V O L U ME 18 | NU M B E R 2 | W I NT E R 20 0 6

Journal of

APPLIED CORPORATE FINANCE

A MO RG A N S TA N L E Y P U B L I C AT I O N

In This Issue: Valuation, Capital Budgeting, and Value-Based Management

London Business School Roundtable on Shareholder Activism in the U.K.

Panelists: Victor Blank, GUS Plc and Trinity Mirror Plc; Alastair
Ross Goobey, Morgan Stanley International; Julian Franks,
London Business School; Marco Becht, Universit Libre
de Bruxelles; David Pitt-Watson, Hermes Focus Asset Management; Anita Skipper, Morley Fund Management; and
Brian Magnus, Morgan Stanley. Moderated by Laura Tyson,
London Business School, and Colin Mayer, Oxford University

The Role of Real Options in Capital Budgeting: Theory and Practice

28

Robert L. McDonald, Northwestern University

How Kimberly-Clark Uses Real Options

40

Martha Amram, Growth Option Insights, and Fanfu Li and

Cheryl A. Perkins, Kimberly-Clark Corporation

Handling Valuation Models

48

Stephen H. Penman, Columbia University

FMA Roundtable on Stock Market Pricing and Value-Based Management

56

Panelists: Tom Copeland, MIT; Bennett Stewart, Stern Stewart;

Trevor Harris, Morgan Stanley; Stephen OByrne,
Shareholder Value Advisors; Justin Pettit, UBS; David Wessels,
University of Pennsylvania; and Don Chew, Morgan Stanley.
Moderated by John Martin, Baylor University, and Sheridan
Titman, University of Texas at Austin

Expectations-Based Management

82

Incentives and Investor Expectations

98

Tom Copeland, MIT, and Aaron Dolgoff, CRAI

Stephen OByrne, Shareholder Value Advisors,
and S. David Young, INSEAD

The Effect of Private and Public Risks on Oileld Asset Pricing: Empirical
Insights into the Georgetown Real Option Debate

106

The Real Reasons Enron Failed

116

Bennett Stewart, Stern Stewart & Co.

Multinationals in the Middle Kingdom: Performance,

Opportunity, and Risk

120

David Glassman, Prince Management Consulting

Gavin L. Kretzschmar and Peter Moles,

University of Edinburgh

Handling Valuation Models

by Stephen H. Penman, Columbia University*

The concept of future prospects and particularly of continued growth in the future
invites the application of formulas out of higher mathematics to establish the present
value of the favored issue. But the combination of precise formulas with highly
imprecise assumptions can be used to establish, or rather justify, practically any value
one wishes, however high, for a really outstanding issue.
Benjamin Graham, The Intelligent Investor, 4th rev.ed. (New York: Harper and Row, 1973), pp. 315-316.

he value of a business is based on its future

prospects so it is understandable that valuation
models that involve forecasts have considerable currency. Benjamin Graham was skeptical,
however. He and his fellow fundamentalists warned that the
mathematical formulas underlying these models convey a
false sense of precision; worse, they provide cover for playing with mirrors.
A valuation model is usually expressed as a formula,
but really is a directive about how to go about the task of
valuation. A valuation model has two features: rst, it species what is to be forecast to capture the future prospects;
second, it dictates how to convert those forecasts to a valuation. For example, the dividend discount model instructs us
to forecast future dividends, d, and convert those expected
dividends to a value by discounting them at a rate, r. Stated
in the form of a formula out of higher mathematics (!), the
value of equity (now, at time 0) is

This model, like most valuation models, views going

concerns as continuing indenitely. But forecasting for very
* This paper draws on themes in the authors book, Financial Statement Analysis and
Security Analysis, 3rd ed. (New York: The McGraw-Hill Companies, 2006). Comments
from Jim Ohlson and Carl Vieregger have been helpful.
1. Later value investing books persist with warnings about growth, though more accommodating. See S. Cottle, R. Murray and F. Block, Graham and Dodds Security Analysis,

48

Journal of Applied Corporate Finance Volume 18 Number 2

long (innite) horizons is impractical, so long-term expectations are summarized by a growth rate, g, which is applied
after a period of years, T, over which dividends are explicitly
forecast. It is this continued growth that draws Grahams
objection. Indeed, due diligence teams in IPOs, acquisitions, and other corporate transactions, as well as expert
witnesses in valuation cases, all understand how a formula
can be used to justify any desired value through the choice
of a growth rate.
In expressing his cynicism about valuation formulas,
Graham was adhering to the fundamentalist dictum: understand what you know and distinguish it from speculation;
put your weight on what you know and avoid building
speculation into your valuation. He saw long-term growth
rates as particularly speculative. That discipline would have
served an investor well in speculative times like the late
1990s. However, under such discipline, one would have
failed to invest in many of the successful growth companies of the last half of the 20th century.1 The mathematical
formulas are correct to say that growth is a part of value,
and to ignore it is to omit a component of value. How can
growth be handled in a disciplined way? This paper explores
schemes for handling growth that honor the fundamentalist
dictum of putting our weight on what we know and avoid5th ed. (New York: McGraw-Hill Book Company, 1988), pp. 542-546 and B. Greenwald, J.
Kahn, P. Sonkin, and M. van Biema, Value Investing: From Graham to Buffett and Beyond.
(New York: John Wiley & Sons, Inc.), pp. 31-43.

