The Japanese Association of Management Accounting NII-Electronic Library Service

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The Japanese Association of Management Accounting

NII-Electronic Library Service

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The 　Japanese 　Assooiation 　^of 　Management 　Aooounting

日本管理会計学会誌

管理会計学2002年第10巻第2_号

論壇

TyingValuation　to　Performance　with 　Financial　Analysis Stephen^H ．Penman

Keywords：accrual

performance

accounting　^valuation 　^mOdels ^；　ânalysis 　ôf　performance^，　âccounting　for

Keynote　^address ^to　theAnnual　 Conference Accounting_，　Sendai，October　28，200L ^pf

　the　Japanese　Association　of　Management

Submit陀d1Novelnbe^匚’₂₀₀₁．

Agc_司pted13Nove^脳^皿^）^er　200L

GTad』ateSchQolofB ひsiness，Columbia^University

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1.Introduction

Thetitleof my address toyou presumes^that^the^valuation ^of ^a firmshould be tiedtothe

firm'sperfbrmance.^This ^statement is^surely non-controversial. Investorsinyestina firmteget^a

return, toadd value totheirinvestment.Firms _conduct theiroperations todeliverthatvaiue, So the value ofa firmisassessed by theperfbrmance^ofthe firmsinadding value. Financialanaly$is is

the method of ascertaining value added, of observing performance,

I^might ^well havetitledmy address as a matter of tying perfbrmancetovaiuation rather than tying valuation toperfbrmance.To encourage managers to make decisionsthatadd value,

inyestorsneed to be sure that those managers are rewarded on the basisof appropriate

perfbrmance^measures. Financialanalysis developsthe appropriate perfbrmance^measures ^that

motlvate managers topursue^tnvestors; ^lnterests.

Financialânalysis, ^then, isbotha .method fbr^valuation ând â ^method fbrperformance

evaluation, The analysis fbrbothislikelytobethesame, fbrvaiuation istiedtoperfbrmance^and perfbrmance^to^valuation. The question^we ^wish ^to ^raise ^today ishow we designa souqd analysis

fbrthesepurposes.

My discussionisfromthepoint^ofview ^ofthe shareholder - thelegalowner ofthefirm^--

who wishes togain^value ^from^the^firm^and ^so ^wants ^management ^to^serve ^thatinterest.Ifyou see thefirmasserving other interests^- employees, banks,or even thenation - thistalkwill not be of much interest.

One ^cannot ôverstate ^the importanceôf ^sound financialahalysis and, with it,seund accounting. Without^sound financialânalysis, investorsbuying^shares do^not ûnderstand ^what they are buying.Sound financialana!ysis challenges speculative beliefsthatleadto stock market

bubbles,liketheone recently experienced intheUnitesStatesand earlier inJapan.From society's

point^of ^view, bubbles^- and theirinevitablebursting^- are very damagingtothe economy, as we

inthe UnitedStatesâre ^now ^learningând âs _you ^jn ^Japan ^have âlso ^learnt.Perfbrmance

measurement ^and ^sound ^valuations based on perfbrmance^are imperativesforwell functioning

capital markets and well functioningeconomies.

BefbreIbegin,^one point^has ^to ^be appreciated. A shareholder perspective^requires ^that gQed performanceme,asureme.ptgohandinband.withgood ^corporate gqvernancg.Fqr,^without ^the^･ governance ^mechanisms to protect^and promote shareholder interests,corporatien.s, lose

accountability, orpursue^theinterestsofmanagement rather thanthoseofshareholders.

My talkisintwo parts,ône ôn ^valuation ând ône ôn theanalysis ofperformance.

2.Valllation

Academics buildmodels toattack practical^problems. Models âre â'fbrmal^way ôf laying

out thethinkinginâ _problem.But ^models ^not ônly convey concepts, they also directhow tocarry out the taskat hand.Valuationmodels embody thethinkingunderlying the^taskôfvatuing a firm.

