ACCT6101 – Session #1: Introduction to Valuation
PART 1 – Background
Our primary focus – corporate form of business:
shareholders board of directors management
re: management operate firm
assumed objective of management = maximize shareholders’ wealth
maximize share price!
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ACCT7106 – Session #3: The Valuation Process
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Why maximize share price?
If management maximizes share price, investors can always sell their shares if they don’t like the firm’s policies and receive maximum price
Further, given well-functioning markets and rational investors, share price will reflect the market’s risk attitude, time preference, and opportunity cost
Why not the more typical economic objective of maximizing profit?
– profit should be viewed relative to investment concept of opportunity cost
– since multiperiod, the time value of money must be acknowledged
– profit must be judged relative to risk
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Roles of Management
1. Controller function asset efficiency
i.e., efficient use of working capital and liquidity management
running the internal accounting system
2. Treasury function long-term funds acquisition
i.e., debt or equity? – will affect the risk and tax position of the firm
3. Capital budgeting real (productive) asset acquisition
i.e., composition of the firm’s fixed assets
mix of capital and labour
determines the firm’s profitability and operating risk
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Operational efficiency – low operating costs
Allocational efficiency – funds to most promising real investment opportunities
Informational (pricing) efficiency – market price reflects all relevant information and further, price adjusts rapidly to the release of any price relevant new information
price = value
Market Efficiency
informational (pricing) efficiency is critical for three key reasons:
encourages people to buy shares (facilitates an active market)
facilitates financial management (decisions evaluated through their impact on price)
helps to allocate resources (to their most productive uses)
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Academic research suggests:
strong form efficiency generally does not hold – further, insider trading is illegal or restricted
stock market probably satisfies weak form efficiency
stock market is largely semi-strong form efficient, but it is unclear if it is completely semi-strong form efficient
Fundamental analysis might still be useful:
the market might not be completely semi-strong form efficient => you might be able to value companies more accurately than the market
investors might be rewarded fairly for doing fundamental research. How do market prices reflect all public information, if no one is doing fundamental research?
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fundamental analysis represents an exercise designed to determine the ‘intrinsic value’ of the company (to form your own view of the value of a company for trading purposes)
it involves analyzing both quantitative and qualitative data about the company and the environment within which it operates including –
macroeconomic factors (the state and prospects of the overall economy; industry conditions and prospects)
company-specific factors (financial conditions; effectiveness of management; strategic initiatives; consumer behaviour)
The end goal is to arrive at a number that an investor can compare with a security’s current price in order to see whether the security is undervalued or overvalued
Fundamental analysis assumes that over the long term, a stock price will reflect the company’s intrinsic value
Aside – ‘fundamental analysis’
PART 2 – Implementing the Valuation Model
Issue #1 – discount rate (k):
Issue #2 – investment horizon (n):
Issue #3 – choice of flow measure (x): (e.g., dividends, free cash flow, earnings)
Issue #4 – estimating future values of ‘x’ (on a year-by-year basis for ‘n’ years, and then the ‘on average’ growth rate, g, over the extended period)
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Issue #1 – discount rate:
In general, the rate of return required by investors to induce them to commit capital, given the level of risk involved R = RF + E(I) + RP
where RF = risk-free rate of return E(I) = expected rate of inflation,
RP = risk premium specific to investment
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The CAPM, which is one relatively well accepted approach to developing a discount rate, predicts that the required rate of return on common equity as:
ke = RF + [E(RM) – RF]
[E(RM) – RF] ‘market price of risk’ (historic range approximately 5% 7%
measure of the firm’s systematic risk (broadly available for most major companies
RF = risk-free rate of return
Issue #2 – investment horizon:
preferred approach to implementing the valuation model
predict future year-by-year flows for some finite number of years and then estimate the terminal value at the end of this forecast horizon.
question of what constitutes an appropriate forecast horizon?
involves trade-offs (between ability to forecast year-by-year accurately and the weight placed on the terminal value component)
Analysts typically select a forecast horizon in the range of 3 to 5 year
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Issue #3 – flow measure:
two basic flow measures
earnings
cash flow
– cash flows to the firm
– cash flows to the investor (dividends)
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General form of the free cash flow model:
General form of the dividend valuation model:
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=
+ ……
+
General form of the ‘abnormal earnings’ model:
Conceptually, the choice of a ‘flows measure’ should not matter (i.e., the dividend, free cash flow, and abnormal earnings valuation models should lead to identical estimates of value!).
