LECTURE 12 EQUITY ANALYSIS AND VALUATION

EARNINGS PERSISTENCE
Defined as the continuity and durability of the current earnings.
The higher persistent earnings are accompanied by more ability to maintain the current
earnings and higher earnings quality (Lipe, 1990).
 Attributes of earnings persistence include:
 Stability
 Predictability
 Variability
 Trend
 Earnings management
 Accounting methods
Analyze
EARNINGS PERSISTENCE
Recasting
A common method that company adjusts their financial statements in order to reflect the actual
financial benefits earned by the company.
Aids in determining the earning power
Example:
Account receivables can be modified by removing uncollectible accounts as the bad debt expense
Damaged and obsolete inventory need to be adjusted out
Purchasing an asset which loses its value over the time the businesses may adjust these to their fair
market value
Depreciation expense of the assets can be adjusted by reviewing its expected useful life.
The expenses incurred at the owner’s discretion can be adjusted during recast finance.
Any one-time transaction needs to be excluded from recast finance.
DETERMINANTS OF EARNINGS PERSISTENCE

Earnings persistence determined by many factors including:

1) Earnings trends
can be assessed by statistical methods or trend statements (Uses

earnings numbers taken from the recasting and adjusting
procedures)
reveal the important of clues of a company current and future

performance
quality of management

DETERMINANTS OF EARNINGS PERSISTENCE

2) Earnings Management (creative use of different accounting

techniques to make financial statements look better)
Changes in accounting methods or assumptions

Offsetting extraordinary or unusual gains and losses

Big baths

Write-downs

Timing revenue and expense recognition

DETERMINANTS OF EARNINGS PERSISTENCE

3) Management Incentives
 Personal objectives and interests
 Companies in distress
 Prosperous companies—preserving hard-earned reputations
 Compensation plans
VALUATION METHODS

1. Discounted Future Cash-Flow methods

2. Market-based methods
3. Residual Income methods (Accounting-based methods) (refer
to lecture 11)
DISCOUNTED FUTURE CASH-FLOW APPROACH

► Estimated future cash flows are discounted back to present value based on the investor’s required rate of return;

1) Discounted dividend valuation

2) Discounted operating (free) cash-flow models
DIVIDEND GROWTH MODEL (DGM)
Assumptions:
 Dividends either show no growth or constant growth. Constant growth rate (g)
into the future.
 Shareholders’ required rate of return kCS is higher than the constant growth rate
g, (kCS > g). Negative share value is meaningless!
 The company’s earnings will increase sufficiently to maintain the dividend
growth levels.
 Estimates of cost of equity (shareholders’ required return) are reasonable.
 Investors are rationale and homogenous, have same expectations on dividends
vs. future capital appreciation on their shares. 9
Constant Growth Model
 

Assumes common stock dividends will grow at a constant rate into the
future.

D1 = the dividend at the end of year 1.

kcs = the required return on the common stock.
g = the constant, annual dividend growth rate.
V = fair market price ex-div, excluding dividends currently payable
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DGM EXAMPLE 1

XYZ stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely. What
would we be willing to pay if our required return on XYZ stock is 15%?

D0 = $5
So, D1 = 5 (1.10) = $5.50

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   stock recently paid a $5.00 dividend. The dividend is expected to grow at 10% per year indefinitely.
XYZ

What would we be willing to pay if our required return on XYZ stock is 15%?

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HOW TO ESTIMATE G?

 Given historical dividend data:

Dt =Dt-n (1+g)n
e.g. D2005 = D2000 (1+g)5
 Estimate using ROE and dividend payout or retention ratio.

g = ROE × retention ratio

g = ROE × (1 – div payout ratio)
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DGM EXAMPLE 2
Q&Q Bhd,a manufacturing company, paid the following per share dividends, from year 2005
to year 2008.

Year Dividend Per Share

2005 RM1.24
2006 RM1.31
2007 RM1.28
2008 RM1.44

 Calculate the annual rate of growth

 What is the most you would be willing to pay per share, if your required rate of return is 15%
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Solution:
To find growth rate:
1.44 = 1.24 (1 + g) 3
g = 5.11%

V0 = D1 ÷ (k - g)
V0 = 1.44(1.0511) ÷ (0.15 – 0.0511)
V0 = RM15.30

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Dividend Growth Model with Multiple
(Variable) Growth Rates
Bintang Bhd is expanding rapidly and now it needs to
retain all its earnings. It therefore does not pay any
dividends. However, investors expect Bintang to begin
paying dividends, with the first dividend of RM1.00
coming 3 years from today. The dividend should grow at
a rate of 25% during Year 4 and Year 5. After Year 5, the
dividend should grow at a constant rate of 8% per year. If
the required return on the stock is 13%, what is the value
of the stock today?
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1. Determine dividend per share for each year

0 0 1 1.25 1.5625 1.6875 ….

0 1 2 3 4 5 6

Year 1 and 2  no dividends

Year 3  dividends = RM1.00
Year 4 and 5  g = 25%
Year 6 and onwards  constant g = 8%
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2. Find PV of dividends that grow at constant rate indefinitely

25% 25% 8%
0 0 1 1.25 1.5625 1.6875 …..

