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TerminalValueTechniquesin

EquityValuation

Implications
- oftheSteadyStateAssumption


JoakimLevin

PerOlsson

SSE/EFIWorking
PaperSeriesiB
n usinessAdministration No2000:7
June
2000

Abstract:Thispaperexaminestheconditionsnecessaryforcalc ulatingsteadystateterminalvaluesin
equity(company)valuationmodels.Wemakeexplicituse ofthefactthatacompany’sincome
statementsandbalancesheetscanbme odeledasys
as temofdifferenceequations.Fromthesedifference
equations,wederiveconditionsforsteadystate.T heconditionsensurethatthecompanyremains
qualitativelysimilaryearbyyearafterthevaluation horizonandthatiht asastabledevelopmentof
earnings,freecashflows,dividendsandresidualin come.
Weshowhowsteadystateconditionviolation s
causeinternalinconsistenciesivnaluationmodelsan hdowthiscan
have substantial
a impactonthevalue
estimates.Steadystateisfurtheranecessarycond itionforafreecashflowvaluation,adividend
valuationandaresidualincomevaluationtoyieldide nticalresultswhenterminalvaluesareused. The
parametersotfhemodelarecommonaccountingandcon trolconcepts,andthederivedconditionshave
accounting meaning,linking stockvariablesitnhe
bal ancesheetwiththe
flowvariablesin(andrelatedt o)
the
income statement.
Keywords: equity
valuation,terminal
value,financial
statement analysis
JELcodes: G12,G31,M49


Thispaperhaspreviouslybeencirculatedunderthetitle HorizonValuesinCompanyValuation The
. helpful
commentsofPeterEaston,JenniferFrancis, Frøystein Gjesdal,PeterJennergren, Thore Johnsen,Kenth
Skogsvik,StefanYard,andtwoanonymousrefereesaswell asworkshopparticipantsatheEUROWorking
GrouponFinancialModelling,theNorwegianSchoolof Ec onomicsandBusinessAdministration,theOhioState
University,andtheStockholmSchooloE f conomicsare gratefullyacknowledged.Financialsupportfromthe
EconomicResearchInstitute andthe BankResearchInstitute Stockholm,
, Sweden,isgratefully
acknowledged.

Joakim
Levin( cjl@hhs.se),StockholmSchoolof
Economics, P.O.Box6501,SE-11383Stockholm

Corresponding
author
Per
–Olsson( polsson@bus.wisc.edu),University
oWisconsin-Madison,
f 975University
Avenue,Madison,Wisconsin53706
Introduction
1
Thispaperexploresseveralissuesassociatedwiththec alculationocfontinuingvalueformulasused
ashorizonvalues(orterminalvalues)incompanyand equityvaluationmodels. Ourprimaryfocusios n
clarifyingthesteadystateassumptionthatunderliet heuseosfuchhorizonvalues,andtheconditions
necessary tm
o ake thisassumption operational.
Thede rivedconditionshaveintuitiveaccountingmeaning
andareshowntoguaranteeinternalconsistencyinv aluationmodels.Theconditionsfurthermore
guaranteethatpopularequityvaluationmodelsderivedfr omthePVEDprinciple(presentvalueof
expecteddividends),suchastheResidualIncomemodel, theFreeCashFlowmodelandtheDividend
Discountmodel,yieldidenticalresultsalsowhenusin ghorizonvalues. Thesemodelsaretheoretically
equivalent,andyetlarge-samplecomparisonsotfheva luationmodels(PenmanandSougiannis[1998]
andFrancis,OlssonandOswald[2000])showthatthemo delsyieldvastlydifferentresults,evenwhen
theyarebasedonthesamesetofproformafinancial statementsandallassumptionsareidentical. We
show howthisanomaly can
bceausedbsyteady
state
co nditionviolations.
Inequityvaluationmodelsbasedonforecastedfinanci alstatementdata(see,e.g.,Palepu,Bernard
andHealy[1996]orCopeland,KollerandMurrin[1994]),one commonlyforecastsfinancialstatements
forafinitenumberoyears
f –theexplicitforecastperi od.
Foreachyearavaluationattribute(e.g.,free
cashfloworresidualincome)iscalculatedfromthe financialstatementforecasts. Thehorizonvalue
refersttohepresentvalue
(atthe
horizon)ofthe
v aluationattributeafterthe
explicitforecastperiod.
Generally,thisvaluation
approach
can
bfeormulated
as:

å (1 + k )
H
VAs PV HVA
(1) Vt = +
s = t +1
s −t
(1 + k )H −t
where: Vt istheestimatedvalue(of
paarticularvaluationconcept) atthevaluationdate t
H isthehorizon(thelastyearof
theexplicitforecastperi od)
VA isthevaluationattribute

PVHVA isthehorizonvalue

k isthediscountrate

Depending otnhe
valuationattribute,formula(1)may
nee correction
ad tyoield
the
equity
value.
So,
forexample,willnetdebtandpreferredstockbededucte dintheFreeCashFlowmodel,whereasbook
valueostockholders’
f equitywill
be
added itnhe
Res idual
Income model.
Wewillconsiderfourcommonlyusedvaluationattributes earnings,
: freecashflows,dividendsand
residualincome.
Freecashflows,dividendsandres idualincomecanbdeirectlyusedinvaluationmodels
thatareformallyequivalenttotheprinciplethatequi tyvalueequalsthepresentvalueofallfuture
expected dividends.
Earningsare often
used
ilnesse laborate valuationmodels,sometimeswithadditional
assumptions(e.g.,anassumeddividend payoutratio).
AsBrealeyandMyers[1991,p.64]suggest,therationalefo ur singahorizonvalueispragmatic:
“Ofcourse,the[...]businesswillcontinueafterthe horizon,butit’snotpracticaltoforecastfreecash
flowyearbyyeartoinfinity.”
Themostcommonmet hodofcalculatinghorizonvaluesistousea
continuingvalue formula:
VAH +1
(2) PV HVA =
k−g

1
where: PVHVA istherelevanthorizonvalue

VA isthevaluationattribute
k isthediscountrate
g isthegrowthrate
( g < k)

Tocalculate(1),oneneedsaforecastof VAH +1this


; isoftenachievedbylettingthevaluation
attribute
atime
t Hgrow by gthe
, growth
rate:
(1 + g )VAH
(3) PV HVA =
k−g
Whenusinganexpressionsuchas(2)or(3)tocalculateh orizonvalues,iitsassumedthatthe
1
valuation
attribute
growsacatonstantrate
and
that the
discountrate
remainsconstant.
Thefactthatthehorizonvalueios ftencalculatedus ingaverysimpleformuladoesnotindicatethat
itisunimportant.
On the
contrary,Copeland,Koller, and
Murrin
[1994,p.275]reporttypicalvaluesfor
someindustries: foracompanyinthetobaccoindustry thehorizonvalueaccountsfor56%ofthetotal
companyvalue,inthesportinggoodsindustryiis t81%, forthetypicalskincarebusinessthefigureis
100%andforahightechcompany125%(thefiguresarecalc ulatedusingahorizoneightyearsintothe
2
future forthe
Free
Cash Flowmodel).
Thevaluationattributederivedfromthefinancialsta tementsforyear Hiscommonlyusedas
numeratorinthecontinuingvalue(asinexpression(3)), sometimeswithsomeadjustmentsto‘normalize’
thevaluationattributetoalevelthatisdeemedsusta inableinthepost-horizonperiod,possiblywith
growth.Thelevelotfheoreticaljustificationfor thisvaries,butageneralthemeisareferencetoth e
steadystateconceptinwhichthecompanyremainsqual itativelysimilaryearby earafterthehorizon.
KaplanandRuback[1995,p.1064],e.g.,placearestrictionon the‘terminalcapitalcashflow’(their
valuationattributeathe
t horizon)bysettingdepreciat ionandamortizationequaltocapitalexpenditures,
notingthatdepreciationandamortizationcannotexce edcapitalexpendituresinsteadystate.Thelatter
restrictionvisualizes,butdoesnotmakeexplicit,that thereiaslinkbetweentheperceivedreasonability
ofthevaluationattributeatthehorizonandtheunder lyingfundamentalsasexpressedinforecasted
financialstatements.
Adjustmentsmade(ornotmade)tothevaluationattri buteusedinthecontinuingvaluecalculation
canhavealargeimpactontheentirevaluation,soi is
timportant howtheseadjustmentsaremade.One
cancomeupwithintuitiverestrictions,forexamplethe above-mentionedconditionthatdepreciationand
amortizationnotexceedcapitalexpendituresinsteadys tate;
however,suchintuitiverestrictionsmaybe
ad-hocandincomplete. Ourobjectiveinthisstudyis tosuggestamoresystematicapproach,making
explicituse
oproperties
f othe
f accountingsystem.In particularwe notethatthe
timeseriesoforecasted
f
financialstatementscanbseeenaassystemofdiff erenceequations. Seeninthatlightthesteadysta te
conceptcan bme adeoperational by
mathematical analysi s,whereall
conditionsnecessary forsteady
state
willbederivedaisnitialvalueconditionsonthesy stemofdifferenceequations. Whilethealgebrafor
showingthismayattimesbetedious,theresultturns outtobeeasytoimplementand,wethink,
intuitivelyappealing.
Theintuition iasfsollows:
Whenfirm
a entersint soteady stateitsqualitative
behaviorisexpectedto
remainthesameyearafteryear. Qualitativebehavio cr anbemadeoperationalbydecomposingiitnto
common accounting and
control
concepts,such
apsrofit margin,salesgrowth,productivityratiosrelating
salestcoapital,etc.
The constancy othese
f parame tersovertime inecessary
as conditionforsteady state

