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+
+
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+
+
(
+
+ =
+ + + + +
t
t t
t
t t t
t
t
BV
BV
k
k ROCE
BV
BV
k
k ROCE
k
k ROCE
BV
V
2
3
3 1
2
2 1
1 1 1
1
Note:
ROCE and growth in book value increase PB increases
Cost (risk) of equity capital increases PB decreases
Present value of future abnormal earnings is positive (negative)
PB is greater (less) than 1.0
11-25
Earnings Based Equity Valuation
Price-to-Earnings (PE) Ratio
Fundamental Valuation Multiples
Market Value of Equity
Net Income
11-26
Earnings Based Equity Valuation
PE ratio can be written as a function of short-term (STG) and
long-term growth (LTG) of earning per share (eps) as follows:
Fundamental Valuation Multiples
Where k is the cost of equity capital, STG (LTG) is the expected short-
term (long-term) % change in eps relative to expected normal growth
(STG>LTG and LTG>k)
Note:
The PE ratio is inversely related to k
The PE ratio is positively related to the expected growth in eps
relative to normal growth.
11-27
Earnings Based Equity Valuation
PEG ratio
If LTG=0 (long-term growth in eps relative to normal
growth is expected to remain constant)
This yields the popular PEG ratio.
Fundamental Valuation Multiples
Example: If PE=20 and k=10%,
proponents of this screening device
recommend stock purchase (sale) if
the expected eps growth is greater
(less) than 20%.
11-28
Earnings Based Equity Valuation
Illustration of Earnings-Based Valuation
Christy Co. book value of equity at January 1, Year 1, is $50,000
Christy has a 15% cost of equity capital (k)
Forecasts of Christys accounting data follow:
Year 1 Year 2 Year 3 Year 4 Year 5
Sales $ 100,000 $ 113,000 $ 127,690 $ 144,290 $144,290
Operating expenses 77,500 90,000 103,500 118,000 119,040
Depreciation 10,000 11,300 12,770 14,430 14,430
Net income $ 12,500 $ 11,700 $ 11,420 $ 11,860 $ 10,820
Dividends 6,000 4,355 3,120 11,860 10,820
Year 6 and beyond = Both accounting data and dividends
approximate Year 5 levels
11-29
Earnings Based Equity Valuation
Illustration of Earnings-Based Valuation
Christys forecasted book value at January 1, Year 1 is
$58,594computed as:
This implies Christy stock should sell at a PB ratio of 1.17
($58,594/$50,000) at January 1, Year 1
11-30
Earnings Based Equity Valuation
Three additional observations:
Expected ROCE = 15% (Christys cost of capital) for Year 5 and
beyond. Since ROCE equals the cost of capital for Year 5 and
beyond, these years results do not change the value of Christy
(i.e. abnormal earnings equal zero for those years). Anticipated
effects of competition are implicit in future profitability estimates.
Since PE ratios are based on both current and future earnings, a
PE ratio for Christy as of January 1, Year 1, cannot be calculated
since prior years data are unavailable. PE ratio at January 1, Year
2 is computed as:
Illustration of Earnings-Based Valuation
11-31
Earnings Based Equity Valuation
Valuation estimates assume dividend payments occur at the end
of each year. A more realistic assumption is that, on average,
these cash outflows occur midway through the year. To adjust
valuation estimates for mid-year discounting, multiply the PV of
future abnormal earnings by (1 + k/2). For Christy Company the
adjusted valuation estimate equals $59,239. This is computed as
$50,000 + (1 + [.15/2]) x $8,594.
Illustration of Earnings-Based Valuation
11-32
Earning Power and Forecasting for Valuation
Earning power is the earnings level expected to persist
into the foreseeable future
Accounting-based valuation models capitalize earning power
Many financial analyses directed at determining earning power
Measurement of Earning Power reflects:
Earnings and all its components
Stability and persistence of earnings
and its components
Sustainable trends in earnings and its
components
Earning Power
11-33
Earning Power and Forecasting for Valuation
Factors in selecting a time horizon for measuring earning
power:
One-year is often too short to reliably measure earning power
Many investing and financing activities are long term
Better to measure earning power by using average (or cumulative)
earnings over several years
An extended period is less subject to distortions, irregularities, and
other transitory effects
Preferred time horizon in measuring earning
power is typically 4 to 7 years
Earning Power
11-34
Earning Power and Forecasting for Valuation
Adjusting Earnings per Share
Earning power is measured using all earnings components.
The issue is to what year we assign these items when computing
earning power.
Earning Power
Our earnings analysis might be limited to a short time
horizon. We adjust short time series of earnings for
items that better relate to other periods. If this is done
on a per share basis, every item must be adjusted for
its tax effect using the companys effective tax rate
unless the applicable tax rate is specified. All items
must also be divided by the number of shares used in
computing EPS.
11-35
Earning Power and Forecasting for
Valuation
11-36
Earning Power and Forecasting for Valuation
Done by analyzing earnings components and considering all
available information, both quantitative and qualitative.
Forecasting benefits from disaggregation.
Disaggregation involves using data by product lines or segments
Especially useful when segments differ by risk, profitability, or growth.
Difference between forecasting and extrapolation.
Earnings Forecasting
Divisional earnings for TechCom, Inc., reveal how different divisional
performance can be masked by aggregate results:
11-37
Earning Power and Forecasting for Valuation
Elements Impacting Earnings Forecasts
Current and past evidence
Forecasts reasonableness.
Continuity and momentum of company performance
Industry prospects
Company's financial condition
Management
Management qualityresourcefulness
Asset managementoperating skills
Economic and competitive factors
Key Indicators such as capital expenditures, order backlogs,
and demand trends
Earnings Forecasting
11-38
Earning Power and Forecasting for Valuation
Limitations in interim reporting related to difficulties in
assigning earnings components to periods of under one
year in length:
Period-end accounting adjustments
Seasonality in business activities
Integral reporting method
SEC interim reporting requirements
Analysis implications of interim Reports
Interim Reports for Monitoring and Revising Earnings Estimates
11-39
Earning Power and Forecasting for Valuation
Available Interim Reports
Quarterly reports (Form 10-Q)
Reports on current developments (Form 8-K)
Disclosure of separate fourth-quarter results
Details of year-end adjustments
Interim reports filed with the SEC such as:
Comparative interim and year-to-date income statement
Comparative balance sheets
Year-to-date statement of cash flows
Pro forma information on business combinations
Disclosure of accounting changes
Managements narrative analysis of operating results
Reports of a change in auditor
Interim Reports for Monitoring and Revising Earnings Estimates