Commerce 4FK3
Financial Statement Analysis
Week 10, 2012
Valuation Models
Cash Flow Valuation Models
• Value of an investment is the present value
of cash to be received in the future
• Dividend discount models do this using
future expected cash flows, often including
a liquidating dividend or sale of shares
• Requires estimating the residual value of
the firm at some point in the future
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Free Cash Flow
• Instead of using dividends, we can use the
cash that the company is “free” to use to
pay dividends (or interest)
• Uses cash generated by the firm that is not
required for the firm’s operations (liquidity,
includes; cash, A/R, inventory etc.) or
required for investment in PPE
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Why Cash?
• Cash is the ultimate source of value
• Cash used to evaluate the worth of an
investment; can measure the relative value
of investing in a stock, bond, or apartment
block by reducing the evaluation of the
options on a cash basis
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Earnings vs. Cash
• Dividends paid in cash not earnings
• Earning are not value (acquisition cost)
• Earnings much easier to manipulate while
still following GAAP
• Cash is comparable between different firms,
earnings may not be
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Considerations
• Cash to investors or the firm
Free cash flow to equity holders
appropriate to portfolio investments
 Free cash flow to the firm
appropriate for acquisitions where the current
capital structure becomes irrelevant

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Valuation Process
•
•
•
•
Decide on forecast horizon
Prepare pro forma statements
Calculate appropriate free cash flows
Determine the continuing value based on
assumed growth rates beyond the horizon
• Take the present value of the forecast cash
flows and continuing value
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Horizon
• Often set at 5-10 years
• Trade-offs between forecast accuracy and
reliability must be made
a longer forecast period before applying the
continuing value period allows for more
flexibility
 more difficult to prepare longer forecast periods
and heightened chance of forecast uncertainty

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Continuing Value
• Also known as Terminal Value
• The expected value of the company as of
the end of the forecast horizon
• Value of company is often very sensitive to
the assumed continuing growth rate (g)
Projected Free Cash Flow T 1
Continuing Value T 
Rg
R is either ke or WACC depending on model
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Non-Operating Items
• Some assets or liabilities may show up on
the balance sheet, but not affect current cash
flows
e.g. land purchased to allow future expansion
 If not included in forecast cash flows (5-year

forecast horizon, development expected in year 7),
then add the current value to the present value
of the forecast cash flows
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Cost of Equity
• Typically based on the CAPM
ke = Rf + (Rm - Rf)b
• Changes in capital structure can lead to
changes in beta
• The cost of equity should be used for
discounting free cash flows to equity
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WACC
• The weighted average cost of capital is used
for free cash to the firm
• Each cost of capital must be estimated, the
current cost is used, not the historical cost
• Capital structure dictates the weights
• To find the value of the equity, subtract the
market value of debt and preferred
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Earnings Based Valuation
• Earnings are the most followed measure of
the firm’s performance
I/B/E/S compiles analyst’s forecasts
 WSJ daily reports on earnings announcements
 Only line item that GAAP requires to be
reported on a per share basis
 Managerial compensation often tied to earnings

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Rationale for Using Earnings
• Captures the creation of wealth rather than
its distribution (dividend models)
• Accrual accounting can measure resources
generated or consumed in a given period
even if no cash changes hands
• Pro forma statements generate the income
statement first, so using earnings skips a
few steps in the valuation process
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Residual Earnings Valuation
• Developed by James A. Ohlson
• Starts with book value of equity
• Adds present value of net income in excess
of required return on equity x book value
• If net income growth drops to required
return after horizon, no further calc. req’d,
otherwise treat it as a growing perpetuity
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Residual Earnings Issues
• Dirty surplus accounting; how to treat the
“equity” item of accumulated other
comprehensive income or loss
• Common stock transactions, especially
those at below market value
• Portion of net income to other equity
claimants, minority interest in consolidated
subsidiaries is the biggest issue
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Dividend Discount Model
•
•
•
•
Simple model from introduction to finance
First published by Myron Gordon
Present value of future dividends
Useful if dividends follow a pattern, but
easily expanded if dividends are expected to
follow a pattern after the forecast horizon

D0 1  g 
D1
DT 1
P0 
or
or 
T
ke  g
ke  g
T 1 1  k e 
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Note on Valuations
• The free cash flow models, residual
earnings model and dividend model should
all come to the same value if all of the
assumptions are internally consistent
• The two cash flow models can differ due to
the difficulty of getting the exact values for
weights since many companies have many
issues of bonds outstanding
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Market Multiples
• A frequently used shortcut technique
• Take one accounting summary number,
multiply by a market multiple to calculate
the value of the company
Price/earnings ratio (PE)
 Market to book ratio

• Multiple chosen based on history of the
company, or competitors
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P/E Ratio
• Often calculated as; most recently reported
earnings divided by current price
• Forecast prices should use forecast earnings
• Theoretical model
P0
1
E1

ke  g
• Note: P/E will change if the capital structure
of the firm changes
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P/E Issues
• Use of comparison companies may not be
useful if the capital structure is not the same
• Transitory earnings: current earnings may
not be the same as permanent earnings
• Anti dividend bias: dividends paid will
reduce the price of the company’s shares
but don’t effect earnings
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Market-to-Book
• Captures “hidden” assets of the company
• Market value of common equity divided by
the book value of common equity
• Theoretical model from Ohlson
BVt 1
ROCE t  ke 

V0
BV0
 1 
BV0
1  ke t
t 1
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