Chapter 8

PROSPECTIVE ANALYSIS: VALUATION

IMPLEMENTATION
 LEARNING OBJECTIVES
LO1: Understand how to estimate discount rates

LO2: Create a structured and systematic performance forecast

LO3: Understand the way in which terminal value assumptions affect overall
valuations
 COMPUTING A DISCOUNT RATE

Common approach to estimating the cost of equity:

Capital Asset Pricing Model (CAPM)

Only the risk that an asset contributes to (a fully diversified) portfolio must be compensated
because of its covariance with the returns of the other assets.

Cost of equity is the sum of

(i) the risk-free rate and (ii) the premium for systematic risk

r! = r" + β[E r# − r" ]

 ESTIMATING KATHMANDU’S COST OF EQUITY
• Beta estimates are shown in Figure 8.3
• The yield on the 10-year Australian government bond at 1 August 2018 was 2.75%
• Risk premium for equity is 6%
• Cost of equity is 7.01%
 ADJUSTING COST OF EQUITY FOR CHANGES IN LEVERAGE

The sensitivity of equity performance to economy-wide changes increases in leverage:

ROE = Return on net operating assets

+ (Return on net operating assets – after tax interest rate) × net debt/equity

Similarly, the relationship between equity and asset betas depends on leverage:

Equity beta risknew = (Asset beta risknew – (Debt beta risknew × %debtnew)
× (1 – tax rate)) / %equitynew
 DETAILED FORECASTS OF PERFORMANCE

Assumptions underlying the forecasts are all-important.

• Strategy analysis is critical to determine if current performance is

sustainable

• Accounting analysis helps understand:

• A company’s current performance, as reported
• The reliability of reported information used in forecasts

Typically, selected financial statement line items are forecasted instead of

complete financials.
• See Figures 8.4 and 8.5 in next slides
FORECASTING ASSUMPTIONS FOR KATHMANDU
FORECAST FINANCIAL STATEMENTS FOR KATHMANDU
 TERMINAL VALUES

The terminal value is the final year of the forecast and

represents the PV of future of abnormal earnings or free
cash flows for the remainder of the firm’s life.

Selecting the terminal year:

• Five- to ten-year forecast horizon should suffice for
most firms.
 TERMINAL VALUE ASSUMPTIONS
Terminal values with the competitive • Assumptions about sales growth beyond the
terminal year may be irrelevant because of the
equilibrium assumptions competitive equilibrium

Competitive equilibrium
• Abnormal earnings on incremental sales may
assumptions only on incremental be assumed
sales

• Terminal values may be forecasted with

Terminal value with persistent growth in abnormal earnings and cash flows
abnormal performance growth at a constant rate

Terminal value based on a • A price multiple may be used to calculate

price multiple terminal value
TERMINAL VALUES FOR KATHMANDU
EQUITY VALUATION FOR KATHMANDU USING
FREE CASH FLOWS
 EQUITY
VALUATION
FOR
KATHMANDU
USING
ABNORMAL
EARNINGS
 OTHER ISSUES RELATED TO VALUE ESTIMATES

It is useful to check
Stock prices of
assumptions used Sensitivity analysis
publicly traded
against the time for different
series trends for a companies are
useful as a economic
company’s scenarios is a
comparison for
performance good idea.
value estimates.
ratios.
 SOME PRACTICAL ISSUES IN VALUATION
• In practice, analysts must deal with a number of issues that have an
important effect on valuation, including:

Excessive cash balances

Accounting distortions Negative book values and cash flows
• Accounting choices, • Start-up firms and • Firms with cash
though self- firms in certain beyond the level
correcting, affect both industrial sectors, required to finance
earnings and book among others, may operations warrant
value have negative further investigation
book equity to understand
whether the excess
cash indicates
governance problems
 CONCLUDING COMMENTS

This chapter applies Strategic and

the valuation theory The Kathmandu accounting analyses
example provides
discussed in are critical to
insights into the
Chapter 7 along arriving at the
with the forecasts challenges posed in assumptions that
the valuation
addressed in drive value
process.
Chapter 6. estimates.
 CASE LINK

• Case 1 Qantas
Part E Valuation

• Case 6 Valuation ratios in the retail industry 2016 to 2018

SUMMARY
This chapter illustrates how to apply the valuation theory discussed in Chapter 7. The
chapter explains the set of business and financial assumptions one needs to make to conduct
the valuation exercise. It also illustrates the mechanics of making detailed valuation forecasts
and terminal values of earnings, free cash flows and accounting rates of return. We discuss
how to compute cost of equity. Using a detailed example, we show how a firm’s equity value
can be computed using earnings, cash flows and rates of return. Finally, we offer ways to deal
with some commonly encountered practical issues, including accounting distortions, negative
book values and excess cash balances.

John 4:23 But the hour comes, and now is, when the true worshippers shall worship the
Father in spirit and in truth: for the Father seeks such to worship him.