Valuaion models, mehods and issues: an overview Rober Herman Jan Lange 0207780 Third draf: 06-09-2007 Supervisor: Dr G. Georgakopoulos, FEE, Universiy of Amserdam Absrac Valuaion models and mehods used o value a firm s asses or equiy are as numerous as grains of sand on a beach. The premise of each of hese models or mehods, is ha hey capure he inrinsic, real value of eiher he firm s asses or equiy. Rarely however will hey produce he same resuls given he same inpu (Francis e al. 2000 p. 46). Several differen mehods are discussed in his paper. This paper focuses on 3 groups of mehods specifically, namely: Firs up are he Discouning-based models, including he Discouned free cash flows- and Abnormal Earnings models. Second are he Relaive Valuaion mehods, including P/E-raio analysis. Third and las is he Linear Informaion Dynamic model (also called he Felham/Ohlson- or Ohlson model ). This discussion shows ha in pracice, given a cerain inpu of accouning numbers, every model or mehod will produce differen resuls. In fac, he discouned dividend derivaives should, in heory a leas, yield he exac same answer, even hough hey usually don in pracice (Francis e al. 2000 p. 46). This explains why invesmen banks for insance use up o en differen models o esimae he fairness of a akeover bid (Palepu e al. 2004 chp. 7 pg. 1). 1
Table of Conens 1. Inroducion 3 2. Abnormal earnings model 4 2.1 Elemens of he model 5 2.2 Assumpions underlying he model 6 2.3 Equiy valuaion using he AE-model, a numerical example 7 3. Free-cash flow model 12 3.1 Elemens of he free-cash flow model 12 3.2 Comparison of he DCF-based models 15 4. Relaive valuaion mehods 17 4.1 How he mehod works 18 4.2 Pracical issues wih using price muliples 18 4.3 Widely used muliples 19 4.4 Relaive mehods versus discouning-based mehods 20 5. Linear informaion dynamic 21 5.1 Deriving he model 21 5.2 Feaures and advanages of he model 24 5.3 Evidence on he validiy of he model 24 6. Conclusion 25 References 26 Tables and illusraions Figure 1 Financial saemen analysis 8 Table 1 Forecasing assumpions for TJX Company 10 Table 2 Beginning balance shee and income saemen forecass 2002-2012 10 Table 3 Valuaion summary for TJX Company under differen scenarios 11 2
1. Inroducion In March of his year, he ABN Amro Corporaion enered ino akeover negoiaions wih he Briish bank Barclays, in order o avoid being spli up by acivis shareholders led by The Children's Invesmen Fund (TCI). In April, Barclays makes an offer of 36.80 euro per share. An inernaional banking consorium however, makes an offer of 39.00 euro per share a few days laer. In July, he consorium finalizes is bid a 39.05 while Barclays said i was sill considering is final bid. Bu hese companies aren he only ones ha are ineresed in he value of ABN Amro shares. Invesmen banks for insance would also be ineresed in he share s rue value in order o advise heir cliens o eiher buy, hold or sell he sock. Clearly, considering he amouns of money involved, he figures menioned above are more han jus educaed guesses. Bu how do hey arrive a hese numbers? Wha mehod or mehods did hey use? There are many differen mehods and models ha are used o esablish a share s rue value. In fac, mos firms ha analyss work for produce heir own, specialized model. The fac ha here are so many differen models and mehods used o deermine a firm s rue, inrinsic value, seems o indicae ha here is no one perfec model or mehod, and ha each mehod has i s own advanages and disadvanages. The purpose of his paper is wofold: firs, o provide an overview of he differen mehods and models used o value he asses and/or equiy of a firm; and second, o describe he advanages and disadvanages of he differen mehods and models and hen o compare hem o see if here is a bes model or mehod. The quesion ha will be answered is: Wha is he bes model or mehod o deermine he value of a firm s equiy or asses? To his end, he elemens, advanages and disadvanages, and underlying assumpions will be discussed for each of he models and mehods highlighed in his paper. For example, he papers by Penman and Sougiannis (1998), Francis e al. (2000) and Kenon (2005) will be used o discuss and evaluae he discouning-based models. Also, he papers by Lundholm (1995), Felham and Ohlson (1995), DeChow e al. (1999), Clubb (1996), Bernard (1995) and Ahmed e al. (2000) will be used o discuss he model proposed by Ohlson (1995 pg. 668). 3
