EF4314 Lecture 4

Accrual Accounting and Valuation:

Pricing Earnings
 Review: The Residual Earnings Model
Valuation Principle
Intrinsic Value = Book Value + Extra Value
Approach

• The Residual Earnings model shows how to price book values on the
balance sheet and suggests how much we should pay for a dollar of book
value.
• In this class, we focus on how to price earnings on the income statement
and calculate how much one should pay for a dollar of earnings.
 Class 4: Key Aspects

• How are price-earnings ratios determined?

• How is a firm valued from forecasts of earnings growth?

• What are advantages and disadvantages of the abnormal

earnings growth valuation model?
The Price-to-Earnings (P/E) Ratio
• Price in numerator of P/E is based on expected future earnings
(i.e., Investor buy future earnings).
• Earnings in denominator of P/E is either current or forward
earnings.
The Price-to-Earnings (P/E) Ratio
• Thus, the P/E ratio should reflect expected growth in earnings:
o Trailing P/E: expected growth from current earnings
o Forward P/E: expected growth from one-year-ahead
earnings
• But…, growth is risky, so the P/E ratio should also involve a
discount for risk (e.g., through the required rate of return):
o Expected earning growth increases the P/E ratio
o Risk reduces the P/E ratio
Beware of Paying Too Much for Earnings Growth
• Empirical evidence has suggested that on average, high P/E
stocks usually yield lower returns than low P/E stocks, and even
lower returns than broad market indexes.
• This suggests that investors may be paying too much for
earnings growth.
• Excessive investment can create earnings growth but does not
necessarily add value.
• Accounting treatment can create earnings growth but does not
add value.
• Therefore, a sound P/E valuation prices earnings growth but
does not price growth that does not add value.
The Valuation Principle
(Intrinsic) Value = Anchor + Extra Value

• Here, the Anchor is Capitalized Earnings:

Value = Capitalized Earnings + Extra Value

• The principle for adding extra value to capitalized earnings:

An asset is worth more than its capitalized earnings only if it can

grow earnings at a rate greater than its required growth rate.
The Valuation Principle
Capitalized Earnings
• In anchoring a valuation on earnings rather than book value,
remember that earnings is a measure of change in value - a
“flow” concept rather than a “stock” concept. We therefore
anchor the valuation on capitalized earnings:

• Value = Capitalized Earnings

+ Extra Value from forecasted earnings growth
Prototype Valuations
Value a Savings Account (Scenario 1: Full Payout)

• The earnings growth rate is 0.

Prototype Valuations
Value a Savings Account (Scenario 2: Zero Payout)

• No withdrawal. All earnings are reinvested. Earnings grow at a

rate of 5% per year.
• Question: Do we want to pay for this 5% earnings growth?
• Answer: No! This earnings growth comes from the reinvested
earnings, and the reinvested earnings only earn the required
return.
Prototype Valuations
Value a Savings Account
• But how to reconcile the two scenarios? The valuation of the
savings account must be the same.
• The earnings growth rates in the two scenarios look different,
but in fact they are not.
• The earnings from the full-payout account are understated, for
the dividends can be reinvested in another identical account to
earn 5%.
• Earnings without the reinvestment of dividends are called ex-
dividend earnings.
• Therefore, to reconcile the two scenarios, we will focus on the
cum-dividend earnings, i.e., earnings with the dividends
reinvested.
Prototype Valuations
Value a Savings Account
• Cum-dividend earnings is earnings with the prior year’s dividend
reinvested.

• The two scenarios have the same cum-dividend earnings! The

cum-dividend earnings grow at a rate of 5%.
• However, in both cases, the earnings growth is not growth that
we will pay for. We only pay for earnings growth that is greater
than the required return.
Prototype Valuations
Abnormal Earnings Growth
• Earnings that are due to growth at the required return are called
normal earnings. For any period t,

where ρ is 1 plus the required return of equity.

• The part of cum-dividend earnings that adds value is the cum-
dividend earnings beyond these normal earnings, that is, the
abnormal earnings growth:
Prototype Valuations
Important Insights
• When forecasting earnings growth, one must focus on cum-
dividend growth. Ex-dividend earnings growth ignores the
value that comes from reinvesting dividends.
• Dividend payout is irrelevant to valuation, for cum-dividend
earnings growth is the same irrespective of dividends.
• An asset is worth more than its capitalized earnings only if it
can grow cum-dividend earnings at a rate greater than the
required return.
Normal Price-to-Earnings Ratios
• Forward P/E: price relative to the forecast of next year’s
earnings
• Normal forward P/E: If there is no abnormal earnings growth,
then the forward P/E ratio must be:

• Trailing P/E: price relative to the current earnings. The trailing

P/E must always be based on the cum-dividend prices:

• Normal trailing P/E: If there is no abnormal earnings growth,

then the normal trailing P/E ratio must be:
Model for Anchoring Value on Earnings
The Anchoring Principle
• If one forecasts that cum-dividend earnings will grow at a rate
equal to the required rate of return, the asset's value must be
equal to its forward earnings capitalized.

