Assignment 2: Key Value Drivers & Valuation

Step 1

Chapter 5 ‘Predicting the Future’

Forecasting a firm’s economic profit requires forecasting of return on net operation assets (RNOA), the required rate of return on operations (WACC), and net operating assets book value (NOA). Economic profit uses the same elements as free cash flow (FCF). So in order to forecast a firm’s economic profit we need to forecast profit margin (PM), asset turnover (ATO) and sales growth. This has made me nervous as it is easy to calculate PM, ATO and sales growth from the past when the figures have been provided to you. How on earth am I going to be able to accurately forecast economic profit and make the correct assumptions for the future of my own firm? This all makes sense when reading the study guide but in practice I am not so sure.

It is important not to focus on the financial figures but to be focussing on what is happening in the company to contribute to NOA and its future sales growth. I guess this is similar to how Townsville Catholic Education forecast their future enrolments which drives their income from collecting tuition fees as well as government funding for students. The number of students with disabilities receive higher government funding to allow for extra staffing requirements. How do they predict how many students they will have in the future?

Forecasting a firm’s accounting drivers must be limited to only a few years ahead as there are many factors which could affect the drivers and are currently unknown. Will the government make changes to legislation that will affect a firm’s sales? Overseas exchange rates could fluctuate significantly which would affect the value of a firm’s overseas operations. If I can’t find information on how many students currently attend Academies Australasia, then how am I going to be able to predict the number of students in future years? What else could affect my firm’s accounting and business drivers? This seems like it is going to be a very daunting task and makes me wonder whether I will be able to forecast with enough accurate information.

Chapter 6: ‘Focus on the Enterprise’

The economic profit framework and subsequent ways to express abnormal earnings formulas are very confusing to me. I will need to read this part of the study guide many times to understand the parts of a firm’s financials it is using, to cement the concept further.

A firm’s leverage is affected by its level of debt and financial obligations. The amount of debt or equity that a firm uses in its operations influences the required rate of return for equity and the return it provides to its equity investors. I am still trying to understand how this concept works as I have not dealt with this kind of analysis before (not that I remember). Analysing and forecasting has always been conducted by the senior accountants where I work. Analysing my firm Academies Australasia will hopefully reinforce these concepts so it makes more sense to me.

Levered price to book ratios use financial and operating values which will change when a firm makes changes to its financial activities. Unlevered price to book ratios only use operating values so will not be influenced by alterations to the firm’s financial activities. This concept is getting easier to understand the more I learn about it, as the figures used to calculate levered ratios use the market value of equity and the book value of equity, which include all financial and operational figures of a firm. The unlevered ratio only focuses on using the value of its net operating assets and the book value of net operating assets.  Will these ratios be different for my firm, Academies Australasia? They do not have net financial obligations, only net financial assets. While checking my ratios I have noticed that I have calculated FLEV using the net financial assets, not obligations as they don’t have any. Is this incorrect? Should FLEV equal 0? I will have to put more thought into this when discussing my ratios with other students.

There are three factors which can be used to increase earnings growth which we need to be wary of: financial leverage, investment and changes in accounting methods. Earnings growth is only “Good” if the changes made will earn the company more than the cost of capital required to back the change. For example, if a company has a cost of capital of 8% and purchases a firm which has is returning 10.1% on the equity invested, then the earnings growth will be good for the company. This example can also be used to illustrate “Bad” earnings growth. Suppose a company has a cost of capital of 8% and buys a firm which is returning 5.8%. This will be bad earnings growth as the investment will reduce equity investors value. Changes in accounting treatments can also make it look like a company has good earnings growth when in fact all they have done is change a policy perhaps, which will change an accounting treatment, which will not add value to its equity investors at all. The concept of good and bad earnings growth is interesting to me, as I always thought that all growth was a good thing for a company. It turns out there are so many more factors to consider when delving into why a company has grown its earnings. I am excited to see what factors I can discover are contributing to the earnings growth (or decreasing earnings) for Academies Australasia.