BAV Lecture 4

Sustainable growth rate tells you how much can a company grow given its current profitability
without borrowing proportionally more and changing its capital structure. 6.1% grow in book equity,
means you can also increase your debt by 6.1% without changing the capital structure -> meaning
you can grow the whole company. The rate also tells how much a company can grow given its
current profitability without start borrowing more, without changing its capital structure.

Given the dividend payout ratio, it may appear that Inditex has a lack of investing opportunities given
the dividend payout ratio (no positive NPVS). It may be a good decision to increased dividends and
decrease sustainable growth rate.

On the other side, if H&M still want to grow they cant do it with internally generated profits, they
have to attract additional debt in order to generate grow – increase leverage.

Remark: You can draw the some conclusion by basically looking at the CF statetements. When we
think about growth at the end of fin analysis you can check sustainable growth rate of CF statements.

Because profitability is going down for H&M prior of 2019, their CF from operations is decreasing.
Investement prior to 2019 are stable so H&M keeps on growing. Finally, given that profitability is
declining, the firm has to finance that growth somehow ina diff way. Negative CF of financing in 2016
indicates that it is paying more to its capital suppliers that receiving from them. This becomes less
negative over time meaning the either pays less dividends or it is attracting more external financing –
H&M attracts more external financing. You see the same at the sust growth rate – the fact that the
company’s cash flow generating ability is not sufficient in order to sustain its investments. In 2019 CF
from O increased just like ROE, and CFI reduced in order to improve profitability. CFO is larger,
therefore they reduced debt so CFF is way more negative since they do not really need it.

1 . Forecasting – not very certain, but it is less uncertain when it is backed up by financial analysis.

 Acc analysis and financial analysis help to understand which factors drove past performance
(and how)
 Forecasting can be seen as performing a reverse financial analysis
o What are the expected future changes in performance drivers?
o How do such expected changes translate into future changes in performance?

Basic rules:

 Forecast revenue first – reason – we have a lot info about the so easy to predict. Revenue
forest = growth forecast, that’s why so much attention to rev forecast
o Identify te company’s primary revenue drivers – retailers have key store as rev driver
(revenue per m2). HelloFres – customer revenue. Management often provides that
much info so it makes it easier for analysts
o Relate past revenue to past values of the revenue driver
o Forecast (1) future values of the revenue driver and (2) future developments in the
revenue/driver ratio
o Key sources of info in this stage:
 Segment and non-fin data
 Management outlook
 Industry and macro economic data.
 Structure: relate most other items to revenue –
 Do not ignore the average trends in ratios
  Check whether your forecast are reasonable – calculate ROEs, turnover and dividend payout.
Maybe you predict very high growth that can either be achieved with attracting more debt or
more equity which can lead to a change in structure (1million shares example)

Chapter 6 Prospective analysis: Forecasting

Most financial statement analysis tasks are undertaken with a forward-looking decision in mind – and
much of the time, it is useful to summarize the view developed in the analysis with an explicit
forecast of a firm’s future performance and financial position. Managers need forecasts to formulate
business plans and provide performance targets, analysts need forecast to help communicate their
views of the firm’s prospects to investors and bankers and debt market participants need forecasts to
assess the likelihood of loan repayment.

Prospective analysis includes 2 tasks – forecasting and valuation – that together represent
approaches to explicitly summarizing the analyst’s forward-looking views.

Forecasting is not so much a separate analysis as it is way of summarizing what has been learned
through business strategy analysis, accounting analysis and financial analysis. However, certain
techniques and knowledge can help a manager or analyst structure the best possible forecast,
conditional on what has been learned in the previous steps.

1 . Overall structure of the forecast – the best way to forecast a future performance is to do it
comprehensively (изчерпателно) – producing not only an earnings forecast but also a forecast of
cashflow and the balance sheet. A comprehensive forecasting approach is useful, even in cases
where one might be interested primarily in a single facet of performance, because it guards against
unrealistic implicit assumptions. For example, if analyst forecasts growth in revenue and earnings for
several years without explicitly considering the required increases in working capital and plat assets
and the associated financing, the forecast might possibly imbed unreasonable assumptions about
asset turnover, leverage, or equity capital infusions.

