Methodologies for Estimating Future Profitability, Growth, and Valuation (Portfolio 5131)

BNA Tax and Accounting Portfolio 5131, Methodologies for Estimating Future Profitability, Growth, and Valuation (Accounting Policy and Practice Series), analyzes the methods used to predict a company's profitability, which is a fundamental goal of financial statement analysis. 

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BNA Tax and Accounting Portfolio 5131, Methodologies for Estimating Future Profitability, Growth, and Valuation (Accounting Policy and Practice Series), analyzes the methods used to predict a company's profitability, which is a fundamental goal of financial statement analysis. Estimates of profitability drive a company's valuation as reflected in the stock price. Substantial academic research has been conducted on methods of improving the estimates of a company's value and the forecasts of its profitability and growth.
This Portfolio explains how to use information in financial statements to evaluate a company's performance. The goal is to provide insights into predicting future profitability and growth under alternative valuation methods as developed and refined by academic research. The Portfolio also discusses potential inefficiencies in the stock market that may be exploited through financial statement analysis.
The Portfolio explains, compares and illustrates various methods of valuing companies. including the dividend discount model, the free cash flow model and the residual income model. The 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 also discussed.
The Portfolio stresses the importance of analyzing a company's operating activities. It explains how a company's balance sheet and income statement can be disaggregated into operating activities and financial activities.
Section XIII, Section XIV, and Section XV discuss quality of earnings. The Portfolio identifies potential incentives for earnings management and suggests warning signals. Finally, the Portfolio discusses some fundamental market anomalies that may affect future financial statements before they affect the price of a company's stock.
This Portfolio may be cited as BNA Tax and Accounting Portfolio 5131, Yohn, Methodologies for Estimating Future Profitability, Growth, and Valuation (Accounting Policy and Practice Series). Within the Accounting Portfolio Series, however, references to the Portfolios will include only the Portfolio numbers and titles.


Teri Yohn, Ph.D., CPA; Ph.D., Accounting, Indiana University; B.S., Accounting, University of Delaware. Dr. Yohn is an Associate Professor at the Kelley School of Business at Indiana University and a Certified Public Accountant in the state of Maryland. Dr. Yohn teaches in the areas of financial accounting and financial statement analysis. Her research focuses on predicting future profitability and examining how accounting information affects information asymmetry in the stock market.


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

Introductory Material

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

a. Dividend Discount Model

b. Discounted Cash Flows Model

c. Discounted Residual Income Model

F. Accounting Methods and Company Value

IV. Forecasting and Valuation

Introductory Material

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

Introductory Material

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

Introductory Material

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

Introductory Material

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

Introductory Material

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

Introductory Material

A. Economy-Down Approach

B. Company-Level Approach

C. Academic Research on Forecasting Sales

X. Predicting Future Profitability

Introductory Material

A. Disaggregated Ratio Analysis

B. Fundamental Signals

C. Accruals

D. Growth in Net Operating Assets

XI. The Behavior of Ratios Over Time

Introductory Material

A. Regression Toward the Mean


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

Introductory Material

A. Definition of Industry

B. Regression Toward the Industry or the Economy

XIII. Indicators of Potential Earnings Quality Issues

Introductory Material

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

Introductory Material

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

Introductory Material

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

Introductory Material

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


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



Financial Accounting Standards Board

Accounting Principles Board

General Accounting Office


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