The Analysis of Growth and Sustainable

Earnings

ACC 4345: Financial Statement Analysis

ACC 3350: Financial Statement Analysis
Semester 2 - 2023

Prof. Athula Manawaduge

1
 What you will learn from this lesson
• Why the analysis of growth is important for valuation
• What is "growth" in a valuation context?
• What a growth firm is
• Why growth analysis focuses on residual earnings growth and abnormal earnings growth rather
than earnings growth
• What sustainable earnings are and how they are identified
• What transitory earnings are
• What “quality of earnings” means
• How firms can generate unsustainable earnings
• How operating leverage affects earnings as sales change
• How changes in ROCE can be created by borrowing
• How is growth in investment analyzed?
• How is the analysis of growth incorporated into the evaluation of P/E and P/B ratios?
• What drives growth in the common shareholders’ equity
Learning Outcomes:
At the end of this lesson, you should be able to:
• Complete an analysis of a change in ‘Return on Net Operating Assets’ (RNOA).
• Complete an analysis of a change in ‘Return on Common Equity’ (ROCE).
• Complete an analysis of growth in investment.
• Complete an analysis of growth in Residual Earnings (RE).
• Identify core or sustainable earnings in income statements.
• Identify transitory (temporary) or unusual items in income statements.
• Analyze the effect of changes in financial leverage on ROCE
• Identify core net borrowing costs.
What Is Growth and How Is It Valued?
–Growth in sales?
–Growth in assets?
–Growth in equity?
–Growth in earnings?
–Does a high P/E ratio indicate a growth company?
–Does a high P/B ratio indicate a growth company?
What Is Growth and How Is It Valued?
• The term growth is often used vaguely, or with a variety of meanings.

• Sometimes the term is used to mean growth in sales, growth in earnings, and
growth in assets. Generally, growth is seen as a positive attribute, an ability to
generate value. But what is growth? What is a growth firm?
• The valuation models provide the answer to this question.

• One pays a premium over book value based on the ability of a firm to grow
residual earnings (RE)
• Residual earnings is the difference between earnings and the required return on
book value. For any year t,
• Residual earnings (REt) = Earningst − [(ρE − 1) × Common shareholders’ equityt−1]
• where ρE − 1 is the required return for equity.

* In this text the symbol ‘ρ’ is equivalent to 1 + r and ρ − 1 to r (required return)

What is Growth and How is It Valued?
Example: Residual earnings (RE)
• Dell, Inc., reported $2,988 million of comprehensive income in
2022 on book value (assets minus liabilities) at the beginning of
the year of $4,328 million.
• If Dell’s shareholders require a 10 percent return, then its 2022
residual earnings was
$2,988 – (0.10 × 4,328) = $2,555.2 million.
Dell added $2,555.2 million in earnings over a 10 percent return on
the shareholders’ investment in book value.
What is Growth and How is It Valued?
Residual earnings (RE)
• Residual earnings measure the value added to book value over
that required to cover the cost of capital.
• So a sensible way of viewing growth that ties into value creation
is in terms of growth in residual earnings:
• A growth firm is one that can grow residual earnings.
What Is Growth and How Is It Valued?
Abnormal earnings growth:
• One pays more than a normal P/E based on the ability of a firm to generate
abnormal earnings growth (AEG)
• Abnormal earnings growth is the difference between cum-dividend earnings
and a charge for the prior year’s earnings growing at the required rate.
• The total earnings from an investment are referred to as cum-dividend
earnings, that is, earnings with the dividend reinvested.
• Cum-dividend earnings2020 = Earnings2020 + (ρ − 1)dividend2019

• Thus, for any year t, abnormal earnings growth is:

Abnormal earnings growtht (AEGt) = [Earningst + (ρE − 1)dt−1] − (ρE x Earningst−1)

where dt−1 is the net dividend paid in the prior year.
What Is Growth and How Is It Valued?
Example - Abnormal earnings growth:
Dell, Inc., reported $12 million of earnings in 2021 on book value at the beginning
of the year of $100 million. The dividend paid during the year 2021 is $9.09 million.
During the year 2022, the company reported $ 12.36 million earnings and the
dividend paid during the year was $9.36.
What is the abnormal earnings growth of Dell if shareholders require return is
10%?
Abnormal earnings growtht (AEGt) = [Earningst + (ρE − 1)dt−1] − (ρE x Earningst−1)
Cum-dividend earnings 2022 = $12.36 + (0.10 × 9.09)
Year 2021 earnings growing at the required rate = (12 x 1.10)
$12.36 + (0.10 × 9.09) – (12 x 1.10) = $ 0.069million.
= 13.269 – 13.2 = 0.069
Remember the Requirement
Earnings growth alone is not a good measure of growth because
earnings growth can be created by investment (that does not
add value) and by accounting methods (that also do not add
value).

