(Moore)
Chapter 8 – Healy and Palepu
Chapter 8 – Prospective Analysis: Valuation
Key Learning Outcomes






Putting everything for the purpose of generating an assessment of the
current market value of the firm (e.g. what is the share price worth)
The ability to estimate the appropriate cost of capital
Working with growth rates and terminal values (equilibrium)
Matching costs of capital with financial statement data and forecasts
The ability to understand and measure Abnormal Earnings and Growth for
terminal values
Assessing the implied cost of capital given the current market price (value)
Chapter 7 Wrap-up – The Abnormal Earnings Growth Model
The Concept Behind the P/E Ratio
•
•
•
•
Price in numerator of P/E is based on expected future earnings
Earnings in denominator is current (or forward) earnings
P/E is thus based on expected growth in earnings
Compare with price-to-book:
 P/B is based on expected earnings relative to current book
value (ROCE)
 ROCE is growth in book value
 P/B is based on expected growth in book value
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Chapter 8 – Healy and Palepu
(Moore)
The Abnormal Earnings Growth Model
Value of savings account = Capitalized forward earnings + No extra value
•
Extra value is added if (cum-dividend) earnings are expected to grow at a
rate greater than the required return
•
The model:
Value of equity = capitalized forward earnings + extra value for abnormal
earnings growth
V0E 

The intrinsic P/E

Earn1
1  AEG2 AEG3 AEG4






 E  1  E  1   E
 E2
 E3


1 
AEG2 AEG3 AEG4




 Earn1 

E 1 
E
 E2
 E3

 V0E 


 Earn 1 
is given by dividing through by Earn1
Measuring Abnormal Earnings Growth for Equities
Abnormal earnings growth t (AEG t) = cum-dividend earn t - normal earn t
= [earn t +(ρE – 1) d t-1] – ρ earn t-1
Dell Computer
Eps 2002
Dps 2001
$0.00
Earnings on reinvested dividends (at 10%)
Cum-dividend earnings 2002
Normal earnings from 2001:
Dell: 0.84 x 1.10; Nike: 2.18 x 1.10
Abnormal earnings growth (AEG) 2002
Assume
EPS (2001)
DPS (2001)
Ke
Dell
$0.84
$0.00
10%
Nike
$2.18
$0.48
10%
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$0.48
Nike Inc.
$0.48
$2.48
$0.00
0.48
0.048
2.528
0.924
$-0.444
2.398
$0.130
Chapter 8 – Healy and Palepu
(Moore)
Forecasting Changes in Residual Earnings
Calculation of equity value using the abnormal earnings growth model. Abnormal
earnings growth is the difference between residual earnings in two subsequent
periods.
Forecasts
Year 1 ahead
Forward
Earnings1
+
PV of
AEG2
Year 2 ahead
Residual
income1
Residual
income2
Abnormal Earnings2
Discount by 
+
PV of
AEG3
Discount by 2
+
PV of
AEG4
Current
Value Capitaliz
e
Discount by 3
+
+
Total
earnings
plus growth
-3-
Year 3 ahead
Residual
income3
Residual
income2
Abnormal Earnings3
Year 4 ahead
Residual
income4
Residual
income3
Abnormal Earnings4
Chapter 8 – Healy and Palepu
(Moore)
A. Which cost of Capital? (Matching with financial statements)
1. Weighted Average Cost of Capital (WACC)
WACC AT 
Vd
Ve
r
(
1

T
)

re


d
Vd  Ve
Vd  Ve
2. Capital Asset Pricing Model (CAPM)

Formula

What about Leverage??
3. Discounted Earnings or Cash Flow?

Free Cash Flow?
B. Time Horizon of Forecasts
1. Short-Term (1-3 years ahead), relatively precise
2. Intermediate-Term (4-7 years ahead), less precise, assumptions matter
3. Long-Term (8-10 years ahead), extremely imprecise, assumptions critical
4. Terminal Forecasts (Present value of an annuity)



Need to make realistic assumptions on SGR
Cost of Capital (discount rate)
Required since firm is assumed to be a going concern
5. Think about severity of errors in terms of discounted future values
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