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The JapaneseAssociation of Management Accounting

1ts'ingX･'atuationte Pertb"nancewith FinancialAiiai>'sis

Valuationmodels also directhow to do financialanalysls. S6, letus' firstask what is^an

appropriate valuation model to guide^the ^analysis ^of perfbrmance.We will think interms of valuing theequity of firms,theshares heldbycommon shareholders.

Cash lillowAnalysis

^The ^valuation ôf â ^share (orâny investment)isbased on the expected return to the

investment.So valuation inevitablyinvolvesfbrecasting.A valuation model hastwo elements.

First,itspecifies what isto befbrecastedtomeasure the return･to an investment^and, secopd, it

explains how theforecastisconverted intoa vatuation. Considerthestandard model forvaluing a

five-yearbond:

Valueof a Bond ⁼ PresentValue^of ExpectedCash Flows

v2=CE.C?.CP.cp.cp

PD

Here CF iscash fiowsand p hereistherequired rate of return on the bond_plus one. The "D"

indicatesthe value is^for^debt(as^a bond^'is commonly identified).This ^model embodies the thinkingbehind debtvaluation: thevalue ofthe debtisbaseden its^expected ^cash fiows(in^form

of coupon paymentsând repayment). Italso directsthetaskof valuing thedebt.Themodel states that,to value the debt,one forecastscash flows(CF)ând ^then ^converts ^those ^fbrecasts^to â

valuation by discountingthem atthe^requjred payoff'^rate ^on ^thedebt,pD,^thatisbased on the risk ofnot receiving delivery^ofthe ^cash flows(the^default^risk),

Finns issueboth debt ^and ^equity shares, but itisthe valuation of the equity that

shareholders are particularly^concerned ^with. We ^could think_about appropriating themodel forthe

valuation of debtfbrthevaluation of equity. Thatis,fbrecast^cash flowsfrom holdingthe equ,ity and discounttheforecasted^cash flowsata discountratethatrefiectstherisk.Dividends(d)^are ^the

cash fiowsfromholdingequities, and thecash fiowmodel thatsubstitutes d'ividendsforinterest

payments isthedividenddiscountmodel:

Valueof equity ⁼ PresentValueofExpected Dividends

^.ff⁼ gL,.s, +g, +

g,

^+---

PE PE

PE

You'll^notice that,unlike the five-yearbond, the forecastingperiodforthe equity continues-

indefinite'ly;firmsare going^concerns. Thisfeaturepresentsâ problem^thatisthemain determinant indevelopingâ ^valuation ^model forêquities: tobepractical,^we don'twant the forecasting_period tobetoo longand, fbrperformancemeasurement, ^we don'twant to wait too longto observe something on which tojudgeperfbrmance.Firms ^may ^not pay dividendsfbrâ ^very longtime.

Indeed,rnany successful firrns(like^Microsoft)^do ^not pay dividends.Imagine ^rewarding Microsoft'smanagement ôn .thebasisofthe dividendstheypay?^The ^truthisthatdividends,inthe short run, hayelittletodowith thegenerationôf ^value; ^theyâre just^thedistributionof ^value, and

firmsmay choose to distributelittle.Thisobservation simply restates the Nobel prize-winning

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dividendirrelevanceideaofMiiler and Medigliani:while theabilitytopay dividendsinthe long

run isof paramou,nt importance,the amount of dividendspaidintheshort run isirrelevant,We havea paradox:dividendsare thereturns to holdingshares, butfbreeastingdividendsisnot a practical^method for^valuing ^shares.

^Thisparadoxiscircumvented by lookinginsidethe firmfbrthevalue generation,^We ^can

carry over the cash flowforecastingideatoforecastingthenet cash flowstobe_generatedbythe

firm,The^net cash flowthata firmgenerates^- itsfreecash fiow^--isthedifflerencebetweencash

fiowfromoperations and cash spent on investment.The discounted^cash flow^model, _popularon

Wall Streetfbrmany years,^expresses ^theidea:

Value^of Equity⁼⁼ ^Present^ValueofExpected FreeCashFlow^- ValueofFirm's Debt

Discountingforecastedfreecash fiowsgives^the^value ^ofthe firm,and thevalue ofthe equity is thatvalue minus thevalue ofthe debtholders'cjaim on thefirm.

