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**Accrual Accounting and Valuation: Pricing Book Values
**

Concept Questions

C5.1. True. A firm with positive expected residual earnings (produced by an ROCE

above the cost of capital) must be valued at a premium.

C5.2. To trade at book value, we expect the ROCE to be equal to the cost of capital,

10%. (The current ROCE is not relevant here: P/B is based on expected future ROCE.)

Accrual Accounting and Valuation: Pricing Book Values 97

C5.3. A P/B of 1.0 implies a future ROCE equal to the cost of capital. An ROCE of 52.2

% is high relative to the cost of capital, so the P/B implies the ROCE is unusually high

and will drop in the future.

C5.4. No. If the firm is expected to earn an ROCE in excess of the required return, it

should sell at a premium over book value. Given the forecast, the firm is a

BUY if it trades below book value.

C5.5. False. If the firm maintains a low ROCE it will be valued at a discount on

book value. But it can survive: it has a positive going-concern value.

C5.6. Firms create residual earnings through ROCE and growth in net assets. The

ROCE for Dell are level (and declining in 2005), but the book values are

increasing. With constant ROCE and growing book values, residual earnings

increase.

C5.7. (a) Share issues produce more earnings because there are more assets earning

in the business. And dividends reduce earnings.

(b) ROCE is a ratio and, as share issues (usually) affect the numerator and

denominator of a ratio in different proportions, the ratio changes. But RE is not affected

by share issues or dividends (in the case of a firm with no leverage).

p. 98 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

C5.8. Yes. Value is generated by growing book values if the book rate of return is

higher than the required return.

C5.9. If the analyst does not forecast all sources of earnings (that is, comprehensive

earnings) then she will ignore some part of the payoff to shareholders, and will lose some

value in her calculation of a value from the forecast.

C5.10. The price-to-book valuation has nothing to do with free cash flow. Look at the

General Electric example in the chapter. GE has negative free cash flows (in Chapter 4),

but a large P/B ratio (in this chapter). Growth in investment determines the P/B ratio

(along with return on investment), but investment reduces free cash flow.

Exercises

Drill Exercises

E5.1. Calculating Return on Common Equity and Residual Earnings

Set up the pro forma as follows:

Accrual Accounting and Valuation: Pricing Book Values 99

2006 2007 2008 2009

Eps 3.00 3.60 4.10

Dps 0.25 0.25 0.30

Bps 20.00 22.75 26.10 29.90

ROCE 15.00% 15.83% 15.71%

RE (10% charge) 1.00 1.325 1.49

a. The answer to the question is in the last two lines of the pro forma

b. As forecasted residual earnings are positive, the shares of this firm are worth a

premium over book value.

E5.2. ROCE and Valuation

As expected ROCE is equal to the required return, expected residual earnings are zero. So

the shares are worth their book value per share. Book value per share = $3,200/500 =

$6.40.

E5.3. A Residual Earnings Valuation

This question asks you to convert a pro forma to a valuation using residual earnings

methods. First complete the pro forma by forecasting book values from earnings and

dividends. Then calculate residual earnings from the completed pro forma and value the

firm.

2007E 2008E 2009E 2010E 2011E

Earnings 388.0 570.0 599.0 629.0 660.4

Dividends 115.0 160.0 349.0 367.0 385.4

Book value 4,583.0 4,993.0 5,243.0 5,505.0 5,780.0

ROCE 9.0% 12.4% 12.0% 12.0% 12.0%

Residual earnings -43.0 111.7 99.7 104.7 109.9

(10%)

Growth in RE -10.7% 5.0% 5.0%

Growth in Book value 8.9% 5.0% 5.0% 5.0%

Discount factor 1.110 1.210 1.331 1.464 1.611

PV of RE -39.1 92.3 74.9

p. 100 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

a. Forecasted book values, ROCE, and residual earnings are given in the completed

pro forma above. Book value each year is the prior book value plus earnings and

minus dividends for the year. So, for 2008 for example,

Book value = 4583 +570 –160 = 4,993.

The starting book value (in 2006) is 4,310. Residual earnings for each year is

earnings charged with the required return in book value. So, for 2008,

RE is 570 – (0.10 × 4,583) = 111.7.

b. Forecasted growth rates in book value and residual earnings are given above.

c. The growth rate in residual earnings is 5% after 2009. Assuming this growth rate

will continue into the future, the valuation is a Case 3 valuation with the

continuing value calculated at the end of 2009:

Book value, 2006 4,310.0

Total present value of RE to 2009 (from last line above) 128.1

Continuing value (CV), 2009:

0 . 2094

05 . 1 10 . 1

7 . 104

·

−

Present value of CV: 2094/1.331 1,573.3

Value of the equity, 2006 6,011.4

Per share value (on 1,380 million shares) 4.36

d. The premium is 6,011.4 – 4,310 = 1,701.4, or 1.23 on a per-share basis.

The P/B ratio is 6,011.4/4,310 = 1.39.

Accrual Accounting and Valuation: Pricing Book Values 101

E5.4. Residual Earnings Valuation and Target Prices (Easy)

This problem applies the residual earnings model and its dividend discount equivalent.

Develop the pro forma as follows:

2006 2007 2008 2009 2010 2011

Eps 3.90 3.70 3.31 3.59 3.90

Dps 1.00 1.00 1.00 1.00 1.00

Bps 22.00 24.90 27.60 29.91 32.50 35.40

(a) RE (0.12) 1.26 .71 0 0 0

Discount rate 1.12 1.2544

PV 1.125 .57

Total PV 1.70

(b) Value 23.70

(c) As residual earnings are expected to be zero after 2011, the equity is expected

to be worth its book value of $35.40.

(d) The expected premium at 2011 is zero because subsequent residual income is

expected to be zero.

As aside:

Note that the dividend discount formula can be applied because we now have a basis for

calculating its terminal value. The terminal value is the expected terminal price, and this

can be calculated at the end of 2008 because, at this point, expected price equals book

value.

∑

·

−

ρ + ρ ·

T

1 t

T

T t

t E

0

/ TV d V

p. 102 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

The TV

2008

is given by the expected 2008 book value:

TV

2008

= 27.60

So the calculation goes as follows:

2006 2007 2008

Dps 1.00 1.00

PV .89 .80

Total PV of divs. 1.69

TV 27.60

PV of TV 22.00

Value 23.69

E5.5. Residual Earnings Valuation and Return on Common Equity

(a) Set the current year as Year 0.

Earnings, Year 1 = 15.60 × 0.15 = 2.34

Residual earnings, Year 1 = 2.34 – (0.10 × 15.60)

= 0.78

This RE is a perpetuity, so

10 . 0

RE

B V

0

0 0

+ ·

40 . 23

10 . 0

78 . 0

60 . 15 · + ·

1.5 15.60 23.40 B P · ·

(b) No effect: future payout does not affect current price (unless you have a tax

story) and future dividends don’t affect current book value.

P/B is still 1.5

E5.6. Using Accounting-Based Techniques to Measure Value Added for a Project

(a)

Accrual Accounting and Valuation: Pricing Book Values 103

Time line:

0 1 2 3 4 5

Depreciation

30 30 30 30 30

Book value

150 120 90 60 30 0

Earnings (15%)

22.5 18 13.5 9 4.5

RE (0.12)

4.5 3.6 2.7 1.8 0.9

PVof RE

4.02 2.87 1.92 1.14 0.51

Total PV of RE

10.47

Value of Project

160.47

The investment added $10.47 million over the cost.

(b)

Time line

0 1 2 3 4 5

Earnings

22.5 18.0 13.5 9.0 4.5

Depreciation

30.0 30.0 30.0 30.0 30.0

Cash from operations

52.5 48.0 43.5 39.0 34.5

PVof cash flow (1.12

t

)

46.88 38.27 30.96 24.79 19.58

Total PV of cash flow

160.47

Cost

150.00

NPV

10.47

t

The NPV is the value added.

p. 104 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

E5.7. Using Accounting-Based Techniques to Measure Value Added for a Going

Concern

(a)

Time line:

0 1 2 3 4 5 6 7

Investment

150 150 150 150 150 150 150 150

Depreciation

1

30 60 90 120 150 150 150

Book value

2

270 360 420 450 450 450 450

Revenue

52.5 100.5 144.0 183.0 217.5 217.5 217.5

Depreciation

30.0 60.0 90.0 120.0 150.0 150.0 150.0

Earnings (15%)

22.5 40.5 54.0 63.0 67.5 67.5 67.5

RE (0.12)

4.5 8.1 10.8 12.6 13.5 13.5 13.5

PV of RE

4.0 6.5 7.7 8.0

Total of PV of RE

26.2

112.5

PV of CV

71.5

Value

247.7

Lost

150

Value added

97.7

Continuing value

3

1. Depreciation is $30 million per year for each project in place

2. Book value (t) = Book value (t-1) + Investment (t) – Depreciation (t)

3. CV =

12 . 0

5 . 13

= 112.5

The value of the firm is $247.7 million. The continuing value is based on a forecast of

residual earning of 13.5 in year 5 continuing perpetually with no growth. This is a Case 2

valuation.

(b) The value added is $97.7 million

Accrual Accounting and Valuation: Pricing Book Values 105

(c) The value added is greater than 15% of the initial investment because there is growth

in investment: value is driven by the rate of return of 15% (relative to a cost of capital of

12%) but also by growth.

E5.8. Creating Earnings and Valuing Created Earnings

a. Earnings = Revenues – Expenses

= $440 - $360 = $80

Earnings in the text example were $40. Clearly earnings have been created,

by expensing $40 of the investment in the prior period and thus reducing

Year 1 expenses by $40.

b. ROCE = $80/$360 = 22.22%

Residual earnings = $80 – (0.10 × 360) = 44

c. Value =

10 . 1

44 $

360 $ +

= $400

Even though earnings have been created, the calculated value is the same as that

in the text (before earnings were created).

E5.9. Reverse Engineering

With a P/B ratio of 2.0 and a price of $26, the book value per share is $13. Thus,

Residual earnings (2007) = $2.60 – (0.10 × 13.0) = $1.30

Reverse engineering solves for g in the following model:

$26 =

g −

+

10 . 1

30 . 1

13 $

The solution is g = 1.0. That is, the growth rate is zero: The market expects residual

earnings to continue at $1.30 per share after 2007.

Applications

p. 106 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

E5.10. Valuing Dividends or Return on Equity: General Motors Corp

a. P/B = 28/49 = 0.57; ROCE = 0.69/49 = 1.41%

b. Yes; the required return is not stated, but any reasonable return is far greater than

1.41 percent. As GM is expected to earn an ROCE far below its required return, it

should have a P/B well below 1.0.

c. The analyst makes a mistake in focusing on the dividend (yield). An unprofitable

firm will drop its dividend – as GM has done in the past in bad times – and GM

does not look profitable. The dividend they have been paying is not a good

indicator of value. A firm can pay a high dividend in the short run, but if

fundamentals give a different message, follow the fundamentals. The dividend

yield (dividend/price) is high because price is low, because of poor prospects.

E5.11. Residual Earnings Valuation: Black Hills Corp

The pro forma for the exercise is as follows:

Forecast Year

____________________________________

1999 2000 2001 2002 2003 2004

Eps 2.39 3.45 2.28 2.00 1.71

Dps 1.06 1.12 1.16 1.22 1.24

Bps 9.96 11.29 13.62 14.74 15.52 15.99

ROCE 24.0% 30.6% 16.7% 13.6% 11.0%

RE (11% charge) 1.294 2.208 0.782 0.379 0.003

Discount rate (1.11)

t

1.110 1.232 1.368 1.518 1.685

Present value of RE 1.166 1.792 0.572 0.250 0.002

Total present value of RE to 2004 3.78

Continuing value (CV) 0.0

Present value of CV 0.00

Value per share 13.74

a. ROCE and residual earnings are in the pro forma

b. If ROCE is to continue at 11% after 2004, then residual earnings are expected to be

zero. The continuing value is zero. The value is $13.74 per share – a Case 1

valuation.

c. As the CV = 0, the target price is equal to forecasted bps of $15.99 at 2004.

