\u03c1 RE \u03c1RE B V Ingredients of the Model For finite horizon forecasts we need

Ρ re ρre b v ingredients of the model for finite

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ρ RE ρ RE B V
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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
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Return on Common Shareholders’ Equity (ROCE) 5-13 t t t-1 Comprehensive earnings to common ROCE Book value
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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
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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
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P/B, ROCE and Growth in Book Value 5-16 ROCE and Growth in BV will change RE. Higher P/B = Higher RE
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ROCE and P/B Ratios: S&P 500, 2010 5-17
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ROCE Over the Years 5-18
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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
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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
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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
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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
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Forecasting Residual Earnings: Nike, Inc. Case 3: Growing RE after T 5-23
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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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