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Chapter 6: The Role of Financial Information in Valuation. Learning objectives: To learn the basic steps in business valuation. Forecast a company’s financial statements. Using the discounted free cash flow approach and the abnormal earnings approach to valuation. 6- 1.

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Chapter 6 the role of financial information in valuation
Chapter 6: The Role of Financial Information in Valuation

  • Learning objectives:

  • To learn the basic steps in business valuation.

  • Forecast a company’s financial statements.

  • Using the discounted free cash flow approach and the abnormal earnings approach to valuation.

6-1


Learning objectives concluded
Learning objectives:concluded

  • What factors contribute to variation in price-earnings multiples.

  • What factors influence earnings quality.

  • How stock returns relate to “good news” and “bad news” about earnings..

6-2


Framework for business valuation
Framework for Business Valuation:

There are three steps involved in valuing a company:

  • Step 1: Understand the past (Ch. 5)

  • Step 2: Forecasting the Future

  • Step 3: Valuation of Equity Price

    • Free cash flow model

    • Abnormal earnings approach


Business valuation contd step 2 and step 3

Step 2:

Step 3:

Forecast future amounts of the financial attribute that ultimately determines how much a company is worth.

a. Determine the risk or uncertainty associated with the forecastedfuture amounts.

b. Determine the discounted present value of the expected future amounts using a discount rate that reflects the risk from Step 2 a.

Business valuation (contd.): Step 2 and Step 3

  • Free cash flows

  • Accounting earnings

  • Balance sheet book values

6-4


Equity valuation step 1 understanding the past
Equity Valuation Step 1: Understanding the past

  • Information Collection

  • Understanding the business

  • Accounting Analysis

  • Financial Ratio Analysis

  • Cash Flow Analysis


Equity valuation step 2 forecasting the future
Equity Valuation Step 2: Forecasting the Future

  • Forecast future amounts of value- relevant financial attributes using a structured forecasting which includes:

  • Income statement forecasts

  • Balance sheet forecasts

  • Cash flow forecasts

  • Examples of Value-relevant financial attributes: cash flows, earnings and book value.


Procedures in financial statement forecasting see appendix b
Procedures in financial statement forecasting (see Appendix B)

  • Project sales revenue for each period in the horizon (i.e., next 5 years).

  • Forecast operating expenses such as COGS, selling and general administration expenses (but not depreciation, interest, or taxes) using expense margin.

  • Forecast balance sheet assets and liabilities (excl. long-term liabilities) needed to support the projected operations in 1 and 2.


Procedures in financial statement forecasting contd
Procedures in financial statement forecasting (contd B).)

  • Forecast depreciation expense and the income tax expense.

  • Forecast financial structure (and therefore, long-term debt), dividend paid, and interest expense.

  • Derive projected cash flow statements from the forecasted income statements and balance sheets.

  • Thus, expected future amounts of value-relevant financial attributes such as cash flows, earnings and book value are obtained.


Financial statement forecasts example source p6 21 of rcjm textbook 4 th edition
Financial Statement Forecasts Example B)(source: P6-21 of RCJM textbook, 4th edition)

Using the steps outlined in previous pages and the following information to forecast 2003 and 2004 financial statements of Krispy Kreme Doughnuts, Inc.:

  • Sales for 2003 and 2004 will equal $657 million and $819 million, respectively.

  • Non-operating expenses and income will be zero.

  • The company’s income tax rate will be 35%.

  • All other income statement items are expected to equal their 2002 levels as a percentage of sales.


Financial statement forecasts example contd
Financial Statement Forecasts Example (contd.) B)

  • Depreciation expense was $12.3 million in 2002 ($10.3 in cost of goods sold and $2.0 in selling, general, and administration (SG&A) and $8 million in 2001 ($6.0 in cost of goods sold and $2.0 in SG&A).

  • All balance sheet items except Common stockholders’ equity are expected to equal their 2002 levels as a percentage of sales. Accumulated depreciation Was 43.9 million and $50.2 million in 2001, and 2002, respectively. Combine long-term investments, intangibles and Other assets into a single balance sheet item (other assets).


Financial statement forecasts example contd1
Financial Statement Forecasts Example (contd.) B)

  • Debt is expected to be 15% assets, and the current portion of long-term debt will be 10% of total debt each year. Interest expense will be 6% of debt at the beginning of each year.

  • The company will issue or buy back stock during 2003 and 2004 to meet its cash flow needs or to distribute excess cash. Dividends and Other comprehensive income will be zero.


Financial statement forecasts example contd2
Financial Statement Forecasts Example (contd.) B)

Additional questions:

  • Analysts’ forecasts of net income are $50.7 million and $65.9 million for 2003 and 2004, respectively. How do your net income forecasts compare with those of the analysts? What does this tell you about your forecasting assumptions compared to those used by the analysts?


