Weis Markets Inc.—Measurement Concepts & Valuation

Teaching Notes:

The first part of this case centers on fundamental accounting concepts and includes questions about specific FASB Concepts Statements. The definitions of assets, liabilities and other components of the financial statements are essential building blocks for an understanding of current U.S. financial reporting and an understanding of its shortcomings. Instructors can supplement textbooks that do not cover the Concepts Statements with excerpts from the Concepts Statements themselves or from the very readable FASB Financial Accounting Series monograph by Reed Storey and Sylvia Storey. The concepts covered tie in nicely with those of the International Accounting Standards Board, too.

Later, the case offers students the opportunity to value a company that owns a number of grocery chains. We make a number of simplifying assumptions, but in class discussion instructors should encourage students to challenge the assumptions and discuss how to arrive at more precise values. The case illustrates the important differences between book and market values. It also illustrates the difference between balance sheet and income statement-based valuation approaches.

The case instructs students to assume a long-term growth rate of 3.87%. The case does not require it, but instructors can challenge students to independently come up with the rate. The easiest way to estimate g is to consider the growth in residual earnings [Bt(ROEt+1 - re)] over the three-year horizon period. That is, the numerator in the valuation model terms for years 1-3 is growing at 3.87%. The theoretical way to arrive at the rate is to note that ROE × (1 – dividend payout ratio – repurchase ratio + stock issuances) = Growth in equity. The term (1 - dividend payout ratio – repurchase ratio + stock issuances) is labeled the “plowback ratio” in some textbooks. For the Weis case: 9% × 43% = 3.87%.

An active learning approach to this case involves splitting the class into three groups: buyers, sellers, and arbitrators. Have each group work independently to arrive at a valuation. Then have the groups negotiate. The arbitrators can determine what they feel is a “fair” price based on the arguments presented. Finally, have each group report back to the class. (Several sets of negotiations can take place. Depending on class size you may need to split them into 6 or 9 groups. An ideal group size is 3-5 students).

a. i. Users of Weis Markets, Inc., (Weis) financial statements include stockholders, financial analysts, creditors, Weis’s managers, and employees. Stockholders and financial analysts would like to know the relative “financial health of the company.” Creditors are interested in whether Weis can pay their debts as they come due. Weis’s management likely has access to more timely information than periodic external reports. However, to the extent that year-end bonuses or other contingent outcomes are based on reported results, managers would be interested in the final audited financials. The employees would like to know how much money the company made in the previous year when it comes time to negotiate their contracts. a. ii. If a company uses accrual-basis accounting, it records the effects of economic events as the events occur and not as cash (or its equivalent) is received or paid. Accrual-based accounting provides a better measure for assessing a firm’s performance because cash flows can be lumpy and not indicative of the firm’s true, underlying performance. Weis uses accrual- basis accounting. For example, Weis records wage expense as wages are earned regardless of whether employees are paid in advance or will be paid in some future period. Weis records these as “Accrued expenses” on the balance sheet. That is one indication that the company uses accrual accounting. a. iii. The going concern assumption is perhaps the most critical assumption underlying accrual accounting. Invoking the assumption, one assumes that the entity will operate beyond the current year, that is, indefinitely into the future. The going concern assumption must be met whenever a company capitalizes costs or records assets on the balance sheet. For example, Weis capitalizes “Prepaid expenses” which represent costs such as rent and insurance paid in advance. Rather than expense these costs immediately, Weis capitalizes the costs and amortizes them over the rental period. If the company was not expected to operate in the future, there would be no basis for calling such costs assets and allocating them over the rental periods. Thus, the going concern assumption is critical to the definition of an asset (from which the definitions of liability, revenue, and expense derive). Similar arguments can be made for the Property and equipment, Intangibles, and Goodwill accounts. In other words, there would be no expected future economic benefit because there is no future expected for the company. b. i. Typically, companies report the financial position of the company every quarter. The audited annual report is typically more detailed than the non-audited quarterly reports but the quarterly reports are made public on a more timely basis. b. ii. There is a trade-off between frequency of financial reports and their reliability. Whenever measurements need to be made prior to the settling of a transaction or residual uncertainty is resolved for an event, management will need to exercise judgment. The shorter the period between measurements, the less new information will be available, and therefore the more uncertain will be the adjustments. The remeasurement of assets and liabilities is what leads to the measurement of income. So, although there may be a demand for more timely performance reporting, users must recognize the trade-off between timeliness and reliability.