A comprehensive approach involvs many forecasts, but in most cases they are all linked to the
behavior of a few key “drivers”. The drivers vary according to the type of business involved, but for
businesses outside the financial services sector, the revenue forecast is nearly always one of the key
drivers profit margin is another. When operating asset turnover is expected to remain stable – often
a realistic assumption – working capital accounts and investment in plant should track the growth in
revenue closely. Most major expenses also track revenues, subject to expected shifts in profit
margins. By linking forecast to such amounts to the revenue forecast, one can avoid internal
inconsistencies and unrealistic implicit assumptions.

2. A practical framework for forecasting

The most practical approach to forecasting a company’s financial statement is to focus on projecting
condensed financial statements rather than projecting detailed financial statements that the
company reports. Several reasons for this recommendation:

 This approach involves making a relatively small set of assumptions about the future of the
firm so that the analyst will have more ability to think about each of the assumptions
carefully. A detailed line item forecast is likely to be very tedious and an analyst may not
have a good basis to make all the assumptions necessary for such forecast.
 Further, for most purposes condensed financial statements are all that are needed for
analysis and decision-making
In Chapter 5 we learned how to decompose ROE in order to separately analyze the consequences on
profitability of management’s (1) operating decisions, (2) non-operating investments, and (3)
financing decisions. To make full use of the info generated through the ROE decomposition, the
forecasting task should follow the same process, forecasting operating items first, then non-
operating investment items, and finally financing items.

 Operating items – to forecast the operating section of the condensed income statement,
one needs to begin with an assumptions about the next-period revenue. Beyond that an
assumptions about NOPAT margin is all that is needed to prepare the operating income
statement items for the period. To forecast the operating section of the condensed balance
sheet for the end of the period (or the equivalent, the beginning of the next period) the
following assumptions need to be made:
o The ratio of operating working capital to revenue to estimate the level of working
capital needed to support revenue-generating activities.
o The ratio of net non-current operating assets to revenue to calculate the expected
level of net non-current operating assets
 Non-operating investment items – forecasting the investment section of the condensed
income statement and balance sheet requires that one make assumptions about the
following 2 items:
o The ratio of non-operating investments to revenue to calculate the expected level of
non-operating investments
o The return on non-operating investments
NIPAT margin then follows as the product of the ratio of non-operating investments
ro revenue and the return on non-operating investements (after tax)
 Financing items - to forecast the financing section of the condensed income statement and
balance sheet, one needs to make assumptions about:
 The ratio of debt to capital to estimate the levels of debt and equity needed
to finance the estimated amounts of assets in the balance sheet.
 The average interest rate (after tax) that the firm will pay on its debt.
Using these forecasts, net interest expense after tax can be calculated as the product
of the average interest rate after tax and the debt-to-capital ratio. Note that a ninth
forecast, that of the firm’s tax rate, is implicit in 3 of the preceding forecasts (NOPAT
maring, NIPAT margin, and interest rate after tax)
Once we have the condensed income statement and balance sheet, it is relatively
straightforward to compute the condensed cash flow statement, including cash flows
from operations before working capital investments, cash flow from operations after
working capital investments, free cash flow available to debt and equity, and free
cash flow available to equity.

3. Information for forecasting – the 3 levels of analysis that precede prospective analysis – strategy,
accounting and financial analysis, can lead to informed decisions by an analyst about expected
performance, especially in the short and the medium term. Specifically, the primary goal of financial
analysis is to understand the historical relationship between a firm’s financial performance and
economic factors identified in the strategy and accounting analysis, such as the firm’s
macroeconomic environment, industry and strategy and acc decisions. Forecasting can be seen as
performing a reverse financial analysis, primarily addressing the question of what the effect will be of
anticipated changes in relevant economic factors on the firm’s future performance and financial
position, conditional on the hisotircal relationship identified in the financial analysis. Thus much of
the info generated in the strategic, accounting and financial analysis is of use when going thoru the
following steps of the forecasting process:

 Step 1: Predict changes in environmental and firm-specific factors - The first step in
forecasting is to assess how the firm's economic environment, such as macroeconomic
conditions and industry competitiveness, will change in future years and how the firm has
indicated to respond to such changes.
o From a macroeconomic analysis
o From industry and business strategy analysis
o From accounting analysis
 Step 2: assess the relationship between Step 1 and financial performance – After having
obtained a thorough understanding of what economic factors are relevant and how these
factors
are expected to change in future years, the next step of the forecasting process is to assess
how such future changes will translate into financial performance trends. This second step
strongly builds on the financial analysis. In particular, observations on how sensitive Hennes
& Mauritz's past ratios have been to variations in, for example, economic growth, price
competition, and input prices can help the analyst learn what will happen to the firm's ratios
if the anticipated changes crystallize. The financial analysis of H&M helps to understand
questions that include the following: What were the sources of H&M's above-average
performance in 2016? Which economic factors caused the firm's profitability to decrease in
2017 (and by how much)
 Step 3: Forecast condensed financial statements – Based on the outcomes of steps 1 and 2,
one can produce forecasts of the line items in firm's condensed financial statements, most
particularly of the operating statement items. For Hennes & Mauritz, the key challenge in
building forecasts is to predict whether the firm will be able to maintain - or possibly improve
– its above-average margins and turnover and grow its revenue at the same rate at which it
expands its store network or whether increasing online competition, adverse economic
conditions in some of its markets, increasing input prices, or the continuing investments in
multichannel retailing will lead to a decline in operating performance. Forecasts of non-
operating investment performance and financing structure typically rely less on business
strategy information and build strongly on firm- specific information about investment and
financing plans as well as historical tr ends in these measures. which we will discuss in the
next section.

4. Performance behavior: A starting point

The preceding forecasting framework implicitly assumes that sufficient info is available. Or is
generated in prior steps of the business process analysis, to produce detailed, informed forecasts.
Quite often such information is not sufficiently obtainable, especially when preparing longer term
forecasts. Therefore, every forecast has, at least implicitly, an initial "benchmark" or point of
departure- some notion of how a particular ratio, such as revenue growth or profit margins, would be
expected to behave in the absence of detailed information. By the time one has completed a
business strategy analysis, an accounting analysis, and a detailed financial analysis, the resulting
forecast might differ significantly from the original point of departure. Nevertheless, simply for
purposes of having a starting point that can help anchor the detailed analysis, it is useful to know
how certain key financial statistics behave "on average" for all firms. As a general rule, the lower the
quality and richness of the available information, the more emphasis one ultimately places on the
initial benchmark.
In the case of some key statistics, such as earnings, a point of departure based only on prior
behaviour of the number is more powerful than one might expect. Research demonstrates that some
such benchmarks for earnings are almost as accurate as the forecasts of professional security
analysts, who have access to a rich information set (we return to this point in more detail shortly).
Thus the benchmark often is not only a good starting point but also close to the amount forecast
after detailed analysis. Larger departures from the benchmark could be justified only in cases where
the fum's situation is demonstrably different from the average situation and after having performed
a careful and thorough analysis. Reasonable points of departure for forecasts of key accounting
numbers can be based on the evidence summarized next. Such evidence may also be useful for
checking the reasonableness of a completed forecast.

 Revenue growth behavior – revenue growth rates tend to be “mean-reverting”: firms with
above-average or below-average rates of revenue growth tend to revert over time to a
“normal” level. In the figure first are grouped into portfolios basd on the relative ranking of
their revenue growth in year 1 (1998). Portfolio 1 consists of top 20% of rankings in terms of
their revenue growth.