2
toprevail;
itisnot,however,sufficient.
Oneals ohastoconsidertheinteractionotfheseparameter s,
notingthattheirvaluescannotbe
setindependently. Furthermore,parametervaluesmustbesetsuchthat
stockrelatestoflowinareasonablemannerinthe forecastedfinancialstatements. Allinall,these
interdependenciesquickly become complicated,and
ourmo delingcanbseeen
away
as odealing
f withthe
complexity. Ouranalysisshowsthe relationsamong
par ametersandtheassociationswithstockvariables
thatmusthold forsteady
state.
Steadystateconditionsmatterinatechnicalsense becausetheyensurethatallimplicitassumptions
behindcontinuingvaluesarefulfilled. Morefundamenta lly,steadystateconditionsensurethatthe
forecastedperformanceistable. Ifsteadystateco nditionsareviolated,thequalitativebehaviorotfh e
companywillchangeafterthevaluationhorizon,and willkeepchangingovertime. Suchchanges
contradictthe
premise forusing valuation
a horizon– namelythatthecompanyiesxpectedtobsetableat
thehorizon,andhencegeneratestableearnings,cas hflows,etc.
Aswdeemonstrate,evenminorintern al
inconsistenciescanhaveasubstantialimpactonthef inalvalueestimateoacfompany.
Thesteadystate
conditionscan also
buesefulintheprocessodetermi
f ningawhich
t pointintimethehorizonitselfshould
be
set.
Themainresultisoanormative
f nature:allflows (incomestatementandrelatedvariables)inthe
firstyearafterthehorizonshouldbedecidedsuchth atcorrespondingstocks(balancesheetvariables)
growattherevenuegrowthrate. Thisruleensuresth atthecompanyremainsqualitativelysimilar
throughoutthepost-horizonperiod. Thisias lsoanec essaryconditionforterminalvaluecalculationsin
the
Free CashFlow model,the
Dividend Discountmode and
l theResidualIncomemodeltoyieldidentical
results.
Thatthese theoreticallyequivalentvaluatio m
n odelscanyielddifferentresultseven
when they are
basedonthesamesetofforecastedfinancialstatem entsandallassumptionsareidenticalisasourceof
confusionbothintheliteratureandintheclassroom. Weshowhowsteadystateconditionviolationscan
be
the
cause osuch
f differences.
Ouranalysisprovidesamethodologythatisquitegene ralandcanbeappliedtoanyvaluation
frameworkthatinvolvesforecastsofuturebalancesh eetandincomestatementdata.Wedonotclaim
thatallcompanyvaluationmodels mustincludesteadystatehorizonvalues.
Wedoclaim,h owever,that
thevastmajorityofvaluationtextsandapplicationsi ncludethistypeohf orizonvaluesandthatiits
thereforeofgreatpracticalimportancetohavethes teadystateissuethoroughlyinvestigatedand
implementation routinesforsteady
state
developed.
Therestofthepaperios rganizedafsollows.
Inth neextsection,wedescribeourmethodologyand
selectedmodelingchoicesanddefinethesteadysta teconceptsassociatedwitheachotfhefourvaluation
attributesweconsider. Section3derivestheconditi onsnecessarytoachievesteadystateforeach
attributeandfortheentirebalancesheet. Section 4arguestheempiricalimportanceoftheresults,
exemplifiesbyacasestudyanddiscussessomerelatedl argesamplefindings. Section5explainsthe
transitionfromtheexplicitforecastperiodtosteady stateandfurtherimplementationissues. Section6
summarizesand concludes.

Terminology
2 andDefinitions
We
setup
valuation
a model
forthe
(steady
state)peri od,wherethecompany'squalitativebehavioris
expectedtoremainthesameyearafteryear.Wedefi nethecompany’sbalancesheetandincome
statementasfollows:

3
Assets Debtand
Equity

NetWorking
Capital Debt

NetProperty,Plantand
Equipment Deferred
Taxes

=GrossPPE–Accumulated
Depr. Equity

Revenues

-Operating
Expenses

-Depreciation
Expense

-Interestexpense

-Taxes

Earnings

Wefurtherdefinethefollowingparameters.Manyof themareratios,andthetermratioanalysisis
3
sometimesused
also
tdoescribethiskind
ovaluation
f :
a networking
capital
as%ofrevenues(sales)
b grossPPEas%ofrevenues(sales)
c increase
idneferred
taxesa%
sofgrossPPE
d depreciation
expense
a%
sofpreceding
year’sgrossPPE
g nominal
growth
rate,revenues(sales)
i interestrate
odnebt
4
k discountrate
p operating
expensesa%
sofrevenues(sales)
r retirementsa%
sofpreceding
year’sgrossPPE
τ taxrate
w debtas%ofbalance
sheettotal
(book
value)

The
following
state-variablesare
also
defined:
Rt revenues(sales)in
year t,

4
At accumulated
depreciation
athe
t end
oyear
f t,
Tt deferred
taxesathe
t end
oyear
f t.

We
can
now
expressthe
balance
sheetand
income
statem entasfunctionsothe
f state
variables:

Assets
NetWorking
Capital aRt

NetProperty,Plantand
Equipment
=GrossPPE–Accumulated
Depr. bRt − At
where At = At −1 + (d − r )bRt −1

Debtand
Equity
Debt w( aRt + bRt − At )

Deferred
Taxes Tt −1 + cbRt

Equity (1 − w)(aRt + bRt − At ) − Tt

Revenues Rt

-Operating
Expenses − pRt

-Depreciation
Expense − dbRt −1

-InterestExpense 5
− iw( aRt −1 + bRt −1 − At −1 )

-Taxes 6 − τ (Rt − pRt − dbRt −1 − iw(aRt −1 + bRt −1 − At −1 ))

Earnings (1 − τ )(Rt − pRt − dbRt −1 − iw(aRt −1 + bRt −1 − At −1 ))

Somemodelingchoicesarestraightforward,suchas definingoperatingexpenseasapercentageof
revenues. Othersaremoredebatable–inparticula trhedeterminationofPPE-relateditems,including
depreciationandretirements,isnotself-evident. Themethodologyinthispaperlendsitselftoany
specification,buttoexemplifywheavechosenasp ecificationintendedtoresembletheverbalexposit ion
inCopeland,KollerandMurrin[1990,1994]. This hastheadvantageodirectly
f couplingouranalytic al
resultstvaluation
ao book
wellknownamong practi tioners,studentsandacademics.
Ouruseoasfingleparametertodeterminenetwork ingcapitalimpliesthatallworkingcapitalitems
can
bdeefined afraction
as ofrevenuesand,therefore,thatthey isnteadysta tecanbaeggregatedinto net
workingcapital,governedbythesameparameter. G rossPPEisalsodeterminedasapercentageof
revenues.Itisthusassumedthatitakesastabl eamountofworkingcapitalandphysicalassetsto
generateeachdollarosfales.
Accumulateddepreci ationisthepriorperiod’saccumulateddepreciatio n
plusthe
currentperiod’sdepreciation expense minu tshebook valueoassets
f retiredinthecurrentp eriod.

5
Bookvalueodebt
f isdefinedapercentage
as oth
f bealancesheetthroughtheparameter w,implyingthat
7
thecompanytriestomaintainaconstantdebt-value ratioinbookvalueterms. Atargetleverageisa
commonassumptioninvaluationtexts. Empirically, FamaandFrench[1997]alsoshowthatthereias
slowmeanreversionto(firm-specific)targetlever age.
Hence,itseemsreasonabletomodelleverage as
constantinthesteadystateperiod.
Webeginbym odelingthisassumptioninbook-valueterms,andla ter
derivetheadditionalconditionsforitoholdin marketvalueterms.Deferredtaxesaremodeledas a
8
separatedebtitem. Book value
oequity
f itsheresidual
itemofthe balancesheet.
Tofurtherlinktheincomestatementwiththebalan cesheetovertime,weassumethecleansurplus
relationholds. Thismeansthatthechangeinbook valueoef quityequalsearningsminusdividends,
where dividendsaredefinednetofcapitalcontribu tions/withdrawals. Asmentionedabove,bookvalue of
equityitsheresidualitemofthebalancesheet. Throughthecleansurplusrelationdividendsarede fined
to
btehe
residual item
ofthe
entire equationssys tem,withany excesscapital distributedtoequity owners.
Forsimplicity,thebookvalueodebtf isassumedt oequalitsmarketvalue.
Itshouldalsobneoted that
therearenoexcessmarketablesecurities; wedefi nedebtasnet
a financialitem.Cashneededtosu pport
operationsiisncluded inetworkingcapital,howe ver.

The
following
valuation
attributescan
now
be
deriv ed:
Earnings,X t :
(4) (1 − τ )(Rt − pRt − dbRt −1 − iw(aRt −1 + bRt −1 − At −1 ))
Freecashflow,FCF t :9
(1 − τ )(Rt − pRt − dbRt −1 ) + dbRt −1 + (Tt − Tt −1 )
(5)
− (aRt − aRt −1 ) − (bRt − bRt −1 + rbRt −1 )
Dividends,DIV t :
(1 − w)(aRt −1 + bRt −1 − At −1 ) − Tt −1
(6) + (1 − τ )(Rt − pRt − dbRt −1 − iw(aRt −1 + bRt −1 − At −1 ))
− ((1 − w)(aRt + bRt − At ) − Tt )
Residualincome,RI t : 10
(1 − τ )(Rt − pRt − dbRt −1 − iw(aRt −1 + bRt −1 − At −1 ))
(7)
− k E ((1 − w)(aRt −1 + bRt −1 − At −1 ) − Tt −1 )

We
distinguish
among
the
following
typesosteady
f state:
Parametricsteadystate (PSS)meansthattheparametersdescribingthecom pany’sdevelopmentare
constant,e.g.,
caonstantrevenue growth,caonsta ntprofitmargin,etc.PSSitsheweakestform
ofs teady
state,because
nroestrictionsare
placed
otnhepa rametersotherthan thatthey remain
constant.
Earningssteadystate (ESS)meansthatthecompany’spredictedearnings willgrowataconstant
rate.
Moreprecisely,earningsinanyyear t+1aredescribedby X t +1 = (1 + g ) X twhere
, gisthe
constantrevenue
growthrate.
Freecashflowsteadystate (FSS)meansthatthecompany’spredictedfreecash flowwillgrowata
constantrate g: FCFt +1 = (1 + g ) FCF.t