Butthereissomething perverse^about ^thisidea.Considerthefbllowingnumbers fbrHome Depot Inc.,the successful U.S.warehouse retailerofhome improvement products,from1997^- 2001 (in^millions ofdoilars). Freecash flowisalways thediffi:rencebetweenoperating income

and the change in^net operating assets over a period,^so ^the^numbers foroperating incomeand net operating assets are also given,

Home DepotInc.

Vlaar 1997 1998 1999 2000 2001

Operatingearnings 941. 1,l29 l,585 2,323 2,565

Book value, operating assets 6,722 8,333 10,248 12,993 16,419

Freecash fiow (149) (482) (330) (422) (861)

Suppose you ^were ^standing ât theend of fiscalyear^1996, âttempting ^to^make â forecast,

and were offered a set･of forecastednumbers forthe fiveforwardyears,1997-2001,^with ^the guarantee^that^these^numbers ^would ^be^the^actual ^reported ^numbers. ^And ^suppose you ^were ^trying

toapply thediscountedcash flowmodel. The fbrecastedfreecash fiowsare negative, so getting^a

valuation fromforecastsof freecash flowsfbrfiveyearsisproblematicalindeed.Home Depot investsqver and above the ^cash generatedfromoperations, resulting innegative freecash flow.

Those investmentsâre likelyto deliverpositivefreecash fiowsinthe distantfiiture,but fbrecastingtheshort run does^not ^work ât âll.

Discountedfree^cash fiowisâ _perverse ^measure ôfvalue becauseinvestipentthatismade to add value istreatednegatively; freecash flowisreduced by investment.Ereecash fiowis partiallyâ liquidationconcept; firmsincreasefreecash flowby liquidating.^'And âs'a pprfbrmance

measure itisperverse.Freecash fiowconfUses investmentfromreturn on investment.An investor

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would not want toreward a manager on the basis^of freecash flow;such a reward system would encourage him not to invest;indeeditwould encourage hjm todisinvest.

AccrualAccountingAnalysis

You'11^netice intheHome Depot example, thatoperating income is_positive.Itlookslikea

betterattribute tobe fbrecasting.Operatingincome,of course, involvesaccrual accounting fic}r

vaiue. Inprincipleât^least,âccrual âccounting ^matches ^value ^received (revenues)^with ^value gjven

up ingenerating^revenues (expenses),^toyieldâ value-added measure. Investmentsâre putôn the balancesheet, not inthe value-added measure, and aceruals (non-cash^value recognition) are added tocash from operations: operating income ⁼⁼ freecash flow⁺ investment⁺ âccruals. Of

course, accrual accounting operating income,likefreecash fiow,can also be^negative inthe short run, butônly becauseof ôperating lossesfromthematching of revenues and expenses, not because investmentsâre "expensed".

How isaccrual accounting builtintovaluation analysis? The residual incomemodel utilizes the accrual accounting rule of separating investmentfrom the return on investment.

Appliedtoequity investments,themodel isstated as fo11ows:

ValueofEquity ⁼⁼ Book Value⁺ PresentValueofExpected FutureResidualEarnings

value ofEquity (v,E)=^B,⁺ ^REi ⁺ ^Rll2 ⁺ IYt;3+--nt PE PE PE

Here B isthe book value ofthe equity investment(the^net âssets) ôn ^the^balance^sheet ând ^RE îs

residual earnings. Value isdeterminedby starting with the equity value on the balance^sheet ^and

adding extra value not ofthe balancesheet. Sethemodel gives^a particular^expression ^to ^the^term,

value added. The êxtra ^value isdeterminedbyfbrecastingresidual eamings and discountingitat therequired return. Residualêarnings isêarnings inêxcess ôfearnings required by the net assets earnings attherequired return, fbrinvestmentsônly âdd value iftheyearn over therequired return.

