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Section 10

Firm Valuation:
Valuation models

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Learning objectives

After studying this chapter, you will understand

• What drives firm value


• The process of firm valuation
• Firm valuation using dividends, free cash flows and
abnormal earnings
• How to forecast future financial performance of the firm
• Understand the sensitivity of the valuation result on the
key parameters

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Firm valuation
• The term firm valuation refers to determining the true or
intrinsic value of the firm
– This value may significantly differ from the asset-based book
value of the firm
• Investors and financial analysts conduct firm valuation for
various purposes needed in their decision making
– Investment decisions
– In M&A transactions and IPOs, firm valuation plays a key role
• From firms’ point of view, valuation models help
understanding the key value drivers of the firm

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Example: What are these two figures?

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Firm valuation in theory and practice

• Richardson et al. (2010), JAE, ’Accounting anomalies and


fundamental analysis: A review of recent research
advances’
– Includes a survey on how investment professionals and
academics apply fundamental analysis and valuation

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Valuation process
Business Analysis

GAAP
Financial Financial Statement Forecast
Statements Analysis Assumptions

Valuation

Time
Historical Periods Valuation Date Forecast Periods

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Valuation process
1. Business analysis
 Internal and external business analysis
 What are the key business drivers of the firm?
2. Financial statement analysis
 Historical financial statements are analyzed to learn about the
profitability, leverage, growth, etc. of the firm
3. Forecasting
 Future financial statements are projected
4. Valuation
 Valuation models
 Relative valuation
 What is the value of the equity of the firm?
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Valuation tools
• Two different types of valuation tools are mainly used
– Valuation models
• Dividend discount model (DDM)
• Free cash flow model (DCF)
• Abnormal earnings model (AE)
– Price multiples
• P/E-, P/B-, EV/EBIT- etc. ratios
• Valuation models are more sophisticated valuation tools
– Infinite forecast horizon
– Risk and time-value of money are taken into account in the cost
of capital

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Valuation process
Business Analysis

GAAP
Financial Financial Statement Forecast
Statements Analysis Assumptions

Valuation

Time
Historical Periods Valuation Date Forecast Periods

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Business analysis and financial
statement analysis
• The key to developing a forecast needed in valuation
is to understand the business
• Business analysis
– Highlights issues we need to study further in the financial
statement analysis stage
• External business analysis
• Internal business analysis
• Financial statement analysis
– Identifies concerns that require more detailed business
analysis

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External business analysis analyzes
• Industry economics
– to determine the firm’s returns, profitability and cash flows
• Individual competitors
– to understand the existing rivalry on a macroeconomic level
– to assess competitors’ strategies, products, marketing, supply
chain and profitability
• Potential entrants
– to know the number of potential competitors, and
– how they will affect competitive rivalry
• Substitute products
– to understand how substitute products can remove profits
– to consider the available substitute products

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External business analysis analyzes

• Buyers
– to understand the customers' strong bargaining position
• Suppliers
– Suppliers generally have more bargaining power to raise prices
and lower quality if there are only a few of them and if there are
not many substitutions for their products
• Customers
– to understand how the customers’ needs drive demand
• Governmental regulations
– to understand the governmental and regulatory environment of a
firm

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Internal business analysis
• Mission
– What the firm hopes to accomplish
• Products and services
– What do these do?
– How does the customer use them?
– What is the market scope?
• Pricing and differentiation
– The more differentiated the product, the less competition
focuses on price
• Marketing and selling strategies
– Are needed to understand the firm's strategy for bringing the
product to the customer

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Internal business analysis
• Supply chain
– To understand how each part works in order to project future
cash flow
– Includes
• Purchasing, Manufacturing, Research and development,
Distribution
• Human resources
– To understand the strengths and weaknesses on the people
side
• Investment priorities
– To know what makes a firm successful through understanding
its investment priorities

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Valuation process
Business Analysis

GAAP
Financial Financial Statement Forecast
Statements Analysis Assumptions

Valuation

Time
Historical Periods Valuation Date Forecast Periods

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Forecast assumptions
• Methods of predicting financial information can be
classified as follows:
Univariate Multivariate
Mechanical Statistical models Statistical models

