Accrual Accounting and Valuation:

Pricing Book Values

Chapter 5
Accrual Accounting and Valuation:
Pricing Book Values



Chapter 4 showed how
accrual accounting modifies
cash accounting to produce a
balance sheet that reports
shareholders equity.
However, Chapter 2 also
explained that the book value
in the balance sheet does not
measure the value of
shareholders equity, so firms
typically trade at price-to-
book ratios different from 1.0.



This chapter shows how to
estimate the value omitted
from the balance sheet and
thus how to estimate intrinsic
price-to-book ratios.


Chapter 6 compliments this
chapter. While Chapter 5
shows how to price the book
value of equity, the bottom
line of the balance sheet,
Chapter 6 shows how to price
earnings, the bottom line of
the income statement

Go to the web page for more
applications of the techniques
in this chapter
How does the
analysts infer
the markets
assessment of
fundamentals?
How are
strategies
evaluated?
How is the
firm valued
by
forecasting
income
statements
and balance
sheets?
How are
premiums
over book
value
determined?
Link to previous chapter
This Chapter
Link to next chapter
Link to web page
What you will Learn from this Chapter
What residual earnings is
How forecasting residual earnings gives the premium
over book value and the P/B ratio
What is meant by a normal price-to-book ratio
How residual earnings are driven by return on common
equity (ROCE) and growth in book value
The difference between a Case 1, 2 and 3 residual
earnings valuation
How the residual earnings model applies to valuing
bonds, projects, strategies as well as equities
How the residual earnings model captures value added
in a strategy
The advantages and disadvantages of using the
residual earnings model and how it contrasts to
dividend discounting and discounted cash flow analysis
How dividends, share issues and share repurchases
affect residual earnings
How residual earnings valuation protects the investor
from paying too much for earnings added by investment
How residual earnings valuation protects the investor
from paying for earnings that are created by accounting
methods
How the residual earnings model is used in reverse
engineering
Valuing a One-Period Project (1)
Investment $400
Required return 10%
Revenue forecast $440
Expense forecast $400
Earnings forecast $ 40













This is a zero NPV project:

DCF Valuation:




400
1.10
0
400 Value
0
400) x (0.10 - 40

) Investment return x Required ( Earnings earnings Residual
1 1
=
+ =
=
=
=
This is a zero-residual earnings project
400
10 . 1
440
= = V
Valuing a One-Period Project (2)
Investment $400
Required return 10%
Revenue forecast $448
Expense Forecast $400
Earnings forecast $ 48


407.27
1.10
8
400 Project Value
8

400) x (0.10 - 48 earnings Residual
1
=
+ =
=
=
The project adds value
(

= = 27 . 407
1.10
448
value DCF
Valuing a Savings Account
Forecast Year
________________________________________

2000 2001 2002 2003 2004 2005

Earnings withdrawn each year (full payout)

Earnings 5 5 5 5 5
Dividends 5 5 5 5 5
Book value 100 100 100 100 100 100

Residual earnings 0 0 0 0 0
______________________________________________________________________________________

No withdrawals (zero payout)

Earnings 5 5.25 5.51 5.79 6.08
Dividends 0 0 0 0 0
Book value 100 105 110.25 115.76 121.55 127.63

Residual earnings 0 0 0 0 0

______________________________________________________________________________________
Value = Book Value + Present Value of Residual Earnings

= 100 + 0

= 100
The Normal Price-to-Book Ratio
Normal P/B = 1.0

(Price = Book Value)


The Normal P/B firm earns a rate of return on
its book value equal to the required return
Lessons from the Savings Account
1. An asset is worth a premium or discount to its book
value only if the book value is expected to earn non-
zero residual earnings.

2. Residual earnings techniques recognize that earnings
growth does not add value if that growth comes from
investment earning at the required return.

3. Even though an asset does not pay dividends, it can be
valued from its book value and earnings forecasts.

4. The valuation of the savings account does not depend
on dividend payout. The two scenarios have different
expected dividends, but the same value.

5. The valuation of a savings account is unrelated to free
cash flows: The two accounts have the same value,
but different free cash flow.
A Model for Anchoring Value on Book Value
( )
1 t E t t
3
E
2
E
2
E
1
0
E
0
1)B ( Earn RE
) book value period of beginning equity x for return
(required - earnings ive comprehens earnings Residual
: equity for earnings residual is RE where
...

