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## Valuation Theory

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**Valuation Theory**Dr. Lewis F. Davidson**Reasons for Valuation**• Buy/Sell Decision • Estimate Value of Target Firms for Acquisition and Synergies They Might Offer • Price Initial Public Offerings (IPO) Dr. Lewis F. Davidson**Valuation Approaches**• Discounted Dividends • Discounted Abnormal Earnings • Valuation Based on Price Multiples (e.g. applying price-to-earnings to forecasted earnings, price to book value, price-to-sales ratio • Discounted Cash Flow Analysis Dr. Lewis F. Davidson**Theoretical Perspective**• Shareholder Value is the PV of Future Dividend Payoffs • Can implemented directly by forecasting and discounting future dividend • Can be framed by recasting dividends in terms of earnings and book values • Can be framed by recasting dividend in terms of free cash flows to share holders Dr. Lewis F. Davidson**Multiples**• Popular because they do not require multi-year forecasts. • Benchmarking is a serious challenging in implementation • Can be mitigated by using abnormal earnings to recast multiples of value-to-book and value-earnings ratios to generate firm specific estimates • Abnormal earnings Dr. Lewis F. Davidson**The Dividend Model**Shown as having infinite life. In reality firms go bankrupt and are taken over. In these cases the shareholders essentially receive a terminating dividend for their stock. Dr. Lewis F. Davidson**Dividend Model with Growth**Assumes constant dividend growth indefinitely Re = Cost of Equity Capital Dr. Lewis F. Davidson**Discounted Abnormal Earnings**• The link between dividends and earnings • Assuming no capital transactions: DIV1 = NI1 + BVE0 – BVE1 Therefore: Equity Value = Book Value of Equity + PV of Expected Future Abnormal Earnings Where: Abnormal Earnings = Comprehensive Income less (BVE0 x re) Dr. Lewis F. Davidson**Discounted Abnormal Earnings Model**Dr. Lewis F. Davidson**Discounted Abnormal Earnings Method**Dr. Lewis F. Davidson**Discounted Abnormal Earnings Method**• Intuitive Appeal. If a firm can only earn a normal return (cost of capital), the investor will be willing only to pay book value. • Stock Value is book value (cost) of existing assets plus the net present value of future growth options (represented by cumulative abnormal earnings) Dr. Lewis F. Davidson**Discounted Abnormal Earnings Method**• Recent research show that the abnormal earnings estimates of value outperforms traditional multiples, such as price-earning ratios, price-to-book ratios and dividend yields in prediction future stock movements. Dr. Lewis F. Davidson**Accounting Methods and Abnormal Earnings**• What about choice of accounting methods? • Accounting choices affect earnings and book value • Double entry is self-correcting (i.e., distortions must ultimately reverse) So earning management through accounting provisions will also reverse. Dr. Lewis F. Davidson**Accounting Methods and Abnormal Earnings**• Provided that the analysts is aware of biases in accounting data, abnormal earnings approaches are unaffected by accounting decisions • Strategic and Accounting analysis tools (assessing the quality of earnings) helps to determine abnormal earnings that arise from sustainable competitive advantage from unsustainable accounting manipulation • Need to know biases for forecasting future earnings Dr. Lewis F. Davidson**Valuation Using Price Multiples**• Popular • Do not require detailed multiple-year forecasts about a variety of parameters including growth, profitability and cost of capital Dr. Lewis F. Davidson**Valuation Using Price Multiples**• Step 1: Select measure of performance or value (e.g., earnings, sales, cash flows, book equity, book assets) • Step 2: Estimate price multiples for comparable firms using the measure • Step3: Apply the comparable firm multiple to the performance or value measure of the firm being analyzed Dr. Lewis F. Davidson**Valuation Using Price Multiples**Problems: • Identification of comparable firms is difficult • Explaining why multiples vary across firms and how applicable another firm’s multiple is for comparison require a sound understanding of the determinants of each firms multiple Dr. Lewis F. Davidson**Valuation Using Price Multiples**• Industry Averages are weighted averages and can be misleading by abnormal performance or transitory effects for a major firm. • Multiples can be based on estimates (leading) vs. historical data (trailing). This may be necessary because of transitory effects. Dr. Lewis F. Davidson**Determinants of Value-to-Book and Value-Earnings Multiples**Dr. Lewis F. Davidson**Determinants of Value-to-Book and Value-Earnings Multiples**Implies the a firm’s equity value-to-book ratio is a function of three factors: • Future abnormal ROE (ROE-re). • Growth of book equity • Cost of equity capital Abnormal earnings = EVA Dr. Lewis F. Davidson**Determinants of Value-to-Book and Value-Earnings Multiples**Two Key Questions: • How much greater (or smaller) than normal will be the firm’s ROE be? • How quickly will the firm’s investment base (book value) gow? Dr. Lewis F. Davidson**Determinants of Value-to-Book and Value-Earnings Multiples**Can also be expressed as debt plus equity value-to-book value The value of equity under this approach is then the estimated multiple times the current book value of assets less the market value of the debt Dr. Lewis F. Davidson**Shortcut forms of Earnings-Based Valuation**Random Walk. • Assumes that the best guess about future expected abnormal earnings are current abnormal earnings • Assumes that past shocks to abnormal earnings persist forever but future shocks are random or unpredictable Dr. Lewis F. Davidson**Shortcut forms of Earnings-Based Valuation**Reality: Abnormal earnings unlikely to last forever Persistence depends on Strategic Factors such as Barriers to Entry, Switching Costs, Dr. Lewis F. Davidson**Shortcut forms of Earnings-Based Valuation**Autoregressive Abnormal earnings expected to decay over time Can be written as a function of current abnormal earnings Dr. Lewis F. Davidson**ROE and Growth Simplifications**• Long term ROE affected by such factors as barriers to entry, change in technologies, organizational infrastructure • These factors tend to force abnormal ROEs to decay over time. Can be modeled as a mean reverting process Dr. Lewis F. Davidson**ROE and Growth Simplifications**Limited value in making forecasts for valuation beyond a relatively short time horizon. Most companies ROEs are mean reverting to that of other firms in the industry within 3 to 5 years. Dr. Lewis F. Davidson**ROE and Growth Simplifications**• For a firms in steady state the formula is Dr. Lewis F. Davidson**The Discounted Cash Flow Model**Dr. Lewis F. Davidson**The Discounted Cash Flow Model**Dr. Lewis F. Davidson**Alternatively, the free cash flow formulation can be**structured by estimating the value of claims to debt and equity, and then deducting the market value of debt. Dr. Lewis F. Davidson**Comparing Valuation Methods**All are derived from the Dividend Discount Model. As long as analysts make the same assumptions about firm fundamentals, value estimates under all four methods will be identical Dr. Lewis F. Davidson**Comparing Valuation Methods**Important Differences: • They focus the analyst’s task on different issues; • They require different levels of structure for valuation analysis; • They have different implications for estimation of terminal values Dr. Lewis F. Davidson**Comparing Valuation Methods**Differences in Required Structure; • Discounted Abnormal Earnings and ROE methods require analysts to construct both proforma income statements and balance sheets and to forecast future earnings and book values • Discounted cash flow method requires analysts to forecast fee cash flows • Discounted dividend method requires analysts to forecast dividend Dr. Lewis F. Davidson**Comparing Valuation Methods**• Discounted abnormal earnings approaches require more structure and work Dr. Lewis F. Davidson**Comparing Valuation Methods**Differences in Terminal Value Implications • Terminal Value estimates much smaller for abnormal earnings and ROE than for discounted cash flow or dividends • For technology driven firms or those requiring high R & D terminal value could be a substantial fraction of total value. • Can adjust the accounting numbers by capitalizing and amortizing Dr. Lewis F. Davidson**Comparing Valuation Methods**• Recent research indicate that over relative time horizons of 10 years or less valuation estimates based upon abnormal earnings or ROE generate more precise estimates of value than either the discounted cash flow or dividend approaches. • Persists whether conservative or aggressive accounting methods used. • Accrual accounting is a better predictor of future cash flows than extrapolating cash flows. Dr. Lewis F. Davidson