Prospective Analysis

Valuation Theory and

Concept
M A G I S T E R A K U N TA N S I
S E K O L A H PA S C A S A R J A N A
U N I V E R S I TA S K ATO L I K W I D YA M A N D A L A S U R A B AYA
INTRODUCTION
Valuation is the process of converting forecasts into an estimate of the value of the firm’s
assets or equity. At some level, nearly every business decision involves valuation, at least
implicitly.
Within the firm
• Capital budgeting involves considering 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 recommendations, and potential acquirers
(often with the assistance of investment bankers) estimate the value of target firms and the synergies
they might offer.
• Even credit analysts, who typically do not explicitly estimate firm value, must at least implicitly consider
the value of the firm’s equity “cushion” if they are to maintain a complete view of the risk associated
with lending activity.
INTRODUCTION
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 ten different methods of valuation. Among the
available methods are the following:
• Valuation based on price multiples. Under this approach, a current measure of performance or single forecast
of performance is converted into value by applying an appropriate price multiple derived from the value of
comparable firms. For example, firm value can be estimated by applying a price-to-earnings ratio to a forecast
of the firm’s earnings for the coming year. Other commonly used multiples include price-to-book ratios and
price-to-sales ratios.
• Discounted dividends. This approach expresses the value of the firm’s equity as the present value of
forecasted future dividends.
• Discounted abnormal earnings. Under this approach, the value of the firm’s equity is expressed as the sum of
its current book value and present value of forecasted abnormal earnings.
• Discounted cash flow (DCF) analysis. This approach involves the production of detailed, multiple-year
forecasts of cash flows. The forecasts are then
VALUATION USING PRICE
MULTIPLES
Valuations based on price multiples are widely used by analysts. The primary reason for their popularity is
their simplicity. The approach typically involves the following steps:
Step 1: Select a measure of performance or value (e.g., earnings, sales, cash flows, book equity, book assets)
as the basis for the multiple. The two most commonly used performance measures are earnings and book
equity.
Step 2: For firms that are comparable to the firm analyzed, deflate their stock prices by their selected
performance measure to generate multiples, such as price earnings multiples or the price-to-book multiples.
Step 3: Apply the average multiple for the comparable firms to the performance or value measure of the
firm being analyzed.
Under this approach, the analyst relies on the market to undertake the difficult task of considering the
short- and long-term prospects for growth and profitability and their implications for the values of the
comparable firms. Then the analyst assumes that the pricing of the comparable firms is applicable to the
firm at hand.
VALUATION USING PRICE
MULTIPLES
Key Issues with Multiples-Based Valuation
On the surface, using multiples seems straightforward. Unfortunately, in practice
it is not as simple as it would appear. Identification of “comparable” firms is
often quite difficult. There are also some choices to be made concerning how
multiples will be calculated. Finally, explaining why multiples vary across firms,
and how applicable another firm’s multiple is to the one at hand, requires a
sound understanding of the determinants of each multiple.
• Selecting Comparable Firms
• Multiples for Firms with Poor Performance
• Adjusting Multiples for Leverage
SELECTING COMPARABLE FIRMS
•Ideally, price multiples used in a comparable firm analysis are those for firms with
similar operating and financial characteristics. Firms within the same industry are the
most obvious candidates. But even within narrowly defined industries, it is often
difficult to identify comparable firms. Many firms are in multiple industries, making it
difficult to identify representative benchmarks. In addition, firms within the same
industry frequently have different strategies, growth opportunities, and profitability,
creating comparability problems.
•One way of dealing with these issues is to average across all firms in the industry. The
analyst implicitly hopes that the various sources of non-comparability cancel each
other out, so that the firm being valued is comparable to a “typical” industry member.
Another approach is to focus on only those firms within the industry that are most
similar.
MULTIPLES FOR FIRMS WITH
POOR PERFORMANCE
Price multiples can be affected when the denominator variable is temporarily
performing poorly. This is especially common when the denominator is a flow
measure, such as earnings or cash flows. For example, Sears Holding Corp., one
of TJX’s mid-market competitors, was barely profitable in the fiscal years ended
January 2009, 2010, and 2011. Its 2010 price-earnings ratio of 63.9, which was
well above the industry average, indicated that investors expected the company
to experience a performance turnaround. Consequently, including Sears as one
of the benchmark firms in computing an industry price-earnings multiple for TJX
would probably be misleading.
• Analysts have numerous options for handling the problems for multiples created by
transitory shocks to the denominator. One option is to simply exclude firms with
large transitory effects from the set of comparable firms.
ADJUSTING MULTIPLES FOR
LEVERAGE
Price multiples should be calculated in a way that preserves
consistency between the numerator and denominator. Consistency
is an issue for those ratios where the denominator reflects
performance before servicing debt.
• Examples include the price-to-sales multiple and any multiple of
operating earnings or operating cash flows. When calculating these
multiples, the numerator should include not just the market value
of equity but the value of debt as well.
THE DISCOUNTED DIVIDEND
VALUATION METHOD
Finance theory holds that the value of any financial claim is the present value of the
cash payoffs that its claimholders receive. Since shareholders receive cash payoffs from
a company in the form of dividends, the value of their equity is the present value of
future dividends (including any liquidating dividend).
Equity Value = PV (Expected Future Dividends)
The present value concept is used to make it possible to sum up future dividends
received in different time periods.
• A dollar of dividends received today is worth more than a dollar received in the
future because the dollar received today can be reinvested, enabling the investor to
receive the reinvested dollar plus a return on that investment in the future.
THE DISCOUNTED DIVIDEND
VALUATION METHOD
To better understand how the discounted dividend approach works, consider
the following simplified example. At the beginning of year 1, Down Under
Company raises $60 million of equity and uses the proceeds to buy a fixed
asset. Operating profits before depreciation (all received in cash) are expected
to be $40 million in year 1, $50 million in year 2, and $60 million in year 3. The
firm pays out all operating profits as dividends and pays no taxes. At the end of
year 3, the company terminates and has no remaining value. If the firm’s
shareholders expect to earn a 10 percent return, the value of the firm’s equity
(after the initial equity has been raised and the fixed asset purchased) is $122.8
million, computed as follows:
THE DISCOUNTED DIVIDEND
VALUATION METHOD
Year Dividend PV Factor PV of Dividend
(1) (2) (1 x 2)
1 $40 M 0.909 $ 36.4 M

