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##### Topic 2 - Equity valuation and financial statement information: an introduction

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SMM111: International Financial Reporting and Analysis

Topic 2 - Equity valuation and financial statement information: an introduction

Prof Colin Clubb

There is an extra example at the end which deals with the effect of growth.  You may want to work through this during the reading week!

Topic 2 outline

Explain the equivalence of the DVM and the AEVM

Use DVM and AEVM to value a simple firm

Show the equivalence of the FCFVM and AOPVM ”…”Ę’Z’ďőńĺWwww.51lunwen.org’ŻņŪŐŠĻ© and their equivalence to DVM and AEVM using example of simple firm

Consider the implications for the importance of financial statement information to investors

1. Using the DVM and AEVM for equity valuation

Some variable definitions to get us started

Pt is total equity value at date t

is the discount rate or °ģcost of equity°Į

Dt+i is expected net dividends for the firm at date t+i

NPt+i is expected net profit period ending at date  t+i

BVEt+i is expected book value of equity at date t+i
Deriving the AEM from the DVM
Dividend valuation model:

Assuming that the °ģclean surplus relation°Į holds:

dividends can be written as:

Deriving the AEVM (continued)
Define abnormal earnings at date t+I as follows:

which implies that:

Replacing dividends with earnings less the change in the book value of equity and then replacing earnings with abnormal earnings plus opening book value of equity gives the AEVM:

Value drivers in the AEVM
We can write the AEVM as follows:

where ROEt+1 denotes expected °ģreturn on equity°Į during period t+1 and is equal to
Value drivers in the AEVM (continued)
Value drivers identified by the AEVM are therefore:
Excess of ROE over the cost of equity
Growth in the book value of equity

According to the AEVM, the market value premium over book value will be positive (ie: the price-to-book ratio will be greater than one) if and only if the present value of future residual earnings is positive
Valu-Co plc Part 1: Equivalence of DVM and AEVM
Slides 9-11 show the following for Valu-Co plc:
Reported balance sheet at end of 2009 and forecasted balance sheets for 2010, 2011, and 2012
Forecasted income statement, dividend payout, ”…”Ę’Z’ďőńĺWwww.51lunwen.org’ŻņŪŐŠĻ© ROE, and growth information for 2010, 2011, and 2012
Valuations based on DVM and AEVM assuming that

Reported balance sheet for 2009 and forecasted balance sheets for 2010, 2011, 2012
Forecasted income statement, dividend payout, ROE, and growth information for 2010, 2011, and 2012
Valuations based on DVM and AEVM
DVM valuation is as follows:

AEVM valuation is as follows:

2. Using the FCFVM and AOPVM for equity valuation
Free cash flow valuation model (FCFVM) and abnormal operating profit  valuation model (AOPVM) provide a valuation of the business as a whole (ie: net debt + equity)
According to FCFVM, value of a business is the present value of future expected free cash flows (cash flow from operations less investment) discounted at the cost of capital for operations
According to AOPVM, value of business is book value of net operating assets plus the present value of future expected abnormal operating profits