Class #4 “Using Accounting Earnings for Valuation” aka “EBO Valuation” or “Abnormal Earnings Valuation” or “Residual Income Valuation” 15.535 - Class #4 1Where have we been & where are we going? • Where have we been? – Valuation Basics – Calculating Cash flows •Today – Overview of Dell Abnormal Earnings Valuation – Quickly discuss accounting and real options • What we still need? – Other techniques: Multiples Valuation (Next Class) – Forecasting earnings and cashflows – Avoid being fooled by financial statements 15.535 - Class #4 2Discussion of E-Assignment #1: Dell Valuation • Approach to teaching Financial Valuation & Analysis: – First, we define the problem we are facing, then knowing the context, we build a set of tools to solve the problem. • We are starting to see the issues: – Must estimate earnings, cashflows, balance sheet items. – Must avoid the pitfalls of “misleading” financial reports … managers may want to fool you. – Must estimate risk, growth, etc. – Yahoo! data and analysts’ estimates are a “crutch” right now. 15.535 - Class #4 3Aside … What is “Value Added” in Performance Measurement? • What is Value Added? – Can we determine if company has invested capital wisely? • Starting Point: Market Value Added (MVA) – MVA for All Investors (Debt+Equity) • MVA = Market Value (D+E) – Invested Capital (D+E) – MVA for Equityholders (just Equity) • MVA = Market Value (Equity) – Invested Capital (Equity) – Qualifications? • Invested Capital is from the past! Market Value is from Today! 15.535 - Class #4 4What is Value Added in Valuation? • The “value added methodologies” are used to measure the profits (or losses) generated by a firm for a given level of capital investment & the risk of these investments: – Also called residual income or abnormal earnings • Value Added (for all investors … Debt + Equity): = Net Operating Profit after tax – Capital charge • NOPAT = Net Operating Profit after Tax • Capital charge = rassets * Value of Assets at start of year • Residual Income for Equityholders: = Net Income – Capital charge • Capital charge = requity* Value of Equity at start of year 15.535 - Class #4 5Why “Abnormal Earnings” or “Residual Income” Valuation? • REMINDER! Valuation ultimately boils down to DCF (or discounted dividends). • Big Problem: Estimating future FCF’s or dividends. – Does there exist a meaningful way to map accounting numbers into equity value given that cash is real? – Traditional answer: NO, given that … • Accrual-based accounting numbers do not take into account the timing of cash flows. • Earnings do not perfectly reflect investments in the same way as FCF does. • (Most of all) Accounting numbers can be manipulated. • BUT: DCF is based on forecasting accruals (sales, profit margins, earnings) and then unraveling them…. 15.535 - Class #4 6Starting Point for “AE" Valuation: Intuition: – The value of the firm (or equity in the firm) can be the sum of three components: 1) Original Invested Capital - What is the starting value of funds originally contributed by investors (equityholders). 2) Normal rate of return on Invested Capital - Basically determined by cost of capital (“r”). 3) Abnormal return on Invested Capital - Abnormal earnings (residual income) above normal rate of return. 15.535 - Class #4 7The Model • Use this idea to express current equity value of the firm as a function of book value of the firms and abnormal earnings: f Equity Value0 = BV0 + ¦ [AEt/(1+r)t] t=1 where: BVt = Book value of equity at beginning of year t r = Cost of equity capital AEt = Expected value of abnormal earnings in year t = Projected earnings in yr t - (r * BV of equity at beginning of year t) 15.535 - Class #4 8Where does model come from? • Basically a rearrangement of the discounted dividend or FCF valuation models. • Combines “current value” on the balance sheet with the present value of future “abnormal earnings”. • In theory, should give the same answer as discounted dividend and DCF (or free cash flow) valuation models. • Uses accounting numbers (which are easy to observe) and future projections of earnings (which are easier to project … analysts). 15.535 - Class #4 9Overview of Steps of Abnormal Earnings Valuation Step 1: Forecast earnings in each year t=1,...,T in the forecast horizon. Step 2: Estimate “r”, the cost of equity capital. Example using CAPM: r = Rf + E* [E(RM) - Rf ] where Rf = “Riskless” return E = Beta on common stock E(RM) – Rf = Expected risk premium on market portfolio 15.535 - Class #4 10Steps - Continued Step 3: Estimate expected abnormal earnings in each yr t = 1,..,T in forecast horizon: AE= Et-(r * BVt-1)t Step 4: Use “r” to estimate the PV of abnormal earnings during the forecast horizon: AE1/(1+r)1 + AE2/(1+r)2 + .... + AET/(1+r)T Step 5: Estimate the PV of expected abnormal earnings beyond the forecast horizon: • Use perpetuity • Use growing perpetuity 15.535 - Class #4 11Steps – Terminal Values • PERPETUITY METHOD – Estimate AE in year T+1 – Assume AE constant beyond year T+1 PV of AE beyond yr T = [AET+1 / r ] / (1+r)T • GROWING PERPETUITY METHOD – Estimate AE in year T+1 – Assume AE grow beyond year T+1 forever at rate g/year PV of AE beyond yr T = [AET+1 / (r – g) ] / (1+r)T 15.535 - Class #4 12Steps – Final Step Step 6: Computer equity value by summing together the parts: Equity Value = BV of equity at beginning of yr 1 + PV of AE during forecast horizon (Step 4) + PV of AE beyond forecast horizon (Step 5) 15.535 - Class #4 13EBO Valuation using Dell Computer Example. • Inputs: –BV0 = $1.80 (Book value of equity per share at the end of the 3rd quarter of fiscal year. From latest financials on Yahoo! http://biz.yahoo.com/z/a/d/dell.html • 2003 year end is NOW! • Therefore, small adjustment to BV0 • Use estimate of current (4th quarter earnings = $0.23) • Therefore, updated BV0 = BV0 + EPS4thQ = 1.80 + 0.23 = $2.03 – Take Yahoo! earnings forecasts for 2004: E1 = $0.99 15.535 - Class #4 14EBO Valuation using Dell Computer Example. • Inputs: – % 5 year growth in EPS is projected to be: 15% • E2 = E1*(1+g) = $0.99*(1.15) = $1.14 • E3 = E2*(1+g) = $1.14*(1.15) = $1.31 • E4 = E3*(1+g) = $1.31*(1.15) = $1.51 • E5 = E4*(1+g) =