Chapter 6: The Role of Financial Information in
Valuation

Learning objectives:
1.
To learn the basic steps in business
valuation.
Forecast a company’s financial
statements.
Using the discounted free cash flow
approach and the abnormal earnings
approach to valuation.
2.
3.
6-1
Learning objectives:
concluded
4.
5.
6.
What factors contribute to variation in
price-earnings multiples.
What factors influence earnings quality.
How stock returns relate to “good news”
and “bad news” about earnings..
6-2
Framework for Business Valuation:
There are three steps involved in
valuing a company:
Step 1: Understand the past (Ch. 5)
Step 2: Forecasting the Future
Step 3: Valuation of Equity Price
•Free cash flow model
•Abnormal earnings approach
3
Business valuation (contd.): Step 2 and
Step 3
Step 2:
Forecast future amounts of the financial
attribute that ultimately determines how much a
company is worth.
Step 3:
a. Determine the risk or uncertainty associated
with the forecastedfuture amounts.
b. Determine the discounted present value of the
expected future amounts using a discount rate
that reflects the risk from Step 2 a.
• Free cash flows
• Accounting earnings
• Balance sheet book values
6-4
Equity Valuation
Step 1: Understanding the past





Information Collection
Understanding the business
Accounting Analysis
Financial Ratio Analysis
Cash Flow Analysis
5
Equity Valuation
Step 2: Forecasting the Future
Forecast future amounts of valuerelevant financial attributes using a
structured forecasting which includes:
 Income statement forecasts
 Balance sheet forecasts
 Cash flow forecasts


Examples of Value-relevant financial attributes:
cash flows, earnings and book value.
6
Procedures in financial statement forecasting
(see Appendix B)
1.
Project sales revenue for each period in
the horizon (i.e., next 5 years).
2.
Forecast operating expenses such as
COGS, selling and general
administration expenses (but not
depreciation, interest, or taxes) using
expense margin.
3.
Forecast balance sheet assets and
liabilities (excl. long-term liabilities)
needed to support the projected
operations in 1 and 2.
7
Procedures in financial statement
forecasting (contd.)
4.
5.
6.

Forecast depreciation expense and the
income tax expense.
Forecast financial structure (and
therefore, long-term debt), dividend paid,
and interest expense.
Derive projected cash flow statements
from the forecasted income statements
and balance sheets.
Thus, expected future amounts of valuerelevant financial attributes such as cash
flows, earnings and book value are
obtained.
8
Financial Statement Forecasts Example (source: P6-21 of
RCJM textbook, 4th edition)
Using the steps outlined in previous pages
and the following information to forecast
2003 and 2004 financial statements of
Krispy Kreme Doughnuts, Inc.:
1.
2.
3.
4.
Sales for 2003 and 2004 will equal $657
million and $819 million, respectively.
Non-operating expenses and income will be
zero.
The company’s income tax rate will be 35%.
All other income statement items are
expected to equal their 2002 levels as a
percentage of sales.
9
Financial Statement Forecasts Example (contd.)
5.
6.
Depreciation expense was $12.3 million in
2002 ($10.3 in cost of goods sold and $2.0
in selling, general, and administration
(SG&A) and $8 million in 2001 ($6.0 in
cost of goods sold and $2.0 in SG&A).
All balance sheet items except Common
stockholders’ equity are expected to equal
their 2002 levels as a percentage of sales.
Accumulated depreciation Was 43.9 million
and $50.2 million in 2001, and 2002,
respectively. Combine long-term
investments, intangibles and Other assets
into a single balance sheet item (other
assets).
10
Financial Statement Forecasts Example (contd.)
7.
8.
Debt is expected to be 15% assets, and
the current portion of long-term debt will
be 10% of total debt each year. Interest
expense will be 6% of debt at the
beginning of each year.
The company will issue or buy back
stock during 2003 and 2004 to meet its
cash flow needs or to distribute excess
cash. Dividends and Other
comprehensive income will be zero.
11
Financial Statement Forecasts Example (contd.)
Additional questions:
1. Analysts’ forecasts of net income are
$50.7 million and $65.9 million for 2003
and 2004, respectively. How do your net
income forecasts compare with those of
the analysts? What does this tell you
about your forecasting assumptions
compared to those used by the analysts?
12
Financial Statement Forecasts Example (contd.)
2. Why is it important to assume the
company will issue or buy back stock
when constructing financial statement
forecasts?
3. How do your sales, net income,
accounts receivable, total assets and
operating cash flow forecasts for 2003
and 2004 compare to the amounts
actually reported by the company in
those two years? What factors are likely
to explain sizable differences between
the actual figures and your forecasts?
 See p9-p13 of chapter 6 homework solutions
on iLearn.
13
Equity Valuation
Step 3: Valuation
Determine the risk (r) or uncertainty
associated with the forecasted future
amounts .
 Use the discount rate that reflects the
risk to calculate the discounted
present value of the expected future
amounts.

