RE = 14 – (0.10 x 120) = 2
Earnings 5 5 5 5 5
Dividends 5 5 5 5 5
Book value 100 100 100 100 100 100
Residual earnings 0 0 0 0 0
Residual earnings 0 0 0 0 0
forward earnings 5 1 1
Value of savings account 100 Forward P/E 20
required return 0.05 required return 0.05
The Trailing P/E and Forward P/E
Price0
Forward P/E
Earnings1
Price0 Dividend0
Trailing P/E
Earnings0
1
Normal Forward P/E
required return
1 required return
Normal Trailing P/E
required return
The two accounts have different (ex-dividend) earnings growth, but the same
cum-dividend earnings growth
Normal Earnings
Earn1
Value
-g
Does not work for a savings account!
g 1.05
A Model of the Forward P/E
Value of savings account =
Capitalized forward earnings + No extra value
The model:
Value of equity = Capitalized forward earnings + Extra value for
abnormal
earnings growth
V0E
The intrinsic P/E Earn is given by dividing through by Earn1
1
Measuring Abnormal Earnings Growth for Equities
Cum-dividend earnings
growth rate (plus one):
Where
For Liberty:
Forecasts
Year 1 ahead Year 2 ahead Year 3 ahead Year 4 ahead
+
PV of
Discount by 2
AEG3
+
PV of
Discount by 3
AEG4
+
-
-
+
Current
Total
Value Capitalize earnings
plus growth
Forward P/E Ratios and Subsequent Earnings Growth
Rates: S&P 500 Firms
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
0 4 8 12 16 20 24 28 32 36 40
F o rwa rd P /E R a tio (2000)
Applying the Model: A Simple Example
Forecast for a firm with expected earnings growth of 3 percent per year. Required return is 10% per year.
RE growth rate 3% 3% 3% 3%
Forecast Year
1.307
Value per share 13.07
0.10
1
E
V1999 1.29 0.017 13.07
0.10
Same as residual earnings valuation
A Case 2 Valuation: PQR Ltd.
Required return is 11%
In this case, abnormal earnings growth is expected to grow at a 6.5 percent rate after 2006
Forecast Year
CV = = 0.873
0.0393
Present value
1.11 of1.CV
065= = 0.576
0.873
1.5181
1
E
V2000 0.84 0.062 0.576 12.31
0.11
Same as residual earnings valuation
Converting Analysts’ Forecasts to a Valuation: Action Ltd.
By the stocks and flows equation for accounting for the book value of equity
B t-1 = B t-2 + earn t-1 – dt-1 , so earn t-1 – d t-1 = B t-1 – B t-2 . Thus,
= RE t – RE t-1
Forecasts
Year 1 ahead Year 2 ahead Year 3 ahead Year 4 ahead
Residual Residual Residual Residual Residual Residual
Forward income2 income1 income3 income2 income4 income3
Earnings1
Earnings on reinvested
dividends 0.936 0.964 0.993 1.023
1 8.729 0.073
E
V2000 20.36 1 .10 133.71
0.10 1.10 1.10 1.03
Abnormal Earnings Growth Analysis:
Advantages and Disadvantages
Advantages Disadvantages
• Easy to understand: Investors think • Accounting complexity: Requires an understanding of how accrual
in terms of future earnings; investors accounting works.
buy earnings. Focuses directly on the • Concept complexity: Requires an appreciation of the concept of cum-
most common multiple used, the P/E dividend earnings; that is, value is based on earnings to be earned within the
ratio. firm and from earnings from the reinvestment of dividends.
• Uses accrual accounting: Embeds • Application to strategy: Does not give an insight into the drivers of earnings
the properties of accrual accounting
by which revenues are matched with growth, particularly balance sheet items, so is not suited to strategy analysis.
expenses to measure value added • Suspect accounting: Relies on earnings numbers that can be suspect
from selling products. • Forecast horizon: Forecast horizons can be shorter than those for DCF
• Versatility: Can be used under a analysis and more value is typically recognized in the immediate future. But
variety of accounting principles the forecast horizon does depend on the quality of the accrual accounting
• Aligned with what people forecast:
Analysts forecast earnings and
earnings growth.
Reverse Engineering: S&P 500
S&P 500, January 2004: 1000
Earnings forecasts:
2004 53.00
Forward P/E = 18.87
2005 58.20
2004 2005
1 1.909
E
V2003 1000 53.00
g = 1.039 (a 3.9% growth rate)
0.09 1.09 - g Compare with GDP growth rate
Reverse Engineering Growth Forecasts: Reebok
Price = 41
2004 2005E 2006E
1 0.067
E
V2004 41 3.43
0.10 1.10 - g
1 AEG2
E
V2004 147.2 million 12.36
1 1.03
Reebok:
11.50%
11.25%
11.08%
11.00%
10.89% BUY
10.75% 10.72%
10.56%
10.50%
SELL 10.42%
10.30%
10.25%
10.19%
10.00%
9.75%
2006 2007 2008 2009 2010 2011 2012
Building Blocks of an AEG Valuation: Action
V alue P er S hare
41.00
6.70
34.3
Captalized
Forward
Earnings
(1) Value from capitalized forward earnings, about which one is reasonably certain
(2) Value from capitalizing two-year-ahead abnormal earnings growth
(3) Value from forecasts of long-term growth, the most speculative part of the valuation.
The “Greenspan” Model
• If Earnings Yield is less than 10-year treasury note yield,
stocks are overpriced
Forward earnings 1
Earnings yield
Price Forward P/E
• A good model?
16
14
12
10
0
The PEG Ratio