1. Lectures 3 and 4Lectures 3 and 4
Multi-period valuation models: Cash Flow and Accrual Based
Valuation
Textbook reading:
Ch. 4, 5, 6 & 7 from Penman.
Paper:
• Francis J., Olsson P. and Oswald D. (2000). Comparing the Accuracy and
Explainability of Dividend, Free Cash Flow, and Abnormal Earnings Equity
Value Estimates. Journal of Accounting Research. Vol. 38 (1), pp. 45-70.
• Ohlson J. (1995). Earnings, Book Values, and Dividends in Equity Valuation.
Contemporary Accounting Research. Vol. 11, No. 2 (spring), pp.661-687.
• Demirakos E., Strong N., and Walker M. (2010). Does Valuation Model
Choice Affect Target Price Accuracy? European Accounting Review. Vol. 19
(1), pp.35-72.

2. Cash Flow Based Valuation ModelsCash Flow Based Valuation Models
d1 d2 d3 d4 d5
Dividend
Flow
1 2 3 4 50
TVT
T
d T
Equity
The terminal value, TVT is the price payoff, PT when the share is sold
Valuation issues :
The forecast target: dividends, cash flow, earnings?
The time horizon: T = 5, 10, ?
The terminal value
The discount rate
∞
CF1 CF2 CF3 CF4 CF5
A (going concern) firm
1 2 3 4 50
T
TVT

3. The Dividend Discount Model: Targeting DividendsThe Dividend Discount Model: Targeting Dividends
• DDM:
Problems: How far does one project?
• Does
provide a good estimate of VE
0?
(i) Dividend policy can be arbitrary and not linked to value added.
(ii) The firm can borrow to pay dividends; this does not create value
(iii) Think of a firm that “pays no dividends”
• The dividend irrelevancy concept
• The dividend conundrum:
Equity value is based on future dividends, but forecasting dividends
over finite horizons does not give an indication of this value
• Conclusion: Focus on creation of wealth rather than distribution of wealth.
...
)1()1(1 3
3
2
21
0 +
+
+
+
+
+
=
EEE
E
r
D
r
D
r
D
V
T
E
T
EEE
E
r
D
r
D
r
D
r
D
V
)1(
...
)1()1(1 3
3
2
21
0
+
++
+
+
+
+
+
=

4. Some Math: The Value of a Perpetuity and aSome Math: The Value of a Perpetuity and a
Perpetuity with GrowthPerpetuity with Growth
The Value of a Perpetuity
A perpetuity is a constant stream that continues without end (annuity). If
the future dividends are expected to be a perpetuity, the capitalised value
of the dividend stream is:
Value of a perpetual dividend stream =
The Value of a Perpetuity with Growth
If dividends are forecasted to grow at a constant rate, the capitalised
value of the dividend stream adjusted for the growth rate is:
Value of a dividend growing
at a constant rate =
E
E
r
D
V 1
0 =
gr
D
V
E
E
−
= 1
0

5. Terminal Values for the DDMTerminal Values for the DDM
A. Capitalize expected terminal dividends (in no growth)
B. Capitalize expected terminal dividends with growth
Will it work?
In practice, analysts tend to estimate the TV by applying a multiple
to a projected terminal value of a fundamental (e.g., Eps, Bps,
FCFE, Sales).
E
T
TT
r
D
PTV 1+
==
gr
D
PTV
E
T
TT
−
== +1

6. Dividend Discount Model:Dividend Discount Model:
Advantages and DisadvantagesAdvantages and Disadvantages
AdvantagesAdvantages
• Easy concept: dividends are
what shareholders get, so
forecast them
• Predictability: dividends are
usually fairly stable in the short
run so dividends are easy to
forecast (in the short run)
LimitationsLimitations
• Relevance: dividends payout is
not related to value, at least in
the short run; dividend
forecasts ignore the capital gain
component of payoffs.
• Forecast horizons: typically
requires forecasts for long
periods; terminal values for
shorter periods are hard to
calculate with any reliability
When It Works BestWhen It Works Best
• When payout is permanently tied to the value generation in the firm.
For example, when a firm has a fixed payout ratio
(dividends/earnings).

