 disposals 56 dispute 49–50 dispute resolution 4 distortion 6, 10, 48, 50, 72–4, 82, 100–1, 196 ‘reversable’ 162 ‘undoing’ see recasting distress 123, 197, 228, 235, 250 distress prediction 227–42 distress prediction models 240 distribution channels 20, 33 distributions 44 diversification 27, 32, 34–6, 252 dividend discount model 159 dividend holds 197–8 dividend payments 159, 197–8, 237 dividend policies 10, 96, 198, 283 dividends 100, 158–9, 172, 197–8, 207 dividend–earnings link 160 Dodd-Frank Act (2010) 275 double-entry bookkeeping 162 doubtful debt 37, 73–4 Down Under Company 159, 161–3, 168, 173 due diligence 75

E early entrants see first movers earning multiples 257–8 earnings 80–1, 85, 135, 160–5, 196, 257 ‘normalised’ 61 quality ‘red flags’ 123 reason for decline 163 volatility 252 earnings before interest and tax margin (EBIT margin) ratio 108–9 earnings before interest and taxes (EBIT) 237, 254 quality ‘red flags’ 123

351

earnings behaviour 138, 150 earnings management 50, 74, 77–80, 82–3, 279 earnings-based valuation 160–1, 167–72 EBITDA margins 108 e-commerce 142–5 economic activities 6, 23 Australian slow in 23–4 economic characteristics 70, 72–3 see also elements economic cycles 142, 186 economic drivers 27 economic environment 5, 291 economic evaluation 23–4 economic growth 23–4 economic outcomes 3 economic power 21 economic theory 32 economic transactions 6 economic value 261 economics 7, 10, 195 economies 3, 19, 23 economies fixed–variable costs ratio 28, 275 economies of scale 20, 28, 250 see also scale economies economies of scope 33 efficiency 4, 28, 108, 209–11 efficient markets hypothesis 209 80–20 rule 287 elements 43–4 enforcement mechanisms 33, 49, 74–5 engagement 38 engineering 29 enterprise value (EV)/EBITDA 257 entrepreneurs 3–4, 33, 273 entry first movers 19–20 new entrant threat 20 entry barriers 20, 101, 171 environmental impact 30 environmental restrictions 23 equilibrium 175, 191, 209, 211 equipment see plant, property and equipment equity 44, 70–2, 99, 101, 104, 159, 163, 182–3, 197, 207, 257 equity beta 185–6 equity capital 106, 135, 158–9, 163 equity funds 207–8 equity holders 44 equity markets 229 equity multipliers see leverage equity security analysis 207–11 equity value 158–62, 172, 193–6 equity value-to-book formulation 169 erroneous results 100 error 99, 176–7, 189, 191, 219, 260 estimates/estimation 6, 10, 48, 59–61, 73, 136, 160–2, 181–6, 194–5, 255–6, 278–9, 292

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best 258–9 critical accounting estimates 57 reasonable 8 see also prediction ethical funds 208 European Competition Commission 267 evaluation 10, 16–38, 62, 110–19 events 21, 47–8, 55–6, 72, 74, 100 ‘evergreens’ 234 excess cash flow 75, 197–8 excess return 184 exchange rate 24 existing firms, rivalry among 19–20 exit barriers 20 expanded bookkeeping equation 44 expected cash receipts/payments 6 expected net income/loss 160 expenditure 23, 49, 135, 147 expense capitalisation 83–5 expenses 6, 37–8, 44, 48, 103, 109–10, 135–6 SG&A 108–9 exports 24 extended external reports (EER) 45