14
Learning Objective:
Step 3: Valuation
15
Equity Valuation
Step 3: Valuation



Cost of capital (risk associated with the
forecasted future amounts).
Valuation Models
 Discounted free cash flow model
 Abnormal earnings model (residual income
model) (see Appendix A, P6-13).
Complications
 Negative values
 Distortions from accounting reporting
16
Equity Valuation
Step 3: Valuation (contd.)
Cost of equity capital (r )
 Models available to estimate cost of
capital include:
 CAPM model: cost of capital = Rf +
beta risk x (Rm – Rf)
 Rf= risk free rate; Rm = market return

17
Cost of Capital ( Weighted Average Cost
of Capital)

The WACC equation is the cost of each
capital component multiplied by its
proportional weight and then summing:
E
D
WACC  ( )* REquity  ( )* RDebt *(1  tax%)
V
V
Where:
R equity = cost of equity
R debt = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tax% = corporate tax rate
18
Learning Objective :
The Discounted Free Cash Flow
Approach to Equity Valuation
19
Corporate valuation:
Discounted free cash flow approach
This approach says the value per share (P0) of a
company’s common stock is given by:
•
1
(1 r )t
20
Corporate valuation:
Discounted free cash flow approach
• CFt is free cash flow of year t.
• CF equals company’s operating cash
flows (before interest) minus cash
needed for routine operating capacity
replacement.
• This CF is cash available for further
expansion of operation, debt reduction,
etc.
1
(1 r )t
21
Corporate valuation:
Discounted free cash flow approach
• If the valuation is for common
stockholders, the CF needs to subtract
interest payments, debt repayments
and preferred dividends.
• r is the discount rate appropriate for
the risk associated with the forecasted
free cash flows.
22
Corporate valuation:
Discounted free cash flow approach
1
(1 r ) t
is the discount factor for forecasted cash
flows in period t.
1
(1 r )t
E0 is investors’ expectations (at time 0)
about future free cash flows.
•
23
Business valuation:
Discounted Free Cash Flow illustration
Estimated DCF value
per share
6-24
Discounted free cash flow approach
- A simplified model
CF0
CF0
CF0
Continuing to infinity
P0 



.....
(1   )1 (1   ) 2 (1   )3
• Expected free cash flow in each year set
equal to the free cash flow realized in Year
0 – a zero growth perpetuity.
•
The above constant perpetuity can be simplified
CF0
to :
P0 

25
Application of Free Cash Flow Valuation in
Goodwill Impairment Estimation
• The free cash flow approach can be used to
estimate the current value of a business with
goodwill from a prior acquisition .
• When the estimated current value of the
1
(1 r )t
business minus the fair value of its net
assets is less than the reported goodwill, an
impairment exists.
26
Learning Objective :
The Role of Earnings in Equity
Valuation
27
The Role of Earnings in Valuation
 FASB’s
assertion: information about
earnings measured by accrual
accounting generally provides a
better indication of a firm’s
performance than information of
cash flows.
 Also, a popular belief is that accrual
accounting earnings are more useful
in predicting future cash flows than
cash flows.
28
The Role of Earnings in Valuation
Both FASB’s assertion and the common
belief has been validated by academic
studies:
 1. Current earnings are a better forecast
of future cash flows than are current cash
flows (Barth, Cram and Nelson, 1998)
 2. accrual earnings are more correlated
with stock returns than operating cash
flows. (Dechow, 1994)

29
The role of earnings in valuation:
Zero growth example

Based on FASB’s assertion, replace the CF from the
equation by Earnings (denoted X) in the zero growth
perpetuity setting:
 The zero growth assumption means that expected future earnings
form a perpetuity so that:
or
Estimated share price
Price earning ratio
(P/E) or earnings
multiple
30
The role of earnings in valuation:
Zero growth example
 The zero growth assumption means that expected
future earnings form a perpetuity so that:
or
Estimated share
price
Under zero growth, P/E
ratio is a reciprocal of cost
of capital. Therefore, if
cost of capital equals 0.1,
the earnings multiple (P/E)
will be 10.
Price earning ratio
(P/E) or earnings
multiple
31
Learning Objective :
The Abnormal Earnings
Approach (the Residual
Income Model) to valuation
32
The abnormal earnings approach to
valuation

What matters most to investors is:
1. The amount of money they turn over to management.
2. The profit management is able to earn on that money.

