EF4314 Class 9

The Analysis of Growth

Review: The Residual Earnings Model
Review: The Abnormal Earnings Growth Model

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 Key Aspects

• What is “growth” in a valuation context? What is a

“growth company”?

• How are sustainable earnings identified?

• What are the drivers of growth?

• How is growth related to the P/B and P/E ratios?

 The Analysis of Growth: the Big Picture
• Valuation is based on forecasting residual earnings and
residual earnings growth,

So, what drives growth?

– Understand what growth is, then identify the drivers

of growth.

– Understand that sustainable earnings is the base from

which growth can take place, so growth analysis starts
with the identification of sustainable earnings.
Part I: What is Growth?
What is Growth?
• The term “growth” is used vaguely in finance. Generally, growth is
seen as a positive attribute, i.e., an ability to generate value.
• Investors pay attention to "growth firms"- and are willing to
paying more for a growth firm.
• But, what is growth?
– Growth in sales?
– Growth in assets?
– Growth in equity?
– Growth in earnings?
• And, what is a growth firm?
What is Growth?
• Remember the tenet of valuation principle: Beware of paying too
much for growth.

• This is because firms can grow sales, assets, equity, and earnings,
but not create value.
– Earnings growth generated by investment
– Earnings growth generated by the accounting

• The accrual accounting valuation models provide the clue to this

question. We should focus on the value added growth: Think of
growth in residual earnings and abnormal earnings growth.
What is Growth?
• The residual earnings valuation model shows that one pays a
premium over book value based on the ability of a firm to earn
residual earnings (RE), where RE is the difference between
earnings and the required return on book value.

• Residual earnings measure the value added to book value over

that required to cover the cost of capital.

• So a sensible way of viewing growth that ties into value creation

is in terms of growth in residual earnings: A growth firm is one
that can grow residual earnings.
What is Growth?
• The abnormal earnings growth valuation model shows one pays
more than a normal P/E based on the ability of a firm to generate
abnormal earnings growth (AEG), where AEG is the difference
between cum-dividend earnings and a charge for the prior year's
earnings growing at the required rate.

• Firms add value only if they can grow earnings at a rate greater than
the required rate, that is, if they can deliver abnormal earnings
growth.

• So another way of viewing growth that ties into the value creation is
in terms of the ability of a firm to deliver abnormal earnings growth.
What is Growth?
• Therefore, residual earnings growth and abnormal earnings growth
are the growth measures that we should focus on if we have
valuation in mind.
• In fact, the two measures are just different ways of looking at the
same thing: We have shown that abnormal earnings growth is equal
to the change in residual earnings: AEG RE RE .
• If a firm has residual earnings growth, it must also have abnormal
earnings growth: The firm is a "growth company.” If a firm has no
growth in residual earnings, its abnormal earnings growth must be
zero: The firm is a "no-growth" firm.
What is Growth?
A Growth Company? General Electric Corp.: 1993-2000

• Up to 2000, General Electric maintained a high growth rate in sales and

earnings, with increasing ROCE and increasing common equity. Residual
earnings (based on a required return of 12%) was on a growth path and
abnormal earnings growth was (mainly) positive.
What is Growth?
A Growth Company? General Electric Corp.: 2001-2010

• General Electric continued to grow sales after 2000, though at a slower

rate after 2000, and the slower sales growth translated into lower earnings
growth rates, leading to lower residual earnings and negative abnormal
earnings growth. Therefore, the growth company of the 1990s became a
no-growth firm of the 2000s.
Warning about Growth
• Growth is difficult to sustain.
– Unless a firm has a clear, sustainable competitive advantage,
market forces will eventually erode growth. Competitive
advantage may be a technological advantage, a dominant first-
mover position, or a brand.