7. Multistage DDM
The assumption of constant g (i.e. Gordon Growth Model)
is not realistic for most firms.
More realistic to use 2 or 3 stage models:
• Growth phase – when company enjoys abnormally high
growth (dividends may be low or zero)
• Transition phase – earnings etc growth slows – transition
to maturity
• Mature phase – company reaches maturity and earns its
opportunity cost of capital. g settles at a long-term level

8. Two-stage DDM
Two versions (both assume constant growth at a mature
stage):
1. Abrupt transition between stage 1 and stage 2 growth:
∑= −+
++
+
+
+
=
n
t L
n
L
n
s
t
t
S
grr
ggD
r
gD
V
1
00
0
)()1(
)1()1(
)1(
)1(
T
g gS
gL

9. Two-stage DDM
2. The H-model - assumes that growth declines linearly over time
from some initial super-normal rate (gS) to the normal rate (gL)
Where H = half-life in years of the declining-growth period
Some intuition on the H-model: On average, the expected excess growth rate in the
supernormal period will be (gS – gL)/2. Through 2H periods, a total excess amount
of dividends over the level given by gLof 2HD0(gS – gL)/2 is expected. This term is
the H-model upward adjustment to the first dividend term, reflecting the extra
expected dividends as growth declines from gS to gL.
For more details on H-model read Fuller and Hsia (1984)
)(
)(
)(
)1( 00
0
L
LS
L
L
gr
ggHD
gr
gD
V
−
−
+
−
+
=
T
gS
gL

10. Example (H-Model)
During the past 5 years XYZ Plc’s dividends grew at 24%
per year, but analysts’ consensus is that the growth rate is
to decline linearly over the next 6 years to a final perpetual
growth rate of 6%. The current dividend is £1.37 per share
and the required rate of return on XYZ’s equity is 10%.
Today’s share price is £57.
What is the current fundamental value of XYZ’s share?
Is XYZ fairly priced?

11. Three-stage DDM
Three periods:
1. short-term high growth period
2. transitional period
3. long-term perpetual growth period
)()1(
)()1(
)1(
)1(
1
0
0
L
k
LSkLk
k
t
t
t
S
grr
ggHDgD
r
gD
V
−+
−++
+
+
+
= ∑=
H-model discounted
back to present
T
gS
gL

12. Cash flows for a going concern firmCash flows for a going concern firm
Cash flow from operations
(inflows)
Cash investment (outflows)
Free cash flow
Time, t
C1 C2 C3 C4
I1 I2 I3 I4
C1-I1 C2-I2 C3-I3 C4-I4
C5
I5
C5-I5
1 2 43 5
Free cash flow is cash flow from operations that results from
investments minus cash used to make investments.

13. Cash flow from
operations (inflows) C1 C2 C3 C4 C5 --->
Cash investment I1 I2 I3 I4 I5 --->
(outflows)
Free cash flow C1 − I1 C2 − I2 C3 − I3 C4 − I4 C5 − I5 --->
________________________________________________ --->
Time, t 1 2 3 4 5
The Discounted Cash Flow (DCF) ModelThe Discounted Cash Flow (DCF) Model
F
OV
D
0
F
0
E
0 VVV −=
D
T
T
T
TTE
V
r
CV
r
IC
r
IC
r
IC
r
IC
V 03
33
2
2211
0
)1()1()1()1()1(
−
+
+
+
−
+−−−+
+
−
+
+
−
+
+
−
=

14. The Continuing Value for the DCF ModelThe Continuing Value for the DCF Model
A. Capitalize terminal free cash flow
B. Capitalize terminal free cash flow with growth
Will it work?
r
1T1T
T
IC
CV ++ −
=
g
IC
CV 1T1T
T
−
−
= ++
r

