LSE AC444 Analysis PDF

Valuation and securities analysis
E. Beccalli, P. Frantz
AC3143
2013
Undergraduate study in
Economics, Management,
Finance and the Social Sciences
This subject guide is for a 300 course offered as part of the University of London
International Programmes in Economics, Management, Finance and the Social Sciences.
This is equivalent to Level 6 within the Framework for Higher Education Qualifications in
England, Wales and Northern Ireland (FHEQ).
For more information about the University of London International Programmes
undergraduate study in Economics, Management, Finance and the Social Sciences, see:
www.londoninternational.ac.uk
This guide was prepared for the University of London International Programmes by:
Dr Elena Beccalli, visiting Senior Fellow in Accounting, The London School of Economics and
Political Science.
Dr Pascal Frantz, Lecturer in Accounting and Finance, The London School of Economics and
Political Science.
Although the syllabus has been jointly structured and organised, Elena Beccalli wrote
Chapters 4, 6, 7, 9, 10 and Pascal Frantz wrote Chapters 3, 5, 8, 11, 12. The authors
jointly wrote Chapter 2.
This is one of a series of subject guides published by the University. We regret that due
to pressure of work the authors are unable to enter into any correspondence relating to,
or arising from, the guide. If you have any comments on this subject guide, favourable or
unfavourable, please use the form at the back of this guide.
University of London International Programmes

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Stewart House
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London WC1B 5DN
United Kingdom
www.londoninternational.ac.uk
Published by: University of London

© University of London 2007
Reprinted with minor revisions 2013
The University of London asserts copyright over all material in this subject guide except where
otherwise indicated. All rights reserved. No part of this work may be reproduced in any form,
or by any means, without permission in writing from the publisher. We make every effort to
respect copyright. If you think we have inadvertently used your copyright material, please let
us know.
Contents
Contents
Chapter 1: Introduction........................................................................................... 1
Aims and objectives........................................................................................................ 1
Learning outcomes......................................................................................................... 1
How to use this subject guide......................................................................................... 2
Structure of the guide..................................................................................................... 2
Essential reading............................................................................................................ 3
Further reading............................................................................................................... 3
Online study resources.................................................................................................... 7
Examination structure..................................................................................................... 8
Examination advice........................................................................................................ 9
Syllabus.......................................................................................................................... 9
List of abbreviations..................................................................................................... 11
Chapter 2: The analysis framework and financial statements.............................. 13
Aim of the chapter........................................................................................................ 13
Learning outcomes....................................................................................................... 13
Essential reading.......................................................................................................... 14
Works cited.................................................................................................................. 14
Capital markets and the role of valuation and securities analysis................................... 14
Introduction to stylised financial statements.................................................................. 18
Accounting relations governing the stylised financial statements................................... 27
Chapter summary......................................................................................................... 30
Key terms..................................................................................................................... 31
A reminder of your learning outcomes........................................................................... 32
Sample examination questions...................................................................................... 32
Part 1: The framework for analysis........................................................................ 33
Chapter 3: Financial analysis: performance evaluation........................................ 35
Further reading............................................................................................................. 35
Works cited.................................................................................................................. 36
Introduction................................................................................................................. 36
Accounting-based measures of performance................................................................. 36
Market-based measures of performance........................................................................ 41
Accounting-based versus market-based performance measures..................................... 43
Present value of abnormal earnings.............................................................................. 44
Accounting choices, accounting-based performance measures and valuation................. 45
Chapter summary......................................................................................................... 46
Key terms..................................................................................................................... 47
Appendix..................................................................................................................... 48
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143 Valuation and securities analysis
Chapter 4: Financial analysis: the determinants of performance......................... 49

Further reading............................................................................................................. 49
Introduction................................................................................................................. 50
Financial analysis: time-series and cross-sectional analysis............................................. 50
Business profitability (RNOA)........................................................................................ 51
Abnormal (residual) operating income (AOI).................................................................. 55
Determinants of business profitability............................................................................ 59
Business profitability and free cash flows...................................................................... 61
Chapter summary......................................................................................................... 62
Key terms..................................................................................................................... 63
Appendix..................................................................................................................... 65
Chapter 5: Accounting and strategy analysis........................................................ 67
Works cited.................................................................................................................. 67
Introduction................................................................................................................. 67
Strategy analysis........................................................................................................... 68
Institutional features of financial reporting.................................................................... 74
Accounting analysis...................................................................................................... 77
Chapter summary......................................................................................................... 81
Key terms..................................................................................................................... 81
Chapter 6: Prospective performance evaluation and valuation............................ 83
Further reading............................................................................................................. 83
Works cited.................................................................................................................. 84
Introduction................................................................................................................. 84
Forecasting: simple forecasting and full-information forecasting.................................... 85
Simple forecasting techniques....................................................................................... 86
Applicability of simple forecasting for valuation............................................................. 95
Full-information forecasting.......................................................................................... 95
Chapter summary....................................................................................................... 103
Key terms................................................................................................................... 104
A reminder of your learning outcomes......................................................................... 105
Sample examination questions.................................................................................... 105
Appendix................................................................................................................... 106
Part 2: Securities valuation................................................................................. 107
Chapter 7: Securities valuation........................................................................... 109
Aim of the chapter...................................................................................................... 109
Learning outcomes..................................................................................................... 109
Essential reading........................................................................................................ 109
ii
Contents
Further reading........................................................................................................... 109

Works cited................................................................................................................ 110
Introduction............................................................................................................... 110
Discounted cash flow method..................................................................................... 111
Dividend discount method and the discounted cash flow to equity method.................. 119
Abnormal earnings method........................................................................................ 122
Abnormal operating income method........................................................................... 126
Advantages and limits of AOI and EVA methods.......................................................... 129
Comparison of methods: empirical evidence................................................................ 130
Chapter summary....................................................................................................... 134
Key terms................................................................................................................... 134
Chapter 8: Implications for price-to-earnings and price-to-book ratios............. 137
Further reading........................................................................................................... 137
Works cited................................................................................................................ 137
Introduction............................................................................................................... 138
Drivers of price-to-book (PB) ratios in efficient markets................................................ 139
Drivers of price-to-earnings (PE) ratios in efficient markets........................................... 141
Implications of PE and PB ratios in efficient markets for current and
future performance..................................................................................................... 143
Joint distribution of PE and PB ratios........................................................................... 144
Implications of strategic taxonomy for PE and PB ratios in efficient markets................. 145
Valuation using the ‘method of comparables’.............................................................. 147
Chapter summary....................................................................................................... 148
Key terms................................................................................................................... 149
Chapter 9: Financial information and stock prices.............................................. 151
Further reading........................................................................................................... 151
Works cited................................................................................................................ 151
Introduction............................................................................................................... 152
Usefulness of earnings to investors: the empirical evidence from capital
markets research........................................................................................................ 152
Methodological issues................................................................................................ 153
Empirical evidence...................................................................................................... 154
Earnings response coefficients.................................................................................... 155
Competing hypotheses to explain the earnings response conundrum........................... 157
Fundamental information analysis and stock prices..................................................... 159
The interpretation of fundamentals by the analysts’ community................................... 160
Methodological issues................................................................................................ 162
Empirical evidence on fundamentals........................................................................... 163
Chapter summary....................................................................................................... 165
Key terms................................................................................................................... 165
iii
Chapter 10: Applications..................................................................................... 167

Further reading........................................................................................................... 167
Works cited................................................................................................................ 168
Introduction............................................................................................................... 168
Internet stocks............................................................................................................ 169
Mergers and acquisitions............................................................................................ 176
Chapter summary....................................................................................................... 182
Key terms................................................................................................................... 183
Part 3: Empirical evidence on returns to fundamental and technical analysis... 185
Chapter 11: Returns to fundamental analysis..................................................... 187
Further reading........................................................................................................... 187
Works cited................................................................................................................ 187
Introduction............................................................................................................... 188
Methodology.............................................................................................................. 188
Returns to contrarian strategies.................................................................................. 188
Returns to accounting analysis.................................................................................... 191
Implications of current earnings for future earnings..................................................... 191
Initial public offerings................................................................................................. 193
Implication of current quarterly earnings for future quarterly earnings.......................... 194
Returns to financial statements analysis...................................................................... 196
Fundamental analysis and market efficiency................................................................ 199
Chapter summary....................................................................................................... 199
Key terms................................................................................................................... 200
Chapter 12: Returns to technical analysis........................................................... 201
Further reading........................................................................................................... 201
Works cited................................................................................................................ 201
Introduction............................................................................................................... 202
Methodology.............................................................................................................. 202
Returns to contrarian strategies.................................................................................. 203
Returns to momentum strategies................................................................................ 204
Reconciliation............................................................................................................. 209
Time-series properties of stock prices.......................................................................... 211
Technical analysis and market efficiency...................................................................... 212
Chapter summary....................................................................................................... 213
Key terms................................................................................................................... 213
iv
Contents
Appendix 1: Solutions to numerical activities..................................................... 215

Chapter 2................................................................................................................... 215
Chapter 3................................................................................................................... 215
Chapter 4................................................................................................................... 216
Chapter 6................................................................................................................... 217
Chapter 7................................................................................................................... 217
Chapter 8................................................................................................................... 218
Chapter 10................................................................................................................. 219
Appendix 2: Sample examination paper............................................................. 221
Appendix 3: Guidance on answering the Sample examination paper................ 227
Section A.................................................................................................................... 227
Section B.................................................................................................................... 233
v
Notes
vi
Chapter 1: Introduction
Route map to the guide

The aim of this subject guide is to help you to interpret the syllabus. It
outlines what you are expected to know for each area of the syllabus and
suggests relevant readings to help you to understand the material.
Unlike many of the International Programmes courses there are only
two set textbooks which you must read for this course. Much of the
information you need to learn and understand is contained in examples
and activities within the subject guide itself.
We would recommend that you work through the guide in chapter order.
First read through a whole chapter to get an overview of the material
to be covered. Subsequently re-read the chapter and follow up the
suggestions for reading in the essential reading or further reading.
Then you need to engage in the activities identified.
At the end of each chapter you will find a checklist of your learning
outcomes – this is a list of the main points that you should understand once
you have covered the material in the guide and the associated readings.
Having said this, it is important that you appreciate that different topics
are not self-contained. There is a degree of overlap between them and you
are guided in this by the cross-referencing between different chapters. In
terms of studying this subject, the chapters of this guide are designed as
self-contained units of study, but for examination purposes you need to
have an understanding of the subject as a whole.
Structure of the guide

This subject covers three broad topics: financial analysis, securities
valuation and returns to fundamental and technical analysis.
• Chapter 1 serves as a foundation to understanding.
• Chapter 2 introduces the case study used throughout this subject
guide. The case study illustrates valuation and securities analysis.
• Chapter 3 introduces the framework used for securities analysis and
valuation, and outlines the structure and articulation of the financial
statements. It aims to enable you to produce reformulated financial
statements to be used for valuation purposes.
• Chapter 4 introduces the tools required to assess the performance of a
firm from the point of view of its shareholders.
• Chapter 5 explains a firm’s bottom-line performance through an
analysis of financial leverage and business performance.
• Chapter 6 covers strategic and accounting analysis.
• Chapter 7 projects the financial analysis in the future. It is all about
forecasting.
• Chapter 8 covers the set of valuation methods. It builds on the
forecasting techniques introduced in Chapter 7.
• Chapter 9 discusses implications of financial analysis for price
multiples (price-to-earnings and price-to-book ratios).
• Chapter 10 covers the link between financial information and stock
prices.
1
• Chapter 11 provides some application of valuation methods described in

Chapter 8, as regard internet stocks and merger and acquisitions (M&A).
• Chapter 12 reviews empirical evidence on the returns to fundamental
analysis.
• Chapter 13 reviews empirical evidence on the returns to technical
analysis.
Introduction to the subject guide

143 Valuation and securities analysis is a 300 course offered on the
Economics, Management, Finance and the Social Sciences (EMFSS) suite
of programmes. It provides insights and understanding of security analysis
and valuation from both theoretical and empirical perspectives. It is aimed
at students who are interested in equity research, corporate finance and
fund management.
We jointly teach a more advanced course at LSE where it is offered as
an MSc course. Our MSc course is based on an economics framework
and draws on articles published in the financial analysis and financial
economic literatures to address issues related to the use of information
in security analysis, fundamental and technical analysis, and efficient
market research. Students in our course are furthermore provided with an
opportunity to apply their skills in a corporate valuation project.
We hope that you enjoy studying this course.
Syllabus
Prerequisites
If taken as part of a BSc degree, courses which must be passed before this
course may be attempted are: FN10 24 Principles of banking and
finance and AC10 25 Principles of accounting.
This course covers three broad topics: financial analysis, securities
valuation and returns to fundamental and technical analysis.
Introduction
The analysis framework and financial statements
Introduction to the analysis framework using financial statements. The setting:
investors, firms, securities and financial markets. The framework for analysis.
Business strategy analysis. Industry analysis. Competitive strategy analysis.
Sources of competitive advantage. Achieving and sustaining competitive
advantage. Accounting analysis. Financial analysis. Prospective analysis.
Introduction to stylised financial statements. Stylised profit and loss,
balance sheet and cash flow statements. Accounting relations governing
the stylised financial statements.
Part One: The framework for analysis

Financial analysis: performance evaluation
Concept of comprehensive earnings. Earnings and stock returns. Bottom-
line profitability. Cost of equity capital. Concept of residual earnings.
Accounting rates of return and stock rates of return.
Financial analysis: the determinants of performance
Business profitability. Economic value added. Link between business and
bottom-line profitability. Determinants of business profitability. Business
2
profitability and free cash flows.

Accounting and strategy analysis
Overview of the institutional setting. Industry analysis. Corporate strategy
analysis. Sources of competitive advantage. Accounting analysis. Factors
influencing accounting quality. Assessing the quality of accounting
Prospective performance evaluation and valuation
Forecasting: simple forecasting and full information forecasting. Empirical
evidence on the behaviour of accounting rates of return, residual earnings,
economic value added, financial leverage. A full-information forecasting
template.
Part Two: Securities valuation

Securities valuation
Introduction to valuation methods based on dividends, free cash flows,
residual earnings and economic value added. Inferences on valuation
accuracy. Comparison of valuation methods: empirical evidence.
Implications for price-to-earnings and price-to-book ratios
Determinants of price-to-book ratios. Residual earnings growth.
Determinants of price-to-earnings ratios. Empirical evidence. Strategic
taxonomy. Implications of strategic taxonomy for price-to-book and price-
to-earnings ratios. Empirical evidence on the joint distribution of price-to-
book and price-to-earnings ratios.
Financial information and stock prices
Usefulness of earnings to investors: the empirical evidence from capital
markets research. Earnings response coefficients. Competing hypotheses
to explain the earnings response conundrum. Fundamental information
analysis and stock prices.
Applications
Internet stock. Financial measures vs usage measures in the valuation
of internet stocks. A time trend analysis of the relative importance of
financial vs usage measures.
Mergers and acquisitions. Motivation for mergers and acquisitions.
Strategic and financial analysis of mergers and acquisitions. Acquisition
pricing. Accounting issues. Acquisition financing. Acquisition outcome.
Part Three: Empirical evidence on returns to fundamental and techni-

cal analysis
Returns to fundamental analysis
Contrarian strategies. Implications of current earnings for future earnings. Do
stock prices fully reflect information in accruals and cash flows about future
earnings? Earnings management and the long run performance of IPOs.
Returns to technical analysis
Contrarian strategies. Momentum strategies. Reconciliation of empirical
evidence.
Changes to the syllabus

The material in this subject guide reflects the syllabus for the year 2013–
2014. The field of accounting changes regularly and there may be updates
to the syllabus for this course that are not included in the subject guide.
Any such updates will be posted on the VLE. It is essential that you check
the VLE at the beginning of each academic year (September) for new
3
material and changes to the syllabus. Any additional material posted on

the VLE will be examinable.
Aims of the course

This course is aimed at students who are interested in equity research,
corporate finance and fund management. It is designed to provide you
with the tools, drawn from accounting, finance, economics and strategy,
required to:
• analyse the performance of securities
• value securities
• assess returns on active investment strategies.
Furthermore, it provides empirical evidence on returns to fundamental
and technical analysis.
Learning outcomes for the course

On completion of this course and the Essential reading and activities, you
should be able to:
• carefully analyse the financial performance of given securities and
critically review equity research published by financial analysts
• competently apply valuation technologies required in corporate finance
with minimum guidance
• critically assess third-party valuation reports
• recall main insights and key facts of the fund management industry
• clearly recognise the difficulties associated with measuring abnormal
returns in fundamental and technical analysis.
Overview of learning resources

Essential reading
You should purchase:
Palepu, K., V. Bernard and P. Healy Business analysis and valuation.
(Mason, Ohio: South-Western College Publishing, 2012) fifth international
edition [ISBN 1133434863].
Penman, S. Financial statement analysis and security valuation. (Boston, Mass.:
McGraw-Hill, 2012) fifth edition [ISBN 9780071326407].
Each chapter of the subject guide begins by identifying the appropriate
chapters from these textbooks. In instances where these textbooks
are inadequate or simply do not cover a particular topic, we have
recommended additional or supplementary reading.
Detailed reading references in this subject guide refer to the editions
of the set textbooks listed above. New editions of one or more of these
textbooks may have been published by the time you study this course.
You can use a more recent edition of any of the books; use the detailed
chapter and section headings and the index to identify relevant readings.
Also check the virtual learning environment (VLE) regularly for updated
guidance on readings.
4
Essential journal articles

Bernard, V. and J. Thomas ‘Evidence that stock prices do not fully reflect
implications of current earnings for future earnings’, Journal of Accounting
and Economics (13), 1990, pp.305–41.
DeBondt, W. and R. Thaler ‘Does the stock market overreact?’, Journal of
Finance (40), 1985, pp.793–805.
Fama, E. and K. French ‘The cross-section of expected stock returns’, Journal of
Finance 47 (2), 1992, pp.427–65.
Jegadeesh, N. and S. Titman ‘Returns to buying winners and selling losers:
Implications for stock market efficiency’, Journal of Finance 48(1), 1993,
pp.65–91.
Jensen, M.C. and R.S. Ruback ‘The market for corporate control: the scientific
evidence’, Journal of Financial Economics 11, 1983, pp.5–50.
Jorion, P. and E. Talmor ‘Value relevance of financial and non financial
information in emerging industries: the changing role of web traffic data’,
SSRN Working Paper, November 2001.
Kothari, S.P. ‘Capital markets research in accounting’, Journal of Accounting and
Economics (31), 2001, section 4.3.
Lakonishok, J., A. Shleifer and R.W. Vishny ‘Contrarian investment,
extrapolation, and risk’, Journal of Finance 49(5), 1994, pp.1541–78.
Lev, B. and R. Thiagarajan ‘Fundamental information analysis’, Journal of
Accounting Research 31 (2), 1993, pp.190–215.
Ou, J. and S. Penman ‘Financial statement analysis and the prediction of stock
returns’, Journal of Accounting and Economics, 11 (4),1989, pp.295–329.
Sloan, R.G. ‘Do stock prices fully reflect information in accruals and cash flows
about future earnings?’, Accounting Review 71(3), 1996, pp.289–315.
Teoh, S.H., I. Welch and T.J. Wong ‘Earnings management and the long-run
market performance of initial public offerings’, Journal of Finance 53 (6),
1998, pp.1935–74.
Trueman, B., M.H.F. Wong, and X. Zhang ‘The eyeballs have it: Searching
for the value in internet stocks’, Journal of Accounting Research 38
(Supplement), 2000, pp.137–62.
Further reading
Please note that as long as you read the Essential reading you are then
free to read around the subject area in any text, paper or online resource.
You will need to support your learning by reading as widely as possible
and by thinking about how these principles apply in the real world. To
help you read extensively, you have free access to the VLE and University
of London Online Library (see below).
A full bibliography of the Further reading is provided below.
Books
Barker, R. Determining value. Valuation models and financial statements.
(Harlow: Pearson Education Limited, 2001) [ISBN 027363979X], Chapter 9.
Copeland, T., T. Koller and J. Murrin Valuation. Measuring and managing the
value of companies. (New York: John Wiley and Sons, 2000) third edition
[ISBN 0471361917], Chapter 8.
Damodaran, A. Investment valuation. Tools and techniques for determining the
value of any asset. (New York: John Wiley and Sons, 2002) second edition
[ISBN 0471414883], Chapters 23 and 25.
Hillier, D., M. Grinblatt and S. Titman Financial markets and corporate strategy.
(Boston, Mass.: McGraw-Hill, 2008) second (international) edition
[ISBN 9780077119027].
5
Journals
Bradley, M., A. Desai and E. Kim ‘The rationale behind interfirm tender offers:
Information or synergy?’, Journal of Financial Economics 11, 1983,
pp.183–206.
Brock, W., J. Lakonishok and B. LeBaron ‘Simple technical trading rules and
stochastic properties of stock returns’, Journal of Finance 47 (5), 1992,
pp.1731–64.
Core, J.E., R.G. Wayne and A. Van Burskirk ‘Market valuations in the new
economy: an investigation of what has changed’, Journal of Accounting and
Economics 34 (1), 2003, pp.43–67.
Francis, J., P. Olsson and D. Oswald ‘Comparing the accuracy and explainability
of dividends, free cash flow and abnormal earnings equity valuation
models’, Working Paper, University of Chicago, 1997.
Hand, J.R.M. ‘The role of book income, web traffic, and supply and demand
in the pricing of US internet stocks’, European Finance Review 5, 2001,
pp.295–317.
Healy, P., S. Myers and C. Howe ‘R&D accounting and the trade-off between
relevance and objectivity’, Journal of Accounting Research 40, 2002,
pp.677–710.
Healy, P.M., K.G. Palepu and R.S. Ruback ‘Does corporate performance improve
after mergers?’, Journal of Financial Economics 31, 1992, pp.135–75.
Jarrell, G., J. Brickley and J. Netter ‘The market for corporate control: the
empirical evidence since 1980’, Journal of Economic Perspectives 2 (1),
1988, pp.49–68.
Jegadeesh, N. and S. Titman ‘Profitability of momentum strategies: an
evaluation of alternative explanations’, Journal of Finance 56 (2), 2001,
pp.699–720.
Working Paper, November 2001.
Keating, E.K., T.Z. Lys and R.P. Magee ‘Internet downturn: Finding valuation
factors in spring 2000’, Journal of Accounting and Economics 34 (1–3),
2003, pp.189–236.
Lang, L.H.P. and R.M. Stulz ‘Tobin’s q, corporate diversification, and firm
performance’, Journal of Political Economy 102(6), 1994, pp.1248–80.
Nissim, D. and S. Penman ‘Ratio analysis and equity valuation: from research
to practice’, Review of Accounting Studies (6), 2001, pp.109–54.
Penman, S.H. and T. Sougiannis ‘A comparison of dividend, cash flow, and
earnings approaches to equity valuation’, Contemporary Accounting
Research 15 (3), 1998, pp.343–83.
Teoh, S.H., T.J. Wong and G.R. Rao ‘Are earnings during initial public offerings
opportunistic?’, Review of Accounting Studies (3), 1998, pp.97–122.
Works cited
For certain topics, we will also list journal articles or texts as
supplementary references to the additional reading. It is not essential
that you read this material, but it may be helpful if you wish to further
understand some of the topics in this subject guide. A full bibliography of
the cited references is provided below:
Akerlof, G. ‘The market for lemons: Quality uncertainty and the market
mechanism’, Quarterly Journal of Economics (84), 1970, pp.488–500.
Ali, A. and P. Zarowin ‘The role of earnings level in annual earnings-returns
studies’, Journal of Accounting Research 30, 1992, pp.286–96.
Ball, R. and P. Brown ‘An empirical evaluation of accounting income numbers’,
Journal of Accounting Research 6, 1968, pp.159–78.
Ball, R. and R. Watts ‘Some time series properties of accounting income’,
Journal of Finance 27(3), 1972, pp.663–81.
6
Basu, S. ‘The conservatism principle and the asymmetry timeliness of earnings’,

Journal of Accounting and Economics (24), 1997, pp.3–37.
Beaver, W., R. Lambert and D. Morse ‘The information content of security prices’,
Bernard, V. and J. Thomas ‘Post-earnings-announcement drift: Delayed price
response or risk premium?’, Journal of Accounting Research (27), 1989,
pp.1–36.
implications of current earnings for future earnings’, Journal of Accounting and
Economics (13), 1990, pp.305–41.
Bernstein, L. Analysis of financial statements. (Homewood, Ill.: Business One Irwin)
fourth edition [ISBN 1556239300].
Brown, L.P. and M. Rozeff ‘Univariate time-series models of quarterly accounting
earnings per share: A proposed model’, Journal of Accounting Research (17),
1979, pp.179–89.
Collins, D., E. Maydew and I. Weiss ‘Changes in the value-relevance of earnings
and book values over the past forty years’, Journal of Accounting and Economics
(24), 1997, pp.39–67.
Comment, R. and G.A. Jarrell ‘Corporate focus and stock returns’, Journal of
Financial Economics 37, 1995, pp.67–87.
Damodaran, A. Investment valuation. (Chichester: Wiley, 1996) [ISBN
0471751219], Chapter 9.
Dechow, P. ‘Accounting earnings and cash flows as measures of firm performance:
the role of accounting accruals’, Journal of Accounting and Economics (18),
1994, pp.3–42.
DeLong, J.B., A. Shleifer, L.H. Summers and R.J. Waldmann ‘Positive feedback
investment strategies and destabilising rational speculation’, Journal of Finance
(45), 1990, pp.379–95.
Demers, E.A. and B. Lev ‘A rude awakening: Internet shakeout in 2000’, Review of
Accounting Studies 6 (2/3), 2001, pp.331–59.
Easton, P. and M. Zmijewski ‘Cross-sectional variation in the stock market response
to accounting earnings announcements’, Journal of Accounting and Economics
(11), 1989, pp.117, 141.
Easton, P., T. Harris and J. Ohlson ‘Aggregate accounting earnings can explain most
of security returns: the case of long-event windows’, Journal of Accounting and
Economics (15), 1992, pp.119–42.
Eckbo, B.E. ‘Horizontal mergers, collusion, and stockholder wealth’, Journal of
Fama, E. ‘Efficient capital markets: II’, Journal of Finance (46), 1991,
pp.1575–618.
Fama, E. and M. Blume ‘Filter rules and stock market trading profits’, Journal of
Business (39), 1966, pp.226–41.
Fama, E.F. and K.R. French ‘Forecasting profitability and earnings’, Journal of
Business 73(2), 2000, pp.161–75.
Foster, G. ‘Quarterly accounting data: Time series properties and predictive-ability
results’, The Accounting Review (52), 1977, pp.1–21.
Franks, J., R. Harris, R. and C. Mayer ‘Means of payment in takeovers: Results
for the UK and US’, CEPR Discussion Paper no. 200, 1987. London Centre for
Economic Policy Research, www.cepr.org/pubs/dps/DP200.asp
Freeman, R.N., J.A. Ohlson and S.H. Penman ‘Book rate-of-return and prediction
of earnings changes: an empirical investigation’, Journal of Accounting Research
20(2), 1982, pp.639–53.
Green, J.H., J.R. Hand and M.T. Soliman ‘Going, going gone?’ The apparent
demise of the accurals anomaly’, Management Science (57), 2011, pp.797–816.
Gordon, M. The investment, financing and valuation of the corporation.
(Homewood, Ill.: Irwin, 1962).
Grassman, S.J. and O.D. Hart ‘Takeover bids, the free-rider problem, and the
theory of corporation’, Bell Journal of Economics (11) 1980, pp.42–64.
7
Hazfalla, N., R. Lundholm and E.M. Van Winde ‘Percent accusals’, Accounting
Review (86), 2011, pp.209–36.
Hong, H and J.C. Stein ‘Disagreement and the stock market’, Journal of
Economic Perspectives (21), 2007, pp.109–28.
Kormendi, R., and R. Lipe ‘Earnings innovation, earnings persistence and stock
returns’, Journal of Business (60), 1987, pp.323–45.
Kothari, S. and R. Sloan ‘Information in prices about future earnings:
Implications for earnings response coefficients’, Journal of Accounting and
Economics (15), 1992, pp.143–71.
Lev, B. ‘On the usefulness of earnings and earnings research: Lessons and
directions from two decades of empirical research’, Journal of Accounting
Research (27), 1989, pp.153–201.
Liu, J., D. Nissim and J. Thomas ‘Equity valuation using multiples’, Journal of
Accounting Research (40), 2002, pp.135–72.
Lo, A. and A.C. MacKinlay ‘When are contrarian profits due to stock market
overreaction?’, Review of Financial Studies (3), 1990, pp.175–208.
Lundholm, R. and T. O’Keefe ‘Reconciling value estimates from the discounted
cash flow value model and the residual income model’, Working Paper,
University of Michigan Business School, 2000.
Miller, M.H. and F. Modigliani ‘Dividend policy, growth, and the valuation of
shares’, Journal of Business 34(4), 1961, pp.411–33.
Morck, R., A. Shleifer and R.W Vishny ‘Do managerial objectives drive bad
acquisitions?’, Journal of Finance XLV (1), 1990, pp.31–48.
Myers, S. and N. Majluf ‘Corporate financing and investment decisions when
firms have information that investors do not have’, Journal of Financial
Economics (13), 1984, pp.187–221.
Ofek, E. and M. Richardson ‘The valuation and market rationality of internet
stock prices’, Oxford Review of Economic Policy 18(3), 2002, pp.265–87.
O’Hanlon, J. and K. Peasnell ‘Wall Street’s contribution to management
accounting: the Stern Stewart EVA financial management system’,
Management Accounting Research 9, 1998, pp.421–44.
Penman, S. ‘An evaluation of accounting rate-of-return’, Journal of Accounting,
Auditing and Finance (Spring), 1991, pp.233–55.
Penman. S. ‘The articulation of price-earnings ratios and the evaluation of
growth’, Journal of Accounting Research (34), 1996, pp.235–59.
Porter, M. Competitive strategy. (New York: The Free Press, 1980) [ISBN
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Rajgopal, S., S. Kotha and M. Venkatachalam ‘The relevance of web traffic for
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Ramakrishnan, R. and R. Thomas ‘Valuation of permanent, transitory, and
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pp.147–58.
Ritter, J. ‘The long-run performance of initial public offerings’, Journal of
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Sharpe, W.F. ‘Capital asset prices: A theory of market equilibrium under
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8
Online study resources

In addition to the subject guide and the Essential reading, it is crucial that
you take advantage of the study resources that are available online for this
course, including the VLE and the Online Library.
You can access the VLE, the Online Library and your University of London
email account via the Student Portal at:
http://my.londoninternational.ac.uk
You should have received your login details for the Student Portal with
your official offer, which was emailed to the address that you gave
on your application form. You have probably already logged in to the
Student Portal in order to register! As soon as you registered, you will
automatically have been granted access to the VLE, Online Library and
your fully functional University of London email account.
If you forget your login details at any point, please email uolia.support@
london.ac.uk quoting your student number.
The VLE
The VLE, which complements this subject guide, has been designed to
enhance your learning experience, providing additional support and a
sense of community. It forms an important part of your study experience
with the University of London and you should access it regularly.
The VLE provides a range of resources for EMFSS courses:
• Self-testing activities: Doing these allows you to test your own
understanding of subject material.
• Electronic study materials: The printed materials that you receive from
the University of London are available to download, including updated
reading lists and references.
• Past examination papers and Examiners’ commentaries: These provide
advice on how each examination question might best be answered.
• A student discussion forum: This is an open space for you to discuss
interests and experiences, seek support from your peers, work
collaboratively to solve problems and discuss subject material.
• Videos: There are recorded academic introductions to the subject,
interviews and debates and, for some courses, audio-visual tutorials
and conclusions.
• Recorded lectures: For some courses, where appropriate, the sessions
from previous years’ Study Weekends have been recorded and made
available.
• Study skills: Expert advice on preparing for examinations and
developing your digital literacy skills.
• Feedback forms.
Some of these resources are available for certain courses only, but we
are expanding our provision all the time and you should check the VLE
regularly for updates.
The field of accounting changes regularly, and there may be updates to
the syllabus for this course that are not included in this subject guide. Any
such updates will be posted on the VLE. It is essential that you check the
VLE at the beginning of each academic year (September) for new material
and changes to the syllabus. Any additional material posted on the
VLE will be examinable.
9
Making use of the Online Library

The Online Library contains a huge array of journal articles and other
resources to help you read widely and extensively.
To access the majority of resources via the Online Library you will either
need to use your University of London Student Portal login details, or you
will be required to register and use an Athens login:
http://tinyurl.com/ollathens
The easiest way to locate relevant content and journal articles in the
Online Library is to use the Summon search engine.
If you are having trouble finding an article listed in a reading list, try
removing any punctuation from the title, such as single quotation marks,
question marks and colons.
For further advice, please see the online help pages:
www.external.shl.lon.ac.uk/summon/about.php
Examination advice
You should ensure that all four questions are answered, allowing an
approximately equal amount of time for each question, and attempting all
parts or aspects of a question. Pay attention to the breakdown of marks
associated with the different parts of each question. Some questions may
contain both numerical and essay-based parts. Examples of these types of
questions (or parts of questions) are provided at the end of each chapter
of this subject guide.
Answers with a clear structure and which show a good understanding
of the material and originality in the approach will be likely to achieve
a good mark. Conversely, answers that simply repeat the subject guide
material in a relevant way may be given a pass at best. In this regard,
please use material only when relevant to the question. Answers that
include a large amount of irrelevant material are likely to be marked
down.
Examination structure
Important: the information and advice given here are based on the
examination structure used at the time this guide was written. Please
note that subject guides may be used for several years. Because of this
we strongly advise you to always check both the current Regulations for
relevant information about the examination, and the VLE where you
should be advised of any forthcoming changes. You should also carefully
check the rubric/instructions on the paper you actually sit and follow
those instructions.
The examination paper for this course is three hours in duration and
you are expected to answer four questions, from a choice of 10. The
Examiners attempts to ensure that all of the topics covered in the syllabus
and subject guide are examined. Some questions could cover more
than one topic from the syllabus since the different topics are not self-
contained. A Sample examination paper appears in an appendix to this
guide, along with a sample Examiners’ commentary.
The Examiners’ commentaries contain valuable information about how to
approach the examination and so you are strongly advised to read them
carefully. Past examination papers and the associated reports are valuable
resources when preparing for the examination.
10
Remember, it is important to check the VLE for:

• up-to-date information on examination and assessment arrangements
for this course
• where available, past examination papers and Examiners’ commentaries
for the course which give advice on how each question might best
be answered.
List of abbreviations
AE Abnormal Earnings
AEG Abnormal Earnings Growth
AOI Abnormal Operating Income
ARNOA Abnormal Return on Net Operating Assets
AROCE Abnormal Return on Common Equity
AT Asset Turnover
ATO Operating Asset Turnover
C Cash flow from operations
CAPEX Capital Expenditures
CAPM Capital Asset Pricing Model
CE Comprehensive Earnings
CSE Common Shareholders’ Equity
DCF Discounted Cash Flow
DCFE Discounted Cash Flow to Equity
DDM Dividend Discount Method
EBILAT Earnings Before Interest Less Adjusted Taxes
EVA Economic Value Added
FA Financial Assets
FCF Free Cash Flow
FCFE Free Cash Flow to Equity-holders
FE Financial Expenses
FLEV Financial Leverage
FO Financial Obligations
FR Financial Revenues
GAAP General Accepted Accounting Principles
GGM Gordon Growth Method
I Cash investments in operations
IE Interest Expenses
IFRS International Financial Reporting Standards
IPO Initial Public Offering
NBC Net Borrowing Costs
NFA Net Financial Assets
NFE Net Financial Expenses
NFO Net Financial Obligations
NI Net Income
11
NOA Net Operating Assets

NOPLAT Net Operating Profits Less Adjusted Taxes
OA Operating Assets
OE Operating Expenses
OI Operating Income
OL Operating Liabilities
OLL Operating Liability Leverage
OR Operating Revenues
PB Price-to-Book ratio
PCFO Price-to-Cash-Flow ratio
PE Price-to-Earnings ratio
PM Profit Margin
PS Price-to-Sales ratio
PVED Present Value of Expected Dividends
PVFCF Present Value of Expected Free Cash Flows
PVFCFE Present Value of Free Cash Flows to Equity-holders
ReOI Residual Operating Income
RNOA Return on Net Operating Asset
ROA Return on Assets
ROCE Return on Common Equity
ROS Return on Sales
SAR Stock Abnormal Return
SARR Stock Abnormal Rate of Return
SR Stock Return
TA Total Assets
WACC Weighted Average Cost of Capital
12
Chapter 2: Introduction to the Ryanair case study
Chapter 2: Introduction to the Ryanair

case study
Aim of the chapter

The aim of this chapter is to introduce the case study used in this subject
guide to illustrate the valuation steps involved in the valuation process.
Learning outcome
By the end of this chapter, you will have accessed the information that was
used to value Ryanair.
Ryanair
Ryanair Ltd is an Irish low-cost airline, established in 1985, with a strategy
not unlike Tesco or Ikea: pile them high and sell them cheap. Its head
office is at Dublin Airport with its primary operational bases at Dublin
Airport and also at London Stansted Airport. Ryanair‘s largest bases
include European destinations such as Milan-Bergamo, Brussels-Charleroi
and Alicante. Ryanair has been characterised by rapid expansion, as a
result of the deregulation of the aviation industry in Europe in 1997 and
the success of its low-cost business model.1 1
http://en.wikipedia.
org/wiki/Ryanair#2011
Ryanair went public in May 1997 and shortly thereafter was voted ‘Airline
of the Year’ by the Irish Air Transport Users Committee, ‘Best Managed
National Airline’ in the world by International Aviation Week magazine,
‘Best Value Airline’ by the UK’s Which consumer magazine and most popular
airline on the web by Google. The number of passengers transported by
Ryanair increased from 5.2m in 1999 to 34.8m in 2006, 42.5m in 2007,
50.3m in 2008, 58.6m in 2009, 66.5m in 2010 and 68.5m in 2011.
At the end of 2011, it was Europe’s largest airline on a market
capitalisation basis – by a long way. Its market capitalisation was £5bn 2
www.telegraph.
compared to British Airways owner IAG at £3.2bn; EasyJet’s was valued co.uk/finance/markets/
at £1.9bn and Air France-KLM, at €1.2bn.2 Some of Ryanair’s biggest questor/9050223/
Questor-share-tip-
competitors are Easyjet, Southwest Airlines and Icelandair. The evolution
Ryanair-holds-course-as-
of Ryanair’s market capitalisation between 2006 and 2011 is illustrated slowdown-boosts-profits.
in Figure 2.1. Ryanair share performance compared to the Eurostoxx 50 html
index between 2006 and 2011 is illustrated in Figure 2.2.
Figure 1: The evolution of Ryanair’s market capitalisation between 2006 and 2011.
Source: Datastream
13
Figure 2: Ryanair’s share performance compared to the Eurostoxx 50 index be-

tween 2006 and 2011.
Source: Datastream
At the end of 2011, Ryanair operated over 290 aircrafts, had 8,900
employees and reported €374.6m of net income for that year.
Reformulated financial statements for Ryanair for the years 2006 to 2011
are provided in Tables 2.1 and 2.2. Excerpts from financial statements for
Southwest Airlines and EasyJet are provided in Tables 2.3 and 2.4.
Over the past few years, Ryanair has been very profitable (with one
exception) in spite of events such as the SARS outbreak, the Iraq war,
disruptions due to the ‘wrong type of snow’ and the eruption of an
Icelandic volcano.
Some of the reasons put forward to explain Ryanair’s profitability include
cut-price deals, point-to-point flights, quick aircraft turnarounds, flights
to secondary airports, no staff overnighting, a single class, one aircraft
type only, low staff costs and high staff incentives, low expenditure on
marketing and an extremely high proportion of internet bookings. More
recently, however, some secondary airports (such as Charleroi in Belgium)
have rebelled by refusing to subsidise Ryanair. Ryanair also was unable to
agree prices with Boeing for the purchase of new aircrafts and, as a result,
Ryanair has started to pay dividends. Ryanair has also been criticised for
poor employment relations, charging excessive fees for ‘optional extras’,
poor customer service and controversial extras.
Europe’s economic slowdown is helping all low-cost carriers to become
more profitable, since consumers are switching to cheaper ways of
travelling. However, the increases in fuel costs do not leave space for huge
profits.
At the end of 2011, Ryanair was presented with an important opportunity
when Spain’s fourth largest airline, Spanair, collapsed. Howard Millar,
Ryanair’s chief financial officer, said that staff had been sent to Spain and
that the airline would offer special ‘emergency fares’ to attract the former
customers of the Barcelona-based Spanair. Miller ruled out a bid for the
group, but said that Ryanair would be interested in some of its more
attractive routes. Ryanair already has a substantial presence in Barcelona
and it was anticipated that that the collapse would boost yields.
Among the latest news about Ryanair’s operations, competitors and
strategic movements is Ryanair’s announcement of 26 new routes from
14
Budapest. This move came in response to the cessation of operations by

the Hungarian carrier Malev, ending 66 years of almost continuous service,
after some of its planes were held overseas for unpaid debts.3 In a move 3
http://news.
to take advantage of this, Ryanair, which had announced plans to fly five airwise.com/story/
view/1328296595.html
routes from Budapest, increased that number to 31.
The biggest future threat to Ryanair is a spike in fuel costs. At the end
of 2011, the group was hedged at about $99 per barrel, with the total
fuel bill expected to rise by about €350m. The oil price is currently being
driven by Iranian sabre-rattling and political brinkmanship over its nuclear
programme. However, Iran postponed a decision it was expected to make
at in early 2012 to halt oil exports to the EU with immediate effect. That 4
www.telegraph.
would have cut supply to the market and sent prices soaring. This was co.uk/finance/markets/
good news, but Iran has made it clear the country is prepared to engineer questor/9050223/
a spike in the oil prices as one of its defensive weapons.4 However, Ryanair Questor-share-tip-
is doing so well with a pricing policy that could increase its prices and Ryanair-holds-course-
as-slowdown-boosts-
keep it cheaper than its competitors.
profits.html
(in €000) 2011 2010 2009 2008 2007 2006

Revenues 3629500 2988100 2942000 2713822 2236895 1692530
Cost of Sales 2986700 2441200 2697500 2159574 1741355 1303572
Gross Margin 642800 546900 244500 554248 495540 388958
Administrative Expenses 154600 144800 151900 17168 23795 13912
Operating Income from Sales 488200 402100 92600 537080 471745 375046
Tax on Op. Income from Sales 53,637 40,803 -7,835 49,663 16,113 35,571
Op. Income from Sales after Tax 434,563 361,297 100,435 487,417 455,632 339,475
Other Operating Gains/(-)Losses

Foreign Exchange -600 -1000 4400 -5606 -906 -1234
Impairment of available-for-sale financial asset
0 -13500 -222500 -91569 0 0
Disposal of PPE 0 2000 0 12153 91 815
Total Other Operating Gains -600 -12500 -218100 -85022 -815 -419
Total Operating Income after Tax 433,963 348,797 -117,665 402,395 454,817 339,056
Net Financing Expense

Interest Expense 93,900 72,100 130,500 97,088 82,876 73,958
Interest Income -27,200 -23,500 -75,500 -83,957 -62,983 -38,219
Net interest expense before tax 66,700 48,600 55,000 13,131 19,893 35,739
Tax benefit of debt 7,337 5,103 3,465 1,444 676 3,395
Net financing expense after tax 59,363 43,497 51,535 11,687 19,217 32,344
NET INCOME 374,600 305,300 -169,200 390,708 435,600 306,712

Table 2.1: Ryanair’s reformulated income statement.
15
(in €000) 2011 2010 2009 2008 2007 2006

Net Operating Assets
Operating Assets
Operating Cash 20283 14779 15832 14708.49 13464.19 14390.04
Accounts Receivable 50600 44300 41800 34178 23412 29909
Inventories 2700 2500 2100 1997 2420 3422
Prepaid Exp. and Other Curr. Assets 94500 74100 85800 159566 123669 20377
Current Tax Prepaid 500 0 0 1585 0 0
Total Operating Current Assets 168583 135679 145532 212034.5 162965.2 68098.04
Property, Plant, and Equipment 4933700 4314200 3644800 3582126 2901505 2532988
Other Operating Assets 46800 46800 46800 46841 46841 46841
Total Operating Assets 5149083 4496679 3837132 3841001 3111311 2647927
Operating Liabilities
Accounts Payable 150800 154000 132700 129289 127243 79283
Tax Payable 0 2600 400 0 20822 15247
Other Current Operating Liabilities 1224300 1086500 905800 919349 807136 570614
Total Current Operating Liabilities 1375100 1243100 1038900 1048638 955201 665144
Deferred Tax 267700 199600 155500 148088 151032 127260
Provisions 89600 102900 72000 42790 28719 16722
Other Operating Liabilities 126600 136600 106500 101950 112177 46066
Total Operating Liabilities 1859000 1682200 1372900 1341466 1247129 855192
Net Operating Assets 3290083 2814479 2464232 2499535 1864182 1792735
Net Financial Assets

Cash Equivalents 2008017 1463121 1567368 1456141 1332955 1424614
Available for Sale Financial Assets 114000 116200 93200 311462 406075 0
Derivative Financial Instruments 274000 69000 -1500 -207168 -61983 -89679
Interest Receivable 4900 6500 5200 10014 9028 9076
Restricted Cash 42900 67800 291600 292431 258808 204040
Financial Assets: Cash > 3 months 869400 1267700 403400 406274 592774 328927
Current Portion of Long term Debt -336700 -265500 -202900 -366801 -178918 -153311
Long Term Debt -2465600 -2129200 -1607700 -1489394 -1441862 -1408642
Capital Leases -847100 -561500 -587800 -410300 -241286 -115775
-336183 34121 -39132 2658.51 675590.8 199250
Common Stockholders' Equity 2953900 2848600 2425100 2502194 2539773 1991985

Table 2.2: Ryanair’s reformulated statements of financial position.
16
(in £000) 2010 2009 2008 2007 2006

Operating Income from Sales 173600 60100 91000 172000 117800
Tax on Op. Income from Sales 36855.2 -18130.8 22296 44876.8 32026.4
Op. Income from Sales after Tax 136744.8 78230.8 68704 127123.2 85773.6
Other gains/losses(-) 0 0 0 10600 0

Interest Expense 26700 27900 34000 35400 24100
Interest Income -7100 -22500 -53200 -54600 -35400
Net interest expense before tax 19600 5400 -19200 -19200 -11300
Tax benefit of debt 4155.2 -1630.8 -4704 -4723.2 -3073.6
Net financing expense after tax 15444.8 7030.8 -14496 -14476.8 -8226.4
NET INCOME 121300 71200 83200 152200 94000
OPERATING ASSETS
2010 2009 2008 2007 2006
Operating Assets
Operating Cash 9119 7886 6322 7191 8607
Assets Held for sale 73200 73200 194900
Accounts Receivable 194100 241800 236900 223600 227200
Goodwill 365400 365400 365400 309600 309600
Other 86800 81700 80600 60200 56200
Current Tax Prepaid 0 400 500 400 300
Property, Plant, and Equipment 1928100 1612200 1102600 935800 695700
Total Operating Assets 2656719 2382586 1987222 1536791 1297607
Accounts Payable 828700 750700 653000 461700 414100
Tax Payable 27500 57700 73200 89700 46800
Maintenance Provisions 215500 213700 216300 138800 139000
Deferred Tax 147900 76700 107800 35000 32000
Deferred Income/others 56600 52600 68800 136000 125100
Total Operating Liabilities 1276200 1151400 1119100 861200 757000
Net Operating Assets 1380519 1231186 868122 675591 540607
Table 2.3: Excerpts from Easyjet’s reformulated financial statements.
17
(in $000) 2010 2009 2008 2007 2006

Operating Income from Sales 988000 262000 449000 791000 934000
Tax on Op. Income from Sales 345520 133508 137336 442250 307192
Op. Income from Sales after Tax 642480 128492 311664 348750 626808
Other Operating Gains/(-)Losses

Capitalised Interest 18000 21000 25000 50000 51000
Other net gains/losses –106000 54000 -92000 292000 –151000
Total Other Operating Gains –88000 75000 -67000 342000 –100000
Total operating Income after tax 554480 203492 244664 690750 526808

Interest Expense 167000 186000 130000 119000 128000
Interest Income –12000 –13000 –26000 –44000 –84000
Net interest expense before tax 155000 173000 104000 75000 44000
Tax benefit of debt 59520 68508 37336 29250 16192
Net financing expense after tax 95480 104492 66664 45750 27808
NET INCOME 459000 99000 178000 645000 499000
OPERATING ASSETS
2011 2010 2009 2008 2007 2006
Operating Assets
Operating Cash 12610 11140 13680 22130 13900
Inventories 243000 221000 203000 259000 181000
Accounts Receivable 195000 169000 209000 279000 241000
Depreciation Allowance –5765000 –5254000 –4831000 –4286000 –3765000
Other 606000 277000 375000 1512000 816000
Current Tax Prepaid 214000 291000 365000 0 0
Property, Plant, and Equipment 16343000 15888000 15871000 15160000 13859000
Total Operating Assets 11848610 11603140 12205680 12946130 11345900
Accounts Payable 739000 732000 668000 759000 643000
Air Traffic Liabilities 1198000 1044000 963000 931000 799000
Other accrued Liabilities 863000 729000 1012000 3107000 1323000
Tax Payable 2493000 2200000 1904000 2535000 2104000
Others 465000 493000 802000 302000 333000
Total Operating Liabilities 5758000 5198000 5349000 7634000 5202000
Net Operating Assets 6090610 6405140 6856680 5312130 6143900

Table 2.4: Excerpts from Southwest Airlines’ reformulated financial statements.
18
Part 1: The framework for analysis
Part 1: The framework for analysis
19
Notes
20
Chapter 3: The analysis framework and financial statements
Chapter 3: The analysis framework and

financial statements
Aim
This course provides an economic framework for business analysis and
valuation. The aim of this chapter is to introduce both the analysis
framework and the stylised financial statements supporting the analysis.
The chapter first explains the role played by capital markets, and securities
analysis and valuation in an economy. It then outlines the key steps used
in the analysis framework and how they relate to each other. It finally
shows how to reformulate financial statements into the stylised ones
used to perform the analysis and explains how the components of the
reformulated financial statement relate to each other (under the so-called
accounting relations). For each statement we will first introduce the form/
content according to the US GAAP, and then explain the template needed
for its reformulation to highlight operating and financing activities. We
will also provide a practical application to an airline company, Ryanair plc.
Learning outcomes
By the end of this chapter, and having completed the Essential readings
and activities, you will be able to:
• briefly recall the role of capital markets in the economy
• critically assess the value of securities analysis in capital markets
• articulate the five steps involved in securities analysis and valuation in
detail
• fully explain how financial statements are used in securities analysis
and valuation
• discuss how financial statements can be reformulated, and prepare
reformulated statements with minimal supervision
• clearly identify what assets and liabilities typically fall into operating
and financing categories, and effectively explain the reasons for given
classifications
• cogently explain the problems associated with the GAAP statement of
cash flow, and adequately perform the adjustments needed to identify
operating, financing and investing activities
• carefully contrast the direct and indirect calculations of cash flow from
operations
• aptly calculate free cash flows from reformulated income statements
and balance sheets autonomously
• thoroughly relate different components of the financial statement to
each other (under the so-called accounting relations).
21
Essential reading
Palepu, K., V. Bernard and P. Healy Business analysis and valuation. (Mason,
Ohio: South-Western College Publishing, 2012) fifth edition, Chapter 1.
McGraw-Hill, 2012) fifth edition, Chapters 7, 8, 9 and 10.
Works cited
Akerlof, G. ‘The market for lemons: Quality uncertainty and the market
mechanism’, Quarterly Journal of Economics (84), 1970, pp.488–500.
Myers, S. and N. Majluf ‘Corporate financing and investment decisions when
firms have information that investors do not have’, Journal of Financial
Economics (13), 1984, pp.187–221.
Capital markets and the role of valuation and securities

analysis
One of the main challenges in any economy is to allocate savings by
investors to entrepreneurs with good investment opportunities. A
good match is valuable as it results in a higher wealth shared in the
economy. The matching process is, however, fraught with potential
difficulties, coming in the form of both information asymmetries and
incentive problems. As a result of both information asymmetries and
incentive problems, capital markets may break down as investors may be
unwilling to provide any financing to the entrepreneurs (Akerlof, 1970).
Furthermore, even if capital markets do not break down, investors may
end up financing some projects with negative net present values and some
entrepreneurs endowed with positive net present value projects may elect
not to invest in them (Myers and Majluf, 1984).
The market for lemons

The market for lemons (Akerlof, 1970) can be illustrated in the following
example. Consider an economy consisting of two types of firms, either
‘good’ or ‘bad’, with the fundamental value of a ‘good’ firm being £10m
and the fundamental value of a ‘bad’ firm being worth £2m. These firms
are currently privately owned by entrepreneurs. Each entrepreneur,
who has private information and knows the true worth of his firm, is
considering selling his firm to a group of competing potential investors in
an initial public offering (IPO). The potential investors do not know the
true worth of any of the firms but know that half of the firms are ‘bad’ and
half of the firms are ‘good’.
Each entrepreneur has the option to go through an IPO but will only do
so if he expects that potential investors will bid either the true value of his
firm or more. Potential investors are only getting any value from buying
a firm if the price paid for the firm is less than or equal to the true value
of the firm. In a competitive market, potential investors hence bid their
expectation of true worth of the firm.
Let us first assume that the potential investors believe that all the
entrepreneurs are selling their firms through IPOs. The potential investors
will hence bid the ex ante expectation of any firm’s true worth, that is, £6m
(50% £10m + 50% £2m). Given the potential investors’ bidding strategies,
the entrepreneurs with the good firms are not willing to go though IPOs.
In equilibrium, only the entrepreneurs endowed with bad firms are willing
to sell their firms and the potential investors hence bid the true value of
22
the ‘bad’ firms, that is, £2m.

Information asymmetry between the entrepreneurs and potential investors
hence leads to a market breakdown. In a setting characterised by a
continuum of types of firms, only the worst type of firm goes through
an IPO.
Distortions in investment decisions

Asymmetry of information between managers and investors can lead to
distorted investment decisions (Myers and Majluf, 1984). Consider an
economy consisting of a population of firms differing in both the quality
(intrinsic value) of their assets in place and the quality (net present value)
of their investment projects. Any investment project has to be financed
through an issue of equity. Assume also that the managers of any firm
are better informed about both the quality of their firm’s assets in place
and the quality of their firm’s investment project than are outsiders.
Furthermore, assume that managers act in the interest of their firm’s
existing shareholders.
Only managers know whether the equity of their firm is over- or
underpriced though and this creates an opportunity for them to exploit
the market in order for existing shareholders to profit. The existence
of information asymmetries thus implies that the market can misprice
corporate equity: some firms’ equity may be overpriced and others will be
underpriced.
In this setting, managers may raise equity for two reasons. They may wish
to invest in a positive net present value investment, which would result in
an increase in the value of the firm’s equity. Alternatively, they may wish
to issue overpriced equity, which would result in a transfer of wealth from
the new to the old shareholders. Given rational expectations, the financial
market correctly recognises both incentives to raise equity. In equilibrium,
managers of low-quality firms, that is, managers of firms with assets in
place whose true worth is low enough (and are hence overvalued), raise
equity in order to take projects with a small but negative net present value.
The benefit to the existing shareholders resulting from issuing overvalued
equity exceeds the cost resulting from taking the negative net present
value project. Similarly, managers of high-quality firms, that is, managers
of firms with assets in place whose true worth is high enough (and are
hence undervalued), abstain from raising equity and hence taking projects
with a small but positive net present value. The dilution to the existing
shareholders resulting from issuing undervalued equity exceeds the benefit
resulting from the positive net present value generated by taking the
project. The presence of information asymmetries between managers and
shareholders hence leads to distortions in investments.
The role of valuation and securities analysis

As shown in the previous sub-sections, information asymmetries in capital
markets can lead to a breakdown of the capital markets. When capital
markets do not break down, information asymmetries can generate
distorted investment decisions. Valuation and securities analysis plays an
important role in any economy by reducing asymmetries of information.
Valuation and securities analysis can lead to more active capital markets,
better valuation in capital markets, better investments by firms and a
higher wealth shared in the economy.
23
Introduction to the valuation and securities analysis framework

A firm’s managers are responsible for acquiring physical and financial
resources from the firm’s environment and using them to create value
for the firm’s investors. Intuitively, value is created when the firm earns
a return on its investment in excess of the cost of capital. The longer the
period over which the firm is able to enjoy superior performance, the
higher the firm’s intrinsic value. The excess of a firm’s return on common
equity over its cost of equity capital may be due to a superior performance
in the product markets. The superior performance in the product markets
reflects both the attractiveness of the industry and the success of the firm’s
competitive and corporate strategies. Alternatively, the excess of the firm’s
return on common equity over its cost of equity capital could be generated
by successful financial engineering. Finally, it could be due to accounting
distortions. Sustainability of performance through time, and hence value,
is shown to depend on the source of performance.
This chapter introduces a framework for securities analysis and valuation.
This framework consists of five key steps:
• a strategy analysis
• an accounting analysis
• a financial analysis
• a prospective analysis
• a valuation.
Step 1: Strategy analysis

The purpose of the strategy analysis is to assess the company’s profit
potential at a qualitative level through an industry analysis, competitive
strategy analysis and corporate strategy analysis:
• The industry analysis is used to assess the profitability of each of the
industries in which the company is competing. The profitability of any
industry is shown to depend on the degree of actual and potential
competition among firms and the relative bargaining power of both
the industry’s suppliers and buyers. The degree of actual and potential
competition is in turn shown to depend on the degree of rivalry among
existing firms within the industry, the threat of new entrants into the
industry and the threat of substitute products from other industries.
• The competitive strategy analysis is used in order to determine the manner
in which the company is competing in each of the industries in which it
is competing. In order to build a sustainable competitive advantage, the
company could adopt either a cost leadership strategy or a differentiation
strategy. Cost leadership enables the company to supply the same product
or service at a lower cost than its competitors. Differentiation may enable
the company to supply a unique product or service at a lower cost than the
price premium customers are willing to pay.
• The corporate strategy analysis is used in order to assess the way in
which the company is creating and exploiting synergies across the
industries in which it is competing.
The strategy analysis is an essential step in the securities analysis and
valuation framework as it provides a foundation for subsequent analysis.
It furthermore enables analysts to ground the subsequent financial and
prospective analysis in business reality.
24
Step 2: Accounting analysis

The purpose of accounting analysis is to evaluate the degree to which a
firm’s accounting captures the underlying economic reality. An accounting
analysis normally consists of the following:
• An analysis of the operating assets and liabilities used in the firm’s
industry. In this context, an analyst will consider the main ‘economic’
operating asset and liabilities and check how these assets and liabilities
are captured in the financial statements.
• An analysis of the key success factors and risks identified in the strategy
analysis. In this context, an analyst will assess the accounting policies
and estimates the firm uses to measure its key success factors and risks.
• A ‘red flags’ analysis. In this context, an analyst will look for red flags
pointing towards earnings management. These red flags are also used
by auditors in order to allocate effort when looking for misstatements.
An accounting analysis enables an analyst to assess the degree of
distortion in a firm’s financial statements and possibly undo any
accounting distortions by recasting the firm’s accounting numbers. The
accounting analysis is an essential step in the securities analysis and
valuation framework as it improves the reliability of inferences made from
the financial analysis.
Step 3: Financial analysis

The purpose of a financial analysis is to evaluate a firm’s performance
and assess its sustainability. A financial analysis may assess the firm’s
performance either from the point of view of its shareholders (bottom-
line performance) or from the point of view of all claimholders in the
capital structure (business performance). It allows an analyst to determine
whether any abnormal performance, as far as shareholders are concerned,
is generated by abnormal performance in the product markets or financial
engineering. It enables the analyst to explain any abnormal performance
in the product markets through an abnormal asset turnover or margin.
Finally, it helps to explain the dynamics of free cash flows.
A financial analysis may involve comparison of a firm’s performance
with the firm’s relevant cost of capital. It may also involve either a cross-
sectional analysis or a time-series analysis:
• in a cross-sectional analysis, analysts compare the firm’s performance
with peers’ performance in the same industry
• in a time-series analysis, analysts examine the firm’s relative
performance over time to determine whether it is improving or
deteriorating.
The financial analysis is an essential step in the securities analysis and
valuation framework as it improves an analyst’s understanding of a firm’s
current performance and future prospects.
Step 4: Prospective analysis

The purpose of a prospective analysis is to forecast the future flows, such
as dividends, free cash flows, abnormal earnings or abnormal operating
income, which are used in the valuation step. These flows are not forecast
directly by any analyst. Instead, in any prospective analysis, the analyst
forecasts future financial statements, such as balance sheets and income
statements, over a number of years. The set of projected financial statements
then generates a set of projected flows used in the valuation step.
25
The set of projected financial statements implies some levels of

performance and growth, which must be consistent with the output of
the financial analysis. The prospective analysis is an essential step in the
securities analysis and valuation framework as it generates the input to the
valuation step.
Step 5: Valuation
The purpose of a valuation is to determine the intrinsic (fundamental)
value of a firm’s equity or a firm’s net operating assets (enterprise value).
This subject guide will consider both accounting-based valuation methods,
such as the abnormal earnings method and the abnormal operating
income method, and cash flow-based valuation methods, such as the
dividend discount method, the discounted cash flow to equity-holders
method and the discounted cash flow method. Any valuation includes
the present value of some flow in the future, where the flow could be a
dividend, cash flow to equity-holders, free cash flow, abnormal earnings or
abnormal operating income. The future consists of an explicit forecasting
period, in which the analyst takes the present value of some flow
generated by the set of projected financial statements from the prospective
analysis, and a post-horizon period, in which the analyst makes some
simplifying assumption about the flow’s growth.
The five steps used in valuation and securities analysis and introduced in
this chapter will be covered in more detail in subsequent chapters. The
remaining part of this chapter introduces the stylised financial statements
used in valuation and securities analysis.
Introduction to stylised financial statements

In this section we focus our attention on financial statements, which
can be described as a lens that provides a picture of the business. The
three primary financial statements required by the accounting rules at
international level are the balance sheet, the income statement and the
cash flow statement. (According to the US rules, firms must produce
a fourth statement, known as statement of shareholders’ equity, that
reconciles beginning and ending shareholders’ equity, whereas according
to international rules, firms have simply to produce an explanation of
changes in shareholders’ equity.)
In the US, the Financial Accounting Standards Board (FASB) establishes
the widely accepted set of rules, standards and procedures for reporting
financial information that is known as GAAP (General Accepted
Accounting Principles). Other countries have similar requirements:
namely, the International Accounting Standard Board (IASB) develops
financial reporting standards (known as International Financial
Reporting Standards, IFRS) with international application. Note that
US-listed firms must also file an annual 10-K report and a quarterly 10-K
report with the Securities and Exchange Commission (SEC). Throughout
this guide the reference will be to the US GAAP.
Activity 3.1
Please visit the websites of FASB (www.fasb.org) and IASB (www.iasb.org) to have a view
of the activity of these accounting bodies. Then download the Pricewaterhouse Coopers’
document available at www.pwc.com/US/en/issues/ifrs-reporting/publications/ifrs-and-us-
gaap-similarities-and-differences/jhtml and read pages 3–10 to have a view of the main
similarities and differences between IFRS and US GAAP.
26
Although reported financial statements are useful tools, they do not

provide an appropriate picture of the business for valuation purposes.
Therefore, the first step of any valuation is to reformulate the financial
statements in a way that better aligns the reported stocks and flows with
the business activities that generate value. The aim is to produce stylised
financial statements (also referred to as reclassified financial statements)
clearly highlighting operating and financing activities. These same
statements are then used to apply valuation models, as illustrated in the
next chapters.
Financing activities involve raising cash from the capital market, where
the investors become claimants on the value generated by the firm. These
claimants can be both debt-holders and shareholders. Operating activities
combines assets with inputs of the production process (like labour and
materials) to produce products and services, which in turn will be sold
to customers to obtain cash. If successful, the excess cash generated
by operating activities can be reinvested in assets to be employed in
operations, or to be returned to claimants. Investing activities use the
cash raised from financing activities and generated in operations to
acquire (physical and intellectual) assets to be used in operations. Given
the nature of investing activities, it is common to refer to the operating
and investing activities together as operating activities. Therefore in the
rest of the subject guide we will refer to operating activities (that include
investing activities) and financing activities.
The aim of this chapter is to answer the following questions. How are
IFRS/GAAP financial statements organised? How are operating and
financing assets/liabilities/income/cash flows identified in the financial
statements? How are the financial statements reformulated to separate
operating and financing activities? To do so, for each statement we will
first introduce the form (i.e. the way in which the financial statement is
organised) and content (i.e. the way in which line items in the financial
statement are measured) according to the US GAAP. We will then explain
the template needed for the reformulation of financial statements. We
will also provide a practical application to an airline company. (Note
that throughout the subject guide you will need to use your pre-existing
technical knowledge about financial statements, with a view to be able
to prepare them in a useful way for financial statement analysis and
valuation.)
Stylised income statement

The IFRS/GAAP income statement (known as profit and loss statement in
the UK) indicates the sources of net income, which represents the bottom-
line measure of value added to shareholders’ equity during a period of
time. These sources are classified as revenues (value coming from sales)
and expenses (value used to earn the revenues). The typical form of an
IFRS/GAAP income statement is represented in Figure 3.1.
Net revenues
– Cost of goods sold
= Gross margin
– Operating expenses
= Operating income (also referred to as earnings
before interests and taxes, EBIT)
– Net interest expenses
= Income before taxes
27
– Taxes
= Income after taxes
+/– Extraordinary items
= Net income
– Preferred dividends
= Net income available to common shareholders
Figure 3.1 Income statement under IFRS/GAAP
Activity 3.2
Go to Ryanair’s website at:
www.ryanair.com/en/investor/investor-relations-news
Here download the financial statements (balance sheet, income statement and cash
flow statement) for the company for the years 2006–2011. It is very important that you
download these statements because we will refer to Ryanair – the leader in the low-
cost sector of the European airline industry – throughout this guide, so that you will be
able to see a complete analysis of this firm carried out, which in turn can be used as a
template to develop a concrete analysis and valuation of any firm.
For equity valuation, however, analysts need to reformulate the IFRS/

GAAP income statement by distinguishing operating and financing
activities. The distinction between these two types of activity is important
because operating activities are typically the source of value generation,
and it is these operating activities that we will particularly focus on when
we analyse firms. (Note that the reformulated income statement also
includes ‘dirty-surplus’ items removed from common equity to produce a
statement of comprehensive earnings, as we will extensively explain in
Chapter 4.)
Operating activities combine net operating assets (such as property, plant
and equipment) with inputs from suppliers (of labour, materials and so on)
to produce products and services, which in turn will be sold to customers.
Thus operating activities involve trading with suppliers (and thus imply
the occurrence of operating expenses) and trading with customers (and
thus determine the obtainment of operating revenues). Financing activities
instead relate to the trading in capital markets, or rather to the transactions
between the firm and the two categories of claimants (shareholders and
debt-holders). Trading with debt-holders (namely bondholders, banks and
other creditors) involves the payment of interests (financial expenses) and
the repayments of principal for the cash borrowed from these creditors:
in this case the firm has financial obligations (also known as financial
liabilities). Alternatively, the firm can also buy financial assets from debt
issuers (governments, banks or other firms). This represents a financing
activity (of a lending nature instead of a borrowing nature), and involves
the receipt of interests (financial revenues) and the repayments of principal
to the firm: in this case the firm holds financial assets.
Operating income (OI) represents the results of operating activities, and
it is obtained as the difference between operating revenues and operating
expenses. Net financial expense (NFE) instead represents the result of
financing activities when financial expense is greater than financial
revenue (in the opposite case the amount is called net financial income).
Operating income is combined with net financial expense to give a
measure of total value added to shareholders, known as net income (NI)
or comprehensive earnings (CE) (for an investigation of the differences
between net income and comprehensive earnings, please refer to Chapter
28
4). Figure 3.2 shows the typical content of a stylised income statement.
Operating revenue OR
Operating expense (OE)
Operating income OI
Financial expense FE
Financial revenue FR
Net financial expense (NFE)
Net income NI
Figure 3.2 Reformulated income statement
The reformulation of the IFRS/GAAP income statement is required mainly
because the reported operating income and the reported net financial
expenses are typically incomplete; hence the adjustments. The first step of
the reformulation requires you to distinguish between operating income
that comes from sales and operating income that does not come from sales.
Note that in the reformulation the lack of disclosure is often a problem (see
for example, the little explanation provided in the financial statements for a
large expense item like selling, administrative and general expenses).
A typical problem in the reformulation concerns tax allocation, or rather
the allocation of the one single income tax number reported in the
financial statements to the two components of income (operating and
financing). This requires first the calculation of the tax shield of debt,
which is the tax benefit of deducting interest expense on debt for tax
purposes and allocating it to operating income. Formally, this after-tax net
interest expense can be calculated as:
After-tax net interest expense = Net interest expense – Tax benefit =
Net interest expense × (1 – tax rate) (3.1)
The tax rate typically used in this calculation is the marginal tax rate
(i.e. the highest rate at which income is taxed), but the effective tax rate
(which is tax expense divided by net income before tax in the income
statement) can also be used.
Without the tax benefit of debt, the taxes on operating income would
be higher; therefore the tax benefit has to be added back to the taxes on
operating income, as shown below.
Tax on operating income = Reported tax expense + Tax benefit =
Reported tax expense + (Net interest expense × Tax rate) (3.2)
Activity 3.3*
Go back to the income statement of Ryanair downloaded for Activity 3.2. Calculate the
tax on operating income from sales for each year in the period 2006–2011.
(*The solution to this activity can be found at the end of the subject guide.)
Another typical issue in the reformulation concerns extraordinary items.

