Equity Security Analysis Fundamental Analysis

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Equity Security Analysis Fundamental Analysis Powered By Docstoc
					Business and Financial Analysis
   Analysis of companies for possible investments
    and valuation involves many components.
   The entire business must be considered.
Components of analysis

   Business strategy analysis
   Accounting analysis
   Financial analysis (ratios etc.)
   Prospective analysis
Business strategy analysis

   Generate Performance expectations through
    industry analysis and competitive strategy
    analysis
Accounting analysis

   Evaluate accounting quality by assessing
    accounting policies and estimates
Financial analysis

   Evaluate performance ratios using ratios and
    cash flow analysis
Fundamental Analysis
Prospective analysis

   Forecast future events and value the
    business
Strategic analyses (Porter)
   Industry analysis
   Competitive strategy analysis
   Corporate strategy analysis
Structural Analysis of Industries
   Determines the ultimate profit potential of the
    industry
   Mix of economic factors and technology
   Level of competition and long-run ROI
   Firm will respond with unique competitive
    strategy
Forces Driving Industry Competition
and profit
   Threat of entry
   Rivalry among current competitors
   Threat of substitution
   Bargaining power of buyers
   Bargaining power of suppliers
Competitive Strategies
   Overall Cost Leadership
   Differentiation
   Focus (unique products/ market niche)
Impact of strategy on financial
statements
   A company’s competitive strategy will affect
    the look of its financial statements.
   In a competitive industry, gross profits will
    tend to equalize.
   In a monopoly we will see very high profits
Quality of Accounting
   We are looking here at the way in which the
    firm applies the rules of accounting
   The quality of accounting relates to the extent
    to which the financial statements reflect the
    true economic picture of the company
Accounting quality?
Factors Influencing Accounting
Quality
   Accounting Rules
       Uniformity of Accounting rules do not reflect the economic
        situation of all firm equally well
   Forecast Errors
       Management must make estimates in preparing financial
        statements
       Some of the estimates are less accurate than others
       Firms differ in the materiality of the effect of estimates on
        inferences made from information in the financial statements
Factors Influencing Accounting Quality and
Manager’s Choices
   Managerial Compensation
   Corporate Control Contests
   Tax Considerations
   Regulatory Considerations
   Capital Market Considerations (international vs. US)
   Stakeholder Considerations
   Competition Within the Industry
Accounting Analysis
   Identify Key Accounting Policies
   Assess Accounting Flexibility
   Evaluate Accounting Strategy
   Evaluate Quality of Disclosure
   Identify Potential Red Flags
   Undo Accounting Distortions
Identify Key Accounting Policies
   We will be learning about how to do this
    throughout the course
   First footnote to financial statements
   Differ somewhat by industry
Assess Accounting Flexibility
   Some of the policies that have a substantial
    effect on one industry are governed by rigid
    rules, while others allow managerial
    discretion
   Need to evaluate both situations carefully
   These differ by industry
Evaluate Accounting Strategy
   Does manager use flexibility to reveal true
    economic situation of the firm or to hide it?
    Questions to ask:
       How do accounting policies compare to industry norms
       Does manager have strong incentive to use discretion to
        manage earnings
       Have accounting policies or estimates changed recently
       Have policies been realistic in the past
Evaluate Quality of Disclosure
   Does firm provide adequate disclosure to allow an
    assessment of its business strategy ?
   Do footnote adequately explain accounting policies ?
   Does management explain current performance
    adequately?
   If rigid accounting rules do not allow the firm the
    flexibility to reveal relevant information in the financial
    statements, do they do so in other sections of the
    financial statements?
   Is segment disclosure adequate?
   How is bad news revealed ?
   Investor relations program?
Identify Potential Red Flags
(Shenanigans)
   Unexpected changes in accounting policies
   Unexpected sale of assets or other actions that boost profits
   Unusual increases in Accounts Receivable relative to sales
   Unusual increases in Inventory relative to sales
   Increasing gap between reported income and CFO
Red flags (continued)