F Facebook 257 facilitation platforms 4 fair (market) value 57, 62, 72–3, 101, 103 fair value derivatives 57 fairness 49 Financial Accounting Standards Board (FASB) 49 financial analysis 9–10, 96–125, 141–3, 291, 315–16 financial covenants 236–7 financial data 10, 165 financial institutions 227–8 financial intermediaries 3, 8, 274, 279–80 financial leverage 102–5, 113–19 financial management 113–19 financial market strategies 96 financial numbers 10, 97, 137 financial policies 10 financial press 4 financial reporting 3–6, 52–5, 278–81, 312–15 limitations 280–1 strategies 7–8, 210 see also corporate financial reports Financial Reporting Council (FRC) 45 financial reporting quality external information 61–2, 276–8 internal influences 285–8 financial statement analysis 11, 100, 210 financial statements 3–11, 44, 59, 61, 103, 278, 291 from business activities to 5–8 business analysis derived from 8–11 ‘condensed’ 135–6, 143

forecasting and valuation 10, 75 formats and terminology 69–70 influencing factors 47–52 managerial involvement 48 manipulation 49 notes 44 number distortion 6 range/type 43 recasting 69–70 transactions external to firm 47, 61–2 financials 5–11, 70, 85, 99, 137, 198 financing 3–4, 33, 96, 103, 136, 228, 251, 261–5, 284 form 262–4 in tandem 228 see also funds/funding financing strategy 96 firm value 162, 198 firms 5–6, 96, 165–6, 214, 227 activity models see financial statements economics 72–3 indefinite existence? 158 intrinsic value 10 processes 28 resources/obligations summaries see statement of financial position sub-group reporting 46–7 transactions, events, conditions 21, 47 underperformers 166, 250 firm-specific factors 144, 212 first movers 19 first-in, first-out (FIFO) 73–4 first-mover advantage 19–20 Fitch 238 fixed costs 19 fixed debt 230 fixed-rate loans 227 flexibility 10 floating debt 230 flow versus stock 99 flows (units) 99 forecast horizon 159, 172–3, 175, 196 forecasting 8, 10, 75, 135–48, 163–4, 257–9, 274–5, 292, 318 considerations 141–3 detailed 135, 137, 141, 186–8 framework 135–6 overall structure 135–6 reference point 137 scenarios 234 steps 143–9 summaries 215 see also prediction foreign currency 47 Foreign Investment Review Board 250 forward integration 22 Foster model 150 Fosters–Southcorp merger 346–8 frameworks 3–11, 30, 135–6

friendly takeovers 249, 255 fully competitive equilibrium 141 fully franked dividends 207 fund management 208, 211–13 fund managers 220–1 funds track indices 208 funds/funding 3–4, 207–8, 214, 251 future abnormal earnings 162, 170–1 future cash flow 59 future earnings 138, 163, 212, 284 future growth options 160 future performance 162 future profitability 101

G gains 61, 100 GDP growth 24 general expenses 108–9 see also selling, general and administrative (SG&A) expenses Generally Accepted Accounting Principles (GAAP) 7, 70, 72, 288 accounting choices within 73 generally accepted accounting standards 44 Getswift 286 Global Financial Crisis (GFC) 36, 142 Global Industry Classification Scheme (GICS) 98 Global Reporting Initiative 45 going concern 54–5 goodwill 57, 80 governance 50–2, 74–5, 273–93 see also communication government 228 monopoly protection 19 regulation 227 graphs 279 Gray-Mirkovic-Ragunathan model 239, 241 gross domestic product (GDP) 23 gross margins 37–8, 110, 149 gross profit margins 107–8 growth/growth rate 17, 23–4, 96, 137–8, 142, 145, 165, 171–2, 188–9, 195, 218 drivers 97 sustainable growth rate assessment 117–19

H hedge funds 208, 219–20, 227 high-frequency trading 212–13 historical capital structure 185 historical cost 72–3 horizontal integration 251 hostile takeovers 249, 255, 276 households 3 housing market 23–4 Howard Smith buy-back 261 human capital 32–3 hypotheses 4, 209

