Download growth and the p/e ratio

Fundamental Valuation-2
GROWTH AND THE P/E RATIO
Can rework the dividend growth model as:
Po = El /k + PVGO (PV og growth opportunities).
Think of the first term as the value of assets in place (disc at perp) and the rest as growth
opportunities.
Rearrange as:
Po / El = (1/k) * [1 + PVGO /(E/k)]
The firm is no-growth where PVGO is zero, growth expands the P/E ratio. The last term is a ratio
of the growth opportunities to assets in place and is a conceptual way to think of how value might
be created.
Sustainable Growth
• Think of this g as an “equilibrium” or “target” growth rate. So, attempt to maintain all financial ratios at
“optimal” levels. Any growth away from this sustainable growth causes imbalances.
Beginning-of-year balance sheet
Income statement
CA
300
CL
200
Sales
1000
NFA
400
Debt
Equity
150
350
Cost of Goods
Earnings before tax
800
200
TA
700
TL
700
EAT
100
Dividends
30
Retained Earnings
70
Represents sales growth
of 10% from previous
year. Costs increase
proportionately
• For simplicity, assume full capacity, so that 10% growth requires a proportional increase in assets from
700 to 770. Financed only by retained earnings. Thus, end-of-year balance sheet will look like:
End-of-year balance sheet
CA
330
CL
200
NFA
440
Debt
150
Equity
420
TA
770
TL
770
(350 +70)
Sustainable Growth
• Retained earnings provided all the funds needed to grow at 10%. More funds available from
“spontaneous” sources i.e. CL. Not using them causes ratios to change. So, can possibly achieve more
growth (above 10%)
• Suppose growth of 15% in sales (and assets) is possible and funds are also generated from CL and debt
from 15% spontaneous growth. The end-of-year balance sheet will look like:
End-of-year balance sheet
CA
345
CL
230.0
NFA
460
Debt
172.5
Equity
420.0
TA
805
TL
822.5
• Now have too much money. Still more growth possible!
Spontaneous
liability change
(350 +70)
Sustainable Growth
• Suppose growth of 20% in sales was reflected in the previous income statement. Asset levels now need
to be 20% higher.
CA
NFA
TA
End-of-year balance sheet
360 (300)
CL
480 (400)
Debt
Equity
840 (700)
TL
240
180
420
840
(200)
(150)
(350)
(700)
• Notice that all the ratios remain unchanged!
• This 20% rate is the sustainable growth rate. It is the rate of growth that is manageable without resort
to additional equity financing. Debt and current liabilities have increased “spontaneously.”
MANAGING EARNINGS
1. Recording revenue before its earned
 Stuff the channel: force customer to take more than they need, pay later, return
whenever (hard to prove)
 book as revenue at sale, even LT contracts, aggressive
 vendor financing (what looks like growth is really bad receivables, various
telcos)
MANAGING EARNINGS
2. Inventing revenue
 McKesson had two books
 Revenue swap arrangements between firms with different quarterly reporting
months.
 Boosting profits with non-recurring items
 gains from investments were treated as income during the bubble, now losses
are treated as non-operating.
 Gains and losses from currency translation, is operational but not treated as
such.
MANAGING EARNINGS
3. Shifting expenses to later periods
 Capitalize software development costs for many years, rather than booking
as expenses, makes earnings look better. E.g many software companies
 Raise assumed rate of return on pension fund, so
decrease in funding costs, increase in profits,GE.
 Failing to disclose or record liabilities: Rite Aid reduced payables because
of discounts it “felt” was due though they never got it
MANAGING EARNINGS
4. Shifting income to later periods
 MSFT used to postpone revenue recognition till long after software sale, (unearned
revenue).
 WR Grace maintained excess earnings in all-purpose reserve.
5. Shifting future expenses to earlier periods
 Front-load write-off of unproductive assets to make future E look good and create
“growth”.
 Asset restructuring: match unusual gain from asset sale with restructuring charges
(GE)
Is all this a good thing or a bad thing?
Ok if compatible with GAAP ?
New industries with evolving acctg practices ?
Don’t we do smooth things at the personal level too ?
Can’t investors figure this out ?
So why bother with earnings at all? Why not use free cash flow as to equity
as above ? Companies then began to redefine free cash flow in their reports
to suit their purposes (EDS, Tyco).
DISCOUNTED CASH FLOW VALUATION
Could value equity directly or value the firm and then take out the non-equity claims.
The DDM’s we did earlier are an illustration of the former, where dividend flows to
equity holders are discounted at the cost of equity.

