SESSION 9

PROSPECTIVE ANALYSIS: VALUATION

OLE-KRISTIAN HOPE (PHD, CFA, CPA)

DELOITTE PROFESSOR
Late Fall Lil Strolls and Enjoying the
Sunset

What a goofy smile!!

 Final Exam

 Monday, December 12, 9-11 AM

 Two-hour exam but should be able to finish more quickly (90 minutes
– compare weight of 23%)

 Can bring one double-sided crib sheet (any font; typed or hand-written)

 Comprehensive (yes, that means all course content)

 Focus on class discussions; assigned readings

 Best of luck!

:
Term Project Report

 Due December 2
 See Course Outline and posted Note. Project contact: Stacey
Choy (CPA)
 Use the company’s original financial statements
 Use consolidated financial statements
 On-line submission, including the report and the Excel file
with all calculations
 Details in appendices

Best of luck and enjoy!

 Steps in FSAV – These are Integrated

 STEP 1: STRATEGIC ANALYSIS

 How attractive is the industry
 What is the core strategy of the firm?
 How is it reflected in the financial statements?
 STEP 2: ACCOUNTING ANALYSIS
 How firms communicate with financial statements and how regulation and managerial discretion
affect financial statements
 How to adjust financial statements for distortions
 STEP 3: FINANCIAL ANALYSIS
 How to interpret financial statements
 Profitability Analysis
 Risk Analysis
 STEP 4: PROSPECTIVE ANALYSIS
 How to forecast future performance and value companies
 STEP 5: APPLICATIONS IN SPECIFIC CONTEXTS
 Credit Analysis, M&A
Some of My Valuation-Related Work (see website/CV for more)

“The (In)Visibility of Political Connections” (WP) – currently close to completing revision

“Private Information and Bank-Loan Pricing: The Effect of Upcoming Corporate Spinoffs” (WP)
“Economic Consequences of Corporate Governance Disclosure: Evidence from the 2006 SEC Regulation o
n Related-Party Transactions.”
2020. The Accounting Review
“Analysts’ Choice of Peer Companies.” 2015. Review of Accounting Studies
“Financial Reporting Quality and Investment Efficiency of Private Firms in Emerging Markets.” 2011. The
Accounting Review
“The Cost of Pride – Why Do Firms from Developing Countries Bid Higher?” 2011. Journal of
International Business Studies
“International Evidence on Analyst Stock Recommendations, Valuations, and Returns.” 2010.
Contemporary Accounting Research
“The Pricing of Conservative Accounting and the Measurement of Conservatism at the Firm-Year Level.”
2010. Review of Accounting Studies
“The Effects of SFAS 131 Geographic Segment Disclosures by U.S. Multinational Companies on the
Valuation of Foreign Earnings.” 2009. Journal of International Business Studies
“Market Reactions to the Closest Peer Firm’s Analyst Revisions.” 2018. Accounting and Business Research
“The Market’s Reaction to Unexpected Earnings Thresholds.” 2011. Journal of Business Finance and
Accounting
Prospective Analysis: Valuation Theory

 How to convert forecasts of future into value?

1. Dividend Discount Models (most fundamental)
2. Discounted Cash Flow Models (DCF)
3. Discounted Abnormal Earnings Models (residual income model)
 Models identical in theory

o Differ in “truncation” assumptions

 What are we valuing?

o Equity directly

o Assets (enterprise) and then equity

 Short-Cut Methods
4. Multiples or comparables
 Ultimately goal is to determine the value of the stock
 Three Fundamental Approaches
o Discounted Dividends
o Equity Value = PV of expected future dividends
DIV 1 DIV 2 DIV 3
V    ........
(1  re ) (1  re ) 2 (1  re ) 3
o Discounted Abnormal Value
o Equity Value = Book Value + PV of exp. abnormal earnings
NI1  re * BVE0 NI 2  re * BVE1 NI 3  re * BVE2
V  BVE0     ........
(1  re ) (1  re ) 2 (1  re )3
o Discounted Free Cash Flows to Equity
o Equity Value = PV of exp. free cash flow to equity