6
Dividendsteadystate (DSS)meansthatthecompany’spredicteddividends willgrowataconstant
rate g: DIVt +1 = (1 + g ) DIV.t
Residualincomesteadystate (RSS)meansthatthecompany’spredictedresidual incomewillgrow
at
caonstantrate g: RI t +1 = (1 + g ) RI .t
Balancesheetsteadystate (BSS),finally,meansthatallitemsonthecompan y’sbalancesheetwill
grow
at
caonstantrate g.
Toobtainsteadystateinthevaluationattributes (ESS,FSS,DSS,RSS),itisnot,mathematically
speaking,anecessaryconditionthatthecompanyis inparametricsteadystate. Thedevelopmentofth e
underlyingparametersmaybsehiftingovertimebut inanoffsettingwaysothatthevaluationattribu te
stillgrowsaactonstantrate.
Wehaveneverseen suchamodelproposedneitherintextbooksnorin the
researchliterature,however,soww e illabstractf romthatpossibilityandtreatparametricsteadyst ateas
naecessary condition.
Theintuitiveinterpretatio nosteady
f stateacompany
as thatremainsqualita tively
similaryearby yearlendssupport,wethink,toth ischoice.
Thenatureotfhegrowthratealsodeservesfurther comment. Usingacontinuingvalueimpliesan
infinitetimeseriesafterthehorizon.
Henceimt ustreallybtehesamegrowthrateindifferentvar iables
andattributes,andthisgrowthratemustbethere venuegrowthrate. If,e.g.,earningsweretohave a
highergrowthratethanrevenues,thenearningswou ldafterafewyearsexceedrevenues. Whilethis
soundslikeafantasticbusiness,itishardlyreal istic.
Reversed,ifearningsgrowslowerthanreve nues,
thenprofitabilitywillapproachzero–alsonota realisticsteadystatescenarioforagoingconcern since
,
anyrationalownerwouldterminateoperationsandt akethefundselsewhere. Asimilarlogicappliest o
11
the
otherattributesaws ell.

Steady
3 StateDevelopment

Introduction
3.1
Thecompanyisexpectedtohavereachedapointin timewheretheparametersgoverningthe
company’sbalancesheetsandincomestatementsare constant,i.e.theparametershavereachedtheir
steadystatevaluesandthecompanyiisnparametri csteadystate(PSS).
Inthissection,weattempt to
investigateunderwhichconditionsontheinputpar ametersPSSwillimplysteadystatealsoforthe
valuationattributes(ESS,DSS,FSS,RSS).
In
Section
2three
, state
variableswere
defined
fo rming
the
following
system
ofdifference
equations:
(8) Rt = (1 + g )Rt −1 (revenuesiynear t)
(9) At = At −1 + (d − r )bRt −1 (accumulated
depreciation
athe
t end
oyear
f t)
(10) Tt = Tt −1 + cbRt (deferred
taxesathe
t end
oyear
f t)
Bysolvingthesystem,analyticalexpressionsfort hestatevariablescanbeobtained; fromthese,
expressionsforthevaluation attributeswill
bede rived.
The solution ttohesystem
ofdifferenceeq uations
is(see
Appendix1fordetails):
Rt = (1 + g ) R0
t
(11)

(1 + g )t − 1 (
(12) At = A0 + d − r )bR0
g

7
é (1 + g )t +1 − 1 ù
(13) Tt = T0 + ê − 1úcbR0
ëê g ûú
R0 , A0and T0aretheinitialvaluesofrevenues,accumulatedde preciationanddeferredtaxes,
respectively.
Theseinitialvaluesforthepost-ho rizonperiodaregivenbytheforecastsofcomplete
financial
statementsmade forthe
explicitforecast period. 12

Steady
3.2 stateinvaluationattributes

Earningssteadystate(ESS)
Earnings, X t are
, givenbyexpression(4).
Rearrangingandsub stitutingexpressions(11)and(12)
into
(4)yields:
X t = (1 + g ) R0 (m − z X ) − χ (γ R0 − A0 ) for t≥1
t
(14)
withthefollowing
constants:

æ æ öö
(1 − τ )çç db + iwçç a + b − d − r b ÷÷ ÷÷
è è g øø (d − r ) b
m = (1 − τ )(1 − p,) zX = , χ = (1 − τ )iw , γ =
1+ g g

Expression(14)saysthatforESStohold,earnings mustgrowby The


g. existenceotfhesecond
term
in
(14)impliesthatearningswill
notgrow
at the
constantrate gunlessthe
second
termiszero:
(15) χ (γ R0 − A0 ) = 0
Orin
termsothe
f original
parameters:
æ ö
(1 − τ )iwçç d − r b R0 − A0 ÷÷ = 0
è g ø
(15a)

Twopossibilitiesforcondition(15a)toholdarer uledoutbyassumption: i=0(zerointerestrate)and


τ=1(100%taxrate).
Thisleavestwopossiblecondi tions,oneowhich
f mustholdforearningstogrow at
the
rate (i)
g:
all-equity financing( w=0); or(ii) gA0 = (d − r )bRThe 0 . left-handside
ocondition
f (ii)is
thegrowthinaccumulateddepreciationinthefirst yearofthesteadystate.Theright-handsideis
depreciationexpenseminusretirementsinthefirst yearofthesteadystateperiod. Intuitively,thi s
conditionestablishestherequiredlinkbetweenacc umulateddepreciation(thestockvariable)and
depreciation-retirements(theflowsthataffecttha st tockvariable).Weexplainandelaborateonthe se
interpretationsathe
t end
othis
f section.

Freecash
flowsteadystate(FSS)
By
substituting
expressions(8),(10)and
(11)into (5),the
following
expression
iosbtained:

8
FCFt = (1 + g ) R0 (m − z FCF ) for t≥1
t
(16)
withthefollowing
constants:
−τdb − (1 + g )cb + ga + (g + r )b
m = (1 − τ )(1 − p,) z FCF =
1+ g

Expression(16)tellsutshatfree
cash
flow
steady state
iasnimmediateconsequenceothe
f constancy
oftheinputparameters;nofurtherparameterrest rictionsarerequired.
Comparedtoearnings,free cash
13
flow isthusconsiderablylessrestricted.

Dividend
steadystate(DSS)
Rearranging
expression
(6),
andsubstituting
expre ssions(10
12)
- yields:
DIVt = (1 + g ) R0 (m − z DIV ) − χ (γ R0 − A0 ) for t≥1
t
(17)
withthefollowing
constants:

m = (1 − τ )(1 − p ) , χ = (1 − τ )iw , γ =
(d − r)
b
g

æ d −r ö æ d −r ö
− τdb − (1 + g )cb + ga + (g + r )b − gwçç a + b − b ÷÷ + (1 − τ )iwçç a + b − b ÷÷
z DIV = è g ø è g ø
1+ g

Thedividendsexpression(17)issimilartotheear ningsexpression(14).
Thisinsotsurprising,sin ce
dividendsaredefinedthroughthecleansurplusrel ation.
Although zdiffersfordividendsvs.earnings,
thatdifferenceiisrrelevantforpurposesoestab
f lishingsteadystate;
fordividendsteadystateto holdthe
same conditionsafsorearningssteadystateapply.

Residual
incomesteadystate(RSS)
Substituting
expressions(11
13)
- into
expression (7)yieldsthe
expression
forresidual
income:
RI t = (1 + g ) R0 (m − z RI ) − (χ + ϑ )(γR0 − A0 ) − k E (κR 0 − T0 ) for t≥1
t
(18)
withthefollowing
constants:

m = (1 − τ )(1 − p ) , κ=
(1 + g )cb , γ =
(d − r ) b , χ = (1 − τ )iw , ϑ = (1 − w)k E
g g

æ æ öö æ æ ö ö
(1 − τ )çç db + iwçç a + b − d − r b ÷÷ ÷÷ + k E çç (1 − w)çç a + b − d − r b ÷÷ − (1 + g )cb ÷÷
è è g øø è è g ø g ø
z RI =
1+ g

Forresidual
income
tgorow
at
caonstantrate
(RSS ),the
following
condition
mustbe
fulfilled:
(19a) (χ + ϑ )(γR0 − A0 ) − k E (κR0 − T0 ) = 0
Orusing
the
original
parameters:

9
((1 − τ )iw + (1 − w)k E )æçç d − r bR0 − A0 ö÷÷ − k E æçç 1 + g cbR0 − T0 ö÷÷ =
è g ø è g ø
(19b) ((1 − τ )iw + (1 − w)k E )((d − r )bR0 − gA0 ) − k E ((1 + g )cbR0 − gT0 ) =
((d − r )bR0 − gA0 ) − kE
((1 + g )cbR0 − gT0 ) = 0
((1 − τ )iw + (1 − w)k E )
We
can
now
more
easily
identify
case
a where
(19b)hol ds.
Asufficientcondition
is:
(19c) gA0 = (d − r )bR0 and gT0 = (1 + g )cbR0
Thefirstconditionin(19c)isthe‘depreciationl ink’seenforearnings(anddividend)steadystate. It
ensuresthatearningsgrowatcaonstantrate.The secondrestrictionconcernsdeferredtaxes,andca nbe
interpretedatsheadditionalconditionneededtog ettaxdeferralsandbookvalueoefquitytogrowa at
constantrate. 14

Summaryand
interpretations
We
can
now
summarize
the
steady
state
conditionsfo the
r differentvaluation
attributes:
Attribute Parameterrestriction

Free
cash
flow None

Earnings gA0 = (d − r )bR0 or w=0

Dividends gA0 = (d − r )bR0 or w=0

Residual
income
((d − r )bR0 − gA0 ) = kE
((1 + g )cbR0 − gT0 )
((1 − τ )iw + (1 − w)k E )
sufficient: gA0 = (d − r )bR0 and gT0 = (1 + g )cbR0

Assoonaisnputparametersareconstantfreecash flowgrowsaaconstant
t rate.
Withall-equity
financing,earningsanddividendsrequirenofurthe rsteadystateconditions.Forresidualincome,
however,all-equityfinancingins otsufficientfor steadystate. Mostcompanieshavesomedebt,sot he
moregeneral
case(valid
forall
financing policies isp) erhapsmoreinteresting:
(20a) gA0 = (d − r )bR0 forearningsanddividendssteadystate,
(21a) gT0 = (1 + g )cbR0 additionalconditionsufficientforresidualincomesteadystate.

