FINANCIAL STATEMENT ANALYSIS

AND VALUATION (ACFI810)

Week 10 –
What You Will Learn in this Chapter

• How rates of return and residual earnings can be created by accounting methods

• How growth in earnings, growth in residual earnings, and abnormal earnings growth can be created by accounting methods

• The difference between economic value added and accounting value added

• How appropriate valuation techniques produce valuations that are not affected by accounting methods

• How P/E and P/B ratios are affected by accounting methods

• How accounting methods affect continuing value calculations

• What are "conservative" accounting and "liberal" accounting and how they affect valuation

• How firms create and release hidden reserves

17-2
The Big Picture for this Chapter
Accounting methods affect accounting numbers and
the measures like RNOA and growth
But----

Accounting methods do not affect value

Residual income valuation builds in protection from

accounting methods.

Accounting methods do not affect

residual income valuation

17-3
Two Accounting Treatments for a Project

• Investment in project $400

• Required retur 10%
• Project life 2 years
______________________________________________________________________________

2010 2011 2012

Accounting Treatment 1

Sales 240 220

Depreciation 200 200
Operating income 40 20

Net operating assets 400 200 0

Free cash flow 240 220

RNOA 10% 10%

ReOI (0.10) 0 0
PV of ReOI 0 0
Total PV of ReOI 0
Value of project 400

17-4
Two Accounting Treatments for a Project

• Investment in project $400

• Required return 10%

• Project life 2 years
______________________________________________________________________________

2010 2011 2012

Accounting Treatment 2 - Conservative

Sales (40) 240 220

Depreciation ___ 180 180
Operating income (40) 60 40

Net operating assets 360 180 0

Free cash flow 240 220

RNOA 16.7% 22.2%

ReOI (.10) 24 22
PV of ReOI 21.82 18.18
Total PV of ReOI 40
Value of project 400

17-5
Projects: Accounting Effects
and Valuation Effects
• Accounting Effects:
• Residual earnings and RNOA can be created by the accounting

• Valuation Effects:
• Residual earnings created by the accounting does not affect the valuation

Distinguish:
• Economic value added
• Accounting value added

Economic value added is measured with residual earnings techniques irrespective of the
accounting: the value conservation principle

17-6
Neutral Accounting, Conservative Accounting, and Liberal Accounting

• Neutral (Unbiased or Normal) Accounting: yields expected RNOA equal to

the cost of capital when operations add no value

• Conservative Accounting: yields expected RNOA greater than the

cost of capital when operations add no value

• Liberal Accounting: yields expected RNOA less than the cost of capital
when operations add no value

The funny thing about conservative accounting: it makes firms look more
profitable than they are

17-7
Going Concerns with Constant Investment:
Neutral Accounting
A firm investing $400 each year with no value added: neutral accounting

2010 2011 2012 2013 2014

Sales
From investments in - 2010 240 220
- 2011 240 220
- 2012 240 220
- 2013 ___ ___ ___ ___ 240
240 460 460 460
Operating expenses (depreciation)
For investments in - 2010 200 200
- 2011 200 200
- 2012 200 200
- 2013 ___ ___ ___ 200
200 400 400 400
Operating income 40 60 60 60

Net operating assets

For investments in - 2010 400 200
- 2011 400 200
- 2012 400 200
- 2013 400 200
- 2014 ___ ___ ___ ___ 400
400 600 600 600 600

17-8
Going Concerns with Constant Investment:
Neutral Accounting

A firm investing $400 each year with no value added: neutral accounting

2010 2011 2012 2013 2014

Investment 400 400 400 400 400

Free cash flow (400) (160) 60 60 60

RNOA 10.0% 10.0% 10.0% 10.0%

Profit margin 16.7% 13.0% 13.0% 13.0%
Asset turnover 0.60 0.77 0.77 0.77
Growth in NOA 50% 0 0 0
ReOI (.10) 0 0 0 0
AOIG 0 0 0

Value 400 600 600 600 600

Premium 0 0 0 0 0
P/B 1.0 1.0 1.0 1.0 1.0
Trailing P/E 11.0 11.0 11.0 11.0
Forward P/E 10.0 10.0 10.0 10.0 10.0
_______________________________________________________________________________________________

17-9
Valuation: Constant Investment with Neutral Accounting

Value = 400 (book value)

40
Value= 0.10 (capitalized forward earnings)

= 400

17-10
Going Concerns with Constant Investment:
Conservative Accounting
_

A firm investing $400 each year with no value added: 10% of investment expensed immediately.