15. DCF Valuation: The Coca-Cola CompanyDCF Valuation: The Coca-Cola Company
Cost of capital is 9%; the terminal growth rate of FCF is forecasted at 5% p.a. The value of
debt as of the end of 1999 is $4,435. The number of shares outstanding is 2,472.
2000E 2001E 2002E 2003E 2004E
Cash from operations: 3,657 4,097 4,736 5,457 5,929
Cash investments: 947 1,187 1,167 906 618
Free cash flow:
PV of FCF:
Total PV of FCF to 2004:
Continuing value (CV):
Present value of CV:
Enterprise value:
Value of net debt:
Value of equity:
Value per share:

16. Assuming the current price per share for Coke is $57:
Reverse engineer as follows:
Can Coke maintain this growth rate?
Reverse Engineering: What Forecasts are Implied by theReverse Engineering: What Forecasts are Implied by the
Current Market Price?Current Market Price?
$140,904shares2,472x$57MVo ==
$4,435-
1.5386
g-0.09
g)(1x311,5
5386.1
311,5
4116.1
551,4
2950.1
569,3
1881.1
910,2
1.09
2,710
140,904$
+
+++++=
rate)growth%6.2a(062.0==> g

17. Simple ValuationsSimple Valuations
Simple valuations use very short forecasts horizons, and isolate more
speculative, long-term forecasts. Accordingly, we anchor on “what we know”
or are relatively sure about.
A simple DCF for Coca-Cola, 2000
DebtNet11
−
−
−
=
gr
IC
V E
O
315,63$$4,435
05.009.0
710,2
=−
−
=

18. Reverse Engineering a Simple Valuation: Coca-ColaReverse Engineering a Simple Valuation: Coca-Cola
435,4$
g-0.09
2,710
140,904$0 −==MV
Applying the simple model to reverse engineer Coke’s stock price:
%)7.13israte(growth0713.0==> g

19. Steps for a basic DCF ValuationSteps for a basic DCF Valuation
1. Forecast free cash flow to a horizon
2. Discount the free cash flow to present value
3. Calculate a continuing value at the horizon with an estimated
growth rate
4. Discount the continuing value to the present
5. Add 2 and 4
6. Subtract net debt

20. Will DCF Valuation Always Work?Will DCF Valuation Always Work?
A Firm with Negative Free Cash Flows: General Electric Company
In millions of dollars, except per-share amounts.
2000 2001 2002 2003 2004
Cash from operations 30,009 39,398 34,848 36,102 36,484
Cash investments 37,699 40,308 61,227 21,843 38,414
Free cash flow (7,690) (910) (26,379) 14,259 (1,930)
Earnings 12,735 13,684 14,118 15,002 16,593
Earnings per share (eps) 1.29 1.38 1.42 1.50 1.60
Dividends per share (dps) 0.57 0.66 0.73 0.77 0.82

21. Calculating Free Cash Flows from EarningsCalculating Free Cash Flows from Earnings
It is difficult to forecast free cash flows without forecasting earnings. First
forecast earnings and then make adjustments to convert earnings to
cash flow from operations. Follow the following steps:
i. Forecast earnings available to common/ordinary
ii. Forecast accruals (the difference between earnings and cash flow from
operations in the cash flow statement)
iii. Calculate cash flow from operations (Step (i) - Step (ii))
iv. Forecast cash investments in operations
v. Calculate forecasted free cash flow, C - I (Step (iii) - Step (iv))

22. Definition of FCFF:
Free Cash Flow to the Firm (FCFF) = CF available to the firm’s
suppliers of capital after all operating expenses (incl. taxes)
have been paid and necessary investments in working capital
(e.g., stock) and fixed capital (e.g., PPE) have been made.
Definition of FCFE:
Free Cash Flow to the Equity (FCFE) = CF available to ordinary
shareholders after all operating expenses, interest, and principal
payments have been paid and necessary investments in working
and fixed capital have been made.
Popular versions of DCF models: FCFE and FCFF:Popular versions of DCF models: FCFE and FCFF:

23. Computation of FCFE and FCFF:Computation of FCFE and FCFF:
Starting from the Statement of Cash Flow:
FCFE = CFO – FCInv + Net Borrowing
FCFF= CFO + Int(1-Tax rate)* – FCInv
Starting from the Income statement (add-back method):
FCFF = Net Income
+ net noncash charges (NNC)
+ Interest expense(1-Tax rate)
- Net Investment in fixed capital (FCInv)
- Net Investment in working capital (WCInv)
=> FCFF = ER + NCC + Int(1-Tax rate) – FCInv – WCInv
=> FCFE = ER + NCC – FCInv – WCInv + Net Borrowing
=> FCFE = FCFF - Int(1-Tax rate) + Net Borrowing
*If the after-tax interest expense was taken out of CFO, as with US GAAP, then after-tax
interest must be added back to get FCFF.

24. The NCC which are added back to Net Income include:
• depreciation, amortisation, impairment of intangibles
• restructuring charges (expense)
• losses
• deferred taxes
The NCC which are subtracted from the bottom line earnings include:
• Restructuring charges (income resulting from reversal)
• Gains
Working capital = Current assets (excluding cash and cash
equivalents) – Current liabilities (excluding notes payable and
the current portion of long-term debt)
Net Investment in working capital (WCInv) =
= working capital (for year t) – working capital (for year t-1)

25. Valuation using the FCFF definition of cash flow:Valuation using the FCFF definition of cash flow:
The FCFF approach yields an estimated value for the entire firm.
⇒the appropriate discount rate is WACC.
Where:
or, assuming constant growth rate for FCFF:
=> Equity Value (V0) = Firm Value0 – Market value of debt 0
∑
∞
=
+
= 10
)1(t t
t
WACC
FCFF
ValueFirm
ed r
equitymvdebtmv
equitymv
TaxRater
equitymvdebtmv
debtmv
WACC
)()(
)(
)1(
)()(
)(
+
+−
+
=
FCFF
FCFF
gWACC
gFCFF
ValueFirm
−
+
=
)1(0
0

26. Valuation using FCFE definition of cash flow:Valuation using FCFE definition of cash flow:
The FCFF approach yields an estimated intrinsic value for the firm’s ordinary
equity. => the appropriate discount rate is the cost of equity capital.
=>
or, assuming constant growth rate for FCFF,
Note that growth rate of FCFF and the growth rate of FCFE may not be the
same!
∑
∞
=
+
= 10
)1(t t
t
r
FCFE
ValueEquity
FCFE
FCFE
gr
gFCFE
ValueEquity
−
+
=
)1(0
0

27. FCFF vs. FCFE in valuation
• FCFE may be more direct and simpler to use (than FCFF) if the
company’s capital structure is relatively stable
• FCFF is more preferable in two cases:
A levered company with negative FCFE
A levered company with a changing capital structure (FCFF
growth might reflect fundamentals more clearly than FCFE
growth, which reflects fluctuating amounts of net
borrowings). Also, WACC is less sensitive to changes in
leverage than r.

28. DCF Valuation and SpeculationDCF Valuation and Speculation
• Formal valuation aims to reduce our uncertainty about value and to
discipline speculation
• The most uncertain (speculative) part of a valuation is the continuing
value. So valuation techniques are preferred if they result in a smaller
amount of the value attributable to the continuing value
• DCF techniques can result in more than 100% of the valuation in the
continuing value

29. Why Free Cash Flow is not a Value-Added ConceptWhy Free Cash Flow is not a Value-Added Concept
• Cash flow from operations (value added) is reduced by investments
(which also add value): investments are treated as value losses
• Value received is not matched against value surrendered to generate
value
A firm reduces free cash flow by investing and increases free cash
flow by reducing investments:
free cash flow is partially a liquidation concept
Note: analysts tend to forecast earnings, not cash flows

30. Discounted Cash Flow Analysis: AdvantagesDiscounted Cash Flow Analysis: Advantages
AdvantagesAdvantages
• Relatively easy concept: cash flows are “real” and easy to think about;
they are not affected by accounting rules
• Familiarity: is a straight application of familiar net present value
techniques
When It Works BestWhen It Works Best
• When the investment pattern is such as to produce constant free cash
flow or free cash flow growing at a constant rate.
• The firm is not dividend paying;
• Dividends differ significantly from the firm’s capacity to pay dividends;
• Free cash flows align with profitability within a reasonable forecast
period with which the analyst is comfortable; or
• The investor takes a control perspective.