The figure shows that the group of firms with the highest growth initially - revenue growth
rates of just over 60 percent - experience a decline to about 10 percent growth rate within
two years and are never above 10 percent in the next seven years. Those with the lowest
initial revenue growth rates, minus 32 percent, experience an increase to about a 7 percent
growth rate by year 3, and average about 5 percent annual growth in years 4 through 10.
One explanation for the pattern of revenue growth seen in Figure 6.1 is that as industries and
companies mature, their growth rate slows down due to demand saturation and intra-
industry competition. Therefore, even when a firm is growing rapidly at present, it is
generally unrealistic to extrapolate the current high growth indefinitely. Of course, how
quickly a firm's growth rate reverts to the average depends on the characteristics of its
industry and its own competitive position within an industry.
 Earnings behavior – they follow a process called “random walk”. In this way the prior year’s
earnings figure is good starting point in considering future earnings potential. Page 237
 ROE Behavior – given that prior earnings seves as a useful benchmark for future earnings,
one might expect the same to be true of rates of return on investment, like ROE. That,
however, is not the case for 2 reasons:
o First, even though the average firm tends to sustain the current earnings level, this is
not true of firms with unusual levels of ROE. Firsm with abnormally high (low) ROE
tend to experience earnings declines (increases).
o Second, firms with higher ROE tend to expand their investment bases more quickly
than others, which causes the denominator of the ROE to increase. Of course, if firms
 could earn returns on the new investments that match the return on the old ones,
then the lvl of ROE would be maintained. However, firms have difficulty pulling that
off, firms with higher ROEs tend to find that, as time goes by, their earnings growth
does not keep pace with growth in their investment base and ROE ultimately falls

The resulting behavior of ROE and other measures of return on investment is

characterized as “mean-reverting”.

The pattern is more than clear – the most profitable group of firms initially experience a
decline to 17% within 3 years. Those with the lowest initial ROEs experience a dramatic
increase in ROE and then level off at 0% in 10 years. The pattern is not a coincidence, it is
exactly what the economics of competition would predict. The tendency of high ROEs to
fall is a reflection of high profitability attracting competition, the tendency of low ROEs to
rise reflects the mobility of capital away from unproductive ventures towards more
profitable ones. Some companies, however, maintain ROEs above or bellow main levels
(like Apple) which is only explained by sustainable competitive advantage. For others
however, that is purely an artifact of conservative accounting methods – example –
pharmaceutical firms, whose major economic asset, the intangible value of R&D is not
recorded on the balance sheet and is therefore excluded from the denominator of ROE.
For those firms, one could reasonably expect high ROEs – in excess of 20% over the long
run, even in the face of strong competitive forces

5. Forecasting assumptions

 Background: Macroeconomic and industry growth

 Revenue growth – a good starting point for developing a forecast of short-term revenue
growth is management’s outlook. Management typically provides guidance about future
revenue and margins in the management report section of the annual report but sometimes
also in interim reports.
The following contributed to the decline of H&M’s revenue per store: check table
 NOPAT margins – in 2017 H&M’s NOPAT margin decreased to 8,6% after a decrease from
12% to 10,3% in 2016. The following economic factors contributed to the changes in the
margins:
o Foreign currency exchange rate changes
o Inventory markdowns
o Effective tax rate
o SG&A cost stickiness
o Net effect of other factors
  Working capital to revenue
 Non-current assets to revenue
 Non-operating investments
 Capital structure

6. From assumptions to forecasts

The analysis of H&M performance in chapte 5 and the preceeding discussions about general market
behavior and strategic position lead to the conclusion that in the near and the medium term it is
likely that the company can, at least temporarily, earn substantial abnormal profits.

Check page 248

From lecture:

Three building blocks of valuation – information used for valuation is derived from 3 different
blokcs. Based on all 3 we try to value a company.

 Block 1 – value derived from historical performance, based on most certain info
 Block 2 – value derived from near-term performance, this is forecast horizon, for which we
make detailed forecast
 Block 3 – value derived from long-term performance, everything after forecast horizon

We want mostly info from block 1&2.

However the alternative valuations models (DCF, AP, APG) may compelte on usefulness as the info in
building block 3 is seemingly most difficult to predict. Hence, what the models assumes for block 3
seems to matter most.