   Increasing gap between reported income and tax income
   Sale of receivables and other off balance sheet financing
   Large asset write-offs
   Qualified audit opinion or change in opinion
Accounting Analysis
   Nature of Accounting policies
       Aggressive
           Income increasing
       Conservative
           Income decreasing
Receivables
   Are they collectible?
   Is the allowance for uncollectible accounts
    reasonable?
Inventory
   FIFO Or LIFO?
   Turnover?
   Read the Footnotes!
Accounting changes
   Discretionary or required
   income increasing or decreasing
   Do they seem justified?
Unusual gains/losses
   What is their impact?
   How are they reported?
Disclosures
   VERY IMPORTANT
   Are they consistent with what you think?
   Are footnotes adequate?
Disclosures (con’t)
   Are there hidden liabilities?
       Operating leases
       Contingent liabilities
       Unfunded pension liabilities
       Purchase commitments
Financial Analysis

   Separate from accounting analysis
   Use ratios and other information to make
    inferences about a company’s prospects and
    performance.
Sources of Information
About Companies

   Information about publicly traded companies comes
    in many forms and may be found in many places.
       Annual reports
       SEC filings and databases
       Company press releases
       Articles that appear in the financial press
       Web sites
Sources of Information
About Companies

Annual report
The annual report is important to investors
 because of its completeness and its reliability
 due to the audit performed by an independent
 auditor.
Annual report components
 Financial statements
     Footnotes to the financial statements
     A summary of accounting principles used
     Management’s discussion and analysis of the
      financial results
     The auditor’s report
     Comparative financial data for a series of years
     Narrative information about the company
Sources of Information
About Companies
   Publicly traded companies must also prepare
    reports for the Securities and Exchange
    Commission (SEC).
       Form 10-K - presents financial statement data in greater
        detail than the financial statements in annual reports
       Form 10-Q - includes quarterly financial statements that
        provide more timely but less complete information than
        annual reports
Sources of Information
About Companies
   Company press releases provide the basis
    for articles in the financial press such as The
    Wall Street Journal and Business Week.
   Services such as Standard and Poor’s
    Industrial Surveys and                     Dun
    & Bradstreet provide useful
    information to investors.
Sources of Information
About Companies
   Large investors often require pro forma statements
    which are carefully formulated expression of
    predicted results.

   Any investor should take the time to gather as much
    information about potential investments as possible.
       There are many sources of information for investors to use.
WEB SITES

   http://www.hoovers.com
   http://www.fool.com
   http://www.wsj.com
   http://quote.yahoo.com
    Objectives of Financial
    Statement Analysis

   Although different investors demand different returns,
    they all use financial statement analysis to:
         predict their expected returns
         assess the risks associated with those returns

         Past performance is only important if it can be used to predict
          future performance
Objectives of Financial
Statement Analysis
   Creditors want to know about short-term
    liquidity and long-term solvency.
       Short-term liquidity - an organization’s ability to
        meet current payments as they become due
       Long-term solvency - an organization’s ability to
        generate enough cash to repay long-term debts
        as they mature
Objectives of Financial
Statement Analysis
   Equity investors look for returns in the form of
    dividends and increased market price of the
    stock.
       These investors are naturally more interested in
        profitability.
       Profits spur both dividends and increased stock
        prices.
Evaluating Trends and Components
of the Business
   Evaluating trends and components of a business
    are two ways of looking at financial information.
       Trend analysis involves comparing financial trends from
        one year to another.
       Evaluating components of a business can be done in more
        than one way.
           Relationships among elements of the financial statements
            may be examined.
           Components may also be thought of as separate business
            units or segments. These components may be examined.
Trend Analysis
   Trends are predictable patterns that have been
    observed in the past and are expected to continue
    into the future.
       A pattern must be identified, and expectations of whether
        the trend will continue must be formed.
       Trends can be shown as changes in amounts from year to
        year or as percentage changes from year to year.
Trend Analysis=% change

