Equity Analysis and Valuation

11
CHAPTER

McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved

 Earnings Persistence
Recasting and Adjusting

• Earnings persistence is a key to effective equity

analysis and valuation
• Analyzing earnings persistence is a main analysis
objective
• Attributes of earnings persistence include:
Stability
Predictability
Variability
Trend
Earnings management
Accounting methods Analyze
 Earnings Persistence
Recasting and Adjusting

Two common methods to help

assess earnings persistence:

 Recasting of income
statement

 Adjusting of income
statement
 Earnings Persistence
Recasting and Adjusting
Information for Recasting and Adjusting

 Income statement, including its subdivisions:

Income from continuing operations
Income from discontinued operations
Extraordinary gains and losses
Cumulative effect of changes in accounting
principles
 Other financial statements and notes
 Management commentary in financial statements
 Management’s Discussion and Analysis
 Other: product‑mix changes, technological
innovations, work stoppages, and raw material
constraints
 Earnings Persistence
Recasting and Adjusting

Objectives of Recasting

1. Recast earnings and earnings components so that stable, normal

and continuing elements comprising earnings are distinguished
and separately analyzed from random, erratic, unusual and
nonrecurring elements

2. Recast elements included in current

earnings that should more properly be
included in the operating results of one
or more prior periods

Recasting and adjusting earnings also

aids in determining earning power
 Earnings Persistence
Recasting and Adjusting

General Recasting Procedures

 Income statements of several years (typically at least

five) are recast
 Recast earnings components to yield meaningful
classifications and a relevant format for analysis
 Components can be rearranged, subdivided, and tax
effected
 Total recasted components
must reconcile to reported
net income
 Earnings Persistence
Recasting and Adjusting