Accrual Accounting and Valuation: Pricing Book Values 107

E5.12. Reverse Engineering: Ford Motor Company

a. In January, the 2005 eps forecast was $1.825 (the midpoint of the range). So,

RE(2005) = $1.825 – (0.12 × 8.76) = $0.774

In April, the 2005 forecast was $1.38 (the midpoint of the range). So,

RE(2005) = $1.375 – (0.12 × 8.76) = 0.324

b. The reverse engineering problem is

g

V

E

−

+ · ·

12 . 1

774 . 0

76 . 8 $ 50 . 14 $

2004

Set g = 1.0 (a zero growth rate) and the value is $15.21. So the market was expecting a

decline in residual earnings after 2005.

c. The reverse engineering problem is now

g

V

E

−

+ · ·

12 . 1

324 . 0

76 . 8 $ 50 . 11 $

2004

The solution is (approximately) g = 1.0 (no growth). That is, the market is

expecting RE to stay at the same level after 2005.

How can a drop in price be associated with an increase in the RE growth rate?

Well the increase is due to a lower base: RE for 2005 is now 0.324 rather than 0.774.

E5.13. Reverse Engineering the S&P 500 Index

(a)

With a P/B ratio is 2.8, investors are paying $2.80 for every dollar of book value in the

S&P 500 companies. With an ROCE of 17%, the current residual earnings on a dollar of

book value is:

RE

0

= (0.17 – 0.09) × 1.0

p. 108 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

= 0.08

That is, 8 cents per dollar of book value. The value of an asset (with a constant growth

rate is mind) is calculated as:

g

g RE

B V

−

×

+ ·

ρ

0

0 0

(One always capitalizes the one-year-ahead amount.) So, for every dollar of book value

worth $2.80,

g

g

−

×

+ ·

09 . 1

08 . 0

0 . 1 8 . 2

Solving for g,

g = 1.0438 (a 4.38 growth rate)

What does this mean? If the S&P 500 firms can maintain an ROCE of 17%, then

investment in net assets must grow by 4.38%. Alternatively, if ROCE were to

improve, a growth in residual earnings of 4.38% can be maintained with a lower

growth rate. Is a 4.38% growth rate reasonable? What is the prospect for ROCE for

the market as a whole? Is the market appropriately priced?

(Analysis in Module II of the course will help answer these questions.)

(b)

See the last paragraph. With a constant ROCE, the growth in residual earnings is

determined by the growth in net assets (book value). Remember, residual earnings is

driven by two factors:

1. Profitability of net assets: ROCE

2. Growth in net assets

E5.14. The Merck Revaluation

Book value of shareholders’ equity = $15,576 million

Shares outstanding = 2,222 million

Book value per share = $7.01

Required rate of return = 10%

Forward P/E = 15.05

Forward Earnings

2004

= $2.99

Accrual Accounting and Valuation: Pricing Book Values 109

Forward Earnings

2005

= $3.12

Current price = $45.00

Dividend per share = $1.52

Payout ratio = $1.52/$2.99 = 50.8%

a. Prepare the pro forma and calculate residual earnings by charging prior book

value at 10%

2003 2004 2005

Eps 2.99 3.12

Dps 1.52 1.586

Bps 7.01 8.48 10.01

Residual earnings 2.289 2.272

b. Apply the residual earnings model:

( )

( )

0

2

2

2.272

2.289 2.272

1.10

7.01

1.10

1.10

1.10

E

g

g

V

×

−

· + + +

Setting g = 1.04 (a 4.00% growth rate), we get $43.52

E

o

V · . Thus, Merck was

reasonably priced at $45.

(Strictly speaking, the $43.52 valuation is that in January, 2004. The September value

would be this value reinvested for nine months at a 10% per annum rate.)

c.

Target price

2005

= Book value

2004

+ Continuing value (CV)

The calculation of continuing value:

CV

E

RE g

g ρ

×

·

−

2.272 1.04

39.38

1.10 1.04

×

· ·

−

Target price

2005

= 10.01 + 39.38 = 49.39

d. Prepare the pro forma and calculate residual earnings by charging prior book

value at 10%

2003 2004 2005

Eps 2.91 3.04

p. 110 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

Dps 1.52 1.588

Bps 7.01 8.40 9.85

Residual earnings 2.209 2.200

Applying the residual earnings model:

( )

( )

0

2

2

2.200

2.209 2.200

1.10

7.01

1.10

1.10

1.10

E

g

g

V

×

−

· + + +

If a firm can maintain net profit margins and sales-to-book ratios (and constant cost of

capital), the growth rate for residual income equals to the sales growth rate.

Setting g = 1.037 (a 0.30% reduction), we get

E

o

V · $40.76

Based on the calculation, the 25% drop in price was not warranted.

e.

The calculation of continuing value:

CV

E

RE g

g ρ

×

·

−

2.200 1.037

36.213

1.10 1.037

×

· ·

−

Target price

2005

= 9.85 + 36.213 = 46.063

Rate of return

2005 2004

2004

1

P Value of Dividends P

P

+ −

· −

46.063 (1.52 1.10) 1.588 34

1

34

+ × + −

· −

45.06% ·

The value of dividends received is the terminal value at the end of 2005, that is, the 2005

dividend plus the 2004 dividend reinvested for one year. (The calculation here assumes

that dividends for 2004 are not paid yet. The rate of return will be lower if Merck already

distributed some dividends to shareholders)

f. Merck’s P/B= Price/BV=34/7.01=4.85

ROCE

2004

=Earnings

2004

/BV

2003

=2.91/7.01=0.415

ROCE

2005

=Earnings

2005

/BV

2004

=3.04/8.40=0.362

Accrual Accounting and Valuation: Pricing Book Values 111

Because the value of intangible assets (i.e., R&D expense) is omitted in the book value,

Merck trades with a high P/B and ROCE. All else equal, if Merck’s book value is

consistently under-valued, it will report ROCE that is higher than the required return of

10%. Because of competition within the industry, Merck’s profitability might decline in

the future, but probably never as low as 10%.

E5.15. Analysts’ Forecasts and Valuation: Hewlett Packard

(a)

Time line: 1999A 2000E 2001E 2002E 2003E 2004E 2005E

Eps 3.33 3.75 4.32 4.83 5.42 6.07 6.80

Dps

1

0.64 0.71 0.82 0.92 1.03 1.15 1.29

BPS 19.36 22.40 25.90 29.81 34.20 39.12 44.63

RE (0.12) 1.43 1.63 1.72 1.84 1.97 2.11

Growth in RE 14.0% 5.5% 7.0% 7.0% 7.0%

Discount factor 1.12 1.254 1.405

PV of RE(1.12

t

)

1.28 1.30 1.22

Total PV of RE to 2002 3.80

Continuing value

2

36.80

PV of CV 26.19

Value per share 49.35

1. The dps forecast is based on maintaining the same pay out ratio as in 1999.

2. CV =

07 . 1 12 . 1

84 . 1

−

= 36.80, where 7% is the long-term growth ratio in RE, set at the

growth rate for 2003-2005.

PV of CV = 36.80/1.405 = 26.19.

p. 112 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

The valuation from the forecasts is less than the market price of $83. The forecasts imply

a SELL, not a BUY. (The 7% growth rate – in perpetuity – is a high one, to boots.)

Note that one could also calculate the continuing value at the end of 2002, based on the

1.72 of RE in 2002 growing at 7%, and get the same answer.

(b) Suppose the market sets the $83 price using analysts’ forecasts for 2000 and 2001

plus a long-term growth rate forecast after 2001. The continuing value at 2001 will be

BPS, 1999 19.36

PV of RE to 2001: (1.28+ 1.30) 2.58

Present value of continuing valueat 2001 ?

Value per share 83.00

The implied PV of CV (?) is 61.06. The implied CV at the end of 2001 = 61.06 x 1.12

2

=

76.59. The implied growth rate in the CV is that which solves the CV calculation:

76.59 = (1.63 x g)/(1.12 – g)

Thus g = 1.0967 (an implied growth rate of 9.67%).

(c) Difficulties:

1. Analysts did not give a forecast of dps (which affects forecasted eps

and bps). We used a constant-payout forecast, but is this what analysts had in mind in

forecasting the eps (that are displaced by dividends)?

2. We relied on analysts’ long-run eps growth forecasts to calculate a

value. These forecasts are suspect. Research shows they are not very accurate and are

usually too optimistic.

3. We relied on analysts’ forecasts to 2002 to get the implied long-run

growth rate from the current market price. Are these good forecasts?

Accrual Accounting and Valuation: Pricing Book Values 113

E5.16. Residual Earnings Valuation and Accounting Methods

a. Inventory in the balance sheet is carried at historical cost but is written down to

market value if market value is less than cost. The carrying amount of inventory

on the balance sheet becomes cost of good sold when the inventory is sold. So, a

write-down of $114 million in 2006 means cost of goods sold in 2007 will be

$114 million lower, and earnings will be $114 million higher, that is, $502

million. The book value at the end of 2006 is $114 million lower, or $4,196

million. So,

ROCE = 502/4,196 = 11.96

This is an increase over the 9% (388/4,310) before the impairment.

b. Refer to the answer to Exercise 5.3. With earnings of $502 million forecasted for

2007, residual earnings is now 502 – (0.10 × 4,196) = $82.4 million. The present

value of this RE is $82.4/1.10 = $74.9 million. As the present value of RE for

2007 prior to the impairment was $-39.1 million, the change in the PV of RE in

the valuation is $114 million. As this is the change in the 2006 book, value the

valuation remains unchanged.

The full pro forma under the changed accounting is below:

2007E 2008E 2009E 2010E 2011E

Earnings 502.0 570.0 599.0 629.0 660.4

Dividends 115.0 160.0 349.0 367.0 385.4

Book value 4,583.0 4,993.0 5,243.0 5,505.0 5,780.0

ROCE 11.96% 12.4% 12.0% 12.0% 12.0%

Residual earnings 82.4 111.7 99.7 104.7 109.9

p. 114 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

Growth in RE -10.7% 5.0% 5.0%

Growth in Book value 8.9% 5.0% 5.0% 5.0%

Discount factor 1.110 1.210 1.331 1.464 1.611

PV of RE 74.9 92.3 74.9

Note that the pro forma is unchanged after 2007 as 2007 book values are the same as

before.

The valuation now runs as follows:

Book value, 2006 4,196.0

Total present value of RE to 2009 (from last line above) 242.1

Continuing value (CV), 2009:

2094

05 . 1 10 . 1

7 . 104

·

−

Present value of CV: 2094/1.331 1,573.3

Value of the equity, 2006 6,011.4

Per share value (on 1,380 million shares) 4.36

This is the same valuation as before.

c. The taxes will affect 2007 earnings and 2006 book values by the after-tax amount

of the impairment:

After-tax effect on 2007 earnings = $114 × (1 – 0.35) = $74.1

After-tax effect on book value in 2006 = $114 × (1 – 0.35) = $74.1

Accordingly,

Earnings, 2007 = 388 + 74.1 = 462.1

Book value at the end of 2006 = 4,310 – 74.1 = 4,235.9

ROCE, 2007 = 462.1/4235.9 = 10.91%

As both 2007 earnings and 2006 book values are affected by the same amount, the value

of the equity is unchanged (following the same calculation as in b).

Accrual Accounting and Valuation: Pricing Book Values 115

E5.17. Impairment of Goodwill

(a) As the asset is at fair value (the acquisition price) on the balance sheet, it is

expected to earn at the required return on book value: Residual earnings is

projected to be zero. (Fair value in an acquisition always prices the acquisition to

earn at the required rate of return.)

(b) The book value must be marked down to fair market value under FASB Statement

No. 142. The book value at the end of 2007, before the write down, is 301 + 79 =

380 (the depreciated amount of the tangible assets plus the good will).

Forecasted earnings for 2008 on this book value (at the forecasted ROCE of 9%) is

380 x 0.09 = 34.2

For a 10% required return, the book value that yields residual earnings in 2008 equal

to zero = 34.2 x 10 = 342:

RE

2008

= 34.2 – (0.10 x 342) = 0

A book value of 342 is thus “fair value.”