   Use of percentages helps to control for scale
    differences
   Percentage change= Amount of change/
    Base year amount x 100
   Trends require more that two years
Common-Size Statements
   Common-size statements - financial statements
    expressed in component percentages
       The income statement is expressed as a percentage of
        sales.
           This makes it easy to compare percentages to those of other
            companies because percentages are a common index.
       The balance sheet is expressed as a percentage of total
        assets.
           This is often referred to as component percentages because
            they measure each component as a percentage of the total.
Common-Size Statements
   For the income statement, sales is set at 100
    percent and each other element is expressed as a
    percentage of the sales figure.

   For the balance sheet, the total assets amount is set
    at 100 percent, and each other element is
    expressed as a percentage of the total assets figure.
Common-Size Statements
                      WASHINGTON COMPANY
                         Income Statements
          For the Years Ended December 31, 1997 and 1996


                                1997                 1996
 Sales                   $ 98,600      100%   $ 89,500      100%
 Expenses
  Wages expense            45,800      46%      42,900      48%
  Rent expense             12,000      12%      12,000      13%
  Utilities expense         6,500       7%       6,450       7%
  Depreciation expense      5,000       5%       5,900       7%
    Total expenses         69,300      70%      67,250      75%
 Net income              $ 29,300      30%    $ 22,250      25%
Management’s Discussion
and Analysis
   Management’s discussion and analysis - a
    required section of the annual report that
    concentrates on explaining the major
    changes in the income statement and the
    major changes in liquidity and capital
    resources
Segment Reporting
   Many large companies are involved in more than
    one type of business activity or market.
       Each individual type of business activity or market may be
        considered a segment.
       The FASB requires that information on each business
        segment be disclosed in the financial statements.
       Segments can be stated in terms of industry segments,
        geographic segments, major customers, etc.
Financial Ratios
   The major component of financial statement
    analysis is the use of ratios.

   Financial ratios are sometimes grouped into four
    categories:
       Short-term liquidity ratios
       Long-term solvency ratios
       Profitability ratios
       Market price and dividends ratios
Financial Ratios
                Short-term liquidity ratios
    Name of Ratio            Numerator                Denominator

Current ratio        Current assets              Current liabilities

Quick ratio          Cash + Marketable          Current liabilities
                       securities + receivables

Average collection   Average accounts            Sales
  period in days       receivable x 365

Inventory turnover   Cost of goods sold          Average inventory at
                                                   cost
Financial Ratios
                Long-term solvency ratios
    Name of Ratio                  Numerator            Denominator

Total debt to total assets Total liabilities        Total assets

Total debt to equity       Total liabilities        Stockholders' equity

Interest coverage          Income before interest   Interest expense
                             and taxes
Financial Ratios
                          Profitability ratios
      Name of Ratio                  Numerator                    Denominator
Return on stockholders'      Net Income                  Average stockholders'
  equity                                                  equity
Gross profit rate or         Gross profit or gross margin Sales
  percentage

Return on sales              Net income                  Sales
Asset turnover               Sales                       Average total assets
                                                          available
Pretax return on operating   Operating income            Average total assets
  assets                                                  available
Earnings per share           Net income less dividends Average common shares
                               on preferred stock, if any outstanding
Financial Ratios
          Market price and dividend ratios
   Name of Ratio         Numerator              Denominator

