FINANCIAL STATEMENT ANALYSIS

AND VALUATION (ACFI810)

Week 4 – Financial Statements and Valuation (3)
What You Will Learn From This Chapter
• What “residual earnings” is
• How forecasting residual earnings gives the premium over book value and the P/B ratio
• What a P/E ratio means
• How residual earnings are driven by return on common equity (ROCE) and growth in book value
• The advantages and disadvantages of using the residual earnings model and how it contrasts to dividend discounting
and discounted cash flow analysis
• What “abnormal earnings growth” is
• How forecasting abnormal earnings growth yields the intrinsic P/E ratio
• How abnormal earnings growth valuation protects the investor from paying too much for earnings growth
• The advantages and disadvantages of using an abnormal earnings growth valuation and how the valuation compares
with residual earnings valuation
• Reverse engineer the market price to ascertain the market’s earnings forecasts
• Challenge the market price of a stock
The Big Picture
Value = Anchor + Extra Value

• The Anchor is Book Value:

Value = Book Value + Extra Value

• The Principle for adding extra value to book value:

Add extra value if the rate of return of book value is expected to be
greater than the required return
Valuing a One-Period Project (1)
Investment $400
Required return 10%
Revenue forecast $440
Expense forecast $400
Forecasted earnings $ 40

Residual earnings 1 = Earnings 1 − (Required return x Investment )

= 40 - (0.10 x 400)

=0

0
Value = 400 +
1.10

= 400
This is a Zero-RE project
This is a zero NPV project:

440
DCF Valuation: V= = 400
1.10
Valuing a One-Period Project (2)
Investment $400
Required return 10%
Revenue forecast $448
Expense forecast 400
Earnings forecast $ 48

Residual earnings1 = 48 - (0.10 x 400) = 8

8
Value Project = 400 + = 407.27
1.10
The project adds value

 448 
 DCF value = = 407.27
1.10
The Normal Price-to-Book Ratio
Normal P/B = 1.0

(Price = Book Value)

The Normal P/B firm earns an expected rate of return on its

book value equal to the required return

The Normal P/B firm earns expected residual earnings of zero.

An Anchoring Principle
If one forecasts that an asset will earn a return on its book value equal to the
required return, it must be worth its book value
A Model for Anchoring Value on Book Value

Where RE is residual earnings for equity:

Residual earnings = comprehensive earnings - (required

return for equity x beginning - of -
period book value)
The Model for Finite Forecasting Horizons
T − BT
E
RE RE RE V
V0 = B0 +
E 1
+ 2 + .....+ T +
2 T
ρE ρE ρE ρ TE

Book Value Residual Earnings Continuing Value:

Anchor Forecast Value not booked
at time T
Ingredients of the Model
For finite horizon forecasts we need three ingredients, besides the cost of capital:

1. The current book value

2. Forecasts of residual earnings to horizon

3. Forecasted premium at the horizon

Component 3 is called the continuing value

RE1 RE 2 RE T VTE − BT
V0E = B0 + + 2 + .....+ T +
ρE ρE ρE ρ TE

(1) (2) (3)

Return on Common Shareholders’ Equity (ROCE)

Comprehensive earnings to common t

ROCE t =
Book valuet-1
Alternative Measure of Residual Earnings
Residual earnings is the rate of return on equity, ROCE, expressed as a dollar
excess return on equity rather than a ratio. But it can be expressed in ratio
form:

Earningst − ( E − 1)Bt −1 = ROCEt − ( E − 1) Bt −1

RE = ROCE Spread  Book value

Drivers of Residual Earnings
Two Drivers:

1. ROCE
• If forecasted ROCE equals the required return, then RE will be zero, and V = B

• If forecasted ROCE is greater than the required return, then V > B

• If forecasted ROCE is less than the required return, then V < B

2. Growth in book value (net assets) put in place to earn the ROCE
RE will change with change with ROCE and growth in book value
P/B, ROCE and Growth in Book Value
ROCE and P/B Ratios: S&P 500, 2010
ROCE Over the Years
Steps for Applying the Model
1. Identify the book value in the most recent balance sheet.
2. Forecast earnings and dividends up to a forecast horizon.
3. Forecast future book values from current book values and your forecasts of earnings and
dividends.
4. Calculate future residual earnings from the forecasts of earnings and book values.
5. Discount the residual earnings to present value.
6. Calculate a continuing value at the forecast horizon.
7. Discount the continuing value to the present value.
8. Add 1, 5, and 7.

RE RE RE V E
−B
V0E = B0 + 1
+ 2 2 + .....+ TT + T T T
ρE ρE ρE ρE
How the Residual Earnings Model Works
Current Data Forecasts

Current year Year 1 ahead Year 2 ahead Year 3 ahead

Current Book Book

ROCE1 book value ROCE2 value1 ROCE3 value2
Current Current
book value book value

Residual earnings1 Residual earnings2 Residual earnings3

PV of RE1
Discount by 

PV of RE2 Discount by 2

PV of RE3 Discount by 3
A Simple Demonstration and a Simple Model

RE1
V0E = B0 +
−g

$2.36
V0E = $100 + = $133.71 million
1.10 − 1.03
Buying Residual Earnings:
Flanigan’s Enterprises Inc. Case 1:
Zero RE after the Forecast Horizon

V0E = B0 + PV of RE for T periods

V0E = 4.53 = 3.58 + 0.95
ContinuingValue (CVT ) = 0
Forecasting Residual Earnings:
General Electric Case 2: Constant RE after the Forecast Horizon

V0E = 13.07 = 4.32 + 3.27 + 5.48

RE T +1 0.882
CVT = = = 8.82 (Constant RE: no growth)
 E −1 0.10
Forecasting Residual Earnings: Nike, Inc. Case 3: Growing RE after T

V0E = 12.31 = 2.06 + 1.75 + 8.50

RE T +1 0.6715
CVT = = = 48.95 (Growth)
ρ E −g 1.09 − 1.045
Continuing Values are Speculative
 The continuing value is the most speculative part of the valuation. Be careful
not to add speculation.

 Anchor on what you know: Cases 1, 2, and 3 use growth rates in years prior
to the continuing value year for an estimate of the long-term growth rate.

 Might we also use the GDP historical GDP growth rate (something else we
know)? See later.

 Financial statement analysis (in Part Two of the book helps in the
determination of the growth rate).
Advantages and Disadvantages of the Residual
Earnings Model
Advantages Disadvantages

• Focus on value drivers: focuses on profitability of investment • Accounting complexity: requires an understanding of how
accrual accounting works
and growth in investment that drive value; directs strategic
thinking to these drivers • Suspect accounting: relies on accounting numbers that can be
suspect (Chapter 18)
• Incorporates the financial statements: incorporates the value
already recognized in the balance sheet (the book value);
forecasts value added in the income statement and balance
sheet rather than the cash flow statement
• Uses accrual accounting: uses the properties of accrual
accounting that recognize value added ahead of cash flows,
matches value added to value given up and treats investment
as an asset rather than a loss of value
• Versatility: can be used with a wide variety of accounting
principles (Chapter 17)
• Aligned with what people forecast: analysts forecast earnings
(from which forecasted residual earnings can be calculated)
• Protection: protects from paying too much for growth
• Reduces reliance on speculation: relies less on uncertain
continuing values and uncertain long-term growth rates
The Big Picture
• To price earnings, one thinks of earnings growth: more growth, higher P/E

• But: Beware of paying for growth

• Only pay for growth that adds value
• Growth is risky: Beware of paying for risky growth

• Abnormal earnings growth is the metric that protects from paying too much for
growth
The Concept Behind the P/E Ratio

