Chapter6WhatYouWillLearnFromThisChapterWhat“abnormalearningsgrowth〞is.HowforecastingabnormalearningsgrowthyieldstheintrinsicP/Eratio.WhatismeantbyanormalP/Eratio.Thedifferencebetweenex-dividendearningsgrowthandcum-dividendearningsgrowth.ThedifferencebetweenaCase1andCase2abnormalearningsgrowthvaluation.Theadvantagesanddisadvantagesofusinganabnormalearningsgrowthvaluationandhowthevaluationcompareswithresidualearningsvaluation.Howdividends,shareissues,andsharerepurchasesaffectabnormalearningsgrowth.ThatabnormalearningsgrowthisequaltothechangeinresidualearningsHowabnormalearningsgrowthvaluationprotectstheinvestorfrompayingtoomuchforearningsgrowth.Howabnormalearningsgrowthvaluationprotectstheinvestorfrompayingforearningsthatarecreatedbyaccountingmethods.Howtousetheabnormalearningsgrowthmodelinreverseengineering.WhataPEGratiois.TheConceptBehindtheP/ERatioPriceinnumeratorofP/EisbasedonexpectedfutureearningsEarningsindenominatoriscurrent(orforward)earningsP/EisthusbasedonexpectedgrowthinearningsComparewithprice-to-book:P/Bisbasedonexpectedearningsrelativetocurrentbookvalue(ROCE)ROCEisgrowthinbookvalueP/BisbasedonexpectedgrowthinbookvalueBewareofPayingTooMuchfor

EarningsGrowthInvestmentcreatesgrowthbutdoesnotnecessarilyaddvalueEarningsgrowthcanbecreatedbytheaccounting WeneedavaluationmethodtoprotectusfrompayingtoomuchforearningsgrowthReminder:ResidualEarningsValuationProtectsYouFromPayingTooMuchForEarningsEarningsfromnewinvestmentischargedwiththerequiredreturnoninvestment Residualearningsbeforenewinvestment:10%hurdlerate

RE=12–(0.10x100)=2(ROCE=12%) Residualearningsafternewinvestmentof$20millionearningat10%

RE=14–(0.10x120)=2 Novalueaddedfromnewinvestment Creatingearningsbyaccountingmethodsalsoincreasesresidualearningsbutreducesbookvalue.Theneteffectiszero.SeeChapter5. AP/Emodelmustalsoprotectyoufrompayingtoomuchforearningsgrowth.ThePrototypeSavingsAccountTheTrailingP/EandForwardP/ECum-DividendEarningsForthezero-payoutaccount:20012002200320042005Cum-dividendearnings5.005.255.515.796.08Forthefull-payoutaccount:Earningsintheaccount5.005.005.005.005.00Dividendreinvested@5%

0.250.510.791.08Cum-dividendearnings5.005.255.515.796.08Thetwoaccountshavedifferent(ex-dividend)earningsgrowth,butthesamecum-dividendearningsgrowthNormalEarningsNormalEarningsisearningsgrowingattherequiredrateofreturn:AbnormalEarningsGrowth(AEG)AbnormalEarningsGrowthisgrowthovernormalearningsgrowth

AEG=Cum-dividendearnings–Normalearnings

FortheSavingsaccount:LessonsfromtheSavingsAccount1.Anassetisworthcapitalizedforwardearningsifabnormalearningsgrowthisexpectedtobezero.2.AnassethasanormalP/Eratioifabnormalearningsgrowthisexpectedtobezero.3.Earningscomesfromtwosources:earningsfromtheassetearningsfromreinvestingdividends4.Dividendsdonotaffectcum-dividendearnings5.Dividendsdonotaffectvalue.ABadP/EModelDoesnotworkforasavingsaccount!AModeloftheForwardP/EValueofsavingsaccount= Capitalizedforwardearnings+NoextravalueExtravalueisaddedif(cum-dividend)earningsareexpectedtogrowatarategreaterthantherequiredreturnThemodel: Valueofequity=capitalizedforwardearnings+extravalueforabnormal earningsgrowthTheintrinsicP/EisgivenbydividingthroughbyEarn1MeasuringAbnormalEarningsGrowthforEquitiesAbnormalearningsgrowtht(AEGt)=cum-dividendearnt-normalearnt

=[earnt+(ρE–1)dt-1]–ρearnt-1DellComputerNikeInc.Eps2002Dps2002Earningsonreinvesteddividends(at10%)Cum-dividendearnings2002Normalearningsfrom2001:Dell:0.84x1.10;Nike:2.18x1.10Abnormalearningsgrowth(AEG)2002$0.00$0.48

