Methodologies for Estimating Future Profitability, Growth, and Valuation, written by Teri Lombardi Yohn, Ph.D., CPA, with Kelley School of Business at Indiana University, analyzes popular methods used to determine a company’s value and predict its profitability. This Portfolio presents a structured framework for forecasting future financial statements, emphasizing the importance of the key accounting inputs that feed into valuation models and explaining how to use information in financial statements to evaluate a company's performance.
This Portfolio discusses potential inefficiencies in the stock market that may be exploited through financial statement analysis and provides academic research on the usefulness of the components of the current income statement for forecasting the company's future financial statements.
Methodologies for Estimating Future Profitability, Growth, and Valuation explains, compares, and illustrates various methods of valuing companies, including the dividend discount model, the free cash flow model, and the residual income model. This Portfolio also discusses methods of forecasting sales and explains the benefits of analyzing various ratios, including profitability ratios and risk ratios. The usefulness of industry benchmarks for forecasting is discussed.
In addition, this Portfolio stresses the importance of analyzing a company's operating activities and explains how a company's balance sheet and income statement can be disaggregated into operating activities and financial activities. Methodologies for Estimating Future Profitability, Growth, and Valuation discusses quality of earnings at length, recommends potential incentives for earnings management, and identifies warning signals.
Finally, this Portfolio discusses some fundamental market anomalies that may affect future financial statements before they affect the price of a company's stock.
Methodologies for Estimating Future Profitability, Growth, and Valuation allows you to benefit from:
This Portfolio is included in the Accounting Policy & Practice Series, a comprehensive series of titles which explain, explicate, and offer commentary on a wide range of accounting and financial management topics, including revenue recognition, income taxes, leasing, business combinations, debt instruments, risk management, internal controls and more.