• Correspondingly, one adds extra value to the anchor if cum-

dividend earnings are forecasted to grow at a rate greater than
the required return: The asset must be worth more than its
forward earnings capitalized.

• Therefore, abnormal earnings growth is the metric that captures

the extra value.
Model for Anchoring Value on Earnings
The Valuation Model
The valuation model that captures the extra value for the equity of
a going-concern is:
Value of equity = Capitalized forward earnings
+ Extra value for abnormal cum-dividend earnings growth

where AEG is the abnormal earnings growth for years after Year 1.
Model for Anchoring Value on Earnings
Model for Anchoring Value on Earnings
Model for Anchoring Value on Earnings
Steps for Applying the Abnormal Earnings Growth Model
1. Forecast earnings and dividends up to a forecast horizon.
Calculate cum-dividend earnings.
2. Calculate AEG after the forward year from the forecasts of
earnings and dividends.
3. Discount the AEG to present value at the end of the forward year.
4. Calculate a continuing value at the forecast horizon.
5. Discount the continuing value to present value at the end of the
forward year.
6. Add 3, 5, and forward earnings
7. Capitalize this total at the required rate of return.
Case 1: Zero AEG after the Forecast Horizon
General Electric
• Required rate of return is 10%, abnormal earnings growth is
expected to be zero after 2004.

• Valuation task: Estimate the intrinsic value using the abnormal

earnings growth model.
Case 1: Zero AEG after the Forecast Horizon
General Electric
• Step 1: Calculate the cum-dividend earnings.

Earnings ρ 1
1.38 0.1 0.57 1.437
1.42 0.1 0.66 1.486
1.50 0.1 0.73 1.573
1.60 0.1 0.77 1.677
Case 1: Zero AEG after the Forecast Horizon
General Electric
• Step 2: Calculate the abnormal earnings growth after the
forward year.

AEG Cumdividend Earnings ρ Earnings

1.437 1.1 1.29 0.018
1.486 1.1 1.38 0.032
1.573 1.1 1.42 0.011
1.677 1.1 1.50 0.027
Case 1: Zero AEG after the Forecast Horizon
General Electric
• Step 3: Discount the AEG to present value at the end of the
forward year

0.018 0.032 0.011 0.027

0.017
1.1 1.1 1.1 1.1
Case 1: Zero AEG after the Forecast Horizon
General Electric

Step 4, 5: Continuing value at 2004 is 0 because no abnormal earnings

growth after 2004.
Step 6: Add 3, 5, and forward earnings:
Total earnings to be capitalized at 2000 = 1.29 + 0.017 =1.307
.
Step 7: Intrinsic value at 1999 = 13.07
.
Case 2: Constant AEG Growth after the Forecast Horizon
Nike, Inc.
• Required rate of return is 9%, AEG is expected to grow at a
constant rate of 4.5% after 2011.

• Valuation task: estimate the intrinsic value of Nike Inc. in

2006.
Case 2: Constant AEG Growth after the Forecast Horizon
Nike, Inc.
• Step 1: Calculate the cum-dividend earnings.

3.80 0.09 0.71 3.864

3.07 0.09 0.88 3.149
3.93 0.09 0.98 4.018
4.28 0.09 1.06 4.375
4.65 0.09 1.20 4.760
Case 2: Constant AEG Growth after the Forecast Horizon
Nike, Inc.
• Step 2: Calculate the abnormal earnings growth after the
forward year.

ρ
3.864 1.09 2.96 0.638
3.149 1.09 3.80 0.993
4.018 1.09 3.07 0.672
4.375 1.09 3.93 0.091
4.760 1.09 4.28 0.095
Case 2: Constant AEG Growth after the Forecast Horizon
Nike, Inc.
• Step 3: Discount the AEG to present value at the end of the
forward year

. . . .
0.332
. . . .
Case 2: Constant AEG Growth after the Forecast Horizon
Nike, Inc.
• Step 4: Calculate a continuing value at the forecast horizon.

.
: 2.111
. . .