Accordingly, the amount of impairment = 380 – 342 = 38.

p. 116 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

Minicases

M5.1 Forecasting from Traded Price-to-Book Ratios: Cisco Systems

Inc.

Price = $21 Required equity return = 12%

Forward P/E = $21/$0.89 = 23.60

Book value per share = $25,826/6,735 = $3.835

P/B = $21/3.835 = 5.48

Introduction

Part A of this case asks you to challenge the market price of $21 or, alternatively stated,

to challenge the current P/B ratio of 5.48. As a P/B ratio is based of expected residual

earnings, this comes down to asking whether the P/B ratio is justified on the basis of

residual earnings forecasts.

Given that we have only two years of analysts’ forecasts, we do not have the complete

set of forecasts to challenge the $21 price. Of course, we might develop a full analysis to

do this (as will be done in Chapters 7 – 15), but for now we are asked to challenge the

price with the limited forecasts. Reverse engineering gives us the handle: What are the

forecasts implicit in the market price, and are these reasonable? This is done in three

steps:

1. Calculate the implied residual earnings growth rate after 2006 that is implicit in

the market price.

2. Translate the residual earnings growth rate into an eps growth rate

3. Ask whether, given our knowledge of Cisco and its operations, the implied eps

growth rates are reasonable.

The assembly of the building blocks of the valuation – to separate the speculative part of

the valuation—also provides insights.

Part B of the case is a check on analysts’ recommendations, first against their target price

and, second, against their forecasts. Are the recommendations consistent with their target

price and their forecasts for the stock?

The Questions

Part A:

1. Implied Residual Earnings Growth Rates

Accrual Accounting and Valuation: Pricing Book Values 117

With a required return on the equity of 12%, the pro forma for a price of $21 is as

follows:

2004 2005 2006

Eps 0.89 1.02

Dps 0.00 0.00

Bps 3.835 4.725 5.745

Residual earnings (RE) 0.4298 0.4530

Discount factor 1.12 1.2544

PV of RE 0.3838 0.3611

Total PV to 2006 0.745

PV of CV 16.420

CV ______ 20.597

Value of Equity 21.000

The present value (PV) of the continuing value (CV) is the plug between $21 and the

other two components of the valuation:

PV of CV = $21.00 – 3.835 – 0.745 = $16.42

The continuing value (at the end of 2006) is the future value of this number:

CV = $16.42 × 1.2544 = $20.597

Given the analysts’ forecasts for 2005 and 2006 are reasonable, this is the continuing

value that the market forecasts; that is, the market attributes $16.42 of the $21 price to

value to be delivered after 2006. From this continuing value, we can impute the implied

residual earnings growth rate after 2006:

CV =

597 . 20

12 . 1

4530 . 0

·

−

×

g

g

So g = 1.0959. The market is forecasting a growth rate for residual earnings of 9.59% per

year indefinitely. Keeping in mind the average GDP growth rate of 4% as a benchmark,

this looks a bit high.

Notice that we have anchored on the book value and the two years of analysts’ forecasts

in order to challenge the speculation in the market price. We would have to revise our

analysis (to anchor solely on the book value) if we were not confident in the integrity of

the analysts’ forecasts.

2. Implied Eps growth rates

p. 118 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

It’s difficult to think in terms of residual earnings growth rates, so convert the growth rate

to eps growth rates using the formula to reverse engineer residual earnings:

Earnings

t

= (B

t-1

× 0.12) + RE

t

The following pro forma gives forecasts RE (growing at 9.59% after 2006) and converts

the RE forecasts to eps forecasts in order to derive eps growth rates:

2005 2006 2007 2008 2009 2010

RE 0.430 0.453 0.496 0.544 0.596 0.653

Bps 4.725 5.745 6.930 8.306 9.899 11.740

Eps 0.89 1.02 1.185 1.376 1.593 1.841

Eps growth

rate 14.61% 16.18% 16.12% 15.77% 15.57%

3. Evaluate Implied Growth Rates

Are these growth rates reasonable? Well, we do not know enough about Cisco to make

the evaluation here, but an analyst who is familiar with the company might well conclude

that these rates are too high, too high, or too low. She might conclude: I just cannot see

Cisco maintaining such high growth rates for such a long period of time. The following

plot will help her:

Plotting the market’s implied Eps growth rates:

Accrual Accounting and Valuation: Pricing Book Values 119

14.61%

16.18% 16.12%

15.77%

15.57%

10.0%

11.0%

12.0%

13.0%

14.0%

15.0%

16.0%

17.0%

18.0%

19.0%

20.0%

2006 2007 2008 2009 2010

If the analyst forecasts growth rates above the path implied by the market, she would say

that Cisco was underpriced at $21. If the analyst forecasts growth rates below the path

implied by the market, she would say that Cisco was overpriced at $21. The path

separates the BUY and SELL regions. To be confident in her assessment, she would

model the eps path, using the full financial statement analysis and pro forma analysis that

we will move on to in Chapters 7-15, and then compare her path to that implied by the

market.

Identifying the speculative component of the market price: the Building Blocks

Refer to Figure 5.7 in the text. The speculative component is that which involves the

more uncertain forecasts for the longer term. The building blocks are:

1. Block 1: Book value $3.84

2. Block 2: Value from two years of forecasts:

Value in Block 2 =

1

]

1

¸

+

12 . 0

4530 . 0

4298 . 0

12 . 1

1

3.75

3. Block 3: Value in speculation about growth

13.41

21.00

p. 120 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

BUY

SELL

The building blocks for Cisco:

A considerable portion of the market price involves speculation about growth in the long

term (Block 3).

At this point, the analyst asks whether this speculation is justified. Maybe the market is

pricing events beyond the forecast horizon or other factors, other than immediate

eps growth, that are pertinent to the value. The analyst (and the student) asks:

what is the market anticipating that I do not anticipate; what do others know that

is not factored into my forecasts? What is the market speculating about to give

Cisco such a high Block 3 value? Is the firm on a takeover list? (Unlikely for

Cisco) Does it have new strategic plans? Is it ripe for breakup? (Unlikely for

Cisco) Having posed these questions, the analyst furthers his research to check on

the answers before being confident in his BUY/HOLD/SELL recommendation.

Note:

We have proceeded with a CAPM required return of 12%. CAPM technology is quite

imprecise, so we must be sensitive to this. We do this by asking if our assessment will

change if the required return is different. A sensitivity analysis for a 10% cost of capital

follows:

Accrual Accounting and Valuation: Pricing Book Values 121

Current Market Value

long-term

forecasts

Value from

short-term

forecasts

$13.41

$3.75

Value from

Book Value

(3)

Book Value

$3.84

(1) (2)

$21.00

$7.59

V

a

l

u

e

P

e

r

S

h

a

r

e

2004 2005 2006

Eps 0.89 1.02

Dps 0.00 0.00

Bps 3.835 4.725 5.745

Residual earnings (RE) 0.5065 0.5475 (Using a 10% required return)

Discount factor 1.10 1.21

PV of RE 0.4605 0.4525

Total PV to 2006 0.913

PV of CV 16.252

CV ______ 19.665

Value of Equity 21.000

CV =

665 . 19

10 . 1

5475 . 0

·

−

×

g

g

So g = 1.0702, or a 7.02% growth rate. Proceed from here, as before. A 7.02% growth

rate is lower, of course, but still high relative to the GDP growth rate. You can now

prepare a similar plot to that above with this 7.02% growth rate (and also a building block

diagram).

Part B:

This part of the case conducts two tests to challenge the integrity analysts’

recommendation (to buy, hold or sell Cisco). Is the recommendation consistent with their

analysis?

First, is the recommendation consistent with the target price?

If one bought Cisco at $21 at the beginning of 2005 and accepted 12% as the required

return, a target price of $23.52 at the end of 2005 would yield the required (normal)

return: $21 × 1.12 = $23.52 (there are no dividends). So, a target price of $24 would be a

(marginal) buy. (Of course, analysts may have a lower required return, which would

make a $24 target price a solid BUY). Analysts were indeed recommending a BUY at the

time (on average).

Second, is the recommendation consistent with analysts’ forecasts?

To start, work with analysts’ 2006 forecast. Their forecast for growth in residual earnings

for 2006 (from the pro forma above) is

Growth rate for RE

2006

= 0.4530/0.4298 = 1.054 (a 5.4%growth rate).

p. 122 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

This is considerably below the market’s implied growth rate of 9.59% for subsequent

years.

Now work with analysts’ 5-year growth rate. Analysts see a growth rate for eps of 14.5%

after 2006 and, on the basis of that forecast, recommend a BUY. But the plot above puts a

growth rate of 14.5% in the SELL region: the implicit market forecast is greater than this.

The recommendation is inconsistent with analysts’ forecast.

There are two provisos to these conclusions.

First, analysts may see higher growth after their 5-year forecast horizon (2010), and are

basing their recommendation on this.

Second, analysts may indeed see the lower growth in the future, but may anticipate that

the market price will (irrationally) increase: the price will move away from fundamentals.

In making a call on the target price, they are predicting prices, not values.

One further point should be noted. There is a possibility that the market is pricing based

on analysts consensus forecasts and both a wrong! Indeed, there are claims that

mispricing is led by analysts (poor) forecasting, as in the bubble. If we do not trust

analysts’ forecasts, there is no avoiding developing our own. Chapters 7-19 of the book

are designed to do this.

Note that, by the end of Cisco’s 2005 fiscal year, the stock price had dropped to $19.

Accrual Accounting and Valuation: Pricing Book Values 123

M5.2 Analysts’ Forecasts and Valuation: PepsiCo and Coca Cola

Introduction

Parts A and B of this case ask students to reverse engineer the traded prices for PepsiCo

and Coca-Cola and then ask whether the implied earnings forecasts are different from

those that analysts are making. Set up the case with two questions:

1. How do we understand the forecasts that are implicit in the market price?

2. How do we challenge the market price?

The first question leads to the second: Rather than challenging a price, we challenge a

forecast. The core tool is the implied earnings growth plot, like that displayed for Nike in

Figure 5.6. This plots the market’s implied earnings growth path and separates BUY and

Sell regions for the analyst who disagrees with the market’s forecast. The case uses

residual earnings methods; a companion case (Minicase M6.2 in Chapter 6) applies

abnormal earnings growth methods.

Part C of the case embellishes student’s understanding of the P/B ratio, emphasizing that

the P/B is determined by how the accounting for net assets is carried out.

The Questions

A. The implied earnings forecasts are calculated in two steps. First, reverse engineer the

RE valuation model to get the implied growth rate in residual earnings. Second, reverse

engineer the residual earnings calculation to get forecasted eps.

The pro forma to calculate the growth in RE is as follows:

PepsiCo

2003 2004 2005

Earnings 2.310 2.560

Dividends (payout = 42.4%) 0.980 1.086

Book value 6.98 8.31 9.784

Residual earnings (9%) 1.682 1.812

Growth rate in RE 7.74%

Reverse engineer the RE model:

1

]

1

¸

−

×

+ + + ·

g

g

V

E

09 . 1

812 . 1

09 . 1

1

09 . 1

812 . 1

09 . 1

682 . 1

98 . 6

2 2

2003

Setting

E

V

0

= $49.80, then g = 1.0497 (a 4.97% growth rate)

p. 124 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

With this growth rate, the RE for 2006 onwards can be forecasted. For example, RE for

2006 = 1.812 × 1.0497 = 1.902. RE forecasts are then reversed engineered to deliver

earnings forecasts:

Earnings

t

= (Book value

t-1

× 0.09) + RE

t

So, for 2005, eps = (9.784 × 0.09) + 1.902 = 2.783.

The following pro forma gives the conversion for years, 2006-2008.

2005 2006 2007 2008

RE (growing at 4.97%) 1.902 1.997 2.096

Book value 9.784

B

t-1

× 0.09 0.881 1.025 1.181

Eps 2.783 3.022 3.277 ←

Dps (payout = 42.4%) 1.180 1.282 1.389

Book value 11.387 13.127 15.105

Coca Cola

2003 2004 2005

Earnings 1.990 2.100

Dividends (payout = 50.3%) 1.000 1.056

Book value 5.77 6.760 7.804

Residual earnings (9%) 1.471 1.492

Growth rate in RE 1.43%

Reverse engineer the RE model:

2003

2 2

1.471 1.492 1 1.492

5.77

1.09 1.09

1.09 1.09

E

g

V

g

1 ×

· + + +

1

−

¸ ]

Setting

E

V

0

= $40.70, then g = 1.0492 (a 4.92% growth rate)

Now, again, reverse engineer the residual earnings formula:

Earnings

t

= (Book value

t-1

× 0.09) + RE

t

The following pro forma gives the conversion for years, 2006-2008.