Weis Markets Inc.—Measurement Concepts & Valuation 1 © Copyright 2012 by Cambridge Business Publishers, LLC. All rights reserved. No part of this publication may be reproduced in any form for any purpose without the written permission of the publisher. b. iii. More timely release of financial information enhances relevance. However, this often means that information may be less reliable. The more quickly a firm publicly releases its financial statements, the less time there is to verify the information. For example, one way to ascertain the accounts receivable balance at year-end is to observe collections after year- end. The shorter the period between year-end and the release of the financial statements, the fewer A/R collections will be observed—the balance must then be estimated.

The trade-off between relevance and reliability is something firms and their auditors have long grappled with. The benefit to managers of increased reliability and relevance of financial reports is reduced cost of capital. Investors and creditors assess the riskiness of a company, in part, by the reliability of its reported financial information. The less risky a company is perceived, the lower the expected returns or the cost of debt. For investors, reliable information enhances investment decisions and reduces risk. c. i. Assets are probable future economic benefits obtained or controlled by the company as a result of past events or transactions. Assets are disclosed on the balance sheet. Some of Weis Markets’ assets include cash, prepaid expenses, accounts receivable, property and equipment, and intangibles like brand names they have acquired. c. ii. Liabilities are probable future economic sacrifices arising from present obligations to transfer assets or provide services to another entity as a result of past events or transactions. Liabilities are disclosed on the balance sheet with the exception of contingent liabilities whose amount cannot be measured. Weis Markets has liabilities in the form of accounts payable, accrued expenses, and income taxes payable. c. iii. Owners’ equity is the residual interest in the company – the difference between assets and liabilities. Some examples of owners’ equity at Weis Markets are common stock and retained earnings. c. iv. Investments by owners refers to any increase in the equity of the firm resulting from something valuable being transferred to the firm by shareholders. Transfers are found on the statement of stockholders’ equity and on the statement of cash flows. Weis issued shares each year as evidenced by the line item, “Proceeds from issuance of common stock” on the statement of cash flows. c. v. Distributions to owners are decreases in the equity of the firm owing to the transfer of assets or services to the shareholders. A common distribution to owners is the payment of dividends which are included on the statement of stockholders’ equity and statement of cash flows in the financing section. Weis Markets paid dividends to shareholders for the past three years. Another distribution is the repurchase of shares by the company from its shareholders. Weis has repurchased shares each of the past three years. c. vi. Revenues are increases in assets or decreases in liabilities due to the firm performing activities (delivering goods or performing services) that are considered central to the firm’s operations. Revenues are found on the income statement. At Weis, they are referred to as Net sales.

Weis Markets Inc.—Measurement Concepts & Valuation 2 c. vii. Expenses are decreases in assets or increases in liabilities that result from the performing activities (delivering goods or performing services) that are considered central to the firm’s operations. Expenses are found on the income statement. Weis’ expenses include cost of goods sold for merchandise, operating, general, and administrative expenses, and income tax expense.

c. viii. Gains are increases in assets or decreases in liabilities that are peripheral or incidental to the firm’s central operations. Gains are reported on the income statement, when they occur. Weis does not report any such gains directly on its income statement, though there may be some small ones in one or another line item.

c. ix. Losses are decreases in assets or increases in liabilities that result from transactions that are peripheral or incidental to the firm’s central operations. Losses are reported on the income statement, when they occur. It does not appear that Weis incurred any losses during the reported years— though, as with the gains, there may be small ones included under some other account.