31. Discounted Cash Flow Analysis: DisadvantagesDiscounted Cash Flow Analysis: Disadvantages
Suspect concept:
• free cash flow does not measure value added in the short run; value
gained is not matched with value given up.
• free cash flow fails to recognize value generated that does not involve
cash flows
• investment is treated as a loss of value
• free cash flow is partly a liquidation concept; firms increase free cash
flow by cutting back on investments.
Forecast horizons: typically requires forecasts for long periods;
terminal values for shorter periods are hard to calculate with any
reliability
Validation: it is hard to validate free cash flow forecasts
Not aligned with what people forecast: analysts forecast earnings, not
free cash flow; adjusting earnings forecasts to free cash forecasts
requires further forecasting of accruals.

32. Accrual Accounting Based Valuation ModelsAccrual Accounting Based Valuation Models
Project 1:Project 1:
Initial investment (opening book value) $400
Required return
10%
Forecasted earnings
$40
This is a Zero-RE project and Zero NPV project:
DCF Valuation:
400
1.10
0
400Value
$0400)x(0.10-40
)investmentInitialreturn xrequired(earningsforecast
yearfor theearningsResidual
=+=
==
=−=
=
400
10.1
440
==V

33. Project 2:Project 2:
Investment $400
Required return 10%
Earnings forecast $ 48
Residual earnings = 48 – (0.1 x 400) = 8
Project Value = 400 + [8/1.1] = 407.27
=> Value = Book Value + Present Value of Residual Earnings
⇒Price-to-Book (P/B ratio) = (BV)/(BV) + (PV of RE)/(BV) =
= 1 +
( PV of RE)/(BV)
The project adds value: 



== 27.407
1.10
448
valueDCF

34. Lessons from Projects 1 and 2Lessons from Projects 1 and 2
1. An asset is worth a premium or discount to its book value only if the book
value is expected to earn non-zero residual earnings.
• A firm with P/B=1 earns an expected rate of return on its book value
equal to the required return, i.e. expected residual earnings are zero.
2. Residual earnings techniques recognize that earnings growth does not add
value if that growth comes from investment earning at the required return.
3. Even though an asset does not pay dividends, it can be valued from its
book value and earnings forecasts.
4. The valuation is unrelated to free cash flows
5. If one forecasts that an asset will earn a return on its book value equal
to the required return, it must be worth its book value

35. A Model for Anchoring Value on Book ValueA Model for Anchoring Value on Book Value
Value of common equity:
Where RE is residual earnings for equity.
Residual Earnings = comprehensive earnings – [required return for
equity X beginning-of-period book value]
...
)1()1(1 3
3
2
21
00 +
+
+
+
+
+
+=
r
RE
r
RE
r
RE
BVV E
1* −−= ttt BVrERRE

36. Derivation of the Equity Valuation Model: One PeriodDerivation of the Equity Valuation Model: One Period
Valuing a one-period payoff equation:
Substitute for the expected dividend
to get
or
)BV(BVERD 0111 −−=
r)(1
BVP
r)(1
BV*ER
BP 1101
00
+
−
+
+
−
+=
r
( )
)r(1
DP
P 11
0
+
+
=
( )
)r(1
BVBV
P 1011
0
+
+−−
=
PER

37. Derivation of the Equity Valuation ModelDerivation of the Equity Valuation Model
Mult-iperiod:Mult-iperiod:
Substituting comprehensive earnings and book value for dividends in each period,
OR:
Or extended for the infinite horizon:
T
TT
2
21
00
r)(1
BVP
....
)r(1
RE
r)(1
RE
BVP
+
−
++
+
+
+
+=
T
TT
T
1-TT
2
1201
00
r)(1
BVP
r)(1
BV*ER
...
r)(1
BV*ER
r)(1
BV*ER
BVP
+
−
+
+
−
++
+
−
+
+
−
+=
rrr
∑
∞
= +
+=
1
t
t
00
)r(1
RE
BVP
t

