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:

P = $10