Module 12
Analyzing and Valuing Equity Securities
DISCUSSION QUESTIONS
Q12-1. 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.
Q12-2. 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).
Q12-3. 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.
©Cambridge Business Publishers, 2015
Solutions Manual, Module 12 12-1
,Q12-5. 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).
Q12-6. Net operating assets are equal to total operating assets less total operating liabilities.
Typically excluded are nonoperating assets such as cash, 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.
Q12-7. 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.
Q12-8. 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 to increase ROPI and therefore, increase stock price.
©Cambridge Business Publishers, 2015
12-2 Financial & Managerial Accounting for MBAs, 4th Edition
, MINI EXERCISES
M12-9. (10 minutes)
Earnings are an important determinant of stock prices whether investors view earnings as an
indicator of prospective free cash flows or consider earnings within the context of the residual
operating income model. Under both models, stock prices incorporate the market’s expectations
of future financial performance. Thus, when Starbucks reported that earnings were up 17 cents
over the previous year, most of this increase had already been impounded into Starbucks’ stock
price before the announcement. That is, the announcement did not contain any news and, thus,
the market price did not react.
The stock price effect of the announcement itself, then, is limited to the effect that it has on the
market’s expectations of future performance. Because earnings were 3 cents greater than
market expectations, we would have expected a stock price increase. The fall in stock price
could be related to other information revealed in the earnings announcement such as revenue
growth or store closings or other news that indicated a decrease in future earnings and cash
flows. While earnings are related to stock price, they are not the only relevant variable in
valuation models.
M12-10. (10 minutes)
ROPI = NOPAT – (WACC × NOABEG)
= $2,799 million – (10% × $15,338 million) = $1,265.2 million.
M12-11. (10 minutes)
FCFF = NOPAT - increase in NOA
= $2,799 million – ($18,126 million – $15,338 million)
= $11 million
M12-12. (15 minutes)
a. CVS Caremark earned a positive ROPI in 2012 because realized NOPAT exceeds the
expected NOPAT (given the cost of capital and the beginning NOA). $4,452 million – (7% ×
$46,152 million) = $1,221 million.
b. CVS Caremark will earn a positive ROPI up to a WACC of 9.646%. At this level of WACC,
ROPI = $46,152 million × 9.646% = $4,452, the level of NOPAT.
©Cambridge Business Publishers, 2015
Solutions Manual, Module 12 12-3
, M12-13. (30 minutes)
a.
Terminal
TGT Reported Forecast Horizon Period
($ millions) 2013 2014 2015 2016 2017
Sales....................................................$73,301 $76,893 $80,660 $84,613 $88,759 $89,646
NOPAT.................................................. 3,479 3,614 3,791 3,977 4,172 4,213
NOA...................................................... 27,581 28,907 30,323 31,809 33,368 33,702
DCF Model
Increase in NOA................................... $1,326 $1,416 $1,486 $1,559 $334
FCFF (NOPAT - Increase in NOA) ....... 2,288 2,3751 2,491 2,613 3,879
Discount factor [1 / (1 + rw)t ] ................ 0.93458 0.87344 0.81630 0.76290
Present value of horizon FCFF............. 2,138 2,074 2,033 1,993
Cum. present value of horizon FCFF
........................................................... $8,238
Present value of terminal FCFF............ 49,321
Total firm value..................................... 57,559
Less (plus) NNO................................... 11,023
Firm equity value..................................$46,536
Shares outstanding (millions) .............. 645.0
Stock price per share............................ $72.15
b. Our stock price estimate of $72.15 is higher than the TGT market price of $68.52 as of
3/20/13, indicating that we believe that Target’s stock is undervalued. Stock prices are a
function of expected NOPAT and NOA, as well as the WACC discount rate. Our higher stock
price estimate may be due to more optimistic NOPAT forecasts or a lower discount rate
compared to other investors’ and analysts’ model assumptions.