Requires –
1. the terminal value perpetuity must be based on internally consistent amounts
the clean surplus relation must hold at all times (SEt = SEt-1 + NIt – Dt ± NCC), and simultaneously and consistently for both models
for the CF model, the terminal value estimate must be based on Dt+1 where Dt+1 follows from the clean surplus relation based, say, on estimates of NIt+1 and SEt+1, not simply on Dt (1+g)
similarly, the terminal value estimate for the AE model must also follow from the clean surplus relation as opposed to simply using AEt (1+g) as the estimate of AEt+1
2. forecasted yearly data consistent with clean surplus and other accounting identities
e.g., the forecasted dividend series must be consistent with the forecasted Shareholders’ Equity and Net Income series, and with the forecasted price)
To illustrate, consider the following (an expanded version of the example used last week):
Example #3-1
An all-equity financed firm has as its only asset, inventory which cost $240 million. The firm’s tax rate is zero and its cost of equity capital is 12%
Analysts forecast that the firm will be able to sell one-sixth of its inventory in each of the next six years for cash
The projected revenues from the first year’s sales are $50 million and the revenues are projected to grow at the expected rate of inflation (3%) each successive year. The firm is then expected to be dissolved at the end of year six
The firm will adopt a 40% payout ratio, with remaining cash reinvested at the cost of equity and paid out as a terminal dividend at the end of year 6
Balance Sheet inventory 240,000,000 shareholders equity 240,000,000
anticipated sales revenue (FCF)
FCF1 = 50,000,000 FCF2 = 50,000,000 (1.03) = 51,500,000
FCF3 = 50,000,000 (1.03)2 = 53,045,000 FCF4 = 50,000,000 (1.03)3 = 54,636,350
FCF5 = 50,000,000 (1.03)4 = 56,275,440 FCF6 = 50,000,000 (1.03)5 = 57,963,700
profit & AE (assuming weighted average inventory method – cost = 40 / year)
π1 = [50 – 40] = 10,000,000 AE1 = (10 – 0.12*240) = -18,800,000
π2 = [51.5 – 40] = 11,500,000 AE2 = (11.5 – 0.12*200) = -12,500,000
π3 = [53.045 – 40] = 13,045,000 AE3 = (13.045 – 0.12*160) = -6,155,000
π4 = [54.63635 – 40] = 14,636,350 AE4 = (14.63635 – 0.12*120) = 236,350
π5 = [56.27544 – 40] = 16,275,440 AE5 = (16.27544 – 0.12*80) = 6,675,441
π6 = [57.9637 – 40] = 17,963,700 AE6 = (17.96374 – 0.12*40) = 13,163,700
proposed dividends (D) (= 40% of profit)
D1 = 0.4(10) = 4,000,000 ( cash retained = 50 – 4 = 46,000,000)
D2 = 0.4(11.5) = 4,600,000 ( cash retained = 51.5 – 4.6 = 46,900,000)
D3 = 0.4(13.045) = 5,218,000 cash retained = 53.045 – 5.218 = 47,827,000)
D4 = 0.4(14.63635) = 5,854,540 ( cash retained = 54.63635 – 5.85454 = 48,781,810)
D5 = 0.4(16.27544) = 6,510,176 ( cash retained = 56.27544 – 6.510176 = 49,765,260)
D6 = 0.4(17.9637) = 7,185,481 ( cash retained = 57.9637 – 7.185481 = 50,778,220)
liquidating dividend = 389,766,488 = 46 (1.12)5 + 46.9 (1.12)4 + 47.827 (1.12)3 + 48.78181 (1.12)2 + 49.765264 (1.12) + 50.77822
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Under the FCF valuation model
Under the AE valuation model, assuming weighted average inventory method
Under the dividend valuation model, assuming a 40% payout ratio, and remaining cash reinvested at the cost of equity and paid out as a terminal dividend at the end of year 6
= + + + + + = $219,475,525.7029
= 240 + + + + + + = $219,475,525.7029
= + + + + + + = $219,475,525.7029
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HOWEVER, what if we “naively” adopt a 5-year forecast horizon and then assume an ‘on average’ growth rate of 4% from year 6 into the foreseeable future (approximately the growth rate in the GDP)
= + + + + + ()= $605,227,861
VAE = 240 + + + + + + ()= $262,048,099
= + + + + + () = $66,389,939
WHY are the estimates no longer identical?