RE

RE

RE
V equity common of Value

=
=
+ + + + =
- -
B
Derivation of the Equity Valuation Model:
One Period
Valuing a one-period payoff equation:



Substitute for the expected dividend



to get



or




The amount, is called
Residual Earnings
E
1 0 1 1
0

P ) B (B Earnings
P
+
=
) B (B Earnings d
0 1 1 1
=
E
1 1
E
0 E 1
0 0

B P

1)B ( Earnings
B P

+

+ =
( )
0 E 1
B 1 Earnings
( )
E
1 1
0

d P
P
+
=
Derivation of the Equity
Valuation Model: Multiperiod
Substituting comprehensive earnings and book value for
dividends in each period,








If we set ,






( ) ( )
( )
T
E
T T
T
E
1 T E T
2
E
1 E 2
E
0 E 1
0 0

B P

B 1 Earnings
...
...

B 1 Earnings

B 1 Earnings
B P

+

+
+

+

+ =

( )
1 t E t t
B 1 Earnings RE

=
T
E
T T
T
E
T
2
E
2
E
1
0 0

B P

RE
....

RE

RE
B P

+ + + + + =
The Equity Valuation Model:
Infinite Horizon
The model can be extended for
infinite horizons







or






( ) ( )
( )
...

B 1 Earnings
...
...

B 1 Earnings

B 1 Earnings
B P
T
E
1 T E
2
E
1 E
E
0 E
0 0
+

+
+

+

+ =

.....

RE

RE

RE

RE

RE
B P
5
E
5
4
E
4
3
E
3
2
E
2
E
1
0 0
+ + + + + + =
1
2
T
Relation Between P/B Ratios and
Subsequent RE
_____________________________________________________________________________________
Residual Earnings for
P/B Years After P/B Groups Are Formed (Year 0)
Group P/B _____________________________________________________________
0 1 2 3 4 5 6
_____________________________________________________________________________________
1 (High) 6.20 .173 .230 .218 .213 .211 .200 .204
2 3.66 .121 .144 .142 .140 .148 .149 .139
3 2.82 .101 .112 .108 .108 .101 .103 .116
4 2.33 .089 .100 .099 .096 .097 .108 .123
5 2.00 .076 .082 .080 .088 .085 .086 .094
6 1.76 .064 .066 .064 .058 .066 .071 .076
7 1.58 .057 .058 .058 .056 .061 .059 .073
8 1.43 .047 .052 .047 .049 .053 .060 .068
9 1.31 .040 .040 .041 .044 .046 .055 .056
10 1.22 .035 .036 .035 .040 .047 .054 .054
11 1.13 .032 .034 .035 .040 .045 .051 .055
12 1.05 .028 .027 .028 .032 .040 .043 .046
13 .98 .023 .023 .025 .031 .035 .037 .045
14 .94 .018 .019 .025 .029 .035 .037 .039
15 .85 .009 .008 .013 .020 .028 .033 .041
16 .79 -.001 -.001 .006 .015 .023 .024 .024
17 .72 -.011 -.015 -.005 .008 .011 .021 .022
18 .64 -.024 -.024 -.012 -.003 .008 .010 .017
19 .54 -.042 -.044 -.028 -.015 -.007 -.007 -.006
20 (Low) .39 -.068 -.070 -.041 -.028 -.020 -.017 -.014
_____________________________________________________________________________________
Residual income is deflated by book value at the beginning of year 0, the year the P/B groups are formed.
Ingredients of the Model
For finite horizon forecasts we need three ingredients,
besides the cost of capital:

1. The current book value

2. Forecasts of residual earnings (earnings and book
values) to horizon

3. Forecasted premium at the horizon


Component 3 is called the continuing value


As efficient prices equal intrinsic values, then

T
E
T
E
T
T
E
T
2
E
2
E
1
0
E
0

B V

RE
.....

