1. Class Business Upcoming Case Clip Proforma Assignment

2. Quality of Earnings: Areas of Accounting Choices Allowance for bad debts Non-securing items Reserves management Stock options Revenue recognition Off-balance sheet assets and liabilities

3. Price Earnings Ratios P/E Ratios are a function of two factors – Required Rates of Return (k) or risk – Expected growth in Dividends Uses – Relative valuation – Extensive Use in industry

4. PE Ratios Define P/E ratio at time t as What does PE ratio tell us?

5. PE Ratios The higher the PVGO, the higher the PE ratio holding all else constant.

6. PE Ratios and Risk If prices are equal to intrinsic value, and earnings growth is constant: The lower the risk (k), the higher the PE ratio holding all else constant

7. PE Ratios and Trading Do we always prefer stocks with high P/E ratios? No – PE ratios tell us something about – Relative expected growth in earnings – Relative risk If markets are efficient, (prices are equal to intrinsic value) then the effects of growth and risk should already be in the stock price. The objective as an analyst is to find stocks with high growth where growth is not already in the price.

8. PE Ratios P/E Effect: The Evidence – Stocks with low price-earnings ratio (value stocks) tend to outperform stocks with high price-earnings ratio (growth stocks). – High PE stocks may be “overpriced” – Holding growth constant, low PE implies high risk (high discount rate) Low PE stocks could just be risker from a CAPM point of view

9. PE Ratios The “normal” PE ratio reported in financial press Not a forecast of future earnings Subject to manipulation by accountants

10. Average PE Ratios (1950 - 2004)

11. Dividend Discount Models: General Model V D k o t t t      ()1 1 V 0 = Value of Stock D t = Dividend k = required return

12. Constant Growth Model g = constant perpetual growth rate

13. Estimating Inputs Dividend Growth Rate ( g ) – g = ROE*b – g = growth rate in dividends – ROE = Return on Equity for the firm – b = plowback or retention percentage rate b = (1- dividend payout percentage rate) Required Rate of Return ( k ) – Use CAPM

14. Shifting Growth Rate Model g 1 = first growth rate g 2 = second growth rate T = number of periods of growth at g 1

15. Problems with Dividend Discount Model Firm does not pay dividends – Valued at zero?? Firm engages in other uses of residual earnings – Stock buybacks – Impact on value Look at cash flows before dividends – Free-cash flows cash flows that the company has available to certain claim holders even if the cash flows are not directly transferred

16. Free Cash Flows Free Cash Flows to the Firm (FCFF) – Cash flows available to debtholders, equity holders (common and preferred) Free Cash Flows to Equity Holders – Cash flows available to equity holders (common and preferred)

17. Free Cash Flows to Firm and Valuation Definition: FCFF = EBIT(1-tax rate) – (Capital Expenditures – Depreciation) – (Change in working capital) Valuation Steps: – Construct forecasts of FCFF – Obtain discount rate for cash flows (WACC) – Construct Value of Firm – Subtract off Market value of Debt

18. Free Cash Flows to Equity and Valuation Definition: FCFE = Net income – (Capital Expenditures – Depreciation) – (Change in working capital) + (New Debt issued – Debt repayments) Valuation Steps: – Construct forecasts of FCFE – Obtain discount rate for cash flows ( k ) - CAPM – Construct Equity Value of Firm