Accounting Valuation Model: Lectures 14 Valuation of Corporations

Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr.
Sohail Zafar
Lectures 14
Valuation of Corporations
Please note once you have done financial planning by preparing next 5 years projected income
statements and balance sheets then you are able to do valuation of the shares of that corporation.
Valuation means estimating fair value of shares of a corporation by a security analyst, and this estimated
value of share is also called intrinsic value. According to the Efficient Markets Hypothesis, in the efficient
markets the market price of a share is equal to its intrinsic value.
Different analysts may arrive at
different fair value estimates for the same corporation depending upon their assumptions about the
future performance of that particular corporation.
Security analysts disagree mostly about expected
growth rate of corporations and this disagreement results in variations in their respective fair value
estimates for a particular corporations share.
Commonly 6 models are used to value the common shares of a corporation, namely, dividend discount
model ( DDM);, its more elaborate form called equity cash flows model ; Free Cash Flows (FCF) Model;
Accounting valuation model; PE ratio; and PB ratio.
Accounting Valuation Model

Valuation refers to estimating a fair value for the equity of a Co, and is stated as rupees per share. The
first thing to understand about value of a companys share is the fact that the only valuable things in a
corporation are its assets which are found on the left hand side (LHS) of its balance sheet. Accountants
prepare balance sheet using historical cost principle whereby an asset is reported on balance sheet at the
cost at which it was bought in the past, and that may be a decade ago. Due to inflation, some of these old
assets have much higher market value (MV) today but accountants continue to report these assets at
their book value (BV). For depreciable assets book value (BV) reported on the balance sheet is cost of
acquisition of asset minus accumulated depreciation since it was acquired. Therefore there is likely to be a
significant difference between market value ( MV ) of some assets and BV of the same assets as reported
on the balance sheet.
Equity of corporation is represented by its shares. Since shares are pieces of papers, as such, shares have
no innate or inherent value.
Equity instruments (preferred and ordinary shares) and debt instruments
(such as bonds, notes, commercial papers, accounts payables) issued by a corporation derive their value
from the value of the assets of a corporation.
In this sense securities issued by corporations are
derivatives whose value is derived from the value of the underlying assets of that corporation.
Since
assets of a corporation are financed both by equity capital (i.e. owners funds) and debt capital (i.e.
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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr. Sohail Zafar
creditors funds, loans) therefore equity holders and debt holders of a company have claim on the assets
of that co.
Therefore ultimate driver of value of corporate shares (and also of corporate bonds and other papers
issued by a corporation) is value of corporate assets. Since we already have argued that BV in balance
sheet is a past oriented number calculated by using historical cost principle of accounting, therefore the
resulting BV of equity (OE = TA TL) is a past oriented number. But use of this BV of OE is made by the
accountants to estimate share price, and it is called accounting valuation model.
The derivation of the accounting valuation model is straight forward as given below:
Statement of changes in OE can be written as an accounting equality.
Please note Ending OE = EOE; and Beginning OE = BOE
EOE = BOE + NI - cash dividends - shares repurchased + shares issued.
Let us symbolize D = (cash dividends shares repurchased + shares issued). In the literature it is called
clean surplus representing what is left out of NI after paying dividends as well as net effect of equity
financing operations through shares issuance are repurchase during that year. Symbolizing it with D is a
convention only.
Therefore we can write statement of changes in OE as:
EOE = BOE + NI D
EOE BOE NI = -D
-(EOE - BOE - NI ) = D
-EOE + BOE + NI = D, rearranging the terms gives :
BOE + NI EOE = D
Now take another perspective, suppose shareholders require risk adjusted rate of return Kc from their
investment in the shares of this company. Think for a moment about money you deposit in the beginning
of a year in bank account and earn a rate of return on it at the end of the year; and then calculate your
end of the year bank balance as:
End of the year bank balance = Beginning bank balance + (beginning balance * rate of return)
for example if you deposited 100 Rs and bank gave 10% interest at the end of the year:
End of the year bank balance =100 + (100 * 10%)
End of the year bank balance = 100 + 10
End of the year bank balance = 110
Similarly if shareholders required rate of return is Kc, then by the same logic EOE should be:
EOE = BOE + (BOE * Kc)
But we saw above that
D = BOE + NI EOE
53
Inserting the above expression of EOE in the expression for D