Some have to be considered operating items (e.g. abnormal gains and
abnormal losses in extraordinary items and income from discontinued
operations), while others (e.g. gain and losses from debts retirement) are
financing items.
29
Activity 3.4
Go back to the income statement of Ryanair downloaded for Activity 3.2. Prepare the
reformulated income statement for the years 2006–2011. Then compare your answer with
the reformulated income statement provided here below.
RYANAIR AIRLINES
Reformulated Income Statements
DESCRIPTION 1999 2000 2001 2002 2003 2004 2005

Euro 000 Euro 000 Euro 000 Euro 000 Euro 000 Euro 000 Euro 000
Operating Income from Sales
Revenues 295759 370137 487405 624050 842508 1074224 1336586

Cost of Sales 177309 251862 344582 448761 564411 790493 987475
Gross Margin 118450 118275 142823 175289 278097 283731 349111
Amortisation of Goodwill 2342 2125

Administrative Expenses 24602 34220 28812 12356 14623 16141 19622
Other Operating Expenses 25986 0 0 0 0 0 0
Total Operating Expenses from Sales 50588 34220 28812 12356 14623 18483 21747
Operating Income from Sales (before tax) 67862 84055 114011 162933 263474 265248 327364
Tax on Operating Income from Sales 16455 16115 17076 20552 25015 25365 32199
Operating Income from Sales (after tax) 51407 67940 96935 142381 238459 239883 295165
Other Operating Expenses (after tax)

Foreign Exchange Losses (Gains) -297 -1029 -1305 -826 -548 -2911 2101
Buzz Reorganization Costs and Aircraft Rentals 14753
Other Non-Recurrent Operating Expenses -906 -731 -42 -446 25 8 -43
Other Comprehensive Operating Income (CI) 0 0 0 0 0 0 0
Total Other Operating Expenses (after tax) -1202 -1760 -1347 -1272 -523 11850 2058
Total Operating Income (after tax) 52609 69700 98282 143652 238982 228033 293107

Interest Expense 237 3781 11962 19609 30886 47564 57499
Interest Income 6610 7498 19666 27548 31363 23891 28342
Net Financing Expense (before tax) -6373 -3717 -7704 -7939 -477 23673 29157
Tax Effect 1510 899 1503 1216 61 -2251 -2791
Net Financing Expense (after tax) -4863 -2818 -6201 -6723 -416 21422 26366
Comprehensive Income 57472 72518 104483 150375 239398 206611 266741

Net Income 57472 72518 104483 150375 239398 206611 266741
Above you can find the reformulated income statement of Ryanair for the years 2006–
2011. A derivation of these reformulated income statements can be found in a spreadsheet
available on the VLE. From this template you can have a view of the classification of the
typical items found in the income statement of any company.
Stylised balance sheet

The IFRS/GAAP balance sheet represents the assets, liabilities and
shareholders’ equity of a given firm, as shown in Figure 3.3. With
reference to a given point in time, it shows the resources (assets) the firm
controls and how it has financed these assets. Assets are investments
that are expected to generate future economic benefits. Liabilities are
obligations to the firm’s claimants other than owners. Shareholders’
(stockholders’) equity is the claim by the owners. Both assets and
liabilities are classified into current (i.e. duration less than one year) and
long-term categories.
30
Assets Liabilities and equity

Current assets: Current liabilities:
Cash and cash equivalents Accounts payable
Short-term investments Total current liabilities
Accounts receivable Long-term debt
Inventories
Total current assets Total liabilities:
Property, plant and equipment (net) Shareholders’ equity
Investments Preferred stocks
Common stocks
Retained earnings
Total shareholders’ equity
Total assets Total liabilities and shareholders’ equity
Figure 3.3 IFRS/GAAP balance sheet
Once again for equity analysis, the published balance sheets are better
reformulated by dividing into operating activities and financing activities
(both for the asset and liability side). Firms often issue debt (financial
obligations) and hold debt (financial assets) at the same time. The stock of
net
debt-holding can thus alternatively be net financial assets (if financial
assets are greater than financial liabilities), or net financial obligations
(in the opposite case). Firms also invest in operating assets (such as land,
factories, inventories) and use operating liabilities (such as accounts
payable) to produce goods for sales.
Positive operating stocks are known as operating assets (OA), while
negative operating stocks are called operating liabilities (OL). Their
difference represents net operating assets (NOA). Financing stocks
can also be either financial assets (FA) or financial obligations (FO).
Their difference can be either negative (and thus generate net financial
obligations, NFO) or positive (and thus be known as net financial assets,
NFA). The common shareholders’ equity (CSE) can be considered as an
investment in net operating assets and net financial assets. (Note that
common shareholders are known as ordinary shareholders in the UK.) A
typical reformulated balance sheet is shown in Figure 3.4.
Net operating assets Net financial obligations and equity
Operating assets (OA) Financial obligations (FO)
Operating liabilities (OL) Financial assets (FA)
Net financial obligations NFO
Common shareholders’ equity CSE
Net operating assets NOA NFO + CSE
Figure 3.4 Reformulated balance sheet
Activity 3.5
Go back to the GAAP balance sheet statement you downloaded for Activity 3.2. Then
classify all the items in the statement according to the categories identified in Figure 3.4.
In distinguishing between operating and financing activities, several issues

arise:
• Cash and cash equivalents. Working cash (also called operating cash)
is the cash needed to carry out normal business and thus represents an
operating asset. However, cash equivalents (i.e. investments with less
than three months’ maturity) and cash invested in short-term securities
31
are financial assets. Usually operating cash and cash equivalents are
reported together, so analysts need some hypothesis/calculation to isolate
the amount of operating cash. The amount of operating cash is very much
related to the actual business of the firm. A procedure often used is to
calculate it as a percentage of sales: for most industrial companies this
percentage is between 1 per cent and 2 per cent.
• Leases. Leases that are capitalised, known as capital leases, represent in
substance purchases of an asset; therefore in the reformulated balance
sheet statement the lease asset is treated as an operating asset and the
lease obligation as a financial obligation. Leases that do not represent a
purchase, called operating leases, do not appear in the balance sheet (just
the rent payments are included in the income statement as an expense).
• Preferred stocks. These represent a financial obligation from the point of
view of a common shareholder.
• Minority interests. These represent an equity sharing in the results of the
consolidated operations, and not a financial obligation. Therefore they
should be included as a separate line item in the common shareholders’
equity.
Activity 3.6
Go back to the balance sheet statement of Ryanair downloaded for Activity 3.2. Prepare the
reformulated balance sheet statement for the years 2006–2011. Then compare your answer
with the reformulated balance sheet provided below.
RYANAIR AIRLINES
Reformulated Balance Sheet Statements
DESCRIPTION 1999 2000 2001 2002 2003 2004 2005

Euro 000 Euro 000 Euro 000 Euro 000 Euro 000 Euro 000 Euro 000
Operating Assets
Operating Cash 2958 3701 4874 6241 8425 10742 13366

Accounts Receivable 18475 21974 8695 10331 14970 14932 20644
Inventories 12917 13933 15975 17125 22788 26440 28069
Prepaid Expenses and Other Current Assets 6306 6478 12235 4918 9357 14640 19495
Total Operating Current Assets 40656 46086 41779 38615 55540 66754 81574
Property, Plant, and Equipment 203493 315032 613591 951806 1352361 1576526 2092283
Other Operating Assets 53 0 0 0 0 44499 30449
Total Operating Assets 244202 361118 655370 990421 1407901 1687779 2204306
Accounts Payable 30764 22861 29998 46779 61604 67936 92118

Income Taxes Payable 33558 18581 8830 6563 9789 9764 17534
Other Current Operating Liabilities 44414 88864 130576 210545 241539 328444 418653
Total Current Operating Liabilities 108736 130306 169404 263887 312932 406144 528305
Provision for Risk and Charges 0 0 0 0 0 6522 7236

Deferred Income Taxes 11277 15279 30122 49317 67833 87670 105509
Other Operating Liabilities 0 0 0 18086 5673 30047 18444
Total Operating Liabilities 120013 145585 199526 331290 386438 530383 659494
Net financial Obligations

Cash Equivalents 155637 351547 621846 893035 1051793 1246608 1600277
Other Current Financial Assets 0 0 0 6117 7013 4611 5117
Current Portion of Long-Term Debt 5658 13347 33072 44305 64607 80682 128935
Capital Leases 408 74 1 0 0 0 114861
Long-Term Debt 22797 112338 374755 511703 773934 872645 1178999
-126774 -225788 -214018 -343144 -220265 -297892 -182599
Commons Stockholders’ Equity 250963 441321 669862 1002274 1241728 1455288 1727411
32
You can find the reformulated balance sheet statements of Ryanair for the years 2006–
2011, which gives the classification of typical items found in the balance sheet of any
company. A derivation of these reformulated balance sheet statements can be found in a
spreadsheet available on the VLE.
Stylised statement of cash flows

The statement of cash flows shows how the firm generates and uses
cash. The IFRS/GAAP statement of cash flows classifies cash flows into
three sections (see Figure 3.5): cash flows from operating activities (cash
generated from selling goods/services minus cash used to pay the cost of
inputs and operations), cash flows used in investing activities (cash paid
for capital expenditure and cash spent in buying assets less cash received
from selling assets) and cash flows from financing activities (cash raised
from or paid to the firm’s claimants – debt-holders and shareholders). The
total cash flows from these sections provide the change in cash and cash
equivalents (note that this amount has to be equal to the difference in
the cash balance between the ending and beginning balance sheet). The
difference between cash flows from operations and cash flows used in
investment activities provides a sort of measure of free cash flow (FCF),
the cash flow associated to operating activities.
Firms use two formats for the statement of cash flows: the direct method
and the indirect method. The key difference between the two formats is
the way in which they represent cash flow from operations. Under the
direct method, cash from operations is calculated by subtracting from the
list of the separate sources of operating cash inflows (e.g. cash from sales,
cash from rents, cash from interest) the list of sources of operating cash
outflows (e.g. cash paid to suppliers, cash paid to employees, cash paid
for interest, cash paid for income taxes). The direct method is used by
only a small number of firms in practice. Under the indirect method, cash
from operations is calculated as the net income including changes in net
working capital items (i.e. accounts receivable, inventories and accounts
payable) plus adjustments for non-cash revenues and expenses (such as
depreciation, amortisation and deferred income taxes).
Cash flow in operating activities

– Cash flow used in investing activities
+ Cash flow from financing activities
= Change in cash and cash equivalents
Figure 3.5 IFRS/GAAP statement of cash flows

The GAAP statement of cash flows seems to distinguish between the
flows from operating activities and from financing activities. However,
it somehow confuses the two categories. Here we analyse a number of
deficiencies.
• Change in cash and cash equivalents. The IFRS/GAAP statement of
cash flows aims at explaining the change in cash and cash equivalents.
Change in operating cash (as defined in the section ‘Accounting
relations on the form of stylised financial statements’ below) should
be included in cash investment (and thus concurs with the formation
of free cash flow), whereas the change in cash equivalents is an
investment of excess cash in financial assets (and thus has to be
included in the debt financing section).
• Net cash interest and tax on net interest. The IFRS/GAAP reported cash
flow from operations includes cash interest payments and receipts for
33
financing activities (this happens because in the calculation of cash

flows from operations the starting line is net income and not operating
income). However, they should be included in the financing flows.
Analogously the reported cash flow from operations include all tax
cash flows (also the ones paid on financing activities, such as interest
income and expense). Tax cash flows related to financing activities
should be separated. The reported cash flow from operations has to be
corrected accordingly.
• Transactions in financial assets. The IFRS/GAAP reported cash flow
from investing includes investments and disinvestments in financial
assets (such as short-term marketable securities and long-term debt
securities). However, these investments should be included in the
financing section because they represent a disposition of free cash flow
(and not a reduction of free cash flow). Similarly, the disinvestments
of financial assets should be classified as financing flows rather than
investing flows: they satisfy a free cash flow shortfall, they do not
create it. Therefore the reported cash flow from investing has to be
corrected accordingly.
Overall, how do we calculate the components of FCF (cash flows from
operations and cash investments in operations) starting from the IFRS/
GAAP statement of cash flow? For the calculation of cash flow from
operations, the IFRS/GAAP reported cash flow from operations has to be
corrected as regards net cash interest and tax on net interest. Formally, this
can be written as:
Cash flow from operations = Reported cash flow from operations +
After-tax net interest payments (3.3)
As for the calculation of cash investments in operations, the IFRS/
GAAP reported cash flow from investing has to be corrected as regards
transactions in financial assets, as shown below:
Cash investments in operations = Reported cash flow from investing –
Net investment in interest-bearing instruments (3.4)
A summary of the adjustments of the IFRS/GAAP statement of cash
flow – necessary because some operating and financing cash flows are
misclassified – is shown in Figure 3.6.
GAAP reported cash from operating activities

+ Net cash interest outflow (after tax)
– GAAP reported cash used in investing activities
+ Purchase of financial assets
– Sale of financial assets
– Increase in operating cash
= Free cash flow
GAAP reported cash from financing activities

+ Net cash interest outflow (after tax)
+ Purchase of financial assets
– Sale of financial assets
+ Increase in cash equivalents
= Financing cash flow
Figure 3.6 Adjusting GAAP statement of cash flows
34
Activity 3.7
Go back to the statement of cash flows of Ryanair downloaded for Activity 3.2. Prepare
the reformulated statement of cash flows for the years 2006–2011. Keep your answer –
it will be needed in Chapter 8.
The above adjustments are quite complex. Nevertheless, the analyst can
produce a reformulated statement (without adjusting the GAAP statement
of cash flows) by recalling all the cash flows to/from product and input
markets on the one hand, and capital markets on the other hand. On
the operating side, the cash flows involved in the purchase of operating
assets to produce goods for sales are cash investments. The cash inflows
from selling products and services less cash outflows from paying wages,
rents, invoices and so on are the so-called cash flow from operations.
On the financing side, the cash flows to and from the debt-holders
(summarised in the net debt financing flow) relate to the payment/receipt
of interests and the repayments of principal to/from the firm for the cash
lent to/borrowed from these creditors. The cash flows to and from the
shareholders (summarised in the net cash flow to shareholders) involve
the payment of dividends and repurchases of stocks in exchange of the
contribution to the firm from the shareholders.
The cash flows associated to operating activities are cash from operations
and cash investments in operations. By comparing these operating flows,
the analyst gets a measure known as free cash flow (FCF). The FCF then
equals the cash paid for financing activities, which is given as the sum
of the net cash flows paid to debt-holders (or issuers) and shareholders.
Figure 3.7 summarises the four flows and represents a typical
reformulated statement of cash flows.
Cash flow from operations

– Cash investments in operations
= Free cash flow from operating activities
Cash paid to debt-holders and issuers

+ Cash paid to shareholders
= Cash paid for financing activities
Figure 3.7 Reformulated statement of cash flows

Note that the value of FCF can be obtained in a more straightforward way
from the reformulated balance sheet and reformulated income statement
(without the need to produce a full reformulated statement of cash flows),
as we will explain in section ‘Business profitability and free cash flows’ in
Chapter 5 (p.xx).
Accounting relations governing the stylised financial

statements
Accounting relations indicate how the financial statements and their
components relate to each other, and also what drives each component.
The understanding of these relations is essential because they provide a
structure for fundamental analysis, which is the object of this guide, and
can be simply defined as a method based on analysing information on
the firm, and forecasting payoffs to get an intrinsic value based on those
35
forecasts. As one of the tasks of fundamental analysis is to correct for

the missing values in the financial statements, the full comprehension of
accounting relations is essential.
Note that in the following sections we will mainly refer to accounting
relations that govern reformulated financial statements, but when required
we will also recall relations related to the GAAP statements.
Accounting relations on the form of stylised financial statements

Accounting relations that govern how different components relate to
each other are said to govern the form of financial statements. Under the
framework of a stylised balance sheet, the main balance sheet equation
relates the net stocks for operating and financing activities to each other.
In particular, shareholders’ equity can be seen as an investment in net
operating assets and net financial assets. Formally this can be written as:
Common shareholders’ equity = Net operating assets + Net financial
assets
CSE = NOA + NFA (3.5)
where net operating assets (NOA) is the difference between operating
assets (OA) and operating liabilities (OL); and net financial assets (NFA) is
the difference between financial assets (FA) and financial obligations (FO).
However, the investment in net financial assets can be negative. When
net financial assets is negative (and it is named net financial obligations),
equation (3.5) becomes:
Common shareholders’ equity = Net operating assets + Net financial
obligations
CSE = NOA + NFO (3.6)
Note that the last two relations restate the well-known balance-sheet
equation used for GAAP balance sheets, which indicates that shareholders’
equity is the residual claim on the assets after subtracting liability claims.
This implies that shareholders’ equity is always equal to the difference
between assets and liabilities, or rather:
Shareholders’ equity = Assets – Liabilities (3.7)
With reference to the stylised statement of cash flows, the well-known
cash-conservation equation (or the sources and uses of cash equation)
relates the four cash-flow components to each other by stating that the
sources of cash must be equal to its uses. Formally this can be expressed as
follows:
Cash from operations – Cash investments in operations = Net dividends
to shareholders + Net payments to debt-holders and issuers
C – I = d + F (3.8)
The left-hand side (C – I) represents the free cash flow (FCF). The right-
hand side (d + F) represents the net cash flows paid to debt-holders (or
issuers) and shareholders. If operations generates more cash than is used
in investments, the free cash flows (FCF) is positive and it is used either
to buy bonds (F) or pay dividends (d). If operations produce less cash
than needed for new investments, the free cash flows (FCF) is negative
and it requires that a firm either issues bonds (negative F) or issues shares
(negative d) to satisfy the cash shortfall. In doing so, the firm has to cover
any net dividend it wants to pay and any net interest cash flow (i). This
can be summarised in the treasurer’s rule, which is:
If C – I – i > d, the firm has to lend or buy back its own debt;
If C – I – i < d, the firm has to borrow or reduce its own debt.
36
Accounting relations on the drivers of each component of

reformulated financial statements
The reformulated statement of cash flows and the reformulated income
statement are statements of flows over a period, while the reformulated
balance sheet is a statement of the stocks at the end of a period. The flows
and the changes in stocks are linked by some accounting relations, which
describe what drives, or determines, each component. Below we analyse
these relations.
The drivers of free cash flow can either relate to its sources or to its uses
To see how the free cash flow is generated, or rather what are the sources
of the free cash flow, we can refer to the following equation:
Free cash flow = Operating income – Change in net operating assets
FCF = OI – ∆NOA (3.9)
That is, operations generate operating income, and the free cash flow is
the part of operating income remaining after reinvesting some of it in net
operating assets. (If the investment in NOA is higher than the operating
income, the free cash flow is negative. This implies that an infusion of cash
is required.)
Alternatively, by focusing on the disposition of free cash flow, the uses of
free cash flow can be formalised in two different ways according to the
presence of net financial obligations or net financial assets.
If the firm has net financial obligations, free cash flow can be written as
follows:
Free cash flow = Net financial expenses – Change in net financial
obligations + Net dividends =
FCF = NFE – ∆NFO + d (3.10)
This implies that the free cash flow is used to pay for the net financial
expenses, to reduce net borrowing and to pay net dividends.
If the firm has net financial assets, the free cash flow can be written as
follows:
Free cash flow = Change in net financial assets – Net financial income +
Net dividends =
FCF = ∆NFA – NF + d (3.11)
Free cash flow and net financial income increase net financial assets and
are also used to pay net dividends.
The drivers of dividends

Dividends, or rather the cash flow paid out to shareholders, can also be
explained on the basis of several operating and financial components of
the financial statements. If the firm has financial obligations, by reordering
the FCF equation (3.10), we identify the following drivers of dividends:
Net dividends = Free cash flow – Net financial expenses + Change in net
financial obligations
d = FCF – NFE + ∆NFO (3.12)
This means that dividends are generated from free cash flow after paying
net interest expenses, but also by increasing borrowing. This accounting
relation explains why dividends are not a good indicator of value
generation in the short term: the firm can borrow in order to pay out
dividends.
37
Conversely, if the firm has financial assets, by reordering equation (3.11),

the drivers of dividends become:
Net dividends = Free cash flow – Change in net financial assets + Net
financial income
d = FCF – ∆NFI + NFA (3.13)
This relation implies that dividends are paid out of free cash flow and net
financial income and by selling financial assets: financial assets are sold to
pay dividends if free cash flow is insufficient to pay dividends.
The drivers of net operating assets and net financial obligations

The changes in the balance sheet components can also be explained on the
basis of the free cash flow accounting relation. By rearranging equation
(3.9), we are able to identify the drivers of net operating assets (at the end
of the year). Formally, this can be written as:
Net operating assets (end) = Net operating assets (beginning) +
Operating income – Free cash flow
NOAt = NOAt–1+ OIt – FCFt (3.14)
The value added from operations (represented by operating income)
increases the net operating assets, whereas the free cash flow reduces
net operating assets as cash is taken from operations and invested in net
financial assets.
Activity 3.8
Correspondingly identify the drivers of net financial obligations by rearranging
equation (3.10).
Activity 3.9
Go to the SEC website (www.sec.gov) and download the financial statements of
Microsoft Corp. for the years 2010 and 2011 (go to ‘EDGAR FILERS’, then to ‘FILINGS
(EDGAR)’, and to ‘Search for company filings’. Finally go to ‘Companies and other filers’
and write down ‘Microsoft Corp’. Now produce reformulated balance sheet and income
statements.
Overview of chapter
This course provides an economic framework for securities analysis and
valuation. This chapter introduced both the analysis framework and the
stylised financial statements supporting the analysis.
In the first part of the chapter, we outlined the role played by capital
markets in the economy. Capital markets were characterised by
asymmetries of information between firms’ managers or entrepreneurs
and potential investors. These asymmetries of information could lead to
distortions in investments by firms as well as to a breakdown in the capital
markets. We hence argued that securities analysis and valuation could
play an important role in the economy by reducing these asymmetries
of information. We then outlined the key steps used in the analysis
framework and how they relate to each other.
In the second part of this chapter we showed that misclassification in the
financial statements can lead to erroneous financial statement analysis
and erroneous valuations. This explains why analysts must reformulate
financial statements before proceeding with valuations. Indeed, as
we proceed with financial analysis and valuation, we will work with
reformulated statements, not published GAAP statements. We have shown
38
how to produce reformulated financial statements clearly highlighting

operating and financing activities (both with regard to stylised statements
and to an application to an airline company). In particular, reformulated
balance sheets must distinguish between operating and financial assets
and liabilities; reformulated income statements have to distinguish
operating and financing income; and reformulated cash flow statements
isolate free cash flow and make it equal to financing cash flows.
Accounting relations are another important tool for analysts because they
basically enable analysts to get at the drivers of the main items in the
reformulated financial statements. In particular, we have described the
ways in which analysts can use accounting relations to understand how
financial statements, and their components, relate to each other, and also
what drives each component. This understanding is essential to have a
structure for fundamental analysis, as developed in the next chapters.
Key terms
accounting analysis International Financial Reporting
accounting relations Standards (IFRS)
assets investing activities
balance sheet liabilities
balance sheet equation minority interest
capital leases net financial assets (NFA)
cash conservation equation net financial expense (NFE)
cash equivalents net financial obligations (NF)
cash flow in operating activities net income (NI)
cash flow statement net operating assets (NOA)
cash flows from financing activities net profit
cash flows from operations operating activities
cash flows used in investing activities operating assets (OA)
cash investments in operations operating cash
common shareholders’ equity (CSE) operating expenses (OE)
comprehensive earnings (CE) operating income (OI)
direct method operating leases
earnings operating liabilities (OL)
expenses operating revenues (OR)
financial analysis ordinary shareholders
financial assets (FA) preferred stocks
financial expenses (FE) profit and loss statement
financial obligations (FO) prospective analysis
financial revenue (FR) revenues
financing activities shareholders’ equity
free cash flow (FCF) statement of cash flows
fundamental analysis stylised statements
General Accepted Accounting stockholders’ equity
Principles (GAAP) strategy analysis
income statement tax allocation
indirect method tax shield
initial public offering (IPO) treasurer’s rule
39
A reminder of your learning outcomes

Having completed this chapter, and the Essential readings and activities,
you should now be able to:
• briefly recall the role of capital markets in the economy
• critically assess the value of securities analysis in capital markets
• articulate the five steps involved in securities analysis and valuation in
detail
• fully explain how financial statements are used in securities analysis
and valuation
• discuss how financial statements can be reformulated, and prepare
reformulated statements with minimal supervision
• clearly identify what assets and liabilities typically fall into operating
and financing categories, and effectively explain the reasons for given
classifications
• cogently explain the problems associated with the GAAP statement of
cash flow, and adequately perform the adjustments needed to identify
operating, financing and investing activities
• carefully contrast the direct and indirect calculations of cash flow from
operations
• aptly calculate free cash flows from reformulated income statements
and balance sheets autonomously
• thoroughly relate different components of the financial statement to
each other (under the so-called accounting relations).
Test your knowledge and understanding

1. How can valuation and securities analysis create value in the economy?
2. What are the five steps involved in securities and valuation analysis?
How do they relate to each other?
3. What are the main adjustments of the GAAP statement of cash flows
needed to separate operating, financing and investing activities? Why
are these adjustments needed?
4. By investing in short-term marketable securities to absorb excess
cash, the firm reduces its reported cash flow after investing activities
prepared according to the GAAP. What is wrong in this picture?
5. Explain the main accounting relations on the drivers of the following
components of the reformulated financial statements: free cash flow,
dividends and net operating assets.
40
Chapter 4: Financial analysis: performance evaluation
Chapter 4: Financial analysis:

performance evaluation
Introduction
In the previous chapter we introduced the analysis framework used in
valuation and securities analysis. In this context, we highlighted the main
steps involved: strategy analysis, financial analysis, accounting analysis
and prospective analysis. This chapter introduces the tools required to
perform a financial analysis and assess the performance of a firm from
the point of view of a shareholder. It considers both accounting-based
and market-based measures of performance. It explains the link between
accounting-based and market-based measures of performance. It explains
the limitations of both classes of performance measures. It shows how
a firm’s stock price obtaining in an efficient market reflects the firm’s
expected future performance. Determinants of performance, as far as
shareholders are concerned, are analysed in the next chapter.
This chapter is organised as follows. We first introduce accounting-based
measures of performance. We then cover market-based measures of
performance and show how these measures are related to the accounting-
based measures. We then show the link between a firm’s intrinsic value of
equity and the firm’s expected future performance.
Aim
The aim of this chapter is to provide tools in order to assess the
performance of a firm from the point of view of a shareholder. We will
introduce accounting-based measures, such as a firm’s return on common
equity and abnormal earnings, used to assess performance and provide
benchmarks to compare these measures with. We will provide intuition for
the use of these accounting-based performance measures and discuss their
limitations. We will introduce market-based measures of performance,
such as stock return and stock rates of return. We will then explain the link
between accounting-based and market-based measures of performance.
Finally, we will explain how a firm’s stock price obtaining in an efficient
market reflects the firm’s expected future performance.
Learning outcomes
and activities, you should be able to:
• soundly assess firm performance from the shareholders’ perspective
using accounting tools and market-based measures with minimal
guidance
• clearly identify the reasons why accounting-based performance
measures may differ from market-based performance measures
• keenly identify the limitations of the accounting-based and market-
based performance measures
• cogently relate the firm’s fundamental value to its firm’s expected
future performance in detail
41
• competently analyse the reasons why a firm’s fundamental value of

equity may differ from its book value of equity.
Essential reading
McGraw-Hill, 2012) fifth edition, Chapter 5.
Further reading
Nissim, D. and S. Penman ‘Ratio analysis and equity valuation: from research to
practice’, Review of Accounting Studies (6), 2001, pp.109–54.
Ohio: South-Western College Publishing, 2012) fifth edition, Chapter5.
Works cited
Hillier, D., M. Grinblatt and S. Titman Financial markets and corporate strategy.
(Boston, Mass.: McGraw-Hill, International edition, 2008).
Healy, P., S. Myers, and C. Howe ‘R&D accounting and the trade-off between
relevance and objectivity’, Journal of Accounting Research 40, 2002,
pp.677–710.
Accounting-based measures of performance

This section introduces in turn the following accounting-based measures of
a firm’s performance as far as a shareholder is concerned: comprehensive
earnings (CE), the return on common equity (ROCE), the abnormal return
on common equity (AROCE), and abnormal earnings (AE).
Comprehensive earnings
Investing in a firm’s shares is a risky proposition. As a reward, shareholders are
entitled to earnings. Earnings capture the net economic resources generated by
the firm for its shareholders during some period. Earnings furthermore result
from the inter-temporal allocation of cash flows (revenue and expenditure).
We will first focus on a measure of earnings, comprehensive earnings,
accruing to shareholders.
SFAC (Statement of Financial Accounting Concepts) 6 defines
comprehensive earnings as ‘the change in common equity...from
transactions...from non-owner sources. It includes all changes in common
equity during a period except those resulting from investments by common
equity owners and distribution to common equity owners.’
More formally, the comprehensive earnings (CE) generated over some
period are given by:
CE = CSE(EP) – CSE(BP) + d (4.1)
where CSE(EP) and CSE(BP), respectively, denote the common
shareholders’ equity, a balance sheet item, also referred to as the book
value of equity, obtaining at the end and at the beginning of the period;
and d denotes the net dividends, that is, the dividends in excess of any
proceeds from issues of shares.
Consider a savings account. According to SFAC 6, earnings on your
savings account are equal to the change in the savings balance over
the period adjusted for any contribution or withdrawal. The concept of
comprehensive earnings is hence quite intuitive.
42
Activity 4.1
On the basis of Ryanair’s balance sheets, derive the comprehensive earnings generated in
each of the last five financial years in the 2006–2011 periods
Using Ryanair as an example, we derive comprehensive earnings

generated in each of the last five financial years in Table 4.1. Ryanair
did not pay any cash dividend during this period but did issue shares.
Comprehensive earnings were hence lower than the increase in the book
value of equity. We also compare comprehensive earnings with net income
and do not find any discrepancy.
(€m) 2011 2010 2009 2008 2007 2006

CSE(EP) 2953.9 2848.6 2425,1 2502.2 2539.8 1992.0
CSE(BP) 2848.6 2425.1 2502,2 2539.8 1992.0 1734,5
d 269.3 -118.2 -92.0 428.3 -112.2 49.2
CE 374.6 305.3 -169.1 390.7 435.6 306.7
NI 374.6 305.3 -169.2 390.7 435.6 306.7
Table 4.1 Derivation of comprehensive earnings (CE) at Ryanair
When evaluating performance, financial analysts tend to distinguish
between recurrent and non-recurrent (also referred to as transitory)
components of comprehensive earnings, as non-recurrent components
of comprehensive earnings reflect one-off events and do not have any
implications for future earnings.
In general, comprehensive earnings, as calculated in equation (4.1),
are different from the net income reported in an income statement. Any
discrepancy between comprehensive earnings and net income comes
from dirty-surplus accounting, that is, net economic resources consumed
or earned during the period, recognised in common stockholders’ equity
(CSE, balance sheet) but unrecognised in net income (income statement).
Dirty-surplus accounting components tend to be quite significant in
continental Europe. They are less common in countries such as the UK
or the USA. Recent international accounting standards are, however,
consistent with clean-surplus accounting as they do not introduce
discrepancies between comprehensive earnings and net income. But, even
in the UK or the USA, there are still accounting standards which are not
consistent with clean-surplus accounting. Revaluation gains and losses, for
instance, do bypass income in both countries.
Activity 4.2*
Consider R&D Inc., a biotech start-up. This firm:
•• incurs expenditure in R&D of $50 at the beginning of its first year of activity
•• has an opening book value of equity of $1,000
•• generates comprehensive earnings (before any R&D expenses) of $205 in year 1 and
$221 in year 2, at the end of which it is liquidated
•• pays $155 in cash dividends at the end of the first year.
Calculate the comprehensive earnings generated by R&D Inc. for its shareholders in each
year of activity, assuming that the firm expenses research and development as incurred (in
the year in which the expenditure is incurred).
43
Comprehensive earnings can hence be thought of as the payoff accruing

to shareholders, as measured by accounting, for holding a firm’s shares.
However, it would be useful to relate this payoff to the investment that
was made. Hence we will introduce in the next section a measure of
bottom-line profitability.
Bottom-line profitability
In order to assess bottom-line performance, that is, performance as far
as shareholders are concerned, analysts tend to use an accounting-based
profitability ratio: the return on common equity (ROCE). A firm’s
ROCE can be defined at the ratio of the shareholders’ payoff, as measured
by accountants, that is, the stock return, over the shareholders’ investment,
as measured by accountants, that is, the book value of equity:
CE
ROCE = (4.2)
CSE (BP)
Financial analysts sometimes also define ROCE by considering the average

of CSE at the beginning of the period (BP) and CSE at the end of the
period (EP):
CE
ROCE =
1 [CSE ( BP ) + CSE ( EP) ] (4.3)
2
ROCE is a comprehensive indicator of a firm’s performance because it
provides an indication of how well managers are employing the funds
invested by the firm’s shareholders to generate returns. A natural
benchmark for a firm’s ROCE is the firm’s cost of equity capital. You
may think of the firm’s cost of equity capital as the opportunity cost
of a shareholder or as the rate of return required by a shareholder to
compensate her or him for the investment’s risk. In the long run, one
would expect the fundamental value (also referred to as intrinsic value) of
a firm’s equity to be determined by the deviation of the firm’s ROCE from
its cost of equity capital, also referred to as the abnormal return on
common equity (AROCE):
AROCE = ROCE – rE (4.4)
The cost of equity capital can be estimated either empirically or from an
asset pricing model. In the context of securities analysis and valuation,
the most widely used asset pricing model is the capital asset pricing
model (CAPM). The CAPM states that any security’s expected return is
equal to the risk-free rate plus a risk premium depending on the security’s
systematic risk:
rE = rF + βE [E(rM) – rF] (4.5)
where rF denotes the risk-free rate
βE denotes the systematic risk of the security
E(rM) denotes the expected return of the market portfolio.
A thorough analysis of a security’s cost of equity capital can be found
either in the FN10 24 Principles of banking and finance subject
guide or in Hillier, Grinblatt and Titman (2012, Chapter 5).
Activity 4.3
Estimate the cost of equity of Ryanair. Given that the yield on government bonds of
medium-long term (10 years) is 4.25 per cent, the market risk premium is 3 per cent, and
Ryanair’s equity beta is 0.8 per cent.
44
On the above data, it follows that Ryanair’s cost of equity is rE = 4.25% +

0.8 * 3% = 7.6%.
Deviations of a firm’s return on common equity from its cost of equity
capital, that is, non-nil abnormal returns on common equity, may arise
for the following reasons. The firm may be in an attractive industry and
its strategic position may enable it to generate supernormal economic
profits at least over the short run. The firm may be at some competitive
disadvantage at least in the short run, leading to subnormal profitability.
Alternatively, the firm may be very skilled (or underskilled) in financial
engineering and may be able to generate supernormal (subnormal)
economic profits. Finally, the accounting used may be biased in the sense
that it fails to capture the underlying business reality. If accounting is
biased, the firm’s abnormal return on common equity is likely to be
distorted and may hence not reflect any abnormal economic profitability.
When assessing a firm’s performance, analysts may also compare the firm’s
current return on common equity with competitors’ performance (cross-
sectional analysis) and with the firm’s own past performance (time-series
analysis). Cross-sectional analysis and time-series analysis are discussed in
more details in the next chapter.
% 2011 2010 2009 2008 2007 2006

Ryanair 13,2% 12,6% –6,8% 15,4% 21,9% 17,7%
Easyjet 13,9% 1,5% 7,2% 15,5% 10,9%
Southwest 14,2% 10,2% –29,7% 20,2% 2,8%
Table 4.2 ROCE (BP) in the airline industry
As an example, we derive the return on common equity (ROCE) generated
by Ryanair in each of the last financial years for which financial information
is available, using the book value of equity as of the beginning of the financial
year. As shown in Table 4.2, Ryanair’s ROCE exceeds its cost of equity capital
by some margin in all years except for 2009. Ryanair also outperformed its
rival, Easyjet, and the leading American low-cost airline, Southwest, in earlier
years (2006, 2007, 2008), but has been trailing behind them more recently.
Activity 4.4*
Calculate the return on common equity for R&D Inc. in each year of activity.
Abnormal earnings
Financial analysts also assess a firm’s performance, as far as shareholders
are concerned, through abnormal earnings. Abnormal earnings
(also referred to as residual earnings) can be defined as the ‘actual’
comprehensive earnings generated by the firm in excess of the firm’s
‘normal’ (comprehensive) earnings, which can be thought as a charge for
the use of equity capital. The firm’s normal earnings are the comprehensive
earnings required for equity to be earning at the cost of equity capital. More
formally, normal earnings are defined as the product of the book value of
equity (as of the beginning of the period), and the cost of equity capital. The
firm’s abnormal earnings can hence be derived as:
AE = CE – rECSE(BP) (4.6)
45
Activity 4.5*
Calculate the abnormal earnings generated by R&D Inc. in each year of activity assuming
that the cost of equity capital is equal to 10 per cent.
Abnormal earnings can also be rewritten as a product of the abnormal

return on common equity and the book value of equity as of the beginning
of the period:
AE = AROCE*CSE(BP) = (ROCE – rE)*CSE(BP) (4.7)
Three different situations can occur:
1. AE = 0 ↔ ROCE = rE The firm shows a ‘normal rate of return’
on common shareholders’ equity. If accounting is unbiased, this
is consistent with the firm not having any source of comparative
advantage and operating in a very competitive industry.
2. AE > 0 ↔ ROCE > rE If accounting is unbiased, the firm is creating
economic value (economic rents) for its shareholders
3. AE < 0 ↔ ROCE < rE If accounting is unbiased, the firm is destroying
economic value for its shareholders.
Activity 4.6
The bulk chemical industry is very competitive. Consider a firm in this industry which does
not have any comparative advantage. Assuming that the accounting used by this firm is
unbiased, what is your best estimate of the firm’s future abnormal earnings. Why?
Non-nil abnormal earnings may arise for the following reasons. The firm may
be in an attractive industry and its strategic position may enable it to generate
returns on common equity in excess of its cost of equity capital at least over
the short run. The firm may be at some competitive disadvantage at least in
the short run, leading to subnormal abnormal profitability. Alternatively, the
firm may be very skilled (or underskilled) in financial engineering and may
be able to generate supernormal (subnormal) economic profits. In any event,
if accounting is unbiased, positive abnormal earnings capture the economic
rent accruing to shareholders generated either in the product markets or in
the financial markets. Finally, the accounting used may be biased in the sense
that it fails to capture the underlying business reality. If accounting is biased,
the firm’s comprehensive earnings and book value of equity are likely to be
distorted and hence may not reflect any economic value created or destroyed
for the firm’s shareholders.
Information on percentiles of ROCE, along with percentiles of annual
growth in the book value of equity, for NYSE and AMEX firms, as reported
by Penman (2012), can be found in Table 4.3. Over the 1963–97 period, the
median ROCE is 12.2 per cent, with variations from –21.5 per cent at the
fifth percentile to 31 per cent at the 95th percentile. Similarly, the median
growth in the book value of equity is 9 per cent, with variations from –18
per cent at the fifth percentile to 50.5 per cent at the 95th percentile. There
thus appears to be a strong correlation between performance as measured
by ROCE and growth as measured by growth in the book value of equity.
46
Percentile ROCE (%) CSE growth (%)

95 31.0 50.5
90 24.5 33.2
75 17.6 17.3
50 12.2 9.0
25 6.3 2.7
10 –4.8 –6.9
5 –21.5 –18.0
Table 4.3 Percentiles of annual growth
As an example, Table 4.4 shows the abnormal earnings generated by Ryanair
in each of the last financial years for which financial information is available
assuming a cost of equity capital rE equal to 7.6 per cent over the period.
2011 2010 2009 2008 2007 2006

CE 374.6 305.3 –169.1 390.7 435.6 306.7
CSE(BP) 2848.6 2425.1 2502.2 2539.8 1992.0 1734.5
AE 158.1 121.0 –359.3 197.7 284.2 174.9
Table 4.4 Derivation of abnormal earnings (AE) at Ryanair
Assuming that accounting is unbiased, Ryanair has hence been generating
economic value for its shareholders over the past five years.
Market-based measures of performance

This section introduces the following market-based measures of a firm’s
performance as far as shareholders are concerned: the stock return (SR),
the stock rate of return (SRR), the stock abnormal rate of return (SARR)
and the stock abnormal return (SAR).
Stock return
Consider the actual return of a share, SR, experienced in the capital
markets over some period. This payoff, also referred to as stock return or
market value added, can be defined as the sum of the change in the market
value of equity and net dividend paid over the period:
SR = MVE(EP) – MVE(BP) + d (4.8)
Substituting the net dividend ND from (4.1) into (4.8) leads to:
SR = CE + [MVE(EP) – CSE(EP)] – [MVE(BP) – CSE(BP)] (4.9)
The return on a share, as experienced in the capital markets over some period,
is hence equal to comprehensive earnings plus the change in premium of the
market value of equity over the book value of equity over the period.
In general, there is no reason for the premium of market over book to
remain constant over any period. The payoff to a firm’s shareholders, as
measured by accounting, comprehensive earnings, hence tends to differ
from the one experienced in the capital markets, the stock return.
Activity 4.7*
Calculate the stock return for R&D Inc. in each year of activity assuming that:
•• the market value of equity at the beginning of the first year is $1,150
•• the market value of equity at the end of the first year is $1,110
•• the market value of equity at the end of the second year is $1,221.
47
Stock rate of return

Consider the actual rate of return, SRR, experienced by a share in the
capital markets over some period. This rate of return, also referred to as
stock rate of return, can be defined as the ratio of the payoff SR over the
market value of equity obtaining at the beginning of the period:
MVE ( EP ) − MVE ( BP ) + d
SRR = (4.10)
MVE ( BP )
CSE(BP) [ MVE ( EP) − CSE ( EP )] − [ MVE ( BP ) − CSE ( BP )]

SRR = ROCE + (4.11)
MVE (BP) MVE ( BP )
The stock rate of return experienced in the capital markets, SRR, is hence
equal to the rate of return calculated by accountants, ROCE, multiplied by
the book-to-market ratio obtaining at the beginning of the period, plus the
change in the premium of the market value of equity over the book value
of equity over the period deflated by the market value of equity obtaining
at the beginning of the period.
In general, the SRR experienced in the capital markets over a period
differs from the measure of bottom-line profitability ROCE derived by
accountants. The relationship between SRR and ROCE furthermore
depends both on the sign of the current premium of market over book and
the sign of the change in premium.
Consider a special case in which the current premium of the market value
of equity over the book value of equity is nil and there is no change in the
premium over the period: MVE(EP) = CSE(EP) = MVE(BP) = CSE(BP).
In this case, it follows from (4.11) that the SRR is equal to the ROCE. In
contrast, with a constant positive premium, the SRR is strictly lower than
the ROCE. Finally, with a premium increasing from zero, the SRR strictly
exceeds the ROCE.
Activity 4.8*
Calculate the stock rate of return (SRR) for R&D Inc. in each year of activity.
In the spirit of the AROCE for accounting-based performance measures,

we can also consider the abnormal rate of return, SARR, experienced by
the share in the capital markets over some period. This abnormal rate of
return, also referred to as the stock abnormal rate of return, can be
defined as:
SARR = SRR – rE (4.12)
Intuitively, the stock abnormal rate of return captures the extent to which the
actual rate of return experienced by a stock in the capital markets exceeds or
falls short of the rate of return required by investors to compensate them for
the risk associated with their investment. In general, as the stock rate
of return experienced in the capital markets over any period differs from the
return on common equity derived by accountants, the stock abnormal rate
of return also differs from the abnormal return on common equity.
Activity 4.9*
Calculate the stock abnormal rate of return (SARR) for R&D Inc. in each year of activity.
48
In the interest of concision, but in an abuse of language, a firm’s stock

rate of return is also referred to in many textbooks as the (stock’s) return.
Similarly, a firm’s abnormal stock rate of return is often referred to as the
(stock’s) abnormal return. Subsequent chapters in this guide will follow
the same approach.
Stock abnormal return

Consider the abnormal return, SAR, experienced by a share in the capital
markets over some period. This abnormal return, also referred to as stock
abnormal return or abnormal market value added, can be defined as:
SAR = SR – rEMVE(BP) (4.13)
Intuitively, the stock abnormal return captures the excess of stock return
(or market value added of the firm’s equity) over the one required by
investors to compensate them for the risk involved with their investment.
Activity 4.10*
Calculate the stock abnormal return (SAR) for R&D Inc. in each year of activity.
SAR = AE + [MVE(EP) – CSE(EP)] – (1 + rE)[MVE(BP) – CSE(BP)] (4.14)
The abnormal payoff obtained from investing in any share over some
period, as experienced in the capital markets, SAR, is hence related to the
abnormal payoff derived by accountants, AE. In general, however, they are
different.
Accounting-based versus market-based performance

measures
In the previous sections, when assessing the performance of a firm from
the point of view of its shareholders, we introduced both market-based
and accounting-based performance measures: the stock return and
comprehensive earnings, the stock rate of return and return on common
equity, the stock abnormal rate of return and abnormal return on common
equity, and the stock abnormal return and abnormal earnings. Both types
of performance measures are related. Although related, measures of
performance as derived by accountants are different from measures of
performance as experienced in the capital markets. The main reason for
this discrepancy comes from the rules used in order to recognise the net
economic resources gained or consumed in any period.
Accountants use very restrictive rules based on the realisation, the matching
and the conservatism principles. As explained by Palepu et al. (2012):
Revenues are economic resources earned during a time period.
Revenue recognition is governed by the realization principle
which proposes that revenues should be recognized when (a) the
firm has provided all, or substantially all, the goods or services to
be delivered to the customer and (b) the customer has paid cash
or is expected to pay cash with a reasonable degree of certainty.
Similarly:
Expenses are economic resources used up in a time period.
Expense recognition is governed by the matching and the
conservatism principles. Under these principles, expenses are (a)
costs directly associated with revenues recognized in the same
49
period, or (b) costs associated with benefits that are consumed

in this time period, or (c) resources whose future benefits are not
reasonably certain.
More intuitively, revenue is only recognised when the firm makes a sale
to a customer. Accounting then matches the expenses incurred in gaining
revenue against the revenue. Earnings can then be derived as the resulting
difference between revenue and expenses.
In efficient markets, stock prices reflect the present value of all net
economic resources to be generated in the future for shareholders. In other
words, stock prices are anticipatory. As a result of both anticipatory stock
prices and the set of restrictive rules used by accountants, stock prices tend
to lead earnings. In other words, the information content from economic
transactions and news tends to get impounded in stock prices before it is
recognised by accounting. As an example, consider the following release
of information by governors of central banks: ‘interest rates are bound to
increase in Europe in the next financial year’. This event has no impact on
the comprehensive earnings (the return on common equity, abnormal return
on common equity or abnormal earnings) generated by Ryanair in the
current financial year. Higher interest rates in the future will, however, lead
to lower demand for travel and a higher cost of equity capital. The present
value of the net economic resources generated in the future for Ryanair’s
shareholders is hence lower after the information release. In efficient
markets, the information release will hence have an adverse effect on
Ryanair’s stock return (as well as on its stock rate of return, stock abnormal
rate of return, or stock abnormal return) over the current financial year.
The fact that stock prices are anticipatory, and hence volatile, implies
that market-based measures of performance may, in some instances, be
less useful than accounting-based measures of performance. Assessing
and rewarding risk-averse managers on the basis of noisy stock prices,
which do not capture accurately the consequences of managers’ actions,
can for instance be sub-optimal. In other situations, when assessing
the performance of a portfolio of stocks, market-based measures of
performance are more appropriate (as illustrated in Chapters 10 and 11 of
this subject guide).
Present value of abnormal earnings

In FN10 24 Principles of Banking and Finance, it has already been
established that the intrinsic value (or fundamental value of a firm’s equity
can be calculated as the present value of the firm’s expected future net
dividends (PVED):
*
VE *t = ∑ Et (dt+i) i
i = +∞
(3.15)
i=1 (1+ rE)
with VEt* denoting the intrinsic value of the firm’s equity at date t
Et*(dt+i) denoting the net dividend expected at date t + i as of date t.
Given (4.15), it can be shown that the intrinsic value of the firm’s equity is
also equal to the sum of the current book value of equity and the present
value of all future expected abnormal earnings (PVAE):
*
VE = CSEt + ∑ Et (AEt+ii)
i = +∞
*
t (4.16)
i=1 (1+ rE)
In efficient markets, the market value of a firm’s equity is equal to the
intrinsic value of the firm’s equity. According to (4.16), the premium of the
50
market value of equity over the book value of equity is hence equal to the
present value of all future expected abnormal earnings. A proof of (4.16)
can be found in the Appendix.
Let us first consider a special case: a firm without any comparative
advantage in a very competitive industry. If accounting is unbiased,
future expected abnormal earnings are expected to be nil and, in efficient
markets, the market value of such a firm’s equity is equal to its book value
(nil premium of market over book). Let us then consider a firm with
some comparative advantage in a more attractive industry, at least in the
short term. For the latter firm, if accounting is unbiased, future expected
abnormal earnings are strictly positive (at least in the short term). In
efficient markets, the market value of such a firm’s equity hence strictly
exceeds its book value (positive premium of market over book). Other
things being equal, the stronger the firm’s comparative advantage and
the longer the time interval over which the firm is able to sustain some
comparative advantage, the higher the market value of equity, and hence,
the higher the premium of market over book.
Accounting choices, accounting-based performance

measures and valuation
Financial statements, such as balance sheet and income statements,
are based on accrual accounting as opposed to cash accounting. The
accounting-based measures of performance introduced in this chapter are
hence not cash-flow based. Assessing a firm’s performance on the basis of
cash flows would, however, discourage investment in the form of capital
expenditure and increases in working capital.
Accounting choices affect the recognition of revenue and expenses in the
income statement and, hence, the valuation of assets and liabilities in the
balance sheet statement. Accounting-based measures of performance,
such as comprehensive earnings, return on common equity and abnormal
earnings, are hence affected by accounting choices too.
Healy et al. (2002) illustrate the effect of accounting choices in the context
of research and development through a simulation. As summarised by
Penman (2012):
In this experiment, a pharmaceutical firm spends each year a
set amount for basic research and development on a number
of drugs with a set probability of success. If the research is
successful, the firm moves to preclinical testing and clinical
trials, again with a set probability of a successful outcome.
Successful drugs are launched commercially with estimated
revenues, production costs, and marketing costs. All estimates,
including the probability of R&D success, are based on
experience in the drug industry, lending them a certain realism.
R&D may be accounted for by using the expensing method, the full costing
method or the successful efforts method. The expensing method expenses
R&D expenditure whenever incurred. The full costing method capitalises
R&D expenditure and amortises it straight-line over a period of 10 years
following the commercial launch. The successful efforts method capitalises
R&D expenditure, writes off R&D expenditure for drugs failing to reach
the next stage of development, and amortises R&D for successful drugs
over a period of 10 years following the commercial launch.
Average ROCE over many trials in the simulation are provided in Table
3.5. These results were generated for a representative firm starting its
51
R&D programme in year 1 with the first revenue being generated in year
14 after a long development period.
A steady state is reached from year 26. Even in this steady state, the
average ROCE generated when using the most conservative accounting
method, that is, the expensing method, is nearly twice the average ROCE
generated when using the least conservative accounting method.
Successful efforts
Year Expensing method Full costing method
method
14 –92.3 –3.4 –15.2
20 8.1 10.7 11.0
26 54.8 27.8 39.6
32 54.0 26.4 39.3
Table 4.5 ROCE (%) from a simulated R&D programme
This experiment calls for caution when using AROCE or AE in order
to assess the performance of any firm from the point of view of its
shareholders. A meaningful interpretation is only possible if accounting is
unbiased. If accounting is biased, it may be possible to remove the bias by
making adjustments. Alternatively, one may evaluate performance over a
longer period, which tends to attenuate the effects of bias in accounting on
reported performance.
Activity 4.11*
Calculate the return on common equity for R&D Inc. in each year of activity assuming that
the firm capitalises and amortises research and development expenditure on a
straight-line basis (e.g. $25 in each period).
Whereas accounting-based measures of performance are affected by

accounting choices, the intrinsic valuation of a firm’s equity obtained
from the PVAE is not affected by the accounting choices made by
analysts. The intuition behind this result is as follows. Given consistent
underlying data, both the PVED and PVAE provide the same valuation
outcomes. The valuation outcome of the PVED is independent of
accounting choices. The valuation outcome of the PVAE is hence also
independent of accounting choices.
Activity 4.12*
Calculate the intrinsic value of R&D Inc. using the PVAE using the following scenarios:
1. The firm expenses research and development as incurred (in the year in which the
expenditure is incurred).
2. The firm capitalises and amortises research and development expenditure on a
straight-line basis (e.g. $25 in each period).
Activity 4.13*
Show that the intrinsic value of the equity of R&D Inc. is the same whether estimated
with the PVED or with the PVAE.
52
Overview of the chapter

This chapter has provided the tools required to assess a firm’s performance
from the point of view of its shareholders. It introduced accounting-based
performance measures, such as the return on common equity (and
abnormal return on common equity) as well as abnormal earnings. It has
shown how these accounting-based performance measures are affected
by the accounting choices made by managers. It provided economic
interpretations whenever these performance measures are derived
using unbiased accounting. It introduced market-based measures of
performance such as the stock rate of return (and stock abnormal rate
of return) as well as the stock abnormal return. It showed how these
market-based performance measures are related to and differ from the
accounting-based performance measures. Furthermore it has shown how
the fundamental value of a firm’s equity and hence the market value of
the firm’s equity in efficient markets reflect the firm’s expected future
performance as captured by accounting-based measures through the
present value of abnormal earnings.
Key terms
abnormal earnings (AE) net income (NI)
abnormal profitability non-recurrent earnings
abnormal ROCE (AROCE) prices-led earnings
biased accounting recurrent earnings
book value of equity (CSE) residual earnings
capital asset pricing model (CAPM) return on common equity (ROCE)
clean-surplus accounting stock abnormal rate of return
comprehensive earnings (CE) (SARR)
cost of equity capital (rE) stock abnormal return (SAR)
dirty-surplus accounting stock rate of return
economic rent stock return (SR)
fundamental value transitory earnings
intrinsic value

• soundly assess firm performance from the shareholders’ perspective
using accounting tools and market-based measures with minimal
guidance
• clearly identify the reasons why accounting-based performance
measures may differ from market-based performance measures
• keenly identify the limitations of the accounting-based and market-
based performance measures
• cogently relate the firm’s fundamental value to its firm’s expected
future performance in detail
• competently analyse the reasons why a firm’s fundamental value of
equity may differ from its book value of equity.
53

1. How may information bearing upon performance evaluation explain
the difference between a firm’s market value of equity and book value
of equity?
2. How does a firm’s stock return differ from its comprehensive earnings?
3. Which benchmark would you use in order to assess how good a firm’s
return on common equity is? What is the intuition for making this
comparison? Discuss any potential problems associated with it.
4. How does a firm’s stock rate of return relate to its return on common
equity?
5. Construct a two-period numerical example to show that the present
value of abnormal earnings yields the same fundamental value for
equity regardless of accounting choices.
6. Earnings Management Inc. is a ‘darling’ of Wall Street analysts. Its
current market value of equity is $15m and its book value of equity
is $5m. Analysts know that the firm’s book value will grow by 10 per
cent per year forever for sure. The cost of equity capital is 15 per cent.
The firm’s return on common equity is believed to stay constant in
the future indefinitely. Given these assumptions, what is the market’s
expectation of the firm’s return on common equity?
Appendix
Reconciling the present value of expected dividends (PVED) and the
present value of abnormal earnings (PVAE)
Assuming that the PVED holds:
E(dt+i) E(dt+2)
VE *t = + + ..... (A1)
(1+ rE) (1+ rE)2
Given clean surplus accounting:

dt+1 = CEt+1 + CSEt – CSEt+1 (A2)
dt+2 = CEt+2 + CSEt+1 – CSEt+2 (A3)
Substituting (A2) and (A3) into (A1) yields:
VE *t = CSEt + E(CEt+i) – rECSEt + E(CEt+2 – rECSEt+1)

–
E(CSEt+2)
(1+ rE) (1+ rE)2 (1+ rE)2
Equivalently:
E(AEt+2)
VE *t = CSEt + E(AEt+1) + – E(CSEt+22 ) + ..... (A4)
(1+ rE) (1+ rE)2 (1+ rE)
As the horizon and the number of dividend terms in (A1) expands, the
number of abnormal earnings terms in (A4) increases and the present
value of the book value of equity term in (A4) converges towards 0. The
PVAE hence obtains.
54
Chapter 5: Financial analysis: the determinants of performance
Chapter 5: Financial analysis: the

determinants of performance
Introduction
In the previous chapter we described the measure of bottom-line
profitability (ROCE). The aim of this chapter is to focus on the drivers
of ROCE, and in particular on one of these drivers, the return on net
operating assets (RNOA) a widely used measure of business profitability.
To do so we need to conduct financial analysis, which aims to investigate
what drives financial statements, in essence what drives profitability.
Financial analysis focuses on the present and past; basically on where the
profitability of the firm is now. But this understanding (and framework) is
essential also in order to forecast where the firm will move in the future
(by conducting prospective analysis, as described in the next chapter).
The forecasts, in turn, determine the value, so much that the profitability
drivers identified in this chapter are sometimes referred to as value
drivers. In short, financial analysis is a necessary step before conducting
forecasting and valuation. (Note that financial analysis enables the analyst
to discover the ratios that determine the value of the firm, whereas ratio
analysis involves simply the assessment of how various line items in a
financial statement relate to one another.)
The aim of this chapter is to focus on the financial analysis of profitability
(called profitability analysis) and to develop a framework to enable
the analyst to identify the key drivers of profitability (the Ryanair case
will be used as a reference). Therefore, we will answer the following
questions: What are the drivers of bottom-line profitability (ROCE)? How
does financial leverage affect ROCE? What are the drivers of business
profitability (RNOA)? What is a measure of abnormal business profitability?
What is the link between business profitability and free cash flow?
The chapter is organised as follows. We will first focus on the return of
operating activities only (or rather the so-called business profitability)
to introduce the concept of return on net operating assets and abnormal
operating income, and then move to the investigation of the link between
business profitability and bottom-line profitability (first-level breakdown
of ROCE). We will then analyse the drivers of business profitability itself
(known as second-level breakdown of ROCE). Finally we will investigate
the link between business profitability and free cash flow.
Activity 5.1
Financial analysis data are provided commercially by investment advisory services (among
others: Moody’s Handbook of Common Stocks by Moody’s/Mergents, and The Value Line
Investment Survey by Value Line). Visit the Value Line website, and analyse Part 3 – Ratings
and reports of the Value Line investment survey, a one-page detailed summary available at
www.valueline.com. Then identify and describe the proposed by Value Line Campbell Soup.
Aim
The aim of this chapter is to analyse the drivers of current profitability, by
conducting the so-called financial analysis. We will develop a framework
to enable the analyst to perform financial analysis, as shown for the
Ryanair case. We will first introduce the concept of return on net operating
55
assets (RNOA, the typical measure of business profitability) and abnormal

operating income (AOI), and then move to the investigation of the link
between business profitability (RNOA) and bottom-line profitability
(ROCE) by conducting the so-called first-level breakdown ROCE. We will
then focus on the analysis of the drivers of business profitability itself
(known as second-level breakdown ROCE). Finally, we will investigate the
link between business profitability and free cash flow.
Learning outcomes
• broadly describe key aspects of financial analysis
• critically explain the concepts of business profitability and abnormal
operating income
• adequately discuss the difference between RNOA and ROA
• clearly define the concept of cost of capital for the firm
• accurately calculate the firm’s cost of capital with minimal guidance
• formally derive bottom-line profitability from business profitability and
financial leverage (known as first-level breakdown ROCE) in detail
• aptly decompose RNOA into its main drivers, and fully explain their
meaning (known as second-level breakdown ROCE)
• relate business profitability and free cash flow in detail
• carefully describe the empirical evidence on the typical median values
of financial ratios for US firms
• competently perform the analysis of profitability of a given firm.
Essential reading
McGraw-Hill, 2012) fifth edition, Chapters 11 and 12.
Further reading
practice’, Review of Accounting Studies (6), 2001, pp.109–54.
Financial analysis: time-series and cross-sectional

analysis
In conducting financial analysis, it is important to refer not simply to
individual ratios, but to ratios in relation to comparable ratios. The
parameters of comparison are:
• the aggregate economy
• the industry or the major competitors within the industry (called cross-
sectional analysis)
• the firm’s past performance (known as time-series analysis).
The comparison of the firm to the economy enables analysts to understand
the influence of economic fluctuations on a firm’s performance (i.e. how
the firm reacts to the business cycle).
56
In cross-sectional analysis, analysts compare the firm either to the average

industry value (if the firms in the industry are homogenous in terms
of technology, products, markets) or to a set of firms in the industry
comparable in terms of structural characteristics (e.g. size, geographical
market, product market, etc.). (Note that for multi-industry firms, analysts
often refer to a rival that operates in many of the same industries, or
alternatively they construct a composite industry average ratio based on
the proportion of total sales derived from each industry.)
Finally, in time-series analysis, analysts examine a firm’s relative
performance over time to determine whether it is improving or
deteriorating.
Business profitability (RNOA)