Price-earnings     Market price of common Earnings per share
                    stock
Dividend yield     Dividends per common    Market price of common
                    share                   stock
Dividend-payout    Dividends per common    Earnings per share
                    share
Evaluating Financial Ratios
   Financial ratios are evaluated using three
    types of comparisons.
       Time-series comparisons - comparisons of
        financial ratios with a company’s own historical
        ratios
       Bench marks - general rules of thumb specifying
        appropriate levels for financial ratios
       Cross-sectional comparisons - comparisons of
        financial ratios with the ratios of other companies
        or with industry averages
Ratios
   Financial analysis using ratios is useful to investors
    because the ratios capture critical dimensions of the
    economic performance of the company.
   Managers use ratios to guide, measure, and reward
    workers.
       Often companies base employee bonuses on a specific
        financial ratio or a combination of some other performance
        measure and a financial ratio.
Ratios
   Ratios mean different things to different groups.
       A creditor might think that a high current ratio is good
        because it means that the company has the cash to pay
        the debt.
       However, a manager might think that a high current ratio is
        undesirable because it could mean that the company is
        carrying too much inventory or is allowing its receivables to
        get too high.
Operating Performance
   Rate of return on investment - evaluates the
    overall success of an investment by
    comparing what the investment returns with
    the amount of investment initially made
   ROI = Income/Invested Capital
Operating Performance
   Income may be defined differently for alternative
    purposes.
       Net earnings
       Pretax income from operations
       Earnings before interest and taxes (EBIT)

   Invested capital may also be defined differently.
       Stockholders’ equity
       Total capital provided by both debt and equity sources
Operating Performance
   Operating performance is best measured by
    pretax operating rate of return on total assets.
   This eliminates any affect related to how
    assets are financed
   Pretax operating rate of return on total assets
    = Operating income/ average total assets
Operating Performance
Operating income/average total assets=
Operating income/Sales
X
Sales/average total assets       
Operating Performance
   The expanded expression of pretax operating rate of
    return on total assets highlights that operating
    income percentage and asset turnover will each
    increase the rate of return on assets.
       Using these two ratios allows manipulation of either one to
        determine what happens to the rate of return under
        different scenarios.
DuPont formula

 ROE = Return on sales X Asset Turnover X
  Leverage
= Net Income/sales X Sales/Average Total
  Assets X Average Total Assets/ Average
  stockholders’ Equity
Use of the Dupont Formula

Allows a breakdown of the effects of the asset
  base, sales growth and financing on ROE
Operating Performance
                                       Operating
                                        Income
                   Operating Income
                     % on Sales            
                                          Sales

  Pretax Return
 on Total Assets
                          x
                                          Sales

                      Total Asset          
                       Turnover
                                      Average Total
                                         Assets
    Financial Performance

   Debt and equity financing must be balanced in
    order to achieve good financial    performance.
       Firms must choose how much debt is appropriate.
       The firms must also choose how to split
        their debt between short-term debt and long-term
        debt.

   The prudent use of debt is a major part of
    intelligent financial management.
Financial Performance
   Short-term debt must be repaid or refinanced
    in a short period of time.
       If a company has trouble repaying the debt, it will
        also generally have trouble refinancing the debt.
       Naturally, lenders like healthy borrowers, not
        troubled borrowers.
Financial Performance
   Long-term debt or equity are generally used
    to finance long-term investments.
       Debt financing is more attractive than equity
        financing.
           Interest payments are deductible for income tax
            purposes, but dividends are not deductible.
           The ownership rights to voting and profits are kept by
            the present shareholders.
Trading on the Equity
   Trading on the equity (leveraging) - using
    borrowed money at fixed interest rates
        with the objective of enhancing the rate
             of return on common equity
   Capitalization (capital structure) - the total of
    a company’s long-term financing
    Trading on the Equity
   There are costs and benefits to the shareholders
    from leveraging.
       Costs:
           Interest payments
           Increased risk
       Benefits:
           Larger returns to the common shareholders, as long as
            overall income is large enough to cover the increased
            interest payments
Trading on the Equity
General comments about leveraging:
   A debt-free, or unleveraged, company has identical
    return on assets (ROA) and return on equity (ROE).
   When a company has an ROA greater than the
    interest rate it is paying its lenders, ROE exceeds
    ROA. (This is called favorable financial leverage.)
   When a company is unable to earn at least the
    interest rate on the money borrowed, the return on
    equity will be lower than it would be for a debt-free
    company.
Economic Value Added (EVA)