Specific Recasting Procedures

• Discretionary expenses are segregated
• Distinct components are segregated (such as equity in income of
unconsolidated subsidiaries) and often reported net of tax
• When components of continuing income are separately
reclassified, their pre-tax amounts along with their tax effects
must be removed
• Income tax disclosures enable one to separate factors that either
reduce or increase taxes such as:
 Deductions—tax credits, capital
gains rates, tax-free
income, lower foreign tax rates
 Additions—additional foreign
taxes, non-tax-deductible
expenses, and state and local
taxes (net of federal tax benefit)
 Earning Persistence
Recasting and Adjusting -- Illustration
Campbell Soup Company
Recast Income Statements ($ mil.)
Item Year 11 Year 10 Year 9 Year 8 Year 7 Year 6
13 Net sales $ 6,204.1 $ 6,205.8 $ 5,672.1 $ 4,868.9 $ 4,490.4 $ 4,286.8
19 Interest income 26.0 17.6 38.3 33.2 29.5 27.4
Total revenue $ 6,230.1 $ 6,223.4 $ 5,710.4 $ 4,902.1 $ 4,519.9 $ 4,314.2
Costs and expenses:
Cost of products sold (see Note 1 below) $ 3,727.1 $ 3,893.5 $ 3,651.8 $ 3,077.8 $ 2,897.8 $ 2,820.5
Marketing and selling expenses (see Note 2 below) 760.8 760.1 605.9 514.2 422.7 363.0
145 Advertising (see Note 2 below) 195.4 220.4 212.9 219.1 203.5 181.4
144 Repairs and maintenance (see Note 1 below) 173.9 180.6 173.9 155.6 148.8 144.0
16 Administrative expenses 306.7 290.7 252.1 232.6 213.9 195.9
17 Research and development expenses 56.3 53.7 47.7 46.9 44.8 42.2
102 Stock pricerelated incentive programs (see Note 3 below)
15.4 (0.1) 17.4 (2.7) — 8.5
20 Foreign exchange adjustment 0.8 3.3 19.3 16.6 4.8 0.7
104 Other, net (see Note 3 below) (3.3) (2.0) (1.4) (4.7) (0.4) (9.0)
162A Depreciation (see Note 1 below) 194.5 184.1 175.9 162.0 139.0 120.8
103 Amortization of intangible and other assets (see Note 3 below)
14.1 16.8 16.4 8.9 5.6 6.0
18 Interest expense 116.2 111.6 94.1 53.9 51.7 56.0
Total costs and expenses $ 5,557.9 $ 5,712.7 $ 5,266.0 $ 4,480.2 $ 4,132.2 $ 3,930.0
23 Earnings before equity in earnings of affiliates & min. interests
$ 672.2 $ 510.7 $ 444.4 $ 421.9 $ 387.7 $ 384.2
24 Equity in earnings of affiliates 2.4 13.5 10.4 6.3 15.1 4.3
25 Minority interests (7.2) (5.7) (5.3) (6.3) (4.7) (3.9)
26 Income before taxes $ 667.4 $ 518.5 $ 449.5 $ 421.9 $ 398.1 $ 384.6
Income taxes at statutory rate* (226.9) (176.3) (152.8) (143.5) (179.1) (176.9)
Income from continuing operations $ 440.5 $ 342.2 $ 296.7 $ 278.4 $ 219.0 $ 207.7
135 State taxes (net of federal tax benefit) (20.0) (6.6) (3.8) (11.8) (8.6) (8.0)
Investment tax credit — — — — 4.4 11.6
137 Nondeductible amortization of intangibles (4.0) (1.6) (1.2) (2.6) (1.4) —
138 Foreign earnings not taxed or taxed at other than statutory rate
2.0 (2.2) (0.2) 3.2 11.1 15.2
139 Other: Tax effects (17.0) (2.2) (0.1) (3.7) 7.5 (4.7)
Alaska Native Corporation transaction — — — — 4.5 —
22 Divestitures, restructuring and unusual charges — (339.1) (343.0) (40.6) — —
Tax effect of divest., restructuring & unusual charges (Note 4)
— 13.9 64.7 13.9 — —
(Continued on next page)
 Earning Persistence
Recasting and Adjusting -- Illustration
Campbell Soup Company
Recast Income Statements ($ mil.)
Item Year 11 Year 10 Year 9 Year 8 Year 7 Year 6
Gain on sale of businesses in (Yr 8) and sub. in Yr 7 — — — 3.1 9.7 —
Loss on sale of exercise equipment subsidiary, net of tax — — — — (1.7) —
LIFO liquidation gain (see Note 1 below) — — — 1.7 2.8 1.4
Income before cumulative effect of accounting change$ 401.5 $ 4.4 $ 13.1 $ 241.6 $ 247.3 $ 223.2
153A Cumulative effect of accounting change for income taxes — — — 32.5 — —
28 Net income as reported $ 401.5 $ 4.4 $ 13.1 $ 274.1 $ 247.3 $ 223.2
14 (Note 1) Cost of products sold $ 4,095.5 $ 4,258.2 $ 4,001.6 $ 3,392.8 $ 3,180.5 $ 3,082.8
144 Less: Repair and maintenance expenses (173.9) (180.6) (173.9) (155.6) (148.8) (144.0)
162A Less: Depreciation(a) (194.5) (184.1) (175.9) (162.0) (139.0) (120.0)
153A Plus: LIFO liquidation gain(b) — — — 2.6 5.1 2.6
$ 3,727.1 $ 3,893.5 $ 3,651.8 $ 3,077.8 $ 2,897.8 $ 2,821.4
15 (Note 2) Marketing and selling expenses $ 956.2 $ 980.5 $ 818.8 $ 733.3 $ 626.2 $ 544.4
145 Less: Advertising (195.4) (20.4) (212.9) (219.1) (203.5) (181.4)
$ 760.8 $ 960.1 $ 605.9 $ 514.2 $ 422.7 $ 363.0
21 (Note 3) Other expenses (income) $ 26.2 $ 14.7 $ 32.4 $ (3.2) $ (9.5) $ 5.5
102 Less: Stock price–related incentive programs (15.4) 0.1 (17.4) 2.7 — (8.5)
103 Less: Amortization of intangible and other assets (14.1) (16.8) (16.4) (8.9) (5.6) (6.0)
Less: Gain on sale of businesses (Yr 8) and sub. (Yr 7) — — — 4.7 14.7 —
104 Other, net $ (3.3) $ (2.0) $ (1.4) $ (4.7) $ (0.4) $ (9.0)
(Note 4) Tax effect of divest, restruc., & unusual charges — $ 115.3(c) $ 116.6(d) $ 13.9 — —
136 Nondeductible divestitures, restructuring, and unusual charges
— (101.4)(e) (51.9)(f) — — —
— $ 13.9 $ 64.7 $ 13.9 — —