FCFE1 FCFE2 FCFE3

V    ........
(1  re ) (1  re ) 2 (1  re )3
 DCF Valuation - Equity

 FCFE: Commonly used valuation method

Critical elements:
i. Estimate Discount rate

 Cost of Equity (re)  using CAPM or more sophisticated approach

ii. Calculate (/Project) Free Cash Flows to Equity

Equity FCF = NI - ΔWC - Capex + dep’n + Δdebt
Or: CFO – Capex + Δdebt
 DCF Valuation - Equity

iii. Estimate Terminal Value

 TV is a simplification because we cannot forecast FCFEs for an

infinite time horizon
o Forecast horizon includes “n” time periods
o Convert cash flows from “n+1” time period onwards until
infinity into simple expression, Terminal Value
o Terminal growth rate (g) assumption crucial

iv. Price per share = Projected Value of Equity / # of shares

outstanding
Capital Asset Pricing Model (CAPM)

Cost of equity using CAPM

RF (risk-free rate): Yield on intermediate-term government securities

β (beta): systematic risk  how much riskier a stock is compared to the market as a
whole

Spread or market risk premium: Extent to which the stock market outperformed risk-
free investments historically. 4-8% commonly used

Obviously encouraged to use more sophisticated models than CAPM

 DCF Valuation - Enterprise

Critical elements:
i. Estimate Discount rate, WACC (more later)
ii. Calculate “Free Cash Flows to Enterprise”
o Enterprise FCF = NI + Int(1-t) – Δ WC - capex + depr
o or CFO + Int(1-t) – Capex
i. Estimate Terminal Value for enterprise

Projected Value of Equity = Projected Value of Firm – Value of Debt

Price per share = Projected Value of Equity/ # of shares outstanding
Weighted Average Cost of Capital (WACC)

o Measure of riskiness or expected return of the firm as a whole

Cost of debt (rD): interest rate on borrowings

Market value of debt (D): fair value of debt (often ≈ BV. Read debt note)

Note: Weight of Debt + Weight of Equity = 1

How Do We Find the Discount Rate?

 WACC(continued):

Cost of Equity (rE): CAPM (or newer approach – Lu Zhang’s q-factor?)

Market value of equity (E): # shares outstanding × stock price
• Circularity in WACC calculation
• Solve E using iteration
• Assume targeted capital structure (i.e., two terms in square brackets above)
 Drawbacks of DCF

o Too much importance to terminal value assumption

o Huge part of valuation
o Weak economic intuition
o Ignores accounting numbers such as Earnings, Book Values
o Research shows earnings dominate cash flow  Earnings
better predictor of future earnings and cash flows than current
cash flows
o Earnings drivers of value; CFs results of that work
o Cannot handle negative numbers well
o Circularity in WACC estimation
 Abnormal Earnings Valuation

o Or Residual Income valuation

o Normal earnings: ROE = cost of equity. Any earnings above that is
referred to as “abnormal earnings” or residual income
o Abnormal Earnings = Earnings - [Cost of Equity × Beginning
BV]

o Value of Equity = BV Equity+ PV of expected abnormal

earnings
o Investors willing to pay premium/discount to BV based on expected
abnormal earnings. If no abnormal earnings, value of equity = BV
 Implementing Abnormal Earnings Valuation

o Terminal value estimated as

o Need forecasts of future earnings and book values

o Calculate Abnormal Earnings
o Estimate Terminal value
o Add all pieces together
 Why is this a good model?
Asset-Based AEV [For Completeness Only]

o If book values are negative, do valuation at the asset level (not

common)

o Calculate enterprise value by substituting

o NOPAT for NI (to capture the debt component)

