Web3ch5 - CHAPTER FIVE Accrual Accounting and Valuation:...

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CHAPTER FIVE Accrual Accounting and Valuation: Pricing Earnings Stephen H. Penman The web page for Chapter Five runs under the following headings: What this Chapter is Doing The Key Ideas Behind Residual Earnings Valuation Lessons from the Savings Account: Applying the Residual Earnings Model in a Case Where There is No Premium Lessons from the Savings Account: Dividend Irrelevance Lessons from the Savings Account: Detecting Value Added More on Dividend Irrelevance Getting Analysts’ Forecasts from the Web Analysts Forecasts and Residual Earnings Valuation: Hewlett Packard Target Prices A Reverse Engineering Exercise: Kimberley Clark The Terminal Value for the Dividend Discount Model Another Reverse Engineering Example A Spreadsheet Program to Develop a Residual Earnings Valuation Readers’ Corner What this chapter is Doing Chapter 5 and Chapter 6 are the conceptual heart of the book. The valuation models laid out in these two chapters provide the platform on which most of the rest of the book is built. The book deals with analysis and valuation; the valuation models here instruct us how to analyze and value firms.
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A valuation model, remember, is not just a guide to calculating value, it is a way of thinking about a business and how a business generates value. The model in this chapter depicts business activity as investing in net assets (recorded in book value) and employing those assets to produce a return. If the rate of return on the book value is greater than the required return, value is added to the recorded book value. In Chapter 1, we depicted valuation as anchoring on a particular fundamental, then adding extra value: Value = Anchor + Extra Value In this chapter, the anchor is the book value of common equity (net assets): Value = Book Value + Extra Value This type of valuation applies to any asset – to equities and bonds -- and to valuing projects and strategies (as the chapter shows). As bonds and projects are terminal investments, discounted cash flow analysis suffices. But for going-concern equities and strategies, the advantages of accrual accounting are desired, and the valuation in this model relies on accrual accounting. The Key Ideas Behind Residual Earnings Valuation The financial statements present three “bottom line” numbers, the free cash flow (in the cash flow statement), the book value (in the balance sheet), and earnings (in the income statement). Chapter 4 explained why we might not focus on the free cash flow. But we can focus on book value and earnings. The focus in this chapter is on pricing the book value, that is, on determining the multiplier (the P/B ratio) to apply to book value to get the value. In Chapter 6 our focus will move to the pricing of earnings, that is, to determining the multiplier to apply to earnings (the P/E ratio) to get value. Book value is a natural starting point to value the equity. After all, it is a measure of the
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This note was uploaded on 10/07/2010 for the course ECTCS ec12947322 taught by Professor Johnathayeri during the Spring '10 term at Life.

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Web3ch5 - CHAPTER FIVE Accrual Accounting and Valuation:...

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