New Tools in Valuation: How to Implement Earnings-Based Valuation Approaches

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1 New Tools in Valuation: How to Implement Earnings-Based Valuation Approaches Bala G. Dharan, Ph.D., CPA Vice President, Charles River Associates (CRA) Robert and Candice Haas Visiting Professor of Accounting, Harvard Law School J. Howard Creekmore Professor of Accounting Emeritus, Rice University IECA Annual Conference, Newport Beach March About the Author Bala Dharan is Vice President at Charles River Associates, a business and litigation consulting firm in Boston. He is also Robert and Candice Haas Visiting Professor of Accounting at Harvard Law School, and J. Howard Creekmore Professor Emeritus at Rice University. He has provided consulting and expert testimony on financial accounting and reporting issues, valuation, internal controls, corporate governance, and the reporting of complex financial transactions, including derivatives and structured finance transactions. He has been invited three times to Congress to testify on financial reporting issues. Dr. Dharan s research centers on the use of financial information by investors, and in particular on the effect of accounting changes on the quality of information reported to investors. He is co-author of four textbooks. Dr. Dharan has been a professor or visiting professor at business schools at Harvard, Berkeley, Northwestern and Rice. He is a Certified Public Accountant with ABV (Accredited in Business Valuation) and CFF (Certified in Financial Forensics) credentials. He has a B.Tech from the Indian Institute of Technology, Madras, MBA from the Indian Institute of Management, Ahmedabad, and MS and Ph.D. in accounting from Carnegie Mellon University. Phone (Mobile): bdharan@crai.com or bdharan@law.harvard.edu. Disclaimer: This presentation highlights concepts and data for educational purposes. The material in this presentation should not be cited or used in any litigation matter as representing the views, analysis, or opinions of the author. 2

2 Residual Income Valuation Learning objectives: Concept: Theory underlying residual income valuation model Tool: Implementing a residual income valuation model to calculate the value of a firm. DCF methodology versus RIV methodology Comparison examples RIV Examples and applications of the methodology. Accounting changes and other accruals Dividends Excess cash Debt and equity structure Analysis: Implementation issues. 3 Usefulness of Book Value: Traditional View Traditional view of the role of book value in valuation: Book value is just the sum of the owners contribution and past earnings streams. It cannot tell us anything about the firm s future earnings or cash flows, and hence is irrelevant for valuation. This view was challenged with the development of the Fama-French multi-factor model of expected return Book value (along with firm size) was found by Fama and French to be a significant factor in explaining asset returns High Market to Book ratio implies low future investment returns 4

3 Usefulness of Book Value: Alternative View Future dividends arise from earnings, which in turn depend on the return on equity earned on current book value. The market premium (the difference between market value and book value) represents a firm s ability to earn abnormal or excess return on equity relative to other firms in the industry. In the absence of this comparative advantage, the firm s market value will simply equal its book value! Market to Book Valuation Multiple Ratios such as price to earnings (P/E), price to book value (P/B), and price to sales revenue (P/S) are widely used as value indicators because they show a predictable long-term association with future stock returns. In general, larger valuation ratios lead to smaller future expected returns. Annual returns by P/E Ratio Size Annual returns by P/B Ratio Size Annual Returns Annual Returns Lowest 2 P/E Size Decile Highest Lowest 2 3 P/B Size Decile Highest 6

4 Valuation: Market-to-Book and Size Fama and French (1992 JF) found that M/B and size explain investment returns. They examined the returns of 10 x 10 equally weighted portfolios based on deciles of size (market capitalization) and book-to-market. The return difference between the highest and lowest B/M deciles was 1.63%-0.64% = 0.99%. The return difference between the smallest and the largest size deciles was 1.47%-0.89% = 0.58%. The M/B effect exists controlling size and vice-versa. In each size class, the average returns generally increase as the B/M increases and the effect is stronger for the smaller stocks. Source: Andrew Dubinsky, Value Investing Retrospective, Private and Confidential; For seminar discussion only7 Overview of Valuation Approaches Income or cash flow-based approaches Discounted cash flow (DCF): net present value of free cash flows Income capitalization method: capitalized value of future earnings Asset-oriented approaches Acquisition cost or net realizable value of all tangible and identifiable intangible assets, less liabilities Valuation of goodwill using the excess earnings method Market-based methods Value multipliers (valuation ratios) price-to-book (P/B), priceearnings (P/E), price-to-sales (P/S), other industry-specific ratios Comparables analysis valuation parameters from recent, comparable transactions

