BUSI 532 Week 5 Discussion Board Forum 3 Example

Discussion Board Forum 3: The Analysis of Profitability and Growth

BUSI 532 Advanced Financial Statement Analysis, Discussion Board Forum 3 Thread and Replies

Thread by [Student Name]

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

Thread

Penman (2013) breaks return on net operating assets (RNOA) into two drivers: profit margin, operating income after tax divided by sales, and asset turnover, sales divided by net operating assets. For forecasting next year's profitability, I would argue that changes in turnover deserve closer attention than changes in margin, and the research on the question points the same way.

Consider two composite retailers, each earning an RNOA of 15 percent. The first is a warehouse club with a 3 percent margin and a turnover of 5; it earns its return by moving large volumes through modest assets. The second is a jewelry chain with a 15 percent margin and a turnover of 1; it earns its return on each sale. The same RNOA tells a different story about each business, and a one-point change in margin would be enormous for the first and small for the second. The warehouse club lives or dies on volume and inventory speed, while the jeweler depends on pricing power and the brand that supports it.

Research suggests three things. First, profitability does not stay where it is. Nissim and Penman (2001) showed that RNOA tends to revert toward typical levels over several years, so a forecast should start from the expectation that an unusual year will fade. Second, Fairfield and Yohn (2001) found that simply splitting RNOA into margin and turnover did not help forecast its change, but the change in asset turnover did: firms whose turnover rose tended to see higher profitability the next year. Third, Soliman (2008) found that this information was useful but that investors and analysts did not fully incorporate it at first, which suggests a payoff to careful analysis.

Why would turnover carry more information? A margin can be lifted for a year by cutting advertising or research, and such gains rarely last. Turnover reflects how efficiently the business uses its assets, which changes more slowly. A rising margin may be borrowed from next year; a rising turnover is more often earned. In practice, I would forecast RNOA by starting from its long-run level, adjusting for changes in turnover, and treating margin gains with suspicion until core earnings confirm them.

Reply to Brianna

Brianna, your thread on sustainable earnings argued that analysts should strip out one-time items before forecasting, and your example of a company that reported a large gain on selling a building made the point well. I would extend it to the part of earnings that comes from accruals. Richardson et al. (2005) sorted accruals by how reliably they can be measured. The less reliable the accruals behind a firm's earnings, the faster those earnings faded, and because the market underestimated that fading, stock returns afterward were predictable. So even after removing unusual items, two firms with the same core earnings can differ in how sustainable those earnings are. Penman (2013) suggests comparing operating income with cash from operations as a first test. Did your company's operating accruals grow faster than its sales during the period you studied? If so, its core earnings may be less sustainable than they appear.

Reply to Malik

Malik, I appreciated your thread on growth, especially your point that Penman distinguishes growth that adds value from growth that only adds size. Your company had grown earnings by more than 20 percent a year for five years, and you projected that rate forward. I would compare your forecast with the evidence. Chan et al. (2003) studied long-term growth in operating performance for U.S. firms and found very little persistence beyond what chance would produce; firms with high past growth were not much more likely than others to keep growing quickly, and analysts' long-term growth forecasts were overly optimistic. That is consistent with Penman's warning to anchor on current earnings and treat high growth as speculative. Would a forecast that fades your company's growth toward the economy's rate over five years still support its current price? If not, the price may be assuming more than the evidence allows. A useful exercise is to solve for the growth rate the current price implies and then ask how many companies in your industry have ever sustained it.

References

Chan, L. K. C., Karceski, J., & Lakonishok, J. (2003). The level and persistence of growth rates. The Journal of Finance, 58(2), 643-684. https://doi.org/10.1111/1540-6261.00540

Fairfield, P. M., & Yohn, T. L. (2001). Using asset turnover and profit margin to forecast changes in profitability. Review of Accounting Studies, 6(4), 371-385. https://doi.org/10.1023/A:1012430513430

Nissim, D., & Penman, S. H. (2001). Ratio analysis and equity valuation: From research to practice. Review of Accounting Studies, 6(1), 109-154. https://doi.org/10.1023/A:1011338221623

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

Richardson, S. A., Sloan, R. G., Soliman, M. T., & Tuna, I. (2005). Accrual reliability, earnings persistence and stock prices. Journal of Accounting and Economics, 39(3), 437-485. https://doi.org/10.1016/j.jacceco.2005.04.005

Soliman, M. T. (2008). The use of DuPont analysis by market participants. The Accounting Review, 83(3), 823-853. https://doi.org/10.2308/accr.2008.83.3.823