2 $50 M 0.826 $ 41.3 M

3 $60 M 0.751 $ 45.1 M

Equity Value $ 122.8 M

THE DISCOUNTED DIVIDEND
VALUATION METHOD
Of course, in reality firms’ lives are not three years but indefinite. How does the
dividend discount model capture an indefinite stream of future dividends? The typical
way is to assume that after some time the owner sells the stock, generating a
terminating dividend or terminal value. But what would the terminating value of the
stock be worth? Several simplifying assumptions can be used to answer this question
and are discussed in the following chapter.
In summary, the dividend discount model is the basis for most of the popular
theoretical approaches for stock valuation. It resolves many of the limitations
discussed for multiples. But it also has its own shortcomings, particularly for firms that
pay no dividends or very low dividends, where it is difficult to forecast future
dividends. We therefore turn to modifications of the dividend discount model.
THE DISCOUNTED ABNORMAL
EARNINGS VALUATION METHOD
There is a direct link between dividends and earnings. If all equity (other than capital
transactions) flows through the income statement,1 the ending book value of equity for existing
shareholders is simply the beginning book value plus net income less dividends. This relation can
be rewritten as follows:
Dividends = Net Income + Beginning Book Equity – Ending Book Equity
By using this identity, we can rewrite the dividend discount formula so that the equity value is as
follows:
Equity Value = Book Equity + PV (Expected Abnormal Earnings)
Book equity is simply the latest book value of equity. Abnormal earnings are net income less a
capital charge and are computed as follows:
Abnormal Earnings = Net Income – (Expected Return * Beginning Book of Equity)
THE DISCOUNTED ABNORMAL
EARNINGS VALUATION METHOD
The capital charge recognizes that shareholders have an opportunity cost for the equity funds
invested in the business. At the beginning of a year (or quarter) on a book basis funds equal to
the beginning book equity are invested in the firm on the shareholders’ behalf. They expect to
earn a return on this investment, their expected return. Abnormal earnings arise when the firm
is able to produce earnings that exceed this capital charge.