Accrual Accounting and Valuation: Pricing Book Values 125

2005 2006 2007 2008

RE (growing at 4.92%) 1.565 1.642 1.723

Book value 7.803

B

t-1

× 0.09 0.702 0.804 0.913

Eps 2.267 2.446 2.636 ←

Dps (payout = 50.3%) 1.140 1.230 1.326

Book value 8.930 10.146 11.456

B. From the pro forma in part a, EPS growth rates for each year are:

PepsiCo 2004 2005 2006 2007 2008

EPS 2.31 2.56 2.783 3.022 3.277

Growth rates (%) 10.83 8.71 8.59 8.44

Coke Cola 2004 2005 2006 2007 2008

EPS 1.99 2.10 2.267 2.446 2.636

Growth rates (%) 5.53 7.95 7.47 7.77

These growth rates can be depicted in a plot, like that in Figure 5.6 for Nike. This plot

separates BUY and SELL regions:

Implied EPS Growth: PepsiCo

p. 126 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

10.83%

8.71%

8.59%

8.44%

8.00%

8.50%

9.00%

9.50%

10.00%

10.50%

11.00%

2005 2006 2007 2008

E

P

S

G

r

o

w

t

h

R

a

t

e

Accrual Accounting and Valuation: Pricing Book Values 127

BUY

SELL

Implied EPS Growth: Coke

5.53%

7.95%

7.47%

7.77%

5.00%

5.50%

6.00%

6.50%

7.00%

7.50%

8.00%

8.50%

2005 2006 2007 2008

E

P

S

G

r

o

w

t

h

R

a

t

e

For PepsiCo, analysts were forecasting a five-year eps growth rate of 11%, consistent

with their 10.83% growth rate for 2005. The eps growth rate implied by the

market price is lower than that forecasted by analysts. The market is seeing lower

eps growth than that forecasted by analysts. If the analysts’ forecasts are to be

believed, the market price is too low: A BUY is indicated. The alternative

interpretation is that analysts are too optimistic in their forecasts. Indeed, sell-side

analysts are notorious for being too high with their 5-year eps growth rates.

For Coca-Cola, analysts were forecasting a growth rate of 8%. This is in line with the

implied forecasts by the market.

There is a proviso to these conclusions: Maybe the market is pricing events beyond the

forecast horizon or other factors, other than immediate eps growth, that are

pertinent to the value. The analyst (and the student) asks: what is the market

anticipating that I do not anticipate; what do others know that is not factored into

my forecasts? Is the firm on a takeover list? (Unlikely for Coke or Pepsi.) Does it

have new strategic plans? Is it ripe for breakup? (Unlikely for Coke or Pepsi.)

Having posed these questions, the analyst furthers his research to check on the

answers before being confident in his BUY/HOLD/SELL recommendation.

p. 128 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

BUY

SELL

A basic point to be made from the case (and indeed the material in the Chapter):

Valuation models are not formulas into which you plug in numbers and magically

an intrinsic value pops out. Yes, you can use the models to convert a forecast to a

valuation. But the models are, more broadly, a way of developing tools for

challenging the market price. They enable you to convert a price to a forecast

which you can then compare to your own forecast. Indeed, the scheme enables

you to challenge your own forecasts with the forecast in the market price.

Broadly, valuations models tell you how to think about the problem (of

appropriate pricing) and to bring tools to resolving the problem. They get you

asking the right questions before reaching a conclusion.

C. The high P/B ratios.

Firms have high P/B ratios if accountant leave value off the balance sheet. For these two

firms, value lies in their brands – Coke, Pepsi, Frito-Lay, and so on. Brand assets are not

booked to the balance sheet. So, one expects these firms to have high P/B ratios.

PepsiCo’s P/B is $49.80/$6.98 = 7.13 and Coke’s is $40.70/$5.77 = 7.05.

Correspondingly, one expects these firms to have high ROCE (and residual earnings):

Earnings from the brands are in the numerator, but the brand asset is missing from the

denominator. PepsiCo’s forecasted ROCE for 2004 is $2.31/$6.98 = 33.1% and Coke’s is

$1.99/$5.77 = 34.5%.

Accrual Accounting and Valuation: Pricing Book Values 129

M5.3 The Goldman Sachs IPO

Introduction

This case introduces residual earnings valuation that evaluates price-to-book

ratios, emphasizes the limitations of short-term forecasts, and compares pro forma

valuation with multiple analysis. It also shows how we separate “what we know” from

speculation when valuing shares. And it leads to a discussion of whether share

transactions in acquisitions can add value for shareholders.

As an introduction, remember the maxim: price is what you pay, value is what

you get. And be particularly careful when the seller is an insider, as in this IPO. There is

an additional wrinkle here: With the $70 offer price at nearly 4 times book value, the

partners have an real incentive to go to market, for without a floatation, they only receive

the book value of their interests when the withdraw from the partnership.

A. The pro forma is simple:

1998A 1999E 2000E

Eps 4.69 4.26

Dps 0.48 0.48

Bps 17.80 22.01 25.79

RE(0.10) 2.91 2.06

ROCE 26.3% 19.4%

With a forecast for a limited period, start with a Case 2 valuation. With this pro forma

and a forecast that the 2000E residual earnings is a good estimate of residual earnings

after 2000, the (Case 2) valuation of Goldman is:

/1.10

0.10

2.06

1.10

2.91

17.80

V

1998

,

_

¸

¸

+ +

·

p. 130 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

= $39.17

This value is considerably lower than the market price of $70. But this valuation assumes

no growth in residual earnings after 2000E. The analysts have not given enough

information to complete this valuation. The market price of $70 has an implied growth

rate that can be tested:

21 . 1 /

10 . 1

06 . 2

21 . 1

06 . 2

1.10

2.91

17.80 70

,

_

¸

¸

−

×

+ + + ·

g

g

g = 1.062 (a 6.2% growth rate)

Note that, while the analysis demonstrates the limitation on having only short-term

forecasts, it serves to illustrate the maxim on fundamental analysis: Distinguish what you

know from speculation and put weight on what you know. We know the book value and

may feel relatively secure in our short-term forecasts (for 1999 and 2000), but the long

term is more speculative. The “g” here identifies the part of the valuation that is more

speculative. Can we come up with scenarios that justify a growth rate of 6.2% for

Goldman? Remember growth in RE come from two factors:

• increase in ROCE

• increase in net assets earning at the ROCE

Much of the apparatus in Part Two of the book bears on the analysis of ROCE and

growth in net assets, bringing focus to this issue of RE growth.

B. Corzine and Paulson saw growth coming from acquisitions. So a complete

analysis would involve acquisition strategy. Who were potential acquirees? An

insurance firm (as in the Citicorp Travelers merger)? A larger asset management

business? Chase? The analysis would also involve costs of acquisitions. Were cheap

Accrual Accounting and Valuation: Pricing Book Values 131

acquisitions available? Were synergistic merges a possibility? Or would Goldman have

to pay a fair price and earn a normal return (a zero RE) on the acquisition?

Do shares give a firm currency? Not if those shares are fairly priced in the

market; using shares in an acquisition gives up the same value as the cash equivalent.

Goldman might face borrowing constraints to raise the cash, however. And, if it found

itself in a position of having its shares overvalued in the market, it might use the shares to

buy another firm cheaply. Which brings us to the question C.

C. If Merrill and Morgan Stanley were “appropriately priced” the use of

multiples is a reasonable way of getting a valuation, with any adjustments for

differences between the firms. But if the prices of comparison firms were too

high—as some maintained—then the Goldman partners may indeed have been

taking advantage of a mispricing. Remember the issue of Ponsi schemes in

multiples (in Chapter 3)? There is further discussion on the Chapter 3 web

page.

Postscript: This case was written in October 1999. Goldman’s strategy might be more

apparent when you read this case later, and its effects can be incorporated into this

analysis. With later numbers, the question arises whether the $70 price was justified. Did

the partners deliver on the growth rates implicit in the $70 price? Here are the actual

results for subsequent years:

1999 2000 2001 2002

Eps 5.69 6.33 4.53 4.27

Dps 0.48 0.48 0.48 0.48

One can see that, while more earnings were delivered in 1999 and 2000 than forecasted,

earnings (and residual earnings) subsequently declined.

At the end of fiscal 2003, GS traded at $91. Adding the terminal value of $2.93 from

getting 48 cents in dividends for 4 years. The cum-dividend price at 2003 was $93.93.

This is an annualized return of 5.8%, less than the 10% required return of 10% specified

(and close to the 30-year bond rate in 1999).

p. 132 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

M5.4. Strategy and Valuation: Weyerhaeuser Company

This case can be combined with the Weyerhaeuser Minicase M2.3 in Chapter 2 to

compare asset-based valuation with pro forma analysis.

The case introduces the analysis of strategies and highlights the problems one

often has in translating statements about strategy into forecasts and a valuation. It also

motivates students to dig for further information.

Some preliminary calculations

Bps, 1997 (on 199.486 million shares) 23.30

Bps, 1998 (on 199.009 million shares) 22.74

ROCE, 1998

,

_

¸

¸

30 . 23

48 . 1

6.4%

P/B ratio, 1998 (at price of $55) 2.4

P/E ratio, 1998 (dividend-adjusted) 38.2

To answer the questions, develop a pro forma based on the plans and their forecasted

outcomes:

Effect on 1999 eps:

Eps, 1998 $1.48

Effect of increasing harvest 0.85

Effect of cost cutting 0.72

Effect of price increases 0.40

Effect of capacity utilization 0.20

Eps, 1999 $3.65

A pro forma that forecasts 1999 residual earnings is as follows:

1997A 1998A 1999E

Eps 1.48 3.65

Dps 1.60 1.60

Bps 23.30 22.74 24.79

RE (0.12) (1.32) 0.92

ROCE 6.4% 16.1%

Accrual Accounting and Valuation: Pricing Book Values 133

Answering the Questions

A. The plans and their forecasted affects yield an ROCE for 1999 of 16.1%, just

short of the goal of 17%.

B. Valuing the firm from the forecast.

Suppose the forecasted residual earnings for 1999 are to continue

indefinitely.

Then the value per share would be:

0.12

0.92

22.74 V 1998 + ·

= 30.41

This value is well below the market price of $55. If the cost of capital were 8%,

the value would be $45.62 per share.

But this valuation is incomplete because there may be growth in RE (and

there may be a decline, negative growth, in RE). What growth is the market

forecasting at $55?

9.15%) of rate growth a or ( 1.0915 g

g - 1.12

0.92

22.74 55

· ∴

+ ·

So, to pay $55, we have to be able to forecast a growth of 9.15% in RE.

This translates into a growth rate in eps of 9%-10% if the $1.60 dps is maintained.

C. The question introduces operating leverage: with fixed cost more of each

additional dollar of revenue goes to the bottom line.

D. There are a number of concerns:

p. 134 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

(i) The forecasted ROCE for 1999 is high by historical standards and is for

anticipated upswing in the cycle. Shouldn’t the valuation be based on the average, long-

term ROCE for the cycle?

(ii) The excess capacity gives us a red flag. Will some of this capacity have to

be written off in a restructuring or more accelerated depreciation in the future? These

actions will lower ROCE.

(iii) Will Weyerhaeuser resist the temptation to overinvest at the top of the

next cycle?

(iv) The increased harvest is a concern. Is the firm planning to cut timber for

short-term gain at the expense of the long-term? Is the anticipated cutting in excess of

accretion through tree growth? Are the timberlands more valuable uncut?

E. There are two issues on which we want further information.

(i) Is the ROCE forecasted for 1999 sustainable? The issues raised in part (d)

are relevant to this question.

