# 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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