D = BOE + NI {BOE +( BOE * Kc)}
D = BOE + NI BOE (BOE*Kc)
as BOE cancels out, we are left with
D = NI (BOE* Kc)
Please note carefully that (BOE * Kc) is expected profit for the year as it was shown in case of the example
given about bank deposit; while NI is actual profit for the year. As D = NI (BOE*Kc), that means D is the
difference between actual profit and expected profit, so it is surprise profits. You would agree if this
surprise: NI (BOE * Kc) is positive number then it is a pleasant surprise, and shareholders would be
happy and therefore demand for such a share would go up in the market resulting in its price moving
northward.
This surprise profit is called in literature as Abnormal Net Income (ANI), or residual net income. So we
found that:
ANI = NI BOE *Kc
For example if BOE = 100, and Kc = 10%, then expected profits for shareholders are
BOE * Kc
100 * 10%
10
Suppose in that year actual NI reported in the income statement is 15, then you can find abnormal net
income as:
ANI = NI BOE*Kc
= 15 - 10
=5
Accounting valuation model discounts expected ANIs of all future years at Kc, and adding PVs of ANIs to
BOE gives value of equity of a company. If ANI expected in each future year is zero till infinity, then
according to accounting valuation model the value of equity should be equal to BOE (beginning OE) or
beginning Book Value (BV) of equity at the beginning of the year which can be taken from previous years
end of the year balance sheet. Therefore source of value creation in this accounting valuation model is
the expectation of positive abnormal net income in future years. This line of reasoning also implies that if
in future years ANIs are expected to be negative, then current share price would be lower than the
beginning BV per share Now we can write the model verbally as
Value of equity at time zero , that is today = BOE1 + Sum of PVs of ANIs of all future years till infinity.
And formally as:
1
Value of equity = BOE1 + ANI1/ (1 + Kc) + ANI2/ (1 + Kc) + ..+ ANI n/(1 + Kc)
54
Please note that BOE 1 is OE at the beginning of this year which is same as OE at the end of the previous
year, and it is found on the previous years balance sheet. But ANI 1 is found at the end of year one from
income statement prepared at the end of the year one, and so on for each subsequent year. The
following analysis shows how ANI can be written in various ways. We know that:
ROE = NI / BOE
and therefore
ROE * BOE = NI
Inserting this expression of NI in
ANI = NI BOE *Kc
We get
ANI = (ROE *BOE) - (BOE * Kc)
Taking BOE common
ANI = BOE (ROE Kc),
and valuation model which was previously written as:
1
now can be written as

1
Value of equity = BOE1 + BOE1 (ROE1 Kc) / (1 + Kc) + BOE2 (ROE2 Kc)/ (1 + Kc) + ..+ BOE n (ROEn Kc)/(1 + Kc)
Whereas subscript 1 to n refer to years, and BOE 1 refers to OE at the beginning of year one and it is same
as Ending OE from balance sheet of year just ended because OE at the end of year just ended is also OE at
the beginning of next year. This model is written for n years while n approaches infinity.
Please note we have estimated value of total equity with this model. To find value per share we
can divide value of equity by number of shares outstanding to get estimate of fair value or justified value
or intrinsic value per share.
We can also divide both sides by number of shares outstanding, but BOE / number of shares is called Beg
BV per share or simply Beg BV. So we get estimate of value per share as:
1
P0 = Beg BV1 + Beg BV1(ROE1 Kc) / (1 + Kc) + Beg BV2(ROE2 Kc) / (1 + Kc) +..+ Beg BVn (ROEn Kc) / (1 + Kc)
equation (1)
Please also note that

ANI = NI BOE *Kc
Dividing both sides by number of shares we get
55
ANI per share = EPS Beg BV*Kc