Non-mechanical Trend analysis Security analyst


approach

• Different methods are based on different forecasting


tools and data sources
• Data availability and the purpose for which the
predictions are made affect the selection of different
prediction methods

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Mechanical prediction methods

• Mechanical prediction methods include


– Univariate statistical models that are based on the analysis of
the time-series of a single financial variable
– Multivariate statistical models that are based on the analysis
of the time-series of multiple financial variables
• In mechanical methods, predictions of the financial
variable are mechanically driven from the data by
applying a specified statistical model
– Statistical model is applied to the past data to estimate the
model parameters
– The estimated paremeters are then applied to current data to
predict the future value of the variable

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Mechanical prediction methods

• Example of a mechanical univariate statistical model is a


model that forecasts earnings (X) to be an equally
weighted average of the past four year’s earnings

4
E(Xi,t )   Xi,t n
1
4
n 1

• This approach assumes that future earnings can be


simply predicted from the time-series of past earnings
• How relevant is this assumption?

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Non-mechanical prediction methods
• In non-mechanical prediction approach, an analyst
incorporates a judgemental factor of her own into the
analysis
• This factor may reflect an ever-changing mix of economic
inputs
• A typical example of univariate non-mechanical approach
is ’free-hand’ extrapolation of a time-series plot of earnings
referred to as a trend analysis
• Analysts’ earnings forecasts are a typical example of a
multivariate non-mechanical prediction method
– Analysts use many quantitative and qualitative information sources
including financial reports of the firm, macro-economic forecasts,
company visits etc. 19
Analysts’ earnings forecasts

• Analysts’ earnings forecasts are frequently used to


assess the future performance of the firm
• Consensus earnings forecasts refer to the means or
medians of the analysts’ earnings forecasts
– Consensus earnings forecasts are probably the most important
piece of financial information, at least for the valuation purposes
• Range of the earnings forecasts of individual analysts
measure the uncertainty in the analysts’ opinions
regarding the value of the upcoming earnings

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Example: Accurace of analysts’ earnings
forecasts

Source: Brown, Foster and Noreen (1985)


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Valuation process
Business Analysis

GAAP
Financial Financial Statement Forecast
Statements Analysis Assumptions

Valuation

Time
Historical Periods Valuation Date Forecast Periods

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Valuation using valuation models
There are three steps involved in valuing a company:

Step 1: Forecast future amounts of the financial attribute that ultimately


determines how much a company is worth.

Step 2: Determine the risk or uncertainty associated with the forecasted


future amounts.

Step 3: Determine the discounted present value of the expected future


amounts using a discount rate that reflects the risk from Step 2.

• Dividends
• Free cash flows
• Accounting earnings

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Dividend discount model (DDM)
• Value of equity is simply the present value of future dividends
• Cost of equity capital is used as a discount rate

Expected future dividends

2015* 2016* 2017* 2018* 2018*-


Sum of the
present values
of future
dividends

= Value of equity

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Dividend discount model (DDM)

• Using the assumption that dividends will grow at a


constant rate, the dividend discount model can be adapted
to the so-called Gordon Growth Model

𝐷𝐼𝑉1
𝑃0 =
𝑘𝐸 −𝑔

• The Gordon Growth Model has three assumptions


– Current dividends (DIV1)
– Cost of equity (kE)
– Dividend growth rate (g)

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Dividend discount model (DDM)

• In practice, we predict future dividend per share (DPS)


for next 3-5 years, and use a growth rate (g) in
dividends to forecast dividend for the period thereafter
(terminal value)

• DDM becomes as follows:

𝐷𝑃𝑆1 𝐷𝑃𝑆2 𝐷𝑃𝑆3 𝐷𝑃𝑆3 × (1 + 𝑔)


𝑃0 = 1
+ 2
+ 3
+
(1 + 𝑘𝑒 ) (1 + 𝑘𝑒 ) (1 + 𝑘𝑒 ) (𝑘𝑒 − 𝑔)(1 + 𝑘𝑒 )3

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Example: Using DDM
• Expected dividends per share (DPS) for the next three
years are 0.84, 0.69 and 0.65
• The estimated long-term dividend growth rate is 3%
• Cost of equity capital is 9,84 %
• Value of equity is:

DPS1 DPS 2 DPS3 D3 (1  g )


P0    
1  re 1  re 2 1  re 3 r  g 1  re 3
0,84 0,69 0,65 0,65 *1,03
   
1,0984 1,0984 2 1,0984 3 0,0984  0,031,0984 3
 9,21

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Where to get the forecasts?

