Valuation: Earnings –Based Approach Chapter 13 Valuation: Earnings –Based Approach

Role of Earnings Primary measure of firm performance under accrual accounting system and hence, provide a basis for valuation. Has a direct impact on the capital markets and the pricing of shares. Used for internal capital allocation. Used for aligning the incentives of managers with shareholders. Chapter: 13

Rationale For Earnings - Based Valuation Economic theory: Expected Future Payoffs - Approaches: Dividends Wealth distribution (or liquidation) Expected future free cash flows Free cash flow realization Earnings Residual income valuation (or wealth creation) Chapter: 13

Valuation Approaches Chapter: 13

Earnings-Based Valuation Value Relevance of Earnings. Residual Income Valuation in Theory. Residual Income Valuation in Practice. Sensitivity Analysis. Potential Causes of Valuation Errors. Chapter: 13

Advantages and Concerns Earnings align more closely to the capital markets and company management’s focus. Residual Income valuation requires fewer steps than free cash flows valuation. Concerns Earnings are not as reliable or as meaningful as cash or dividends. Chapter: 13

Advantages and Concerns (Contd.) Accrual accounting earnings reflect accounting methods and not underlying economic values. Chapter: 13

Value Relevance of Earnings Most widely followed measure of firm performance. Only accounting number firms must report on a per-share basis. Share prices react quickly to earnings announcements. Accruals and deferrals in earnings figure. Measures wealth created for shareholders by the firm. Chapter: 13

Residual Income Valuation Basis is dividends-based valuation model. Assumes Clean surplus accounting: Net income includes all income items Dividends include all direct capital transactions between the firm and the shareholders Use finite horizon residual income model with continuing value computation. Chapter: 13

Residual Income Valuation Model Basic Model Continuing Value Chapter: 13

Residual Income Is the excess earnings over required (or normal) earnings i.e., “abnormal earnings”. Normal earnings of the firm = RE × BVt-1 RE = Required rate of return BVt-1 = Book value at the beginning of the year Measures the amount of wealth creation (or destruction) by firm for common equity shareholders. Chapter: 13

Residual Income Calculation Steps Forecast expected future net income for each period. Forecast expected book value of common shareholders’ equity at the beginning of each period. Compute expected future required income. Subtract future required income from expected net income. Chapter: 13

Discount Rate Risk-adjusted expected rate of return on equity capital. Computed based on Capital Asset Pricing Model (CAPM). Adjusted for capital structure changes. Chapter: 13

Capital Asset Pricing Model E[REj] = E[RF] + ßj × {E[RM] – E[RF]} Where: E denotes expectation REj = return on common equity in firm j RF = risk-free rate of return ßj = market beta for firm j RM = return on market as a whole RF can use yield on short- or intermediate-term US government securities for risk-free rate {E[RM] – E[RF]} known as “market risk premium” Chapter: 13

Continuing Value Analyst should forecast over a foreseeable finite horizon, until the firm achieves “steady-state” growth pattern. Apply growth rate to Net Income (NIT). Apply perpetuity-with-growth factor and present value factor to Residual Income (RIT+1). Discount continuing value to present value. Chapter: 13

Sensitivity Analysis Use to get a range of firm values. Value estimate will be inversely related to discount rate. Value estimate will be positively related to growth rate. Cannot compute continuing value if growth rate > discount rate. Chapter: 13

Implementation Issues “Dirty surplus” accounting Should analyst include other comprehensive income items? Common stock transactions Exercise of employee stock options Other equity claimants Minority interest shareholders Preferred shareholders Negative book value of common equity Chapter: 13

Internal Consistency Among Three Approaches Reasons why value estimates from the three valuation approaches may not agree Incomplete or inconsistent earnings and cash flow forecasts. Inconsistent estimates of weighted average costs of capital. Incorrect continuing value computations. Chapter: 13