Firms raise cash from capital markets to invest in financing assets that
are then turned into operating assets. They then use the operating assets
in operations. This involves buying inputs from suppliers and applying
them with operating assets to produce the goods and services to be sold
to customers. Operating activities thus involve trading with customers and
suppliers in the product/services and input markets. In contrast, financing
activities involve trading in financial markets. The separation between
financing and operating activities emerges, and has been clearly stated in
the reclassification of financial statements proposed in Chapter 2. In the
income statement we identify the profit flows from either operating or
financing activities; analogously in the balance sheet we find the net assets
or obligations put in place in order to generate the flows from the two
activities.
The comparison of the flows from operating activities to the relevant
operating stocks yields a ratio that measures business profitability as a
rate of return, the return on net operating assets (RNOA), which can be
measured as follows:
measured as follows (5.1)
where OI = operating income (after taxes); NOA = net operating assets

(i.e. difference between operating assets and operating liabilities) at the
beginning of the period.
More commonly, financial analysts define RNOA by looking at the average
between NOA at the beginning of the period (BP) and NOA at the end of
the period (EP), or rather:
(5.2)
The operating profitability measure (RNOA) gives the percentage return

of the net operating assets (NOA), and therefore measures how profitably
a company is able to deploy its operating assets to generate operating
profits. As such, RNOA expresses the return to all the claimholders (both
shareholders and debt-holders).
RNOA enables us to analyse business profitability effectively for two
reasons. First, it considers (after tax) income on a comprehensive
(clean surplus) basis, as defined in Chapter 4. Second, it appropriately
distinguishes between operating and financing activities. Interest-bearing
financial assets are treated as negative financial obligations, and thus they
do not affect the operating profitability. Instead operating liabilities reduce
the needed investments in operating assets providing for operating liability
57
leverage (OLL, calculated as operating liabilities divided by net operating

assets), and thus are subtracted from the denominator.
Activity 5.2
Go back to the financial statements of Ryanair provided in Chapter 3. Estimate the value
of RNOA (using both methods) for each year during the period 2006–2011.
Below you can find our example for the financial analysis of Ryanair’s
RNOA.
To conduct the time-series analysis of Ryanair’s RNOA, we calculate
its RNOA over time (as shown in the table here). Following high levels
close to or exceeding 20% in 2007 and 2008, the RNOA crashed in
2009 but recovered to a level ground 14% in 2010 and 2011.
2011 2010 2009 2008 2007 2006
RNOA=OI/NOA(BP) 15,4% 14,2% -4,7% 21,6% 25,4% NA
RNOA=OI/(1/2*(NOA(EP)+NOA(BP))) 14,2% 13,2% -4,7% 18,4% 24,9% NA
To conduct cross-sectional analysis, we need to compare Ryanair’s RNOA

with the ratio of its competitors (e.g. EasyJet and South West), as shown
in the table below.
2010 2009 2008 2007 2006
Easyjet 9,9% 6,4% 7,9% 18,8% 15,9%
Southwest 9,1% 3,2% 3,6% 13,0% 8,6%
It emerges that Ryanair’s RNOA has been significantly higher than that of
Easyjet and Southwest over the last four years (with exception of 2009).
An alternative measure of business profitability is ROA (return on assets),
which is calculated as:
(5.3)
where NI = net income; IE = interest expenses; TA = total assets.
Activity 5.3*
Go back to the financial statements of Ryanair and calculate the value of ROA for each
year during the period 2007–2011. Compare these values with the ones estimated for
RNOA.
Although ROA is commonly used, it is affected by some drawbacks. On the

one hand it considers net income rather than comprehensive earnings, and
on the other it mixes up financing and operating activities. In particular:
• interest income, which is part of the financing activities, is included in
the numerator
• total assets, that include both financing and operating assets, constitute
the denominator
• operating liabilities instead are excluded from the denominator.
It follows clearly that the difference between ROA and RNOA is explained
by the operating liability leverage and the amount of financial assets
relative to total assets. This difference finds confirmation in the empirical
evidence about the two measures. The median RNOA for NYSE and AMEX
firms over the period 1963–99 is equal to 10.0 per cent, whereas the
median ROA is 6.8 per cent (see Nissim and Penman, 2001). The RNOA
measure is closer to what we typically think of as an average business
58
profitability (please refer to Figure 6.2 to have a preliminary idea on the

typical behaviour of RNOA over time). Conversely, the ROA measure is
below what we would expect the cost of capital for the firm to be, and
seems more in line with a debt capital rate. (It follows that values of ROA
reported in texts and in the business press often seem too low, and this
seems to be due to poor measurement.)
Operating income
Let us now focus on the numerator of RNOA, or rather operating income.
In order to calculate operating income, we need to make a distinction
based on the presence of dirty- or clean-surplus accounting.
In presence of dirty-surplus accounting (which means, as previously
explained, that income items are considered as part of equity rather than
in the income statement), operating income can be written as:
OI = CE + NFE (5.4)
where NFE = net financial expense (after taxes) (= financial expense (FE)
on financial obligations – financial revenue (FR) on financial assets).
Conversely, in presence of clean-surplus accounting (when comprehensive
earnings equal net income), the operating income is calculated as follows:
OI = OR – OE = NI + NFE (5.5)
where OR = operating revenue; OE = operating expenses (after taxes).
Operating income is an accounting measure of net value added from
operations. If everything goes well (and the firm adds value), operating
income is a positive value. Why does it represent a measure of operating
value added? Let us refer to the business process of the firm. Trading with
suppliers involves giving up resources and this loss of value is named
operating expenses. The inputs purchased have value because they can
be combined with the operating assets to yield products and services to
be sold to customers. The sale of these products and services generates
operating revenues. The difference between operating revenues and
operating expenses represents operating income (as shown in equation
(5.5)), and is a measure of value added by operating activities.
The benchmark to evaluate RNOA: the cost of capital for the firm
Payoffs must be discounted at a rate that reflects their risk, and the risk for
operations may be different from the risk for equity (measured by the cost
of equity, as illustrated in Chapter 4). The risk in operations is referred to
as firm risk (or operational risk) and arises from factors that may affect
business profitability. Just as an example consider the sensitivity of sales to
recession and other shocks: this sensitivity determines the operational risk.
Activity 5.4
Focus now on an airline company, such as Ryanair. What is the level of its operational risk
in comparison to companies operating in other industries? What are its determinants?
The operational risk is relatively high for airline companies in comparison

with other industries. In fact, people fly less during recessions and fuel
costs are subject to shocks in oil prices.
The required return that compensates for this operational risk is the firm’s
cost of capital, which is denoted by r (and is also referred to as normal
rate of return or cost of capital for operations). Since this is the required
return for operating activities, it is the benchmark against which to
evaluate RNOA.
59
In the long run, the value of the firm depends on where RNOA stands
relative to this norm (r), as implied in the measure of abnormal
operating income (illustrated in the next section). In the long run, and
in the absence of any barriers to competitive forces (i.e. the possibility
of achieving the competitive equilibrium status), RNOA will tend to be
pushed towards the cost of the firm’s capital (r). Therefore the cost of
capital for operations represents the benchmark against which to evaluate
the RNOA of a given company. (Note that the implication is that since rE is
lower than r, then RNOA tends to be pushed to a lower level than ROCE.).
Computing the cost of capital for the firm

The cost of capital for operations (r) is sometimes referred to as the
weighted average cost of capital (WACC), where capital consists of all
financial claims. If the capital structure consists solely of debt and equity
capital, the required return to invest in operations is calculated as the
weighted average of the required return of the shareholders and the cost
of net financial debt, and the weights are given by the relative values of
equity and debt in the value of the firm. As interest payments can be used
to reduce corporate taxes, the WACC can be devised as:
(5.6)

where VE= market value of equity; VD= market value of debt; rD = cost of
debt capital; T = tax rate reflecting the marginal tax benefit of interest.
To compute the WACC, please find here below some insights.
Weights assigned to the cost of debt and equity represent their
respective fractions of total capital, measured at market values.
The market value of debt can be reasonably approximated by the book
value of debt, if interest rates have not changed significantly since the time
the debt was issued. Otherwise, the market value of debt can be estimated
by discounting the future payouts at the current market interest rates
appropriate for the specific firm. Note that both short-term and long-term
financing debt should be considered as part of capital when computing
WACC, whereas for internal consistency operating liabilities (such as
accounts payable and accruals) should not be included.
The market value of equity is instead very complicated to calculate in
a forward-looking perspective. It represents the very amount that analysts
try to estimate through all the valuation process, but it is required to get
the valuation itself. To solve this problem, a common approach used by
analysts is to insert the target ratio of debt to capital (VD/(VD + VE)) and
equity to capital (VE/(VD+VE)) in the WACC calculation. An alternative
approach to solve the problem is to use a reasonable approximation of the
value of equity (based for example on multiples of next year’s earnings
forecasts). In a valuation process, which will be extensively explained
in Chapter 8, this approximation can be used as a weight in an initial
calculation of WACC, which in turn can be used in the discounting process
to generate an initial estimate of the value of the firm. This initial estimate
of the value of equity can then be used in place of the guess to arrive
at a new measure of WACC, on the basis of which a new value can be
estimated. The process can be repeated until the value used in the WACC
calculation and the estimated value of the firm converge.
The cost of debt (rD) should be based on current market interest rates.
For privately held debt, with no quoted rates, the cost of debt can be
calculated as interest expenses (from the income statement) divided by
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interest-bearing debts (from the balance sheet). The cost of debt should
be expressed on a net-tax basis, because we use this cost of capital as a
benchmark for RNOA, which is calculated on the basis of operating income
after taxes. The after-tax interest rate can be calculated by multiplying the
market interest rate by one minus the marginal (or effective) corporate
tax rate (as previously shown in equation (5.6)). In a forward-looking
perspective, which is the one needed in any valuation (as discussed in
Chapter 8), the current interest rate on debt will be an appropriate proxy
for the future expected cost of debt, if the assumed capital structure in
future periods is the same as the historical structure. However, when the
analyst projects a change in the capital structure, it is essential to estimate
the expected cost of debt given the new level of the debt-to-capital ratio.
One method of estimation could be based on the estimation of the expected
credit rating for the firm at the new level of debt, and consequently on the
use of the appropriate debt interest rate for that category. Note that in a
forecasting perspective, the cost of debt should be expressed on a net-of-tax
basis because it is after-tax cash flows that are discounted (as discussed in
Chapter 8, ‘Discounted cash flow method’ section).
As regards the estimation of the cost of equity, please refer to the
discussion in Chapter 4.
We now have the estimates of all the elements needed to compute the
WACC.
Activity 5.5*
Calculate the WACC for Ryanair in the year 2011. Make appropriate assumptions when
required. Keep this answer, as you will need it in the application of valuation methods in
Chapter 8.
Abnormal (residual) operating income (AOI)

Abnormal operating income (AOI) also referred to as residual operating
income (ReOI) can be defined as the operating income in excess of the
operating income required for the net operating assets in the balance
sheet to be earning at the relevant cost of capital. It can thus be viewed
as the ‘actual’ operating income minus the normal operating income,
which can be thought of as the charge for using net operating assets.
Normal operating income can be defined as the net operating assets (at
the beginning of the period) multiplied by the cost of capital for the firm
(r). Therefore, the abnormal operating income measures the abnormal
earnings from net operating assets, and formally can be written as:
AOI = OI – r*NOA(BP) (5.7)
where OI denotes the after-tax operating income. Abnormal operating
income charges the operating income with a charge for using net operating
assets. Abnormal operating income is also referred to as economic profit
or economic value added. Note that some consulting firms have taken this
concept (and terms) as trademarks for their valuation products (we will
discuss the general form of the economic value added valuation model in
Chapter 7).
Activity 5.6*
Go back to the financial statements of Ryanair, and calculate the AOI measure for each
year during the period 2007–2011.
61
As outlined in Chapter 4, abnormal (residual) earnings can be broken

down into its drivers. Similarly we can identify the abnormal operating
income drivers. Given that RNOA = OI/NOA (BP), it follows that
OI = RNOA × NOA(BP). Substituting this in equation (5.7), we obtain:
OI – r*NOA(BP) = RNOA*NOA(BP) – r*NOA(BP) = RNOA–r)*NOA(BP)
= ARNOA*NOA(BP) (5.8)
From this equation, it is clear that the drivers of residual operating
income are: abnormal return on net operating assets (ARNOA), which is
the difference between RNOA and r; and NOA. This means that AOI is
driven by the amount of NOA put in place at the beginning of the year
and the profitability of those assets relative to the relevant cost of capital.
Therefore by comparing RNOA and its benchmark, we introduce the
concept of AOI.
Let us now focus on the abnormal RNOA. Three different situations can
occur:
1. AOI = 0 ↔ RNOA = r: The firm shows a ‘normal rate of return’ on its
NOA.
2. AOI > 0 ↔ RNOA > r: If accounting is unbiased, the firm is creating
economic value (economic rents).
3. AOI < 0 ↔ RNOA < r: If accounting is unbiased, the firm is destroying
economic value.
Link between business and bottom-line profitability
The bottom-line profitability (ROCE, as illustrated in Chapter 4) is affected
both by operating activities (whose profitability has been discussed in the
previous sections of this chapter) and financing activities. The first level of
breakdown of ROCE allows us to distinguish the profitability of operating
and financing activities, and also to distinguish the effect of financial
leverage. Furthermore, the first-level breakdown is a way to identify a link
between business profitability and bottom-line profitability. Formally, this
decomposition of ROCE can be written as:
ROCE = RNOA + FLEV(RNOA − NBC) = RNOA + (FLEV*SPREAD) (5.9)
Activity 5.7*
Formally derive the first-level breakdown of ROCE.
(*The solution to this activity can be found at the end of this subject guide.)
From equation (5.9), it emerges clearly that ROCE can be broken down
into three drivers:
1. RNOA = return on net operating assets (= OI/NOA), a measure of
how profitably the firm employs its net operating assets (as previously
explained)
2. FLEV = financial leverage (= NFO/CSE), a measure of the degree to
which net operating assets are financed by net financial obligations
(NFO) or by common shareholders’ equity (CSE)
3. SPREAD = operating spread (= RNOA – NBC), where NBC = net
borrowing costs (after tax).
In short, ROCE is determined by operating profitability, financial leverage
and the operating spread.
Financial leverage levers the ROCE up or down through financing
liabilities. This means that the extent to which net operating assets (NOA)
are financed by common shareholders’ equity (CSE) or net financial
62
obligations (NFO) affects ROCE. In particular, ROCE (bottom-line

performance) is levered up over the RNOA (operating profitability) if the
firm has financial leverage and the return from operations is greater than
the borrowing costs. In this case the firm earns more on its equity if NOA
are financed by NFO, provided that the spread is positive (i.e. profitability
of operations higher than net borrowing costs).
Figure 5.1 shows how the difference between ROCE and RNOA changes
with FLEV according to the level of the spread. If a firm has zero FLEV,
then ROCE = RNOA. If a firm has (positive) FLEV, then the difference
between ROCE and RNOA is determined by the very amount of FLEV and
the operating spread.
• If the spread is positive (i.e. RNOA > NBC), it is commonly said to
have favourable leverage (or favourable gearing): this implies that the
RNOA is levered up to generate a higher ROCE.
• If the spread is negative (i.e. RNOA < NBC), the FLEV effect is negative
(as will be shown in the case of Ryanair).
To the presence of financial leverage can be attached alternatively good or
bad news. There is good news (financial leverage generates greater return
to shareholders) if the firm earns more on its operating assets than its
borrowing costs. Conversely, financial leverage hurts shareholders’ return,
if it doesn’t. Influence of FLEV on ROCE and RNOA
0.1
0.08
0.06
0.04
ROCE-RNOA
4% SPREAD
2% SPREAD
0.02
-2% SPREAD
0 SPREAD
0
0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2
-0.02
-0.04
-0.06
FLEV
Figure 5.1 Influence of FLEV over the difference between ROCE and RNOA
Source: Adapted from Penman (2012, p.368)
The empirical evidence for the sample of NYSE and AMEX firms over the
period 1963–99 used in the study by Nissim and Penman (2001) shows
a median FLEV 0.40 (much lower than the value measured for the debt/
equity ratio, equal to 1.19). This occurs because FLEV recognised only
financial obligations, and also recognised that financial activities reduce
financial obligations. It is interesting to note that about 20 per cent of firms
have negative financial leverage, which means that they hold financial
assets rather than financial obligations (as shown in the Ryanair case).
Also note that there is considerable variation across industries as regards
the value of financial leverage. The median net borrowing cost after tax is
5.2 per cent, while the spread over the net borrowing cost is positive at the
median. The higher median value of ROCE (12.2 per cent) in comparison
with the median value of RNOA (10.0 per cent) indicates that typically
positive FLEV combines with positive spread to lever ROCE favourably.
63
Activity 5.8
Go back to the financial statements of Ryanair, and show the first-level breakdown for
each year during the period 2007–2011. Use a graph to support your answer.
Below you can find the first-level breakdown for Ryanair’s ROCE.
First-level breakdown ROCE (RNOA, FLEV, SPREAD): RYANAIR

The aim is to explain Ryanair’s comparatively high ROCE in relation to its components
of RNOA, FLEV and NBC.
Figure 5.2
Figure 5.2 shows that Ryanair’s RNOA exceeds ROCE during the 2007–2011 period,
except in 2009, leading to the conclusion that the high profitability of Ryanair can be
explained mainly as a result of operations. Also, that the increase in financial leverage
does not create any value for Ryanair’s shareholders
Determinants of business profitability

In the second level of breakdown, the focus is specifically on the drivers
of operating profitability (which in turn is identified as a driver of bottom-
line profitability, as shown in the previous section). The decomposition of
business profitability (called also the Du Pont model) leads to:
(5.10)
where PM = profit margin; ATO = net operating asset turnover.

The profitability of operations comes from two sources:
• profit margin, or rather a profitability measure: RNOA is higher the
more of each pound of sales ends up in operating income
• net operating asset turnover, which is an efficiency measure: RNOA is
higher the more sales are generated from net operating assets.
Note that an analogous decomposition is possible for ROA, which can be
thought as the product of two factors:
(5.11)
where ROS = return on sales (also known as net profit margin), and
AT = asset turnover. The return on sales indicates how much the firm
is able to keep as net income for each pound of sales. Asset turnover
indicates how many pounds of sales the firm is able to generate from each
pound of its assets.
In terms of empirical evidence, the mean value for PM is 6.2 per cent,
while that for ATO is 2.33 per cent for the same sample of NYSE and
64
AMEX firms over the period 1963–99 (Nissim and Penman, 2001).
Empirical evidence also suggests that firms can generate the same RNOA
with different combinations of PM and ATO. This is very much determined
by the nature of the industry to which the firm belongs, as will be shown
in the next activity.
Activity 5.9
Please visit the webpage http://pages.stern.nyu.edu/~adamodar/pc/datasets/mgnroc.
xls to get a sense of the typical values of profit margins and asset turnover in the United
States, classified by industry. Then plot these values on an XY diagram.
The result you will obtain by plotting the PM and ATO values of different
industries over an XY diagram is the one shown in Figure 5.3. We clearly
observe a trade-off between PM and ATO. PM and ATO reflect the
technology for delivering the services. On the one hand, there are capital-
intensive industries, with low ATO and high PM (examples are: electric/
water utilities, precious metals, securities brokerage industries). On the
other hand, we find competitive businesses, characterised by low PM and
high ATO (examples are: food wholesalers, building materials, groceries,
human resources and pharmacy services industries).
Figure 5.3 PM and ATO combinations

In the next sections we will focus our attention on each of the two drivers
of RNOA.
(Please read Penman, 2012, for a description of the third-level breakdown,
which refers to the identification of the drivers of profit margin, operating
asset turnover and net borrowing cost.)
Profit margin
Profit margin measures how much the firm is able to keep as operating
profits (after taxes) for each pound of sales it makes. In short, it reveals
the profitability of each pound of sales. Formally, it is calculated as:
65
(5.12)
Over time, profit margin is a more variable measure than operating asset
turnover. This happens because profit margin, like ROCE, tends to be
driven by competition to ‘normal’ levels over time (for an analysis of the
ROCE behaviour over time please refer to Chapter 7, ‘Empirical evidence
on the patterns of accounting resources’ section).
Net operating asset turnover

Net operating asset turnover indicates the ability of NOA to generate sales,
or rather how many pounds of sales the firm is able to generate for each
pound of its NOA. The formula for the ATO calculation is:
(5.13)
Operating asset turnover (ATO) tends to be rather stable over time, in part
because it is so much a function of the technology used in an industry as
well as the firm’s strategy, which tend not to change very frequently.
Activity 5.10
Go back to the financial statements of Ryanair, and show the second-level breakdown
(referred to RNOA) for each year during the period 2007–2011.
Below you can find the second-level breakdown for Ryanair’s ROCE.
Second-level breakdown ROCE (PM and ATO): Ryanair

By looking at the RNOA (as calculated in Activity 5.2), we clearly observe significantly
better performance of Ryanair in comparison with other firms in the industry.
In order to get further understanding as to what are the drivers behind this high
RNOA, we will look into its drivers, namely profit margin (PM) and operating asset
turnover (ATO), by conducting second-level breakdown ROCE. The table below shows
the values for the two drivers over the period 2007–2011.
2011 2010 2009 2008 2007
PM 11,96% 11,67% -4,00% 14,83% 20,33%
ATO(NOA(BP)) 1,29 1,21 1,18 1,46 1,25
Table 5.1
Ryanair has an operating asset turnover (ATO) that is very small compared with that
of the industry. For example, the ATO of Easyjet was 2.66 in 2007, 2.72 in 2008, 2.17
in 2009 and 2.15 in 2010. In order to understand why Ryanair’s ATO is lower than the
industry level, we need to examine its investment policy. Ryanair own most of its fleet
and thus has high investments in tangible assets (high CAPEX). At Ryanair, tangible
fixed assets (property, plant and equipment (PPE)) make up about 95 per cent of its
operational activities. In contrast, at Easyjet this proportion varies between 53 and 72
per cent. Easyjet, unlike Ryanair, leases most of its aircrafts. These leased aircrafts do
not appear on Easyjet’s balance sheet as they are accounted for under the operating
lease method. The resulting higher ATO is, however, associated with a lower gross
margin (because leasing rents are higher than depreciation charges). Ryanair’s ATO is
relatively stable, suggesting that no significant technological progress has been made
over this time and that Ryanair is not able to generate much more revenue with fewer
assets. Therefore Ryanair’s profit margin (PM) is the key driver of its RNOA, which is
much higher than that of other companies in the industry (in 2010, the profit margin
of Easyjet was 9 per cent while Southwest was 4.5 per cent). It is thus necessary to
analyse the drivers of Ryanair’s PM by performing the third-level breakdown of ROCE.
66
Business profitability and free cash flows

As discussed in Chapter 3, the reformulated cash flow statement
identifies the (operating and financing) flows over a period. The cash
flows associated with operating activities are cash from operations (C)
and cash investments in operations (I). By comparing these operating
flows we get the free cash flow (FCF), which can be calculated as:
FCF = Cash flow from operations – Cash investments in operations
= C – I (5.14)
FCF represents the net cash generated (or absorbed) by operations,
which determines the ability of the firm to satisfy its debt- and equity-
holders. If the FCF is positive, operating activities are generating net
cash; if FCF is negative, operating activities absorb net cash.
The calculation of FCF starting from the GAAP statement of cash
flow is complex because it requires a reformulation to correct for the
misclassification of some operating and financing cash flows. However,
if the balance sheet and the income statement are appropriately
reformulated (according to what has been explained in Chapter 3), the
calculation of FCF becomes straightforward. By recalling equation (2.5),
FCF can be expressed as follows:
FCF = Operating income – Change in net operating assets = OI – ∆NO
(5.15)
This means that operations generate operating income, and FCF is the
part of operating income remaining after reinvesting some of it in NOA.
(If the investment in NOA is higher than the operating income, the FCF
is negative. This implies that an infusion of cash is required.) There
emerges a clear link between FCF and business profitability. In fact,
recalling that RNOA = OI/NOA(BP), equation (5.15) can be rearranged
as:
(5.16)
The calculation of FCF is important for preparing pro-forma future cash

flow statements for the discounted cash flow (DCF) analysis, the most
common valuation technique, which will be discussed in Chapter 8.
Overview of chapter
This chapter has uncovered the drivers of the current bottom-line
profitability (ROCE), and focused attention on the measure of business
profitability (RNOA), by conducting financial analysis of profitability.
This enables analysts not just to penetrate the financial statements, but
also to provide a framework to understand how these drivers affect the
value of the firm (i.e. how the business affects the financial statement
drivers, and how in turn they affect ROCE and abnormal earnings). By
focusing on the present and the past, financial analysis is an essential
step before conducting prospective analysis and valuation.
In the profitability analysis framework, the first-level breakdown ROCE
enables analysts to uncover the key drivers of bottom-line profitability,
which are business profitability, financial leverage and the operating
spread. The first driver is business profitability, which is measured
by the return on net operating assets (RNOA): it refers to operating
activities only, and measures how profitably a company is able to deploy
67
its operating assets to generate operating profits. Nevertheless, ROCE is

levered up over the RNOA if the firm has financial leverage and the return
from operations is greater than the borrowing costs (which means positive
operating spread). This qualifies the so-called favourable leverage, an
increase in ROCE over RNOA induced by borrowing.
The second-level breakdown enables analysts to identify the key drivers
of business profitability itself, which are profit margin (PM) and net
operating asset turnover (ATO). The former is a profitability measure that
indicates how much of each pound of sales ends up in operating income.
The latter is an efficiency measure expressing the technology of the
firm, which indicates how many pounds of sales are generated from net
operating assets. Empirical evidence shows a trade-off between PM and
ATO: similar RNOA are generated with quite dissimilar combinations of
PM and ATO in different industries.
By comparing business profitability (RNOA) and its relevant cost of
capital (cost of capital for the firm, sometimes referred to as weighted
average cost of capital), we introduced the concept of abnormal (residual)
operating income (AOI), which can be viewed as the ‘actual’ operating
income minus the ‘normal’ operating income (i.e. the operating income
required for the NOA to be earning at the relevant cost of capital). This
concept (also known as economic value added or economic profit) is the
basis of a valuation method described in Chapter 8.
Key terms
abnormal operating income (AOI) free cash flow (FCF)
abnormal operating income drivers market value of debt
abnormal RNOA market value of equity
business profitability normal operating income
clean-surplus accounting normal rate of return
cost of capital for operations operating liability leverage (OLL)
cost of capital for the firm operational risk
cost of debt profitability analysis
cost of equity ratio analysis
cross-sectional analysis required return
dirty-surplus accounting residual operating income (ReOI)
Du Pont model return on net operating assets (RNOA)
economic profit return on sales (ROS)
economic value added second level of breakdown
economic value economic rent target ratios
favourable gearing time-series analysis
favourable leverage value drivers
financial analysis weighted average cost of
capital(WACC)
firm risk weights assigned to the cost of debt
and equity
first level of breakdown
68

• broadly describe key aspects of financial analysis
• critically explain the concepts of business profitability and abnormal
operating income
• adequately discuss the difference between RNOA and ROA
• clearly define the concept of cost of capital for the firm
• accurately calculate the firm’s cost of capital with minimal guidance
• formally derive bottom-line profitability from business profitability and
financial leverage (known as first-level breakdown ROCE) in detail
• aptly decompose RNOA into its main drivers, and fully explain their
meaning (known as second-level breakdown ROCE)
• relate business profitability and free cash flow in detail
• carefully describe the empirical evidence on the typical median values
of financial ratios for US firms
• competently perform the analysis of profitability of a given firm.

1. Under what conditions is the measure of business profitability (RNOA)
equal to the measure of bottom-line profitability (ROCE)?
2. Describe the commonly used measure of return on assets (ROA), and
critically discuss its main limits. Then relate these limits to the low
value empirically measured for ROA in comparison to RNOA.
3. What is the benchmark against which to evaluate RNOA? Why?
4. Discuss why financial leverage should lever up the return on common
equity.
5. How does business profitability relate to free cash flow?
6. Critically explain the meaning of the abnormal operating income
concept.
7. The reformulated financial statements of company ABC are as follows
(values in millions of dollars):
2012 2011
PPE 1000 1700
Accounts receivable 500 500
Inventories 500 500
Operating liabilities (100) (300)
Bonds payable (200) (1200)
Common equity 800 1200
Sales 2100
Operating expenses 1700
Interest expenses 120
Tax expense 30
Net income 250
69
a. Calculate ROCE, RNOA, FLEV and FCF for the firm in the year
2012.
b. Show the first-level breakdown ROCE for the year 2012.
c. Show the second-level breakdown ROCE for the year 2012.
70
Chapter 6: Accounting and strategy analysis
Chapter 6: Accounting and strategy

analysis
Introduction
The previous chapters introduced tools to perform a financial analysis.
In these chapters, we learned how to measure a firm’s performance from
the point of view of its shareholders and explain it through financial
engineering and the performance of the firm’s net operating assets. Any
strictly positive abnormal return on common equity was hence attributed
to a superior performance in the product markets, successful financial
engineering or accounting distortions. A strategy analysis enables an
analyst to assess whether the firm is able to derive any economic rent
either by trading in the product markets or though financial engineering.
An accounting analysis enables an analyst to assess whether the firm’s
abnormal performance is due to accounting distortions. This chapter
introduces frameworks for performing a strategy analysis and an
accounting analysis.
This chapter first focuses on strategy analysis. In this context, it covers
industry analysis, competitive strategy analysis and corporate strategy
analysis. It then describes the institutional setting behind corporate
financial reporting. It then moves to accounting analysis. In this context,
it introduces an analysis of the economic operating assets and liabilities
used in the industry, an analysis of the way the firm’s competitive strategy,
key success factors and key risks are captured through corporate financial
reporting, and a search for signs of earnings management (red flags
analysis).
Aim
The aim of this chapter is to explain a firm’s abnormal performance. A
firm’s positive abnormal performance can be attributed to a superior
performance in the product markets, successful financial engineering or
accounting distortions. A strategy analysis enables an analyst to assess
whether the firm is able to derive any economic rent either by trading
in the product markets or though financial engineering. An accounting
analysis enables an analyst to assess whether the firm’s abnormal
performance is due to accounting distortions. This chapter introduces
frameworks for performing a strategy analysis and an accounting analysis.
Learning outcomes
• concisely recall the institutional setting underlying accounting and
strategy analysis
• adequately recognise the effect of industry structure in the industry’s
average profitability
• outline the sources of a firm’s competitive advantage in detail
• carefully identify potential biases in a firm’s financial statements
• accurately perform an accounting analysis in an independent manner
71
• briefly discuss key pitfalls of accounting analysis

• explain why both strategy analysis and accounting analysis are key
steps in the securities analysis and valuation framework in detail.
Essential reading
Ohio: South-Western College Publishing, 2012) fifth edition, Chapters 2, 3
and 4.
Works cited
Accounting Research 31 (2), 1993, pp. 190–215.
McGraw-Hill, 2012) fifth edition. Chapters 7, 8, 9 and 10.
Porter, M. Competitive strategy. (New York: The Free Press, 1980).
Porter, M. Competitive advantage: Creating and sustaining superior performance.
(New York: The Free Press, 1985).
Strategy analysis
Corporate managers are responsible for acquiring physical and financial
resources from the firm’s environment and using them to create value
for the firm’s investors. Value is created when the firm earns a return
on its investment in excess of the cost of capital. Corporate managers
formulate business strategies to achieve this goal and implement them
through business activities: a firm’s business activities are influenced by
its economic environment and its own business strategy. The economic
environment includes the firm’s industry, its input and output markets and
the regulations under which the firm operates. The firm’s business strategy
determines how the firm positions itself in its environment to achieve
a competitive advantage. The purpose of a strategy analysis is to assess
the company’s profit potential at a qualitative level through an industry
analysis, competitive strategy analysis and corporate strategy analysis.
Industry analysis
The performance of the net operating assets employed in a given industry,
as measured by the median RNOA, is shown to vary greatly across
industries. For instance, Penman (2012) reports that over a period from
1963 to 1996, the median RNOA in the restaurants industry was 14.2 per
cent while the median RNOA in the railroads industry was only 7.1 per
cent. The aim of an industry analysis is to assess the average profitability
in each of the industries in which the company is competing.
Porter (1980) argues that the average profitability in an industry is
affected by five forces: rivalry among existing firms, threat of new
entrants, threat of substitute products, bargaining power of buyers and
bargaining power of suppliers. The potential for generating abnormal
profitability is determined by the intensity of actual and potential
competition (rivalry among existing firms, threat of new entrants, threat
of substitutes). The actual abnormal profitability is determined by the
relative bargaining power of the industry compared with that of its
suppliers and buyers.
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Degree of actual and potential competition

The degree of actual and potential competition affects the average
profitability of an industry through the prices set by firms. In order to
facilitate the exposition, consider an industry consisting of a very large
number of similar firms supplying homogeneous goods. If the number of
firms is large enough, microeconomic theory suggests that prices are set
equal to the firms’ marginal cost (perfect competition). On the other hand,
if the industry consists of a single firm, this firm sets prices in such a way
that the marginal revenue is equal to the marginal cost (monopoly). Prices
in the monopolistic setting exceed prices in the perfect competition setting.
If accounting is unbiased, abnormal profitability can not be achieved in
the perfect competition setting. Both the monopolistic and the perfect
competition settings are extreme settings, however. So let us consider a
more realistic setting consisting of a small number of competing firms
(oligopoly). In the latter setting, other things being equal, the smaller
the number of firms, the higher the prices set by firms and the higher the
economic rents derived by firms in the industry. The prices set by firms may
also be affected by the threat of entry and substitutes even in monopolistic
settings. The threat of entry and substitutes generates limit prices which
may be binding.
The rivalry among existing firms is determined by the industry growth rate,
the concentration and balance of competitors, the degree of differentiation
and switching costs, the ratio of fixed to variable costs, economies of scale
and excess capacity. The threat of new entrants is determined by economies
of scale, any first-mover advantage, access to distribution channels and
relationships, and legal barriers. The higher the economies of scale,
the stronger the first-mover advantage, the more difficult the access to
distribution channels and relationships; and the taller the legal barriers, the
higher the barriers to entry, and hence, the lower the threat of new entrants
to an industry’s incumbent firms.
The threat of substitutes is determined by the relative performance and
price of the substitutes and on customers’ willingness to substitute.
Bargaining power of buyers and suppliers

The bargaining power of buyers is determined by both their price sensitivity
and their relative bargaining power. The price sensitivity of buyers captures
the extent to which they care about prices. The relative bargaining power
of buyers captures the extent to which they are likely to succeed in forcing
prices down.
The price sensitivity of buyers is determined by the extent to which the
product is differentiated, the magnitude of switching costs, the contribution
of the product or service in the buyers’ cost structure, and the importance
of the product to the buyers’ product quality. Other things being equal, the
lower the product differentiation and switching costs, the higher the price
sensitivity of buyers. Other things being equal, the higher the contribution
of the product to the buyers’ cost structure and the lower the contribution of
the product to the buyers’ product quality, the higher the price sensitivity of
buyers.
The relative bargaining power of any party depends on the cost to each
party of not completing the transaction with the other party. The relative
bargaining power of buyers is hence determined by the volume of
purchases made by a single buyer, the number of buyers relative to the
number of suppliers, the number of alternative products available to the
buyer, buyers’ switching costs and buyers’ threat of backward integration.
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Other things being equal, the higher the volume of purchases made by
a single buyer, the lower the number of buyers relative to the number of
suppliers, the higher the number of alternative products available to the
buyers, the lower the buyers’ switching costs, and the more credible the
threat of backward integration, the higher the relative bargaining power of
the buyers.
The analysis of the bargaining power of suppliers is a mirror image of the
analysis of the bargaining power of buyers. It is determined by both the
price sensitivity and relative bargaining power of the suppliers’ buyers.
The bargaining power of the suppliers is hence increasing in the extent
to which the suppliers’ products are differentiated, the credibility of their
threat of forward integration and the importance of the product to the
buyers’ product quality. In contrast, the bargaining power of the suppliers
is decreasing in the importance of the product in the buyers’ cost structure.
Application to the airline industry

As shown in Table 6.1, the median ROCE in the airline industry over the
1963–96 period in the US was 12.4 per cent, which is close to the median
ROCE across all industries. This ROCE was generated by a low RNOA
of 9 per cent but did benefit from a high leverage with a FLEV of 0.841.
Business performance in the US airline industry, as measured in Table 6.1,
has thus been poor, even though, as argued later on, it is likely to overstate
the true underlying economic reality. Let us apply the industry analysis
framework in order to explain the poor business performance of the airline
industry, whether in the US or in other parts of the world.
As shown in Table 6.1, the ratio of fixed to variable costs, as measured
by OLLEV, is the second highest in the sample of industries analysed. A
high ratio of fixed to variable costs provides airlines strong incentives to
cut prices in order to increase capacity utilisation. There is indeed casual
evidence suggesting that price wars are common in the airline industry.
The airline industry is furthermore characterised by high exit barriers
as its main assets, the planes, are highly specialised assets which, with
a few exceptions, are of no use in other industries. The concentration in
the airline industry has been historically quite low. Differentiation and
switching costs in the airline industry are furthermore also low. Rivalry
among existing firms is hence high.
First-mover advantage and legal barriers were historically high but have
come down quite dramatically in the last 15 years. Historically, most
countries in Europe and Asia had national carriers and flights between two
countries were governed by bilateral agreements. In 1992, however, the
EU took measures to liberalise internal air travel between member states.
The EU and the US are currently negotiating in order to liberalise air travel
across the Atlantic Ocean. Emerging economies within Asia are liberalising
their skies too. Access to channels of distribution was historically a
problem for new entrants. The emergence of the internet, however,
removed this problem. The threat of new entrants is thus high. There is
certainly a lot of casual evidence suggesting that the rate of entry in the
airline industry in the past decades has been very high with a number of
entrants, like Ryanair and EasyJet in Europe and Tiger Airlines in Asia,
becoming significant players in the industry.
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ROCE(%) RNOA(%) FLEV

Pipelines 17.1 12.0 1.093
Tobacco 15.8 14.0 0.307
Restaurants 15.6 14.2 0.313
Printing and publishing 14.6 13.6 0.154
Business services 14.6 13.5 0.056
Chemicals 14.3 13.4 0.198
Food stores 13.8 12.0 0.364
Trucking 13.8 10.1 0.641
Food products 13.7 12.1 0.414
Communications 13.4 9.1 0.743
General stores 13.2 11.3 0.389
Petrol refining 12.6 11.2 0.359
Transportation equipment 12.5 11.2 0.369
Airlines 12.4 9.0 0.841
Utilities 12.4 8.2 1.434
Wholesalers, non-durable goods 12.2 10.2 0.584
Paper products 11.8 10.2 0.436
Lumber 11.7 10.4 0.312
Apparel 11.6 10.1 0.408
Hotels 11.5 8.5 1.054
Shipping 11.4 9.1 0.793
Amusement and recreation 11.4 10.1 0.598
Building and construction 11.4 10.6 0.439
Wholesalers, durable goods 11.2 9.9 0.448
Textiles 10.4 9.3 0.423
Primary metals 9.9 9.4 0.424
Oil and gas extraction 9.1 8.3 0.395
Rail roads 7.3 7.1 0.556
Table 6.1 Median ROCE, RNOA and FLEV
The airline industry in both the US and Europe is hence very competitive,
which is inconsistent with a high potential for generating abnormal
profitability. In addition, both the suppliers of aircrafts and the unions
of pilots have strong bargaining powers. The average profitability in the
airline industry is hence expected to be quite low.
Activity 6.1
In the spirit of Porter (1980), rate the pharmaceutical and memory chip industries as low,
medium and high on the following dimensions: rivalry, threat of new entrants, threat of
substitute products, bargaining power of suppliers and bargaining power of customers.
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Competitive strategy analysis

Although a firm’s performance is affected by the structure of its industry,
there are significant cross-sectional variations in the performances of firms
within any industry. As an example, consider Ryanair. As shown in prior
chapters, Ryanair has been enjoying high abnormal profitability in a very
competitive industry. The reason for this is that the performance of a firm is
also influenced by the manner in which the firm is competing in its industry,
that is, by the strategic choices made by the firm to position itself in its
industry (competitive strategy). The competitive strategy analysis is used
in order to determine the manner in which the firm is competing in each
of the industries in which it is competing, and whether or not the firm’s
current profitability is sustainable.
There are potentially many ways to compete, but Porter (1985) identifies
two different generic strategies that may provide a firm with a sustainable
competitive advantage. A firm could adopt a cost leadership strategy or a
differentiation strategy. A firm following a cost leadership strategy delivers
the same product or service offered by its competitors at a lower cost. A firm
following a differentiation strategy delivers a unique product or service.
Cost leadership
In a homogeneous market for products or services, the firm with a cost
leadership strategy can make a profit at market prices at which other firms
are unprofitable. In such a market, cost leadership thus leads to abnormal
profitability. Cost leadership may be achieved through economies of scale,
economies of scope, vertical integration, economies of learning, superior
manufacturing processes, simpler product design, lower input costs, lower
distribution costs or efficient organisational processes. Tight cost control is
essential to cost leadership. Firms achieving cost leadership hence tend to
focus on core customers, invest in minimum efficient scale plants, minimise
investment in research, design products minimising manufacturing costs
and minimise overhead costs. Firms achieving cost leadership furthermore
have organisational structures, including management compensation, and
control systems focusing on cost control.
Differentiation
In a heterogeneous market for products and services, a firm with a
differentiating strategy can make abnormal profits by identifying some
attribute of the product or service that is highly valued by customers and
positioning itself in order to meet the customers’ need in a unique way at a
cost that is lower than the price premium the customers are willing to pay.
Differentiation may be achieved by providing superior tangible value in the
form of superior product design, product quality, product variety, customer
service or more flexible delivery. Differentiation may also be achieved
through superior intangible value in the form of a superior brand image
or reputation. In any event, differentiation requires some investment in
marketing, engineering or research and development. Differentiation also
calls for organisational structures, including management compensation,
and control systems fostering creativity or innovation.
Achieving and sustaining competitive advantage

Researchers in strategy historically argued that both cost leadership and
differentiation strategies are mutually exclusive strategies. Firms aiming
to straddle both strategies were furthermore ‘stuck in the middle’ and
condemned to experience low profitability. As explained by Palepu et al.
(2012), ‘these firms run the risk of not being able to attract price conscious
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customers because their costs are too high’ and ‘are also unable to
provide adequate differentiation to attract price premium customers’. A
combination of cost advantage and differentiation is possible, however,
when a firm introduces a significant technological or business innovation.
Deciding to adopt either a cost leadership or a differentiation strategy
does not necessarily lead to abnormal economic profitability. In order to
derive any economic rent in the product markets, the firm has to get some
competitive advantage. Competitive advantage is only gained when the
firm acquires the core competencies required and structures its value chain
appropriately in order to implement and sustain the selected strategy.
Palepu et al. (2012) define ‘core competencies as the economic assets that
the firm possesses’ and ‘the value chain as the set of activities performed
by the firm to convert inputs and outputs’. Competitive advantage once
achieved may not be sustainable over a long period. The sustainability of a
firm’s comparative advantage depends on the uniqueness of the firm’s core
competencies and value chain, and the ease with which other firms can
imitate them.
An analysis of the value chain is important for identifying the key factors
for success. Key success factors relate to the specific strategy elements,
product or service attributes, resources, competencies and business
outcome that influence a firm’s profitability in its industry. An analysis
of the risks associated with the firm’s chosen competitive strategy is
furthermore recommended.
Activity 6.2
Please visit the following web page for an analysis of the key success factors in
technology-based entrepreneurship: www.angelcapitalassociation.org/data/Documents/
Resources/AngelGroupResearch/1d%20-%20Resources%20-%20Research/31%20
Research_Entrepreneurship.pdf
Application to Ryanair
Ryanair follows a cost leadership strategy. Its value chain, that is, its set of
performed activities, is designed to keep costs low:
• Ryanair only flies short-haul point-to-point flights. Flying short-haul
flights allows Ryanair to maximise the number of rotations per aircraft
per day. Flying point-to-point allows Ryanair to avoid the costs of
providing a through service for connecting passengers (such as baggage
transfer costs).
• Ryanair only uses secondary airports. Using secondary airports makes
Ryanair the largest customer in many secondary airports in Europe,
providing Ryanair significant bargaining power when negotiating
landing charges. Using secondary airports also minimises turnaround
times, and hence, maximises aircraft utilisation.
• Ryanair has a homogeneous fleet of Boeing 737s. Having a
homogeneous fleet reduces the cost of training maintenance staff
and allows Ryanair to gain significant discounts with respect to
maintenance and spare parts.
• Ryanair offers a ‘no frills’ service. Ryanair serves beverages and snacks
but only for a fee. Some snacks, such as peanuts, are not sold in order
to minimise the time having to be spent cleaning the aircraft and hence
the turnaround time. Ryanair does not assign seats to passengers.
Assigning seats would cause passengers to spend time looking for their
assigned seats, which would increase the turnaround time.
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• Ryanair does not issue any ticket. Issuing tickets is costly and does not
serve any purpose which can not be served through reservations.
• Ryanair sells 99 per cent of its reservations through its website. Selling
through its website enables Ryanair to cut travel agent commission
costs and gives the airline control and flexibility.
Activity 6.3
In the spirit of Porter (1985), why did Delta, United and American Airlines launch
frequent-flyer programmes in the early 1980s? Would you expect such initiatives to have
been successful?
Corporate strategy analysis

Many firms operate in multiple industries. The corporate strategy analysis
is used to assess the way in which the firm is creating and exploiting
synergies across the industries in which it is competing. Operating in
multiple industries makes sense if the cost of performing a set of activities
across industries within a firm is lower than the cost of doing so in
separate firms. Transactions within a firm may indeed be less costly than
market-based transactions. As discussed by Palepu et al. (2012),
First, communication costs inside an organization may be reduced
because confidentiality can be protected and credibility can be
assured through internal mechanisms. Second, the headquarters
office can play a critical role in reducing costs of enforcing
agreements between organizational subunits. Third, organizational
subunits can share valuable nontradable assets such as
organizational skills, systems, and processes, or non-divisible assets
such as brand names, distribution channels, and reputation.
Intuitively, operating across industries within a firm may be efficient when
co-ordination costs among independent firms within a market involve high
transaction costs arising from either highly specialised assets or market
imperfections such as information and incentive problems. There are,
however, also transactions within a firm. As discussed by Palepu et al. (2012):
Top management of an organization may lack the specialized
information and skills necessary to manage businesses across
several different industries. This lack of expertise reduces
the possibility of actually realizing economies of scope, even
when there is potential for such economies. This problem can
be remedied by creating a decentralised organization, hiring
specialist managers to run each business unit, and providing
these managers with proper incentives. However decentralisation
will also potentially decrease goal congruence among subunit
managers, making it difficult to realise economies of scope.
Whether or not operating in multiple industries is efficient is therefore
context-dependent.
Institutional features of financial reporting

A firm’s financial statements summarise the economic consequences of
its business activities. In any period, the firm’s business activities are too
numerous to be reported individually to outsiders. Disclosing some of
these activities could furthermore be detrimental to the firm’s competitive
position. The firm’s accounting system provides a mechanism through
which business activities are selected, measured and aggregated into
financial statement data.
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Financial reporting is characterised by the following features:

• accrual accounting
• delegation of financial reporting to managers
• generally accepted accounting principles, external auditing and legal
liability.
Accrual accounting
Corporate financial reports are prepared using accrual rather than cash
accounting. The need for accrual accounting arises from investors’ demand
for financial reports on a periodic basis (performance evaluation):
• firms undertake economic transactions on a continual basis
• cash accounting does not report the full economic consequences of the
transactions undertaken in a given period.
Unlike cash accounting, accrual accounting distinguishes between the
recording of costs and benefits associated with economic activities and the
actual payment and receipt of cash. The effects of economic transactions
are recorded on the basis of expected as opposed to actual cash receipts
and payments. Expected cash receipts from the delivery of products or
services are recognised as revenues and expected cash outflows associated
with these revenues are recognised as expenses.
Accrual accounting is based on the realisation, the matching and the
conservatism principles. As explained by Palepu et al. (2012):
Revenues are economic resources earned during a time period.
Revenue recognition is governed by the realization principle
which proposes that revenues should be recognised when (a) the
firm has provided all, or substantially all, the goods or services to
be delivered to the customer and (b) the customer has paid cash
or is expected to pay cash with a reasonable degree of certainty.
In contrast, expenses are economic resources used up in a time
period. Expense recognition is governed by the matching and the
conservatism principles. Under these principles, expenses are (a)
costs directly associated with revenues recognized in the same
period, or (b) costs associated with benefits that are consumed
in this time period, or (c) resources whose future benefits are not
reasonably certain.
More intuitively, revenue is only recognised when the firm makes a sale
to a customer. Accounting then matches the expenses incurred in gaining
revenue against the revenue, Earnings can then be derived as the resulting
difference between revenue and expenses.
Assets are economic resources owned by the firm that are
(a) likely to produce economic benefits and (b) measurable
with a reasonable degree of certainty. Liabilities are economic
obligations of a firm arising from benefits received in the past
that (a) are required to be met with a reasonable degree of
certainty and (b) whose timing is reasonably well defined. Equity
is the difference between a firm’s assets and its liabilities.
Delegation of financial reporting to managers

Accrual accounting involves expectations of future cash consequences of
current events. Accrual accounting is subjective and relies on a variety of
assumptions. A firm’s managers have intimate knowledge of their firm’s
business. Firms’ managers are hence entrusted with the task of making
these assumptions to prepare the financial statements.
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The accounting discretion granted to managers is potentially valuable as it

allows them to reflect inside information in reported financial statements.
As investors view profits as a measure of managers’ performance,
managers, however, have incentives to use their accounting discretion to
distort reported profits by making biased assumptions. The delegation of
financial reporting decisions to corporate managers has therefore both
costs and benefits.
Generally accepted accounting principles, external auditing and

legal liability
Accounting standards, external auditing and legal liability are institutional
features ensuring that managers use their accounting flexibility to
summarise their knowledge of the firm’s business activities and not to
disguise reality for self-serving purposes.
The measurability and conservatism conventions attempt to limit
managers’ optimistic bias by imposing their own pessimistic bias. Uniform
accounting standards attempt to reduce managers’ ability to record similar
economic transactions in dissimilar ways either over time or across firms.
Increased uniformity from accounting standards, however, comes at the
expense of reduced flexibility for managers to reflect genuine business
differences in their firms’ financial statements.
Auditing can be broadly defined as the process of verification of the
integrity of the reported financial statements by an independent
professional. Auditing improves the quality of accounting data by ensuring
that managers use accounting rules and conventions consistently over time
and that their accounting estimates are reasonable.
Legal liability provides incentives for managers to limit any bias in
disclosures and financial reporting. Legal liability also provides incentives
for auditors to supply effort in finding discrepancies and not to collude
with managers.
Implications for corporate financial reporting

Because the mechanisms that limit managers’ ability to distort accounting
data add noise, it is not optimal to use accounting regulation to eliminate
managerial flexibility completely. Accounting leaves considerable
discretion for managers to influence financial statements. A firm’s
reporting strategy, that is, the manner in which managers use their
reporting discretion, has an important influence on the firm’s financial
statements. Corporate managers can choose accounting and disclosure
policies that make it more or less difficult for external users to understand
the true economic picture of their businesses. Accounting rules often
provide a broad set of alternatives from which managers can choose.
Further, managers are entrusted with making a range of estimates in
implementing these accounting policies. Accounting regulations usually
prescribe minimum disclosure requirements, but do not restrict managers
from voluntarily providing additional disclosures.
A superior disclosure strategy will enable managers to communicate the
underlying business reality to outside investors. An important constraint
on a firm’s disclosure strategy is the competitive dynamics in product
markets. Disclosure of proprietary information about business strategies
and their expected economic consequences may hurt the firm’s competitive
position. Subject to this constraint, managers can use financial statements
to provide information useful to investors in assessing their firm’s true
economic performance.
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Managers can also use financial reporting strategies to manipulate

investors’ perceptions:
• They can choose accounting policies and estimates to provide an
optimistic assessment of the firm’s true performance.
• They can also make it costly for investors to understand the true
performance by controlling the extent of information disclosed
voluntarily.
The extent to which financial statements are informative varies greatly.
The process through which analysts can separate noise from information
in financial statements is discussed next.
Accounting analysis
The purpose of an accounting analysis is to evaluate the degree to which a
firm’s accounting captures the underlying economic reality. If accounting is
unbiased, that is, undistorted:
• A firm without any comparative advantage in a very competitive
industry is not expected to generate any abnormal economic
profitability, and hence abnormal return on net operating assets.
• A firm with a strong comparative advantage in an oligopolistic industry
is expected to generate abnormal economic profitability and, hence,
abnormal returns on net operating assets. The stronger the comparative
advantage or the more concentrated the industry, the higher the
abnormal returns on net operating assets.
An accounting analysis enables an analyst to assess the degree of
distortion in a firm’s financial statements and possibly undo any
accounting distortions by recasting the firm’s accounting numbers. The
accounting analysis is hence an essential step in the securities analysis and
valuation framework as it improves the reliability of inferences made from
the financial analysis.
An accounting analysis normally consists of the following elements:
• An analysis of the operating assets and liabilities used in the firm’s
industry. In this context, an analyst will consider the main ‘economic’
operating assets and liabilities and check how these economic assets
and liabilities are captured in the financial statements.
• An analysis of the competitive strategy, key success factors and risks
identified in the strategy analysis. In this context, an analyst will assess
the accounting policies and estimates the firm uses to capture its
competitive strategy and measure its key success factors and risks.
• A ‘red flags’ analysis. In this context, an analyst will look for red flags
pointing towards earnings management. These red flags are also used
by auditors in order to allocate effort when looking for misstatements.
Analysis of the economic operating assets and liabilities used in

the firm’s industry
Consider the main economic operating assets and liabilities used in the
firm’s industry. How are these economic assets and liabilities captured by
corporate financial reporting?
Non-recognition of these economic assets and liabilities will lead to biased
accounting. As an example, consider the higher education (universities)
industry. The main economic assets are human capital (academics) and
alumni networks. High-quality academics and strong alumni networks
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tend to lead to better jobs and higher wages for graduates and enable
universities to charge higher fees. Both high-quality academics and strong
alumni networks are hence potentially economic assets as they provide
future benefits coming in the form of higher fees that future students
are willing to pay. In most countries, universities are prevented from
recognising either human capital or alumni networks as assets in their
balance sheets. Non-recognition of human capital and alumni networks
will typically lead to undervalued assets and overstated returns on capital.
Activity 6.4
Why is human capital not recognised as an asset in balance sheets?
Application to Ryanair
The main ‘economic operating assets’ used in the airline industry are
planes. Ryanair owns most of its planes. In 2006, Ryanair initiated a
leasing programme. As of the end of the 2011 fiscal year, Ryanair operated
272 planes, with 51 being leased. These leases are long-term leases with
substantial penalties for cancelling them. Economists would hence argue
that these leases offer the same level of risk and benefits as ownership and
should hence be accounted for in the same way as ownership. In line with
industry, however, Ryanair accounts for leases using the operating lease
method. Under this method, Ryanair does not recognise the planes leased
as assets but instead recognises lease payments whenever incurred as
operating expenses. However, in order to portray the underlying economic
reality, Ryanair should use the financial (or capital) lease method. Under
the latter method, the present value of the future lease payments is
capitalised as an operating asset as well as a financial liability (debt).
For a fast-growing company such as Ryanair, business performance, as
measured by RNOA under the operating lease method, is hence higher
than the true underlying performance derived under the financial lease
method as long as the interest implicit in the lease charge is lower than
RNOA.
Ryanair follows an aggressive growth strategy. As part of this growth
strategy, Ryanair acquired 25.2% of the capital of Aer Lingus in 2007.
Ryanair made a second offer to acquire all the remaining ordinary shares
in December 2008, but was unsuccessful. Ryanair took over Buzz, a
rival low-cost airline. This acquisition generated a substantial amount of
goodwill, which Ryanair is amortising over a period of 20 years. Goodwill
is part of the price paid for Buzz (the excess over the market value over
the book value of Buzz). Amortising goodwill implies that the value
generated by the takeover is decreasing in a linear way through time. In
order to portray the underlying economic reality (as is now recommended
by IAS/IFRS), goodwill should be recognised as an asset but should not be
amortised. Instead, goodwill should be subject to an impairment test every
year. More information on goodwill impairment tests can be found on
www.nysscpa.org/cpajournal/2002/0302/features/f033202.htm
Activity 6.5
What are the main economic operating assets used in the pharmaceutical industry? How
are the economic assets captured by corporate financial reporting?
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Analysis of the firm’s competitive strategy, key success factors

and risks
How are the parameters of the firm’s competitive strategy, key success
factors and risks captured by corporate financial reporting? Are they
captured in a way which is consistent with the underlying economic
reality? A negative answer to the last question will typically result in bias.
As a first example, consider Zara, a very successful firm in the retail
clothing industry. Zara follows a differentiation strategy based on design
and brand image. In order to build its brand, Zara is investing substantial
amounts of money in advertising. Zara’s brand should enable it to sell
clothes in future years at high average prices (and hence gross margins).
Zara’s brand is hence an economic asset. However, Zara is prevented by
accounting standards from recognising its internally generated brand as
an asset in its balance sheet. Instead, Zara has to expense its advertising
expenditure in the year in which it is incurred.
As a second example, consider a manufacturer of white goods following
a differentiation strategy based on offering extended warranties. For
accounting to be unbiased, the firm must create an operating liability
adequately reflecting the firm’s exposure.
Analysis of red flags

As explained earlier, managers have considerable discretion in choosing
accounting policies and making accounting estimates. Managers also
have incentives to use their discretion to dress up financial statements
and manage earnings. A red-flags analysis enables an analyst to evaluate
how managers exercise their accounting flexibility. It provides the
analyst with red flags pointing at questionable accounting quality and
earnings management. Although these flags do not necessarily imply
earnings management, they suggest that the analyst should gather more
information in order to explain them. It is hence not surprising that
red flags are used by auditors in order to allocate effort when looking
for misstatements in their analytical reviews. An obvious red flag is the
presence of a qualified audit opinion or unjustified change in the external
auditor, which may signal the use of aggressive accounting or opinion
shopping. Following are some red flags discussed by Palepu et al. (2012),
many of them being used by Lev and Thiagarajan (1993) to construct an
indicator of overall accounting quality and discussed further in this study
guide in Chapter 10.
• Unexplained changes in accounting policies may signal that the firm’s
managers are using their discretion in accounting in order to manage
earnings.
• Unexplained transactions that boost reported earnings. Unexplained
transactions, such as disposals of operating assets, equity interests
in other firms, or debt for equity swaps, may be undertaken with the
objective of boosting reported earnings when business performance is
poor.
• An increasing gap in accruals. There is no reason to expect reported
earnings to be equal to the cash flow generated by the firm’s
operations. An increasing gap in accruals, that is, the difference
between reported earnings and the cash flow generated by the firm’s
operations may, however, signal changes in the firm’s accounting
estimates.
• An increasing gap between income before taxes and taxable income.
There is no reason for income before taxes (appearing in the income
83
statement) to be equal to taxable income (income as far as the taxation

authorities are concerned). An increasing gap between income before
taxes and taxable income may, however, signal a use of more aggressive
accounting policies and estimates.
• A disproportionate increase in inventory in relation to sales. A
disproportionate increase in finished goods inventory over the increase
in sales may signal difficulties in generating sales, forthcoming price
cuts and inventory write-offs. Alternatively, a disproportionate increase
in raw materials over the increase in sales may signal inefficiencies in
procurement or manufacturing and forthcoming decreases in growth
margins.
• A disproportionate increase in receivables in relation to sales may
signal a more aggressive selling strategy involving a relaxation of the
firm’s credit policies. Alternatively, it may signal an artificial loading
up of the firm’s distribution channels in order to record revenue. Either
case may lead to forthcoming receivables write-offs.
• Large fourth-quarter adjustments. Interim financial statements, and
hence quarterly earnings, are usually not subject to any audit. The
annual report, however, is. Managers thus have considerable discretion
in making their accounting estimates in the interim financial statements
but less so in the annual report. A consistent pattern of large fourth-
quarter adjustments may hence signal earnings management.
• Unexpected large asset write-offs may signal that the firm’s managers
are not reflecting changes in the firm’s fortune into accounting
estimates in a timely manner.
• Transactions between related entities may not take place at market
prices and may be used for earnings management purposes.
While the list of red flags points towards potentially questionable
accounting quality, it does not necessarily imply poor accounting. Instead
it merely suggests that the analyst should gather more information in
order to understand whether or not the accounting choices made by
managers are consistent with the underlying economic reality. For each of
the red flags appearing in our list, there are interpretations consistent with
questionable accounting and earnings management. But there is also an
interpretation which is consistent with unbiased accounting. As suggested
by Palepu et al. (2012), it is ‘best to use the red flag analysis as a starting
point for further probing, not as an end in itself’.
Activity 6.6
Find an interpretation of the ‘unusual increase in accounts receivables in relation to sales’
that is consistent with unbiased accounting.
Chapter summary
This chapter’s aim was to explain a firm’s profitability as measured by the
returns on investment (equity or net operating assets) introduced in prior
financial analysis chapters.
We already knew that any abnormal return on common equity must
be attributed to an abnormal ‘economic’ performance in the product
markets, an abnormal ‘economic’ performance in financial engineering
or accounting distortions. This chapter introduced tools to measure
qualitatively any firm’s profit potential through an industry analysis,
competitive strategy analysis and corporate strategy analysis. This chapter
also introduced tools to evaluate the degree to which a firm’s accounting
84
captures the underlying economic reality. These tools consisted of an

analysis of the economic operating assets and liabilities used in the
industry, an analysis of the way the firm’s competitive strategy, key success
factors and risks were captured through corporate financial reporting, and
a red-flags analysis.
Key terms
accounting analysis generally accepted accounting principles
accounting rules accruals industry analysis
bargaining power of buyers industry structure
bargaining power of suppliers legal liability
competitive advantage red-flags analysis
competitive strategy analysis rivalry among firms
core competencies strategy analysis
corporate strategy analysis success factors
cost leadership differentiation threat of new entrants
external auditing threat of substitute products

• concisely recall the institutional setting underlying accounting and
strategy analysis
• adequately recognise the effect of industry structure in the industry’s
average profitability
• outline the sources of a firm’s competitive advantage in detail
• carefully identify potential biases in a firm’s financial statements
• accurately perform an accounting analysis in an independent manner
• briefly discuss key pitfalls of accounting analysis
• explain why both strategy analysis and accounting analysis are key
steps in the securities analysis and valuation framework in detail.