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I IAS 2 ‘Inventories’ 72–3 IAS 8 ‘Accounting policies, changes in accounting estimates and errors’ 58 IAS 16 ‘Property, plant and equipment’ 73, 83 IAS 23 ‘Borrowing costs’ 83 IAS 36 ‘Impairment of assets’ 72–3, 80 IAS 38 ‘Intangible assets’ 72, 83, 291 IAS 38/AASB138 291 IFRS 5 56 IFRS 8 46 illiquidity 80 imitation 29, 36 impairment 56, 80–1 implementation 69–85, 181–98 impressions management 279 incentives 3, 6, 19–20, 33–4, 48, 72, 74, 209, 273, 283 income 44, 75, 103, 160, 230 income statement analysis 107 income statement effect 71 income statements 44, 99, 106–7, 110 incremental investment 191 independence 49, 53, 56, 287 index funds 208 indirect effect 103 industry 5, 16–17, 19, 25–6, 136 influence of structure on profitability 17–18 insights – practitioner 11, 38, 62, 85, 124–5, 151, 176–7, 198, 221, 242, 268–9, 292–3 industry analysis 299 industry averages 185 industry dynamics 29 industry evaluation 16–26 industry factors 144 industry growth rate 19, 143 industry norms 58 inference 214–17 inflation 24, 73, 188, 190 information 8–9, 48, 52, 210, 262–3, 274–5, 282 about cash flow see cash flow analysis enhanced 48 external 61–2, 276–8 flows 209 for forecasting 136 proprietary 7 publicly available 211 qualitative assessment of 62 quality 3, 6, 276–8 residual 275–6 segment 44 sources 4, 277–8 verifiable 49, 273 information analysts 4 information asymmetries 251 information intermediaries 3–4, 8, 274

infrastructure funds 207 infrastructure investment 23–4 initial public offerings (IPOs) 274 initiatives 30 innovation 3, 19, 29–30, 34, 291 input markets 5 inputs 21, 28–9 insider trading 213 institutional factors 48–52 insurance companies 4 intangible assets 49, 72, 75, 83, 146 integration 22, 36, 210, 251 interest 48, 56, 75, 101, 103, 135–6, 234, 260 interest rates 136, 227, 230 interested parties 277–8 interim forecasts 149–51 intermediaries 3–4, 6, 8, 21, 274, 276, 279–80 intermediate-term treasury notes/bonds 182 intermediation chain 274 internal governance agents 274–5 International Accounting Standards Board (IASB) 7–8, 44 IFRS issue 48 International Financial Reporting Standards (IFRS) 7, 44, 48–9, 52 aims 48–9 also under IFRS range international influences 17 International Integrated Reporting Council 45 international trade 24 intrinsic value 29 inventory 57, 72–4, 99, 162, 235 inventory management 56 investment 5, 23–4, 136, 191, 197, 207, 213–14, 274–5 investment decisions 96 investment horizons 217 investment management 96, 110–13 investment operating activities 103, 159 investment opportunities 3–4, 159, 252, 275 investment vehicles 207–9 investors 275 best interests 273 communication and 279–85 compensation 209 confidence 50 objectives 207–9 perceptions, manipulation of 7–8 iphones 31–2

J jobs 3 judgement 7, 35, 48, 59, 212, 291

K Kathmandu 23, 25–6, 36–7, 45–6, 51, 53–5, 57, 60, 71, 101, 105–6, 108, 110, 123–4, 143–5, 163–5, 169, 182, 185, 187, 192–5, 201–3, 231–4, 236

353

key audit matters (KAMs) 53, 55 ‘kitchen sink’ methods 241

L Lachlan Star 54 leadership 28–9 leading multiples 166 league tables 220 learning economies 19 legal considerations 49–50 legal barriers 20 legal considerations 49, 252 legal environment 8, 49–50 legal framework 4 legal liability 8, 50, 277, 280–1 legal protections 29 legislation 228, 250, 252, 275 leisure time 25 ‘lemons’ problem 3–4 leverage 27, 101–5, 113–19, 135, 140, 166, 185–6, 251, 262, 284 leverage ratios 103 leveraged buyouts 228 liabilities 8, 44, 70, 73–4, 113–14, 135, 147, 277, 280–1 linear regression 150 liquidation 197, 234 liquidity 10, 113–14, 211, 233, 235 listed debt markets 228–9 loan covenants 236–7 loans 72, 227, 233, 235–6 London Interbank Offer Rate (LIBOR) 238 long-run competitive equilibrium 101 long-run inflation rate 190 long-term assets/management 111–13, 135–6 long-term loans 227 long-term solvency 114–16 losses 61, 100, 160 ‘loyalty programs’ 20

