Mini Case Assignment 7

Mini Case Assignment 7 - CEG GSB 703 Mini Case Assignment...

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CEG GSB 703 Mini Case Assignment #7 Adam Ohanesian Email: Adam.Ohanesian@nichols.edu Table of Contents I. Joe Watts quote a. Valuing earnings b. Accounting based valuation c. Back-of-envelope II. Why terminal values are lower than DCF valuation a. Compare and contrast III. Markets expectation of long-term ROE IV. Stock price if ROE is 20 percent V. Impact on market-to-book ratio VI. How can high ROE have low PE ratio VII. Types of companies have the following a. b. c. d. VIII. a. Which affect free cash flows to debt and equity holders
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b. Which affect free cash flows to equity alone c. Why and how IX. Starite Company implied cost of equity capital X. Comment regarding Janet Stringer’s statement 1. Joe Watts, an analyst at EMH Securities states: “I don’t know why anyone would ever try to value earnings. Obviously, the market knows that earnings can be manipulated and only values cash flows.” Discuss. Valuing earnings is an alternative way of valuing a company even if earnings can be manipulated. Note that, with an infinite forecast horizon, the valuation based on discounted abnormal earnings delivers exactly the same estimate as DCF-based methods, even if there is earnings manipulation. The estimated values using accounting-based valuation are not affected by accounting choices because of the self correcting nature of double entry bookkeeping. Current period earnings can be manipulated, but the values estimated with accounting based valuation are not to be manipulated. However, with finite horizons, earnings manipulation can affect value unless the analyst recognizes and undoes the manipulation. Also, when accounting data is used to forecast cash flows, even a DCF valuation is potentially vulnerable to accounting manipulation. There are two practical advantages to valuing earnings. First, accounting based valuation, using earnings, frames the valuation task differently and can immediately focus the analyst’s attention on the key measure of performance such as ROE and its components. Second, if it is more natural to think about future performance in terms of accounting returns, and if the analyst faces a context where a “back-of-envelope” estimate of value would be of use,
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the accounting based technique can be simplified to deliver such an estimate. “Shortcut” estimates are useful in a variety of contexts where the cost and time involved in a detailed DCF
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Mini Case Assignment 7 - CEG GSB 703 Mini Case Assignment...

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