FINANCIAL INFORMATION ANALYSIS
ACCOUNTING-BASED VALUATION TECHNIQUES
Application Exercises
Question 2
Construct a two-period numerical example to show that the accounting-based valuation of a firm is the same whether R&D is capitalized or expensed.
ACCOUNTING-BASED VALUATION TECHNIQUES
Application Exercises
Question 2
Consider R&D Inc., a biotech start up. This firm:
· Incurs expenditures in R&D of $50 in the first year of activity;
· Has an opening book value of equity of $1,000;
· Generates income (before R&D expenses) of $200 in year 1 and $220 in year 2, at the end of which it is liquidated;
· Has a cost of equity capital of 10%;
· Pays no dividends prior to liquidation;
Show that the PVAE obtains regardless of whether R&D Inc. expenses R&D expenditure as incurred or capitalizes and amortizes R&D expenditure!
ACCOUNTING-BASED VALUATION TECHNIQUES
Application Exercises
Question 2
Expensing R&D As Incurred
Assume that the R&D expenditure is expensed at the end of year1:
And Thus:
PVAE = 1132.2
ACCOUNTING-BASED VALUATION TECHNIQUES
Application Exercises
Question 2
Capitalising And Amortising R&D (1)
Assume that the R&D expenditure is capitalised and amortised linearly:
· R&D expense recognised at end of year 1: 25;
· R&D expense recognised at end of year 2: 25;
And thus:
PVAE = 1132.2
ACCOUNTING-BASED VALUATION TECHNIQUES
Application Exercises
Question 2
Capitalising And Amortising R&D (2)
Assume that the R&D expenditure is capitalised and amortised as follows:
· R&D expense recognised at end of year 1: x;
· R&D expense recognised at end of year 2:
· 50-x;
ACCOUNTING-BASED VALUATION TECHNIQUES
Application Exercises
Question 2
Capitalising And Amortising R&D (3)
As:
PVAE is thus independent of x and hence accounting policy for R&D expenditure!
FINANCIAL INFORMATION ANALYSIS
ACCOUNTING-BASED VALUATION TECHNIQUES
Application Exercises
Question 3
Explain why terminal values in accounting-based valuation are significantly less than those for DCF valuation.
ACCOUNTING-BASED VALUATION TECHNIQUES
Application Exercises
Question 3
· DCF terminal values include the PV of all expected CFs beyond the forecast horizon;
· The expected cash flows beyond the forecast horizon can be broken down into 2 parts: normal and abnormal;
· Since the terminal value in the PVAE includes only abnormal earnings, terminal values in accounting-based valuations are significantly less than those in DCF valuations;
FINANCIAL INFORMATION ANALYSIS
ACCOUNTING-BASED VALUATION TECHNIQUES
Application Exercises
Question 5
· 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% per year, indefinitely, and the cost of equity capital is 15%;
· Given these facts, what is the market’s expectation of the long-term average ROE?
ACCOUNTING-BASED VALUATION TECHNIQUES
Application Exercises
Question 5
ve*/se = 1 + [ ( ROE - rE ) / (rE - g ) ]
where:
· ROE is the expected long-term average ROE;
· g is the expected long-term average growth in book value;
· rE is the cost of equity capital;
· ve* is the stock price;
· se is the book value of equity per share;
ACCOUNTING-BASED VALUATION TECHNIQUES
Application Exercises
Question 5
Equivalently:
ROE = rE + (rE - g )* (ve*- se) / se
And hence:
ROE = 15% + ( 15% - 10% ) * ( 15 - 5 ) / 5 = 25%
FINANCIAL INFORMATION ANALYSIS
ACCOUNTING-BASED VALUATION TECHNIQUES
Application Exercises
Question 6
Given the information in the previous question, what will be Manufactured Earnings’ stock price if the market revises its expectations of long-term average ROE to 20%?
ACCOUNTING-BASED VALUATION TECHNIQUES
Application Exercises
Question 6
Using the same formula:
ve*/se = 1 + (20% - 15%)/(15% - 10%)
Hence: