Using Accounting Earnings for Valuation - Why Earnings and Not Cash Flow

“Using Accounting Earnings for Valuation” Where have we been & where are we going? • Where have we been? – Valuation Basics – Calculating Cash flows • Today – Overview of Dell Abnormal Earnings Valuation – Quickly discuss accounting and real options • What we still need? – Other techniques: Multiples Valuation (Next Class) – Forecasting earnings and cashflows – Avoid being fooled by financial statements Discussion of E-Assignment #1: Dell Valuation • Approach to teaching Financial Valuation & Analysis: – First, we define the problem we are facing, then knowing the context, we build a set of tools to solve the problem. • We are starting to see the issues: – Must estimate earnings, cashflows, balance sheet items. – Must avoid the pitfalls of “misleading” financial reports … managers may want to fool you. – Must estimate risk, growth, etc. – Yahoo! data and analysts’ estimates are a “crutch” right now. Aside … What is “Value Added” in Performance Measurement? • What is Value Added? – Can we determine if company has invested capital wisely? • Starting Point: Market Value Added (MVA) – MVA for All Investors (Debt+Equity) • MVA = Market Value (D+E) – Invested Capital (D+E) – MVA for Equityholders (just Equity) • MVA = Market Value (Equity) – Invested Capital (Equity) – Qualifications? • Invested Capital is from the past! Market Value is from Today! What is Value Added in Valuation? • The “value added methodologies” are used to measure the profits (or losses) generated by a firm for a given level of capital investment & the risk of these investments: – Also called residual income or abnormal earnings • Value Added (for all investors … Debt + Equity): = Net Operating Profit after tax – Capital charge • NOPAT = Net Operating Profit after Tax • Capital charge = rassets * Value of Assets at start of year • Residual Income for Equityholders: = Net Income – Capital charge • Capital charge = requity* Value of Equity at start of year Why “Abnormal Earnings” or “Residual Income” Valuation? • REMINDER! Valuation ultimately boils down to DCF (or discounted dividends). • Big Problem: Estimating future FCF’s or dividends. – Does there exist a meaningful way to map accounting numbers into equity value given that cash is real? – Traditional answer: NO, given that … • Accrual-based accounting numbers do not take into account the timing of cash flows. • Earnings do not perfectly reflect investments in the same way as FCF does. • (Most of all) Accounting numbers can be manipulated. • BUT: DCF is based on forecasting accruals (sales, profit margins, earnings) and then unraveling them…. Starting Point for “AE" Valuation: Intuition: – The value of the firm (or equity in the firm) can be the sum of three components: 1) Original Invested Capital - What is the starting value of funds originally contributed by investors (equityholders). 2) Normal rate of return on Invested Capital - Basically determined by cost of capital (“r”). 3) Abnormal return on Invested Capital - Abnormal earnings (residual income) above normal rate of return. The Model • Use this idea to express current equity value of the firm as a function of book value of the firms and abnormal earnings: f Equity Value0 = BV0 + ¦ [AEt /(1+r)t] t=1 where: BVt = Book value of equity at beginning of year t r = Cost of equity capital AEt = Expected value of abnormal earnings in year t = Projected earnings in yr t - (r * BV of equity at beginning of year t) Where does model come from? • Basically a rearrangement of the discounted dividend or FCF valuation models. • Combines “current value” on the balance sheet with the present value of future “abnormal earnings”. • In theory, should give the same answer as discounted dividend and DCF (or free cash flow) valuation models. • Uses accounting numbers (which are easy to observe) and future projections of earnings (which are easier to project … analysts). Overview of Steps of Abnormal Earnings Valuation Step 1: Forecast earnings in each year t=1,...,T in the forecast horizon. Step 2: Estimate “r”, the cost of equity capital. Example using CAPM: r = Rf + E* [E(RM) - Rf ] where Rf = “Riskless” return E = Beta on common stock E(RM) – Rf = Expected risk premium on market portfolio Steps - Continued Step 3: Estimate expected abnormal earnings in each yr t = 1,..,T in forecast horizon: AEt = Et - (r * BVt-1) Step 4: Use “r” to estimate the PV of abnormal earnings during the forecast horizon: AE1/(1+r)1 + AE2/(1+r)2 + .... + AET/(1+r)T Step 5: Estimate the PV of expected abnormal earnings beyond the forecast horizon: • Use perpetuity • Use growing perpetuity Steps – Terminal Values • PERPETUITY METHOD – Estimate AE in year T+1 – Assume AE