0 1 2 3 4 5 6
V5

V
V55 == 1.6875/(0.13-0.08)
1.6875/(0.13-0.08) == RM33.75
RM33.75

V5 RM33.75 (value of the share at the BEGINNING of Year

6) already summarized all the dividends from end of 18

Year 6 onwards until infinity.

3. Find intrinsic value of the share by discounting
25% 25% 8%
V5 = RM33.75
0 0 1 1.25 1.5625

0 1 2 3 4 5 6

V = 1/(1.13) 33
+ 1.25/(1.13)44
+ 1.5625/(1.13)
V00 = 1/(1.13) + 1.25/(1.13) + 1.5625/(1.13) 55

++ 33.75/(1.13)
33.75/(1.13) 55

V
V00 == 0.693
0.693 ++ 0.7666
0.7666 ++ 0.8481
0.8481 ++ 18.3181
18.3181
V
V00 == RM20.63
RM20.63 19
DISCOUNTED FREE CASH FLOW MODEL

 The free cash flow valuation model estimates the value of the entire
company and uses the cost of capital as the discount rate.
 As a result, the value of the firm’s debt and preferred stock must be
subtracted from the value of the company to estimate the value of
ordinary equity (VS).

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FCF EXAMPLE
Dewhurst Inc. wishes to value its stock using the free cash flow model.
To apply the model, the firm’s CFO developed the data given in Table 7.4.
Table 7.4 Dewhurst, Inc.’s Data for the Free Cash Flow Valuation Model

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Step 1. Calculate the present value of the free cash flow occurring from the
end of 2015 to infinity, measured at the beginning of 2015 (end of 2014).

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Step 2. Add the PV (in 2014) of the FCF for 2015 until infinity
found in Step 1 to the FCF for 2014 to get total FCF for 2014.

Total FCF2014 = $600,000 + $10,300,000 = $10,900,000

Step 3. Find the sum of the present values of the FCFs for 2010 through 2014
to determine, VC, and the market values of debt, VD, and preferred stock, VP,
given in Table 7.5 on the following slide.
Step 4. Calculate the value of the common stock using equation 7.8.
Substituting the value of the entire company, VC, calculated in Step 3, and
the market value of the debt, VD, and preferred stock, VP, yields the value of
the common stock, VS.

VS = $8,628,620 - $3,100,000 - $800,000 = $4,728,620

P0 = $4,728,620 / 300,000 shares = $15.76 per share
LIMITATIONS OF FCF

 This method of valuation is appropriate when one company intends to

acquire another company.
 It may not be appropriate to use the investing company’s cost of capital to
discount cash flows of new investment because:
i) the business risk of the new investment could be different from the
investing company’s existing investments.
ii) the method of financing of the new investment may be different from
the current debt/equity mix of the investing company.
P/E MULTIPLES METHOD
 This is a common method of valuing a controlling interest in a
company where the owner can decide on dividend and retention
policy. P/E method related earnings per share (EPS) to share
value.
 To value a company’s share, it decides a suitable P/E ratio (usually
industry average P/E) and multiply it with EPS of the company’s
shares.
 Suitable to value the stock of company that pay no dividends.

Value of company i = Total earningsi × P/E

Value per share i = EPSi × P/E
P/E MULTIPLES METHOD

 The EPS could be historical EPS or expected future EPS.

For a given EPS, a higher P/E ratio would result in higher
share value.
 For example, QT Berhad expected EPS is RM2.60/share
and the industry average P/E multiple is 7, then P0 =
RM2.60 X 7 = RM18.20/share.
SIGNIFICANCE OF HIGH P/E RATIO

 Expectation that the EPS will grow rapidly. A higher share price is
being paid for future profit prospects. Usually, small and fast growing
companies tend to have high P/E ratios.
 A well-established low-risk company typically has higher P/E ratio
than a similar company whose earnings are subject to greater
uncertainty.
 A listed company is ought to be less risky and its shares can be readily
sold in the stock market. Therefore, investors are willing to pay more
for its shares than a similar unlisted company. Hence, P/E ratio of listed
company is higher than unlisted company.
 LIMITATIONS OF P/E METHOD
 When EPS is negative (loss) for a particular financial year, P/E
multiples method cannot be applied.
 Using P/E ratios of quoted (listed) companies to value unquoted (non-
listed) companies could be problematic because:
1) difficult to find a quoted company in the similar range of business activities
2) quoted company may have different capital structure from the unquoted company
3) a single year P/E ratio of the quoted company might be biased by earnings volatility and events such
as expectation of takeover bid.
 Future earnings and earnings growth are uncertain, even if a trend of
previous years earnings and EPS are available.
 SELECTING A MODEL
Dividend The company is dividend paying
Discounted The company’s dividend paying policy has a consistent relationship with
Model earnings.
The investors takes a non-control perspective
Discounted Cash The company does not pay a dividend or dividends do not exhibit a
Flow Model consistent relationship with earnings.
Free cash flow aligned with profitability and can be forecasted
The investors takes a control perspective
Market-based Publicly traded peer companies exist
Models A proxy of value such as earnings is positive and a consistent relationship
with the value of the firm
The analysis is confident about the valuation in the market and the peers.