the assumption that each stream (earnings, dividends, and cash flows) can grow at the same rate indefinitely violates ‘clean surplus’ !!
HOW? sales, inventory, dividends, cash balance, etc. etc. etc.
fundamental analysis represents an exercise designed to determine ‘intrinsic value’
it involves analyzing both quantitative and qualitative data about the company and the environment within which it operates including –
macroeconomic & industry factors (e.g., the state and prospects of the overall economy; industry conditions and prospects)
company-specific factors (e.g., financial conditions; effectiveness of management; strategic initiatives; consumer behaviour)
PART 3 – Implementing the Valuation Model (cont)
Issue #4 – estimating future values of ‘x’
on a year-by-year basis over the forecast horizon (‘n’ years)
the ‘on average’ growth rate, g, that applies over the foreseeable future post the forecast horizon
undertaking ‘fundamental analysis’ is a relatively involved and complex process
i.e., FCF and earnings-based valuation models require analysts to project likely amounts of revenues, expenses, assets, liabilities, and shareholders’ equity.
their use requires analysts to undertake the very complex and “labour intensive” task of developing an understanding of the firm’s future operating, investing, and financing decisions
To illustrate, Palepu, Bernard, and Healy characterize the process followed by a thorough analyst as involving the following 7 steps:
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#1 Analyse strategy to understand factors driving the performance of an industry and a firm, and to assess whether those factors are likely to persist
#2 Analyse accounting to assess whether management has made conservative or aggressive accounting decisions.
#3 Forecast future earnings to the firm for a finite horizon (to the terminal year).
#4 Forecast growth in book value for the firm for the same horizon.
#5 Forecast earnings and book value growth beyond the terminal year.
#6 Estimate the firm’s cost of equity.
#7 Use the cost of equity to estimate the abnormal earnings and discount these amounts.
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Financial Analyst
A ‘securities analyst’ is an “individual, usually employed by a stock brokerage house, bank, or investment institution, who performs investment research and examines the financial condition of a company or group of companies in an industry” (Downes, J., & Goodman, J. (2014). Dictionary of Finance and Investment Terms (Barron’s Business Dictionaries).
There are sell-side and buy-side analysts
Buy-side: work for an investment fund (e.g. Blackrock, Vanguard, Franklin Templeton, superannuation funds) and provide advice internally on what the fund should invest in
Sell-side: provide advice to investors on the financial condition of companies. Most work for investment banks or brokers and write regular ‘research reports’ on the companies that they ‘cover’, giving their opinion about whether the company represents a good investment
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Typical contents of a sell-side analyst report include:
the analyst’s share price valuation of the company, usually expressed as a ‘price target’, which is the price the analyst expects in 12 months
a buy/sell/hold recommendation based on comparing the price target to the current market price
detailed forecasts of the major financial statement items for the next 2 or 3 years, such as earnings per share (EPS), dividends per share (DPS), sales, capex, etc.