1. Porter (1980) argues that the average profitability in an industry
is affected by five forces. What are these forces? What are the
determinants of these forces?
2. Penman (2012) reports that the tobacco industry did enjoy high
profitability from 1963 to 1996, with a median RNOA of 14 per cent.
Using an industry analysis, explain why the profitability of the industry
was so high.
3. Within the European airline industry, the low-cost segment has
been growing very fast over the past decade. How easy would it be
for traditional European airlines to imitate the strategy used by a
successful low-cost airline such as Ryanair?
4. Should firms be allowed to capitalise research and development
expenditure in their balance sheets? Discuss.
85
Notes
86
Part 2: Securities valuation
Part 2: Securities valuation
87
Notes
88
Chapter 7: Prospective performance evaluation and valuation
Chapter 7: Prospective performance

evaluation and valuation
Introduction
Prospective analysis includes two tasks (forecasting and valuation), and
aims to provide forecasts in order to value the firm. Thus it represents the
core step of fundamental analysis.
Forecasting is a matter of financial statement analysis for the future. In
particular, forecasting is a way of summarising strategic analysis, financial
analysis and accounting analysis (as discussed in the previous chapters)
adopting a forward-looking perspective. Forecasting aims to answer
the following question: how will the drivers of abnormal earnings and
earnings growth differ in the future from their current levels? There are
two approaches to forecasting: simple forecasting and full-information
forecasting, which differ on the information set used and on the set of
drivers of profitability and growth taken into account.
Valuation is the process of converting forecasts into an estimate of the
value of the firm. There are a variety of contexts in which forecasts are
usefully summarised in a valuation both at the internal and external level.
Within the firm, in capital budgeting and strategic planning, managers
need to consider how a specific project or a larger set of actions would
affect the value of the firm. Outside the firm, security analysts provide
valuations to support their buy/sell recommendations, and potential
acquirers use valuations to price the target company. Also, valuation is used
to price an initial public offering. Even credit analysts should at least consider
the value of the firm’s equity as a proxy for the risk of the lending activity.
In this chapter, we will first focus on simple forecasting and valuation. In
order to see how applicable the simple forecasts are we will provide some
empirical evidence on the typical behaviour across firms and industries of
the main profitability and abnormal earnings measures involved in simple
forecasts. We will thus draw some conclusions about the cases under
which simple forecasting provides good approximations. Finally, we will
focus on full-information forecasting, and will propose a framework for the
development of pro-forma financial analysis.
Aim
The aim of this chapter is to move from the analysis of where the firm
is currently (financial analysis and accounting analysis) to the analysis
of where the firm will be in the future (prospective analysis). We will
develop a framework to enable the analyst to get good and quick
forecasts (and valuations), known as simple forecasting, based on
information in the current financial statements. Also, we will investigate
how applicable simple forecasts are on the basis of the typical historical
patterns of the profitability and abnormal earnings measures involved in
the simple forecasts. Finally, we will construct a framework to develop
full-information forecasts of business profitability based on the full set of
information and drivers, and we will investigate how to produce a pro-
forma income statement and balance sheet.
89
Learning outcomes
• explain how forecasting (and valuation) can be conducted
• explain what forecasts can be obtained from current financial
statements
• describe how simple forecasts give simple valuations and calculate
simple valuations from simple forecasts
• outline the typical behaviour of the measures on which simple
forecasting methods place assumptions (return on net operating assets,
return on common equity, abnormal earnings, abnormal operating
income and financial leverage)
• know when simple forecasting and simple valuation work as reasonable
approximations
• understand how to get full-information forecasts
• conduct full-information pro-forma analysis.
Essential reading
Further reading
practice’, Review of Accounting Studies (6), 2001, pp. 109–54.
Works cited
Ball, R. and R. Watts ‘Some time series properties of accounting income’,
Journal of Finance 27(3), 1972, pp.663–81.
Brown, L.P. and M. Rozeff ‘Univariate time-series models of quarterly
accounting earnings per share: A proposed model’, Journal of Accounting
Research (17), 1979, pp.179–89.
Fama, E.F. and K.R. French ‘Forecasting profitability and earnings’, Journal of
Business 73(2), 2000, pp.161–75.
Foster, G. ‘Quarterly accounting data: Time series properties and predictive-
ability results’, The Accounting Review (52), 1977, pp.1–21.
Freeman, R.N., J.A. Ohlson and S.H. Penman ‘Book rate-of-return and
prediction of earnings changes: an empirical investigation’, Journal of
Accounting Research 20(2), 1982, pp.639–53.
Penman, S. ‘An evaluation of accounting rate-of-return’, Journal of Accounting,
Auditing and Finance (Spring), 1991, pp.233–55.
Watts, R.L. and R.W. Leftwich ‘The time series of annual accounting earnings’,
Journal of Accounting Research (Autumn), 1977, pp.253–71.
Forecasting: simple forecasting and full-information

forecasting
Simple forecasting (and valuation) is based on historical (current and
past) financial statements. The focus is only on the (limited) information
set available in the financial statements. Thus the idea is to analyse
the present and past financial statements to forecast the future. Simple
90
forecasts embed all the concepts needed for forecasting, but they use fewer
factors to make the forecasts, and also take into account no information
outside the financial statements (just to give some examples, they do not
consider information on the macroeconomic conditions, on the industry
and competitors, on the business and on the strategic plans of the firm).
Simple valuations meet an important practical criterion in any valuation:
parsimony (or rather the possibility of using fewer pieces of information to
obtain an estimate of the firm’s value).
Full-information forecasting (and valuation) instead takes into account
the full set of factors that drives business profitability and growth, and
is based both on the information from the financial statements and on
the information outside the financial statements. It emerges immediately
that the focus of full-information forecasting is primarily on operating
activities, and the attention is thus on business profitability and its
determinants (as described in Chapter 5). Full-information forecasting
forecasts the full set of drivers of operating income and net operating
assets, and from these forecasts it builds up an explicit forecast of
abnormal operating income and abnormal operating income growth
from which valuation can be made. In other words, it aims to answer
the following question: how will future profitability and growth evolve
from their current levels, and what forecasts can be made on the basis
of current levels? As described in Chapter 5, financial statement analysis
(aiming at identifying the determinants of performance, or rather the
drivers of business profitability) is an analysis of the present and the past.
However, these same factors drive future profitability and growth. Thus
the analysis of drivers provides information to forecast the future. And
also it provides the framework for forecasting. In short, forecasting is the
analysis of the drivers of profitability and growth with a forward-looking
perspective in mind, or rather it is a matter of financial statement analysis
of the future.
Simple forecasts are quick approximations, but they serve as a starting
point to full-information forecasts (in other words, as a benchmark for full-
information forecasting). They are dirty, but in many cases, particularly for
relatively mature firms, simple forecasts can provide reasonable valuations
because financial statements aggregate considerable information and can
be a reasonable indicator for the future. In general, simple forecasts are
justified if the benefits of reduced information outweigh the cost of having
only approximate valuations. They basically ensure simplicity at the
expense of accuracy.
The aim of this chapter is to answer the following questions: What
forecasts (and valuations) can be made solely on the basis of current and
past financial statements? How good are the approximations obtained by
simple forecasts? What forecasts can be made by taking into account the
full set of profitability drivers and the information both from and outside
the financial statements?
Simple forecasting techniques

Simple forecasts (and valuations) assume that current profitability and/
or growth will continue in the future. Their aim is to forecast earnings and
abnormal earnings as regards to three earnings components: operating
income, net financial expense and comprehensive earnings. In particular,
three simple forecasting methods have been derived on the basis of
several assumptions about the behaviour of profitability and growth (for a
detailed description see Penman, 2012):
91
• forecasting from book values: SF1 forecasting

• forecasting from earnings and book values: SF2 forecasting
• forecasting from accounting rate of return: SF3 forecasting.
Each of these methods will be described in the next sections.
Forecasting from book values (SF1 forecast)

Forecasting from book values (SF1) derives forecasts from balance sheet
amounts, by multiplying the so-called required return to the relevant
balance sheet amount. The required rate of return is the expected earnings
rate, which indicates future earnings expected if the book values earn at this
rate. Given the balance sheet amounts, Table 7.1 shows the one-year-ahead
forecasts of the earnings and abnormal earnings components related to the
three balance sheet sections representing, respectively, operating, financing
and equity activities. The assumption is that next period’s earnings are this
period’s closing book values multiplied by the required return. In particular:
• Operating income (OI) is forecast by expecting net operating assets
(NOA) to earn at the required rate of return for operations (rF, as
described in Chapter 5).
• Net financial expenses (NFE) are forecast by expecting net financial
obligations (NFO) to incur the expense at the cost of net debt (rD).
• Comprehensive earnings (CE) are forecast by expecting the common
shareholders’ equity (CSE) to earn at the required rate of return for
equity (rE).
SF1 always forecasts that the abnormal earnings (AOI, ANFE and AE) for
the relevant balance sheet components will be zero.
Earnings forecast Abnormal earnings

forecast
Operating E(OIt+1) – r*NOAt E(AOIt+1) = 0
Financing E(NFEt+1) – rD*NFOt E(NFEt+1) = 0
Earnings E(CEt+1) – rE*CSEt E(AEt+1) = 0
Table 7.1 Simple forecasts from SF1

The implied valuations (as summarised in Table 7.2) are based on balance
sheet measures only. Thus the intrinsic value of common equity is equal
to the book value of CSE, and the intrinsic value of operating activities is
equal to the book value of NOA. SF1 valuations are usually appropriate for
the financing activities (because the relevant balance sheet amount, NFO,
is typically at fair value), but tend not to be appropriate for NOA and CSE.
Note that even if investments are marked to market, the market value on the
balance sheet may not be a good indicator of future earnings (nor of value) if
the market prices at which they are recorded are not efficient prices.
Intrinsic value
Net operating assets VFt = NOAt
Net financing obligations VDt = NFOt
Common stockholders equity VEt = CSEt
Table 7.2 Simple valuations from SF1
92
Forecasting from earnings and book values (SF2 forecast)

As the balance sheet is an imperfect predictor, forecasts can be derived
both from current income statement and balance sheet numbers.
Forecasting from earnings and book values (SF2) works as follows. On
the one hand, current earnings are used as a predictor, by assuming that
future earnings are equal to current earnings. On the other hand, changes
in the relevant balance sheet amount are assumed to earn the required
return (i.e. if there has been an increase in the relevant balance sheet
amount, there will be an increase in the future earnings, and the addition
to the balance sheet amount will earn at the required return).
As shown in Table 7.3, SF2 forecasts that next period’s earnings will be
the same as in the current year, adjusted for changes in the balance sheet
earning at the required return (increase in earnings proportional to the
increase in book value, earning the required return). This means that the
SF2 forecast of operating income predicts that current income from assets
in place at the beginning of the current year earning at the current rate of
return will continue, but any addition to assets over the year will earn at
the required return.
Abnormal earnings will be the same as in the current year, which implies
that abnormal earnings growth will be zero. Abnormal earnings are
expected to be as they are now perpetually into the future.
Earnings forecast Abnormal earnings forecast

Operating E(OIt+1) = OIt + r*∆NOAt E(AOIt+1) = AOIt = OIt – r*NOAt–1
Financing E(NFEt+1) = NFEt + rD* ∆NFOt E(ANFEt+1) = ANFEt = NFEt – rD * NFO t–1
Earnings E(CEt+1) = CEt + rE* ∆CSEt E(AEt+1) = AEt = CEt – rE* NCSEt–1

The implication for valuation (as shown in Table 7.4) is that the intrinsic
value of operations (Vt) is obtained by just capitalising the SF2 forecast OI
for next year:
Vt = NOAt + (AOI t / r ) = NOAt + [OI t +1 − (NOAt × r )] / r = OI t +1 / r
(7.1)
If Vt can be calculated by capitalising forward OI, it must be that abnormal
OI growth (AOIG) is expected to be zero.
Similarly, the intrinsic value of the net financial obligation is obtained by
capitalising the SF2 forecast of NFE for next year, the intrinsic value of
equity is obtained by capitalising the SF2 forecast of CE for next year.
Intrinsic value
Net operating assets Vt = NOAt + AOIt/rF = OIt+1/r
Net financial VDt = NFOt + NFEt/rD
obligations
Common stockholders VEt = CSEt + AEt/rE
equity
93
Activity 7.1*
On the basis of the financial statements of Ryanair provided in Chapter 3, use SF2 to
estimate the intrinsic values of Ryanair’s net operating assets and equity as of 2011.
With strictly positive abnormal earnings, intrinsic values derived with SF2
forecasts strictly exceed values derived with SF1 forecasts.
Forecasting from current accounting rate of return (SF3 forecast)

Forecasting from current accounting rate of return (SF3) predicts that a
firm will maintain its current rate of return in the future, and the relevant
balance sheet components will earn at the current profitability. SF3
predicts that all assets will earn at the current profitability, as opposed to
SF2 (assets in place at the beginning of the current period). As shown in
Table 7.5, the SF3 forecast of operating income predicts that all the assets
(both those in place at the beginning of the current year and those added
over the period) will earn at the accounting rate of return: the NOA in
place at the beginning of year t+1 (equal to those at the end of year t,
NOAt) will earn – in year t+1 – at the RNOA of the current year (RNOAt).
Abnormal earnings will change, not because of changes in profitability, but
because of changes in the relevant balance sheet amounts earning at the
current profitability.
Earnings forecast Abnormal earnings forecast
Operating E(OIt+1) = RNOAt*NOAt E(AOIt+1) = (RNOAt) – r*NOAt
Financing E(NFEt+1) = NBCt*NFOt E(ANFEt+1) = (NBCt – rD) *NFO t
Earnings E(CEt+1) = ROCEt*CSEt E(AEt+1) = (ROCEt – rE)*CSEt

In order to derive implied simple valuations, let us assume that we use
SF3 forecasts for all future periods, that is, profitability will be the same
as current rates indefinitely, but relevant balance sheet items will continue
to grow at the current rate g. Thus we need to capitalise the forecast of
E(AOI) as a perpetuity with growth.
Activity 7.2
Try to derive mathematically the simple valuation of NOA under SF3. Then compare your
derivation with the one shown at the end of the subject guide.
The expected growth in the relevant abnormal earnings (denoted by g)

is given by the current growth in the relevant balance sheet amounts
(it is thus given by information in the balance sheet), i.e. the growth in
abnormal operating income is given by the current growth of NOA because
RNOAt+1= RNOAt:

(7.1)
Thus:
(7.2)
94
Intrinsic value
Net operating assets Vt = NOAt *[(RNOAt – g)/(r – g)]
Net financial VDt = NFOt *[(NBCt-g)/(rD – g)]/rD
obligations
Common stockholders VEt = CSEt *[(ROCEt – g)/(rE– g)]
equity
Activity 7.3*
The financial statements of Ryanair provided in Chapter 3, assuming g =1.5 per cent,
use SF3 to estimate the intrinsic values of Ryanair’s net operating assets and equity as
of 2011. Then compare results obtained with SF1, SF2 (Activity 7.1) and SF3, and try to
explain the reasons for the differences in valuation results.
With current strictly positive abnormal earnings, intrinsic values derived

with SF3 forecasts strictly exceed values derived with SF2 forecasts.
SF3 can be used as a valuation tool. In the first place, it can be used in
sensitivity analysis, in order to answer to the following questions: How
does the valuation change, as inputs (RNOA and growth rate) to the
model change? How is the valuation sensitive to alternative speculations
about the future? Second, SF3 allows analysts to impute the market’s
forecast (i.e. do reasonable scenarios justify any of the market forecasts)?
Finally, SF3 enables investors to discover the value in the analyst’s forecast
(i.e. is the analyst supplying a forecast that can be made from the financial
statements, or does it reflect any other information)?
Empirical evidence on the patterns of accounting measures

To understand how applicable the simple valuations are, we need to
consider the typical behaviour of the measures on which simple forecasting
methods place assumptions. (Please note that these patterns are also
useful in full-information forecasting, as we will discuss in the section
‘Full-information forecasting’). In order to do so, we will consider the
empirical evidence on how the aggregate of US-listed firms has typically
behaved over a long period of time. The underlying idea is that a specific
simple forecasting method will be applicable – at least at an aggregate
level – if its implied assumptions are coherent with the empirical evidence
for a typical listed firm. More in general, typical patterns are a good point
of departure when forecasting for individual firms.
We will consider both the empirical evidence related to the assumptions
implied under the valuation of CSE (behaviour of ROCE and AE) and the
empirical evidence relevant to judge the assumptions implied to value
NOA (behaviour of RNOA and AOI). In particular, we will first examine the
empirical evidence on the behaviour of accounting rates of returns (ROCE
and RNOA), then we will move to the behaviour of abnormal earnings (AE
and AOI) and finally we will focus on the behaviour of the determinants of
RNOA (PM and ATO).
Accounting rates of return (ROCE and RNOA)

Changes in annual earnings are unpredictable, that is, annual earnings
follow approximately a random walk (i.e. next year’s earnings will be
equal to current earnings plus a random error) or a random walk with
a drift, which means that next year’s earnings will be equal to current
95
earnings plus a random error plus an intercept. In symbols: Yt = α + Yt-1+

εt. The intercept allows for changes in annual earnings to be on average
non-zero, and represents a relevant benchmark for the firm taking into
account its risk and other characteristics. The random walk with a drift
model can be interpreted as implying that annual earnings, on average,
increase by α per year, but are otherwise unpredictable. More precisely, the
consensus is that earnings follow a martingale (possibly with drift) so that,
conditioned on past earnings, earnings changes (net of drift) are drawn
from a distribution with mean zero. In symbols: E(Yt+1Y0…Yt) = Yt. This
evidence has been documented among the others in Ball and Watts (1972)
and Watts and Leftwich (1977). Intuitively, the random walk model implies
that annual earnings are equally likely to go up or down on any particular
year irrespective of what happened to the earnings in the previous year.
Changes in value are thus independent of one another, and investors
cannot gain information about future annual earnings on the basis of past
annual earnings.
Note that the evidence is different as regards the time-series behaviour of
quarterly earnings, which can be represented naively as a seasonal random
walk, where expected earnings are simply earnings for the corresponding
quarter of the previous year, and not the most recent quarter. However,
several studies (see, among others, Brown and Rozeff, 1979; Foster,
1977) have shown that quarterly earnings follow a more complex process
characterised by positive correlation between adjacent seasonally adjusted
first differences in quarterly earnings that are one, two and three quarters
apart, and negative serial correlation between seasonally adjusted
differences in quarterly earnings that are four quarters apart.
Should we expect the same random-walk behaviour for ROCE and other
measures of returns on investments? The answer is no. Let us understand
what happens. Firms with unusually high (low) levels of ROCE tend to
experience earnings decline (or increase) over time. This documents the
‘mean-reverting’ behaviour for ROCE within as well as across industries:
high or low measures revert to the mean over time.
The mean reversion pattern reflects exactly what the economics of
competition would predict. The tendency of low ROCE to rise reflects
the mobility of capital away from unproductive ventures and towards
more profitable ones: the prospect of failure or takeovers gives firms
an incentive to allocate capital towards more productive uses; and the
incentive is stronger the further ROCE is below its mean. Conversely, the
tendency of ROCE to fall is a reflection of high profitability attracting
competition. The incentives of other firms to mimic their rivals increase
when the rivals are more profitable, and this drives out the competitive
advantage. Despite the general tendency, there are some firms whose
ROCE may remain at above or below normal levels for long periods of
time. This could reflect the ability to maintain the strength of a brand
name or it is purely an artefact of accounting methods. (Try to provide
some examples before reading on.) Good examples of high ROCEs due
to accounting artefacts are represented by pharmaceutical firms, football
clubs and universities. Their major assets (respectively, the intangible
value of research and development, football players and teachers) are not
recorded in the balance sheet and are thus excluded from the denominator
of ROCE. For all these firms we can reasonably expect high ROCEs, even in
the face of strong competitive forces.
96
Activity 7.4
Suppose you are an analyst of an airline company that mainly leases the aircrafts in its
fleet. What is the impact of this policy (lease instead of direct purchase) on the company’s
ROCE? What would be the impact on ROCE of a change in this policy (i.e. from leases to
direct purchase)?
Figure 7.1 documents the mean reversion behaviour for ROCE. The
empirical evidence is represented by typical values for ratios of NYSE and
AMEX firms over the period 1963–99 as provided by Nissim and Penman
(2001). The methodology used to provide this evidence is based on
ranking each ratio in a base year (year 0), forming 10 portfolios from the
ranking and then tracing median and mean values for each portfolio over
the next five years. The firms with the highest 10 per cent of the relevant
measure are shown in the top group, and the firms with the lowest 10
per cent in the bottom group. The most profitable group of firms (initially
with an ROCE of more than 30 per cent) experienced a decline to 20 per
cent in three years. Those firms with the lowest initial ROCE (–15 per
cent) experienced an increase to breakeven after two years. In short, firms
with above-average or below-average rates of ROCE tend to revert to a
‘normal’ level within three to 10 years. Based on past history for US firms,
we expect the normal level of ROCE to be in the range 10 to 14 per cent
(similar evidence is provided in Freeman, 1982; Ohison and Penman, 1982
and Penman, 1991).
0.4
0.3
0.2
Portfolio 10 (Best performance)

Portfolio 8
ROCE
0.1 Portfolio 3
Portfolio 1 (Worst performance)
0
0 1 2 3 4 5 6
-0.1
-0.2
Years from the portfolio formation
Figure 7.1 The behaviour of ROCE

Source: Adapted from Nissim and Penman (2001, p.141)
The main methodological issue of this approach relates to survivor bias:

the test is restricted to firms with a long earnings history (in Nissim and
Penman, 2001, 36 years of data are required). The behaviour of the rate
of return for long-term survivors may not be representative. To overcome
this methodological issue, cross-section regressions of changes in rate
of returns on lagged changes and other variables can be used (Fama
and French, 2000). This allows for the use of large samples of firms and
minimises survival requirements to test for predictability. A further concern
when using cross-section tests refers to the need to allow for residual
cross-section correlation (i.e. the standard errors of the regression slopes
have to be adjusted for the correlation of regression residuals across
firms).
97
Finally, the representation of the pattern in the behaviour of ROCE

requires us to test whether there is non-linearity in the autocorrelation in
the changes in ROCE, which would require us not to use a linear model
with a uniform rate of mean reversion. Interestingly, the pattern in the
behaviour of ROCE is non-linear: specifically the mean reversion is faster
when profitability is below its mean and when it is far from its mean in
either direction (Fama and French, 2000).
The pattern in the behaviour of RNOA is similarly mean-reverting, as
documented in Figure 7.2. There are large differences in current RNOA
in year 0, ranging from –7.5 per cent for the lowest RNOA group to 33
per cent for the highest group. However, after five years, the differences
are smaller, with a reduced range of 8 per cent to 19 per cent, and all the
groups (expect the top one) in the range of 8 to 15 per cent. Based on past
history, we typically expect RNOA to be in the range of 8 to 15 per cent
after five years. Note, however, that firms with higher RNOA currently
tend to have higher RNOA later, even if the difference tends to decrease
over time.
Several economic reasons explain why RNOA shows a ‘mean-reverting’
behaviour within as well as across industries. Firms may have temporary
advantages that distinguish them from others (during a so-called
competitive advantage period), but forces of competition and the imitation
by other firms drive out the temporary advantage. Also, firms with high
RNOA tend to expand their investment base more quickly than others,
which causes the denominator of RNOA to increase. The issue relates to
the return of additional investments. As typically firms have difficulties
in maintaining this same level of return on additional investments, the
earnings growth will be lower than their investment base growth.
0.35
0.3
0.25
0.2
0.15 Portfolio 10 (Best performance)

Portfolio 8
RNOA
Portfolio 3
0.1 Portfolio 1 (Worst performance)
0.05
0
0 1 2 3 4 5 6
-0.05
-0.1
Figure 7.2 The behaviour of RNOA

Abnormal earnings and abnormal operating income

Abnormal earnings (AE) measures are driven by equity rate of return
(ROCE) and the growth in the equity book value (CSE growth), whereas
abnormal operating income (AOI) measures are driven by operating
activities rate of return (RNOA) and the growth in book value of
98
net operating assets (NOA growth). Moreover, both AE and AOI are
determined in part by the cost of capital (respectively, cost of equity capital
and cost of capital for the firm). Let us now see if we observe for AOI (AE)
the same mean-reverting behaviour of their relevant drivers (respectively,
ROCE and RNOA).
As clearly shown in Figures 7.3 and 7.4, once again drawn from the study
by Nissim and Penman (2001), the patterns of the behaviour of AE and
AOI (very similar to each other) show mean reversion: AOI (AE) tends to
converge to central values, with the more extreme becoming more typical
over time. This mean reversion is driven in part by that of the accounting
rate of return, and in part by that of the growth in the relevant balance
sheet amount (i.e. the growth in NOA and CSE also decays towards
economy-wide levels).
Interestingly, however, the mean reversion of abnormal earnings is less
pronounced than the one for the accounting rate of return. In fact, current
AOI (and AE) forecast future AOI (and AE), not only in the immediate
future but five years ahead. Firms with relatively high AOI (AE) tend
to maintain high AOI (AE) in the subsequent five years, and firms with
relatively low AOI (AE) tend to have low AOI (AE) later. There are two
possible reasons why abnormal earnings remain positive over time: a)
presence of economic rents; b) accounting reasons (e.g. conservative
accounting, like expensing R&D assets, enables firms to keep low book
value).
Finally, note that the majority of firms have negative AOI (AE) by the fifth
year. However, with conservative accounting practised on average, we
would expect long-run AOI (AE) to be positive (greater than the cost of
capital). Thus these figures indicate that the typically assumed equity risk
premium of 6 per cent (that has been used also in this specific study by
Nissim and Penman, 2001) is too high.
0.3
0.2
0.1
AE deflated by CSE in year 0
0 Portfolio 10 (Best performance)

0 1 2 3 4 5 6 Portfolio 8
Portfolio 3
-0.1 Portfolio 1 (Worst performance)
-0.2
-0.3
-0.4
Year from the portfolio formation
Figure 7.3 The behaviour of AE

99
0.3
0.25
0.2
0.15
AOI deflated by NOA year 0
0.1
0.05 Portfolio 10 (Best performance)

Portfolio 8
Portfolio 3
0 Portfolio 1 (Worst performance)
0 1 2 3 4 5 6
- 0.05
- 0.1
- 0.15
- 0.2
- 0.25
Figure 7.4 The behaviour of AOI

Financial leverage
The difference between AE and AOI is driven by financial leverage (FLEV).
So we need to focus on its behaviour. As shown in Figure 7.5, financial
leverage is fairly constant for all groups of firms, with the exception of
the top group. Recall the leverage effect on ROCE discussed in Chapter 5.
This effect explains why a temporarily high FLEV can produce temporarily
high AE, even when RNOA is normal. However, mean reversion in FLEV
forecasts that unusually high AE, induced by FLEV, will become more
normal. It is important to note that valuations based on AOI avoid these
considerations, and also avoid forecasting changes in discount rates due to
changes in leverage (as we will see in Chapter 8).
2.5
1.5
1 Portfolio 10 (Best performance)

Portfolio 8
FLEV
Portfolio 3
0.5 Portfolio 1 (Worst performance)
0
0 1 2 3 4 5 6
-0.5
-1
Figure 7.5 The behaviour of FLEV

100
Applicability of simple forecasting for valuation

Let us now recall the typical patterns to judge how applicable the simple
valuations are.
SF1 valuations are usually appropriate for the financing activities if net
financial obligations (NFO) are measured at market value (i.e. their book
value is a good proxy of their market value). Contrarily, SF1 valuations are
unlikely to perform well for operating activities (NOA) and equity (CSE).
SF2 valuations, which forecast constant AOI, are appropriate for firms with
average AOI and average RNOA, or for firms with average AE and ROCE.
These firms are the ones located in the central groups in Figures 7.4 and
7.3. However, SF2 valuations tend not to be appropriate for firms with
high or low RNOA or growth in NOA, or for firms with high or low ROCE
or growth in CSE.
SF3 valuations work only for firms with positive AOI (AE). Also, SF3
valuations, which forecast growth in NOA at the current level, but with
constant RNOA, are appropriate for firms with average RNOA and average
growth in NOA, or average ROCE and growth in CSE. These are the
firms in central groups in Figures 7.2 and 7.1, whose current accounting
measures are indicative of future values. Recalling from Chapter 5 that
RNOA=PM × ATO and NOA=Sales/ATO, SF3 valuations also work well
for firms with reasonably constant profit margin and turnover and steady
sales growth rates.
Activity 7.5
Suppose that you forecast that next year’s operating income for a given firm will be
the same as the current year’s operating income. Under what conditions is this a good
forecast?
Full-information forecasting
From simple forecasting we now move on to full-information forecasting,
a scheme that exploits all the useful information (also the ones outside
the financial statements) to forecast the full set of drivers of business
profitability. It follows clearly that the knowledge of the business is an
essential key step to discover all the information needed in this scheme.
The analyst must understand the business model and alternative strategies,
the firm’s products, its marketing policies and production methods, the
competitive environment and the firm’s competitive advantage, and even
the legal, political and regulatory constraints. The analyst then needs a
process to translate these factors into values that can lead to a valuation.
The structure of financial analysis (as discussed in Chapter 4) provides
this translation (just to take few examples: market power translates into
higher operating margins, competition reduces margins, the technology
used to produce sales is reflected into asset turnover). Financial statement
analysis is the framework to translate economic factors into values because
it provides the information to forecast the future on the basis of past and
current values. Financial analysis thus provides the framework for full-
information forecasting, enabling the analyst to identify and forecast the
factors that drive future profitability and growth. In short, forecasting is a
financial statement analysis of the future.
The best way to forecast future performance is to do it comprehensively
by producing not only an earnings forecast but a forecast of cash flows
and balance sheet as well. Such a comprehensive approach, also referred
to as full-information forecasting, is useful, even in cases in which one
101
may be interested primarily in a single aspect of performance, because it

guards against unrealistic implicit assumptions. For example, if an analyst
forecasts growth in sales and earnings for several years without explicit
consideration of an increase in fixed assets and the associated financing,
the forecast might possibly embed unreasonable assumptions about asset
turnover and leverage (it follows that, when AT is expected to remain
stable, fixed assets are expected to follow the growth in sales closely).
Forecasting involves the projection of future drivers (instead, financial
analysis identifies current drivers). To forecast these future drivers,
historical patterns are starting points. In fact, driver patterns are
determined by two elements:
1. the current level of the rate of return relative to its typical level for
comparable firms
2. the rate of reversion to a long-run level (known as persistence rate).
Element 1 is identified by financial analysis, while element 2 is subject to
forecasting. This explains why the empirical evidence on the patterns of
accounting measures (as described in the section ‘Empirical evidence on
the patterns of accounting measures’ above) is relevant also for
full-information forecasting: typical patterns are a good point of departure
when forecasting for individual firms. In short, benchmark trends serve
as a tool to get started.
It is interesting to note that although full-information forecasting involves
many forecasts, in many cases they are all linked to the behaviour of a
few key drivers. The drivers vary according to the type of business, but
for businesses outside the financial services industry, the sales forecast is
nearly always one of the key drivers; profit margin is another.
A full-information forecasting template: pro-forma future

financial statements
Full-information forecasting builds up pro-forma future financial
statements from forecasts of drivers. The forecasting scheme follows a
straightforward outline. The starting point is the forecasting of sales. The
scheme then forecasts gross margins and operating expenses. Finally, it
forecasts net operating assets to complete the abnormal operating income
calculation. Below we summarise the series of elements of detailed
forecasts. They can be seen as a series of steps that constitute a forecasting
template and that can be built into a spreadsheet.
Sales
The sales forecast is the starting point and usually requires the most
investigation and a thorough understanding of the business. There is no
set approach to forecasting sales; instead such approach should be tailored
to the context. The typical questions to be asked relate to:
• the firm’s strategy (i.e. What lines of business is it likely to be in? Are
new products likely? What is the product quality strategy? At what
point in the product life cycle is the firm? What is the firm’s acquisition
and takeover strategy?)
• the market for the products (i.e. How will consumer behaviour change?
What is the elasticity of demand for products? Are substitute products
emerging?)
• the firm’s marketing plan (i.e. Are new markets opening? What is the
pricing plan? What is the promotion and advertising plan? Does the
firm have the ability to develop and maintain brands?)
102
• the expected sales growth (i.e. What is the customer acceptance of

new product lines? What is the competitors’ behaviour? What is the
expected state of economy?)
A possible approach to forecast sales of a retail firm could be first to
consider prior years’ sales, and then forecast sales growth, which in turn
can be due either to pure expansion or to ‘comparable store growth’
(known as like for like). Another approach – useful when little history
exists – could be to estimate the size of the target market, project the
degree of market penetration, and then consider how quickly the degree of
penetration might be achieved.
Activity 7.6
Let us now go back to the Ryanair case study. Which factors would you consider in order
to get a forecast of Ryanair’s sales? Attempt to provide a forecast for sales on the basis of
all the information shown in previous chapters.
Below you can find a possible full-information forecast of Ryanair’s sales.
Sales forecast: Ryanair

The operating revenues of Ryanair come from plane ticket sales (scheduled flights) and
ancillary revenues. These will now be analysed.
1. Scheduled flights
Revenues from scheduled flights depend on the number of passengers and the ticket
price and are calculated as follows:
Operating revenues (scheduled flights) = Total number of passengers × Average ticket
price
Passengers
In terms of the historical perspective, Ryanair has enjoyed a strong growth over a
number of years, as illustrated in Table 7.7. These figures were down compared with
what was observed in the period 2000–2003 (when the average growth rate stood
at 38 per cent). The lower growth experienced over the 2009–2011 period (and
particularly in 2011) is primarily due to the European economic crisis. Therefore,
although historical performance offers a good indication of projected passenger
growth, it is not an entirely reliable prospective.
2011 2010 2009 2008 2007 2006
Passengers’ 68536536 66503999 58559123 50256679 42509112 34768813
number
Growth % 3,1% 13,6% 16,5% 18,2% 22,3% 26,0%
Table 7.7: Growth of passenger numbers.
In essence, in recent years, the low-cost segment of the aviation sector has grown
rapidly, despite a slowdown in 2009. It therefore seems reasonable to assume that the
industry will continue to experience growth in the number of passengers it transports.
Since Ryanair is currently the leader in the field, it is also reasonable to assume that it
will retain its dominant position in the next 10 years, although with low growth in the
near future due to the economic crisis.
The effect of investment in aircraft
Period: 2012–2017: This projection is based on past information, which suggests
that the increase in aircrafts used was directly proportional to the increase in revenue
(except in the years 2009–2010, in which the increase was greater in the fleet). We
base our figures on the firm’s orders of purchase entered into between Ryanair and
Boeing, not taking into consideration the option purchases. Ryanair expected to have
294 aircraft by 31 March 2012 and 299 aircraft by 31 March 2013.
103
It is also important to note that investment in assets will generate immediate revenue.
This is because once an aircraft is acquired and all the documents are signed, the
plane can start to fly. In order to estimate the total number of passengers, we shall use
the following formula.
Total number of passengers = Number of active airplanes × Weighted average of seats
per aircraft × Load factor × Total number of flights per aircraft
Explanation of variables
Active airplanes: Number of planes that are allowed to fly, which is equal to the
number of airplanes a company has minus number of airplanes that have to remain
grounded for maintenance.
Maintenance: usually the plane supplier determines the man-hours necessary per
number of flight hours to carry out standard maintenance. Any faults with the aircraft
are added to this number. Our best source of information in this case is a report by
Ryanair which claims, on average, 1/15 of the fleet has to be in maintenance at any
time. We assume that this proportion will not change over time. This is because Ryanair
flies a homogeneous fleet of aircraft (as was detailed in the strategic analysis).
Seats per aircraft: Boeing 737-800s have 189 seats.
Load factor: We believe that the average load factor for the past few years is the
best estimate for the future value. We think it is prudent to assume that the effect of
new route openings is already incorporated in this number. We assume therefore that
the load factor will remain at 82 per cent.
2011 2010 2009 2008 2007 2006

Load factors 83% 82% 81% 82% 82% 83%
Table 7.8: Load factors.

Total number of flights per aircraft: This measure is influenced by the turnaround
time and base availability. It is true that the acquisition of new airplanes and the
increased use of primary airports (such as Gatwick in the UK) may adversely affect the
25-minute turnaround time. However, since the new aircrafts are Boeing 737-800, it
limits the costs associated with training, maintenance and the purchase and storage
of spare parts. This offers great flexibility in the scheduling of crews and equipment.
Since we assume that the business model of Ryanair will not change over the years,
the turnaround times will remain constant from 2012 onwards. Therefore the average
number of flights per aircraft per day will remain at 6.6.
Total number of passengers: The growth of passengers projected in this way is
summarised in Table 7.9, opposite.
The effect of the increasing market saturation: 2018–2021: No data are
available on orders of aircraft after 2017. It is also necessary to take into account
the phase of the life cycle of the sector. Currently, the demand for low-cost carriers
is expanding, although at decreasing rates. For this reason, in the first part of the
explicit forecast period, growth in assets will lead to growth in revenue. However, at
maturity, this will not be the case and demand will become the driving force. Therefore,
from 2017 on, we assume that the growth in the number of passengers will decrease
(compared with the growth rate of the previous year) to settle at 1.5 per cent per
annum.
Average ticket price: Over the past year, the average ticket price grew by 12.3 per
cent. Ryanair attributed this increase to the rise in fuel prices (average prices were
at levels so low that they could not be maintained, given the increase in the cost of
fuel). However, it is considered overly optimistic to forecast further price increases
in the future for an airline in the low-cost segment, which stands out as particularly
competitive. For this reason, the hypothesis is that average rates will remain constant
in the coming years.
104
2012e
225
210
189
0.84
2415
6.6
95.016.378 102.701.526 104.448.151 106.224.480 108.348.970 111.057.694 116.610.579 80,500,000

2017e
334
312
189
82%
2415
6,6
2016e
318
297
189
82%
2415
6,6
2015e
310
289
189
82%
2415
6,6
2014e
304
284
189
82%
2415
6,6
2013e
299
279
189
82%
2415
6,6
2012e
294
274
189
82%
2415
6,6
2011
272
254
189
82%
2415
6,6
Boeing 737-
daily flights
Load factor
passengers
per aircraft
Number of
Number of
Number of
Number of
Number of
flights per
aircrafts
aircrafts
aircraft
Active
seats
800
Table 7.9: Growth in the number of passengers.

2. Ancillary revenues
Ryanair has a number of ancillary revenues, including car hire commission, in-flight
revenues, internet income, charter revenues and non-flight scheduled revenues. Due
to the lack of more precise data, we assume that, in general, the proportion of these
revenues, relative to the sales originating from scheduled flights, will remain constant.
Specifically, these revenues represented 28.5 per cent of the scheduled flights in 2010
and 28.3 per cent in 2011. Hence, we assume that ancillary revenues will represent
28 per cent of revenues from the scheduled flights in the year 2012 and 30 per cent
in subsequent years, including the post-horizon period. As part of this assumption we
imply that the company will not change its main business activity in the future.
3,09% 2012
1,70% 2013
1,70% 2014
2,00% 2015
2,50% 2016
5,00% 2017
4,00% 2018
3,00% 2019
2,00% 2020
1,50% 2021
Table 7.10: Summary of sales growth.
105
Gross margin and operating expenses

The forecast of gross margin (the difference between sales and cost of
sales) requires the projection of the cost of sales. Analysts often use the
historical gross margin percentage, the ratio of gross margin to sales, to
project the cost of sales. This is done because for the revenues and cost of
sales forecasts to be internally consistent, the cost of sales forecast must
depend on sales.
The next item to forecast is represented by operating expenses. Generally
expenses are forecast item by item as different expenses are driven by
different factors. Nevertheless, most variable expenses are clearly related
to sales, and they are naturally framed as fraction of sales (e.g. selling,
general and administrative expenses, SG&A).
Activity 7.7
Let us now go back to the Ryanair case study. How do you forecast Ryanair’s gross
margin and operating expenses?
Gross margin and operating expenses forecast: Ryanair

Gross margin
Presently, Ryanair’s margins are much higher than the average margins of the industry
and the sector. We believe that these margins are too high to be sustainable in
the future. However, we have seen in the last five years (five years before Ryanair’s
margins were again too high compared to those of any other comparable company)
that Rynair’s margins have been decreasing, but at the very slow rate of about 0.1 per
cent annually. We should take into consideration the fact that, despite an increase of
37 per cent in its fuel bill in 2011, Ryanair was able to maintain its high margins due
to numerous strategic policies (these include oil-price hedging, grounding of some
planes during the winter months, increase in ticket prices, etc.).
Operating expenses
Operating expenses are marketing and distribution costs, which represented
approximately 4.3 per cent of the sales in 2011, 4.9 per cent in 2010 and 5.2 per cent
in 2009. We assume that this proportion is not going to change significantly, so we
are going to calculate operating expenses as 4.75 per cent of the sales. As a result, the
increase of these costs will be correspondent with the sales increase.
Depreciation, amortisation and CAPEX

Other items that require detailed forecasts are depreciation, amortisation
and CAPEX. Depreciation is a difficult item to model formally. Some
analysts project depreciation by examining historical changes in
depreciation and forecasting analogous changes. This is a reasonable
approach when depreciation tends to be stable over time (i.e. depreciation
remains constant as a percentage of net property, plant and equipment at
the beginning of the year). Alternatively, depreciation can be calculated
by assuming that the historical percentage of depreciation over net fixed
assets remains constant of time.
CAPEX (that represent additions to property, plant and equipment) are
often projected by assuming that the firm’s investments are closely related
to sales. This relationship is reasonable because more sales generates more
cash flow, which in turn generates more capacity to invest. (Note that
interest expense is an expense of a financing nature more closely related to
drivers other than sales, namely debt level and interest rates.)
106
CAPEX, depreciation and amortisation forecasts: Ryanair

CAPEX and depreciation
We believe that the firm’s investments are closely related to sales in its core airline
business. This relationship is reasonable for two other reasons:
1. More sales → More cash flow → More capacity to invest
2. More sales → More aircrafts used → More investment needed to renew assets
We also checked that the planes are available to fly from the moment they have been
acquired and have obtained all the necessary documents. Therefore, we reasonably
assume that aircrafts that have been acquired in a particular period are generating
sales in that period.
Assumptions to estimate CAPEX

First, to be able to sustain the projected growth of sales, we need the same growth
rate in the net fixed assets. So a priori we have to invest a certain percentage of the
net fixed operating assets of the previous year, equal to the percentage of projected
sales growth. Subsequently, we have to add the amortisation of the previous period to
the result.
CAPEX (year n) = (Sales growth (n) × Net operating fixed assets (n–1)) + Amortisation
(n–1)
For the final value we have to calculate CAPEX according to the g value. We believe
that the total net operating investment must be a proportion, g, of the total operating
fixed assets.
CAPEX TV = (g × Net operating assets TV) + Amortisation TV
Assumptions to estimate depreciation

We take gross operating assets from the financial statements and then calculate the
percentage of the net fixed assets that get amortised each year:
Annual percentage = Depreciation costs 2011 / Net fixed operating assets 2010
We assume that this percentage will remain constant. Table 7.11 shows the
calculations.
Table 7.10 Summary of the forecast CAPEX and net operating fixed assets
Balance sheet items

We then move to the forecast of balance sheet items. It is best to forecast
these items individually as they may be driven by different factors.
However, several assets (such as working capital and property plant and
equipment) are generally driven over the long run by sales activity. As
regards to PPE, they are generally forecast as fraction of sales, allowing
for changes in efficiency of asset utilisation. (This obviously requires
the knowledge of the product technology.) Unless there are alternative
management plans, if capital expenditure is known, sales are useful in
forecasting property, plant and equipment assets. Similarly, the working
capital components (current assets and current liabilities) are generally
related to sales changes: as the firm expands its sales, it needs additional
accounts receivable, inventories and other current operating assets (net of
additional accounts payable and other current operating liabilities).
107
We are now able to get the forecasts of the accounting rate of business
profitability (RNOA) and the abnormal operating income (AOI), which
represent the aim of any prospective analysis. Our forecasting task is thus
accomplished.
Assets and RNOA: Ryanair

To estimate future RNOA it is necessary to estimate Ryanair’s assets.
Working capital
Within assets, we differentiate between net operating fixed assets (previously
measured), inventories, accounts receivables, accounts payable and other assets. With
regard to working capital, we assume that the future payment terms will be the same
as the average in the years 2009, 2010 and 2011. In comparison to five years ago,
Ryanair has drastically decreased the number of days of inventory. They are now about
1/3 of a day, whereas five years ago they were about 10. The average days for accounts
payable are 19.8 and for accounts receivable are 5.2. These numbers are assumed to
be sustainable in the future. In any event, working capital represents a low proportion
of net operating assets. The resulting forecasts for inventories, accounts receivables and
accounts payable are reported in Table 7.12.
Other operating assets and operating liabilities

Other operating assets include prepaid expenses and operating cash, which are
assumed to stay constant in value over the explicit forecasting period. We do not
include the cash equivalents or other current financial assets in these assets since they
are not operating assets. There also exists current operating liabilities and non-current
operating liabilities which are assumed to grow in line with revenue.
(in€m) 2011 2012e 2013e 2014e 2015e 2016e 2017e 2018e 2019e 2020e 2021e 2022 (PH)
Inventories 2.7 2.6 2.7 2.7 2.8 2.8 3.0 3.1 3.2 3.3 3.3 3.4
Accounts
50.6 53.6 54.5 55.4 56.5 58.0 60.9 63.3 65.2 66.5 67.5 68.5
Receivable
Accounts
150.8 158.4 161.1 163.8 167.1 171.3 179.9 187.1 192.7 196.5 199.5 202.5
Payable
Working
-97.5 -102.2 -103.9 -105.7 -107.8 -110.5 -116.0 -120.7 -124.3 -126.8 -128.7 -130.6
Capital
Table 7.12: Summary of the forecasted working capital.
RNOA
As a result of the previous assumptions, RNOA remains broadly constant through time
in the explicit forecasting period.
Table 7.13: RNOA forecast from 2011 to 2022.
Other balance sheet items (including financing liabilities and equity) may
depend on a variety of factors, including policies on capital structure and
dividend policies. In case analysts presume the maintenance of the current
capital structure and dividend policies, financing liabilities are maintained
at nearly identical fractions of total assets (or sales). Equity is thus
obtained as a residual value.
Figure 7.6 summarises forecasting techniques for the main financial
variables, as previously discussed. It is obvious that this is only a rough
guide and alternative approaches can be used depending on the specific
situation of a firm.
108
Financial variable Forecasting technique

Cost of sales Percentage of forecast sales
SG&A Percentage of forecast sales
Depreciation Percentage of net fixed assets
Interest expense Percentage of interest-bearing debt
CAPEX Percentage of forecast sales or inferred from the fixed assets
Percentage of forecast sales or inferred from CAPEX forecasts
PPE
in conjunction with depreciation
Current assets Percentage of forecast sales
Current liabilities Percentage of forecast sales
Financing liabilities Constant percentage of total assets
Figure 7.6 Typical forecasting techniques for financial variables
Finally, we have to note that the forecast of cash flow is best done by
forecasting directly from reformulated income statements and balance
sheet statements, without the need to produce a forecast statement of cash
flows, as we will explain in Chapter 8.
Chapter summary
We provided in this chapter an analysis of forecasting, which is a way of
summarising what has been learnt from strategic analysis, accounting
analysis and financial analysis (discussed in the previous chapters).
We provided first an analysis of how to forecast future profitability and
growth on the basis of current and past financial statements only (we thus
referred to simple forecast methods), and then moved to the investigation
of how to forecast the full set of profitability drivers on the basis of
information both inside and outside the financial statements (known as
full-information forecasting).
Simple forecast methods aim to forecast earnings and abnormal earnings
for the three main areas of activities (operating, financing and equity) on
the basis of the following assumptions:
• Forecasting from book values (SF1) derives a forecast of earnings from
balance sheet amounts (by multiplying the required return to the relevant
balance sheet amount); abnormal earnings are instead forecast to be zero.
• Forecasting from earnings and book values (SF2) assumes that future
earnings are equal to current earnings and that changes in the relevant
balance sheet amount earn the required return; abnormal earnings,
however, are assumed to remain perpetually at their current value.
• Forecasting from current accounting rate of return (SF3) predicts that
a firm will maintain its current rate of return in the future, and the
relevant balance sheet components will earn at the current profitability;
abnormal earnings moreover are assumed to grow perpetually at a
given rate.
The implied valuations for each of the three areas of activities (operating,
financing and equity) are the following:
• Under SF1, they are based on balance sheet measures only.
• Under SF2, they are based on the capitalisation as a perpetuity of the
relevant SF2 earnings forecast.
• Under SF3, they are based on the relevant balance sheet measures
plus the capitalisation as a perpetuity with growth of the relevant SF3
forecast of abnormal earnings.
109
Having identified different methods for simple forecasting (and

valuations), we investigated the empirical evidence on the typical
behaviour of the measures on which these methods place assumptions
(namely, a very pronounced mean reversion for accounting rates of return,
and a less pronounced mean reversion for abnormal earnings). This
enabled us to understand how applicable the simple valuations are. In
short, typically we observed that:
• the SF1 valuation usually does not work
• the SF2 valuation works best for firms with average current accounting
rate of return and average abnormal earnings
• the SF3 valuation usually works best for firms with average current
accounting rate of return and average growth in the relevant balance
sheet amount.
The simple prospective analysis should be used as a starting point for
more comprehensive forecasts, known as full-information forecasting. We
have illustrated in this chapter a template to develop pro-forma income
statements and balance sheets for the future, by pointing out general
forecasting policies usually adopted by analysts. The reference to the
Ryanair case study has provided an application on how to produce full-
information forecasts. In the next chapter we will investigate how to use
these forecasts to get full-information valuations.
Key terms
annual earnings full-information forecasting
business profitability key driver
competitive advantage period martingale
comprehensive approach mean reversion
current rate of return parsimony
driver pattern persistence rate
expected growth pro-forma future financial statements
financial statement analysis of the prospective analysis
future quarterly earnings
forecasting random walk
forecasting from book values (SF1) random walk with a drift
forecasting from current accounting required return
rate of return (SF3)
sensitivity analysis
forecasting from earnings and book
values (SF2) simple forecasts (and valuations)
valuation
110

• explain how forecasting (and valuation) can be conducted
• explain what forecasts can be obtained from current financial
statements
• describe how simple forecasts give simple valuations and calculate
simple valuations from simple forecasts
• outline the typical behaviour of the measures on which simple
forecasting methods place assumptions (return on net operating assets,
return on common equity, abnormal earnings, abnormal operating
income and financial leverage)
• know when simple forecasting and simple valuation work as reasonable
approximations
• understand how to get full-information forecasts
• conduct full-information pro-forma analysis.

1. How does simple forecasting differ from full-forecasting?
2. In the context of simple forecasting, describe the following methods:
forecasting from book values (SF1 forecasting), forecasting from
earnings and book values (SF2 forecasting) and forecasting from
accounting rates of return (SF3 forecasting).
3. What is the difference between SF1 and SF2 forecasts? What is the
difference between SF2 and SF3 forecasts?
4. What is the empirical evidence about the behaviour of accounting rate
of return? How does this differ from the evidence about the behaviour
of annual earnings?
5. Describe the statistical process followed by annual earnings. Describe
then how the process followed by quarterly earnings differs from the
one followed by annual earnings.
6. How is simple forecasting applicable for valuation?
7. Why is a simple forecast of comprehensive earnings based on book
value usually not a good forecast?
8. What factors determine the rate at which high operating profitability
declines over time?
9. Why may abnormal earnings increase, although return on common
equity is fairly constant?
10. Describe full-information forecasting and how to get pro-forma
income statements and balance sheets for the future.
11. The summary balance sheet of company ABC is the following (values
in millions of pounds):
2011 2012
Net operating assets 4500 5000
Net financial obligations 1200 1300
Common shareholders’ equity 3300 3700
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The 2012 operating income is £550 (million), the 2012 RNOA is

about 14 per cent and the forecast growth rate of net operating assets
5 per cent. Assuming r = 9 per cent and rE = 11 per cent, use SF1,
SF2 and SF3 to estimate the value of NOA in year 2012. Critically
discuss your results.
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Chapter 8: Securities valuation
Introduction
Valuation represents the process of converting a forecast into an estimate
of the value of a firm. Valuation, together with forecasting, is the second
task of prospective analysis (as explained in Chapter 7). The idea is to
convert the stream of forecasts of future payoffs into a single number, the
valuation.
The purpose of producing a valuation is to get a measure of the value
added by an investment (or rather by a firm, which can be thought as a
combination of investments). The economic intuition is that a valuation
enables an inside investor to make an investment decision, and an outside
investor to trade on the valuation. In fact, the inside investor compares the
estimated value of an investment to its cost, whereas the outside investor
decides to trade securities by comparing their estimated value to their price.
To accomplish the valuation purpose, analysts adopt a valuation model,
which can be defined as the architecture used to estimate the firm’s value.
It specifies the payoffs to forecast into the future. Moreover, it affects the
analysis of the information on the business and the financial analysis; this
occurs because the relevant information for forecasting can be identified
only with an appropriate analysis of the firm and its industry, strategy
and financial statements. Finally, a valuation model tells analysts how to
convert forecasts to a valuation.
The valuation models can be classified on the basis of two parameters:
• the focus of the valuation: this can be alternatively on the equity
activities (measured by CSE) or operating activities (measured by
NOA)
• the approach used for the valuation: this can alternatively be based on
cash flows or abnormal income.
By combining these parameters, as shown in Table 8.1, the valuation
models are typically based on the following forecast payoffs:
• present value of free cash flow (PVFCF) as in the discounted cash flow
method (DCF)
• present value of expected dividends (PVED) as in the dividend discount
method (DDM), or present value of free cash flow to equity (PVFCFE)
as in the discounted cash flow to equity method (DCFE)
• present value of abnormal earnings (PVAE) as in the abnormal earnings
method (AEM)
• present value of abnormal operating income (PVAOI) as in the
abnormal operating income method (AOIM).
The first two methods are based on discounted cash flow analysis, which
involves the production of detailed multiple-year forecasts of cash flows.
These forecasts are then discounted at an estimated cost of capital to
arrive at an estimated present value.
The other two methods are based on capitalised abnormal earnings
analysis. In principle, this approach is equivalent to the discounted cash
flow analysis. That is, the approach expresses the value of the firm’s equity
as the sum of the book value and the discounted forecasts of abnormal
earnings.
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Approach
Cash flows Abnormal earnings
Focus Equity (CSE) DOM DCFE AEM
Net operating assets DCF AOIM EVA
Table 8.1 Valuation methods
In the next sections we aim to answer the following questions: How
can we convert a forecast to a valuation? What are the above valuation
methods? How do they work? For what firms are they best suited?
Aim
The aim of this chapter is to show how valuation is carried out under
different valuation frameworks on the basis of full-information forecasting
(as conducted in the previous chapter), and how reformulated financial
statements are used in this process. We will show how to get valuations
from the discounted cash flow (DCF) method, the dividend discount
method (DDM), the discounted cash flow to equity-holders (DCFE)
method, the abnormal earnings method (AEM), the abnormal operating
income method (AOIM), and the economic value added (EVA) method.
We will then provide some empirical evidence about the ability of the
estimates from these valuation methods to explain stock prices.
Learning outcomes
• thoroughly describe the process of securities valuation
• describe the discounted cash flow (DCF) method in detail
• explain the dividend discount method (DDM) in detail
• discuss the discounted cash flow to equity-holders (DCFE) method in
detail
• review the abnormal earnings method (AEM) in detail
• present the abnormal operating income method (AOIM) and the
economic value added (EVA) method in detail
• competently apply each of these valuation methods, and perform
valuations based on current financial statements in complex situations
• critically assess the advantages and limits of each valuation method
• adequately explain why DCF and DDM may not measure value added
in operations
• carefully review the economic concepts underlying different
continuing-value calculations
• coherently outline the empirical evidence on the efficacy of each
valuation method under specific circumstances.
Essential reading
Penman, S. Financial statement analysis and security valuation. (Boston,
Mass.: McGraw-Hill, 2012) fifth edition, Chapters 6 and 7.
114
Further reading
Barker, R. Determining value. Valuation models and financial statements. (Harlow:
Pearson Education Limited, 2001), Chapter 9.
Copeland, T., T. Koller and J. Murrin Valuation. Measuring and managing the
value of companies. (New York: John Wiley and Sons, 2000) third edition,
Chapter 8.
Francis, J., P. Olsson and D. Oswald ‘Comparing the accuracy and explainability
of dividends, free cash flow and abnormal earnings equity valuation
models’, Working paper, University of Chicago, 1997.
Ohio: South-Western College Publishing, 2012) fifth edition, Chapters 7
and 8.
Penman, S.H. and T. Sougiannis ‘A comparison of dividend, cash flow, and
earnings approaches to equity valuation’, Contemporary Accounting Research
15(3), 1998, pp.343–83.
Works cited
Gordon, M. The investment, financing and valuation of the corporation.
(Homewood, Ill.: Irwin, 1962).
Lundholm, R. and T. O’Keefe ‘Reconciling value estimates from the discounted
cash flow value model and the residual income model’, Working Paper,
University of Michigan Business School, 2000.
Miller, M.H. and F. Modigliani ‘Dividend policy, growth, and the valuation of
shares’, Journal of Business 34(4), 1961, pp.411–33.
O’Hanlon, J. and K. Peasnell ‘Wall Street’s contribution to management
accounting: the Stern Stewart EVA financial management system’,
Management Accounting Research 9, 1998, pp.421–44.
Williams, J.B. The theory of investment value. (Cambridge, Mass: Harvard
University Press, 2012).
Discounted cash flow method

Valuation based on cash flows can be structured in a number of ways:
• focus on the present value of expected dividends (PVED)
• focus on the present value of expected free cash flows available to
equity-holders (PVFCFE)
• focus on the present value of expected free cash flows available to all
providers of capital (PVFCF).
The first two approaches value the equity in the firm, while in the third
approach the entire firm is valued.
By focusing on the equity value, the dividend discount method (DDM) and
the discounted cash flow to equity-holders method (DCFE) can be used.
These methods involve the following steps: forecasting expected dividends
or cash flows available to equity-holders; discounting the expected
dividends or cash flows at the cost of the firm’s equity capital. This results
in an estimated value of equity.
By focusing on the entire firm’s value, the third approach estimates
the present value of free cash flows (PVFCF) available to all providers
of capital. This approach, known as the discounted cash flow method
(DCF), involves the following steps: forecasting cash flows available to
all providers of capital (debt and equity); discounting the expected cash
115
flows at the cost of capital for the firm (debt and equity). This results in
an estimated value of the firm’s net operating assets (financed by debt and
equity), which must be reduced by the value of debt to arrive at the value
of equity. Because of the widespread use of this method, we will focus here
on the steps needed to get a valuation by using it.
• Step 1: Forecast free cash flows (FCF) over a finite forecast horizon,
usually 5 to 10 years.
• Step 2: Discount FCFs at the cost of capital for the firm (weighted
average cost of capital, WACC).
• Step 3: Forecast FCFs in the post-horizon period based on some
simplifying assumptions. The sum of the discounted FCF forecast over
the finite horizon and in the post-horizon period gives the value of the
firm’s operations.
• Step 4: Subtract the estimated current market value of debt from the
discounted FCFs, and finally add any non-operating (financial) assets
held by the firm. This gives the value of equity.
In the next sections we illustrate in detail each of the four steps of the DCF
(and apply this valuation technique to Ryanair plc), whereas the dividend
discount method and the discounted cash flow to equity (DCFE) will be
analysed in the section ‘Dividend discount method and the discounted cash
flow to equity method’.
Step 1: Forecast FCF over a finite forecast horizon

Under the DCF method, the firm is seen as a bundle of investment projects
combined together. The value of the firm equals the discounted value
of expected future free cash flows from all these projects in the firm’s
operations. Therefore FCF is the main focus of the DCF method, and the
first step of any DCF valuation concerns the forecast of future FCF.
As previously outlined in the section ‘Stylised statement of cash flows’
(Chapter 3), the total cash flow from all projects is known as cash flow
from operations, while the cash outflows required for investments are
called cash investments. Therefore, operations yield a net cash flow,
referred to as free cash flow, calculated as the difference between cash
from operations and cash investments. FCF thus determines the ability
of the firm to pay all its claimants, both debt-holders and shareholders.
Given that FCF reflects the cash generated by operation that is available to
both shareholders and debt-holders, it is the correct cash flow to obtain an
estimate of the firm value.
Free cash flow can be calculated as after-tax operating income (known
as NOPLAT, net operating profits less adjusted taxes, or EBILAT, earnings
before interest less adjusted taxes), plus non-cash charges, minus
investments in operating working capital, property, plant and equipment
and other assets. In Table 8.2, you can see how to calculate FCF available
to both equity-holders and debt-holders. Note that you can see also how
to calculate the free cash flow to equity-holders only (FCFE) and the net
change in cash balance.
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Earnings before interests and taxes (EBIT)

– Cash tax on EBIT
= Net operating profits less adjusted taxes (NOPLAT, also known as EBILAT)
+ Depreciation
+ Amortisation
– Increase in working capital
= Cash from operations
– Cash investments (= CAPEX + Increase in net other assets)
= FCF (available to equity-holders and debt-holders)
+ Cash associated to debt financing (= Debt issues – Debt repayments – Net
interest expense after taxes)
= FCF available to equity-holders (FCFE)
+ Cash to/from shareholders (= Stock issuance – Stock repurchase – Net dividends)
= Net increase/decrease in cash balance
Figure 8.1 FCF calculation
Activity 7.1
Let us now go back to the Ryanair case study. Provide forecasts of FCF to equity-
holders and debt-holders for the period 2012–2022. Please make sure that you use the
information provided in Chapter 7 on full-information forecasting for Ryanair.
Below you can find a possible forecast of Ryanair’s FCF.
Clearly to forecast FCF requires earnings, accruals and investments to

be forecast. This represents a considerable challenge. However, from
the reformulated income statement and the reformulated balance sheet,
analysts can simply calculate FCF by recalling the accounting relations
about the drivers (sources and uses) of free cash flow, as extensively
explained in the section ‘Accounting relations on the drivers of each
component of reformulated financial statements’ (Chapter 3). If those
statements are appropriately reformulated, FCF is given by the following
quick calculation referred to the sources of FCF:
FCF = Operating income – Change in net operating assets (= OI – ∆NOA)
(8.1)
Alternatively, FCF can also be calculated by looking at its sources:
FCF = Net financial expenses – Change in net financial obligations +
Net dividends (= NFE – ∆NFO + d) (8.2)
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Step 2: Discount expected FCF

Forecast FCF are future and uncertain values. Therefore, these expected
payoffs must be discounted for the time value of money (i.e. investors
prefer value now rather than in the future) and for risk (i.e. investors
typically prefer less risky payoffs to more risky ones). For consistency
with the cash flow definition, the discount rate applied to free cash flow
(to shareholders and debt-holders) should reflect the opportunity cost
to all the capital providers weighted by their relative contribution to the
total capital of the firm. As previously discussed, this opportunity cost
represents the rate of return that investors in a similar class of risky assets
could expect. Thus the appropriate discount rate of free cash flow is the
WACC (also denoted as r) which is calculated by weighting the cost of debt
and the cost of equity capital according to their respective market values.
(Please refer back to the section ‘Computing the cost of capital for the firm’
for an extensive discussion on how to calculate this cost of capital.)
Step 3: Valuing post-horizon FCF

An additional issue in valuing firms is their indefinite life. The DCF
method seems to require forecasting over an infinite horizon, because we
are valuing a going concern investment. This problem could be solved by
forecasting free cash flows for hundreds of years. However, the criteria
for a practical valuation model require finite forecast horizons because
the further into the future we have to forecast, the more uncertainty there
is about the forecast. Indeed, in practice, analysts solve this problem by
separating the value of the firm in two periods, during and after an explicit
forecast period. In short, the value of the firm can be written as:
Value of the firm = PV FCF over explicit forecast horizon + PV FCF post-
explicit forecast horizon (8.3)
The last year of the explicit forecast horizon is known as the terminal year.
The present value of free cash flow beyond the terminal year is called
continuing value (CV), and it can be thought of as the value omitted in the
calculation when the analyst forecasts only up to the terminal year, and
not to infinity. As for this calculation, which involves the forecasting of
the performance over the remainder of the firm’s life, analysts must make
some assumptions that simplify the forecasting process. Typically, there are
two alternative assumptions that are based on the forces of competition.
Alternative 1
Competition tends to limit the ability of a firm to consistently identify
growth investment opportunities that generate abnormal profits. At a
given point in time, firms may have a competitive advantage that enables
them to achieve earnings higher than the cost of capital. But under
competition the expectation is that, sooner or later, we would typically
not expect a firm to continue to extend its abnormal profitability to
new additional projects (note, however, that there are several ways,
such as strong brand name or patents, that enable firms to maintain
this competitive advantage over long periods of time, even indefinitely.)
Ultimately, we expect that high profits attract new investments, which in
turn drive the firm’s accounting rate of returns down to normal level. At
this stage each new investment will be a zero-NPV investment (i.e. each
new investment would generate cash flows with a present value no greater
than the cost of the investment itself). This qualifies the competitive
equilibrium assumption. Formally, this can be written as:
1 E (FCFT +1 ) (8.4)
PVt ( PH FCF ) = CVt =
(1 + WACC ) T −t WACC
118
where E denotes the expectation as of date t. In this case, analysts forecast

that the FCF beyond the terminal year will be a constant perpetuity, and
so they capitalise the perpetuity. The continuing value is then discounted
to present value. The consequence of alternative 1 is that any incremental
investment beyond year T will not create value, because the incremental
value of the new project will be zero. The firm can thus be valued as if
there was no new net investment after year T. Alternative 1 does not
assume that abnormal profitability is driven away completely. Instead it
assumes that any abnormal performance related to the asset base at the
terminal year will remain forever, but because of competition, abnormal
profitability cannot be extended to new, additional projects year after year.
The length of the explicit forecasting period may thus be chosen so that
the incremental investments made in any year after the terminal year are
zero-NPV projects. Therefore the length of the explicit forecast horizon is
whatever time is required for the firm’s incremental investments to reach
the equilibrium, an issue that turns on the sustainability of the firm’s
competitive advantage. Recalling the empirical evidence on the patterns
of accounting rate of return, as shown in the section ‘Accounting rates
of return (ROCE and RNOA)’ Chapter 7, it is evident that most US firms
should expect ROCE and RNOA to revert to normal levels within five to 10
years. Therefore a five- to 10-year horizon should be more than sufficient
for most firms. Note, however, that analysts can justify to end the explicit
forecast horizon even earlier because the return on incremental investment
can be normal even while the return on total investment (and thus ROCE
and RNOA) remains abnormal.
Activity 8.2
Provide a few examples of firms for which you could justify a longer explicit forecast
horizon, and clearly explain the reasons on the basis of this choice.
Alternative 2
The firm is expected to derive economic profits from new projects forever
(in substance, abnormal profitability is extended to a larger investment
base year after year). Under these circumstances, the analyst is willing
to assume that the firm may defy competitive forces and earn abnormal
rates of return on new projects for many years. One possibility would be
to forecast free cash flows over longer periods, until when the competitive
equilibrium assumption could be used. However, this conflicts with the
practical requirement of simplicity, essential for any valuation technique.
Another possibility is to forecast growth in free cash flow at some constant
rate g after the terminal year. Formally, this can be written as:
1 E ( FCFT +1 ) (8.5)
PVt ( PH FCF ) = CVt = T −t
(1 + WACC ) WACC − g
Alternative 2 assumes that abnormal profitability can be extended to
an investment base that grows at a rate g. This assumption is more
aggressive, but it could also be more realistic in some circumstances.
Note that typically the growth rate used in the model is less than or equal
to the growth rate in the economy (nominal growth if the cost of capital is
in nominal terms, or real growth if the cost of capital is in real terms).
Step 4: Calculate the value of equity

By recalling the balance sheet relation formalised in equation (3.6), we
know that common shareholders’ equity is equal to net operating assets
minus net financial obligations. It follows that the value of common
119
shareholders’ equity is the value of the firm less the value of net debt
(VE = VF – VD). Thus, to get the value of equity, the analyst has to subtract
from the total present value of FCF (both over the explicit forecast horizon
and in the post-horizon) the market value of debt (short- and long-term
financing liabilities, including preferred stocks that are really debt from the
point of view of common shareholders). Moreover, if the firm maintains
any non-operating assets that will generate cash flows not included in the
forecasts, the value of these assets must be added at this stage (a common
example is the non-operating cash included in the financial assets under
the reformulation). As debt is typically reported in the balance sheet at
the market value, the analyst can subtract the book value of net debt.
Anyway the market value of debt is usually reported in the footnotes of the
financial statements.
In short, the value of equity at time t can be estimated as:
T
E (FCFi ) E (CVT )
Vt E = ∑ + − Vt D (8.6)
i =t (1 + WACC ) i
(1 + WACC ) T
where V is the net value of debt, which is the debt the firm holds as
D
financial liabilities less any debt investments that the firm holds as
financial assets.
The estimated value of equity (called intrinsic value) is divided by the
outstanding number of shares to arrive at an estimated per-share value.
Activity 8.3*
Consider the following expected cash flow from operations and cash investment for Oxo
plc (in £m).
2013 2014 2015 2016 2017
Cash flow from operations 380 500 520 530 535
Cash investments 245 300 210 165 215
Table 8.4: Title to come

Use the following information: cost of equity capital = 13 per cent, cost of capital for the
firm = 12 per cent, long-term growth rate = 3 per cent, number of shares outstanding =
250m; NFO = £280m. Use the DCF method to calculate the value of equity for Oxo plc
in 2012 under two different assumptions for the post-horizon continuing value: a) no
growth rate; b) growth rate equal to 3 per cent.
Activity 8.4
Let us now go back to the Ryanair case study. Given the forecasts of FCF to shareholders
and debt-holders for the period 2012–2022 (obtained in Activity 8.1), use the DCF
method to estimate the value of equity for the company. Assume a long-term growth rate
of 1.5 per cent and use all the relevant information provided throughout the guide.
Here below you can find a possible estimate of the equity value of Ryanair
on the basis of the DCF method.
120
Through analysis of the company’s strategy and financials, it is our

understanding that Ryanair is overvalued. By using this DCF analysis,
we suggest a target price of €2.62 (market price at close of business on
31.12.2011: €3.63). The set of forecasts used in the explicit forecasting
period is not consistent with any mean reversion in RNOA. Furthermore,
even if the growth rate used in the post-horizon period was higher and
equal to 3 per cent, the target price would only raise to €2.81. Therefore
we recommend a sell..
Advantages of DCF
The DCF method is best suited for firms where the investment pattern
produces positive constant free cash flows or free cash flow growing at
a constant rate. Anyway, it is the valuation method more widely used in
practice. What determines this preference in practice? It does not require
any explicit forecast of cash flows related to debt (in contrast, these
debt cash flows have to be taken into account in estimating FCFE). This
represents an important feature when the leverage is particularly high
or when it is expected to change significantly over time, because of the
complexity of the estimation of future debt issues and repayments. It also
represents an important feature for comparisons of companies with very
different levels of leverage. Nevertheless, note that the DCF method requires
information about debt ratios and interest rate to estimate the WACC.
Limits of DCF
To infer the accuracy of the DCF method, we need to observe the
relationship between FCF and other business measures (such as ROCE,
price-to-book and price-to-earnings). As clearly shown by the empirical
evidence for listed US firms provided in Figures 8.1, 8.2 and 8.3:
• FCF is not a good indicator of profitability. Lower ROCE is associated
with both low and high FCF, and also low variability of ROCE over a
wide range of positive and negative FCF. This implies that if ROCE is a
value driver, then forecasting FCF is not likely to capture value.
• Current FCF is not a good indicator of PB and PE ratios. ROCE varies
with PB and PE, while low PB (and PE) are associated with both high
and low FCF. Therefore FCF is not a good indicator of the premium or
the multiple of earnings at which the firm should trade.
100.00% 16.00%
80.00%
14.00%
60.00%
12.00%
40.00%
10.00%
20.00%
ROCE
FCF
0.00% 8.00%
1 2 3 4 5 6 7 8 9 10
-20.00%
6.00%
-40.00%
4.00%
-60.00%
2.00%
-80.00%
-100.00% 0.00%
FCF groups
FCF/Price ROCE
Figure 8.2 Various levels of FCF and ROCE
121
100.00% 1.8
80.00% 1.6
60.00%
1.4
40.00%
1.2
20.00%
1
FCF
P/B
0.00%
1 2 3 4 5 6 7 8 9 10 0.8
-20.00%
0.6
-40.00%
0.4
-60.00%
-80.00% 0.2
-100.00% 0
FCF groups
FCF/Price P/B
Figure 8.3: Various levels of FCF and 7.3

Figure P/BVarious levels of FCf and P/E
100.00% 25
80.00%
60.00% 20
40.00%
20.00% 15
FCF
P/E
0.00%
1 2 3 4 5 6 7 8 9 10
-20.00% 10
-40.00%
-60.00% 5
-80.00%
-100.00% 0
FCF groups
FCF/Price P/E
Figure 8.4: Various levels of FCF and P/E

Two practical issues arise as regards the use of the DCF method. The first
is that this valuation method does not work in some cases, specifically
when firms tend to invest markedly in operations. This happens because
FCF is not a measure of the value-added concept, but it is partially an
investment (or liquidation) concept: particularly, it confuses investments
(and the value they create) with the payoffs from the investments. When
a firm invests more cash in operations than it takes in from operations,
FCF decreases (even if the investment is positive NPV); conversely when
a firm reduces its investments, FCF increases (but a firm is worth more
if it invests profitably, not less). This occurs because in the DCF analysis,
cash receipts from investments are usually recognised in periods after
the investment is made. The solution would be that analysts make their
forecasts over long horizons so that cash receipts are matched in the same
period with the cash investments that generate them. But this contrasts
with the criterion of practical analysis because the more investing the firm
does for a longer period in the future, the longer the forecasting horizon
has to be to capture these cash inflows. (A classical example of the inability
of the DCF method to provide appropriate valuations is represented by the
estimated values in the 1980s for Wal-Mart Stores Inc., the largetst grocery
retailer in the USA.
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Another practical issue associated with the use of the DCF method is
that free cash flows are not what professional analysts forecast. Analysts
usually forecast earnings, not FCF, probably because earnings (and not
FCF) are a measure of success in operations. The solution would be to
convert earnings forecasts into FCF forecasts. This could be done, but it
would require further analysis.
Dividend discount method and the discounted cash flow

to equity method
Dividend discount method
If you think of dividends as the only cash flow that shareholders receive
from the firm, the dividend discount method (DDM) can be seen as
a straight application of bond valuation methods to equity. Under the
framework of the dividend discount method, the value of the firm is equal
to the present value of expected dividends (PVED). This method requires
the analyst to forecast dividends and to convert the forecast to a value by
discounting them at the cost of equity capital.
Many analysts have turned away from the DDM, although much of the
intuition of the DCF method is embedded in it. The issue here is that bond
valuation models work for a terminal investment; would such a model
work for a going concern investment, or rather an investment – in the
equity of the firm – which is expected to pay dividends for many (infinite)
periods in the future? Clearly, forecasting over infinite horizons is a
problem. A possible solution to this problem is to include both the forecast
dividends over a finite forecast horizon and the value at the end of the
horizon (where T is the last year of the finite forecasting period). This can
be formalised as:
Value of equity = Present value of expected dividends + Present value of
expected terminal, value that is:
T
E (d t+i ) E (TVT )
Vt E = ∑ i
+ (8.8)
i =1 (1 + rE ) (1 + rE )T –t
where E(dt+i) = expected dividend; E(TVT) = expected terminal value at T

(i.e. price at which we might sell the firm at the forecast horizon) and
rE = cost of equity capital.
The terminal value estimation is essential (in a parallelism with bond
pricing, note that forecasting just the dividends would be like forecasting
the coupon payments and forgetting the bond repayment). However,
this same terminal price is the value we are trying to assess: this means
that the value of the stock at time zero depends on its expected value in
the future. Here we have a circular problem, which severely affects the
dividend discount method. In practice analysts adopt several assumptions
about future growth to solve this problem.
1. The dividend at the forecast horizon will be the same forever afterward
(Williams, 1938). Thus the value of equity becomes:
VE =
T
E (d t+i ) E ( d T +1 ) 1 (8.9)
t ∑
i =1 (1 + rE )
i
+
rE (1 + rE ) T–t
That is, the terminal value is the value of a perpetuity calculated by
capitalising the forecast dividend at T+1 at the cost of equity capital.
This represents a strong assumption because if earnings are retained,
dividends should grow as retained funds should earn more in the firm.
123
This idea can be accommodated in a terminal value calculation that

incorporates growth.
2. If dividends are assumed to grow and the constant growth starts in
the first period, we have the so-called Gordon growth model (Gordon,
1962), which formally can be written as:
E ( dt–1 ) (8.10)
Vt E =
rE − g
This is a simple model to valuing equity, but it is extremely sensitive
to the inputs for the growth rate. Used incorrectly it can lead to
misleading or absurd results. This shifts the problem to identify g.
When is it realistic to assume that dividends grow at a constant rate in
perpetuity? The use of this model is limited to firms in a ‘steady state’,
or rather with dividends growing at a stable rate. Since the growth rate
of dividends is expected to be sustained forever, the other performance
measure (e.g. earnings) can also be expected to grow at the same rate.
Also, it is reasonable that this growth rate is less than or equal to the
growth rate of the economy in which the firm operates. It remains that
there can be differences in the benchmark growth rate used by different
analysts because of the uncertainty associated with the estimates of
expected inflation and real growth in the economy.
This method is best suited for firms with growth rate equal to or lower
than the nominal growth rate in the economy and with well-established
dividend payout policies that firms intend to continue into the future.
3. If dividends are assumed to grow at a constant rate after the terminal
year, the model is referred to as dividend growth model. In symbols,
the value of equity is calculated as:

T
E (d t–i ) E ( d T +1 ) 1 (8.11)
Vt E = ∑ i
+
i =1 (1 + rE ) rE − g (1 + rE ) T–t
The terminal value here is the value of a perpetuity with growth.

