Financial Statement Analysis

Transcription

1 Financial Statement Analysis MSc. in Financial Analysis for xecutives Department of Banking & Financial Management University of Piraeus Dr. Georgios A. Papanastasopoulos 4-

2 4-2

3 4-3

4 Simple (and Cheap) Approaches to Valuation Fundamental analysis is detailed and costly. Simple approaches avoid forecasting and minimize information analysis. But they lose precision. Simple methods: Method of Comparables Screening on Multiples Asset-Based Valuation 4-4

5 The Method of Comparables. Identify comparable firms that have similar operations to the firm whose value is in question (the target ). 2. Identify measures for the comparable firms in their financial statements earnings, book value, sales, cash flow and calculate multiples of those measures at which the firms trade. 3. Apply these multiples to the corresponding measures for the target to get that firm s value. 4-5

6 The Method of Comparables: Dell, Gateway and Hewlett Packard, 22 Sales arnings Book Value Market Value P/S P/ P/B Hewlett Packard Co. $45,226 $624 $3,953 $32, Gateway 2 Inc. 6,8 (,29),565, Dell Computer Corp. 3,68,246 4,694???? Average Multiple for Comparables Dell's Number Dell's Valuation Sales.53 $3,68 $6,59 arnings 52.8,246 65,789 Book Value.8 4,694 8,449 Average of Valuations 3,

7 How Cheap is this Method? Conceptual problems: Circular reasoning: Price is ascertained from price (of the comps) Violates the tenet: When calculating value to challenge price, don t let price enter the calculation If the market is efficient for the comparable companies...why is it not for the target company? Implementation problems: Finding the comparables that match precisely Different accounting methods for comps and target Different prices from different multiples What about negative denominators? Applications: IPOs; firms that are not traded (to approximate price, not value) 4-7

8 Unlevered (or nterprise) Multiples (that are Unaffected by the Financing of Operations) Market Value of quity + Net Debt Unlevered Price/Sales Ratio = Sales Market Value of quity + Net Debt Unlevered Price/ebit = ebit Market Value of quity + Net Debt Unlevered Price/ebitda = ebitda nterprise P B = Market Value of Book Value of quity quity + + Net Debt Net Debt 4-8

9 Rolling Variations of the P/ Ratio Price per share Trailing P/ = Last annual ps Price per share P/ = Sum of ps for most recent four quarters Price per share Forward P/ = Forecast of next year' s ps 4-9

10 Dividend Adjusted P/ Price per share + Annual Dps Dividend - Adjusted P/ = ps Rationale : Dividend affects prices but not earnings 4-

11 Typical Values for Common Multiples Multiple nterprise Trailing Forward Unlevered Unlevered Unlevered Percentile P/B P/B P/ P/ P/S P/S P/CFO P/ebitda P/ebit Negative Negative 3. Negative earnings cash flow ebit

12 Screening Analysis Technical screens: identify positions based on trading indicators Price screens Small stock screens Neglected stocks screens Seasonal screens Momentum screens Insider trading screens Fundamental screens: identify positions based on fundamental indicators of the firm s operations relative to price Price/arnings (P/) ratios Market/Book Value (P/B) ratios Price/Cash Flow (P/C) ratios Price/Dividend (P/d) ratios Any combination of these methods is possible 4-2

13 How Multiple Screening Works. Identify a multiple on which to screen stocks. 2. Rank stocks on that multiple, from highest to lowest. 3. Buy stocks with the lowest multiples and (short) sell stocks with the highest multiples. 4-3

14 Fundamental Screening: Return to Price-to-Book Mean Price/Book Monthly Mean Group Return (%) Beta (High) (Low) Source: Fama and French (992) 4-4

15 Technical Screening: Returns to Size Mean Size Mean Monthly Group Beta Return (%) (Large) (Small) Source: Fama and French (992) Average Monthly Returns and stimated Betas from July 963 to December 99 for Ten Size Groups 4-5

16 Returns to Beta: Is Beta Dead? Mean Beta Monthly Mean Group Return (%) Beta (High) (Low).2.8 Source: Fama and French (992) Average Monthly Returns and stimated Betas from July 963 to December 99 for Ten Beta Groups 4-6

