Firms with negative earnings

Consequences of Negative or low earnings

- Earnings growth rate cannot be estimated or used in valuation

- Tax computation becomes complicated
- The going concern assumption may not apply

Causes of Negative Earnings

Temporary Problems

Long term problems

Life cycle

-Firms specific (strike, product

- Strategic choices
(product mix, marketing
policy)

- Infrastructure firms

recall, lawsuit)
-Sector specific ( hike in raw
material prices, downturn in
selling prices)
- Cyclical firms (automobiles)
( expect them to bounce back)

(phone and cellular)

- Small biotech firms
or pharmaceuticals

- Inefficient operations
( obsolete assets, poorly
trained workforce, poor -Young start ups
( By passing the venture
decisions in the past)
capital route)
(series of acquisitions)
- High financial leverage
(leveraged buyouts)

Firm with temporary Problems

Firm Specific Problems

- If the loss can be attributed to
a specific event and financial
statements specify it, isolate it and
calculate earnings prior to this.
- If the cause of the loss is more
diffused or the cost of the event is
not separated , prepare common
size income statement or use the
operating margin of the previous
year.
-Consider making adjustments to the
earnings of firms after years in which they
made major acquisitions

Cyclical firms
(significantly affected by
level base year earnings)
- If earnings are not
negative, adjust the
growth rate.
- economic growth rate
- growth rates in turning point
in prior recessions
-Normalized Earnings
- Average the firms rupee
earnings during prior period
(appropriate for firms in mature
Business)
- Average ROIC or profit
margins over prior periods
(All the methods assume that
Normalization will occur
Instantaneously)

Volvo
In 2002, towards the end of a recession in
Europe and the United States, Volvo reported an
operating loss of 2,249 million Swedish Kroner
(Sk) on revenues of 83,002 million Sk.
Normalize earnings
using Volvos average pre-tax operating margin from
1998 to 2002 of 4.1% as a measure of the normal
margin
applied it to revenues in 2002 to estimate normalized
operating income.
Normalized operating income in 2002 = 83002*.041
= 3,403 million Sk

Volvo
assumed Volvo was in stable growth, given its
size and the competitive nature of the
automobile industry, and that the expected
growth rate in perpetuity would be 4%.
assumed that Volvos return on capital in the
future would be equal to the average return on
capital that the firm earned between 1998 and
2002 of 12.2 %
Thus Reinvestment Rate = g/ROC = 32.78%

Volvo
Expected free cash flow to the firm in 2003
= 3403 (1.04) (1-.35) (1 - .3278) = 1,546 mn Sk

Discounting at WACC of 7.36%

Then Value of Operating Assets =
1546 / (.0736 - .04) = 45977

Volvo
Implicit Assumption
Volvos earnings will rebound quickly to
normalized levels and that the recession will
end in the very near future

If recovery will take time, say 2 years

discount the value of the firm back two years
at the cost of capital
Value of the operating assets assuming 2-year
recovery = 45977/1.07362 = 39,889

Firms with long term problems

Strategic Problems
- Scaled down revenue growth
and expected margins if the firm
will never recover
- Optimistic of recovery or entry into
new market, you can assume that
the firm will revert to its traditional
margins and growth

Operating Problems

Financial Leverage

- Gradually improve

(Operating earnings
May be positive but
Equity earnings may
Be negative)

operating margins
to industry average.
The speed of recovery would
depend on:
- Size of the firm
- Nature of inefficiency
( equipment Vs. training)
- External constraints
( contractual and social
pressure)
- Management quality

- No immediate
threat of bankruptcy
- Adjust debt ratio,
cost of capital
- APV
( Adjust operating margins
to industry average, if
necessary)
-Threat of bankruptcy
- Liquidation value
- Option pricing

Life Cycle

Infrastructure firms

Firms with patents

( negative earnings and high

leverage)

( will be discussed later)

- Assume that revenue growth

will be brisk for the next few years
taper of to a stable growth rate
- EBITDA will gradually move from
the current level to industry average
- Capital spending will be high in the
initial years and will be at maintenance
levels during the later years.
- Depreciation tracks capital expenditure
with a one year lag.
- Working capital is a % of sales ( industry
averages)

Young firms
( will be discussed
later)