ρ
RE
ρ
RE
B
V

Ingredients of the Model
For finite horizon forecasts we need three ingredients,
besides the cost of capital:
1. The current book value
2. Forecasts of residual earnings to horizon
3. Forecasted premium at the horizon
Component 3 is called the continuing value
(1)
(2)
(3)
5-12
T
E
T
E
T
T
E
T
2
E
2
E
1
0
E
0
ρ
B
V
ρ
RE
.....
ρ
RE
ρ
RE
B
V

Return on Common Shareholders’ Equity (ROCE)
5-13
t
t
t-1
Comprehensive earnings to common
ROCE
Book value

Alternative Measure of Residual Earnings
Residual earnings is the rate of return on equity, ROCE, expressed as a dollar excess
return on equity rather than a ratio. But it can be expressed in ratio form:
5-14
Book value
Spread
ROCE
RE
1
1
1
1
t
E
t
t
E
t
B
ROCE
B
Earnings

Drivers of Residual Earnings
Two Drivers:
1. ROCE
•
If forecasted ROCE equals the required return, then RE will be zero,
and V = B
•
If forecasted ROCE is greater than the required return, then V > B
•
If forecasted ROCE is less than the required return, then V < B
2.
Growth in book value (net assets) put in place to earn the ROCE
RE will change with change with ROCE and growth in book value
5-15

P/B, ROCE and Growth in Book Value
5-16
ROCE and Growth in
BV will change RE.
Higher P/B = Higher
RE

ROCE and P/B Ratios: S&P 500, 2010
5-17

ROCE Over the Years
5-18

Steps for Applying the Model
1.
Identify the book value in the most recent balance sheet.
2.
Forecast earnings and dividends up to a forecast horizon.
3.
Forecast future book values from current book values and your
forecasts of earnings and dividends.
4.
Calculate future residual earnings from the forecasts of earnings and
book values.
5.
Discount the residual earnings to present value.
6.
Calculate a continuing value at the forecast horizon.
7.
Discount the continuing value to the present value.
8.
Add 1, 5, and 7.
5-19
T
E
T
E
T
T
E
T
2
E
2
E
1
0
E
0
ρ
B
V
ρ
RE
.....
ρ
RE
ρ
RE
B
V

The intrinsic price-to-book ratio
(P/B) is $133.71 / $100 = 1.34.
BV = 100+12.36-9.36
RE =( (12.36/100) – 0.1)*100

Buying
Residual
Earnings:
Flanigan’s
Enterprises
Inc. Case 1:
Zero RE after
the Forecast
Horizon
5-21
ROCE = 0.73/3.58
V
B
PV of RE f
E
0
0
or T periods
95
.
0
58
.
3
53
.
4
0
E
V
0
)
(CV
Value
Continuing
T

Forecasting
Residual
Earnings:
General
Electric Case 2:
Constant
RE
after the
Forecast
Horizon
(Constant RE: no growth)
=
5-22
48
.
5
27
.
3
32
.
4
07
.
13
0
E
V
1
RE
CV
E
1
+
T
T
82
.
8
10
.
0
882
.
0

Forecasting
Residual
Earnings:
Nike, Inc.
Case 3:
Growing
RE
after T
5-23

Continuing Values are Speculative
The continuing value is the most speculative part of the valuation. Be careful not
to add speculation.
Anchor on what you know: Cases 1, 2, and 3 use growth rates in years prior to
the continuing value year for an estimate of the long-term growth rate.
Might we also use the GDP historical GDP growth rate (something else we
know)? See later.
Financial statement analysis (in Part Two of the book helps in the determination
of the growth rate).

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