Detailed Analysis
I. Purposes and Scope of Portfolio
II. Review of Basic Financial Statements
Introductory Material
A. Primary Financial Statements
B. Balance Sheet
1. Assets
2. Liabilities
3. Equity
C. Income Statement
1. Revenues
2. Expenses
3. Gains
4. Losses
5. Revenue Recognition Principle
6. Comprehensive Income
D. Statement of Changes in Owners' Equity
E. Cash Flow Statement
1. Operating Cash Flows
2. Investing Cash Flows
3. Financing Cash Flows
F. Other Sources of Information in the Financial Statements
1. Footnotes
2. Management Discussion and Analysis
III. Valuation Methods
A. Dividend Discount Model
B. Discounted Cash Flows Model
C. Discounted Residual Income Model
D. Valuation Techniques Compared
E. Examples of Applying the Valuation Models
1. Example 1
a. Dividend Discount Model
b. Discounted Cash Flows Model
c. Discounted Residual Income Model
2. Example 2
F. Accounting Methods and Company Value
IV. Forecasting and Valuation
A. Forecasting Dividends, Cash Flows, or Earnings and Book Values
B. Consistent Terminal Forecasts Across Models
1. Residual Income Model
2. Dividend Discount Model
C. What Drives Value?
V. Components of the Income Statement
A. Income Statement Components
1. Gross Profit
2. Operating Income
3. Income From Continuing Operations
4. Nonoperating Income/Expense
5. Special Gains/Losses
6. Net Income
7. Discontinued Operations
8. Extraordinary Items
B. Incorporating Earnings Components for Forecasting Future ROE
C. Management Manipulation of Earnings Components
D. Pro Forma Earnings
VI. Ratio Analysis
A. Profitability Ratios
1. Return on Assets
2. Disaggregating Return on Assets
a. Profit Margin Ratio
b. Asset Turnover
3. Disaggregating the Profit Margin Ratio
4. Disaggregating the Asset Turnover Ratio
a. Accounts Receivable Turnover
b. Inventory Turnover
c. Plant Asset Turnover
5. Return on Common Stockholder Equity
B. Risk Ratios
1. Long-Term Liquidity Risk
a. Debt-to-Asset Ratio
b. Interest Coverage Ratio
2. Short-Term Liquidity Risk
a. Current Ratio
b. Quick Ratio
3. Other Measures of Liquidity
a. Working Capital
b. Turnover Ratios
c. Cash Flows From Operations
C. Summary of Results of Ratio Analysis
D. Ratio Analysis and Company Value
VII. Disaggregating ROE Into Operating and Financing Activities
A. Operating Activities Drive Company Value
B. Disaggregating the Financial Statements into Operating and Financial Activities
1. Operating Assets and Liabilities
2. Financing Assets and Liabilities
3. Disaggregating the Balance Sheet
4. Disaggregating the Income Statement
5. Disaggregated Ratios
6. Examples of Disaggregating the Financial Statements
a. Microsoft
b. Kellogg's
C. Implications for Valuation
VIII. Forecasting Framework
A. Key Drivers of Value
B. Key Drivers of the Income Statement
C. Key Drivers of the Balance Sheet
D. Framework for Forecasting
1. Step 1: Choose a Forecast Horizon
2. Step 2: Forecast Sales Growth
3. Step 3: Forecast the Income Statement Components
4. Step 4: Forecast the Balance Sheet Components
5. Step 5: Forecast Depreciation Expense
6. Step 6: Forecast the Financing Activities
a. Forecast Interest Expense and Financial Leverage
b. Forecast Equity Financing
7. Step 7: Forecast Income Tax Expense
E. Forecasting Example
IX. Forecasting Sales
A. Economy-Down Approach
B. Company-Level Approach
C. Academic Research on Forecasting Sales
X. Predicting Future Profitability
A. Disaggregated Ratio Analysis
B. Fundamental Signals
C. Accruals
D. Growth in Net Operating Assets
XI. The Behavior of Ratios Over Time
A. Regression Toward the Mean
B. RNOA
C. Growth in NOA
D. ATO and PM
E. The Change in PM and ATO
F. Sales Growth
G. Accounting Methods and RNOA
H. Conservative Accounting and Future RNOA
I. Investment and Future RNOA
XII. Using Industry Benchmarks
A. Definition of Industry
B. Regression Toward the Industry or the Economy
XIII. Indicators of Potential Earnings Quality Issues
A. Earnings Quality Signals
B. Net Sales
C. Bad Debt Expense
D. Cost of Goods Sold
E. Depreciation Expense
F. Nonoperating Items
G. Special Items
H. Income Tax Expense
I. Pension Expense
J. Discretionary Spending
K. Capitalizing Versus Expensing Costs
L. Estimated Liabilities
M. Contingencies
N. General Signals of Potential Earnings Quality Issues
1. Earnings Versus Sales Growth
2. Cash Flows Versus Net Income
O. Earnings Quality Adjustments and Company Value
XIV. Potential Incentives for Earnings Management
A. Trends
B. Incentives to Report Earnings Increases
C. Incentives to Meet or Beat Analyst Earnings Forecasts
D. Other Incentives
XV. Signals of Potential Earnings Management
A. Accruals
B. Discretionary Accruals
C. Net Operating Assets
D. Contemporaneous Increases (Decreases) in Profit Margin and Decreases (Increases) in Asset Turnover
XVI. Market Anomalies
A. Glamour Versus Value Stocks
B. Cash Flows and Accruals
C. Discretionary Accruals
D. Inventory Accruals
E. Growth in Long-Term Net Operating Assets
F. Cash Flows From Operations to Price
G. Net Operating Assets
H. Pro Forma Earnings
XVII. Conclusion
Working Papers
TABLE OF WORKSHEETS
Worksheet 1 Significant Acronyms and Abbreviations
Worksheet 2 Excerpts From Best Buy's 2002 Annual Report
Worksheet 3 Excerpts From Microsoft's 2003 Annual Report
Worksheet 4 Excerpts From Kellogg's 200 Annual Report
Worksheet 5 Excerpts From Whirlpool's 2002 Annual Report
Worksheet 6 Whirlpool Corporation Table of Forecasted Ratios, Forecasted Income Statements, and Forecasted Balance Sheets
Worksheet 7 Models for Predicting Future RNOA
Worksheet 8 Disaggregating Net Income Into Accruals and Cash Flows From Operations
Worksheet 9 Income Statement Assumptions Used in Valuations
Worksheet 10 List of Significant Accounting Pronouncements Principally Discussed
Bibliography
OFFICIAL
Financial Accounting Standards Board
Accounting Principles Board
General Accounting Office
UNOFFICIAL
Journal Articles