The earnings-based formulation has intuitive appeal. If a firm can earn only the required rate of
return on its book value, then investors should be willing to pay no more than book value for
the stock. Investors should pay more or less than book value if earnings are above or below
this normal level. Thus, the deviation of a firm’s market value from book value depends on its
ability to generate “abnormal earnings.” The formulation also implies that a firm’s stock value
reflects the cost of its existing net assets (i.e., its book equity) plus the present value of future
growth options (represented by cumulative abnormal earnings).
THE DISCOUNTED ABNORMAL
EARNINGS VALUATION METHOD
To illustrate the earnings-based valuation approach, let us return to the Down Under
Company three-year example. Assuming the company depreciates its fixed assets using
the straight-line method, its accounting-based earnings will be $20 million lower than
dividends in each of the three years.
• Year 1 earnings are therefore expected to be $20 million (the projected cash
inflows/dividends of $40 million net of depreciation).
• The capital charge is $6 million, representing investors’ required return of 10 percent
times the book value of assets at the beginning of year 1 ($60 million, the cost of
fixed assets).
• Consequently, expected abnormal earnings for year 1 are $14 million ($20 million less
the $6 million capital charge). The firm’s beginning book equity, earnings, capital
charges, abnormal earnings, and valuation will be as follows:
THE DISCOUNTED ABNORMAL
EARNINGS VALUATION METHOD
Year Expected Expected Capital Expected PV Factor PV of Expected
Beginning Earnings Charge Abnormal Abnormal Earnings
Book Value Earnings
1 $60 M $ 20 M $6M $ 14 M 0.909 $ 12.7 M

2 $40 M $ 30 M $4M $ 26 M 0.826 $ 21.5 M

3 $20 M $ 40 M $2M $ 38 M 0.751 $ 28.6 M

Cumulative PV of Abnormal Earnings $ 62.8 M

+ Beginning Book Value $ 60.0 M
Equity Value $ 122.8 M
ACCOUNTING METHODS AND
DISCOUNTED ABNORMAL
EARNINGS
One question that arises when valuation is based directly on earnings and book values is how the
estimate is affected by managers’ choice of accounting methods and accrual estimates. Would
estimates of value differ for two otherwise identical firms if one used more conservative accounting
methods than the other?
We will see that, provided analysts recognize the impact of differences in accounting methods on
future earnings (and hence their earnings forecasts), the accounting effects per se should have no
influence on their value estimates.
There are two reasons:
• First, double-entry bookkeeping is self-correcting. Inflated earnings for one period ultimately have to be
reversed in subsequent periods.
• Second, accounting choices that affect a firm’s current earnings also affect its book value, and therefore affect
the capital charges used to estimate future abnormal earnings. For example, conservative accounting lowers a
firm’s current earnings and book equity, but also reduces future capital charges and inflates its future abnormal
earnings.
ACCOUNTING METHODS AND
DISCOUNTED ABNORMAL
EARNINGS
To see how these two effects undo the effect of differences in accounting methods or accrual estimates
let us return to Down Under Company and see what happens if its managers choose to be conservative
and expense some unusual costs that could have been capitalized inventory at year 1.
• This accounting decision causes earnings and ending book value to be lower by $10 million. The inventory is then
sold in year 2. For the time being, let us say the accounting choice has no influence on the analyst’s view of the
firm’s real performance.
• Management’s choice reduces abnormal earnings in year 1 and book value at the beginning of year 2 by $10
million.
• However, future earnings will be higher, for two reasons:
• First, future earnings will be higher by $10 million when the inventory is sold in year 2.
• Second, the capital charge for normal earnings in year 2 will be $1 million lower, representing 10 percent
(investors’ required return) times $10 million decline in book value of equity at the beginning of year 2. The
$10 million decline in abnormal earnings in year 1 is therefore perfectly offset (on a present value basis) by the
$11 million higher abnormal earnings in year 2. As a result, the value of Down Under Company under
conservative reporting is identical to the value under the earlier accounting method ($122.8 million).
ACCOUNTING METHODS AND
DISCOUNTED ABNORMAL
EARNINGS
Year Expected Expected Capital Expected PV Factor PV of Expected
Beginning Earnings Charge Abnormal Abnormal Earnings
Book Value Earnings
1 $60 M $ 10 M $6M $4M 0.909 $ 3.6 M

