Prospective Analysis: Valuation Theory

How do we convert forecasts of future into value?

Variety of Methods

Dividend Discount Models Discounted Cash Flow Models Discounted Abnormal Earnings Models Differ because of truncation assumptions

All models are identical in theory

What are we valuing?

Equity Directly Assets (Enterprise) and then Equity Multiples or Comparables Can we ground these in theory?

Short Cut Methods

The Three Fundamental Approaches

Approaches are equivalent in theory

Examples in book, Simple example in excel Equity Value = PV of expected future dividends DIV3 DIV1 DIV 2 V ........ (1 re ) (1 re ) 2 (1 re ) 3 Equity Value = Book Value + PV of expected abnormal earnings NI r * BVE0 NI 2 re * BVE1 NI 3 re * BVE2 ........ V BVE0 1 e (1 re ) (1 re ) 2 (1 re )3 Equity Value = PV of expected free cash flow to equity
V FCFE1 FCFE2 FCFE3 ........ (1 re ) (1 re ) 2 (1 re )3

Discounted Dividends

Discounted Abnormal Value

Discounted Cash Flows

Multiples Based Valuation

Why are they popular?

Simplicity Can work without detailed data or analysis

Problems

Choice of Comparable Simple or Simplistic? Propagation of Misvaluation Can be used to justify almost any valuation

Can we do muliples based valuation in a more analytical way?

Rigorous Multiples Based Valuation

Start with
NI1 re * BVE0 NI 2 re * BVE1 NI 3 re * BVE2 ........ (1 re ) (1 re ) 2 (1 re )3

V BVE0

Divide Equation by starting book value (BVE0)

NI / BVE0 re NI 2 / BVE0 re * BVE1 / BVE0 NI3 / BVE0 re * BVE2 / BVE0 V 1 1 ........ (1 re ) BVE0 (1 re ) 2 (1 re )3

This can easily be simplified to

ROE1 re ( ROE 2 re ) * BVE1 / BVE 0 ( ROE 3 re ) * BVE 2 / BVE 0 V 1 ........ BVE 0 (1 re ) (1 re ) 2 (1 re ) 3

Interpreting Price to Book Ratios

A Firms Price to Book Ratio Depends on

Ability to generate ROEs in excess of cost of equity Cumulative Growth in Investment Base Cost of Equity

A Firm with forecasted ROE above cost of equity will have P/B greater than 1

Growth in investment base will further increase P/B Why payout when future projects generate + NPV?

A Firm that meets cost of equity will have P/B close to 1. A Firm with ROE below cost of equity will have P/B below 1

Growth will further lower P/B Better to payout, rather than invest in NPV projects

Interpreting Price to Earnings Ratios

Value/Earnings = Value/Book * Book/Earnings in other words Value/Earnings = (Value/Book) / (Earnings/Book) or Value/Earnings = (Value/Book)/ROE PE Ratios are hence affected by current ROEs

Very high current ROEs => lower PE ratios as market expects current ROE to potentially not be sustainable Very low current ROE => higher PE ratios as market expects current downturns to be temporary