$0.000.48

0.924$-0.444$0.48$2.48

0.0482.528

2.398$0.130AlternativeCalculationofAEGAbnormalearningsgrowtht=[Gt–ρE]xearningst-1whereGt=Cum-dividendearningsgrowthrate(plusone)ForNike:G2002=2.528/2.18=1.1596%(a15.96%growthrate)AEG2=[1.1596–1.10]x2.18=$0.130ApplyingtheModelForecastone-year-aheadearnings.Addthepresentofvalue(attheendoftheyear1)ofexpectedabnormalearningsgrowthforyeartwoaheadandonwardsCapitalizedthetotalofforwardearningsandthevalueofabnormalearningsgrowth.ApplyingtheModelCumdividendearnings2

Normalearnings2

Cumdividendearnings3

Normalearnings2

Cumdividendearnings4

Normalearnings4

Year4aheadYear3aheadYear2aheadAbnormalEarnings2AbnormalEarnings3AbnormalEarnings4ForwardEarnings1

Year1aheadPVofAEG2TotalearningsplusgrowthCurrentValueCapitalizeDiscountbyDiscountby2Discountby3ForecastsPVofAEG3PVofAEG4++++--+ApplyingtheModel:AnExampleForecastforafirmwithexpectedearningsgrowthof3percentperyear(indollars).Requiredreturnis10%peryear.Residualearningsvaluation:AEGvaluation:ACase1Valuation:Wal-MartWal-MartStores,Inc.Inthiscase,abnormalearningsgrowthisexpectedtobezeroafter1996

SamevaluationasREmodelACase2Valuation:GeneralElectricGeneralElectricCo.Inthiscase,abnormalearningsgrowthisexpectedtogrowata6percentrateafter1992

ConvertinganAnalyst’sForecasttoaValuation:NikeInc.AbnormalEarningsGrowthisEqualtotheChangeinResidualEarningsAEGt

=[earnt+(ρE

–1)dt-1]

-ρEearnt-1

Bythestocksandflowsequationforaccountingforthebookvalueofequity(Chapter2),Bt-1=Bt-2+earnt-1

–

dt-1,soearnt-1

–dt-1=Bt-1–Bt-2.Thus,

AEGt=earnt

–earnt-1-(ρE

–1)[Bt-1–Bt-2]

=[earnt

-(ρE

–1)Bt-1]-[earnt-1

-(ρE

–1)Bt-2]

=REt

–REt-1

ForecastingChangesinResidualEarningsCurrentValueForecastsResidualincome2Residualincome1Residualincome3Residualincome2Residualincome4Residualincome3Year4aheadYear3aheadYear2aheadAbnormalEarnings2AbnormalEarnings3AbnormalEarnings4ForwardEarnings1

Year1aheadPVofAEG2TotalearningsplusgrowthCapitalizeDiscountbyDiscountby2Discountby3PVofAEG3PVofAEG4++++--+Calculationofequityvalueusingtheabnormalearningsgrowthmodel.Abnormalearningsgrowthisthedifferencebetweenresidualearningsintwosubsequentperiods.ProtectionFromEarningsCreatedbyAccounting:ARestructuringChargeAbnormalEarningsGrowthAnalysis:

AdvantagesandDisadvantagesAdvantagesEasytounderstand:Investorsthinkintermsoffutureearnings;investorsbuyearnings.Focusesdirectlyonthemostcommonmultipleused,theP/Eratio.Usesaccrualaccounting:Embedsthepropertiesofaccrualaccountingbywhichrevenuesarematchedwithexpensestomeasurevalueaddedfromsellingproducts.Versatility:Canbeusedunderavarietyofaccountingprinciples(Chapter16).Alignedwithwhatpeopleforecast:Analystsforecastearningsandearningsgrowth.DisadvantagesAccountingcomplexity:Requiresanunderstandingofhowaccrualaccountingworks.Conceptcomplexity:Requiresanappreciationoftheconceptofcum-dividendearnings;thatis,valueisbasedonearningstobeearnedwithinthefirmandfromearningsfromthereinvestmentofdividends.Applicationtostrategy:Doesnotgiveaninsightintothedriversofearningsgrowth,particularlybalancesheetitems,soisnotsuitedtostrategyanalysis.Suspectaccounting:Reliesonearningsnumbersthatcanbesuspect(Chapter17).Forecasthorizon:ForecasthorizonscanbeshorterthanthoseforDCFanalysisandmorevalueistypicallyrecognizedintheimmediatefuture.Buttheforecasthorizondoesdependonthequalityoftheaccrualaccounting(Chapter16).ReverseEngineering:NikeNiketradesat$57(in2003)g=1.044(a4.4%growthrate)C