2 $30 M $ 40 M $3M $ 37 M 0.826 $ 30.6 M

3 $20 M $ 40 M $2M $ 38 M 0.751 $ 28.6 M

Cumulative PV of Abnormal Earnings $ 62.8 M

+ Beginning Book Value $ 60.0 M
Equity Value $ 122.8 M
ACCOUNTING METHODS AND
DISCOUNTED ABNORMAL
EARNINGS
Provided the analyst is aware of biases in accounting data that arise from managers’ using
aggressive or conservative accounting choices, abnormal earnings-based valuations are
unaffected by variation in accounting decisions. This shows that strategic and accounting
analyses are critical precursors to abnormal earnings valuation. The strategic and accounting
analysis tools help the analyst to identify whether abnormal earnings arise from sustainable
competitive advantage or from unsustainable accounting manipulations.
• For example, consider the implications of failing to understand the reasons for a decline in
earnings from a change in inventory policy for Down Under Company. If an analyst mistakenly
interpreted the decline as indicating that the firm was having difficulty moving its inventory,
rather than that it had used conservative accounting, the analyst might reduce expectations
of future earnings. The estimated value of the firm would then be lower than that reported in
our example.
THE DISCOUNTED CASH FLOW
MODEL
The final valuation method discussed here is the discounted cash flow approach. This is the
valuation method taught in most finance classes. Like the abnormal earnings approach, it is
derived from the dividend discount model. It is based on the insight that dividends can be recast
as free cash flows:
Dividends = Operating Cash Flow – Capital Outlays + Net Cash Flows from Debt Owners
As discussed in Chapter 5, operating cash flows to equity holders are simply net income plus
depreciation less changes in working capital accruals. Capital outlays are capital expenditures
less asset sales. Finally, net cash flows from debt owners are issues of new debt less retirements
less the after-tax cost of interest. The dividend discount model can therefore be written as the
present value of free cash flows to equity. Under this formulation, value to shareholders is
estimated as follows:
Equity Value = PV (Expected Free Cash Flow to Equity)
THE DISCOUNTED CASH FLOW
MODEL
Valuation under the discounted cash flow method therefore involves the
following steps:
Step 1: Forecast free cash flows available to equity holders over a finite forecast
horizon (usually 5 to 10 years),
Step 2: Forecast free cash flows beyond the terminal year based on some
simplifying assumption, and
Step 3: Discount free cash flows to equity holders at the cost of equity. The
discounted amount represents the estimated value of free cash flows available
to equity.
THE DISCOUNTED CASH FLOW
MODEL
Returning to the Down Under Company example, there is no debt, so that the free cash flows to
owners are simply the operating profits before depreciation. Since the company’s required
return for shareholders is assumed to be 10 percent, the present value of the free cash flows is
calculated as follows:
Year Expected of PV Factor PV of Expected Free
Free Cash Flows (2) Cash Flows
1 $40 M 0.909 $ 36.4 M