A0(accumulated depreciation), R0(revenues)and T0(deferredtaxes)arealreadygiven(principally


bytheforecastsfrom the
explicitforecastperiod) We .conjecturethatonehassomebasisfordecidi ngon
thevalueothe
f growthrate,withalowersteadys tateboundbeingexpectedinflation.Furthermore, we
findireasonable
t thatonehasanideaaboutthea mountoffixedassetsnecessarytogenerateadolla or f
15
sales,providing value
a forthePPE-parameter In
be.xpression(20a)oneitshenleftwith (d − r )i.e.
,
thedepreciationandretirementsparameters; inex pression(21a)theparametergoverningdeferredtax es,
cremains.
, Viewedinthismanner,theconditionsc anbue sedtodetermineparameters(suchas or
r c)

10
whichmayotherwisebe lusive.Themainimportanc eotfheconditions,however,ismoreintuitive.
Expression(20a)establishesthesteadystatedepre ciationlinkbetweenthebalancesheetandtheinco me
statement.
Thisbecomesclearerafterraeformulat ion:
(d − r )bR0
(20b) g=
A0

Inserting
expression
(12)for t=1yields:
A1 − A0
(20c) g=
A0
Theright-handsidein(20c)itshegrowthratein accumulateddepreciationinyearThis 1. growth
ratemustbethesameatsherevenuegrowthrate How
g. thiscanbeachievedisgivenbyexpression
(20a)or(20b):
one
can
vary the
forecastofdepre ciationexpense iynear1(= dbR0and/or
) ofretirements
inyear1(= rbR0Operationally
). thiscanbedonebyvaryinganyo tfheparametersinvolved. This
exemplifiesageneralfeature: Theleft-handside in(20a)standsforthegrowthinthestockvariabl ein
thefirstpost-horizonyear,i.e.,the
growthianc cumulated depreciation. Theright-handsidedescri besthe
relatedflowvariables,depreciationexpense(= dbR0 a)ndretirements(= rbR0 i)nthefirstyearafterthe
horizon. Similarlyfor(21b),theleft-handsidei tshegrowthindeferredtaxes,thegrowthinthes tock
variable,andtheright-handsideitsherelatedfl owvariable. Inbothcases,theflowsmustbedeci ded
suchthattherelatedstocksgrowattherevenuegr owthrate.
Notethattheintuitionintermsoflo ws
beingdecidedtoyieldcertain
a growthrateforth setocksiqsuitegeneral.
Similarconditionswill appear
16
ifwe
usedifferentmodelspecifications.

Capital
3.3 structureissues
Inthepriorsectionswefocusedonthesteadystat econditionspertainingtothevaluationattribute
(thenumeratorinthecontinuingvalue). Thedisco untrate k(whichappearsinthedenominatoro(f2))
wasnotanalyzed,even thoughtheuseocafontinui ng
value formulaalso
assumesthatthediscountrat ies
constant.Inearnings-basedvaluationmodels,int heResidualIncomemodelandintheDividend
Discountmodeltherelevantdiscountrateisthe costoef quity which, canvarywithcapitalstructure
17
because of,e.g.,expectedcostsofinancial
f distr essand
agency costs. Costofequityalso
entersinto
the
weightedaveragecostofcapital( waccused
) intheFreeCashFlowmodel(whereinadditi ontheweights
forthe
differentcostsocapital
f aregiven btyhe capitalstructure).
Capitalstructureisusuallyviewedtobeinmarket valueterms.Inaccounting-basedvaluation
modelsweworkwithbookvalues,however,anditis thereforeofinteresttoexaminethedifference
betweencapitalstructureinbookvaluetermsandc apitalstructureinmarketvalueterms.
Here,wew ill
18
lookatthedifferencebetweenthebookvaluedebt ratioandthemarketvaluedebtratio. Any
differencesbetweenthetwowillbeattributableto differencesbetweenthebookassetvalueandthe
marketassetvalue,sincebookvalueodebt
f equals marketvaluebyassumption. Themarketvaluedebt
ratio
iananrbitrary
year in
t he
steady
state
period
will
thusbe:
Dt
(22a) ωt =
Assetst (at marketval ue)
Weneedanexpressionforthemarketvalueotfhea ssetside.
TheFreeCashFlowmodelprovides
thisdirectly.
Sinceouraimistoderiveconditio nsforaconstantmarketvaluecapitalstructure,i its
appropriate tuose
constant
a discountrate
itnhe derivation(in
thiscase wacc):

11
Dt w(aRt + bRt − At ) w(aRt + bRt − At )
ωt = = =
(22b)
Assetst FCFt +1 (1 + g )Rt (m − z FCF )
kWACC − g kWACC − g
Substituting
expressions(11)and
(12)for Rand
t Aand
t rearranging:

æ d −r ö æ ö
wçç a + b − b ÷÷ wçç A0 − bR0 ÷÷
d −r

ωt = è ø− è ø
g g
(22c)
(1 + g )(m − z FCF ) (1 + g ) R0 (m − z FCF )
t +1

kWACC − g kWACC − g
Thefirstofthetwotermsinexpression(22c)ist hesteady-statemarketvaluedebtratio.
Thesecon d
term
istime-dependentandgoestozeroonlyas becomes
t large.
Thuswneeed parameter
a restricti onto
ensurethatthemarketcapitalstructureicsonstan There
t. aretwopossibilities: (i)
all-equityf inancing
(w=0);or(ii) gA0 = (d − r )bRThese
0 . a re
exactly
t he
s ameconditions t hatwere derived
i t
n he
p revious
sectionforvaluationattributesthatincludefinan cing(i.e.,allattributesexcept FCF),sorequiringa
constantcapitalstructurewillonlyimposefurther conditionsontheFreeCashFlowmodel–thesame
conditionsaswealreadyhadforearningsanddivid ends.Notsurprisingly,thereisnoescapingthese
conditionswhichevermodelonechoosestoworkwith whereas
: FCFsteadystatemayrequirefewer
conditions,thoseconditionswillinsteadappearin thediscountrate,thedenominatorinthehorizon value
formula.

Balance
3.4 sheetsteadystate(BSS)
FromtheresultsinSections3.2and3.3,itisstr aightforwardtodeterminetheconditionsneededto
ensurethateachothe
f balancesheetitemsgrowsa catonstantrate.
Thismeansthatthebalanceshe etin
relative
termsremainsunchanged. Thiswould baen otherintuitive
steady
statedefinition.
Assets definition steadystatecondition
NetWorking
Capital aRt none

NetProperty,Plant
and
Equipment
= Gross PPE – bRt − At
gA0 = (d − r )bR0
Accum.
where
Depreciation At = At −1 + (d − r )bRt −1

Debtand
Equity definition steadystatecondition
Debt w( aRt + bRt − At ) gA0 = (d − r )bR0

Deferred
Taxes Tt −1 + cbRt gT0 = (1 + g )cbR0

Equity (1 − w)(aRt + bRt − At ) − Tt (d − r )bR0 − gA0 = (1 + g )cbR0 − gT

12
Iftheparametersareconstant,i.e.thecompanyis inparametricsteadystate,itimmediatelyfollows
that:
networkingcapitalwillgrowattheconstan rate
t gand
, grossproperty,plantandequipmentwill
grow by Ifcondition
g. (20a)holds(linking depreciation
s tock and
flow),then:
accumulateddepreciation
willgrow by net
gproperty,
; plantand equipmentwillgrowby debt
g; willgrowby Ifgalso
. condition
(21a)holds(linkingstockandflowoftaxdeferral s),then:
deferredtaxeswillgrowbygand
, book value
ofequity will
growby g.
TohaveBSStherearethustwonecessaryconditions : gA0 = (d − r )bR0and gT0 = (1 + g )cbR0 .
Thesetwoconditionshavebeendiscussedearlier,a ndonecanseethatthereisaguidingprincipleat
work:
whenestablishingavaluationhorizon,ones houldforecasttheflowssothatthecorresponding
stockvariablesgrowattherevenuegrowthrate. O necanalsousethisprincipleinreverse:
onesho uld
definethevaluationhorizonasthepointintimew henitisdeemedreasonablethattheflowsimplya
growthrateinthestockvariablesequaltotherev enuegrowthrate. Thisprincipleiqs uitegeneral, and
whilewehaveshowniw t ithratios(theparameters) here,itwouldbeapplicablealsotoothermodels,
where one
directly forecastsbalance sheetand
inco mestatementitemswithoutusing ratios.
TheBSSconceptisuseful becauseiensures
t thatt heentirecompanyremainssimilaryearafteryear,
thatonehasforecastedaninternallyconsistentsc enariothatwillprevail.Infact,wehavea general
steadystate wherethecompletesystemoffinancialstatementsi isnsteadystate:thevaluationattributes,
theincomestatement,andbalancesheetitems,asw ellasotherrelevantitems(likecapitalexpenditu res
and retirements)all
grow atthe
sameconstantrate .

