CHAPTER FOURTEEN
  
The Value of Operations and the Evaluation of Enterprise Price-to-Book Ratios and Price-Earnings Ratios

Stephen H. Penman

The web page for Chapter Fourteen runs under the following headings:

            What this Chapter is Doing

            Demonstration of the Equivalence of Residual Earnings (RE) and Residual Operating
Income (ReOI) Valuation Methods

            Corresponding Equity (Levered) Measures and Enterprise (Unlevered) Numbers

            Summary of Leverage Effects

            Understanding Enterprise Valuation Models

            Free Cash Flow as a Dividend

            Pitfalls in Focusing on Earnings Growth

            Should Managements’ Bonuses be tied to Earnings-per-share Growth?

            Share Issues and EPS Compensation

            Stock Repurchases and Earnings-per-Share Growth: Papa John’s International

            Bubble Bubble

            What’s Wrong with this Picture?

            Buffett on Stock Repurchases at Berkshire Hathaway

            A Financing Arbitrage Opportunity?

            Active Financing and Capital Structure

Leverage and Active Investing

            Levered and Unlevered P/B Ratios: Reebok

A Formula for Levered and Unlevered B/P Ratios

The Circularity Problem in Estimating the Cost of Capital

            Dealing with the Valuations Effects of Employee Stock Options

Valuation Methods and the Impairment of Goodwill

Readers’ Corner

 

What this Chapter is Doing

The analysis in Chapter 14 is built on the following notion: If an asset or liability is measured at its (market) value on the balance sheet, there is no work for the analyst to do. The accountant has already carried out the valuation. Putting it in terms of the task required, valuation involves forecasting future residual earnings, as directed by the residual earnings model. If assets and liabilities are already valued correctly in the balance sheet, the forecast of residual earnings must be zero. Accordingly there is no need to forecast: There is no work to do.

While operating assets and liabilities are rarely valued correctly in the balance sheet, financial assets and liabilities usually are – or their market values can easily be obtained from the mark-to-market footnote to the statements required by FASB Statement No. 107. The chapter exploits this feature. The value of the equity is determined as follows:

Value of Equity = Value of Operations – Value of the Net Financial Obligations

If net financial obligations are measured at market value on the balance sheet, we only have to value the operations. Chapters 8 – 10 took us through methods to separate net operating assets (NOA) and net financial obligations (NFO) in income statements and balance sheets. Chapter 14 applies the valuation methods in Chapters 5 and 6 – residual earnings valuation and abnormal earnings growth valuation – to these reformulated financial statements:

   Residual operating income valuation: Anchor on the book value of NOA and add value by
forecasting residual the residual income from operations (ReOI).

   Abnormal operating income valuation: Anchor on capitalized forward operating income and
add value by forecasting abnormal growth in (cum-dividend) operating income (AOIG).

Remember that AOIG = Change in ReOI, so forecasting ReOI is sufficient for both methods.

The advantages of these unlevered approaches:

• The valuation task is simpler: The financing activities do not have to be forecasted.

 

• Changes in leverage change the cost of equity capital (see equation 14.7). So, if one forecasts residual earnings to the equity, the cost of capital has to be adjusted each future period for the anticipated change in leverage. Working with residual operating income, it is much more reasonable to assume a constant cost of capital (for operations).

• Working with unlevered numbers avoids the pitfalls of levered numbers. ROCE, residual earnings, earnings and eps growth, and abnormal earnings growth can be created by leverage, but do not add value if financing activities are zero NPV (irrelevant to value). See Tables 14.5 and 14.6 and Box 14.5 in the text and below. Unlevering the numbers brings a focus to the operations where the value is generated.

 

Demonstration of the Equivalence of Residual Earnings (RE) and Residual Operating
Income (ReOI) Valuation Methods

The demonstration below starts with an initial balance sheet (in Year 0). RNOA follows a decaying pattern, then levels off at 12% in Year 4. Net operating assets reach a 4% growth rate by Year 4. With constant RNOA from Year 4 onwards, ReOI grows at the growth rate for NOA, 4%, and a continuing value is calculated accordingly.

