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MEASURING AND FORECASTING

EARNINGS OF A COMPANY

SOUMENDRA ROY
MEASURING EARNINGS
• Measurement of earnings is based on two
types of information:
1) Internal Information consists of data and
events made public by firms concerning their
operations.
2) External sources of information are those
generated independently outside the
company. They provide supplement to
internal sources .
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BACKBONE OF INTERNAL INFORMATION

• Income Statement
• Balance sheet
• Statement of Cash flows

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BACKBONE OF EXTERNAL INFORMATION
• Rating agencies reports
• Economic surveys

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EARNINGS FROM REGULAR OPERATIONS
• The analyst must recognize the earnings from
regular operations because they show the
major thrust of a business.
• These earnings must be segregated from
earnings from infrequent, unusual or
nonrecurring events . Because earnings from
regular operations are supposed to consistent
through reasonable period of time.

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EXTRAORDINARY ITEMS
• These need to arise from material
transactions that are both unusual in nature
and occur infrequently in the operating
environment of the business.
• If a corporation in the same year had normal
operations, had extraordinary items, and
disposed of a segment of its business , then
three different income figures would be
disclosed in the income statement.
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Cont…………………
• The first would probably be labeled “income
from continuing operations” .
• The second would be “income before
extraordinary items”
• Finally a section for disclosing the
extraordinary item would be included, which
would lead to final figure labeled “net
income”

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MATCHING PRINCIPLE
• Matching Principle requires that expenses be
reflected in the same period as the revenues
to which they are related.
• The utility of accounting information on the
investment analyst is impaired if
1. Expenses and revenues are improperly
matched.
2. Methods employed are switched over time.

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INVENTORY COST
• Accounting convention permits placing a
value upon inventory in any of a number of
ways .The most widely known methods are :
1. LIFO(Last In First Out)
2. FIFO(First In First Out)

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DEPRECIATION ACCOUNTING
• It recognizes that an asset will be exhausted at
some reasonable point of time. So we need to
deduct their cost .
• In the same firm all assets are not depreciated on
the same basis ,and shifts in the rate of charge –off
takes place over time.
• Commonly used methods for writing of
depreciation :
1. Straight Line method
2. Written down value
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PROVISION FOR INCOME TAXES
• During years when a loss is shown and no
prior year income is available , the tax saving
could be utilized in offsetting possible income
in future years.
• The tax expenses income shown on the
income statement conforms to the income
reported on the statements, rather than to
the income reported on the tax authorities.

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Cont……………..
• For example , it is both legal and quite
common to use accelerated depreciation on
tax returns and straight line on the financial
statements . The result is that tax savings now
from accelerated depreciation will be offset
by higher taxes in later years.
• Therefore it is compulsory to set up a long
term or deferred tax liability for the savings,
which is converted into a current liability in
the future period in which the later tax is due.
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EARNING PER SHARE
• In order to determine earnings per share ,the
analyst must calculate the number of common
share outstanding, as follows
First number of shares issued is reduced by the
number of treasury shares.
Second, a weighted average is used when stock
transactions involving asset accounts have taken
place during the period.
Third, when stock transaction takes place that do
not involve assets , such as stock dividends or splits,
the new no. of shares is treated as being effective
from the beginning of the year.
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Cont…………
• The increasing use of securities that are convertible
into common shares and of stock options through
warrants create the overhang, or contingent
creation of new common shares . These resulted
into two types of earning per share:
1. Primary earning per share:-It reflects the
assumption that all options and warrants are
exercised ,but reflects convertible securities only if
at the time of issuance their value by the market
was was mostly due to conversion privilege.
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Cont………………..
2. Secondary or diluted earning per share:-It assumes
that all options , warrants ,and convertibles were
turned into stock.
• Secondary earnings per share would always be less
than or equal to primary earning per share.

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THE COST PRINCIPLE
• The assets are carried at original or historical
cost when they are first acquired . During
subsequent time periods, they may be valued
at cost or market, whichever is lower.
• In addition, the framework of historical cost
does not make reference to the purchasing
power of the currency.