Does
4 iall
t matter?
We willnowtry
tgoauge the
empiricalimportanceo steady
f stateviolationsthrough
valuation
a case
studyandthroughobservationsonempiricallarges amplestudies. Thecasestudy,whichisanormal
financialstatementanalysistype case,isthe
Swed ish
forestry company AssiDomänATheB. valuationi s
madeaosJfanuary11998.
, Explicitforecastsare madefortenyears,witheachincomestatementand
balancesheetitemforecastedyearby ear. Theti meafterthat(i.e.afteryear2008)isaccountedf or
through horizon
a value.
In
thispaperwe
concentr ate
otnhe
partofthevaluationthatconcernsthe issues
involved idnetermining thehorizon
value.
Fromyear2008andonwardsthecompanyiesxpected tohavethefollowingsteadystateparameter
values: a=15.1%, b=130.9%, c=0.26%, d=4.7%, g=4.0%, i=7.5%, kE=10.2%, p=81%, r=3.0%,
τ=28% and w=25%. Theforecastsmadefortheexplicitforecast periodgivetheinitialvaluesotfhe
statevariables: R0=43.5, A0=24.2 and T0=3.9(billionSEK). Wewillrefertothisasthe basecase .
Thebasecaseparametervaluesfulfillconditions( 20a)and(21a),sowheaveageneralsteadystate( all
balancesheetitemsgrowataconstantrateasdoa llvaluationattributes). Theequityvalueofthe
19
company whenenteringsteady
state
athe
t end
oye
f ar2008i4s3.8billion
SEK.
Nowconsidertheretirementsparameter, Assume
r. thatonedoes notusethesteadystatereasoning
andcondition(20a)todetermineit,butratherloo ksaht istoricalfiguresforthelastfewyears. I nthe
AssiDomäncasethehistoricalfigurei1s .7%(compa redtothesteadystatefigureo3f .0%).Historica l
figuresareoftensuggestedasproxiesforthelong -termsteadystatevalueodf ifferentparameters,b ut
setting r=1.7%meansthatthesteadystatecondition(20a)i sviolated.Isthisthenofeconomic
importanceinthevaluation? InAssiDomän(with r=1.7%),usingtheResidualIncomemodelwitha
perpetuityformulayieldsanequityvalueoSEK
f 44 .2billionathe
t horizon.
TheFreeCashFlowmode l
withaperpetuityyieldsanequityvalueo5f 5.9bi llionathehorizon,i.e.around25%higher. Sot he
violationofthesteadystateconditionisnotonly atheoreticalproblem. Ithasnon-trivialeconomi c
consequences,consequencesthataredifferentford ifferentvaluationmodels. Inthiscase,theviola tion

13
hasamuchlargerimpactontheFreeCashFlowmode tlhanontheResidualIncomemodel,andthe
Residual Income modelisthusmore
‘robust’to
this steady state
violation.
There are
two
reasonsfor this:
First,theResidualIncomemodelplaceslessrelian cethantheFreeCashFlowmodelontheterminal
value,soterminalvalueproblemscausedbysteady stateviolationswillhavelessimpactontheResid ual
Incomemodel.Second,accrualaccountingplacesco nstraintsonthebehaviorofresidualincome,
whereasfreecashflowsareunconstrainedbyanyre portingsystem. Amistakeinforecastingthe r
parameterwillimpactthecapitalexpenditureforec ast,andallocf apitalexpendituresaffecttheFCF
amountusedintheterminalvaluecalculationwhile onlyaportion(thedepreciation)willaffectthe
residual incomeamount.
Tofurtherillustrate the
effectsosteady
f state v iolationwcean look
aother
t performancevariables as
well.
Figure1hasreturnon(beginning-of-year)b ookequity,i.e.,ameasureoprofitability.
f Intu itively,
onewouldexpectprofitabilitytobceonstantinst eadystate.
Thisiisndeedthecasewhen r=3.0%(i.e.
whencondition (20a)isfulfilled).
Notsowhen r=1.7%,however: whensteadystateivsiolated,then the
performancechangesafterthehorizon. Andiisnt otonlyone-time
a change;
ratherchangebecomest he
predominantfeatureinthepost-horizonperiod. Th e1.7%casegivesaprofitabilitythatincreasesfr om
20
the
basecaselevelof14.6%and approaches34.0%.

Returnonbookequity
35.0%

30.0%

25.0%
r=3.0%
r=1.7%
20.0%

15.0%

10.0%
2008 2028 2048 2068 2088 2108
Year

Figure
Return
- 1 onbookequity
Returnonbookequity(ROE)isaparticularlygood indicatorforourpurposes. Intuitively,future
profitabilityiscentraltovaluation.
Morefundam entally,ROEincludesthe‘residuals’otfhemodele d
financialstatements: earnings(netincome)isthe endingitemintheincomestatementandbookvalue of
21
equityistheendingiteminthemodeledbalancesh eet.And thisisthekey:
ifthesystem(i.e.,the
modeledfinancialstatements)iisnsteadystate,t henthe‘residual’oefachfinancialstatementwill bein
steadystate,i.e.both
earningsand
book value
of equitywillhavetherevenuegrowthrate.Conseque ntly,
the
ratio
between earningsand
bookvaluewill
bec onstant.
Oneshouldalsonotethatitistheaccrualaccount ingconceptofreturnonbookequitythatservesas
acheckonsteadystate.
Undoingtheaccruals(e.g .,tocalculateFCF)ins othelpfulinthisrespect As.
wesaw in
section3.2free
cashflow can growata constantrate evenisteady
f stateivsiolated,and aswe
sawearlierinthissectiontheconsequencesoasf teadystateviolationarelikelytobm e uchmorese vere
forthe
FreeCash Flow model.

14
TheResidualIncomemodelandtheFreeCashFlowmo delareboththeoreticallyequivalenttothe
DividendDiscountmodel(givencleansurplus). Wit hthefiguresfromtheexampleabovewehavea
situationwhereformallyequivalentvaluationmodel shavetheexactsameinputdataandassumptions.
Butthe
violation
othe
f steady
state
condition,in troducing changing
a profitability,hasdifferentia impact
l
on
themodelscausing the
modelstyoield
different values,in
thiscase
difference
a o25%.
f
There isome
confusion itnhe
debate aboutthese
i ssues.
On
the
onehand
mostpapersand textbooks
agreethatthemodelsareformallyequivalent. On theotherhand,empiricalstudiesfindthatthemod els
yieldvastlydifferentvalueestimates(see,e.g., PenmanandSougiannis[1998]andFrancis,Olssonan d
22
Oswald[2000]). We claim thatoneothe
f mostimportantandgener allyunrecognizedreasonsforsuch
differencesistheuseopf erpetuityformulasfort hehorizonvaluewhensteadystaterequirementsare
violated.
ConsiderPenmanandSougiannis[1998].Theirsample isbasicallytheentirepopulationofirmson
Compustat. Furthermore,they use
realizationstpo roxy forforecastsodifferent
f accountingitems,w hich
meansthatthesampleisbydefinitioninternallyc onsistentinthesensethatallvaluationattribute sare
derivedfrom thesamesetof(realized)financials tatements. Yetthemodels(usingcontinuing-value type
horizonvalues)yieldcompletelydifferentresults. Usinganexplicitforecastperiodoffouryears, the
Residual Income model hasaanverage
overestimation of6%ofactualprice,whereastheFreeCashFlow
23
modelonaverageunderestimatespriceby76%. Since theunderlyingforecastsareidenticalfor the
valuationmodels(i.e.realizedfinancialstatement data)andthemodelsaretheoreticallyequivalent, the
mainreasonforthedifferencesisthebreakupoft heinfiniteforecasthorizonintoanexplicitforec ast
periodandahorizonvalue. Asshownearlier,the modelswillyieldidenticalvalueestimatesonlyif the
steadystateconditionsholdatthehorizon. This isobviouslynotthecaseinPenmanandSougiannis
[1998](norinFrancis,OlssonandOswald[2000]), sotheresultsinlargesampleempiricalstudies
indicatethatsteadystateviolationsareveryimpo rtant.
Asintheexcerptfromthecasestudyrepor ted
earlierin
thissection,itseemsthattheResidual Income model isfarmorerobustthan the
FreeCash Flow
modelto such violations.

The
5 Transition
tS
o teadyState
Wenowmovetothequestionof whensteadystateias chieved.TheanalysisinSection 3produced
expressionsforthevaluationattributesandparame terrestrictionsthatwerefunctionsothe
f initial values
ofthestatevariables, R 0, Aand
0 TThat
0. analysis wasapuresteady-stateanalysisa ndasuchwasde-
coupled from
onevery importantimplementation issu the
e:transitiontosteadystate.
Exactdetails about
howtheinitialvaluesorevenues,
f accumulateddeprec iationanddeferredtaxesshouldbsepecifiedwere
omitted. Intuitively,onewouldliketousetheva luesotfhesestatevariablesat Hasinitialvalues,i.e.
take thevaluesfromthefinancial statementsothf leastyearintheexplicitforecastperiodandset R0=R H,
A0=A and H T 0=T Unfortunately,
H. thelagsint hemodel
complicate the
issue
s omewhat. Tos ee
w hy,
consideraccumulateddepreciationaesxample. Accu mulateddepreciationinanyyearisdefinedasthe
precedingyear’saccumulateddepreciationplusthe currentperiod’sdepreciationexpenseminustheboo k
value oassets
f retired itnhecurrentperiod.
In termsoour
f model:
(23) At = At −1 + (d − r )bRt −1

where bRt −1 representsgrossPPEat t-1.


