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cally allowing for ¬rms™ future performance and investment opportunities. Similarly, the
discounted abnormal earnings/ROE method requires more structure and work than the
discounted cash ¬‚ow method to build full proforma balance sheets. This permits analysts
to avoid inconsistencies in the ¬rm™s ¬nancial structure.


Differences in Terminal Value Implications
A third difference between the methods is in the effort required for estimating terminal
values. Terminal value estimates for the abnormal earnings and ROE methods tend to
represent a much smaller fraction of total value than under the discounted cash ¬‚ow or
dividend methods. On the surface, this would appear to mitigate concerns about the as-
pect of valuation that leaves the analyst most uncomfortable. Is this apparent advantage
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real? As explained below, the answer turns on how well value is already re¬‚ected in the
accountant™s book value.
The abnormal earnings valuation does not eliminate the discounted cash ¬‚ow termi-
nal value problem, but it does reframe it. Discounted cash ¬‚ow terminal values include
the present value of all expected cash ¬‚ows beyond the forecast horizon. Under abnor-
mal earnings valuation, that value is broken into two parts: the present values of normal
earnings and abnormal earnings beyond the terminal year. The terminal value in the ab-
normal earnings technique includes only the abnormal earnings. The present value of
normal earnings is already re¬‚ected in the original book value or growth in book value
over the forecast horizon.
The abnormal earnings approach, then, recognizes that current book value and earn-
ings over the forecast horizon already re¬‚ect many of the cash ¬‚ows expected to arrive
after the forecast horizon. The approach builds directly on accrual accounting. For ex-
ample, under accrual accounting, book equity can be thought of as the minimum recov-
erable future bene¬ts attributable to the ¬rm™s net assets. In addition, revenues are
typically realized when earned, not when cash is received. The discounted cash ¬‚ow ap-
proach, on the other hand, “unravels” all of the accruals, spreads the resulting cash ¬‚ows
over longer horizons, and then reconstructs its own “accruals” in the form of discounted
expectations of future cash ¬‚ows. The essential difference between the two approaches
is that abnormal earnings valuation recognizes that the accrual process may already have
performed a portion of the valuation task, whereas the discounted cash ¬‚ow approach
ultimately moves back to the primitive cash ¬‚ows underlying the accruals.
The usefulness of the accounting-based perspective thus hinges on how well the ac-
crual process re¬‚ects future cash ¬‚ows. The approach is most convenient when the ac-
crual process is “unbiased,” so that earnings can be abnormal only as the result of
economic rents, and not as a product of accounting itself.13 The forecast horizon then
extends to the point where the ¬rm is expected to approach a competitive equilibrium
and earn only normal earnings on its projects. Subsequent abnormal earnings would be
zero, and the terminal value at that point would be zero. In this extreme case, all of the
¬rm™s value is re¬‚ected in the book value and earnings projected over the forecast
horizon.
Of course, accounting rarely works so well. For example, in most countries research
and development costs are expensed, and book values fail to re¬‚ect any research and de-
velopment assets. As a result, ¬rms that spend heavily on research and development”
such as pharmaceuticals”tend on average to generate abnormally high earnings even in
the face of stiff competition. Purely as an artifact of research and development account-
ing, abnormal earnings would be expected to remain positive inde¬nitely for such ¬rms,
and the terminal value could represent a substantial fraction of total value.
If desired, the analyst can alter the accounting approach used by the ¬rm in his/her
own projections. “Better” accounting would be viewed as that which re¬‚ects a larger
fraction of the ¬rm™s value in book values and earnings over the forecast horizon.14 This
same view underlies analysts™ attempts to “normalize” earnings; the adjusted numbers
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are intended to provide better indications of value, even though they re¬‚ect performance
only over a short horizon.
Recent research has focused on the performance of earnings-based valuation relative
to discounted cash ¬‚ow and discounted dividend methods. The ¬ndings indicate that over
relatively short forecast horizons, ten years or less, valuation estimates using the abnor-
mal earnings approach generate more precise estimates of value than either the dis-
counted dividend or discounted cash ¬‚ow models. This advantage for the earnings-based
approach persists for ¬rms with conservative or aggressive accounting, indicating that ac-
crual accounting in the U.S. does a reasonably good job of re¬‚ecting future cash ¬‚ows.15


Key Analysis Questions
The above discussion on the trade-offs between different methods of valuing a
company raises several questions for analysts about how to compare methods and
to consider which is likely to be most reliable for their analysis:
• What are the key performance parameters that the analyst forecasts? Is more
attention given to forecasting accounting variables, such as earnings and
book values, or to forecasting cash flow variables?
• Has the analyst linked forecasted income statements and balance sheets? If
not, is there any inconsistency between the two statements, or in the implica-
tions of the assumptions for future performance? If so, what is the source of
this inconsistency and does it affect discounted earnings-based and dis-
counted cash flow methods similarly?
• How well does the firm™s accounting capture its underlying assets and obli-
gations? Does it do a good enough job that we can rely on book values as the
basis for long-term forecasts? Alternatively, does the firm rely heavily on off-
balance-sheet assets, such as R&D, which make book values a poor lower
bound on long-term performance?
• Has the analyst made very different assumptions about long-term perfor-
mance in the terminal value computations under the different valuation meth-
ods? If so, which set of assumptions is more plausible given the firm™s
industry and its competitive positioning?