RE

RE
B V

+ + + + + =
Return or Common Shareholders
Equity (ROCE)
1
t
t
Book value
common to earnings ive Comprehens
ROCE

=
t
Alternative Measure of Residual
Earnings
Residual earnings is the rate of return on equity, ROCE,
expressed as a dollar excess return on equity rather than a
ratio. But it can also be expressed in ratio form:



( ) ( ) | |
1 t E t 1 t E t
B 1 ROCE B 1 Earnings

=
Drivers of Residual Earnings
Two Drivers:

1. ROCE

If forecasted ROCE equals the required return, then
RE will be zero, and V = B

If forecasted ROCE is greater than the required
return, then V > B

If forecasted ROCE is less than the required return,
then V < B


2. Growth in book value (net assets) put in place to
earn the ROCE

RE will change with change with ROCE and growth in
book value


P/B, ROCE and Growth in Book
Value
P/B in 2003 ROCE in 2004 Growth Rate for
Book Value in 2004
The Gap Inc. 4.23 28.1% 30.7%
General Electric Co. 4.16 22.3% 39.3%
Verizon Comm. Inc. 3.32 23.4% 12.2%
Citigroup Inc. 2.79 17.4% 11.5%
Home Depot Inc. 2.62 19.2% 13.2%
General Motors Corp. 1.19 11.1% 9.7%
Federated Dept. Stores 0.92 12.0% 3.1%
How the Residual Earnings Model Works
ROCE
1

Current book
value
ROCE
2

Book value
1

ROCE
3

Book
value
2

Year 3 ahead Year 2 ahead Year 1 ahead
Residual earnings
1
Residual earnings
2
Residual earnings
3

Current book
value
Current year
PV of RE
1

Discount by
Forecasts
PV of RE
2

PV of RE
3

Current book
value
Discount by
3

Discount by
2

Current Data
ROCE and P/B Ratios: S&P 500


Growth in Book Values (Net Assets)
and P/B Ratios


ROCE Over the Years



-0.2
-0.1
0
0.1
0.2
0.3
0.4
0.5
1
9
6
3
1
9
6
5
1
9
6
7
1
9
6
9
1
9
7
1
1
9
7
3
1
9
7
5
1
9
7
7
1
9
7
9
1
9
8
1
1
9
8
3
1
9
8
5
1
9
8
7
1
9
8
9
1
9
9
1
1
9
9
3
1
9
9
5
1
9
9
7
1
9
9
9
2
0
0
1
2
0
0
3
R
O
C
E

(
S
&
P

5
0
0
)
p10 p25 median p75 p90
Growth in Book Value (Net Assets)
Over the Years


A Simple Demonstration

In millions of dollars. Required return is 10% per year.

Forecast Year

0 1 2 3 4 5

Earnings 12.00 12.36 12.73 13.11 13.51 13.91

Dividends 9.09 9.36 9.64 9.93 10.23 10.53

Book value 100.00 103.00 106.09 109.27 112.55 115.93

RE (10% charge) 2.36 2.43 2.50 2.58 2.66

RE growth rate 3% 3% 3% 3%


.
With g = 1.03 and = 1.10, the valuation is:


$133.71 million


The intrinsic price-to-book ratio (P/B) is $133.71 / $100 = 1.34.

g
RE
B V
E

+ =

1
0 0
=

+ =
03 . 1 10 . 1
36 . 2 $
100 $
0
E
V
Buying Residual Earnings: Flanigans
Enterprises Inc.
Case 1: Zero RE after T
V B PV of RE f
E
0 0
= + or T periods
95 . 0 58 . 3 53 . 4
0
+ = =
E
V
Required rate of return is 9 percent.


Forecast Year

1999 2000 2001 2002 2003


Eps 0.73 0.80 0.71 0.47
Dps 0.11 0.24 0.25 0.27
Bps 3.58 4.20 4.76 5.22 5.41

ROCE 20.4% 19.0% 14.9% 9.0%
RE (9% charge) 0.408 0.422 0.282 0.000
Discount rate (1.09)t 1.09 1.188 1.295 1.412
Present value of RE 0.374 0.355 0.217 0.000
Total present value
of RE to 2003 0.95
Value per share 4.53

Assuming zero RE after period T (zero premium at T):
Continuing Value
Case 1: Zero RE after T
RE is forecasted to be zero in perpetuity at the horizon