If t=0,thenweneedgrossPPEattime(-1)whichin
generalcannotbedeterminedas bR (−1)because
, inyear(-1),whichdoesnotbelongtoth ePSSperiod,
thevalueof b maydifferfrom itssteadystatevalue.
Similarpr oblemsapplyforincomestatementitems
like
depreciation
expenseand interestexpense –in fact,forallitemsthataremodeledusinglagged values

15
ofsomevariable.In
ourmodel
themaximum
lag
ios neyear,sotheproblem
canbaeddressedbydefinin g
thehorizon Hasfollows:
Explicitforecastsofullfinancialstatementsare madeuntilandincludingyear Hwhere
, year His
the
firstyearwithconstantparameters.
From the beginningoyear
f Handon,allparametersdefiningthe
developmentofthe company are
constant,i.e.the
c ompanyiispnarametricsteady
state (PSS).
yearH- 1 year
year
HH +1
H -2 H- 1 H H+1
| ⋅⋅⋅ |||| ⋅⋅⋅ →
valuation horizon ∞
date
←forecastperiod
explicit →← PSSperiod(perpetuityperiod) →
The
initial
valuesare
then
defined
as:
(24) R0 = (1 + g )R H −1 = R H

(25) A0 = AH −1 + (d − r )G H −1 = AH (where GH-1


isthe
forecasted
grossPPEatthe
end
oyear
f H-1)
(26) T0 = T H −1 + cbR 0 = T H
Next,considerthevaluationattributes.
Remember thattheyinturncontainlaggedvaluesotfhestat e
variables.
Asaconsequencethesteadystateexpre ssionsforthevaluationattributeswillonlybeva lid
fromtime H+1. Thisalsomeansthat VA H +1willgenerallynotequal (1 + g )VAHandjusttakingthe
valuationattributeathe
t horizon(year Hand
) insertingiinto
t ahorizonvalueformula(as inexpression
24
(3))can
lead
tsoevere
valuationerrors. Insummary,oneyearlagsinboththestatevaria blesandinthe
valuationattributesimplythatyear H+1itsheappropriatetimeformeasuringtheinputs tothehorizon
valueformula:
VAH +1
(2) PV HVA =
k−g
Thismeansthatthe
forecasting
model(offinancial statements)should includethefirsttwoyearswit h
constantparameters(years H and H+1). Financialstatementanalysistextbooksgeneral lyrecognizethat
valuationattributes arelaggedfunctionsotfheunderlyingforecastso financialstatements(see,e.g.,
Palepu,BernardandHealy [1996,Ch.6 ]However,
). the lagsinthestatevariables dependonthe
particularsoftheforecastingmodelandareseldom discussed,eventhoughitisverycommonin
accounting-based forecasting
tm
o odel
atleastsome ofthe
driving
variablestionclude
lag.
a
Itistime
tsoummarize the
steady
staterequiremen (i)
ts:
the
parametersshould bceonstantfrom tim e
H-1,(ii)theinitialvalueconditionsshouldbefulf illedatime
t Hand, (iii)thehorizonvaluecalculation
shouldbm e adeusingthevaluationattributeatimt e H+1. Fortunately,thisias lleasierdonethansaid :
Onenormallysetsupforecastsoafllnecessaryite msinaspreadsheet(incomestatement,balanceshee t,
perhaps FCFcalculations,etc.). Ifoneusesratioforecasts forthistask,thenthefirstthingtoremember
isthatthefirstyearwithconstantratios(parame ters)shouldbue sedays ear Hthe, horizon,wherealso
theinitialvalueconditionsmustbefulfilled. Th iscaneasilybdeonethrough,e.g.,thegoalseek function
inExcel: theforecastarofatiogoverninganin comestatementvariable(orotherflowitem)should be
madesuchthatthecorrespondingstockvariable(ty picallyinthebalancesheet)growsatherevenue
growthrate. Thesameprincipleappliesalsoiof n edoesnotuseratiosforforecasting: thenthedi rect

16
forecastsoincome
f statementitemsshould bm
e ade suchthatthecorrespondingbalancesheetitemsgro w
attherevenuegrowthrate.
Ifonedoesnotfindt hisareasonableassumption,thenoneshouldnotus ae
horizonvalueathat
t time,butrathercontinueto makeyear-by-yearforecastsuntilrealisticvalues fulfil
thesteadystate
conditions. Thus,thesteadystat ceonditionscanbuesefulindeterminingtheappro priate
horizon.Theotherthingtorememberitshatther atiosshouldbceonstantfortwoyears(oneyearpl us
themaximumlaginthevaluationmodel)beforeone usesavaluationattributeasnumeratorina
continuing valueformula.

Summary
6 andConcludingRemarks
Thispaperanalyzesthe time-seriesoforecasted
f i ncome statementsandbalance sheetsasystem
as of
differenceequations,andderivessteadystatecond itionsthatboundtheterminalvalueotfhefirm.T he
steadystateconditionsensurethatthecompany’sf orecastedperformanceistableafterthehorizon. The
basicassumptionbehindthesteadystateconceptis thattheexpecteddevelopmentotfhecompany,as
describedbytheparameters,holdsforever(ininfi nity).Internallyinconsistentparameterdetermina tions
mayresultinanunrealisticforecastofthecompan y’sperformanceafterthevaluationhorizon,which can
significantlyaffectthevalueestimatecalculated forthefirm.
Thesteadystateconditionscanthus serve
bothaacheck
s againstinconsistenciesbetweenpar ametervalues,andaatoolkit
s fordeterminingwhe re
the
horizon should bseet.
Animmediateaccountinginterpretationofthestead ystateconditionsisthattheyrelatestock
(balance sheet)to
flow(incomestatementandrelat ed).
The methodology useditnhispaperisgeneral and
can
accommodate anyforecasting
modelbasedopnroj ected
financialstatements. Thegeneralprinciple is
thatallflowitemsinthepost-horizonperiodshou ldbedecidedsothatthecorrespondingstockitems
grow attheconstantrevenuegrowthrate.
Thiswil yield
l general
a steadystate,whichinturnguara ntees
thatkeyvariableslikeprofitabilityremainconsta ntafterthevaluationhorizon. Thisias lsoanec essary
conditionfortheFreeCashFlowmodel,theDividen dDiscountmodelandtheResidualIncomemodelto
yieldidenticalresultswhen implementing themwith horizon values.

17
References
Brealey,R.andSMyers.
. 1991. PrinciplesoCorporate
f Finance (4thedition).
NewYork:McGraw-
Hill.
Copeland,T.,
T.Kollerand
JMurrin.
. 1990(1994) . Valuation:MeasuringandManagingtheValueof
st nd
Companies1, edition (2 edition).
New
York:
Wiley
&Sons.
Fama,E.andKFrench.
. 1997.
Earnings,Investment Dividends,
, andDebt.
Workingpaper.
University
ofChicago and
YaleUniversity.
Francis,J.,P.OlssonandDOswald.
. 2000.
Compar ingtheAccuracyandExplainabilityoD
f ividend,
FreeCashFlowandAbnormalEarningsEquityValueE stimates. JournaloA
f ccountingResearch
38/1,45-70.
Kaplan,S.,andR.Ruback.1995.
TheValuationof CashFlowForecasts:AnEmpiricalAnalysis.
JournalofFinance 50/4:1059-93.
Modigliani,Fa. ndM.Miller.
1958.
TheCostofC apital,CorporationFinanceandtheTheoryof
Investment. AmericanEconomicReview 48:
261-297.
Palepu,K.,VB
. ernardandP.Healy.1996. BusinessAnalysisandValuation:
UsingFinancial
Cincinatti,Ohio:
Statements. South-Western
College
Publishi ng.
Penman,S.1997.ASynthesisoE
f quityValuationTe chniquesandtheTerminalValueCalculationfor
the
Dividend DiscountModel.Working paper.Univers ity
oCalifornia
f aBerkeley.
t
Penman,S.andTSougiannis.
. 1998.
AComparisono Dividend,
f CashFlow,andEarningsApproaches
to
Equity Valuation. ContemporaryAccountingResearch 15:343-383.
Zhang,X.-J.1998.ConservativeAccountingandEqu ityValuation.Workingpaper.Universityof
CaliforniaaBerkeley.
t

18
Appendix
Derivations
1-

Solutiontosystemofdifferenceequations
ìRt = (1 + g ) Rt −1
í
î At = (d − r )bRt −1 + At −1

In
matrixnotation: x t = Ax t −1

æR ö æ 1+ g 0ö
÷÷
where: x t = çç tand A = çç ÷÷
è At ø è (d − r )b 1 ø
The
rootsothe
f characteristicequation
are λ1 = 1 + gand λ 2 = 1 . Aisdiagonalizedby P:

æ 1 0ö
P = çç ( d − r )b ÷
1 ÷÷
ç
è g ø
æ1 + g 0ö
P −1 AP = çç ÷
è 0 1 ÷ø

Substituting x t = Puand
t x t +1 = Pu t +1yieldsthesystem u t +1 = P −1 APuthe
t, solution
owhich
f
is:
æ c (1 + g ) t ö
u t = çç 1 ÷
÷
è c2 ø
Substituting
back
yieldsthe
solution
ttohe
original
sy stem:

æ 0 öæ æ ö
ö ç ÷
x t = Pu t =çç (d − r )b ÷ç c1 (1 + g )
c1 (1 + g ) t
÷=ç ( d − r )b
1
c1 (1 + g ) + c 2 ÷÷
t

ç 1 ÷÷ç ÷
è øè ø ç
t

è ø
g c2
g

and
since
the
initial
valuesare R 0and A0the
, complete
solution
is:

ìRt
ï
= (1 + g ) t R0
í (1 + g ) t − 1
ï At = ( d − r )bR0 + A0
î g

In
the
same
way,the
solution
for Tisdt erived.

Derivationoearnings
f expression
equation
- (14)
Theearningsexpression(14)ios btainedbyrearranginge quation(4)andthensubstituting(11)and
(12)for Rand
t ANote
t-1. thattheexpressionios nlydefinedfor t≥1(sinceicontains
t t-1valuesosftate
variablesthatare
definedwithinitial
valuesatim
t zeero).