And first dividing the valuation model repeated below by number of shares and then inserting this
expression of ANI we get
1
P0
= Beg BV1 + (EPS1 Beg BV1* Kc)/ (1 + Kc) + (EPS2 Beg BV2* Kc)/ (1 + Kc) + . + (EPSn Beg BVn* Kc)/ (1 + Kc)
So this model can be written in term of EPS.
But the expression with ROE repeated below is used more frequently:
(
(
)
)
(
(
)
)
(
(
)
)
Please also do not make the mistake of attempting to forecast Kc for future years, you are estimating PVs
of future years ANI, so Kc of today is the relevant discount rate to discount expected abnormal net
income (ANI) of all future years.
The popularity of this expression is based upon the fact that it allows clear comparison of the accounting
rate of return actually earned by the shareholders in a year (ROE) and the risk adjusted rate of return
required by the shareholders (Kc). You already know that to estimate risk adjusted required rate of return
for shareholders, the relevant risk is beta of that share; and CAPM is the model used to estimate such risk
adjusted required rate of return by shareholders. Kc = Rf + (Rm - Rf) beta
This expression of share valuation using accounting data also clearly shows that to create value for the
owners (shareholders of a Co) , the management of a company should strive to earn ROE greater than Kc.
As long as a company reports ROE Kc as a positive number, the ANI of that year is positive , and the
market value of the share would be higher than the beginning book value per share. Value would be
created for the shareholders in the stock market in the form of increase in share price if expected ANIs of
future years are positive; or in other words if in future years ROEs are expected to be greater than todays
Kc.
On the other hand if ROEs in future years are expected to be lower than todays Kc, then value would be
destroyed and share price would be less than BV per share. One can mention example of the shares of
Modarba companies in Pakistan as mostly these shares are trading below their book value implying that
market believes their future ANIs are going to be negative. Also if in future years ROEs are expected to be
56
same as todays Kc then ROE Kc = 0; and ANIs would be zero, and PV of ANIs would be zero; therefore
fair value estimate for such a share would be equal to its beg BV per share. For example if todays beg BV
is 200 Rs per share, and in all future years ROE is expected to be same as todays Kc which is 20%
, then you would estimate fair value of share as :
1
P0 = Beg BV1 + {Beg BV1(ROE1 Kc) / (1 + Kc) } + { Beg BV2(ROE2 Kc)/(1 + Kc) } +
n
..+ { Beg BVn (ROEn Kc) / (1 + Kc) }

1
P0 = 200 + {200(20% - 20%)} / (1 + 0.2) + {Beg BV2 (20% - 20%)}/ (1 + Kc) + .

P0 = 200 + 0
+0
P0 = 200
And it is same as its book value per share today.
Though the model is written for n years, in real life as an analyst it is not possible for you to forecast ANI
for all future years; therefore practically you forecast ANI or ROE for the next 4 or 5 years. Doing such
forecasting requires preparing next 4 or 5 years projected income statements and balance sheets: a skill
which you have learned in previous lectures. Beyond 4 , 5 years either a zero ANI is assumed in all future
years; or a constant ANI is assumed for all future years; or a growing ANI is assumed for all future years.
Assuming zero ANI after year 5, you have the following pricing formula:
1
P0 = Beg BV1 + {Beg BV1(ROE1 Kc) / (1 + Kc) } + { Beg BV2(ROE2 Kc)/(1 + Kc) } + ..+
5
{ Beg BV5 (ROE5 Kc) / (1 + Kc) }
Assuming a constant ANI after year 5, you have the following pricing formula:
(
)
}
)
(
)
(
{
)
)
}
)
}
}
Please note the term

(
} is called terminal value of ANIs beyond year 5.
It is in fact present value of a perpetuity at the end of year 5, whereas perpetuity is ANI of year 5 that is
expected to remain constant each year after year 5 till infinity. Like ANI of year 5 this PV of perpetuity at
the end of year 5 is a future value when looked at from the vantage point of time zero, that is now;
therefore it has to be discounted for 5 years to get PV at time zero , that is why the denominator is:
5
(1 + Kc) within large bracket.
57
Assuming ANI beyond year 5 is growing at a constant growth rate, g, then the accounting valuation
formula is:
)
(
)(
(
))
{
)
The term {
)
(
{
(
}
)(
))
}
}
} is called terminal value of ANIs beyond year 5.
In this case it is assumed that ANI of year 5 is a perpetuity that is expected to grow at a constant growth
rate in all subsequent future years till infinity; and the terminal value in year 5 is PV of a growing
perpetuity at the end of year 5. Since the PV of growing perpetuity is found at the end of year 5 in this
example therefore from the vantage point of time zero it is still a future value; therefore the denominator
5
(1 + Kc)
is a discount factor of 5 years, and it is discounting both the ANI of year 5 as well as the terminal
value at the end of year 5 within large brackets .