2010 2011 2012 2013 2014

Sales
From investments in - 2010 240 220
- 2011 240 220
- 2012 240 220
- 2013 ___ ___ ___ ___ 240
240 460 460 460
Operating expenses
For investments in - 2010 40 180 180
- 2011 40 180 180
- 2012 40 180 180
- 2013 40 180
- 2014 ___ ___ ___ ___ 40
40 220 400 400 400
Operating income (40) 20 60 60 60

Net operating assets

For investments in - 2010 360 180
- 2011 360 180
- 2012 360 180
- 2013 360 180
- 2014 ___ ___ ___ ___ 360
360 540 540 540 540

17-11
Going Concerns with Constant Investment:
Conservative Accounting
_

A firm investing $400 each year with no value added: 10% of investment expensed immediately.

2010 2011 2012 2013 2014

Investment 400 400 400 400 400

Free cash flow (400) (160) 60 60 60

RNOA 5.6% 11.1% 11.1% 11.1%

Profit margin 8.3% 13.0% 13.0% 13.0%
Asset turnover .67 .85 .85 .85
Growth in NOA 50% 0% 0% 0%
ReOI (.10) (16) 6 6 6
AOIG 22 0 0

Value 400 600 600 600 600

Premium 60 60 60 60
P/B 1.11 1.11 1.11 1.11 1.11
Trailing P/E 22.0 11.0 11.0 11.0
Forward P/E 20.0 10.0 10.0 10.0 10.0
_______________________________________________________________________________________________

17-12
Valuation: Constant Investment with Conservative Accounting

16  6 
ReOI Value = 360 - +   /1.10
1.10  0.10 

= 400

1  22 
AOIG Value = 20 +
0.10  1.10 

= 400

17-13
Going Concerns with Constant Investment:
Accounting Effects and Valuation Effects

Accounting Effects Valuation Effects

1. Operating income is not affected by the
1. Value is not affected by the accounting
accounting once a constant level of
investment is reached
2. Conservative accounting induces non-
2. NOA are permanently lower with conservative normal P/B ratios
accounting
3. P/E ratios are not affected by the
3. Conservative accounting increases RNOA
and residual income accounting once the permanent level of
investment is reached
4. RNOA and residual operating income are
constant for both types of accounting once a [Liberal accounting has opposite effects]
constant level of investment is reached; AOIG
is thus zero in both cases

17-14
Going Concerns with Growing Investment:
Neutral Accounting
A firm with investment growing at 5% per year with no value added: neutral accounting

2010 2011 2012 2013 2014

Sales
From investments in - 2010 240.0 220.0
- 2011 252.0 231.0
- 2012 264.6 242.6
- 2013 ____ ____ ____ 277.8
240.0 472.0 495.6 520.4
Operating expenses (depreciation)
For investments in - 2010 200.0 200.0
- 2011 210.0 210.0
- 2012 220.5 220.5
- 2013 231.5
- 2014 ____ ____ ____ ____
200.0 410.0 430.5 452.0
Operating income 40.0 62.0 65.1 68.4

Net operating assets

For investments in - 2010 400.0 200.0
- 2011 420.0 210.0
- 2012 441.0 220.5
- 2013 463.1 231.5
- 2014 ____ ____ ____ ____ 486.2
400.0 620.0 651.0 683.6 717.7

17-15
Going Concerns with Growing Investment:
Neutral Accounting
A firm with investment growing at 5% per year with no value added: neutral accounting

2010 2011 2012 2013 2014

Investment 400 420 441 463.1 486.2

Free cash flow (400) (180) 31 32.5 34.4

RNOA 10.0% 10.0% 10.0% 10.0%

Profit margin 16.7% 13.1% 13.1% 13.1%
Asset turnover .60 .76 .76 .76
Growth in NOA 55% 5% 5% 5%
ReOI (.10) 0 0 0 0
Growth in ReOI − 0% 0% 0%
Growth in cum-dividend OI − 10% 10% 10%
AOIG 0 0 0

