Chapter 7 Prospective Analysis: Valuation Theory and

Concepts
Question 1.
Jonas Borg, an analyst at EMH Securities, states: "I don't know why anyone would ever try to value
earnings. Obviously, the market knows that earnings can be manipulated and only values
cash flows." Discuss.

Valuing earnings is an alternative way of valuing a company even if earnings can be

manipulated. Note that, with an infinite forecast horizon, the valuation based on
discounted abnormal earnings delivers exactly the same estimate as DCF-based methods,
even if there is earnings manipulation. The estimated values using accounting-based
valuation are not affected by accounting choices because of the self-correcting nature of
double-entry bookkeeping. Current period earnings can be manipulated, but the values
estimated with accounting-based valuation are not to be manipulated. However, with finite
horizons, earnings manipulation can affect value unless the analyst recognizes and undoes
the manipulation. Also, when accounting data is used to forecast cash flows, even a DCF
valuation is potentially vulnerable to accounting manipulation.
There are two practical advantages to valuing earnings. First, accounting-based
valuation (using earnings) frames the valuation task differently and can immediately focus
the analyst's attention on the key measure of performance: ROE and its components (i.e.,
value drivers such as profit margins, sales turnover, and leverage).
Second, if it is more natural to think about future performance in terms of accounting
returns, and if the analyst faces a context where a "back-of-envelope" estimate of value
would be of use, the accounting-based technique can be simplified to deliver such an
estimate. "Short-cut" estimates are useful in a variety of contexts where the cost and time
involved in a detailed DCF analysis is not justified. In this context, the detailed DCF method
is analogous to a manual camera for which the distance, light exposure, and shutter speed
need to be set before taking a picture whereas the "short-cut" accounting-based valuation is
analogous to an automatic camera.

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Question 3
Manufactured Earnings is a “darling” of European analysts. Its current market price is €15 per
share, and its book value is €5 per share. Analysts forecast that the firm’s book value will grow by 10
percent per year indefinitely, and the cost of equity is 15 percent. Given these facts, what is the
market’s expectation of the firm’s long-term average ROE?

P ROE  r 
1
B r  g 

where ROE is the long-term average ROE,

g is the long-term average growth in book
value, r is the cost of equity,
P is the stock price, and
B is the book value per share.

Using the information in the

question,

15 ROE  0.15
 1
5 0.15  0.10
or ROE = 0.25 (or 25%).

Question 4.
Given the information in Question 3, what will be Manufactured Earnings' stock price if the market
revises its expectations of long-term average ROE to 20 percent?

Once again, using the same formula as in the answer to Question 3, we have

P 0.2  0.15
 1
5 0.15  0.10
or P = €10

Based on above equation, the Manufactured Earnings' stock price will be revised to €10.

Question 8.
Which of the following items affect free cash flows to debt and equity holders? Which affect free cash
flows to equity alone? Explain why and how.

All answers assume a tax rate > 0.

An increase in trade receivables will cause both FCFE and FCFD+E to decrease, since it increases
the firm's cash required for working capital.

A decrease in gross margins will cause both FCFE and FCFD+E, to decrease by lowering both
EBIT (1 - tax rate) and NI.

An increase in property, plant, equipment will decrease both FCFE and FCFD+E due to an
increase in capital expenditures.

An increase in inventories will decrease both FCFE and FCFD+E through an increase in cash
required for working capital.

Interest expense will decrease FCFE only. For calculating free cash flows to debt, additional
interest expense does not change EBIT (1 - tax rate).

An increase in prepaid expenses will cause both FCFE and FCFD+E to decrease through an
increase in working capital.

An increase in notes payable to the bank will increase FCFE only. The increase in notes payable
will increase debt, increasing the FCFE by the same amount.

Problem 1. Estimating Hugo Boss’ equity value (updated 1-2011)

1. Calculate free cash flows to equity, abnormal earnings, and abnormal earnings growth for the
years 2009 – 2011.
2. Assume that in 2012 Hugo Boss AG liquidates all its assets at their book values, uses the
proceeds to pay off debt and pays out the remainder to its equity holders. What does this
assumption imply about the company’s:
a. Free cash flow to equity holders in 2012 and beyond?
b. Abnormal earnings in 2012 and beyond?
c. Abnormal earnings growth in 2012 and beyond?
3. Estimate the value of Hugo Boss’ equity on April 1, 2009 using the above forecasts and
assumptions. Check that the discounted cash flow model, the abnormal earnings model and
the abnormal earnings growth model yield the same outcome.
4. The analyst estimates a target price of €20 per share. What is the expected value of Hugo
Boss’ equity at the end of 2011 that is implicit in the analysts’ forecasts and target price?
5. Under the assumption that the historical trends in the company’s ROE (i.e.,
approximately 18 percent), payout ratio (70 percent) and book value growth (5.5 percent)
continue in the future, what would be your estimate of Hugo Boss’ equity value-to-book ratio
before the company paid out its special dividend? How does the special dividend payment
change your estimate of the equity value-to-book ratio?

