Copyright © 2011 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 13 Valuation: Earnings-Based Approaches

Chapter: 132 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: 133 Rationale For Earnings - Based Valuation Economic theory: Expected Future Payoffs - Approaches: DividendsWealth distribution (or liquidation) Expected future free cash flows Free cash flow realization EarningsResidual income valuation (or wealth creation)

Chapter: 134 Valuation Approaches

Chapter: 135 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: 136 Advantages and Concerns Advantages 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: 137 Advantages and Concerns (Contd.) Accrual accounting earnings reflect accounting methods and not underlying economic values.

Chapter: 138 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: 139 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: 1310 Residual Income Valuation Model Basic Model Continuing Value

Chapter: 1311 Residual Income Is the excess earnings over required (or normal) earnings i.e., “abnormal earnings”. Normal earnings of the firm = R E × BV t-1 R E = Required rate of return BV t-1 = Book value at the beginning of the year Measures the amount of wealth creation (or destruction) by firm for common equity shareholders.

Chapter: 1312 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: 1313 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: 1314 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 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”

Chapter: 1315 Continuing Value Analyst should forecast over a foreseeable finite horizon, until the firm achieves “steady-state” growth pattern. Apply growth rate to Net Income (NI T ). Apply perpetuity-with-growth factor and present value factor to Residual Income (RI T+1). Discount continuing value to present value.

Chapter: 1316 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: 1317 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: 1318 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.