(ii) Getting a handle on the long-term growth is clearly the key here. A

forecast (or objective) for ROCE is not enough. Growth in investment (book value) must

be considered.

The student does not have the tools to develop growth forecasts at this stage.

These are at the heart of the analysis in Part Two of the book. A key element is the

growth in revenues, for growth in revenues is the primary driver of growth in RE.

Weyerhaeuser’s revenues had been flat or declining, over the prior three years. Is this to

change? The professor could explore the growth issue as an introduction to Part Two

.

Accrual Accounting and Valuation: Pricing Book Values 135

Another question: Is Weyerhaeuser worth more than its going concern value?

Look back at the asset-based valuation in case M3.4 in Chapter 3. Should timberlands

not be cut because the return they produce from cutting is valued less than their value

uncut?

The student might look at how Weyerhaeuser has performed since 1999. Was the

$55 price (that rose to $70 by mid 1999) justified ex post?

p. 136 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

(Blank page)

Accrual Accounting and Valuation: Pricing Book Values 137

C5.3. A P/B of 1.0 implies a future ROCE equal to the cost of capital. An ROCE of 52.2 % is high relative to the cost of capital, so the P/B implies the ROCE is unusually high and will drop in the future.

C5.4.

No. If the firm is expected to earn an ROCE in excess of the required return, it should sell at a premium over book value. Given the forecast, the firm is a BUY if it trades below book value.

C5.5.

False.

If the firm maintains a low ROCE it will be valued at a discount on

book value. But it can survive: it has a positive going-concern value.

C5.6.

Firms create residual earnings through ROCE and growth in net assets. The ROCE for Dell are level (and declining in 2005), but the book values are increasing. With constant ROCE and growing book values, residual earnings increase.

C5.7.

(a) Share issues produce more earnings because there are more assets earning in the business. And dividends reduce earnings. (b) ROCE is a ratio and, as share issues (usually) affect the numerator and

denominator of a ratio in different proportions, the ratio changes. But RE is not affected by share issues or dividends (in the case of a firm with no leverage).

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C5.8.

Yes. Value is generated by growing book values if the book rate of return is higher than the required return.

C5.9. If the analyst does not forecast all sources of earnings (that is, comprehensive earnings) then she will ignore some part of the payoff to shareholders, and will lose some value in her calculation of a value from the forecast. C5.10. The price-to-book valuation has nothing to do with free cash flow. Look at the General Electric example in the chapter. GE has negative free cash flows (in Chapter 4), but a large P/B ratio (in this chapter). Growth in investment determines the P/B ratio (along with return on investment), but investment reduces free cash flow.

**Exercises Drill Exercises
**

E5.1. Calculating Return on Common Equity and Residual Earnings Set up the pro forma as follows:

Accrual Accounting and Valuation: Pricing Book Values 99

2006 Eps Dps Bps 20.00 ROCE RE (10% charge)

2007 3.00 0.25 22.75 15.00% 1.00

2008 3.60 0.25 26.10 15.83% 1.325

2009 4.10 0.30 29.90 15.71% 1.49

a. The answer to the question is in the last two lines of the pro forma b. As forecasted residual earnings are positive, the shares of this firm are worth a premium over book value. E5.2. ROCE and Valuation As expected ROCE is equal to the required return, expected residual earnings are zero. So the shares are worth their book value per share. Book value per share = $3,200/500 = $6.40.

E5.3. A Residual Earnings Valuation This question asks you to convert a pro forma to a valuation using residual earnings methods. First complete the pro forma by forecasting book values from earnings and dividends. Then calculate residual earnings from the completed pro forma and value the firm. 2007E Earnings Dividends Book value 388.0 115.0 4,583.0 2008E 570.0 160.0 4,993.0 12.4% 111.7 8.9% 1.210 92.3 2009E 599.0 349.0 5,243.0 12.0% 99.7 -10.7% 5.0% 1.331 74.9 2010E 629.0 367.0 5,505.0 12.0% 104.7 5.0% 5.0% 1.464 2011E 660.4 385.4 5,780.0 12.0% 109.9 5.0% 5.0% 1.611

ROCE 9.0% Residual earnings -43.0 (10%) Growth in RE Growth in Book value Discount factor 1.110 PV of RE -39.1

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011.0 1.380 million shares) 1.23 on a per-share basis.310 = 1. 2006 Per share value (on 1.011.4 4.4 – 4. Forecasted book values.583) = 111.993.011.10 × 4. Accrual Accounting and Valuation: Pricing Book Values 101 . the valuation is a Case 3 valuation with the continuing value calculated at the end of 2009: Book value. b. Book value each year is the prior book value plus earnings and minus dividends for the year.3 6. The P/B ratio is 6.10 −1. Residual earnings for each year is earnings charged with the required return in book value. RE is 570 – (0.36 d.701. Forecasted growth rates in book value and residual earnings are given above.331 Value of the equity.05 4.7. for 2008. c.39. The growth rate in residual earnings is 5% after 2009. ROCE. So.0 128.310 = 1. 2006 Total present value of RE to 2009 (from last line above) Continuing value (CV). So.573. Book value = 4583 +570 –160 = 4.310. The starting book value (in 2006) is 4. and residual earnings are given in the completed pro forma above. or 1. Assuming this growth rate will continue into the future. for 2008 for example.7 = 2094 . 2009: 104 .1 Present value of CV: 2094/1.310. The premium is 6.4.a.4/4.

91 0 2010 3.12) Discount rate PV Total PV 1.90 1.00 29. Develop the pro forma as follows: 2006 Eps Dps Bps (a) RE (0.00 32. the equity is expected to be worth its book value of $35.4.59 1.70 22. V0E = ∑ ρ − t d t + TV T / ρ T t =1 T p.70 (c) As residual earnings are expected to be zero after 2011.71 1. As aside: Note that the dividend discount formula can be applied because we now have a basis for calculating its terminal value.E5.12 1.90 1.70 1.90 1.31 1.00 24.00 35. at this point.00 27.40 0 (b) Value 23.26 1. 102 Solutions Manual to accompany Financial Statement Analysis and Security Valuation . The terminal value is the expected terminal price.00 2007 3. and this can be calculated at the end of 2008 because.125 2008 3.60 . expected price equals book value. Residual Earnings Valuation and Target Prices (Easy) This problem applies the residual earnings model and its dividend discount equivalent.40. (d) The expected premium at 2011 is zero because subsequent residual income is expected to be zero.2544 .57 2009 3.50 0 2011 3.

60 22.00 23. (a) Residual Earnings Valuation and Return on Common Equity Set the current year as Year 0.5 1 = 15 .10 0.34 Residual earnings.40 0.The TV2008 is given by the expected 2008 book value: TV2008 = 27.60 So the calculation goes as follows: 2006 Dps PV Total PV of divs.60 + P B =2 .15 = 2. so V0 = B 0 + RE 0 0.6.60) = 0.80 2008 E5.4 3 0 1 .78 This RE is a perpetuity.5 E5.10 × 15.69 27. Using Accounting-Based Techniques to Measure Value Added for a Project (a) Accrual Accounting and Valuation: Pricing Book Values 103 .6 5 0 (b) No effect: future payout does not affect current price (unless you have a tax story) and future dividends don’t affect current book value.60 × 0.00 . Year 1 = 15. Earnings.78 = 23 . TV PV of TV Value 1. P/B is still 1. Year 1 = 2.00 .89 1.69 2007 1.34 – (0.5.10 = .

0 34.9 0.5 4.47 million over the cost.58 t 160.12 ) Total PV of cash flow Cost NPV t 0 1 22.5 30.0 52.0 39.47 The NPV is the value added.92 4 30 30 9 1.14 5 30 0 4.96 4 9.0 43.0 24.27 3 13.5 30.8 1.5 4.5 19.0 30.12) PV of RE Total PV of RE Value of Project 0 150 1 30 120 22.0 30.7 1. (b) Time line Earnings Depreciation Cash from operations PV of cash flow (1.47 The investment added $10.00 10.Time line: Depreciation Book value Earnings (15%) RE (0.6 2.47 160.02 2 30 90 18 3.5 0.5 30.5 30.88 2 18.87 3 30 60 13.5 2.0 38.79 5 4. 104 Solutions Manual to accompany Financial Statement Analysis and Security Valuation .47 150.5 46. p.51 10.0 48.

7.5 26.5 7 150 150 450 217.5 13.0 54.5 13. (b) The value added is $97.1 6.5 4.0 120. The continuing value is based on a forecast of residual earning of 13.5 6 150 150 450 217. Using Accounting-Based Techniques to Measure Value Added for a Going Concern (a) Time line: Investment Depreciation Book value Revenue Depreciation Earnings (15%) RE (0.7 1.5 30.2 112.6 8.5 = 112.5 247.5 in year 5 continuing perpetually with no growth.5 0.0 67.8 7. CV = 13 .5 71.5 8.7 million Accrual Accounting and Valuation: Pricing Book Values 105 .7 150 97.0 40.5 150.5 13.12) PV of RE Total of PV of RE Continuing value PV of CV Value Lost Value added 3 2 1 0 150 1 150 30 270 52.5 3 150 90 420 144.0 10.5 150.0 63.0 67.0 12.5 150. This is a Case 2 valuation.5 4.0 5 150 150 450 217.12 The value of the firm is $247.0 2 150 60 360 100. Book value (t) = Book value (t-1) + Investment (t) – Depreciation (t) 3.0 90.5 60.7 4 150 120 450 183.0 22.0 67.E5.7 million. Depreciation is $30 million per year for each project in place 2.

the calculated value is the same as that in the text (before earnings were created).0) = $1.60 – (0.0.0 and a price of $26.9. E5.30 Reverse engineering solves for g in the following model: $26 = $13 + 1. 106 Solutions Manual to accompany Financial Statement Analysis and Security Valuation .10 × 13.10 c. Value = $360 + Even though earnings have been created. 1.30 per share after 2007.8. E5. Thus. the book value per share is $13.$360 = $80 Earnings in the text example were $40. by expensing $40 of the investment in the prior period and thus reducing Year 1 expenses by $40.30 Applications p. the growth rate is zero: The market expects residual earnings to continue at $1.10 − g The solution is g = 1. Creating Earnings and Valuing Created Earnings a. That is. Earnings = Revenues – Expenses = $440 .(c) The value added is greater than 15% of the initial investment because there is growth in investment: value is driven by the rate of return of 15% (relative to a cost of capital of 12%) but also by growth.10 × 360) = 44 $44 = $400 1. b. ROCE = $80/$360 = 22. Clearly earnings have been created. Reverse Engineering With a P/B ratio of 2. Residual earnings (2007) = $2.22% Residual earnings = $80 – (0.

11.002 0.0.45 1.74 per share – a Case 1 valuation.29 24.12 13.379 1.28 1.99 11.57. follow the fundamentals.71 1. then residual earnings are expected to be zero.0 ROCE RE (11% charge) Discount rate (1.99 at 2004. As the CV = 0. As GM is expected to earn an ROCE far below its required return. Residual Earnings Valuation: Black Hills Corp The pro forma for the exercise is as follows: Forecast Year ____________________________________ 1999 2000 Eps Dps Bps 9.00 Value per share 13.685 0. Valuing Dividends or Return on Equity: General Motors Corp a.0% 1.368 1. c.06 11. The dividend yield (dividend/price) is high because price is low.69/49 = 1.11)t Present value of RE Total present value of RE to 2004 3. the target price is equal to forecasted bps of $15. Accrual Accounting and Valuation: Pricing Book Values 107 .232 1.0% 0.16 14. it should have a P/B well below 1.792 0.39 1.003 1. The analyst makes a mistake in focusing on the dividend (yield).74 30. E5.250 2004 1. A firm can pay a high dividend in the short run.E5.572 a.782 1. The continuing value is zero.208 0. ROCE = 0.52 13.6% 16.10.294 1.74 2003 2.7% 2.62 2002 2.6% 0. The dividend they have been paying is not a good indicator of value. If ROCE is to continue at 11% after 2004. the required return is not stated.41% b.24 15. P/B = 28/49 = 0. The value is $13. but any reasonable return is far greater than 1.166 2001 3.110 1. ROCE and residual earnings are in the pro forma b. An unprofitable firm will drop its dividend – as GM has done in the past in bad times – and GM does not look profitable.78 Continuing value (CV) Present value of CV 0.96 2.00 1. but if fundamentals give a different message. because of poor prospects.22 15. c.41 percent.518 0. Yes.