17 Returns to two fundamental screens Value Glamour Source: Lakonishok, Shleifer, & Vishny, Contrarian Investment, xtrapolation, and Risk, Journal of Finance, Vol. 49, No. 5. (Dec., 994), p

18 Year by Year Returns: Value Minus Glamour Source: Lakonishok, Shleifer, & Vishny, Contrarian Investment, xtrapolation, and Risk, Journal of Finance, Vol. 49, No. 5. (Dec., 994), p

19 P/B and P/V Ratios: The Dow Stocks Source: Lee, Myers & Swaminathan, What is the Intrinsic Value of the Dow, Journal of Finance, (Oct., 999). 4-9

20 Problems with Screening You could be loading up on a risk factor You need a risk model You are in danger of trading with someone who knows more than you You need a model that anticipates future payoffs A full-blown fundamental analysis supplies this 4-2

21 Asset Based Valuation Values the firm s assets and then subtracts the value of debt: The balance sheet does this calculation, but imperfectly: Shareholders quity = Total Assets -Total Liabilities Problems with this approach: Getting the value of operating assets when there is not a market for them Identifying value in use for a particular firm Getting the value of intangible assets (brand names, R&D) Getting the value of synergies of assets being used together Applications: Asset-based firms such as oil and gas and mineral products Calculating liquidation value 4-2

22 4-22

23 Business Activities Financing Activities: Raising cash from investors and returning cash to investors Investing Activities: Investing cash raised from investors in operational assets Operating Activities: Utilizing investments to produce and sell products 4-23

24 What Creates Value in a Firm? quity Financing Activities? Share Issues? Share Repurchases? Dividends? Debt Financing Activities? Investing and Operating Activities? Distinguish anticipated (exante) value in investing activities from realized (expost) value in operations Value is created in product and factor markets 4-24

25 The No Arbitrage Condition (NA) If the price paid for a stock is P (expected payoff discounted at the required payoff per dollar, ρ), the stock is appropriately priced: the market price is efficient = P + ρ d Or, price is efficient if it equals the expected return capitalized at the required rate-of-return: Or, today s price (P ) must be such that the required rate-of-return, ρ -, will equal the (expected) rate-of-return: ρ P = = P P + d ρ Required Rate-of Return = xpected Rate-of-Return + d P P P 4-25

26 Arbitrage Trading Strategies If NA holds, the market is efficient for that stock: there is no arbitrage opportunity Any discrepancy between expected and required rate-of-return, is an arbitrage opportunity that, if exploited, will profit the arbitrage trader. An arbitrage opportunity arises if P + d P If then BUY P > P + d P If then SLL ρ ρ < P The difference is called the expected abnormal return and the rule can be restated as: BUY if the expected abnormal return is positive, and SLL if negative. If it is zero, do nothing (HOLD) 4-26

27 Measuring Returns Hewlett-Packard: Returns for 99 Hewlett-Packard Company: Returns for 99 Required return is 2% Price at end of 99 $ Dividend Payoff Price at end of Return Logo used with permission of Hewlett Packard Rate of return = $ / 26. = 95.6% 4-27

28 Hewlett-Packard: Returns for 99 Required return is 2% Price at end of 99 $ Dividend Payoff Price at end of Return Logo used with permission of Hewlett Packard Rate of return = $24.855/26. = 95.6% Normal return: $26 x Abnormal return Abnormal rate of return = 2.735/26. = 83.6% Rate of return 95.6% Normal return 2.% Abnormal rate of return 83.6% 4-28

29 The Process of Fundamental Analysis Step 5 - Trading on the Valuation Outside Investor Compare Value with Price to BUY, SLL, or HOLD Inside Investor Compare Value with Cost to ACCPT or RJCT Strategy Step 4 - Convert Forecasts to a Valuation Step 3 - Forecasting Payoffs Measuring Value Added Step - Knowing the Business Forecasting Value Added The Products The Knowledge Base The Competition The Regulatory Constraints Strategy Step 2 - Analyzing Information In Financial Statements Outside of Financial Statements A valuation model guides the process Forecasting is at the heart of the process and a valuation model specifies what is to be forecasted (Step 3) and how a forecast is converted to a valuation (Step 4). What is to be forecasted (Step 3) dictates the information analysis (Step 2) 4-29