This model can be framed as a two-stage dividend discount model,
allowing for an initial phase where the growth rate is extraordinary,
and a subsequent steady state where the growth rate is stable and is
expected to remain constant forever. Typically the growth rate during
the initial phase is higher than the stable growth rate, but it can be
used even in cases with negative growth rates in the initial phase.
The same constraints that apply to the Gordon growth model (i.e.
growth rate in the firm equal to or lower than the nominal growth rate
in the economy) apply to the dividend growth model. In addition, the
payout ratio has to be consistent with the estimated growth rate: if the
payout ratio is expected to decrease significantly after the initial phase,
the payout ratio should be higher in the stable phase than in the initial
growth phase. In the estimation of this new payout ratio, it is useful
to recall that the growth rate should depend on the extent of earnings
reinvestment into the firm and the rate of return on the investments
(reinvestments do not increase market value today unless future
return on investments exceeds the discount rate of the cost of capital).
Formally, the growth rate can be estimated as:
Expected growth (g) = Retention ratio × ROCE = (1 – Payout ratio)
× ROCE
Several practical problems affect the model: the definition of the
length of the extraordinary growth period; the assumption of a sudden
transformation from an extraordinary growth rate to a stable rate at
124
the end of the finite horizon; the negatively skewed estimates for firms
not paying out the dividends they can afford (i.e. underestimation of the
value of firms that accumulate cash and pay out too little dividends).
The use of this model is most appropriate for firms that expect to
maintain a high growth rate for a specific period. This could happen in
several cases: firms with patent rights to a very profitable product for a
given number of years, or firms operating in an industry with barriers
to entry. In both cases, such firms may expect abnormal growth for that
specific period. Note that this model can be used appropriately also to
value firms that pay low or no dividends, if the dividend payout ratio is
adjusted to reflect changes in the expected growth rate.
Discounted cash flow to equity method

The dividend discount method is based on the assumption that the only
cash flow received by shareholders is dividends, whereas the discounted
cash flow to equity method (DCFE) uses a more comprehensive definition
of cash flow to equity in terms of cash flow left over after meeting financial
obligations and after covering capital expenditure and working capital
needs (for an explanation please refer back to the section ‘Step 1: Forecast
FCF over a finite forecast horizon’).
The discounted cash flow to equity method does not represent a radical
departure from the dividend discount method. In fact, we can define DCFE
as a method where we discount potential dividend rather than actual
dividend. Consequently, analysts use variants of the same three versions
of the DDM, with a significant change – free cash flows to equity replace
dividends in DCFE.
However, the implicit assumption of the two methods is different. Under
the DDM, only dividends are paid (and the remaining earnings are invested
back into the firm both in operating assets and in cash/cash equivalents).
Conversely, under the DCFE, the FCFE is paid out the shareholders, and the
remaining earnings are reinvested only in operating assets.
What is the relationship between the valuation provided by DCFE and
DDM? There are two conditions under which the DDM and the DCFE
provide the same valuation:
• when the dividends are equal to the FCFE
• when the FCFE is higher than dividends, but the excess cash (i.e. FCFE
minus dividends) is employed in zero net present value projects.
What is the relationship between the valuation provided by DCFE and DCF?
The value obtained from the two methods is the same if the analyst makes
consistent assumptions about financial leverage. However, this is far from
the usual case. In fact, this happens under the following conditions: the
values for debt and equity used in the cost of capital calculation have to be
the same values obtained in the valuation; the difference between operating
income and net income is represented only by net interests and taxes (no
extraordinary item affects the result); interest expenses are equal to the pre-
tax cost of debt multiplied by the market value of debt.
Limits of the dividend discount method

The logical problem of the dividend discount model is that the equity
value is based on future dividends, but to forecast dividends over a finite
horizon does not give an indication of value. Value depends on the forecast
profitability of current investments and forecast future investments,
which means dividend policy per se does not affect firm value (Miller and
Modigliani, 1961). (Please recall also the discussion on the account relation
125
on the drivers of dividends in the section ‘Accounting relations on the

drivers of each component of reformulated financial statements’.)
Dividends are not relevant to value, and their payment represents just a
distribution of value, not a creation of value. If dividends are irrelevant,
we have to forecast the terminal value (when the dividend discount
model is used), but this is what we are looking for. This leaves us with
the so-called ‘dividend conundrum’ (Penman, 2012). The presence of this
conundrum implies that the dividend discount model typically does not
work. Therefore we need to shift the focus to predicting earnings by using
accrual accounting valuation models. The abnormal earnings method and
the abnormal operating income method, discussed in the next sections,
enable us to do so.
Abnormal earnings method

Under the abnormal earnings method, the intrinsic value of a firm’s equity
can be expressed as the sum of the current book value of equity plus the
present value of future expected abnormal earnings (PVAE). Formally this
can be written as:
Value of equity = Book value of equity + Present value of expected
abnormal earnings (PVAE), that is:
+∞
E (AEt +τ ) (8.11)
Vt E = BPt + ∑ t
τ =1 (1 + rE )
t +τ
where CSEt = book value of equity at date t; AEt = abnormal earnings

generated in year t; VEt = the intrinsic value of equity at date t (market
value of equity obtaining in efficient markets).
That is, the valuation task is now framed in terms of the identification of
the value drivers for the firm: How much greater (or smaller) than the
normal level will the ROCE be? How quickly will the firm’s investment
base (book value) grow?
The intuition behind the AE-based method is that there is a missing value
in the balance sheet, although the valuation model itself is anchored
on the book value of equity in the balance sheet. The missing value is
represented by the premium over book value (that is, VEt – CSEt). This
premium is equal to the sum of discounted expected abnormal earnings.
If accounting is unbiased, investors should be willing to pay no more
than the book value of equity to acquire the equity of a firm in a perfectly
competitive industry if the firm can earn only a normal rate of return on
its book value. Conversely, investors should pay more (or less) than the
book value if earnings are above (or below) this normal level. This means
that the deviation of a firm’s market value from its book value depends on
the firm’s ability to generate abnormal earnings.
It is interesting to note that the PVAE formula obtains regardless of how
biased the accounting is (please see the explanation provided in Chapter
4). In the presence of clean-surplus accounting, equation (8.12) obtains.
In the absence of clean-surplus accounting, a firm’s actual earnings
(net income) will be different from the firm’s comprehensive earnings.
Nevertheless, if abnormal earnings are derived from comprehensive
earnings (instead of net income), the same result obtains.
Step 1: Forecast AE over a finite forecast horizon

As in the FCF-based valuation, analysts distinguish between a short
forecasting period in which detailed forecasts are produced (explicit
forecasting period) and a longer period for which simplifying assumptions
126
are used (post-horizon period). Therefore, the first step is to forecast

abnormal earnings (AE) over a finite forecast horizon T.
Abnormal (residual) earnings are the central concept in the model. The
idea is to make an adjustment to accounting earnings to reflect the fact
that accountants do not recognise any opportunity cost for equity funds
used. As already explained in Chapter 4, abnormal earnings are calculated
as comprehensive earnings (CE, which is equal to net income in presence
of clean-surplus accounting) adjusted for a capital charge computed as
the discount rate (i.e. the required return for equity, rE ) multiplied by the
beginning book value of equity (CSEt–1). In symbols:
AEt = CEt − (rE xCSE t −1 ) (8.12)
To get the measure of the payoff to be used in this method, analysts need
to forecast the balance sheet and the income statement.
Activity 8.5
Let us now go back to the Ryanair case study. Provide forecasts of AE for the period
2012–2021.
Below is the forecast for the period 2012–2022.
Step 2: Valuing post-horizon AE

Equation (8.12) represents a going-concern model, which involves
forecasting performance over the remainder of the firm’s life. However,
as for the DCF model, the criteria for a practical valuation require finite
forecast horizon. To simplify the process of forecasting, as regards the
post-horizon forecast, analysts must adopt one of the following three
alternative assumptions.
1. If an industry is expected to become perfectly competitive, then, at
some date, firms’ subsequent expected AEs become equal to zero. An
analyst may thus choose as the first year of the post-horizon period
the first year in which AEs are expected to become equal to zero. If AE
after the forecast horizon is forecast to be zero, then the forecast of the
premium equals zero. Thus PVt(PH AE) = CVt = 0.
The economic motivation is that high profits attract earnings
competition to drive profitability down to a normal level, so that
ROCE = rE. As illustrated as regards the ROCE mean reversion,
competition tends to limit the firm’s ability to identify growth
opportunities that generate abnormal earnings.
2. If, on the strength of the strategic analysis, a firm is expected to derive
some limited economic rents forever, the following approach may be
127
used: the analyst may assume that, beyond some year T, abnormal
earnings remain as at T. (Note that the analyst should choose the
length of the explicit forecasting period so that the explicit forecasting
period ends at the end of year T.) Formally this can be written as:
1 E ( AET +1 ) (8.13)
PVt ( PH AE ) = CVt =
(1 + rE ) T− t rE
If AE after the forecast horizon is forecast to remain as at T, then the

forecast of the premium equals the capitalised amount of a perpetuity.
The economic motivation is that the analyst expects that abnormal
earnings can be expanded to new projects for many years, but only
with reference to an investment base that remains constant.
3. Assume that, beyond some year T, any growth above some rate g comes
in the form of normally profitable projects. Choose the length of the
explicit forecasting period so that the explicit forecasting period ends at
the end of year T. Formally, this can be written as:
1 E ( AET +1 ) (8.14)
PVt ( PH AE ) = CVt =
(1 + rE ) T −t rE − g
If abnormal earnings after the forecast horizon are forecast to grow at
a constant rate, then the forecast of the premium equals the capitalised
amount of a perpetuity with growth. The growth rate distinguishes
alternatives 2 and 3 because alternative 2 is just the case of no growth
(g = 0). The economic motivation is that the analyst believes that the
abnormal profitability can be extended to an investment base that
grows at the expected long-term inflation rate or at the expected long-
term GDP growth rate. The idea is that the firm may defy competition
forces and earn abnormal earnings on new projects that grow
according to some parameter. Note that the valuation can be quite
sensitive to the growth rate – so analysts tend to use financial analysis
to uncover the growth rate. The long-term level of the abnormal
earnings and its growth rate are sometimes referred to as the steady-
state condition for the firm.
Alternatives 1 and 2 cover many of the cases you will run into in practice.
We might expect alternative 1 to be typical: a firm might earn positive
abnormal earnings for a while, but forces of competition will drive down
its abnormal earnings so that ROCE equals the cost of equity capital.
However, the empirical evidence shows that high abnormal earnings
do decline, but it is quite common for high abnormal earnings to level
off at a positive amount. As already explained, abnormal earnings can
remain positive not only for the presence of economic rents, but also
for accounting reasons (firms keep their book value low because of
conservative accounting, for example by expensing R&D assets). Although
alternative 3 is more aggressive, it may be more realistic for some firms.
For example, in the 1980s, Wal-Mart Stores Inc. and General Electric
Co. were forecast to have negative free cash flow for some years, but the
abnormal earnings were forecast to grow continually: thus it probably
would have been unreasonable to expect abnormal earnings to be constant
or zero after the terminal year.
Step 3: Calculating the value of equity

To calculate the value of equity, the analyst needs to discount the
abnormal earnings, to add the book value of equity and to discount the
premium at the horizon. Formally, this can be written as:
128
T −t
Et ( AEt +i ) (8.15)
Vt E = CSEt + ∑
(1 + rE ) i CV t
+
i =1
Therefore, to value the equity, the analyst needs three elements: the
current book value of equity; the forecast of the abnormal earnings during
the explicit forecast period; and the continuing value (CV), which is the
forecast value of abnormal earnings beyond the finite horizon. Because the
analyst may adopt for the estimation of the continuing value any of the
three assumptions specified in the previous section, equation (8.15) can be
framed in the three following ways:
T −t
E ( AEt +i )
Under assumption 1: Vt = CSEt + ∑ t
E
i (8.16)
i =1 (1 + rE )
Under assumption 2:

T −t
E ( AEt +i ) 1 E ( AET +1 )
Vt E = CSEt + ∑ t i
+ T −t
(8.17)
i =1 (1 + rE ) (1 + rE ) rE
T −t
Et ( AEt +i ) 1 E ( AET +1 )
Under assumption 3: Vt E = CSEt + ∑ + (8.18)
i =1 (1 + rE ) t (1 + rE ) T −t rE − g
It is essential to note that g could be negative, which would allow for the
gradual disappearance of abnormal earnings.
Also note that in any version of the model, the appropriate discount rate is
the cost of equity capital.
Activity 8.6*
Let us now go back to the Oxo plc activity (Activity 8.3). Assume the expected amounts
for comprehensive earnings and common shareholders’ equity (in £m) reported below.
Use the AE-based method to estimate the value of equity under the three alternative
assumptions for the post-horizon continuing value.
2012 2013 2014 2015 2016 2017
Comprehensive Earnings (CE) 250 280 350 360 400
Book Value of Equity (CSE) 650 700 800 960 1150 1320
Activity 8.7
Let us now go back to the Ryanair case study. Given the forecasts of AE for the period
2012–2022 (obtained in Activity 8.5), use the abnormal earnings method to estimate the
value of equity for the company. Assume a long-term growth rate of 1.5 per cent and use
all relevant information provided throughout the guide.
Below you can find a possible equity value of Ryanair on the basis of the
abnormal earnings method.

understanding that Ryanair is overvalued. By using the AE-based valuation
method, we suggest a target price of €2.41 (market price at close of
business on 31/12/2011: €3.63). The set of forecasts used in the explicit
forecasting period is not consistent with any mean reversion in RNOA.
129
Furthermore, even if the growth rate used in the post-horizon period was
higher and equal to 3 per cent, the target price would only raise to €2.56.
Therefore we recommend a sell.
Advantages and limits associated with the AE-based method

Several advantages characterise the AE-based method, a valuation
architecture oriented to the measurement of value generation in a
business:
• Its focus is on the value drivers (profitability and growth in
investments).
• It is aligned with the measure (earnings) typically forecast by analysts.
• It directs strategic and financial analysis to value generation: a direct
link is made between financial statement analysis, analysts’ earnings
forecasts and value creation.
• The forecast horizon needed to permit an accurate approximation of
the firm value is typically shorter for the AE-based method than for the
DCF method. This happens because more value tends to be recognised
in the immediate future, rather than in the continuing value. Two
reasons explain the lower percentage of the value coming from the
continuing value in the AEM than in the DCF method: value is usually
recognised earlier in AE forecasts than in FCF forecasts; the current
book value of equity is incorporated in the estimate of the value.
However, one main disadvantage of the AE-based method is that the
length of the forecast horizon does depend – inversely – on the quality of
accrual accounting: high-quality accounting systems reflect value over a
shorter forecast horizon (note nevertheless that the method is not overall
affected by the quality of accounting).
Activity 8.8
As regards the Ryanair valuation, compare the time required for the recognition of value
under the DCF and AE-based methods. Then compare the percentage of the total value
coming from continuing value under the DCF and AE-based methods.
The AE-based method has had a long history. Although used as far back
as the nineteenth century, cash flow methods have dominated practice.
However, in the 1990s, the AE-based method was applied in consulting,
investment advising and valuation practices, and this generated a
proliferation of variations of the model.
Abnormal operating income method

A special case of the abnormal earnings-based method is represented by
the abnormal operating income method (also known as economic value
added method or economic profit method). Under this method, the value
of the firm equals the amount of net operating assets, plus a premium
equal to the present value of the value created each year (or rather the
abnormal operating income) by an investment, plus the continuing value.
In short, this is:
Value of the firm = Net operating assets + Present value of expected
abnormal operating income + Present value of the continuing value
which is:
T–t
E(AOIt+i ) E (CVT ) (8.19)
Vt = NOAt + ∑ +
i =1 (1 + rF ) i (1 + rF ) T
130
That is, the analyst needs three elements to calculate the value of the
firm (also referred to as enterprise value): a measure of the firm’s
invested capital, typically the current book value of net operating assets;
the present value of the forecast abnormal operating income during the
explicit forecast period; and the continuing value, which is the forecast
value of abnormal operating income beyond the horizon. Note that the
appropriate discounting rate is the WACC, because abnormal operating
income refers to the firm’s invested capital, which is financed both by
shareholders and debt-holders.
The economic intuition is straightforward. A firm is worth more or less
than its invested capital only to the extent that it earns more or less than
its WACC. Therefore the premium or discount relative to the invested
capital must equal the present value of the firm’s future expected
abnormal operating income.
The AOI-based model is extremely popular nowadays, as the next activity
demonstrates.
Activity 8.9
Visit the Stern Stewart & Co. website at www.sternstewart.com/1?content=
proprietarylp=eva. Stern Stewart & Co. is the New York-based consulting firm that most
heavily promoted EVA during the 1990s. Its success determined the emergence of a
series of imitators from other consulting firms (such as value-based management from
Marakon Associates, cash flow return on investment from Holt Value Associates, economic
profit model from McKinsey & Co., value builder from Pricewaterhouse-Coopers, and
economic value management from KPMG), all of which were variants of the economic
profit measure. In the website of Stern Stewart & Co., critically read how Bennett Stewart
explains EVA, and identify similarities/differences with our definition of the AOI concept.
Step 1: Forecast AOI over a finite forecast horizon

As we now focus on operating activities, we need to consider the relevant
measure of abnormal income. This is the abnormal operating income,
which is a measure of the value created by a firm in a single year. The
first step of the abnormal operating income model is thus to forecast AOI
over a finite forecast horizon. To do so, analysts need three basic inputs:
the return on capital earned on investments, the cost of capital for those
investments, and the capital invested in net operating assets. Formally, AOI
can be written as:
AOI t = OI t − r NOAt −1 = ( RNOAt − r) NOAt −1 (8.20)
where OI denotes the after-tax operating income that you use to estimate
free cash flow. The AOI measure is similar to an accounting earnings
concept, but it explicitly charges the firm for all its capital (both from debt-
holders and shareholders).
By adopting the framework used by EVA consultants, AOI is framed as
economic value added (EVA), which can be calculated as:
EVAt = NOPLATt − r CI t −1 (8.21)
where NOPLAT (net operating profits less adjusted taxes) is a variant of
OI, and CI (capital invested) is a variant of NOA. However, consultants
advocating EVA argue that NOPLAT and capital invested cannot be directly
calculated using accounting data (respectively NOPLAT and NOA), but
need to be calculated on an economic basis. As a consequence, they
have identified a series of accounting adjustments to reported financial
statement data. (Note that Stern Stewart does not disclose fully the precise
adjustments to make, but plenty of guidance exists in the literature.)
131
Adjustments fall into three broad categories: the undoing of accounting

conservatism, the discouragement of earnings management, and the
immunisation of performance measurement against past accounting
errors (as explained in O’Hanlon and Peasnell, 1998). The most common
category is the redoing of accounting conservatism, which in particular
concerns the following items:
1. Research and development (R&D) costs, advertising and marketing
costs, training costs, namely expenditures designed to generate future
growth and typically qualified as intangible investments. Accounting
standards require firms to treat all outlays for such expenditures as
operating expenses. According to EVA consultants, this represents
an accounting distortion that has be corrected by: adding back these
expenses in the NOPLAT calculation; capitalising such expenses in
capital invested and; amortising these capitalised expenses over an
appropriate period.
2. Operating lease expenses are usually considered as operating costs
in the income statement. However, operating leases are disguised
financial expenses since companies acquire productive assets (and,
therefore, finance their future production) by paying periodic rent (i.e.
operating leases expenses). According to EVA consultants, in order to
face this conservative accounting practice, it is necessary to: capitalise
any operating lease expenses in the NOPLAT calculation; treat the
present value of expected lease commitments over time as capital
invested in the firm; and amortise these capitalised expenses over an
appropriate period.
Conceptually, EVA differs from AOI only in so far as there are adjustments
to be made to NOPLAT and capital invested mainly to undo accounting
conservatism (recall that in turn AOI differs from traditional accrual
accounting because the cost of capital is charged).
Step 2: Valuing post-horizon AOI

The analyst’s expectation on the firm’s performance beyond the terminal
year is summarised in the continuing value. Correspondingly to the
three alternatives for the abnormal earnings model illustrated in the
section ‘Step 2: Valuing post-horizon AE’, the analyst can make any of the
following assumptions:
• If AOI after the forecast horizon is forecast to be zero, then the
forecast of CV equals zero. This implies that the analyst expects the net
operating assets to earn at the cost of capital.
• If AOI after the forecast horizon is forecast to be a constant, then the
forecast of CV equals the capitalised amount of a perpetuity. In symbols
this is:
E ( AOI T +1 ) 1 (8.22)
CVt =
r (1 + r ) T–t
• If AOI after the forecast horizon is forecast to grow at a constant
rate, then the forecast of the CV equals the capitalised amount of a
perpetuity with growth. In symbols this is:
CV = E ( AOI T +1 ) 1 (8.23)
t
r−g (1 + r ) T
132
Step 3: Calculating the value of equity

To get the value of equity, the analyst needs to discount the forecast
abnormal operating income over the finite horizon, add the book value of
net operating assets, discount the premium at the horizon and take away
the value of net financial obligations. In symbols this is:
T–t
E ( AOI i ) (8.24)
Vt E = NOAt + ∑ + CVT − NFOt
i –1 (1 + r ) i
where the continuing value can take the three forms illustrated in the
previous section. Note that in the EVA methods proposed by consultants,
NOA is replaced by adjusted capital invested, and AOI by an EVA measure
calculated on the basis of the adjusted NOPLAT.
Activity 8.10
Let us now go back to the Ryanair case study. Forecast AOI for the period 2012–2022,
and then use the AOI method to estimate the value of equity for the company. Assume a
zero long-term growth rate and use all the relevant information provided throughout the
guide.

understanding that Ryanair is overvalued. By using the AOI-based
valuation method, we suggest a target price of €2.62p (market price at
close of business on 31/12/2011: €3.63). The set of forecasts used in the
explicit forecasting period is not consistent with any mean reversion in
RNOA. Furthermore, even if the growth rate used in the post-horizon period
was higher and equal to 3 per cent, the target price would only raise to
€2.81. Therefore we recommend a sell. Therefore we recommend a sell.
Advantages and limits of AOI and EVA methods

It is clear that the AOI-based method (and the EVA method developed by
consultants) are special cases of the abnormal earnings model. However,
two main differences qualify these methods.
First, the AOI-based method applies to operating activities, whereas the
AE-based method applies to equity. What are the advantages? As some
financial assets and financial obligations are measured in the balance
sheet at the market value, they do not add value to their reported
balances. Therefore, we get a valuation by forecasting only the abnormal
earnings from net assets that add value (i.e. net assets not at market
value). This method makes the forecasting task easier because it requires
us to forecast the abnormal operating income generated by net operating
assets, but not net financial obligations as they are at market value in the
balance sheet (and thus abnormal net financial expense equals to zero).
VE = VNOA – VNFO, but VNFO = NFO as ANFE = 0. Thus the valuation task is
reduced to the estimation of VNOA.
133
Second, the EVA method developed by consultants imposes a specific

method of accounting, whereas the AE-based method does not.
Different accounting methods produce different measures of book
value and earnings. Although AEs differ across periods according to the
accounting method used, the sum of the present values of abnormal
earnings will remain the same. This explains why, for the AE-based
method, it is not necessary to undo accounting for valuation purposes,
because accounting does not matter: accounting effects do not have
any valuation effects under the AE-based method. Conversely, in the
EVA method, a series of adjustments are made to financial statement
data to undo accounting effects. Note, however, that these adjustments
introduce even more subjectivity into accounting than would normally
be the case (i.e. capitalising and amortising introduce the problem of
estimating amortisation rates to measure the decline in economic value of
intangibles).
In comparison with the DCF method, an advantage of the AOI-based
method (and the EVA method) is that economic profit is a useful measure
for understanding the firm’s performance in any single year, while free
cash flow is not (as it is determined by discretionary investments in fixed
assets and working capital). Note, however, that the PVFCF and PVAOI
provide the same value of equity if we forecast no growth in NOA and
constant RNOA after the horizon.
Comparison of methods: empirical evidence

In theory all the above valuation methods (either cash flow or abnormal
earnings based) provide the same answer: the intrinsic value of equity. In
infinitive settings, PVAE, PVAOI, PVED, PVFCFE and PVFCF are equivalent.
Under these infinitive settings valuation methods require us to forecast
an infinitive stream of fundamentals. Nevertheless, most forecasting
difficulties lie in the long term. To solve this problem in practice, analysts
make some simplifying assumptions and use a truncated version (finite
settings).
Would one expect a given valuation method to dominate the remaining
ones in finite settings? Given that all the valuation methods make
unrealistic assumptions, it would be fruitless to criticise on the basis
of their realism. Therefore, to get some inferences on the quality of a
valuation method, we need to refer to its objectives, namely:
• to explain observed stock prices, assuming efficient capital markets
• to predictably generate positive or negative abnormal returns,
assuming inefficient capital markets.
Following on, in the next sections, we aim to identify which of these
methods best explains stock prices and/or which has the most predictive
power with respect to future returns. We will do so by investigating the
empirical evidence provided by Penman and Sougiannis (1998) and
Francis et al. (1997).
A comparison of the accuracy of dividend, free cash flow and ab-

normal earnings valuation methods
Penman and Sougiannis (1998) recognise that valuation methods based
on dividends (DDM), free cash flows (DCF) and abnormal earnings (AEM)
are equivalent when the respective payoffs are predicted to infinity.
However, in practice forecasts are made over finite horizons. This causes
problems. Following on, their research aims to:
134
• compare the intrinsic value estimated by DDM, DCF and AEM in a

finite horizon using ex post realisations as proxies for expected values
to assess the accuracy of valuation methods
• identify what methods work best for forecast over one-, two-, five- and
eight-year horizons.
In the estimation of the intrinsic value, the following assumptions have
been adopted: valuations are calculated from subsequent realisations
of the payoffs specified by the various methods and from actual stock
prices. Inferring ex ante valuation errors from ex post data and actual
prices assumes that ex post average realisations are equal to their ex ante
rational expectations and observed market prices are efficient; valuations
are calculated with or without continuing/terminal value to account for
the value of the firm after time T.
The methodology of Penman and Sougiannis aims to assess the accuracy
of valuation methods by comparing actual traded prices with intrinsic
values based on ex post payoffs (as prescribed by the model) to calculate
valuation errors. Firms are randomly assigned to 20 portfolios at the end
of each year of the sample (1973–90). Average portfolio intrinsic values
are then calculated from accounting realisations for each horizon (up to
10 subsequent years). The valuation errors for various valuation methods
are per unit of price at t, and calculated as:
Errort = [Pt – Valuet ]/Pt (8.25)
where Valuet = portfolio intrinsic value at t calculated from actual ex post
payoffs, that is realisations of ex ante payoffs; Pt = observed portfolio price
at t.
The empirical results, summarised in Table 8.3, emphasise the following:
1. The benchmark error (also known as market forecasting error) is
calculated by applying the cost of capital to the actual price. It indicates
the error one would expect to observe even for a perfect valuation
technique. The observed negative errors arise for any of the following
reasons: average market inefficiency at time t; misspecification of the
cost of capital; systematic ex post deviations from expectations in the
period.
2. The errors for the DDM are large and positive for short horizons, but
decline toward the benchmark error as more dividends are included in
the calculation.
3. The errors for DCF are positive and large over all horizons (greater
than 150 per cent of actual prices). With the terminal value calculation,
the errors are still large, though decreasing with higher values of the
growth rate.
4. The errors for the AEM are lower, regardless of the length of the
horizon.
5. Let us now focus on a typical four-year forecast horizon and a terminal
value with growth. The related average prediction errors are: –6.1
per cent for the AEM; 76.5 per cent for the DCF; 16.7 per cent for the
Gordon growth method. This shows that errors are lower using the
AE-based method rather than the DCF method, with Gordon dividend
estimates falling in between.
135
Horizon (t+T)
t+1 t+2 t+4 t+6 t+8 t+10
Benchmark -0.031 -0.085 -0.177 -0.294 -0.381 -0.538
DCF 1.937 1.868 1.762 1.67 1.552 1.45
AEM 0.175 0.176 0.103 0.038 -0.028 -0.12
DDM 0.923 0.845 0.663 0.478 0.283 0.069
DCF (CV: 1.0) 1.254 1.188 1.112 0.946 0.782 0.827
AEM (CV: 1.0) 0.206 0.192 0.083 0.037 0.008 -0.164
DDM (CV: 1.0) 0.574 0.504 0.314 0.132 -0.061 -0.295
DCF (CV: 1.04) 0.918 0.853 0.765 0.558 0.378 0.506
AEM (CV: 1.02) 0.058 0.049 -0.061 -0.099 -0.117 -0.307
GGM (CV:1.04) 0.424 0.356 0.167 -0.01 -0.203 -0.452
Table 8.7 Ex post valuation errors for valuation techniques for selected horizons
Source: Adapted from Penman and Sougiannis (1998, p.356)
With DCF denoting the discounted cash flow method; AEM denoting the abnormal
earnings method; DDM denoting the dividend discount model; GGM denoting the
Gordon growth method. Terminal value TV was calculated for going concerns with one
plus the assumed growth rate in the terminal payoff indicated within the parentheses.
A comparison of the accuracy and explainability of dividend, free

cash flow and abnormal earnings valuation methods
Another study providing empirical evidence on the reliability of the value
estimates obtained from three valuation methods (based on dividends,
free cash flows and abnormal earnings) was conducted by Francis et al.
(1997). By using forecasts supplied by Value Line over a five-year forecast
horizon for the period 1989–93, they compared valuation methods in
terms of:
• Accuracy: difference between the value estimate and the current
market price, divided by the market price. (Note that accuracy is
measured inversely in Penman and Sougiannis, 1998.) This enables
us to identify the most reliable method.
• Explainability: ability of the value estimates to explain cross-sectional
variation in current price. This means to control for systematic over- or
underestimation by valuation methods.
Pause and think about the difference between accuracy and explainability.
To understand this difference consider the argument that the DDM
underestimates intrinsic values of firms that do not distribute dividends.
This means that dividend method estimates have low accuracy, but says
nothing about explainability. If the bias in estimates based on dividends is
constant and stable, analysts could adjust these estimates to obtain more
accurate valuations.
In contrast to Penman and Sougiannis (1998), Francis et al. (1997) use
Value Line annual forecasts of the payoffs in these models to calculate
value estimates (recall Activity 4.1 to have a view of the elements forecast
by Value Line): thus their empirical evidence is based on forecast (not
realised) proxies of the payoffs. As regards the terminal value, three
different assumptions are used: long-term price-to-earnings ratio provided
by Value Line; zero growth perpetuity; and constant growth perpetuity
(4 per cent).
The test of accuracy is based on the measurement of prediction errors
(both signed and absolute mean and median), whereas the methodology
used to test for explainability is based on regressing market prices on
values predicted by dividend, free cash flow and abnormal earnings
136
methods and measuring the incremental contribution made by each

method.
As regards accuracy, the empirical evidence (adapted in Table 8.10) shows:
• the most accurate value estimates also explain the most variation in
contemporaneously observed prices
• when continuing/terminal value is based on Value Line 3–5 year ahead
P/E forecast, there are slight differences between methods: dividend
and abnormal earnings-based methods perform similarly, while the
discounted cash flow method performs slightly worse
• when continuing/terminal value is included (which is more common in
practice, as described in the previous sections), all of the methods tend
to underestimate stock prices
• with the perpetuity-based continuing/terminal value (growth 4 per
cent), AE-based estimates are more accurate than the estimates from
the Gordon growth method and the discounted cash flow – the median
absolute prediction error for the AE is about two-thirds that of the DCF
(30 per cent vs 45 per cent), and less than one-half that of the GGM
(30 per cent vs 70 per cent).
TV=Value line P/E g=0% g=4%

DDM DCF AEM DDM DCF AEM GGM DCF AEM
Median 0.1623 0.2298 0.1768 0.7582 0.486 0.3284 0.6904 0.4554 0.3003
Central tendency 0.4702 0.4314 0.3381 0.0093 0.1379 0.2019 0.0172 0.1751 0.225
Table 8.8 Valuation errors for valuation techniques (5-year horizon)

Source: Adapted from Francis et al. (1997, p.26). With central tendency denoting the percentage of
observations with value estimates within 15 per cent of observed prices.
With regard to explainability, the empirical evidence (summarised in Table

7.5) using univariate regressions shows that AEM and DDM consistently
explain more in the variation of current stock prices than DCF. For OLS
regressions, the difference is especially pronounced for the perpetuity-
based continuing/terminal value specification when AEM (DDM) estimates
explain 71 per cent (51 per cent) of the variation in current prices,
compared with 23 per cent for DCF estimates. (Note that the difference
is more modest for rank regressions.) As regards multivariate regressions,
the empirical evidence shows that only the AEM has incremental power:
incremental R2 (OLS regression) shows that AE estimates add 17 per cent
in the explanatory power. In contrast, neither DCF nor DDM estimates add
much to explaining variation in prices after controlling for the other two
value estimates.
It is essential to note that the AE-based method does not provide less
reliable value estimates for firms where we expect book values to poorly
reflect intrinsic values (i.e. firms with high R&D expenditures and high
levels of accounting discretion). The results actually suggest the opposite:
AE-based estimates for high R&D spending firms are more accurate and
explain more in the variation of the current stock prices than DCF and
DDM value estimates.
This evidence confirms that the AEM obtains regardless of how biased the
accounting is.
137
Univariate regressions of price on value estimate

OLS coefficient 1.01 0.83 0.94 1.75 0.67 1.23 1.3 0.31 1.09
OLS R^2 0.91 0.8 0.88 0.53 0.35 0.73 0.51 0.22 0.71
Rank R^2 0.96 0.89 0.95 0.84 0.76 0.9 0.84 0.73 0.9
Multivariate regressions of price on value estimate

Incremental OLS R^2 0.03 0.00 0.00 0.00 0.00 0.15 0.00 0.01 0.17
Incremental Rank R^2 0.01 0.00 0.00 0.00 0.00 0.04 0.00 0.00 0.05
Table 8.9 Regression of contemporaneous stock prices on value estimates

Source: Adapted from Francis et al. (1997, p.27)
The incremental R2 is the difference between the adjusted R2 for the OLS
(rank) regression containing all three value estimates and the adjusted R2
for the OLS (rank) regression, which excludes the value estimate in the
noted column. That is, the incremental explanatory power of abnormal
earnings method equals the R2 of minus the R2 of
P = r0 + r1VDDM + r2 VDCF + r3VAEM
P = r0 + r1VDDM + r2 VDCF
The main limit of the above studies (Francis et al., 1997; Penman and
Sougiannis, 1998) relates to an inconsistent application of the DDM
(Lundholm and O’Keefe, 2000). The hypothesis is to estimate the value
as explicit dividend forecasts over a five-year horizon plus terminal value
(using a growth rate, g = 0 or 4 per cent in perpetuity). The dividend
forecasts for five years account for a small fraction of current market
value. Then, if g = 0, in practice we observe a huge permanent increase in
dividends from year 5 to year 6, with dividends equal to earnings in year
6 and beyond. Instead, Francis et al. (1997) and Penman and Sougiannis
(1998) forecast dividends in year 6 as DIVt+5(1+g). Naturally they find the
DDM to perform poorly.
Overview of chapter
We provided in this chapter an investigation of how valuation is carried
out under different valuation models on the basis of full-information
forecasting. A valuation model provides the architecture for valuation. It
tells the analyst how to think about the value generation in the future,
and also how to account for the value generation to translate the thinking
into a valuation. Should the analyst account in terms of cash flow for the
future (e.g. free cash flow or dividend)? Or should the analyst use accrual
accounting for the future (e.g. abnormal earnings or abnormal operating
income)? In this chapter we have explained how to get valuations from
the discounted cash flow (DCF) method, the dividend discount method
(DDM), the abnormal earnings method (AEM), the abnormal operating
income (AOI) method and the economic value added (EVA) method.
The DCF method focuses appropriately on operating activities (which
include, as previously specified, investing activities), where the value is
generated. However, free cash flow is a doubtful measure of value added
because it is reduced by a firm’s investments, although investments are
made to generate value. Of course, the forecast of free cash flow captures
value in the long run. But this goes against the practical valuation
criterion, which is the use of relatively short forecasting horizons.
To solve this problem associated with the free cash flow concept, analysts
can base their valuation on accrual accounting numbers. Under accrual
accounting, investments are not deducted from revenues (as is the case
138
with free cash flow), but they are put in the balance sheet as an asset,
to be matched as expenses against revenues at an appropriate time.
Accordingly, accrual accounting produces a measure, earnings, of the
value added in operations. Accrual accounting models, such as the AE-
based method and the AOI-based method, utilise book value in the current
balance sheet and also calculate a premium over book value from forecasts
of earnings and book values (as reported in the forecast income statement
and balance sheet).
Finally, we provided some empirical evidence about the accuracy and
explainability of different valuation methods. With perpetuity-based
terminal value, AE-based estimates are shown to be more accurate (and
to perform better in terms of the ability to explain stock prices) than the
estimates from the DCF and DDM.
Key terms
abnormal earnings method free cash flow to equity-holders (FCFE)
abnormal operating income method going concern investment
accrual accounting valuation models Gordon growth method (GGM)
accuracy intrinsic value
capital invested net operating profits less adjusted taxes
(NOPLAT)
competitive equilibrium assumption perpetuity
continuing value premium over book value
dividend conundrum present value of expected dividends
(PVED)
discounted cash flow (DCF) present value of expected free cash
flows (PVFCF)
discounted cash flow to equity present value of free cash flows to
(DCFE) equity-holders (PVFCFE)
dividend discount method (DDM) steady-state condition
dividend growth model terminal price
earnings before interest less adjusted terminal year
taxes (EBILAT)
economic profit method two-stage dividend discount model
economic value added (EVA) valuation model
enterprise value value of equity
explainability valuation model
free cash flow to equity-holders value of equity
(FCFE)
going concern investment value of the firm’s operations
Gordon growth method (GGM)
139

• thoroughly describe the process of securities valuation
• describe the discounted cash flow (DCF) method in detail
• explain the dividend discount method (DDM) in detail
• discuss the discounted cash flow to equity-holders (DCFE) method in
detail
• review the abnormal earnings method (AEM) in detail
• present the abnormal operating income method (AOIM) and the
economic value added (EVA) method in detail
• competently apply each of these valuation methods, and perform
valuations based on current financial statements in complex situations
• critically assess the advantages and limits of each valuation method
• adequately explain why DCF and DDM may not measure value added
in operations
• carefully review the economic concepts underlying different
continuing-value calculations
• coherently outline the empirical evidence on the efficacy of each
valuation method under specific circumstances.

1. What is the difference between the valuation of a terminal investment
and a going-concern investment?
2. How does the abnormal operating income method work? What are the
differences in the assumptions used to calculate the continuing value?
3. When does the DCF method work? Why the DDM does not work?
4. Outline the main differences and similarities between the abnormal
operating income method and the economic value added method as
developed by consultants.
5. ‘A firm cannot maintain an ROCE lower than its equity cost of capital
and remain in business indefinitely.’ Critically discuss this statement.
6. In the context of full-information forecasting, what methods work best
for forecasting over a finite five-year horizon? Provide some empirical
evidence to support your answer.
7. As regards valuation methods, what is the difference between accuracy
and explainability?
8. The following forecasts were made at the end of 2011 for a firm with a
book value of equity of £1,100:
2012E 2013E 2014E 2015E 2016E
FCF 200 220 210 225 235
OI 110 115 120 125 130
Assume the following: cost of equity capital = 10 per cent; cost of
capital for the firm = 9 per cent; long-term growth rate = 1 per cent;
net operating assets = £1,000; value of debt = £200; number of
outstanding shares =100. Apply the DCF and EVA methods to value
this firm.
140
Chapter 9: Implications for price-to-earnings and price-to-book ratios
Chapter 9: Implications for price-to-

earnings and price-to-book ratios
Introduction
In Chapter 4, we introduced accounting-based measures of performance,
such as a firm’s abnormal earnings and abnormal return on common
equity, in order to assess performance from the point of view of the
firm’s shareholders. Subsequent chapters focused on both the drivers of
performance and the extrapolation of past and present performance into
the future. This chapter investigates the implications of a stock’s expected
performance in the future for pricing with respect to fundamentals in
efficient markets.
Percentile PB PE Multiples PE PS PCFO

(Trailing a) (Leading b)
95 7.4 Negative 41.7 4.1 Negative
Earnings CFO
75 2.5 29.4 19.2 1.7 21.9
50 1.5 17.5 14.3 0.8 10.0
25 0.9 12.3 10.9 0.4 5.8
5 0.5 7.6 7.3 0.2 2.5
a. A trailing PE ratio is defined as the ratio of the market value of equity over the last
reported earnings.
b. A leading PE ratio is defined as the ratio of the market value of equity over one-
year-ahead earnings forecasts.
Table 9.1 Percentiles of common price multiples for US-listed firms
Liu et al. (2002) provide percentiles for a number of price multiples for
all US-listed stocks for the years 1963–2000. Table 9.1 displays their
findings for price-to-book (PB), price-to-earnings (PE), price-to-sales
(PS) and price-to-cash flow generated by the firm’s operations (PCFO).
Price multiples are calculated as ratios of market value of equity over
fundamentals (book value of equity, earnings, sales and cash flow
generated by the operations). As shown in Table 9.1, there is considerable
cross-sectional variability in these price multiples. For instance:
• while the median PB is 1.5, the top 5 per cent of stocks did trade on an
average PB of 7.4 and the bottom 5 per cent on an average PB of 0.5
• while the median leading PE is 14.3, the top 5 per cent of stocks
did trade on an average PE of 41.7 and the bottom 5 per cent on an
average PE of 7.3
• while the median PS is 0.8, the top 5 per cent of stocks did trade on an
average PS of 4.1 and the bottom 5 per cent on an average PS of 0.2.
This chapter explains why investors are willing to purchase some stocks on
very high price multiples and other stocks only on very low price multiples.
These explanations are furthermore fully consistent with market efficiency.
This chapter also provides empirical evidence validating our findings. Later
on, in Chapter 12, we will drop the assumption that capital markets are
efficient and check whether or not it is possible to make some economic
profit by trading on the basis of the information supplied in Table 9.1.
141
This chapter is organised as follows. It provides the drivers of price-to-

book ratios and, subsequently, the drivers of price-to-earnings ratios.
It then provides empirical evidence on the joint distribution of price-
to-earnings (PE) and price-to-book (PB) ratios, introduces a strategic
taxonomy of firms, and derives implications of taxonomy for both price-to-
book and price-to-earnings ratios. It finally introduces valuation using the
‘method of comparables’ and discusses implementation issues.
Aim
The aim of this chapter is to explain the evidence on price multiples
reported in empirical studies. We will provide empirical evidence on
price multiples such as price-to-earnings (PE), price-to-book (PB), price-
to-sales (PS) and price-to-cash flows (PCFO) ratios. We will analyse the
determinants of both price-to-earnings (PE) and price-to-book (PB) ratios.
We will introduce a strategic taxonomy and derive implications for pricing
with respect to fundamentals. Finally, we will introduce valuation using the
‘method of comparables’ and discuss some of its implementation problems.
Learning outcomes
By the end of this chapter, and the Essential readings and activities, you
should:
• aptly recognise the empirical distribution of price multiples such as
price-to-book, price-to-earnings, price-to-sales and price-to-cash flow
ratios with minimal support
• clearly describe the determinants of price-to-book ratios in efficient
markets
• thoroughly examine the implications of a firm’s expected future
performance for its price-to-book ratio
• clearly describe the determinants of price-to-earnings ratios in efficient
markets
performance for its price-to-earnings ratio
• cogently derive the implications of the given taxonomy for price-to-
book and price-to-earnings ratios
• critically evaluate the pitfalls associated with valuation using the
‘method of comparables’.
Essential reading
Further reading
Works cited
Liu, J., D. Nissim and J. Thomas ‘Equity valuation using multiples’, Journal of
Accounting Research (40), 2002, pp.135–72.
Penman, S. ‘The articulation of price-earnings ratios and the evaluation of
growth’, Journal of Accounting Research (34), 1996, pp. 235–59.
142
Drivers of price-to-book (PB) ratios in efficient markets

This section first derives the drivers of price-to-book ratios in efficient
markets. It then provides empirical evidence supporting our derivation.
Theory
In Chapter 4, we stated that the intrinsic value of a firm’s equity can be
derived as the sum of the book value of equity and the present value of the
future expected abnormal earnings (PVAE):
i=+∞ Et (AEt+i) (9.1)
VEt*= CSEt + ∑
i=1 Et (1+rE)i
with Vt* denoting the intrinsic (ex-dividend) value of the firm’s equity at
date t; Et(AEt+i) denoting the abnormal earnings expected at date t+i as of
date t; rE denoting the cost of equity capital.
By dividing both sides of the equation by the book value of equity, one
obtains:
(9.2)
The left-hand side of (9.2) is the ratio of the fundamental value over the
book value of the firm’s equity, which is also referred to as the (levered)
price-to-book ratio. A firm’s levered price-to-book ratio thus depends on
the level of future expected abnormal earnings, the current book value of
equity and the cost of equity capital. Other things being equal:
• the higher the level of future expected abnormal earnings, the higher
the price-to-book ratio (assuming a non-negative book value of equity)
• the lower the book value of equity, the higher the price-to-book ratio
(assuming non-negative expected abnormal earnings)
• the lower the cost of equity capital, the higher the price-to book ratio
(assuming a non-negative book value of equity and non-negative
expected abnormal earnings).
Let us consider a special case: a firm without any comparative advantage
in a very competitive industry. If accounting is unbiased, future abnormal
earnings are expected to be nil and the firm’s (levered) price-to-book ratio
is hence equal to 1. This particular price-to-book ratio is also referred to
as the normal price-to-book ratio. Let us then consider a firm with some
comparative advantage, at least in the short term, in a more attractive
industry. For the latter firm, if accounting is unbiased, future expected
abnormal earnings are strictly positive (at least in the short term). The
firm’s (levered) price-to-book ratio hence strictly exceeds the normal
price-to-book ratio. Other things being equal, the stronger the firm’s
comparative advantage, the longer the time interval over which the firm
is able to sustain some comparative advantage, and the lower the risk, the
higher the price-to-book ratio.
The abnormal earnings generated at date t+i can be rewritten as the
product of the abnormal return on common equity obtaining at date t+i
and the book value of equity as of date t+i–1:
(9.3)
The book value of equity obtaining at date t+i–1 can furthermore be
rewritten as a function of the book value obtaining at date t and the
growth rates in the book value of equity between dates t and date t+i–1:
(9.4)
143
where gj, with j ≥ 1, denotes the growth in the book value of equity from
date to t + j – 1 to date t+j, and g0 is assumed to be equal to 1.
By substituting (9.4) into (9.3), and (9.3) into (9.2), one obtains:
(9.5)

A firm’s (levered) PB ratio thus depends on the level of future abnormal
profitability, as captured by AROCE, growth in the book value of equity
and the cost of equity capital. Other things being equal (assuming positive
price-to-book ratios):
• the higher the level of future expected abnormal earnings, the higher
the price-to-book ratio
• the lower the book value of equity, the higher the price-to-book ratio
• the lower the cost of equity capital, the higher the price-to book ratio.
It should be noted that the growth in the book value of equity is related to
the investments made by the firm. The valuation task can thus be framed
in terms of two key questions about the firm’s value drivers:
• How much greater or smaller than normal will the firm’s ROCE be?
• How quickly will the firm’s investment base grow?
Activity 9.1*
Assuming that ROCEt+i = ROCE and gi = g for all i, show that:
Activity 9.2*
ABC plc currently trades on a PB ratio of 3. ABC’s current ROCE is equal to 20 per cent
and rE is equal to 10 per cent. Assuming efficient capital markets and stationarity as
defined in Activity 9.1, what is the implied growth in ABC’s book value of equity?
Empirical evidence
If our theory is correct, controlling for risk (and hence the cost of equity
capital), the higher a stock’s price-to-book ratio, the higher the stock’s
subsequent expected abnormal earnings deflated by the current book
value of equity. Penman (2013) checks whether PB ratios do forecast
subsequent abnormal earnings.
In his empirical study, Penman considers all firms listed on the NYSE,
AMEX and NASDAQ for the years 1965–95. Penman calculates price-to-
book ratios, with a stock’s price-to-book ratio being estimated as the ratio
of its market value of equity over its book value of equity. Penman then
groups all the listed stocks into 20 portfolios on the basis of the magnitude
of the stocks’ price-to-book ratios. Portfolio P1 consists of the stocks with
the 5 per cent highest PB ratios and trades on a median PB ratio of 6.7.
Portfolio P20 consists of the stocks with the 5 per cent lowest PB ratios
and trades on a median PB ratio of 0.4. Penman then measures the median
abnormal earnings (deflated by the current book value of equity) for each
portfolio in the year of allocation of the stocks to the portfolios as well
as in the five subsequent years. As shown in Table 8.2, there is a strong
144
correlation between PB ratios and subsequent performance. On average,

the higher the PB ratio, the higher the subsequent abnormal earnings.
Portfolio P15, which is trading on a median PB equal to the normal PB
ratio, yields subsequent abnormal earnings which are close to zero.
Portfolios trading on PB ratios exceeding the normal PB ratio yield positive
subsequent abnormal earnings while portfolios trading on PB ratios below
the normal PB ratio yield negative subsequent abnormal earnings. Our
theory is thus validated.
PB 0 1 2 3 4 5
P1 6.7 0.18 0.23 0.22 0.22 0.23 0.24
P2 4.0 0.13 0.16 0.14 0.15 0.15 0.14
P5 2.3 0.08 0.08 0.07 0.07 0.08 0.07
P10 1.4 0.03 0.03 0.03 0.04 0.05 0.03
P15 1.0 0.01 0.01 0.01 0.02 0.03 0.02
P19 0.6 –0.05 –0.05 –0.04 –0.01 –0.00 –0.01
P20 0.4 –0.09 –0.07 –0.07 –0.04 –0.02 –0.04
Table 9.2 Abnormal earnings in post-formation years
Drivers of price-to-earnings (PE) ratios in efficient

markets
This section first derives the drivers of price-to-earnings ratios in efficient
markets. It then provides empirical evidence supporting our derivation.
Theory
By dividing both sides of the PVAE (9.1) by the comprehensive earnings
obtaining at date t and rearranging the expression on the right-hand side,
one obtains:
VEt* + NDt = 1 + rE
CEt rE [
1+ 1
CEt
i=+∞
∑
i=1
Et (AEGt + i)
(1+ rE) i
[
(9.6)
with VEt*+NDt denoting the intrinsic (cum-dividend) value of the firm’s

equity at date t; CEt denoting comprehensive earnings generated at date
t; AEGt+i = AEt+i – AEt+i–1 denoting the growth (change) in abnormal
earnings between dates t+i–1 and t+i.
According to (9.6), a firm’s (levered) cum-dividend trailing price-to-
earnings ratio is hence a multiple (depending solely on the cost of equity
capital) of 1 plus the present value of the expected changes in future
abnormal earnings deflated by current comprehensive earnings. A stock’s
cum-dividend trailing price-to-earnings ratio thus depends on the expected
changes in abnormal earnings, the current comprehensive earnings and
the cost of equity capital. Assuming non-negative current comprehensive
earnings, other things being equal:
• the higher the expected changes in abnormal earnings, the higher the
price-to-earnings ratio
• the higher the current comprehensive earnings, the lower the price-to-
earnings ratio (assuming non-negative expected changes in abnormal
earnings)
• the higher the cost of equity capital, the lower the price-to earnings
ratio (assuming non-negative expected changes in abnormal earnings).
145
Let us consider a special case: a firm without any comparative advantage

in a very competitive industry. If accounting is unbiased, future abnormal
earnings are expected to be nil and the expected changes in abnormal
earnings are hence nil too. This firm’s (levered) cum-dividend price-to-
earnings ratio is hence given by:
(9.7)
This price-to-earnings ratio is also referred to as the normal price-to-

earnings ratio.
Let us then consider a firm with some comparative advantage expecting
growth in abnormal earnings, at least in the short term, before levelling off.
This firm should trade on a (levered) cum-dividend price-to-earnings ratio
exceeding the normal price-to-earnings ratio. On the other hand, a firm
subject to increasing competition, and expected to generate diminishing
abnormal earnings, should trade on a (levered) cum-dividend price-to-
earnings ratio which is lower than the normal price-to earnings ratio.
Activity 9.3
The bulk chemical industry is very competitive. Consider a firm in this industry which does
not have any comparative advantage. Assuming that the accounting used by this firm is
unbiased and the firm’s cost of equity capital is 10 per cent, what is your best estimate of
the (levered) cum-dividend price-to-earnings ratio this firm is trading on?
Activity 9.4
As of March 2000, a number of internet stocks traded on PE ratios in the order of
magnitude of 100 to 1,000. Would you expect internet stocks to trade on high PE ratios in
efficient markets? Why or why not?
Empirical evidence
If our theory is correct, controlling for risk and, hence, the cost of equity
capital, our theory suggests that:
• the higher a stock’s expected growth in abnormal earnings, the higher
the price-to-earnings ratio the stock should be trading on
• the higher the current comprehensive earnings, the lower the price-to-
earnings ratio the stock should be trading on.
Penman (1996) provides an empirical test of our theoretical predictions.
Penman considers all firms listed on the NYSE and AMEX for the years
1968–85. Penman calculates price-to-earnings ratios, with a stock’s price-
to-earnings ratio being estimated as a contemporaneous ratio of its (cum-
dividend) market value of equity over its comprehensive earnings. Penman
then groups all the listed stocks into three portfolios on the basis of the
magnitude of the stocks’ price-to-earnings ratios. As shown in Table 9.3,
the high PE portfolio trades on an average price-to-earnings ratio of 25.6.
The medium PE portfolio trades on an average price-to-earnings ratio of
10.6. The low PE portfolio trades on an average price-to-earnings ratio of
5.2. Penman then measures the average abnormal earnings (deflated by
the current book value of equity) for each portfolio in the year of allocation
of the stocks to the portfolios as well as in the four subsequent years. As
shown in Table 9.3, there is a strong correlation between the magnitude
of a portfolio’s PE ratio and subsequent growth in abnormal earnings.
On average, the higher the PE ratio, the higher the growth in subsequent
abnormal earnings. The three portfolios are highly diversified. Assuming
146
that the typical cost of equity capital is 10 per cent, the normal price-to-
earnings ratio is hence about 11, which is very close to the price-to-earnings
ratio of the medium PE portfolio. As expected, the medium PE portfolio
shows close to no growth in abnormal earnings over the three years
following the allocation of the stocks to the portfolios. Also as expected,
the high PE portfolio enjoys positive growth in abnormal earnings while
the low PE portfolio enjoys negative growth in abnormal earnings over the
same period. Finally, there is also a strong negative correlation between the
magnitude of the price-to-earnings ratio a portfolio is trading on and the
current performance enjoyed by the stocks in the portfolio. This captures
the effect of transitory (non-recurrent) earnings. The high PE portfolio
consists of stocks having enjoyed low growth in abnormal earnings (0.9 per
cent) in the year of allocation of the stocks to the portfolios. The medium
PE portfolio consists of stocks having enjoyed medium growth in abnormal
earnings (4 per cent) while the low PE portfolio consists of stocks having
enjoyed high growth in abnormal earnings (5.8 per cent) in the same year.
Our theory is thus again validated.
Year
PE level PE 0 1 2 3 4
High 25.6 0.9% 3.4% 3.8% 5.4% 6.1%
Medium 10.6 4.0% 4.3% 4.3% 4.4% 5.1%
Low 5.2 5.8% 4.1% 3.5% 3.6% 4.1%
Table 9.3 Abnormal earnings by PE level
Implications of PE and PB ratios in efficient markets for

current and future performance
In this section, we infer information on both current performance and
expected future performance from the price-to-earnings and price-to-book
ratios observed in the capital markets assuming that capital markets are
efficient. In practice, this means that we are aiming at filling in the cells
denoted by A to I in Table 9.4 with inferred performance. In order to
facilitate the exposition, let us consider solely current and expected future
abnormal earnings. Our inferences are summarised in Table 9.5.
PB ratio
High Normal Low
High A B C
PE ratio Normal D E F
Low G H I
Table 9.4 Implications of PE and PB ratios in efficient markets for abnormal
earnings
Let us start with the central cell (cell E) associated with both a normal
PE ratio and a normal PB ratio. A normal PE ratio implies no growth in
expected abnormal earnings. A normal PB ratio implies a nil present value
of future expected abnormal earnings. For both a firm’s PB and PE ratios to
be normal, it must hence be that both current abnormal earnings, AEt, and
future expected abnormal earnings, E[AEt+i] are nil.
Let us then move horizontally from the central cell. Whenever the PE ratio
is normal, there is no growth in expected abnormal earnings. A high PB
ratio implies a strictly positive present value of future expected abnormal
earnings. The combination of a normal PE ratio and a high PB ratio (cell
147
D) hence implies the same strictly positive abnormal earnings now and,
in expected terms, in the future. A low PB ratio implies a strictly negative
present value of future expected abnormal earnings. A normal PE ratio and
a low PB ratio (cell F) hence imply the same strictly negative abnormal
earnings now and, in expected terms, in the future.
Let us then move vertically from the central cell. Whenever the PB ratio is
normal, the present value of future expected abnormal earnings is nil. A
high PE ratio implies positive growth in expected abnormal earnings. The
combination of a normal PB ratio and a high PE ratio (cell B) hence implies
negative current abnormal earnings and higher future expected abnormal
earnings. A low PE ratio implies negative growth in expected abnormal
earnings. A normal PB ratio and a low PE ratio (cell H) hence imply positive
current abnormal earnings and lower expected future abnormal earnings.
Let us finally consider the corner cells. Both a high PB and a high PE ratio
(cell A) imply that future expected abnormal earnings are positive and
growing. Both a low PB and a low PE ratio (cell I) imply that expected
abnormal earnings are negative and becoming more negative through time.
The combination of a high PB ratio and a low PE (cell G) ratio suggests that
current abnormal earnings are high and expected abnormal earnings in the
future are lower and decreasing. The combination of a low PB ratio and a
high PE ratio (cell C) calls for negative expected abnormal earnings in the
future and even lower current abnormal earnings.
PB ratio
High Normal Low
High E[AEt+i] > 0 E[AEt+i] = 0 E[AEt+i] < 0
E[AEt+i] > AEt AEt < 0 AEt < 0
E[AEt+i] > AEt
E[AEt+i] > AEt
PE ratio Normal AEt > 0 AEt = 0 AEt < 0