©Cambridge Business Publishers, 2015
12-4 Financial & Managerial Accounting for MBAs, 4th Edition
Analyzing and Valuing Equity Securities
DISCUSSION QUESTIONS
Q12-1. 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.
Q12-2. 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).
Q12-3. 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.
©Cambridge Business Publishers, 2015
Solutions Manual, Module 12 12-1
,Q12-5. 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).
Q12-6. Net operating assets are equal to total operating assets less total operating liabilities.
Typically excluded are nonoperating assets such as cash, 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.
Q12-7. 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.
Q12-8. 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 to increase ROPI and therefore, increase stock price.
©Cambridge Business Publishers, 2015
12-2 Financial & Managerial Accounting for MBAs, 4th Edition
, MINI EXERCISES
M12-9. (10 minutes)
Earnings are an important determinant of stock prices whether investors view earnings as an
indicator of prospective free cash flows or consider earnings within the context of the residual
operating income model. Under both models, stock prices incorporate the market’s expectations
of future financial performance. Thus, when Starbucks reported that earnings were up 17 cents
over the previous year, most of this increase had already been impounded into Starbucks’ stock
price before the announcement. That is, the announcement did not contain any news and, thus,
the market price did not react.
The stock price effect of the announcement itself, then, is limited to the effect that it has on the
market’s expectations of future performance. Because earnings were 3 cents greater than
market expectations, we would have expected a stock price increase. The fall in stock price
could be related to other information revealed in the earnings announcement such as revenue
growth or store closings or other news that indicated a decrease in future earnings and cash
flows. While earnings are related to stock price, they are not the only relevant variable in
valuation models.
M12-10. (10 minutes)
ROPI = NOPAT – (WACC × NOABEG)
= $2,799 million – (10% × $15,338 million) = $1,265.2 million.
M12-11. (10 minutes)
FCFF = NOPAT - increase in NOA
= $2,799 million – ($18,126 million – $15,338 million)
= $11 million
M12-12. (15 minutes)
a. CVS Caremark earned a positive ROPI in 2012 because realized NOPAT exceeds the
expected NOPAT (given the cost of capital and the beginning NOA). $4,452 million – (7% ×
$46,152 million) = $1,221 million.
b. CVS Caremark will earn a positive ROPI up to a WACC of 9.646%. At this level of WACC,
ROPI = $46,152 million × 9.646% = $4,452, the level of NOPAT.
©Cambridge Business Publishers, 2015
Solutions Manual, Module 12 12-3
, M12-13. (30 minutes)
a.
Terminal
TGT Reported Forecast Horizon Period
($ millions) 2013 2014 2015 2016 2017
Sales....................................................$73,301 $76,893 $80,660 $84,613 $88,759 $89,646
NOPAT.................................................. 3,479 3,614 3,791 3,977 4,172 4,213
NOA...................................................... 27,581 28,907 30,323 31,809 33,368 33,702
DCF Model
Increase in NOA................................... $1,326 $1,416 $1,486 $1,559 $334
FCFF (NOPAT - Increase in NOA) ....... 2,288 2,3751 2,491 2,613 3,879
Discount factor [1 / (1 + rw)t ] ................ 0.93458 0.87344 0.81630 0.76290
Present value of horizon FCFF............. 2,138 2,074 2,033 1,993
Cum. present value of horizon FCFF
........................................................... $8,238
Present value of terminal FCFF............ 49,321
Total firm value..................................... 57,559
Less (plus) NNO................................... 11,023
Firm equity value..................................$46,536
Shares outstanding (millions) .............. 645.0
Stock price per share............................ $72.15
b. Our stock price estimate of $72.15 is higher than the TGT market price of $68.52 as of
3/20/13, indicating that we believe that Target’s stock is undervalued. Stock prices are a
function of expected NOPAT and NOA, as well as the WACC discount rate. Our higher stock
price estimate may be due to more optimistic NOPAT forecasts or a lower discount rate
compared to other investors’ and analysts’ model assumptions.
©Cambridge Business Publishers, 2015
12-4 Financial & Managerial Accounting for MBAs, 4th Edition