• Current dividends (DIV1) can be obtained from


– Newspapers
– Annual reports
– Other public sources
• Dividend growth rate (g) should be determined such that
the analyst
– Shows how sensitive value is to this assumption
– Introduces the concept of a just barely sustainable dividend
growth rate
– Shows this is the appropriate growth rate to be used in the
model

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Equity value and dividend growth rate

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Discounted free cash flow (DCF) model
Expected future free cash flows

2015* 2016* 2017* 2018* 2019*-

Present value of
future free cash
flows
+
Financial assets • Present value of future cash flows is the
 Enterprise Value, i.e. the value of both equity
Interest-bearing debt and debt
= • After adding financial assets and substracting
Value of equity interest-bearing debt (i.e. interest-bearing net
debt), we get the value of equity

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Discounted free cash flow (DCF) model
• Value of the firm, i.e. the Enterprise Value (debt plus
equity), is the present value of the expected free cash
flows discounted by WACC:

FCF1 FCF2 FCF3


EV0    
1  WACC ( 1  WACC) 2
( 1  WACC)3

• Expected free cash flows have to be positive some time


over the life of the asset
• Firms that generate cash flows early in their life will be
worth more than firms that generate cash flows later
– the latter may however have greater growth and higher cash flows
to compensate

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Value creation, cash flows and WACC

• A firm can be seen as a portfolio of projects


– Some with positive Net Present Values (NPV) and some with
negative NPVs
• The value of the firm is the sum of the NPVs of its
component projects
• Greater future cash flows increase NPVs
Increasing ROIC will increase firm value
• Lower discount rates increase NPVs
Decreasing WACC will increase firm value
Discounted free cash flow (DCF) model

• Forecasts and discounts the expected free cash flows


the core operations will generate
• Most widely used valuation model
• First step in financial statement analysis is to develop
historical free cash flow statements
• These statements separate free cash flows from all
other cash flows
• Historical statements can be utilized in predicting future
free cash flows

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Valuation process Business Analysis
revised

Financial Statement Forecast


Analysis Assumptions
Historical Ratios Forecast Ratios

Free Cash
GAAP Historical Free Cash
Flow Forecast
Financial Flow Statements
Statements

Valuation

Time Historical Periods Valuation Date Forecast Periods


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Example: Applying DCF model to Kesko
Reported numbers
2010 2011 2012 2013 2014
Net sales 8 776,8 9 460,4 9 685,9 9 315,2 9 070,6
Costs and expenses -8 349,2 -9 055,1 -9 315,4 -8 913,8 -8 913,8
EBITDA 427,6 405,3 370,5 401,4 156,8
EBITDA-% 4,9 % 4,3 % 3,8 % 4,3 % 1,7 %
Depreciations -120,9 -124,7 -158,5 -153,0 -195,1
EBIT 306,7 280,6 212,0 248,4 151,4
EBIT-% 3,5 % 3,0 % 2,2 % 2,7 % 1,7 %
Financial items 6 0,8 -0,6 -5,8 -40,7
Taxes, reported -96,7 -85,2 -74,6 -57,7 -36,6
Net tax effect on financial items 0,9 0,1 0,1 0,9 6,1
Taxes, adjusted -95,8 -85,1 -74,5 -56,8 -30,5
Taxes, adjusted / EBIT -31,24 % -30,32 % -35,15 % -22,88 % -20,14 %
Earnings before financial items 210,9 195,5 137,5 191,6 120,9
+ Depreciations 120,9 124,7 158,5 153,0 195,1
- Capital expenditures -325,0 -425,0 -378,0 -171,0 -194,0
Capital expenditures / Net sales -3,7 % -4,5 % -3,9 % -1,8 % -2,1 %
- Change in working capital 54,8 -81,2 -8,4 90,7 3,9
Change in Working capital / Change in Net sales -11,9 % -3,7 % -24,5 % -1,6 %
Free cash flow 35 -186,0 -90,4 264,3 125,9
Example: Applying DCF model to Kesko