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NOTES TO THE FINANCIAL STATEMENTS
• Footnotes to the balance sheet often show many of the
following items of importance to the analyst:-
1) Contingent liabilities for taxes ,dividends, and pending
lawsuits.
2) Particulars on options outstanding ,leases , loans and
other financing arrangements.
3) Changes in accounting principles and techniques,
including bases of valuation, and the currency effect
on income.
4) Facts of importance occurring between the balance-
sheet data and date of submissions of statements
that might have a material effect on the statements.
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THE CASH FLOW STATEMENT
• The statement of cash flow discloses clearly and
individually the significant operating, financing and
investing activities of the company during an
accounting period, giving the analyst an overall view
of the financial management of company and its
policies .

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Cont………………
• The statement help to answer some of the following
questions:
 How much cash was generated from operations?
 How were dividends possible despite a loss for the
period?
 How can the company be experiencing cash flow
problems while reporting such large profits ?
 Why are dividends not larger or smaller?
 How were fixed asset additions financed?
 Why was additional debt financing necessary?
 What was the change in working capital and how was it
financed?
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Forecasting Earning

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ASSET PRODUCTIVITY AND EARNINGS
• Firm invests capital in assets.
• And these assets are used by management to
generate revenue or income.
• Firms strive in such a way so as to provide
shareholders best possible return per rupee
invested.

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ASSET PRODUCTIVITY AND EARNINGS

• EBIT= Earning before interest and taxes.


• EBT= Earning before taxes
• EAT= Earnings after tax
• EPS= Earnings per share
• DPS= Dividend per share
• Return on assets
» =EBIT/Assets
• Greater return on assets higher the market value of firm….

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DEBT FINANCING AND EARNING
• Productivity of fund is called return on assets.
• Cost of borrowed capital fund is called effective rate
of interest.
• Effective interest rate=interest expense/total
liabilities.
• Benefits of borrowed money=R-I
• R= Return on assets
• I= effective interest rate

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DEBT FINANCING AND EARNING
• Example:-
• Return on assets=24%
• Effective interest rate=8%
• Benefits of borrowed money=.24-.08
• =.16 or 16%

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EQUITY FINANCING AND EARNING
• Assets value per share=assets/no of common share
• Example:-
• 5million share already there, asset value per share
is 10(50/5)
• See earning affect of new share worth 1 million at
15,10,5 per share.

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EFFECT OF TAXES

• Eat =(1-T)EBT
• T = Effective tax rate=Tax Expense/EBT

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FORECASTING VIA THE EARNINGS MODEL
• ROI can be used as a forecasting toll.
• Once the analyst understands this inner workings of the firm’s
earnings – formation process, he can forecast the key
variables, substitute the values into the model, and forecast
EAT for the next period.
• For example, assume that a firm’s tax bracket is forecast to be
50 percent in 201X, that 15% will be earned on its assets, and
that it will pay an effective interest rate of 6%. Further
assume that the firm will have Rs 100 million of equity and Rs
100 million of debt in its capital structure on 201X. Then, if
we substitute these values into the model.
• EAT = (1 – T) [R + (R – I)L/E]E, its forecast will be as follows:
EAT = (1 – 0.5) [0.15 + (0.15 – 0.06) 100/100] x Rs 100
= 0.5 [0.15 + (0.09) x 1] x 100
= 0.5 x 0.24 x 100 = Rs 12Soumendra Roy
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FORECASTING VIA THE EARNINGS MODEL
• We can subtract any forecast preferred dividends
that will be paid, and divide the remainder by the
projected number of outstanding common shares
to arrive at the EPS.
• This can be multiplied by the projected P/E ratio to
get the projected price.
• To continue with our example, if our firm is
expected to have 3 million shares outstanding and a
P/E of 15 in 201X, then the EPS will be forecast at Rs
4 (Rs 12 million/3 million) and the price per
common share at Rs 60 (15 x Rs 4).
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FORECASTING VIA THE EARNINGS MODEL
• This can be translated to Holding Period Yield
(HPY) by subtracting the beginning price per
share price, adding dividends paid in 201X
and dividing by the beginning price.
• Of the price at the end of 201X is Rs 50 no
dividends are expected during 201X, then the
projected HPY for 201X is 20 percent [(60 –
50)/50]