For example
In the latest balance sheet OE per share was Rs 200. In the next 5 years ROE is expected to be 22%, 23%,
25%, 22% and 21%. Shareholders require a risk adjusted Return of 20%. Beginning OE per share in the
year 2, 3, 4, and 5 is estimated as Rs 220, 230, 250, and 260. And thereafter ANI is expected to grow at
constant growth rate of 2% per year forever. Please estimate fair value of share using accounting
valuation model.
1
ANI of year 1 = 200(0.22 0.2) = 4 ; and PV of ANI = 4 / (1.2) = 3.33 Rs per share
2
ANI of year 2 = 220 (0.23 0.2) = 6.6; and PV of ANI = 6.6/(1.2) = 4.58 Rs per share
3
ANI of year 3 = 230 (0.25 -0.2) = 11.5 ; and PV of ANI = 11.5 /(1 . 2) = 6.65 Rs per share
ANI of year 4 = 250 (0.22 - 0.2) = 5 ; and PV of ANI = 5 /(1.2)
= 2.41 Rs per share

5
ANI of year 5 = 260 (0.21 0.2) = 2.6 ; and PV of ANI = 2.6 /(1.2) = 1.04 Rs per share
Terminal Value of ANI in year 5 = 260 (0.21 0.2)(1 + 0.02) / (0.2 - 0.02) = 2.65/ 0.18 = 14.4 Rs per share
5
PV of terminal value = 14.4/(1.2) = 5.78 Rs per share

Fair value of share = 200 + 3.33 + 4.58 + 6.65 + 2.41 + 1.04 + 5.78 = 223 Rs per share
Since ANIs of future years are positive therefore you have estimated a fair value of 223 Rs that is higher
than the beginning OE per share of 200 Rs.
58
Price To Earnings Ratio (PE) Or Earnings Multiple Model Of

Valuation
Another popular valuation model is price to earnings ratio (PE) to value the shares. It also called earnings
multiple because it states price of a share as multiple of EPS.
Since PE ratio =P0 /EPS, therefore PE ratio * EPS = Po.
For example if PE ratio is 12 times and EPS is 6 Rs then you would estimate the share price as:
12 * 6 = 72 Rs
This method of valuation of share assumes that PE ratio of a co is stable over time; and multiplying EPS by
PE ratio gives an estimate of share price. This model uses the logic that price of share depends on
earnings per share, and companies whose EPS is higher should have higher price. On the other hand if 2
companies have same EPS but PE is different than their estimated share value would be different.
For Example
Co
PE
EPS
Estimated share value
12
60
10
50
Please note PE ratio brings price in relation to one rupee of earning. For example
Co
EPS
PE
100
10
10/1
200
25
8/1
So the comparison between 2 companies share price is based on the one rupee of earnings, in this
example co X one rupee of earning is priced in the market at 10 rupees but same one rupee of earnings of
co Z is priced in the market at 8 rupees.
But implicit in this model is an ambiguity as to why 1 Rs of EPS of one co is priced more highly than the
same 1 Rs of EPS of another Co as implied by different PE ratios for the 2 companies? For example:
Co A
Co B
P0
100
500
EPS
100
PE ratio
20 /1
5/1
In both companies 1 Rs of EPS is priced differently in the market. For co A it is 20 Rs while in Co B it is only
5 Rs. Note in co A, both its share price and EPS are much lower than co B, but PE ratio of co A is 4 times
more than PE ratio of co B. That means stock market participants are putting much greater value on 1
rupee of earnings of co A than on 1 rupee of earnings of co B. Why it is so?
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Usually the prospects for future growth is given as reason for this difference in earnings valuation, that is
difference in PE ratios; implying that market believes co A is likely to grow much faster in future than co
B, and that is why earnings of co A are considered more valuable today as these earnings are likely to
grow faster in future, and therefore owner of share of co A are likely to enjoy fast growth in earnings in
future years and therefore higher DPS in future years and also higher share price in future. Therefore, it
is argued that, it makes sense to pay more to get ownership right of such a company whose growth
prospects are brighter.
If you divide both sides of DDM with constant growth model, you get a more clear idea about PE ratio
and its relationship with growth rate as shown below: according to Gordons model
P0 = DPS1 / (Kc - g)
Dividing by EPS0 (1 + g)
P0 / EPS0 (1 + g) = {DPS0 (1 + g) / EPS0 (1 + g)} / (Kc - g)
PE ratio = d / (Kc g).
Note DPS / EPS = d, dividend payout ratio.
This expression of PE ratio clearly shows that PE ratio has 3 drivers:
1) dividend payout ratio (d) positively affects PE ratio;
2) required rate of return of shareholders (Kc) negatively affects PE ratio,
3) growth rate (g) positively affects PE ratio.
Interestingly relationship of PE ratio with growth rate is positive under this formulation. Thus companies
that are expected to grow fast are likely to have higher PE ratio implying that companies with slow growth
prospects are likely to have low PE ratio.
Valuing The Private Limited Companies Using PE Ratio :