   Firm must earn more than the capital
    invested to increase value
   Requires a measure of Cost of Capital
   The intuition is that the cost of capital is that
    this is the cost that must be paid to attract
    funds
Example

   Assume that the cost of capital is 12%
   Invested capital is $5,000,000
   Investments must earn more than $600,000
    to increase firms value
Income Tax Effects
   If all things are equal, debt financing is less costly to
    a corporation than equity financing because interest
    payments are deductible for income tax purposes.
       Dividends paid on stock are not deductible.
       Also, dividend rates on stock are generally higher than
        interest rates on debt because of the increased risk
        associated with stock.
Income Tax Effects

General comments on debt financing versus
equity financing:
   Because interest is deductible for income tax purposes, net
    income attributable to common shareholders can be higher if
    debt is used because taxes are lower.
   Book net income is higher if equity financing is used because
    there are no interest payments to be deducted.
   Failure to pay interest is an act of bankruptcy, which gives
    creditors the right to control the company. Failure to pay
    dividends has less severe consequences.
Measuring Safety
   Investors in debt securities want assurance that the
    company in which they have invested will be able to
    make the scheduled interest and principal
    payments.
       These investors want to avoid the trouble of recovering
        their investments through bankruptcy of the company.
       They would much rather a steady stream of income from a
        healthy company.
Measuring Safety
 Interest coverage (times interest earned) - a
  ratio that focuses on the interest-paying
  ability of a company
Interest coverage+
Income before interest and taxes/
Interest expense
Measuring Safety
   A rule of thumb for debt investors is that the interest
    coverage should be at least five times even in the
    poorest year in a span of 7 to 10 years.

   The tax deductibility feature of interest is a major
    reason why debt financing is used more than equity
    financing using preferred stock.
Prominence of Earnings Per Share
   Earnings per share is a basic reporting element in
    the financial statements.

   Some issues tend to complicate the calculation of
    earnings per share.
          •   Preferred stock
          •   Stock issues and redemptions
          •   Possibility of exercise of options or various
              convertible securities
Prominence of Earnings Per Share
    The formula for Earnings per Share is:
   (Net income-preferred dividends)/weighted
    average shares outstanding during the period
Weighted-Average Shares
and Preferred Stock
   Earnings per share is calculated as net
    income divided by weighted-average number
    of shares outstanding during the period.
       The weighted-average number of shares is based
        on the number of months that the shares were
        outstanding during the year.
Weighted-Average Shares
and Preferred Stock
 Home, Inc., has 450,000 shares of common
 stock outstanding at the beginning of the
 calendar year, and 150,000 additional shares
 were issued on August 30. What is the
 weighted-average number of shares
 outstanding during the year?
Weighted-Average Shares
and Preferred Stock
 The weighted-average number of shares is
 computed as follows:
         450,000 x weighting of 12/12 = 450,000
         150,000 x weighting of 4/12 = 50,000
                                         500,000
              =
Weighted-Average Shares
and Preferred Stock
   Another complication arises if there are
    shares of nonconvertible preferred stock
    outstanding.
       The dividends on preferred stock for the current
        period, whether or not paid, should be deducted in
        calculating EPS.
Basic and Diluted EPS
   When a company has convertible securities
    or stock options outstanding, the calculation
    of EPS becomes even more complicated.
       When convertible securities exist, EPS is
        calculated using the assumption that any and all
        convertible shares are turned into common stock.
Basic and Diluted EPS
   The presence of convertible securities increases the
    number of common shares to the highest possible
    number considering the convertible securities and
    stock options outstanding.
       If the number or shares outstanding is increased, earnings
        per share is decreased.
       These convertible securities are said to dilute (reduce)
        earnings per share.
Disclosure of Nonrecurring Items
   Financial statement analysis focuses on normal
    recurring items of the financial statements, not
    nonrecurring items.
   Four major categories of nonrecurring items:
       special items
       extraordinary items
       discontinued operations
       accounting changes
Special Items
   Special items - expenses that are large enough and
    unusual enough to warrant separate disclosure
       Special items appear as separate line items among
        operating expenses on the income statement.
       Any necessary discussion must be included in the
        footnotes to the financial statements.
       Companies generally have flexibility in deciding when to
        treat something as a special item.
    Extraordinary Items