M machinery and equipment 235 macroeconomic factors 136, 141–4, 212 managed funds 4, 275 management 7, 50, 55–6, 62, 106–19 active versus passive 212 techniques 214 see also fund management management bias 73–5, 77 management commentary 44–5, 61, 278 management communication 210, 278–9 manager discretion 6–7, 48, 70, 74, 77–8 managers 7–8, 210, 218–21 inside information 8–9, 48, 52 power and prestige 252 resource acquisition 5 manipulation 48–9, 163 marginal cost 18–19

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INDEX

market confidence 4 market efficiency 4, 11, 209–11 evidence 210–11 market expectations 214–17 market indices 182, 184, 212 market mechanisms 32–3 market model 3 resource channelling see capital markets market movement 182 market prices 215 market risk premium 182, 184 market share 19 market value 62, 101, 160, 166, 186 versus value estimates 194–5 marketing 29, 108 markets 4–5, 23–4 imperfect 33 new entrant threat 20 also under specific market type materiality 53 materials 20, 251 maturity profiles 234 mean-reverting properties 136–41, 171 measurement 73 of performance 44 of premiums 255–6 of profitability 100–1 unit and scope consistency 99–100 media 4, 25, 144 mergers 10, 55, 249–69, 346–8 economic/non-economic motivations 250–1 by listed Australian entities 256 see also acquisitions metrics 143, 184, 260 see also measurement microeconomic theory 18 migration 24 misleading results 50, 100 mismeasurement 99 mispricing 209, 214 misrepresentation 6 modelling 124–5 Modigliani–Miller theorem 197 monetary policy 24 monitoring 279–80 monopoly 18, 191 Moody’ 238 multiples 161, 166–9, 176–7, 191, 257–8 Myspace 257

N national trade protection 23 natural monopoly 191 needs 27 negative book value 196–8 negative debt 103 negotiation 228, 287 net assets 160

net debt 104, 143 net income 101, 135–6 net interest expense after tax 104, 135–6 net non-current operating assets to sales forecast 146–7 net operating profits after tax (NOPAT) 104, 135–6, 140–1, 167–8, 259 net operating working capital to sales forecast 146 net present value 160 net profit after tax for year 101 net profit after tax with cash inflow 60 net profit margins 102, 106–9 net realisable value 72–3 new entrant threat 20, 25–6 New Zealand Stock Exchange (NZX) 275 noise 7–8, 50 nominal sales 190 non-current assets 135, 146 non-divisible assets 33 non-financial assets 72–3 non-financial data ratios 117 non-GAAP financial statements 75–7 non-operating investments 136 non-tradable assets 33 NOPAT margin/forecast 105, 108, 110, 136, 143, 145–6, 149 norms 58 notes 44, 278 numerators 99–100, 104, 166 see also denominators NZASB 49

O objectives 50, 52, 62, 207–9 objectivity 6–7 obligations 43–4, 73, 231 Oboz 145–6 observation-based models 150, 166 off-balance sheet structures 56 on- or off-market takeover offers 249 one-off transactions 56 one-quarter-ahead forecasting 150 online vendors 142–5 opening (backlog) adjustment 80–2 operating activities 60, 103, 159 operating asset turnover 140 operating decisions 136 operating earnings 85 operating income 75 operating management 96, 106–9 operating policies 96 operating ROA 104–5 operating segments 44–7 operational effectiveness 27 opinion 44, 53, 198, 209, 238 opportunity cost 160 optimism 219 organisational know-how 33

outcomes 3, 151, 266–9, 283 output markets 5 outputs 21, 29 overconfidence 252 see also confidence overestimation 198 overheads 108 overpayment 255–6 overvaluation 73, 276 ownership 44, 72, 284

