Financial Statement Analysis

PART IV FAS APPLICATIONS

L12 Valuation
⚫ Chapter 9 of textbook + Chapter 19 of The
Analysis and Use of Financial Statements
➢Valuation: screening for potential equity investments
◆Comparative/multiples method
◆Discounted dividend model (DDM)
◆Free cash flow model (FCF)
◆Residual income model (RI)

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⚫ Valuation Methods
➢Comparative (Multiples) Method
◆P/E, PEG = (P/E)/(5-year future earnings growth rate)
◆P/B
◆P/S
◆P/CF

➢Discounted Cash Flow (DCF) Model

◆FreeCash Flow Model
◆Dividend Discounted Model
◆Residual Income Model
◆Adjusted Present Value Model
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 • Trailing P/E ratio vs.
Leading P/E ratio
Price per share • Earnings yield (E/P) is used
P/E = in value rankings
EPS

Advantages Drawbacks

• Earnings power is the • Earnings can be negative

primary determinant of • Sensitive to volatile,
value transitory portion of
• Popularly used earnings
• Management discretion
can distort reported
earnings
4
 BV per share = common
shareholders’ equity per
≥1: Price per share share = (total assets –
future returns ≥ P/BV = total liabilities –
required return Book value per share preferred stock)/shares

Advantages Drawbacks

• Usually positive • Not recognize the value of nonphysical

• More stable than EPS assets
• Appropriate for firms that primarily • Can be misleading when there are
hold liquid assets significant difference in the asset
• Useful in valuing firms expected to go intensity of production methods
out of business • Can be distorted by different
accounting conventions
• Inflation and technology changes
cause BV to significantly differ from
MV
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 Price per share
P/S =
Sales per share

Advantages Drawbacks

• Meaningful even for distressed firms • High growth in sales does not
as sales are always positive necessarily indicate operating profits
• Not as easy to manipulate or distort • Do not capture differences in cost
as EPS and BV structures
• Not as volatile as P/E multiple • Revenue recognition practices can
• Particularly appropriate for valuing still distort sales forecast
stocks in mature or cyclical
industries and for start-up
companies with no record of
earnings
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 Price per share
P/CF =
Cash flows per share

Advantages Drawbacks

• Most difficult to • Some items affecting CFO

manipulate are ignored when the EPS
• Address the differences in plus noncash charges
the quality of reported estimate is used
earnings • FCFE is probably preferred,
• More stable however, it is more volatile
than straight CF
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⚫ Steps of Comparative/Multiples Method
➢Select financial performance measures: EPS, sales,
book value, cash flow, etc.
➢Estimate price multiples for comparable firms using the
selected measure of performance.
➢Take an average or median of these estimates.
➢Apply the comparable firms’ average/median multiple
to the performance measure of the firm being analyzed.

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 ⚫ Case 12.1:
Suppose the following information for a target
corporation X and 4 peer companies A, B, C and D:

X A B C D
Market Price ? $25 $48 $16 $33
EPS est. $1.5 $1.8 $2.0 $1.2 $1.5
Sales per share est. $45 $50 $48 $36 $40
BV per share est. $28 $30 $40 $24 $25
CF per share est. $22 $20 $25 $15 $24

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⚫ Case 12.1:
What is Corporation X’s fair price based on P/E, P/S,
P/BV, and P/CF, respectively?
Solutions.
X’s performance
Average X’s fair price
A B C D measure
 = ×

P/E 13.89 24 13.33 22 18.3056 EPS = $1.5 $27.46
P/S 0.5 1 0.44 0.825 0.6924 S/share = $45 $31.16
P/BV 0.83 1.2 0.67 1.32 1.005 BV/share = $28 $28.14
P/CF 1.25 1.92 1.07 1.375 1.4029 CF/share = $22 $30.86
Average fair price $29.40

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 ⚫ Discounted Dividend Valuation
➢Dividend-Related Quantities
Common share dividends
Dividend Payout Ratio =
Net income attributable to common shares