*Statutory federal tax rate is 34% in Year 8 through Year 11, 45% in Year 7, and 46% in Year 6.
†
This amount is not disclosed for Year 6.
(a)
We assume most depreciation is included in cost of products sold.
(b)
LIFO liquidation gain before tax. For example, for Year 8 this is $2.58 million, computed as $1.7/(1  0.34).
(c)
$339.1 22  0.34 = $115.3.
(d)
$343.0 22  0.34 = $116.6
(e)
$179.4 26  0.565 136 = $101.4.
(f)
$106.5 26  0.487 136 = $51.9.
 Earnings Persistence
Recasting and Adjusting -- Illustration

Objective of Adjusting

Assign earnings components to periods where they

most properly belong

Note: Uses data from recast income statements and

any other relevant information
 Earnings Persistence
Recasting and Adjusting
General Adjusting Procedures
All earnings components must be considered
When a component is excluded from the period when
reported, then
1. Shift it (net of tax) to the operating results of one or
more prior periods, or
2. Spread (average) it over earnings for the period
under analysis

Note: Only spread items over prior

earnings when they cannot be
identified with specific periods
 Earnings Persistence
Recasting and Adjusting
Specific (Typical) Adjusting Procedures
• Assign extraordinary and unusual items (net of tax) to
applicable years
• Tax benefit of carryforwards normally moved to the loss year
• Costs or benefits from lawsuit settlements moved to
relevant prior years
• Gains and losses from disposals of discontinued
operations usually relate to operating results of several prior
years
• Changes in accounting principles or
estimates yield adjustments to all
years under analysis to a comparable
basis—redistribute “cumulative effect”
to the relevant prior years
• Normally include items that increase or decrease equity
 Earnings Persistence
Recasting and Adjusting
Campbell Soup Company
Adjusted Income Statements ($ mil.)
Year 11 Year 10 Year 9 Year 8 Year 7 Year 6 Total
Net income as reported $ 401.5 $ 4.4 $ 13.1 $ 274.1 $ 247.3 $223.2 $ 1,163.6
Divestitures, restructuring & unusual charges
339.1 343.0 40.6
Tax effect of divestitures, restructuring, etc.
(13.9) (64.7) (13.9)
Gain on sale of businesses (Yr 8) and sale of
subsidiary (Yr 7), net of tax (3.1) (9.7)
Loss on sale of exercise equipment subsidiary 1.7
ANC transaction (4.5)
LIFO liquidation gain (1.7) (2.8) (1.4)
Cumulative effect of change in acctg for taxes (32.5)
Adjusted net income $ 401.5 $329.6 $291.4 $ 263.5 $ 232.0 $221.8
Total net income for the period $ 1,739.8
Average earnings for the period $
289.97
 Earnings Persistence
Determinants of Persistence

Earnings persistence determined by many

factors including:

Earnings variability
Earnings trend
Earnings stability
Earnings predictability
Earnings Management
Management Incentives

Note: Assess earnings persistence over both the

business cycle and the long term
 Earnings Persistence
Measuring Persistence

Earnings variability can be measured:

1. Standard variability measures

2. Average earnings--typically using 5 to 10

years of data

3. Minimum earnings--typically selected from

the most recent business cycle, reflecting a
worst-case scenario
 Earnings Persistence
Measuring Persistence

Earnings Trend can

be measured:
1. Statistical methods

2. Trend statements
(such as Index numbers)
 Earnings Persistence
Measuring Persistence

Earnings Management is reflected as follows:

• Changes in accounting
methods or assumptions
• Offsetting extraordinary
/unusual gains and
losses
• Big baths
• Write-downs
• Timing revenue and expense recognition
• Aggressive accounting applications
 Earnings Persistence
Measuring Persistence
Management Incentives affecting persistence include:

 Personal objectives and interests

 Companies in distress
 Prosperous companies—preserving
hard‑earned reputations
 Compensation plans
 Accounting-based incentives and constraints
 Analysts targets
Earnings Persistence
Measuring Persistence

Earnings persistence of
components depends on key
attributes

Recurring vs Non-recurring
Operating vs Non-operating

Key application of these

attributes is the reporting of

Extraordinary vs Non-
extraordinary
Earnings Persistence
Measuring Persistence
Analyzing and Interpreting
Extraordinary Items

1. Determine whether an item

is extraordinary (less
persistent) or not
2. Assessing whether an item
is unusual, non-operating,
or non-recurring
3. Determine adjustments
necessary given
assessment of persistence