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Valuation Issues

Price-Earnings Ratios as Forecasters of Returns, Shiller, 1996
The simplest and most widely used ratio used to predict the market is the price-earnings ratio. The use of one-year's earnings in the price-earnings ratio is an unfortunate convention, recommended by tradition and convenience rather than any logic. As long ago as 1934, Benjamin Graham and David Dodd, in their now famous textbook Security Analysis, said that for purposes of examining such ratios, one should use an average of earnings of "not less than five years, preferably seven or ten years."

Company Valuation Methods: The Most Common Errors in Valuations, Fernandez, 2004
Description of the four main groups comprising the most widely used company valuation methods: balance sheet-based methods, income statement-based methods, mixed methods, and cash flow discounting-based methods.
Toolbox: DCF Valuation Model (xls format)
M&M on Valuation, Mauboussin, Legg Mason, 2005
Price-earnings (P/E) multiples are by far the most popular valuation metric on Wall Street. Still, most investors don't have a clear sense of what a price-earnings multiple implies about a company's future financial performance, or how a company's price-earnings multiple will likely change over time. In this short piece, we offer an analytical bridge between earnings multiples (and multiples of any kind) and sound economic reasoning (The role of growth in valuation is completely contingent on a firmís return on capital). (see also Buffett on Growth Vs. ROIC, 1992, 2000)
Common Errors in DCF Models, Michael Mauboussin, Legg Mason, 2006
First principles tell us the right way to value a business is to estimate the present value of the future cash flows. While most Wall Street professionals learned about discounted cash flow (DCF) models in school, in practice the models they build and rely on are deeply flawed. Not surprisingly, the confidence level in these DCF models is very low. This faint confidence is not an indictment of analytical approach but rather of analytical methods. Here's our list of the most frequent errors we see in DCF models. We recommend you check your models, or the models you see, versus this list. If one or more of the errors appear, the model will do little to inform your business judgment.
Activity-Based Valuation of Bank Holding Companies, Calomiris and Nissim, 2007
Despite their importance in the stock market, there is no existing satisfactory valuation approach for banks comparable to the discounted cash flow approach used for nonfinancial firms. This study develops and tests a valuation model for Bank Holding Companies, which is based on the cross-sectional relationship between the market-to-book ratio and proxies for the value generated by various bank activities and bank attributes.
Accounting for Intangible Assets: There Is Also an Income Statement, Stephen Penman, 2009
When Benjamin Graham was first developing the principles of fundamental analysis some 80 years ago, the bulk of a firmís value came from its tangible assets, the physical materials the firm was composed of: its factory, its inventory on hand, its fleet of delivery trucks. In the ensuing shift away from manufacturing, a firmís assets are increasingly in its entrepreneurial ideas, brands and research and development. Distribution systems have replaced delivery trucks as the main source of value. Professor Penman provides evidence that income statements are the best source for deciphering the value that intangible assets bring to the bottom line.
Returns Issues
Death, Taxes, and Reversion to the Mean; ROIC Patterns: Luck, Persistence, and What to Do About It; Michael Mauboussin, Legg Mason, 2007
Analysts modeling future corporate financial performance should use past ROIC patterns, including a strong tendency toward mean reversion, as an appropriate reference class but rarely do. Some companies do post persistently high or low returns beyond what chance dictates. But the ROIC data incorporate much more randomness than most analysts realize.
ROIC Patterns and Shareholder Returns, Michael Mauboussin, Legg Mason, 2008
Does an understanding of ROIC patterns help with stock picking? This piece addresses that question and finds that there is a huge payoff for correctly anticipating changes in ROIC. Unfortunately, there appears to be no simple, systematic way to predict future, unanticipated ROICs.
Return on Invested Capital (ROIC) and Enterprise Value/Invested Capital (EV/IC) Mechanics
Notwithstanding the fascination of Wall Street with EPS growth rates, there is neither a statistical relationship nor a common sensible relationship between EPS growth rates and stock prices. Over an intermediate- to long-term investment horizon, an investor's primary focus should be value creation - how much economic value has been and will be created from the funds invested in and deployed by a company - and Return On Invested Capital (ROIC) is a superior quantitative touchstone with which to assess value creation.
Same-Store Sales and ROIC, Edward Lampert, Chairman of Sears, 2005
The discussion of profitable growth brings me to the issue of same-store sales, and why I believe it is not always the best measure of a retailer's performance. Many analysts and commentators focus on same-store sales (SSS) as the most important statistic in retail, almost to the exclusion of any other statistic (even above profit). I consider SSS to be an important metric for retail performance, but one that is vastly overrated.
The Level and Persistence of Growth Rates, Chan, Karceski, Lakonishok, 2001
Expected long-term earnings growth rates are crucial inputs to valuation models and for cost of capital estimates. The paper analyzes historical long-term growth rates across a broad cross-section of stocks using several operating performance indicators. We test whether growth persists, and whether it is forecastable. Cases of very high growth have occurred, but are relatively rare. There is scant persistence in growth beyond chance, and limited ability to identify firms with high future long-term growth. IBES forecasts are too optimistic, and have low predictive power for long-term growth. Regressions using a variety of predictors confirm the low predictability in growth. Valuations that assume persistently high growth over prolonged periods rest on shaky foundations.
Cash Flow Issues
How Some Companies Abuse Cash Flow
Cash flow is often considered to be one of the cleaner figures in the financial statements. Companies have a way to inflate or artificially "pump up" their earnings - it's called cash flow manipulation. Here we look at how it's done, so you are better prepared to identify it.
Calculating Sustainable Cash Flow: A Study of the S&P 100 Using 2002 Data
