Chapter 7

PROSPECTIVE ANALYSIS: VALUATION

THEORY AND CONCEPTS
 LEARNING OBJECTIVES
LO1: Understand how to define value for shareholders

LO2: Understand that earnings-based valuation methods should reconcile with dividends-based
valuation methods

LO3: Remember the benefits and potential pitfalls of using multiples as valuation metrics

LO4: Apply ‘short cut’ forms of valuation and understand their benefits and limitations

LO5: Apply the discounted cash flow model to company valuation and understand its equivalence
to the discounted dividends model

LO6: Evaluate the differences between the dividends-, cash flows- and earnings-based valuation
models
 DISCOUNTED DIVIDENDS VALUATION

The present value of future cash flows to shareholders is the

basis of the discounted dividends method.

This method is the basis for most theoretical approaches to

stock valuation, including the other methods discussed in
this chapter.

Dividends1 Dividends2 Dividends3

Equity value = + + +…
(1+re ) (1+re )2 (1+re )3

Where re is the cost of equity capital

 DISCOUNTED DIVIDENDS EXAMPLE
• Down Under Company
– Initial equity investment is $60m; invested in a fixed asset
– Dividends in years 1, 2 and 3 are $40m, $50m and $60m
 DISCOUNTED ABNORMAL EARNINGS

Abnormal earnings are those that differ from the expected return: NIt – re ×
BVE0

The discounted dividends method can be modified to yield the following

relation:

Equity value = BVE0 + PV expected future abnormal earnings

NI − r ×BVE0 NI2 − re ×BVE1 NI3 − re ×BVE2
Equity value = BVE0 + 1 e + + +…
(1+re ) (1+re )2 (1+re )3
 DISCOUNTED ABNORMAL EARNINGS EXAMPLE
• Down Under Company depreciates its fixed assets using the straight-line method
• Net income before depreciation is $40m, $50m and $60m in years 1, 2 and 3
• (d) (d)x(c)
 ACCOUNTING METHODS AND
DISCOUNTED ABNORMAL EARNINGS
Analysts must recognize the impact of different accounting methods on
value estimates:

Valuations are based on Accounting choices affect Double-entry bookkeeping

earnings and book values earnings and book values is by nature self-correcting

Strategic and accounting analyses are important steps to precede

abnormal earnings valuation
 VALUATION USING PRICE MULTIPLES

Price multiple valuation methods are popular because of their perceived

simplicity

Three steps are involved:

3. Apply comparable firm

1. Select base measure 2. Calculate price multiples multiple to firm being
for comparable firms analyzed
 PRECAUTIONS IN USING
PRICE MULTIPLES VALUATION

Selecting Firms with poor Adjustments for

comparable firms performance leverage

It may be difficult to
identify comparable
firms, even within an Take care to
industry maintain
Marginal profitability
or earnings shocks consistency
must be considered between numerator
Industry averages and denominator
may be used
instead
 USING
MULTIPLES
TO VALUE
KATHMANDU
Not every firm in the specialty retail industry competes in
the same market as Kathmandu
Not all competitors follow similar strategy or financing
policy as Kathmandu
Some competitors operate on a different scale, in terms
of both revenue and geographic reach

Not all competitors exhibit similar growth rates as Kathmandu

 DETERMINANTS OF VALUE TO BOOK/EARNINGS
MULTIPLES
Value-to-book ratio is driven largely by:

Magnitude of future abnormal ROEs Growth in book value

Equity value-earnings can be derived from the value-to-book formula:

ROE1 − re (ROE2 − re )(1 + gbve1)
Equity value-to-book ratio = 1+ +
(1+re ) (1+re )2
(ROE3 − re )(1 + gbve1)(1 + gbve2)
+ +…
(1+re )3
ROE, PRICE-TO-BOOK RATIO
AND PRICE-EARNINGS RATIO
 SHORTCUT FORMS OF EARNINGS-BASED VALUATION

Assumptions may be made to simplify abnormal earnings

and equity value-to-book methods:

1. Abnormal earnings: random walk and autoregressive models

2. ROE and Growth: ROE mean reversion, other assumptions

(e.g., decay)
 DISCOUNTED CASH FLOW MODEL

Derived from the discounted dividends model:

Equity value = PV of free cash flows to equity claim holders
NI1 – "BVA1×"BVND1 NI2 – "BVA2×"BVND2
= + +
(1+re ) (1+re )2
…

• Requires:
• 1. Forecasts of free cash flows (usually 5–10 years)
• 2. Forecasts of free cash flows beyond terminal year
• 3. Discounting free cash flows using the cost of equity
 DISCOUNTED CASH FLOW EXAMPLE
• Down Under Company depreciates its fixed assets using the straight-line method
• Net income before depreciation is $40m, $50m and $60m in years 1, 2 and 3
 COMPARING VALUATION METHODS

No one method is superior

Using the same assumptions about firm fundamentals should

yield the same value estimates from any of the methods used

Methods can differ in the following respects:

• Focus – earnings or cash flow
• Amount of analysis or structure required
• Terminal value implications
 CONCLUDING COMMENTS

The value of a share is the present value of future dividends.

Three methods are derived from this rule:

• Discounted dividends
• Abnormal earnings
• Discounted cash flows

Each of these methods focuses the analyst’s attention on different

underlying variables and requires a different level of structure.
 CASE LINK

• Case 1 Qantas
Part D Forecasting

• Case 6 Valuation ratios in the retail industry 2016 to 2018

SUMMARY

Valuation is the process by which forecasts of performance are converted into estimates of price. A
variety of valuation techniques are employed in practice and there is no single method that clearly
dominates others. In fact, since each technique involves different advantages and disadvantages, it can be
advantageous to consider several approaches simultaneously. For shareholders, a share’s value is the
present value of future dividends.

This chapter described three valuation techniques directly based on this dividend discount definition of
value: discounted dividends, discounted abnormal earnings/ROEs and discounted free cash flows. The
discounted dividend method attempts to forecast dividends directly. The abnormal earnings approach
expresses the value of a firm’s equity as book value plus discounted expectations of future abnormal
earnings. Finally, the discounted cash flow method represents a firm’s equity value by expected future
free cash flows discounted at the cost of capital.
 Although these three methods were derived from the same dividend discount model, they frame the
valuation task differently. In practice, they focus the analyst’ attention on different issues and require
different levels of structure in developing forecasts of the underlying primitive, future dividends. Price
multiple valuation methods were also discussed. Under these approaches, analysts estimate ratios of
current price to historical or forecasted measures of performance for comparable firms. The benchmarks
are then used to value the performance of the firm being analyzed. Multiples have traditionally been
popular, primarily because they do not require analysts to make multi-year forecasts of performance.
However, it can be difficult to identify comparable firms to use as benchmarks. Even across highly related
firms, there are differences in performance that are likely to affect their multiples.

The chapter discussed the relation between two popular multiples, value-to-book and value-earnings
ratios and the discounted abnormal earnings valuation. The resulting formulations indicate that value-to-
book multiples are a function of future abnormal ROEs, book value growth and the firm’s cost of equity.
The value-earnings multiple is a function of the same factors and also the current ROE

Matthew 7:7-8 Ask, and it shall be given you; seek, and you shall find; knock, and it shall be opened to
you: For every one that asks receives; and he that seeks finds; and to him that knocks it shall be opened.