the analyst’s commentary on recent company news
information about how the analyst valued the stock
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Aside – once the various year-by-year estimates and the post-horizon terminal growth estimate have been developed, as implied by the preceding material, the valuation exercise is essentially ‘mechanical’ – to illustrate:
re: Coles (COL) – from the CommSec website
5-year beta 0.73 k = 0.03 + 0.73 [0.06] = 0.0738 7.4%
forecasts current 2021 E 2022 E 2023 E
EPS ($) 0.715 0.785 0.785 0.889
DPS ($) 0.575 0.660 0.653 0.733
forecasts current 2021 E 2022 E 2023 E
EPS ($) 1.268 1.482 1.547 1.718
DPS ($) 0.940 1.103 1.158 1.274
re: Woolworths (WOW) – from the CommSec website
5-year beta 0.64 k = 0.03 + 0.64 [0.06] = 0.0684 6.8%
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+ ()
note – the forecasts represent the ‘consensus analyst forecast’
mean / median forecast across all sell-side analysts covering the company
(used as a proxy for the ‘markets’ forecast of earnings or dividends)
Based on these forecasts, we can then directly apply the ‘dividend valuation model’ to both COL and WOW
The remaining issue is then that of what constitutes an appropriate ‘g’ – the ‘on average’ post-horizon (terminal) growth rate (??)
could assume that Coles / Woolies will stop paying dividends after 2023
could assume that Coles / Woolies will pay dividends at the 2023 level into the foreseeable future (i.e., g = 0)
could (should) independently develop a defensible value for g that reflects the company’s like future path
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assuming that Coles & Woolies will stop paying dividends after 2023:
assuming that Coles & Woolies pay dividends at the 2023 level in perpetuity (g = 0):
As a frame of reference, the current share prices for COL and WOW at the close of trade on Friday 4 December are:
PCOL = $17.98
PWOW = $37.72
both estimates significantly understate the current share price (since g is likely inappropriate)
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What is an appropriate post-horizon (terminal) growth rate, g?
g represents how fast the company will grow (on average) forever
you should not use a g that is greater than the nominal GDP growth of the country where the company operates (assuming it operates primarily in one country)
it is unreasonable to assume that a company can grow faster than the economy as a whole forever, as eventually its size would exceed the size of the entire economy!
Australia’s historical nominal GDP growth has been affected by fluctuations in real GDP growth and inflation (primarily inflation). The averages for the measure are:
over the last 10 years: about 4.2%
over the last 20 years: about 5.8%
over the last 50 years: about 8.4%
g likely should not therefore exceed 4 – 4.5% for an Australian company, and could be less (depending upon the company’s circumstances and prospects)
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assuming g = 3%:
assuming g = 4%:
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Actual Price Estimated post-horizon dividend growth rate, g
(4/12/20) D = 0 g = 0% g = 3% g = 4%
PCOL $18 1.772 9.923 15.220 19.175
PWOW $38 3.094 18.473 30.615 40.444
Summary reflection –
for both companies, clearly the capital markets appear to factoring in growth estimates of between 3% and 4%, currently closer to 4%
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re: use of the ‘discounted dividend’ valuation model (DDM) –
Advantages:
dividends are what shareholders actually receive and thereby not affected by ‘earnings management’ (strategic manipulation of accounting figures to portray a desired image or picture)
can work reasonably well for mature companies with high dividend payout rates
dividends can be more stable than FCF, as companies tend to ‘smooth’ their dividends
Disadvantages:
dividends are the result of present/past profitability and a financing decision (to pay out shareholders equity – it is therefore better to focus on the source of dividends, which is earnings and cash flow
the DDM is difficult to implement if the company is not paying any dividends (you have to forecast when the company will eventually begin paying dividends)
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re: use of the ‘abnormal earnings (residual income)’ valuation model (AE / RIM) –
Advantages:
Focuses on earnings, which is a better measure of performance than dividends or FCF
advantages of accrual accounting
not the result of a financing decision unlike dividends
earnings does not punish investment in net operating assets (NOA) unlike FCF
for some companies, the forecast horizon (years until RI reaches a steady state) will be shorter than for the DDM
can use analyst forecasts of DPS and EPS as these are readily available
Disadvantages:
more complex than DDM
earnings can be manipulated, in particular accruals are easier to manipulate than FCF
still requires forecasting dividends as dividends are needed to calculate future ‘shareholders’ equity’ (for clean surplus)
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Sell-side analysts: provide advice to investors on the financial condition of companies. Most work for investment banks or brokers and write regular ‘research reports’ on the companies that they ‘cover’, giving their opinion about whether the company represents a good investment
Investopedia – the job of a sell-side research analyst is to follow a list of companies, all typically in the same industry, and provide regular research reports to the firm’s clients. As part of that process, the analyst will typically build models to project the firms’ financial results, as well as speak with customers, suppliers, competitors, and other sources with knowledge of the industry.