• Price in numerator of P/E is based on expected future earnings

• Earnings in denominator is current (or forward) earnings

• P/E is thus based on expected growth in earnings:

✓ for trailing P/E, growth from current earnings onwards
✓ for forward P/E, growth from one-year-ahead earnings onwards

• But…
…growth is risky, so the P/E ratio also involves a discount for risk
✓ expected earning growth increases the P/E ratio
✓ risk reduces the P/E ratio
Beware of Paying Too Much for Earnings Growth
• Investment creates growth but does not necessarily add value
• Earnings growth can be created by the accounting

We need a valuation method that protects us from paying too much

for earnings growth
P/B Valuation for Nike, Inc. (Ch. 5)
From P/B Valuation to P/E Valuation
The residual earnings pro forma for Nike, Inc:
Change in Residual Earnings and Abnormal Earnings Growth

• Equivalent valuations:

V = Book Value + PV of Residual Earnings

= Capitalized forward earnings + PV of Changes in Residual Earnings

• Equivalent measures:

Change in Residual Earnings = Abnormal Earnings Growth

Abnormal Earnings Growth (AEG) is growth in earnings over the required growth rate

AEG is the focus for P/E valuation

Measuring Abnormal Earnings Growth for Equities: Dell and Nike, 2010

Abnormal earnings growtht (AEGt) = Cum-dividend earnt - Normal earnt

= [Earnt + (ρE – 1) dt-1] – ρ Earnt-1
Dell: Required return = 9% Eps 2009 = $1.25
Nike: Required return = 9% Eps 2009 = $3.07

Dell Inc. Nike, Inc.

Eps 2010 $0.73 $3.93
Dps 2009 $0.00 $0.98
Earnings on reinvested 2009 dividends $0.00 0.088
Cum-dividend earnings 2010 0.73 4.018

Normal earnings from 2009:

Dell: 1.25 x 1.09; Nike: 3.07 x 1.09 1.363 3.346
Abnormal earnings growth (AEG) 2010 -$0.633 $0.672
Cum-dividend Earnings Growth Rate

Cum-dividend earnings growth rate (plus one):

Cum − dividendearningst
Gt =
Earningst −1

Cum − divided earningst

Note: This is not
Cum − dividend earningst −1
Alternative Calculation of AEG
Abnormal earnings growtht = [Gt – ρE] x Earningst-1

Where

Gt = Cum-dividend earnings growth rate (plus one)

For Nike:

G2010 = 4.018/3.07 = 1.3088 (a 30.88% growth rate)

AEG2010 = [1.3088 – 1.09] x 3.07

= $0.672
 Steps in Applying the Model
1. Forecast earnings and dividends up to a forecast horizon.
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.

1  AEG2 AEG3 AEG4 AEGT +1 

V0E = + + + + 
 E − 1  
Earn1
E  E2  E3  T −1 (  − g ) 
Applying the Model
Forecasts
Year 1 ahead Year 2 ahead Year 3 ahead Year 4 ahead

Cum Normal Cum Normal Cum

Normal
Forward dividend earnings2 dividend earnings2 dividend
earnings4
Earnings1 earnings2 earnings3 earnings4

Abnormal Earnings2 Abnormal Earnings3 Abnormal Earnings4

+
PV of
Discount by 
AEG2

+
PV of
Discount by 2
AEG3

+
PV of
AEG4 Discount by 3

+
-
-
+
Current
Value Capitalize Total
earnings
plus growth
Applying the Model: A Simple Example and a Simple Model
Forecast for a firm with expected earnings growth of 3 percent per year (in dollars). Required
return is 10% per year.
2000 2001 2002 2003 2004 2005
Earnings 12.00 12.36 12.73 13.11 13.51 13.91