Value 400 620.0 651.0 683.6 717.7

Premium 0 0 0 0 0
P/B 1.0 1.0 1.0 1.0 1.0
Trailing P/E 11.0 11.0 11.0 11.0
Forward P/E 10.0 10.0 10.0 10.0 10.0
_______________________________________________________________________________________________

17-16
Valuation: Growing Investment with Neutral Accounting

ReOI Value = 400 (book value)

40
AOIG Value = 0.10 (capitalized forward earnings)

= 400

Even though earnings are growing, residual

earnings and abnormal OI growth are zero:
No value added

17-17
Going Concerns with Growing Investment:
Conservative Accounting
A firm with investment growing at 5% per year with no value added: 10% of investment
expensed immediately.
2010 2011 2012 2013 2014

Sales
From investments in - 2010 240.0 220.0
- 2011 252.0 231.0
- 2012 264.6 242.6
- 2013 ____ ____ ____ 277.8
240.0 472.0 495.6 520.4
Operating expenses
For investments in - 2010 40.0 180.0 180.0
- 2011 42.0 189.0 189.0
- 2012 44.1 198.5 198.5
- 2013 46.3 208.4
- 2014 ____ ____ ____ 48.6
40.0 222.0 413.1 433.8 455.5
Operating income (40.0) 18.0 58.9 61.8 64.9

Net operating assets

For investments in - 2010 360.0 180.0
- 2011 378.0 189.0
- 2012 396.9 198.5
- 2013 416.8 208.4
- 2014 ____ ____ ____ ____ 437.6
360.0 558.0 585.9 615.2 646.0

17-18
Going Concerns with Growing Investment:
Conservative Accounting

A firm with investment growing at 5% per year with no value added: 10%
of investment expensed immediately.
2010 2011 2012 2013 2014

Investment 400 420 441 463.1 486.2

Free cash flow (400) (180) 31 32.5 34.2

RNOA 5.0% 10.6% 10.6% 10.6%

Profit margin 7.5% 12.5% 12.5% 12.5%
Asset turnover .67 .85 .85 .85
Growth in NOA 55% 5% 5% 5%
ReOI (.10) (18.0) 3.10 3.25 3.42
Growth in ReOI − − 5% 5%
Growth in cum-dividend OI − 127% 10.3% 10.3%
AOIG 21.10 0.155 0.163
AOIG growth rate - - 5%

Value 400.0 620.0 651.0 683.6 717.7

Premium 62.0 65.1 68.4 71.8
P/B 1.11 1.11 1.11 1.11 1.11
Trailing P/E 24.4 11.6 11.6 11.6
Forward P/E 22.2 10.5 10.5 10.5 10.5
_______________________________________________________________________________________________

17-19
Valuation: Growing Investment with Neutral Accounting

ReOI Value 18  3.1 

= 360 − +  / 1.10
1.10  1.10 − 1.05 
= 400

AOIG Value 1  21.10 0.155 

= 18 + + / 1.10
0.10  1.10 1.10 − 1.05 
= 400

Even though earnings are growing and residual earnings and abnormal
OI growth have been created (by the accounting), there is no value
added.

17-20
Going Concerns with Growing Investment: Accounting Effects and Valuation Effects

Accounting Effects Valuation Effects

1. Conservative accounting reports lower 1. Value is not affected by the accounting
operating income
2. P/B ratios with conservative accounting
2. Conservative accounting produces above-
normal RNOA and residual operating income
are the same as the no-growth case

3. Conservative accounting produces lower 3. P/E ratios with conservative accounting

RNOA and residual operating income than the are higher than the no-growth case: P/E
no-growth case reflects anticipated growth
4. Conservative accounting creates growth in
operating income and residual operating
[Liberal accounting has opposite effects]
income, and also creates abnormal OI growth

17-21
Accounting Methods, Profit Margins and Asset
Turnovers
• Conservative accounting increases ATO; for both no-growth case and growth
case

• Conservative accounting does not affect PM in no-growth case

• Conservative accounting reduces PM in growth case

• RNOA = PM x ATO

17-22
An Exception: LIFO Accounting Creates Economic Value
• If LIFO is used for tax purposes, it must be used for financial reporting

• LIFO defers tax payments through higher cost of goods sold if inventories are
growing

• The present value of tax payments is lower, so firm value is higher

• The higher firm value is captured in a residual earnings valuation through

higher forecasted after-tax profits margins

17-23
 Hidden Reserves and the Creation of Earnings
A firm with investment initially growing at 5% and then leveling off, with no value added: 10% of investment expensed
immediately.

