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You are on page 1of 12

Teaching Assistants

Ruchit Agarwal ra343@cornell.edu

Manish Bhargava mb724@cornell.edu

Odelia D’Mello od36@cornell.edu

David Wu dw326@cornell.edu

For 01/27/08:

Familiarize yourself with the 10-K for Cracker Barrel (CBRL). We will be applying all

the tools we learn in class to CBRL. You can download the 10-K from the SEC Edgar

website (http://www.sec.gov/edgar.shtml).

accounting policies.

Lecture 2 Page 1 of 12

Valuation

Economic theory teaches that the value of any resources equals the

present value of the payoffs expected from the resource, discounted at a

rate compensating for the inherent risk & delayed consumption of the

payoffs.

The first financial model for common equity (and the basis for all models

used today) is the dividend-discounting model:

∞ Dividends t + j

Equity Valuet = Et ∑ j

j =1 (1 + re )

Lecture 2 Page 2 of 12

Residual Income Valuation

of equity).

Then, using the dividend-discounting model, we get the following (see last

page of notes for a derivation):

Residual Income is simply

earnings less a charge for

the use of capital

Et ( NI t + 1 - re BVEt ) Et ( NI t + 2 - re BVEt +1 )

Equity Valuet = BVEt + + + ...

(1 + re ) (1 + re ) 2

It simply states that the value of an investment is equal to the amount

invested, plus the present value of all future abnormal earnings or residual

income.

Lecture 2 Page 3 of 12

The Residual Income Model reformulated in terms of ROEs:

Equity Valuet = BVEt + + + ...

(1 + re ) (1 + re ) 2

Thus, equity value is simply the book value of equity plus the present value

of future abnormal returns on equity, weighted by the BVE outstanding at

the time.

Lecture 2 Page 4 of 12

Nichols and Wahlen (2004): How do accounting numbers relate to

stock returns?

Figure 1

The Three Links Relating Earnings to Stock Returns

Link 1

Expected Future

Current Period Earnings Link 1 assumes that current Earnings

period earnings numbers

provide information that equity

shareholders can use to form

expectations for future earnings.

Link 2 assumes

that current and

Test: expected future

How do earnings profitability

numbers relate to determines the

share prices? firm’s expected

Link 2

future dividend-

paying capacity.

Link 3

Expected Future

Current Share Price

Link 3 assumes that share Dividends

prices reflect the present value

of all expected future dividends.

If information changes from period t to period t+1, price should change

between those dates.

examining the association between earnings and returns.

and not just differences in risk, we subtract returns on a portfolio of firms

with comparable size.

Lecture 2 Page 5 of 12

Testing the three links: The relation between earnings changes and

stock returns

Compare earnings this year (t) to earnings last year (t-1). If the change is

positive, put the firm in one portfolio; if the change is negative, put the firm

in another portfolio. Do the same thing for operating cash flows.

below.

Testing

the three

links,

Lecture 2 Page 6 of 12

Instead of forming portfolios on just the sign of the change, group firms into

10 portfolios based on the magnitude of earnings (scaled by assets to allow

cross-sectional comparability).

Testing

link 1:

Earnings

If new earnings will persist, then the new earnings should have a greater

effect on price.

Lecture 2 Page 7 of 12

Another test of the three links: Does accounting provide new

information to market participants?

Rank all firms based on the magnitude of their quarterly earnings surprise

using analyst forecasts 5 days before the announcement as an

expectation.

Lecture 2 Page 8 of 12

Is the

market

Rank all firms based on the magnitude of their quarterly earnings surprise

using analyst forecasts 60 days before the announcement as an

expectation.

Take a long position in the 10% of firms with the greatest unexpected

earnings, and an offsetting short position in the 10% of firms with the lowest

unexpected earnings. Hold these stocks for either 60 (trading) days.

Lecture 2 Page 9 of 12

Nichols and Wahlen (2004): Summary and Takeaways

Accounting earnings capture many of the same events affecting firm value

that are reflected in price.

The accrual accounting process starts with cash flows and adds

information about transactions and events during the year to arrive at a

more useful measure of firm performance (earnings).

earnings management.

capital markets.

Evidence strongly suggests that stock prices are not fully efficient with

respect to accounting information.

Lecture 2 Page 10 of 12

Additional Notes: Deriving the Residual Income Model from the DDM

Thus, we can express the value of the equity as follows (expectation operators are

omitted for simplicity):

Value0 = + + ...

(1 + re ) (1 + re ) 2

NI 1 - BVE1 + BVE0 NI 2 - BVE2 + BVE1

= + + ...

(1 + re ) (1 + re ) 2

Add and subtract reBVE0 (sum=0). We can then

rearrange to express value as a function of

beginning BVE and future residual income.

= + + ...

(1 + re ) (1 + re ) 2

= + + ...

(1 + re ) (1 + re ) 2

= BVE0 + − + + − + + ...

(1 + re ) (1 + re ) (1 + re ) (1 + re ) 2 (1 + re ) 2 (1 + re ) 2

NI 1 − re BVE0 NI 2 − re BVE1

= BVE0 + + + ...

(1 + re ) (1 + re ) 2

Lecture 2 Page 11 of 12

This works as long as . But thanks to our steady state assumption,

BVET −1

lim =0

T → ∞ (1 + r )T

e

Lecture 2 Page 12 of 12

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