Financial statement forecasts example contd3
Financial Statement Forecasts Example (contd.) B)

  • Why is it important to assume the company will issue or buy back stock when constructing financial statement forecasts?

  • How do your sales, net income, accounts receivable, total assets and operating cash flow forecasts for 2003 and 2004 compare to the amounts actually reported by the company in those two years? What factors are likely to explain sizable differences between the actual figures and your forecasts?

  • See p9-p13 of chapter 6 homework solutions on iLearn.


Equity valuation step 3 valuation
Equity Valuation B)Step 3: Valuation

  • Determine the risk (r) or uncertainty associated with the forecasted future amounts .

  • Use the discount rate that reflects the risk to calculate the discounted present value of the expected future amounts.


Learning objective
Learning Objective: B)

Step 3: Valuation


Equity valuation step 3 valuation1
Equity Valuation B)Step 3: Valuation

  • Cost of capital (risk associated with the forecasted future amounts).

  • Valuation Models

    • Discounted free cash flow model

    • Abnormal earnings model (residual income model) (see Appendix A, P6-13).

  • Complications

    • Negative values

    • Distortions from accounting reporting


Equity valuation step 3 valuation contd
Equity Valuation B)Step 3: Valuation (contd.)

  • Cost of equity capital (r )

  • Models available to estimate cost of capital include:

  • CAPM model: cost of capital = Rf + beta risk x (Rm – Rf)

  • Rf= risk free rate; Rm = market return


Cost of capital weighted average cost of capital
Cost of Capital ( Weighted Average Cost of Capital) B)

  • The WACC equation is the cost of each capital component multiplied by its proportional weight and then summing:

    Where: R equity = cost of equity R debt = cost of debt E = market value of the firm's equity D = market value of the firm's debt V = E + D E/V = percentage of financing that is equity D/V = percentage of financing that is debt Tax% = corporate tax rate


Learning objective1
Learning Objective : B)

The Discounted Free Cash Flow Approach to Equity Valuation


Corporate valuation discounted free cash flow approach
Corporate valuation: B)Discounted free cash flow approach

This approach says the value per share (P0) of a company’s common stock is given by:


Corporate valuation discounted free cash flow approach1
Corporate valuation: B)Discounted free cash flow approach

  • CFt is free cash flow of year t.

  • CF equals company’s operating cash flows (before interest) minus cash needed for routine operating capacity replacement.

  • This CF is cash available for further expansion of operation, debt reduction, etc.


Corporate valuation discounted free cash flow approach2
Corporate valuation: B)Discounted free cash flow approach

  • If the valuation is for common stockholders, the CF needs to subtract interest payments, debt repayments and preferred dividends.

  • r is the discount rate appropriate for the risk associated with the forecasted free cash flows.


Corporate valuation discounted free cash flow approach3
Corporate valuation: B)Discounted free cash flow approach

  • is the discount factor for forecasted cash flows in period t.

  • E0 is investors’ expectations (at time 0) about future free cash flows.


Business valuation discounted free cash flow illustration
Business valuation: B)Discounted Free Cash Flow illustration

Estimated DCF value per share

6-24


Discounted free cash flow approach a simplified model
Discounted free cash flow approach B)- A simplified model

Continuing to infinity

  • Expected free cash flow in each year set equal to the free cash flow realized in Year 0 – a zero growth perpetuity.

  • The above constant perpetuity can be simplified to :


Application of free cash flow valuation in goodwill impairment estimation
Application of Free Cash Flow Valuation in Goodwill Impairment Estimation

  • The free cash flow approach can be used to estimate the current value of a business with goodwill from a prior acquisition .

  • When the estimated current value of the business minus the fair value of its net assets is less than the reported goodwill, an impairment exists.


Learning objective2
Learning Objective : Impairment Estimation

The Role of Earnings in Equity Valuation


The role of earnings in valuation
The Role of Earnings in Valuation Impairment Estimation

  • FASB’s assertion: information about earnings measured by accrual accounting generally provides a better indication of a firm’s performance than information of cash flows.

  • Also, a popular belief is that accrual accounting earnings are more useful in predicting future cash flows than cash flows.


The role of earnings in valuation1
The Role of Earnings in Valuation Impairment Estimation

  • Both FASB’s assertion and the common belief has been validated by academic studies:

  • 1. Current earnings are a better forecast of future cash flows than are current cash flows (Barth, Cram and Nelson, 1998)

  • 2. accrual earnings are more correlated with stock returns than operating cash flows. (Dechow, 1994)


The role of earnings in valuation zero growth example

Estimated share price

Price earning ratio (P/E) or earnings multiple

The role of earnings in valuation:Zero growth example

  • Based on FASB’s assertion, replace the CF from the equation by Earnings (denoted X) in the zero growth perpetuity setting:


The role of earnings in valuation zero growth example1

Estimated share price

Price earning ratio (P/E) or earnings multiple

The role of earnings in valuation:Zero growth example

Under zero growth, P/E ratio is a reciprocal of cost of capital. Therefore, if cost of capital equals 0.1, the earnings multiple (P/E) will be 10.


