Chapter 13

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Chapter 13Chapter 13

Valuation: Valuation: Earnings-Based Earnings-Based

Approaches Approaches

Chapter: 13 2

Role of EarningsPrimary 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.

Chapter: 13 3

Rationale For Earnings - Based ValuationEconomic theory:

Expected Future Payoffs - Approaches:

Dividends Wealth distribution (or liquidation)

Expected future free cash flows

Free cash flow realization

Earnings Residual income valuation (or wealth creation)

n

1tt

t0 Rate) Discount(1

Payoffs Future ExpectedV

Chapter: 13 4

Valuation Approaches

Chapter: 13 5

Earnings-Based ValuationValue Relevance of Earnings.Residual Income Valuation in Theory.Residual Income Valuation in Practice.Sensitivity Analysis.Potential Causes of Valuation Errors.

Chapter: 13 6

Advantages and ConcernsAdvantages

Earnings align more closely to the capital markets and company management’s focus.

Residual Income valuation requires fewer steps than free cash flows valuation.

ConcernsEarnings are not as reliable or as meaningful

as cash or dividends.

Chapter: 13 7

Advantages and Concerns (Contd.)Accrual accounting earnings reflect

accounting methods and not underlying economic values.

Chapter: 13 8

Value Relevance of EarningsMost 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.

Chapter: 13 9

Residual Income ValuationBasis 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.

Chapter: 13 10

Residual Income Valuation Model

1t

tE

1-tE t00 )R(1

)BV (R NIBVV

Basic Model

Continuing Value

T

1tt

E

1-tE t00 )R(1

)BV (R NIBVV

T

EETET

R1

1

gR

1)BV (Rg1NI

Chapter: 13 11

Residual IncomeIs 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.

Chapter: 13 12

Residual Income Calculation StepsForecast 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.

Chapter: 13 13

Discount RateRisk-adjusted expected rate of return on

equity capital.Computed based on Capital Asset Pricing

Model (CAPM).

Adjusted for capital structure changes.

Chapter: 13 14

Capital Asset Pricing Model E[REj] = E[RF] + ßj × {E[RM] – E[RF]}

Where: 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”

Chapter: 13 15

Continuing ValueAnalyst 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.

Chapter: 13 16

Sensitivity AnalysisUse 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.

Chapter: 13 17

Implementation Issues“Dirty surplus” accounting

Should analyst include other comprehensive income items?

Common stock transactionsExercise of employee stock options

Other equity claimantsMinority interest shareholdersPreferred shareholdersNegative book value of common equity

Chapter: 13 18

Internal Consistency Among Three Approaches

Reasons why value estimates from the three valuation approaches may not agreeIncomplete or inconsistent earnings and cash

flow forecasts.Inconsistent estimates of weighted average

costs of capital.Incorrect continuing value computations.