2 $50 M 0.826 $ 41.3 M

3 $60 M 0.751 $ 45.1 M

Equity Value $ 122.8 M

COMPARING VALUATION
METHODS
We have discussed three methods of valuation derived from the dividend
discount model: discounted dividends, discounted abnormal earnings (or
abnormal ROEs), and discounted cash flows. Since the methods are all derived
from the same underlying model, no one version can be considered superior to
the others. As long as analysts make the same assumptions about firm
fundamentals, value estimates under all three methods will be identical.
However, there are important differences between the models that are
discussed below:
• Differences in Focus
• Differences in Required Structure
• Differences in Terminal Value Implications
DIFFERENCES IN FOCUS
The methods frame the valuation task differently and can in practice focus the analyst’s
attention on different issues. The earnings-based approaches frame the issues in terms of
accounting data such as earnings and book values rather than cash flows. Analysts spend
considerable time analyzing historical income statements and balance sheets, and their primary
forecasts are typically for these accounting variables.
Defining values in terms of ROEs has the advantage that it focuses analysts’ attention on ROE,
the same key measure of performance that is decomposed in a standard financial analysis.
Furthermore, because ROEs control for firm scale, it is likely to be easier for analysts to
evaluate the reasonableness of their forecasts by benchmarking them with ROEs of other
firms in the industry and the economy. This type of benchmarking is more challenging for free
cash flows and abnormal earnings.
DIFFERENCES IN REQUIRED
STRUCTURE
The methods differ in the amount of analysis and structure required for valuation. The
discounted abnormal earnings and ROE methods require analysts to construct both proforma
income statements and balance sheets to forecast future earnings and book values. In
contrast, the discounted cash flow method requires analysts to forecast income statements and
changes in working capital and long-term assets to generate free cash flows. Finally, the
discounted dividend method requires analysts to forecast dividends.
The discounted abnormal earnings, ROE, and free cash flow models all require more structure
for analysis than the discounted dividend approach. They therefore help analysts avoid
structural inconsistencies in their forecasts of future dividends by specifically requiring a
prediction of firms’ future performance and investment opportunities. Similarly, the
discounted abnormal earnings/ROE method requires more structure and work than the
discounted cash flow method to build full pro forma balance sheets. This permits analysts to
avoid inconsistencies in the firm’s financial structure.
DIFFERENCES IN TERMINAL
VALUE IMPLICATIONS
A third difference between the methods is in the effort required for estimating terminal values.
Terminal value estimates for the abnormal earnings and ROE methods tend to represent a much
smaller fraction of total value than under the discounted cash flow or dividend methods. On
the surface, this would appear to mitigate concerns about the aspect of valuation that leaves
the analyst most uncomfortable. Is this apparent advantage real? As explained below, the
answer turns on how well value is already reflected in the accountant’s book value.
The abnormal earnings valuation does not eliminate the discounted cash flow terminal value
problem, but it does reframe it. Discounted cash flow terminal values include the present value
of all expected cash flows beyond the forecast horizon. Under abnormal earnings valuation,
that value is broken into two parts: the present values of normal earnings and abnormal
earnings beyond the terminal year. The terminal value in the abnormal earnings technique
includes only the abnormal earnings. The present value of normal earnings is already reflected
in the original book value.
DIFFERENCES IN TERMINAL
VALUE IMPLICATIONS
The abnormal earnings approach, then, recognizes that current book value and earnings over
the forecast horizon already reflect many of the cash flows expected to arrive after the
forecast horizon. The approach builds directly on accrual accounting. For example, under
accrual accounting book equity can be thought of as the minimum recoverable future benefits
attributable to the firm’s net assets. In addition, revenues are typically realized when earned,
not when cash is received. The discounted cash flow approach, on the other hand, “unravels” all
of the accruals, spreads the resulting cash flows over longer horizons, and then reconstructs its
own “accruals” in the form of discounted expectations of future cash flows. The essential
difference between the two approaches is that abnormal earnings valuation recognizes that the
accrual process may already have performed a portion of the valuation task, whereas the
discounted cash flow approach ultimately moves back to the primitive cash flows underlying
the accruals.
DIFFERENCES IN TERMINAL
VALUE IMPLICATIONS
The usefulness of the accounting-based perspective thus hinges on how well the
accrual process reflects future cash flows. The approach is most convenient
when the accrual process is “unbiased,” so that earnings can be abnormal only
as the result of economic rents and not as a product of accounting itself. The
forecast horizon then extends to the point where the firm is expected to
approach a competitive equilibrium and earn only normal earnings on its
projects. Subsequent abnormal earnings would be zero, and the terminal value
at that point would be zero. In this case, all of the firm’s value is reflected in the
book value and earnings projected over the forecast horizon.
DIFFERENCES IN TERMINAL
VALUE IMPLICATIONS
Of course, accounting rarely works so well. For example, in most countries research and
development costs are expensed, and book values fail to reflect any research and
development assets. As a result, firms that spend heavily on research and development—
such as pharmaceutical companies—tend on average to generate abnormally high earnings
even in the face of stiff competition. Purely as an artifact of research and development
accounting, abnormal earnings would be expected to remain positive indefinitely for such
firms, and the terminal value could represent a substantial fraction of total value.
If desired, the analyst can alter the accounting approach used by the firm in his or her own
projections. “Better” accounting would be viewed as that which reflects a larger fraction of
the firm’s value in book values and earnings over the forecast horizon. This same view
underlies analysts’ attempts to “normalize” earnings; the adjusted numbers are intended to
provide better indications of value, even though they reflect performance only over a short
horizon.
DIFFERENCES IN TERMINAL
VALUE IMPLICATIONS
Recent research has focused on the performance of earnings-based valuation relative to
discounted cash flow and discounted dividend methods. The findings indicate that over
relatively short forecast horizons, ten years or less, valuation estimates using the abnormal
earnings approach generate more precise estimates of value than either the discounted
dividend or discounted cash flow models. This advantage for the earnings-based approach
persists for firms with conservative or aggressive accounting, indicating that accrual accounting
in the United States does a reasonably good job of reflecting future cash flows
Research also indicates that abnormal earnings estimates of value outperform traditional
multiples, such as price-earnings ratios, price-to-book ratios, and dividend yields, for
predicting future stock movements. Firms with high abnormal earnings model estimates of
value relative to current price show positive abnormal future stock returns, whereas firms with
low estimated value-to-price ratios have negative abnormal stock performance.
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