X t = (1 − τ )[Rt + pRt − dbRt −1 − iw (aRt −1 + bRt −1 − At −1 )]

19
= (1 − τ )(1 − p )Rt − (1 − τ )(db + iw(a + b ))Rt −1 + (1 − τ )iwAt −1

é (1 − τ )(db + iw(a + b)) ù + (1 − τ )iwæç A + (d − r )b (R − R )ö÷


= Rt ê(1 − τ )(1 − p ) − ú ç 0 0 ÷
ë û è ø
t −1
1+ g g

é
ê (1 − τ )(db + iw(a + b )) − (1 − τ )iw (d − r )b ùú
æ (d − r )b R ö÷
= Rt ê(1 − τ )(1 − p ) − ú + (1 − τ )iwç A0 −
ç 0÷
g
ê 1+ g ú è ø
ê ú
g
ë û

é æ æ öö ù
ê (1 − τ )çç db + iwçç a + b − (d − r )b ÷÷ ÷÷ ú
ê è è g øø ú æ (d − r )b ö
= (1 + g ) R0 ê(1 − τ )(1 − p ) − ú − (1 − τ )iwçç R0 − A0 ÷÷
t

ê 1+ g ú è g ø
ê ú
ë û

Thisyieldsequation
(14)for t≥1:
X t = (1 + g ) R0 (m − z X ) − χ (γ R0 − A0 )
t
(14)
withthefollowing
constants:

æ æ öö
(1 − τ )çç db + iwçç a + b − d − r b ÷÷ ÷÷
è è g øø
m = (1 − τ )(1 − p ) , zX =
1+ g

χ = (1 − τ )iw , γ=
(d − r ) b
g

Derivationofree
f cashflowexpression
equation
- (16)
Thederivation
icsarried
outby
rearranging
expression (5)andmakingsubsequentuseoexpressions
f
(8)and
(10):
FCFt = (1 − τ )(Rt − pRt − dbRt −1 ) + dbRt −1 + (Tt − Tt −1 ) − (aRt − aRt −1 ) − (bRt − bRt −1 + rbRt −1 )

= Rt [(1 − τ )(1 − p ) − a − b ] + Rt −1[a + (1 − r )b + τdb] + Tt − Tt −1

é (1 + g )(a + b ) − a − (1 − r )b − τdb ù + cbR


= Rt ê(1 − τ )(1 − p ) − ú
ë 1+ g û
t

é − τdb − (1 + g )cb + ga + (g + r )b ù
= Rt ê(1 − τ )(1 − p ) − ú
ë 1+ g û

By
using
expression
(11),we
obtain
expression
(16)for t≥1:
FCFt = (1 + g ) R0 (m − z FCF )
t
(16)
withthefollowing
constants:
−τdb − (1 + g )cb + ga + (g + r )b
m = (1 − τ )(1 − p ) , z FCF =
1+ g

20
Derivationodividend
f expression
equation
- (17)
Thedividendexpression(17)isderivedbyrearranginge xpression(6),andusingexpressions(10),
(11)and
(12):
DIVt = (1 − w)(aRt −1 + bRt −1 − At −1 ) − Tt −1 + (1 − τ )(Rt − pRt − dbRt −1 − iw(aRt −1 + bRt −1 − At −1 ))

− [(1 − w )(aRt + bRt − At ) − Tt ]

= Rt [(1 − τ )(1 − p ) − (1 − w)(a + b )] + Rt −1 [(1 − w)(a + b ) − (1 − τ )(db + iw(a + b ))]

+ At (1 − w ) + At −1[(1 − τ )iw − (1 − w )] + Tt − Tt −1

é (1 + g )[(1 − w)(a + b)] − [(1 − w)(a + b ) − (1 − τ )(db + iw(a + b))]ù


= Rt ê(1 − τ )(1 − p ) − ú
ë 1+ g û

+ At (1 − w) + At −1 [(1 − τ )iw − (1 − w)] + cbRt

é (1 + g )[(1 − w)(a + b) − cb] − [(1 − w)(a + b ) − (1 − τ )(db + iw(a + b ))]ù


= Rt ê(1 − τ )(1 − p ) − ú
ë 1+ g û

+ At (1 − w) + At −1 [(1 − τ )iw − (1 − w )]

é − (1 − τ )db − (1 + g )cb + g (1 − w )(a + b ) + (1 − τ )iw(a + b ) ù


= Rt ê(1 − τ )(1 − p ) − ú
ë 1+ g û

+
(1 + g )t − 1 (d − r )bR (1 − w) + A (1 − w)
0 0
g

+
(1 + g )t −1 − 1 (d − r )bR [(1 − τ )iw − (1 − w)] + A [(1 − τ )iw − (1 − w)]
0 0
g

é − (1 − τ )db − (1 + g )cb + g (1 − w)(a + b ) + (1 − τ )iw(a + b ) ù


= Rt ê(1 − τ )(1 − p ) − ú
ë 1+ g û

+ Rt
(d − r )b (1 − w) + R (d − r )b [(1 − τ )iw − (1 − w)] − R (d − r )b [(1 − τ )iw] + A (1 − τ )iw
g (1 + g )
t 0 0
g g

é − (1 − τ )db − (1 + g )cb + g (1 − w)(a + b ) + (1 − τ )iw(a + b ) ù


Rt ê(1 − τ )(1 − p ) − ú
ë û
=
1+ g

é (d − r )b (1 − w) + (d − r )b [(1 − τ )iw − (1 − w)] ù


ê (1 + g ) g ú (d − r )b [(1 − τ )iw] + A (1 − τ )iw
+ Rt ê ú − R0
g
ê ú
0
1+ g
ê ú
g
ë û

é (d − r )b ù
ê − (1 − τ )db − (1 + g )cb + g [(1 − w)(a + b )] + (1 − τ )iw(a + b ) − [g (1 − w) + (1 − τ )iw] ú
= Rt ê(1 − τ )(1 − p ) − ú
g
ê 1+ g ú
ê ú
ë û

æ (d − r )b ö
− (1 − τ )iwçç R0 − A0 ÷÷
è g ø

21
Expression
(17)isobtained
for t≥1:
DIVt = (1 + g ) R0 (m − z DIV ) − χ (γ R0 − A0 )
t
(17)
withthefollowing
constants:
m = (1 − τ )(1 − p )

æ ö æ ö
− τdb − (1 + g )cb + ga + (g + r )b − gwçç a + b − b ÷÷ + (1 − τ )iwçç a + b − b ÷÷
d −r d −r
è g ø è g ø
z DIV =
1+ g

χ = (1 − τ )iw , γ =
(d − r ) b
g

Derivationoresidual
f incomeexpression
equation
- (18)
Theresidualincomeexpression(18)isobtainedbyrearran gingequation(7)andthensubstituting
expressions(11),
(12)and
(13):
RI t = (1 − τ )[Rt + pRt − dbRt −1 − iw(aRt −1 + bRt −1 − At −1 )] − k E [(1 − w )(aRt −1 + bRt −1 − At −1 ) − Tt −1 ]

= (1 − τ )(1 − p )Rt − [(1 − τ )db − [(1 − τ )iw + (1 − w)k E ](a + b )]Rt −1 + [(1 − τ )iw + (1 − w)k E ]At −1 + k ETt −1

é (1 − τ )(db + iw(a + b)) + k E (1 − w)(a + b) ù


= Rt ê(1 − τ )(1 − p ) − ú
ë 1+ g û

æ (d − r )b (R − R )ö÷ + k éT + cb R − cb R − cbR ù
+ [(1 − τ )iw + k E (1 − w)]çç A0 + 0 ÷ Eê 0 0ú
è ø ë û
t −1 t 0
g g g

é æ æ öö é æ ö ùù
ê (1 − τ )çç db + iwçç a + b − (d − r ) b ÷÷ ÷÷ + k E ê(1 − w)çç a + b − (d − r ) b ÷÷ − (1 + g )cb ú ú
ê è è øø ëê è ø ûú ú
= Rt ê(1 − τ )(1 − p ) − ú
g g g

ê 1+ g ú
ê ú
ë û

æ (d − r )b ö é (1 + g )cb ù
− [(1 − τ )iw + k E (1 − w)]çç R0 − A0 ÷÷ − k E ê R0 − T0 ú
è g ø ë g û

Thisyieldsequation
(18)for t≥1:
RI t = (1 + g ) R0 (m − z RI ) − (χ + ϑ )(γR0 − A0 ) − k E (κR 0 − T0 )
t
(18)
withthefollowing
constants:
m = (1 − τ )(1 − p )

æ æ öö æ æ ö ö
(1 − τ )çç db + iwçç a + b − d − r b ÷÷ ÷÷ + k E çç (1 − w)çç a + b − d − r b ÷÷ − (1 + g )cb ÷÷
è è g øø è è g ø g ø
z RI =
1+ g

χ = (1 − τ )iw , ϑ = (1 − w)k E , γ =
(d − r ) b , κ=
(1 + g )cb
g g

22
Appendix
Steady
2- stateconditionsforalternativemodel specifications
Thisappendixprovidessteady state
conditionsfortwo alternative model specificationsthathavebeen
suggestedintheliterature.
Thealternativespecific ationsdifferfromtheoneusedinthemaintextinh ow
theinvestmentsinPPEaremodeled. Previously, grossPPEhasbeenmodeledaasconstantpercentage
ofrevenues,denotedbytheparameter b(asinCopeland,KollerandMurrin[1990]). Inthefirs t
alternativehere,following Palepu,BernardandHealy [1996]andCopeland,KollerandMurrin[1994],it
is net PPEthatisinsteadmodeledapercentage
as oreven
f ues, The
n. secondalternative,alsosuggested
inCopeland,KollerandMurrin[1994],modelsthecapital expendituresaaspercentageorfevenues, e.
Forthese
alternativesthefollowing differsfrom
t he
original
modeling isnection
2:

Alternative
1(Palepu,Bernard
and
Healy
[1996],Copeland, Kollerand
Murrin
[1994]):
NetProperty,Plantand
Equipment: nRt
GrossProperty,Plantand
Equipment nRt + At
Accumulated
Depreciation: At = At −1 + ( d − r )(nRt −1 + At −1 )
Deferred
taxes: Tt = Tt −1 + c(nRt + At )

Alternative
2(Copeland,Kollerand
Murrin
[1994]):
--G gross
t, PPE,isanadditionalstatevariable--
NetProperty,Plantand
Equipment: G t − At
GrossProperty,Plantand
Equipment G t = G t −1 + eRt − rGt −1
Accumulated
Depreciation: At = At −1 + ( d − r )G t −1
Deferred
taxes: Tt = Tt −1 + cGt
Byusingthesamelineoreasoning
f afsortheorig inalspecification,wegetthefollowingconditions
forthe
alternative specifications:
Alternative
1:
Attribute Parameterrestriction
Free
cash
flow gA0 = (d − r )(nR0 + A0 )