Dividends 9.09 9.36 9.64 9.93 10.23 10.53

Book value 100.00 103.00 106.09 109.27 112.55 115.93

RE (0.10) 2.36 2.43 2.50 2.58 2.66

RE growth rate 3% 3% 3% 3%

Earnings on reinvested dividends 0.936 0.964 0.993 1.023

Cum-dividend earnings 13.667 14.077 14.499 14.934

Normal earnings 13.596 14.004 14.424 14.857

Abnormal earnings growth 0.071 0.073 0.075 0.077

Earnings growth rate 3% 3% 3% 3%

Cum-dividend 10.6% 10.6% 10.6% 10.6%

earnings growth rate

Abnormal earnings growth rate 3% 3% 3%

Residual earnings valuation: AEG valuation:

2.36 1  0.071 
E
V2000 = 100 + = 133.71 E
V2000 = 12.36 + = 133.71
1.10 − 1.03 0.10  1.10 − 1.03
A Case 1 Valuation: General Electric
Required return is 10%
In this case, abnormal earnings growth is expected to be zero after 2004

Forecast Year

1999 2000 2001 2002 2003 2004

Dps 0.57 0.66 0.73 0.77 0.82

Eps 1.29 1.38 1.42 1.50 1.60
Dps reinvested at 10% 0.057 0.066 0.073 0.077
Cum-dividend earnings
(eps + dps reinvested) 1.437 1.486 1.573 1.677
Normal earnings (1.10 x epst-1) 1.419 1.518 1.562 1.650
Abnormal earnings growth (AEG) 0.018 -0.032 0.011 0.027
Discount rate (1.10t) 1.100 1.210 1.331 1.464
PV of AEG 0.016 -0.026 0.008 0.028
Total PV of AEG 0.017
Total earnings to be capitalized 1.307
Capitalization rate 0.10

 1.307 
Value per share   13.07
 0.10 

E
V1999 =
1
1.29 + 0.017 = 13.07
0.10

Same as residual earnings valuation

 Required return is 9%
A Case 2 In this case, abnormal earnings growth is expected to grow at a 4.5 percent rate after 2012
Valuation:
Nike, Inc.

E
V2006 =
1
2.96 + 0.332 + 1.495 = 53.18
0.09
Same as residual earnings valuation
 Price, early 2011 = $624
Required return = 11%
Converting Analysts’ Consensus eps forecasts:
Forecasts to a Valuation: 2011 $33.83

2012 $39.47
Google Inc., 2010 5-year growth rate forecasted = 17.4%
Abnormal Earnings Growth is Equal to the Change in Residual Earnings
AEG t = [earn t + (ρ E – 1)d t-1] - ρ E earn t-1
= earnt − earnt −1 − (ρ E −1)[earnt −1 − d t −1 ]

By the stocks and flows equation for accounting for the book value of equity (Chapter 2),

B t-1 = B t-2 + earn t-1 – dt-1 , so earn t-1 – d t-1 = B t-1 – B t-2 . Thus,

AEG t = earn t – earn t-1 - (ρ E – 1)[Bt-1 – B t-2 ]

= [earn t - (ρ E – 1)B t-1 ] - [ earn t-1 - (ρ E – 1)B t-2 ]

= RE t – RE t-1

So, the AEG model can be written as:

1  RE2 RE3 RE4 

V0E =  Earn1 + + 2 + 3 + ....
E −1  E E E 
Protection From Earnings Created by Accounting: A Restructuring Charge
2000 2001 2002 2003 2004 2005