Furhermore, numerical examples will be provided for several of he models. For insance i will be shown ha, in heory a leas, he hree discouning-based models should yield he same value of he firm s equiy or asses, given he same accouning daa (Francis e al. 2000 p. 46). I will be shown ha, he Abnormal Earnings model has a pracical advanage over oher models (Francis e al. 2000 pg. 69; Penman and Sougiannis 1998 pg. 376-377). The source of his advanage seems o be ha earnings are a beer predicor of value han are cash flows (Francis e al. 2000 pg. 69). I will be argued ha he main appeal of relaive valuaion mehods, such as P/Eraio analysis, is heir ease of use. They however do have heir problems as well, such as problems wih selecing comparable firms. I will also be shown ha he model presened by Ohlson (1995 pg. 668) does show promise, however he evidence on he validiy of he model is no very good. The paper s findings are ha here is no one perfec model or mehod o value equiy or asses, bu ha each have heir meris and ha each are bes suied o be used in specific siuaions. The paper s limiaion however is ha i does no include any empirical daa. For insance, he models described in he paper could be subjeced o empirical esing in order o deermine which is beer a predicing share prices han ohers. Anoher suggesion for fuure research migh be an adapaion of one of he models o see if ha may increase he performance of ha model. Finally, he models presened here migh be used o deermine he value of companies in exreme siuaions, in order o see if cerain models produce beer resuls han ohers in cerain siuaions. For example, companies wih very high or very low profiabiliy, do-com sarups, or companies wih exreme capial srucures (near-all equiy or near-all deb). The paper is srucured as follows: Secion 2 provides an in-deph overview of he abnormal earnings model (see for example Penman and Sougiannis 1998 pg. 350). Secion 3 describes he oher main discouning-based model, namely he discouned free-cash-flow model (see for example Penman and Sougiannis 1998 pg. 349). Secion 4 hen proceeds o discuss relaive valuaion mehods like P/E-raio analysis (see for example McGir 2004 pg. 73). Secion 5 considers a possible alernaive o he oher 4
models and mehods (see for example Ohlson 1995 pg. 668). Lasly, secion 6 provides some concluding houghs. 2. Abnormal Earnings Model As saed above, he discouned abnormal earnings model (from his poin on also referred o as he AE-model ) (see for example Penman and Sougiannis 1998 pg. 350; Francis e al. 2000 pg. 50) is one mehod commonly used o value eiher a firm s equiy or is asses. The oher main discouning-based model considered in his paper, he discouned free-cash-flow model (see for example Penman and Sougiannis 1998 pg. 349; Francis e al. 2000 pg. 49), will be discussed in he nex secion. This secion of he paper will discuss he fundamenal elemens of he AE-model. Then he discussion will shif o he underlying assumpions of he model, including how i is derived from he dividend discoun model (Penman and Sougiannis 1998 pg. 348; Francis e al. 2000 pg. 48), followed by a numerical example of he AE-model. 2.1 Elemens of he model: The discouned abnormal earnings model relaes a firm s abnormal earnings o he value of is equiy or asses (Francis e al. 2000 pg. 50). The model is based on valuaion echniques developed by Preinreich (1938) and Edwards and Bell (1961), and hen furher developed by Ohlson (1995) (as cied by Francis e al. 2000 pg. 49-50). The formula used o deermine value is defined as (Penman and Sougiannis 1998 pg. 350; Francis e al. 2000 pg. 50): Where: V AE = BVE ( 1 r ) = 1 + AE V = The value of he firm s equiy a ime BVE 0 = The beginning book value of equiy a ime = 0 0 + T AE e (1) 5
AE = Abnormal earnings in year r e = The cos of equiy capial 1 Abnormal earnings reflec he difference beween book- and marke value of he equiy of a firm. A socks marke value ( V AE ) can hus be seen as he cos of he firms exising asses (is book equiy) plus he ne presen value of he firms fuure growh opporuniies (he sream of discouned fuure abnormal earnings) (Palepu e al. 2004 ch. 7 pg. 3). Abnormal earnings are defined as follows (Francis e al. 2000 pg. 50): Where: AE AE = Abnormal earnings in year NI = Ne Income in year = NI re BVE 1 r e = The cos of equiy capial BVE 0 = The beginning book value of equiy a ime = 0 The AE-model, along wih he oher wo models described in he nex secion, builds on he noion ha oday s share price is deermined by he expeced fuure payoffs generaed by he share (Francis e al. 2000 pg. 48). (1a) 2.2 Assumpions underlying he model: The main underlying assumpion ha mus be made in order o use he AE-model, is he assumpion of clean surplus accouning. Under his assumpion, all non-capial gains and losses are assumed o flow hrough he income saemen. Also, accouning is assumed o be unbiased, and here is dividend irrelevancy (Kenon 2005 pg. 466). Changes in equiy book value also include capial conribuions and wihdrawals. However, capial ransacions do no affec firm value, because an assumpion of he model is ha new capial is issued a fair value, so ha any incremenal book value increases are exacly offse by he discouned value of fuure dividends o he new shareholders. 1 r is generally compued using he CAPM model: r r + ( r r ) e premium usually se a 5 10% (Palepu e al. 2004 ch. 8 pg. 3 ) e = f β m f, where m f r r is he risk 6