c. x. Comprehensive Income is the change in the firm’s equity during the period from all transactions except those with owners. Comprehensive income is reported in the statement of shareholders’ equity. Weis’s comprehensive income differs from net income largely due to the recording directly in equity of unrealized gains and losses on available-for-sale marketable securities. d. i. Cash and interest-bearing deposits are measured at market value which is typically the same as face value. d. ii. Accounts receivable are measured at net realizable value. Net realizable value begins with the gross amount of the accounts receivable (that is, their face value) and adjusts the total for any amount that Weis does not expect to collect. d. iii. Inventories are valued at the lower of cost or market value. Because Weis does not track each unit of inventory individually, they adopt a cost flow assumption (in this case a Last In First Out or LIFO) assumption for much of their inventories. d. iv. Property and equipment is measured at historical cost less the accumulated depreciation and amortization that has been recorded to date. In other words, the company spreads the cost of the assets over its useful life. However, if Weis had evidence that the value of their land was permanently impaired, then the company would need to write down the historic cost to market value. This could occur, for example, if land is found to be environmentally compromised. In that case, the probable future economic benefit is reduced and so the asset’s book value is changed to reflect that. d. v. Accrued-self insurance is an account that captures an estimate of the payments Weis will make to cover claims for accidents that have taken place at their stores but have not yet been settled. The balance represents the amount Weis expects to pay.

Weis Markets Inc.—Measurement Concepts & Valuation 3 e. Aside from the fact that current GAAP does not permit full fair value reporting, Weis Markets does not measure all of their elements at market value because there may not be a reliable fair value for each item. Hence, fair value is subject to interpretation. The FASB’s Statement of Concepts #5, paragraph 90, explains, “Information based on current prices should be recognized if it is sufficiently relevant and reliable to justify the costs involved and more relevant than alternative information.” More and more measurements are, however, being made at fair value. In large part this stems from a better understanding of the limitations of historical cost accounting and a growing set of items that can, after all, be measured reasonably reliably at their fair values. f. i. The net book value (NBV) of Weis at December 29, 2007, is $648,228,000, which is the difference between Weis’ assets and liabilities. NBV is analogous a homeowner’s equity calculated by comparing the purchase price of the home and the current mortgage balance. Note that NBV is not likely to be the same as the “fair value” of the company, which is based on present-day asset and liability values or the future earnings of the firm. f. ii. Generally, current assets and liabilities are stated at close to fair market value. (Indeed, the Marketable securities are reported at fair market value.) One important exception is inventory, which is stated at historical cost using the LIFO cost flow assumption. Because that assumption can lead to old prices being associated with current items, LIFO companies are required to disclose in a note what the current value of their inventories is.

Fixed assets represent the company’s land, building, and equipment and are stated at their original cost to the company less depreciation. Depreciation, in accounting, is a means of allocating the original cost of an asset to the periods that benefit from its use. It is not a means of valuing an asset. Therefore, there’s a good chance that the FMV of the fixed assets is different than their NBV.

Goodwill is reported when a company has made an acquisition of another company and the purchase price exceeds the fair value of the net identifiable assets (i.e., assets less liabilities) acquired. Thus, it represents things like a control premium paid to acquire the company, synergies, and other intangible benefits that Weis paid for and that are expected to result in enhanced future cash flows. Goodwill is reported at cost less any impairment adjustments, thus it could have a fair value that differs from book value.

Liabilities generally have NBVs that approximate FMV. This assumption may not always hold, however, if a company has long-term debt (e.g., bonds) during periods of fluctuating interest rates. As most of Weis’s liabilities are current, it is reasonable to assume that NBV approximates FMV.

One exception is Deferred Income Taxes. These represent expected future tax obligations (or benefits in the case of Deferred Tax Assets). They are measured with no consideration of the time value of money and, thus, generally overstate their true obligation.

