Section 10
Firm Valuation:
Valuation models
‘
1
Learning objectives
After studying this chapter, you will understand
• What drives firm value
• The process of firm valuation
• Firm valuation using dividends, free cash flows and
abnormal earnings
• How to forecast future financial performance of the firm
• Understand the sensitivity of the valuation result on the
key parameters
2
Firm valuation
• The term firm valuation refers to determining the true or
intrinsic value of the firm
– This value may significantly differ from the asset-based book
value of the firm
• Investors and financial analysts conduct firm valuation for
various purposes needed in their decision making
– Investment decisions
– In M&A transactions and IPOs, firm valuation plays a key role
• From firms’ point of view, valuation models help
understanding the key value drivers of the firm
3
Example: What are these two figures?
4
Firm valuation in theory and practice
• Richardson et al. (2010), JAE, ’Accounting anomalies and
fundamental analysis: A review of recent research
advances’
– Includes a survey on how investment professionals and
academics apply fundamental analysis and valuation
5
Valuation process
Business Analysis
GAAP
Financial
Statements
Financial Statement
Analysis
Forecast
Assumptions
Valuation
Time
Historical Periods
6
Valuation Date Forecast Periods
Valuation process
1. Business analysis


Internal and external business analysis
What are the key business drivers of the firm?
2. Financial statement analysis

Historical financial statements are analyzed to learn about the
profitability, leverage, growth, etc. of the firm
3. Forecasting

Future financial statements are projected
4. Valuation



Valuation models
Relative valuation
What is the value of the equity of the firm?
7
Valuation tools
• Two different types of valuation tools are mainly used
– Valuation models
• Dividend discount model (DDM)
• Free cash flow model (DCF)
• Abnormal earnings model (AE)
– Price multiples
• P/E-, P/B-, EV/EBIT- etc. ratios
• Valuation models are more sophisticated valuation tools
– Infinite forecast horizon
– Risk and time-value of money are taken into account in the cost
of capital
8
Valuation process
Business Analysis
GAAP
Financial
Statements
Financial Statement
Analysis
Forecast
Assumptions
Valuation
Time
Historical Periods
9
Valuation Date Forecast Periods
Business analysis and financial
statement analysis
• The key to developing a forecast needed in valuation
is to understand the business
• Business analysis
– Highlights issues we need to study further in the financial
statement analysis stage
• External business analysis
• Internal business analysis
• Financial statement analysis
– Identifies concerns that require more detailed business
analysis
10
External business analysis analyzes
• Industry economics
– to determine the firm’s returns, profitability and cash flows
• Individual competitors
– to understand the existing rivalry on a macroeconomic level
– to assess competitors’ strategies, products, marketing, supply
chain and profitability
• Potential entrants
– to know the number of potential competitors, and
– how they will affect competitive rivalry
• Substitute products
– to understand how substitute products can remove profits
– to consider the available substitute products
11
External business analysis analyzes
• Buyers
– to understand the customers' strong bargaining position
• Suppliers
– Suppliers generally have more bargaining power to raise prices
and lower quality if there are only a few of them and if there are
not many substitutions for their products
• Customers
– to understand how the customers’ needs drive demand
• Governmental regulations
– to understand the governmental and regulatory environment of a
firm
12
Internal business analysis
• Mission
– What the firm hopes to accomplish
• Products and services
– What do these do?
– How does the customer use them?
– What is the market scope?
• Pricing and differentiation
– The more differentiated the product, the less competition
focuses on price
• Marketing and selling strategies
– Are needed to understand the firm's strategy for bringing the
product to the customer
13
Internal business analysis
• Supply chain
– To understand how each part works in order to project future
cash flow
– Includes
• Purchasing, Manufacturing, Research and development,
Distribution
• Human resources
– To understand the strengths and weaknesses on the people
side
• Investment priorities
– To know what makes a firm successful through understanding
its investment priorities
14
Valuation process
Business Analysis
GAAP
Financial
Statements
Financial Statement
Analysis
Forecast
Assumptions
Valuation
Time
Historical Periods
15
Valuation Date Forecast Periods
Forecast assumptions
• Methods of predicting financial information can be
classified as follows:
Mechanical
Univariate
Statistical models
Multivariate
Statistical models
Non-mechanical
Trend analysis
Security analyst
approach
• Different methods are based on different forecasting
tools and data sources
• Data availability and the purpose for which the
predictions are made affect the selection of different
prediction methods
16
Mechanical prediction methods
• Mechanical prediction methods include
– Univariate statistical models that are based on the analysis of
the time-series of a single financial variable
– Multivariate statistical models that are based on the analysis
of the time-series of multiple financial variables
• In mechanical methods, predictions of the financial
variable are mechanically driven from the data by
applying a specified statistical model
– Statistical model is applied to the past data to estimate the
model parameters
– The estimated paremeters are then applied to current data to
predict the future value of the variable
17
Mechanical prediction methods
• Example of a mechanical univariate statistical model is a
model that forecasts earnings (X) to be an equally
weighted average of the past four year’s earnings
4
1
E(Xi,t )   Xi,t n
4
n 1
• This approach assumes that future earnings can be
simply predicted from the time-series of past earnings
• How relevant is this assumption?
18
Non-mechanical prediction methods
• In non-mechanical prediction approach, an analyst
incorporates a judgemental factor of her own into the
analysis
• This factor may reflect an ever-changing mix of economic
inputs
• A typical example of univariate non-mechanical approach
is ’free-hand’ extrapolation of a time-series plot of earnings
referred to as a trend analysis
• Analysts’ earnings forecasts are a typical example of a
multivariate non-mechanical prediction method
– Analysts use many quantitative and qualitative information sources
including financial reports of the firm, macro-economic forecasts,
company visits etc. 19
Analysts’ earnings forecasts
• Analysts’ earnings forecasts are frequently used to
assess the future performance of the firm
• Consensus earnings forecasts refer to the means or
medians of the analysts’ earnings forecasts
– Consensus earnings forecasts are probably the most important
piece of financial information, at least for the valuation purposes
• Range of the earnings forecasts of individual analysts
measure the uncertainty in the analysts’ opinions
regarding the value of the upcoming earnings
20
Example: Accurace of analysts’ earnings
forecasts
Source: Brown, Foster and Noreen (1985)
21
Valuation process
Business Analysis
GAAP
Financial
Statements
Financial Statement
Analysis
Forecast
Assumptions
Valuation
Time
Historical Periods
22
Valuation Date Forecast Periods
Valuation using valuation models
There are three steps involved in valuing a company:
Step 1: Forecast future amounts of the financial attribute that ultimately
determines how much a company is worth.
Step 2: Determine the risk or uncertainty associated with the forecasted
future amounts.
Step 3: Determine the discounted present value of the expected future
amounts using a discount rate that reflects the risk from Step 2.
• Dividends
• Free cash flows
• Accounting earnings
23
Dividend discount model (DDM)
• Value of equity is simply the present value of future dividends
• Cost of equity capital is used as a discount rate
Expected future dividends
2015*
Sum of the
present values
of future
dividends
= Value of equity
24
2016*
2017*
2018*
2018*-
Dividend discount model (DDM)
• Using the assumption that dividends will grow at a
constant rate, the dividend discount model can be adapted
to the so-called Gordon Growth Model
𝑃0 =
𝐷𝐼𝑉1
𝑘𝐸 −𝑔
• The Gordon Growth Model has three assumptions
– Current dividends (DIV1)
– Cost of equity (kE)
– Dividend growth rate (g)
25
Dividend discount model (DDM)
• In practice, we predict future dividend per share (DPS)
for next 3-5 years, and use a growth rate (g) in
dividends to forecast dividend for the period thereafter
(terminal value)
• DDM becomes as follows:
𝐷𝑃𝑆1
𝐷𝑃𝑆2
𝐷𝑃𝑆3
𝐷𝑃𝑆3 × (1 + 𝑔)
𝑃0 =
+
+
+
1
2
3
(1 + 𝑘𝑒 )
(1 + 𝑘𝑒 )
(1 + 𝑘𝑒 )
(𝑘𝑒 − 𝑔)(1 + 𝑘𝑒 )3
26
Example: Using DDM
• Expected dividends per share (DPS) for the next three
years are 0.84, 0.69 and 0.65
• The estimated long-term dividend growth rate is 3%
• Cost of equity capital is 9,84 %
• Value of equity is:
P0 
DPS3
D3 (1  g )
DPS1 DPS 2



1  re 1  re 2 1  re 3 r  g 1  re 3
0,84
0,69
0,65
0,65 *1,03



1,0984 1,0984 2 1,0984 3 0,0984  0,031,0984 3
 9,21

27
Where to get the forecasts?
• Current dividends (DIV1) can be obtained from
– Newspapers
– Annual reports
– Other public sources
• Dividend growth rate (g) should be determined such that
the analyst
– Shows how sensitive value is to this assumption
– Introduces the concept of a just barely sustainable dividend
growth rate
– Shows this is the appropriate growth rate to be used in the
model
28
Equity value and dividend growth rate
29
Discounted free cash flow (DCF) model
Expected future free cash flows
2015*
Present value of
future free cash
flows
+
Financial assets

Interest-bearing debt
=
Value of equity
2016*
2017*
2018*
2019*-
• Present value of future cash flows is the
Enterprise Value, i.e. the value of both equity
and debt
• After adding financial assets and substracting
interest-bearing debt (i.e. interest-bearing net
debt), we get the value of equity
30
Discounted free cash flow (DCF) model
• Value of the firm, i.e. the Enterprise Value (debt plus
equity), is the present value of the expected free cash
flows discounted by WACC:
EV0 
FCF3
FCF1
FCF2



2
3
1  WACC ( 1  WACC)
( 1  WACC)
• Expected free cash flows have to be positive some time
over the life of the asset
• Firms that generate cash flows early in their life will be
worth more than firms that generate cash flows later
– the latter may however have greater growth and higher cash flows
to compensate
31
Value creation, cash flows and WACC
• A firm can be seen as a portfolio of projects
– Some with positive Net Present Values (NPV) and some with
negative NPVs
• The value of the firm is the sum of the NPVs of its
component projects
• Greater future cash flows increase NPVs
Increasing ROIC will increase firm value
• Lower discount rates increase NPVs
Decreasing WACC will increase firm value
Discounted free cash flow (DCF) model
• Forecasts and discounts the expected free cash flows
the core operations will generate
• Most widely used valuation model
• First step in financial statement analysis is to develop
historical free cash flow statements
• These statements separate free cash flows from all
other cash flows
• Historical statements can be utilized in predicting future
free cash flows
33
Valuation process
revised
Business Analysis
Forecast
Assumptions
Financial Statement
Analysis
Historical Ratios
GAAP
Financial
Statements
Forecast Ratios
Free Cash
Flow Forecast
Historical Free Cash
Flow Statements
Valuation
Time
Historical Periods
34
Valuation Date
Forecast Periods
Example: Applying DCF model to Kesko
Reported numbers
2010
2011
2012
8 776,8
-8 349,2
427,6
9 460,4
-9 055,1
405,3
9 685,9
-9 315,4
370,5
4,9 %
4,3 %
3,8 %
4,3 %
1,7 %
-120,9
306,7
-124,7
280,6
-158,5
212,0
-153,0
248,4
-195,1
151,4
3,5 %
3,0 %
2,2 %
2,7 %
1,7 %
6
-96,7
0,8
-85,2
-0,6
-74,6
-5,8
-57,7
-40,7
0,9
0,1
0,1
0,9
6,1
-95,8
-85,1
-74,5
-56,8
-30,5
-31,24 %
-30,32 %
-35,15 %
-22,88 %
-20,14 %
210,9
120,9
-325,0
195,5
124,7
-425,0
137,5
158,5
-378,0
191,6
153,0
-171,0
120,9
195,1
-194,0
Capital expenditures / Net sales
-3,7 %
-4,5 %
-3,9 %
-1,8 %
-2,1 %
- Change in working capital
54,8
-81,2
-8,4
90,7
3,9
-11,9 %
-3,7 %
-24,5 %
-1,6 %
-186,0
-90,4
264,3
125,9
Net sales
Costs and expenses
EBITDA
EBITDA-%
Depreciations
EBIT
EBIT-%
Financial items
Taxes, reported
Net tax effect on financial items
Taxes, adjusted
Taxes, adjusted / EBIT
Earnings before financial items
+ Depreciations
- Capital expenditures
Change in Working capital / Change in Net sales
Free cash flow
35
2013
2014
9 315,2 9 070,6
-8 913,8 -8 913,8
401,4
156,8
-36,6
Example: Applying DCF model to Kesko
Summary of forecast assumptions
Mechanical forecast assumption:
Net sales
CaGr (2010-2014)
0,83 %
EBITDA-%
Average (2012-2014)
3,80 %
EBIT-%
Average (2012-2014)
2,60 %
Taxes, adjusted / EBIT
Average (2012-2014) -27,94 %
Capital expenditures / Net sales
Average (2012-2014)
-3,21 %
Change in Working capital / Change in Net sales Average (2012-2014) -10,42 %
Free cash flow
CaGr (2015-2018)
0,83 %
36
We use:
0,83 %
3,80 %
2,60 %
-27,94 %
-2,10 %
-10,42 %
3,00 %
Example: Applying DCF model to Kesko
Cost of Capital calculation
Risk-free rate of return
Beta
Risk premium
Cost of Equity
Cost of Debt
Equity/(Equity+Debt)
Debt/(Equity+Debt)
WACC
3,5 %
0,8
4,5 %
7,1 %
5,0 %
0,8
0,2
6,4 %
37
Example: Applying DCF model to Kesko
Predicted numbers
2015
2016
2017
2018 Term. Value
9 145,9 9 221,8 9 298,3 9 375,5
-8 798,0 -8 871,0 -8 944,6 -9 018,9
347,9
350,8
353,7 356,6
Net sales
Costs and expenses
EBITDA
EBITDA-%
3,8 %
3,8 %
3,8 %
3,8 %
-110,4
237,5
-111,3
239,5
-112,2
241,5
-113,1
243,5
2,6 %
2,6 %
2,6 %
2,6 %
-66,4
-66,9
-67,5
-68,0
-27,9 %
-27,9 %
-27,9 %
-27,9 %
171,1
110,4
-192,1
172,6
111,3
-193,7
174,0
112,2
-195,3
175,4
113,1
-196,9
Capital expenditures / Net sales
-2,1 %
-2,1 %
-2,1 %
-2,1 %
- Change in working capital
-7,8
-7,9
-8,0
-8,0
-10,4 %
-10,4 %
-10,4 %
-10,4 %
81,6
77
82,3
73
83,0
69
83,7
65
Depreciations
EBIT
EBIT-%
Financial items
Taxes, reported
Net tax effect on financial items
Taxes, adjusted
Taxes, adjusted / EBIT
Earnings before financial items
+ Depreciations
- Capital expenditures
Change in Working capital / Change in Net sales
Free cash flow
Present values of free cash flow
38
2521,1
1967,8
Example: Applying DCF model to Kesko
Valuation summary
2015
81,6
76,7
Free cash flow
Present values of free cash flow
Sum of PVs (2015-2018)
Present value of Terminal Value
Interest-bearing net debt
Total
283,6
1967,8
99,2
2350,6
39
2016
82,3
72,7
2017
83,0
68,9
2018 Term. Value
83,7
2521,1
65,3
1967,8
Long-term growth in FCF:
WACC:
# of shares outstanding:
Value per share:
3,00 %
6,4 %
99,161
23,70
Example: and the formula behind the DCF
valuation of Kesko…
FCF1
FCF2
FCF3
FCF4
FCF '4 (1  g )