This valuation model , Po = PE ratio * EPS, can be used for companies which do not pay cash dividends. It
is also usable to value companies whose shares are not listed and therefore their share price is not
observable, such as private limited companies. In such situations average PE ratio of comparable
companies is used as proxy for PE ratio of the private co of interest; and then that average PE ratio is
multiplied by EPS of the private co of interest to arrive at an estimate of fair value of the shares of this co.
Po of a private limited Co = Average PE ratio of comparable companies * EPS of this private Ltd co.
Please note if data is not per share then PE ratio = MV of equity / NI
60
PE Ratio and its bifurcation into Tangible PE and Franchise PE; and the use of PE ratio in identifying
undervalued shares
PE ratio (price of share / EPS) is also called earning multiplier, and it is commonly used to identify
whether a share is undervalued or over valued at its prevailing current market price. As a rule
undervalued shares are bought and overvalued shares are not bought or sold if investor already owns
these shares. Generally it is believed that relatively high PE ratio for a stock indicates high growth
prospects for that company, and low PE stocks have relatively low growth prospects. But on the other
hand high PE ratio may indicate overvalued stock and low PE ratio may indicate undervalued stock. Then
the question arises if high PE ratio means expected high growth of share price and also over valuation at
the current price then how come overvalued share is expected to grow in price because common sense
tells us that overvalued shares are expected to experience a fall in their price not an increase. Therefore
this possible conflicting signal sent by PE ratio must be kept in mind.
More clarity is needed while using PE ratio. Using current P0 and last years EPS to calculate PE ratio gives
Actual Trailing PE because it relates latest price to last years earnings ( PE = P0 /EPS0). But you know that
current price is based on future expectation about earning , dividends and growth in share price; and not
on past earning performance. Therefore calculating such PE ratio is not very useful though most of the
text book while discussing PE ratio show calculation using latest EPS, that is EPS0. Relating current price
of share with the expected earnings makes sense because buying share at todays price gives investor
right on future earnings, therefore such PE ratio is called Actual Leading PE ratio
Actual Leading PE ratio = P0 / EPS1

This conflicting signals sent by high PE ratio about overvaluation at current price and expected high
growth is resolved by having clarity that actual PE ratio is based upon actual (last years) EPS and is called
actual trailing PE, or based on estimated next year earnings (EPS1) and current market price of the share
and called actual leading PE. On the other hand intrinsic leading PE ratio is calculated from fair value
estimates of share price using Gordon model called DDM with constant growth. The two PE ratios ( actual
leading PE and intrinsic leading PE) can be different.
The decision rule is :
If actual leading PE is greater than intrinsic leading PE, the share is overvalued at its current market
price. If actual leading PE ratio is greater than the intrinsic leading PE ratio, then actual price of share is
more than the intrinsic value of that share; and therefore the share is over valued at its current market
61
price. Since undervalued assets are the ones you like to buy (if you do not have a twisted personality
tainted by the false concept of status) and overvalued shares are not to be bought and not to be included
in your portfolio as an individual investor. Corporate finance mangers also look for undervalued shares to
identify and select target companies to do mergers with or to takeover such companies as part of their
growth strategy.
Example of Actual PE ratio
For Example Last years EPS of a Co was Rs 5 (EPS0), and currently its share price (P0 ) in the market is 100
Rs, and it is expected to have a growth rate {ROE (1 - d)} of 5%. Based on CAPM its Kc (risk adjusted
required ROR for shareholders) is 13%. It has paid last year 25% of its profits as cash dividends and that
policy is likely to continue next year. So dividend payout ratio (d) is 25%.
You can calculate 2 actual PE ratios called Trailing PE ratio and Leading PE ratio.
Actual Trailing PE ratio is P0 / EPS0 = 100 / 5 = 20 times.
Actual Leading PE ratio is P0 / EPS1
Since EPS1= EPS0 (1 + g) therefore
Leading PE ratio = P0 / EPS0 (1 + g)
= 100 / 5 (1 + 0.05)
= 100 / 5.25
= 19.04
Intrinsic Leading PE Ratio (Also called Justified PE ratio)