38. Relation Between P/B Ratios and Subsequent RERelation Between P/B Ratios and Subsequent RE

39. Ingredients of the ModelIngredients 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 (earnings and book values) to horizon
3. Forecasted premium at the horizon
Component 3 is called the continuing value
As efficient prices equal intrinsic values, then
T
T
E
T
T
T
2
21
0
E
0
)r(1
BVV
r)(1
RE
.....
)r(1
RE
r)(1
RE
BV
+
−
+
+
++
+
+
+
+=

40. Alternative Measure of Residual EarningsAlternative Measure of Residual Earnings
Residual earnings can also be expressed as:
Where:
[ ] 11 ** −− −=−= ttttt BVrROCEBVrERRE
t
t
t-1
Comprehensive earnings to common
ROCE
Book value
=

41. Drivers of Residual EarningsDrivers 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

42. ROCE and P/B Ratios: S&P 500 FirmsROCE and P/B Ratios: S&P 500 Firms
ROCE on P/B Ratio
-0.6
-0.4
-0.2
0
0.2
0.4
0.6
0.8
1
1.2
0 2 4 6 8 10 12 14
Price to Book Ratio (2001)

43. Steps in Applying the RIV modelSteps in Applying the RIV 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.

44. A Simple Demonstration and a Simple ModelA Simple Demonstration and a Simple Model
In millions of dollars. Required return is 10% per year. Fixed dividend payout
ratio of 75.7%. RE growth rate is forecast at 3%.
Forecast Year
0 1E 2E 3E
4E 5E
Earnings 12.00 12.36 12.73
13.11 13.51 13.91
Dividends 9.09 9.36 9.64
9.93 10.23 10.53
Book value 100.00
What is the value of intrinsic price-to-book ratio (P/B) ?
gr
RE
BVV E
−
+= 1
00 ?0 =E
V

45. Reverse EngineeringReverse Engineering
Determining the implied growth rate:
Suppose the actual market cap. of equity (P0) is $133m:
=> g = 3% i.e. the market is forecasting a growth rate for residual earnings of 3%
per year
Determining the implied expected return:
Suppose the actual market cap. of equity (P0) is $147m:
=> RE1 = $12.36 – [r × 100.0] => r = 0.0936 => you expect a 9.36% return from
buying the stock at the current market price.
g
P
−
+==
10.0
36.2$
100$71.133$0
03.0
100$2.147$ 1
0
−
+==
r
RE
P

46. Case1: Residual Earning Valuation withCase1: Residual Earning Valuation with ZeroZero RE after TRE after T
V B PV of RE fE
0 0= + or T periods
53.495.058.3VE
0 =+=
Required rate of return is 9%
Forecast Year
1999 2000E 2001E 2002E 2003E
Eps 0.73 0.80 0.71 0.47
Dps 0.11 0.24 0.25 0.27
Bps 3.58 4.20 4.76 5.22 5.41
ROCE 20.4% 19.0% 14.9% 9.0%
RE 0.408 0.422 0.282 0.000
Discount rate 1.09 1.188 1.295 1.412
Present value of RE 0.374 0.355 0.217 0.000
Total PV of RE to 2003 0.95
Value per share 4.53
Assuming zero RE after period T (zero premium at T):