Dividend payout is such as to maintain constant market leverage of 46%, so the equity cost of capital is a constant. With a cost of capital for operations of 10%, the equity cost of capital is 13%. (You should prove this to yourself with formula 14.7 in the text.) Residual earnings, with the 13% charge, also grow at 4% from Year 4 onwards. A continuing value is calculated accordingly.

Both residual earnings (RE) and residual operating income (REOI) methods give the same valuation. Provided we use the relevant cost of capital, this is always so.

 

 

 

 

 

 

 

 

Corresponding Equity (Levered) Measures and Enterprise (Unlevered) Numbers

Purging a number of leverage effects is called unlevering the number. The resultant (unlevered) number applies to the operations. As the operations are sometimes referred to as the enterprise, the resultant number is also referred to as an enterprise number.

Here are some levered measures and the corresponding enterprise number:

            Levered (Equity) Number                                        Unlevered (Enterprise) Number

               (Comprehensive) earnings                                      (Comprehensive) operating income
Residual earnings                                                     Residual operating income
ROCE                                                                      RNOA
Abnormal earnings growth                                      Abnormal operating income growth
Dividends                                                                 Free cash flow
CSE                                                                          NOA
Value of equity                                                         Value of NOA (Enterprise value)
Levered P/B                                                              Enterprise P/B
Levered P/E                                                              Enterprise P/E

Summary of Leverage Effects

Here is a summary of leverage effects on levered measures relative to the unlevered measure (without leverage):

Leverage increases ROCE over RNOA – provided the operating spread is positive
Leverage increases Residual Earnings (RE) over ReOI – provided the operating spread is
positive
Leverage increases earnings growth – provided the operating spread is positive
Leverage increases the P/B ratio – provided the enterprise P/B is greater than 1.0.
Leverage reduces the P/E ratio – provided that the operating income yield is greater than the net
borrowing cost

But note: leverage does not affect the value of the operations, nor does it affect equity value (if financing activities are irrelevant).

Understanding Enterprise Valuation Models

Though it might appear that there are a lot of new valuation techniques here (over those in Chapters 5 and 6), there is not much that is new once you realize that the shift is from equity numbers to the corresponding enterprise numbers. The form of the valuation models is the same:

ReOI valuation model 14.3 corresponds to RE valuation model 5.3 in Chapter 5, and there are the same three cases (Case 1, Case 2, Case 3) for the continuing value. Just substitute

ReOI for RE
The cost of capital for operations, rF for the cost of capital for the equity, rE.

 

AOIG valuation model 14.4 corresponds to the AEG model 6.2 in Chapter 6. Just substitute

            Operating income (OI) for Earnings
AOIG for AEG
The cost of capital for operations, rF for the cost of capital for the equity, rE.

 

AOIG, like AEG, must be cum-dividend growth. Appreciate that free cash flow is the dividend from operating activities.

Free Cash Flow as A Dividend

To appreciate the concept of free cash flow as a dividend, cast back to early chapters.

Chapter 4 (that deals with discounted cash flow analysis) makes an important point: Free cash flow is not a value-added concept. The free cash flow calculation treats investment as a negative – a reduction in value – whereas investment is made in order to add to value. Chapter 8 reinforces this notion. It shows that free cash flow, like dividends to shareholders,
is a distribution of value rather than generation of value.

   Look again at Figure 8.3. It depicts the operations adding value to the net operating assets. The cash is passed from the operating activities to the financing activities: The net cash from operations (free cash flow) is a dividend from the operating activities that is invested in the financing activities – either by buying debt or buying back the firm’s own debt. Net financial assets are then sold to pay any dividends.

It is easy to see that free cash flow is a dividend in the case where there is no net debt. In that case, the cash conservation equation is:

            C – I = d

That is, free cash flow is paid out as a net dividend. In the case where there is net debt, the dividend from the operating activities is split between a dividend to shareholders and a dividend to the debt holders (F):

            C – I = d + F

Free cash flow is reinvested in the AOIG calculation, just as the dividend is in the AEG calculation.