E[AEt+i] = AEt E[AEt+i] = 0 E[AEt+i] = AEt
Low AEt > 0 AEt > 0 E[AEt+i] < AEt
E[AEt+i] < AEt E[AEt+i] < AEt
Table 9.5 Implications of PE and PB ratios in efficient markets for abnormal

earnings
Joint distribution of PE and PB ratios

Penman splits NYSE and AMEX firms at their median PE and PB each year
from 1968 to 1985. Penman then counts the frequency with which firms
had:
• a high PB (above the median) and a high PE (above the median)
• a low PB (below the median) and a high PE (above the median)
• a high PB (above the median) and a low PE (below the median)
• a low PB (below the median) and a low PE (below the median).
As shown in Table 9.6, Penman finds evidence of a positive correlation
between PB and PE ratios. About one-third of the stocks are trading on
higher PB and PE ratios than the median ratios and about one-third of the
stocks are trading on lower PB and PE ratios than the median ratios. The
positive correlation between PB and PE ratios may be generated by the
common driver: the cost of equity capital. There are, however, also about
148
one-sixth of the stocks trading on a higher PB ratio and lower PE ratio

and about one-sixth of the stocks trading on a lower PB ratio and higher
PE ratio. The strategic taxonomy introduced in the next section aims to
explain the joint distribution of PB and PE ratios displayed in Table 9.6.
PB ratio
High Low
High 32.8% 16.7%
PE ratio
Low 17.1% 33.4%
Table 9.6 Joint distribution of PE and PB ratios
Implications of strategic taxonomy for PE and PB ratios

in efficient markets
This section first introduces a strategic taxonomy and subsequently derives
implications for PE and PB ratios in efficient markets.
Strategic taxonomy
Let us introduce the following types of firms:
• ‘Rising stars’. A rising star is defined as a firm with assets in place,
currently generating high AROCE and expected to continue to generate
high AROCE over some period in the future. A rising star is furthermore
assumed to enjoy significant and high-quality growth opportunities
over some period in the future.
• ‘Falling stars’. A falling star is defined as a firm with assets in place
currently generating high AROCE and expected to continue to generate
high AROCE over some period in the future. Future investment
opportunities are, however, expected to be fewer and of lower quality.
• ‘Dogs’. A dog is defined as a firm with assets in place, currently
generating low (close to nil) AROCE and expected to continue to
generate low AROCE in the future. Future investment opportunities are
furthermore expected to be limited and of low quality (low expected
AROCE).
• ‘Recovering dogs’. A recovering dog is defined as a firm presently in
distress but expected to recover. A recovering dog is, however, not
expected to ever enjoy high AROCE.
Activity 9.5
Provide examples of dogs, recovering dogs, falling stars and rising stars in the European
airline industry.
This strategic taxonomy is hence related to the so-called ‘BCG matrix’. In

the BCG matrix, one of the four players, the question mark, is not properly
defined. In our strategic taxonomy, each player is properly defined. Our
matrix, however, is not exhaustive in the sense that not all firms in the
economy can be associated with one of our four types of firms.
Implications for PE and PB ratios

A falling star has assets in place, resulting from past investments, of high
quality. These assets in place are expected to generate high abnormal
earnings in the future. A falling star hence trades on a high price-to-book
ratio in efficient markets. Future investment opportunities, however, are
expected to be fewer and of lower quality. A falling star is hence expected
149
to enjoy low growth (if any) and trades on a low price-to-earnings ratio in
efficient markets.
A rising star has assets in place, resulting from past investments, of high
quality. A rising star hence trades on a high price-to-book ratio in efficient
markets. A rising star is furthermore assumed to enjoy significant and
high-quality growth opportunities over some period in the future. These
significant and high-quality growth opportunities should translate into
growth in abnormal earnings. A rising star hence trades on a high price-to-
earnings ratio in efficient markets.
A dog has assets in place currently generating low (close to nil) abnormal
earnings and expected to continue to generate low abnormal earnings in
the future. A dog hence trades on a low price-to-book ratio in efficient
markets. Future investment opportunities are furthermore expected to be
limited and of low quality. A dog is hence expected to enjoy low growth in
abnormal earnings and trades on a low price-to-earnings ratio in efficient
markets.
A recovering dog has the long-term prospects of a dog. In the short term,
the recovering dog is experiencing problems and the assets in place are
yielding negative abnormal returns on common equity (and negative
abnormal earnings). A recovering dog hence trades on a low price-to-
book ratio in efficient markets. A recovering dog is furthermore expected
to recover from its current crisis and is expected to generate close to nil
abnormal earnings in the long-term. A recovering dog is hence expected
to experience significant growth in abnormal earnings (from significantly
negative to insignificant abnormal earnings). A recovering dog thus trades
on a high price-to-earnings ratio.
PB ratio
High Low
PE ratio High Rising stars Recovering dogs
Low Falling stars Dogs
Table 9.7 Strategic taxonomy and implications for PE and PB ratios
The implications of our strategic taxonomy for price-to-book and price-to-
earnings ratios in efficient markets are illustrated in Table 9.7.
Activity 8.6
Check that the firms you identified as dogs, recovering dogs, falling stars and rising stars
in Activity 9.5 were correctly identified by finding out the PE and PB ratios which these
firms are currently trading on.
Activity 8.7*
Firms A, B, C and D have a current book value of equity (CSEt) of $1m and a cost of equity
capital of 10 per cent. Firms A, B, C and D, however, differ in the following respects:
• Firm A has current comprehensive earnings (CEt) of $0.01m, expects forthcoming
abnormal earnings (AEt+1) of $0.01m and subsequent abnormal earnings growing
by 2 per cent per year. The book value of equity at the end of the previous period
(CSEt–1) was equal to $0.99m.
• Firm B has current comprehensive earnings (CEt) of about $0.11m, expects
forthcoming abnormal earnings (AEt +1) of $0.01m and subsequent abnormal
earnings growing by 2 per cent a year. The book value of equity at the end of the
previous period (CSEt–1) was equal to $0.89m.
• Firm C has current comprehensive earnings (CEt) of about $0.2m, expects
150
forthcoming abnormal earnings (AEt+1) of $0.05m and subsequent abnormal

• Firm D has current comprehensive earnings (CEt) of about $0.15m, expects
forthcoming abnormal earnings (AEt+1) of $0.05m and subsequent abnormal
On which PE and PB multiples would you expect firms A, B, C and D to trade on in
efficient markets?
Valuation using the ‘method of comparables’

This course introduces a number of valuation methods, such as the present
value of expected dividends (PVED) or the present value of abnormal
earnings (PVAE), requiring extensive information in order to generate
expectations of the future flows which are valued. In order to use these
methods, one needs to supply expectations of a very large number of flows
such as dividends or abnormal earnings (up to infinity as far as the theory
goes). Using these valuation methods, which are often also referred to as
full information-based valuation methods, may hence appear to be costly
and involve much effort.
The method of comparables appears to be much easier to implement.
According to Penman (2012), the method of comparables works as follows:
• Identify comparable firms that have operations similar to those of the
target firm whose value is in question.
• Identify measures for the comparable firms in their financial statements
– (comprehensive) earnings, book value, sales, cash flow – and
calculate multiples of these measures at which the firms trade.
• Apply these multiples to the corresponding measures for the target firm
to get the firm’s value.
In order to illustrate the application of the method of comparables, let
us attempt to value Dell as of April 2002. Table 9.8 lists the most recent
‘fundamentals’, such as sales, earnings before any extraordinary items, and
the book value of equity, for Dell and two other firms, HP and Gateway,
producing personal computers. Table 9.8 also provides the price-to-sales
ratios, price-to-earnings ratios, and the price-to-earnings ratios the other
two firms are trading on. One may hence value Dell by applying these
price multiples to Dell’s fundamentals.
Sales Earnings CSE MV PS PE PB

$m $m $m $m
HP 45226 624 13953 32963 0.73 52.8 2.4
Gateway 6080 (1290) 1565 1944 0.32 NR 1.2
Dell 31168 1246 4694 ? ? ? ?
NR stands for non-relevant (Gateway is reporting losses)
Table 9.8 Pricing multiples for comparative firms to Dell
It could be argued that Dell and Gateway are competing on the same basis
and do follow similar strategies. If Gateway is used as the comparable, the
resulting valuation of Dell is:
$31.2bn × 0.32 = $10.0bn when using the PS ratio as the price multiple
$4.7bn × 1.20 = $5.5bn when the PB ratio is used as the price multiple
151
Alternatively, one may consider both Gateway and HP as comparables.

In the latter case, we may use a relevant PS ratio equal to 0.68 [($33.0
+ $1.9)/($45.2 +6.1)] and a relevant PB ratio equal to 2.25 [($33.0
+ $1.9)/($14.0 +1.6)]. When both Gateway and HP are used as
comparables, the resulting valuation of Dell is:
$31.2bn × 0.68 = $21.2bn when using the PS ratio as the price multiple
$4.7bn × 2.25 = $10.6bn when the PB ratio is used as the price multiple.
So, what is our best estimate of Dell’s fundamental value? Is it $7.8bn,
the average of $10bn and $5.5bn we obtain by using Gateway as the
relevant comparable? Or $15.9bn, the average of $21.2bn and $10.6bn
we obtain by using both Gateway and HP as relevant comparables? Do
these valuations leave you with a nice and warm feeling? Let’s just say
that the authors are very uneasy about these valuations. We can see many
problems associated with them:
1. We have used market value of equity of firms in the personal computer
industry in order to value Dell. Hence, implicitly, we are assuming that
capital markets are efficient. But, if capital markets are efficient, why
do we not use the market value of Dell’s equity as our best estimate of
the true value of Dell’s equity? By the way, Dell’s market value of equity
reported by Penman (2012) was about $70bn.
2. Finding the right comparable is difficult, possibly impossible. One
would have to get a match for industry, products, strategy, growth
prospects, size and risk (including both business risk and financial
risk).
The method of comparables should hence be restricted to back-of-the-
envelope checks (quick but hopefully not too nasty), in the case of IPOs
(initial public offerings) or stocks which are private or thinly traded with
no reliable trading prices.
When pricing a stock on the basis of a fundamental, we would encourage
you to use appropriately the relevant pricing formula. For instance, let us
assume that you wish to price a stock on the basis of earnings. You may
hence estimate (9.6). Instead, if you wish to price a stock on the basis of
its book value of equity, you may estimate (9.2) or (9.5).
Case study: The IPO of Air Berlin (2006)

Consider Air Berlin, a German airline, going through an IPO in 2006. At that time, Air
Berlin was Germany’s largest low-cost carrier, Germany’s second-largest airline behind
Lufthansa, and Europe’s third-largest airline behind Ryanair and Easyjet. Air Berlin
went through 350 flights per day and exploited 135 routes and 74 destinations in
Europe and North Africa, with 25% of arrivals and departure attributable to Palma de
Mallorca. Its main hubs were Nuremberg, Palma de Mallorca, and London Stansted.
There was limited overlap in direct competition with Ryanair and easyJet.
In terms of competitive strategy, Air Berlin was moving away from a historical reliance
on charter flights. It was competing on the basis of a differentiation strategy by
“offering some of the frills of full-service flights … while still delivering an average
lower fare than full-service airlines”. Its intention was to strengthen its position in the
business traveller market. Air Berlin is thus neither comparable to a legacy carrier nor
is it comparable to low cost carrier.
Table 9.9 provides financial information for Air Berlin related to 2004 and 2005 as
well as expected performance in 2006.
152
(€bn) 2004 2005 2006e

Revenue (REV)
Net Income (NI) (Earnings Before 0.0 (0.12) 0.15 0.06
Interest, Taxes,
Depreciation,
Amortization,
and Aircraft
Rentals –EBITDAR)
Book Value of Net Operating 0.74 0.78 0.90
Assets (NOA)
Table 9.9: Air Berlin fundamentals.
Table 9.10 provides the price multiples legacy carriers (LC) such as Iberia, British
Airways, and Lufthansa were trading on in 2006 as well as the price multiples low cost
carriers (LCC) such as EasyJet and Ryanair were trading on.
MVE (€bn) PE MV/EBITDAR MV/NOA MV/REV
Iberia 1.9 22.6 5.4 0.8 0.8
Lufthansa 6.5 17.0 5.7 0.5 0.5
BA 3.8 8.9 4.4 0.7 0.7
LC AVG 8.2 5.1 0.8 0.7
Easyjet 1.6 20.9 9.1 1.4 1.4
Ryanair 5.4 17.4 10.0 2.0 2.9
LCC AVG 17.6 9.5 1.8 2.5
Table 9.10: Price multiples in the airline industry.
with:
• MVE denoting the market value of equity
• PE denoting the leading price-to-earnings ratio
• MV denoting the enterprise value (intrinsic value of the net operating assets)
observed in the capital markets.
Airlines thus trade on widely different price multiples. Furthermore, there is no airline
directly comparable to Air Berlin. Table 9.11 provides estimates of intrinsic value for
Air Berlin, using the method of comparables and average price multiples for legacy
carriers and average price multiples for low cost carriers. The range of intrinsic value
estimates generated is rather wide!
LC LCC
Equity Value of Air Berlin using average P/E ratio €447m €959m
Enterprise Value of Air Berlin using average MV/EBITDAR ratio €780m €1454m
Enterprise Value of Air Berlin using average MV/REV ratio €854m €1220m
Table 9.11: Estimates of Air Berlin’s intrinsic values.
Overview of chapter
This chapter investigated the implications of a stock’s expected
performance in the future for pricing with respect to fundamentals in
efficient markets. It introduced the drivers of price-to-book ratios and
provided empirical evidence validating the analysis. It introduced the
drivers of price-to-earnings ratios and provided empirical evidence
validating the analysis. It introduced empirical evidence on the joint
distribution of price-to-earnings (PE) and price-to-book (PB) ratios,
introduced a strategic taxonomy of firms and derived implications of
taxonomy for both price-to-book and price-to-earnings ratios. It finally
153
introduced valuation using the method of comparables and discussed

implementation issues.
The empirical evidence reported in this chapter explains why investors
are willing to purchase some stocks on very high price multiples and other
stocks only on very low price multiples. These reasons are furthermore
fully consistent with market efficiency. Later on, in Chapter 11, we will
drop the assumption that capital markets are efficient and check whether
or not it is possible to make some economic profit by trading on the basis
of price multiples.
Key terms
abnormal earnings (AE) leading PE ratio
abnormal earnings growth (AEG) method of comparables
abnormal profitability non-recurrent earnings
abnormal ROCE (AROCE) normal ratio
book value of equity (CSE) price-to-book (PB) ratio
comprehensive earnings (CE) price-to-cash-flow (PCFO) ratio
cost of equity capital (rE) price-to-earnings (PE) ratio
cum-dividend value price-to-sales (PS) ratio
dog price multiples
economic rent price to fundamentals
efficient markets PVAE
ex-dividend value recovering dog
falling star rising star
fundamental value strategic taxonomy
initial public offering (IPO) trailing PE ratio
intrinsic value transitory earnings

• aptly recognise the empirical distribution of price multiples such as
price-to-book, price-to-earnings, price-to-sales and price-to-cash flow
ratios with minimal support
• clearly describe the determinants of price-to-book ratios in efficient
markets
performance for its price-to-book ratio
• clearly describe the determinants of price-to-earnings ratios in efficient
markets
performance for its price-to-earnings ratio
• cogently derive the implications of the given taxonomy for price-to-
book and price-to-earnings ratios
• critically evaluate the pitfalls associated with valuation using the
‘method of comparables’.
154
Sample examination questions

1. How can a company with a high ROCE trade on a high price-to-
earnings (PE) ratio?
2. How can two companies with the same price-to-book (PB) ratio trade
on different price-to-sales ratios?
3. Janet Starite is valuing the first French low-cost airline in the context
of an IPO. She is considering valuing this firm on the basis of price
multiples and using Air France as the comparable firm. Discuss.
4. What types of companies trade on:
a. a high PE ratio and a low PB ratio?
b. a high PE ratio and a high PB ratio?
c. a low PE ratio and a high PB ratio?
d. a low PE ratio and a low PB ratio?
155
Notes
156
Chapter 10: Financial information and stock prices
Chapter 10: Financial information and

stock prices
Introduction
We now move on to consider the usefulness of financial information to
investors by analysing the relationship between earnings information
(from the financial statements) and stock prices (on the financial
markets), and by further testing the incremental value relevance of
fundamental analysis.
We will first examine the so-called capital market researches, which aim
to test the association between earnings information and stock returns.
The low magnitude of the association between earnings and returns will
force us to understand the main economic hypotheses explaining the
existing empirical evidence. Finally, we will analyse a useful tool that
enables investors to increase their ability to predict returns on the basis of
accounting information: fundamental analysis.
Aim
The aim of this chapter is to investigate the usefulness of financial
information to investors by analysing the relationship between financial
information (from the financial statements) and stock prices (on the
financial markets), and by further testing the incremental value relevance
of fundamental analysis.
Learning outcomes
• understand critically explain the usefulness of financial information to
investors
• outline the theoretical and methodological framework of the so-called
capital market research in accounting
• explain the association between annual earnings and stock returns in
the early capital market research in accounting
• describe the concept of earnings response coefficients (ERC), and
compare the expected magnitude of ERC and the actual values of ERC
• describe the main hypotheses explaining the poor performance of ERC
(price led earnings, transitory earnings, raise in earnings and deficient
GAAP, inefficient capital markets)
• outline the theoretical and methodological framework of research on
fundamental analysis
• explain the incremental value relevance of fundamental analysis over
annual earnings
• explain the possibility of using fundamental signals to assess the
persistence (quality) of reported earnings.
157
Essential reading
Further reading
and Economics (13), 1990, pp.305–41.
Works cited
Ali, A. and P. Zarowin ‘The role of earnings level in annual earnings-returns
studies’, Journal of Accounting Research 30, 1992, pp.286–96.
Journal of Accounting Research 6, 1968, pp.159–78.
Basu, S. ‘The conservatism principle and the asymmetry timeliness of earnings’,
Beaver, W., R. Lambert and D. Morse ‘The information content of security
prices’, Journal of Accounting and Economics (2), 1980, pp.3–28.
Bernard, V. and J. Thomas ‘Post-earnings-announcement drift: Delayed price
response or risk premium?’, Journal of Accounting Research (27), 1989,
pp.1–36.
and Economics (13), 1990, pp.305–41.
Collins, D., E. Maydew and I. Weiss ‘Changes in the value-relevance of earnings
and book values over the past forty years’, Journal of Accounting and
Economics (24), 1997, pp.39–67.
Dechow, P. ‘Accounting earnings and cash flows as measures of firm
performance: the role of accounting accruals’, Journal of Accounting and
Economics (18), 1994, pp.3–42.
Easton, P. and M. Zmijewski ‘Cross-sectional variation in the stock market
response to accounting earnings announcements’, Journal of Accounting and
Economics (11), 1989, pp.117, 141.
Easton, P., T. Harris and J. Ohlson ‘Aggregate accounting earnings can explain
most of security returns: the case of long-event windows’, Journal of
Accounting and Economics (15), 1992, pp.119–42.
Kormendi, R. and R. Lipe ‘Earnings innovation, earnings persistence and stock
returns’, Journal of Business (60), 1987, pp.323–45.
Kothari, S. and R. Sloan ‘Information in prices about future earnings:
Implications for earnings response coefficients’, Journal of Accounting and
Economics (15), 1992, pp.143–71.
Economics (31), 2001, pp.105–231.
Lev, B. ‘On the usefulness of earnings and earnings research: Lessons and
directions from two decades of empirical research’, Journal of Accounting
Research (27), 1989, pp.153–201.
returns’, Journal of Accounting and Economics 11(4),1989, pp.295–329.
Ramakrishnan, R. and R. Thomas ‘Valuation of permanent, transitory, and
price-irrelevant components of reported earnings’, Journal of Accounting,
Auditing, and Finance 13(3), 1998, pp.301–36.
Sharpe, W.F. ‘Capital asset prices: A theory of market equilibrium under
conditions of risk’, Journal of Finance 19(3), 1964, pp.425–42.
158
Usefulness of earnings to investors: the empirical

evidence from capital markets research
The investigation of the usefulness of earnings to investors qualifies the
main issue of the so-called capital market research in accounting. The
seminal contribution in the field – opening up all the subsequent studies –
was written by Ball and Brown in 1968. Two main research questions are
addressed in this study:
• Are there changes in stock prices around the release of financial
information?
• Whether and how quickly accounting measures capture changes in the
information set that is reflected in securities return over a given period.
The first question represents a typical event study: we need to infer
whether an event (such as an earnings announcement) brings new
information to participants in the market, information that is then reflected
in changes in the level (or variability) of securities prices over a short time
period around the even. If the level (or variability) of prices change around
the event date, the accounting information is a surprise to the market, that
revises its own previous expectations according to the new information.
In other words, new accounting information (associated with the release
of the financial statements) determines changes in the related securities
prices (and thus in the related securities returns) on the stock market.
The second question represents an association study, which tests for a
positive correlation between an accounting performance measure (e.g.
earnings) and stock returns on the market, both measured over relatively
long time periods (for example, one year).
Here we summarise the methodology used to investigate the two above
questions.
Methodological issues
To test the association between financial information and stock prices, Ball
and Brown (1968) use three classes of data:
• the content of income reports
• the dates of the reports’ announcements
• the movements of securities prices (returns) on the market around the
event date.
As regards to the content of income reports, we need to identify what
is the new information conveyed by the present income number. The
information conveyed by the total income number can be divided into two
components:
• The unexpected income change (or forecasts error, j,t), which
represents the amount of new information conveyed by the present
income number. This can be approximated by the difference between
the actual change in the net income (∆ jt) and its conditional
expectation (∆ jt). This can be written as:
(10.1)
• The expected income change, which is due to the fact that historically
the incomes of firms have tended to move together (in particular, about
50 per cent of the variability in the level of an average firm’s earnings
per share (EPS) can be associated with economy-wide effects). This
implies that at least a part of the income’s change from one year to
159
the other can be predicted by using the change in the income for the
market (∆Mjt):
(10.2)
Since the two effects (economy effects and business policy effects)
are present simultaneously, the total change in firm’s j income can be
expressed as:
(10.3)
Also with reference to the market’s reaction to new income information,
the rate of return on the market is determined by two components: one
pertaining to individual firms and one related to market-wide effects. Note
that firm-specific return can be calculated by referring to the capital asset
pricing model as developed by Sharpe in 1964.
Activity 10.1
In the absence of any information about a firm over a particular period, which information
will its total rate of return reflect?
Activity 10.2
Under the CAPM assumptions, how can you express the equilibrium between risk and
return? Please write down the main equation expressing the equilibrium under the
CAPM.
Now we can test if part of the rate of return pertaining to the individual
firm can be associated with the new information conveyed by the firm’s
income number:
• If the income forecast error is negative (i.e. if the actual change in
income is less than its conditional expectation), we have bad news: if
there is any association between stock prices and accounting income
numbers, then the release of the income number would result in the
return of the security being less than otherwise expected. Such a result
would be associated with a negative behaviour in stock return around
the annual report announcement.
• If the income forecast error is positive, we have good news: then the
release of the income number should result in the return of the security
being more than otherwise expected.
Acting as if this knowledge was known, Ball and Brown (1968) construct
two portfolios on the basis of the bad and good news partition and
measure abnormal returns (market adjusted). Abnormal stock returns are
estimated as the difference between the actual return and the expected
return for the firm given the realisation of the return of the market as a
whole:
(10.4)
where ARjt = abnormal return of security j in period t; Rjt = actual return
of security j in period t; RMt = actual return of the market as a whole
(excluding j) in period t; E(Rjt/RMt) = expected return of security j in
period t given the actual return of the market.
Empirical evidence
From the above methodology some interesting results emerge. They are
summarised in Figure 10.1, which shows the abnormal returns for three
portfolios which the income forecast errors were positive (the top half);
for three portfolios in which the income forecasts errors were negative (the
160
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Figure 10.1: Abnormal returns for different levels of unexpected earnings (with
abnormal performance index denoting abnormal returns, and Variables 1, 2 and
3 denoting the portfolio based on the relevant level of unexpected abnormal
earnings).
Source: Ball and Brown (1968, p.169).
bottom half); and a single portfolio consisting of all the firms and years in
the sample (the line just below the line dividing the two halves).
An important result emerges. The information contained in the annual
income number is useful in that if actual income differs from the expected
income, the market typically has reacted in the same direction. A portion of
the earnings increase (decrease) experienced by the good (bad) news firms
was a surprise to the market, which led to increased (decreased) securities
prices. This implies the existence of a positive association between the sign
of the error in forecasting income and the abnormal return.
However, most of the information contained in the reported income
is anticipated by the market before the annual report is released. The
anticipation is so accurate that the actual income number does not
seem to generate any unusual change in the abnormal return around
the announcement month. In fact, the drift upward and downward
begins at least 12 months before the report is released and continues for
approximately one month.
Although the information content of the income number is very large,
the annual income statement does not rate highly as a timely source of
information. Most of its content (about 85 to 90 per cent) is captured by
161
more prompt sources, which include interim reports. In this sense, annual
accounting numbers are not regarded as a particularly timely source of
information in the capital market.
A second important intuition, which is stated in Ball and Brown (1968)
is the existence of the so-called post-announcement earnings drift,
which is further analysed and confirmed by Bernard and Thomas (1989,
1990). As reported in Bernard and Thomas (1989), cumulative abnormal
returns (CAR) are calculated for 10 portfolios with different levels of
unexpected good or bad earnings during 1974–86. CAR are measured
for the pre- and post-announcement period. As shown in Figure 10.2,
portfolio 10 outperformed portfolio 1 in the two months following the
announcement, and the difference in the excess returns has been equal to
+4 per cent. Prices of good news stocks continue to rise after the earnings
announcement, while prices of bad news stocks continue to fall. The
market adjustment to unexpected news (bad in particular) takes several
months. This suggests market underreaction and subsequent gradual
adjustment in the information in earnings. This evidence is inconsistent
with the semi-strong form efficiency.
Figure 10.2 Relationship between abnormal returns and unexpected earnings

in the pre- and post-announcement period. (CAR denotes cumulative abnormal
returns, and SUE, standardised unexpected earnings.)
Source: Bernard and Thomas (1989, p.10).
Earnings response coefficients

The empirical evidence in Ball and Brown (1968) is intriguing: accounting
reports have information content and influence security prices, but not
on a timely basis. The decades following the early study witnessed a huge
growth in capital markets research.
A very prominent stream of the capital markets research is the one
devoted to the estimation of the so-called earnings response coefficient
162
(ERC), which is an estimate of the magnitude of the relationship between

stock returns (on the market) and reported earnings (in the financial
statements). In the framework of an association study, ERC measures
the stock price change associated with a given unexpected earnings
change. In the framework of an event study, ERC measures the response
of stock prices to accounting earnings announcements. Whatever the
framework used, ERC magnitudes are particularly useful in valuation and
fundamental analysis, as we will show below.
The relationship between returns and earnings can be formally expressed
by the conventional returns–earnings regression, which measures the
response of stock returns to changes in accounting earnings. In this
framework, the ERC is represented by the coefficient of the earnings
change, or rather b in the following equation:
ari = a + b(∆EPSi) + ui (10.5)
Activity 10.3
Draw in a Cartesian diagram the returns–earnings relation, and show the related ERC.
In his review of the capital markets research in accounting, Kothari (2001)

provides a useful intuition of the ERC concept. ERC represents a way
to link an earnings change to a security returns change. If the earnings
changes are permanent, then assuming a one-to-one relationship between
the earnings change and the net cash flow change, the ERC is the present
value of the perpetuity at the risk-adjusted return on equity.
There are therefore two underlying assumptions:
1. The dividend discount model is used as a valuation model and total
amount of annual earnings is distributed as dividends (see our previous
analysis of valuation models in Chapter 8).
2. Earnings follow a random walk with a drift (please recall the concept
of random walk from the section ‘Empirical evidence on the patterns of
accounting measures’).
Under this framework, the price change (ΔP, which is equivalent to the
stock return) induced by a £1 permanent change in annual earnings is
the £1 change in earnings (in the current year) plus the present value of
the expected earnings in all future periods (measured by a perpetuity). In
symbols:
1
∆P = 1 +
re
(10.6)
where rE = annual discount rate for equity (calculated for example by
using the CAPM).
Therefore, to predict ERC, a researcher requires a valuation model (i.e.
the dividend discount model here above), revisions in forecasts of future
earnings based on current earnings information (i.e. permanent earnings
change of £1), and a discount rate (i.e. the cost of equity capital).
Activity 10.4
Assuming the £1 permanent change in earnings forever here above, and assuming a 10
per cent cost of equity capital, which one is the ERC magnitude you would expect.
From the above activity, you immediately realise that assuming a random
walk as a reasonable description of the time series of annual earnings, and
a discount rate of 10 per cent, the expected magnitude of the ERC is 11 [=
163
1 + (1/0.1)]. The empirical evidence on the magnitude of ERC is immense

because of the striking empirical evidence generally found: hundreds of
studies find that the ERC magnitude ranges between 1 and 3 (among
others, see Easton and Zmijewski, 1989; Kormendi and Lipe, 1987; Ali and
Zarowin, 1992). The relative small magnitude of ERC (1–3) compared with
its predicted value (11) motivated researchers to advance several hypothesis
and explanations, critically investigated in the next paragraph.
Competing hypotheses to explain the earnings response

conundrum
To explain the low magnitude of the ERC, we can use at least four
hypotheses (as usefully summarised in Kothari, 2001):
1. effects of prices-lead earnings
2. transitory earnings
3. noise in earnings and deficient GAAP
4. inefficient capital markets.
Prices-lead earnings means that the information set reflected in stock prices
on the market is richer than that in contemporaneous accounting earnings
in the financial statements (as theorised by Beaver et al., 1980, and further
investigated by Easton et al., 1992, and Kothari and Sloan, 1992). In an
efficient market, price changes instantaneously incorporate the present
value of the changes in the expectation about future cash flows. In contrast,
because of the use of accounting principles (such as revenue realisation
and expense matching – that deeply influence the earnings determination
process, accounting earnings incorporate the information reflected in price
changes systematically with a lag. This phenomenon is known as prices-
lead earnings. From the perspective of the market, future annual earnings
changes are not totally unpredictable: only a portion of the earnings change
is a surprise to the market. In an efficient market (where most of the future
earnings change are captured in market prices), the anticipated portion of
earnings change is irrelevant in explaining contemporaneous returns. This
irrelevance of the contemporaneous earnings change drives downwards the
ERC magnitude and reduces the explanatory power of the returns–earnings
regression. The presence of the prices-lead earnings phenomenon is one of
the main reasons that ERC is too small.
Although one of the assumptions under the ERC calculation is that annual
earnings follow a random walk, the presence of transitory earnings has long
been recognised in the accounting literature. Several factors determine the
presence of transitory earnings (Ou and Penman, 1989):
• Certain business activities, such as asset sales, produce one-time gains
and losses.
• Because of the information asymmetry between managers and outsiders,
and because of potential litigation, conservative accounting dominates
accounting practices. Following on, conservatism can be defined in terms
of the asymmetry in the speed with which accounting numbers reflect
economic gains and losses, or rather earnings reflect bad news more
quickly than good news (Basu, 1997).
Activity 10.5
Provide examples of three business activities associated with transitory earnings, and
specify their impact on specific items in the financial statements.
The consequence of the presence of a large transitory earnings component

164
(proxied by the non-recurring items in the financial statements) is that

the market does not expect these transitory earnings to be permanent, so
the return adjustment to the earnings change is smaller. This is a second
important economic explanation as to why ERC is too small, and it has
been supported and shown in many empirical studies (Kormendi and Lipe,
1987; Collins et al., 1997; Ramakrishnan and Thomas, 1998).
Two other economic reasons deriving from the prices-lead earnings
hypotheses are the noise in earnings and deficient GAAP hypothesis.
Noise in earnings means that earnings can be thought as the sum of ‘true
earnings’ plus value-irrelevant noise uncorrelated with returns (basically
represented by accruals). Although Beaver et al. (1980) originally proposed
the good intuition about prices-lead earnings, this model on the irrelevant
accrual component seems counterintuitive for two reasons (Kothari, 2001).
First, there is evidence that accounting accruals are informative (Dechow,
1994). Second, regardless of whether accruals are informative or not,
it seems unlikely that earnings without the accruals would lead to ‘true
income’. A normative interpretation of the prices-lead earnings hypothesis
is given in the deficient GAAP (generally accepted accounting principles)
argument, known as Lev’s critique – in fact, in a series of papers, Lev is the
single biggest advocate of the deficient GAAP argument (e.g. Lev, 1989).
The deficient GAAP argument states that financial statements are slow to
incorporate the information reflected in contemporaneous market values.
In addition, it argues that the greater the contemporaneous correlation
of earnings with returns, the more desirable the GAAP that produces the
earnings number. In fact, the proponents of the deficient GAAP argument
use the returns–earnings correlation as a measure of the GAAP’s success in
fulfilling its objective, which basically is to correctly predict future returns
(or cash flows) for investors. The implication in terms of ERC magnitude
is that deficient GAAP produces low-quality earnings that are only weakly
correlated with returns. The normative implication of this form of prices-
led earnings is to propose alternative accounting methods that improve the
correlation with stock returns.
Activity 10.6
Go and visit the Financial Accounting Standards Board (FASB) website, and read this
document (available at www.fasb.org/news/fasb_role.pdf) on ‘The FASB’s role in serving
the public. A response to the Enron collapse’ by Edmund Jenkins (Chairman, Financial
Accounting Standards Board). Then answer these questions:
a. What is the role of the FASB?
b. What are the main objectives of financial reporting according to the FASB?
c. According to this document, today do the objectives of financial reporting according
to the FASB differ from the objectives assigned by Lev (or rather, do they correctly
predict future returns or cash flows for investors)?
Finally, the inefficient capital market hypothesis might explain the poor
magnitudes of ERC. This implies that the price change associated with
the earnings change will be too small if the market fails to appreciate the
implications of a current earnings surprise in revising its expectations
of future returns. Coherently, there is a large body of empirical studies
that show that the stock market underreacts to earnings information
and recognises the full impact of earnings information only gradually
over time (please recall the evidence on post-earnings announcement
drift investigated above). The capital market inefficiency hypotheses
is consistent with the evidence of ERC values smaller than predicated.
However, this interpretation requires caution: in fact, this interpretation
165
can hold only if there is a consistent market inefficiency theory that

predicts underreaction to earnings information. Otherwise, without a
theory that predicts a particular phenomenon, overreaction would be just
as easily possible as underreaction in an inefficient market.
The dominant hypothesis for the explanation of the poor relationship
between earnings and returns (and for the smaller than predicted ERC
magnitudes) are prices-lead earnings and the large presence of transitory
earnings (Kothari, 2001). Today capital market research is particularly
focused on the investigation of the possible theoretical and methodological
explanations of the poor ERC magnitudes, given that the status of the
evidence and the theory is very much similar to the one prior to the
seminal contribution by Ball and Brown (1968).
Fundamental information analysis and stock prices

Given the poor ERC magnitude, we now move on to consider whether
fundamental information analysis can help in increasing the value
relevance of earnings in comparison with stock returns.
The principal objective of fundamental analysis is aimed at determining
the value of corporate securities by a careful examination of the key value
drivers, such as earnings, risk, growth and competitive position. Therefore,
fundamental analysis enables investors to identify mispriced securities for
investment purposes, and to understand the determinants of the value and
to determine the intrinsic value of a firm (as extensively explained in the
previous chapters).
Activity 10.7
Please visit www.investorguide.com/igustockfundamental.html to familiarise yourself with
the basics of fundamental analysis.
In the context of such analysis, Lev and Thiagarajan (1993) identify a

set of fundamental variables (named ‘fundamentals’) claimed by analysts
to be useful in securities examination, and they examine this claim
by estimating the incremental value relevance of these variables over
earnings. Moreover, they investigate the usefulness of fundamentals to
assess the quality (measured in terms of persistence) of earnings. In short,
they aim to investigate the following:
• Do stock prices reflect the fundamental signals? What is the
incremental value relevance of the signals over earnings?
• Are the fundamental signals used by investors to assess the persistence
(quality) and growth of reported earnings? How do investors
operationally determine earnings persistence?
The authors identify candidate fundamentals to be included in the
empirical analysis from the written pronouncements of financial analysts
by using a guided search (and not a statistical search as done in previous
studies; see, for example, Ou and Penman, 1989). A direct search for
fundamentals, guided by theory or experts’ judgments, is claimed by
the authors to be a natural extension of a statistical search procedure.
In particular, the sources used are: Wall Street Journal, Barron’s, Value
Line publications on ‘quality of earnings’, professional commentaries
on corporate financial reporting and analysis, and newsletters of major
securities firms. The period under investigation is 1974–88.
The interpretation of fundamentals by the analysts’

166
community
Their guided search yielded 12 fundamental signals claimed by analysts to
be useful in securities valuation, as listed in Table 10.1. For each signal we
now summarise the interpretation attached by analysts as a community, or
rather the common view of analysts as a whole.
Inventory increases that outrun cost of sales increases are frequently
considered by the analysts’ community to be a negative signal because
such increases suggest difficulties in generating sales. Furthermore, such
inventory increases suggest that earnings are expected to decline as
management attempts to lower inventory levels (e.g. price concessions).
Disproportionate inventory increases may also suggest the existence of
slow-moving or obsolete items that will be written off in the future. Finally,
inventory build-ups increase current earnings at the expense of future
earnings, by absorbing overhead costs.
Activity 10.8
Do you think this is the only possible interpretation of the inventory signal? Before
reading on, see if you can write down another interpretation (i.e. increase in inventory as
good news).
The assumption used in this study is that analysts generally attach a

unique interpretation to a fundamental signal (i.e. a disproportionate (to
sales) increase in inventory is associated with bad news). Nevertheless,
this is not always the appropriate interpretation: for example, this increase
could sometimes provide a positive signal about managers’ expectation of
sales increases, and thus it could be interpreted as good news.
Activity 10.9
For each of the fundamental signals in Table 10.1, try to identify an alternative
interpretation of the one here reported, which is the dominant interpretation of the
analysts as a community.
Signal Measured as:

Inventory ∆ Inventory – ∆ Sales
Accounts receivable ∆ Accounts receivables – ∆ Sales
CAPEX; R&D ∆ Industry CAPEX (or R&D) – ∆ Firm CAPEX (or R&D)
Gross margin ∆ Sales – ∆ Gross margin
S&A expenses ∆ S&A – ∆ Sales
Provision for doubtful
∆ Gross receivables – ∆ Doubtful receivables
receivables
Effective tax Pre-tax earnings x (Tt–1 – Tt) where T = effective tax rate
Order backlog Δ Sales – Δ Order backlog
Labour force  Salest–1

–
Salest  / (Sales
 
) / No.of Employeest–1
t–1


No.of Employeest–1 No.of Employeest
LIFO vs FIFO 0 for LIFO, 1 for FIFO

Audit qualification 1 for Qualified, 0 for Unqualified
Table 10.1 Fundamental signals: definition and measurement
Source: Adapted from Lev and Thiagarajan (1993, p.193)
Disproportionate (to sales) increases in accounts receivable are mentioned

167
by analysts as conveying a negative signal almost as often as inventory

increases. The analysts’ community supports this interpretation by
referring to the following reasons. First, disproportionate accounts
receivable increases may suggest difficulties in selling the firm’s products
(generally inducing firms to grant credit extensions), as well as an
increase in the likelihood of future earnings decreases from increases in
the provision for doubtful debts. Moreover, a disproportionate accounts
receivable increase might also suggest earnings manipulation, as yet
unrealised revenues are recorded as sales. Receivable increases thus imply
low persistence of current earnings and future earnings decreases.
With regard to capital expenditure (CAPEX) and research and
development expenditure (R&D), relative decreases are often perceived
negatively by analysts. The largely discretionary nature of these
expenditures makes disproportionate decreases a priori suspect. A
decrease in CAPEX may indicate managers’ concerns with the adequacy
of current and future cash flows to sustain the previous investment level.
Lev and Thiagarajan (1993) use an industry benchmark for CAPEX (and
R&D) innovations, defining them as the annual percentage change in the
industry CAPEX (or R&D) minus the annual percentage change in the
corresponding item for the firm.
A disproportionate (to sales) decrease in the gross margin (sales minus
cost of sales) is perceived negatively by analysts. (Note that in this
study, Lev and Thiagarajan (1993) define the gross margin signal as
the difference between the percentage change in sales and that in gross
margin.) Gross margin is generally a less noisy indicator than earnings
of the relationship between firms’ input and output prices (we will
investigate this point further in the next chapter on the application of
fundamental analysis to internet stocks). This relation is driven by several
underlying factors, and mainly by the intensity in competition. Variations
in this fundamental factor (indicated by disproportionate changes in gross
margin) obviously affect the long-term performance of the firm, and are
informative with respect to earnings persistence of the firm’s earnings.
Selling and administrative expenses (S&A) are approximately fixed,
therefore a disproportionate (to sales) increase is viewed by analysts as a
negative signal, which suggests a loss in managerial control or an unusual
sales effort.
Another item in the financial statement with a very discretionary nature is
the provision for doubtful debts, so unusual changes (relative to accounts
receivable) are generally suspect by analysts. Firms with inadequate
provisions for doubtful debts are expected to suffer future earnings
decreases from provision increases. In this analysis, the provision for
doubtful debts signal was measured relative to the change in the gross
accounts receivable. Positive values of this signal are generally considered
a negative signal by analysts.
A significant change in the effective tax rate (that is not caused by a
statutory tax change) is generally considered transitory by analysts.
Accordingly, an unusual decrease in the effective tax rate is usually
interpreted as a negative signal about earnings’ persistence.
Order backlog is perceived as a leading indicator of future sales, and it is
generally defined as the dollar amount of the unfilled orders at the end
of the year (particularly relevant in the heavy industries such as aircraft
manufacturers). On the one hand, a relative (to sales) decrease in order
backlog may suggest a genuine change in the demand for the firm’s
products, and on the other hand the recognition in the current period of
168
yet unrealised sales (equivalent to a practice for earnings manipulation).

A decrease in order backlog is therefore perceived as a negative signal by
analysts as a community.
Financial analysts usually perceive favourably announcements of corporate
restructuring, involving in particular labour force reductions. In this
analysis, Lev and Thiagarajan (1993) define the labour force signal in terms
of labour efficiency, as the annual percentage change in sales per employee.
As regards the accounting method used to measure inventory, the use of
LIFO (instead of FIFO) implies that the resulting earnings are regarded
as more sustainable or closer to ‘economic earnings’, when input prices
increase. The reasons come from the fact that LIFO cost of sales is a closer
proxy to current (replacement) costs than FIFO cost of sales. The use of
LIFO is therefore perceived as a positive signal by analysts as a community.
The last signal refers to the audit qualification. An adverse audit opinion
gives a negative message to investors. Both the use of LIFO vs FIFO and
the audit qualification signals are represented by a dummy variable in the
analysis.
Activity 10.10
Visit the Value Line website, and analyse ‘The Value Line investment survey’. Go to Part 3
– Ratings and Reports (www.valueline.com/freedemo/productsamples.html), list the main
fundamental signals identified by Value Line analysts and describe their interpretation of
each signal.
Methodological issues
To answer the two research questions previously outlined, Lev and
Thiagarajan (1993) use the following methodology:
1. To examine empirically the incremental value relevance over earnings of
the 12 fundamentals, the methodology employed in the study is based
on two cross-sectional regressions. The conventional returns–earnings
regression is used as a benchmark, against which the regression
including both earnings and fundamentals is evaluated.
The conventional returns–earnings regression (as already described in
the paragraph on the ERC) can be written as:
ari = a + b(∆EPSi) + ui (10.7)
where ari = 12 months’ excess return of the firm i. The excess return
is calculated as the actual (realised) return minus the expected return
(that is calculated on the basis of a market model, such as the capital
asset pricing model); ∆EPSi = annual change in earnings per share
(excluding extraordinary items)
The second regression includes the fundamentals as dependent variables
(in addition to earnings):
12
ari = a + b0∆PTE + Σ bjSji + vi (10.8)
j = 1

where ΔPTEi = annual change in the pre-tax earnings multiplied by
(one minus last year’s effective tax rate); the second component of the
tax signal is one of the 12 fundamentals; Sij = fundamentals signals
(previously described) for each firm i, j = 1…12.
2. To investigate the usefulness of fundamental signals in the assessment

of the persistence (sometimes referred to as quality) and growth of
reported earnings, the methodology is based on the construction of
an ‘aggregate fundamental score’, reflecting the combined message in
169
the signals. Assuming that the fundamental signals help to assess the
earnings persistence, the fundamental signal should be associated with
the ERC, used as a measure of earnings persistence (for the definition
and interpretation of the ERC concept, please refer to the previous
paragraphs). Firms with high-quality fundamental scores should have
large ERC relative to firms with low-quality fundamental scores.
The ‘aggregate fundamental score’ is constructed as follows:
a. Calculation of the value for every firm of each of the 12 fundamentals.
b. Assignation of a value of 1 for a positive signal, and 0 for a negative
signal. Recall that a positive value for a fundamental implies ‘bad
news’, and vice versa for a negative number.
c. Summing up the 0–1 values for each firm and year, and standardising
by the number of available fundamentals, to yield an aggregate
fundamental score. Low aggregate fundamental scores (0 at limit)
indicate high quality of earnings, while high aggregate scores imply low
quality.
d. Allocation of the firms in the sample for each year to five groups based
on their aggregate fundamental scores, and calculation for each group
and year of the related ERC (by running the conventional return–
earnings regression) and of the related future earnings growth.
Empirical evidence on fundamentals

With regard to the first research interest (the incremental value relevance
of the fundamentals over earnings), Lev and Thiagarajan (1993) find
several important results.
First, for most years, with a few exceptions, the coefficients of the
fundamental variables are both statistically significant and of the sign
predicted, as shown in Table 10.2. For example, the coefficient of
inventory is negative, indicating a negative signal in association with an
increase in inventory. The only exception is the LIFO–FIFO signal, which
exhibits an unpredicted sign. Note also that the accounts receivable and
provision for doubtful debts coefficients are weak.
Second, they find support of the incremental value relevance of
the fundamentals over earnings: in the 1980s, fundamentals add
approximately 70 per cent on average to the explanatory power of
earnings with respect to excess returns. Comparison of the R2 of the full
model (equation (10.8)) with the R2 of the benchmark model (equation
(10.7)) shows that fundamental signals contribute significantly to the
explanation of excess returns, beyond reported earnings. In almost every
year, the R2 of the full model is larger than that of the benchmark, and
in some years substantially so. Most of the large R2 differences between
the full and benchmark models are recorded in the 1980s, when the
improvement is about 70 per cent.
Third, to advance previous research on the value relevance of
fundamentals over earnings, Lev and Thiagarajan (1993) extend the
preceding analysis to allow for different economic conditions. The
returns–fundamentals relation is strengthened when it is conditioned
on macroeconomic variables, thus demonstrating the importance of
contextual (to the economy, the market, the industry) fundamental
analysis. For example, when inflation is taken into account, the accounts
receivable signal is statistically significant only in high inflation years,
as is the provision for doubtful debt signal. This inflation-specific value
relevance explains the previously mentioned weak performance of these
170
signals in the unconditional framework.
with *, ** denoting statistically significant at 0.05 and 0.01 alpha levels, respectively.
Table 10.2 Value relevance of fundamental signals

Source: Adapted from Lev and Thiagarajan (1993, pp.202–3)
As regards the second issue (the usefulness of fundamental signals in the
assessment of the quality of reported earnings), Lev and Thiagarajan (1993)
demonstrate a significant relationship between the aggregate fundamental
score and two indicators of persistence (ERC and future earnings growth).
For most of the years under investigation, the highest-quality group (group
1 in Table 10.3) shows larger ERC than the lowest-quality group (group
5). Note, however, that the decreasing trend is not strictly monotonic
(probably because the individual fundamental signals are equally weighted
in the aggregate score). Moreover, the fundamental score is more strongly
associated with the ERC than a time-series based persistence measure:
this suggests that the fundamental score is more effective in capturing the
permanent component of earnings (or rather their quality).
with *, ** denoting statistically significant at 0.05 and 0.01 alpha levels, respectively.
Table 10.3 Fundamental signals and earnings response coefficients
Source: Adapted from Lev and Thiagarajan (1993, p. 211)
171
Overview of chapter
The chapter investigated the usefulness of financial information to
investors by analysing the relationship between earnings and stock
returns, and by further testing the incremental value relevance of
fundamental analysis.
Capital market research in accounting aims to test the relation between
unexpected annual earnings changes and return changes. The empirical
evidence shows that the information contained in the annual income
number is useful in that if actual income differs from the expected income,
the market typically has reacted in the same direction. Nevertheless,
most of the information contained in the reported income is anticipated
by the market before the annual report is released. Moreover, the market
adjustment to unexpected news (bad news in particular) takes several
months, thus suggesting the presence of market underreaction and
subsequent gradual adjustments.
The earnings–return relation is further analysed by introducing the
earnings response coefficient concept. The relative small magnitude of
the actual ERC compared to its predicted value motivated researchers to
advance several hypotheses of the phenomenon, such as effects of prices-
lead earnings; transitory earnings; noise in earnings and deficient GAAP;
and inefficient capital markets.
To identify a better tool for investors to predict future returns on the basis
of accounting information, we analysed the relation between fundamental
information and stock returns. The community of financial analysts
assigns specific interpretation to the so-called fundamental signals, such
as inventory, accounts receivable, CAPEX, R&D, gross margin, S&A,
provision for doubtful debts, effective tax rate, order backlog, labour force,
LIFO vs FIFO and audit qualification. Empirical evidence supports the
incremental value relevance of the fundamentals over earnings. Moreover,
the returns–fundamentals relation is strengthened when it is conditioned
on macroeconomic variables, thus demonstrating the importance of
contextual fundamental analysis. Finally, there is a significant relationship
between an aggregate fundamental score and two indicators of persistence
(ERC and future earnings growth).
Key terms
accounts receivable inventory
anticipation noise in earnings
association study post-announcement earnings drift
CAPEX prices-lead earnings
capital market research in accounting R&D selling and administrative
deficient GAAP expenses (S&A)
fundamental analysis transitory earnings
earnings response coefficient (ERC) underreaction
gross margin unexpected income change
inefficient capital market
172

• understand critically explain the usefulness of financial information to
investors
• outline the theoretical and methodological framework of the so-called
capital market research in accounting
• explain the association between annual earnings and stock returns in
the early capital market research in accounting
• describe the concept of earnings response coefficients (ERC), and
compare the expected magnitude of ERC and the actual values of ERC
• describe the main hypotheses explaining the poor performance of ERC
(price led earnings, transitory earnings, xxxxx in earnings and deficient
GAAP, inefficient capital markets)
• outline the theoretical and methodological framework of research on
fundamental analysis
• explain the incremental value relevance of fundamental analysis over
annual earnings
• explain the possibility of using fundamental signals to assess the
persistence (quality) of reported earnings.

1. What is the main issue investigated by the so-called capital market
research in accounting? What is the methodology used to analyse this
issue? What are the main empirical results?
2. What is the difference between an event study and an association
study?
3. How and to what extent are earnings useful to investors? Discuss the
empirical evidence supporting and contrasting the usefulness of the
returns/earnings relation.
4. Describe the meaning and the interpretation of the main fundamental
signals in accordance with the community of financial analysts.
Critically explain the limit of this approach.
5. What is fundamental analysis? What is the incremental value relevance
of fundamental analysis information over accounting earnings?
6. How can you justify the usefulness of fundamental analysis in the
evaluation of earnings persistence?
173
Notes
174
Chapter 11: Applications
Introduction
This chapter investigates the issues associated with two applications of
valuation analysis: the case of internet stock and the case of merger and
acquisition operations (M&A). They are both characterised by the fact that
traditional fundamental analysis has to be rethought in order to take into
account their peculiarities.
As regards to internet stocks, the traditional relationships between
financial variables and equity valuations have been called into question.
Traditionally, a large empirical literature documents the ability of financial
variables (such as earnings and cash flows) to explain equity values, and
accordingly practitioners use financial variables to get valuations. However,
in the latter half of the 1990s, the growing importance of the internet
industry led academics and practitioners to suggest that equity valuation
needed to be different for internet firms than for other industries. Although
only few would have argued that valuation was not any longer related to
the expectations about discounted cash flows, many used to argue that
financial variables played a very different role (or more precisely a less
important role) as proxies for expectations about future cash flows. In the
first part of the chapter, we aim to investigate whether, and to what extent,
traditional financial proxies for future cash flows/earnings have to be
considered relevant for explaining values of internet firms.
With regard to mergers and acquisitions, although their valuation is not
fundamentally different from the valuation of any firm, the existence
of control premiums and synergies introduces some complexity. Value
creation in an M&A may result from a number of factors such as
economies of scale in production, distribution and management, and
complementarity in resources and markets. The translation of these
factors into a valuation of the synergies requires a deep understanding
of the strategic rationale of the operation and the knowledge of the
appropriate relevant valuation tools. In the second part of the chapter, we
will appreciate the market value effects of M&A operations (particularly
doubtful for the acquiring firm) and we will provide a framework for the
estimation of the intrinsic value of the target/combined firm able to take
into account the synergies associated with the operation.
Aim
The aim of this chapter is to investigate two particular applications
of valuation analysis with regard to internet stocks and merger and
acquisition (M&A) operations. We will first analyse the empirical evidence
about the relative importance of financial versus usage measures in
the valuation of internet firms. We will then move to the investigation
of the empirical evidence on the market value effects of mergers and
acquisitions, on their motivations (and the associated synergies) and on
their financing. We will also construct frameworks to develop forecasts and
valuations for both cases.
Learning outcomes
175
• understand and critically explain the usefulness of financial

information vs non-financial information to investors in the valuation
of internet stocks
• appreciate the role of fundamental accounting analysis in the valuation
of internet stocks, and the changing role of non-financial information
over time
• perform valuations of internet stocks
• explain the empirical evidence on the market value effects of mergers
and acquisitions (for the shareholders of both the acquiring and target
firm)
• appreciate the effects of financing (by stocks, cash or debt) on the deal
• be able to identify the strategic motivations of mergers and
acquisitions, and associate a value in terms of synergies
• undertake valuations of mergers and acquisitions.
Essential reading
SSRN Working Paper, November 2001.
Trueman, B., M.H.F. Wong, and X. Zhang ‘The eyeballs have it: Searching for
the value in internet stocks’, Journal of Accounting Research 38
(Supplement), 2000, pp.137–62.
Further reading
Bradley, M., A. Desai and E. Kim ‘The rationale behind interfirm tender offers:
Information or synergy?’, Journal of Financial Economics 11, 1983, pp.183–
206.
Core, J.E., R.G. Wayne and A. Van Burskirk ‘Market valuations in the new
economy: an investigation of what has changed’, Journal of Accounting
and Economics 34(1), 2003, pp.43–67.
Damodaran, A. Investment valuation. Tools and techniques for determining the
value of any asset. (New York: John Wiley and Sons, 2002) second edition,
Chapters 23 and 25.
Grassman, S.J. and O.D. Hart ‘Takeover bids, the free-rider problem, and the
theory of corporation’, Bell Journal of Economics (11) 1980, pp.42–64.
Hand, J.R.M. ‘The role of book income, web traffic, and supply and demand
in the pricing of US internet stocks’, European Finance Review 5, 2001,
pp.295–317.
Healy, P.M., K.G. Palepu and R.S. Ruback ‘Does corporate performance improve
after mergers?’, Journal of Financial Economics 31, 1992, pp.135–75.
Jarrell, G., J. Brickley and J. Netter ‘The market for corporate control: the
empirical evidence since 1980’, Journal of Economic Perspectives 2(1), 1988,
pp.49–68.
Keating, E.K., T.Z. Lys and R.P. Magee ‘internet downturn: Finding valuation
factors in spring 2000’, Journal of Accounting and Economics 34 (1–3),
2003, pp.189–236.
Lang, L.H.P. and R.M. Stulz ‘Tobin’s q, corporate diversification, and firm
performance’, Journal of Political Economy 102(6), 1994, pp.1248–80.
176
Palepu, K., V. Bernard, V. and P. Healy Business analysis and valuation. (Mason,
Ohio: South-Western College Publishing, 2006) fourth edition. Chapter 10.
Works cited
Comment, R. and G.A. Jarrell ‘Corporate focus and stock returns’, Journal of
Demers, E.A. and B. Lev ‘A rude awakening: internet shakeout in 2000’, Review
of Accounting Studies, 6 (2/3), 2001, pp.331–59.
Eckbo, B.E. ‘Horizontal mergers, collusion, and stockholder wealth’, Journal of
Finance (47), 1992, pp.427–65.
Franks, J., R. Harris and C. Mayer ‘Means of payment in takeovers: Results for
the UK and US’, CEPR Discussion Paper no. 200, 1987. London Centre for
Economic Policy Research, www.cepr.org/pubs/dps/DP200.asp
Morck, R., A. Shleifer and R.W Vishny ‘Do managerial objectives drive bad
acquisitions?’, Journal of Finance XLV (1), 1990, pp.31–48.
Ofek, E. and M. Richardson ‘The valuation and market rationality of internet
stock prices’, Oxford Review of Economic Policy 18(3), 2002, pp.265–87.
Rajgopal, S., S. Kotha and M. Venkatachalam ‘The relevance of web traffic for
stock prices of internet firms’, Working Paper October 2000.
Rappaport, A. and M.L. Sirower ‘Stock or cash? The trade-offs for buyers and
sellers in mergers and acquisitions’, Harvard Business Review 77(6), 1999,
pp.147–58.
Internet stocks
In association with the growing importance of the internet industry,
practitioners and academics used to emphasise the difficulties in
evaluating internet stocks. In particular, several facts about these firms
affect their valuation:
• The industry is young, and therefore little historical financial
information is available to forecast profitability.
• The industry is evolving at a rapid and unpredictable rate. This implies
that whatever historical information exists is likely to be less useful
for valuing internet firms than for valuing firms in more established
industries.
From the above facts, practitioners seemed to suggest that financial
information was of very limited use in the evaluation of internet
stocks, and new valuation paradigms seemed to be needed. Moreover,
practitioners typically argued that the industry offers a substantial
amount of non-financial data on internet use, which could be used in the
prediction of future revenues. Analysts used to argue that current internet
traffic is likely to be positively related to future revenues because it reflects
potential future demand for the company’s products and affects the rates
the company can charge for advertising.
The issue here is that by February 2000, the internet industry accounted
for 6 per cent of the market capitalisation of all US public companies.
This was a sector, however, which in aggregate had negative earnings.
In the spring of 2000, the internet Stock Index (ISDEX) took a dramatic
downturn, falling by approximately 45 per cent from mid-March through
to the end of May. The extraordinary rise and fall in internet values has
generally been referred to as the ‘internet bubble’.
177
Activity 11.1
Pause and think: Is the rise and fall of internet stock prices evidence per se of market
irrationality?
As argued by Ofek and Richardson (2002), one cannot infer necessarily

from ex post realisations that market values did not in fact reflect
fundamental values about cash flows/abnormal earnings. The rise and fall
could be due to changes in expectations about future cash flows/abnormal
earnings or discount rate.
Several questions arise. Are stock price movements associated with the
disclosure of new (financial and non-financial) information? Is there any
difference in the relative importance of financial and web usage measures
pre- and post- the internet peak? Do analysts need different valuation
methods for internet firms than for other industries?
Financial measures vs usage measures in the valuation of internet

stocks
To understand the relative importance of financial versus web traffic
measures in the valuation of internet firms, we need to distinguish
between the pre- and post-peak period in internet stock prices.
Evidence on the pre-peak period

In their paper ‘The eyeballs have it: Searching for the value in internet
stocks’, Trueman et al. (2000) aim to answer the following research
question: in which manner is accounting information, along with measure
of internet usage, employed by the market in the evaluation of internet
firms? The idea is to investigate the extent to which market prices are
associated with fundamental accounting information along with internet
usage measures.
The valuation model employed in their analysis is the abnormal earnings
model. Recalling Chapter 8, it can be written as:
E ( AE j ,t +1 ) (11.1)
MV jt = CSE jt + ∑
(1 + rE ) j
where MVjt = firm j’s market value at t; CSEjt = book value of firm j’s
common equity at t; AEjt+1 = abnormal earnings, with earnings (net
income) equal to gross profit minus operating expenses (such as research
and development expenditures and selling general and administrative
expenses) minus non-operating expenses; rE= rate of return of equity
capital.
The methodology used to test the research question is based on a series of
regressions. First, a simple regression where the intrinsic value of equity is
set against net income:
MV jt α0  NI jt  (11.2)
= + α1 + α 2   + ε jt
CSE jt CSE jt  CSE 
 jt 
where NIjt = net income available to firm j’s shareholders; t = quarter of
earnings announcement.
Then net income is decomposed into its determinants, and the related
estimated regression becomes:
MV jt α0 GPjt MKTG jt RND jt OTHEXPjt (11.3)
= + α1 + α 2 + + + + ε jt
CSE jt CSE jt CSE jt CSE jt CSE jt CSE jt
178
where GPjt = firm j’s gross profit (note that gross profit is coded as gross
margin in Chapter 2); MKTGjt = firm j’s sales and marketing expenses;
RNDjt = firm j’s research and development expenses; OTHEXPjt = firm j’s
other operating expenses.
The decomposition of the net income into its various components allows
for the possibility that the individual line items have different implications
for future firm profitability: future gross profits are assumed to be
positively and linearly related to current gross profit, operating expenses
and website usage; future expected operating expenses are assumed to
be linearly related to current operating expenses; future non-operating
expenses (different from interest expenses) are expected to be zero.
Including internet usage (USAGEjt) as an additional independent variable,
together with financial data, equations (11.2) and (11.3) become
respectively:
MV jt α0  NI jt  USAGE jt (11.4)
= + α1 + α 2  + β + ε jt
CSE jt CSE jt  CSE  CSE jt
 jt 
MV jt α0 GPjt MKTG jt RND jt OTHEXPjt USAGE jt

= + α1 + α 2 + + + +β + ε jt
CSE jt CSE jt CSE jt CSE jt CSE jt CSE jt CSE jt
(11.5)
where the internet usage measure can be: unique visitors (i.e. the
estimated number of different individuals who visit the firm’s website(s)
during a particular month); or page views (i.e. the estimated number of
pages viewed by those individuals visiting the firm’s website(s) during the
month). As regards internet usage measure, the assumption is that current
web usage is positively related to next period’s gross profits and website
usage.
The empirical evidence obtained refers to the pre-peak period, because
the sample consists of 63 publicly traded internet companies (classified
as portals, content/community providers, e-tailers) covering the quarters
from September 1998 to December 1999. The main findings for this
period can be summarised as follows:
1. There is no significant association between net income and market
value (adjusted R2 is zero, as shown in column A of Table 11.1). This
could be due either to the effect of transitory items, or to the effect
of bad accounting (investors consider some line items in the income
statement to be investments rather than expenses).
2. When including the components of net income in the regression, the
adjusted R2 jumps to 52 per cent (column D). Furthermore, as regards
the components of net income, the evidence shows that:
a. There is a positive and significant association between gross
profit and market value (column D). This suggests that investors
view gross profit as more permanent in nature and as a less noisy
measure of current operating performance than is net income.
b. There is a negative and significant relation between sales and
marketing costs and market value (column D). This could mean that
investors may view sales and marketing costs as normal expenses
of doing business rather than as investments, just as would be
expected for firms in more established industries.
c. Research and development costs are not significantly associated
with stock prices (column D). This finding could either suggest that
investors view R&D expenses to be of little use in valuing internet
179
firms, or alternatively investors view R&D costs as normal expenses

for some internet firms and as investments for others.
3. When including internet usage measures, the adjusted R2 increases:
from zero to 34 per cent when page views are combined with net
income (column C); from 52 per cent to 65 per cent when page
views are combined with the components of net income (column F);
from zero to 11 per cent when unique visitors is combined with net
income (column B). Also, page views and unique users are positively
and significantly associated with the market value of equity, jointly
considering financial information (columns B, C, E and F). Note
that the latter result is confirmed in Rajgopal et al. (2000): unique
visitors are positively associated with stock prices, and add significant
incremental explanatory power (24 per cent) to a regression of just
financial information against stock prices.
A B C D E F
Intercept 20.05 11.18 8.92 –0.89 –1.34 –4.59
1/BV –99128 –246531 –68872 –73186 –88122 –89356
NTINC/BV –12.03 –13.81 –24.33
GP/BV 302.19 296.00 185.14
MKTG/BV –46.47 –44.82 –37.85
RND/BV 103.33 102.75 292.22
OTHEXP/BV 3.73 3.40 7.22
VISITORS/BV 252.52 23.78
PAGEVIEWS/BV 3.93 2.71
Adjusted R 2
0.00 0.11 0.34 0.52 0.52 0.65
Table 11.1 Relevance of financial vs non-financial information
Source: Adapted from Truman et al. (2000, p.151, Table 3)
In short, in the pre-peak period, measures of internet usage are important

factors in the valuation of internet stocks, but also the individual income
statement components (especially gross profits) deliver some relevant
information too. Instead, earnings (net income) are useless. What
happened after the peak period?
Evidence on the post-peak period

The empirical evidence on the post-peak confirms the results referred to
in the pre-peak period, as clearly crystallised by Keating et al. (2003). The
methodology used in Keating et al. (2003) is based on a set of regressions
analogous to the one used in Trueman et al. (2000), and the related
evidence is in line with the findings in Trueman et al. (2000). When a
summary net income number is used, traditional financial measures do not
significantly outperform the explanatory power of web usage measures.
However, when earnings are decomposed into gross profits, marketing
expenditures and research and development expenses, then the financial
information has a significantly higher association than usage information
with stock prices (both in the pre- and post-peak periods).
A particular focus on the role of web usage measures in the post-
peak period is provided by Demers and Lev (2001). By undertaking a
factor analysis on an extensive set of raw web variables, they identify a
parsimonious set of relevant web traffic measures: reach (i.e. ability of
the internet firm to attract unique visitors); stickiness (i.e. average time
spent at the site per visit and the average number of pages viewed per
180
visit); and customer loyalty (i.e. average number of visits to the website
per unique visitor per period). The empirical evidence suggests that reach
and stickiness measures are value-relevant to the stock price of internet
firms both in the pre- and post-peak (note, however, that loyalty is not
significant at traditional levels in either periods).
Finally, as regards the presence of market rationality versus irrationality,
Keating et al. (2003) interestingly found that the stock price decline in
spring 2000 was not associated with disclosure of new information (such
as earnings, analyst forecasts revisions or web traffic measures). However,
the decline was very much associated with a reassessment by investors
of pre-existing information, so that post-bubble prices were significantly
explained by 1999 financial information in the annual reports of internet
firms. This would suggest internet market irrationality in the latter half of
the 1990s.
A time trend analysis of the relative importance of financial vs

usage measures
In contrast with Trueman, et al. (2000) and Keating et al (2003), Hand
(2001) finds that before the peak of internet prices in March 2000 the
market rewarded losses of web-traffic-intense firms, but did not reward
profits. This negative pricing of losses almost certainly arose not because
the market perversely rewards poor operating performance, but because
losses used to reflect the expensing of significant investments in intangible
assets. However, the pricing of profits and losses changed systematically
over time. After the peak, profits become significantly positively priced,
while losses are no longer significantly negatively priced. (Note, however,
that web traffic is found to be positively priced both at and after the
internet peak.) The shift in the pricing of losses can be explained by
the fact that the market became unwilling to view the expenditures on
research and development and marketing as asset-like items. The market
conversely started to reward those firms that were on a clear path to
profitability, in the form of financial measures. Essentially we can conclude
that there is a kind of convergence in the pricing of internet and non-
internet firms.
The same kind of convergence is documented by Core et al. (2003). In
contrast to Hand (2001), Core et al. (2003) do not focus on internet firms
in the sub-period around the peak. Instead, they investigate the ability of
traditional financial variables to explain equity valuation in broad samples
of firms over a long time period, with the aim of examining whether the
relation between financial variables and equity valuation has undergone
unusual changes in recent years, after the development of the so-called
New Economy Period (NEP). By using a similar model to the one in
Trueman et al. (2000), they examine a broad sample of internet and non-
internet firms between 1975 and 1999. The main finding is that compared
with earlier periods, the relationship between financial variables and
equity valuation remained very stable during the 1990s. In particular, the
ability of financial variables to explain firm value decreased in the NEP,
but this decline in the explanatory power does not appear to be due to an
unstable relationship between firm value and financial variables (such as
earnings, book value of equity and growth opportunities). This finding
suggests that traditional explanatory variables of equity valuations remain
applicable to firms in the internet sub-period, but that there is greater
variation in firm values remaining to be explained by omitted factors.
This intuition of convergence in the valuation of internet and non-internet
firms is further developed by Jorion and Talmor (2001), in a study aiming
181
to test the usefulness of a theory of life-cycle stages in the understanding

of the relevance of financial and non-financial information for internet
firms. The underlying assumption is that as a company matures, the nature
of its production function changes. A consequence would be that, as the
internet industry matures, there should be a decrease in the importance of
non-financial variables.
A set of regressions is used to test the above relationship over time.
Similarly to Trueman et al. (2000), the benchmark regression can be
written as:
MVt = α 0 + α1 BVt + α 2 Ft + α 3WEBt + ε t (11.6)
where F = vector of financial variables; WEB = vector of web traffic
measures. In particular, they use two traffic measures: a measure of ‘reach’
(unique visitors) and measures of ‘stickiness’ (page views and hours, which
is the total number of hours each site is viewed by all of the users during
the reported time period).
To test for the life-cycle stage, a time trend variable is added to the
benchmark equation here above. Formally this can be written as:
′ ′
MVt = α 0 + α1 BVt + α 2 Ft + α 2 (TxF ) + α 3WEBt + α 3 (TxWEBt ) + ε t (11.7)
where T = measure of calendar time. The coefficient α3' is expected be
positive but decreasing over time.
The empirical evidence refers to the period around the peak (in fact, the
sample analysed consists of 259 companies over the period January 1996
– December 2000). In particular, the empirical results without a time trend
variable, are in line with previous studies:
• The initial link between financial information and market value is low
(this confirms Rajgopal et al., 2000).
• Gross profit is significantly and positively related to market value,
whereas net income is only weakly positive (this confirms Trueman et
al., 2000) and R&D is irrelevant.
• Both reach and stickiness are highly relevant and provide a significant
increase in explanatory power (this confirms Demers and Lev, 2001).
Moreover, stickiness is found to be more relevant than reach (this
confirms Truman et al., 2000; but contrasts Hand, 2001 and Demers
and Lev, 2001).
Several interesting findings are obtained by adding a time trend variable.
First, gross profits and research and development expenditures become
increasingly value relevant over time; whereas eyeball measures show a
negative time trend. This seems to suggest that as the internet industry
matures, key financial variables get increasingly value relevant and non-
financial information plays a significantly decreasing role. The implication
is that different value metrics should be used at different stages of the
life of an industry. Furthermore, it is interesting to note that the changing
role of web traffic data versus financial variables is anchored more to
the technological state of the industry than to the life-cycle stage of the
specific company.
A valuation framework for internet firms

As discussed in Chapter 8, the value of a firm is typically based on its
capacity to generate cash flows/abnormal earnings and the risk associated
with these payoffs. However, young internet firms often support losses, but
still seem to have high values attached to them. Also, they tend to have
low investments in tangible assets, but seem to derive the bulk of their
182
value from intangible assets.