Residual income (abnormal earnings) is
measured as follows:
AE  Earnings  r  Capital(Book Value of Equity)
What
management
does with the
money
Expected
return
What investors
entrust to
management
Abnormal Earnings = Actual Earnings – Required earnings
33
Abnormal earnings

Abnormal earnings is:
a)
Management does better
than expected:
+ $100 of
abnormal
earnings
$300
$200

Suppose investors
contribute $2000 of capital,
and expect to earn a 10%
rate of return.
Earnings
b)
Management does worse
than expected:
$200

Total Expected return is
2000*10%=200
r  Capital
- $50 of
abnormal
earnings
$150
Earnings
34
Abnormal earnings valuation approach
What shareholders have
invested in the firm
Expectations operator
What management
accomplished
Cost of equity capital
What shareholders expected
35
Abnormal earnings:
Price premium and discount
The following is a hypothetical example
[1]
$20
$15
$5
$15
- $5
$5 premium
[2]
$10
Investors willingly pay
a premium over BV for
companies that earn
positive AE
Firms that earn
negative AE sell at
discount to BV
$5 discount
AE stands for abnormal earnings.
36
Terminal Value

The explicit forecast of a firms’
performance(i.e., earnings) generally
extend for only a period of time. (e.g. from
2003 to 2007).

The final year of this forecast period is
labeled the terminal year.

Terminal value is the present value of a
firm beyond the terminal year of forecast.
37
Terminal Value (contd.)

Assuming year 5 is the terminal year, the
terminal value can be estimated by :
(Estimated Abnormal Earnings of Year 6/ r)

(1+ r) T
r = cost of capital
T=to the 5th power when the explicit
forecast is for 5 years.
If a non-zero growth rate is assumed, the
growth rate should be subtracted from r in
estimating the value beyond the terminal
year.
38
Abnormal earnings approach: Summary


A company’s future earnings are
determined by:
1. the resources (net assets) available to
management;
2. the rate of return (profitability) earned
on those net assets.
The abnormal earnings valuation model
makes explicit the role of:
1. Income statement and balance sheet
information.
2. Cost of capital
39
Abnormal earnings approach: Summary
If a firm can earn a return above its
cost of capital (i.e., r x BV), then it
will generate positive abnormal
earnings.
 Firms expected to generate
positive abnormal earnings sell at
a premium to equity book value.

40
Valuing a business opportunity:
The BookWorm store Example
6-41
Valuing a business opportunity:
Free cash flow approach
What the business
is worth
6-42
Valuing a business opportunity:
Abnormal earnings approach
The same as our previous
FCF estimate
6-43
Equity Valuation Using the Abnormal Earnings
Approach (P6-13 of RCJM textbook)
 This problem illustrates how the abnormal
earnings valuation model can be combined
with security analyst’ published earnings
forecasts to estimate stock price and to spot
potentially overvalued stocks.
 Use the abnormal earnings model and the
following information to derive an estimate of
Krispy Kreme (KK) stock price as of August
2003.
 Additional information:
• Actual EPS for 2001 and 2002 were $0.49
and $0.70, respectively.
44
Equity Valuation (contd.)
• The per share amount of stock issued in 2001
and 2002 was $0.65 and $0.39, respectively.
NO stock is expected to be issued or bought
back during the next five years.
• Other comprehensive income per share was
$0.32 in 2002 and zero in 2001. Analysts are
forecasting other comprehensive income to be
zero each year during the next five years.
• KK does not pay dividends.
• ROE, calculated using the beginning-of-year
equity book value, was 21.1% and 20.2% in
2001 and 2002, respectively.
45
Equity Valuation (contd.)
• Analysts are forecasting EPS to be $0.70 and
$0.89 in 2003 and 2004, respectively. The
estimated long-term EPS growth rate is 32.5%
for 2005 through 2007.
• KK’s equity cost of capital is 11%, and the
long-term growth rate (beyond 2007) is
assumed to be 3%.
 Why might the value estimate from the above
differ from the company’s stock price in
August 2003 (i.e., $44 per share)?
 See Solutions posted on iLearn.
46
Learning Objective :
Research on
Earnings and Equity Valuation
47
Earnings and stock prices:
Evidence on value relevance

If investors use accrual
earnings to price stocks,
then earnings differences
across firms should explain
differences in stock prices.