 

Pitfalls in Focusing on Earnings Growth

Box 14.5 in Chapter 14 shows how leverage creates eps growth. The box also shows how the added growth does not add value; leverage also increases the required return for equity and the net effect on equity value of the increased eps growth and the increased leverage is zero. The stock market very much focuses on earnings growth. The abnormal earnings growth model justifies this focus, provided the growth comes from operations. Investors should be skeptical of eps growth, otherwise they might pay too much for growth. Does it come from operating income growth or does it come from leverage?

These considerations reinforce a theme begun in Chapter 6: Be very careful in evaluating earnings growth. There we made two observations. First, earnings will grow if a firm invests more. However, if new investment earns only at the required return, the earnings growth does not add value. Accordingly, such earnings growth does not affect the P/E ratio. Second, earnings growth can be generated by accounting methods. Now we have a third caveat: Earnings growth that is generated from financial leverage does not add value. Let’s state the three caveats clearly:

Beware of growth that comes from investment. Think of firms that grow earnings dramatically through acquisitions. The market often sees these firms as “growth firms” and gives them a high P/E multiple. But, if an acquirer pays fair value for an acquisition, it may not add value to the investment: even though the acquisition adds a lot of earnings; the investment just earns the required return. The analysis in Chapter 5 is designed to prevent you from making the mistake of valuing growth that does not add value. Accordingly, the chapter says that you should focus on residual earnings growth because, in the residual earnings calculation, new investment is charged with the cost of capital. So residual earnings can increase only if new investment earns more than the cost of capital. Equivalently, Chapter 6 shows that valuing abnormal earnings growth, rather than earnings growth, provides the same protection, for then earnings growth is charged for normal growth and the P/E ratio is higher than normal only if one expects positive abnormal earnings.

Beware of growth that comes from accounting methods. Firms can create earnings growth by using accounting methods that shift earnings to the future. Chapters 5 and 6 illustrate. But those chapters also show that applying residual earnings or AEG valuations models protect you from paying too much for this growth.

Beware of growth that comes from financial leverage. Firms can generate earnings growth by borrowing, and Chapter 14 makes the point. The analysis in the chapter is designed to prevent you from making the mistake of giving a firm a higher P/E ratio because it has generated earnings growth through borrowing or through stock repurchases. In fact, more leverage implies a lower P/E ratio (in most cases).The chapter instructs you to focus on residual operating income and growth in operating income (that are not affected by leverage). It instructs you to focus on the unlevered P/B ratio, the multiplier to apply to the book value of the operations, and on the unlevered P/E ratio, the multiplier to apply to operating income. Operations add value, not the financing activities. The unlevered P/B and P/E ratios are determined by expected growth in operating income that does not come purely from new investment earning at the required return.

 

Should managements’ bonuses be tied to earnings-per-share growth?

The short answer is: No. The tree caveats above should persuade you. With respect to the leverage caveat in this chapter, compensation should be tied to operating income growth, not earnings growth, for management can increase eps growth just by borrowing (and thus imposing risk in the shareholder). For the same reason, management should not be rewarded on ROCE.

The long answer is a little more complicated. Leverage (and the earnings growth is can deliver) is “good” if it induces management to work harder to ensure leverage is favorable, that is, to ensure RNOA is higher than the borrowing rate. One might want to reward a manager who decides to lever up, knowing he or she can deliver favorable leverage. However, the temptation for the manager to “role the dice” by borrowing, and put the risk onto shareholders, must be guarded against.

Here is a particular scam to watch for. Management exercise stock options (at less than market price). The increased number of shares from the issue will reduce eps, for dilution of earnings occurs when shares are issued at less than market price. So the firm repurchases stock to maintain eps growth (but also adding leverage). This growth is illusory.