So


The forecasted premium at the horizon is
0 CV
T
=
0 B V
T
E
T
=
Buying Residual Earnings: General
Electric (GE)
Case 2: Constant RE after T
Required rate of return is 10 percent.
Forecast Year

1999 2000 2001 2002 2003 2004

Eps 1.29 1.38 1.42 1.50 1.60
Dps 0.57 0.66 0.73 0.77 0.82
Bps 4.32 5.04 5.76 6.45 7.18 7.96

ROCE 29.9% 27.4% 24.7% 23.3% 22.3%
RE (10% charge) 0.858 0.876 0.844 0.855 0.882
Discount rate (1.10)t 1.100 1.210 1.331 1.464 1.611
Present value of RE 0.780 0.724 0.634 0.584 0.548
Total present value
of RE to 2004 3.27
Continuing value (CV) 8.82
Present value of CV 5.48
Value per share 13.07

The continuing value:

CV = = 8.82

Present value of continuing value = = 5.48

Assuming constant RE after period T:
10 . 0
882 . 0
6105 . 1
82 . 8
5.48 3.27 4.32 13.07 V
E
0
+ + = =
Continuing Value
Case 2: Constant RE after T
RE is forecasted to be constant in perpetuity at the horizon

So





The forecasted premium at the horizon is


1
RE
CV
E
1 + T
T

T T
E
T
CV B V =
For GE, CV
T
= 82 . 8
10 . 0
882 . 0
=
Buying Residual Earnings: Dell Inc.
Case 3: Growing RE after T

Required rate of return is 11 percent.
Forecast Year

2000 2001 2002 2003 2004 2005

Eps 0.84 0.48 0.82 1.03 1.18
Dps 0.0 0.0 0.0 0.0 0.0
Bps 2.06 2.90 3.38 4.20 5.23 6.41

ROCE 40.8% 16.6% 2 4.3% 24.5% 22.6%
RE (11% charge) 0.613 0.161 0.448 0.568 0.605
Discount rate 1.110 1.232 1.368 1.518 1.685
PV of RE 0.553 0.131 0.328 0.374 0.359
Total PV
of RE to 2005 1.75
CV 14.32
PV of CV 8.50
Value 12.31

The continuing value (growth at 6.5%):

CV = = 14.32

Present value of continuing value = = 8.50

Assuming growing RE after period T :
|
|
.
|

\
|

+ + =
+
g
RE
B V
E
T
T
E
E

1
0 0
1
periods T for RE of PV
50 . 8 75 . 1 06 . 2 31 . 12
0
+ + = =
E
V
065 . 1 11 . 1
065 . 1 605 . 0

685 . 1
32 . 14
Continuing Value
Case 3: Growing RE after T
RE is forecasted to grow at constant rate in perpetuity at the
horizon

So




The forecasted premium at the horizon
g
RE
CV
E
1 + T
T

=
T
E
T T
B V CV =
14.32
1.065 1.11
1.065 0.605
CV Dell, For
T
=

=
Forecasting Target Prices
T T T
CV B Price Target + =
41 . 5
2003 2003
= = B V
E
73 . 20 32 . 14 41 . 6
2005 2005 2005
= + = + = CV B V
E
Case 1 (Flanigans)
Case 2 (GE)
Case 3 (Dell)
16.78 82 . 8 96 . 7
2004 2004 2004
= + = + = CV B V
E
Converting an Analysts Forecast to a
Valuation: Nike Inc.
Forecasts:

2005 $4.45
2006 $5.04
Five-year eps growth rate: 14%

2004A 2005E 2006E 2007E 2008E 2009E

Eps 3.59 4.45 5.04 5.75 6.55 7.47
Dps 0.74 0.92 1.04 1.18 1.35 1.54
Bps 18.17 21.70 25.71 30.27 35.47 41.40

ROCE 24.49% 23.23% 22.36% 21.64% 21.06%
RE (10%) 2.633 2.870 3.175 3.523 3.920
Discount rate 1.110 1.210 1.331 1.464 1.611
PV of RE 2.394 2.372 2.386 2.406 2.434
Total PV
to 2009 11.99
CV 67.95
PV of CV 42.19
Value 72.35

The continuing value (4% growth = GDP growth rate):