• Growth is risky.
– Buying a firm where the market price has a lot of growth built
in is risky. Growth can be competed away, but also growth
gets hit in bad times.
Part II: Identifying Sustainable Earnings
Sustainable Earnings
• The analysis of growth starts with an identification of earnings on
which growth is possible.
• Sustainable earnings are earnings that can be repeated (sustained)
in the future and which can grow. Sustainable earnings are also
called persistent earnings and core earnings.
• Unsustainable earnings are based on temporary factors.
Unsustainable earnings are also called transitory earnings or
unusual items.
• Identifying core earnings is referred to as normalizing earnings
because it establishes "normal" ongoing earnings unaffected by
one-time components.
Sustainable Earnings
Core Operating Income
• Distinguish core operating income from unusual income:
Operating Income = Core OI + Unusual items
• Distinguish core income from sales from other core
operating income:
Operating Income = Core OI from Sales
+ Core Other OI
+ Unusual items
Sustainable Earnings
Identify Core and Unusual Items in the Reformulated
Income Statement
Issues in Identifying Core Operating Income
• Deferred Revenue
– Firms typically recognize revenue when goods are delivered or
services are rendered. Deferred (unearned) revenues are booked as a
current liability on the balance sheet.
– Firms can be aggressive (booking too much revenue to the current
income statement) or conservative (deferring too much to the future).
– The latter practice is actually more common: Defer revenue and bleed
it back to the income statement in the future so as to give investors a
picture of growth.
– Example: Microsoft (2008-2010)
Issues in Identifying Core Operating Income
• Deferred Revenue
– Deferred (unearned) revenue is like a "cookie jar": Firms can dip into
the cookie jar when they need more earnings in the income statement.
– One would be concerned if more current revenue was coming from
bleedback than was being deferred for.
– Therefore, if sales growth is reported, but with considerable bleedback
from recognition of deferred revenue, the growth is not likely to be
sustainable.

Caution: Firms can defer too much earnings to the future and thus create
too much earnings growth. Conversely, firms can defer too little earnings
and so report unsustainable earnings in the current period.
Issues in Identifying Core Operating Income
• Restructuring and merger charges
– When firms decide to restructure, they often write off the expected
restructuring costs against income before the actual restructuring
begins, and recognize an associated liability, or "restructuring
reserve," that is reduced later as restructuring costs are incurred.
– These charges are mostly unusual, but note that firms can have
repetitive restructuring charges.

Caution: Firms can make excessive restructuring charges in one year

and bleed them back to earnings in future years, giving the appearance
of growth.
Issues in Identifying Core Operating Income
• Research and development (R&D) expenditure
– R&D expenditures on a special project might be considered a
one-time expense, but R&D expenditures as part of a
continuing R&D program are persistent. Investigate whether
changes in R&D expenditures are temporary.

Caution: Firms can increase earnings by temporarily reducing

R&D. This not only inflates current earnings but damages
future earnings that the expenditures would otherwise produce.
Issues in Identifying Core Operating Income
• Advertising expenses
– A drop in advertising expenditures increases current earnings
but may damage future earnings. Investigate whether changes
in advertising are temporary.

Caution: Advertising expenses may be lumped into selling,

administrative, and general expenses. S,A&G is a large,
aggregated number that covers a multiple of items. Penetrate its
composition.
Issues in Identifying Core Operating Income
• Pension expenses
– Firms report the cost of providing defined benefit pension plans
as part of the cost of operating expenses.
– Example: IBM’s pension expenses, 2001-2004.
Issues in Identifying Core Operating Income
• Pension expense
– Pension expense has the following major component:
o Service cost: The present value of wages for employees to be paid in pension
benefits when employees retire.
o Interest cost: This cost recognizes that, as wages will be paid in the future, the
firm must pay wages with interest.
o Expected return on plan assets: The expected earnings on the assets of the pension
fund, which reduce the cost of the plan to the employer. The expected earnings on
plan assets is the market value of the assets multiplied by an expected rate of
return. Differences between expected returns and actual returns are reported in
other comprehensive income.
o Actuarial gains and losses: Changes in the pension liability due to changes in
actuaries’ estimates of employees' longevity and turnover.
o Amortization of prior service cost: The amortization of the cost of pension
entitlements for service periods prior to the adoption or amendment of a plan.
o Amortization of transition asset or liability: The amortization of the initial pension
asset or liability established when pension accounting was first adopted.
Issues in Identifying Core Operating Income
• Pension expense
– Be ware of expected gains on pension assets. They should be
identified outside of core income from sales.
– It is important to disentangle these earnings and attribute them
to the profitability of the pension fund rather than the
profitability of the business.
o For many firms, gains on pension fund assets may be a significant
portion of earnings.
o Applying a high rate of return to bubble asset prices produces bubble
earnings. Pricing on the basis of bubble earnings perpetuates the bubble!
Caution: Gains on pension plan assets may be commingled with
core operating income from the business. Expected returns on
plan assets can be overestimated.
Issues in Identifying Core Operating Income
• Gains and losses on asset sales
– Many realized gains and losses are not detailed in the income
statement. They can be found in the cash flow statement in
the reconciliation of cash flow from operations and net
income.