Summary of forecast assumptions


Mechanical forecast assumption: We use:
Net sales CaGr (2010-2014) 0,83 % 0,83 %
EBITDA-% Average (2012-2014) 3,80 % 3,80 %
EBIT-% Average (2012-2014) 2,60 % 2,60 %
Taxes, adjusted / EBIT Average (2012-2014) -27,94 % -27,94 %
Capital expenditures / Net sales Average (2012-2014) -3,21 % -2,10 %
Change in Working capital / Change in Net sales Average (2012-2014) -10,42 % -10,42 %
Free cash flow CaGr (2015-2018) 0,83 % 3,00 %

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Example: Applying DCF model to Kesko

Cost of Capital calculation


Risk-free rate of return 3,5 %
Beta 0,8
Risk premium 4,5 %
Cost of Equity 7,1 %
Cost of Debt 5,0 %
Equity/(Equity+Debt) 0,8
Debt/(Equity+Debt) 0,2
WACC 6,4 %

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Example: Applying DCF model to Kesko
Predicted numbers
2015 2016 2017 2018 Term. Value
Net sales 9 145,9 9 221,8 9 298,3 9 375,5
Costs and expenses -8 798,0 -8 871,0 -8 944,6 -9 018,9
EBITDA 347,9 350,8 353,7 356,6
EBITDA-% 3,8 % 3,8 % 3,8 % 3,8 %
Depreciations -110,4 -111,3 -112,2 -113,1
EBIT 237,5 239,5 241,5 243,5
EBIT-% 2,6 % 2,6 % 2,6 % 2,6 %
Financial items
Taxes, reported
Net tax effect on financial items
Taxes, adjusted -66,4 -66,9 -67,5 -68,0
Taxes, adjusted / EBIT -27,9 % -27,9 % -27,9 % -27,9 %
Earnings before financial items 171,1 172,6 174,0 175,4
+ Depreciations 110,4 111,3 112,2 113,1
- Capital expenditures -192,1 -193,7 -195,3 -196,9
Capital expenditures / Net sales -2,1 % -2,1 % -2,1 % -2,1 %
- Change in working capital -7,8 -7,9 -8,0 -8,0
Change in Working capital / Change in Net sales -10,4 % -10,4 % -10,4 % -10,4 %
Free cash flow 81,6 82,3 83,0 83,7 2521,1
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Present values of free cash flow 77 73 69 65 1967,8
Example: Applying DCF model to Kesko

Valuation summary
2015 2016 2017 2018 Term. Value
Free cash flow 81,6 82,3 83,0 83,7 2521,1
Present values of free cash flow 76,7 72,7 68,9 65,3 1967,8

Sum of PVs (2015-2018) 283,6 Long-term growth in FCF: 3,00 %


Present value of Terminal Value 1967,8 WACC: 6,4 %
Interest-bearing net debt 99,2 # of shares outstanding: 99,161
Total 2350,6 Value per share: 23,70

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Example: and the formula behind the DCF
valuation of Kesko…

FCF1 FCF2 FCF3 FCF4 FCF '4 (1  g )


EV0     
1  WACC 1  WACC 2 1  WACC 3 1  WACC 4 WACC  g 1  WACC 4
81,6 82,3 83,0 83,7 83,0 *1,03
    
1,064 1,064 2 1,064 3 1,064 4 0,064  0,031,064 4
 2206,4 (Value of Firm)
 99,2 (Interest - bearing net debt)
 2350,6 (Value of Equity)
/ 99,161 (# of shares outstanding)
 23,70 (Value per share)

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Example: Direct method of measuring
free cash flow, Kone 2013

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Case: Direct method of measuring free
cash flow, Kone 2013
• Interest received and paid (and other financial items) are
not included in the free cash flow
• Taxes include the amount of taxes that Kone has paid for
its financial income
– Since the free cash flow measures the cash flow before financial
related items and taxes on operations include taxes on net
financial items, we need to add taxes on net financial back to
cash flow
– Tax adjustment: 0,245*(29,5-2,4+10,8+2,7) = 9,9
– Adjusted taxes: -231,3 + 9,9 = -221,4