Operating cash flow in 2000, 2001, and 2002 for the S&P 100 was adjusted to remove items that may provide misleading signals of operating performance. Nine adjustments were made, separated into three categories - (1) where flexibility in GAAP for cash flow reporting was used to alter cash flow, (2) where the requirements of GAAP result in misleading operating cash flow amounts, and (3) where nonrecurring operating cash receipts and payments lead to operating cash flow that is non-sustainable. Adjustments resulted in an average reduction in operating cash flow in 2000 of 5% and an average increase in operating cash flow in 2001 of 3.1% and in 2002 of 2.9%. Certain individual company adjustments were quite significant, resulting in some cases, in much more operating cash flow than actually reported, and in other cases, much less.
The Impact of Securitizations of Customer-Related Receivables on Cash Flow and Leverage: Implications for Financial Analysis
Understanding the extent to which transactions create recurring cash flow is vital to investment and credit analysis. In addition to cash flow, the extent to which a firm uses borrowed funds or financial leverage to finance its operations impacts its overall financial health. In this research report we look at the financial statement effects of customer receivable securitization transactions and their effects on analysis from two points of view - their impact on cash flow and financial leverage. The report includes a discussion of why companies choose to use the securitization tool, how they use it, and what goals they achieve. Our findings indicate that securitizations can have significant effects on a firm's apparent ability to generate sustainable cash flow and on its use of debt financing. (see also Fitch's analysis of accounting issues in Y2006, p.13)
A Re-examination of Cash Flow Reporting in the Presence of Overdrafts
Numerous companies maintain cash overdraft balances. These seemingly innocuous accounts can have material effects on reported amounts of cash and operating cash flow. In this report, we survey reporting practices for overdrafts and draw attention to cases where analysts may be misled.
The Inclusion of Short-term Investments in Operating Cash Flow
Companies use short-term investments as a vehicle to park surplus cash. When such investments are classified as trading securities, cash used in their purchase and proceeds provided from their sale are included in operating cash flow. Classifying cash flow from trading securities as operating by non-financial companies can mislead users of financial statements regarding a company's ability to generate cash flow from sustainable sources. In this report we survey the practices of non-financial companies regarding their inclusion of cash provided (used) by trading securities in operating cash flow.
Cash-Flow Reporting Practices for Customer-Related Notes Receivable
While there is general agreement on the reporting treatment for changes in accounts receivable in the computation of operating cash flow, reporting practices differ when customers are offered more formal repayment arrangements, for example, in the form of notes receivable. Some companies include such customer-related receivables in the computation of operating cash flow, while others report them in the investing section. Reporting such receivables as investing cash flow results in higher operating cash flow when the balance of such receivables is rising. As a result, the potential exists for a misimpression of a company's operating performance. In this study we highlight cash-flow reporting practices for such customer-related receivables. 2005 Update
Non-cash Investing and Financing Activities and Free Cash Flow
Items of property, plant and equipment are often acquired through non-cash investing and financing activities. In these transactions, equipment-purchase financing is provided at the time of purchase. While such transactions increase a company's productive capacity, they are not reported as capital expenditures in the statement of cash flows. Accordingly, free cash flow calculated based on capital expenditures reported in the statement of cash flows will often be overstated when assets are acquired through such non-cash transactions. In this report we look at a series of non-cash investing and financing transactions and assess their effects on calculated free cash flow.
Camouflaged Earnings Management, Itay Kama, Nahum Melumad, 2010
In recent years, there has been increased scrutiny of financial reporting and greater analysts and investors attention to indicators of potential earnings management, in particular, to cash and accruals relative to earnings and revenues. We assert that, in response, firms have increased their focus on cash management aimed at aligning these variables, which has resulted in camouflaged earnings management (An example of an AC cash management transaction is the factoring of receivables (also securitization and discounting)). Analytically, we develop indicators of camouflaged earnings management and use them empirically to test whether the alignment of cash and earnings has intensified following the legislation of the Sarbanes-Oxley Act. The empirical results are all in line with, and reinforce, our assertion..
The Detection of Earnings Manipulation, Beneish, 1999
This paper presents a model to distinguish manipulated from non-manipulated reporting. I define earnings manipulation as an instance where management violates Generally Accepted Accounting Principles (GAAP) in order to beneficially represent the firmís financial performance. I use financial statement data to construct variables that seek to capture the effects of manipulation and preconditions that may prompt firms to engage in such activity. Since manipulation typically consists of an artificial inflation of revenues or deflation of expenses, I find that variables that take into account the simultaneous bloating in asset accounts have predictive content. I also find that sales growth has discriminatory power since the primary characteristic of sample manipulators is that they have high growth prior to periods during which manipulation is in force. I find that sample manipulators typically overstate earnings by recording fictitious, unearned, or uncertain revenue, recording fictitious inventory, or improperly capitalizing costs. The evidence indicates that the probability of manipulation increases with: (i) unusual increases in receivables, (ii) deteriorating gross margins, (iii) decreasing asset quality (as defined later), (iv) sales growth, and (v) increasing accruals.
Toolbox: Beneish MScore (xls format)
Who broke the story?, Pizzani, 2004
A look at 10 of the worst U.S. accounting scandals, and who brought them to light. This is a two-part series (part one, part two) that examines some of the baddest "bad boys" of the world of corporate accounting scandals - who actually broke the story, what the company executives did and what transgressions caused their house of cards to tumble.