The clean surplus assumpion can also be viewed as he following relaion, called he clean surplus relaion (Francis e al. 2000 pg. 50; Penman and Sougiannis 1998 pg. 348; Kenon 2005 pg. 465): BVE = BVE 1 + NI DIV Where: (1b) BVE = The book value of equiy a ime NI = Ne Income in year DIV = Dividends in year The assumpion is imporan because i is needed o arrive a formula (1) (Kenon 2005 pg. 465). This can be proven wih some simple rearranging of erms (DeChow e al. 1999 pg. 3; Palepu e al. 2004 ch. 7 pg. 2). The dividend discoun model (upon which he AE-model is based), saes ha: Equiy value = Which is analogous wih: PV of expeced fuure dividends Equiy value DIV1 DIV2 = + 2 ( + r ) ( 1 + r ) 1 e e + L (2) Rearranging formula (1b) yields (Palepu e al. 2004 ch. 7 pg. 20): DIV = NI + BVE 1 Subsiuing expression (2a) ino formula (2) yields: BVE (2a) Equiy value NI1 + BVE0 BVE1 NI 2 + BVE1 = + 2 ( + r ) ( 1 + r ) 1 e e BVE 2 + L 7
This can be simplified as (DeChow e al. 1999 pg. 3-4): Equiy value AE ( V ) = BVE 0 + T AE ( 1 r ) = 1 + e (1) 2.3 Equiy valuaion using he AE-model, a numerical example: Now ha he model has been described and is underlying assumpions examined, he quesion can be asked, how he model is used in pracice. Valuaion, or prospecive analysis as i is also called (Palepu e al. 2004 ch. 1 pg. 7), is only a small par of financial saemen analysis as a whole. Financial saemen analysis is imporan because i aemps o derive managemen s inside knowledge of he firm hrough public financial saemens (Palepu e al. 2004 ch. 1 pg. 2). Financial saemen analysis can be broken down ino four seps (Palepu e al. 2004 ch. 1 pg. 7): (1) Business sraegy analysis, (2) accouning analysis, (3) financial analysis and (4) prospecive analysis (he focus of his paper). Figure 1: Financial saemen analysis Source: Palepu e al. 2004 ch. 1 pg. 7 8
Analysis of he firm s business sraegy is he obvious saring poin, since i affecs all aspecs of he firm. This mainly qualiaive analysis includes he idenificaion of key profi drivers and is abiliy o creae and mainain a compeiive advanage. Accouning analysis enails he idenificaion and undoing of accouning disorion. In essence, he purpose here is o assess he degree o which he accouning capures he underlying business realiy. Financial analysis focuses on he curren and pas performance of he firm, and he susainabiliy of ha performance. Cash flow- and raio analysis are imporan and ofen used ools. Finally, prospecive analysis uses he insighs provided by he previous hree seps o synhesize a predicion abou he firm s fuure. This par of he analysis includes he forecasing of a firm s balance shee and income saemen using esimaes of cerain key variables such as sales growh, ne working capial as a proporion of oal asses and ohers. These esimaes are hen cas in a able such as able 1 presened below. The goal of his phase of he analysis is o ge muli-year esimaes of a cerain financial measure, such as free-cash flows, or in his case, abnormal earnings (Palepu e al. 2004 ch. 1 pg. 7-8). A numerical example of how he AE-model would be used in prospecive analysis is given below (see able 1 below). As saed above, he valuaion process sars by making several assumpions abou cerain key variables ha make up he firm s balance shee and income saemen. These esimaes are usually made for 5 o 10 years ino he fuure, saring from he curren year. This is called he forecasing horizon. All he years afer he forecasing horizon are summarized by he erminal value(palepu e al. 2004 ch. 8 pg. 5). The saring poin for he analysis is he projecion of sales growh raes. Then, esimaes of NOPAT margin and several balance shee raios are made, as well as esimaes of he cos of deb and equiy capial. This is all he informaion needed o consruc he forecass of he wo financial saemens which are presened in 2. Table 2 shows a 10 year forecas of he balance shee and income saemen for TJX Company. This able is hen used o compue he variables ha are needed in each of he differen discouning-based valuaion mehods, such as abnormal earnings and free-cash flows (Palepu e al. 2004 ch. 8 pg. 6). 9
Table 1: Forecasing assumpions for TJX Company Source: Palepu e al. 2004 ch. 8 pg. 5 Table 2: Beginning balance shee and income saemen forecass 2002-2012 Source: Palepu e al. 2004 ch. 8 pg. 6 10
Table 3: Valuaion summary for TJX Company under differen scenarios Source: Palepu e al. 2004 ch. 8 pg. 7 Table 3 summarizes he oucome of he analysis under differen scenarios. Also he erminal value is lised here. The final par of he valuaion is o ener each elemen ino he relevan valuaion formula (free-cash flow or AE formula) and hen divide he 11
