BUSI 532 Week 2 Discussion Board Forum 2 Example

Discussion Board Forum 2: Cash Accounting, Accrual Accounting and Valuation

BUSI 532 Advanced Financial Statement Analysis, Discussion Board Forum 2 Thread and Replies

Thread by [Student Name]

The forum prompt, the two classmates and the retailer in the thread are composites standing in for the course's own prompt; the figures in the worked example are the writer's, and the textbook and research cited are real.

Thread

Penman (2013) makes a claim in chapters 4 through 6 that surprised me: for many firms, valuing the equity from forecasts of accrual earnings and book values works better than discounting free cash flow. In theory the methods agree. In practice, analysts forecast only a few years ahead, and free cash flow over a short horizon can describe a successful business as a failing one.

Consider a composite restaurant chain with 100 stores. Each store costs $3 million to build and earns $600,000 a year after tax, a 20 percent return. The chain opens 20 new stores a year. Its stores produce about $60 million a year in earnings and somewhat more in operating cash flow, since depreciation is a noncash charge, but building the next 20 stores costs $60 million, so free cash flow is only slightly positive. If it speeds up to 30 openings, spending $90 million, free cash flow turns sharply negative even though earnings will rise faster. A five-year discounted cash flow forecast for this chain shows little or no cash, and nearly all of its value lands in the terminal value, the most speculative number in the model. Accrual accounting avoids this by capitalizing the stores as assets and charging their cost against earnings over time through depreciation, so earnings and book value reflect the 20 percent return on each store as it is earned.

The research supports the chapters. Penman and Sougiannis (1998) ran a horse race: they applied dividend discounting, cash flow discounting and accrual earnings methods over finite forecast horizons, set each result against actual market prices, and found the accrual earnings methods missed by the least. Dechow (1994) showed that over short measurement periods earnings were the better gauge of performance, since accruals smooth out the mismatch between when cash moves and when value is earned; earnings held the biggest edge where working capital and investment swung the most.

Free cash flow describes how a firm finances its growth; accrual earnings describe whether that growth is profitable. That does not make cash flow useless. Penman stresses that cash flows test the quality of earnings, so a firm whose earnings rise while operating cash flow falls deserves a closer look.

Reply to Olivia

Olivia, your thread focused on the price-to-book ratio, and I agreed that it follows directly from chapter 5: a stock should trade above book value only if the firm is expected to earn residual earnings. I would add evidence that the ratio carries information investors seem to miss. Fama and French (1992) found that, across U.S. stocks from 1963 to 1990, book-to-market equity, together with size, explained the cross-section of average returns far better than market beta did, with high book-to-market stocks earning higher average returns. Fama and French read this as compensation for risk; others, pointing to how often cheap stocks were simply out of favor, read it as mispricing. Penman's framework offers a way to compare the two readings: if low price-to-book stocks really lack future residual earnings, the low ratio is justified, and if they do not, the market has been too pessimistic. Which reading did your company's ratio suggest when you compared it with its forecast return on equity?

Reply to Nathan

Nathan, thank you for explaining the residual income model so clearly, especially the idea that equity is worth its book value plus whatever residual earnings the firm is expected to produce, discounted to today. You described it as Penman's model, and in its modern form it owes much to Ohlson (1995), who showed formally that when accounting satisfies the clean-surplus relation, with all changes in book value other than dividends and capital transactions running through earnings, then value can be expressed in terms of current book value and expected abnormal earnings. Where I would compare ideas with you is on the clean-surplus condition. Some gains and losses, currency translation for example, go to other comprehensive income and bypass the income statement, so an analyst who forecasts from net income alone can miss them. Pension remeasurements and unrealized gains on certain securities can be large as well, and they belong to shareholders just as surely as reported profit does. Did your chosen company report large items in other comprehensive income? If so, Penman's advice is to reformulate the statements so comprehensive income is used in the model.

References

Dechow, P. M. (1994). Accounting earnings and cash flows as measures of firm performance: The role of accounting accruals. Journal of Accounting and Economics, 18(1), 3-42. https://doi.org/10.1016/0165-4101(94)90016-7

Fama, E. F., & French, K. R. (1992). The cross-section of expected stock returns. The Journal of Finance, 47(2), 427-465. https://doi.org/10.1111/j.1540-6261.1992.tb04398.x

Ohlson, J. A. (1995). Earnings, book values, and dividends in equity valuation. Contemporary Accounting Research, 11(2), 661-687. https://doi.org/10.1111/j.1911-3846.1995.tb00461.x

Penman, S. H. (2013). Financial statement analysis and security valuation (5th ed.). McGraw-Hill Education.

Penman, S. H., & Sougiannis, T. (1998). A comparison of dividend, cash flow, and earnings approaches to equity valuation. Contemporary Accounting Research, 15(3), 343-383. https://doi.org/10.1111/j.1911-3846.1998.tb00564.x