30 Valuation Models: Going Concerns A Firm CF CF 2 CF 3 CF 4 CF 5 quity T Dividend Flow d d 2 d 3 d 4 d 5 The terminal value, TV T is the price payoff, P T when the share is sold d T TV T Valuation issues : The forecast target: dividends, cash flow, earnings? The time horizon: T = 5,,? The terminal value The discount rate 4-3

31 DDM: The Dividend Discount Model: Targeting Dividends Problems: How far does one project? Does V V d d 2 d = ρ ρ ρ d d d d = ρ ρ ρ ρ 3 T T provide a good estimate of V? (i) Dividend policy can be arbitrary and not linked to value added. (ii) The firm can borrow to pay dividends; this does not create value (iii) Think of a firm that pays no dividends The dividend irrelevancy concept The dividend conundrum: quity value is based on future dividends, but forecasting dividends over finite horizons does not give an indication of this value Conclusion: Focus on creation of wealth rather than distribution of wealth. 4-3

32 Some Math: The Value of a Perpetuity and a Perpetuity with Growth The Value of a Perpetuity A perpetuity is a constant stream that continues without end. A constant stream is sometimes referred to as an annuity, so a perpetuity is an annuity that continues forever. To value that stream, one capitalizes the constant amount expected. If the dividend expected next year is expected to be a perpetuity, the value of the dividend stream is Value of a perpetual dividend stream = V = d ρ The Value of a Perpetuity with Growth If an amount is forecasted to grow at a constant rate, its value can be calculated by capitalizing the amount at the required return adjusted for the growth rate: Value of a dividend growing at a constant rate = V = ρ d g 4-32

33 Terminal Values for the DDM Model A. Capitalize expected terminal dividends TV = P = T T d ρ T + B. Capitalize expected terminal dividends with growth TV = P = T T d ρ T + g Will it work? 4-33

34 Dividend Discount Analysis: Advantages and Disadvantages Advantages asy concept: dividends are what shareholders get, so forecast them Predictability: dividends are usually fairly stable in the short run so dividends are easy to forecast (in the short run) Disadvantages Relevance: dividends payout is not related to value, at least in the short run; dividend forecasts ignore the capital gain component of payoffs. When It Works Best When payout is permanently tied to the value generation in the firm. For example, when a firm has a fixed payout ratio (dividends/earnings). 4-34

35 Cash Flows for a Going Concern Free cash flow is cash flow from operations that results from investments minus cash used to make investments. Cash flow from operations (inflows) C C 2 C 3 C 4 C 5 Cash investment (outflows) I I 2 I 3 I 4 I 5 Free cash flow C -I C 2 -I 2 C 3 -I 3 C 4 -I 4 C 5 -I 5 Time, t

36 The Discounted Cash Flow (DCF) Model Cash flow from operations (inflows) C C2 C3 C4 C5 ---> Cash investment I I2 I3 I4 I5 ---> (outflows) Free cash flow C I C2 I2 C3 I3 C4 I4 C5 I5 ---> ---> Time, t F V V = V D C I C I C I C I CV V ρ ρ ρ ρ ρ T T T = V 2 3 T T F F F F F D F V O 4-36

37 The Continuing Value for the DCF Model A. Capitalize terminal free cash flow CV T C ρ F I T + T + = B. Capitalize terminal free cash flow with growth CV T C ρ F I T + T + = g Will it work? 4-37

38 DCF Valuation: The Coca-Cola Cola Company Cash from operations 3,657 4,97 4,736 5,457 5,929 Cash investments 947,87, Required return is 9% Book value of net debt is 4,435 Shares outstanding are 2,472 Assume growing FCF at 5% after period T Value per share? 4-38

39 DCF Valuation: The Coca-Cola Cola Company In millions of dollars except share and per-share numbers. Required return for the firm is 9% Cash from operations 3,657 4,97 4,736 5,457 5,929 Cash investments 947,87, Free cash flow 2,7 2,9 3,569 4,55 5,3 Discount rate (.9)t Present value of free cash flows 2,486 2,449 2,756 3,224 3,452 Total present value to 24 4,367 Continuing value (CV)* 39,44 Present value of CV 9,6 nterprise value 4,978 Book value of net debt 4,435 Value of equity (),543 Shares outstanding 2,472 Value per share $4.67 *CV = 5,3 x.5 = 39, Present value of CV = 39,44 = 9,

