When constrained to using only prior earnings data a

when constrained to using only prior earnings data, a reasonable forecast of earnings for
quarter t includes the following elements:
- The earnings of the comparable quarter of the prior year (Q
t-4
)
- a long-run trend in year-to-year quarterly earnings increased (δ)
- a fraction (φ) of the year-to-year increase in quarterly earnings experienced most
recently (Q
t-1
– Q
t-5).
For most firms the parameter tends to be in the range of 0,25 to 0,5, indicating that 25 to 50
percent of an increase in quarterly earnings tends to persist in the form of another increase in
the subsequent quarter. The parameter reflects in part the average year-to-year change in
quarterly earnings over past years, and it varies considerably from firm to firm.
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Chapter 7:
Prospective Analysis: Valuation Theory and Concepts
This chapter focuses on valuation theory and concepts. Valuation is the process of converting
a forecast into an estimate of the value of the firm's assets or equity. Investment bankers
commonly use five to ten different methods of valuation: discounted dividends; discounted
cash flow analysis (DCF); Discounted abnormal earnings, discounted abonormal earnings
growth; valuation based on price multiples. In this chapter valuation is illustrated using an all-
equity firm to simplify the discussion.
Defining value for shareholders
Shareholders receive cash payoffs from a company in the form of dividends, the value of their
equity is the present value of future dividends
r
e
= cost of equity capital
If a firm had a constant dividend growth rate (g
div
) indefinitely, its value would simplify to the
following formula:
The above valuation formula is called the dividend discount model. The dividend discount
model is not a very useful valuation model in practice. This is because equity value is created
primarily through the investment and operating activities of a firm. Within a period of five to
ten years, which tends to be the focus of most prospective analyses, dividends may therefore
reveal very little about the firm's equity value.
The discounted cash flow model
The value of an asset or investment is the present value of the net cash payoffs that the asset
generates. This model is the sum of the free cash flows to debt and equity holders discounted
at the weighted average cost of debt and equity (WACC).
Asset value = PV of free cash flows to debt and equity claim holders =
OCF
1
- Investment
1
/ (1+WACC) + OCF
2
- Investment
2
/ (1+WACC)
2
+ ...
OCF=PV of cash flows generated by the assets
The cash flows that are available to equity holders are the cash flows generated by the firm's
net assets minus capital outlays, adjusted for cash flows from and to debt holders, such as
interest payments, debt repayments and debt issues. Capital outlays are capital expenditures
less asset sales. Finally, net cash flows from debt owners are issues of new debt less
retirements less the after-tax cost of interest.