Learning objective3
Learning Objective : Impairment Estimation

The Abnormal Earnings Approach (the Residual Income Model) to valuation


The abnormal earnings approach to valuation
The abnormal earnings approach to valuation Impairment Estimation

  • What matters most to investors is:

    • The amount of money they turn over to management.

    • The profit management is able to earn on that money.

  • Residual income (abnormal earnings) is measured as follows:

(Book Value of Equity)

What management does with the money

What investors entrust to management

Expected return

Abnormal Earnings = Actual Earnings – Required earnings


Abnormal earnings

Management does Impairment Estimationbetter than expected:

+ $100 of abnormal earnings

$300

$200

Management does worse than expected:

- $50 of abnormal earnings

$200

$150

Abnormal earnings

  • Abnormal earnings is:

  • Suppose investors contribute $2000 of capital, and expect to earn a 10% rate of return.

  • Total Expected return is 2000*10%=200


Abnormal earnings valuation approach
Abnormal earnings valuation approach Impairment Estimation

What shareholders have invested in the firm

Expectations operator

Cost of equity capital

What management accomplished

What shareholders expected


Abnormal earnings price premium and discount the following is a hypothetical example

[2] Impairment Estimation

$10

$15

- $5

Firms that earn negative AE sell at discount to BV

$5 discount

Abnormal earnings:Price premium and discountThe following is a hypothetical example

[1]

$20

$15

$5

Investors willingly pay a premium over BV for companies that earn positive AE

$5 premium

AE stands for abnormal earnings.


Terminal value
Terminal Value Impairment Estimation

  • The explicit forecast of a firms’ performance(i.e., earnings) generally extend for only a period of time. (e.g. from 2003 to 2007).

  • The final year of this forecast period is labeled the terminal year.

  • Terminal value is the present value of a firm beyond the terminal year of forecast.


Terminal value contd
Terminal Value (contd.) Impairment Estimation

  • Assuming year 5 is the terminal year, the terminal value can be estimated by :

    (Estimated Abnormal Earnings of Year 6/ r)

    (1+ r) T

    r = cost of capital

    T=to the 5th power when the explicit forecast is for 5 years.

  • If a non-zero growth rate is assumed, the growth rate should be subtracted from r in estimating the value beyond the terminal year.


Abnormal earnings approach summary

A company’s future earnings are determined by: Impairment Estimation

the resources (net assets) available to management;

the rate of return (profitability) earned on those net assets.

The abnormal earnings valuation model makes explicit the role of:

Income statement and balance sheet information.

Cost of capital

Abnormal earnings approach: Summary


Abnormal earnings approach summary1

If a firm can earn a return Impairment Estimationabove its cost of capital (i.e., r x BV), then it will generate positive abnormal earnings.

Firms expected to generate positive abnormal earnings sell at a premium to equity book value.

Abnormal earnings approach: Summary


Valuing a business opportunity the bookworm store example
Valuing a business opportunity: Impairment EstimationThe BookWorm store Example


Valuing a business opportunity free cash flow approach
Valuing a business opportunity: Impairment EstimationFree cash flow approach

What the business is worth


Valuing a business opportunity abnormal earnings approach
Valuing a business opportunity: Impairment EstimationAbnormal earnings approach

The same as our previous FCF estimate


Equity valuation using the abnormal earnings approach p6 13 of rcjm textbook

This problem illustrates how the abnormal earnings valuation model can be combined with security analyst’ published earnings forecasts to estimate stock price and to spot potentially overvalued stocks.

Use the abnormal earnings model and the following information to derive an estimate of Krispy Kreme (KK) stock price as of August 2003.

Additional information:

Actual EPS for 2001 and 2002 were $0.49 and $0.70, respectively.

Equity Valuation Using the Abnormal Earnings Approach (P6-13 of RCJM textbook)


Equity valuation contd

The per share amount of stock issued in 2001 and 2002 was $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.

Other comprehensive income per share was $0.32 in 2002 and zero in 2001. Analysts are forecasting other comprehensive income to be zero each year during the next five years.

KK does not pay dividends.

ROE, calculated using the beginning-of-year equity book value, was 21.1% and 20.2% in 2001 and 2002, respectively.

Equity Valuation (contd.)


Equity valuation contd1

Analysts are forecasting EPS to be $ $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.0.70 and $0.89 in 2003 and 2004, respectively. The estimated long-term EPS growth rate is 32.5% for 2005 through 2007.

KK’s equity cost of capital is 11%, and the long-term growth rate (beyond 2007) is assumed to be 3%.

