Valuation and Forecasting

1. Valuation and Forecasting

2. Introduction Valuation models: Asset-based valuation models Discounted cash flow models The abnormal earnings or Edwards-Bell-Ohlson (EBO) model

3. Asset-Based Valuation Models Asset-based models assign a value to the firm by aggregating the current market value of its individual component assets and liabilities Discrepancy between market price and book value

4. Asset-Based Valuation Models Book value: measurement issues Used book value is an “index” against which to compare the stock price Assumption: historical cost-based book value reflects the minimum value of the firm Book value is also a function of management’s financial reporting choices

5. Asset-Based Valuation Models Stability and growth of book value: Earnings retention Effect of new equity financing Effect of acquisitions Effect of changing exchange rates Effect of financial reporting choices and accounting changes Restructuring provisions and write-offs

6. Discounted Cash Flow Valuation Models 3 alternative cash flow measures: Dividends Accounting earnings Free cash flows (cash available to debt and equityholders after investment)

7. The Abnormal Earnings or EBO Model A model based on book values and abnormal earnings

8. Terminal Value In DCF models: terminal value frequently constitute 60 to 70% of total value All parameters must be estimated and those that are most difficult to estimate play a large role in valuation In EBO model: the book value approximates 75% of firm value Book value is given and does not have to be estimated Forecasting is simpler for EBO model

9. Forecasting Models and Time Series Properties of Earnings Permanent versus transitory components: When using time series of a firm’s earnings, it is important to separate the permanent and transitory components