During the latter half of the 1990s, the negative earnings and the large
presence of intangible assets were used by practitioners as a motivation
for abandoning traditional valuation methods and developing new ways
to value these firms. As documented in the section ‘Financial measures vs
usage measures in the valuation of internet stocks’, attempts have been
made to value internet firms on the basis of web usage metrics. This search
for new valuation paradigms, however, can be very misleading.
Conversely, the difficulties in the valuation of internet firms can be solved
by crystallising the life-cycle stage in which they are located. As shown
in the empirical evidence presented in the previous section, internet
firms in later life-cycle stages can be valued analogously to established
firms. Problems for internet firms occur earlier in their life cycles than
established firms. The valuation here is still based on the present value of
cash flows/abnormal earnings, but those cash flows/abnormal earnings
are likely to be much more difficult to estimate. Some typical issues (and
suggested solutions) that arise at each step in the valuation of internet
firms in their early life-cycles are outlined below.
• Financial analysis. Given that so little historical information is
available, and given the rapid pace at which historical information
changes, analysts should refer to the most recent information they can
obtain, at least on sales and earnings (i.e. information from the trailing
12 months, rather than from the last year’s financial statement).
Activity 11.2
What is a trailing 12-month earnings?
• Prospective analysis and the forecast of sales growth. Given the high
expectations of sales growth usually associated with internet firms,
this represent a key input in the valuation. The reference to a number
of sources is thus recommended. Not very differently than for more
mature firms, reference should be made to past growth rate in sales
at the firm itself, growth rate in the overall market that the firm
serves, barriers to entry and competitive advantage held by the firm.
Nevertheless, given that uncertainty is much higher in the valuation of
an internet firm in comparison with an established firm, practitioners
suggest the use of probability-weighted scenarios. This method requires
us to repeat the process of estimating a future set of financials for a
full range of scenarios (typically optimistic, neutral and pessimistic).
Strategic and financial analysis plays a critical role in the proper
definition of future scenarios. In short, the construction of scenarios
requires the knowledge of what actually drives the value creation.
Activity 11.3*
Assume that for CompanyOne.com analysts identify the four potential scenarios below.
Scenario A Scenario B Scenario C Scenario D
Forecast DCF value (£m) 80 35 15 5
Forecast probability 5 35 35 25
What is your best estimates of the intrinsic value of the firm?

• Prospective analysis and the forecast of sustainable gross margin. For

a firm with negative earnings, high sales growth just makes the losses
183
become larger over time. A key component for an internet firm to

become valuable is the expectation that the gross margin, although
negative now, will become positive in the future. In fact, the empirical
evidence analysed in the previous sections suggests how strongly
related gross margin is to stock prices. One important caution in
forecasting the value of internet firms is thus to decompose current
net income to get a true measure of gross margin. In fact, negative net
income can be due to accounting conventions that require the reporting
of capital expenses as operating expenses (and not to the fact that
operating expenses are larger than sales). Since many of these capital
expenses are treated as SG&A expenditures, it is particularly useful
to estimate margins prior to these expenses. (Recall that in the EVA
method developed by practitioners, instead, expenditures in research,
development and marketing have to be treated as investments, not
period expenses, and NOPLAT and capital invested have to be adjusted
accordingly.)
• Estimation of the discount rate. In the standard approach for estimating
the beta to be used in the calculation of the cost of equity capital,
analysts regress stock returns against market returns. However, this
approach cannot be used for young internet firms because of the
availability of little historical data. Alternative approaches have to be
used. One approach, known as bottom-up, suggests that the current
beta for the firm can be estimated on the basis of the averages of
comparable firms that have been listed for two or more years. If
those firms do not exist, beta can be estimated using the financial
characteristics of the firm itself (i.e. volatility in earnings, size, cash
flow characteristics, financial leverage).
Activity 11.4
Create a table that lists the main issues associated with the valuation of internet stocks
and the possible solutions for solving them.
Mergers and acquisitions

The main concern of security analysts for merger and acquisition
operations relates to the ability of the deal to create value for the
shareholders of the bidder (also known as the acquiring firm) and the
target. In particular there are three ways for the acquisition to be value
increasing for the bidder firm:
• buying the target firm’s shares at less than their fair value
• generating value – synergies – by combining the operations of the two
firms
• using its own overvalued shares to buy the shares of the target cheaply.
In this section we will investigate the issues associated with these ways
of value creation. First, we will examine some empirical evidence about
the effects of M&A operations on the market prices of the target and
acquiring companies, given that their value to acquiring firms is still
under doubt. Then we focus on the main issues analysts face in evaluating
whether the operation creates value for the acquiring firm. We start from
the investigation of the motivations for mergers and acquisitions (and
their value in terms of synergies) and we then continue with the issues
associated with the financing of the operation (use of overvalued shares vs
cash or debt). Finally, we illustrate the framework for the valuation of an
M&A operation.
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Empirical evidence on the value effects of mergers and

acquisitions
There is a great deal of empirical evidence on the effects of mergers and
acquisitions on the stock prices of both the target firm and the bidder firm.
This evidence shows that the excess returns (i.e. returns over and above
the expected return, after adjusting for risk and market performance) of
the shareholders of target firms are extremely positive. In their review of
13 studies on the value effects around the announcement date, Jensen
and Ruback (1983) report that the target stock prices increase from
about 16 to 30 per cent around the date of the announcement of the
successful tender offers. These figures are consistent with the ones for the
663 successful tender offers that occurred from 1962 to 1985 reviewed
by Jarrell et al. (1988): the estimated premium averaged 19 per cent in
the 1960s, 35 per cent in the 1970s and 30 per cent from 1980 to 1985.
More astonishingly is the premium measured in another study reviewed
by Jarrell et al. (1988): by comparing the price per share offered by the
bidder to the trading price of the stock one month before the offer (not
adjusting for changes in the market index), the average increase in returns
was about 53 per cent in the 1980s.
In unsuccessful tender offers (the failure can be due either to the
withdrawal of the offer from the bidder or to the fight of the offer from
the target), the target firm continues to earn significant positive abnormal
returns on the offer announcement and through the realisation of the
failure (Jensen and Ruback, 1983). In particular, Bradley et al. (1983)
report a permanent positive revaluation of unsuccessful target stocks
primarily because of the emergence and/or the anticipation of another
bid that would ultimately result in the transfer of control of the target.
The entire excess return to the shareholders of the target firms that
are not subsequently taken over within five years from an unsuccessful
offer dissipate within two years of the initial unsuccessful bid. Instead,
the shareholders of the targets subsequently taken over experience an
additional positive and significant excess return (50 to 66 per cent).
The value effects of mergers and acquisitions on the stock prices of the
bidder (acquiring) firm is not as clear cut. The average excess return to
acquiring firms is only about 3.8 per cent in successful tender offers and
is zero in mergers (Jensen and Ruback, 1983). Consistently, Jarrell et al.
(1988) in their review of the tender offers from 1962 to 1985 report for
successful tender offers a decline in excess returns over time: from 4.4 per
cent in the 1960s, to 2 per cent in the 1970s, to –1 per cent in the 1980s.
What are the reasons of a lower gain for the bidder firm? First, the market
feels the acquiring firm is overpaying for the acquisition. Second, the
market interprets the bid as a signal that the bidder’s shares are overpriced.
In unsuccessful tender offers, the average return becomes negative for
the bidder firm (Jensen and Ruback, 1983). Bradley et al. (1983) report
negative excess return of 5 per cent to bidding firms around the failure
announcement. In particular, when the target firm rejects one bid and
accepts another bid made by a rival bidding firm, the unsuccessful bidder
firm supports significant negative excess returns (of approximately 8 per
cent). Most of this loss of the shareholders of the bidder firm occurs in the
days around the announcement of the successful rival bidder firm.
It is interesting to note that significant stock price increases occur prior
to formal announcements of corporate events (the announcement date
is the date the target firm is put in play): almost half of the abnormal
returns associated with the merger announcement occur prior to their
public announcement. This price run-up before the formal announcement
185
suggests either a very perceptive financial market or information leakages of

about prospective deals.
Total returns for bidder and target firms

The evidence shows that target firms realise large positive excess returns
in successful takeovers, whereas the reward for bidding firms is mixed
(zero returns are earned by successful bidding firms in mergers, and small
positive abnormal returns are realised by bidders in tender offers). Targets
gain and bidders do not appear to lose. Takeovers therefore create value.
(Note, however, that bidders tend to be larger than targets, so that the sum
of the returns to bidders and targets does not measure the gains for the
merging firm.) Overall, successful tender offers increased the combined
values of the merging firms by an average of 10.5 per cent (Bradley et al.,
1982).
Specifically, they generate positive excess returns for the shareholders of the
target firm only if the control of their firm is transferred to another firm. This
implies that the shareholders of unsuccessful tender offers do not realise
permanent increases in excess returns. This evidence on the value effects of
unsuccessful offers is consistent with the synergy hypothesis, or rather tender
offers are attempts by the bidding firms to exploit potential synergies, not
simply superior information about the true value of the target resources.
In the next section, we analyse the typical synergies creating value, having
in mind the caution that the empirical studies have had little success in
distinguishing between these alternative sources of gains.
Motivations for mergers and acquisitions

As emphasised by the empirical evidence presented in the previous section,
acquisitions are value-increasing because they generate synergies. Synergies
can be generated by several sources:
1. Taking advantage of economies of scale in production and distribution.
The resulting combined firm can perform a function/activity more
efficiently than the target and bidder separately. For example, the
combined firm can economise on research and development expenses
and management costs.
2. Improving target management. Typically targets systematically
underperformed their respective industry in the period approximately
six months before the acquisition. This below-normal performance
can either be due to bad luck or to poor management. (Note that bad
management can result either from managers taking poor investment
operating decisions or from managers deliberately pursuing goals
increasing their personal power but decreasing shareholders’ wealth.)
Therefore the below-normal performance is consistent with the
hypothesis that inefficient target management caused targets to perform
badly. However, there is currently no evidence that links these negative
pre-merger returns to inefficiency.
3. Combining complementary resources/markets. A takeover may take place
in order to combine complementary resources/competencies, particularly
when the target and the bidder have distinctive resources/competencies in
different areas (e.g. one firm has a strong distribution unit, while the other
has a strong research and development unit). Note that these synergies
gain increasingly in importance when the specific resources involved
become more costly. It is essential to note that the complementarity can
also refer to markets/products of the target and bidder: differences in the
geographical dominant location or in the product segment for the two
companies represent a motivation for takeovers.
186
Synergies deriving from points 1–3 can be synthetically named as

improvements in operating performance that result from takeovers.
Healy et al. (1992) document an increase in this operating performance
(attributable to an improvement in the asset turnover ratio): in years
–5 to –1 prior to the operation, the combined firms had industry-
adjusted asset turnover of –0.2 (i.e. they generated 20 cents less in
sales than their competitors for each dollar of assets). In years 1 to 5
after the operation, they close this gap as they achieved asset turnovers
comparable to their industries. This evidence indicates an improvement
in operating performance in the post-merger period.
4. Financial motivations. These include the use of underutilised tax shields,
avoidance of bankruptcy costs and increase in the financial leverage. In
particular, takeovers represent a way to provide low-cost financing to a
financially constrained target from a bidder.
5. Capturing tax benefits. Although tax benefits have long been suspected
as an important cause of the takeover activity, in the US Tax Reform Act
of 1986 there are several provisions aiming to reduce the tax benefits
associated with mergers. In the US, one of the major remaining tax
benefits is the utilisation of operating tax losses by a bidder that does
not expect to earn sufficient profits to fully use its operating loss carry-
forward benefit. The operating losses and loss carry-forward of the
acquirer can be offset against the taxable income of the target. Another
remaining tax benefit is the option to set up the basis of the target’s
assets without paying corporate-level capital gains. However, most of
the empirical evidence assigns tax benefits a minor role in explaining
merger and takeover activity (Jarrell et al., 1988).
6. Increased market power in product markets. Takeovers increase product
prices, thereby benefiting the combined firms and other competing
firms in the industry. By becoming a dominant firm in the industry,
the target and the bidder can collude to restrict their output and raise
prices, and therefore to increase their profits and value. It is essential,
however, to note that the existing empirical evidence rejects the market
power hypothesis as a determinant of the takeovers (Eckbo, 1983). By
focusing on the stock price reactions of rivals at the announcement of
the antitrust challenge, the empirical evidence shows that rivals with
a positive market reaction to the initial merger do not tend to have
negative abnormal returns to the time of the complaint. This goes
against the market power hypothesis, which predicts negative excess
returns for rivals at the time of the complaint because the complaint
reduces the probability of completion of the merger.
Although most of the motivations for acquisitions are likely to create new
economic value for shareholders, some are value-destroying. They tend
to be motivations valued by managers of bidding firms pursuing their
own personal objectives other than maximisation of stockholder value.
(Note that when an investment provides a manager with particularly large
personal benefits, managers tend to overpay for the target. This would not
be allowed if investors could perfectly monitor and control the investment
decisions of managers, but the existing devices are not an effective deterrent
to investments that dissipate market value.) Typical investments that pursue
personal manager non-value-maximising objectives are as follows.
1. Use of surplus cash. Firms with surplus cash and no new profitable
investment opportunities can use the surplus cash to make acquisitions.
The acquisition here represents an alternative to paying out funds to
shareholders as dividends, or to use the funds to repurchase the firm’s
stocks. As these alternatives would reduce the size of the firm, and
187
the assets under management control, managers prefer to invest the

excess cash to buy new companies, even if they are not valued by
shareholders.
2. Diversification. This was a popular motivation for acquisitions in the
1960s and early 1970s in the USA as a way to attenuate earnings
volatility by buying firms in unrelated businesses. Since then, this
strategy has been widely discredited. Not only does it lead firms to
lose sight of their major competitive advantage and to expand into
businesses where they do not have specific expertise, also, modern
finance teaches that investors can diversify by themselves, and do not
need managers to do so for them.
Consistently, the empirical evidence shows that firms destroy value when
diversifying and create value when selling off divisions and becoming
more focused. Specifically, Lang and Stultz (1994) compare the Tobin’s q
(i.e. the present value of future cash flows divided by the replacement cost
of tangible assets) of diversified and specialised firms. Their findings show
that during the 1970s and the 1980s, specialised firms were valued more
highly by the capital markets than diversified firms.
Complementary evidence is provided in Comment and Jarrell (1995):
shareholder wealth maximisation is associated with greater corporate
specialisation. In particular, there is evidence during the 1980s of a
positive relation between stock returns and specialisation increases, and
also that large focused firms are less likely to be subject to hostile takeover
attempts than diversified firms. Instead, in the 1980s diversified firms
were active participants (as both buyers and sellers) in the market for
corporate control.
Other interesting findings are provided by Morck et al. (1990): the average
bidder return is positive in a related acquisition, whereas it is negative in
an unrelated acquisition. This result becomes sharper by distinguishing
between the 1970s and 1980s: bidder stock returns for diversifying
acquisitions became more negative in the 1980s, whereas bidder stock
returns increased for non-diversifying acquisitions. This evidence confirms
that diversification became unattractive in the 1980s.
Acquisition financing
When the bidder has to make decisions about a deal, in addition to the
focus on the price to be paid for the acquisition, the attention has to
be on whether to finance the deal using stocks, cash or debt. In stock
transactions, the bidder can alternatively: issue stocks to the public; raise
cash and use the cash to pay for the acquisition; or exchange its own
stocks with stocks of the target (i.e. stock swap). Note that if the bidder
decides to issue stock, it then must decide whether to offer a fixed value of
shares or a fixed number of them.
The market often interprets stock payments as a lack of confidence in the
value of the bidder’s stock. Why? Bidding firms that believe that their
stocks are overvalued are much more likely to use stocks. Nevertheless,
offering a fixed value of shares sends a more confident signal to the
markets, as the bidder assumes all the risk that the value of its stock will
decline before the deal goes through.
As shareholders of the target firm are also aware of this, they may require
a larger premium when the payment is made entirely in stocks. However,
in a stock swap, shareholders of the target may be able to defer capital
gain taxes on the exchanged shares: the potential tax gain arising from the
stock swap can be large enough to balance any perceived disadvantage.
188
Cash transactions require that the bidder has accumulated substantial

amounts of cash, and enable the bidder to send a strong signal to the
markets that it has confidence in the value not only of the deal but in its
own stocks.
In debt transactions, the bidder raises the funds required for the
acquisition from debt. The use of this means of payment depends on the
existing leverage of the bidder and target. The acquisition of an under-
levered target may be carried out by using a larger portion of debt than
in the case of an acquisition of a target with an optimal leverage. This has
implications in terms of the cost of capital of the combined firm, but does
not affect the cost of capital used in valuing the acquisition.
Stock returns and means of payment

There has been a profound change in the means of payments used in
acquisitions. In the US over the period from 1955 to 1985 there was a
substantial increase in the proportion of acquisitions financed with cash
(Franks et al., 1987). In 1988, nearly 60 per cent of the value of large
deals (over $100 million) was paid for entirely in cash, and less than 2 per
cent entirely in stocks. But by 1998, the profile reversed: 50 per cent of
the value of large deals was paid entirely in stocks, and only 17 per cent
entirely in cash (Rappaport and Sirower, 1999). Note that mixed bids are
more common in the UK (Franks et al., 1987).
The choice of the means of payment has strong implications for the
shareholders of the bidding company. In fact, cash acquisitions display a
better post-acquisition performance than equity acquisitions. In particular,
the two-day returns to the bidder are positive for cash offers (+2 per cent
in the US and 0.7 per cent in the UK) while they are negative for equity
offers both in the US and in the UK (Franks et al., 1987). Overall, the
bidder’s stock price reacts more favourably, on average, when the bidder
makes a cash offer than an offer to exchange stock. Moreover, this early
performance difference between stock and cash transactions is shown to
become greater over time. This evidence can be explained on the basis
of the information content about the bidder conveyed by the choice to
finance the acquisition by stocks.
Valuation of acquisitions
The valuation of an acquisition is not fundamentally different from any
other valuation. It first requires the valuation of the target as a stand-
alone firm (by using the valuation methods illustrated in Chapter 8).
Note that even in efficient markets, there is no reason for the stand-alone
value of a firm to be equal to the firm’s market value, partly because the
latter includes the probability of the firm being taken over as well as
the expected takeover premium. Then the valuation follows up with the
estimation of the present value of the synergies or gains associated with
the acquisition. Therefore the gross value of the target to the acquirer is
the sum of the value of the target as a stand-alone firm plus the present
value of the synergies. This delivers the maximum bid price. In symbols:
PT = VT + PV Synergies (11.8)
where PT denotes the gross value of the target to the acquirer and VT
the value of the target as a stand-alone entity. In general, the bid price
is less than this sum. However, you would expect an acquirer to pay a
control premium over the market price to control the management of
firms, especially those that are perceived to be poorly run. The existence
of a market for corporate control causes many hostile takeovers and the
payment of such a control premium.
189
The value generated by the acquisition or net value of the target to the
acquirer is the difference between the gross value of the target and the
price paid: VT + PV Synergies – MVT – Control Premium, where MVT
denotes the market value of the target.
The value generated by the acquisition to the acquirer, or net value of
the target to the acquirer, is the difference between the gross value of the
target and the price paid. VT + PVSynergies – MVT – Control Premium,
where MVT denotes the market value of the target
Several important issues have to be taken into account in the valuation of
acquisitions. First, the market value of the target firm may differ from the
intrinsic value of the firm valued as a stand-alone entity. This may arise for
two reasons:
• stock prices may not incorporate proprietary information that the
acquiring firm’s analysts may have obtained during the course of the
investigation
• stock prices of the target may reflect takeover probabilities and
takeover premiums.
Second, the process for the valuation of the synergies is very complex and
subjective, but it is worth accomplishing. It requires assumptions to be
made about the future cash flows associated with the synergies identified
through a careful strategic analysis of the acquisition. On this point, two
important questions have to be answered:
• In which form will the synergy materialise? This means to infer
whether the synergy will affect the cost or revenue side of the
combined entity.
• When will the synergy start to affect the forecast payoffs? Since the
value of the synergies is summarised in the present value of the cash
flows created by them, the longer it takes the synergies to materialise,
the smaller is the value added for the intrinsic value of the target as an
independent entity.
Activity 11.5*
Company ABC is currently valued at $50 in the market. A potential acquirer, XYZ, believes
that it can add value in two ways:
• $15 through better working capital management
• $10 by making available a unique technology to expand ABC’s new product
offerings.
In a competitive bidding contest, how much of this additional value will XYZ have to pay
out to ABC’s shareholders to emerge as a winner?
The magnitude of the control premium offered to the shareholders from the target firm
depends on strategic considerations: what is the magnitude of the present value of
synergies available to other bidders? In the event an acquisition leads to an increase in
the value of the target firm, shareholders in the target firm – believing the bid will be
successful – will furthermore be tempted to free-ride on the acquirer and refuse to tender
their shares unless the acquirer is willing to give away all the value generated by the
acquisition. Any acquirer incurring costs associated with bids, such as due diligence and
legal fees, will hence be unable to agree to these terms and no efficient takeover will
obtain (Grossman and Hart, 1980). Institutional mechanisms that restore the possibility
of having efficient takeovers, include toeholdings and dilution.
190
Overview of chapter
In this chapter, we analysed two peculiar applications of valuation
analysis: the case of internet stocks and the case of mergers and
acquisitions.
As regards to internet stocks, we showed the relative importance of
financial versus web traffic measures for valuation purposes. Interestingly,
in both the pre- and post-bubble periods, measures of internet usage
are important factors in the valuation, but also the individual income
statement components (especially gross profits) provide some relevant
information. Instead, earnings (net income) are useless. Nevertheless,
as the internet industry matures, key financial variables get increasingly
value-relevant and non-financial information plays a significantly
decreasing role. The implication is that different value metrics should
be used at different stages of the life of the internet industry, and the
difficulties in the valuation of internet firms can be solved by crystallising
the life-cycle stage in which they are located. Internet firms in later life-
cycle stages can be valued analogously to established firms. Problems are
for internet firms earlier in their life cycles than established firms. The
valuation here is still based on the present value of cash flows/abnormal
earnings, but those cash flows/abnormal earnings are likely to be much
more difficult to estimate. In this respect, we suggested possible solutions
for the typical issues that arise at each step in the valuation of internet
firms in their early life cycles.
With respect to mergers and acquisitions, the empirical evidence shows
that the shareholders of target firms realise large positive excess returns
in successful takeovers, whereas the reward for the shareholders of the
bidding firms is mixed (zero returns are earned by successful bidding firms
in mergers, and small positive abnormal returns are realised by bidders
in tender offers). A deal is attractive to the shareholders of the companies
involved if it increases the value of their share. Value creation may result
from a number of synergies such as economies of scale in production and
distribution, improvement in the target management, complementarity
in resources and markets, and tax benefits. Instead, some other factors
(diversification and use of the surplus cash to make acquisitions)
are proved to be value-destroying. In the valuation of mergers and
acquisitions, these synergies have to be added up to the value of the target
as a stand-alone firm in order to get the value of the deal. When the
bidder has to make decisions about a deal, in addition to the focus on the
price to be paid for the acquisition, the attention has to be on financing
means to be used in the deal (use of stocks, cash or debt). Particularly, the
market often interprets stock payment as a lack of confidence in the value
of the bidder’s stocks (i.e. the bidder believes its stocks are overvalued
and uses them to finance the deal). As the shareholders of the target are
aware of this, they may require a larger premium. Consistently, empirical
evidence proves that the bidder’s stock price reacts more favourably when
the bidder makes a cash offer than a stock offer.
Key terms
acquiring firm probability-weighted scenarios
bid price reach
bidder firm stand-alone firm
control premium stickiness
diversification synergies
191
internet bubble target firms

internet usage theory of life-cycle stages
leakages unique visitors
page views unsuccessful tender offers

• understand and critically explain the usefulness of financial
information vs non-financial information to investors in the valuation
of internet stocks
• appreciate the role of fundamental accounting analysis in the valuation
of internet stocks, and the changing role of non-financial information
over time
• perform valuations of internet stocks
• explain the empirical evidence on the market value effects of mergers
and acquisitions (for the shareholders of both the acquiring and target
firm)
• appreciate the effects of financing (by stocks, cash or debt) on the deal
• be able to identify the strategic motivations of mergers and
acquisitions, and associate a value in terms of synergies
• undertake valuations of mergers and acquisitions.

1. Is there any difference in the relative importance of financial and web
usage measures pre- and post- the internet peak?
2. Is there any financial information more relevant than others in the
explanation of the relation between internet stock price and firm value?
3. What is the role of fundamental accounting analysis in the valuation of
internet stocks?
4. How can the theory of life-cycle stages help in the valuation of internet
stocks?
5. Do analysts need different valuation methods for internet firms than
for other industries? What are the main issues associated with the
valuation of internet stocks?
6. What is the effect of a typical M&A operation on the stock prices of the
target and acquiring firm? How do successful and unsuccessful tender
offers differ in this respect? Provide some empirical evidence to support
your answer.
7. What are the motivations that typically are considered to be value-
destroying for shareholders? Provide some empirical evidence to
support your answer.
8. How does the market typically interpret stock payments in M&A
operations? How frequent is stock payment in M&A operations? What
is its impact on the price of the bidding company in the post-acquisition
period?
192
Chapter 12: Returns to fundamental analysis
Chapter 12: Returns to fundamental

analysis
Introduction
In a previous chapter, we established that the principal objective of a
fundamental analysis is to determine the intrinsic value of corporate
securities such as stocks through a careful examination of fundamentals
such as earnings, risk, growth and competitive position. Fundamental
analysis may hence be used by investors to identify mispriced securities for
investment purposes. In this chapter, we investigate whether it is possible
to make some economic profit by trading on the basis of a fundamental
analysis.
This chapter provides empirical evidence on returns to selected investment
strategies based on:
• price multiples (Lakonishok et al., 1994)
• accounting analysis (Sloan, 1996; Teoh, Welch and Wong, 1998)
• quarterly earnings (Bernard and Thomas, 1990)
• financial statement analysis (Ou and Penman, 1989).
This chapter closes by discussing implications of fundamental analysis for
market efficiency.
Aim
The aim of this chapter is to investigate whether it is possible to make
some economic profit by trading on the basis of a fundamental analysis.
In order to do so, this chapter reviews empirical evidence on returns
to fundamental analysis published in financial analysis and financial
economics literature.
Learning outcomes
• outline the theoretical and methodological framework used in order to
report returns of fundamental analysis
• report empirical evidence on returns to selected investment strategies
• follow some of the investment strategies used by fundamental analysts
in order to exploit any mispricing in the capital markets
• outline the implications of fundamental analysis for market efficiency
• examine the difficulties involved in testing market efficiency through
returns of fundamental analysis.
Essential reading
implications of current earnings for future earnings?’, Journal of Accounting
and Economics (13), 1990, pp.305–41.
Finance 47(2), 1992, pp.427–65.
193
Lakonishok, J., A. Shleifer and R.W. Vishny ‘Contrarian investment, extrapolation,

and risk’, Journal of Finance 49(5), 1994, pp.1541–78.
returns’, Journal of Accounting and Economics 1989, pp. 295–329.
Sloan, R.G. ‘Do stock prices fully reflect information in accruals and cash flows
about future earnings?’, Accounting Review 71(3), 1996, pp.289–315.
Teoh, S.H., I. Welch and T.J. Wong ‘Earnings management and the long-run
market performance of initial public offerings’, Journal of Finance 53(6), 1998,
pp.1935–74.
Further reading
Teoh, S.H., T.J. Wong and G.R. Rao ‘Are earnings during initial public offerings
opportunistic?’, Review of Accounting Studies (3), 1998, pp. 97–122.
Works cited
Journal of Accounting Research 6, 1968, pp. 159–78.
Bernstein, L. Analysis of financial statements. (Homewood. Ill.: Business One Irwin,
1993) fourth edition.
Brown, L.P. and M. Rozeff ‘Univariate time-series models of quarterly accounting
earnings per share: A proposed model’, Journal of Accounting and Economics
(24), 1997, pp.179–89.
DeBondt, W. and R. Thaler ‘Does the stock market overreact?’, Journal of Finance
(40), 1985, pp.793–805.
Fama, E. ‘Efficient capital markets: II’, Journal of Finance (46), 1991, pp.1575–618.
Green, J.H., J.R. Hand and M.T. Soliman ‘Going, going gone?’ The apparent
demise of the accurals anomaly’ Management Science (57), 2011, pp.797–816.
Hazfalla, N., R. Lundholm and E.M. Van Winde ‘Percent accusals’, Accounting
Review (86), 2011, pp.209–36.
Hong, H and J.C. Stein ‘Disagreement and the stock market’, Journal of Economic
Perspectives (21), 2007, pp.109–28.
Ritter, J. ‘The long-run performance of initial public offerings’, Journal of Finance
(46), 1991, pp.3–27.
Methodology
The methodology used in these studies is as follows. Stocks are allocated
to portfolios on the basis of some fundamentals. The performance of each
portfolio over a number of years following the allocation of the stocks is
then reported. The performance is measured as an abnormal return, that is,
the difference between the actual return and the one that was required to
compensate investors for the risk involved. As there is a lack of a consensus on
the nature of the risk priced in the capital markets, empirical studies tend to
report abnormal returns using different underlying asset pricing models. Some
empirical studies implicitly assume that systematic risk, beta, is the measure of
risk priced by the capital markets and hence do report abnormal returns in the
form of Jensen’s alpha. Other empirical studies implicitly assume that size, e.g.
market capitalisation, is the measure of risk priced by the capital markets and
hence do report abnormal returns in the form of size-adjusted returns.
Returns to contrarian strategies

Lakonishok et al. (1994) investigate whether or not it is possible to beat the
market by choosing shares whose price is low relative to fundamentals such
as earnings, dividends, the book value of equity, or cash flows. In order to
194
do so, Lakonishok et al. consider the stocks listed on the American Stock
Exchange (AMEX) and the New York Stock Exchange (NYSE) and allocate
them to 10 different portfolios according to the magnitude of prices relative
to a given fundamental, the portfolio consisting of the stocks with the
lowest prices to fundamental being referred to as the ‘value portfolio’ and
the portfolio consisting of the stocks with the highest prices to fundamental
being referred to as the ‘glamour portfolio’. Lakonishok et al. subsequently
track the performance of these portfolios in the stock markets over a
period of five years following the allocation of the stocks to the portfolios.
Performance is measured through size-adjusted returns.
Glamour Value
1 2 3 4 5 6 7 8 9 10
B/M
AR 9.3 12.5 14.6 15.4 15.8 16.6 18.4 18.9 19.6 19.8
CR5 56.0 80.2 97.3 104.5 108.2 115.2 132.0 137.5 144.9 146.2
SAAR –4.3 –2.0 –0.3 0.4 0.6 1.2 2.4 2.8 3.3 3.5
C/P
AR 9.1 12.2 14.5 15.7 16.6 17.1 18.0 19.2 19.9 20.1
CR5 54.3 77.9 96.9 107.4 115.8 120.6 128.3 140.6 147.6 149.4
SAAR –4.9 –2.5 –0.6 0.5 1.3 1.9 2.5 3.4 3.7 3.9
with B/M denoting the (average) book to market ratio (book value of equity divided by the market
value of equity); AR denoting the average raw return over the five years following the allocation of
stocks to portfolios; CR5 denoting the cumulative return over the five years following the allocation
of stocks to portfolios; SAAR denoting the average annual size-adjusted return over the five years
following the allocation of stocks to portfolios; C/P denoting the (average) cash-flow yield (cash flow
generated by the operations divided by the market value of equity).
Table 12.1 Returns to portfolios based on measures of value (%)

Selected empirical evidence on the performance of the value and glamour
portfolios is reported in Table 12.1. When stocks are allocated to the value
and glamour portfolios on the basis of a stock’s book-to-market ratio, the
glamour portfolio’s average annual size-adjusted return over a period of
five years following the allocation of the stocks to the portfolios is equal to
–4.3 per cent whereas the value portfolio’s average annual size-adjusted
return over the same period is equal to 3.5 per cent. This implies that the
average return enjoyed by the value portfolio exceeds the rate of return that
would have been expected by investors, in order to compensate them for the
portfolio’s risk as measured by size, by 3.5 per cent. In contrast, the average
return enjoyed by the glamour portfolio falls short of the rate of return
which would have been expected by investors by 4.3 per cent. Furthermore,
the higher the portfolio’s average book-to-market ratio at the time of the
allocation of the stocks to the portfolios, the higher the portfolio’s subsequent
average return. As shown in Table 12.1, the excess returns of value over
glamour are even higher when stocks are allocated to the value and glamour
portfolios on the basis of a stock’s cash-flow yield. The excess returns of value
over glamour stocks have persisted over the 1968–90 period.
The empirical evidence reported by Lakonishok et al. in the context of
fundamental analysis is furthermore consistent with that reported by
DeBondt and Thaler (1985) in the context of technical analysis. DeBondt
and Thaler allocate stocks to portfolios on the basis of past performance
as measured by excess returns in prior years. Portfolios of prior ‘losers’ are
found to subsequently outperform prior ‘winners’: over the three years
following the allocation of the stocks to the portfolios, the losing stocks
earn up to 25 per cent more than the winners, even though the latter are
195
significantly more risky. The subsequent excess returns furthermore tend

to obtain in January.
The empirical evidence reported by Lakonishok et al. would appear
to call for investing in a zero-wealth hedge portfolio long in the value
portfolio and short in the glamour portfolio. This strategy, however, is only
meaningful if a stock’s size (e.g. market capitalisation) is the measure of
risk priced in the capital markets. Lakonishok et al. hence check whether
the value portfolio is riskier than the glamour portfolio using other
measures of risk. Using conventional measures of risk such as a measure
of systematic risk (beta) or the standard deviation of portfolio returns, the
value portfolio is found to be quite risky. The difference in risk between
the value and glamour portfolios, however, is not remotely high enough to
justify the observed differences in subsequent average portfolio returns.
An examination of the value portfolio reveals that value stocks tend to
experience poor performance in prior years, as measured by growth in
sales, earnings or cash flows, resulting in highly negative excess stock
returns. Value stocks also tend to have small market capitalisations. In
contrast, glamour stocks tend to experience high performance in prior
years, resulting in highly positive excess stock returns, and tend to have
large market capitalisations. In a period of two to five years following the
allocation of the stocks to the portfolios, the performance of the glamour
stocks, as measured by growth, tends to deteriorate while the performance
of the value stocks tends to improve to the point where it exceeds on many
attributes that of the glamour stocks. This is illustrated in Table 12.2 in the
case in which stocks are allocated to the glamour and value portfolios on
the basis of a stock’s book-to-market ratio.
Glamour [B/M1] Value [B/M10]

Fundamental variables
C/P 5.9 17.2
B/M 22.5 199.8
SIZE $663m $120m
Past performance
AEG (–5,0) 30.9 –27.4
ACG (–5, 0) 21.7 –1.3
ASG (–5,0) 9.1 3.0
CR (–3,0) 145.5 –11.9
Future performance
AEG (2,5) 7.0 21.5
ACG (2,5) 8.6 11.1
ASG (2,5) 5.9 2.3
with C/P denoting the (average) cash-flow yield (cash-flow generated by the operations divided
by the market value of equity); B/M denoting the (average) book-to-market ratio (book value of
equity divided by the market value of equity); SIZE denoting the (average) market capitalisation;
AEG (–5,0) denoting the average earnings growth in the five years prior to the allocation of the
stocks to the portfolios; ACG (–5,0) denoting the average growth in the cash-flow generated by the
operations in the five years prior to the allocation of the stocks to the portfolios; ASG (–5,0) denot-
ing the average sales growth in the five years prior to the allocation of the stocks to the portfolios;
CR (–3,0) denoting the cumulative return over the three years prior to the allocation of the stocks
to portfolios; AEG (2,5) denoting the average earnings growth in the three-year period starting two
years after the allocation of the stocks to the portfolios; ACG (2,5) denoting the average growth in
the cash flow generated by the operations in the three-year period starting two years after the allo-
cation of the stocks to the portfolios; ASG (2,5) denoting the average sales growth in the three-year
period starting two years after the allocation of the stocks to the portfolios.
Table 12.2 Fundamental variables, past performance, and future performance for
glamour and value stocks
196
By comparing the actual earnings growth rates with the expected earnings
growth rates implicit in stock prices, Lakonishok et al. furthermore find
that the high expected earnings growth rate of glamour stocks is only
validated for one to two years. The empirical evidence reported by
Lakonishok et al. is hence consistent with naive investors underestimating
the rate of mean reversion in performance. More generally, Lakonishok
et al. argue that their empirical evidence is consistent with investors
pursuing naive strategies by treating a well-run company as always a good
investment, extrapolating trends and overreacting. Their interpretation
is furthermore consistent with evidence from the psychology literature
suggesting that we tend to rely too much as individuals on very recent
data when making decisions.
Returns to accounting analysis

Financial statements are used to evaluate performance and are hence
based on accrual accounting. However, accrual accounting is subjective
and relies on a variety of assumptions which managers are best placed
to make. Financial reporting is hence delegated to managers. This,
however, generates moral hazard problems in reporting as managers may
be tempted to engage in earnings management. Information in financial
statements may hence be biased. The objective of accounting analysis is to
evaluate the degree to which a firm’s accounting captures the underlying
business reality and to undo any accounting distortions whenever
required.
As shown by Lev and Thiagarajan (1993), stock prices do reflect to some
extent the quality of accounting. Sloan (1996) and Teoh, Welch and Wong
(1998), however, investigate whether stock prices do fully reflect the
quality of accounting. In order to do so, they check whether or not it is
possible to successfully trade on the basis of an accounting analysis.
Implications of current earnings for future earnings

Texts on financial statement analysis emphasise the importance of
considering both the accrual and the cash-flow components of current
earnings when assessing future earnings. For instance, according to
Bernstein (1993):
The cash-flow from operations, as a measure of performance,
is less subject to distortion than is the net income figure. This
is so because the accrual system, which produces the income
number, relies on accruals, deferrals, allocations and valuations,
all of which involves higher degrees of subjectivity than what
enters the determination of the cash-flow from operations. That
is why analysts prefer to relate the cash-flow from operations to
reported net income as a check on the quality of that income.
Some analysts believe that the higher the ratio of cash-flow from
operations to net income, the higher the quality of that income.
Put in another way, a company with a high level of net income
and a low cash-flow may be using recognition of expense accrual
criteria that are suspect.
Following up on Bernstein, Sloan investigates whether stock prices
fully reflect the information contained in accruals and cash flows in an
empirical study covering in excess of 40,000 firm-years over a period
ranging from 1962 to 1991. Sloan hypothesises that the persistence
of current earnings performance is decreasing in the magnitude of the
197
accruals component of earnings and is increasing in the magnitude of

the cash-flow component of earnings. More formally, Sloan estimates the
following regression:
Earningst+1= γ 0+ γ 1 Accrualst + γ 2CFOt + ε t+1 (12.1)
with:
Earningst = CFOt + Accrualst (12.2)
and:
γ1 denoting the persistence of the accruals component of earnings;
γ2 denoting the persistence of the cash-flow component of earnings;
εt+1 denoting the earnings surprise obtaining at date t+1.
From pooled regressions, the persistence of the cash-flow component
of earnings, γ1, is reported to be equal to 0.855, which exceeds the
persistence of the accruals component of earnings, γ2, which is reported to
be equal to 0.765. In industry-specific regressions, the persistence of the
cash-flow component is furthermore higher than the persistence of the
accruals component in 86 per cent of the industries examined.
Sloan then investigates whether or not the earnings expectation embedded
in stock prices fails to reflect fully the higher earnings persistence
attributable to the cash-flow component of earnings and the lower
earnings persistence attributable to the accrual component of earnings by
estimating jointly the following regressions:
ARt+1= β [Earningst+1− E t ( Earningst+1)]
M
(12.3)
and:
M * *
E t ( Earningst+1) = γ0 + γ1 Accrualst + γ 2CFOt (12.4)
with ARt+1 denoting the abnormal return obtaining around the
announcement of earnings at date t+1; β denoting the earnings response
coefficient; EMt denoting the capital market’s expectation as of date t; γ*1
denoting the capital market’s estimation of the accruals’ persistence; γ*2
denoting the capital market’s estimation of the cash flow’s persistence.
From pooled regressions, when inferred by investors, the persistence of
the cash-flow component of earnings, γ*2, is reported to be equal to 0.826,
which is lower than the persistence of the accruals component of earnings,
γ*1, which is reported to be equal to 0.911.
Sloan finally investigates whether it is possible to make some abnormal
profit by exploiting investors’ overreliance on accruals. Firms are ranked
on the basis of the relative magnitude of the accrual component of
earnings and assigned in equal numbers to 10 portfolios each year.
Abnormal returns are then recorded for each portfolio over a period
of three years following the allocation of the stocks to the portfolios.
Abnormal returns are provided in the form of size-adjusted returns
and Jensen alphas. As shown in Table 12.3, there is a negative relation
between accruals and subsequent abnormal returns. For instance, in the
year following the allocation of stocks to portfolios, size-adjusted stock
returns range from 4.9 per cent for the lowest accrual portfolio to –5.5
per cent for the highest accrual portfolio. This negative relation weakens
in the second year and becomes statistically insignificant in the third year
following the allocation of stocks to portfolios. The findings are similar
when abnormal performance is measured through Jensen alphas.
198
The apparent demise of the accruals anomaly

As mentioned by Hafzallah et al. (2011), the accruals anomaly originally
identified by Sloan (1996) is one of the most intriguing discoveries in the
field of capital markets research. According to Sloan, purchasing firms
with low accrual and selling short firms with high accruals is associated
with significant hedge portfolio returns. A key reason for the attention
given to this is that scholars have been fiercely divided on whether the
anomaly truly represents market mispricing and, if so, what causes it, why
it has not been arbitraged away and whether or not an investor can earn
rents by trading on it (Green et al., 2011)? A number of sophisticated and
quantitative investors have claimed to exploit this ‘market inefficiency’.
The hedge returns to Sloan’s accrual anomaly have, however, decayed in
the new millennium up to the point where they are no longer positive on
average. Green et al. (2011) provide empirical evidence suggesting that
‘the anomaly’s demise stems in part from an increase in the amount of
capital invested by hedge funds in exploiting it’ . Hafzallah, Lundholm and
van Winkle (2011) have, however, documented that a trading strategy
based on accruals still yields significantly large annual hedge returns,
whenever accruals are scaled by earnings rather than total assets.
Initial public offerings

Teoh, Welch and Wong (1998) argue that initial public offerings (IPO)
do provide strong incentives for entrepreneurs to manage earnings
opportunistically by reporting high accruals in the year prior to the IPO.
Going through an IPO is an opportunity for an entrepreneur to get a
return from their venture. There are few reliable independent sources of
information about the newly public firm leading potential investors to
rely heavily on the IPO prospectus. If investors are unable to understand
fully the extent to which an IPO firm engages in earnings management by
delaying the recognition of expenses and bringing forward the recognition
of revenue, high reported earnings hence translate directly into a higher
offering price.
Teoh, Welch and Wong (1998) test their hypothesis by comparing the
earnings performance of IPO firms with that of their non-issuing peers.
In the IPO year, the earnings performance of IPO firms is shown to be
unusually high compared with that of non-issuing industry peers. In the
years following the issues, IPO firms are however shown to underperform
their non-issuing industry peers. The reported empirical evidence is hence
consistent with earnings management. It is, however, also consistent
with entrepreneurs going through IPOs at a time at which performance is
abnormally high
Teoh, Welch and Wong (1998) investigate whether it is possible to trade
successfully on the basis of the magnitude of abnormal accruals in IPO years.
Each stock is allocated to one of four portfolios on the basis of the relative
magnitude of discretionary current accruals. Discretionary accruals are
accruals over which managers are deemed to have control. Discretionary
accruals hence do proxy for earnings management. Issuers with unusually
high accruals in the IPO year experience poor stock return performance
in the three years following the issues. IPO issuers in the most aggressive
quartile of earnings managers experience on average a 15 to 30 per cent
worse subsequent three-year performance than IPO issuers in the most
conservative quartile. Issuers in the most conservative quartile also return
to the capital market for a seasoned equity offering about 20 per cent more
frequently over a five-year period than those in the most aggressive quartile.
199
A number of empirical studies report underperformance by IPO stocks

in the capital markets after the issues. For instance, Ritter (1991) finds
evidence that the sample of IPO stocks underperforms on average a sample
of size-adjusted and industry-matched stocks by 27 per cent over a period
of three years following the issues. Teoh, Welch and Wong (1998) hence
also offer an explanation for the underperformance of IPOs.
Portfolio SAAR Jensen alphas

accrual
ranking
t+1 t+2 t+3 t+1 t+2 t+3
Lowest 4.9** 1.6 0.7 3.9* 0.7 0.1
2 2.8** 1.9 0.6 2.0 2.2 1.2
3 2.4** 1.2* –0.6 1.8 1.4 –0.6
4 1.2 0.1 0.2 1.7* 0.2 1.7
5 0.1 0.2 0.6 1.0 0.4 1.4
6 1.0 0.5 1.6 0.6 0.2 0.3
7 –0.2 0.3 –0.6 0.4 0.6 0.5
8 –2.1** –0.2 –0.1 1.1 –0.4 0.2
9 –3.5** –1.8* –1.5 –2.8** –1.2 –1.2
Highest –5.5** –3.2* –2.2 –6.4** –4.0** –3.6*
HP 10.4** 4.8** 2.9 10.4** 4.8* 3.8

with SAAR denoting average annual size-adjusted return; HP denoting the hedge portfolio
consisting of a long position in the lowest accrual portfolio and an offsetting short position
in the highest accrual portfolio
* indicating statistical significance at the 5 per cent level using a two-tailed t test;
** indicating statistical significance at the 1 per cent level using a two-tailed t test.
Table 12.3 Average abnormal returns to portfolios selected on the basis of

accruals
Implication of current quarterly earnings for future

quarterly earnings
Bernard and Thomas (1990) investigate whether stock prices fully reflect
the implication of current quarterly earnings for future quarterly earnings.
In doing so, Bernard and Thomas build on the empirical evidence on the
process followed by quarterly earnings reported by Brown and Rozeff
(1997):
Qt+1 = Qt–3 + ϕ (Qt – Qt–4) + θεt–3 + εt+1 (12.5)
with Qt denoting quarterly earnings obtaining in quarter t; ϕ, with 0<ϕ<1,
denoting the correlation factor between adjacent seasonally adjusted
differences in quarterly earnings; θ, with θ < 0 and θ + ϕ4 < 0, introducing
negative serial correlation in adjacent seasonally adjusted differences in
quarterly earnings four quarters apart; εt denoting the earnings surprise
obtaining in quarter t.
Given this process, adjacent seasonally adjusted differences in quarterly
earnings are positively correlated when one quarter, two quarters and
three quarters apart and negatively correlated when four quarters apart.
More formally, Qt+1 – Qt–3 is positively correlated with Qt – Qt–4 (the
correlation factor being ϕ) Qt–1 – Qt–5 (the correlation factor being ϕ2), Qt–2
200
– Qt–6 (the correlation factor being ϕ3)and negatively correlated with Qt–3 –
Qt–7 (the correlation factor being θ + ϕ4).
In the design of their test, Bernard and Thomas make the following
assumptions. Quarterly earnings Qt follow Brown and Rozeff’s model
adjusted for a long-term trend δ so that Qt+1 = Qt–3 + ϕ (Qt – Qt–4) + θεt–3
+ δ + εt+1. The capital market, however, believes that quarterly earnings
Qt follow a random walk with a trend δ so that EM(Qt+1) = Qt–3 + δ, where
EM denotes the capital market’s expectation. Given these assumptions, if
λ represents the earnings response coefficient, the abnormal return ARt
around the disclosure of quarterly earnings Qt is given by the following
equality:
ARt = λ [Qt – EM(Qt)] (12.6)
which hence leads to:
• a positive but declining correlation between the abnormal return ARt
around the disclosure of quarterly earnings Qt and the three previous
detrended seasonal differences in quarterly earnings
Qt–1 – Qt–5 – δ, Qt–2 – Qt–6 – δ, Qt–3 – Qt–7 – δ
• a negative correlation between the abnormal return ARt around
the disclosure of quarterly earnings Qt and the detrended seasonal
difference in quarterly earnings obtaining one year ago Qt–4 – Qt–8 – δ.
According to the story presented by Bernard and Thomas, market
reactions to future quarterly announcements become to some extent
predictable if the market believes that quarterly earnings follow a random
walk (adjusted for a trend term) as opposed to the real and more complex
process derived from Brown and Rozeff.
In order to test their story, Bernard and Thomas estimate a measure of
standardised unexpected quarterly earnings Qt – EM(Qt) at announcement
dates of quarterly earnings for NYSE and AMEX stocks over a period from
1974 to 1986. Bernard and Thomas then allocate stocks to portfolios
on the basis of the magnitude of the standardised unexpected quarterly
earnings. They then record the three-day market abnormal returns to
quarterly earnings announcements for subsequent quarters for each
portfolio. Abnormal returns are size-adjusted and derived for any stock by
subtracting from the stock’s actual three-day return the three-day return
on a large portfolio of NYSE/AMEX firms in the same size decile.
If the story presented by Bernard and Thomas is correct, we should
observe:
• a positive association (with the magnitude of the association declining
through time, e.g. ϕ, ϕ2, ϕ3) between the current unexpected earnings
and the next three abnormal returns around the announcement of
quarterly earnings.
• a negative association between the current unexpected earnings and
the abnormal return obtaining around the announcement of quarterly
earnings four quarters away.
As shown in Table 12.4, the empirical evidence is consistent with the
story presented by Bernard and Thomas. Portfolio 10, which consists
of the decile of stocks for which the capital market was most positively
surprised in quarter t, experiences, on average, positive but declining
abnormal returns around quarterly earnings announcement dates in the
next three quarters and negative abnormal returns in the subsequent
quarter. Portfolio 1, which consists of the decile of stocks for which the
capital market was most negatively surprised in quarter t, experiences,
201
on average, negative but improving abnormal returns around quarterly

earnings announcement dates in the next three quarters and positive
abnormal returns in the subsequent quarter. Bernard and Thomas hence
conclude that stock prices fail to reflect fully the implications of current
quarterly earnings for future quarterly earnings.
Portfolio t+1 t+2 t+3 t+4

0.76 0.44 0.13 –0.22
10 (Good news)
(13.2) (8.1) (2.2) (4.1)
–0.56 –0.26 0.09 0.43
1 (Bad news)
(8.0) (4.2) (0.1) (6.8)
Long in 10 1.32 0.70 0.04 –0.66
Short in 1 (14.6) (8.5) (0.4) (3.4)
with t+i denoting the date of release of the first quarterly earnings following the allocation of stocks
to the portfolios; numbers in parentheses denoting t-statistics values.
Table 12.4 Three-day percentage abnormal return in quarter t+k based on

earnings information from quarter t
Taking advantage of the mispricing by investing in a hedge portfolio long
in portfolio 10 and short in portfolio 1 generates, on average, a significant
three-day abnormal return of 1.32 per cent in the next quarter and a further
0.7 per cent in the following quarter. By reversing the positions in the hedge
portfolio, investors get, on average, a significant three-day abnormal return
of 0.66 per cent in the fourth quarter. As shown in Table 12.5, using this
investment strategy generates, on average, a cumulative abnormal return of
8.61 per cent per year.
Portfolio Holding period t+1 t+2 t+3 t+4

Long in 10 Short in 1 Sum of 3-day abnormal returns
1.32 2.02 2.06 2.72
(Reversed after quarter t+3) for quarters t+1, ..., t+4
From day after announcement
Long in 10 Short in 1
for quarter t through 5.69 7.48 8.10 8.61
(Reversed after quarter t+3)
announcement for quarter t+k
with t+i denoting the date of release of the ith quarterly earnings following the allocation of stocks
to the portfolios.
Table 12.5 Cumulative abnormal returns
Returns to financial statements analysis

Ou and Penman (1989) use financial statement analysis in order to derive
a summary measure from financial statements, an indicator of future
earnings changes, that predicts future stock returns. Ou and Penman are
hence looking for indicators of future earnings changes and investigate
whether one can beat the market by investing on this basis.
Ou and Penman focus on earnings per share. As earnings increases tend
to outnumber earnings decreases, Ou and Penman furthermore define
the change in earnings (per share) as the change in earnings (per share)
adjusted for the firm-specific trend in earnings. If earnings (per share)
follow a random walk adjusted for a trend term, the change in earnings
(per share) is hence also the surprise in earnings (per share). In their
empirical study, Ou and Penman thus exploit the contemporaneous
correlation between earnings surprises and abnormal returns reported by
Ball and Brown (1968) and reviewed in this subject guide in Chapter 10.
Potential indicators predicting future earnings changes are obtained though
interviews with financial analysts. These indicators include performance,
202
asset turnover, leverage ratios, as well as more complex and hybrid ratios
which can be derived using financial statements and stock prices. The
pertinence of the 68 indicators provided by analysts is then investigated by
using the following logistic regression across stocks quoted on the AMEX
and NYSE over two estimation periods, 1965–72 and 1973–77:
Pr (12.7)
1 − Pr θ 0 θ 1Y 1 θ 2 Y 2
Ln[ ]= + + + ...θ n Y n
with Pr denoting the probability of seeing an earnings increase in the next

year; Yi denoting a potential predictor of next period’s earnings change; θi
denoting the weight put on indicator Yi.
The logistic regression provides Ou and Penman with a parsimonious
linear combination of 16 indicators of earnings changes in one estimation
period and 18 indicators in the second estimation period. The accuracy
of the outcomes of the logistic regression is subsequently assessed in
validation periods, 1973–77 and 1978–83, differing from the estimation
periods. Ou and Penman report an accuracy of about 67 per cent when
focusing solely on stocks with estimated probabilities of seeing earnings
increases exceeding 60 per cent (and hence predicting for these stocks an
earnings increase) and on stocks with estimated probabilities of seeing
earnings decreases exceeding 60 per cent (and hence predicting for these
stocks an earnings decrease).
Stocks are then assigned to 10 different portfolios on the basis of the
estimated probability of seeing an earnings increase in the following year.
Ou and Penman subsequently track the performance of these portfolios
in the stock markets over a period of 36 months following the allocation
of the stocks to the portfolios. Performance is measured through market-
adjusted returns (excess of the actual return over the return of the market
portfolio).
As shown in Table 12.6, there is a very strong correlation between the
estimated probability of seeing an earnings increase and subsequent
performance in the stock markets: the higher the probability of seeing an
earnings increase, the higher the mean cumulative market-adjusted return
after 24 months. By trading on the basis of the outcome of the logistic
regression and investing in a zero-wealth hedge portfolio, long in the
stocks estimated to enjoy an earnings increase with a probability exceeding
60 per cent and short in the stocks estimated to enjoy an earnings decrease
with a probability exceeding 60 per cent, one would have generated an
abnormal return of 14.5 per cent over a the same period. These results
appear to be quite impressive given the relatively low performance of the
earnings prediction model.
As shown in Table 12.7, there is a strong negative correlation between
a stock’s probability of seeing an earnings increase and its market
capitalisation (there is, however, no correlation between a stock’s
probability of seeing an earning’s increase and its beta). A number
of financial economists argue that size is a measure of risk priced in
the capital markets. Ou and Penman hence also measure abnormal
performance following the allocation of the stocks to the portfolios
through size-adjusted returns. As shown in Table 12.8, after controlling for
size, the mean cumulative abnormal return on the hedge portfolio over 24
months is now much lower: about 9 per cent (compared with about 14.5
per cent when performance is measured through market-adjusted returns).
Most of the abnormal return accruing to the hedge portfolio is furthermore
generated by the portfolios which are predicted to experience earnings
decreases with a high probability and are hence shorted.
203
Mean cumulative market-adjusted returns (%)

P Pr N CP (%) Month of holding period
3 6 9 12 18 24 36
1 0.9 < Pr ≤ 1 658 85.2 –0.29 0.85 1.18 5.48 4.43 6.33 18.64
2 0.8 < Pr ≤ 0.9 928 75.5 0.15 0.21 –2.01 –0.31 –1.29 0.58 9.31
3 0.7 < Pr ≤ 0.8 2174 67.8 1.84 2.28 3.46 5.25 5.76 7.87 10.08
4 0.6 < Pr ≤ 0.7 4359 59.2 1.09 1.24 2.95 3.84 5.45 7.19 10.45
7 0.3 < Pr ≤ 0.4 1174 68.5 –1.24 –2.42 2.93 3.79 5.57 6.29 8.04
8 0.2 < Pr ≤ 0.3 417 73.9 –1.05 –2.47 –4.30 –6.25 –10.72 –10.98 –11.71
9 0.1 < Pr ≤ 0.2 154 72.7 –0.00 0.85 –1.82 –2.41 –2.46 –5.52 –14.68
10 0 < Pr ≤ 0.1 84 66.7 –0.84 –3.99 –9.91 –11.09 –16.04 –21.85 –18.81
HP 9948 66.3 2.14 3.56 5.77 8.34 11.52 14.53 20.83

with P denoting portfolio; Pr denoting the probability of seeing an increase in earnings; N denoting
the number of stocks in each portfolio; CP denoting the proportion of correct predictions; HP denot-
ing the hedge portfolio long in portfolios 1 to 4 and short in portfolios 7 to 10.
Table 12.6 Mean cumulative abnormal return from investment in stocks on the
basis of estimated probability of an earnings increase (1973–83)
Pr Portfolio Relative % Relative % Mean CAR Mean b Relative Relative Relative

EPS change in EPS change in over prior over prior equity market market market-to-
prediction current yeara) 2 years 5 years valueb) ($m) leverageb)c) book ratiosb)
year )
a
1 81.3 –168.3 –42.4 1.18 –56.3 0.188 –0.283

