Chapter 7

Prospective Analysis: Valuation Theory and Concepts

Question 1. Joe Watts, an analyst at EMH Securities, states: "I don't know why anyone would ever try to
value earnings. Obviously, the market knows that earnings can be manipulated and only values
cash flows." Discuss.

Valuing earnings is an alternative way of valuing a company even if earnings can be manipulated. Note that,
with an infinite forecast horizon, the valuation based on discounted abnormal earnings delivers exactly the same
estimate as DCF-based methods, even if there is earnings manipulation. The estimated values using
accounting-based valuation are not affected by accounting choices because of the self-correcting nature of
double-entry bookkeeping. Current period earnings can be manipulated, but the values estimated with
accounting-based valuation are not to be manipulated. However, with finite horizons, earnings manipulation
can affect value unless the analyst recognizes and undoes the manipulation. Also, when accounting data is used
to forecast cash flows, even a DCF valuation is potentially vulnerable to accounting manipulation.

There are two practical advantages to valuing earnings. First, accounting-based valuation (using earnings)
frames the valuation task differently and can immediately focus the analyst's attention on the key measure of
performance: ROE and its components (i.e., value drivers such as profit margins, sales turnover, and leverage).

Second, if it is more natural to think about future performance in terms of accounting returns, and if the analyst
faces a context where a "back-of-envelope" estimate of value would be of use, the accounting-based technique
can be simplified to deliver such an estimate. "Short-cut" estimates are useful in a variety of contexts where the
cost and time involved in a detailed DCF analysis is not justified. In this context, the detailed DCF method is
analogous to a manual camera for which the distance, light exposure, and shutter speed need to be set before
taking a picture whereas the "short-cut" accounting-based valuation is analogous to an automatic camera.

Question 2. Explain why terminal values in accounting- based valuation are significantly less than those
for DCF valuation.

DCF terminal values include the present value of all expected cash flows beyond the forecast horizon. Note that
the expected cash flows beyond the forecast horizon can be broken down into two parts: normal and abnormal.
Since the terminal value in the accounting-based technique includes only the abnormal earnings (expected
earnings minus cost of capital times beginning book value of equity), the terminal values in accounting-based
valuation are significantly less than those for DCF valuation. The accounting-based approach recognizes that
current book value and earnings within the forecast horizon already reflect many of the cash flows expected to
arrive after the forecast horizon.
Question 3. Manufactured Earnings is a "darling" of Wall Street analysts. Its current market price is $15
per share, and its book value is $5 per share. Analysts forecast that the firm’s book value will
grow by 10 percent per year indefinitely, and the cost of equity is 15 percent. Given these facts,
what is the market’s expectation of the firm’s long- term average ROE?

P
 1
 ROE  r 
B r  g
where ROE is the long-term average ROE,
g is the long-term average growth in book value,
r is the cost of equity,
P is the stock price, and
B is the book value per share.

Using the information in the question,

15
 1
 ROE  0.15
5  0.15  0.10
or ROE = 0.25 (or 25%).

Question 4. Given the information in Question 3, what will be Manufactured Earnings' stock price if the
market revises its expectations of long-term average ROE to 20 percent?

Once again, using the same formula as in the answer to Question 3, we have

P
 1
 0.2  0.15
5  0.15  0.10 
or P = $10

Based on above equation, the Manufactured Earnings' stock price will be revised to $10.

Question 5. Analysts reassess Manufactured Earnings’ future performance as follows: growth in book value
increases to 12 percent per year, but the ROE of the incremental book value is only 15 percent.
What is the impact on the market-to-book ratio?

Since the ROE from the incremental growth value is equal to cost of equity, there is no increase in value.
Question 6. How can a company with a high ROE have a low PE ratio?

Accounting-based valuation suggests that the stock price (a numerator of the PE ratio) can be viewed as the sum
of the current book value per share plus the discounted expected future abnormal earnings per share.