40 The DCF Model: Will it work for Wal-Mart Stores? Wal-Mart Stores, Inc. (Fiscal years ending January 3. Amounts in millions of dollars.) Cash from operations ,422,553,54 2,573 3,4 2,993 Cash investments ,526 2,5 3,56 4,486 3,792 3,332 Free cash flow (9) (4) (597) (,966) (,93) (382) (339) Dividends per share Price per share 6⅞ 8½ ⅝ 6½ 27 32½ 26½ 25⅞ 24⅜ 4-4

41 Why Free Cash Flow is not a Value-Added Concept Cash flow from operations (value added) is reduced by investments (which also add value): investments are treated as value losses Value received is not matched against value surrendered to generate value A firm reduces free cash flow by investing and increases free cash flow by reducing investments: free cash flow is partially a liquidation concept Note: analysts forecast earnings, not cash flows 4-4

42 Discounted Cash Flow Analysis: Advantages and Disadvantages Advantages asy concept: cash flows are real and easy to think about; they are not affected by accounting rules Familiarity: is a straight application of familiar net present value techniques Disadvantages Suspect concept: free cash flow does not measure value added in the short run; value gained is not matched with value given up. free cash flow fails to recognize value generated that does not involve cash flows investment is treated as a loss of value free cash flow is partly a liquidation concept; firms increase free cash flow by cutting back on investments. Forecast horizons: typically requires forecasts for long periods; terminal values for shorter periods are hard to calculate with any reliability Validation: it is hard to validate free cash flow forecasts Not aligned with what people forecast: analysts forecast earnings, not free cash flow; adjusting earnings forecasts to free cash forecasts requires further forecasting of accruals. When It Works Best When the investment pattern is such as to produce constant free cash flow or free cash flow growing at a constant rate. 4-42

43 Features of the Income Statement. Dividends don t affect income 2. Investment doesn t affect income 3. There is a matching of Value added (revenues) Value lost (expenses) Net value added (net income) 4. Accruals adjust cash flows Accruals Value added that is not cash flow Adjustments to cash inflows that are not value added 4-43

44 arnings and Cash Flows arnings = [C - I] - i + I + accruals = C - i + accruals The earnings calculation adds back investments and puts them back in the balance sheet. It also adds accruals. 4-44

45 The articulation of the financial statements through the recording of cash flows and accruals Net cash flows from all activities increases cash in the balance sheet Cash from operations increases net income and shareholders equity Cash investments increase other assets Cash from debt financing increases liabilities Cash from equity financing increases shareholders equity Accruals increase net income, shareholders equity, assets and liabilities Beginning stocks Flows nding stocks Cash Flow Statement year nding Balance Sheet year Cash from operations Cash from investing Debt financing quity financing nding Balance Sheet year Cash Net change in cash Cash + Other Assets Total Assets - Liabilities Statement of Shareholders quity year Investment and disinvestment by owners arnings + Other Assets Total Assets - Liabilities Owners equity Net change in owners equity Owners equity Income Statement year Cash from operations + Accruals Net income 4-45

46 5-46

47 Valuation of Investments Value of Investment = Book Value of Investment + Value added from Investment Value added from Investment is expressed though Residual arnings Residual arnings: arnings above or below a normal level. Q: Normal Level? A: Required return X Investment 5-47

48 Valuing a One-Period Project () Investment $4 Required return % Revenue forecast $44 xpense forecast $4 Forecasted earnings $ 4 (Revenue $44 - Depreciation $4) Residual earnings = arnings (Required return x Investment ) = 4 - (. x 4) = Value = 4 +. = 4 This is a Zero-R project This is a zero NPV project: DCF Valuation: V = 44 =

49 Valuing a One-Period Project (2) Investment $4 Required return % Revenue forecast $448 xpense forecast $4 arnings forecast $ 48 (Revenue $448- Depreciation $4) Residual earnings = 48 - (. x 4) = 8 8 Value Project = 4 + = The project adds value DCF value 448 = =