There are a number of templates that detail the type of inputs the analyst utilizes in developing their reports. On balance, however, these template incorporate the same material.
One such template is the so-called ‘top down’ approach detailed on the next slide
PART 4 – Issue #4: Estimating future values of ‘x’
Typical analyst’s report – Top down approach
Macroeconomic factors e.g.,
GDP
Interest rates
Inflation
Foreign exchange (FOREX) rates
Oil and commodity prices
Hedging
Business cycle
Industry factors e.g.,
Sensitivity to macroeconomic factors
Industry operation, ratios and stats
Competition
Firm level e.g.,
Strategy
Synergy
Financial Performance
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Bradshaw, 2011
“Analysts’ forecasts: What do we know after decades of work?”
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Starting with the ‘Macroeconomic Factors’ e.g.,
GDP; Business cycle; Inflation
Interest rates; Foreign exchange (FOREX) rates; Commodity Prices
These factors are largely outside the control of the company but have the potential to significantly impact the company’s performance.
The RBA provides data on both the historical trends in the relevant dimensions and projections. Consider, for example, the summary ‘snapshot’ of key indicators provided by the RBA dated 3 December
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While the ‘macroeconomic factors’ are largely (or wholly) outside the control of the company, the company can however undertake steps to mitigate its exposure to various risks that the factors pose to its profitability
treasury risk management:
managing the firm’s exposure to unanticipated changes in interest rates, foreign exchange rates, and commodity prices.
focus: fluctuations in the firm’s profit, ROE, and/or market value
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main sources of risk include:
a) interest rate risk fluctuations that result from changes in interest rates
b) exchange rate risk fluctuations that result from changes in exchange rates
c) commodity price risk fluctuations that arise from changes in the prices of commodities that the firm either sells or purchases
note: even firms that do not directly use a commodity may face commodity price risk as price increases affect other factors of production (e.g., delivery costs)
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Managing risk: hedging strategies
hedge: adopting an offsetting position to reduce (or eliminate) risk exposure
typically involves the creation of a position in the derivatives market to offset an existing risk in the cash market.
hedger: a person or firm who has a direct interest in the actual commodity or asset underlying the hedge instrument
note: by hedging, have reduced (eliminated) downside risk BUT have also reduced (eliminated) upside potential!
note: can have risk exposure either when hold the asset or when wish to acquire the asset (i.e., “long” position or “short” position).
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e.g., Coles 2020 Annual Report
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e.g., Qantas 2020 Annual Report
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PART 5 – ‘strategy analysis’ ‘understanding the business’
Penman presents on possible structure (template) in Figure 3.1 (page 85) around ‘the process of fundamental analysis’
Step #1 Knowing the business
Step #2 Analyzing information
Step #3 Forecasting payoffs
Step #4 Converting forecasts to valuation
Step #5 Trading on valuation
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The final three steps of the basic process are relatively “straightforward” or non-contentious
For example, Step #3 basically involves interpretation of the information developed in the first two steps and then its transformation/translation into the pro-forma financial statements.