1  WACC 1  WACC 2 1  WACC 3 1  WACC 4 WACC  g 1  WACC 4
81,6
82,3
83,0
83,7
83,0 *1,03





1,064 1,064 2 1,064 3 1,064 4 0,064  0,031,064 4
 2206,4 (Value of Firm)
 99,2 (Interest - bearing net debt)
 2350,6 (Value of Equity)
/ 99,161 (# of shares outstanding)
 23,70 (Value per share)
EV0 
40
Example: Direct method of measuring
free cash flow, Kone 2013
41
Case: Direct method of measuring free
cash flow, Kone 2013
• Interest received and paid (and other financial items) are
not included in the free cash flow
• Taxes include the amount of taxes that Kone has paid for
its financial income
– Since the free cash flow measures the cash flow before financial
related items and taxes on operations include taxes on net
financial items, we need to add taxes on net financial back to
cash flow
– Tax adjustment: 0,245*(29,5-2,4+10,8+2,7) = 9,9
– Adjusted taxes: -231,3 + 9,9 = -221,4
42
DCF model, summary
• DCF model is the most commonly used valuation model
that has a clear logic
– Value of the firm is the sum of the NPVs of projects
– The same model works for both project and firm valuation
– There is a link between the DCF model and the current value
creation of the firm
• DCF model also has its problems
– It relies heavily on the terminal value
→Very sensitive to the estimated growth rate, WACC, and steady
state conditions
– It is subject to the timing of payment streams
→ Estimating the period in which payments will occur is difficult
→ Free Cash Flow streams are highly volatile over time.
DCF model is not a value creation concept
• Cash flow from operations (value added) is reduced by
investments (which also add value)
 Investments are treated as value losses
• Value received is not matched against value
surrendered to generate value
• A firm reduces free cash flow by investing and increases
free cash flow by reducing investments
– Free cash flow is partially a liquidation concept
• Also, analysts forecast earnings, not cash flows
4-44
Can EVA be used in a valuation model?
• Earnings-based valuation models are based on the logic
of EVA and residual income we have already learnt
– Rely on future EVA or residual income (abnormal earnings) –
not the current or past
• Important characteristics
– Much smaller terminal value
 less forecasting needed
– Earnings are less volatile than cash flows
more precise forecasting
 Directly associated with the value creation of the firm
Abnormal earnings (AE) model
Book value of
equity
2014
Book value of
equity, B0
+
Present value of
future abnormal
earnings PV(AE)
=
Value of equity, V0
46
Expected future abnormal earnings
2015*
2016*
2017*
2018*
2019*-
Principle in the AE model is the same as
in the DDM and DCF models...
DDM model:
DIV3
DIV1
DIV2
Equity value0  V0 


 ...
2
3
(1  rE ) (1  rE )
(1  rE )
DCF model:
FCF3
FCF1
FCF2
Enterprise Value0  EV0 


 ...
2
3
(1  WACC ) (1  WACC )
(1  WACC )
47
… but the algebra is different:
If accounting follows a clean surplus relation:
DIVt  NI t  Bt 1  Bt
Clean Surplus Relation:
Bt = Bt-1 + NIt – DIVt
Add and subtract rEBt-1:
DIVt  NI t  rE Bt 1  Bt 1  rE Bt 1  Bt
DIVt  ( NI t  rE Bt 1 )  (1  rE ) Bt 1  Bt
Normal earnings = rEBt-1
Define abnormal earnings as:
AEt  NI t  rE Bt 1
Then DIVt can be written as:
DIVt  AEt  Bt  (1  rE ) Bt 1
48
Abnormal earnings model, derivation
Substitute this expression for DIV into the Dividend Discount Model:

V0  
DIVt
t 1 (1  rE )
DIVt  AEt  Bt  (1  rE ) Bt 1
t


AEt  Bt  (1  rE ) Bt 1
(1  rE )t
t 1
V0  
Write out the expression:
t=2
t=1
t=3
 AE  B
  AE  B
B1   AE3  B3
B2 
1
2
1
2
  ...

V0  
 B0   


1
2
3
2
(1  rE )   (1  rE )
 (1  rE )
  (1  rE )
(1  rE ) 

 
 
49
Abnormal earnings model, derivation
 AE
B1   AE2
B2
B1 
1


V0  B0  



2
2
(1  rE ) 
 (1  rE ) (1  rE )   (1  rE )
(1  rE )

 

 AE
B3
B2 
3
  ...



3
3
2
 (1  rE ) (1  rE ) (1  rE ) 


 AE   AE   AE 
3   ...
1 
2 
 B0  
 (1  rE )   (1  rE ) 2   (1  rE )3 

 
 


 B0  

AEt
t 1 (1  rE )
T
t
NI t  rE Bt 1
t
t 1 (1  rE )
 B0  
NI t  rE Bt 1 (1  g )( NIT  rE BT 1 )

t
(rE  g )(1  rE )T
t 1 (1  rE )
 B0  
50
Recall that
AEt  NI t  rE Bt 1
Abnormal earnings model, derivation
 NI t rE Bt 1 
 NIT rE BT 1 