SUMMARY
Valuation is the process by which forecasts of performance are converted into estimates
of price. A variety of valuation techniques are employed in practice, and there is no sin-
gle method that clearly dominates others. In fact, since each technique involves different
advantages and disadvantages, there are gains to considering several approaches simul-
taneously.
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For shareholders, a stock™s value is the present value of future dividends. This chapter
described three valuation techniques directly based on this dividend discount de¬nition
of value: discounted dividends, discounted abnormal earnings/ROEs, and discounted
free cash ¬‚ows. The discounted dividend method attempts to forecast dividends directly.
The abnormal earnings approach expresses the value of a ¬rm™s equity as book value
plus discounted expectations of future abnormal earnings. Finally, the discounted cash
¬‚ow method represents a ¬rm™s stock value by expected future free cash ¬‚ows dis-
counted at the cost of capital.
Although these three methods were derived from the same dividend discount model,
they frame the valuation task differently. In practice they focus the analyst™s attention on
different issues and require different levels of structure in developing forecasts of the un-
derlying primitive, future dividends.
Price multiple valuation methods were also discussed. Under these approaches, ana-
lysts estimate ratios of current price to historical or forecasted measures of performance
for comparable ¬rms. The benchmarks are then used to value the performance of the
¬rm being analyzed. Multiples have traditionally been popular, primarily because they
do not require analysts to make multiyear forecasts of performance. However, it can be
dif¬cult to identify comparable ¬rms to use as benchmarks. Even across highly related
¬rms, there are differences in performance that are likely to affect their multiples.
The chapter discussed the relation between two popular multiples, value-to-book and
value-earnings ratios, and the discounted abnormal earnings valuation. The resulting
formulations indicate that value-to-book multiples are a function of future abnormal
ROEs, book value growth, and the ¬rm™s cost of equity. The value-earnings multiple is a
function of the same factors, and also the current ROE.


APPENDIX:
Reconciling the Discounted Dividends and
Discounted Abnormal Earnings Models
To derive the earnings-based valuation from the dividend discount model consider the
following two-period valuation:
DIV 1 DIV 2
Equity value = ----------------------- + ------------------------
-
( 1 + re ) ( 1 + re ) 2
With clean surplus accounting, dividends (DIV ) can be expressed as a function of net in-
come (NI), and the book value of equity (BVE):
DIVt = NI t + BVE t “1 “ BVE t
Substituting this expression into the dividend discount model yields the following:
NI 1 + BVE 0 “ BVE 1 NI 2 + BVE 1 “ BVE 2
Equity value = ------------------------------------------------------- + -------------------------------------------------------
- -
( 1 + re ) (1 + r ) 2
e
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This can be rewritten as follows:
NI 1 “ re BVE 0 + BVE 0 ( 1 + re ) “ BVE 1
Equity value = -------------------------------------------------------------------------------------------------------------
-
( 1 + re )
NI 2 “ re BVE 1 + BVE 1 ( 1 + re ) “ BVE 2
+ -------------------------------------------------------------------------------------------------------------
-
( 1 + re ) 2
NI 1 “ re BVE 0 N I 2 “ re BVE 1 BVE 2
Equity value = BVE 0 + ------------------------------------- + -------------------------------------- “ --------------------------
- -
( 1 + re ) ( 1 + re ) 2 ( 1 + re ) 2
The value of equity is therefore the current book value plus the present value of future
abnormal earnings. As the forecast horizon expands, the ¬nal term (the present value of
liquidating book value) becomes inconsequential.


DISCUSSION QUESTIONS
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 ma-
nipulated and only values cash flows.” Discuss.
2. Explain why terminal values in accounting-based valuation are significantly less
than those for DCF valuation.
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 eq-
uity is 15 percent. Given these facts, what is the market™s expectation of the firm™s
long-term average ROE?
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?
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?
6. How can a company with a high ROE have a low PE ratio?
7. What type of companies have:
a. a high PE and a low market-to-book ratio?
b. a high PE ratio and a high market-to-book ratio?
c. a low PE and a high market-to-book ratio?
d. a low PE and a low market-to-book ratio?
8. Free cash flows (FCF) used in DCF valuations discussed in the chapter are defined
as follows:
FCF to debt and equity = Earnings before interest and taxes — (1 “ tax rate)
+ Depreciation and deferred taxes “ Capital
expenditures “/+ Increase/decrease in working capital
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FCF to equity = Net income + Depreciation and deferred taxes “ Capital
expenditures “/+ Increase/decrease in working capital
+/“ Increase/decrease in debt
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.
• An increase in accounts receivable
• A decrease in gross margins
• An increase in property, plant and equipment
• An increase in inventory
• Interest expense
• An increase in prepaid expenses
• An increase in notes payable to the bank
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?
10. Janet Stringer argues that “the DCF valuation method has increased managers™
focus on short-term rather than long-term performance, since the discounting pro-
cess places much heavier weight on short-term cash flows than long-term ones.”
Comment.


NOTES
1. The incorporation of all noncapital equity transactions into income is called clean surplus
accounting. It is analogous to comprehensive income, the concept defined in FAS 130.
2. Changes in book value also include new capital contributions. However, the dividend dis-
count model assumes that new capital is issued at fair value. As a result, any incremental book
value from capital issues is exactly offset by the discounted value of future dividends to new
shareholders. Capital transactions therefore do not affect firm valuation.
3. Appendix A provides a simple proof of the earnings-based valuation formula.
4. !See C. Lee and J. Myers, “What is the Intrinsic Value of the Dow?,” Cornell University,

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