Firms can grow earnings, but not create value:

• Earnings growth generated by the investment
•Earnings growth generated by the accounting
Earnings growth and Valuation
• Residual earnings growth and abnormal earnings growth
are the growth measures we must focus on if we have a
valuation in mind.
• Residual earnings is the relevant growth measure when
evaluating the price-to-book (P/B) ratio.
• Abnormal earnings growth is the relevant growth measure
when evaluating the price-earnings (P/E) ratio.

• A reminder: abnormal earnings growth (AEG) is equal to

the change in residual earnings (ΔRE)
A Growth Company: General Electric, Corp.
(Dollar amounts in millions) 2002 2001 2000 1999 1998 1997

Sales 131,698 125,913 129,853 111,630 100,469 90,840

Sales growth rate 4.6% (3.0%) 16.3% 11.1% 10.6% 14.7%
Common equity 68,706 54,824 50,492 42,557 38,880 34,438
Common equity growth rate 16.2% 8.6% 18.6% 5.5% 12.97% 10.6%
ROCE 25.8% 27.1% 29.9% 27.6% 26.2% 27.2%
Residual earnings 7,539 7,625 7,628 6,065 5,221 4,994
Abnormal earnings growth (86) (3) 1,563 844 227

General Electric has maintained a high growth rate in sales, which translates into
both increasing ROCE and increasing investment. Accordingly, with the
exception of 1996, residual earnings (based on a required return of 12%) was on
a growth path up to 2000 and abnormal earnings growth was (mainly) positive.
Growth slowed after 2000. Can GE generate more growth in the future?

A reminder: Abnormal earnings growth = ΔRE

Is Nike a Growth Firm?
(Dollar amounts in millions) 2004 2003 2002 2001 2000 1999

Sales 12,253 10,697 9,893 9,489 8,995 8,777

Sales growth rate 14.6% 8.1% 4.3% 5.5% 2.5% 8.1%
Common equity 4,840 4,028 3,839 3,495 3,136 3,335
Common equity growth rate 19.8% 4.0% 9.8% 11.4% -6.0% 2.2%
ROCE 23.0% 10.3% 19.1% 18.8% 17.4% 13.0%
Residual earnings 642 (71) 280 241 210 64
Abnormal earnings growth 572 (209) 39 31 146 36

Apart from 2003, Nike grew sales and earned a high ROCE, increasing
investment, increasing residual earnings, and delivering positive abnormal
earnings growth. Can Nike maintain growth in the future?
A No-Growth Firm: Reebok
A GROWTH FIRM?:
REEBOK
(Dollar amounts in 2004 2003 2002 2001 2000 1999 1998
millions)
Sales 3,785 3,485 3,128 2,993 2,865 2,900 3,225
Sales growth rate 8.6% 11.4% 4.5% 4.5% −1.2% −10.1% −11.5%
Common equity 1,226 1,035 886 720 608 529 524
Common equity growth rate 18.5% 16.8% 23.1% 18.4% 14.9% 1.0% 3.4%
ROCE 18.9% 18.1% 16.6% 16.9% 15.3% 2.1% 5.8%
Residual earnings (12%) 78 58 37 30 17 (52) (32)
Abnormal earnings growth (12%) 20 21 7 13 69 (20) (87)

After decreasing residual earnings and abnormal earnings growth in the

late 1990s from declining sales growth rates and low ROCE, Reebok
moved to a growth path in 2002–2004. Will it be a growth company in the
future? (Reebok was subsequently acquired by Adidas.)
A Cyclical Firm: American Airlines
(Dollar amounts in millions) 2000 1999 1998 1997 1996 1995