2010 2011 2012 2013 2014 2015 2016 2017

Sales
From investments in - 2010 240.0 220.0
- 2011 252.0 231.0
- 2012 264.6 242.6
- 2013 277.8 254.7
- 2014 291.7 267.4
- 2015 291.7 267.4
- 2016 _____ _____ _____ _____ _____ _____ _____ 291.7
240.0 472.0 495.6 520.4 546.4 559.1 559.1

Operating expenses
For investments in - 2010 40.0 180.0 180.0
- 2011 42.0 189.0 189.0
- 2012 44.1 198.5 198.5
- 2013 46.3 208.4 208.4
- 2014 48.6 218.8 218.8
- 2015 48.6 218.8 218.8
- 2016 48.6 218.8
- 2017 _____ _____ _____ _____ _____ _____ _____ 48.6
40.0 222.0 413.1 433.8 455.5 475.8 486.2 486.2
Operating income (40.0) 18.0 58.9 61.8 64.9 70.6 72.9 72.9

17-24
Hidden Reserves and the Creation of Earnings (Cont.)
2010 2011 2012 2013 2014 2015 2016 2017
Net operating assets
For investments in - 2010 360.0 180.0
- 2011 378.0 189.0
- 2012 396.9 198.5
- 2013 416.8 208.4
- 2014 437.6 218.8
- 2015 437.6 218.8
- 2016 437.6 218.8
- 2017 _____ _____ _____ _____ _____ _____ _____ 437.6
360.0 558.0 585.9 615.2 646.0 656.4 656.4 656.4

Investment 400 420 441 463.1 486.2 486.2 486.2 486.2

Free cash flow (400) (180) 31 32.5 34.2 60.2 72.9 72.9

RNOA 5.0% 10.6% 10.6% 10.6% 10.9% 11.1% 11.1%

Profit margin 7.5% 12.5% 12.5% 12.5% 12.9% 13.0% 13.0%
Asset turnover .67 .85 .85 .85 .85 .85 .85
Growth in NOA 55% 5% 5% 5% 1.6% 0.0% 0.0%
ReOI (.10) (18.0) 3.10 3.26 3.42 6.02 7.29 7.29
Growth in ReOI ----- ----- 5% 5% 76% 21% 0%
Growth in cum-dividend OI ----- 127% 10.3% 10.3% 14.0% 11.8% 10.0%
AOIG 21.10 0.155 0.163 2.602 1.270 0.0

