Accrual Accounting and Valuation: Pricing Earnings

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Accrual Accounting and Valuation Pricing Earnings
Chapter 6
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Accrual Accounting at Valuation Pricing Earnings
Chapter 5 showed how to price book values in
the balance sheet and calculate intrinsic
price-to-book ratios.
Link to previous chapter
This chapter shows how to price earnings in
the income statement and calculate intrinsic
price-earnings ratio
This Chapter
How are price-earnings ratios determined?
How does the analyst infer the markets forecast
of earnings growth?
How do valuation methods protect the investor
from paying too much for earnings growth?
How is the firm valued from forecasts of earnings
growth? When should an investor not pay for
growth?
Chapter 7 begins the financial statement
analysis that is necessary to carry out the
price-to-book and price- earnings valuations
discussed in Chapters 5 and 6
Link to next chapter
Link to web page
The web page has more applications of the
techniques in this chapter
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What You Will Learn From This Chapter

• What abnormal earnings growth is.
• How forecasting abnormal earnings growth yields
  the intrinsic P/E ratio.
• What is meant by a normal P/E ratio.
• The difference between ex-dividend earnings
  growth and cum-dividend earnings growth.
• The difference between a Case 1 and Case 2
  abnormal earnings growth valuation.
• The advantages and disadvantages of using an
  abnormal earnings growth valuation and how the
  valuation compares with residual earnings
  valuation.
• How dividends, share issues, and share
  repurchases affect abnormal earnings growth.
• That abnormal earnings growth is equal to the
  change in residual earnings
• How abnormal earnings growth valuation protects
  the investor from paying too much for earnings
  growth.
• How abnormal earnings growth valuation protects
  the investor from paying for earnings that are
  created by accounting methods.

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The Concept Behind the P/E Ratio

• Price in numerator of P/E is based on expected
  future earnings
• Earnings in denominator is current (or forward)
  earnings
• P/E is thus based on expected growth in earnings
• Compare with price-to-book
• P/B is based on expected earnings relative to
  current book value (ROCE)
• ROCE is growth in book value
• P/B is based on expected growth in book value

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Beware of Paying Too Much for Earnings Growth

• Investment creates growth but does not
  necessarily
• add value
• Earnings growth can be created by the accounting

We need a valuation method to protect us from
paying too much for earnings growth
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Reminder Residual Earnings Valuation Protects
You From Paying Too Much For Earnings

• Earnings from new investment is charged with the
  required return on investment
• Residual earnings before new investment 10
  hurdle rate
• RE 12 (0.10 x 100) 2 (ROCE 12)
• Residual earnings after new investment of 20
  million earning at 10
• RE 14 (0.10 x 120) 2
• No value added from new investment
• Creating earnings by accounting methods increases
  residual earnings but reduces book value. The
  net effect is zero. See Chapter 5.
• A P/E model must also protect you from paying too
  much for earnings growth.

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The Prototype Savings Account
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The Trailing P/E and Forward P/E
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Cum-Dividend Earnings
The two accounts have different (ex-dividend)
earnings growth, but the same cum-dividend
earnings growth
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Normal Earnings

• Normal Earnings is earnings growing at the
  required rate of return

1.05 x 5.00 5.25
5.5125
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Abnormal Earnings Growth (AEG)

• Abnormal Earnings Growth is growth over normal
  earnings growth
• AEG Cum-dividend earnings Normal earnings
• For the Savings account

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Lessons from the Savings Account

• 1. An asset is worth capitalized forward earnings
  if abnormal earnings growth is expected to be
  zero.
• 2. An asset has a normal P/E ratio if abnormal
  earnings growth is expected to be zero.
• 3. Earnings comes from two sources
• earnings from the asset
• earnings from reinvesting dividends
• 4. Dividends do not affect cum-dividend earnings
• 5. Dividends do not affect value.

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A Bad P/E Model

• Does not work for a savings account!

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A Model of the Forward P/E

• Value of savings account Capitalized forward
  earnings
• No
  extra value
• Extra value is added if (cum-dividend) earnings
  are expected to grow
• at a rate greater than the required return
• The model

Value of equity capitalized forward earnings
extra value for abnormal
earnings growth
The intrinsic P/E
is given by dividing through by Earn1
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Measuring Abnormal Earnings Growth for Equities
Abnormal earnings growtht (AEGt) cum-dividend
earnt - normal earnt
earnt (?E 1) dt-1 ?Eearnt-1
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Alternative Calculation of AEG

• Abnormal earnings growtht Gt ?E x
  earningst-1
• Where
• Gt Cum-dividend earnings growth rate (plus one)
• For Nike
• G2002 2.528/2.18 1.1596 ( a 15.96 growth
  rate)
• AEG2002 1.1596 1.10 x 2.18
• 0.130

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Applying the Model

• Forecast one-year-ahead earnings.
• Add the present of value (at the end of the year
  1) of expected abnormal earnings growth for year
  two ahead and onwards
• Capitalized the total of forward earnings and the
  value of abnormal earnings growth.

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Applying the Model
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Applying the Model An Example

• Forecast for a firm with expected earnings growth
  of 3 percent per year
• (in dollars). Required return is 10 per year.

Residual earnings valuation
AEG valuation
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A Case 1 Valuation Wal-Mart
Wal-Mart Stores, Inc. In this case, abnormal
earnings growth is expected to be zero after 1996
Same valuation as RE model
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A Case 2 Valuation General Electric
General Electric Co. In this case, abnormal
earnings growth is expected to grow at a 6
percent rate after 1992
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Converting an Analysts Forecast to a Valuation
Nike Inc.
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Abnormal Earnings Growth is Equal to the Change
in Residual Earnings
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Protection From Earnings Created by Accounting A
Restructuring Charge
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Abnormal Earnings Growth Analysis
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Reverse Engineering Nike

• Nike trades at 57 (in 2003)
• g 1.044 (a 4.4 growth rate)
• Convert growth in AEG to an earnings forecast for
  2005

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The Greenspan Model

• If Earnings Yield is less than 10-year treasury
  note yield,
• stocks are overpriced
• In 1998 irrational exuberance speech
• Treasury yield 5.60 (P/E 17.86)
• Earnings yield 4.75 (P/E 21.05)
• A good model?
• Different risk for bonds and stocks
• ? P/E should be higher for bonds (and earnings
  yields lower)
• Stocks deliver AEG, bonds do not
• ? P/E can be higher for stocks (and earnings
  yields lower)

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P/E Ratios and Interest Rates
Median P/E ratios and interest rates (in
percentages) on one-year Treasury bills
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The PEG Ratio

• PEG RATIO P/E
• 1-year ahead percentage earnings
  growth
• Does it work as a screen?