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DCF model, summary
• DCF model is the most commonly used valuation model
that has a clear logic
– Value of the firm is the sum of the NPVs of projects
– The same model works for both project and firm valuation
– There is a link between the DCF model and the current value
creation of the firm
• DCF model also has its problems
– It relies heavily on the terminal value
→Very sensitive to the estimated growth rate, WACC, and steady
state conditions
– It is subject to the timing of payment streams
→ Estimating the period in which payments will occur is difficult
→ Free Cash Flow streams are highly volatile over time.
DCF model is not a value creation concept

• Cash flow from operations (value added) is reduced by


investments (which also add value)
 Investments are treated as value losses
• Value received is not matched against value
surrendered to generate value
• A firm reduces free cash flow by investing and increases
free cash flow by reducing investments
– Free cash flow is partially a liquidation concept
• Also, analysts forecast earnings, not cash flows

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Can EVA be used in a valuation model?
• Earnings-based valuation models are based on the logic
of EVA and residual income we have already learnt
– Rely on future EVA or residual income (abnormal earnings) –
not the current or past
• Important characteristics
– Much smaller terminal value
 less forecasting needed
– Earnings are less volatile than cash flows
more precise forecasting
 Directly associated with the value creation of the firm
Abnormal earnings (AE) model

Book value of Expected future abnormal earnings


equity

2014 2015* 2016* 2017* 2018* 2019*-


Book value of
equity, B0
+
Present value of
future abnormal
earnings PV(AE)
=
Value of equity, V0

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Principle in the AE model is the same as
in the DDM and DCF models...

DDM model:
DIV1 DIV2 DIV3
Equity value0  V0     ...
(1  rE ) (1  rE ) 2
(1  rE ) 3

DCF model:
FCF1 FCF2 FCF3
Enterprise Value0  EV0     ...
(1  WACC ) (1  WACC ) 2
(1  WACC ) 3

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… but the algebra is different:
If accounting follows a clean surplus relation:
Clean Surplus Relation:
DIVt  NI t  Bt 1  Bt
Bt = Bt-1 + NIt – DIVt
Add and subtract rEBt-1:
DIVt  NI t  rE Bt 1  Bt 1  rE Bt 1  Bt

DIVt  ( NI t  rE Bt 1 )  (1  rE ) Bt 1  Bt Normal earnings = rEBt-1

Define abnormal earnings as: AEt  NI t  rE Bt 1

Then DIVt can be written as: DIVt  AEt  Bt  (1  rE ) Bt 1

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Abnormal earnings model, derivation
Substitute this expression for DIV into the Dividend Discount Model:

DIVt
V0   DIVt  AEt  Bt  (1  rE ) Bt 1
t
t 1 (1  rE )

AEt  Bt  (1  rE ) Bt 1
 V0  
t 1 (1  rE )t

Write out the expression:


t=1 t=2 t=3

 AE  B   AE  B B1   AE3  B3 B2 
V0   1 1
 B0    2 2
     ...
 (1  rE )1   (1  rE ) 2 (1  rE )   (1  rE ) 3
(1  rE ) 
2
    

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Abnormal earnings model, derivation

 AE B1   AE2 B2 B1 
V0  B0   1     
 (1  rE ) (1  rE )   (1  rE ) 2
(1  rE ) 2 (1  rE ) 
   

 AE B3 B2 
 3     ...
 (1  rE ) (1  rE ) (1  rE ) 
3 3 2
 

 AE   AE   AE 
 B0   1  2  3   ...
 (1  rE )   (1  rE ) 2   (1  rE )3 
     
 
AEt NI t  rE Bt 1
 B0    B0  
Recall that
t t
t 1 (1  rE ) t 1 (1  rE ) AEt  NI t  rE Bt 1

T
NI t  rE Bt 1 (1  g )( NIT  rE BT 1 )
 B0   
t
t 1 (1  rE ) (rE  g )(1  rE )T
50
Abnormal earnings model, derivation

 NI t rE Bt 1   NIT rE BT 1 
T Bt 1  B   (1  g ) BT 1   
V0  B0    t 1 Bt 1 
  T 1
B B T 1 
t 1 (1  rE )t (rE  g )(1  rE )T

NIt
ROEt 
Bt 1

T
( ROEt  rE ) Bt 1 (1  g )( ROET  rE ) BT 1
 V0  B0   
t
t 1 (1  rE ) (rE  g )(1  rE )T