50 Valuing a Savings Account Forecast Year arnings withdrawn each year (full payout) arnings Dividends Book value Residual earnings No withdrawals (zero payout) arnings Dividends Book value Residual earnings Value = Book Value + Present Value of Residual arnings = + = 5-5

51 Lessons from the Savings Account. 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. ven 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. 5-5

52 Price-to to-book Ratio P/B ratio is based on expected future earnings that have been not yet recognized to the book value. Thus, if expected future earnings are equal to required earnings (i.e., normal earnings) then we get normal P/B =. expected future earnings are above required earnings (i.e., positive abnormal earnings) then we get P/B >. expected future earnings are below required earnings (i.e., negative abnormal earnings) then we get P/B <. 5-52

53 A Model for Anchoring Value on Book Value R R R Value of common equity ( V ) 2 = B ρ ρ ρ where R is residual earnings for equity: Residual earnings = comprehensive earnings - (required return for equit y x beginning - of - period book value) R = arn (ρ )B t t t 5-53

54 Derivation of the quity Valuation Model: One Period Valuing a one-period payoff equation: ( P + d ) P = ρ Substitute for the expected dividend d = arnings (B B ) to get P arnings = (B ρ B ) + P P or = B arnings + ρ (ρ )B P + ρ B ( ) The amount, arnings ρ is called Residual arnings B 5-54

55 5-55 Derivation of the quity Valuation Model: Derivation of the quity Valuation Model: Multiperiod Multiperiod Substituting comprehensive earnings and book value for dividends in each period, If we set As efficient prices equal intrinsic values, then ( ) ( ) ( ) T T T T T T 2 2 ρ B P ρ B ρ arnings ρ B ρ arnings ρ B ρ arnings B P = ( ) t t t B ρ arnings R = T T T T T 2 2 ρ B P ρ R... ρ R ρ R B P = T T T T T 2 2 ρ B V ρ R... ρ R ρ R B V =

56 The Continuing Value for the R Model ( ) V T B Premium is assessed through the present value of residual earnings: T ( ) CV T i.e., the continuing value of the model. Case : R is forecasted to be zero in perpetuity after T So CV T = Case I: R is forecasted to be constant in perpetuity after T So CV T R = ρ T+ Case II: R is forecasted to grow at constant rate in perpetuity after T CV So T = R ρ T + g 5-56

57 Alternative Measure of Residual arnings ROC t = Comprehensive earnings to common Book value t- t Residual earnings is the rate of return on equity, ROC, expressed as a dollar excess return on equity rather than a ratio. But it can be expressed in ratio form: ( ρ ) B t = [ ROC t ( ρ ) ] t arnings t B 5-57

58 Drivers of Residual arnings Two Drivers:. ROC If forecasted ROC equals the required return, then R will be zero, and V = B If forecasted ROC is greater than the required return, then V > B If forecasted ROC is less than the required return, then V < B 2. Growth in book value (net assets) put in place to earn the ROC R will change with change with ROC and growth in book value 5-58

59 P/B, ROC and Growth in Book Value P/B in 23 ROC in 24 Growth Rate for Book Value in 24 The Gap Inc % 3.7% General lectric Co % 39.3% Verizon Communications Inc % 2.2% Citigroup Inc %.5% Home Depot Inc % 3.2% General Motors Corp..9.% 9.7% Federated Department Stores.92 2.% 3.% 5-59

60 Valuing Flanigan s nterprises Case : Zero R after T Forecast Year ps Dps Bps 3.58 Required rate of return is 9 %. Assume zero R after period T (zero premium at T). V? 5-6

61 Valuing Flanigan s nterprises Case : Zero R after T Forecast Year ps Dps Bps ROC 2.4% 9.% 4.9% 9.% R (9% charge) Discount rate (.9) Present value of R Total present value of R to Value per share 4.53 Assuming zero R after period T (zero premium at T): V = =

62 Valuing General lectric Case 2: Constant R after T Forecast Year ps Dps Bps 4.32 Required rate of return is %. Assume constant R after period T: V? 5-62