Value 400.0 620.0 651.0 683.6 717.7 729.3 729.3 729.3

Premium 62.0 65.1 68.4 71.7 72.9 72.9 72.9

P/B 1.11 1.11 1.11 1.11 1.11 1.11 1.11 1.11

Trailing P/E 24.4 11.6 11.6 11.6 11.2 11.0 11.0

Forward P/E 22.2 10.5 10.5 10.5 10.2 10.0 10.0 10.0

17-25
Valuation with Hidden Reserves

ReOI value

18 3.1 3.26 3.42 6.02 7.29

= 360 - + + + + + / 1.611
1.10 1.21 1.331 1.464 1.611 0.10

= 400

17-26
LIFO Reserves for NYSE and AMEX Firms, 1976-2004
LIFO Reserve/Shareholders' Change in LIFO Reserve/
Equity, % Revenue, %
%
Change 75th 25th 75th 25th
Year in CPI Percentile Median Pencentile Percentile Median Pencentile
1976 4.86 15.0 10.07 5.13 0.88 0.39 0.12
1977 6.70 15.5 10.20 4.98 0.93 0.49 0.16
1978 9.02 16.7 10.70 5.36 1.04 0.55 0.23
1979 13.29 20.9 12.85 6.52 1.84 1.06 0.51
1980 12.52 22.6 13.49 6.65 1.50 0.75 0.29
1981 8.92 21.5 12.72 6.35 1.10 0.53 0.12
1982 3.83 20.1 11.57 5.24 0.28 -0.03 -0.50
1983 3.79 18.1 10.40 4.72 0.19 -0.04 -0.43
1984 3.95 16.5 9.48 4.12 0.25 0.02 -0.24
1985 3.80 14.9 7.98 3.23 0.08 -0.10 -0.47
1986 1.10 12.6 6.18 2.27 0.08 -0.10 -0.51
1987 4.43 12.6 6.16 2.35 0.35 0.11 -0.09
1988 4.42 13.4 6.31 2.33 0.56 0.25 0.05
1989 4.65 13.0 6.04 2.32 0.38 0.13 -0.05
1990 6.11 13.3 6.08 2.05 0.32 0.08 -0.09
1991 3.06 12.0 5.42 1.86 0.12 -0.03 -0.27
1992 2.90 12.1 5.28 1.73 0.09 -0.03 -0.21
1993 2.75 10.7 4.52 1.41 0.06 -0.05 -0.30
1994 2.67 10.2 4.41 1.65 0.26 0.07 -0.05
1995 2.54 9.8 4.50 1.94 0.32 0.10 -0.02
1996 3.32 8.5 3.96 1.53 0.11 -0.02 -0.22
1997 1.70 7.6 3.31 1.29 0.06 -0.03 -0.19
1998 1.61 6.4 2.85 1.09 0.01 -0.08 -0.27
1999 2.68 6.4 2.64 0.93 0.07 -0.03 -0.16
2000 3.39 6.6 2.90 1.09 0.16 0.03 -0.07
2001 1.55 6.4 2.52 0.83 0.06 -0.05 -0.22
2002 2.38 7.4 2.99 0.88 0.12 0.00 -0.10
2003 1.88 6.7 2.90 0.79 0.15 0.01 -0.06
2004 3.26 8.7 3.00 0.96 0.48 0.11 0.00

Total 14.05 6.50 2.45 0.40 0.06 -0.13

17-27
Valuation Fallacies
These statements are not necessarily true:

• Firms with higher anticipated earnings growth are worth more.

Rejoinder: Earnings growth can be created by accounting methods.

• Firms with high anticipated return on equity are worth more.

Rejoinder: High return on equity means a higher premium but not a higher value;
ROCE can be created by the accounting.

• Increasing residual earnings indicates a firm that is adding more and more value.
Rejoinder: Probably, but growth in residual earnings can be induced with
conservative accounting.
17-28
Valuation Fallacies (Cont.)
These statements are not necessarily true:

• If a firm is earning an RNOA that is higher than the cost of capital, it will add value by investing more.
Rejoinder: A firm can create a high RNOA through accounting methods but may not be able to add value
through investment.

• If RNOA is higher than the cost of capital, a reduction in investment (or slowing of its growth rate)
reduces residual earnings.
Rejoinder: A reduction of investment can create residual earnings if conservative Accounting has
created hidden reserves.

• Low profit margins mean a firm cannot generate much value from sales.
Rejoinder: Low profit margins may be induced by conservative accounting if net assets are growing.

17-29
Valuation Fallacies (Cont.)
These statements are not necessarily true:

• High asset turnovers mean a firm is efficient in generating sales.

Rejoinder: High turnovers can be produced by keeping asset values low with
Conservative accounting.

• Hidden reserves always mean higher profits later.

Rejoinder: Hidden reserves created by conservative accounting will not be
realized if a firm continues to grow its net operating assets.

• Conservative accounting reduces profits and results in higher P/E ratios.

Rejoinder: Not always; only if investments are growing.
17-30
Summary of Accounting Effects

Accounting Effects for a Firm with Zero Value Added

Accounting Investment Operating Residual Residual P/B P/E
Method Pattern Income Income Level Income Pattern
Neutral Constant Normal Zero Constant Normal Normal

Conservative Constant Normal Positive Constant Above Normal Normal

Liberal Constant Normal Negative Constant Below Normal Normal

Neutral Growing Normal Zero Constant Normal Normal

Conservative Growing Below Normal Positive Growing Above Normal Above Normal

Liberal Growing Above Normal Negative Declining Below Normal Below Normal
Neutral Declining Normal Zero Constant Normal Normal