51
Abnormal earnings model
Important points
• One assumption - Clean Surplus Relation
• Definition of ROE as current Net Income over last period’s
book value of equity
• Definition of abnormal earnings as the difference between:
• Net Income and cost of equity (in $ terms), or equivalently,
• ROE and rE, multiplied by last period’s book value of
equity (in % terms)
• A firms creates value when ROE > rE
52
Abnormal earnings model, implications
a) Management does better than
expected:
• What matters most to investors is: + $100 of
1. The amount of money they turn abnormal
over to management earnings
$300
2. The profit management is able to
$200
earn on that money

Abnormal earnings: r  Capital Earnings


Required earnings
b) Management does worse than
AE  Earnings  r  Capital expected:
What - $50 of
management What shareholders abnormal
Expected
does with the entrust to earnings
return management $200
money $150
 Suppose investors contribute
r  Capital Earnings
$2,000 of capital, and expect to
earn a 10% rate of return.
Abnormal earnings model:
Premium and discount

a) $20 = $15 + $5 • Investors willingly pay


a premium over BV for
companies that earn
$5 premium positive AE
• ROE exceeds the cost
of equity

• Firms that earn


b) $10 = $15 + - $5 negative AE sell at
discount to BV
• ROE is less than the
$5 discount cost of equity

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AE model protects from paying too much
for earnings growth
• Suppose a firm increases earnings by a new investment
– Abnormal earnings before the new investment:
AE = 12 – (0.10 x 100) = 2
– Abnormal earnings after the new investment of $20 million
earning at 10%:
AE = 14 – (0.10 x 120) = 2
• No value added from the new investment
• Creating earnings by accounting methods also increases
residual earnings but reduces book value
The net effect of these action on the equity value is zero

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Beware of paying too much for growth

• Investment creates growth but does not necessarily


add value
• Earnings growth can be created by the accounting
• Current stock price may reflect too high growth
expectations!
“But the combination of precise formulas with highly
imprecise assumptions can be used to establish, or rather
justify, practically any value one wishes, however high, for
a really outstanding issue.”
--Benjamin Graham, The Intelligent Investor, 4th Ed., p.315.

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Example: Applying AE model to Kesko
Analysts' earnings forecasts
2014 2015 2016 2017 2018
EPS 1,45 1,85 1,96 2,28
DPS 1,60 1,65 1,70 2,17
Pay-out ratio 1,10 0,89 0,87 0,95
BPS 22,00 21,85 22,05 22,31 22,41
Required earnings 1,56 1,55 1,57 1,58
Abnormal earnings, AE -0,11 0,30 0,39 0,69
Present values of AE, PV(AE) -0,10 0,26 0,32 0,53
Terminal Value, TV 13,90

Valuation summary
BPS (2014) 22,00
Sum of PVs (2015-2018) 1,00 Long-term growth in AE: 2,00 %
Present value of TV 10,56 Cost of equity capital: 7,1 %
Value of equity: 33,57

57
Example: Value profile of Kesko
0,80
0,70
0,60
0,50
0,40
%
0,30
0,20
0,10
0,00
-0,10

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Example: Value profile of Novo Nordisk
0,50
0,45
0,40
0,35
0,30
% 0,25
0,20
0,15
0,10
0,05
0,00

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AE model, some modifications
• If the balance sheet is at market value, then
– Book value of equity is expected to earn at the required
return, that is, ROE = cost of equity
– Abnormal earnings are expected to be zero
V0 = B0 , that is, the market and book values of
equity are equal

• What if some assets or liabilities really are at


market value?
• Well, we get back to the concept of analytical
balance sheet and income statement

13-60
AE model, some modifications

• AE model:
V0  B0  PV ( AE )

• Some assets and liabilities have zero expected AE,


because they are measured at market value
Modified AE model:

V0  B0  PV (abnormal earnings from net assets not at market value)

61
AE model, some modifications
This is the AE model we have been
talking about so far

Net Income Component Book Value Component Residual Earnings Measure

Earnings Equity Earnt – rEBt-1


(Earn) (B) (AE)
Net Operating Profit Net Operating Assets NOPATt – WACC×NOAt-1
(NOPAT) (NOA) (EVA)