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MARKET SHARE/PROFIT - MARGIN
APPROACH
• The market share/profit-margin approach estimates
directly from the industry analysis.
• Once the industry forecast of market shares is
completed, the analyst must next decide which firms
are likely to be dominant factors, pacesetters, in the
industry.
• If an investor has his choice, he will undoubtedly select
a leader rather than a follower.
• Thus the next logical step for the analyst is to
determine what share of the industry’s total market the
firm under analysis can reasonably be expected to
achieve
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MARKET SHARE/PROFIT - MARGIN
APPROACH
• If the industry is established and has a track record of
performance and stability, the analyst can probably make
good use of the historical shares of the market attained by
the competing firms.
• Industries such as autos, steel, oil, and cooper have well –
entrenched member firms. In a slightly more dynamic
industry, such as household appliances, the analyst must
translate the ability and aggressiveness of management
relative to the competition into a forecast of market share.
• However, in an evolving and somewhat unstable market- such
as the fast – food industry – the analyst’s job is considerably
more difficult, perhaps even impossible, using this approach.
• He must attempt to start with those firstart with those firms
that have begun to establish their performance in the
industry.
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MARKET SHARE/PROFIT - MARGIN
APPROACH
• He can then subjectively determine the relative strengths and
weaknesses of the firm’s most pressing competition.
• Assume that the analyst is studying an industry that produces
auxiliary swimming – pool equipment – items such as lounge
chairs, pads, and beach umbrellas
• Industry sales for 20X2 are Rs 10 million, and Danes Co. captured
10% of this market in 20X2 or Rs 1 million in sales
• The analyst forecast a 20% increase in 20X3 sales for the industry
because of a more favourable economic environment climate for
leisure – time products.
• If he expects Danes Co. to increase its market share to 12%
because of an aggressive campaign, what would its projected sales
be?
• Industry sales will be Rs 10 million plus the 20X3 increase of 20%
(Rs 2 million) for a total of Rs 12 million
• Danes
11/21/2019 Co. share is 12%, its sales will
Soumendra Roy be Rs 1.44 million 32
MARKET SHARE/PROFIT - MARGIN
APPROACH
• For a multi – product firm, the analyst multiplies the sales of
each division by the appropriate profit margin to obtain the
various division’s earnings, totals these, and arrives at the
firm’s total earnings.
• The earnings are then divided by the number of common
shares outstanding (after deducting any preferred dividends,
to get EPS
• Then the EPS is multiplied by the forecast P/E ratio to get the
forecast price.
• The price at the beginning of the period is subtracted from
the ending price to calculate the price change for the period.
• Then the annual dividend is added to the price change, and
the sum is divided by the beginning price to calculate the
holding period yield.
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FORECASTING OF REVENUES AND
EXPENSES
• The ROI method skirts the issue of specifically
forecasting various categories of income and
expenses
• Two approaches were followed.
• The first approach is to forecast each and every
revenue and expense item separately.
• The advantage of this approach is that it forces the
analyst to become intimately familiar with the inner
workings of the business - both manufacturing
operations and sales and administrative operations.
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FORECASTING OF REVENUES AND
EXPENSES
• The disadvantage of this method is that for a
company for any size, it is an extremely time –
consuming and often tedious procedure.
• Analyst may become so involved with the detail
that he misses some broader, but very fundamental,
point of interest.

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FORECASTING OF REVENUES AND
EXPENSES
• The second approach is to take a broader – brush
approach to the forecasting problem.
• Here the analyst hopes to overcome the pitfalls of the
earlier method by analyzing the forecasting category
totals rather than all the individual components.
• For example he would look at the sales of the various
divisions as totals, rather than attempting to forecast
the sales of all the individual product lines of each
division
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FORECASTING OF REVENUES AND
EXPENSES
• He would forecast broad categories of expenses such as
administration and sales expenses rather than
attempting to break these down finely into categories
such as salaries, rent and insurance
• The advantage of this approach is that it avoids most of
the problems of the above approach and is more
efficient.
• It is perhaps more accurate per unit of time spent on
the forecast because generally there are over and
under estimates of individual components that may be
misleading when looked at separately
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FORECASTING OF REVENUES AND
EXPENSES
• When the analyst has completed his forecast of
revenues and expenses by using either the specific or
the broad approach, he merely subtracts expenses
from the revenues, and he has his forecast of earnings.
• Then he determines the number of common shares
that will be outstanding in the forecast period, and
divides it into the forecast earnings to EPS.
• Then he multiply this with the P/E ratio to arrive at the
best estimate of the market price.
• Then he would subtract the price at the beginning of
the period, add dividends and divide by the beginning
price to calculate the HPY.
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