5 Free Cash Flow and Valuation Free cash flow (FCF) is commonly used for the valuation of companies and for performance evaluation of managers. It is a non-gaap performance measure. SEC Reg G requires definitions and reconciliations of non-gaap measures with GAAP net income. FCF is used for valuation in two ways, requiring different definitions. To value the entire enterprise (debt and equity): Use debt-free free cash flows. The value of the firm (debt and equity) is the NPV of debt-free FCF, discounted at the weighted average cost of capital. To value just the equity of the enterprise: Use free cash flows to equity holders. The value of the equity of the firm is the NPV of the FCF to equity holders, discounted at the cost of equity. Free Cash Flow Definitions Debt-free FCF, or FCF to enterprise, is a cash flow measure used to determine the value of the entire firm as opposed to just the equity of the firm. Note: Enterprise value is the total value of both debt and equity of the firm. Debt-free FCF = (CFO + After-tax cost of net interest expense) Capital expenditure Free cash flow to equity holders is a cash flow measure used to determine the value of the firm s equity only. Compute it by subtracting from CFO the capital expenditures and various cash flows to/from debt holders FCF to equity holders = (CFO Capital expenditure +/ cash flows from/to debt holders)

6 Discounted Cash Flow: Enterprise Value Using Debt-Free FCF to the Enterprise The enterprise value (defined as the sum of debt and equity values) is the discounted present value of debt-free free cash flows to the enterprise. Debt-free free cash flow for all debt and equity holders (i.e., the enterprise) is the cash flow from operations plus after-tax interest minus capital expenditure needed for maintenance of organic growth. Cash flows and capital expenditures are forecasted for a time horizon during which the company is expected to have a strategic and operational competitive advantage (usually 5, 7 or 10 years). The terminal value cash flow at end of time horizon is based on a forecasted low growth rate when the company has no competitive advantage. Cash flows are discounted using the weighted average cost of capital (WACC) appropriate for the project. From the enterprise value, subtract the value of debt and add any excess cash and financial investments to get the value of equity. Adjust the value of equity for any discounts for lack of control and/or lack of marketability. Example: Value Pro web-based model Discounted Cash Flow: Equity Value Using FCF to Equity Holders The value of the equity of the firm can also be calculated as the discounted present value of free cash flows to equity holders. Free cash flow to equity holders is the cash flow from operations minus capital expenditure needed for maintenance of organic growth, plus or minus cash flows from/to debt holders. Cash flows and capital expenditures are forecasted for a time horizon during which the company is expected to have a strategic and operational competitive advantage (usually 5, 7 or 10 years). The terminal value cash flow at end of time horizon is based on a forecasted low growth rate when the company has no competitive advantage. Cash flows are discounted using the cost of equity appropriate for the project. Add any excess cash and financial investments to get the adjusted value of equity. Adjust the value of equity for any discounts for lack of control and/or lack of marketability.

7 Terminal Value Terminal value is the net present value of free cash flows going forward from terminal year. V T = FCF T+1 / (k - g) where g is the long-term growth rate, and k is the weighted average cost of capital (for enterprise value calculation) or cost of equity (for equity value calculation). Note: 1/(k-g) is known as the terminal value multiplier. The model assumes that the free cash flows will grow from period T+1 into perpetuity at a sustainable rate, g. Residual Income Valuation (RIV) Concept A firm adds value to its book value when its return on equity (i.e., net income to common divided by book value) is greater than its cost of equity. If a firm s ROE = r, then its value is its book value. P/B = 1. When ROE > r, the firm creates value to shareholders. Value of a firm s equity = Book value + Incremental value from discounted future residual incomes. Residual income = Earnings Required Earnings. RI t = E t (r BV t-1 ), or (ROE t r) x BV t-1 where ROE t is E t / BV t-1. 14

