Solutions – Chapter 7

Chapter 7 Prospective Analysis: Valuation Theory and

Concepts
Question 1.
Jonas Borg, an analyst at EMH Securities, states: "I don't know why anyone would ever try to value
earnings. Obviously, the market knows that earnings can be manipulated and only values cash
flows." Discuss.

Valuing earnings is an alternative way of valuing a company even if earnings can be

manipulated. Note that, with an infinite forecast horizon, the valuation based on discounted
abnormal earnings delivers exactly the same estimate as DCF-based methods, even if there
is earnings manipulation. The estimated values using accounting-based valuation are not
affected by accounting choices because of the self-correcting nature of double-entry
bookkeeping. Current period earnings can be manipulated, but the values estimated with
accounting-based valuation are not to be manipulated. However, with finite horizons,
earnings manipulation can affect value unless the analyst recognizes and undoes the
manipulation. Also, when accounting data is used to forecast cash flows, even a DCF
valuation is potentially vulnerable to accounting manipulation.
There are two practical advantages to valuing earnings. First, accounting-based
valuation (using earnings) frames the valuation task differently and can immediately focus
the analyst's attention on the key measure of performance: ROE and its components (i.e.,
value drivers such as profit margins, sales turnover, and leverage).
Second, if it is more natural to think about future performance in terms of accounting
returns, and if the analyst faces a context where a "back-of-envelope" estimate of value
would be of use, the accounting-based technique can be simplified to deliver such an
estimate. "Short-cut" estimates are useful in a variety of contexts where the cost and time
involved in a detailed DCF analysis is not justified. In this context, the detailed DCF method
is analogous to a manual camera for which the distance, light exposure, and shutter speed
need to be set before taking a picture whereas the "short-cut" accounting-based valuation is
analogous to an automatic camera.

Question 2.
Explain why terminal values in accounting-based valuation are significantly less than those for DCF
valuation.

DCF terminal values include the present value of all expected cash flows beyond the
forecast horizon. Note that the expected cash flows beyond the forecast horizon can be
broken down into two parts: normal and abnormal. Since the terminal value in the
accounting-based technique includes only the abnormal earnings (expected earnings minus
cost of capital times beginning book value of equity), the terminal values in
accounting-based valuation are significantly less than those for DCF valuation. The
accounting-based approach recognizes that current book value and earnings within the
forecast horizon already reflect many of the cash flows expected to arrive after the forecast
horizon.

Question 3.

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Solutions – Chapter 7

Manufactured Earnings is a “darling” of European analysts. Its current market price is €15 per
share, and its book value is €5 per share. Analysts forecast that the firm’s book value will grow by 10
percent per year indefinitely, and the cost of equity is 15 percent. Given these facts, what is the
market’s expectation of the firm’s long-term average ROE?

P
 1
ROE  r 
B r  g 

where ROE is the long-term average ROE,

g is the long-term average growth in book value,
r is the cost of equity,
P is the stock price, and
B is the book value per share.

Using the information in the question,

15
 1
ROE  0.15
5 0.15  0.10
or ROE = 0.25 (or 25%).

Question 4.
Given the information in Question 3, what will be Manufactured Earnings' stock price if the market
revises its expectations of long-term average ROE to 20 percent?

Once again, using the same formula as in the answer to Question 3, we have

P
 1
0.2  0.15
5 0.15  0.10
or P = €10

Based on above equation, the Manufactured Earnings' stock price will be revised to €10.

Question 5.
Analysts reassess Manufactured Earnings’ future performance as follows: growth in book value
increases to 12 percent per year, but the ROE of the incremental book value is only 15 percent. What
is the impact on the market-to-book ratio?

Since the ROE from the incremental growth value is equal to cost of equity, there is no
increase in value.

Question 6.

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Solutions – Chapter 7

How can a company with a high ROE have a low PE ratio?

Accounting-based valuation suggests that the stock price (a numerator of the PE ratio) can be
viewed as the sum of the current book value per share plus the discounted expected future
abnormal earnings per share.

Price per share = Book value per share x

1   
 
 E1 ROEt 1  rE  Et ROEt 1  rE 1  g t 1  Et ROEt 1  rE 1  g t 1 2 
 
 1  rE  1  rE  2
1  rE  3


A company with a high (current period) ROE may have a low price and PE ratio when

1. cost of equity capital (r E ) is high;

2. expected growth of book value is low; and

3. expected future ROE is low (relative to current period ROE).

Question 7.
What type of companies have:

a. a high PE ratio and a low market-to-book ratio?

Recovering firms, like Apple in 1993, are expected to rebound from temporarily low earnings
levels but will not be able to return to an abnormally high level of ROE due to competition.
PE ratio looks high due to low current earnings.

b. a high PE ratio and a high market-to-book ratio?