CV = = 67.95


04 . 1 10 . 1
04 . 1 920 . 3

Project Evaluation: Residual Earnings

Approach
Project evaluation: residual earnings approach.
Forecast year, t 0 1 2 3 4 5
Revenues $430 $460 $460 $380 $250
Depreciation 216 216 216 216 216
Net Income 214 244 244 164 34
Book value $1,200 984 768 552 336 120
ROCE 17.8% 24.8% 31.8% 29.7% 10.1%
RE (.12) 70 126 152 98 (6)
Discount rate (1.12
t
) 1.120 1.254 1.405 1.574 1.763
PV of RE 62.5 100.5 108.2 62.3 (3.4)
Total PV of RE 330
Value of project $1,530
Value added: PV of RE = 330 (same as NPV)
Strategy Evaluation: Residual Earnings
Approach and DCF Approach


Hurdle rate: 12%
Forecast Year , t
0 1 2 3 4 5 6
Residual Earnings Approach
Revenues $430 $890 $1,350 $1,730 $1,980 $1,980
Depreciation 216 432 648 864 1,080 1,080
Strategy income 214 458 702 866 900 900
Book value $1,200 2,184 2,956 3,504 3,840 3,840 3,840
Book rate of return 17.8% 21.0% 23.8% 24.7% 23.4% 23.4%
Residual Income (0.12) 70 195.9 347.8 445.5 439.2 439.2
PV of RE 62.5 156.2 247.5 283.0 249.3
Total PV of RE 999
Continuing value
1
3,660
PV of CV 2,077
Value of strategy $4,276 Value add: $3,076

Discounted Cash Flow Approach
Cash inflow $430 $890 $1,350 $1,730 $2,100 $2,100
Investment $(1,200) (1,200) (1,200) (1,200) (1,200) (1,200) (1,200)
Free cash flow (FCF) (1,200) (770) (310) 150 53 0 900 900
PV of FCF (687.5) (247.2) 106.8 336.7 510.7
Total PV of FCF 20
Continuing value
2
7,500
PV of CV 4,256
Value of Strategy $4,276 Net present value: $3,076




1
CV= 439.2/0.12=$3,660.
2
CV=900/0.12=$7,500.
Advantages and Disadvantages of the
Residual Earnings Model
Advantages
Focus on
value drivers:
focuses on profitability of investment and growth in investment
that drive value; directs strategic thinking to these drivers
Incorporates the
financial
statements:
incorporates the value already recognized in the balance sheet (the
book value); forecasts the income statement and balance sheet
rather than the cash flow statement
Uses accrual
accounting:
uses the properties of accrual accounting that recognize value
added ahead of cash flows, matches value added to value given up
and treats investment as an asset rather than a loss of value
Versatility: can be used with a wide variety of accounting principles (Chapter
16)
Aligned with what
people forecast:
analysts forecast earnings (from which forecasted residual
earnings can be calculated)
Validation: forecasts of residual earnings can be validated in subsequent
audited financial statements
Disadvantages
Accounting
complexity:
requires an understanding of how accrual accounting works
Suspect
accounting:
relies on accounting numbers that can be suspect (Chapter 17)
Forecast horizon: forecast horizons can be shorter than for DCF analysis and more
value is typically recognized in the immediate future; also,
forecasts up to the horizon give an indication of profitability and
growth for a continuing value calculation; but the forecast horizon
does depend on the quality of the accrual accounting (Chapter 16)
Protection from Paying Too Much for
Earnings Generated by Investment
Invest $50 million in Year 1 with proceeds from a share
issue:

Forecast Year

0 1 2 3 4 5

Earnings 12.00 12.36 17.73 18.61 19.56 20.57

Net dividends 9.09 (40.64) 9.64 9.93 10.23 10.53

Book value 100.00 153.00 161.09 169.77 179.10 189.14

RE (10% charge) 2.36 2.43 2.50 2.58 2.66

RE growth rate 3% 3% 3% 3%






$133.71 million. =

+ =
03 . 1 10 . 1
36 . 2 $
100 $
0
E
V
Beware!
Protection from Paying Too Much for
Earnings Created by the Accounting:
the Project
Project (1): Write down book value to $360

Book Value $360
Required Return 10%
Revenue $440
Earnings 80 ($440 360)