Consider a simple valuation task where an investment’s performance is constant over time,
rendering the long-term value info in building block 3 irrelevant

 An investment of 100 at the beg of the year 1 pays 6% interest annually at the end of the
year. Value is equal to 6/0.05=120
 The required rate of return on the investment is 5%.

For this task the two models produce the same value outcomes.

Chapter 7 Prospective analysis: Valuation theory and concepts

Valuation is the process of converting a forecast into an estimate of the value of the firm’s assets or
equity. At some level, nearly every business decisions involves valuation, at least implicitly. Within
the firm, capital budgeting involves consideration of how a particular project will affect firm value.
Strategic planning focuses on how value is influenced by larger sets of actions. Outside the firm
security analysts conduct valuation to support their buy/sell decisions, and potential acquirers (often
with the assistance of investment bankers) estimate the value of target firms and the synergies they
might offer.

In practice, a wide variety of valuation approaches are employed. For example, in evaluating the
fairness of a takeover bid, investment bankers commonly use five to 10 different methods of
valuation. Among the available methods are the following:
  Discounted dividends – this approach expresses the value of the firm’s equity as the present
value of forecasted future dividends
 Discounted cash flow analysis (DCF) – this approach involves the production of detailed,
multiple-year forecasts of cash flows. The forecasts are then discounted at the firm’s
estimated cost of capital to arrive at an estimated present value.
 Discounted abnormal profit – under this approach the value of the firm’s equity is expressed
as the sum of its book value and the present value of forecasted abnormal profits/losses.
 Discounted abnormal profit growth – this approach defines the value of the firm’s equity as
the sum of its capitalized next-period profit or loss forecast and the present value of
forecasted abnormal profit growth beyond the next period.

1 . Defining value for shareholders – how should shareholders think about the value of their equity
claims on a firm? Finance theory holds that the value of any financial claim is simply the present
value of the cash payoffs that its claimholders receive. Since shareholders receive cash payoffs from a
company in the forms of D,the value of their equity is the present value of future Ds (including any
liquidating Ds).

The valuation formula views a frim as having an indefinite life. But in reality firms can go bankrupt or
get taken over. In these situations shareholders effectively receive a terminating D on their shares.

In practice, analysts tend to produce detailed forecasts for a finite near-term period, referred to as
the forecast horizon, and make simplifying assumptions about firm performance after the forecast
horizon. Using a forecast horizon of 3 years, equity value can be written as follows:

In this equiation, the last term represents the terminal value – in this particular model the expected
value of equity at the end of the forecast horizon. If a firm had a constant dividend growth rate (g DIV)
indefinitely, its value would simplify to the following formula:
The preceding formula is called the dividend discount model. It forms the basis for most of the
popular theoretical approaches for equity valuation. Despite its theoretical importance, the dividend
discount model is not a very useful valuation model in practice. This ie because equity value is
created primarily through the investment and operating activities of a firm. Dividend payments tend
to be a by-product of such activities and their timing and amount depends strongly on the firm’s
investment opportunities. Within a period of 5 to 10 years, which tends to be the focus of most
prospective analyses, dividends may therefore reveal very little about the firm’s equity value. For
example, high-growth start-up firms tend not to pay out dividends until later into their life cycle, but
they nonetheless have value when they start their operations. Predicting long-run dividends for
these firms is a tedious, virtually impossible task. Because the first stage of the prospective analysis,
as discussed in Chapter 6, typically produces comprehensive, detailed forecasts for the near term but
unavoidably makes simplifying assumptions for the longer term, useful valuation models value near-
term profitability and growth directly rather than indirectly through long-run dividends. The
remainder of this chapter discusses how the dividend discount model can be recast to generate such
useful models. The models that we discuss are the discounted cash flow, discounted abnormal profit,
discounted abnormal profit growth.

The last 2 models are based on acc information, first one is based more on CF info. Technically they
should lead to the same value estimate since they are derived form the dividend outcome model.
In real life setting, where company is still growing we can get different values as it is seen in the
examples from the lecture.