The process can be considered ‘relatively “straightforward” and non-contentious’ because, while it involves considerable subjective judgment (the ‘art’), the objective / purpose of the exercise (pro-forma statements) is well-defined and unambiguous
development of the ‘pro forma’ financial statements through to the forecast horizon
the heart of good valuation is good forecasting (‘Good Forecasts’)
forecasts are only as good as the information supporting them
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NOTE: the ultimate objective of the processes in Steps #1 and #2 is then to gain the knowledge and understanding necessary to develop the pro-forma financial statements (as inputs into the estimation of value using the fundamental valuation models)
Step #1 Knowing the business
the products
the knowledge base
the competition
the regulatory constraints
Step #2 Analyzing information
in financial statements
outside financial statements
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there are a number of different strategies (structures or processes) to guide the acquisition of the information
for example, consider the following two presentations (generically labeled A and B) which are virtually identical in substance, if not in form
note, while each of these presentations is couched in terms of how a firm might evaluate its own current position and then shape an appropriate response strategy, they can alternatively be viewed as providing the external analyst with a “checklist” from which to develop an indepth understanding of the firm, its current circumstances, and its prospects
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Approach A –
Motivation – to add value for stakeholders (EVA = difference between the value of a firm’s outputs and the value of its inputs)
External Analysis – evaluation of the business environment
business strategy consists of
– corporate level strategy
– competitive (business level) strategy
– functional (operations level) strategy
analysis of the business environment
analyze conditions outside the firm to assess opportunities and threats
the general environment
the industry
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general environment – PEST analysis
political forces
e.g., trade liberalization and emergence of trade blocs
economic forces
e.g., world and local economic changes; wage differentials; exchange rate movements
social changes
e.g., as caused by advances in transport & communications
global products
technological change
e.g., computers, satellites, ceramic superconductor
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analyzing the firm’s industry environment
Porter’s five forces model
the bargaining power of suppliers
the bargaining power of the buyers
the threat of potential new entrants
the threat of substitutes
the extent of competitive rivalry
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Internal Analysis
Value chain (Porter) – breaks activities of an organization into
– primary activities creating products, marketing, sales & service
– support activities inputs allowing primary activities to occur
looks inside the firm to assess its internal strengths and weakness
is performed to identify strengths to build on and weaknesses to overcome in building strategies for competitive advantage
identifying / building
– core competencies or distinctive capabilities
e.g., innovation, reputation, and/or business relationships
– strategic assets
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methods for assessing internal strengths and weakness
the balanced scorecard
examines all aspects of the organization’s activities that impact on the ‘bottom line’
Financial
Customer
Operations
Organizational
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SWOT analysis
– strengths, weaknesses, opportunities, and threats
– strengths and weaknesses based on the internal analysis
– opportunities and threats based on the external analysis
a potentially useful way of drawing together the analysis of the external environment and the analysis of (internal) resources
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Approach B –
I. Situational Analysis
General external environment
political / legal
sociolcultural
technological
demographic
global
Industry analysis (Porter’s five forces)
threat of new entrants and barriers to entry
intensity of rivalry among competitors
product substitutes
suppliers
buyers
Competitive environment analysis
are other companies developing similar products?
what resources do potential competitors have?
Environmental trends
attractiveness of external (market) environment
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1. key success factors
e.g., first mover advantage; marketing & distribution capabilities; production efficiencies
2. strategies
business level e.g., high price strategy; market penetration strategy
competitive strategy e.g., first mover into industry
corporate level e.g., diversification into new areas; core business
3. core competencies
resources
tangible – financial; physical; human
intangible – resources for innovation; reputation
capabilities
operations
marketing and sales
management
technology
Strategic analysis
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II. SWOT
Opportunities e.g.,
develop additional products
expand into new markets
Threats e.g.,
regulatory hurdles
rivals with similar products
competency of competition
Strengths e.g.,
product development
professional network
management
Weaknesses e.g.,
marketing and/or distribution
production
experience with product
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