Why might the value estimate from the above differ from the company’s stock price in August 2003 (i.e., $44 per share)?

See Solutions posted on iLearn.

Equity Valuation (contd.)


Learning objective4
Learning Objective : $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.

Research on

Earnings and Equity Valuation


Earnings and stock prices evidence on value relevance
Earnings and stock prices: $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.Evidence on value relevance

  • If investors use accrual earnings to price stocks, then earnings differences across firms should explain differences in stock prices.

  • The test:

Stock price

Earnings per share

2002 P/E relationship for 40 restaurant companies

Stock price at $0 EPS

Earnings multiple (should be statistically positive)


Earnings and stock prices contd
Earnings and Stock prices (contd.) $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.

  • Why would two firms with identical current earnings have very different stock price ?

  • Why can earnings explain 100% of stock price variation?


Sources of variation in p e multiples
Sources $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years. of Variation in P/E Multiples

  • In addition to earnings, Stock prices (and thus earnings multiples) are influenced by:

    • Risk differences

    • The mix of earnings components ( transitory, permanent, and valuation irrelevant)

    • Growth opportunities:

NPVGO : Net present value of future growth opportunities


The mix of earnings components
The Mix of Earnings Components $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.

  • Stock prices reflect information about the components of earnings.

e.g. loss from discontinued operations

e.g. cumulative effect of changes in accounting methods

e.g. income from continuing operations


The mix of earnings components earnings components and p e
The Mix of Earnings Components : $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.Earnings components and P/E

Differences in earnings components mix produces differences in P/E


Earnings and stock prices earnings quality
Earnings and stock prices: $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.Earnings quality

  • The notion of earnings quality is multifaceted, and there is no consensus on how best to measure it.

  • Most observers agree that earnings are high quality when they are sustainable over time.


Earnings and stock prices earnings quality1
Earnings and stock prices: $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.Earnings quality

  • Unsustainable earnings might arise from:

    • Debt retirement

    • Corporate restructurings

    • Temporary reductions in advertising or R&D spending

    • Inherent subjectivity of accounting estimates.

  • Research evidence shows that earnings quality matters to investors.


Learning objective5
Learning Objective : $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.

Earning surprises


Earning surprises share price response to earnings information
Earning surprises: $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.Share price response to earnings information

  • Here’s an expression that describes how stock prices change in response to earnings information:

  • If GM’s quarterly earnings announcement just confirms investors’ expectations, there is no surprise and no change in expected future earnings, so GM’s share price is also unchanged.

GM’s earnings announcement could inform investors about

current

or future earnings


Earnings surprises typical behavior of stock returns
Earnings surprises: $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.Typical behavior of stock returns

Stock returns and quarterly earnings “surprises”


Cash flow analysis and credit risk traditional lending products
Cash flow analysis and credit risk: $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.Traditional lending products

Short-term

Loans

  • Seasonal lines of credit

  • Special purpose loans (temporary needs)

  • Secured or unsecured

Long-term

Loans

  • Mature in more than 1 year

  • Purchase fixed assets, another company,

  • refinance debt ,etc.

  • Often secured

Revolving

Loans

  • Like a seasonal credit line

  • Interest rate usually “floats”

Public Debt

  • Bonds, debentures, notes

  • Sinking fund and call provisions

  • Covenants


Credit analysis evaluating the borrower s ability to repay

Step 2: $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.

Evaluate

accounting quality

  • Spot potential distortions

  • Adjust reported numbers as needed

Step 3:

Evaluate current

profitability and health

  • Examine ratios and trends

  • Look for changes in profitability, financial

  • conditions, or industry position.

Step 4:

Prepare “pro forma”

cash flow forecasts

  • Develop financial statement forecasts

  • Assess financial flexibility

Step 5:

Due diligence

  • Kick the tires

Step 6:

Comprehensive risk

assessment

  • Likely impact on ability to pay

  • Assess loss if borrower defaults

  • Set loan terms

Credit analysis:Evaluating the borrower’s ability to repay

Step 1:

Understand

the business

  • Business model and strategy

  • Key risks and successful factors

  • Industry competition


The credit rating process
The Credit Rating Process $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.


Standard poor s ratings
Standard & Poor’s Ratings $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.


Based on
Based On: $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.


Summary
Summary $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.

  • This chapter provides a framework for understanding equity valuation.

  • The framework illustrates how accounting numbers are used in valuation, and cash flow analysis.


Summary1
Summary $0.65 and $0.39, respectively. NO stock is expected to be issued or bought back during the next five years.

  • You have also seen how financial reports help investors and lenders assess the “amounts, timing, and uncertainty of prospective net cash flows”.

  • Knowing what numbers are used, why they are used, and how they are used is crucial to understanding the decision-usefulness of accounting information.


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