1. The calculations are:

2008R 2009E 2010E 2011E

Net assets 890.3 868.5 878.5 891.0
Net debt 691.3 668.3 656.9 632.0
Equity 199.0 200.2 221.6 259
Implied dividends 97.1 78.5 80.3
Net profit 98.3 99.9 117.7
- Change in net assets +21.8 -10.0 -12.5
+ Change in net debt -23.0 -111.4 -24.9
Free cash flow to equity 97.1 78.5 80.3

Net profit 98.3 99.9 117.7

Beginning BE x 12% 23.88 24.024 26.592
Abnormal profit 74.42 75.876 91.108
 Change in net profit 1.6 17.8
(Profit t-1 - Dividends t-1) x 12% 0.144 2.568
Abnormal earnings growth 1.456 15.232

2. If Hugo Boss liquidates all its assets at their book values in 2012, the company’s 2012 net
profit is zero and
a. 2012 free cash flow to equity, defined as net profit minus the change in net
assets plus the change in net debt, is equal to: 0 – (-891.0) + (-632.0) = 259 (i.e.,
expected equity at the end of 2011).
b. 2012 abnormal earnings, defined as net profit minus 12 percent of 2011
ending equity, is equal to: 0 – 0.12 x 259 = -31.08.
c. 2012 abnormal earnings growth, defined as the change in abnormal
earnings, is equal to: -31.08 - 91.108 = 122.188.
In 2013 (and beyond), free cash flows to equity and abnormal earnings are zero.
Abnormal earnings growth is equal to 31.08 in 2013 (0 – [-31.08]) and zero in the years
after 2013.
To summarize:

2009E 2010E 2011E 2012E 2013E

Free cash flow to equity 97.1 78.5 80.3 259 0
Abnormal profit 74.42 75.876 91.108 -31.08 0
Abnormal earnings growth 1.456 15.232 -122.188 31.08

3. On January 1, 2009, the value of Hugo Boss’ equity equals:

Equity
value FCFE 2009 FCFE 2010 FCFE 2011 FCFE 2012
   
1  re  1  re 2 1  re 3 1  re 3
end 2008

 97.1 78.5 80.3 259.0

  1.12 1.12 4  371.03
1.12 1.12 2
3
Or
Equity value AE2009 AE2010 AE2011 AE2012
 BVE   2 3
end 2008 end 2008 1  r  1  r  1  r  1  r 4
e e e e

 199 
74.42 75.876 91.108 31.08  371.03
  
1.12 1.12 1.124
 

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Or
Equity valueend 2008 1.12 2

Profit   
 r 2009 r 1 AEG   AEG
1  r 2010 2  AEG
1  r 2011 3  AEG
1  r2012 4
1  r 2013
e e  e e e 
e

98.3 31.08 
 1.456 15.232 122.188
1   371.03
   
   

0.12 0.12 1.12 1.122

 
1.123 1.124

An equity value of €371.03 million on January 1, 2009, corresponds with a value of

€381.55 million (371.03 x 1.1290/365), €5.42 per share (381.55/70.4), on April 1, 2009.
4. A target price of €20 per share implies a market value (on April 1, 2009) of €1,408
million. A market value of €1,408 million on April 1, 2009, corresponds with a market
value of €1,369.20 million on January 1, 2009. The discounted value of Hugo Boss’
expected free cash flows in 2009-2011 equals:

Value FCFE 2009 FCFE 2010 FCFE 2011

  
 1  re   1  re 
2
1  re 3
 97.1 78.5 80.3
    206.43
1.12 1.12 1.123
2

Hence, with a current equity value of €1,369.20 million, the present value of the
expected equity value at the end of 2011 must be equal to: 1,369.20 – 206.43 = 1,162.77.
The future value of the expected equity value at the end of 2011 is therefore €1,633.60
million (1,162.77 x 1.123), or €23.20 per share. Note that this future expected market
value of equity is substantially higher than the expected future book value of equity of
(€1,633.60 million versus €259 million).
5. As described in Chapter 7, for a firm in steady state, the value-to-book multiple formula
simplifies to:
Equity value - to - book ROE0  re
multiple  1
re  g equity

For Hugo Boss, this would imply that the equity value-to-book multiple is:

0.18  0.12
Equity value - to - book multiple  1  1.923
 0.12  0.055

The special dividend of €345.1 million decreases both the market value and the book
value of equity by the same amount. Consequently, the expected value-to-book
multiple would increase from 1.923 to 3.524:

Adjusted equity value - to - book multiple

1.923  199  345.1   3.524
345.1
 199

This multiple would imply an equity value of €701.25 million, or €9.96 per share, on
January 1, 2009. This would be equivalent to €10.24 per share on April 1, 2009, when
Hugo Boss’ shares traded at €11.