Copyright © 2007 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Valuation: Earnings-Based Approaches Slides Prepared by Karen Foust Tulane University

Valuing the Firm Economic theory tells us: n Expected Future Payoffs t (1 + Discount Rate) t V 0 = ∑ t=1 Expected future payoffs can be measured in terms of: Dividends Cash flows Earnings

Valuing the Firm

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

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

Residual Income May know from managerial accounting –Evaluation technique for managers –Responsibility accounting Simply put, residual income is the excess earnings over required (or normal) earnings Sometimes called “abnormal earnings”

Residual Income Valuation Clean surplus accounting –Net income includes all income items –Dividends include all direct capital transactions between the firm and the shareholders Use finite horizon with continuing value computation

Continuing Value Analyst should forecast over a finite horizon, until think that firm will achieve “steady-state” growth pattern. Apply growth rate to Net Income (NOT to residual income!) Then apply perpetuity-with-growth factor AND present value factor

Risk-Adjusted Expected Rates of Return Risk-adjusted expected rate of return on equity capital used as discount rate to compute present value of expected future payoffs Can use Capital Asset Pricing Model (CAPM) Have to adjust if capital structure changes

Capital Asset Pricing Model E[R Ej ] = E[R F ] + ß j × {E[R M ] – E[R F ]} Where: E denotes expectation R Ej = return on common equity in firm j R F = risk-free rate of return ß j = market beta for firm j R M = return on market as a whole

Capital Asset Pricing Model E[R Ej ] = E[R F ] + ß j × {E[R M ] – E[R F ]} R F can use yield on short- or intermediate- term US government securities for risk-free rate {E[R M ] – E[R F ]} known as “market risk premium”

Four Steps 1.Forecast expected net income for each period 2.Forecast expected book value of common shareholders’ equity at beginning of each period 3.Compute expected future required income 4.Subtract future required income from expected net income

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

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

Potential Causes of Error 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