Earnings 4.00 20.36 12.73 13.11 13.51 13.91

Dividends 9.09 9.36 9.64 9.93 10.23 10.54

Book value 92.00 103.00 106.09 109.27 112.55 115.93

Earnings on reinvested
dividends 0.936 0.964 0.993 1.023

Cum-dividend earnings 13.667 14.077 14.499 14.934

Normal earnings 22.396 14.004 14.424 14.857

Abnormal earnings growth (8.729) 0.073 0.075 0.077

Abnormal earnings growth rate 3% 3% 3%

1  8.729 0.073 
E
V2000 =  20.36 − + 1.10 = 133.71
0.10  1.10 1.10 − 1.03 
Abnormal Earnings Growth Analysis:
Advantages and Disadvantages
Advantages
• Easy to understand: Investors think in terms of
future earnings; investors buy earnings. Focuses
directly on the most common multiple used, 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.
• Versatility: Can be used under a variety of
accounting principles.
• Aligned with what people forecast: Analysts
forecast earnings and earnings growth.
Disadvantages
• Accounting complexity: Requires an
understanding of how accrual accounting works.
• Concept complexity: Requires an appreciation of
the concept of cum-dividend earnings; that is,
value is based on earnings to be earned within
the firm and from earnings from the reinvestment
of dividends.
• Application to strategy: Does not give an insight
into the drivers of earnings growth, particularly
balance sheet items, so is not suited to strategy
analysis.
• Suspect accounting: Relies on earnings numbers
that can be suspect.
The Big Picture
• Don’t take valuation models literally
• Use valuation models to challenge the market price rather than for
calculating intrinsic value
• Use valuation models to convert the market price to a forecast – then
challenge that forecast

• Investing is not a game against nature, rather a game against other investors
• Therefore, use valuation models to play the game against other investors
 Common Misconceptions About Valuation
• The idea of “intrinsic value” is not useful
✓ Don’t pretend that you can calculate a precise intrinsic value

• We do not know the required return

✓ Building a required return into a valuation puts speculation into the
calculation

• We do not know the long-term growth rate

✓ Building a growth rate into a valuation is speculative

Active investing finesses these issues

Challenging the Market Price:
Reverse Engineering the Growth Rate
The Simple Example of Chapter 5

If price = $133.71, then

Solve for g:
g = 1.03, or a 3% growth rate
Challenging the Market Price:
Reverse Engineering the Expected Return
The Simple Example of Chapter 5

If price = $133.71 and one forecasts a growth

rate of 3%, then
2.36
P0 = $133.71 = $100 +
ER − 1.03

Solve for ER:

ER = 1.10 (a 10% expected return)
A Formula for the Expected Return

The Expected Return is a weighted average

of the forward ROCE and growth, where the
weights are given by book-to-price (B/P)

Note!
ER is the expected return to buying at the
current market price, not the required return
Reverse Engineering the S&P 500, May 2011
Inputs:
Index level: 1357
Book value: 588
P/B: 2.3
B/P: 0.435
Forward Earnings (for the next year) $98.76
Long-term treasury rate: 3.3%
Risk premium: 5.7%

Forward ROCE = 98.76 / 588 = 16.8%

Required Return = 3.3% + 5.7% = 9%
Reverse Engineering the S&P 500, May 2011 (cont.)
1. The implied growth rate:

g = 1.03 (a 3% growth rate)

If one expects the historical GDP growth rate of

4%, the S&P 500 is cheap.

2. The implied expected return:

If one requires a 9% return to invest in the S&P

500, the index is cheap.
Challenging the Market Price: Google Inc, May 2011
Price: $535
Book value: $143.92
Analysts’ EPS forecast for 2011: $33.94
Analysts’ EPS forecast for 2012: $39.55
Required return: 10%

Value = Value based on what we know + Speculative value

(1) (2)
(1) Value based on what we know is the no-growth valuation

= $143.92 + $215.62 = $359.54

(2) Speculative value is the value from speculating about growth

= Market price – No-growth value
= $535 - $359.54
= $175.46
The Building Blocks of the Market: Valuation of Google
Market price = $535 in May 2011
The Implied Growth Rate: Google

Solution for g: 1.047 (a 4.7% growth rate)

Homework
• Read chapter 5,6,7

• Attempt E5.1 to E5.12

• Attempt E6.1 to 6.11 (excluding E6.2)
• Attempt E7.1 to E7.6 (excluding E7.5)
QUESTIONS?