Class Note for SCH-MGMT 797 at UMass(2)
Class Note for SCH-MGMT 797 at UMass(2)
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This 5 page Class Notes was uploaded by an elite notetaker on Friday February 6, 2015. The Class Notes belongs to a course at University of Massachusetts taught by a professor in Fall. Since its upload, it has received 23 views.
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Date Created: 02/06/15
Eugene M Is enb erg School ofManagemem SCHMGMT 797AA Financial Statement Analysis Notes for second day of class Ray Pfeiffer July 11 2005 Administrative items Music Additional resource Penman s book website wwwmhhecompenman2e More stuff on course website Mintel reports 7 on library website httpwwwlibrarVumassedusubiectbusiness Today Questions Valuation technologies shortcuts multiples assetbased valuation fundamental analysis discounted dividends discounted cash flows Cash and accrualbasis accounting For Tomorrow Suggested homework E41 E44 Valuation models based on accounting numbers Study chapters 5 and 7 Valuation technologies Multiple analysis Method of CDmpambles 1 Identify comparable firms usu based on industry product size risk etc Calculate multiples of earnings book values sales cash flows or other variables eg Pna PB 3 Apply these multiples to the accounting measures of the target firm to predict value Illustration E32 see separate solution Issues 1 Different implied prices for different multiples 2 Could have negative values for earnings book value or cash flow Then what 3 Assumes markets are efficient but then why are we doing the analysis Screening on multiples 1 Identify a multiple on which to screen stocks 2 Rank stocks on that multiple from highest to lowest 3 Buy stocks with the lowest multiples and sell stocks with the highest multiples Brown and Pfeiffer 2005 evidence see website for PDF file Assetbased valuation Value of equity is equal to the value of the assets less the value of the liabilities of a firm Problems 1 some assets and liabilities are in illiquid markets and thus market values are not readily available 2 asset and liability values are not additive they are complementary and 3 some assets and liabilities are not recognized under GAAP Fundamental analysis The above methods are shortcuts They do not require forecasts of the future Fundamental analysis is the method of analyzing information forecasting payoffs from that analysis and basing the valuation on the forecasts See figure 33 from book slide 1 Some valuation models based on fundamental analysis The Dividend Discount Model gt Terminal investments such as a bond or a company with a finite life Demonstrate with an example bank CD 7 1000 deposit with a 18month maturity 375 interest rate Some Additional Tools gt How do we choose an expected rate of return aka discount rate for discounting payoffs Penman recommends using the Capital Asset Pricing Model See Box 38 on how to use the Capital Asset Pricing Model to estimate required return for a firm Assumptions wellfunctioning markets risk free asset diversification and thus no returns to diversifiable risks Conclusion expected return will depend only on 1 riskfree return 2 beta and 3 expected return on market portfolio gt Required return riskfree return Beta market risk premium where market risk premium expected return on market portfolio riskfree return gt Market portfolio portfolio of ALL risky assets not just stocks gt Beta covariance of security with market portfolio variance of the return on the market gt Choose a riskfree rate usually a US Treasury security with term that matches the forecasting horizon gt Get Beta from financeyahoocom or other source gt Inexact science Note that it is assumed that a firm has a constant beta Also note unrealistic assumptions above gt What is a perpetuity Infinite series of equal payoffs Note that after the end of the forecasting horizon we typically assume some constant payment or a constantly growing payment from then until infinity thus causing the need for the value of a perpetuity gt How do you compute the value of a perpetuity V payoff r where r is the discount rate gt Goingconcern investments indefinite future payoffs Demonstrate with an example 7 Sears What to do with continuing value Assume zero assume constant assume constantly growing gt Problems with DDM Dividends are not relevant to value they are distributions of value not creation of value Dividends are arbitrary and perhaps unrelated to performanceprofitability So what to do Perhaps we should focus instead on value generating activities 7 operations and investing The Discounted Cash Flow Model PCP PCP 1 2 1 r 1 r2 m gt What do we do to deal with the continuing value Assume zero constant or constantly growing cash flow beyond the forecast horizon Note that free cash flows belong to both investors and creditors Thus V in the equation is an expression for the value of the wholefirm in other words the assets not the value of equity To get the value of the equity alone we need to subtract from V the value of nonequity claims on assets 7 debt and preferred stock and any classes of common stock other than the one being valued Notation pp 1 r g 1 rate of growth PCP P 1 that this is the value as of period T i the end of the horizon It must be discounted back to the present as well T So what is the continuing value if we assume constant FCF forever CVT Note FCPT P g What is the continuing value if we assume constantly growing FCF CVT Gordon Growth Model How to use the model Forecast earnings why earnings instead of cash flow Forecast the accrual adjustments to earnings in the cash flow statement Calculate cash flow from operations steps 1 and 2 i called levered because interest has been subtracted even though it s a financing activity Forecast aftertax net interest payments Add back the aftertax interest to get unlevered cash flow from operations Forecast cash investments in operations excluding net investment in interest bearing securities financing activities Calculate forecasted free cash flows Illustration See NY State Electric and Gas slide 2 and WalMart example slide 3 Issues What happens with negative free cash flows What do negative free cash flows imply about the firm Problems with the use of earnings to get to cash flows Accrual accounting and its usefulness in valuation Things to notice about the income statement based on accrual accounting Dividends do not appear there Investment is not subtracted so earnings are not negatively affected by investment other than RampD Value inflows and outflows are matched gt What is accrual accounting Adjusts cash flows for timing Recognizes revenues when earned and expenses when incurred Shortens the forecasting horizon i eg pension expenses are recorded now in the income statement but cash outflows might not happen for decades Accruals require implicit and explicit assumptions about the future eg bad debts pension expenses etc In doing so they provide information about managements views of the future gt Why would we want to throw this away gt Think of the relationship between earnings and cash flows Earnings Free cash flow investments accruals net cash interest Adds back investments to fix the mismatching problem Adds accruals to enhance the informativeness of the performance measure through revealing management implicit forecasts Subtracts net cash interest to separate financing and operating activities Not perfect however i limitations of GAAP and of application of GAAP Isn t accrual accounting useful Or should we just get rid of all of that noise and get back to cash gt Accrual accounting information in financial statements helps to provide information that cash flow alone cannot Consider the financial statement articulation stocks and flows picture again Show figure 42 from textbook p 127 Summary of today 1 You saw a variety of valuation technologies and discussed their strengths and weaknesses multiples assetbased valuation dividend discount model discounted cash flow model 2 You learned how to use the CAPM to estimate the discount rate to be used for a firm s equity 3 You learned how to deal with estimating values beyond the forecast horizon 4 You thought about accrual accounting and its possible usefulness in valuation
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