• Step 5: Discount the continuing value to present value at the

end of the forward year.
.
1.495
. .
Case 2: Constant AEG Growth after the Forecast Horizon
Nike, Inc.

• Step 6: Calculate total earnings to be capitalized.

2.96 0.332 1.495 4.787
.
• Step 7: Intrinsic value = 53.18
.
Converting Analyst’s Forecast to a Valuation
Example: Analysts’ EPS forecasts (Google Inc., 2010):
2011 $33.83
2012 $39.47
Five-year EPS growth rate forecast: 17.4%
Required return: 11%

Google has no dividend payout. Suppose that after five years,

Google will grow at the GDP growth rate of 4%.
Valuation Task: Estimate Google Inc.’s intrinsic value in 2010.
Converting Analyst’s Forecast to a Valuation
Google Inc.

Step 1: Calculate cum-dividend earnings.

33.83
39.47
39.47 1 17.4% 46.34
46.34 1 17.4% 54.40
54.40 1 17.4% 63.87

Given 0 dividends, earnings is the same as cum-dividend earnings.

Converting Analyst’s Forecast to a Valuation
Google Inc.

Step 2: Calculate AEG after the forward year:

39.47 33.83 1 11% 1.92
46.34 39.47 1 11% 2.53
54.40 46.34 1 11% 2.96
63.87 54.40 1 11% 3.49
Step 3: Calculate present value of AEG at the end of the forward year:
. . . .
8.25
. . . .
Converting Analyst’s Forecast to a Valuation
Google Inc.

Step 4: Calculate a continuing value at the forecast horizon.

3.49 1.04
Continuing Value 51.85
1.11 1.04
Step 5: Calculate the present value of the continuing value at the
forward year:
.
34.16
.
Converting Analyst’s Forecast to a Valuation
Google Inc.

Step 6: Calculate total earnings to be capitalized at the forward year.

Total earnings to be capitalized 33.83 8.25 34.16 76.24

Step 7: Calculate the intrinsic value

76.24
Intrinsic value 693.09
0.11
Abnormal Earnings Growth and Residual Earnings
• The abnormal earnings growth valuation model is internally
consistent with the residual earnings valuation model discussed
in the previous lecture.

• In fact, the abnormal earnings growth (AEG) is equal to the

change in residual earnings (RE), as shown below.

1
1
1 1
1

• Recall that , then

= 1
1 1 ]
 Abnormal Earnings Growth Model: Advantages
• Easy to understand: Investors think in terms of future earnings;
investors buy earnings. Focuses directly on the most commonly
used multiple, the P/E ratio.

• Uses Accrual accounting: embeds the properties of accrual

accounting by which revenues are matched with expenses to
measure value added from selling products. Compared to the
residual earnings model, the AEG valuation is more convenient
for one does not have to worry about book values.

• Aligned with what people forecast: Analysts forecast earnings

and earnings growth.
 Abnormal Earnings Growth Model: Advantages
• Forecast horizon: Forecast horizons are typically shorter than
those for DCF analysis and more value is typically recognized in
the immediate future. There is less reliance on continuing values.

• Robustness: Focuses on cum-dividend earnings. Thus, the

valuation is not affected by dividends, share Issues, or share
repurchases.

• Protection: Protects from paying too much for growth because by

design only the abnormal earnings growth will increase value.
Also, the AEG model, like the residual earnings model, provides
protection against paying for growth that is created by accounting.
 Abnormal Earnings Growth Model: Disadvantages

• Sensitive to the required return estimate: As the value derives

completely from forecasts that are capitalized at the required
return, the valuation is sensitive to the estimate used for the
required return. The residual earnings valuation model derives
partly from book value that does not involve a required return.

• Use in strategy analysis: Does not give an insight into the drivers
of earnings growth, particularly balance sheet items. The residual
earnings valuation model provides better insight into the analysis
of value creation and the drivers of growth.
 Abnormal Earnings Growth Model: Disadvantages

• Accounting complexity: requires an understanding of how

accrual accounting works.

• Concept complexity: requires an appreciation of the concept of

cum-dividend earnings and abnormal earnings growth.

• Suspect accounting: relies on accounting numbers that can be

suspect and fraudulent.
 Next Class
• Mini-case exercise 2: Analysts’ Forecasts and Valuation:
PepsiCo and Coca-Cola (Part II). Please work it out and we
will discuss this case at the beginning of next class.

• Then we will start to reformulate financial statements for

equity analysis. The focus will be on the Statement of
Shareholders’ Equity.

• Have a nice week ahead.