Formally,residual earnings isdefinedas earnings for^a _period^minus a ^charge (at^the ^required

return) on thebookvalUe atthebeginningofthe year.^Foryear^2001,^say, ^residual ^earnings fbra required return of 1O% is

ResidualEarnings⁼ Earnings(2001)^- (O.IO^x ^Book ^Valueât ^theênd ôf2000)

So,ifbookvalue at theend of2000 is$400^million ^and ^earnings for2001 are $55^milliori,^residual

earnings fbr2001 are $15million. Iftheexpected earnings rate is109,6on boek^value, ^residual incomeis^zero: there isno ^value ^added over bookvalue, and so theequity isworth itsbook yalue.

Correspondingly,theanalyst assesses thatshares are worth apremium ^over bQok value ifheor she expects the firmto earn inexcess of the required return on book ^value. This^isa model of the

price-to-book^ratio.

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Residualearnings isa value-added measure, so itisa measure thatan analyst might

forecastto value a share insteadof dividerpdsor 'free

cash flow.But itisalso a performance

measure. Rewarding managers on how well theyadd value toinvestmentsover therequired return

is^consistent ^with how investors^view ^value ^added. As a shareholder, Isay tomanagement: add value tomy investmentinthefirmbyincreasing^residual earnings.

3.Analysis^of Performance

Thisresidual earnings model directshow tocarry out thefinancialanalysis that_getstothe source of the valuation creation. The modern term forthe factorsthat determinevalue added is

"vatue drivers."Driversare measures on which the perfbrmance^of ^management ^isjudged,^The

references at the end ofthis essay will giveyou^the fullanalysis. Hereare thehighlights:

. To begintheanalysis of residual earnings drivers,recognize thatresidual earnings

^calculated inanother way:

can be Residualearnings ⁼⁼ (ROCE^- ^Required^Retum) ^x ^Book ^value

ROCE isthe^rate ^of ^return on common equity, so residual earnings isdeterminedby return on common equity and growthininvestmentinthebook values. The highertheROCE, the

higheris^residual êarnings. But, ifmanagers can add investmentto earn at the higher ROCE, they earn additional residual earnirtgs. So thereare two driverstopay âttention ^to in^valuation (and^two ^driversôn ^which ^management perfbrmance^should ^focus):ROCE

and growth ininvestment,Both producegrowth inresidua} earnings, and so add value,

Both however,work tegether.Growth ininvestmentby itselfdoesnot add value. Indeed,

reducing investmentininventor.iesbyJust-in-Time_productionincreases^residual earnings

becauseitincreasesearnings perdollarofinvestment; thatis,ROCE. But investingin^new investmentopportunities fora givenROCE adds value, provided^the^ROCE ^fbr^the ^new investmentisgreater^than^the^required ^retum.

. Recognizethatreturn on common equity isdffectedby leveragefrom borrowing.The ^fo11owingêquation îsâ ^financialânalysis ^tool^thatdistinguishestwo components ofROCE,

ône ^thathas to･do with the profitabilityôf ôperations ^- ^return ôn ^net ôperating âssets (RNOA)^--ând ône ^the^has^to^do^with ^leverage:

ROCE ⁼ RNOA ⁺ [Leverage^x (RNOA ^-^Borrowing^Cost^on ^Net^Debt)]

Leverageisthe_amount _ofnet debtto^common equity. LeverageleverstheROCE over

the RNOA, ^and the amount depends^on the diffbrencebetweenthe RNOA and the

borrowing^cost ^of ^net debt.As a shareholder, do Iwant to reward management on the

basisQfROCE? No. Becausehe^can increasetheROCE byborrowingand borrowingisa zero net present^value ^actiyity.Borrowing does^not ^add ^value; itincreases.ROCE butit

also increaserisk with an exactly offSetting effect on value. Rather,lwant to^reward hjm

on making profitsfromoperations, on thereturn on net operating assets, foritisin

operations - _selling goods^and ^services ^to^customers ^-thatvalue is^added.