Earnings have been created

Residual Earnings = 80 (0.10 x 360)
= 44

Value = 360 + 44
1.10

= 400

The valuation is unchanged.
Beware!
Protection from Paying Too Much for
Earnings Created by the Accounting:
the Simple Example
Writing inventory down by $8 million in Year 0 creates lower
cost-of-goods sold in Year 1:

Forecast Year

0 1 2 3 4 5

Earnings 4.00 20.36 12.73 13.11 13.51 13.91

Dividends 9.09 9.36 9.64 9.93 10.23 10.53

Book value 92.00 103.00 106.09 109.27 112.55 115.93

RE (10% charge) 1.16 2.43 2.50 2.58 2.66

RE growth rate 3% 3% 3%



= $133.71 million.
(
(
(

+ + =
10 . 1
03 . 1 10 . 1
43 . 2
10 . 1
16 . 11
92 $
0
E
V
Beware!
Tracking V/P Ratios: All U.S.
Stocks, 1975 - 2002


0
0.5
1
1.5
2
2.5
1
9
7
5
1
9
7
7
1
9
7
9
1
9
8
1
1
9
8
3
1
9
8
5
1
9
8
7
1
9
8
9
1
9
9
1
1
9
9
3
1
9
9
5
1
9
9
7
1
9
9
9
2
0
0
1
V
/
P

R
a
t
i
o
Median V/P Ratio
) (
x
2
2
2
2 1
0 0
g
g RE RE RE
B V
E

+ + + =

Inputs:

Analysts consensus forecasts
Required return = Risk-free rate + 5%
g = 4%
Reverse Engineering the Growth Rate:
A Simple Demonstration

=


g = 1.03


The market is forecasting a growth rate for residual
earnings of 3% per year
71 . 133 $
0
= P
g
+
10 . 1
36 . 2 $
100 $
Reverse Engineering the Expected
Return: A Simple Demonstration

=


RE
1
= $12.36 [( 1) 100.0]

Solution: = 1.0936

You expect a 9.36% return from buying the stock at the
current market price.

The formula for is:

2 . 147 $
0
= P
03 . 1
100 $
1

RE
( )
0
1
0
0 0
1 1
P
Earn
P
B P
g +

+ =
Reverse Engineering the S&P 500
S&P 500 Index, beginning of 2005 =1200

S&P 500 P/B ratio = 3.0

S&P 500 ROCE for 2004 = 16%

Required return = Risk-free rate + risk premium
= 4.6% + 5%
= 9.6%






g
g RE
B P

+ =

x
2004
2004 2004
g
g

+ =
096 . 1
x ) 096 . 0 16 . 0 (
$1.0 $3.0
rate) growth (6.2% 1.062 g =
Reverse Engineering for Nike Inc.
P
2004
=
$
75


Consensus forecast for 2005 =
$
4.45

Consensus forecast for 2006 =
$
5.04




21 . 1
10 . 1
x 870 . 2
21 . 1
870 . 2
10 . 1
633 . 2
17 . 18 $ 75 $
2004
g
g
P

+ + + = =
rate) growth 5.2% (a 052 . 1 = g
Implied Earnings Forecasts and
Earnings Growth Rates
Convert residual earnings forecasts to
earnings forecasts as follows:

This formula reverse-engineers the residual earnings calculation


t t t
earnings Residual return) Required x value Book forecasts Earnings + =
1
(
019 . 3 870 . 2
$ $
2007
1.052 RE Nike, For = =
019 . 3 0.10) x (25.71 eps Implied
2007
+ =
25.71
$
2006
= B
5.59
$
=
2007 for rate growth eps Implied
10.91% 04 . 5 5.59/
$ $
= =
Plotting Implied Eps Growth
Rates: Nike Inc.






BUY
SELL
Building Blocks of a Residual Earnings
Valuation: Nike Inc.





Current Market Value
short-term long-term
forecasts forecasts
$28.35
Book Value Value from Value from
(1) (2) (3)
V
a
l
u
e

P
e
r

S
h
a
r
e
$75
$46.65
$28.48
$18.17
Book Value
(1) Book value, known for sure
(2) Value from near-term forecasts (for two years ahead), usually are made with
some confidence
(3) Value from long-term growth forecasts, the most speculative part of the valuation