   Extraordinary items - items that are unusual in
    nature and infrequent in occurrence that are
    shown separately, net of tax, in the income
    statement
       Unusual in nature means that an item is different from
        the typical or normal operating activities of a business.
       Infrequent in occurrence means that an event should
        not be expected to recur often.
    Extraordinary Items
   Examples of extraordinary items are the financial
    effects of natural disasters such as earthquakes
    or hurricanes and government expropriations.
       Whether an item is extraordinary sometimes depends
        on where the event occurs.
           For example, losses from damage resulting from a hurricane
            on the coast of Louisiana would not be considered
            extraordinary, but losses from damage resulting from a
            hurricane in South Dakota would be extraordinary.
Extraordinary Items
   Extraordinary items must be shown
    separately on the income statement.

   They must also be shown net of tax, which
    means that the amount on the income
    statement includes any tax effect the item
    might have.
Discontinued Operations
   Discontinued operations - the termination (closing or
    sale) of a business segment reported separately, net
    of tax, in the income statement
       Any gain or loss from the actual disposal of the segment
        must be disclosed along with the results of operations
        (income or loss) for that segment during the period before
        the disposal.
Accounting Changes
   Accounting changes occur when the FASB
    requires a new way of accounting for a
    particular item.
       When the FASB changes its rules, it often
        requires a major one-time recognition (revenue or
        expense).
       Accounting changes are shown separately and
        are shown net of tax.
Accounting Changes
   The presentation of nonrecurring items on the
    income statement is as follows:
       Income from continuing operations before income taxes
         Deduct income taxes
       Income from continuing operations
         Discontinued operations, net of tax
       Income before extraordinary items
         Extraordinary items, net of tax
       Income before cumulative effect of an accounting change
         Cumulative effect of an accounting change, net of tax
       Net income
International Considerations
   Financial statement analysis may be complicated by
    several factors when companies carry on
    operations in different countries.
       Language in which the results              are
        reported
       Currency in which results are       reported
       Different securities markets, tax
        structures, and local customs
Basics of Valuation using financial data
Goal of Valuation

   Search for undervalued or overvalued
    securities
   To what extent is a company’s stock price
    supported by evidence?
Methods

   Present value of dividends
   Asset based Price multiples
   Abnormal earnings based
   Free cash flows
Dividend based

   Value = present value of future dividends
   = Dividends /(cost of equity capital- growth in
    dividends)
   Estimate market value of net assets (equity) by
    adjusting the balance sheet
   compare market value of equity to adjusted book
    value
Asset based (price multiples)
Reasons market differs from adjusted
book value
   future earning prospects
   missing assets/ liabilities
   asset in place synergies
Growth in PB ratio- determinants

   PB = PE * ROE
   How much greater than expected is ROE?
   How quickly will book value grow ?
       Dividend policy
       acquisitions
How to evaluate multiples

   Low PB - Low PE - “dog” little or no future prospects
   high PB- High PE “rising star” with strong prospects
   high P B- Low PE- “falling star”- mature firm with low
    growth
   Low PB- High PE “ recovering firm” has had damage
    but is in the early stage of rising star
Use of asset based methods

   Look at PE/PB and try to determine why the
    company differs from the market
       consider earnings prospects
       management quality
       accounting methods
       Contingencies
Earnings and cash flow models

   Both earnings and cash flow models require
    forecasts
Free Cash flow

   Amount of cash available for growth
   Various definitions but means cash from
    operations minus replacement investment
Free cash flow debt and equity

   Cash from operations
   + Interest expense (net of tax)
   - capital expenditures
   -increases in working capital
Free cash flow to equity