NI attributable to common shares − Common share dividends

Retention Rate (b) =
Net income attributable to common shares
= 1 - Dividend Payout Ratio

Sustainable Growth Rate = b  ROE

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⚫ Discounted Dividend Valuation
➢Gordon constant growth model
D0 (1 + g )
V=
re − g
re : cost of equity capital, g: sustainable growth rate
➢Two-stage DDM

D0 (1 + g S ) D0 (1 + g S ) (1 + g L )
t n
n
V = +
(1 + re ) (1 + re ) ( re − g L )
t n
t =1

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⚫ Discounted Dividend Valuation
➢H-model

D0 (1 + g L ) D0  H  ( g S − g L )
V= +
re − g L re − g L
t
H=
2
➢Recommendations:
◆If Vt > Pt, buy
◆If Vt < Pt, sell
◆If Vt = Pt, hold
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⚫ Case 12.2
Funny Toy Company just announced a dividend payment of
$80 million from its current period net income of $200
million.
A. Suppose this company has reported a ROE of 15%
(which is also its cost of equity capital), compute its
sustainable growth rate.
B. If the company can maintain the above sustainable
growth rate forever, what is the fair value of Funny Toy
Company’s equity?
C. At present, Funny Toy Company has a total of 100
million common shares outstanding. If its common stock
is currently trading at $18 per share, should you buy, sell,
or hold this company’s common stock?
14
⚫ Case 12.2
Solutions.
A. Sustainable growth rate = (1 – payout ratio)*ROE =
(1 - $80/$200)*15% = 9%
B. V = $80*1.09/(15% - 9%) = $1,453.33 million
C. Fair price of common stock = $1,453.33/100 =
$14.53 per share. As the common stock is currently
overpriced, you should sell it.

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⚫ Free Cash Flow Valuation
FCFE1 FCFEH PV (Horizon Value)
V= + + +
1 + re (1 + re ) (1 + re )
H H

FCFEH (1 + g )
PV (Horizon Value) =
re − g
re : cost of equity capital, g: sustainable growth rate
➢If Vt > Pt, buy
➢If Vt < Pt, sell
➢If Vt = Pt, hold

16
⚫ Case 12.3:
Suppose Acme Corporation’s FCFEs in the next three years are
estimated as follow:
Year 1 $480
Year 2 $500
Year 3 $550

A. If its cost of equity capital is 10% and the sustainable growth

rate is 5%, calculate the fair value of Acme’s common stock
(assuming Acme has 1,000 common shares outstanding).
B. If current market price of Acme’s common stock is $10, which
investment recommendation would you offer to your client?

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⚫ Case 12.3:
Solutions.
A. FCFEH (1 + g ) $550 (1 + 5% )
PV (Horizon Value) = = = $11,550
re − g 10% − 5%
$480 $500 $550 + $11,550
V= + + = $9,940.49
1 + 10% (1 + 10% ) 2
(1 + 10% )
3

So, fair value per share is $9.94.

B. As the fair value is less than current market price, a
“sell” recommendation should be issued.

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⚫ Residual Income Valuation/Abnormal
Earnings Valuation
RI t = NIt − Equity Ch arg et = NI t − re  BVEt −1
= ( ROE − re )  BVEt −1
EVAt = NOPATt − Captial Ch arg et
= EBITt (1 − t ) − WACC  Total Captialt −1
= EBITt (1 − t ) − WACC  ( BVEt −1 + BVDt −1 )
NOPAT : Net Operating Pr ofit After Tax
WACC :Weighted Average Cost of Capital
D E
= rd  ( 1 − t )  + re 
A A 19
⚫ Case 12.4
Axis Manufacturing Company, Inc. (AXCI), a very small
company in terms of market capitalization, has total
assets of $2 million financed 50% with debt and 50%
with equity capital. The total cost of debt is 7% before
taxes (4.9% after taxes) and the cost of equity is 12%.
The company has EBIT of $200,000 and a tax rate of
30%.
A. Calculate AXCI’s residual income and EVA.
B. State whether AXCI is profitable in an accounting
sense and in an economic sense, respectively.
Explain why.
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⚫ Case 12.4
Solutions.
A. AXCI’s net income is:

Thus, AXCI’s residual income = NIt – re × BVEt-1

= $91,000 – 12% × ($2,000,000 × 50%) = –
$29,000.
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⚫ Case 12.4
Solutions.
A. Alternatively, AXCI’s NOPAT = EBIT × (1 – t) =
$200,000 × (1 – 30%) = $140,000. As AXCI’s
WACC = 4.9% × 50% + 12% × 50% = 8.45%, its
EVA = NOPATt – WACC × TCt-1 = $140,000 –
8.45% × $2,000,000 = – $29,000.

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⚫ Case 12.4
Solutions.
B. AXCI is clearly profitable in an accounting sense as
its NI is positive. However, AXCI is economically
unprofitable as its residual income is negative. In
fact, the ROE is only 9.1% ($91,000/$1,000,000),
which is less than its cost of equity required by
equity holders (12%). Consequently, AXCI is not
earning sufficient earnings to cover its cost of
equity.

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⚫ Residual Income Valuation/Abnormal
Earnings Valuation
E ( RI t +1 ) E ( RI t + H ) PV (Horizon Value)
Vt = BVEt + + + +
1 + re ( e)+ ( e)
+
H H
1 r 1 r
E ( RI t + H )(1 + g )
PV (Horizon Value) =
re − g
RI t = NI t − re  BVEt −1

➢If Vt > Pt, buy

➢If Vt < Pt, sell
➢If Vt = Pt, hold
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⚫ Case 12.5:
➢Net income at year 1 =$1,000
➢Net Income expected to growth at 10% for next 3 years
➢Dividend payout ratio remain at 40%
➢Book value of equity at end of year 1 = $3,000
➢Cost of equity capital (re) = 15%
➢Total outstanding shares =1,000

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⚫ Case 12.5:
Solutions: Year 01 Year 02 Year 03 Year 04
1. Projected Net income 1000 1100 1210 1331
2. Dividend payout ratio 40% 40% 40% 40%
3. Dividend 400 440 484 532
4. Projected net earnings 600 660 726 799
5. End of year BV of equity 3000 3660 4386 5185
6. Cost of equity re 15% 15% 15% 15%
7. Expected earnings (re × beg equity) 450 549 658
8. Residual income - 650 661 673
9. Discount factor - 0.870 0.756 0.658
10. PV of residual income - 565 500 443
11. Sum of PV of RI = 565+500+443=$1508
12. Add beginning BV of equity =$3000
13. Total intrinsic value of equity= $4508
14. No. of share O/S = 1000
15. Value per share =$4.508

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⚫ Case 12.5:
Recommendations:
A. If market price = $4.5, this company’s stock is
(fairly/under-/over-) priced and a (hold/buy/sell)
recommendation should be issued.
B. If market price = $2.5, this company’s stock is
(fairly/under-/over-) priced and a (hold/buy/sell)
recommendation should be issued.
C. If market price = $5.5, this company’s stock is
(fairly/under-/over-) priced and a (hold/buy/sell)
recommendation should be issued.
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单选题 2分

P/B is most likely appropriate in valuing

firms:

A that have a majority of liquid assets.

B that hold a lot of intangible assets.

C that operate in an inflationary economy.

D
that experience significant technology
advances.
提交
单选题 2分

Which of the following ratios DOES NOT relate to

market price of a company under analysis?