80 for every dollar of book value in the S&P 500 companies. 108 Solutions Manual to accompany Financial Statement Analysis and Security Valuation .76 + 0. So. the 2005 eps forecast was $1. the current residual earnings on a dollar of book value is: RE0 = (0.21. c.17 – 0.774.0 p. Reverse Engineering the S&P 500 Index (a) With a P/B ratio is 2.12 − g Set g = 1.774 In April. The reverse engineering problem is now E V2004 = $11 .825 (the midpoint of the range). the market is expecting RE to stay at the same level after 2005.12 − g The solution is (approximately) g = 1. How can a drop in price be associated with an increase in the RE growth rate? Well the increase is due to a lower base: RE for 2005 is now 0. That is. The reverse engineering problem is E V2004 = $14 .12 × 8.50 = $8. So the market was expecting a decline in residual earnings after 2005.324 b. With an ROCE of 17%.50 = $8.375 – (0. So.13.38 (the midpoint of the range). RE(2005) = $1.324 rather than 0.76 + 0. In January.8.825 – (0. Reverse Engineering: Ford Motor Company a. E5. RE(2005) = $1.76) = 0.12.0 (a zero growth rate) and the value is $15.76) = $0.09) × 1. investors are paying $2.324 1.E5.0 (no growth).12 × 8.774 1. the 2005 forecast was $1.

residual earnings is driven by two factors: 1.08 × g 1.0 + 0.8 =1.09 − g Solving for g.99 Accrual Accounting and Valuation: Pricing Book Values 109 .14. Is a 4. g = 1.) (b) See the last paragraph.= 0. Profitability of net assets: ROCE 2.80.38 growth rate) What does this mean? If the S&P 500 firms can maintain an ROCE of 17%. Alternatively. for every dollar of book value worth $2.05 Forward Earnings2004 = $2. With a constant ROCE. Growth in net assets E5.38% can be maintained with a lower growth rate. 2. 8 cents per dollar of book value.08 That is. The value of an asset (with a constant growth rate is mind) is calculated as: V0 = B0 + RE 0 × g ρ−g (One always capitalizes the one-year-ahead amount.576 million Shares outstanding = 2. The Merck Revaluation Book value of shareholders’ equity = $15.01 Required rate of return = 10% Forward P/E = 15. then investment in net assets must grow by 4. if ROCE were to improve.222 million Book value per share = $7.38%. Remember. the growth in residual earnings is determined by the growth in net assets (book value). a growth in residual earnings of 4.38% growth rate reasonable? What is the prospect for ROCE for the market as a whole? Is the market appropriately priced? (Analysis in Module II of the course will help answer these questions.0438 (a 4.) So.

272 × g 2.586 10. Target price2005 = Book value2004 + Continuing value (CV) The calculation of continuing value: CV = RE × g 2.01 Residual earnings b.52 . Prepare the pro forma and calculate residual earnings by charging prior book value at 10% 2003 2004 2005 Eps 2.99 = 50. 110 Solutions Manual to accompany Financial Statement Analysis and Security Valuation .) c.52 8.289 3.04 p.01 + 39.10 − 1.38 = 49.00% growth rate).12 1.01 2.52 Payout ratio = $1.00 Dividend per share = $1.12 Current price = $45.91 3. Apply the residual earnings model: 2.38 ρ E − g 1.39 d. Merck was reasonably priced at $45.99 1. Thus.04 (a 4.272 7. Prepare the pro forma and calculate residual earnings by charging prior book value at 10% 2003 2004 2005 Eps Dps Bps 2.10 ( 1.289 2.04 Target price2005 = 10. 2004. we get VoE = $43.52/$2.52 valuation is that in January.272 V0E = 7.272 × 1.10 − g 1. (Strictly speaking.10 ) 2 Setting g = 1.8% a. the $43.04 = = 39.10 ) 2 ( 1. The September value would be this value reinvested for nine months at a 10% per annum rate.01 + + + 1.48 2.Forward Earnings2005 = $3.

(The calculation here assumes that dividends for 2004 are not paid yet.91/7.85 2.415 ROCE2005=Earnings2005/BV2004=3.01=0.209 1.Dps Bps 7. e.063 + (1. Setting g = 1.04/8.200 × g 2.10 ) 2 If a firm can maintain net profit margins and sales-to-book ratios (and constant cost of capital).200 × 1.01 + + + 1.10 ) ( 1. The calculation of continuing value: CV = RE × g 2.40=0.01 1.588 9.037 (a 0.01=4.52 × 1.213 = 46. Merck’s P/B= Price/BV=34/7.10 ( 1.10) + 1. The rate of return will be lower if Merck already distributed some dividends to shareholders) f. the 25% drop in price was not warranted.037 = = 36.06% Rate of return = The value of dividends received is the terminal value at the end of 2005.209 2.10 − 1.200 V0E = 7.85 ROCE2004=Earnings2004/BV2003=2.30% reduction).037 Target price2005 = 9. the growth rate for residual income equals to the sales growth rate.213 ρ E − g 1. we get VoE = $40.76 Based on the calculation.52 8.40 2.063 P2005 + Value of Dividends − P 2004 −1 P2004 46.200 Residual earnings Applying the residual earnings model: 2. that is.85 + 36.10 − g 2 1.588 − 34 = −1 34 = 45.362 Accrual Accounting and Valuation: Pricing Book Values 111 . the 2005 dividend plus the 2004 dividend reinvested for one year.

where 7% is the long-term growth ratio in RE.35 1.19.254 1. but probably never as low as 10%.0% RE (0.28 3.07 1. Because of competition within the industry.64 19. p.30 2002E 4.90 1.5% 1.12 ) Total PV of RE to 2002 Continuing value PV of CV Value per share 2 t 1.0% 2005E 6. Merck trades with a high P/B and ROCE.83 0. PV of CV = 36.405 1.33 0.15. if Merck’s book value is consistently under-valued.84 = 36.42 1.80 36.80.80 1.0% 2004E 6. CV = 1.36 2000E 3.0% 1.80/1. it will report ROCE that is higher than the required return of 10%.43 2001E 4.19 49.03 34.92 29. 2. set at the 1.12 1.75 0.63 14.81 1.11 7. The dps forecast is based on maintaining the same pay out ratio as in 1999. 112 Solutions Manual to accompany Financial Statement Analysis and Security Valuation .15 39.32 0. E5.Because the value of intangible assets (i. Merck’s profitability might decline in the future.22 2003E 5.07 growth rate for 2003-2005.12 1.40 1.20 1.71 22. R&D expense) is omitted in the book value.12) Growth in RE Discount factor PV of RE(1.29 44. Analysts’ Forecasts and Valuation: Hewlett Packard (a) Time line: Eps Dps BPS 1 1999A 3.82 25.e..72 5.80 26.63 2.84 7.405 = 26. All else equal.12 −1.97 7.

12 – g) Thus g = 1. The implied growth rate in the CV is that which solves the CV calculation: 76. based on the 1. Are these good forecasts? Accrual Accounting and Valuation: Pricing Book Values 113 .The valuation from the forecasts is less than the market price of $83. The continuing value at 2001 will be BPS.06 x 1. (c) Difficulties: 1.36 2. 3. The forecasts imply a SELL. We used a constant-payout forecast. We relied on analysts’ long-run eps growth forecasts to calculate a value. We relied on analysts’ forecasts to 2002 to get the implied long-run growth rate from the current market price.67%). Research shows they are not very accurate and are usually too optimistic.72 of RE in 2002 growing at 7%.0967 (an implied growth rate of 9.) Note that one could also calculate the continuing value at the end of 2002. not a BUY.63 x g)/(1.30) Present value of continuing value at 2001 Value per share 19. (The 7% growth rate – in perpetuity – is a high one. (b) Suppose the market sets the $83 price using analysts’ forecasts for 2000 and 2001 plus a long-term growth rate forecast after 2001. but is this what analysts had in mind in forecasting the eps (that are displaced by dividends)? 2. Analysts did not give a forecast of dps (which affects forecasted eps and bps). and get the same answer.06. These forecasts are suspect. The implied CV at the end of 2001 = 61. 1999 PV of RE to 2001: (1.58 ? 83.59 = (1.59.00 The implied PV of CV (?) is 61.122 = 76. to boots.28+ 1.

and earnings will be $114 million higher.0 115. the change in the PV of RE in the valuation is $114 million.4 385.96% 82.505.0 12.0 12.0 12. As the present value of RE for 2007 prior to the impairment was $-39. As this is the change in the 2006 book.0 4. The book value at the end of 2006 is $114 million lower.0 349.0 5.4 2008E 570. a write-down of $114 million in 2006 means cost of goods sold in 2007 will be $114 million lower. that is. residual earnings is now 502 – (0. So. b.196 = 11.196) = $82.0 11.0 5. With earnings of $502 million forecasted for 2007.0 367. 114 Solutions Manual to accompany Financial Statement Analysis and Security Valuation .7 2009E 599.4% 111.196 million.3.583. So.4 5.0 4.9 million. The carrying amount of inventory on the balance sheet becomes cost of good sold when the inventory is sold.4 million. ROCE = 502/4. value the valuation remains unchanged.7 2011E 660.10 × 4.310) before the impairment.E5. Refer to the answer to Exercise 5. The present value of this RE is $82.780.993. $502 million.0 160.243.4/1.16. or $4.0% 99. Inventory in the balance sheet is carried at historical cost but is written down to market value if market value is less than cost.0% 104. The full pro forma under the changed accounting is below: 2007E Earnings Dividends Book value ROCE Residual earnings 502.0 12.1 million. Residual Earnings Valuation and Accounting Methods a.10 = $74.9 p.0% 109.96 This is an increase over the 9% (388/4.7 2010E 629.

7% 5.310 – 74.196. Earnings.7 = 2094 1. 2006 Total present value of RE to 2009 (from last line above) Continuing value (CV).331 74.3 -10.611 Note that the pro forma is unchanged after 2007 as 2007 book values are the same as before.35) = $74.3 6.91% As both 2007 earnings and 2006 book values are affected by the same amount.1 Accordingly.9 = 10.235. The taxes will affect 2007 earnings and 2006 book values by the after-tax amount of the impairment: After-tax effect on 2007 earnings = $114 × (1 – 0.0% 1. 1.10 −1. 2009: 104 .9 ROCE. The valuation now runs as follows: Book value. 2006 Per share value (on 1.0 242.0% 1.4 4.1/4235.380 million shares) This is the same valuation as before.1 = 4.0% 1.1 = 462. Accrual Accounting and Valuation: Pricing Book Values 115 .210 92. 2007 = 388 + 74.05 4. 2007 = 462.35) = $74.011.110 PV of RE 74.9 8.9% 1.0% 5. the value of the equity is unchanged (following the same calculation as in b).0% 5.Growth in RE Growth in Book value Discount factor 1.1 Present value of CV: 2094/1.36 c.331 Value of the equity.464 5.9 5.1 After-tax effect on book value in 2006 = $114 × (1 – 0.1 Book value at the end of 2006 = 4.573.

the book value that yields residual earnings in 2008 equal to zero = 34. the amount of impairment = 380 – 342 = 38. p.2 – (0.17.) (b) The book value must be marked down to fair market value under FASB Statement No.10 x 342) = 0 A book value of 342 is thus “fair value.2 For a 10% required return. is 301 + 79 = 380 (the depreciated amount of the tangible assets plus the good will).2 x 10 = 342: RE2008 = 34. The book value at the end of 2007. it is expected to earn at the required return on book value: Residual earnings is projected to be zero. (Fair value in an acquisition always prices the acquisition to earn at the required rate of return. Impairment of Goodwill (a) As the asset is at fair value (the acquisition price) on the balance sheet. Forecasted earnings for 2008 on this book value (at the forecasted ROCE of 9%) is 380 x 0. 142.09 = 34. 116 Solutions Manual to accompany Financial Statement Analysis and Security Valuation . before the write down.” Accordingly.E5.