   Cash from operations
   - capital expenditures
   - debt repayment
   -Change in cash balance needed to maintain
    operations
How do we forecast earnings and free
cash flows?
   Starting point is usually sales forecast
   This serves as the basis for a forecast of the
    remaining income statement and balance
    sheet components
   The earnings forecast is used to derive the
    forecast of FCF
Forecast of financial statements

   Income statement
   Balance sheet
   Statement of cash flows
Income forecast

   Sales
   Expenses (separate into fixed and variable)
Balance sheet

   Forecast assets individually
   Usually tie to sales
       Working capital
       Long term assets
   Some accounts you may assume constant
    ratios
Cash flows

   Need forecasted net income
   Depreciation
   Expected interest
   Changes in balance sheet accounts
   Planned investments
   Planned dividends and debt repayments
Free cash flow model

   Value= sum of discounted free cash flows
    +the present value of the terminal value
Shareholder value

   Basic idea: value to shareholders is the
    present value of future cash flows to owners.
Earnings based model

   Value=Current book value plus the
    discounted sum of abnormal earnings
   Abnormal earnings= earnings- cost of
    capital * (book value (t-1))
   May use abnormal earnings over a forecast
    horizon + terminal value
Cost of capital=all equity firm

   RE = RF +  [E (RM )- RF]
       RE = return to equity
       RF = risk free rate
        = systematic risk (you can find estimates of
        this)
       [E (RM )- RF] = market risk premium
Estimation of cost of capital

   risk free rate- intermediate term t bill rate-
    avg. around 6%, presently about 4.5%
   Market risk premium- 7.6% = average from
    1923-1993
    = systematic risk- firm specific can obtain
    beta from PC compustat
Cost of capital with debt-

   use Weighted average cost of capital
   WACC =
   (value of debt/total firm value) * int. rate (1-t)
   + Value of equity/(total firm value)* RE
Short cut valuation method

   V(t) = estimated value of equity at time t
    b(t) = book value at time t
    r(e) = cost of equity capital
    g(t + n) = growth in book value in year t+ n =
    (b(t+n)- b(t+n-1))/(b(t+n-1))
Short cut valuation method-con’t

   V(t)/b(t) = 1 + E(t) [(ROE (t+1) - r(e))]/(1+r(e)) +
    E(t) [(ROE (t+2) - r(e))(1+g(t+1))]/(1+r(e))2 +
    E(t) [(ROE (t+3) -r(e))(1+g(t+2))]/(1+r(e))3 + ....+
    Terminal value
Terminal value

   Usually assume that growth in book value
    stops or reduces at some point.
Example

   Assume the following:
   Cost of capital = 14%
    goals for ROE are 34%.
   Assume growth in book value = 10% for three
    years then dropping to 3%
Example continued

   V/b= 1+ (.34-.14)/(1.14) + (.34-
    .14)(1.1)/(1.14)2 + (.34-.14)(1.10)2/(1.14)3+
    terminal value = 1+.1754+.1692+.1633 +
    terminal value=
   =1.5079+ .10/(.14-.03)/(1.14)3 = 1.5079+
    .6135= 2.1214
Example, continued

   book value is $677,788,000 on 1/1/92
   and the number of shares are 142,139,577
   The model above implies that firm value
    should be 10.10 per share.
Short cut earnings method

   Stock value = BVE0 + AE/ cost of equity
    capital
       BVE0 = book value of equity
       AE = BV * (actual return –cost of capital)
       677,788,000 *(.34-.14) =135,557,600 (abnormal
        earnings)
       equity value = 677,788,000+
        135,557,600/.14=1,646,056,571
       price/share=11.58
Free cash flow model:

   value = present value of free cash flows to
    equity
   forecast free cash flows to equity
       NI –capital outlays +/- net cash flows from/to debt
        holders
       discount free cash flows at cost of equity capital
Steps in valuation

   Forecast sales and financial statements
   Forecast earnings and or free cash flow
   Determine discount rate
   Determine forecast horizon
   Apply model