Download Chapter 13 Valuation: Earnings

Chapter 13
Valuation: Earnings –
Based Approach
Role of Earnings
 Primary measure of firm performance
under accrual accounting system and
hence, provide a basis for valuation.
 Has a direct impact on the capital markets
and the pricing of shares.
 Used for internal capital allocation.
 Used for aligning the incentives of
managers with shareholders.
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Rationale For Earnings - Based Valuation
 Economic theory:
n
Expected Future Payoffs t
V0  
t
(1

Discount
Rate)
t 1
 Expected Future Payoffs - Approaches:
Dividends
Expected future
free cash flows
Earnings
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Wealth distribution (or liquidation)
Free cash flow realization
Residual income valuation (or
wealth creation)
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Valuation Approaches
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Earnings-Based Valuation
 Value Relevance of Earnings.
 Residual Income Valuation in Theory.
 Residual Income Valuation in Practice.
 Sensitivity Analysis.
 Potential Causes of Valuation Errors.
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Advantages and Concerns
 Advantages


Earnings align more closely to the capital
markets and company management’s focus.
Residual Income valuation requires fewer
steps than free cash flows valuation.
 Concerns

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Earnings are not as reliable or as meaningful
as cash or dividends.
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Advantages and Concerns (Contd.)

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Accrual accounting earnings reflect
accounting methods and not underlying
economic values.
7
Value Relevance of Earnings
 Most widely followed measure of firm
performance.
 Only accounting number firms must report
on a per-share basis.
 Share prices react quickly to earnings
announcements.
 Accruals and deferrals in earnings figure.
 Measures wealth created for shareholders
by the firm.
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Residual Income Valuation
 Basis is dividends-based valuation model.
 Assumes Clean surplus accounting:
 Net income includes all income items
 Dividends include all direct capital transactions
between the firm and the shareholders
 Use finite horizon residual income model
with continuing value computation.
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Residual Income Valuation Model
 Basic Model
NI t  (RE  BVt -1 )
V0  BV0  
t
(1

R
)
t 1
E

 Continuing Value
NI t  (RE  BVt -1 )
V0  BV0  

t
(1 RE )
t 1

1
1 

NI T  1 g  (RE  BVT )
T
RE  g 1 RE  

T
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Residual Income
 Is the excess earnings over required (or
normal) earnings i.e., “abnormal earnings”.
 Normal earnings of the firm = RE × BVt-1
 RE = Required rate of return
 BVt-1 = Book value at the beginning of the year
 Measures the amount of wealth creation (or
destruction) by firm for common equity
shareholders.
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Residual Income Calculation Steps
 Forecast expected future net income for
each period.
 Forecast expected book value of common
shareholders’ equity at the beginning of
each period.
 Compute expected future required income.
 Subtract future required income from
expected net income.
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12
Discount Rate
 Risk-adjusted expected rate of return on
equity capital.
 Computed based on Capital Asset Pricing
Model (CAPM).
 Adjusted for capital structure changes.
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13
Capital Asset Pricing Model
E[REj] = E[RF] + ßj × {E[RM] – E[RF]}
Where:







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E denotes expectation
REj
= return on common equity in firm j
RF
= risk-free rate of return
ßj
= market beta for firm j
RM
= return on market as a whole
RF can use yield on short- or intermediate-term US government
securities for risk-free rate
{E[RM] – E[RF]} known as “market risk premium”
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Continuing Value
 Analyst should forecast over a foreseeable
finite horizon, until the firm achieves
“steady-state” growth pattern.
 Apply growth rate to Net Income (NIT).
 Apply perpetuity-with-growth factor and
present value factor to Residual Income
(RIT+1).
 Discount continuing value to present value.
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Sensitivity Analysis
 Use to get a range of firm values.
 Value estimate will be inversely related to
discount rate.
 Value estimate will be positively related to
growth rate.
 Cannot compute continuing value if growth
rate > discount rate.
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Implementation Issues
 “Dirty surplus” accounting
 Should analyst include other comprehensive
income items?
 Common stock transactions
 Exercise of employee stock options
 Other equity claimants
 Minority interest shareholders
 Preferred shareholders
 Negative book value of common equity
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Internal Consistency Among Three
Approaches
 Reasons why value estimates from the
three valuation approaches may not agree
 Incomplete or inconsistent earnings and cash
flow forecasts.
 Inconsistent estimates of weighted average
costs of capital.
 Incorrect continuing value computations.
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