o BV of Assets for BV of Equity

o WACC instead of cost of equity

o Once enterprise value estimated, obtain equity value by

subtracting debt
Ways to Estimate Terminal Value

 Terminal value is inherently less important in AEV

o Don’t start from scratch – start from BV
o Terminal value of “abnormal” earnings
 Alternate approach
o Assume ROE converges to industry median say 10 years after
explicit forecast
o After that, firm earns cost of equity (AE=0, TV=0)
 Gives more economic intuition to terminal value and scenarios
 Valuation Using Price Multiples

o Simplicity  no detailed data analysis, no forecasting

o Popular: Price/Book (P/B; market-to-book) and Price/Earnings (P/E)
o Ratio of market value/ performance value
o Select comparable firm, calculate multiples for this firm and apply
same multiple to earnings or BV of focal firm
o Variety of multiples (sales for firms with no profits or # of web hits, etc.)
o Problems
o Choice of comparable (try to find close peers)

o Simple or simplistic?

o If one firm misvalued  can further propagate misvaluation

 Can justify almost any valuation… See my article: “

Analysts’ Choice of Peer Companies.” 2015. Review of Accounting Studies
Rigorous Multiples-Based Valuation

More analytical approach

1. Start with AEV model
NI1  re * BVE0 NI 2  re * BVE1 NI 3  re * BVE2
V  BVE0     ........
(1  re ) (1  re ) 2
(1  re ) 3

2. Divide Equation by current book value (BVE0)

V NI / BVE0  re NI 2 / BVE0  re * BVE1 / BVE0 NI 3 / BVE0  re * BVE 2 / BVE0
1 1    ........
BVE0 (1  re ) (1  re ) 2
(1  re ) 3

3. Simplified to
V ROE1  re ( ROE 2  re ) * BVE1 / BVE 0 ( ROE 3  re ) * BVE 2 / BVE 0
1    ........
BVE 0 (1  re ) (1  re ) 2 (1  re ) 3
 Interpreting P/B Ratios

V ROE1  re ( ROE 2  re ) * BVE1 / BVE 0 ( ROE 3  re ) * BVE 2 / BVE 0

1    ........
BVE 0 (1  re ) (1  re ) 2
(1  re ) 3

o Left-hand side is the value/book or what P/B should be based on the

AEV model
o Implies that P/B (or M/B) depends on
1. Ability to generate ROEs in excess of cost of equity
o Magnitude of future abnormal ROEs
2. Cumulative Growth in Investment Base (BVE)
o Growth in book value (retention)
3. Cost of Equity (re)
 Interpreting P/B Ratios

V ROE1  re ( ROE 2  re ) * BVE1 / BVE 0 ( ROE 3  re ) * BVE 2 / BVE 0

1    ........
BVE 0 (1  re ) (1  re ) 2 (1  re ) 3

o If firm’s ROE > cost of equity  P/B >1

o Growth in investment base will further increase P/B
o Invest or payout?  Why payout when future projects generate +
NPV?

o If firm’s ROE = cost of equity  P/B close to 1

o Invest or payout less crucial (shareholders indifferent)

o If firm’s ROE < cost of equity  P/B < 1

o Growth will further lower P/B  Better to payout, rather than
invest in –NPV projects
 Interpreting P/E Ratios

P/E ratio is commonly used valuation ratio

o Value/Earnings = Value/Book × Book/Earnings

o Value/Earnings = (Value/Book) / (Earnings/Book)

OR = (Value/Book)/ROE

o PE Ratios are hence affected by current ROEs

o Very high current ROEs => lower PE ratios as market expects current
ROE to potentially not be sustainable
o Very low current ROE => higher PE ratios as market expects current
downturns to be temporary
Have a Nice Week
 Stay healthy, physically and mentally
 Always prioritize your health!
 Help each other!
 Exercise (whatever you enjoy)
 Sufficient sleep
 Diet (variety more than specific foods)
 Social contact
 Fresh air – get out there!
  Healthy & Happy Lives