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TyingX･hluatianta P,eifbrniance ",ith FinancialAnalysis

. Recognizethattheappropriate rate ofreturn foroperations is^return ôn ^net ôperating âssets (R[NOA),^not ^the ^more _popular^return ôn âssets (ROA).^RNOA îs^measured âs ôperating

income dividedby net operating assets (NOA),^where ^net ôperating âssets âre ôperating

âssets likeinventoriesand plant)^net ôf ôperating liabilities(likeâccounts payable ând âccrued liabilities).The ^net investmentin inyentories,fbrexample, isthe amount of

inventoriesheld^minus the^accounts payablefrom thecredit givenby suppliers of the inventory.Shareholders'invgstmentinthe operating assets isreduced ifinventoriesare

^reduced (throughJust-In-Timepractices,forexample),.but also by ^supp'liers êxtending ^credit ^terms ôn ^thepayment fbrthe inventory,Thisfeatureôf thevalue creation must be ^captured. The traditionalROA measure iscalculated as operating income plusinterestôn financialassets dividedbytotalassets. Totalassets includefinancialassets (thatâre ^not

partôf operations) butexclude ôperating tiabilities(thatâre).^The âverage ^historica]^return

ôn âssets (ROA)ⁱⁿ^the Û.S.îs^6.6%.^Thisîs^too ^tow;ît^looks^more ^likeâ ^bond^return ^than

a return tobusinessinvestments.^The reason is^thatitismeasured. The historicalreturn on

^net ôperating âssets (RINOA)^has^been ^10.5%,^more ⁱⁿ^line^with ^what ^we'd êxpect âs â

^return fbrbusinessDperations.

. Accordingly,reward managers on thefactorsthatdrivereturn on net operating assets.

Standard^Du ^Pont^ratio ânalysis ^tellsûs ^that_profit^margins ând âsset ^turnovers ^drive^return

ôn ^net ôperatlng âssets:

RNOA== ProfitMarginx AssetTurnover

Profitmargin isthepercentage^of^sales ^revenue ^thatisdeliveredasoperating

profit:^profit^margin ⁼⁼ ^operating income!sales.Assetturnoveristheefficiency

inwhich assets are utilized:assets turnover⁼⁼ _saleslnet _operating _assets. You can see herehow thestandard ratios offinancialstatement analysis come intoplay intyingperformance^to^valuation. Bothprofit^margin ând âsset ^turr}overêan be

furtherbroken down intothe various expense ratios and individual^assets turnovers fbr

which different^managers ^may beresponsible.

. Appropriateperfbrmance^measures distinguisheomponents ofearnings thatErpply

tothe^current periodônly ^- ^sometimes ^referred ^toâs ^non-core êarnings ôr non-sustainable

^earnings ^--from earnings thatare likelytopersistinthefuture.So unusual, one-time items ^are ^rewarded differentlyfromincreasedincomefromcore business.

.Financial analysis ofvaluation generationfbcusesnot only on profitability^and itsdrivers,

butâlso ôn ^thegrowthⁱⁿinvestment(asdemonstratedunder the firstbulletabove). Justas the fbcusinprofitabilityânalysis ^shifts fromthe return on equity (ROCE)^to ^the ^return

from operations (RNOA)^to^remove ^the ^effects ^of ^leverage(as^disoussedⁱⁿ^the ^second

bullet),so the fbcusintheanalysis of growthis^on the growthin^net ^operating assets, not

growthintheequity (netôperating âssets ^rninus ^net ^debt).Âgain, ^the ^manager ^should ^not

berewarded forborrowing ifborrowingdoesnot affect value, Net operating assets (NOA)

are drivenas fbllows:

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