Web3ch6 - CHAPTER SIX Accrual Accounting and Valuation:...

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CHAPTER SIX Accrual Accounting and Valuation: Pricing Earnings Stephen H. Penman The web page for Chapter Six runs under these headings: What this Chapter is Doing A Summary of the Simple Demonstration of Valuation Methods The Key Ideas Behind Abnormal Earnings Growth Valuation The Trailing P/E and the Forward P/E The Normal P/E Lessons from the Savings Account: Why Capitalizing Forecasted Earnings Works for a Savings Account Lessons from the Savings Account: Dividend Irrelevance Lessons from the Savings Account: Detecting Value Added A Bad Earnings Growth Model A Comparison of AEG Valuation and Residual Earnings Valuation: Maytag Corporation A Demonstration of AEG Valuation and Reverse Engineering: Dell Computer Corporation Two Ways of Thinking About Normal Earnings Growth Dividends, Share Issues and Share Repurchases A Spreadsheet Program to Develop an Abnormal Earnings Growth Valuation Using P/E Ratios in the Method of Comparables The Greenspan Model P/E Ratios and Interest Rates

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P/E Ratios and Inflation Readers’ Corner What this Chapter is Doing One way of approaching fundamental analysis is to ask how much per dollar of an observed fundamental one should pay. That is, what is the multiplier that one should apply to a fundamental number to calculate equity value? Or, having anchored on a number, what is the extra value that determines the multiple? This question requires that we first identify appropriate fundamentals to which we might apply a multiplier. Would dividends be a good thing to multiply? Might we ask what multiple of the current dividend is the equity worth? Well, Chapter 3 convinced us that the answer is NO. The amount of payout has little to do with the value generation: many very successful firms (Cisco, for example) do not pay dividends. Indeed, the higher the dividend the lower the price, because dividends reduce (ex-dividend) prices. Should we try to calculate free cash flow multipliers? NO, again, for Chapter 4 showed us that many successful firms (like Wal-Mart and Home Depot) generate negative free cash flow. Indeed, because cash investment reduces free cash flow but (usually) creates value, we might pay more for a firm the lower its free cash flow. Chapter 5 showed how to value the bottom line of the balance sheet, the book value of owners’ equity. This chapter shows how to value the bottom line of the income statement, the earnings. Thus, while Chapter 5 shows how to calculate the intrinsic price-to-book ratio (P/B), this chapter shows how to calculate the intrinsic price-earnings (P/E) ratio. In Chapter 1, we depicted valuation as anchoring on a particular fundamental, then adding extra value: Value = Anchor + Extra Value In Chapter 5, the anchor is the book value of common equity (net assets): Value = Book Value + Extra Value In this chapter, the anchor is (trailing or forward) earnings: Value = Earnings + Extra Value
Book value is a stock of value, but earnings are a flow from the stock (of net assets). A flow is converted to a stock equivalent by capitalizing the flow at the required rate of

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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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Web3ch6 - CHAPTER SIX Accrual Accounting and Valuation:...

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