oucome (oal asse or equiy value) by he number of shares o arrive a he share price (Palepu e al. 2004 ch. 8 pg. 7). One paricular deail ha sands ou is ha each of he mehods used produces he same oucome. Though heoreically his should occur, in pracice however his will almos never happen. This has o do wih he properies of he abnormal earnings o beer capure he value of a company. However, his will be discussed furher in he nex secion of he paper, which will wrap up he discussion of he discouning-based models. 3. Free-Cash Flow model Secion 2 above described he feaures and underlying assumpions of he abnormal earnings model. This secion will consider he oher main discouning-based model, namely he discouned free-cash flow model (Francis e al. 2000 pg. 49; Penman and Sougiannis 1998 pg. 349). This model, along wih he abnormal earnings model, is derived from he same model, namely he dividend discoun model, as described in secion 2.2. This secion will firs discuss he elemens of he free-cash flow model. Included in his discussion will be how he formula is derived from he discouned dividend model. Also provided is a numerical example based on he daa provided in secion 2.3. Lasly, he differen discouning-based models will be compared o each oher, and he advanages and disadvanages will be discussed. 3.1 Elemens of he free-cash flow model: Like he abnormal earnings model, he free-cash flow model is derived from he dividend discoun model. I follows he same paern as he AE-model in ha i forecass a financial measure over a finie horizon (usually 5 10 years), in his case free-cash flows, and hen discouns hese forecass using a relevan discoun rae. A erminal value is also deermined, discouned and hen added o he discouned sream of free- 12
cash flows from he forecasing horizon o arrive a an esimae of firm value (Palepu e al. 2004 ch. 8 pg. 7). The formula for he free-cash flow model used o value equiy is as follows: Equiy value = PV of free-cash flows o equiy claim holders Which equals: Where: V FCF T = FCF = 1 1 equiy ( + r ) e (3) FCF V = The value of he firm s equiy a ime equiy FCF = The free-cash flows o equiy holders in year r e = The cos of equiy capial equiy FCF is defined as (Francis e al. 2000 pg. 49; Penman and Sougiannis 1998 pg. 349): Dividends = Free-cash flows o equiy holders Which equals: FCF equiy = NI Δ BVA + Δ BVND (3a) Where: NI = Ne Income in year Δ BVA = The change in he book value of asses in year Δ BVND = The change in ne deb in year 13
The model can also be used o value a firm s asses. The formula ha needs o be used in his case is (Francis e al. 2000 pg. 49; Penman and Sougiannis 1998 pg. 349): V FCF T = = 1 1 FCF asses ( + r ) wacc (4) Where asses FCF is he free-cash flows o deb- and equiy holders and equals: FCF asses = NOPAT Δ BVA (4a) And r wacc is he weighed average cos of capial, which is defined as (Francis e al. 2000 pg. 49): Where: D E r wacc V V D = Toal marke value of deb ( T ) + re = rd 1 (4b) E = Toal marke value of equiy V = Toal marke value of he firm (i.e. D + E) T = The ax rae r d = The cos of deb capial Valuing a firm s equiy using his model is now prey sraigh forward. The firs sep, making assumpions of key variables from he balance shee and income saemen, is he same as wih he AE-model described above in able 1. These assumpions are hen used o creae forecas balance shees and income saemens for abou 5 10 years, depending on he lengh of he forecasing horizon (see able 2). Table 2 produces forecass of he variable we are ineresed in, which in his case is he free-cash flows o equiy, for each of he years in he forecasing horizon. A erminal 14
value also needs o be deermined in order o complee he analysis (Palepu e al. 2004 ch. 8 pg. 7). Table 3 again summarizes he analysis. One hing o noe is how he erminal value componen is much larger han wih he abnormal earnings model. Also, boh models yield he same resul, a share price of $ 11.91. Subsecion 3.2 will discuss why. 3.2 Comparison of he DCF-based models: Up unil now, 3 differen valuaion models have been discussed: he abnormal earnings model, he dividend discoun model and he free-cash flows model. This subsecion will compare he hree models and describe heir advanages and disadvanages. Since all hree models are based on he same foundaion, no one model can be viewed as being superior o he oher wo. As long as he analys makes he same assumpions abou firm fundamenals, value esimaes will be he same wih all hree models (Francis e al. 2000 pg. 48). Bu each model does esimae a differen aribue, so here mus be some advanages of using one model insead of anoher. These differences fall in hree caegories (Palepu e al. 2004 ch. 7 pg. 14), namely: Focusing on differen issues Differen levels of srucure needed for he analysis Implicaions for erminal value esimaes The dividend discoun model only needs forecass of fuure dividends in order o deermine value. This shouldn be oo difficul, since dividend policy doesn end o change oo radically in he shor run. The oher wo models require exensive, muli-year forecass of key variables from he firm s balance shee and income saemen. Then hey require he consrucion of ables such as hose presened above in secion 2 (Palepu e al. 2004 ch. 8 pg. 6), in order o deermine he forecass of he variables hey acually need o creae an esimae of value. Simply pu, hey require a lo more work han he relaively simple dividend discoun model. Anoher difference beween he approaches is he way in which he erminal value is deermined. Wih he AE-model, he erminal value represens a much smaller 15
