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HLEN-09-1211-FM.qxd:. 6/30/10 3:21 PM Page xxvii Step 2: Projecting Operating Expenses 800 Projecting Cost of Goods Sold 801 Projecting Selling, General, and Administrative Expenses 802 Projecting Other Operating Expenses 803 Projecting Nonrecurring Operating Gains and Losses 804 Step 3: Projecting Operating Assets and Liabilities on the Balance Sheet 804 Projecting Cash 807 Operating Asset and Liability Forecasting Techniques 811 Projecting Marketable Securities 812 Projecting Accounts Receivable 813 Projecting Inventories 814 Projecting Prepaid Expenses and Other Current Assets 814 Projecting Investments in Noncontrolled Affiliates 815 Projecting Property, Plant, and Equipment 815 Projecting Amortizable Intangible Assets 818 Projecting Goodwill and Nonamortizable Intangible Assets 818 Projecting Other Noncurrent Assets 819 Projecting Assets That Vary as a Percentage of Total Assets 819 Projecting Accounts Payable 820 Projecting Other Current Accrued Liabilities 820 Projecting Current Liabilities: Income Taxes Payable 821 Projecting Other Noncurrent Liabilities 821 Projecting Deferred Income Taxes 822 Step 4: Projecting Financial Assets, Financial Leverage, Common Equity Capital, and Financial Income Items 822 Projecting Financial Assets 823 Projecting Short-Term Debt and Long-Term Debt 823 Projecting Interest Expense 824 Projecting Interest Income 825 Projecting Bottling Equity Income 826 Projecting Preferred Stock and Minority Interest 827 Projecting Common Stock and Capital in Excess of Par Value 827 Projecting Treasury Stock 827 Projecting Accumulated Other Comprehensive Loss 829 Step 5: Projecting Nonrecurring Items, Provisions for Income Tax, and Changes in Retained Earnings 829 Projecting Nonrecurring Items 830 Projecting Provisions for Income Taxes 830 Net Income 830 Retained Earnings 831 Step 6: Balancing the Balance Sheet 832 Balancing PepsiCo’s Balance Sheets 832 Closing the Loop: Solving for Co-determined Variables 834 Step 7: Projecting the Statement of Cash Flows 835 Tips for Forecasting Statements of Cash Flows 835 Specific Steps for Forecasting Implied Statements of Cash Flows 836 Shortcut Approaches to Forecasting 840 Projected Sales and Income Approach 841 Projected Total Assets Approach 841 Analyzing Projected Financial Statements 843 Contents xxvii HLEN-09-1211-FM.qxd:. 6/30/10 3:21 PM Page xxviii Sensitivity Analysis and Reactions to Announcements Summary Questions and Exercises Problems and Cases Integrative Case 10.1 Starbucks Case 10.2 Massachusetts Stove Company: Analyzing Strategic Options Chapter 11 Risk-Adjusted Expected Rates of Return and the Dividends Valuation Approach 846 847 848 849 862 875 884 Introduction and Overview Equivalence among Dividends, Cash Flows, and Earnings Valuation Risk-Adjusted Expected Rates of Return Cost of Common Equity Capital 889 Adjusting Market Equity Beta to Reflect a New Capital Structure 894 Evaluating the Use of the CAPM to Measure the Cost of Equity Capital 895 Cost of Debt Capital 896 Cost of Preferred Equity Capital 897 Computing the Weighted Average Cost of Capital 897 Rationale for Dividends-Based Valuation Dividends-Based Valuation Concepts 902 The Dividends Valuation Model Implementing the Dividends Valuation Model Measuring Dividends 907 Selecting a Forecast Horizon 909 Continuing Value of Future Dividends 911 Using the Dividends Valuation Model to Value PepsiCo 915 Sensitivity Analysis and Investment Decision Making 918 Evaluation of the Dividends Valuation Method 920 Summary Questions and Exercises Problems and Cases Integrative Case 11.1 Starbucks xxviii Valuation: Cash-Flow-Based Approaches 928 Introduction and Overview Rationale for Cash-Flow-Based Valuation Free-Cash-Flows-Based Valuation Concepts Risk, Discount Rates, and the Cost of Capital 932 Free Cash Flows Valuation Examples for a Single-Asset Firm 933 Cash Flows to the Investor versus Cash Flows to the Firm 935 Nominal versus Real Cash Flows 937 Pretax versus After-Tax Free Cash Flows 938 Selecting a Forecast Horizon 938 Computing Continuing Value of Future Free Cash Flows 939 Chapter 12 884 887 888 928 930 931 Contents 901 905 907 921 921 922 926 HLEN-09-1211-FM.qxd:. 6/30/10 3:21 PM Page xxix Measuring Periodic Free Cash Flows A Framework for Free Cash Flows 943 Free Cash Flows Measurement 945 Cash-Flow-Based Valuation Models Valuation Models for Free Cash Flows for Common Equity Shareholders 955 Valuation Models for Free Cash Flows for All Debt and Equity Capital Stakeholders 956 Free Cash Flows Valuation of PepsiCo PepsiCo Discount Rates 958 Computing Free Cash Flows for PepsiCo 959 PepsiCo’s Free Cash Flows to All Debt and Equity Capital Stakeholders 959 PepsiCo’s Free Cash Flows to Common Equity 962 Valuation of PepsiCo Using Free Cash Flows to Common Equity Shareholders 963 Valuation of PepsiCo Using Free Cash Flows to All Debt and Equity Capital Stakeholders 964 Sensitivity Analysis and Investment Decision Making 967 Evaluation of the Free Cash Flows Valuation Method Summary Questions and Exercises Problems and Cases Integrative Case 12.1 Starbucks Case 12.2 Holmes Corporation: LBO Valuation Chapter 13 Valuation: Earnings-Based Approaches 943 954 957 971 971 971 972 988 990 1004 Introduction and Overview Rationale for Earnings-Based Valuation Earnings-Based Valuation: Practical Advantages and Concerns Theoretical and Conceptual Foundations for Residual Income Valuation Intuition for Residual Income Measurement and Valuation 1013 Illustrations of Residual Income Measurement and Valuation 1014 Residual Income Valuation Model with Finite Horizon Earnings Forecasts and Continuing Value Computation Coaching Tip: Avoid This Crucial But Common Mistake 1019 Valuation of Pepsico Using the Residual Income Model Discount Rates for Residual Income 1020 Pepsico’s Book Value of Equity and Residual Income 1020 Discounting Pepsico’s Residual Income to Present Value 1022 Computing Pepsico’s Common Equity Share Value 1022 Sensitivity Analysis and Investment Decision Making 1025 Residual Income Model Implementation Issues Dirty Surplus Accounting 1025 Common Stock Transactions 1027 Consistency in Residual Income, Dividends, and Free Cash Flow Value Estimates Contents 1004 1007 1009 1011 1017 1019 1025 1029 xxix HLEN-09-1211-FM.qxd:. 6/30/10 3:21 PM Page xxx Summary Comments on Valuation Questions and Exercises Problems and Cases Integrative Case 12.1 Starbucks Chapter 14 Valuation: Market-Based Approaches 1031 1031 1032 1039 1041 Introduction and Overview 1042 Market Multiples of Accounting Numbers 1044 Market-to-Book and Value-to-Book Ratios 1045 A Theoretical Model of the Value-to-Book Ratio 1045 The Value-to-Book Model with Finite Horizon Earnings Forecasts and Continuing Value Computation 1049 Application of the Value-to-Book-Model to PepsiCo 1051 Reasons Why VB Ratios and MB Ratios May Differ From 1 1054 Empirical Data on MB Ratios 1056 Empirical Research Results on the Predictive Power of MB Ratios 1056 Price-Earnings and Value-Earnings Ratios 1059 A Model for the Value-Earnings Ratio 1059 Price-Earnings Ratios 1060 Summary of Value-Earnings and Price-Earnings Ratios 1071 Using Market Multiples of Comparable Firms 1072 Price Differentials 1072 Computing PDIFF for PepsiCo 1074 Reverse Engineering 1075 Reverse-Engineering PepsiCo’s Stock Price 1076 The Relevance of Academic Research for the Work of the Security Analyst 1077 Creating Relevant Academic Research Results 1078 What Does “Capital Market Efficiency” Really Mean? 1079 Striking Evidence on the Degree of Market Efficiency and Inefficiency with Respect to Earnings 1080 Striking Evidence on the Use of Valuation Models to Form Portfolios 1082 Summary 1084 Questions and Exercises 1084 Problems and Cases 1086 Integrative Case 14.1 Starbucks 1094 Appendix A Financial Statements and Notes for PepsiCo, Inc. and Subsidiaries 1097 Management’s Discussion and Analysis for PepsiCo, Inc. and Subsidiaries 1129 Appendix C Financial Statement Analysis Package (FSAP) 1159 Appendix D Financial Statement Ratios: Descriptive Statistics by Industry and by Year 1197 Appendix B Index xxx 1247 Contents HLEN-09-1211-001.qxd:. 6/30/10 2:58 PM Page 1 Chapter 1 Overview of Financial Reporting, Financial Statement Analysis, and Valuation Learning Objectives 1 Understand the six-step analytical framework that is the logical structure for financial statement analysis and valuation, and establishes the foundation for this book. This framework enables the analyst to link the economic characteristics and strategies of a firm, its financial statements and notes, assessments of its current and forecasted profitability and risk, and its market value. 2 Apply three tools for assessing the economic characteristics and dynamics that drive competition in an industry: (a) value chain analysis, (b) Porter’s five forces framework, and (c) an economic attributes framework. 3 Review the purpose, underlying concepts, and format of the balance sheet, income statement, and statement of cash flows. 4 Become familiar with PepsiCo, the firm analyzed throughout the book, obtaining an overview of its economics, strategy, and financial statements. 5 Examine the provisions of the Sarbanes-Oxley Act of 2002 that relate to financial statement information. 6 Obtain an introduction to the tools used to analyze a firm’s profitability and risk, including financial ratios, common-size financial statements, and percentage change financial statements. 7 Obtain an overview of how to use financial statement information to forecast the future business activities of a firm and to value a firm. 8 Examine the role of financial statement analysis in an efficient capital market. 9 Review sources of financial information available for publicly held firms. 10 Obtain guidance and direction for conducting a financial statement analysis project (Appendix 1.1). T he principal activity of security analysts is to value firms. Security analysts collect and analyze a wide array of information from financial statements and other sources to evaluate a firm’s current and past performance and to predict its future performance. Then they use the expected future performance to measure the value of the firm’s shares. Comparisons of the analysts’ estimates of the firm’s share value with the market price for the shares provide the basis for making good investment decisions.