Share Issues and EPS Compensation

Just as share repurchases increase EPS, so do share issues decrease EPS. Thus, if compensation is tied to EPS, management have an incentive to issue dent rather than equity (and so lever up the firm). The following paper suggests that this indeed happens:

R. Huang, C. Marquardt, and B. Zhang, “Why do Managers Avoid EPS Dilution” at http://ssrn.com/abstract=1464496 

Stock Repurchases and Earnings-per-Share Growth: Papa John’s International

Papa John’s operates pizza parlors – about 2,500 of them in 2000. For the first nine quarters of 2000, eps rose over 18 percent to $1.42 for $1.20 from a year earlier. But earnings (net income) was actually down, to $35,978 million from $36,083 million. Why?

Well, in the prior year, Papa John’s repurchased 6.3 million shares. This reduced earnings (on increasing operating earnings) because, to finance the repurchase, the firm increased borrowings by $133 million, increasing interest expense (before-tax) from $151 thousand to $4,854 million. The repurchase indeed increased eps, but also significantly increased leverage – and thus the risk to shareholders.

A firm has to be careful in taking on debt to finance a stock repurchase. Borrowing to invest in the business adds value (one would hope). Borrowing to buy back shares is doubtful unless the shares are underpriced. After all, the purchase is really on behalf of the shareholders, so they are effectively borrowing money to pay to themselves.

Papa John’s stock price dropped 21 percent over the year after the stock repurchases.

Bubble Bubble

Earnings growth, incorrectly analyzed, can lead to bubble prices. Consider a firm that creates earnings growth (and ROCE) by buying back stock and borrowing – much like the example in Box 14.5. This activity does not add value. But if the market, after observing the earnings growth, gives the firm a higher stock price, the firm might be tempted to buy back more stock (at high prices), creating earnings growth that perpetuates the mispricing. A bubble forms. But, of course, the bubble must burst; as the firm is paying took much to repurchase the overpriced stock, it is destroying value for shareholders.

 

What’s Wrong with this Picture?

In an article in the Financial Times in May, 2012, it was reported that the shares of InterContinental Hotels hit a five-year high after it was revealed that the firm was likely to sell off its landmark Barclay New York Hotel for $1.5 billion and taking on debt to make a share repurchase. The act of “returning cash to shareholders” would increase 2014 EPS by 18 percent, it was said.

The repurchase may very well increase EPS, at Box 14.5 illustrates. But if the shares are purchased at fair market value, there would be no value added. One would hope that the firm was not selling off the landmark hotel just to raise EPS through a stock repurchase!

Buffett on Stock Repurchases at Berkshire Hathaway

Here is an excerpt from Warren Buffett’s 1999 annual letter to shareholders of Berkshire Hathaway:

Postscript:

In September, 2011, Berkshire announced that it would begin a stock buyback plan for the first time in its history. The firm had $47 million of cash in hand at the time. The Class A share jumped 6.2% to $106,540 on the announcement. Apparently, Buffett saw the stock as underpriced, and the market reaction to the announcement would suggest so.

A Financing Arbitrage Opportunity?

This chapter stresses the point: Leverage may add to accounting numbers like ROCE and EPS growth, but does not add value. The point recognizes the following principle: One cannot add value by buying and selling debt and shares if the shares are fairly priced.

The case of either debt or equity shares being mispriced of course provides the exception: Firms add value by issuing debt for more than it is worth and buying back stock for less than it is worth. The added leverage then adds value.

In 2010, with the recession still entrenched, firms began to buy back their own stock. In the first 9 months of that year, $258 billion in buybacks had been announced compared with $52 billion in the first three quarters of 2009…the biggest increase since 2000. At the same time, firms were heavily borrowing at the very low interest rates at the time (the 10-year US government rate was below 2%): IBM issued debt at 1%, Microsoft issued debt at 0.875%, WalMart issued debt at 0.75%. And stock prices were low relative to standard fundamentals like book value and earnings.

This can be seen as financing arbitrage: issue debt cheaply and use the proceeds to buy cheap stock.

The specific example of Microsoft is in Box 14.6. See also Box 14.7 on issuing debt to add value.

PepsiCo sold $4.25 billion of bonds in 2010 and authorized a stock repurchase of $15 billion.