(1  g ) BT 1 



T Bt 1  B
B
B
B
t 1 
T 1 
 t 1
 T 1
V0  B0  

(1  rE )t
(rE  g )(1  rE )T
t 1
ROEt 

T
NIt
Bt 1
( ROEt  rE ) Bt 1 (1  g )( ROET  rE ) BT 1

t
(1  rE )
(rE  g )(1  rE )T
t 1
V0  B0  
51
Abnormal earnings model
Important points
• One assumption - Clean Surplus Relation
• Definition of ROE as current Net Income over last period’s
book value of equity
• Definition of abnormal earnings as the difference between:
• Net Income and cost of equity (in $ terms), or equivalently,
• ROE and rE, multiplied by last period’s book value of
equity (in % terms)
• A firms creates value when ROE > rE
52
Abnormal earnings model, implications
a) Management does better than
expected:
•
What matters most to investors is:
+ $100 of
abnormal
earnings
The amount of money they turn
over to management
2. The profit management is able to
earn on that money
1.
$300
$200
Abnormal earnings:
r  Capital
Earnings
Required earnings
AE  Earnings  r  Capital
What
management
does with the
money

Expected
return
b) Management does worse than
expected:
What shareholders
entrust to
management
Suppose investors contribute
$2,000 of capital, and expect to
earn a 10% rate of return.
$200
r  Capital
- $50 of
abnormal
earnings
$150
Earnings
Abnormal earnings model:
Premium and discount
a)
$20
=
$15
+
$5
$5 premium
•
•
•
b)
$10
=
$15
+
- $5
•
$5 discount
54
Investors willingly pay
a premium over BV for
companies that earn
positive AE
ROE exceeds the cost
of equity
Firms that earn
negative AE sell at
discount to BV
ROE is less than the
cost of equity
AE model protects from paying too much
for earnings growth
• Suppose a firm increases earnings by a new investment
– Abnormal earnings before the new investment:
AE = 12 – (0.10 x 100) = 2
– Abnormal earnings after the new investment of $20 million
earning at 10%:
AE = 14 – (0.10 x 120) = 2
• No value added from the new investment
• Creating earnings by accounting methods also increases
residual earnings but reduces book value
The net effect of these action on the equity value is zero
55
Beware of paying too much for growth
• Investment creates growth but does not necessarily
add value
• Earnings growth can be created by the accounting
• Current stock price may reflect too high growth
expectations!
“But the combination of precise formulas with highly
imprecise assumptions can be used to establish, or rather
justify, practically any value one wishes, however high, for
a really outstanding issue.”
--Benjamin Graham, The Intelligent Investor, 4th Ed., p.315.
6-56
Example: Applying AE model to Kesko
Analysts' earnings forecasts
2014
2015
2016
2017
1,45
1,85
1,96
1,60
1,65
1,70
1,10
0,89
0,87
22,00
21,85
22,05
22,31
1,56
1,55
1,57
-0,11
0,30
0,39
-0,10
0,26
0,32
EPS
DPS
Pay-out ratio
BPS
Required earnings
Abnormal earnings, AE
Present values of AE, PV(AE)
Terminal Value, TV
2018
2,28
2,17
0,95
22,41
1,58
0,69
0,53
13,90
Valuation summary
BPS (2014)
22,00
1,00
10,56
33,57
Sum of PVs (2015-2018)
Present value of TV
Value of equity:
57
Long-term growth in AE:
Cost of equity capital:
2,00 %
7,1 %
Example: Value profile of Kesko
0,80
0,70
0,60
0,50
0,40
%
0,30
0,20
0,10
0,00
-0,10
58
Example: Value profile of Novo Nordisk
0,50
0,45
0,40
0,35
0,30
% 0,25
0,20
0,15
0,10
0,05
0,00
59
AE model, some modifications
• If the balance sheet is at market value, then
– Book value of equity is expected to earn at the required
return, that is, ROE = cost of equity
– Abnormal earnings are expected to be zero
V0 = B0 , that is, the market and book values of
equity are equal
• What if some assets or liabilities really are at
market value?
• Well, we get back to the concept of analytical
balance sheet and income statement
13-60
AE model, some modifications
• AE model:
V0  B0  PV ( AE )
• Some assets and liabilities have zero expected AE,
because they are measured at market value
Modified AE model:
V0  B0  PV (abnormal earnings from net assets not at market value)
61
AE model, some modifications
This is the AE model we have been
talking about so far
Net Income Component
Book Value Component
Residual Earnings Measure
Earnings
(Earn)
Net Operating Profit
(NOPAT)
Equity
(B)
Net Operating Assets
(NOA)
Earnt – rEBt-1
(AE)
NOPATt – WACC×NOAt-1
(EVA)
Net Financial Expense
(NFE)
Net Financial Obligations
(NFO)
NFEt – rDNFOt-1
(ReNFE)
These are the two modifications of the
model
62
AE model, some modifications
• NFO are usually at market value on the balance sheet (or
close to it). So residual earnings from NFO are expected to
be zero:
V0NFO  NFO0 
ReNFE1 ReNFE 2
ReNFET


...