63 Valuing General lectric Case 2: Constant R after T Forecast Year ps Dps Bps ROC 29.9% 27.4% 24.7% 23.3% 22.3% R (% charge) Discount rate (.) Present value of R Total present value of R to Continuing value (CV) 8.82 Present value of CV 5.48 Value per share 3.7 The continuing value:.882. CV = = 8.82 Present value of continuing value = = Assuming constant R after period T: V = =

64 Valuing Dell Inc. Case 3: Growing R after T Forecast Year ps Dps..... Bps 2.6 Required rate of return is %. Assume growing R at 6.5% after period T : V? 5-64

65 Valuing Dell Inc. Case 3: Growing R after T Forecast Year ps Dps..... Bps ROC 4.8% 6.6% 2 4.3% 24.5% 22.6% R (% charge) Discount rate (.) t Present value of R Total present value of R to Continuing value (CV) 4.32 Present value of CV 8.5 Value per share 2.3 The continuing value (with growth at 6.5%): CV = = Present value of continuing value = = 8.5 Assuming growing R after period T : V = = 5-65

66 Forecasting Target Prices by Analysts Case (Flannigan s): Target Price = B + CV T T V 23 = B 23 = 5.4 T Case 2 (G): V 24 = B 24 + CV 24 = = 6.78 Case 3 (Dell): V 25 = B 25 + CV 25 = =

67 Converting an Analyst s s Forecast to a Valuation: Nike Inc. ) Bps (24): $8.7 2) Constant Payout Ratio (dividends to earnings) :.26 3) arnings Forecasts: 25 $ $5.4 Five-year eps growth rate: 4% 4) Required Rate of Return: % 5) Assume growing R at GDP growth rate of 4% after T Price = $75 V? 5-67

68 Converting an Analyst s s Forecast to a Valuation: Nike Inc. 24A ps Dps Bps ROC 24.49% 23.23% 22.36% 2.64% 2.6% R (% charge) Discount rate (.)t Present value of R Total PV to Continuing value (CV) Present value of CV 42.9 Value per share The continuing value (with growth at GDP growth rate of 4%): CV = =

69 Advantages Residual arnings Model : Advantages and Disadvantages 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. 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 Predictability: dividends are usually fairly stable in the short run so dividends are easy to forecast (in the short run) Disadvantages Accounting complexity: requires an understanding of how accrual accounting works Suspect accounting: relies on accounting numbers that can be suspect. 5-69

70 A Simple Demonstration In millions of dollars. Required return is % per year. Forecast Year arnings Dividends Book value R (% charge) R growth rate 3% 3% 3% 3%. R V $2.36 = B + = $ + = $33. 7 million ρ g..3 The intrinsic price-to-book ratio (P/B) is $33.7 / $ =

71 Protection from Paying Too Much for arnings Generated by Investment Invest $5 million in Year with proceeds from a share issue: Forecast Year arnings Net dividends 9.9 (4.64) Book value R (% charge) Beware! R growth rate 3% 3% 3% 3% $2.36 V = $ + = $33. 7 million

72 Creative Accounting Suppose that the manager of the firm decided to create more earnings for Year by writing down inventory by $8 in year. loss from inventory will be $8 in year, while cost of goods will be understated by the same amount in Year. arnings will be $4 (2-8) in year and $2.36 (2.36+8) in Year. Clean surplus accounting implies that book value will be $92 (-8) in year. : 5-72

73 Protection from Paying Too Much for arnings Created by the Accounting: the Simple xample Writing inventory down by $8 million in Year creates lower \ cost-of-goods sold in Year : Forecast Year arnings Dividends Book value R (% charge) R growth rate 3% 3% 3% V..3 = $ = $ million Beware! 5-73

74 6-74

75 The Concept Behind the P/ Ratio Price in numerator of P/ is based on expected future earnings arnings in denominator is current (or forward) earnings P/ is thus based on expected growth in earnings 6-75

76 The Trailing P/ and Forward P/ Price Forward P/ = arnings Trailing P/ = Price + Dividend arnings [Dividendsreduce current price, but not current earnings] Normal Forward P/ = required return Normal Trailing P/ = + required return required return Normal Forward P/ = Normal Trailing P/ 6-76