proporion of he oal value esimae han wih he oher wo models (see able 3). Since he erminal value is always he hardes par o esimae, i logically follows ha he AE-model has an accuracy advanage over he ohers. This is only rue however, if he beginning book value of equiy is accurae (Palepu e al. 2004 ch. 7 pg. 15). This is due o how he AE-model is srucured. The erminal value of he cash flow and dividend models includes he presen value of all cash flows beyond he forecas horizon. In he AE-model, erminal value only includes he presen value of all abnormal earnings, bu no he presen value of all normal earnings as well 2. The presen value of normal earnings is already represened by he beginning book value of equiy and he growh (if any) of he book value of equiy over he forecas horizon (Palepu e al. 2004 ch. 7 pg. 15). This is a clear advanage since he AE-model assumes ha he accrual process has already done a lo of he valuaion. The free-cash flow model on he oher hand unravels he accruals ino cash flows and hen recreaes is own accruals in he form of discouned esimaes of fuure cash flows (Palepu e al. 2004 ch. 7 pg. 15; Penman and Sougiannis 1998 pg. 377). Therefore, wih he AE-model, he book values of equiy a differen poins in ime need o accuraely represen value. Accouning needs o be unbiased. No one model can be viewed as being superior o he oher wo, since all are based on he same heoreical foundaion. However, recen research has indicaed some advanage o using he AE-model. Francis e al. (2000 pg. 69) find ha, over shorer ime horizons such as 5 10 years, he AE-model produces more accurae forecass and explain more of he variaion in securiy prices han he oher wo models do. They believe i is likely due o he accuracy of book value of equiy as a predicor of value and he greaer precision and predicabiliy of abnormal earnings (Francis e al. 2000 pg. 69). However, hey do conclude ha here is lile o gain from choosing abnormal earnings over free-cash flows or dividends as he fundamenal elemen o be valued (Francis e al. 2000 pg. 69). 2 Which are defined as: r e BVE 1. Since abnormal earnings are defined as he difference beween book- and marke value of he equiy of a firm, which is represened by: NI re BVE 1 (Francis e al. 2000 pg. 50) 16
Penman and Sougiannis (1998 pg. 376-377) also find ha he abnormal earnings model has a pracical advanage over he oher wo. Wih regards o he dividend discoun model his advanage is due o he fac ha dividends need o be forecased ino infiniy. Bu, according o Miller and Modigliani (1961) (as cied by Penman and Sougiannis 1998 pg. 348), he dividend irrelevancy proposiion saes ha price is unrelaed o he iming of expeced payou prior o or afer any finie horizon. This means ha price canno be (fully) explained by forecased dividends over a finie horizon (Penman and Sougiannis 1998 pg. 348). And wih regards o he discouned cash flow model, he advanage he AE-model has is due o he fac ha cash flows seem o leave ou a porion of he value. Tha value does seem o be capured when using he AE-model. I should be noed however ha he cash flow model used in heir analysis is usually modified in pracice so i may resolve he above discussed issue o a cerain exen (Penman and Sougiannis 1998 pg. 377). I has been he auhor s experience ha he AE-model is he easies o use and ha i gives he mos precise esimae of he value of a firm s equiy or asses. The auhor has found he free-cash flow model in paricular difficul o use because of he problems wih deermining he free-cash flows hemselves. The auhor always had difficulies wih deermining which enries on a firm s balance shee should be deduced or added o he free-cash flow. Abnormal earnings are much easier o calculae, since normal earnings are much easier o forecas han oher variables. Based on his, i is he auhor s opinion ha he AE-model has a definie advanage over he oher models. This wraps up he discussion of he discouning based models. The nex wo secions describe wo differen approaches o he valuaion issue, namely: relaive valuaion mehods including P/E-raio analysis and he Felham-Ohlson model. 4. Relaive Valuaion Mehods The models discussed up unil now, he abnormal earnings model and he free-cash flow model, boh have he same common ancesor, namely he dividend discoun model. They all use he same mehod for valuing a firm s asses or equiy. They all use 17