Sales 19,703 17,730 16,299 15,856 15,136 15,610

Sales growth rate 11.1% 8.8% 2.8% 4.8% -3.0% 5.2%

Common equity 7,176 6,858 6,428 5,354 4,528 3,646

Common equity growth rate 4.6% 6.7% 20.1% 18.2% 24.2% 12.8%

ROCE 11.9% 15.6% 18.0% 16.2% 16.7% 6.2%

Residual earnings (147) 85 238 107 112 (274)

Abnormal earning growth (232) (153) 131 (5) 386 (94)

American Airlines, the air carrier, grew residual earnings from 1996 to 1998. (Residual earnings is
calculated using a 14 percent required return, as befits a risky airline.) But airlines are cyclical, as the
residual earnings and abnormal earnings growth in the earlier and later years show. Sales growth has
been modest and variable, and the increase in ROCE from 1996 to 1998 was also modest, with growth
coming from growth in investment. ROCE declined after 1998, even with growing sales, and residual
earnings also declined.
Analyzing Growth in Residual Earnings
Change in Change due to Change due
residual = change in ROCE + to change in common
earnings over the cost of capital equity
ΔRE1= Δ  ROCE-cost of capital  xCSE 0  + ΔCSE1x  ROCE-cost of capital  
 1   1
=AEG1

• Changes in residual earnings are driven by:

1. Changes in ROCE
2. Changes in required return
3. Changes in investment
A reminder: ΔRE=AEG, so this calculation also gives AEG
Analysis of Growth in Residual Earnings and AEG: Nike, Inc.
2004 2003

Net operating assets $4,441 $4,395

Net financial obligations 7 495
Common shareholders' equity $4,434 $3,936

Sales $12,253 $10,697

Operating income $ 1,035 $ 423
Return on common equity (ROCE) 22.98% 10.29%
Return on net operating assets (RNOA) 23.31% 9.62%
Profit margin (PM) 8.45% 3.95%
Asset turnover (ATO) 2.76 3.90
Financial leverage (FLEV) 0.001 0.117

Assumes no change in required equity return of 8.5%

Residual Earnings2004 = (22.98%  8.5%) x $4,434 million = $642.0 million

Residual Earnings2003 = (10.29%  8.5%) x $3,936 million = $70.5 million

RE2004 = (12.69 x $3,936 million) + [$498 million x (22.98%  8.5%)]

= $499.5 million + $72.1 million
= $571.5 million
= AEG2004
Analysis of Growth in Residual Earnings and AEG: Reebok
2004 2003

Net operating assets $972 $685

Net financial obligations (170) (286)
Minority interest 11 10
Common shareholders' equity $ 1,131 $ 961

Sales $3,785 $3,485

Operating income $ 237 $ 191
Return on common equity (ROCE) 18.93% 18.12%
Return on common equity (before minority interest) 19.19% 18.45%
Return on net operating assets (RNOA) 24.40% 27.88%
Profit margin (PM) 6.26% 5.48%
Asset turnover (ATO) 3.90 5.09
Financial leverage (FLEV) -0.149 -0.294
Assumes no change in required equity return of 9%

Required:
1. Residual earnings of Reebok in 2003 and 2004
2. Abnormal earnings growth in 2004
SUSTAINABLE EARNINGS

In analyzing growth, the analyst has her eye on the future:

• Can the firm grow residual earnings in the future?
• Past growth is only an indicator of future growth.

• So, in asking whether American Airlines, Reebok, Nike, and

General Electric are growth companies, the question is whether
past growth can be sustained in the future.
SUSTAINABLE EARNINGS
• The analysis of growth starts with an identification of earnings on which growth is
possible.
• Earnings from a one-time special contract cannot grow;
- Earnings depressed by a labor strike are not a basis for continuing growth;
- Earnings from gains on asset sales or restructurings will not repeat in the future.

