eVal
Chapter 10
Valuation
STEP 2
Forecasting the Future
1. Information
Collection
1. Structured
Forecasting
2. Understanding the
Business
2. Income Statement
Forecasts
3. Accounting Analysis
3. BalanceSheet
Forecasts
4. Financial Ratio
Analysis
5. Cash Flow Analysis
4. CashFlowForecasts
STEP 3
Valuation
1. CostofCapital
2. ValuationModels
Residual Income-Based
Valuation
Cash Flow-Based
Valuation
3. ValuationRatios
4. Complications
Negative Values
Value Creation and
Destruction though
Financing Transactions
of Capital
Forecast
Value
Financial Statements
Dividends
Discounted
Discounted
Residual Income
Earnings
Div t
P0
t
t 1 (1 re )
where
P0 = equity value at the end of period 0
Divt = net cash distributions to equity at the end of period t
re = cost of equity capital
FCFt
P0
Debt 0
t
t 1 (1 rW )
where
P0 = equity value at the end of period 0
FCFt = free cash flows to debt and equity holders during
period t
rW = weighted average cost of capital
Debt0 = value of debt at the end of period 0
FCFE t
P0
t
(1
r
)
t 1
e
where
P0 = equity value at the end of period 0
FCFEt = free cash flows to equity holders during period t
re = cost of equity capital
where
P0 = equity value at the end of period 0
NIt = net income for period t
re = cost of equity capital
CEt = book value of common equity at the end of period t
where
P0 = equity value at the end of period 0
NOIt = net operating income (after taxes)
rW = weighted average cost of capital
NOAt = net operating assets at the end of period t
Debt0 = value of debt at the end of period 0
t
T
(1
r
)
(r
g
)
(1
r
)
t 1
e
e
e
T
where
P0 = equity value at the end of period 0
NIt = net income for period t
re = cost of equity capital
CEt = book value of equity at the end of period t
g = constant terminal growth rate in residual income beyond period
T+1
r
)
t 1
e
This expression indicates that value is created by:
1. Generating a long-run ROE that exceeds the cost of
capital (focus on profit margin and asset turnover)
2. Growing the size of the investment base on which the
ROE is generated (focus on sales growth)
Residual Income
0
-0.05
-0.1
-0.15
-0.2
-0.25
-0.3
-0.35
0
Note that FAS123R essentially does this for employee stock options, in that it
requires an expense equal to the estimated cash value of the options granted
but we dont currently have similar accounting for convertible bonds
Valuation Example
EnCom
Corporation Stage 3
0
1
2
3
Residual Income Valuation (amortizing marketing costs over 3 years)
Residual Income
158
98
128
Discounted Residual Income
143.64
80.99
96.17
Residual Income Valuation
2,160.17
108
73.77
128
79.48
-60
-33.87
108
73.77
128
79.48
-60
-33.87
Stage 3 Questions
2. In question 1 above, you should have arrived at the same
valuation regardless of the accounting method employed.
Provide a qualitative explanation as to why the different
accounting methods have no impact on the valuation.
The accounting technique selected has no effect on cash
flows or dividends, and hence has no impact on the
valuation. Note that conservative accounting leads to low
residual income in earlier years and high residual income
in later years. Conversely, aggressive accounting leads to
high residual income in earlier years and low residual
income in later years.
Upcoming Cases
Overstock.com E