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Chapter 7
Prospective Analysis: Valuation Theory and Concepts
Discussion Questions
1. Joe Watts, an analyst at EMH Securities, states: “I don’t know why anyone would ever try to value
earnings. Obviously, the market knows that earnings can be manipulated and only values cash flows.”
Discuss.
Valuing earnings is an alternative way of valuing a company even if earnings can be manipulated.
Note that, with an infinite forecast horizon, the valuation based on discounted abnormal earnings
delivers exactly the same estimate as DCF-based methods, even if there is earnings manipulation.
The estimated values using accounting-based valuation are not affected by accounting choices
2. Explain why terminal values in accounting-based valuation are significantly lower than those for
DCF valuation.
DCF terminal values include the present value of all expected cash flows beyond the forecast
horizon. Note that the expected cash flows beyond the forecast horizon can be broken down into
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3. Manufactured Earnings is a “darling” of Wall Street analysts. Its current market price is $15 per
share, and its book value is $5 per share. Analysts forecast that the firm’s book value will grow by 10
percent per year indefinitely, and the cost of equity is 15 percent. Given these facts, what is the market’s
expectation of the firm’s long-term average ROE?
where ROE is the long-term average ROE,
Using the information in the question,
4. Given the information in Question 3, what will be Manufactured Earnings’ stock price if the market
revises its expectations of long-term average ROE to 20 percent?
Once again, using the same formula as in the answer to Question 3, we have
5. Analysts reassess Manufactured Earnings’ future performance as follows: growth in book value
increases to 12 percent per year, but the ROE of the incremental book value is only 15 percent. What is
the impact on the market-to-book ratio?
P
B
––– 1ROE r–( )
r g–( )
–––––––––––––––––––––––––––––
+=
Chapter 7 Prospective Analysis: Valuation Theory and Concepts 3
6. How can a company with a high ROE have a low PE ratio?
Accounting-based valuation suggests that the stock price (a numerator of the PE ratio) can be
viewed as the sum of the current book value per share plus the discounted expected future abnormal
earnings per share.
7. What types of companies have:
a. a high PE ratio and a low market-to-book ratio?
Recovering firms are expected to rebound from temporarily low earnings levels but will not be able
b. a high PE ratio and a high market-to-book ratio?
“Rising stars” which are expected to grow quickly and enjoy high ROEs during the growth period
c. a low PE ratio and a high market-to-book ratio?
“Falling stars” that enjoy high ROEs on existing investments but are no longer growing fast. PE
d. a low PE ratio and a low market-to-book ratio?
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8. Free cash flows (FCF) used in DCF valuations discussed in the chapter are defined as follows:
FCF to debt and equity = Earnings before interest and taxes × (1-tax rate) + Depreciation and deferred
taxes – Capital expenditures -/+ Increase/decrease in working capital
FCF to equity = Net income + Depreciation and deferred taxes – Capital expenditures -/+
Increase/decrease in working capital +/- Increase/decrease in debt.
Which of the following items affect free cash flows to debt and equity holders? Which affect free cash
flows to equity alone? Explain why and how.
An increase in inventory will decrease both FCFE and FCFD+E through an increase in cash required
for working capital.
9. Starite Company is valued at $20 per share. Analysts expect that it will generate free cash flows to
equity of $4 per share for the foreseeable future. What is the firm’s implied cost of equity capital?
With a single, unchanging free cash flow to equity for the foreseeable future, we can calculate the
implied cost of equity capital using the following formula:
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10. Janet Stringer argues that “the DCF valuation method has increased managers’ focus on short-term
rather than long-term performance, since the discounting process places much heavier weight on short-
term cash flows than long-term ones.” Comment.
While it is true that DCF valuation places more weight on earlier cash flows than on later ones, this
reflects the time value of money. A dollar in one year is more valuable than a dollar in five years’