1 Forecasting from Traded Price-to-Book Ratios: Cisco Systems Inc.48. second. we might develop a full analysis to do this (as will be done in Chapters 7 – 15). the implied eps growth rates are reasonable.826/6. 2. As a P/B ratio is based of expected residual earnings. Price = $21 Forward P/E = $21/$0.Minicases M5.735 = $3.48 Introduction Part A of this case asks you to challenge the market price of $21 or. against their forecasts. Given that we have only two years of analysts’ forecasts.835 P/B = $21/3. Are the recommendations consistent with their target price and their forecasts for the stock? The Questions Part A: 1. alternatively stated. first against their target price and. to challenge the current P/B ratio of 5. Part B of the case is a check on analysts’ recommendations. Ask whether. Reverse engineering gives us the handle: What are the forecasts implicit in the market price.60 Book value per share = $25. Implied Residual Earnings Growth Rates Required equity return = 12% Accrual Accounting and Valuation: Pricing Book Values 117 . Calculate the implied residual earnings growth rate after 2006 that is implicit in the market price. but for now we are asked to challenge the price with the limited forecasts. and are these reasonable? This is done in three steps: 1. we do not have the complete set of forecasts to challenge the $21 price.835 = 5. Of course.89 = 23. The assembly of the building blocks of the valuation – to separate the speculative part of the valuation—also provides insights. given our knowledge of Cisco and its operations. Translate the residual earnings growth rate into an eps growth rate 3. this comes down to asking whether the P/B ratio is justified on the basis of residual earnings forecasts.

420 ______ 21.89 0.745 0.12 0. Notice that we have anchored on the book value and the two years of analysts’ forecasts in order to challenge the speculation in the market price.835 The present value (PV) of the continuing value (CV) is the plug between $21 and the other two components of the valuation: PV of CV = $21.00 4.4530 × g p. we can impute the implied residual earnings growth rate after 2006: CV = 1. this looks a bit high. The market is forecasting a growth rate for residual earnings of 9. We would have to revise our analysis (to anchor solely on the book value) if we were not confident in the integrity of the analysts’ forecasts.2544 0.4530 1. this is the continuing value that the market forecasts.2544 = $20.3838 0.42 × 1.42 The continuing value (at the end of 2006) is the future value of this number: CV = $16.With a required return on the equity of 12%. the market attributes $16. From this continuing value.42 of the $21 price to value to be delivered after 2006.745 = $16.00 – 3.745 16.0959.000 2006 1. the pro forma for a price of $21 is as follows: 2004 Eps Dps Bps Residual earnings (RE) Discount factor PV of RE Total PV to 2006 PV of CV CV Value of Equity 2005 0.597 3.597 So g = 1.597 Given the analysts’ forecasts for 2005 and 2006 are reasonable. 2.835 – 0.12 − g = 20 . that is.3611 20.00 5.02 0. 118 Solutions Manual to accompany Financial Statement Analysis and Security Valuation . Implied Eps growth rates 0.4298 1. Keeping in mind the average GDP growth rate of 4% as a benchmark.59% per year indefinitely.725 0.

61% 2007 0.12% 2009 0. but an analyst who is familiar with the company might well conclude that these rates are too high.593 15. or too low.77% 2010 0.725 0.12) + REt The following pro forma gives forecasts RE (growing at 9.653 11.430 4. so convert the growth rate to eps growth rates using the formula to reverse engineer residual earnings: Earningst = (Bt-1 × 0.740 1.899 1.It’s difficult to think in terms of residual earnings growth rates.306 1.185 16. She might conclude: I just cannot see Cisco maintaining such high growth rates for such a long period of time.57% 3.596 9. we do not know enough about Cisco to make the evaluation here. The following plot will help her: Plotting the market’s implied Eps growth rates: Accrual Accounting and Valuation: Pricing Book Values 119 .745 1.544 8.02 14.18% 2008 0. too high.841 15.496 6.59% after 2006) and converts the RE forecasts to eps forecasts in order to derive eps growth rates: 2005 RE Bps Eps Eps growth rate 0.376 16. Evaluate Implied Growth Rates Are these growth rates reasonable? Well.89 2006 0.453 5.930 1.

If the analyst forecasts growth rates below the path implied by the market.75 Block 3: Value in speculation about growth 13. To be confident in her assessment.0% 17.0% 14.0% 2006 14.0% 13.12 $3.4530 0. she would model the eps path. The building blocks are: 1.0% 16. 21.0% 19.0% 11.41 p.4298 + 0.12 0. 120 Solutions Manual to accompany Financial Statement Analysis and Security Valuation . using the full financial statement analysis and pro forma analysis that we will move on to in Chapters 7-15.12% 15.84 3. she would say that Cisco was overpriced at $21.0% 18. The path separates the BUY and SELL regions.0% 10.61% 16. The speculative component is that which involves the more uncertain forecasts for the longer term.7 in the text. she would say that Cisco was underpriced at $21. Block 1: Book value 2.77% 15.0% 12.20.00 1 1. and then compare her path to that implied by the market. Identifying the speculative component of the market price: the Building Blocks Refer to Figure 5. Block 2: Value from two years of forecasts: Value in Block 2 = 3.0% 15.57% BUY SELL 2007 2008 2009 2010 If the analyst forecasts growth rates above the path implied by the market.18% 16.

75 $3.41 $7. A sensitivity analysis for a 10% cost of capital follows: Accrual Accounting and Valuation: Pricing Book Values 121 . Note: We have proceeded with a CAPM required return of 12%. that are pertinent to the value. We do this by asking if our assessment will change if the required return is different.The building blocks for Cisco: Value Per Share $21. what do others know that is not factored into my forecasts? What is the market speculating about to give Cisco such a high Block 3 value? Is the firm on a takeover list? (Unlikely for Cisco) Does it have new strategic plans? Is it ripe for breakup? (Unlikely for Cisco) Having posed these questions. the analyst asks whether this speculation is justified. other than immediate eps growth. Maybe the market is pricing events beyond the forecast horizon or other factors. so we must be sensitive to this.00 Current Market Value $13.84 Book Value (1) Book Value (2) Value from short-term forecasts Value from long-term forecasts (3) A considerable portion of the market price involves speculation about growth in the long term (Block 3). The analyst (and the student) asks: what is the market anticipating that I do not anticipate. the analyst furthers his research to check on the answers before being confident in his BUY/HOLD/SELL recommendation. CAPM technology is quite imprecise. At this point.59 $3.

a target price of $23. is the recommendation consistent with analysts’ forecasts? To start.4525 19. Their forecast for growth in residual earnings for 2006 (from the pro forma above) is Growth rate for RE2006 = 0.913 16. of course. A 7. hold or sell Cisco). So.02% growth rate is lower. Second. work with analysts’ 2006 forecast. as before.054 (a 5.02% growth rate (and also a building block diagram).665 3. Proceed from here.745 0.725 0.4298 = 1.10 0.10 − g = 19 .2004 Eps Dps Bps Residual earnings (RE) Discount factor PV of RE Total PV to 2006 PV of CV CV Value of Equity 0.21 0. is the recommendation consistent with the target price? If one bought Cisco at $21 at the beginning of 2005 and accepted 12% as the required return.4%growth rate). p.000 CV = 1. You can now prepare a similar plot to that above with this 7.52 at the end of 2005 would yield the required (normal) return: $21 × 1.4605 2006 1. but still high relative to the GDP growth rate. 122 Solutions Manual to accompany Financial Statement Analysis and Security Valuation . Is the recommendation consistent with their analysis? First.0702.12 = $23.5065 1.00 4.835 0.252 ______ 21. which would make a $24 target price a solid BUY). or a 7.89 0.5475 (Using a 10% required return) 1. Part B: This part of the case conducts two tests to challenge the integrity analysts’ recommendation (to buy. analysts may have a lower required return.665 So g = 1.00 5. Analysts were indeed recommending a BUY at the time (on average).02% growth rate. a target price of $24 would be a (marginal) buy.5475 × g 2005 0.52 (there are no dividends).02 0. (Of course.4530/0.

there is no avoiding developing our own. not values. The recommendation is inconsistent with analysts’ forecast. Analysts see a growth rate for eps of 14. But the plot above puts a growth rate of 14. but may anticipate that the market price will (irrationally) increase: the price will move away from fundamentals. recommend a BUY. Note that. If we do not trust analysts’ forecasts. the stock price had dropped to $19. First. and are basing their recommendation on this. by the end of Cisco’s 2005 fiscal year.5% after 2006 and. analysts may indeed see the lower growth in the future. Second. there are claims that mispricing is led by analysts (poor) forecasting. as in the bubble. analysts may see higher growth after their 5-year forecast horizon (2010). on the basis of that forecast. One further point should be noted.5% in the SELL region: the implicit market forecast is greater than this. they are predicting prices. In making a call on the target price. There are two provisos to these conclusions.This is considerably below the market’s implied growth rate of 9. Now work with analysts’ 5-year growth rate.59% for subsequent years. Accrual Accounting and Valuation: Pricing Book Values 123 . There is a possibility that the market is pricing based on analysts consensus forecasts and both a wrong! Indeed. Chapters 7-19 of the book are designed to do this.

98 2. then g = 1.682 2005 2.980 8.09 1.97% growth rate) p. emphasizing that the P/B is determined by how the accounting for net assets is carried out.784 1. The pro forma to calculate the growth in RE is as follows: PepsiCo 2003 Earnings Dividends (payout = 42. How do we challenge the market price? The first question leads to the second: Rather than challenging a price.812 7. The Questions A. Part C of the case embellishes student’s understanding of the P/B ratio.310 0. The core tool is the implied earnings growth plot. How do we understand the forecasts that are implicit in the market price? 2.M5. reverse engineer the residual earnings calculation to get forecasted eps. The case uses residual earnings methods.812 1 1.812 × g + + 2 1.09 1.80. a companion case (Minicase M6. reverse engineer the RE valuation model to get the implied growth rate in residual earnings.682 1.09 2 1.0497 (a 4. Set up the case with two questions: 1.2 in Chapter 6) applies abnormal earnings growth methods.74% 1.09 − g Setting V E 0 = $49.6.98 + 2004 6. This plots the market’s implied earnings growth path and separates BUY and Sell regions for the analyst who disagrees with the market’s forecast.086 9.31 1.560 1. First. 124 Solutions Manual to accompany Financial Statement Analysis and Security Valuation . we challenge a forecast. Second. like that displayed for Nike in Figure 5.4%) Book value Residual earnings (9%) Growth rate in RE Reverse engineer the RE model: E V2003 = 6. The implied earnings forecasts are calculated in two steps.2 Analysts’ Forecasts and Valuation: PepsiCo and Coca Cola Introduction Parts A and B of this case ask students to reverse engineer the traded prices for PepsiCo and Coca-Cola and then ask whether the implied earnings forecasts are different from those that analysts are making.

471 2005 2. The following pro forma gives the conversion for years.97%) Book value Bt-1 × 0. for 2005.056 7.09) + 1.09 1.0492 (a 4.492 1 + + 2 1.282 13.902. 2006-2008.181 3.92% growth rate) Now.77 + E 0 2004 5.783 1.812 × 1.77 1.471 1. then g = 1.492 1. For example.389 15.804 1.4%) Book value 9.180 11.760 1.783. eps = (9.09 Eps Dps (payout = 42. 2005 RE (growing at 4.127 1.277 1.09 1.09 − g Setting V = $40.092 1.43% 1. RE for 2006 = 1.881 2.784 0.902 = 2.09) + REt So.105 ← 2006 1.096 Coca Cola 2003 Earnings Dividends (payout = 50.387 1. RE forecasts are then reversed engineered to deliver earnings forecasts: Earningst = (Book valuet-1 × 0. again.With this growth rate. Accrual Accounting and Valuation: Pricing Book Values 125 . reverse engineer the residual earnings formula: Earningst = (Book valuet-1 × 0.492 × g 1.100 1.0497 = 1.022 1.784 × 0.3%) Book value Residual earnings (9%) Growth rate in RE Reverse engineer the RE model: E V2003 = 5. the RE for 2006 onwards can be forecasted.000 6.09) + REt The following pro forma gives the conversion for years.70.902 2007 1. 2006-2008.025 3.990 1.997 2008 2.

