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Earnings Based Valuations

Earnings Based Valuations. Dr. Mangold California State University, East Bay. Dividend capitalization model: P 0 = One of these dividends is the expected liquidating dividend: P 0 =. Cash Flows to the Firm: P 0 =

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Earnings Based Valuations

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  1. Earnings Based Valuations Dr. Mangold California State University, East Bay

  2. Dividend capitalization model: P0 = One of these dividends is the expected liquidating dividend: P0 =

  3. Cash Flows to the Firm: P0 = When expected leveraged free cash flows are projected to remain constant into perpetuity: P0 = When expected free cash flows are projected to grow at a constant rate equal to g: P0 = Expected Cash Flowt=1 *

  4. Expected Earnings: Substitute a firm’s expected earnings for its expected leveraged free cash flows in the formulation of market price: P0 = Firm’s earnings constant: P0 = Firm’s earnings to grow at a constant rate g: P0 = Expected Earningst=1 *

  5. Actual Earnings: Substitute actual earnings of the most recent period for expected permanent earnings: P0 = Steady growth rate g: P0 = Actual Earningst-1 *

  6. Market Price = PV of Future Dividends to Shareholders ↓ = PV of Future Leveraged Free Cash Flows of the Firm ↓ = Capitalized Value of Future Earnings of the Firm ↓ = Capitalized Value of Current Earnings of the Firm

  7. Theoretical Model (P/E ratios): No Growth Firm:

  8. Example 1: No growth Earnings = 700 Cost of Equity Capital = 0.14 PE Ratio = 1/0.14 = = 7.14 P = 700x (1/0.14) = 5000

  9. Constant Growth Firm:

  10. Example 2 Earnings = 700 Cost of Equity Capital = 0.14 g = 0.05 PE Ratio =(1+0.05)/(0.14-0.05) = 11.67 P = 700*11.67 = $8,167

  11. Example 3 Earnings = 700 Cost of Equity Capital = 0.14 g= 0.06 PE Ratio = (1+0.06)/(0.14-0.06) = 13.25 P = 700*13.25 = $9,275

  12. Let’s now apply the theoretical P-E Model (growth version) to Coke. Market Price per Share (Dec. 31, Year 7) $52.63 Earnings per Share (Year 7) $1.40 Market Beta 0.97 Cost of Equity Capital 12.8%* Five-year Compound Annual Growth Rate in Earnings 16.7% Risk-free Interest Rate 6.0% Market Risk Premium 7.0% [*12.8% = 6.0% +0.97(7%)] Solution P-E ratio = 37.6 = $52.63/$1.40 Cost of Equity Capital = 19.8% when the Growth Rate in Earnings is 16.7% ∵37.6 = 1.167/(x – 0.167) ∴x = 0.198 Implied Growth Rate in Earnings = 9.9% ∵37.6 = (1 + g)/(0.128 – g) ∴g = 0.099

  13. The difference between Actual P/E and Theoretical P/E: Actual < Theoretical Buy or Sell Actual > Theoretical Buy or Sell 1. Actual earnings of the current period is a poor predictor of expected earnings.  2. Impact of accounting principles: Industry - Use conservative accounting principles -Technology – expense R&D -LIFO -Lower earnings -Higher P/E ratios

  14. P/E ratios: • Risk. • Growth. • Difference between current and expected future (permanent) earnings. • Alternative accounting principles.

  15. Price to Book value Ratios: P0 = P0 =

  16. In Equilibrium, ROCE = r, P = BV, P/BV = 1 P0 = BV0 +

  17. If firm can generate excess returns forever, n → ∞ infinity,

  18. P-BV Ratio • A function of • The expected level of profitability relative to the required rate of return • Growth in the book value of common shareholders’ equity • Growth in book value is a function of • Earnings generated each period in excess of dividends paid plus additional capital contributions by shareholders

  19. Example Earnings = 700 Cost of Equity Capital = 0.14 t0 = $4,375 Expected ROCEt=1 = 16% = 700/4,375 Assume ROCEt=2 = 15% and thereafter is 14%, then P0 = $4,375 + (0.16-0.14)(4,375)/(1.14)1 + (0.15-0.14)* (4,375+700)/(1.14)2 = $4,375 + $76.75 + $39.05 = $4,490.80 The P-BV Ratio at t0 = P0/BV0 =1 + (76.75+39.05)/4,375 = 1+ 0.0265 = 1.0265

  20. Market Value of Shareholders’ Equity on Dec. 31, Year 7 (in millions) $130,575 Book Value of Shareholders’ Equity on Dec. 31, Year 7 (in millions) $6,156 Cost of Equity Capital 12.8%* ROCE for Year 7 60.5% Dividends as a Percentage of Net Income 35.7% Coke Example:

  21. Assume that Coke is expected to generate an ROCE of 60.5% for five years, and then the ROCE reverts to 12.8%. The P-BV ratio is calculated as follows: = 1 + [(2603 + 3206 + 3947 + 4861 +5989)/ 6156 = 4.437

  22. Shareholders’ Equity grows each year by the amount of earnings and decreases by the amount of dividends. For example, the calculation of shareholders’ equity at the end of Year 8 is as follows: Shareholders’ Equity, Dec 31 Year 7 $6,156 Net Income for Year 8: 0.605 × $6,156 3,724 Less Dividends: 0.357 × $3,724 (1,329) Shareholders Equity, Dec 31 Year 8 $8,551 The actual P-BV ratio = 21.2 = $130,575/$6,156

  23. Differences between Actual and Theoretical Levels of P-BV ratios • Errors in estimating the level or sustainability of ROCE • Errors in measuring the cost of equity capital • Errors in measuring the growth in common shareholders’ equity • Using an actual ROCE that includes transitory earnings • Using an actual ROCE that incorporates biases caused by alternative accounting principles

  24. Using P/E ratios and P/BV ratios of Comparable Firms: • Analysts can use • P-E and P-BV ratios of comparable firms • to assess the corresponding ratios of publicly traded firms.

  25. Valuation Approaches: 1. PV of projected cash flows. 2. a). Price – earnings ratios using theoretical models. b). Multiples for comparable companies. 3. a). P-BV ratios using theoretical models. b). Multiples for comparable companies.

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