forecass of a paricular financial measure, like abnormal earnings or free-cash flows, hen discoun ha financial measure o arrive a an esimae of firm value. Relaive valuaion mehods use a compleely differen mehod o gain insigh ino asse or equiy value. They are very widely used by analyss and invesors alike do o he fac ha hey are very simple o use (McGir 2004 pg. 73). This secion will begin by discussing how his mehod of valuaion works. Also, several issues wih he mehod are discussed. Then, several widely used mehods are described. 4.1 How he mehod works: Valuaion using muliples is very popular because of he simple fac ha i is relaively easy. The mehod doesn require deailed, muli-year forecass of a hos of differen variables. All ha is needed are he following seps (Palepu e al. 2004 ch. 7 pg. 6): 1. Selec he measure of performance or value as he basis for he analysis 2. Find a group of comparable firms and deermine heir price muliples. 3. Compare hese muliples o he one from he firm ha s being analyzed, or average hese muliples ou and hen compare hem o he firm s muliple. Basically, his approach enails he making of shor- and long erm growh and profiabiliy esimaes, based on he values for comparable firms. This seems prey sraigh forward. All ha is needed are wo ses of numbers for several firms, namely share price and anoher variable such as earnings per share, or oal asses minus inangibles. However, here are several pracical issues ha need o be aken ino accoun when underaking his ype of analysis. 4.2 Pracical issues wih using price muliples: These issues fall ino hree caegories: Problems wih selecing comparable firms, calculaing muliples for firms wih poor performance and adjusmens needed when dealing wih leverage. 18
Using muliples requires ha he performance of one firm be compared o he performance of oher, comparable firms. Bu herein lays a problem. Mos firms operae in muliple indusries, and even if hey don, hey sill differ on hings like growh opporuniies and profiabiliy. The soluion o dealing wih his problem is o average he raios of all firms in an indusry. I is implicily assumed ha his way, he facors ha cause he non-comparabiliy are filered ou. The firm is compared o an average indusry member (Palepu e al. 2004 ch. 7 pg. 6; McGir 2004 pg. 73). Anoher issue arises when using muliples for firms ha are performing poorly, especially when i affecs he denominaor. If earnings are lagging for insance, hen he price-earnings raio will be very high. And if a firm has a ne loss, hen he P/E-raio will be negaive. One way o overcome his problem, when he loss is caused by a oneime wrie-off or a special iem, is o exclude his effec from ne earnings and hen calculae he raio. Anoher way o deal wih his is o simply exclude hese firms from he analysis alogeher (Palepu e al. 2004 ch. 7 pg. 7). I is imporan o preserve consisency beween he numeraor and he denominaor. Someimes his is an issue when he denominaor for example does no ake ino accoun he effec of deb on income. This happens when measures like EBITDA and such are used as he measure of performance insead of ne earnings. The effec of deb on income should always be included in he measure of performance (Palepu e al. 2004 ch. 7 pg. 7). 4.3 Widely used muliples: This subsecion will describe some of he mos widely used muliples. The price earnings raio relaes a company s curren share price wih is earnings-per-share: P / E = Marke price EPS If he raio is high, hen ha means ha invesors expec ha he earnings growh of ha firm will be higher relaive o hose of oher firms wih lower P/E-raios. The raio is usually calculaed using earnings over he las four quarers, his is called he railing 19
P/E-raio. However i is possible o use forecas of EPS in order o calculae he raio, i is hen called a leading muliple (Palepu e al. 2004 ch. 7 pg. 7). Anoher widely used muliple is he price-o-book raio, or P/B-raio. I is defined as: P / B = Marke price BVE per share This raio relaes curren share price o he book value of equiy per share. In oher words, i relaes marke o book values. A lower P/B-raio could indicae ha he sock is undervalued. However, he low raio could also mean ha here is a fundamenal flaw in he company. I also indicaes wheher an invesor is paying oo much for he equiy if he firm goes bankrup a his momen (Pra 2001 pg. 44). 4.4 Relaive mehods versus discouning-based mehods: So far, wo broad caegories of valuaion mehods have been discussed: he discouning-based models and he relaive valuaion measures. The main difference beween he wo is how hey work. Discouning-based models use forecas and hen discoun hose o arrive a an esimaed share price. Relaive measures jus give indicaions ha shares are eiher over- or undervalued. They don give a precise esimae of share price. Wha relaive measures do have working for hem, is heir simpliciy. The discouning-based models all require abou wo o hree full pages of spreadshees. In order o use relaive measures, you jus need wo variables for a number of companies. The las secion will discuss he Ohlson (1995) model. This model was presened as a possible alernaive o he oher models and mehods described in his paper. 20