2 49.5 –74.3 –29.3 1.10 –51.4 0.144 –0.309
3 31.8 –28.0 –12.9 1.06 –39.4 0.095 –0.243
4 3.1 –5.4 –1.6 1.05 –19.4 0.032 –0.144
7 –11.5 15.8 27.1 1.03 118.7 –0.016 0.541
8 –20.8 23.1 35.0 1.09 97.2 0.010 0.576
9 –17.8 45.8 52.4 1.12 16.6 0.058 0.695
10 –10.9 66.3 36.7 1.17 55.2 0.061 0.644
Hedge
portfolio 26.1 –35.3 –42.4 0.01 –132.1 0.025 –0.763
(all stocks)
with a) the %EPS change being defined as the change in EPS divided by the absolute value of prior
year’s EPS
b) values being means (over 11 years) of differences (in each year) in portfolio median values from
the median value for all firms in the year
c) market leverage being defined as the ratio of book value of debt over the sum of the market
value of equity and the book value of debt.
Table 12.7 Summary of selected attributes of Pr portfolios

As shown in Table 12.7, the stocks predicted to experience an earnings
increase with a high probability also tend to have experienced poor
earnings performance in the year of allocation of the stocks to the
portfolios. Their poor earnings performance was furthermore reflected
in their stock market’s performance in the form of negative cumulative
abnormal returns over a period of two years prior to the allocation of
the stocks to the portfolios. These stocks were furthermore trading on
comparatively low market-to-book ratios and may hence not be very
different from the value stocks identified by Lakonsishok et al. (1994).
Similarly, the stocks predicted to experience an earnings decrease with a
high probability may not be very different from the glamour stocks.
204
Mean cumulative market-adjusted returns (%)

P Pr N CP (%) Month of holding period
3 6 9 12 18 24 36
1 0.9 < Pr ≤ 1 658 85.2 –1.62 –1.49 –2.16 0.36 –2.00 –2.41 2.86
2 0.8 < Pr ≤ 0.9 928 75.5 –0.94 –1.65 –4.53 –4.19 –6.81 –6.56 –3.30
3 0.7 < Pr ≤ 0.8 2174 67.8 0.71 0.69 0.97 2.25 1.68 2.67 2.19
4 0.6 < Pr ≤ 0.7 4358 59.2 0.17 –0.13 0.56 1.49 2.09 2.95 3.72
7 0.3 < Pr ≤ 0.4 1159 68.5 –0.99 –2.48 –3.69 –3.62 –5.19 –5.65 –7.13
8 0.2 < Pr ≤ 0.3 417 73.9 –0.10 –2.82 –5.54 –6.30 –11.16 –10.45 –10.83
9 0.1 < Pr ≤ 0.2 154 72.7 –0.13 0.33 3.32 –3.22 –4.05 –6.43 –16.51
10 0 < Pr ≤ 0.1 84 66.7 –1.10 –4.51 –10.79 –12.91 –17.97 –24.74 –21.65
HP 9932 66.3 0.98 2.20 4.24 5.54 7.63 9.08 11.85

with P denoting portfolio; Pr denoting the probability of seeing an increase in earnings; N denoting
the number of stocks in each portfolio; CP denoting the proportion of correct predictions; HP denot-
ing the hedge portfolio long in portfolios 1 to 4 and short in portfolios 7 to 10.
Table 12.8 Mean cumulative abnormal return from investment in stocks on the
basis of estimated probability of an earnings increase (1973–83)
Fundamental analysis and market efficiency

Fundamental analysis is the evaluation of securities, firms and possibly
markets mispricing based on the analysis of economic and financial
factors. According to fundamental analysts, as explained by Ou and
Penman (1989):
Firms’ fundamental (or intrinsic) values are indicated by information
in financial statements. Stock prices (however) deviate at times from
these values and only slowly gravitate towards the fundamental
values. Thus analysis of published financial statements can discover
values that are not reflected in stock prices. Rather than taking prices
as value benchmarks, intrinsic (fundamental) values discovered
from financial statements serve as benchmarks with which prices are
compared to identify overpriced and underpriced stocks. Because
deviant prices ultimately gravitate to the fundamentals, investment
strategies which produce abnormal returns can be discovered by the
comparison of prices to these fundamental values.
Returns to fundamental analysis are related to the efficiency of the capital
markets. According to Fama (1991), a market is efficient in the semi-
strong form if it is impossible to make any economic profit by trading on
the basis of an information set consisting of all public information. By
economic profit, Fama means the risk-adjusted rate of return, or in the
language used in this subject guide, the abnormal return, net of all costs.
As the information used by fundamental analysts is public information, the
existence of strictly positive returns to fundamental analysis hence implies
that capital markets are not efficient.
This chapter has reviewed empirical returns to selected fundamental
analysis strategies. Although these studies did suggest that some
investment strategies provide, on average, higher returns than other
investment strategies, we cannot conclude from them that it is possible
to make some economic profit by trading on the basis of a fundamental
analysis. The reason for this is that empirical researchers do not know
the true model generating expected returns in the economy. Hence, their
choice of expected return-generating mechanism, used to adjust actual
returns, may be wrong, which implies that abnormal returns may be
205
incorrectly measured. These (inaccurate) abnormal returns are then used

in tests of market efficiency. Therefore, we are left in a position where
we are not sure whether markets are inefficient or our model of expected
returns is wrong. This is known as the joint hypothesis problem associated
with testing market efficiency. The null hypothesis of any test of efficiency
is comprised of two components: informational efficiency and the accuracy
of one’s model for expected returns. As the true model of expected returns
is unknown, a rejection of this null hypothesis cannot be immediately
taken as evidence that markets are not efficient.
Overview of chapter
In this chapter, we investigated whether it was possible to make some
economic profit by trading on the basis of a fundamental analysis. In
order to do so, we reviewed empirical evidence on returns to investment
strategies based on price multiples (Lakonishok et al., 1994), accounting
analysis (Sloan, 1996; Teoh, Welch and Wong, 1998), quarterly earnings
(Bernard and Thomas, 1990) and financial statement analysis (Ou and
Penman, 1989). These studies suggested that some investment strategies
did provide, on average, higher returns than other investment strategies,
but we can not conclude from them that it is possible to make some
economic profit by trading on the basis of a fundamental analysis. Average
returns obtaining in the future may differ from average returns generated
in the past. Moreover, superior returns associated with some investment
strategies may not compensate for a higher level of risk. As there is no
consensus on the sources of risk priced in the capital markets, it is hence
not possible to state that it is possible to make some economic profit by
trading on the basis of a fundamental analysis, or equivalently, that capital
markets are inefficient in the semi-strong form (joint hypothesis problem).
Key terms
abnormal return market efficiency
accounting analysis overreaction
accruals persistence
contrarian strategy random walk
cumulative abnormal return risk-adjusted return
fundamental analysis semi-strong form
Jensen’s alpha size-adjusted return
market-adjusted return trend extrapolation

report returns of fundamental analysis
• report empirical evidence on returns to selected investment strategies
• follow some of the investment strategies used by fundamental analysts
in order to exploit any mispricing in the capital markets
• outline the implications of fundamental analysis for market efficiency
• examine the difficulties involved in testing market efficiency through
returns of fundamental analysis..
206

1. How does the process followed by quarterly earnings differ from the
process followed by annual earnings?
2. How can fundamental analysts exploit the difference between the
process followed by quarterly earnings and the process followed by
annual earnings?
3. How can fundamental analysts trade on the basis of an accounting
analysis?
4. What evidence is there of abnormal returns to accounting analysis?
5. How do contrarian analysts attempt to beat the market?
6. How do glamour stocks differ from value stocks?
207
Notes
208
Chapter 13: Returns to technical analysis
Introduction
In the previous chapter, we established that the main objective of a
fundamental analysis was to determine the intrinsic value of corporate
securities such as stocks through a careful examination of fundamentals
such as earnings, risk, growth and competitive position. Fundamental
analysis could hence be used by investors to identify mispriced securities
for investment purposes. In this context, we hence investigated whether
it is possible to make some economic profit by trading on the basis of a
technical analysis.
In this chapter, we consider technical analysis as opposed to fundamental
analysis. The main objective of a technical analysis is to identify mispriced
securities such as stocks through a careful examination of past and present
securities prices. We hence investigate whether it is possible to make some
economic profit by trading on the basis of a technical analysis.
This chapter first discusses methodological issues. It then provides
empirical evidence on returns to:
• contrarian strategies (DeBondt and Thaler, 1985)
• momentum strategies (Brock et al., 1992).
This chapter then provides some rationale for focusing on contrarian
and momentum strategies. It then reconciles the empirical evidence on
contrarian and momentum strategies (Jegadeesh and Titman, 1993). It
finally closes by discussing implications of technical analysis for market
efficiency.
Aim
The aim of this chapter is to investigate whether it is possible to make
some economic profit by trading on the basis of a technical analysis. In
order to do so, this chapter reviews empirical evidence on returns to
technical analysis published in the financial economics literature.
Learning outcomes
• appreciate the difference between technical analysis and fundamental
analysis
report returns of technical analysis
• report empirical evidence on returns of contrarian investment strategies
used by technical analysts
• quote empirical evidence on returns of momentum investment
strategies used by technical analysts
• reconcile the empirical evidence on returns with contrarian and
momentum strategies
• outline the implications of technical analysis for market efficiency
• understand the difficulties involved in testing market efficiency through
returns to technical analysis.
209
Essential reading
DeBondt, W. and R. Thaler ‘Does the stock market overreact?’, Journal of
Finance (40), 1985, pp.793–805.
Jegadeesh, N. and S. Titman ‘Returns to buying winners and selling losers:
Implications for stock market efficiency’, Journal of Finance 48(1), 1993,
pp.65–91.
Further reading
Brock, W., J. Lakonishok and B. LeBaron ‘Simple technical trading rules and
stochastic properties of stock returns’, Journal of Finance 47(5), 1992,
pp.1731–64.
Jegadeesh, N. and S. Titman ‘Profitability of momentum strategies: an
evaluation of alternative explanations’, Journal of Finance 56(2), 2001,
pp.699–720.
Works cited
Damodaran, A. Investment valuation. (Chichester: Wiley, 1996). Chapter 9.
DeLong, J.B., A. Shleifer, L.H. Summers and R.J. Waldmann ‘Positive feedback
investment strategies and destabilising rational speculation’, Journal of
Finance (45), 1990, pp.379–95.
Fama, E. ‘Efficient capital markets: II’, Journal of Finance (46), 1991,
pp.1575–618.
Fama, E. and M. Blume ‘Filter rules and stock market trading profits’, Journal of
Business (39), 1966, pp.226–41.
Lakonishok, J., A. Shleifer and R.W. Vishny ‘Contrarian investment,
extrapolation, and risk’, Journal of Finance (49), 1994, pp.1541–78.
Lo, A. and A.C. MacKinlay ‘When are contrarian profits due to stock market
overreaction?’, Review of Financial Studies (3), 1990, pp.175–208.
Poterba, J. and L. Summers ‘Mean reversion in stock prices: Evidence and
implications’, Journal of Financial Economics (22), 1988, pp.27–59.
Methodology
The methodology used in the empirical studies reviewed in this chapter
is as follows. Stocks are allocated to portfolios on the basis of past
performance in the stock markets. The performance of each portfolio
is then reported over a number of years following the allocation of the
stocks. The performance is measured as an abnormal return, that is,
the difference between the actual return and the one that was required
to compensate investors for the risk involved. As there is a lack of a
consensus on the nature of the risk priced in the capital markets, empirical
studies, however, tend to report abnormal returns using different
underlying asset pricing models. Some empirical studies implicitly assume
that systematic risk, beta, is the measure of risk priced by the capital
markets and hence report abnormal returns in the form of Jensen’s
alpha. Other empirical studies implicitly assume that size (e.g. market
capitalisation) is the measure of risk priced by the capital markets and
hence do report abnormal returns in the form of size-adjusted returns.
Returns to contrarian strategies

DeBondt and Thaler (1985) hypothesise that investors tend to overreact
to unexpected and dramatic news events. Overreaction implies price
reversals: stocks that have gone up most over some period are more
likely to go down in future periods and vice versa. In order to test their
210
overreaction hypothesis, DeBondt and Thaler investigate whether it is

possible to make some economic profit by taking a long position in the
stocks that have gone up most recently (i.e. the winners) and taking a
short position in the stocks that have gone down most over the same
period (i.e. the losers).
In their empirical test, DeBondt and Thaler allocate stocks to portfolios
based on prior abnormal performance measured through market-adjusted
excess returns (returns in excess of the market return). They furthermore
focus on two portfolios: the winner portfolio, consisting of the stocks
having experienced the highest cumulative abnormal return (CAR) in the
capital markets over the past years, and the loser portfolio, consisting of
the stocks having experienced the lowest cumulative abnormal return
over the same period. They subsequently measure the performance of
the winner and loser portfolios, as well as the difference in performance
between the loser and the winner portfolios, over a period of up to three
years following the allocation of the stocks to the portfolios through
cumulative market adjusted excess returns.
Difference in CAR (%) (t statistics)

CAR (%) at end of
Months after portfolio formation
formation period
Portfolio
Winner Loser
selection N(b) 1 12 24 36
portfolio portfolio
procedure(a)
7.0 15.6 19.6 23.8
5 years 50 146.3 –119.4
(3.13) (2.04) (2.15) (2.07)
10.5 5.4 18.1 24.6
3 years 35 137.5 –106.4
(3.29) (0.77) (1.71) (2.20)
6.2 –0.6 10.1
2 years 35 113.0 –85.7 NA
(2.91) (0.16) (1.41)
4.2 –7.6 –0.5
1 year 35 77.4 –58.5 NA
(2.45) (2.32) (0.09)
(a) The portfolio selection procedure provides the number of years used in the formation period, that
is, the number of years used to assess performance prior to allocating the stocks to the portfolios.
(b) N denotes the number of stocks in both the winner and the loser portfolios.
Table 13.1 Results of the empirical test
The results of the empirical test, displayed in Table 13.1, are consistent
with the overreaction hypothesis: over the last 50 years, loser portfolios
of 50 stocks, formed after a performance assessment period of five
years, outperform, on average, winner portfolios of 50 stocks by about
24 per cent in the three years following the formation of the portfolios.
This excess return is furthermore statistically significant. Similarly, loser
portfolios of 35 stocks, formed after a performance assessment period
of three years, outperform, on average, winner portfolios of 35 stocks
by about 25 per cent in the three years following the formation of the
portfolios.
DeBondt and Thaler show that most of the trading gains in the hedge
portfolio come from the loser portfolio. Most of the market correction
furthermore occurs in years 2 and 3: the difference in performance
between extreme portfolios is not statistically significant after one year.
The story reported by DeBondt and Thaler in the context of technical
analysis is hence not dissimilar to the story reported by Lakonishok et
al. (1994) in the context of fundamental analysis. DeBondt and Thaler,
however, also report that most of the market correction occurs in January.
211
Returns to momentum strategies

A technical analyst using momentum investment strategies is betting that
stocks that have gone up strongly in the past are more likely to keep going
up than go down.
Filter rule
The simplest momentum strategy is the filter rule tested by Fama and
Blume (1966). According to Fama and Blume, the filter rule calls for the
following trades:
Using price history, buy a stock if the price rises x per cent,
hold it until the security falls x per cent, then sell and go short.
Maintain this short position until the price rises x per cent, then
cover the short position and establish a long position.
The magnitude of the threshold change (x per cent) triggering trades
varies from filter rule to filter rule, with smaller values resulting in more
transactions per period and higher transaction costs.
Fama and Blume (1966) investigate whether it is possible to make some
economic profit by trading on the basis of a filter rule. They consider
a wide range of filter rules, with threshold changes ranging from 0.5
per cent to 20 per cent. Table 13.2 provides the average return gross
of transaction costs, number of transactions and average return net of
transaction costs associated with a given threshold change as well as the
average return from a simple buy-and-hold strategy. There is only one
filter rule beating the simple buy-and-hold investment strategy before any
transaction costs. This rule calls for investing in a stock if the price rises
by 0.5 per cent from a previous low and holding it until the price drops
by 0.5 per cent from a previous high. This investment strategy, however,
generates in excess of 10,000 trades and transaction costs in excess of the
funds invested. Many of these transactions wrongly identify stocks on a
momentum.
There is thus no filter rule, as implemented by Fama and Blume,
generating abnormal profits to investors. In order to generate profits, one
needs a better technology to identify stocks on a momentum.
Moving-average oscillators
Brock et al. (1992) introduce a more sophisticated technology in order
to identify when to buy and when to sell stocks. Brock et al. introduce
moving-average oscillators in order to reduce the number of ‘whiplash’
signals leading to profit-reducing trades. Brock et al. furthermore focus
on the market index as opposed to individual stocks: they essentially try
to find out when to get away from cash and bond markets and invest in
stock markets (and vice versa). According to the moving-average rule,
‘buy’ and ‘sell’ signals are generated by two moving averages of the level
of the market index: a long-run moving average and a short-run moving
average. This strategy calls for buying when the short-run moving average
rises above the long-run moving average and for selling when the short-
run moving average falls below the long-run moving average. The moving-
average decision rule is often modified by introducing a band around the
moving average in order to reduce the number of buy and sell signals by
eliminating ‘whiplash’ signals when the short-run and the long-run moving
averages are close to each other.
212
x (%) Filter rule return Buy and hold Number of Filter rule return
(%) (b.t.c)(a) return (%) transactions (%) (a.t.c)(b)
0.5 11.5 10.4 12514 –103.6
1 5.5 10.3 8660 –74.9
2 0.2 10.3 4764 –45.2
3 –1.7 10.1 2994 –30.5
4 0.1 10.1 2013 –19.5
5 –1.9 10.0 1484 –16.6
6 1.3 9.7 1071 –9.4
7 0.8 9.6 828 –7.4
8 1.7 9.6 653 –5.0
9 1.9 9.6 539 –3.6
10 3.0 9.6 435 –1.4
12 5.3 9.4 289 2.3
14 3.9 10.3 224 1.4
16 4.2 10.3 172 2.3
18 3.6 10.0 139 2.0
20 4.3 9.8 110 3.0
(a) b.t.c. stands for before transaction costs.
(b) a.t.c. stands for after transaction costs.
Table 13.2 Returns on filter rule strategies
There are two main variants of moving-average oscillators:
• the variable-length moving-average oscillator (VMA)
• the fixed-length moving-average oscillator (FMA).
The VMA oscillator

The VMA oscillator method calls for:
• buying the market index when the short-run moving average crosses
from below the long-run moving average (possibly adjusted for some
bandwidth)
• staying long while the short-run moving average stays above the long-
run moving average (possibly adjusted for some bandwidth)
• selling the market index when the short-run moving average crosses
from above the long-run moving average (possibly adjusted for some
bandwidth).
Brock et al. investigate whether it is possible to make some economic profit
by trading on the basis of such a variable-length moving-average oscillator.
They test a number of rules using the Dow Jones series from 1897 to
1986. Each rule is denoted by (short, long, width), with ‘short’ capturing
the number of days in the short-run moving average, ‘long’ capturing the
number of days in the long-run moving average, and ‘width’ capturing the
bandwidth. The results are shown in Table 13.3.
213
Test N(Buy) N(Sell) Buy (%) Sell (%) Buy > 0 (%) Sell > 0 (%) Buy–Sell (%)
(1,50,0%) 14,240 1,0531 0.047 –0.027 53.87 49.72 0.075
(1,50,1%) 11,671 8,114 0.062 –0.032 54.28 49.42 0.094
(1,150,0%) 14,866 9,806 0.040 –0.022 53.73 49.62 0.062
(1,150,1%) 13,556 8,534 0.042 –0.027 54.02 49.43 0.070
(5,150,0%) 14,858 9,814 0.037 –0.017 53.68 49.70 0.053
(5,150,1%) 13,491 8,523 0.040 –0.021 53.82 49.42 0.061
(1,200,0%) 15,182 9,440 0.039 –0.024 53.58 49.62 0.062
(1,200,1%) 14,105 8450 0.040 –0.030 53.84 49.24 0.070
(2,200,0%) 15,194 9,428 0.038 –0.023 53.51 49.71 0.060
(2,200,1%) 14,090 8,442 0.038 –0.024 53.68 49.49 0.062
Average 0.042 –0.025 0.067
where Test represents a rule denoted by (short, long, width), with short capturing the number of
days in the short-run moving average, long capturing the number of days in the long-run moving
average, and width capturing the bandwidth; N(Buy) denotes the number of buy signals in the
sample; N(Sell) represents the number of sell signals in the sample; Buy denotes the average daily
return associated with a buy signal; Sell denotes the average daily return associated with a sell
signal; Buy > 0 denotes the proportion of buy returns which are strictly positive; Sell > 0 denotes
the proportion of buy returns which are strictly positive; Buy–Sell denotes the difference between
the average daily return associated with a buy signal and the average daily return associated with
a sell signal.
Table 13.3 Test results using VMA rules
For the sample of rules tested, a buy signal generated an average daily
return of 0.042 per cent (around 12 per cent per annum), which compares
with an unconditional average daily return of 0.017 per cent (from a
simple buy-and-hold strategy). Although all the rules generate positive
average daily returns to buy signals, six of them generate average daily
returns which are statistically different from the unconditional average
daily return (at the 5 per cent level). In contrast, a sell signal is associated
on average with a negative daily return of 0.025 per cent (around 7 per
cent per annum). All the rules generate negative average daily returns
to sell signals. These returns are furthermore statistically different from
the unconditional average daily return (at the 5 per cent level). The high
proportion of buy signals, compared with the proportion of sell signals,
is consistent with rising stock markets. All the rules generate positive
differences between the average daily return to a buy signal and the
average daily return to a sell signal. These differences are furthermore
statistically different from zero (at the 5 per cent level). The introduction
of a 1 per cent band always increases the spread between the buy and sell
returns.
Although potentially interesting, the returns displayed in Table 12.3 are
expressed gross of transaction costs. Given the high number of trades
generated, however, transaction costs are very likely to exceed the gains
from trading using a VMA rule. We hence have a look at returns to FMA
rules.
The FMA oscillator

The FMA oscillator method calls for:
• buying the market index for a fixed number of days following the
moment when the short-run moving average cuts (from below) the
long-run moving average (adjusted for the bandwidth)
214
• shorting the market index for a fixed number of days following the
moment when the short-run moving average cuts (from above) the long-
run moving average (adjusted for the bandwidth).
Brock et al. investigate whether it is possible to make some economic profit
by trading on the basis of such a fixed-length moving-average oscillator
using the Dow Jones series from 1897 to 1986. Each rule is again denoted
by (short, long, width), with ‘short’ capturing the number of days in the
short-run moving average, ‘long’ capturing the number of days in the long-
run moving average, and ‘width’ capturing the bandwidth. The results are
shown in Table 13.4.
Test N(Buy) N(Sell) Buy (%) Sell (%) Buy > 0 (%) Sell > 0 (%) Buy–Sell (%)
(1,50,0%) 340 344 0.29 –0.44 58.82 46.22 0.72
(1,50,1%) 313 316 0.52 –0.46 62.30 45.89 0.98
(1,150,0%) 157 188 0.66 –0.13 59.87 56.91 0.79
(1,150,1%) 170 161 0.71 –0.39 65.29 55.28 1.10
(5,150,0%) 133 140 0.74 –0.06 62.41 57.86 0.80
(5,150,1%) 127 125 0.62 –0.33 66.14 55.20 0.95
(1,200,0%) 114 156 0.50 –0.19 62.28 55.13 0.69
(1,200,1%) 130 127 0.58 –0.77 63.85 47.24 1.35
(2,200,0%) 109 140 0.50 –0.35 63.30 55.0 0.86
(2,200,1%) 117 116 0.18 –0.88 55.56 43.97 1.062
Average 0.53 –0.40 0.93
where Test represents a rule denoted by (short, long, width), with short capturing the number of days
in the short-run moving average, long capturing the number of days in the long-run moving average,
and width capturing the bandwidth; N(Buy) denotes the number of buy signals in the sample; N(Sell)
represents the number of sell signals in the sample; Buy denotes the average cumulative return to a
buy signal over 10 days; Sell denotes the average cumulative return to a sell signal over 10 days;
Buy > 0 denotes the proportion of buy returns which are strictly positive; Sell > 0 denotes the propor-
tion of buy returns which are strictly positive; Buy–Sell denotes the difference between the average
cumulative return to a buy signal and a sell signal over 10 days.
Table 13.4 Test results using FMA rules
For the sample of rules tested, a buy signal generated an average 10-day
return of 0.53 per cent, which compares with an unconditional average
10-day return of 0.17 per cent. All the rules furthermore generate average
returns to buy signals exceeding the average unconditional return. In
contrast, a sell signal is associated on average with a negative 10-day return
of 0.4 per cent. Finally, all the rules generate negative average returns. The
average difference between the 10-day return to a buy signal and the 10-day
return to a sell signal is 0.77 per cent without a band and 1.09 per cent with
a 1 per cent band. Although all the rules generate positive differences, these
differences are statistically different from zero for seven rules out of 10.
The FMA oscillator generates much fewer trades than the VMA oscillator:
the average number of signals per year varies between 2.8 for the
(2,200,1%) rule and 7.6 for the (1,50,0%) rule. While potentially
interesting, an average 10-day return before transaction costs of 0.40 per
cent obtained by short-selling the Dow Jones index may not exceed the
transaction costs involved. An average 10-day return before transaction
costs of 0.53 per cent following a buy signal may not exceed the transaction
costs involved either. These 10-day returns furthermore do not measure
economic profitability as they are merely raw as opposed to abnormal
returns.
215
The TRB oscillator

According to the trading range break-out oscillator:
• a buy signal is generated when the price penetrates the ‘resistance
level’ defined as the local maximum price
• a sell signal is generated when the price penetrates the ‘support level’
defined as the local minimum price.
In essence, technical analysts recommend buying when the price rises
above its last peak and selling when the price sinks below its last trough.
The underlying rationale for the first recommendation is that the price
has difficulties penetrating the support level because many investors are
willing to buy at the minimum price. The underlying rationale for the
second recommendation is that the price has difficulties breaking through
the resistance level because many investors are willing to sell at the
maximum price.
Brock et al. investigate whether it is possible to make some economic
profit by trading on the basis of such a trading range break-out oscillator
using the Dow Jones series from 1897 to 1986. Local maxima and minima
are computed over the preceding 50, 150 and 200 days. Brock et al. also
consider a bandwidth of 1 per cent, with trades being triggered when the
price level either exceeds the local maximum by 1 per cent or falls below
the local minimum by 1 per cent. The results are shown in Table 13.5.
For the sample of rules tested, a buy signal generated an average 10-
day return of 0.63 per cent, which compares with an unconditional
average 10-day return of 0.17 per cent. For three out of the six rules, the
average 10-day returns are furthermore statistically different from the
unconditional 10-day return (at the 5 per cent level). The average 10-
day returns to buy signals are negative across all the rules, the average
being –0.24 per cent. The average difference between the 10-day return
to a buy signal and the 10-day return to a sell signal is 0.86 per cent. All
the rules generate positive differences. These differences are furthermore
statistically different from zero.
As emphasised for FMA rules, the average 10-day returns generated by the
TRB rules, while potentially interesting, may not exceed the transaction
costs involved. These returns furthermore do not measure economic
profitability as they are merely raw as opposed to abnormal returns.
Buy > 0 Sell > 0 Buy–
Test N(Buy) N(Sell) Buy (%) Sell (%)
(%) (%) Sell (%)
(1,50,0%) 722 415 0.50 0.00 58.03 54.22 0.49
(1,50,1%) 248 252 0.82 –0.08 62.90 53.97 0.90
(1,150,0%) 512 214 0.46 –0.30 57.62 49.53 0.76
(1,150,1%) 159 142 0.86 –0.35 64.78 47.89 1.20
(1,200,0%) 466 182 0.43 –0.23 57.94 50.00 0.67
(1,200,1%) 146 124 0.72 –0.47 61.64 46.77 1.19
Average 0.63 –0.24 0.87
where Test represents the particular rule tested; N(Buy) denotes the number of buy signals in
the sample; N(Sell) represents the number of sell signals in the sample; Buy denotes the average
cumulative return to a buy signal over 10 days; Sell denotes the average cumulative return to a sell
signal over 10 days; Buy > 0 denotes the proportion of buy returns which are strictly positive; Sell >
0 denotes the proportion of buy returns whic;h are strictly positive; Buy–Sell denotes the difference
between the average cumulative return to a buy signal and a sell signal over 10 days.
Table 13.5 Test results using TRB rules
216
Reconciliation
As discussed in the section ‘Returns to contrarian strategies’ in Chapter
12, DeBondt and Thaler (1985) provide evidence of overreaction in the
capital markets. Exploiting overreaction by naive investors calls for using
contrarian investment strategies and, hence, buying losers and short-
selling winners. On the other hand, as discussed in the section ‘Returns to
accounting analysis’ in Chapter 12, Brock et al. (1992) report evidence of
underreaction in the capital markets. Exploiting underreaction by naive
investors calls for using momentum investment strategies and, hence,
buying winners and short-selling losers.
These apparently contradictory investment rules are reconciled by
evidence reported by Jegadeesh and Titman (1993). They test whether
it is possible to make some economic profit by trading on the basis of
relative strength using stock prices from NYSE and AMEX stocks from
1965 to 1989. A stock’s relative strength is measured through cumulative
returns over the prior J months. Stocks are then ranked and allocated
to 10 portfolios, the buy (or winner) portfolio consisting of the decile of
stocks with the highest relative strength (past performance) and the sell
portfolio consisting of the decile of stocks with the lowest relative strength.
This position is then held for K months. The average monthly returns to
these portfolios are displayed in Table 13.6.
Allocation Portfolio
Average monthly return (%) over K months
basis
J K=3 K=6 K=9 K = 12
3 Sell 1.08 0.91 0.92 0.87
3 Buy 1.40 1.49 1.52 1.56
3 Buy–Sell 0.32 0.58 0.61 0.69
6 Sell 0.87 0.79 0.72 0.80
6 Buy 1.71 1.74 1.74 1.66
6 Buy–Sell 0.84 0.95 1.02 0.86
9 Sell 0.77 0.65 0.71 0.82
9 Buy 1.86 1.86 1.76 1.64
9 Buy–Sell 1.09 1.21 1.05 0.82
12 Sell 0.60 0.65 0.75 0.87
12 Buy 1.92 1.79 1.68 1.55
12 Buy–Sell 1.31 1.14 0.93 0.68
where J denotes the number of months, prior to allocation of the stocks to the portfolios, over
which performance is assessed; K denotes the number of months, following the allocation of the
stocks to the portfolios, over which performance is assessed; Buy (Winner) denotes the highest rela-
tive strength portfolio; Sell (Loser) denotes the lowest relative strength portfolio; Buy–Sell denotes
the zero-cost portfolio long in the Buy portfolio and short in the Sell portfolio.
Table 13.6 Returns to relative strength portfolios
The returns to all the zero-cost, winners minus loser, portfolios are
positive. All these returns are furthermore statistically significant except
for the zero-cost portfolio formed by assessing returns over the prior three
months and held over three months. These returns furthermore cannot
be explained by either size or conventional measures of risk such as beta.
Jegadeesh and Titman (1993) argue that the most successful zero-cost
portfolio selects stocks on the basis of returns derived over the prior 12
months and holds the portfolio for three months. This portfolio yields
217
on average 1.31 per cent per month. Further tests, however, suggest that
part of the cumulative returns generated over the 3- to 12-month holding
periods may not be permanent. For instance, as shown in Table 13.7, the
zero-cost portfolio formed on the basis of returns realised in the past sixth
months generates an average cumulative return of 9.5 per cent over the
next 12 months but loses more than half of this return in the following 24
months.
T MR (%) CR (%) T MR (%) CR (%) T MR (%) CR (%)

1 –0.25 –0.25 13 –0.36 9.15 25 –0.35 5.21
2 1.24 0.99 14 –0.39 8.76 26 –0.30 4.92
3 1.16 2.16 15 –0.34 8.42 27 –0.24 4.67
4 1.10 3.26 16 –0.38 8.04 28 –0.32 4.35
5 0.93 4.19 17 –0.47 7.57 29 –0.32 4.03
6 0.91 5.10 18 –0.56 7.01 30 –0.30 3.73
7 1.34 6.44 19 –0.26 6.75 31 –0.01 3.72
8 1.15 7.59 20 –0.32 6.42 32 0.08 3.80
9 0.85 8.44 21 –0.32 6.11 33 0.13 3.94
10 0.48 8.92 22 –0.34 5.77 34 0.08 4.02
11 0.45 9.38 23 –0.11 5.66 35 0.10 4.12
12 0.13 9.51 24 –0.10 5.56 36 –0.05 4.06
where T denotes the Tth month following the allocation of the stocks to the portfolios; MR denotes
the average monthly return to the zero-cost portfolio (buy minus sell) in each month following the
allocation of the stocks to the portfolios; CR denotes the cumulative return to the zero-cost
portfolio (buy minus sell) in each month from the date of allocation of the stocks to the portfolios.
Table 13.7 Performance of relative strength portfolios in event time
More recently, and consistent with their earlier work, Jegadeesh and
Titman (2001) find that over the sample period of 1965–93, the
momentum portfolio yields significant positive returns in the first 12
months following the formation period. The cumulative return in months
13 to 60 is, however, negative. The evidence of reversal is furthermore
strongest for small firms. The empirical evidence reported by Jegadeesh
and Titman hence calls for investing on the basis of:
• momentum strategies over a short horizon (less than 12 months)
• contrarian strategies over a longer horizon (between 36 and 60
months).
DeLong et al. (1990) introduce a model consistent with both
underreaction in the capital markets in the short term and overreaction
in the capital markets in the long term. This model consists of
both ‘fundamentalists’, getting signals about intrinsic values, and
‘chartists’, learning indirectly about intrinsic values from prices. When
fundamentalists receive good news and trade on this news, they recognise
that the initial price increase will stimulate buying by chartists. In
anticipation of these purchases, fundamentalists buy more today and
so drive prices up today higher than the fundamental news warrants.
Tomorrow, chartists buy in response to today’s price increase and so keep
prices above fundamentals even as fundamentalists are selling out and
stabilising prices. This model hence generates a positive correlation of
stock returns at short horizons, as chartists respond to past price increases
by flowing in the market, and a negative correlation of stock returns at
long horizons, as prices eventually revert to fundamentals.
218
Time-series properties of stock prices

The trading rules used by technical analysts and reviewed in this chapter
exploit the time-series properties of stock prices. Before reviewing
empirical evidence on the time-series properties of stock prices, let us
introduce the random walk model of stock prices.
The random walk model of stock prices
According to the random walk model of stock prices:
Pt +1 = Pt + ε t +1 , E (ε t +1 ) = 0, Cov(ε t , ε s ) = 0 ∀ t ≠ s (13.1)
where Pt+1 denotes the stock price obtaining at date t+1; εt+1 denotes the
innovation in the stock price obtaining at date t+1.
Equation (13.1) states that the change in price from date t–1 to t is a
mean zero, serially uncorrelated innovation (surprise), εt. We can think
of this innovation as representing new public information arriving in the
capital markets between dates t–1 and t. As it represents new information
that is equally likely to be good or bad, it has zero mean. Further, new
information is by definition unpredictable such that εt is uncorrelated with
its own past values. Hence, past price changes carry no information about
current or future price changes.
Note that the stock return, rt, is equal to (Pt– Pt–1)/Pt–1, and hence εt/Pt–1.
Given the properties of the innovation, εt, it is clear that returns have zero
mean and are uncorrelated over time in line with equation (13.1). Hence,
tests of autocorrelation (serial correlation) in returns can be viewed as
tests of the random walk model.
Empirical evidence
Serial correlation in price changes measures the correlation between price
changes in consecutive periods, whether daily, weekly or monthly. If stock
prices follow a random walk, as displayed in equation (13.1), stock price
changes in consecutive periods are uncorrelated and the serial correlation
in price changes is hence nil. As explained by Damodaran (1996), a serial
correlation of 0 can thus be viewed as a rejection of the hypothesis that
investors can learn about future price changes from past ones. A serial
correlation that is positive and statistically significant could be viewed as
evidence of price momentum in markets and would suggest that returns
in a period are more likely to be positive (negative) if the prior period’s
returns were positive (negative). A serial correlation that is negative and
statistically significant could be evidence of price reversals in markets and
would be consistent with a market where positive returns are more likely
to follow negative returns and vice versa.
Daily, weekly and monthly returns to portfolios are shown to be positively
autocorrelated. As shown in Table 13.8, the shorter the time window
considered, the stronger the correlation. Lo and MacKinlay (1990)
show that the strength of the autocorrelation depends on the size of
the stocks in the portfolio (where size might be measured by market
capitalisation). Portfolios of small stocks tend to have much higher positive
autocorrelation in returns than portfolios of large stocks. One reason put
forward to explain this is that infrequent and non-synchronous trading
of small stocks will generate positive portfolio return autocorrelation
even when individual stock returns are uncorrelated over time. Hence,
it is not obvious that the return predictability implied by short-term
autocorrelation evidence reflects informational inefficiency.
219
Market index Size-sorted portfolios

Value weighted Equally weighted Small stocks Large stocks
Daily returns 18 35 39 19
Weekly returns 2 20 37 1
Monthly returns 4 17 21 3
Table 13.8 Autocorrelation in returns (%)
Autocorrelation evidence is reversed when one looks at very long horizons
though. Poterba and Summers (1988) show that portfolio returns
measures over three to five years demonstrate negative autocorrelation.
This would seem to indicate that stocks that have increased in price over
the five years up to today should tend to fall in price in the five years
from today and hence to indicate informational inefficiency. However, it
might be the case that such long swings in prices (which generate mean
reversion in long-horizon returns) reflect mean reversion in expected
returns over time which is not picked up by our expected return-
generating model (i.e. this result may be a manifestation of the joint
hypothesis problem).
Technical analysis and market efficiency

According to Fama (1991), a market is efficient in the weak form if it
is impossible to make any economic profit by trading on the basis of an
information set consisting of all past and present stock prices and returns.
By economic profit, Fama means the risk-adjusted rate of return, or in the
language used in this subject guide, the abnormal return, net of all costs.
The inability of current and past returns to generate any economic profit
can thus be written as:
E ( rt +1 | rt , rt −1 , rt − 2 , rt −3 ,....) = r E ,t +1 (13.2)
where rt denotes the most recent realised stock return; rt+1 denotes next
period’s stock return; rE,t+1 denotes next period’s cost of equity capital.
The weak form of market efficiency hence requires that the expectation of
next period’s return conditional on the entire history of returns is equal to
the cost of capital.
The first tests of market efficiency focused on the autocorrelation of
returns with lagged returns. Markets were deemed to be efficient if there
was no serial correlation in returns, which can be written as:
Cov(rt , rt − s ) = ρt ,t − s σt σt − s = 0, s>0 (13.3)
A
where cov(rt, rt–s) denotes the covariance between returns in periods t and
t–s; ρt,t–s denotes the correlation between returns in periods t and t – s
(autocorrelation of returns lagged by s); σt denotes the standard deviation
of returns in period t; σt–s denotes the standard deviation of returns in
period t–s.
As explained in the previous section, it is possible for markets to be
efficient even in the presence of a non-nil autocorrelation of returns.
This chapter reviewed empirical returns to selected technical analysis
strategies. Although these studies suggested that some investment
strategies did provide, on average, higher returns than other investment
strategies, we cannot conclude from them that it is possible to make
some economic profit by trading on the basis of a technical analysis.
The reason for this is that empirical researchers do not know the true
model generating expected returns in the economy. Hence, their choice
220
of expected return-generating mechanism, used to adjust actual returns,

may be wrong, which implies that abnormal returns may be incorrectly
measured. These (inaccurate) abnormal returns are then used in tests of
market efficiency. Therefore, we are left in a position where we are not
sure whether markets are inefficient or our model of expected returns
is wrong. This is known as the joint hypothesis problem associated with
testing market efficiency. The null hypothesis of any test of efficiency is
comprised of two components: informational efficiency and the accuracy
of one’s model for expected returns. As the true model of expected returns
is unknown, a rejection of this null hypothesis cannot be immediately
taken as evidence that markets are not efficient.
Overview of chapter
In this chapter, we investigated whether it is possible to make some
economic profit by trading on the basis of a technical analysis. In order to
do so, we reviewed empirical evidence on returns to contrarian investment
strategies (DeBondt and Thaler, 1985) as well as empirical evidence
on returns to momentum strategies (Brock et al., 1992). These studies
suggest that momentum strategies are, on average, reasonably successful
in the short term, in the absence of transaction costs, whereas contrarian
strategies are, on average, successful in the long term (Poterba and
Summers, 1988). The success of momentum investment strategies was
explained through positive serial correlation of daily, weekly and monthly
returns, as shown by Lo and MacKinlay (1990). The success of contrarian
investment strategies was explained through negative serial correlation of
returns, when returns are measured over three to five years.
However, we cannot conclude from the studies reviewed in this chapter
that it is possible to make some economic profit by trading on the basis of
a fundamental analysis. Average returns obtaining in the future may differ
from average returns generated in the past. Moreover, superior returns
associated with contrarian and momentum strategies may not compensate
for a higher level of risk. As there is no consensus on the sources of
risk priced in the capital markets, it is hence not possible to state that
it is possible to make some economic profit by trading on the basis of a
technical analysis, or equivalently, that capital markets are inefficient in
the weak form (joint hypothesis problem).
Key terms
abnormal return overreaction
autocorrelation random walk
chartism resistance level
contrarian strategy risk-adjusted return
cumulative abnormal return semi-strong form
filter rule serial correlation
fixed length moving average size-adjusted return
fundamental analysis strong form
Jensen’s alpha support level
market efficiency technical analysis
market-adjusted return trend extrapolation
momentum strategy underreaction
moving average oscillator variable length moving average
221

• appreciate the difference between technical analysis and fundamental
analysis
report returns of technical analysis
• report empirical evidence on returns of contrarian investment strategies
used by technical analysts
• quote empirical evidence on returns of momentum investment
strategies used by technical analysts
• reconcile the empirical evidence on returns with contrarian and
momentum strategies
• outline the implications of technical analysis for market efficiency
• understand the difficulties involved in testing market efficiency through
returns to technical analysis.

1. How does a technical analysis differ from a fundamental analysis?
2. In the context of a technical analysis, how would you invest on the
basis of a momentum strategy? Why?
3. In the context of a technical analysis, how would you invest on the
basis of a contrarian strategy? Why?
4. What evidence is there of abnormal returns to momentum investment
strategies?
5. What evidence is there of abnormal returns to contrarian investment
strategies?
6. According to contrarian analysts, one should sell winners and buy
losers. According to momentum analysts, one should sell losers and
buy winners. Could both types of analysts be right? Provide empirical
evidence supporting your claim.
7. Is it ever possible to test market efficiency alone? Why?
222
Appendix 1: Solutions to numerical activities
Appendix 1: Solutions to numerical

activities
Answers to Activities marked with an asterisk.
Chapter 3
Activity 3.3
(€000 unless otherwise specified) 2011 2010 2009 2008 2007 2006
Interest Expense 93,900 72,100 130,500 97,088 82,876 73,958
Interest Income –27,200 –23,500 –75,500 –83,957 –62,983 –38,219
Net Interest Expense Before Tax 66,700 48,600 55,000 13,131 19,893 35,739
Tax Benefit of Debt 7,337 5,103 3,465 1,444 676 3,395
Net Interest After tax 59,363 43,497 51,535 11,687 19,217 32,344
Effective Tax Rate (%) 11 10.5 6.3% 11% 3.4% 9.5%
Reported Tax Expense 46,300 35,700 –11,300 48,219 15,437 32,176

Tax Benefit 7,337 5,103 3,465 1,444 676 3,395
Tax on Operating Income 53,637 40,803 –7,835 49,663 16,113 35,571
Chapter 4
Activity 4.2
Statements of Common Stockholders’ Equity
Year 1 Year 2
CSE0 1000 CSE1 1000 CSE1 1000 d2 1221
CE1 155 d1 155 CE2 221
CE1 = 205 – 50 = 155
CE2 = 221
Activity 4.4
CSE1 = CSE0 + CE1 – d1 = 1000 + 155 – 155 = 1000
ROCE1(BP) = CE1/CSE0= 155/1000 = 15.5%
ROCE2(BP) = CE2/CSE1= 221/1000 = 22.1%
Activity 4.5
AE1 = CE1 – rE CSE0 = 155 – 10% * 1000 = 55
AE2 = CE2 – rE CSE1 = 221 – 10% * 1000 = 121
Activity 4.7
SR1 = MVE1 + d1 – MVE0 = 1110 + 155 – 1150 = 115
SR2 = MVE2 + d2 – MVE1 = 1221 – 1110 = 111
223
Activity 4.8
SRR1 = (MVE1 + d1 – MVE0)/MVE0
= (1110 + 155 – 1150)/1150 = 10%
SRR2 = (MVE2 + d2 – MVE1)/MVE1
= (1221 – 1110)/1100 = 10%
Activity 4.9
SARR1 = SRR1 – rE = 10% – 10% = 0%
SARR2 = SRR2 – rE = 10% – 10% = 0%
Activity 4.10
SAR1 = SR1 – rE MVE0 = 115 – 10% * 1000 = 15
SAR2 = SR2 – rE MVE0 = 111 – 10% * 1000 = 11
Activity 4.11
Statements of common stockholders’ equity
Year 1 Year 2
CSE0 1000 CSE1 1025 CSE1 1025 d2 1221
CE1 180 d1 155 CE2 196
CE1 = 205 – 25 = 180
CE2 = 221 – 25 = 196
CSE1 = CSE0 + CE1 – d1 = 1000 + 180 – 155 = 1025
ROCE1(BP) = CE1/CSE0= 180/1000 = 18.0%
ROCE2(BP) = CE2/CSE1= 196/1025 = 19.1%
AE1 = CE1 – rE CSE0 = 180 – 10% * 1000 = 80
AE2 = CE2 – rE CSE1 = 196 – 10% *1025 = 93.5
Activity 4.12
V* = CSE0 + [AE1/(1+ rE)] + [AE2/(1+ rE)2]
If the firm expenses R&D expenditure is incurred:
V* = 1000 + [55/1.1] + [121/(1.1)2] = 1150
In contrast, if the firm capitalises R&D and amortises it straight line over
both periods:
V* = 1000 + [80/1.1] + [93.5/(1.1)2] = 1150
Activity 4.13
V* = [d1/(1+ rE)] + [d2/(1+ rE)2]
= (155/1.1) + [1221/(1.1)2]
= 1150
224
Chapter 5
Activity 5.3
The estimated ROA values are as follows:
2011 2010 2009 2008 2007
ROA=(NI+IE)/TA(BP) 10,3% 9,9% –1,0% 12,9% 18,2%
Activity 5.5
Elements needed for the WACC calculation:
Cost of debt (rD) = Actual net borrowing costs calculated as net interest
expenses/ net interest-bearing debt = 8.14%
Tax rate (T) =11%
Cost of debt after taxes = 7.25%
Cost of equity (rE) = 7.6%
Weight of debt = 6.36
Weight of equity = 93.64%
E D
V0 V0
By applying WACC =
E D
* rE +
E D
(
* rD * 1 − T ), it follows that
V0 + V0 V0 + V0
WACC = 7.58%
Activity 5.6
The AOI for the year 2011 was calculated as follows:
(€ 000) 2011 2010 2009 2008 2007
AOI 220,695.6 162069.6 -307,067.5 261,136.0 318,972.0
Activity 5.7
As we have seen in Chapter 4, the return on common equity, can be
written as:
CE (A1)
ROCE =
1 (CSE ( BP) + CSE ( EP))
2
where CE = comprehensive earnings and CSE = common shareholders’

equity.
Comprehensive earnings in equation (A1) are composed of operating
income (OI) and net financial expenses (NFE) as in equation 5.4. Thus
equation (A1) can be rewritten as follows:
OI − NFE (A2)
ROCE =
1 (CSE ( BP ) + CSE ( EP ))
2
As implied in equation (5.1), operating income is generated by net

operating assets and the operating profitability measure (RNOA) (OI =
RNOA × NOA(BP)). Similarly, net financial expenses (NFE) is generated by
net financial obligations (NFO) and the rate at which the NFE is incurred,
which is the net borrowing cost (NBC) (NFE = NBC × NFO). On this basis,
equation (A2) formally becomes:
 NOA   NFO  (A3)
ROCE =  RNOA  −  NBC 
 CSE   CSE 
225
This equation represents the weighted average of the return of operating

activities and the (negative) return from financing activities. It can be
rearranged as:
 NFO
ROCE = RNOA +  (RNOA − NBC ) = RNOA + ( FLEV * Spread ) (A4)
 CSE 
Chapter 7
Activity 7.1
The SF2 value of NOA2011 is:
NOA
V2011 = NOA2011 +
AOI 2011 OI
= NOA2011 + 2011
− r * NOA2010 ( )=
r r
433,963 − ( 7.58% * 2,814,479 )
= 3,290,083 + = 6,202,592 ( €000)
7.58%
The SF2 value of CSE2011 is:

CE2011 − rE * CSE2005
E
V 2011 = CSE2011 +
rE
374,600 − ( 7.6% * 2,848,600)

= 2,953,900 + = 5,034,247 ( €000)
7.6%
Activity 7.2
Let us now derive mathematically the simple valuation of NOA under SF3.
F 2
V t = NOAt + NOAt (RNOAt − rF) /( 1 + rF) + NOAt ( 1 + g) (RNOA t − rF) / (1 + rF)
2
+ NOAt (1 + g) (RNOAt − rF ) / (1 + rF) + ... =
3
[A1]
 1 + g  1 + g 2 
NOAt + NOAt [(RNOAt − rF )/ (1 + rF )]1 + +   + ... = [A2]
 1 + rF  1 + rF  
 
 1 
NOA t + NOA t [(RNOA t − r F ) / (1 + r F )]  = [A3]
 1 − 1 + gF 
 1+ r 
 
NOAt + NOA t [(RNOA t − rF )/ (rF − g )] = [A4]
NOAt [(RNOAt − g )/ (rF − g )] [A5]
Activity 7.3
The SF3 value of NOA2011 is:
2011
V NOA = NOA
2011
[(RNOA2011 − g)(r − g)]
= 3,290,083 * [15.4% − 1.5% ]/[7.58% − 1.5% ] = 7,535,076 (€000)
The SF3 value of CSE2011 is:

2011 = CSE
VE [
2011 ( ROCE2011 − g )( rE − g ) ]
= 2,953,900 * [(13.2% − 1.5%)( 7.6 − 1.5%)] = 5,641,619( €000)
226
Chapter 8
Activity 8.3
£m 2012 2013 2014 2015 2016 2017
CFO 380 500 520 530 535
CAPEX 245 300 210 165 215
FCF 135 200 310 365 320
PV Factor 1.12 1.25 1.40 1.57 1.76

PV FCF 120.5 159.4 220.7 232.0 181.6
PV FCF (2013-17) 914.2

Assuming a long-term growth rate g=3%:
Assuming no growth instead:
The continuing value is calculated as follows:

Case 1: no growth CV2017 = £320 / 0.12 = £2,666.7
Case 2: growth g = 3%: CV2017 = £320 / (0.12 – 0.03) = £3,662.2
Activity 8.6
227
Case 1: No continuing value
Case 2: No growth
Case 3: Long-term growth rate g = 3%
PV AE (2013-17) 745.2
CSE (2012) 650
Continuing Value (as of 2017) 2580.2
Continuing Value (as of 2012) 1400.4
Equity Value 2795.6
Number of Shares 250
Share Price 11.18
Chapter 9
Activity 9.1
Let us start with (9.5):
j = i −1
E [( ROCE − r E)
t t +i
∏ (1+ g )]
j
(A1)
V
*
i = +∞ j =0
t
= 1+ ∑
CSE t i =1
(1+ r E )
i
Let us then recognise that ROCEt+i = ROCE and gj = g for all i. (A1) can
then be rewritten as:
i
V t*  ROCE − rE i = +∞  1 + g  (A2)
∑ 
 i =0 1 + r 
= 1+ 
CSE t  1+ r
 E   E
But, for any x, with 0 ≤ x ≤ 1, we know that:
i = +∞
1
∑x
i
=
i =0 1 − x (A3)
By using (A3) with x = [(1+g)/(1+rE)], (A2) becomes:
  (A4)
V  ROCE − r E    ROCE − r E
*
t  1 
= 1+   = 1+
CSE t  1 + r E  1 − 1 + g 
 1+ 
rE − g
 rE 
228
Activity 9.2
By reverse-engineering (A4), we obtain:
ROCE − r E (A5)
g = rE −
V
*
t
−1
CSE t
By substituting numerical values in (A5), we obtain g = 5%.
Activity 9.7
Let us start with PB ratios and (9.2):
(A6)
V ∑ E AE
*
1 i = +∞ ( )
t
= 1+ t t +i
CSE CSE (1+ r E )

i
t t i =1
If abnormal earnings grow at a constant rate g from the current year t+1,
(A6) reduces to:
V AE
*
t
= 1+ t +1
CSE t (r E
− g )CSE
t
(A7)
Let us then move to PE ratios and consider (9.6):
1 + r E   (A8)
V + ND 1 i =+∞ E t ( AEGt +i ) 
*
t t
= 1+ ∑
CE t r E  CE t i=1 (1+ r E) 
i
If expected abnormal earnings grow at a constant rate, denoted by g:

Et(AEGt+2) = Et (AEt+2 – AEt+1) = g Et(AEt+1)
Et(AEGt+3) = Et (AEt+3 – AEt+2) = g Et(AEt+2) = g(1+g) Et(AEt+1)
Et(AEGt+i) = Et(AEt+i – AEt+i–1) = g Et(AEt+i-1) = g(1+g)i–2 Et(AEt+1)
With constant growth g in expected abnormal earnings, (A8) becomes:
 i 
  (A9)
V + ND 1+ rE  1  E t (AEGt +1)  1+ g 
*
g 
 E ( AE ) 
i = +∞
t t
= 1 +  + ∑
CE rE  CE t  rE (1+ rE )  1+ r 
2
1 + t t +1
t i =0

  E

By using (A3) with x = (1 + g)/(1 + rE), this expression becomes:
V + ND 1 + r E  E t ( AEG t +1) E t (AE t +1)

*
t t g
= 1 + +
CE t r E  (1 + r E )CE t (1+ r E )( rE − g ) CE t  (A10)
By substituting numerical values for firms A, B, C and D in (A7) and
(A10), one obtains:
Firm A Firm B Firm C Firm D
PB 1.1 1.1 1.6 1.7
PE 113.0 10.3 7.8 11.7
Chapter 11
Activity 11.3
Our best estimate of the intrinsic value of CompanyOne.com is:
(5%*£80m) + (35%*£35m) + (35%*£15m) + (25% * £5m) = £22.75m.
Activity 11.5
Answer: $15. The reason for this is that the improvement in working
capital management can be delievered by many potential acquirers. The
suggested bid price is thus $65.
229
Notes
230
Appendix 2: Sample examination paper
Important note: This Sample examination paper reflects the

examination and assessment arrangements for this course in the academic
year 2010–2011. The format and structure of the examination may have
changed since the publication of this subject guide. You can find the most
recent examination papers on the VLE where all changes to the format of
the examination are posted.
Time allowed: three hours

Candidates should answer FOUR of the following TEN questions. ONE
from Section A, ONE from Section B and TWO further questions from
either section. All questions carry equal marks.
Answer ONE question from this section and no more than a further two
questions. (You are reminded that FOUR questions in total are to be
attempted with at least one question from Section B.)
1. Project Universe is a pharmaceutical firm. It reported earlier today
comprehensive earnings equal to £120m which were generated over
the past twelve months. Its book value of equity is currently £1bn, as it
was twelve months ago, and its cost of equity capital is 10%.
a. Assuming that residual (abnormal) earnings follow a random walk:
i. on which price-to-book ratio would you expect Project Universe
to trade in efficient markets? (8 marks)
ii. on which price-to-earnings would you expect Project Universe to
trade in efficient markets? (4 marks)
b. Is it reasonable to assume that residual earnings follow a random
walk? Explain. (5 marks)
c. Assume now that residual earnings, AEt, follow the following
process:
AEt+1 = AEt + t+1
with 0 <  < 1, cov(t+i , t+j) for all i≠j, and E(t+i) = 0 for all i.
Show that the price-to-book ratio Project Universe is trading on
in efficient markets is increasing in the persistence of residual
earnings. (8 marks)
Hint: For any x, with 0 < x < 1:
i = +∞
1
∑x
i
=
i =0 1− x
2. Consider Cool London plc. The firm’s cost of equity is 12%, the cost of
debt is 5% and the weighted average cost of capital is 9%. Extracts from
reformulated financial statements are as follows (values in millions of
pounds):
231
2012 2013
Property, Plant, and Equipment 12000 19500
Accounts receivables 5100 4300
Inventories 5100 5250
Operating liabilities 12000 14500
Investments in bonds 1500 2000
Financial liabilities 3000 2500
Common equity 8700 14050
Sales 5100
Operating expenses 1260
Depreciation 300
Net interest revenues 120
Tax expense 100
Net income 3560
a. Calculate the free cash flow (FCF) of London Care plc in 2013.
(9 marks)
b. “By investing in short-term marketable securities to absorb excess
cash, the firm reduces its reported cash flow after investing activities
prepared according to the GAAP (General Accepted Accounting
Principles)”. Discuss. (8 marks)
c. Theoretically derive the present value of abnormal earnings (PVAE)
from the present value of expected dividends (PVED). (8 marks)
3. Answer all parts of this question.
a. Do earnings follow a random walk? Do you expect the same
behaviour for Return on Common Equity (ROCE)? Explain.
(8 marks)
b. Explain the empirical evidence reported in the following table by
Penman. (9 marks)
Return on Common Equity (ROCE) and Price-Earnings (P/E) Ratios for Varying
Levels of Levered Free Cash Flow (FCF) Based on all NYSE, AMEX, and
NASDAQ firms for 1973-1990
FCF Group FCF/Price (%) ROCE (%) P/E
1 87.1 4.7 17.4
2 23.4 9.2 10.3
3 10.8 12.1 9.6
4 6.3 13.7 10.4
5 2.2 14.6 11.6
6 –1.4 13.2 13.0
7 –6.1 12.6 12.8
8 –13.4 11.6 12.5
9 –25.9 9.9 12.2
10 –78.8 4.2 22.7
232
c. Theoretically derive the link between business profitability (Return

on Net Operating Assets, RNOA) and bottom line profitability
(Return on Common Equity, ROCE
4. Consider the following values from First Corp’s financial statements
Balance sheet (values in millions of £) 2012 2013
Current operating assets 40 41
PPE 250 254
Current operating liabilities 120 125
Long-term financial liabilities 80 75
Common shareholders’ equity 50 54
Income statement (values in millions of £) 2012 2013
Revenues 300 310
Gross margin 120 125
Depreciation 20 22
Tax on operating income 20 23
Operating income after tax 80 75
Net financing expenses 10 8
Comprehensive earnings 70 67
Assume that the cost of the firm’s capital, rF, is equal to 7%, the cost of
the firm’s equity capital, rE, is equal to 10%, and the growth rate, g, is
equal to 1%.
a. In the context of simple forecasting, estimate the value of Abnormal
Operating Income and Abnormal Earnings in year 2014 under the
following methods: Forecasting from Book Values (SF1 Forecasting),
Forecasting from Earnings and Book Values (SF2 Forecasting) and
Forecasting from Accounting Rates of Return (SF3 Forecasting).
(12 marks)
b. In the context of simple forecasting, estimate the value of Net
Operating Assets and Common Shareholders’ Equity in year 2013
under the following methods: Forecasting from Book Values (SF1
Forecasting), Forecasting from Earnings and Book Values (SF2
Forecasting) and Forecasting from Accounting Rates of Return (SF3
Forecasting). (13 marks)
a. What are the determinants of price-to-book ratios (PB) in efficient
markets? (4 marks)
b. What are the determinants of price-to-earnings ratios (PE) in
efficient markets? (4 marks)
c. Introduce and discuss a strategic taxonomy with implications for
the pricing of stocks (with respect to earnings and the book value of
equity). (8 marks)
233
d. Consider the following sample of airlines:
Airlines Trailing PE Ratios PB Ratios

A 13.0 1.2
B 32.1 0.8
C 15.2 2.1
D 26.8 4.9
Apply the above taxonomy to this sample of airlines. Explain.
(9 marks)
6. Manufactured Earnings is a “darling” of Wall Street’s financial analysts.
Its current market price is $15 per share and its book value is $5 per
share. Analysts forecast that the book value of equity per share will
grow by 10% per year indefinitely and the cost of equity capital is 15%.
a. What is the financial market’s expectation of the long-term’s Return
on Common Equity (ROCE)? (10 marks)
Hint: For any x, with 0 < x < 1:
i = +∞
1
∑x
i
=
i =0 1− x
b. What will be Manufactured Earnings stock price if the financial
market revises its expectation of the firm’s long-term ROCE upwards
to 20%? (5 marks)
c. Analysts reassess Manufactured Earnings’ future performance in the
following way: growth in the book value of equity increases to 12%
per year whilst the ROCE on the incremental book value is only
15%. What is the impact of this reassessment on Manufactured
Earnings’ price-to-book ratio? Explain. (5 marks)
d. In which circumstances may incremental growth in a firm’s future
revenue have no impact on the firm’s fundamental equity value?
Explain. (5 marks)
Section B
Answer at least ONE question from this section.
(You are reminded that FOUR questions in total are to be attempted for
this paper with at least ONE from this section.)
a. Explain what contrarian investment are about and provide empirical
evidence on their returns in the context of fundamental and
technical analysis. (13 marks)
b. On what basis would contrarian analysts refute the arguments put
forward by Fama and French (1992) and argue that contrarian
strategies generate abnormal returns? Explain. (6 marks)
c. How is it possible for the literature to report superior returns to
both momentum and contrarian strategies? Explain. (6 marks)
a. It is often argued that, if any earnings management ever takes place,
it is more likely to take place during IPOs. Discuss. (6 marks)
b. How would you test for earnings management in the context of
IPOs? (6 marks)
234
c. Provide empirical evidence on returns to accounting analysis in the

context of IPOs. (10 marks)
d. Discuss implementation issues associated with investment strategies
designed to exploit mispricing of IPOs. (3 marks)
a. Provide empirical evidenceon the magnitude of the changes in stock
prices around the release of earnings information. (8 marks)
b. Describe and discuss the methodology used in capital market
research to test the usefulness of earnings to investors? (9 marks)
c. Discuss the competing hypotheses to explain the earnings response
conundrum. (8 marks)
a. In the context of full information forecasting, which methods work
best for forecast over a finite five-year horizon? (8 marks)
b. What are the main limitations of the dividend discount method
and the discounted cash flow method? (8 marks)
c. How does the abnormal operating income method work? What
assumptions can be made to calculate the continuing value?
(9 marks)
235
Notes
236
Appendix 3: Guidance on answering the Sample examination paper
Appendix 3: Guidance on answering the

Sample examination paper
237
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239
240
241
242
243
244
245
246
247
248

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Valuation and securities analysis

University of London International Programmes

Published by: University of London

Chapter 4: Financial analysis: the determinants of performance......................... 49

Further reading........................................................................................................... 109

Chapter 10: Applications..................................................................................... 167

Appendix 1: Solutions to numerical activities..................................................... 215

Route map to the guide

Structure of the guide

• Chapter 11 provides some application of valuation methods described in

Introduction to the subject guide

Part One: The framework for analysis

profitability and free cash flows.

Part Two: Securities valuation

Part Three: Empirical evidence on returns to fundamental and techni-

Changes to the syllabus

material and changes to the syllabus. Any additional material posted on

Aims of the course

Learning outcomes for the course

Overview of learning resources

Essential journal articles

Basu, S. ‘The conservatism principle and the asymmetry timeliness of earnings’,

Online study resources

Making use of the Online Library

Remember, it is important to check the VLE for:

NOA Net Operating Assets

Chapter 2: Introduction to the Ryanair

Aim of the chapter

Figure 2: Ryanair’s share performance compared to the Eurostoxx 50 index be-

Budapest. This move came in response to the cessation of operations by

(in €000) 2011 2010 2009 2008 2007 2006

Other Operating Gains/(-)Losses

Net Financing Expense

NET INCOME 374,600 305,300 -169,200 390,708 435,600 306,712

(in €000) 2011 2010 2009 2008 2007 2006

Net Operating Assets 3290083 2814479 2464232 2499535 1864182 1792735

Net Financial Assets

Common Stockholders' Equity 2953900 2848600 2425100 2502194 2539773 1991985

(in £000) 2010 2009 2008 2007 2006

Other gains/losses(-) 0 0 0 10600 0

Net Financing Expense

NET INCOME 121300 71200 83200 152200 94000

Net Operating Assets 1380519 1231186 868122 675591 540607

Table 2.3: Excerpts from Easyjet’s reformulated financial statements.

(in $000) 2010 2009 2008 2007 2006

Other Operating Gains/(-)Losses

Net Financing Expense

NET INCOME 459000 99000 178000 645000 499000

Net Operating Assets 6090610 6405140 6856680 5312130 6143900

Part 1: The framework for analysis

Chapter 3: The analysis framework and

Capital markets and the role of valuation and securities

The market for lemons

the ‘bad’ firms, that is, £2m.

Distortions in investment decisions

The role of valuation and securities analysis

Introduction to the valuation and securities analysis framework

Step 1: Strategy analysis

Step 2: Accounting analysis

Step 3: Financial analysis

Step 4: Prospective analysis

The set of projected financial statements implies some levels of

Introduction to stylised financial statements