Again given below is Gordon valuation formula for fair value or intrinsic value of share:
Po = DPS1 / (Kc g)
Dividing both sides of equation by expected earnings per share for next year, that is expected EPS,
symbolized here as EPS1, you get:
Po / EPS1 = {DPS1 / (Kc g)} / EPS1
Which can be written as :
Po / EPS1 = {(DPS1 / EPS1)/ (Kc g)} .
62
But DPS1 / EPS1 is dividend payout ratio of next year symbolized as d1, and since it is assumed that this
wont change from the last years d of 25% in future years therefore though strictly speaking this is d 1
for the next year but it is same as d0 for the previous year so
Po / EPS1 = d / (Kc g)
Intrinsic Leading PE ratio = d / (Kc g)
Using the data from the example above
Intrinsic Leading PE ratio =Po / EPS1 = 0.25 / (0.13 0.05)
Intrinsic Leading PE ratio= 3.125
Decision rule to decide mispricing of a share is:

Overvalued if actual leading PE ratio > Intrinsic Leading PE ratio.
Undervalued if actual leading PE < intrinsic leading PE
In this company actual leading PE ratio 19.04, as calculated above, and it is greater than intrinsic leading
PE of 3.125. So you decide that this share is overvalued in the market at its current price of 100 rupees.
So we found that intrinsic leading PE ratio = dividend payout ratio / difference between required rate of
return and constant growth rate ; and it is called Intrinsic Leading PE ratio because it is derived by using
Gordon formula for intrinsic (or fair) value of a share. We need to have greater understanding of the
intrinsic leading PE ratio.
Intrinsic PE = Tangible PE + Franchise PE
Intrinsic PE ratio is sum of two components:
1) Tangible PE ratio :
Tangible PE ratio refers to a situation where co does no reinvestment of its profits, rather all the NI is
given out as cash dividends, the resulting PE is based on perpetual use of existing assets, and resulting
earnings or profits from the productive use of such non growing assets. Please note that if all the NI is
given out as cash dividends then dividend payout rate (d) is 1, ; that means 100% of earning is given out as
dividends and no portion of NI is kept as retained earnings and reinvested in the business therefore there
is no growth in the co that is financed from internally generated equity funds in the form of addition to
63
RE. But such a co can still finance growth in its assets by raising external equity funds through issuance of
more shares and/or by raising more debt capital from bond market or banks. With no retention of NI,
constant growth rate is calculated as:
g = ROE (1 - d) = ROE ( 1 - 1) = ROE (0) = 0 . In this case intrinsic leading PE ratio is :
Intrinsic Leading PE ratio =Po / EPS1 = d / (Kc g)
=1 / (Kc 0)
=1 / Kc
Let us see how this result is attained.
Since DPS = EPS *d, and if d = 1, then DPS = EPS; therefore
Gordon valuation model becomes:

Po = DPS1 / (Kc g)
Po = EPS 1 / (Kc 0)
Po = EPS 1 / Kc
current price is based on perpetual earning. EPS is a perpetuity that is discounted at discount rate Kc;
and PV of this perpetuity is the current price of the share in the absence of growth. It further means that
Intrinsic leading PE ratio is derived by taking EPS1 on the LHS of equation :
Po / EPS1 = 1 / (Kc 0)
=1 / Kc
And such PE ratio is called tangible PE because it is expected to be the PE if assets of co are not growing
because no portion of earnings is retained and reinvested in the business, therefore expected stream of
EPS is constant in all future years due to a non growing asset base.
2) Franchise PE:
It has 2 components, namely Franchise Factor (FF) and Growth Factor (G). Franchise
factor is result of a company earning on projects financed from RE a higher ROE than Kc, while Kc is risk
adjusted ROR for share holders.
The growth factor is PV (present value) of constant growth rate attained from reinvesting of some NI into
business as addition to RE and not giving out all of NI as dividends.
Again as you know from corporate finance course that growth rate of a companys OE can translate into
growth rate of its Sales, TA, TL, NI, EPS, DPS, and ultimately growth rate of share price if 5 policies are kept
64
constant. These 5 policies are : net profit margin, total asset turnover, equity multiplier, dividend payout
rate, and number of shares outstanding ; and you have already learnt that such growth rate can be
quantified as:
g = ROE * (1 d).
Thus Gordon formula for fair value of share:
Po = DPS1 / (Kc g)
becomes
Po = DPS1 / [Kc ROE * (1- d)]
And by dividing both sides of equation with EPS1 , intrinsic leading PE ratio becomes:
Intrinsic leading PE ratio = Po / EPS1 = d / [Kc ROE (1 d)]
Now multiply RHS with Kc / Kc (E1 is used for EPS1 for ease)
(
)[
)[
]
))
]
))
It can be written as
Since (1 - d) is called retention ratio , let us show it with symbol b, and thus
d = (1 b), now inserting this value, you get
(
)[
)[
]
)
Kc multiplies with (1 b) in the numerator