Conservative Declining Above Normal Positive Declining Above Normal Below Normal

Liberal Declining Below Normal Negative Growing Below Normal Above Normal

Constant residual income implies zero AOIG

Growing residual income implies positive AOIG
Declining residual income implies negative AOIG

17-31
 Typical Conservative Accounting Practices

Practices that decrease book values:

• Accelerated depreciation of tangible assets

• Accelerated amortization of intangible assets such as patents, copyrights
and purchased goodwill
• LIFO inventory methods
• Underestimates of
− net accounts receivable (high bad debt estimates)
− impairment values
• Overestimates of
− pension and postemployment benefits liabilities
− warranty liabilities
− provisions for restructuring and other future events
− deferred revenue
• Conservative (high) estimates of
− pension and post-employment benefit liabilities
− warranty expenses
− provisions for restructurings and other future events

17-32
Typical Conservative Accounting Practices

Practices that record no book value at all:

• Expensing R&D expenditures

• Expensing advertising expenditures ("brand assets")
• Expensing investment in intellectual and human capital

17-33
Typical Liberal Accounting Practices
Practices that increase book values:

• Revaluing tangible assets upwards (UK)

• Booking brand-name assets (UK)
• Charging no depreciation (some firms in UK)
• Overstating deferred tax assets through valuation allowances (US)

Practices that record no book value at all:

• Omitting contingent liabilities (for environmental damage, lawsuits and stock

compensation, for example)

17-34
LIFO vs. FIFO: Nike vs. Reebok

1997 1996

Nike Reebok Nike Reebok

RNOA 25.7% 16.0% 22.6% 14.1%

ATO 2.97 3.23 2.66 2.92
Inventory turnover 8.09 6.58 8.26 5.75
Gross margin 40.1% 37.0% 36.9% 38.4%
PM 8.7% 4.9% 8.5% 4.8%
Inventory ($ thousand) 1,338,640 563,735 931,151 544,522
Growth in inventory 43.8% 3.5% 47.8% -14.2%
LIFO reserve ($ thousand) 20,716 ------- 16,023 -------

17-35
R&D in Pharmaceutical Firms

Ratios from a Simulated Research and Development Program using Different Accounting Methods

Year from ROCE (%) P/B Ratios E/P Ratios

Beginning of _____________________________________ ______________________________________ ___________________________________
Program Expense Full Successful Expense Full Successful Expense Full Successful
Method Costing Efforts Method Costing Efforts Method Costing Efforts
________________________________________________________________________________________________________________________________

14 -92.3 -3.4 -15.2 17.9 2.7 4.5 -.043 -.012 -.035

20 8.1 10.7 11.0 11.4 2.9 5.2 .016 .029 .018

26 54.8 27.8 39.6 7.3 2.7 4.5 .098 .101 .098

32 54.0 26.4 39.3 7.4 2.6 4.5 .096 .097 .096

___________________________________________________________________________________________________________

Source: P. Healy, S. Myers, and C. Howe, "R&D Accounting and the Relevance-Objectivity Tradeoff: A Simulation Using Data
from the Pharmaceutical Industry," MIT, 1998.

17-36
Conservative Accounting:
Glaxo Wellcome plc

______________________________________________________________________________

Glaxo Wellcome plc

______________________________________________________________________________

Return on Operations: 1991 1992 1993 1994 1995 1996

As reported 50.6% 54.2% 51.5% 55.5% 75.5% 96.4%

With R&D capitalized 39.8 41.2 39.4 39.4 50.5 55.0

______________________________________________________________________________
Source: C. Higson, "Value Metrics in Equity Analysis," London Business School, 1998.

17-37
Liberal Accounting:
UK Hotels

______________________________________________________________________________

Forte plc
______________________________________________________________________________

1991 1992 1993 1994 1995

ROCE (%) 1.2 1.2 4.1 2.4 3.8

Depreciation/sales (%) 3.0 3.3 3.6 4.6 4.9
Revaluation reserve/equity (%) 69.8 71.0 67.5 73.9 70.9
P/B 0.58 0.61 0.58 1.03 0.94

Hilton Hotels Corp.

ROCE (%) 9.0 10.6 10.3 11.1 14.5

Depreciation/sales (%) 9.1 8.9 8.5 8.9 8.6
P/B 2.01 2.06 2.75 2.90 2.37
______________________________________________________________________________

17-38
QUESTIONS?