• Earnings that can repeat in the future, and grow, are called sustainable earnings,
persistent earnings, core earnings, or underlying earnings. Core earnings are the
base for growth
• Earnings based on temporary factors are called transitory earnings or unusual items.
• The growth analysis should distinguish core earnings from transitory components.
• Identifying these core earnings is a starting point not only for evaluating growth
prospects but also for answering this question: Does the firm have durable competitive
advantage?
Core Operating Income
• Operating income consists of core (sustainable) operating income and unusual
(transitory) items:

Operating income (OI) = Core operating income + Unusual items

Core Operating income = Income from sales + Other operating income

Thus:
Operating Income (OI) = Core OI from sales + Core other OI + UI
 Reformulation of Operating Income (OI)
• Reformulation of the OI Section of the Income Statement to Identify Core Income and Unusual Items.
• Core OI is core income from sales plus core other OI. Taxes are allocated to each component.
Reformulation of Operating Income (OI)
Core Operating Profitability
With the identification of core operating income, it requires to distinguish core
return on net operating assets (RNOA) from the transitory effects on RNOA:

Return on net operating assets (RNOA) = Core RNOA + Unusual items to net
operating assets

The first component of RNOA: Income from sales + From other operating income
Core Operating Profitability
Return on net operating assets (RNOA) can break down into profit margin (PM)
and asset turnover (ATO) components:
Core Borrowing Cost
• The net financing expense component of the income statement can also be
broken into core expense and one-time effects.

• The breakdown yields core net borrowing cost, which should apply in
forecasting future borrowing costs:
Net borrowing cost = Core net borrowing cost + Unusual borrowing costs

NFO (Net financial obligations) = (Financial obligations – Financial assets)

ANALYSIS OF GROWTH
• The focus for growth is Residual earnings. This is driven by;

Return on common equity (ROCE) and the amount of common shareholders’

equity:

Residual Earningst = (ROCEt − Cost of equity capital) × CSEt−1

• Growth in residual earnings is driven by:

- Increases in ROCE and
- Growth in common shareholders’ equity
Growth Through Profitability
• ROCE is driven by operating profitability (RNOA), the amount of financial
leverage (FLEV), and the spread of operating profitability over the net borrowing
cost (NBC):

ROCE = RNOA + [FLEV × (RNOA − NBC)]

Sustainable Drivers of Return on Common Equity (ROCE)
Analyzing Change in Return on Common Equity (ROCE):
 ROCE

RNOA  in Financing

 SPREAD  FLEV
Core OI from Sales Core Other Items Unusual Items
Level 1 =  [RNOANBC]
NOA NOA NOA

Core Sales PM ATO

Level 2  Core Sales PM x ATO  ATO x Core Core NBC Unusual

Sales PM Financing Items

Level 3

 in Core Sales  in ATO Drivers  in Core  in Unusual  in Core  in Unusual  in NFO

PM Drivers Other Income Item NBC Drivers Components Components
Components Components
Analysis of Changes in ROCE
1. Analyze Changes in Profitability of Operations
2. Analyze the Effects of Changes in Financing

ROCE  RNOA  [FLEV x SPREAD]

(1) (2)
Explaining the Changes in Operational Profitability
Explaining RNOA
1. Distinguish core and transitory components

Core OI UI
RNOA  
NOA NOA

Core OI from Sales Core Other OI UI

  
NOA NOA NOA

Core OI is persistent income from core business

UI is unusual items that are non-recurring, sometimes called transitory
items.
All items are after tax
Explaining Changes in Operational Profitability (cont’d.)

2. Distinguish margin and turnover drivers of core income

RNOA  Core OI from Sales  Core Other OI  UI

NOA NOA NOA

 Core Sales PM x ATO   Core Other OI  UI

NOA NOA

where Core Sales PM  Core OI from Sales

Sales
Explaining Changes in Operational Profitability (cont’d.)
3. Explain changes in profit margins and asset turnovers
Explain changes in Core PM by looking at profit margin drivers
 GM (by segment)
 Selling Expenses / Sales
 Administrative Expenses / Sales
 R&D / Sales
Pay particular attention to GM: per unit sales prices, production costs…
Explain changes in ATO by looking at turnovers
 Accounts receivables turnover
 Inventory turnover
 PPE turnover
 Accounts payable turnover
 Operating liability turnover
Also
 Look at operating asset composition ratios
 Look at operating liabilities composition ratios
 Look at OLLEV
Reformulating Income Statements to Identify Core and Unusual Items
Reformulated Operating Income Statement: Core and Unusual Items