Price per share = Book value per share x

1   
 
 E1   ROEt 1  rE   Et   ROEt 1  rE 1  g t 1   Et  ROEt 1  rE 1  g t 1  2 
 
 1  rE  1  rE  2
1  rE  3


A company with a high (current period) ROE may have a low price and PE ratio when

1. cost of equity capital (rE ) is high;

2. expected growth of book value is low; and

3. expected future ROE is low (relative to current period ROE).

Question 7. What type of companies have:

a. a high PE ratio and a low market-to-book ratio?

Recovering firms, like Apple in 1993, are expected to rebound from temporarily low earnings levels but will
not be able to return to an abnormally high level of ROE due to competition. PE ratio looks high due to low
current earnings.

b. a high PE ratio and a high market-to-book ratio?

"Rising stars" which are expected to grow quickly and enjoy high ROEs during the growth period and/or
after the growth occurs.

c. a low PE ratio and a high market-to-book ratio?

"Falling stars" that enjoy high ROEs on existing investments but are no longer growing fast. PE ratio is low
due to relatively high earnings in current year.

d. a low PE ratio and a low market-to-book ratio?

"Dogs" which have little prospect for either growth or high ROEs.
Question 8. Which of the following items affect free cash flows to debt and equity holders? Which affect free
cash flows to equity alone? Explain why and how.

All answers assume a tax rate > 0.

An increase in accounts receivable will cause both FCFE and FCFD+E to decrease, since it increases the firm's
cash required for working capital.

A decrease in gross margins will cause both FCFE and FCFD+E, to decrease by lowering both EBIT (1 - tax rate)
and NI.

An increase in property, plant, equipment will decrease both FCFE and FCFD+E due to an increase in capital
expenditures.

An increase in inventory will decrease both FCFE and FCFD+E through an increase in cash required for working
capital.

Interest expense will decrease FCFE only. For calculating free cash flows to debt, additional interest expense
does not change EBIT (1 - tax rate).

An increase in prepaid expenses will cause both FCFE and FCFD+E to decrease through an increase in working
capital.

An increase in notes payable to the bank will increase FCFE only. The increase in notes payable will increase
debt, increasing the FCFE by the same amount.

Question 9. Starite Company is valued at $20 per share. Analysts expect that it will generate free cash flows
to equity of $4 per share for the foreseeable future. What is the firm's implied cost of equity
capital?

With a single, unchanging free cash flow to equity for the foreseeable future, we can calculate the implied cost
of equity capital using the following formula:

Free cash flow to equity

Value per share 
Cost of equity capital
Using a value per share = 20 and a free cash flow to equity = 4, solving the equation for cost of equity capital
yields, rE = 20%.
Question 10. Janet Stringer argues that "the DCF valuation method has increased managers' focus on
short-term rather than long- term performance, since the discounting process places much
heavier weight on short-term cash flows than long-term ones." Comment.

While it is true that DCF valuation places more weight on earlier cash flows than on later ones, this reflects the
time value of money. A dollar in one year is more valuable than a dollar in five year's time. However, this does
not imply that the long-term is less important than the short-term. Typical DCF valuations show that the value
of cash flows beyond, say, five years is a substantial fraction of the overall firm value. If managers believe that
long-term performance of the firm is the most significant driver of value, they will certainly focus appropriately
on making sure that they do not under-emphasize the long-term.

DCF valuation helps a manager understand the tradeoffs between short-term and long-term actions. Consider
management's decision if it has a choice between two mutually exclusive investments that generate equivalent
cash flows, one with a short horizon and the other with a long horizon. DCF analysis implies that firm value
will increase more if the management takes the short-term project. In this sense, DCF helps managers trade off
how much they should focus on short-term versus long-term considerations.

One concern often raised about DCF analysis is that it focuses attention on quantifiable costs and benefits from
investing. It is probably more difficult to quantify long-term costs and benefits than short-term ones. If
management ignores these types of costs and benefits, they may end up making decisions that have a short-term
focus. However, this is really not the fault of DCF as a method. It is simply an indication of the difficulty in
making decisions with highly uncertain payoffs.