"Rising stars" which are expected to grow quickly and enjoy high ROEs during the growth
period and/or after the growth occurs.

c. a low PE ratio and a high market-to-book ratio?

"Falling stars" that enjoy high ROEs on existing investments but are no longer growing fast.
PE ratio is low due to relatively high earnings in current year.

d. a low PE ratio and a low market-to-book ratio?

"Dogs" which have little prospect for either growth or high ROEs.

Question 8.
Which of the following items affect free cash flows to debt and equity holders? Which affect free cash
flows to equity alone? Explain why and how.

All answers assume a tax rate > 0.

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Solutions – Chapter 7

An increase in trade receivables will cause both FCF E and FCF D+E to decrease, since it increases
the firm's cash required for working capital.

A decrease in gross margins will cause both FCF E and FCF D+E , to decrease by lowering both
EBIT (1 - tax rate) and NI.

An increase in property, plant, equipment will decrease both FCF E and FCF D+E due to an
increase in capital expenditures.

An increase in inventories will decrease both FCF E and FCF D+E through an increase in cash
required for working capital.

Interest expense will decrease FCF E only. For calculating free cash flows to debt, additional
interest expense does not change EBIT (1 - tax rate).

An increase in prepaid expenses will cause both FCF E and FCF D+E to decrease through an
increase in working capital.

An increase in notes payable to the bank will increase FCF E only. The increase in notes payable
will increase debt, increasing the FCF E by the same amount.

Question 9.
Starite Company is valued at €20 per share. Analysts expect that it will generate free cash flows to
equity of €4 per share for the foreseeable future. What is the firm's implied cost of equity capital?

With a single, unchanging free cash flow to equity for the foreseeable future, we can
calculate the implied cost of equity capital using the following formula:

Free cash flow to equity

Value per share 
Cost of equity capital
Using a value per share = 20 and a free cash flow to equity = 4, solving the equation for cost
of equity capital yields, r E = 20%.

Question 10.
Janet Stringer argues that "the DCF valuation method has increased managers' focus on short-term
rather than long-term performance, since the discounting process places much heavier weight on
short-term cash flows than long-term ones." Comment.

While it is true that DCF valuation places more weight on earlier cash flows than on later
ones, this reflects the time value of money. A euro in one year is more valuable than a euro
in five year's time. However, this does not imply that the long-term is less important than
the short-term. Typical DCF valuations show that the value of cash flows beyond, say, five
years is a substantial fraction of the overall firm value. If managers believe that long-term
performance of the firm is the most significant driver of value, they will certainly focus
appropriately on making sure that they do not under-emphasize the long-term.

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Solutions – Chapter 7

DCF valuation helps a manager understand the tradeoffs between short-term and
long-term actions. Consider management's decision if it has a choice between two mutually
exclusive investments that generate equivalent cash flows, one with a short horizon and the
other with a long horizon. DCF analysis implies that firm value will increase more if the
management takes the short-term project. In this sense, DCF helps managers trade off how
much they should focus on short-term versus long-term considerations.
One concern often raised about DCF analysis is that it focuses attention on
quantifiable costs and benefits from investing. It is probably more difficult to quantify
long-term costs and benefits than short-term ones. If management ignores these types of
costs and benefits, they may end up making decisions that have a short-term focus.
However, this is really not the fault of DCF as a method. It is simply an indication of the
difficulty in making decisions with highly uncertain payoffs.

Problem 1. Estimating Hugo Boss’ equity value (updated 1-2011)

1. Calculate free cash flows to equity, abnormal earnings, and abnormal earnings growth for the
years 2009 – 2011.
2. Assume that in 2012 Hugo Boss AG liquidates all its assets at their book values, uses the
proceeds to pay off debt and pays out the remainder to its equity holders. What does this
assumption imply about the company’s:
a. Free cash flow to equity holders in 2012 and beyond?
b. Abnormal earnings in 2012 and beyond?
c. Abnormal earnings growth in 2012 and beyond?
3. Estimate the value of Hugo Boss’ equity on April 1, 2009 using the above forecasts and
assumptions. Check that the discounted cash flow model, the abnormal earnings model and
the abnormal earnings growth model yield the same outcome.
4. The analyst estimates a target price of €20 per share. What is the expected value of Hugo
Boss’ equity at the end of 2011 that is implicit in the analysts’ forecasts and target price?
5. Under the assumption that the historical trends in the company’s ROE (i.e., approximately
18 percent), payout ratio (70 percent) and book value growth (5.5 percent) continue in the
future, what would be your estimate of Hugo Boss’ equity value-to-book ratio before the
company paid out its special dividend? How does the special dividend payment change your
estimate of the equity value-to-book ratio?