constant beyond year T+1 PV of AE beyond yr T = [AET+1 / r ] / (1+r)T • GROWING PERPETUITY METHOD – Estimate AE in year T+1 – Assume AE grow beyond year T+1 forever at rate g/year PV of AE beyond yr T = [AET+1 / (r – g) ] / (1+r)T Steps – Final Step Step 6: Computer equity value by summing together the parts: Equity Value = BV of equity at beginning of yr 1 + PV of AE during forecast horizon (Step 4) + PV of AE beyond forecast horizon (Step 5) EBO Valuation using Dell Computer Example. • Inputs: – BV0 = $1.80 (Book value of equity per share at the end of the 3rd quarter of fiscal year. From latest financials on Yahoo! http://biz.yahoo.com/z/a/d/dell.html • • • • 2003 year end is NOW! Therefore, small adjustment to BV0 Use estimate of current (4th quarter earnings = $0.23) Therefore, updated BV0 = BV0 + EPS4thQ = 1.80 + 0.23 = $2.03 – Take Yahoo! earnings forecasts for 2004: E1 = $0.99 EBO Valuation using Dell Computer Example. • Inputs: – % 5 year growth in EPS is projected to be: 15% • • • • E2 = E1*(1+g) = $0.99*(1.15) = $1.14 E3 = E2*(1+g) = $1.14*(1.15) = $1.31 E4 = E3*(1+g) = $1.31*(1.15) = $1.51 E5 = E4*(1+g) = $1.51*(1.15) = $1.73 – Cost of Capital (from CAPM) R = Rf + Beta*(Rm-Rf) = 5% + 1.79*(8%) = 19.3% EBO Valuation using Dell Computer Example. • Calculations: BV1=BV0 + (E1 – DIV1) = 2.03 + (0.99 – 0) =$3.02 BV2=BV1 + (E2 – DIV2) = 3.02 + (1.14 – 0) =$4.16 BV3= BV4= BV5= AE1 = E1 – r*BV0 = 0.99 - (0.193)*2.03 = $0.60 AE2 = E2 – r*BV1 = 1.14 - (0.193)*3.02 = $0.55 AE3 = ? AE4 = ? AE5 = ? EBO Valuation using Dell Computer Example. • Final Calculation: P = BV0 + AE1/(1+r) + AE2/(1+r)2 + PV of future AE? In this case, let’s assume AE Æ 0 in year 9: P = 2.03 + 0.60/(1+r) + 0.56/(1+r)2 + 0.51/(1+r)3 + 0.45/(1+r)4 + 0.38/(1+r)5 + …. Extreme Earnings Reverts to “Normal Rate of Return” 0.2 Mean Earnings 0.15 z z z z ` ` z z z z z z z ` ` ` 0.1 0.05 0 -0.05 ` ` ` ` ` Low Earnings Portfolio z High Earnings Portfolio ` ` -0.1 -5 -4 -3 -2 -1 0 1 2 Event Year 3 4 5 How Will Abnormal Earnings Evolve in the Future? • By their very definition, AE are hard to sustain: – Positive abnormal earnings – Competitors enter – Negative abnormal earnings – Takeover, management fired, restructuring, etc. • Potential Problems: – What if Book Value of Equity (BV) is incorrectly measured? – Why might BV be too low? Final Calculations for DELL Predicted Price of Dell based on abnormal earnings valuation is: P = _____ What is current price of DELL? Around $23.00 Is our assumption about future AE valid? Why? Comparison with DCF – Equivalent? • Simpler than DCF: – Forecast accounting variables directly – Cost of capital calculation is easier (than WACC) – Terminal value is less important than in DCFcontext … Easier to implementation assumption about future earnings (or abnormal earnings). Compare this with your DCF analysis for DELL! – Terminal value represents only stream of abnormal earnings beyond the forecast horizon Problems with Residual Income Valuation • If the balance sheet does not recognize the current value of assets (or fails to recognize them at all), then what does this imply for abnormal earnings? – Book value fails to account for certain assets that do generate cashflows! – AEt = Et – r*BVt-1 – Implications for future AE? – Intangibles: patents, R&D, trademarks, brandnames, etc. Intangibles • If the balance sheet does not recognize intangible assets, then what does this imply for abnormal earnings? – Measured “abnormal earnings” may persist forever. • Intangibles: – Patents, trademarks, brandnames, etc. – Account for “investments” in a factory? – Account for “investments” R&D, advertising, employee training? Real Options • Most valuation approaches (DCF, AE, etc) fail to account for real options: – Option to abandon poorly-performing businesses – Option to expand the “winners” – Option to redeploy or adapt assets to superior use – Option to wait before investing (gold-mine example) Real Options: Practical Issues • How do you take into account real options? – Practical approach #1: Consider P/E ratio or M/B ratio for valuation. If firm is earning losses then which should you use? – Berger, Ofek and Swary (JFE 1995) • Consider the type of assets on the balance sheet – tangible versus intangible (cash versus brand-name) • What type of assets are valuable if firm “crashes“? • The “Worst Case Scenario” valuation of assets on balance sheet …. Explains why balance sheets often have “conservative” valuation of assets (Historical cost). Where Next? • Next Class – “Comparative Analysis” – Priced Based Financial Ratios – Accounting Based Ratios • Skim Section F of Course Reader (“Introduction to Profitability and Risk Analysis”). • Assignment #1 is due in class on Tuesday, February 25, 2003.