WEEK 10 .pptx - Financial Statement Analysis and Security...

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Financial Statement Analysis and Security Valuation Pricing Book Values May 3, 2018
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What You Will Learn From This Chapter What “ residual earnings ” is How forecasting residual earnings gives the premium over book value and the P/B ratio What is meant by a “normal price-to- book ratio” How residual earnings are driven by return on common equity (ROCE) and growth in book value How residual earnings valuation protects the investor from paying too much for earnings added by investment 5-2
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Price-to-Book Ratio The value of the shareholders’ investment – and the value of the net assets- is based on how much the investment is expected to earn in the future. P/B ratio: the higher the expected earnings relative to book value, the higher the P/B ratio. The rate of return on book value, or profitability, is a measure that features in the determination of P/B ratio. P/B ratios should increase only if earnings from investment yield a return that is greater than the required return on book value.
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The Big Picture for the Chapter Value = Anchor + Extra Value The Anchor is Book Value: Value = Book Value + Extra Value The Principle for adding extra value to book value: Add extra value if the rate of return of book value is expected to be greater than the required return 5-4
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Valuing a One-Period Project (1) 5-5 Investment $400 Required return 10% Revenue forecast $440 Expense forecast $400 Forecasted earnings $40 Residual earnings 1 = earnings 1 – (required return x investment) = 40 (0.10 x 400) = 0 Value = 400 + 0/1.10 This is a Zero-residual earning (RE) project = 400 DCF Valuation: Discount cash flow (s c h p d n nhà đ u t ) ư 400 10 . 1 440 V
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Valuing a One-Period Project (2) Investment $400 Required return 10% Revenue forecast $448 Expense forecast 400 Earnings forecast $ 48 The project adds value 5-6 1 Residual earnings 48 - (0.10 x 400) = 8 8 Value Project 400 407.27 1.10 27 . 407 1.10 448 value DCF
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Valuing a Savings Account (or stock) p.143 Value = Book Value + Present Value of Residual Earnings = 100 + 0 = 100 Forecast Year ________________________________________ 2012 2013 2014 2015 2016 2017 Earnings withdrawn each year (full payout) Earnings 5 5 5 5 5 Dividends 5 5 5 5 5 Book value 100 100 100 100 100 100 Residual earnings 0 0 0 0 0 ______________________________________________________________________________________ No withdrawals (zero payout) Earnings grows 5% (required rate of return) every year Earnings 5 5.25 5.51 5.79 6.08 Dividends 0 0 0 0 0 Book value 100 105 110.25 115.76 121.55 127.63 Residual earnings 0 0 0 0 0 ______________________________________________________________________________________ 5-7 Required rate=5% t t t t d ea rn B B  1
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Lessons from the Savings Account 1. An asset is worth a premium or discount to its book value only if the book value is expected to earn non- zero residual earnings. 2. Residual earnings techniques recognize that earnings growth does not add value if that growth comes from investment earning at the required return.
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