P parameters 150, 182 patents 29, 189 patterns 17, 137–8, 140, 149–50, 171–2 payments 6, 78, 100, 197–8, 233 forms 262–5 payoffs 48, 158, 197 payout 283 peer companies 26, 83–4, 97–8, 101, 165–6, 171–2 penalties 49–50 perfect competition 18 performance 6–7, 61, 100–1, 142, 149–50, 162, 214, 218–21, 284, 287 detailed forecasts of 135, 186–8 ‘discounting’ 8 talking up 273 performance behaviour 137–41 performance drivers 103, 135 performance measurement 44, 59, 190 non-GAAP 61 plant, property and equipment 80, 83, 135 point of reference 137, 141 points in time 99 policy 10, 24, 44, 56–9, 73, 96, 198, 231, 283–5 politics 23 population 23–4 portfolios 34, 137, 183–4, 207, 209, 212, 227 positioning (corporate) 5–6, 27–8, 43–4, 142 potential competition 18–21 power 21, 250, 252 see also bargaining power pre- and post-acquisition cost of capital 259 pre- and post-acquisition value 263 prediction 10, 61 see also distress prediction; forecasting preference capital 100 preferred dividends 100 premiums 21, 108, 182, 184, 250, 252, 255–6, 284 present value (PV) 78, 158, 160, 172, 256 press releases 144 price competition 19 price multiples 164–70, 191 price premiums 21, 108 price sensitivity 21–2 price wars 17, 19, 25 price-earnings (PE) ratio 165–6, 191, 260

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price-earnings multiples 258 price-earnings to growth (PEG) model 218 price-earnings valuation/limitations 258 price/pricing 4, 18–20, 50, 182–5, 210, 215, 238, 255–61 price-to-book (PB) ratio 165–6, 169, 172 principle-based standards 49 Principles of Good Corporate Governance and Best Practice Recommendations 30 principles; procedures 28, 99 ASX principles 50–2 GAAP see Generally Accepted Accounting Principles principle-based standards 49 prior period adjustment 58–9 private equity firms 4 private equity takeover 249–50 product market performance 10 product markets 7, 96 product markets strategies 283 product mix 145–6 production 28, 36 productivity 146 product-market rents 251 products 19, 21–2, 28–9 attributes 28, 108 quality 29, 33, 36 segregation of 82 see also gross domestic product profit 4, 21, 23, 30, 44, 48, 75, 102, 104–5, 135–6, 161, 251 gross 107–8 net 106–9 transfers 80 profit drivers 9, 17–18, 97 profit margin (PM) 106, 141, 146 see also gross profit margins profit numbers 70 profit potential 16–17 profitability 21, 27, 96, 101–19, 136 areas see segment reports five forces influences on 17–18 measuring overall 100–1 property see plant, property and equipment property funds 207 proprietary activities 6 proprietary technology 32–3 prospective analysis 9–10, 135–51, 291–2 valuation and 158–77, 181–98 provisions 77–80 public announcements 144, 278 public information 276 public offerings 274 publicly traded firms 182, 195, 209, 249 puff ups 61

Q Qantas 298–321 qualitative assessment 61–2

quality assessment 3, 59–62 quantitative approaches 212 quintiles 183

R ‘random walk’ 138 random walk model 170 ranking 137 rates of return 97, 184 ratings 238–9 ratio analysis 10, 96–101, 291 terminology 104 ratio of net debt to capital 136 ratio of net operating long-term assets to the following year’s sales 136 ratio of net working capital to sales 136 ratio of tax expense to earnings before tax 109–10 ratio of tax expense to sales 109 ratios 19, 37–8, 77, 83, 99–100, 103, 109, 117, 136, 146–7, 161, 190–1, 336–8 numerator/denominator relation 99 raw returns 183 real estate 235 real terms 190 real world/reality 11, 50, 162, 186, 287 reasonableness 137, 150, 257 recasting 10, 50, 69–70, 160–76 receipts 6 receivables 235 recession 23–4 recommendations 215, 217, 219 reconciliation 59–60, 332–5 records/recording in a like manner 7 see also reports/reporting refinancing 55, 233 regression 150, 212 regulation/regulatory bodies 4–5, 20, 27, 250, 252, 275 post-COVID-19 increase 23 regulatory policy 4 related parties 61–2 relationships/relations 20, 73 current/future earnings relations 170–1 numerator/denominator relation 99 ROE–cost of equity capital relation 101 relative bargaining power 21–2 relative ranking 137 reliability 10, 273 repayment 257 reports/reporting 6, 45–7, 49, 52–5, 144, 162, 276–81 breakdown 280 managers’ reporting strategy 7–8, 210 also under specific report type/method; see also records/recording representations 43, 274 repurchases 284