 Unusual Items
Core Operating Income  Special charges
Core sales revenue  Special liability accruals
 Core cost of sales  Nonrecurring items
= Core gross margin  Asset write-downs
 Core operating expenses  Changes in estimates
= Core operating income from sales before tax  Start-up costs expensed
 Tax on core operating income from sales  Profits and losses from asset sales
+ Tax as reported  Restructuring charges
+ Tax benefit from net financial expenses  Profits and losses from discontinued operations
 Tax allocated to core other operating income  Extraordinary operating items
 Accounting changes
 Tax allocated to unusual items
 Unrealized gains and losses on equity investments
= Core operating income from sales
+ Gains from share issues in subsidiaries
+ Core other operating income
 Currency gains and losses
+Equity income in subsidiaries
 Derivative gains and losses (operations)
+Earnings on pension assets
 Tax allocated to unusual items
+Other income not from sales
Tax on core other income = Comprehensive Operating Income
= Core operating income
Reformulation to Identify Core Income: Nike
Reformulation to Identify Core Income: Reebok
Comprehensive Tax Allocation
GAAP Income Statement Reformulated Statement

Revenue $ 4,000 Core revenue $ 4,000

Operating expense (3,400) Core operating expense (3,400)
Restructuring charge (300) Core operating income before tax 600
Interest expense (100) Tax:
Income before tax 200 Tax reported $ 45
Income tax 45 Tax benefit of interest 35
Net earnings $ 155 Tax on unusual items 105 185
Core operating income after tax 145
Unusual Items:
Tax rate is 35% Restructuring charge $ 300
Tax deduction 105 195
Operating income 220
Interest expense $ 100
Tax on interest (35) 65
Net earnings $ 155
Explaining Changes in Operational Profitability:
The Change in RNOA is explained as:

RNOA1  Core PM1 x ATO 0   ATO 1 x Core PM1  

 UI 
 
 NOA 

Note: (i) is usually more important than (ii)

Issues in Identifying Core Operating Income: Items to Consider
Here are the main issues in identifying sustainable operating income(PP 398 – 403):
1. Deferred (unearned) Revenue
2. Restructuring charges, asset impairments, special charges
3. Research and development
4. Advertising and promotion
5. Pension expense
6. Changes in estimates
7. Realized gains and losses: Cherry Picking
8. Unrealized gains and losses
9. Income taxes
10. “Other” income
Analyze R&D
THE ANALYSIS OF R&D: MERCK & CO.

(In billions of dollars) 2004 2003 2002

Sales 22.9 22.5 21.4

R&D 4.0 3.3 2.7
R&D Sales 17.5% 14.7% 12.5%
Sales growth rate 2.0% 4.8% 1.2%
Income from continuing operations 9.1 9.7 9.9
Analyze Marketing Expenditures
THE ANALYSIS OF ADVERTISING COSTS: COCA-COLA

(In billions of dollars) 2004 2003 2002

Revenues 22.0 21.0 19.6
Cost of goods sold 7.6 7.8 7.1
Gross profit 14.4 13.2 12.5
Selling, administrative and general 8.7 8.0 7.0
Operating income (before tax) 5.7 5.2 5.5

Advertising expenses 2.2 1.8 1.7

Advertising expenses/Sales 10.0% 8.6% 8.7%
Analyze Pension Costs
_____________________________________________________________________
International Business Machines (IBM)
Components of pension expense, 2001-2004
(In millions of dollars)
2004 2003 2002 2001
Service cost 1,263 1,113 1,155 1,076
Interest cost 4,071 3,995 3,861 3,774
Expected return on plan assets (5,987) (5,931) (6,253) (6,264)
Amortization of transition asset (82) (159) (156) (153)
Amortization of prior service 66 78 89 80
cost
Actuarial losses (gains) 764 101 105 (24)
Net pension expense 95 (803) (1,199) (1,511)

Components of Pension Expense:

1. Service Cost
2. Interest Cost
3. Expected Return on Plan Assets
4. Amortization of Prior Service Cost
5. Amortization of Transaction Asset or Liability
6. Changes in Actuarial Estimates (accrual gains and losses)
Watch Gains and Losses on Sales of Shares
Intel
In its report for its third quarter for 1999, Intel reported net income of $1,458 million, with no
indication of unusual items. Its cash flow statement, however, reported $556 million in gains on
sales of investments, along with a $161 million loss on retirements of plant, as add backs to net
income to calculate cash from operations.
Delta Air Lines
Delta reported operating income (before tax) of $350 million for its September quarter in 1999.
However, notes to the report indicated that these earnings included pre-tax gains of $252 million
from selling its interest in Singapore Airlines and Priceline.com.
IBM
IBM reported before-tax operating income of $4,085 for its June, 1999 quarter. However,
footnotes revealed that this income included a $3,430 million gain from the sale of IBM's Global
Network to AT&T. This gain reduced selling, general and administrative expenses in the income
statement!
 Watch for Changes in Estimates
• Bad debt allowances

