Accounting Based Stock Valuation by wlp14137

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									                      FINANCIAL INFORMATION ANALYSIS
                  ACCOUNTING-BASED VALUATION TECHNIQUES
                              Application Exercises

                                          Question 2
Construct a two-period numerical example to show that the accounting-based valuation of a firm
is the same whether R&D is capitalized or expensed.


                  ACCOUNTING-BASED VALUATION TECHNIQUES
                             Application Exercises
                                  Question 2

Consider R&D Inc., a biotech start up. This firm:
 Incurs expenditures in R&D of $50 in the first year of activity;
 Has an opening book value of equity of $1,000;
 Generates income (before R&D expenses) of $200 in year 1 and $220 in year 2, at the end of
   which it is liquidated;
 Has a cost of equity capital of 10%;
 Pays no dividends prior to liquidation;

Show that the PVAE obtains regardless of whether R&D Inc. expenses R&D expenditure as
incurred or capitalizes and amortizes R&D expenditure!


                  ACCOUNTING-BASED VALUATION TECHNIQUES
                             Application Exercises
                                   Question 2
                           Expensing R&D As Incurred

Assume that the R&D expenditure is expensed at the end of year1:


                                                 150 - 100 220 - 115
     PVAE( Yr 0 ) = 1000 +                                +
                                                   1.1       1.12

And Thus:
PVAE = 1132.2
                  ACCOUNTING-BASED VALUATION TECHNIQUES
                                Application Exercises
                                     Question 2
                        Capitalising And Amortising R&D (1)

Assume that the R&D expenditure is capitalised and amortised linearly:
 R&D expense recognised at end of year 1: 25;
 R&D expense recognised at end of year 2: 25;



                                               175 - 100 195 - 117.5
       PVAE( Yr 0 ) = 1000 +                            +
                                                 1.1        1.12


And thus:
PVAE = 1132.2


                  ACCOUNTING-BASED VALUATION TECHNIQUES
                                Application Exercises
                                     Question 2
                        Capitalising And Amortising R&D (2)

Assume that the R&D expenditure is capitalised and amortised as follows:
 R&D expense recognised at end of year 1: x;
 R&D expense recognised at end of year 2:
 50-x;



                                      200 - x - 100 220 - 50 + x - (1200 - x) 0.1
 PVAE( Yr 0 ) = 1000 +                             +
                                          1.1                   1.12
                    ACCOUNTING-BASED VALUATION TECHNIQUES
                                  Application Exercises
                                       Question 2
                          Capitalising And Amortising R&D (3)


As:


                         x     x       0.1 x
                    -      +      2
                                    +       2
                                              =0
                        1.1 (1.1 )    (1.1 )


PVAE is thus independent of x and hence accounting policy for R&D expenditure!


                        FINANCIAL INFORMATION ANALYSIS
                    ACCOUNTING-BASED VALUATION TECHNIQUES
                                Application Exercises

                                         Question 3
Explain why terminal values in accounting-based valuation are significantly less than those for
DCF valuation.


                    ACCOUNTING-BASED VALUATION TECHNIQUES
                               Application Exercises
                                    Question 3

     DCF terminal values include the PV of all expected CFs beyond the forecast horizon;

     The expected cash flows beyond the forecast horizon can be broken down into 2 parts:
      normal and abnormal;

     Since the terminal value in the PVAE includes only abnormal earnings, terminal values in
      accounting-based valuations are significantly less than those in DCF valuations;
                       FINANCIAL INFORMATION ANALYSIS
                   ACCOUNTING-BASED VALUATION TECHNIQUES
                               Application Exercises

                                            Question 5

   Manufactured Earnings is a “Darling” of Wall Street analysts;
   Its current market price is $15 per share and its book value is $5 per share;
   Analysts forecast that the firm’s book value will grow by 10% per year, indefinitely, and the
    cost of equity capital is 15%;
   Given these facts, what is the market’s expectation of the long-term average ROE?


                   ACCOUNTING-BASED VALUATION TECHNIQUES
                              Application Exercises
                                   Question 5


                              ve*/se = 1 + [ ( ROE - E ) / (E - g ) ]

where:
 ROE is the expected long-term average ROE;
 g is the expected long-term average growth in book value;
 E is the cost of equity capital;
 ve* is the stock price;
 se is the book value of equity per share;


                   ACCOUNTING-BASED VALUATION TECHNIQUES
                              Application Exercises
                                   Question 5

Equivalently:

                               ROE = E + (E - g )* (ve*- se) / se

And hence:

                       ROE = 15% + ( 15% - 10% ) * ( 15 - 5 ) / 5 = 25%
                      FINANCIAL INFORMATION ANALYSIS
                  ACCOUNTING-BASED VALUATION TECHNIQUES
                              Application Exercises

                                          Question 6

Given the information in the previous question, what will be Manufactured Earnings’ stock price
if the market revises its expectations of long-term average ROE to 20%?


                  ACCOUNTING-BASED VALUATION TECHNIQUES
                             Application Exercises
                                  Question 6


Using the same formula:

                            ve*/se = 1 + (20% - 15%)/(15% - 10%)

Hence:

                                            P = $10

								
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