8 Residual Income Valuation vs. DCF The following equity valuation methods are equivalent. PV of free cash flows to firm discounted at WACC Value of debt PV of free cash flows to equity discounted at cost of equity Book Value + PV of residual incomes discounted at cost of equity 15 Dividend Discount Model Basis for the RIV Model The dividend discount model is the basis for both DCF and RIV. From the dividend discount model, the equity value of a firm is: Value = D 1 / (1+r) + D 2 / (1+r) 2 + (r = cost of equity) The DCF valuation model treats free cash flows as dividends. To get RIV, use the clean surplus equation to replace dividends with earnings: D t = E t + BV t-1 BV t. Rearranging terms, Value = BV 0 + (E 1 rbv 0 )/(1+r) + (E 2 rbv 1 )/(1+r)

9 Residual Income Valuation Model From the dividend discount model (DDM), the equity value of a firm is: Equity Value 0 = D 1 / (1+k e ) + D 2 / (1+k e ) 2 + But D 1 = E 1 + BV 0 BV 1, D 2 = E 2 + BV 1 BV 0 Substituting these into DDM: Equity Value 0 = BV 0 + (E 1 k e BV 0 )/(1+k e ) + (E 2 k e BV 1 )/(1+k e ) 2 + (E t k e BV 0-1 ) is the residual income (earnings minus a charge for cost of equity). Hence, Equity value equals current book value plus the sum of discounted future residual incomes. Note: EVA is a version of residual income. 17 Three Sources of Value in Residual Income Valuation Model The finite period implementation version of the RIV model shows that a firm gets value from three sources of increasing uncertainty: Value = BV 0 1) Value on hand at 0 (bird in hand) + RI 1 /(1+r) RI T /(1+r) T 2) Value added in 0 to T (short-term opportunities) + (V T -BV T )/(1+r) T 3) Value added after T (speculative long-term value) For (V T -BV T ), use this: RI T+1 / (r-g) Note: The terminal residual value term represents only the premium over book value, i.e., (V T -BV T ), and not the full terminal value or the net realizable value at time T. Hence it would be much smaller than the terminal value calculated under the DCF valuation. 18

10 Residual Income Valuation and the Return Spread The residual income model can be rewritten in terms of the return on equity (ROE) ratio. Assume that ROE is calculated using beginning book value, as follows: ROE t = E t / BV t-1. Then residual income of period t is given by: RI t = (ROE t k e ) BV t-1 The term (ROE t k e ) is the return spread. Managers are contributing real value to the company only when the return spread is positive, i.e., ROE is greater than the cost of equity capital. Note: Return spread is similar to the financing spread (ROA after-tax cost of debt) we learned in an earlier session. In both cases, a positive spread adds to the firm s equity value. 19 Estimating Equity Value Using the Residual Income Valuation Model: Data Needs What s needed: Forecasts of earnings or ROE for years 1 to T, from pro-forma financial statements. For some valuation applications, use management s or analysts earnings forecasts, or publicly available forecasts in Capital IQ, IBES/First Call, etc. Cost of equity, r, from CAPM, Fama-French, build-up model, or other models. What s not needed: Unwinding or unbundling of reported accrual earnings to get cash flows. 20

11 1-Minute Valuation of MSFT using RIV Inputs: - Initial book value - Two EPS forecasts - One dividend forecast - Cost of equity - Long-term growth RI(t+1) = E(t+1) r x BV(t) RI(t+2) = E(t+2) r xbv(t+1) RI(t+3) = RI(t+2) * (1 + g) V(t+2) - BV(t+2) = RI(t+3) / (r g) Inputs: - Initial book value - Three EPS forecasts - Two dividend forecasts - Cost of equity - Long-term growth 21 RIV Example (and Comparison to DCF) The difference of 0.1 in valuation is due to round-offs in underlying financial statement data. 22