Net Financial Expense Net Financial Obligations NFEt – rDNFOt-1


(NFE) (NFO) (ReNFE)

These are the two modifications of the


model

62
AE model, some modifications

• NFO are usually at market value on the balance sheet (or


close to it). So residual earnings from NFO are expected to
be zero:

ReNFE1 ReNFE 2 ReNFET


V0NFO  NFO0    ...   NFO0
ρD 2
ρD T
ρD

• NOA are not usually at market value in the balance sheet


EVA1 EVA2 EVA3
V0NOA  NOA0     ...
WACC WACC 2 3
WACC

63
AE model, some modifications

Value of Equity  V0  V0NOA  V0NFO

V0NOA
 V0NFO
EVA1 EVA2 EVA3 
V0  NOA0     ...  NFO0
( 1  WACC) ( 1  WACC)2 ( 1  WACC)3

EVA1 EVA2 EVA3


V0  B0    ...
 ( 1  WACC) ( 1  WACC)2 ( 1  WACC)3
The same NOA0  NFO0
model, but
different
inputs!  AE   AE   AE  Our ”original” AE model
V0  B0   1  2  3   ...
 (1  rE )   (1  rE ) 2   (1  rE )3 
     

64
Abnormal earnings (AE) model:
Summary
• A company’s future earnings are • Firms expected to generate
determined by: positive abnormal earnings sell at
1. the resources (net assets) a premium to equity book value.
available to management;
2. the rate of return (profitability)
• Those expected to generate
earned on those net assets.
negative abnormal earnings sell at
a discount to equity book value.
• If a firm can earn a return above its
cost of capital, then it will generate
positive abnormal earnings. • The abnormal earnings valuation
model makes explicit the role of:
1. Income statement and balance
• Firms that earn less than their cost sheet information;
of capital generate negative 2. Cost of capital
abnormal earnings.

65
IAS 36: Valuation of assets for potential
impairment

• The objective of IAS 36 is to prescribe the procedures that


the firm applies to ensure that its assets are carried at no
more than their recoverable amount
• These requirements apply equally to an individual asset
or a cash-generating unit (CGU)
• A firm has to estimate the recoverable amount of an asset
if there is any indication that the asset may be impaired
– Indications of impairment are assessed at each reporting date
• Firm valuation is needed when preparing financial
statements!

66
IAS 36 (p. 18-57), Measuring recoverable
amount
• Recoverable amount is defined as the higher of an
asset’s or CGU’s fair value less costs of disposal and its
value in use (p. 18)
 recoverable amount = max (fair value, value in use)

If carrying amount > recoverable amount: impairment loss


If carrying amount ≤ recoverable amount: no impairment loss

Carrying amount Recoverable amount:


higher of

Fair value less Value in use


costs of disposal
IAS 36, Example of an impairment test

• Firm M has a cash-generating unit A


• Carrying amount of A is 123 000 and its useful life is 4
years
• M recognizes indications that A may need to be
impaired
• The estimated fair value less costs to sell of A is 84 500
• How to perform the impairment test of A according to
IAS 36?

68
IAS 36, Example of an impairment test

2005 2006 2007 2008


Revenues 75 000 80 000 65 000 20 000
Costs (excluding depreciations) -28 000 -42 000 -55 000 -15 000
Cash flows 47 000 38 000 10 000 5 000

Present values with


a discount rate of 5% 44762 34467 8638 4114

Value in use = 91981

69
IAS 36, Example of an impairment test

• Recoverable amount of A is 91 981, because its value


in use (91 981) is greater than its fair value less costs
to sell (84 500)
• Because the recoverable amount of A (91 981) is
smaller than its carrying amount (123 000), the firm M
recognizes an impairment loss of A
• Impairment loss is 123 000 – 91981 = 31 019, which is
– recorded as a cost in a profit or loss (unless the impairment is
observed as a part of the revaluation under IAS 16)
– deduction in a carrying amount of A in a balance sheet

70
Summary

• Investors and financial analysts conduct firm valuation


for various purposes
• Valuation process involves 1) business analysis, 2)
financial statement analysis, 3) forecasting, and 4)
actual valuation
• In valuation models, future cash flows or other
measures of financial performance are discounted to get
the value of the firm
• Impairment tests are example of cases when valuation
is needed in preparing financial reports

71

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