(
(
Adding and subtracting ROE * b in numerator of right hand side will give:
65
]
)
)[
)[
and placing ROE* b closer to Kc gives:

]
Bringing divisor {Kc ROE* b}] under both the terms of RHS
(
And {(
) [{
(
}]
} is 1 so
)[
)
(
}]
Taking b as common in numerator of 2nd term on RHS

(
)[
{
(
)
}]
)
Multiplying and dividing the term in large bracket after 1 with ROE we get
(
)[
)
}]
)
Since b = (1- d) and ROE * (1 d) = g, so you can write ROE * b = g. Now inserting this g in place of
ROE*b you get
(
)[
(
(
)
}]
)
When 1 / Kc is brought inside the bracket, it multiplies with both 1 and with the term right of 1, and you
get
[
(
(
)
}]
)
And second 1/Kc can be written as Kc multiplying with the denominator so you get
66
)
(
}]
Further simplification gives

(
{
{
(
}]
Bringing denominator (Kc* ROE) under both terms of the numerator , that is under ROE as well as under
Kc gives
[
{
(
}]
ROE and Kc cancels out in middle bracket leaving

[
{
(
}]
is called Tangible PE ratio

{
} is called franchise factor; and it represents competitive advantage of a business over its
competitors. If it is positive it means co has competitive advantage in the product market and if it is
negative then it means co has a competitive disadvantage in the product market. Bigger franchise factor
means ability of a company to earn on shareholders invested funds a rate of return higher than the
shareholders expected (risk adjusted required) rate of return (Kc). The underlying logic is that a company
can earn ROE higher than Kc only if its management selects promising projects in which it invests retained
earnings and then manages these projects such as new product lines and new factories in a manner that it
ends up earning a ROE higher than Kc from these projects due to superior product offering, better quality,
cost control in production, better marketing, and better innovation according to consumers needs.
{(
} is called growth factor. So
Intrinsic Leading PE = Tangible PE
+ Franchise PE
Franchise PE ratio = Franchise factor * Growth factor