47. Case 2: Residual Earning Valuation withCase 2: Residual Earning Valuation with ConstantConstant RE after TRE after T
Required rate of return is 10%
Forecast Year
1999 2000E 2001E 2002E
2003E 2004E
Eps 1.29 1.38 1.42
1.50 1.60
Dps 0.57 0.66 0.73
0.77 0.82
Bps 4.32 5.04 5.76 6.45 7.18
7.96
ROCE 29.9% 27.4% 24.7%
23.3% 22.3%
RE (10% charge) 0.858 0.876 0.844
0.855 0.882
Discount rate (1.10) 1.100 1.210 1.331
1.464 1.611
Present value of RE 0.780 0.724 0.634
0.584 0.548
Total PV of RE to 2004 3.27
Continuing value (CV) 8.82 = [0.882/0.1]
Present value of CV 5.48 = [0.882/1.611]
07.1348.527.332.4VE
0 =++=

48. Case3: Residual Earning Valuation withCase3: Residual Earning Valuation with GrowingGrowing RE after TRE after T
Required rate of return is 11%
Forecast Year
2000 2001 2002 2003
2004 2005
Eps 0.84 0.48 0.82
1.03 1.18
Dps 0.0 0.0
0.0 0.0 0.0
Bps 2.06 2.90 3.38 4.20 5.23 6.41
ROCE 40.8% 16.6% 2
4.3% 24.5% 22.6%
RE 0.613 0.161 0.448
0.568 0.605
Discount rate (1.11)t
1.110 1.232
1.368 1.518 1.685
Present value of RE 0.553 0.131
0.328 0.374 0.359
Total PV of RE to 2005: 1.75
Continuing value (CV) 14.32
Present value of CV 8.50
Value per share 12.31
31.1250.875.106.20
=++=E
V
32.14
065.011.0
065.1605.0
=
−
×
50.8
685.1
32.14
=

49. Forecasting Target Prices at the horizonForecasting Target Prices at the horizon
ofRECVB TTTPriceTarget +=
41.520032003 == BV E
73.2032.1441.6200520052005 =+=+= CVBV E
Case 1 (zero RE after forecast horizon => CV=0):
Case 2 (constant RE after forecast horizon):
Case 3 (growing RE after forecast horizon):
16.7882.896.7200420042004 =+=+= CVBV E

50. Converting an Analyst’s Forecast to a Valuation: Nike Inc.Converting an Analyst’s Forecast to a Valuation: Nike Inc.
Forecasts:
2009 $3.90
2010 $4.45
Dividend payout ratio forecast: 23%
Five-year Eps growth rate forecast: 13%
Long-term RE growth rate: 4% (at GDP growth rate)
Required Return = 10%
2008A 2009E 2010E 2011E 2012E 2013E
Eps 3.80 3.90 4.45 5.03 5.68
6.42
Dps 0.88 0.90 1.02 1.16 1.31
1.48
Bps 15.93 18.93 22.36 26.23 30.60
35.54
ROCE 24.5% 23.5%
22.5% 21.7% 21.0%
RE (10% charge) 2.307 2.557 2.794 3.057
3.360
Discount rate (1.10)t
1.110 1.210 1.331 1.464
1.611
Present value of RE 2.097 2.113
2.099 2.088 2.086
Total PV to 2009 10.48
Continuing value (CV) 58.24
Present value of CV 36.15
Value per share 62.56
58.24
04.010.0
04.1360.3
=
−
×
=CV

51. Residual Earnings Model: Pros and ConsResidual Earnings Model: Pros and Cons
AdvantagesAdvantages
• Focus on value drivers and profitability of investment and growth in investment
that drive value
• Incorporates the financial statements and the value already recognized in the
balance sheet. Forecasts the income statement and balance sheet rather than the
cash flow statement
• Uses accrual accounting matches value added to value given up and treats
investment as an asset rather than a loss of value
• Versatility: can be used with a wide variety of accounting principles
• Aligned with what analysts forecast: analysts forecast earnings
• Validation: forecasts of RE can be validated in subsequent audited fin. statements
• Predictability: dividends are usually fairly stable in the short run so dividends are
easy to forecast
DisadvantagesDisadvantages
• Accounting complexity: requires an understanding of how accrual accounting
works
• Suspect accounting: relies on accounting numbers that can be suspect
• Forecast horizon: forecast horizons can be shorter than for DCF, but the forecast
horizon does depend on the quality of the accrual accounting