77 Valuation with arnings Value = Capitalized Forward arnings + xtra Value for Forecasted arnings Growth arn V = + ρ - xtra Value for Forecasted Abnormal arnings Growth 6-77

78 The Prototype Savings Account arnings withdrawn each year (full payout) arnings Dividends Book value arnings growth rate No withdrawals (zero payout) arnings Dividends Book value arnings growth rate 5% 5% 5% 5% 6-78

79 Full Payout Scenario: Value of the Savings Account - arn 5.5 Value = = = ρ $ Logical? Yes, there is no earnings growth for the savings account. Zero Payout Scenario: arn 5 Value = = = ρ - g.5.5? Does not work for the savings account, but why? Yes, it is a bad P/ model, since it focuses only on normal earnings growth (i.e., growth rate equals required return: g=ρ=.5) and ignores abnormal earnings growth (what if g>ρ?). But what do we mean with abnormal earnings growth? To answer the question, recall that the only difference between the two savings accounts is based on the payout ratio. 6-79

80 Cum-Dividend arnings For the zero-payout account: Cum-dividend earnings For the full-payout account: arnings in the account Dividend 5% Cum-dividend earnings Cum-dividend earnings (22) [ ] arnings (22) +.5 Dividend (2) = The two accounts have different (ex-dividend) earnings growth, but the same cum-dividend earnings growth 6-8

81 Normal arnings Normal arnings is earnings growing at the required rate of return: ρ Normal arnings = arnings t For the savings account: Normal arnings (22) =.5 arnings (2) =.5 x 5.= 5.25 Normal arnings (23) = =

82 Abnormal arnings Growth (AG) Abnormal arnings Growth is growth over normal earnings growth AG = Cum-dividend earnings Normal earnings For the Savings account: AG AG ( 22 ) = = ( 23 ) = = 6-82

83 Lessons from the Savings Account. An asset is worth capitalized forward earnings if abnormal earnings growth is expected to be zero. 2. An asset has a normal P/ ratio if abnormal earnings growth is expected to be zero. 3. arnings comes from two sources: earnings from the asset earnings from reinvesting dividends 4. x-dividend growth rates are affected by dividends: dividends reduce assets which then earn lower earnings. 5. Cum-dividend growth rates are not affected by dividends (since they reflect earnings from dividends) : they are effectively the rates that firms would have if they did not pay dividends 6-83

84 A Model of the Forward P/ The model: Value of equity = Capitalized forward earnings + xtra value for abnormal earnings growth V arn AG 2 AG 3 AG 4 = ρ ρ ρ ρ ρ AG 2 AG 3 AG 4 = arn ρ ρ ρ ρ The intrinsic P/ V arn is given by dividing through by arn 6-84

85 Measuring Abnormal arnings Growth for quities Abnormal earnings growth t (AG t ) = Cum-dividend earn t - Normal earn t Dell: Required return = % ps 24 = $.3 Nike: Required return = % ps 24 = $3.59 = [arn t + (ρ ) d t- ] ρarn t- ps 25 Dps 24 arnings on reinvested dividends Cum-dividend earnings 25 Normal earnings from 24: Dell:.3 x.; Nike: 3.59 x. Abnormal earnings growth (AG) 25 Dell Computer Nike Inc. $. $.8 $ $.37 $.74 $ $

86 Alternative Calculation of AG Abnormal earnings growth t = [G t ρ ] x arnings t- Where G t = Cum dividend earnings arnings t t For Nike: G 25 = 4.524/3.59 =.262% (a 26.2% growth rate) AG 25 = [.262.] x 3.59 = $

87 Abnormal arnings Growth is qual to the Change in Residual arnings AG t = [earn t + (ρ )d t- ] -ρ earn t- = earn t earn t (ρ )[earn t d t ] By the stocks and flows equation for accounting for the book value of equity (Chapter 2), B t- = B t-2 + earn t- d t-, so earn t- d t- = B t- B t-2. Thus, AG t = earn t earn t- - (ρ )[B t- B t-2 ] = [earn t - (ρ )B t- ] - [earn t- - (ρ )B t-2 ] = R t R t- So, the AG model can be written as: V = ρ R 2 R 3 R arn ρ ρ ρ