1. The calculations are:

2008R 2009E 2010E 2011E

Net assets 890.3 868.5 878.5 891.0
Net debt 691.3 668.3 656.9 632.0
Equity 199.0 200.2 221.6 259
Implied dividends 97.1 78.5 80.3

Net profit 98.3 99.9 117.7

- Change in net assets +21.8 -10.0 -12.5
+ Change in net debt -23.0 -111.4 -24.9
Free cash flow to equity 97.1 78.5 80.3

Net profit 98.3 99.9 117.7

Beginning BE x 12% 23.88 24.024 26.592
Abnormal profit 74.42 75.876 91.108

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Solutions – Chapter 7

Change in net profit 1.6 17.8

(Profit t-1 - Dividends t-1) x 12% 0.144 2.568
Abnormal earnings growth 1.456 15.232

2. If Hugo Boss liquidates all its assets at their book values in 2012, the company’s 2012 net
profit is zero and
a. 2012 free cash flow to equity, defined as net profit minus the change in net
assets plus the change in net debt, is equal to: 0 – (-891.0) + (-632.0) = 259 (i.e.,
expected equity at the end of 2011).
b. 2012 abnormal earnings, defined as net profit minus 12 percent of 2011
ending equity, is equal to: 0 – 0.12 x 259 = -31.08.
c. 2012 abnormal earnings growth, defined as the change in abnormal earnings,
is equal to: -31.08 - 91.108 = 122.188.
In 2013 (and beyond), free cash flows to equity and abnormal earnings are zero.
Abnormal earnings growth is equal to 31.08 in 2013 (0 – [-31.08]) and zero in the years
after 2013.
To summarize:

2009E 2010E 2011E 2012E 2013E

Free cash flow to equity 97.1 78.5 80.3 259 0
Abnormal profit 74.42 75.876 91.108 -31.08 0
Abnormal earnings growth 1.456 15.232 -122.188 31.08

3. On January 1, 2009, the value of Hugo Boss’ equity equals:

FCFE 2009 FCFE 2010 FCFE 2011 FCFE 2012
Equity value end 2008    
1  re  1  re  2
1  re  3
1  re 3
97.1 78.5 80.3 259.0
     371.03
1.12 1.12 2
1.12 3
1.124
Or
AE 2009 AE 2010 AE 2011 AE 2012
Equity value end 2008  BVE end 2008    
1  re  1  re  2
1  re 
3
1  re 4
74.42 75.876 91.108 31.08
 199      371.03
1.12 1.12 2
1.12 3
1.124
Or
Equity value end 2008
Profit 2009 1  AEG 2010 AEG 2011 AEG 2012 AEG 2013 
      
re re  1  re  1  re 2 1  re 3 1  re 4 
98.3 1  1.456 15.232 122.188 31.08 
        371.03
0.12 0.12  1.12 1.122 1.123 1.124 

An equity value of €371.03 million on January 1, 2009, corresponds with a value of

€381.55 million (371.03 x 1.1290/365), €5.42 per share (381.55/70.4), on April 1, 2009.

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Solutions – Chapter 7

4. A target price of €20 per share implies a market value (on April 1, 2009) of €1,408
million. A market value of €1,408 million on April 1, 2009, corresponds with a market
value of €1,369.20 million on January 1, 2009. The discounted value of Hugo Boss’
expected free cash flows in 2009-2011 equals:

FCFE 2009 FCFE 2010 FCFE 2011

Value   
1  re  1  re  2
1  re 3
97.1 78.5 80.3
    206.43
1.12 1.12 2
1.123
Hence, with a current equity value of €1,369.20 million, the present value of the
expected equity value at the end of 2011 must be equal to: 1,369.20 – 206.43 = 1,162.77.
The future value of the expected equity value at the end of 2011 is therefore €1,633.60
million (1,162.77 x 1.123), or €23.20 per share. Note that this future expected market
value of equity is substantially higher than the expected future book value of equity of
(€1,633.60 million versus €259 million).
5. As described in Chapter 7, for a firm in steady state, the value-to-book multiple formula
simplifies to:
ROE 0  re
Equity value - to - book multiple  1 
re  g equity

For Hugo Boss, this would imply that the equity value-to-book multiple is:

0.18  0.12
Equity value - to - book multiple  1   1.923
0.12  0.055

The special dividend of €345.1 million decreases both the market value and the book
value of equity by the same amount. Consequently, the expected value-to-book
multiple would increase from 1.923 to 3.524:

Adjusted equity value - to - book multiple 

1.923  199  345.1  345.1  3.524
199

This multiple would imply an equity value of €701.25 million, or €9.96 per share, on
January 1, 2009. This would be equivalent to €10.24 per share on April 1, 2009, when
Hugo Boss’ shares traded at €11.