Comparison of Intrinsic Leading PE ratio with the Actual Leading PE ratio allows you to make a decision
about overvaluation or undervaluation of a share.
67
For Example
ROE 15%, dividend payout ratio (d) is 70%, NI expected for next year 100 million, market value of its
equity is 600 million Rs. Shareholders require a risk adjusted ROR from share of this Co , Kc, 20% which
was estimated using CAPM.
Please Find: growth rate g; Tangible PE, franchise factor, growth factor, franchise PE, and intrinsic
Leading PE, Actual Leading PE ratio, your verdict about over or under valuation of this share on its current
price.
Answers:
g = ROE ( 1 - d) = 15% (1 - 0.7) = 4.5%
Tangible PE ratio = 1 / Kc = 1 / 0.2 = 5
Franchise factor = 1/Kc 1/ROE = 1/0.2 1/.15 = 5 6.67 = -1.67
Growth factor = g / (kc g) = 0.045 / (0.2 0.045) = 0.045 / .155 = 0.29
Franchise PE ratio = franchise factor * growth factor
= -1.67 * 0.29
= -0.48
Intrinsic Leading PE ratio = Tangible PE ratio + Franchise PE ratio
=5
+ -0.48
= 4.52
As a double check of the accuracy of the bifurcation of Intrinsic Leading PE into Tangible PE and
Franchise PE you can apply directly intrinsic leading PE formula derived from Gordon model:
Intrinsic Leading PE
Po / EPS1 = d / (Kc g)
= 0.7 / (0.2 - 0.045)
= 0.7 / 0.155
= 4.52
68
So we get the same answer from both methods, but the former method of bifurcating into tangible PE
and franchise PE provides additional insight. For example in this case growth factor (0.29) is very small;
and franchise factor depicting the ability to earn ROE higher than Kc is negative ( - 1.67) implying poor
competitive advantage of this company in the product markets. Therefore overall contribution growth by
reinvesting profits in the business is negative as depicted by negative franchise PE.
Actual Leading PE ratio = P0 / EPS1
since per share data is not given you can use total amounts of expected NI of next year instead of EPS and
total MV of equity instead of MV per share , that is P 0.
Actual Leading PE ratio
= MV of equity / NI1
= 600 / 100
= 6
Decision : Since
actual leading PE > Intrinsic leading PE
6
> 4.52
Therefore actual price is greater than theoretical price, and the share of this co is overvalued at its
current price in the market and you should not invest in it; rather wait for fall in its price because
overvalued assets are expected to experience decline in their market price: once that happens then it
would be ok to buy it. Another possibility is to attempt to make profit by short selling this share in the
hope of price fall in future.
Please note that ROE was less than Kc, so franchise factor (an evidence of competitive advantage of this
co over its competitors) is negative. Though this co has positive growth prospects as shown by positive
growth factor of 0.29, but due to its inability to earn ROE > Kc on reinvested earnings, the growth is going
to be value destroying instead of value creating; and therefore ultimately its intrinsic PE would be less
than its tangible PE which is result of no growth in business and is based on doing no retention and
reinvesting of profits. In simple word this company would have been better off by giving all its NI as cash
dividends instead of retaining some of NI and reinvesting it in projects which earn ROE lesser than Kc thus
resulting in negative franchise factor; though growth has occurred as growth factor is positive yet the
combined effect of franchise factor and growth factor is negative franchise PE; and when that negative
franchise PE is added to tangible PE the resulting intrinsic PE is lower than the tangible PE. In simple words
this company has growth opportunities, but its management decided to invest in such projects which
69
were not very profitable enough to give ROE exceeding the Kc, and therefore its growth has not been
creating value, rather it is value destroying growth.
Companies with profitable investment opportunities in new projects have positive franchise factor and
therefore their franchise PE is positive resulting in their intrinsic PE being higher than their tangible PE.
And such companies should not give all their NI in dividends, rather some NI should be retained and
reinvested in profitable projects whose ROE is greater than Kc.
The lesson is important: It is not growth per se that creates value for the shareholders, but profitable
growth where new projects earn ROE greater than Kc, only then value would be created and intrinsic PE
would be higher than tangible PE, that is PE based on no growth; otherwise growth can turn into a
value destroying phenomenon instead of being a value creating phenomenon, as was the case in this
example.
70

Accounting Valuation Model: Lectures 14 Valuation of Corporations

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Lahore School of Economics. MBA II. Advance Corporate Finance. Winter 2014. Dr.

Different analysts may arrive at

Security analysts disagree mostly about expected

Accounting Valuation Model

Equity instruments (preferred and ordinary shares) and debt instruments

In this sense securities issued by corporations are

Inserting the above expression of EOE in the expression for D

now can be written as

Please also note that

ANI per share = EPS Beg BV*Kc

So this model can be written in term of EPS.

..+ { Beg BVn (ROEn Kc) / (1 + Kc) }

P0 = 200 + {200(20% - 20%)} / (1 + 0.2) + {Beg BV2 (20% - 20%)}/ (1 + Kc) + .

{ Beg BV5 (ROE5 Kc) / (1 + Kc) }

Please note the term

} is called terminal value of ANIs beyond year 5.

(1 + Kc) within large bracket.

} is called terminal value of ANIs beyond year 5.

value at the end of year 5 within large brackets .

= 2.41 Rs per share

PV of terminal value = 14.4/(1.2) = 5.78 Rs per share

Price To Earnings Ratio (PE) Or Earnings Multiple Model Of

Estimated share value

Valuing The Private Limited Companies Using PE Ratio :

Actual Leading PE ratio = P0 / EPS1

Intrinsic Leading PE Ratio (Also called Justified PE ratio)

Decision rule to decide mispricing of a share is:

Since DPS = EPS *d, and if d = 1, then DPS = EPS; therefore

Gordon valuation model becomes:

Kc multiplies with (1 b) in the numerator

and placing ROE* b closer to Kc gives:

Taking b as common in numerator of 2nd term on RHS

Further simplification gives

ROE and Kc cancels out in middle bracket leaving

is called Tangible PE ratio

} is called growth factor. So

Intrinsic Leading PE = Tangible PE

Franchise PE ratio = Franchise factor * Growth factor

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