Value Destruction and Financial Reporting Decisions, Graham, Harvey and Rajgopal, 2006
We document a willingness to routinely sacrifice shareholder value to meet earnings expectations or to smooth reported earnings. While much previous research has focused on the use of accounting for earnings management, such as accrual decisions, we provide new evidence of the widespread use of 'real' earnings management, which might include deferring a valuable project or slashing research and development expenditures.

The Use of Special Items to Inflate Core Earnings, McVay, 2004
Prior accounting research has documented two main methods of earnings management. The most commonly-studied method of earnings management is accrual management. Essentially, a manager can borrow earnings from future periods, through the acceleration of revenues or deceleration of expenses, in order to improve current earnings. Managers can also use accrual management to overstate current period expenses (i.e. take a 'big bath'). The overstatement can be used to offset future operating expenses or reversed into income in future periods. A second type of earnings management can occur through the manipulation of real activities, such as providing price discounts to increase sales, cutting discretionary expenditures such as R&D and structuring other transactions, such as debt-to-equity swaps or asset sales to manage earnings. This paper investigates a third method of earnings management, the classification of core operating expenses as special within the income statement. The misclassification of expenses within the income statement, from core to transitory, offers a unique earnings management tool. This misclassification can influence investors' perceptions of firm performance and firm value. In this paper I document the shifting of operating expenses, such as cost of goods sold, to special items in the year the special item is reported.

In-Process R&D: To Capitalize or Expense?, Deng and Lev, 2004
The FASB recently proposed the capitalization of acquired in-process R&D costs to replace the current practice of expensing this item. This proposal will likely be strongly opposed by corporate executives. The consequences of the immediate expensing of IPRD and the means for managing (manipulating) earnings they create attracted the media attention. As indicated by the above example of Lotus' acquisition, the higher the valuation of IPRD - a very soft and subjective value - the lower is the residual value of goodwill, and in turn the lower the hits to future earnings from goodwill amortization. The immediate expensing of IPRD also obviated the future amortization of this asset had it been capitalized, further contributing to future reported earnings. Finally, the immediate expensing of IPRD substantially reduced the asset and equity bases of the acquiring company, thereby inflating widely used profitability measures, such as the return on assets or equity.
Expensing Options 2006-
[Fitch] "Debate over whether stock options should be expensed has finally come to an end, but valuation issues remain, and identifying related cash outflow is a challenge. Fitch believes that the real cost of employee options is not the amount that will be reported in the income statement; rather, it is the propensity of companies to offset exercised employee options with share repurchase programs and the associated cash outlay".
Stock Options: Old Game, New Tricks, BusinessWeekOnline, 2005
After losing a decade-long battle with regulators, U.S. companies will finally be required to deduct the cost of options from their earnings starting in fiscal 2006, which for most means the quarter beginning in January. Companies are finding ways to lower options costs despite stricter rules. One gambit is tinkering with the formulas used to assign options a value, which can result in lower costs. A more popular strategy has been to accelerate the vesting of options.
Two Decades of Overstated Corporate Earnings, The Surprisingly Large Exaggeration of Aggregate Profits, The Levy Forecasting Center, 2001
Over the past 10 years, the financial media have spotlighted case after case of earnings misrepresentation and reported the SEC's and other authorities' efforts to reign in misleading practices. Yet the focus of public concern remained on finding the bad apples; little attention was paid to the quality of the entire bushel. People are starting to ask, "Just how widespread and serious is the overstatement of aggregate corporate profits?" The answer is startling. The macroeconomic evidence indicates that corporate operating earnings for the Standard & Poors' 500 have been significantly exaggerated for nearly two decades - by about 10 percent or more early in this period and by over 20 percent in recent years. These figures are conservative - the magnitude of the overstatement may be considerably larger.