The test:
Stock
price
Stock
price at
$0 EPS
Earnings
per share
Earnings multiple
(should be statistically positive)
2002 P/E relationship for 40 restaurant companies
Pi  $9.54  8.18 X i
R 2  30.0%
48
Earnings and Stock prices (contd.)


Why would two firms with identical
current earnings have very different
stock price ?
Why can earnings explain 100% of
stock price variation?
49
Sources of Variation in P/E
Multiples

In addition to earnings, Stock prices (and thus
earnings multiples) are influenced by:



Risk differences
The mix of earnings components
( transitory, permanent, and valuation
irrelevant)
Growth opportunities:
P0 
X0

 NPVGO
NPVGO : Net present value of future growth opportunities
50
The Mix of Earnings Components

Stock prices reflect information about the components
of earnings.
e.g. income from
continuing operations
e.g. loss from
discontinued
operations
e.g. cumulative effect
of changes in
accounting methods
51
The Mix of Earnings Components :
Earnings components and P/E
Differences in earnings
components mix produces
differences in P/E
52
Earnings and stock prices:
Earnings quality

The notion of earnings quality is
multifaceted, and there is no
consensus on how best to measure
it.

Most observers agree that earnings
are high quality when they are
sustainable over time.
53
Earnings and stock prices:
Earnings quality


Unsustainable earnings might arise
from:
 Debt retirement
 Corporate restructurings
 Temporary reductions in advertising or
R&D spending
 Inherent subjectivity of accounting
estimates.
Research evidence shows that earnings
quality matters to investors.
54
Learning Objective :
Earning surprises
55
Earning surprises:
Share price response to earnings information

Here’s an expression that describes how stock prices change
in response to earnings information:
GM’s earnings announcement
could inform investors about current or future earnings

If GM’s quarterly earnings announcement just confirms investors’
expectations, there is no surprise and no change in expected
future earnings, so GM’s share price is also unchanged.
56
Earnings surprises:
Typical behavior of stock returns
Stock returns and quarterly earnings “surprises”
57
Cash flow analysis and credit risk:
Traditional lending products
Short-term
Loans
• Seasonal lines of credit
• Special purpose loans (temporary needs)
• Secured or unsecured
Long-term
Loans
• Mature in more than 1 year
• Purchase fixed assets, another company,
refinance debt ,etc.
• Often secured
Revolving
Loans
• Like a seasonal credit line
• Interest rate usually “floats”
Public Debt
• Bonds, debentures, notes
• Sinking fund and call provisions
• Covenants
6-58
Credit analysis:
Evaluating the borrower’s ability to repay
Step 1:
Understand
the business
Step 2:
Evaluate
accounting quality
Step 3:
Evaluate current
profitability and health
Step 4:
Prepare “pro forma”
cash flow forecasts
Step 5:
Due diligence
Step 6:
Comprehensive risk
assessment
• Business model and strategy
• Key risks and successful factors
• Industry competition
• Spot potential distortions
• Adjust reported numbers as needed
• Examine ratios and trends
• Look for changes in profitability, financial
conditions, or industry position.
• Develop financial statement forecasts
• Assess financial flexibility
• Kick the tires
• Likely impact on ability to pay
• Assess loss if borrower defaults
• Set loan terms
6-59
The Credit Rating Process
6-60
Standard & Poor’s Ratings
6-61
Based On:
6-62
Summary

This chapter provides a framework
for understanding equity valuation.

The framework illustrates how
accounting numbers are used in
valuation, and cash flow analysis.
63
Summary
You have also seen how financial
reports help investors and lenders
assess the “amounts, timing, and
uncertainty of prospective net cash
flows”.
 Knowing what numbers are used,
why they are used, and how they
are used is crucial to understanding
the decision-usefulness of
accounting information.

64