Hewlett Packard borrowed $6 billion in 2010 and spent $8.4 billion on its stock repurchase plan.

 

Active Financing and Capital Structure

What determines a firm’s capital structure? This is an eternal question in corporate finance classes, with many alternative theories trying to explain away the Modigliani & Miller proposition that capital structure does not matter.

There is an active investing reason for capital structure (to appreciate it, you might first read the preceding item): Firms capital structure is determined by their active timing of debt and equity markets. When debt financing is cheap, they raise capital from debt issues. When equity financing is cheap (with the shares overpriced), they issue shares. When debt is cheap and shares are underpriced, they issue debt and use the proceeds to buy back the stock (as in the financing arbitrage play above). The resulting capital structure is a result of this market timing.

On this, see M. Baker and J. Wurgler, “Market Timing and Capital Structure,” Journal of Finance LVII (February 2002), page 1.

 

Leverage and Active Investing

This chapter warns about buying with leverage: Leverage is risky (as the shareholders of Lehman brothers certainly found out in 2008). But an active investor can use leverage to advantage: If they feel that a stock is underpriced, they lever up the abnormal return they get from buying the stock. This of course can be done by borrowing to buy the stock, but also by buying stocks which are deemed underpriced and which have a lot of leverage: if your position is based on expectations that operating income (and ReOI) will increase in the future, the presence of leverage in the firm will yield yet higher (levered) earnings.

This of course is quite dangerous: One has to be very sure of one’s fundamental analysis to do this. Most fundmentalists take the view that one should not mess around with leverage. Warren Buffet avoids stock with high leverage.

 

Levered and Unlevered P/B Ratios: Reebok

The relationship between levered and unlevered (or enterprise) price-to-book ratios can be demonstrated with the Reebok case in Box 14.4. Remember that Reebok increased its leverage substantially by repurchasing its stock and financing the repurchase with borrowing. This substantially decreased its equity and increased its net financial obligations (NFO).

The numbers after the stock purchase:

Value of NOA            3,472      Book value of NOA           1,135       Unlevered P/B          3.059
NFO                               720      NFO                                     720        FLEV (720/415)      1.735
Value of Equity           2,752      Book value of equity           415        Levered P/B             6.631

Notice how leverage increases the levered P/B over the unlevered P/B. The reconciliation between the two is as follows:

      Levered P/B = Unlevered P/B + FLEV(Unlevered P/B – 1)

                 6.631 = 3.059 + (1.735 x 2.059)

The “As-If” Numbers Without a Stock Repurchase:

Value of NOA            3,472      Book value of NOA           1,135       Unlevered P/B          3.059
NFO                               119      NFO                                     119        FLEV (119/1,016)   0.117
Value of Equity          3, 353      Book value of equity         1,016        Levered P/B             3.300

The levered and unlevered P/B ratios now reconcile as follows:

            3.300 = 3.059 + (0.117 x 2.059)

Notice that, while the unlevered P/B is not affected by the stock repurchase, the levered P/B is considerably higher. One is buying at 6.631 times book value after the stock repurchase rather than the 3.30 before. But only operating activities lead to a premium, and one is buying only 3.059 times the book value of net operating assets (both before and after the repurchase).

A Formula for Levered and Unlevered B/P Ratios

Equation 14.9 in the text reconciles levered P/ rations to unlevered or enterprise P/B ratios.

A similar formula reconciles levered and unlevered B/P ratios:

           

where   (market leverage).

The Circularity Problem in Estimating the Cost of Capital

Box 14.3 in the chapter points out a circularity problem in estimating the Weighted Average Cost of Capital (WACC): one has to use the market price, yet we want to use the WACC to get valuations that challenge the market price.

