Valuation: Earnings-Based Approaches (Chapter 13) Professor Cooperberg June 19th, 2013 [Part 1] Earnings are the single most widely followed measure of performance. It is based on accrual accounting and is often released prior to quarterly reports (i.e. as soon as they have been calculated and verified). Analysts build models to forecast earnings based on fundamentals. They sell research to interest parties. They have a huge influence on markets and can move them (i.e. earnings and professional expectations can shift entire markets). To facilitate the comparison, earnings are reported on a per share basis (EPS or earnings per share). The rationale for earnings based valuation is that it measures the wealth businesses create for shareholders, and creating wealth for its shareholders should be the goal of every company. It also complements the dividend and free cash flow approaches. It uses expected future earnings, combined with the book value of common shareholder equity, to determine expected future payoffs. While imperfect, accrual accounting measures earnings by self correcting over time (i.e. depreciating) and is subject to manipulation and management (should be discounted). Even with these imperfections, earnings more closely match wealth creation in a given period than cash flows do. As with dividend valuation, earnings valuation begins with clean surplus accounting (i.e. net income includes all income items). Dividends include all direct capital transactions between the firm and the common shareholders. Residual income is excess earnings, also referred to as "abnormal" or "economic earnings." It measures the amount of wealth creation (or destruction) for common equity shareholders. When net income growth matches the discount rate, value exactly equals book value. Residual income calculation forecasts future net income for each period, forecasts expected book value of common shareholders' equity at the beginning of each period, computes expected future required income, and subtracts future required income from expected net income. Similarities between residual income and dividend valuation models include CAPM being handled the same way. Nominal growth is also used as long as it is consistently applied (nominal growth is growth that does NOT take inflation into account). The growth rate cannot equal or exceed the discount rate. Otherwise, it assumes perpetual growth faster than investors require. It would also be mathematically incorrect as it would result in an infinite or negative result. More similarities shared with the dividend valuation model include a forecast horizaon for earnings that can be infinitely long (the timeframe is usually 5 to 10 years, and then a steady state growth rate is applied). It also utilizes sensitivity analysis. Implementation issues include the fact that GAAP does not follow clean surplus accounting. There are 4 "dirty" surplus items in "other comprehensive income" (OCI) that firms recognize directly in shareholder's equity: (1) unrealized fair value gains / losses on investment securities, (2) foreign currency gains / losses, (3) minimum pension liability adjustments, and (4) the effects of cash flow hedges. This information is reported in the statement of common shareholders equity or in the footnotes section (at the bottom). Also, at times a portion of net income is attributable to claimants other than common shareholders. Preferred shareholders may have preference for dividends and minority shareholders may have a claim on a subsidiary. It is not available to all common shareholders and should be excluded. Advantages include the fact that earnings align closely to the capital markets and managements focus. Also, residual income valuation requires fewer steps than free cash flows valuation (i.e. it is easier and more simple to utilize). Disadvantages include the fact that earnings are not as reliable or as meaningful as cash or dividends. Accrual accounting earnings also do not directly reflect underlying economic value. Step 6: Value the Firm (cash flow based approaches): 0:30 Valuing the Firm: 0:59 Earnings: 1:54 Rationale for Earnings Based Valuation: 3:27 Foundation for Residual Income Valuation: 6:00 Residual Income Valuation Model Before Continuing Value: 13:03 Residual Income: 15:43 Residual Income Valuation Model With Continuing Value: 16:12 Residual Income Calculation: 18:11 Similarities to the Dividend Valuation Model: 18:49 Sensitivity Analysis [chart]: 19:37 Implementation Issues: 25:49 Advantages & Concerns: 27:24

• published: 11 Jul 2013
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