12 RIV Value is Unaffected by Zero-Sum Accrual Changes Zero-sum accrual changes that don t affect DCF valuation also don t affect RIV valuation. 23 Valuation of Home Depot Using RIV 24

13 Example: Residual Income and DCF Valuation of Pinkerton Data to prepare pro forma Income Statement and valuation: Note: Y1 to Y5 is forecast period; Y6 is for terminal year cash flows. Based on an HBS case Y1 Y2 Y3 Y4 Y5 Y6 Net working capital/sales 8.6% 7.4% 6.2% 6.2% 6.2% 6.2% Gross margin 8.5% 9.0% 9.5% 10.25% 10.25% 10.25% Operating expenses/sales 6.0% 5.9% 5.8% 5.8% 5.8% 5.8% Revenue ($ million) Other data: At end of Year 0: Net PPE = $17.6 million; Net working capital = $38.8 million. Sales/Net PPE (ending balance) = 25. Income tax rate = 33.33%. Weighted average cost of capital = 14%. Growth rate after terminal year = 5% Any available free cash flows will be paid out in dividends. RI Valuation in xls file RI Valuation in ppt file 25 Pinkerton Valuation Using Free Cash Flows: Pro- Forma Data Y1 Y2 Y3 Y4 Y5 Y6 Net PPE Working capital Revenue Gross profit Operating expenses = Operating profit Income tax = Net income Change in PPE Change in WC Free cash flows

14 Pinkerton Valuation Using Free Cash Flows: Results PV of free cash flows Y1-Y5, at 14%= $45.1 Terminal cash flow multiplier = 1/( ) = Terminal cash flow value as of Y5 end = 8.2 x = $91.2 PV of terminal value = $47.4 Total present value of FCFs = = $92.5 million Note: Terminal Value/Total Value = 52% 27 Pinkerton Valuation Using Residual Income: Pro- Forma Data Y1 Y2 Y3 Y4 Y5 Y6 Net PPE Working capital Revenue Gross profit Operating expenses = Operating profit Income tax = Net income Change in PPE Change in WC Free cash flows Book value (BV+NI-FCF) Residual income (1.8)

15 Pinkerton Valuation Using Residual Income: Results Book value at Y0 = $56.4 PV of residual income, Y1-Y5, at 14%= $5.4 Terminal cash flow multiplier = 1/( ) = Terminal Residual Income at Y5 end = 5.3 x = $59.1 m PV of terminal value premium = $30.7 m Total present value = = $92.5 million Note: Terminal Residual Income/Total Value = 33% 29 Why Use the Residual Income Method Instead of the Free Cash Flow Method The Residual Income method produces a valuation quickly using very few forecasted input variables (initial book value, cost of equity estimate, EPS forecasts, dividend payout assumption). The method focuses on value drivers and financial measures that managers already use (ROE, cost of equity, etc.). The forecast horizon can be short, as little as 2-3 years. The method does not require restating or reformatting earnings to get free cash flows. Unlike free cash flow-based DCF method, forecasting financing and investing cash flows is not important. 30

16 Residual Income Valuation: Implementation Issues The clean surplus equation (BV t-1 + E t -D t = BV t ) may not hold on a per share basis when share count changes during a year. Equivalently, using a total-value RIV (rather than a per-share method), capital contributions/distributions may not be at market values (e.g., firm may issue dilutive securities). The estimated value is generally, but not completely, independent of timing shifting of accruals under alternative accounting methods. If an accrual shift increases earnings and thus book value (but not cash flows), it also increases the charges for cost of equity in future periods until the accrual reverses. The total effect is to leave the valuation mostly unchanged. Firm value may not be independent of dividend policy. In theory, any increase in dividend will be reflected in smaller equity and less earnings in subsequent years, etc. In practice, EPS forecasts differ from the expected EPS growth given by ROE x Retention Rate. 31