2. The discounted cash flow model – the value of an asset/investment is the present value
of the net cash payoffs to shareholders that the asset generates. The DCF valuation model clearly
reflects this basic principle of finance. The model defines the value of a firm’s business assets as the
PV of cash flows generated by these assets (OCF) minus the investments made in new business assets
(investment) are alternatively stated, as the sum of the free cash flows to debt and equity holders
discounted at the cost of capital.
You start with profit/loss, you add back non-cash expenses like depreciation, you subtract
investments made because they lead to cash outflows. Increase in debt leads to increase in free cash
flow.

In this equation, OCF excludes interest payments as these are distributions to debt holders. The cash
flows that are available to equity holders are the cash flows generated by the firm’s business assets
minus investment outlays, adjusted for cash flows and to debt holders, such as interest payments,
debt repayments and debt issues. As discussed in Chapter 5, operating CF to equity holders are siply
profit or loss plus depreciation and amortization less changes in working capital. Investment outlays
are expenditures for non-current operating assets and non-operating investment asset sales. Fnally,
net CF from debt owners are issues of new debt less retirements. By rearranging these terms, the
free cash flows to equity can be written as follows:

If we assume a forecast horizon of 3 years, the last term in this equation again represents the
terminal value. Valuation under this method therefore involves the following 3 steps:

 Step 1 – forecast free cash flows available to equity holders over a finite forecast horizon
(usually five to 10 years, three years in the example) using detailed info obtained during the
first three steps of the business analysis process
 Step 2 – forecast free cash flows beyond the terminal year based on some simplifying
assumptions (to estimate the terminal value)
 Step 3 – discount free CFs to equity holders at the cost of equity. The discounted amount
represents the estimated value of free cash flows available to equity.
Earlier we indicated that the DCS model can be obtained by recasting the dividend discount model.
To see how this works, recall our formulation of the free CFs to equity holders in terms of profit or
loss, the change in the book value of business assets (лBVA), and change in the Book value of debt
(лBVD). In the recast financial statements, which were described in Chapter 5 and use throughout
the book, the change in BV of BA minus the change in BV of debt is equal to the change in the book
value of equity (лBVE). The free CF to E can therefore be written as:

Which illustrates the relationship between free CF to equity and dividends.

3. The discounted abnormal profit model also known as Residual Income (RI) – there is a
link between dividends, profits and equity. At the end of each accounting period, profit or loss for the
period is added to (subtracted from) retained earnings, a component of equity. Dividends are taken
out of retained earnings. Stated differently, if all equity effects (other than capital transactions) flow
through the income statement, the expected book value of E for existing shareholder at the end of
the year 1 (BVE1) is simply the book value at the beginning of the year (BVE 0) plus expected
profit/loss (Profit or loss1) less expected dividends (Dividend1). This relation can be written as follows:
where the last term in the equation denotes the terminal value.

The profit-based fomualtion, which is alsor effered to in practices as the residual income model, has
intiuitive appeal. If a frim can earn only a normal rate of return on its book value, then investors
should be willing to pay no more than BV for its shares. Investors should pay more or less than book
value if profits are above or below this normal level. Thus the deviation of a firm’s market value from
BV depends on its ability to generate “abnormal profit”. The formulation also implies that a firm’s
equity value reflects the cost of its existing net assets (its book equity) plus the net PV of futue
growth options (represented by cumulative abnormal profits and losses).