Problem 2. Estimating Adidas’ equity value

1. Check whether all changes in the book value of equity that the analyst predicts can be fully
explained through earnings and dividends. Why is this an important property of the
analyst’s equity estimates?
2. When using these forecasts to estimate the value of equity, the analyst can deal with minority
interests in the following ways:
a. (1) Classify minority interests on the balance sheet as a non-interest-bearing liability
(and hence as a negative operating asset) and (2) exclude income from minority
interests from earnings (i.e., focus on net profit);

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Solutions – Chapter 7

b. (1) Classify minority interests on the balance sheet as (group) equity, (2) include
income from minority interests in earnings (i.e., focus on group profit), and (3)
subtract the book value of minority interests from the estimated value of group equity
to arrive at the value of shareholders’ equity.
These approaches may yield different values. Discuss potential drawbacks of both approaches.
3. Based on a market value of €4,849 million on March 31, 2009 and the analyst’s estimates,
Adidas’ leading market value-to-earnings ratio is 10.9. What does this ratio suggest about
the analyst’s expectations about future abnormal earnings growth?
4. Calculate abnormal earnings for the years 2009 – 2011.
5. Assume that abnormal earnings in 2012 and beyond are zero. Estimate the value of Adidas’
group equity (group equity is the sum of shareholders’ equity and minority interests). What
might explain the difference between your equity value estimate and Adidas’ actual market
value (of €4,849 million)?

1. If all changes in the book value of equity can be explained through earnings and
dividends, this means that the analysts’ predictions are consistent with the clean
surplus assumption. This is a necessary requirement for the equivalence of the dividend
discount model and the abnormal earnings valuation model.

2008R 2009E 2010E 2011E

Beginning shareholders' equity 3386.0 3735.5 4181.2

Net profit +446.3 +557.9 +607.0
Dividends -96.8 -112.2 -121.9
Ending shareholders' equity 3386.0 3735.5 4181.2 4666.3

2. The first approach implicitly assumes that the investors holding the minority interest
hold a claim on non-current assets only and that none of the consolidated liabilities
“belongs” to these investors. Although these assumptions do not affect the valuation
analysis directly they do affect the ratios in the financial analysis and, as such, may
indirectly affect the analyst’s predictions. The second approach implicitly assumes that
the value of minority interests equals its book value, which is typically lower than the
value of other equity components.

3. The leading market value-to-earnings ratio is calculated as follows:

Leading equity value - to - earnings ratio 

1 1  g profit
  2 

 d1  1re 1  g profit 
g 3profit  d 2  1re  

1  g profit  
1  g 3profit g profit 
 d 3  1re 

2 2 4
re re  1  re  1  re  2
1  re  3

1 1
 Sum of future (scaled) abnormal earnings growth 
.12 .12
1
8.33  Sum of future (scaled) abnormal earnings growth  10.9
.12

Hence, the analyst expects that the sum of future abnormal earnings growth is positive.

4. When focusing on group equity and group profit, the calculations are:

2009E 2010E 2011E

(a) Beginning group equity 3400.0 3742.5 4184.7

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Solutions – Chapter 7

(b) "Normal" profit = (a) x 0.12 408.0 449.1 502.2

(c) Group profit 448.8 561.2 610.5
(d) Abnormal earnings = (c) – (b) 40.8 112.1 108.3

Alternatively, when focusing on shareholders’ equity and net profit, the calculations
are:

2009E 2010E 2011E

(a) Beginning shareholders' equity 3386.0 3735.5 4181.2
(b) "Normal" profit = (a) x 0.12 406.3 448.3 501.7
(c) Net profit 446.3 557.9 607.0
(d) Abnormal earnings = (c) – (b) 40.0 109.6 105.3

5. The calculations are:

2008R 2009E 2010E 2011E

(a) Beginning group equity 3400.0
(b) Abnormal (group) earnings 40.8 112.1 108.3
(c) Discount factor (r = 12%) 0.8929 0.7972 0.7118
(d) Discounted abnormal (group) earnings 36.4 89.4 77.1

Present value of future abnormal (group)

earnings 202.9
Group value 3602.9

Our estimate is much lower than Adidas’ current market value, primarily because our
assumption that abnormal earnings is zero after 2011. Although it is reasonable to
expect that competition will drive down Adidas’ abnormal earnings in the future, it is
not likely that this will happen overnight. Hence, it is necessary to include an estimate
of the value of Adidas’ post-2011 abnormal earnings in our calculations, i.e., the
terminal value. Terminal value calculations will be the topic in Chapter 8.