Earnings gA0 = (d − r )(nR0 + A0 )

Dividends gA0 = (d − r )(nR0 + A0 )

Residual
income gA0 = (d − r )(nR0 + A0 ) and gT0 = (1 + g )c (nR0 + A0 )

23
Alternative
2:
Attribute Parameterrestriction
( g + r )G0 = e(1 + g )R0 ⇔ gG0 = e(1 + g )R0 − rG0
25
Free
cash
flow

Earnings
gA0 = (d − r )e
(1 + g ) R
(g + r ) 0
Dividends
gA0 = (d − r )e
(1 + g ) R
(g + r ) 0
Residual
income
gA0 = (d − r )e
(1 + g ) R and gT0 = (1 + g )ce
(1 + g ) R
(g + r ) 0 (g + r ) 0

Inbothalternativecases,notevenFCFgrowsaat constantrate,unlessaninitialvalueconditionis
fulfilled.
Moreover,all-equityfinancingins olo ngerasufficientconditionforhavingaconstantg rowth
inearningsanddividends. Infact,boththesespe cifications(whicharetheadvocatedbythemostre cent
textbooksinthearea)aredangerousinthisrespec continuing
t: valuecalculations(regardlessow fh ich
valuationmodel isused)willbe
incorrect,unless the
initial
valueconditionifsulfilled.
Takingcapitalstructureintoconsideration,thusc ompletingthevaluationmodels,theabovetables
givethecorrectconditions,exceptforFCFinAlte rnative2,whereboth (g + r )G0 = e(1 + g )R0
and gA0 = (d − r )e
(1 + g ) Rhavetbofeulfilled.
(g + r ) 0

1
Penman (1997)providesahorizonvalueapproachfocusingon themeasurementerrorothe
f accounting,
whereformula(2)arisesaspecialcase. Theunderlyin grequirementisthatthegrowthrateothef measurement
errorisconstantbetweenany subsequentsetofSyear (sbeyondHIn ).practice,theproblemistodetermine this
S-yeargrowthrate. Itcanbeinferredfromtheproje ctedconstantgrowthrateorfesidualincomebeyondthe
horizon;theapproachstillrequiressteadystateassumpti ons.
Inthispaperwesticktothestandardapplication
with1-yearperiodlength(and1-yeargrowthrates),butno tethattheanalysiscouldbeperformedusingS-year
cyclesinsteadwithoutany effectonthe
intuitionof ourresults.
2
Horizon valueproblemsarelikelytobemostsevere invaluationmodelsthatplacethelargestweighton
thehorizonvalues.
Forga ivencompany,thefreecas hflowhorizonvalueigsenerally
largerthanthedivide nds
(orearnings)horizonvalue,whichinturnilarger
s th antheresidualincome horizonvalue.
3
The parametersareinitially restrictedafsollows: b>0; c∈[0,1]; d∈(0,1]; g∈(0, k); i>0; k>0; p∈(0,
1); r∈(0,1]; τ∈[0,1); w∈[0,1). Networkingcapitalisthusunrestricted. GrossP PEmustbepositive.
The
changeindeferredtaxescanbezerobutnotnegativein theperpetuityperiod,alsonewtaxdeferralsduringa
yearcannotexceedgrossPPE. Atleastsome
fraction of
theprioryear’sphysicalcapitalmustbedepreciated, but
depreciationcannotexceed100%. Thegrowthratemustbepos itivebutsmallerthanthediscountrate(sincethe
company valuewouldotherwisebienfinite). Theintere strateips ositive,asitshediscountrate.
Theoper ating
profitmarginips ositivebutlessthan100%.Somefracti onofprecedingyear’sphysicalassetsmustberetired,
butonecannotretiremorethan100%. Thetaxratecan bezerobutmustbesmallerthan100%. Debtcanbe
zero,butthe
company inot
s allowedtbo1e00%debtfinan ced.
4
Cost
ofequity, kEfor
, dividends,earningsandresidualincome;weightedaver agecostofcapital
( wacc)
forfree
cashflow.
5
Interest
expense
icalculated
s basedonbeginning-of-yea debt.
r

24
6
Notethatcaompany
cannotmakelossesinperpetuity, soearningsbeforetaxesarenon-negativeinsteady
state.
Thismakesthemodellingotaxes
f straightforwar d.
7
Deferred taxesareexplicitlyexcludedfromthedebtgovern edby w.Thereasonisthattaxdeferralsare
linkedttohe
firmsoperationsandthusnotreally
anit emincludedinfinancingdecisions.
Conceptually,onemay
eventhinkaboutdeferredtaxesas
na egative
itemonthe assetside.
8
Modelling deferredtaxesmayseemsomethingofanoverkil in
l astylizedmodellikethis.
Theyservea
specialpurpose,however. Inmanycountriestaxaccountin gids istinctfromGAAPaccountinginsomeaspects.
Thuswewanttomodelthedifferencebetweentheprovis ionfortaxesinthe(GAAP)incomestatementand
actualtaxespaid.
Inaparticularyearthisdifferencee qualsthechangeindeferredtaxesonthebalancesheet.
Exactly howthischangeshouldbsepecifieddependsonacoun try’staxrules.Here,wemodeldeferredtaxesas
theyaredefinedinCopeland,KollerandMurrin[1990],notin gthatmuchmoreexactcountry-specificmodels
canbaepplied.
9
(1–tax
rate)(revenues–op.exp.–depr)+depr+changein def.taxes–changeinnetworkingcap.–
capitalexpenditures.
10
Residual
income
equalsearningsminusthe
costof
capita times
l thelaggedbookvalue
oequity.
f
11
Palepu,BernardandHealy [1996] discussgrowthrateassumptions,i.e.,thevalueof ginourmodel.
In
particular,theyarguetheinsensitivityofcompanyvalue tosalesgrowthassumptionsifoneassumesa
competitiveequilibrium. Note,however,thatalthoughth ecompanyvaluemay–insomecircumstances–be
insensitivetotheexactvalueothe
f growthrate g,itwillstillbenecessarytohavethe samegrowthrate, g,for
the
differentattributes.
12
Asmentionedintheintroduction,thetypicalsituatio nisthatfullfinancialstatementsaremodeled
explicitlyforalimitednumberoyears,
f ‘theexplicitf orecastperiod’.Thevaluesovariables
f athe
t endof this
period–atthehorizon–areinessencetheinitialva luesothe
f post-horizonperiod(seeSection5formore exact
implementationdetails).
13
Becausefreecashflowisbydefinitionindependentof financing,theall-equityfinancingrestrictionis
irrelevant.
Free
cashflowalso
doesnotinclude deprec iation,sodepreciationissuesbecomeirrelevant(except for
theirinfluence
ontaxespaid,butthateffectisincluded inthe zFCF constant).
14
For earningssteadystateanalternativesufficient conditionwasall-equity
financing( w=0).
Thiswillnot
sufficeforresidualincometogrowataconstantrate, however.
Withall-equityfinancingexpression(19b)
reducesto: (d − r )bR0 − gA0 = (1 + g )cbR0 − gT0 .
15
Based
onthe
analyst’sknowledge
othe
f company,compar able
companies,etc.
16
SeeAppendix2forthe
resultingconditionsfortwo
alter native
modelspecificationsfromthe
literature.
17
EveninaModiglianiandMiller[1958]worldthecostoef quityisafunctionofleverage(whilethe
weightedaveragecostofcapitalisconstant).
Inase ttingwithcorporatetaxes,boththecostofequityandt he
weightedaverage
costof
capitalcanvarywithleverage.
18
Thereins opreferredstockinthemodel,sowne eedo nlylookathe
t debtratio(sincetheequityratiois
simply
one
minusthe debtratio).
19
Calculated using,e.g.,theResidualIncomemodel: Equityvalue 0 = Book equity0 + RI1 / (k E − g ) =/
usingtheresidualincomeexpression(17)/ = 25.6 + 1.13 / (0.102 − 0.040) = 43.8(billionSEK). Sincethe
steady state
conditionsarefulfilled,theFreeCashFl owmodelandtheDividendDiscountmodelgiveexactly the
sameresult.See,e.g.,Zhang[1998]forananalyticalpro of.
Notethatwhilethatpaperpointstotheimportanc e
ofthesteadystateconceptinthisrespect,thepurpose ofourpaperitsodevelopageneralmethodologytomake
steady state
operational.

25
20
Figure1isderivedbyusingtheinitialvaluesof R0 , A0and T0asgivenfromtheexplicitforecast
periodandusingtheconstantparameterstoderiveallinc omestatementandbalancesheetvariablesyearbye ar
afterthe
horizon.Thisinturnmakesitpossible
to calculate
ROEyearby
year.
21
Remember thatwhileinactual,realized,financial statementsthesethingsaredefinedsimultaneously
throughdouble-entrybookkeeping,invaluationwedealwithf orecastsobf othincomestatementandbalance
sheet,whereearningsaretheresidualitemoftheinc omestatementandbookvalueoequity
f itsheresidualite m
of
the
balance
sheet.
22
We stressthatthisisnotacriticism.
BothPen manandSougiannis[1998]andFrancis,Olssonand
Oswald[2000]areperfectly representative
ocommon
f practi ce
inthisregard(whichialso
s theirpurpose).
23
PenmanandSougiannis[1998,table1The
]. differencesare vastregardlessothe
f lengthoftheexplicit
forecastperiod.
24
In
theAssiDomänAB
case,thiswouldleadtaonover pricingbayround22%.
25
Theinterpretationothis
f conditionitshatcapital expenditures( = e(1 + g ) R0 minus
) retirements( =) rG0
inthe
firstyearof
the
steady
state
periodmustbe
dec idedsuchthatgrossPPEgrowsatthe
revenue
growthrate.

26

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