Analyzing and Valuing Equity Securities
Current and historical financial information are the primary sources of information for forecasting future financial performance. Analysts frequently eliminate transitory items from reported earnings to gain a clearer perspective of the expected future earnings of the company, that is, those earnings that are likely to persist into the future. The trend in these persistent earnings is, then, used to form an initial estimate of future earnings. Thus, transitory items are less useful in valuing equity securities. Nonfinancial information, such as order backlog, an assessment of macroeconomic activity, the industry competitive environment, and so forth, is also used in the forecasting process.
The DCF and ROPI models define the price of a security in terms of the company’s expected free cash flow to the firm (FCFF) and the expected residual operating income (ROPI), respectively. These expectations are, then, discounted to the present, using the WACC as the discount rate, to calculate an estimated share price. Expectations about the future financial performance of a company, therefore, significantly influence expected market value. There is an inverse relation between securities prices and expected return, the discount rate (WACC in this case).
Free cash flows to the firm are equal to NOPAT minus the increase in NOA (or plus the decrease in NOA). The discounted cash flow (DCF) model defines securities prices in terms of the present value of expected free cash flows to the firm (FCFF). Q12-4.
The “weighted average cost of capital” captures the average cost of funds that the firm has raised from both debt and equity sources, weighted by the proportion received from each financing source. The cost of debt is measured as the company’s after-tax interest rate. The cost of equity is the expected return required by equity investors, usually approximated using the Capital Asset Pricing Model (CAPM) which posits the expected return as a function of the risk-free rate, the company’s beta (the historic variability of its stock returns), and the “spread” of equity securities over the risk-free rate.
NOPAT is pretax operating profit adjusted for taxes on operating profit. Pretax operating profit is sales less cost of goods sold and SG&A expenses, in short, all income and expenses other than nonoperating items, such as financial income and interest expense related to investments and borrowing. Operating tax expense is total taxes plus the tax shield relating to net interest expense (or minus the additional taxes resulting from net interest income).
Net operating assets are equal to total operating assets less total operating liabilities. Typically excluded are nonoperating assets such as investments in marketable securities, non-strategic equity investments (but not equity method investments made for strategic purposes), net assets of discontinued operations, and nonoperating liabilities such as interest-bearing debt and capitalized lease obligations.
Residual operating income (ROPI) is NOPAT – (WACC NOABeg), where WACC is the weighted average cost of capital (see Question 12-4). ROPI is, therefore, the excess of reported NOPAT over what we expected NOPAT to be, given the level of NOA and the firm’s WACC. The ROPI model defines the value of the company as its current NOA plus the present value of its expected future ROPI.
Disaggregating RNOA into its component parts (as the ROPI model does) highlights that the value of a firm depends critically on both turnover and profit margin. Company value will be increased if managers can increase NOPAT while holding NOA constant, and/or if managers can reduce NOA while holding NOPAT constant. Of course, any action to improve either NOPM and NOAT likely has consequences on the other measure, which points out that the company must manage both measures...
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