5. Linear Informaion Dynamic The las secion of he paper will discuss he model ha Ohlson proposed (Ohlson 1995 pg. 668) and was presened as a possible alernaive o oher mehods of valuaion. As will be shown below, he premise of his model was ha valuaion could be based on curren numbers, hus eliminaing he need for muli-year forecass of financial measures, and especially eliminaing he need for a erminal value esimae, which is always he mos uncerain par of he analysis (Palepu e al. 2004 ch. 8 pg. 7). The appeal of his model is obvious: i has he simpliciy of raio analysis and he accuracy of fundamenal analysis, since, as will be shown, one using he model only needs a forecas of earnings o make i work (DeChow e al. 1999 pg. 6 7). However as he discussion will show, he evidence unforunaely isn very posiive abou he model. The discussion will proceed as follows. Secion 5.1 will describe how he model is derived. The discussion hen proceeds o highligh he main feaures of he model and is advanages over oher models. Lasly, secion 5.3 will presen he evidence on he validiy of he model. 5.1 Deriving he model: Basically he model ha Ohlson describes in his aricle is a logically consisen frameworks for hinking abou he valuaion of accouning numbers (as cied by Lundholm 1995 pg. 749). Deriving he model sars wih he following equaions: τ P = R f E ( d + τ ) (5) τ = 1 y And: = y 1 + x d (5a) 21
Formula (5) is he dividend discoun model where: P = Ex-dividend equiy price a dae d = Dividends in year R f = Risk free reurn (is he discoun rae) And formula (5a) is he clean surplus relaion where: y = Equiy book value a ime x = Ne Income in year d = Dividends in year He hen arrives a he abnormal earnings model by combining he wo formulas above: P [ x R 1) y ] τ = y R f E + τ ( f + τ 1 τ = 1 (5b) Since abnormal earnings are equal o he las par of equaion (5b): a x + τ = x + τ ( Rf 1) y + τ 1 (5c) So rewriing (5b) yields: P = y τ = 1 R τ f E a [ x ] + τ (5d) Which is he abnormal earnings model presened above in secion 2. The discussion hen proceeds o inroduce a feaure of he new model ha Ohlson (1995) proposes, called he linear informaion dynamic: 22
x a a + τ = ω x + v + ε1 +1 (6) v And: + 1 = γ v + ε 2 + 1 (6a) Where: ω and γ = Known parameers beween 0 and 1 γ = Ne Income in year v = Oher, non-accouning informaion Linear informaion dynamics links abnormal earnings o non accouning informaion. I saes ha boh abnormal earnings and oher informaion are auoregressive, which is illusraed by he fac ha ω and γ boh have values beween 0 and 1. ω and γ represen he persisence of respecively earnings and oher informaion (DeChow e al. 1999 pg. 6). If he LID-assumpion is combined wih equaion (5d) hen he valuaion model as proposed by Ohlson (1995) becomes: a P = y + α 1x + α2 v α 2 = α 1 = Wih: ω ( 1 + ω) And: R f ( 1 + R f ) [( 1 + R ω)( 1 + R γ )] f f So all ha is needed in order o use his model is: curren abnormal earnings, which can easily be calculaed; a measure of oher informaion ; and figures for ω andγ. 23
The oher informaion can be esimaed from analyss forecass as DeChow e al. show in heir paper (DeChow e al. 1999 pg. 6 7). All ha is needed now are figures for ω andγ. This is wha DeChow e al. (1999) do in heir paper. They find ha ω has an approximae value of 0.62 (DeChow e al. 1999 pg. 16). andγ has an approximae value of 0.32 (DeChow e al. 1999 pg. 20). Wih hese esimaes, i is now possible o use he model. 5.2 Feaures and advanages of he model: Now ha he model has been derived, is feaures and advanages can be discussed. The mos sriking feaure is ha he analysis does no require an esimae of he erminal value, which is usually he mos uncerain par of he analysis (Palepu e al. 2004 ch. 8 pg. 7). This means ha, in heory, he model should be beer a esimaing securiies prices han analyss would be. Secion 5.3 however will show ha his is probably no he case. Anoher feaure is he fac ha all he forecass ha are needed are hose of fuure normal earnings, which is amongs he mos widely forecas variables and should be readily available. Wih hese esimaes, oher informaion v can be esimaed. All ha is needed now is curren abnormal earnings, which can be easily calculaed and hen he model is ready o be used (DeChow e al. 1999 pg. 6 7). The main advanage of he Ohlson (1995) model is ha exensive forecass of several variables are no longer needed. Forecass are always accompanied by uncerainy, so his model should produce more accurae esimaes of value han oher models (Palepu e al. 2004 ch. 8 pg. 7). However, as secion 5.3 will show, his is, in pracice, no exacly he case. 5.3 Evidence on he validiy of he model: DeChow e al. for insance find in heir sudy ha analyss forecass are acually more accurae han he models predicions abou securiies prices (DeChow e al. 1999 pg. 22). Their sudy indicaes ha he model ranks behind analyss forecass. 24