A Price-to-earnings

B Earnings yield

C Price-to-book

D Return on common equity

提交
单选题 4分

3
The Limited Co. just announced a dividend of $4 million
from its net income of $16 million in 2018. Given that its
ROE is 10% and its ROA is 8%, the Limited Co. would
probably enjoy a SUSTAINABLE GROWTH RATE of：
A 7.5%

B 6%

C 2.5%

D 2%

提交
单选题 2分

Company A is a high-tech company and Company B

is a financial institution. Which one of the following
statements is appropriate?

A P/B is appropriate for both A and B.

B P/B is appropriate for A but not for B.

C P/B is appropriate for B but not for A.

D P/B is appropriate for neither A nor B.

提交
单选题 4分

An analyst gathered the following information for

Greenhouse Technology from its 2016 Annual
Reports. If the return on equity in 2016 is 15%, this
company would earn a residual income of __________.

A $55.5 million.
Balance Sheet December December
(in millions) 31, 2015 31, 2016
B $60 million. Total assets $1,150 $1,280
Total liabilities 750 850
Income Statement 2015 2016
C $83.5 million. (in millions)
Net income $120 $148

D $88 million.
提交
单选题 4分

Lightening Consolidated Corp. reported a NI of $200 million, a

dividend payment of $120 million in 2016. If its book value of
equity was $1200 million at the beginning of 2016, what will
the sustainable growth rate most likely be?

A 40%

B 16.67%

C 10%

D 6.67%

提交
单选题 4分

Rosita's announced that its next annual dividend will be $1.65 a

share and all future dividends will increase by 2.5% annually.
What is the maximum amount you should pay to purchase a
share of this stock if you require a 12% rate of return?

A $15.46

B $16.94

C $17.37

D $17.80

提交
填空题 3分

The Bell Weather Co. is a new firm in a rapidly

growing industry. The company is planning on
increasing its annual dividend by 20% next year and
then decreasing the growth rate to a constant 5%
per year. The company just paid its annual dividend
in the amount of $1 per share. If the required rate of
return is 14%, the current value of a share would be
$________________ [填空1] .

正常使用填空题需3.0以上版本雨课堂

作答
填空题 3分

Last week, Railway Tours paid its annual dividend of

$1.20 per share. The company has been paying the
dividends at a growth rate of 20% each year in the
past and currently. Now it is considering to reduce
the growth rate gradually to 5% during the
following 10 years. At a discount rate of 13%, the
value of this stock would be $________________ [填空1]
.

正常使用填空题需3.0以上版本雨课堂

作答
单选题 2分

10
A company just reported a NOPAT of $800,000. It has a total
debt of $6 million with an after-tax cost of 6% (that is, a pretax-
cost of 15% given its marginal tax rate of 40%), and a total of
equity of $6 million with a cost of 10% at the beginning of this
year. Would the company be profitable in an accounting sense
or an economic sense?
A
profitable in an accounting sense but not in an economic
sense.

B
profitable in an economic sense but not in an accounting
sense.

C profitable in both an accounting sense and an economic sense.

D
profitable in neither an accounting sense nor an economic
sense.
提交
⚫ Consider ABC Co. in Group Discussion Questions
2.1~11.1. Assume the following information:
2021F
Cost of equity 16%
Pre-tax cost of debt 4.8%
Forecasted FCFF in next year $2 million
Forecasted FCFE in next year $12 million
Growth of FCFF afterwards 4%
Growth of FCFE afterwards 5%

⚫ Calculate the fair price of ABC Co.’ equity based

on FCFF and FCFE, respectively.
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⚫ Suppose the residual income of the company in
Case 12.5 is expected to grow at 4% forever
after Year04. Recalculate the fair price of this
company’s stock. If the stock is currently trading
at $8.10, what investment recommendation
should you issue, sell, buy or hold?

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⚫ Select a group of peer companies for your target
company containing at least 2 peer firms.
Calculate the 4 price multiples for both your
company and peer companies.
⚫ Determine the cost of equity for your target
company using CAPM, based on a daily sample
of at least 3 years.
⚫ Value the stock of your target company by end of
this year using comparative method and FCFE
method.
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