355

reputation 29, 33, 280 research and development 29, 48–9, 83–4, 242, 291 residual income model see earnings-based formulation Resinex 341–5 resources 3, 5, 43–4, 209, 250–1, 273 restructuring 251 retail industry 22, 25–6, 36, 142, 172, 336–8 return measures 101 return on assets (ROA) 102–3, 106, 140, 197 return on common shareholders’ equity (ROCE) 100 return on equity (ROE) 10, 100–6, 138–41, 167, 173, 185, 190–1 behaviour 138–40 growth simplifications and 171–2 ROE and component behaviour 140–1 return on net operating assets (RNOA) 136 return on sales (ROS) 102, 106 returns 35, 183–4, 220, 255 revaluation model 73 revenue 6, 44, 59, 144, 307–10 revenue recognition 48–9 timing of 82–3 review 62, 274–5, 286–8 revised cost of debt 186 risk 8–9, 45, 56, 99, 165, 183, 209, 213–14, 217–18, 220, 227, 230, 233, 235–6, 262, 284, 288 risk factors 24, 290–1 risk mitigation 151 risk premium 182–6 risk rate of return 184 risk-free interest rates 166 risk-free rate 186 riskless profit 4 riskless rate 182 rivalry 19–20, 25 rules 8, 72–5, 250, 291 rules-based standards 49

S sales 23, 25, 102, 135–6, 189–90 sales growth/rate 137–8, 143–5, 188–9 Sarbanes-Oxley Act (2002) 275 savings/savers 3, 23, 258 scale economies 19, 251 scheme of arrangement 249 scope 100 screening 212, 214, 241 ‘scrip for scrip’ rollover 251, 263 seasonality forecasts 149–51 securities 207 securities analysis 10, 207–13, 217 final product 217–18 process (comprehensive) 213–18 securities exchange 249 securities markets 210–11

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356

INDEX

security 235–6 security analysts 218–20 security prices 209, 228 segment data 26 segment reports 44–7 segments 32, 61 sellers/selling 4, 21, 219–20, 228 see also buyers/buying; sales selling, general and administrative (SG&A) expenses 108–9 sell-side analysts 213–14, 218, 221 sensitivity 21–2, 149–51, 182, 195–6, 259, 319 service 28–9 share buy-backs 284 share capital 249 share markets 4, 278 share price 4, 35, 50, 175, 182, 209–10, 214, 218, 276, 282 share repurchases 197–8 share returns 183 share transfer 249 share valuation 159, 161 shareholder value 262, 266 shareholders 35, 62, 75, 158, 197–8, 249–50, 255–6, 261, 268–9, 276 shares 158, 160, 212, 218, 263, 274 short-selling 219–20 short-term liquidity 113–14 size effect 182–4 size premiums 184 size quintiles 183 smart beta funds 214 smartphones 31–2 social media 25 social responsibility reports 45 solvency 83–4, 114–16 spanning design 36 spillover benefits 258 spin-offs 34 spread (financial) 105 Standard & Poor’s 238 standardised financials 70, 99–100 standards 6–7, 48–9, 72–3 principle-based versus rules-based 49 also under specific standard start-ups 196, 242 statement of cash flow 99 statement of changes in equity 99 statement of comprehensive income 44 statement of financial position 43–4 revenue–expenses link 44 stewardship 4 stock 99 stock exchanges 4 stock items 99, 255, 282 straight-line method 161 strategic risk 45

strategy 29, 37–8, 61, 96, 100–1, 136, 141–2, 210, 307–11 mutually exclusive 27 also under specific strategy strategy (strategic) analysis 10, 16–38, 143, 162–3, 290, 306–7 strategy evaluation 36–7 competitive 27–32 corporate 32–8 subjectivity 6, 61–2 subnormal profits 101 sub-periods 149–50 substitute products 21, 26 sub-units 33 Super Retail Group 101, 105–6, 108, 110, 123–4, 165 superannuation funds 4 supernormal profits 101, 190–1 suppliers 21–2, 26–7, 227–30 surplus 44 sustainability 7, 10, 26–7, 29–30, 186, 191, 278 sustainability reports 45 sustainable growth 117–19 swaps 230 switching costs 19, 21, 29, 171 SWOT analysis 37 systematic risk 182