88 The Continuing Value for the AG Model Case : AG is forecasted to be zero in perpetuity after T So CV T = Case I: AG is forecasted to be constant in perpetuity after T So CV T = AG ρ T+ Case II: AG is forecasted to grow at constant rate in perpetuity after T So CV T = AG ρ T + g 6-88

89 Valuing General lectric Case : Zero AG after T Forecast Year Dps ps Required rate of return is %. Assume zero AG (i.e., constant R) after period T: V? 6-89

90 Valuing General lectric Case : Zero AG after T Forecast Year Dps ps Dps reinvested at % Cum-dividend earnings (eps + dps reinvested) Normal earnings (. x epst-) Abnormal earnings growth (AG) Discount rate (. t ) PV of AG Total PV of AG.7 Total earnings to be capitalized.37 Capitalization rate..37 Value per share. 3.7 =. [ ] 3.7 V 999 = Same as residual earnings valuation 6-9

91 Valuing Dell Inc. Case 3: Growing AG after T Forecast Year ps Dps..... Bps 2.6 Required rate of return is %. Assume growing AG at 6.5% after period T : V? 6-9

92 Valuing Dell Inc. Case 3: Growing AG after T Forecast Year Dps ps Dps reinvested (. dps t- )..... Cum-dividend earnings Normal earnings (. eps t- ) Abnormal earnings growth Discount rate (. t ) Present value of AG Total PV of AG -.62 Continuing value (CV).873 PV of CV.576 Total earnings to be capitalized.354 Capitalization rate. Value per share The continuing value calculation: CV =.393 = Present value of CV =.873 = V. [ ] = = Same as residual earnings valuation 6-92

93 Converting an Analyst s s Forecast to a Valuation: Nike Inc. ) Constant Payout Ratio (dividends to earnings) :.87 2) arnings Forecasts: 25 $ $3.8 Five-year eps growth rate: 4% 3) Required Rate of Return: % 4) Assume growing AG at GDP growth rate of 4% after T Price = $4 V? 6-93

94 Converting Analysts Forecasts to a Valuation: Rebook International Dps ps Dps reinvested (. x dps t- ) Cum-dividend earnings Normal earnings (. x eps t- ) Abnormal earnings growth Cum-div eps growth rate.95% 4.78% 4.93% 5.% Discount rate (. t ) Present value of AG Total PV of AG.54 Continuing value (CV) PV of CV 2.94 Total earnings to be capitalized 6.9 Capitalization rate. Value per share $ The continuing value calculation:.248 x.4 CV = = Present value of CV = =

95 Applying the Model: A Simple xample Forecast for a firm with expected earnings growth of 3 percent per year (in dollars). Required return is % per year arnings Dividends Book value R (.) R growth rate 3% 3% 3% 3% arnings on reinvested dividends Cum-dividend earnings Normal earnings Abnormal earnings growth arnings growth rate 3% 3% 3% 3% Cum-dividend earnings growth rate.6%.6%.6%.6% Abnormal earnings growth rate 3% 3% 3% Residual earnings valuation: 2.36 V 2 = + = V AG valuation: = + =

96 Protection From arnings Created by Accounting: A Restructuring Charge arnings Dividends Book value arnings on reinvested dividends Cum-dividend earnings Normal earnings Abnormal earnings growth (8.729) Abnormal earnings growth rate 3% 3% 3% V = =

97 Abnormal arnings Growth Analysis: Advantages and Disadvantages Advantages asy to understand: Investors think in terms of future earnings; investors buy earnings. Focuses directly on the most common multiple used, the P/ ratio. Uses accrual accounting: mbeds the properties of accrual accounting by which revenues are matched with expenses to measure value added from selling products. Versatility: Can be used under a variety of accounting principles. Aligned with what people forecast: Analysts forecast earnings and earnings growth. Disadvantages Accounting complexity: Requires an understanding of how accrual accounting works. Concept complexity: Requires an appreciation of the concept of cum-dividend earnings; that is, value is based on earnings to be earned within the firm and from earnings from the reinvestment of dividends. Suspect accounting: Relies on earnings numbers that can be suspect. 6-97