Web3ch12 - CHAPTER TWELVE The Analysis of Growth and...

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CHAPTER TWELVE The Analysis of Growth and Sustainable Earnings Stephen H. Penman The web page for Chapter Twelve runs under the following headings: What this Chapter is Doing Prelude to Growth analysis: Trend Analysis How Past Growth Typically Forecasts Future Growth Answering Questions Regarding a Change in Income: Boeing Company Pensions and Profits: Boeing Company FASB Statement 146 on Restructurings Sustainable Earnings and Quality of Earnings Analysis What this Chapter is Doing The ability to grow residual earnings (and thus generate abnormal earnings growth) are the central determinants of a firm’s P/B and P/E ratios. Accordingly, the analysis of growth is central to the analyst’s evaluation of the P/B and P/E ratio. Chapter 12 carries out this analysis. It complements Chapter 11 that analyzes profitability. Profitability alone is not sufficient, for profitability (ROCE) just gives profits for one dollar of equity. Growth in the equity base must also come into play. Understand that the growth that matters in valuation is growth than increases residual earnings. Firms can grow earnings, but will not grow value unless they can grow residual earnings. Understand also that abnormal earnings growth (that determines the P/E ratio in Chapter 6) is always equal to the change in residual earnings. (See Box 6.3 in Chapter 6). So by analyzing residual earnings growth, we are also analyzing abnormal earnings growth.
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Prelude to Growth Analysis: Trend Analysis Before beginning the formal growth analysis of Chapter 12, it is worthwhile to carry out the tend analysis at the end of Chapter 9. Trend analysis documents past growth in financial statement items that can be used as information to forecast future growth. Of particular importance is growth in sales, growth in net operating assets (NOA), growth in net financial obligations (NFO), for these items drive the growth in shareholders’ equity (CSE). Trend analysis is interpreted with the help of the growth analysis in Chapter 12: CSE = NOA - NFO Growth in net operating assets is determined by sales growth and any change in the assets turnover: CSE = (Sales x 1/ATO) - NFO If the asset turnover (ATO) is constant (which often it is), then growth in NOA is driven by growth on sales. How Past Growth Typically Forecasts Future Growth The analysis of current growth is made with the view to forecasting future growth. Is it the case that current growth is a good indicator of future growth? The following graphs give the answer. In these graphs, firm are ranked on a current growth measure – the current sales growth rate or the current NOA growth rate – and put into ten groups based on their current level of growth. The average growth rates for each group are then tracked over subsequent years.
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-30% -20% -10% 0% 10% 20% 30% 40% 50% 0 1 2 3 4 5 Year Relative To Current Year (Year 0) Sales Growth Rate Sales Growth Rates
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Growth Rates for Net Operating Assets (NOA) You see than in both cases, growth rates tend to move toward the average growth rates
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Web3ch12 - CHAPTER TWELVE The Analysis of Growth and...

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