T takeover bids/offers 249–50, 253–4, 257 takeovers 32, 249–50, 256, 267–8, 276 see also acquisitions; mergers target management 250 target management entrenchment 267 target premiums 256 target prices 215 target shareholders 255–6, 261, 263–4, 266, 268–9 target-initiated deals 252 tax adjustments 78–9 tax effects 75, 263–4 double taxation effect 75 tax rates 136 tax rules 72 tax-deferred capital gains 207 taxes 70–1, 84, 101, 109–10, 135–6, 237, 251 taxonomy 98 tech brands 31–2 technical analysis 212 technology 21, 32–3, 124–5, 218, 251, 291 terminal values 174–5, 188–98 terminal year 188–94 terms of trade 23 theory/theories 10, 32, 159, 197 of valuation 158–77 third parties 8, 47 threats 20–1, 25–6 see also SWOT analysis

time constant over time 141 over time comparisons 73–4, 138–9 at a point in time 99 reversal over time 74, 80 timing of revenue recognition 82–3 time-series comparison/model 37–8, 97, 140–1, 218 tools (analysis/valuation) 16–38, 43–62, 69–85, 96–125, 135–51, 158–63, 181–98, 290–3 top-down approach 212 total investment 191 tourism 24 Trade Practices Act 1974 252 trade protection 23 trade-offs 283 trade/trading 210–13, 218 trailing multiples 166 transaction costs 32–3, 209, 264 transaction facilitators 4 transactions 21, 47–8, 72 comparable 255 financial results of see financial statements ‘like economic transactions in like manner’ 49 ownership type 44 substance versus legal form 49 unusual/underlying 55–6 transitory effects 166 treasury notes 182 trends 106, 137–8, 142, 212 trust schemes 249 trust units 251 t-statistic 184 turnover ratios 146

U unavoidable risk 209 uncertainty 23, 48, 53–4, 73, 77–8, 149, 283 undervaluation 73, 276–7 undifferentiated products 21–2 units 99–100, 251 useful life 72

V valuation 10, 75, 198, 273, 284, 319 challenges 197–8 connecting strategy analysis to 37–8 focus and structural differences 174 formal versus informal 213 implementing 181–98 information sources see financial reporting issues 196–7 methods 158–70, 176–7 pathway to analysis and 5–11

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INDEX

skills 62 techniques 256–7 theory and concepts 158–77 using price multiples 164–70 see also business analysis and valuation valuation ratios 336–8 value 3–4, 28–9, 48, 158, 214, 220, 257, 262, 266 see also fair (market) value; present value value chains 29 value creation 5, 32–4, 250–1, 256 value estimates 175, 194–5 ‘value’ firms 183 value-adding 4, 8, 11, 22, 50, 251, 276, 287 value-earnings multiples 167–9 values, small or zero 100

value-to-book multiples 167–9, 172 value-to-price ratios 161, 175 variable costs 19 venture capital 4 venture capital firms 228, 275 vertical analysis 106–7 vertical integration 36, 251 volatility 23, 214

W wages growth 23–5 warranty 33 wealth 3, 47, 62 wealth reduction 253 weighted average cost of debt and equity capital (WACC) 106, 259

357

weighted averages 106 weightings 73–4, 186 Wesfarmers 34–6 willingness to pay/switch/substitute 18–19, 21, 28, 256 Woolworths Limited 215–16 working capital 48, 59, 110–11, 123–4, 135–6 worksheet approach 70–7 world economic growth 24 world economy 23 write-downs 47, 80–1 write-offs 56, 85, 100, 166

Z zero value 100 Z-score 240–1

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202

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Copyright 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-202