 NFO0
2
T
ρD
ρD
ρD
• NOA are not usually at market value in the balance sheet
V0NOA  NOA0 
EVA3
EVA1
EVA2


 ...
2
3
WACC WACC
WACC
63
AE model, some modifications
Value of Equity  V0  V0NOA  V0NFO
V0NOA

V0  NOA0 
The same
model, but
different
inputs!
V0 
V0NFO

EVA3
EVA1
EVA2


 ...  NFO0
( 1  WACC) ( 1  WACC)2 ( 1  WACC)3
EVA3
EVA1
EVA2
B0



...
 ( 1  WACC) ( 1  WACC)2 ( 1  WACC)3
NOA0  NFO0
 AE   AE   AE 
3   ...
1 
2 
V0  B0  
 (1  rE )   (1  rE ) 2   (1  rE )3 

 
 

64
Our ”original” AE model
Abnormal earnings (AE) model:
Summary
•
A company’s future earnings are
determined by:
•
Firms expected to generate
positive abnormal earnings sell at
a premium to equity book value.
•
Those expected to generate
negative abnormal earnings sell at
a discount to equity book value.
1. the resources (net assets)
available to management;
2. the rate of return (profitability)
earned on those net assets.
•
•
If a firm can earn a return above its
cost of capital, then it will generate
•
positive abnormal earnings.
Firms that earn less than their cost
of capital generate negative
abnormal earnings.
65
The abnormal earnings valuation
model makes explicit the role of:
1. Income statement and balance
sheet information;
2. Cost of capital
IAS 36: Valuation of assets for potential
impairment
• The objective of IAS 36 is to prescribe the procedures that
the firm applies to ensure that its assets are carried at no
more than their recoverable amount
• These requirements apply equally to an individual asset
or a cash-generating unit (CGU)
• A firm has to estimate the recoverable amount of an asset
if there is any indication that the asset may be impaired
– Indications of impairment are assessed at each reporting date
• Firm valuation is needed when preparing financial
statements!
66
IAS 36 (p. 18-57), Measuring recoverable
amount
• Recoverable amount is defined as the higher of an
asset’s or CGU’s fair value less costs of disposal and its
value in use (p. 18)
 recoverable amount = max (fair value, value in use)
If carrying amount > recoverable amount: impairment loss
If carrying amount ≤ recoverable amount: no impairment loss
Carrying amount
Recoverable amount:
higher of
Fair value less
costs of disposal
Value in use
IAS 36, Example of an impairment test
• Firm M has a cash-generating unit A
• Carrying amount of A is 123 000 and its useful life is 4
years
• M recognizes indications that A may need to be
impaired
• The estimated fair value less costs to sell of A is 84 500
• How to perform the impairment test of A according to
IAS 36?
68
IAS 36, Example of an impairment test
Revenues
Costs (excluding depreciations)
Cash flows
2005
2006
75 000 80 000
-28 000 -42 000
47 000 38 000
Present values with
a discount rate of 5%
44762
Value in use =
91981
69
34467
2007
2008
65 000 20 000
-55 000 -15 000
10 000
5 000
8638
4114
IAS 36, Example of an impairment test
• Recoverable amount of A is 91 981, because its value
in use (91 981) is greater than its fair value less costs
to sell (84 500)
• Because the recoverable amount of A (91 981) is
smaller than its carrying amount (123 000), the firm M
recognizes an impairment loss of A
• Impairment loss is 123 000 – 91981 = 31 019, which is
– recorded as a cost in a profit or loss (unless the impairment is
observed as a part of the revaluation under IAS 16)
– deduction in a carrying amount of A in a balance sheet
70
Summary
• Investors and financial analysts conduct firm valuation
for various purposes
• Valuation process involves 1) business analysis, 2)
financial statement analysis, 3) forecasting, and 4)
actual valuation
• In valuation models, future cash flows or other
measures of financial performance are discounted to get
the value of the firm
• Impairment tests are example of cases when valuation
is needed in preparing financial reports
71