• Deferred revenue

• Warranty allowances

• Residual values for leases

Watch Income Taxes
• One-time or expiring credits

• Changes in valuation allowances for deferred tax assets

Effective tax rates tend to move towards the statutory rate

over time
 Analyzing Operating Leverage
Operating Leverage is the proportion of total costs that are fixed versus variable

Sales PM  Sales - Variable Cost - Fixed Costs

Sales
 Contributi on Margin - Fixed Costs
Sales Sales
The first component here is called the contribution margin ratio

Contribution Margin
Contribution Margin Ratio  1 - Variable Costs 
Sales Sales

This ratio measures the change in income

from a change in one dollar of sales
 Operating Leverage Measures
Operating Leverage is sometimes calculated as the ratio of fixed costs to variable costs

Another measure is:

OLEV  Contribution Margin  Contribution Margin Ratio
Operating Income Profit Margin

% Change in Core OI  OLEV x % Change in Core Sales

Applying this measure to core operations:

Preparing Financial Statements for Forecasting
1. Identify dirty surplus and calculate ROCE from the statement of
shareholders’ equity
2. Reformulate balance sheet
3. Reformulate income statement
4. Decompose ROCE: Profitability Analysis
5. Analyze ROCE: Sustainability of Earnings
6. Analyze Growth
Now you are ready to forecast future ROCE and growth and carry out
valuations
Using Growth Analysis to Understand P/B and P/E Ratios

• How does P/B relate to growth?

• How does P/E relate to growth?

• How does P/E relate to transitory earnings?

The Benchmark Case of Normal P/B and Normal P/E

Normal P/B Ratio Normal P/E Ratio

Book values expected to grow at equity cost of Earnings expected to grow at equity cost of capital
capital
Abnormal earnings growth expected to be zero
Residual earnings expected to be zero (Residual earnings expected to be unchanged)

Trailing normal P/E:

V  CSE0
0
E

V0E  d 0 E
  E 1
Earn0
Forward normal P/E:

V0E 1

Earn1  E  1
A Normal P/E: Whirlpool Corporation
______________________________________________________________________________

Whirlpool Corp.: Analyst Forecast, December, 1994

1993A 1994A 1995E 1996E 1997E

Eps 4.43 4.75 5.08 5.45

Dps 1.22 1.28 1.34 1.41

Bps 22.85 25.83 29.30 33.04 37.07

RE (.10) 2.15 2.17 2.15 2.15

AEG 0.02 (0.02) (0.00)

______________________________________________________________________________
Valuation:
2.15
V0E  25.83   47.33
0.10
V0E  d 0 47.33  1.22
  11 .00
Earn0 4.33 (approx)

V0E 47.33
  10.00
Earn1 4.75 (approx)

Normal P/E for a 10% cost of capital

P/E Ratios Different from Normal
• If earnings are expected to grow faster than the cost of capital (cum-
dividend), P/E > Normal
• If earnings are expected to grow slower than the cost of capital (cum-
dividend), P/E < Normal
OR
• If AEG is forecasted to be positive, P/E > Normal
• If AEG is forecasted to be negative, P/E < Normal
OR
• If RE is forecasted to increase, P/E > Normal
• If RE is forecasted to decrease, P/E <Normal
The P/E Ratio and the P/B Ratio
• P/B indicates expected growth in book value
• P/E indicates expected growth in earnings

OR
• P/B indicates future RE
• P/E indicates future changes in RE from current RE
What is a Growth Stock?
• P/E indicates growth in RE but this could be from a very low
base

• Trailing P/E reflects growth and transitory earnings. If earnings

are temporarily low, P/E will be high

• P/E is not a good indicator of future profitability

P/E, P/B and ROE
• P/B is assessed by forecasting future ROE (Return on
Equity), not current ROE.
• P/E is determined by comparing forecasted future ROE
with current ROE.
Thank you

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