Another liability with a fair-market value that differs from the amount on the balance sheet is contingent liabilities. This includes items such as pending lawsuits or the future cost of environmental remediation. Such items can often not be accurately estimated and so are disclosed in the footnotes to the financial statements but not recorded on the balance sheet.

All in all, most of Weis’s balance sheet accounts are measured at historical cost. In many cases, that measure is not far off a fair value estimate. Where the differences are larger, the main reason for sticking to historical costs has been the lack of a reliable current value figure. Weis Markets Inc.—Measurement Concepts & Valuation 4

f. iii. 2007 2007 Adjusted

Assets

Cash and cash equivalents $ 41,187 $41,187

Marketable securities 26,182 26,182

Accounts receivable, net 48,460 48,460 193,732 + 54,494 = Inventories 193,732 248,226

Prepaid expenses 3,317 3,317

Income taxes recoverable 8,074 8,074 499,246 + (200,000 – Property and equipment, net 499,246 85,158)= 614,088

Goodwill 15,722 15,722

Intangible and other assets, net 4,149 4,149 + 4,500 = 8,649

Total assets $840,069 $1,013,905

Total liabilities (no change) $191,841 $191,841

Net Book Value (Total assets – Total liabilities) $648,228 $ 822,064

f. iv. The difference between the amounts in parts f i. and f iii. is attributable to the appreciation in value of individual assets. If the company were to sell the individual assets of Weis, we would expect a gain equal to the difference between the net FMV and the NBV. g. i. 21.11 = 1 / r. This implies that, r = 4.74%.

This rate seems very low. It is only slightly above the rate paid by long- term government bonds—and those bonds are substantially less risky than a firm that derives the bulk of its revenues from running a set of grocery chains. On the other hand, the low rate compensates for the fact that no growth in earnings was factored in (see below). g. ii. Using the Price-Earnings multiple of 21.11 and net income for 2007 of $50,990, we arrive at a value of $1,076,399 (thousands) (i.e., 21.11 × $50,990).

By using net income, we are implicitly assuming that net income does not include any nonrecurring gains or losses. In other words, we assume that the figure is representative of the future earnings that the company will generate.

Weis Markets Inc.—Measurement Concepts & Valuation 5 g. iii. The difference between f iii. and g ii. represents the value of Weis’s assets taken together. That is, owning buildings, inventory, and having a reputation with your customers is worth more together than if each was owned individually by others. The value of the sum is worth more than the individual parts. In addition, we only valued the reported assets and liabilities when we adjusted our balance sheet values. We didn’t consider missing assets like, for example, the value of a happy and trained workforce- in-place or a well-functioning supply chain. If Weis was bought by another entity for the amount in part g ii., the difference between f iii. and g ii. would be set up as an asset called “goodwill.” g. iv. 21.11 = (1 + g) / (r - g). If r = 8%, then g = 3.11%.

We could assess whether the growth rate was reasonable by looking at past growth rates for Weis and other grocery companies. We also could look to industry trends and expansion plans announced by the company. A growth rate of 3.11% for an infinite period seems reasonable—especially if we assume the company remains in the fairly stable U.S. market for groceries. That is an industry that likely grows as the population of the country and its GDP grows. h. i. Calculating Bt involves estimating future earnings and the dividends and net share buybacks the company will make. That is, we need to forecast what makes owners’ equity increase (earnings) and decrease (dividends). We can calculate earnings through our estimate of future ROE. The earnings each year will be the book value at the start of the year times the ROE for the year. We can forecast buybacks by looking at Weis’s historical payout ratios for dividends and buybacks (scaled by earnings). The assumption is that the company will continue to pay dividends and repurchase stock at historic levels. If analysts have reason to believe otherwise, the correct payout ratios are the expected future ratios.