3%) Book value 7.71 2006 2.83 2005 2.446 7.146 2008 1.99 2004 2. like that in Figure 5.326 11.230 10.47 2008 3.44 2008 2.140 8.31 2005 2.022 8.59 2007 2.446 1.2005 RE (growing at 4.10 5.783 8.267 1.636 7.930 2007 1.95 2007 3.53 2006 2.6 for Nike.913 2.56 10.642 0.456 ← B.702 2. From the pro forma in part a. 126 Solutions Manual to accompany Financial Statement Analysis and Security Valuation .636 1.267 7.92%) Book value Bt-1 × 0.09 Eps Dps (payout = 50.565 0.804 2.77 These growth rates can be depicted in a plot.277 8. This plot separates BUY and SELL regions: Implied EPS Growth: PepsiCo p.803 2006 1.723 0. EPS growth rates for each year are: PepsiCo EPS Growth rates (%) Coke Cola EPS Growth rates (%) 2004 1.

50% Accrual Accounting and Valuation: Pricing Book Values 127 .BUY SELL 11.00% 1 10.

The analyst (and the student) asks: what is the market anticipating that I do not anticipate. 8.83% growth rate for 2005. consistent with their 10. analysts were forecasting a five-year eps growth rate of 11%. what do others know that is not factored into my forecasts? Is the firm on a takeover list? (Unlikely for Coke or Pepsi. analysts were forecasting a growth rate of 8%. that are pertinent to the value. There is a proviso to these conclusions: Maybe the market is pricing events beyond the forecast horizon or other factors. If the analysts’ forecasts are to be believed. The market is seeing lower eps growth than that forecasted by analysts. The alternative interpretation is that analysts are too optimistic in their forecasts. 128 Solutions Manual to accompany Financial Statement Analysis and Security Valuation 7.) Having posed these questions.) Does it have new strategic plans? Is it ripe for breakup? (Unlikely for Coke or Pepsi. the analyst furthers his research to check on the answers before being confident in his BUY/HOLD/SELL recommendation. For Coca-Cola.Implied EPS Growth: Coke BUY SELL 8. The eps growth rate implied by the market price is lower than that forecasted by analysts. This is in line with the implied forecasts by the market. Indeed. the market price is too low: A BUY is indicated.50% .00% p. other than immediate eps growth. sell-side analysts are notorious for being too high with their 5-year eps growth rates.50% For PepsiCo.

but the brand asset is missing from the denominator. Indeed. They get you asking the right questions before reaching a conclusion. Accrual Accounting and Valuation: Pricing Book Values 129 . C.70/$5. you can use the models to convert a forecast to a valuation. value lies in their brands – Coke. one expects these firms to have high P/B ratios.05. They enable you to convert a price to a forecast which you can then compare to your own forecast. more broadly.98 = 33. PepsiCo’s P/B is $49. a way of developing tools for challenging the market price. Firms have high P/B ratios if accountant leave value off the balance sheet. one expects these firms to have high ROCE (and residual earnings): Earnings from the brands are in the numerator. the scheme enables you to challenge your own forecasts with the forecast in the market price. Correspondingly.A basic point to be made from the case (and indeed the material in the Chapter): Valuation models are not formulas into which you plug in numbers and magically an intrinsic value pops out. valuations models tell you how to think about the problem (of appropriate pricing) and to bring tools to resolving the problem.77 = 7.5%.31/$6. Brand assets are not booked to the balance sheet. But the models are. For these two firms.77 = 34.99/$5. Frito-Lay.1% and Coke’s is $1.13 and Coke’s is $40. The high P/B ratios. Pepsi. Broadly. PepsiCo’s forecasted ROCE for 2004 is $2. Yes.80/$6. So.98 = 7. and so on.

they only receive the book value of their interests when the withdraw from the partnership. the (Case 2) valuation of Goldman is: 2. the partners have an real incentive to go to market.10) ROCE 1999E 4.26 0. remember the maxim: price is what you pay.80 + + 1.48 22.91 26.79 2.06 V1998 = 17. 130 Solutions Manual to accompany Financial Statement Analysis and Security Valuation .69 0.10 /1.4% 17. There is an additional wrinkle here: With the $70 offer price at nearly 4 times book value. And it leads to a discussion of whether share transactions in acquisitions can add value for shareholders. The pro forma is simple: 1998A Eps Dps Bps RE(0. start with a Case 2 valuation. emphasizes the limitations of short-term forecasts.80 With a forecast for a limited period.3% 2000E 4.06 19. value is what you get.3 The Goldman Sachs IPO Introduction This case introduces residual earnings valuation that evaluates price-to-book ratios. and compares pro forma valuation with multiple analysis. for without a floatation.91 2.M5. And be particularly careful when the seller is an insider.48 25.10 0. A.01 2.10 p. as in this IPO. As an introduction. It also shows how we separate “what we know” from speculation when valuing shares. With this pro forma and a forecast that the 2000E residual earnings is a good estimate of residual earnings after 2000.

17 This value is considerably lower than the market price of $70. The market price of $70 has an implied growth rate that can be tested: 70 =17. We know the book value and may feel relatively secure in our short-term forecasts (for 1999 and 2000).21 1. while the analysis demonstrates the limitation on having only short-term forecasts. So a complete analysis would involve acquisition strategy. But this valuation assumes no growth in residual earnings after 2000E. The analysts have not given enough information to complete this valuation. Corzine and Paulson saw growth coming from acquisitions. but the long term is more speculative.2% for Goldman? Remember growth in RE come from two factors: • • increase in ROCE increase in net assets earning at the ROCE Much of the apparatus in Part Two of the book bears on the analysis of ROCE and growth in net assets.10 1. it serves to illustrate the maxim on fundamental analysis: Distinguish what you know from speculation and put weight on what you know. Were cheap Accrual Accounting and Valuation: Pricing Book Values 131 .062 (a 6. Who were potential acquirees? An insurance firm (as in the Citicorp Travelers merger)? A larger asset management business? Chase? The analysis would also involve costs of acquisitions. The “g” here identifies the part of the valuation that is more speculative.21 g = 1. Can we come up with scenarios that justify a growth rate of 6.10 − g / 1.2% growth rate) Note that.91 2.80 + 2.06 × g + + 1.= $39. B.06 2. bringing focus to this issue of RE growth.

while more earnings were delivered in 1999 and 2000 than forecasted.48 2001 4.93 from getting 48 cents in dividends for 4 years. C. This is an annualized return of 5. using shares in an acquisition gives up the same value as the cash equivalent.48 2000 6. 132 Solutions Manual to accompany Financial Statement Analysis and Security Valuation . however.53 0. At the end of fiscal 2003. less than the 10% required return of 10% specified (and close to the 30-year bond rate in 1999). Postscript: This case was written in October 1999.48 2002 4. With later numbers. it might use the shares to buy another firm cheaply.69 0. if it found itself in a position of having its shares overvalued in the market. But if the prices of comparison firms were too high—as some maintained—then the Goldman partners may indeed have been taking advantage of a mispricing. The cum-dividend price at 2003 was $93.48 One can see that. GS traded at $91. Which brings us to the question C. Goldman might face borrowing constraints to raise the cash. the question arises whether the $70 price was justified. and its effects can be incorporated into this analysis. Adding the terminal value of $2. If Merrill and Morgan Stanley were “appropriately priced” the use of multiples is a reasonable way of getting a valuation.27 0. with any adjustments for differences between the firms.acquisitions available? Were synergistic merges a possibility? Or would Goldman have to pay a fair price and earn a normal return (a zero RE) on the acquisition? Do shares give a firm currency? Not if those shares are fairly priced in the market. Remember the issue of Ponsi schemes in multiples (in Chapter 3)? There is further discussion on the Chapter 3 web page.33 0.93. Did the partners deliver on the growth rates implicit in the $70 price? Here are the actual results for subsequent years: Eps Dps 1999 5.8%. earnings (and residual earnings) subsequently declined. p. Goldman’s strategy might be more apparent when you read this case later. And.

92 16.4 38.30 Accrual Accounting and Valuation: Pricing Book Values 133 .4.20 $3.1% 23.32) 6.48 23 . Strategy and Valuation: Weyerhaeuser Company This case can be combined with the Weyerhaeuser Minicase M2.74 6.48 1.79 0.12) ROCE 1998A 1.65 A pro forma that forecasts 1999 residual earnings is as follows: 1997A Eps Dps Bps RE (0.30 23. 1998 1.4% 1999E 3. 1998 (dividend-adjusted) To answer the questions.40 0.60 22. It also motivates students to dig for further information. The case introduces the analysis of strategies and highlights the problems one often has in translating statements about strategy into forecasts and a valuation.3 in Chapter 2 to compare asset-based valuation with pro forma analysis.M5.65 1. 1999 $1.009 million shares) ROCE.30 22. develop a pro forma based on the plans and their forecasted outcomes: Effect on 1999 eps: Eps.486 million shares) Bps. 1998 Effect of increasing harvest Effect of cost cutting Effect of price increases Effect of capacity utilization Eps.48 0.74 (1. Some preliminary calculations Bps.72 0.60 24. 1997 (on 199.85 0.2 P/B ratio. 1998 (at price of $55) P/E ratio.4% 2. 1998 (on 199.

g 2 ∴ =1 91 g . B.74 + 2 1. we have to be able to forecast a growth of 9.1%.12 = 30. The plans and their forecasted affects yield an ROCE for 1999 of 16. But this valuation is incomplete because there may be growth in RE (and there may be a decline.0 5 ( or a g w ro th rate o 9 5 ) f . This translates into a growth rate in eps of 9%-10% if the $1. The question introduces operating leverage: with fixed cost more of each additional dollar of revenue goes to the bottom line. C. What growth is the market forecasting at $55? 0 . If the cost of capital were 8%.92 55 =2 . 134 Solutions Manual to accompany Financial Statement Analysis and Security Valuation . in RE). just short of the goal of 17%. Then the value per share would be: V1998 = 22. Suppose the forecasted residual earnings for 1999 are to continue indefinitely. the value would be $45.62 per share. to pay $55.1 . negative growth. D.74 + 0.60 dps is maintained. There are a number of concerns: p. Valuing the firm from the forecast.1 % So.Answering the Questions A.92 0.41 This value is well below the market price of $55.15% in RE.

(ii) Getting a handle on the long-term growth is clearly the key here. longterm ROCE for the cycle? (ii) The excess capacity gives us a red flag. Is the firm planning to cut timber for Will Weyerhaeuser resist the temptation to overinvest at the top of the short-term gain at the expense of the long-term? Is the anticipated cutting in excess of accretion through tree growth? Are the timberlands more valuable uncut? E. Accrual Accounting and Valuation: Pricing Book Values 135 . Growth in investment (book value) must be considered. A forecast (or objective) for ROCE is not enough. for growth in revenues is the primary driver of growth in RE. Shouldn’t the valuation be based on the average. The student does not have the tools to develop growth forecasts at this stage. over the prior three years. Weyerhaeuser’s revenues had been flat or declining. Is this to change? The professor could explore the growth issue as an introduction to Part Two . A key element is the growth in revenues. (iii) next cycle? (iv) The increased harvest is a concern. These are at the heart of the analysis in Part Two of the book. There are two issues on which we want further information.(i) The forecasted ROCE for 1999 is high by historical standards and is for anticipated upswing in the cycle. Will some of this capacity have to be written off in a restructuring or more accelerated depreciation in the future? These actions will lower ROCE. (i) Is the ROCE forecasted for 1999 sustainable? The issues raised in part (d) are relevant to this question.

Should timberlands not be cut because the return they produce from cutting is valued less than their value uncut? The student might look at how Weyerhaeuser has performed since 1999.Another question: Is Weyerhaeuser worth more than its going concern value? Look back at the asset-based valuation in case M3.4 in Chapter 3. 136 Solutions Manual to accompany Financial Statement Analysis and Security Valuation . Was the $55 price (that rose to $70 by mid 1999) justified ex post? p.

(Blank page) Accrual Accounting and Valuation: Pricing Book Values 137 .

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