Estimate life: Usually as 1 or 2 stages, high growth + stable.

Estimate Cash flows to the firm
Earnings before interest and taxes * ( 1- tax rate)
Plus:
Depreciation
Minus:
Capital Expenditure
Minus:
Change in Working Capital
Equals:
Cash flow to the firm
I. EBIT = Earnings before interest and taxes
 must reflect only income and expenses from operations, not finance.
 If there are no earnings, use revenue * operating margin
 Operating leases are treated as financial expenses but should operating expenses (so
adjust EBIT)
 R&D is treated as operating but could be a capital expense. Some tech companies have
argued that SG&A is a capital expense not operating (AOL and free-CDs
 Tax rate: Marginal or effective? Marginal understates income early but more accurate
later. Effective rate really measures the difference between acctg and tax books.
Estimate growth rate for this over time as: a) historical growth in EPS and/or dividends,
b) arithmetic or geometric; c) sustainable growth).
II. Net capital expenditures = Capital Expense –
Depreciation
 Includes research and development expenses, acquisitions (look in
SOCF under investment activities, can normalize).
 Think of the depreciation as a cash flow that finances capital
expense
 Firms in high growth phase need more, for mature firms, this may
net to zero.
III. Change in Net Working Capital
Increases in NWC ties up cash and reduces cash flow
Cleaner to think of it as Non Cash CA – Non Debt CL
IV. Estimate discount rate
Weighted average cost of capital (WACC) using MV weights
this reflects the cost of issuing securities to finance projects.
C.I. Cost of equity = Risk-free + Equity beta * Risk Premium




a) Risk-free rate => no default risk, no reinvestment risk,
match duration of instrument with life
use real rates on inflation indexed bond ?
10-year bond yield presently 4.1%
For some countries. There may not even be a risk-free security.
b) Risk premium => even historical has some variance.
1928-2000
1990-2000
8.4
11.3
Stocks – T-bills
Arith
Geom
7.2
8.4
Stocks – T-bonds
Arith
Geom
6.6
5.6
12.7
8.9
 Are investor risk patterns are changing
 When the Fed stays accommodative, there is an implicit reduction in the
risk premium (the Fed put)
Could reverse the logic and estimate an “implied” risk
premium from current stock prices, e.g
E(R) = D1/P0 + g and take out a risk free rate.
Has varied from 2% in 2000, 3% in the 1960’s and 6.25% in
the late 1970’s.
BETA ESTIMATION
 Slope of regression of stock return against market
return
 Higher with both operating and financial leverage
Adjust for leverage, βl = βu * [1 + {(1-t) * D/E}
 Depends on the time frame, Value line uses adjusted
betas, probably the easiest to use and reflect
changes over time as firm matures
 Could also do it bottom-up or fundamental betas
(take weighted beta of different lines of business)
C.II. Cost of Debt = After-tax yield to
maturity
FINALLY, THE VALUE OF THE FIRM IS:
PV of operating assets, (the CF’s above, discounted at the WACC)
Plus: Cash and Non operating assets.
AND The Value of the Equity = Value of the Firm – Value of Debt.
CAVEAT
a) Models are geared more towards traditional manufacturing firms. Cash flow
fluctuations for financial firms and cyclical firms are tied more closely to economic
activit, so time cycle? he business cycle. Firms in trouble/ restructuring/acquisition
make CF estimation difficult.
b) Because of the accounting games that companies play, tremendous attention is
devoted to getting the cash flow estimates right. However, valuations are often
much more sensitive to small variations in the market-driven estimates that
comprise the discount rate.
c) Even after such care, considerable sensitivity analysis is warranted.