Ahmed e al. find some suppor for he model in heir paper (Ahmed e al. 1996 pg. 291), bu only under cerain circumsances. They only find suppor for he model for firms wih high profiabiliy. They also sugges ha fuure research should focus on idenifying oher facors where he Ohlson (1995) model bes describes marke value. They sugges firm life cycle, growh and produciviy of asses as possible oher facors. Bernard suggess ha while he model may seem primiive, i does show promise (Bernard 1995 pg. 745). He describes he sudy by Ohlson as offering a heoreical grounding moving research away from price explanaion as he dominan paradigm and oward research designs buil around he predicion of fundamenals such as earnings. Clubb (1996) finds ha, The usefulness of he Felham-Ohlson (1995) model in relaion o capial marke research lies in is conribuion o a clearer undersanding of he facors affecing he form of he relaionship beween share prices and accouning daa (Clubb 1996 pg. 335). To summarize, he model is viewed as showing promise, meaning ha wih more research i could be a useful conribuion o he valuaion issue. 6. Conclusion In his paper, several differen models and mehods used for he valuaion of sock or asses have been discussed. The abnormal earnings model (see for example Penman and Sougiannis 1998 pg. 350) was discussed in secion 2 and i was shown how ha model can be derived from he dividend discoun model (Penman and Sougiannis 1998 pg. 348; Francis e al. 2000 pg. 48) given a cerain assumpion, he clean surplus relaion. The free-cash flow model (see for example Penman and Sougiannis 1998 pg. 349) was also discussed. The paper showed ha i, alhough i along wih he abnormal earnings model are boh derived from he dividend discoun model, was less accurae han is earnings-based counerpar. Reasons given for his were ha book value of equiy was a beer predicor of value and he greaer precision and predicabiliy of abnormal earnings over cash flows. 25
Then he discussion urned o relaive valuaion mehods. Several differen muliples were discussed, namely he P/E-raio and he value-o-book raio, and also how o use hem. Also discussed where he differences beween he discouning models and he muliples mehod. The Ohlson (1995) model was discussed las. The paper showed how he model was derived, and wha is underlying assumpions were. Then he discussion urned o is feaures and is advanages over he discouning models. Finally, he evidence on he validiy of he model was discussed, and alhough viewed as promising, he model sill needs o be furher researched. I is clear from he discussion above, ha here is no perfec model or mehod ha bes describes he value of a firm s equiy or asses. I is he auhor s view ha each model or mehod has is meris, and some work beer in cerain siuaions han ohers. Tha is no o say ha some models don have pracical advanages over he ohers. The AE-model for insance has a pracical advanage over he oher discouning models due o he fac ha i is based on accrual accouning. Areas for fuure research include finding more evidence on he validiy of he Ohlson (1995) model. Also, field work comparing he discouning models and he Ohlson (1995) model could be done. Finally, i should be noed ha, since mos of he models and mehods illusraed in his paper use forecass of cerain variables, he oucome of each model is only as good as he forecass and assumpions underlying hem. References Ahmed A. S., R. M. Moron, T. F. Schaeffer. 2000. Accouning Conservaism and he Valuaion of Accouning Numbers: Evidence on he Felham-Ohlson (1996) Model. Journal of accouning, audiing & finance 15: 271-292 Bernard V. L. 1995. The Felham-Ohlson framework: Implicaions for empiriciss. Conemporary accouning research 11: 733-748 26
Clubb C. D. B. 1996. Valuaion and clean surplus accouning: some implicaions of he Felham and Ohlson model for he relaive informaion conen of earnings and cashflows. Conemporary accouning research 13: 329-338 Dechow, P. M., A. P. Huon, and R. G. Sloan. 1999. An Empirical Assessmen of he Residual Income Valuaion Model. Journal of Accouning and Economics 26: 1-34 Felham G. A., J. A, Ohlson. 1995. Valuaion and clean surplus accouning for operaing and financial aciviies. Conemporary accouning research 11: 689-732 Francis J., P. Olsson and D. R. Oswald. 2000. Comparing he Accuracy and Explainabiliy of Dividend, Free Cash Flow, and Abnormal Earnings Equiy Value Esimaes. Journal of Accouning Research 38: 46-70 Kenon K. Yee. 2005. Aggregaion, dividend irrelevancy and earnings-value relaions. Conemporary Accouning Research 22: 453-480 Lundholm, R. J. 1995. A uorial on he Ohlson and Felham/Ohslon models: Answers o some frequenly asked quesions. Conemporary accouning research 11: 749-762 McGir, E. 2004. The ruh abou P/E. Money 33: 73-73 Ohlson, J. A. 1995. Earnings, book values and Dividends in equiy valuaion. Conemporary accouning research 11: 661-687 Palepu K. G., P. M. Healy, V. L. Bernard. 2004. Business Analysis & Valuaion. 3d ed. Mason, OH: Thomson Souh-wesern Penman, S. H. and Sougiannis, T. 1998. A comparison of dividend, cash flow and earnings approaches o equiy valuaion. Conemporary Accouning Research 15: 343-383 Pra, M. K. 2001. Price-o-earnings raio. Compuerworld 35: pg. 44 27