Accounting methods and discounted abnormal profit – one question that arises when valuation is
based directly on profits/losses and BVs is how the estimate is affected by manager’s choice of
accounting methods and accrual estiamtes. Would eestimates of value differ for 2 otherwise identical
firms if one is used more conservative accunting methods than the other? Provided analysts
recognize the impact of differences in accounting methods on future profits (and hence their profit
or loss forecasts), te accounting effects per se should have NO influence on their value estimates.
There are 2 reasons for that:

 Accounting choices that affect a firm’s current profit or loss also affect its BV and therefore
they affect the capital charges used toe stimate future abnormal profits. For example,
 conservative accounting not only lowers a firm’s current profit or loss and BV but also
reduces future capital charges and inflates its future abnormal profits.
 Double-entry bookkeeping is by nature self-correcting. Inflated profits for one period have to
be ultimately reversed in subsequent periods.
4. The discounted abnormal profit growth model – abnormal profit is the amount of
profit that a firm generates in excess of the opportunity cost for equity funds used. The annual
change in abnormal profit is generally referred to as abnormal profit growth and can be rewritten as
follows:
This formula shows that abnormal profit growth is actual profit growth benchmarked against normal
profit growth. Normal profit growth is caclcualted as the protion of prior profit or loss that is retained
in the firm times a normal rate of return. When abnormal profit growth is 0, the firm functions like a
savings account. In this case, the firm earns an abnormal return on its existing investement but is
able to earn only a normal rate of return on the additional investements that is fiannces from its
retained profit. Consequently, an investor would be indifferent between reinvesting profits in the
firm or receiving all profits in dividens.

The discounted dividend model can also be recast to generate a valuation model tat defines equity
value as the capitalized sum of (1) next-period profit or loss and (2) the discounted value of abnormal
profit growth beyond the next period. Using a forecast horizon of three years, the discounted
abnormal profit growth valuation formula is:

this approach, under which valuation starts with capitalizing next-period profit/loss, has practical
appeal because investment analysts spend much time and effort on estimating near-term profit as
the starting point of their analysis. The valuation formula shows that differences between equity
value and capitalized next-period profit or loss are explained by abnormal changes in profit – or
changes in abrnomal profit – beyond the next period. Notice that this formula also views the firm as
having an indefinite life. However, the formula can be easily used for the valuation of a finite life
investment by extending the investment’s life by one years and setting profits and dividends equal to
zero in the last year. For example, consider the profits and dividends of DU Company during the 3
years of existence. Capitalized year 1 profit is equal to 200 million (20/0.1). abnormal profit growth
equals 12 million in year 2 (30+40*0.1-20*1.1) and 12 million in year 3 (40+50*0.1-30*1.1). in year 4
when profit and dividends are 0, abnormal profit growth is -38 million (0+60*0.1-40*1.1). The total
value of the firm’s equity is computed as follows:
DU Company gradually reduces its investment because the annual dividend payments exceed annual
profits. Consequently, normal profits growth is negative, and the firm’s abnormal profit growth is
greater than its actual profit growth in year 2 and 3.

Like the abnormal profit method, the value estimate from the abnormal profit growth is not affected
by the firm’s accounting choices. For example, recall the situation where the DU Company reports
conservatively and expenses unusual costs that could have been capitalized in year 1, thereby
reducing profits by 10 million. Under conservative accounting, the value of capitalized year 1 profit
decreases from 200 million to 100 million. This reduction, however, is exactly offset by an increase in
the discounted value of abnormal profit growth, as shown in the following table:
You are able to explain a lot more. APG focuses less on uncertain info from block 3. In accrual acc
when you value a company, cash is not a king.
3 possible scenarios under terminal values:
block 3 use perpetuity, scenarios 2 ignores inflation but 3 does assume inflation, most applicable

Check example on page 282

Also check page 292

CONCLUSION:

We want valuation models that focus more on blocks 1 and 2 and put less emphasis on block 3.
Comparing the AP and APG to DCF mode. For companies that are still growing block 1&2 explained
much smaller proportion of the value of the firm than the AP and APG model. Emphasis on block 3 is
much higher in DCF model for growing companies. Why? Why does growth drive the DCF model to
perform less than the acc based models? If a company is growing, it invests a lot in the
short-term/present and these investments decrease your CFs, thy lead to higher CFs in the future,
but if at the end at your forecast horizon you still have these large investments so you still have a low
CFs at the end of your forecast horizon than your base your terminal value estimates, estimates of
value in block 3 on these low CFs at te end of your horizon – then you underestimate the value of
your company.