The complete table is as follows:

Residual income valuation model input Estimated model input ROEt – expected return on equity 2007: 7.9% 2006: 8.9% 2005: 10.5% Average: 9.0% Dividend payout ratio 2007: 61.4% 2006: 56.0% 2005: 47.7% Average: 55.0% Stock repurchase ratio (repurchases, net 2007: 2.8% of new stock issuances) 2006: 2.1% 2005: 0.9% Average: 2.0% B0 –book value of equity at December 29, $648,228 2007 B1 – expected book value of equity at $648,228 + $648,228 × 0.09 December 29, 2008 × (1 - 0.57)= $673,314 B2 – expected book value of equity at $673,314 + $673,314 × 0.09 × December 29, 2009 (1 - 0.57)= $699,372 B3 – expected book value of equity at $699,372 + $699,372 × 0.09 × December 29, 2010 (1 - 0.57)= $726,437

Weis Markets Inc.—Measurement Concepts & Valuation 6 h. ii. The valuation model is:

B (ROE -r ) B (ROE -r ) B (ROE -r ) B (ROE -r ) V=B++++0 1e 1 2e 2 3e 3 4e 00 123 3 (1+re ) (1+r e ) (1+r e ) (r ee -g)(1+r )

Applying our assumptions and model inputs from above, the calculation is:

648,228(0.09 0.08) 673,314(0.09 0.08) 699,372(0.09 0.08) 726,437(0.09 0.08) = 648,228 + + + + 1.08 1.08 1.08 (0.08 0.0387)1.08 − − − − 푉0 1 2 3 3 V0 = $805,185 −

Using these assumptions, the intrinsic value of Weis Markets is $805,185 (thousands). h. iii. Shares issued, in thousands 33,044.357 Treasury shares, in thousands 6,077.311 Shares outstanding in thousands 26,967.046

Intrinsic value per share = $805,185 ÷ 26,967.046 shares $ 29.86

h. iv. The net book value of equity (part f i.) was based on historical cost figures. Historical cost is based on past transactions and does not consider fair value changes (for the most part). The adjusted book value of equity (part f iii.) considered the assets and liabilities individually and did not consider the value they create as a coherent whole. The fair market value, based on the observed stock price (i.e., the one embedded in the PE ratio we used in part g ii.) considered the interrelations among the assets and liabilities of the company as well as the value created by unrecognized net assets (intangible assets that are not on Weis’s balance sheet as well as any unrecognized liabilities). The market value captured what market participants thought the company was worth. Finally, the intrinsic value (part h i.) used a formal valuation model that we estimated with our best beliefs about returns, growth, book values, and cost of capital to arrive at what we thought the company was worth.

Each value is different because they make different assumptions. Is there a “true” value? No. Each is used for different purposes. The book value could be used as a minimum value or used in contracting (e.g., a bond covenant might be based on the book value of assets or liabilities). The adjusted book value helps explain part of the difference between book and market values. The market value tells you what you would have to pay for the shares today or what you would get if you were to sell them today. Finally, the intrinsic value is what you think the whole company is worth.

Weis Markets Inc.—Measurement Concepts & Valuation 7 i. Yahoo.finance reveals the following price history:

Date Open High Low Close Volume Adj close

2-Jan-08 39.76 40.18 39.11 39.28 74,700 38.60

31-Dec-07 39.75 40.20 39.36 39.94 39,700 39.25

28-Dec-07 40.30 40.53 39.80 39.90 22,400 39.21

27-Dec-07 41.73 41.73 40.20 40.39 25,200 39.70

The difference between the two prices (the estimated intrinsic value versus the NYSE stock price) could be due to the assumptions and model inputs. For example, perhaps the cost of equity of 8% is too high. Changing re from 8% to 7% leads to an estimate of intrinsic value of $1,052,988. Or perhaps the long-term growth rate of 3.87% is too low. Or perhaps analysts believe the company will pay less dividends or buy back future shares in the future (the higher the plowback ratio, the lower the future book values).

The calculated intrinsic price of $29.86 indicates that the stock is significantly overvalued. To profit from this situation, I might consider selling short Weis’s stock.

Weis Markets Inc.—Measurement Concepts & Valuation 8