Some authors have produced numerical iterative methods to deal with this. Here are some papers:

P. Mohanty, “A Practical Approach to Solving the Circularity Problem in Estimating the Cost of Capital” at http://ssrn.com/abstract=413240

S. Schmidle, “Simultaneous Determination of Enterprise Value and Cost of Unlevered Equity.” The only reference I have is schmidle@sympatico.ca

Professor Pierre Liang at Carnegie Mellon University has developed a spreadsheet with his students to deal with the problem. He is at liangj@andrew.cmu.edu

 

Dealing with the Valuations Effects of Employee Stock Options

Chapter 14 shows how one can take a balance sheet approach to incorporating the cost of stock options in a valuation. If we can calculate the fair value of outstanding options, we can deduct that fair value from the valuation: We are essentially marking the liability for the options to market. With this approach, we do not have to forecast the income statement effects of the options.

Here’s a further example.

       You have valued the equity of a firm at $10,825 million. The stock compensation footnote for a firm indicates that that there are employee stock options on 28 million shares outstanding at the end of 2004. These options vest in 2005 and after. A modified Black-Scholes valuation of these options is $15 each. How does this information change your valuation? (The firm has a 35% tax rate.)

 

(See the related example on the web page for Chapter 15.)

Valuation Methods and the Impairment of Goodwill

FASB Statement 144 requires firms to write down goodwill recorded on acquisitions if the fair value of the goodwill is below the carrying value. The residual earnings valuation approach is particularly suited to this task. An example illustrates.

A firm made an acquisition at the end of 2004 and recorded the acquisition cost of $428 million on its balance sheet as tangible assets of $349 million and goodwill of $79 million. The firm used a required return of 10% as a hurdle rate when evaluating the acquisition and determined that it was paying fair value.

By the end of 2005, the tangible assets from the acquisition had been depreciated to a book value of $301 million. It was ascertained that the acquisition would subsequently earn an annual rate of return of only 9% on book value at the end of 2005.

The amount by which goodwill should be impaired under the FASB requirements for impairment can be calculated as follows.

As the asset is at fair value on the balance sheet, it is expected to earn at the required return on book value. Thus, if this is the case,

If  is expected to be less than 0 at the carrying value for goodwill, then goodwill must be written down to render:

Book value end of 2005                      = 301 + 79     = 380    (tangible assets + gw)
Forecasted earnings 2006                              = 380 x 0.09   =   34.2
*Book value that yields RE = 0  (at 10%) = 342
Amount of impairment 380 – 342              =   38 (1% of book value)

So the good will is written down from 79 to 41.

*

Readers’ Corner

On the effect of stock repurchases on EPS, management compensation, and value:

J. Oded, A. Michel, “Stock Repurchases and the EPS Enhancement Fallacy,” Financial Analysts Journal (July/August, 2008), pp.62-75.

A Michel, J. Oded, and I. Shaked, “Not All Buybacks are Created Equal: The Case of Accelerated Stock Repurchases,” Financial Analysts Journal 66 (Nov/Dec, 2010), 55-72.

P. Griffin and N. Zhu, “Accounting Rules? Stock Buybacks and Stock Options: Additional Evidence.” At http://ssrn.com/abstract=1316623

           
See also case studies on stock repurchases for Oracle, Texas Instruments, and Symantec, see

            http://papers.ssrn.com/sol3/papers.cfm?abstract_id=995639

            http://papers.ssrn.com/sol3/papers.cfm?abstract_id=993122

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=996342

The following paper covers accelerated share repurchase programs and their effect on EPS:

C. Marquardt, C. Tan, and S. Young, “Managing EPS through Accelerated Stock Repurchases: Compensation Versus Capital Market Incentives. Baruch College paper, 2007.    

The following papers deal with the circularity in estimating the cost of capital from market prices:        

P. Mohanty, “A Practical Approach to Solving the Circularity Problem in Estimating the Cost of Capital,” at http://ssrn.com/abstract=413240

S.Schmidle, “Simultaneous Determination of Enterprise Value and the Cost of Unlevered Equity”  Paper at schmidle@sympatico.ca

For a review of payout policy:

A. Brav., J. Graham, C. Harvey, and R. Michaely, “Payout Policy in the 21st Century,” Journal of Financial Economics 77 (2005), pp. 483-527.

For more on handling leverage in financial statement analysis and valuation, see 

S. Penman, Accounting for Value, Chapter 4.