Caution: Firms can cherry-pick which securities to sell such

that realized gains are booked into the income statement, while
unrealized losses are booked to other comprehensive income in
the statement of shareholders’ equity.
 Issues in Identifying Core Operating Income
• Changes in estimates
– Some expenses like bad debts, warranty expenses, depreciation,
and accrued expenses are estimates. When estimates for previous
years turn out to be incorrect, the correction is made in the
current year.
– The effect of these changes in estimates should be classified as
unusual.
• Unrealized gains and losses from fair value accounting
– These gains and losses arise from marking assets or liabilities to
fair value (market value) in the balance sheet.
– Treat these unrealized gains and losses as transitory.
 Issues in Identifying Core Operating Income
• Income taxes
– To assess the component parts of the income statement
effectively, income taxes must be allocated to the component
income that attracts the taxes.
– Unusual aspects of income tax expense such as one-time tax
credits and loss carryforwards can be found in the tax
footnote.

• Other comprehensive income

– Most operating items reported in other comprehensive income
are unusual items rather than core income.
 Issues in Identifying Core Operating Income
• For many firms (e.g., Nike and Dell), the separation of operating
income into operating income from sales and other operating income
makes the division between core income and usual items.
• In this case, operating income from sales is core income and other
operating income identifies unusual items.
• Including the unusual items in a reformulated income statement only
to take them out again to identify core income seems pointless, but
there are important reasons for doing so:
o The discipline of identifying all the sources of profitability is important;
Cherry picking is identified only if income is on a comprehensive basis.
o The accounting relationships that govern the financial statement analysis
work only if earnings are on a comprehensive basis.
o The other comprehensive income items can reveal the risk to which the
business is subject. For example, translation gains and losses, show how a
firm can be hit by exchange rate changes.
 Issues in Identifying Core Operating Income
• For some firms, the identification of core operating income is not so
straightforward. For example, General Mills included expected returns
from pension assets in “operating income from sales”, while earnings
from joint ventures was reported as “other operating income”. In this case,
we make the reclassification and tax allocation as follows:
 Core Operating Profitability
• With the identification of core operating income, we can distinguish
core return on net operating assets (RNOA) from the transitory
effects on RNOA:
RONA = Core RNOA + Unusual items to net operating assets

Core OI is persistent operating income from core business. UI is unusual

items that are non-recurring. All items are after tax.
• We can further distinguish profit margin and asset turnover drivers
of core income from sales:

RNOA  Core OI from Sales  Core Other OI  UI

NOA NOA NOA

 Core Sales PM x ATO   Core Other OI  UI

NOA NOA
 Core Borrowing Costs
• The net financing expense component of the reformulated income
statement can also be broken into core expense and one-time effects.

Net borrowing cost

= Core net borrowing cost + Unusual borrowing costs

(Unusual financial items are those that are not likely to be repeated in the future
or are unpredictable. They include realized and unrealized gains and losses on
unusual financial items and unusual interest income or expenses.)
Part III: Analyzing the Drivers of Growth
 The Analysis of Growth
• With the identification of sustainable earnings, we are in a
position to analyze growth.
• Residual earnings, the focus for growth, are driven by return on
common equity (ROCE) and the amount of common
shareholders' equity:

• Therefore, growth in residual earnings is driven by:

– growth through ROCE
– growth in common shareholders' equity
 Growth Through ROCE
• ROCE is driven by operating profitability (RNOA), the amount of
financial leverage (FLEV), and the spread of operating
profitability over the net borrowing cost (NBC):

• Analyze changes in profitability of operations

• Analyze the effects of changes in financing

 Growth Through ROCE
Changes in Financing with a Warning
• Financial leverage can lever the ROCE above RNOA.
Accordingly, firms can create ROCE by increasing financial
leverage.

• Reebok's ROCE dropped by only 0.3% in 1996, but this masks a

considerably higher drop of 2.8% in RONA. The ROCE was
maintained with financial leverage.
 Growth Through ROCE
Changes in Financing with a Warning

• However, changes in financial leverage does not create value.

Firms buy and sell debt and stock at the fair value. The value
generation is in the firm’s operations.

• Warning: Beware of increases in ROCE. Analyze the change in

profitability to see if it is driven by core operations or by changes
in financial leverage.

• Question: Growing residual earnings generates value, as noted.

But residual earnings are driven by ROCE, and ROCE may be
generated by financial leverage, which we argue does not create
value. How to explain the seemly contradicting arguments?
 Growth Through ROCE
Changes in Operating Profitability (RONA)

Note:
=
=∆ ∆
 Growth Through ROCE
Changes in Operating Profitability (RONA)
Example: Nike Inc.

∆RONA 30.60% 28.03%

10.05% 9.71% 3.12 3.21 3.12 10.05% 0 1.62%
2.24%
=1.06% + 0.90% + 0.62%
= 2.58%
 Growth Through ROCE
Changes in Core Sales PM

1 × (1 + )

• Changes in core sales PM are also determined by how costs change

as sales change.
• Some costs change as sales change, i.e., variable costs (e.g., labor
and material costs).
• Other costs don't change as sales change, i.e., fixed costs (e.g.,
depreciation and administrative expenses).
• The ratio of fixed to variable costs can be a proxy for the
sensitivity of core operating income from sales to changes in sales.
 Growth in Common Shareholders’ Equity
• Residual earnings are driven not only by the rate of return on
common equity but also by the amount of common shareholders'
equity that earns at that rate.

∆CSE ∆NOA ∆NFO

∆ Sales ∆NFO

• Therefore, ∆CSE can be explained by three components:

– Growth in sales.
– Change in net operating assets that support each dollar of sales.
– Change in the amount of net debt that is used to finance the change
in net operating assets rather than equity.
 The Analysis of Growth
• What is a growth firm? A growth firm is one that can
increase its residual earnings.

• To do so, a growth firm will have the following

features:
– Sustainable, growing sales.
– High or increasing core profit margins.
– High or improving asset turnovers.
Part IV: Growth, P/B and P/E Ratios
 The P/E Ratio and the P/B Ratio
Frequency of Firms with High and Low P/B and P/E Ratios

• Does a high P/B ratio indicate a growth company?

• Does a high P/E ratio indicate a growth company?
Caution: There is much confusion around the notions of value vs.
growth in investing.
The P/B Ratio and the P/E Ratio
 The P/B Ratio and the P/E Ratio
• The residual earnings model

– If RE is forecasted to be positive, P/B > Normal

– If RE is forecasted to be negative, P/B <Normal

• The abnormal earnings growth model

– If RE is forecasted to increase, P/E > Normal

– If RE is forecasted to decrease, P/E <Normal
 The P/B Ratio and the P/E Ratio
Cell Analysis of the P/B and P/E Relationship
 The P/B Ratio and the P/E Ratio
Cell Analysis of the P/B and P/E Relationship
 Growth and the P/B Ratio
• P/B is determined by the level of future RE a firm is
expected to deliver.

• P/B (or market-to-book ratio) is often used to identify a

growth stock, but it may not be correct.
– A firm can have a high P/B but zero growth (Cell D)
– A firm can have a high P/B and negative growth (Cell G)
– A firm can have a low P/B and positive growth (Cell C)
 Growth and the P/E Ratio
• P/E is determined by the difference between current RE and the
forecast of future RE, that is, growth in RE from current levels.

• P/E indicates growth but this could be from a very low base:
Firms in cell C can be high P/E firms.

• Caution: Trailing P/E reflects growth and transitory earnings. If

earnings are temporarily low, then trailing P/E will be high, and
vice versa. This is called the Molodovsky effect.
 Growth and the P/E Ratio
• The analysis of sustainable earnings identifies the transitory
aspects of current earnings and so helps to ascertain the
Molodovsky effect on the trailing P/E ratio.

• Forward earnings are less affected by the transitory items in the

current period. P/E valuation should focus on the forward P/E and
thus the pricing of next year's earnings and growth after that year.

• To evaluate the forward P/E, sustainable earnings analysis very

much comes into play. To forecast forward earnings after
observing current earnings, we can identify the core earnings that
can be sustained in the forward year.
 Next Class
• Next class we will discuss active investing and valuation.

• Mini-case Exercise 6: Financial Statement Analysis: Procter

& Gamble (Part IV). Please work it out and we will discuss
this case at the end of next class.

• Have a nice week ahead.