A Morgan Stanley Publication Spring 2006

ing speculation. Indeed, the paper will show how valuation

models can be applied to use what we know to challenge
speculation about growth.
Growth rates are not the only component of a valuation
model that is suspect. All valuation models incorporate a
discount ratethe r in the dividend discount model above
and a desired valuation can also be justied by the choice
of discount rates. Despite considerable effort to develop socalled asset pricing models, we really do not know how
to quantify discount rates. The premier model, the Capital
Asset Pricing Model (CAPM), is another formula, among
many, that encourages playing with mirrors; the duediligence team and valuation expert know well that changes
in beta estimates or in the market risk premium (which is
essentially a guess) have a signicant effect on the discount
rate and the value calculated. If we are honest, the discount
rate is a matter of considerable speculation and, again, sound
fundamental analysis warns about building speculation
into a valuation. Valuation formulas are correct to include
discount rates, for expected payoffs must be discounted for
their risk and the time value of money. Can we develop
schemes that acknowledge this principle but honestly recognize that we dont know how to measure the discount rate?

piece of information (earnings) and one ignores information at ones peril. Screeners typically add information by
using multiple screens (both P/E and P/B, say), but are
still in danger of trading with someone who has done their
homework, someone with an anticipation of the future
based on wider information. Further, the screener could be
loading up on risk, and both P/E and P/B surface as risk
attributes in the asset pricing literature. Thus both methods,
pricing from comparables and screening analysis, are too
simple. The diligent investor requires a model that builds in
anticipations and incorporates risk. A valuation model does
both. But, given Grahams objections to valuation models
and uncertainty about the discount rate, there clearly is a
tension. How can this tension be resolved?

Minimalist Valuation Schemes

Since anticipating payoffs is inherently speculative, one
might throw up ones hands and avoid any forecasting at
all. The widespread use of comparables does this by simply
pricing a target rm on the basis of price multiplespriceto-earnings, price-to-book, and so onof comparable
rms. Such methods are useful for identifying the price at
which a private rm might trade were it listed, but hardly
provide the discipline of avoiding speculation. If the comparable rm is trading at a speculative price, one will overprice
the target. Indeed prices bubbles are perpetuated if prices
are set on the basis of speculative prices of other stocks in
the mode of a chain letter. The method delivers price but
not value. It dees another fundamentalist dictum that says
that, when valuing stocks (to challenge prices), be careful
not to build price into the valuation. The method assumes
that markets are efcient in capturing future prospects, but
if all stocks were priced on the basis of each others price,
how would future prospects ever show up in price?
Valuation via comparables cuts against another investing strategy: distinguish price from value by observing
differences between price multiples within a set of comparable rms. These are so-called screening technologies: buy
low P/E stocks and sell high P/E stocks, or buy low priceto-book (P/B) stocks and sell high P/B stocks, for example.
But this raises another issue. With such simple schemes to
identify mispriced stocks, why would one embrace a valuation model? Well, the short answer is that such schemes are
too simple. Using a single screen (like P/E) uses only one

(2)
(3)

Journal of Applied Corporate Finance Volume 18 Number 2

Accounting for Value:

Anchoring on What We Know
Consider how the fundamentalist dictumunderstand what
you know, anchor to it, and separate it from speculation
might be operationalized in a valuation model. A valuation
model can be broken down into three components:
V0 = Value based on the present
+ Value based on information about
near-term prospects
+ Value based on long-term prospects

(1)

The rst component is based on what we know now

(from the present and the past) and includes the earnings,
book values, cash ows, and so on that are used in active
screens. If we are to anchor on what we know, this part of
the valuation gets signicant weight. The second component is based on forecasts of earnings, book values and cash
ows for the near term (two years, say) about which we are
less sure but feel we can get a reasonable grip on. The third
component is the speculative component. We have separated
what we know (and are reasonably sure about), components
(1) and (2), from speculation, component (3). What is now
needed is a model that shows how to convert the information we rely on into a valuation.
The dividend discount model introduced earlier involves
components (2) and (3): one forecasts dividends over the
near term up to a horizon, T, then adds a growth rate for the
long term. This model is intuitively appealing, for the value
of equity is surely based on the dividends it is expected to pay.
But does it anchor on what we know about value? Well, no.
We may be fairly sure about near-term dividendsthey are
typically predictablebut that knowledge does not get us
far. A basic (Miller and Modigliani) proposition in nance
says that value should not be affected by the dividends a
rm is expected to pay over the near term. Value is based
on dividends that the rm will pay eventually, in the speculative long term, but forecasting dividends over the near
A Morgan Stanley Publication Spring 2006

49

Table 1

Free Cash Flows and Earnings for General Electric Co. for 2000-2004.
(In millions of dollars, except EPS amounts)
2000

2001

2002

2003

2004

Cash from operations

30,009

39,398

34,848

36,102

36,484

Cash investments

37,699

40,308

61,227

21,843

38,414

Free cash ow

(7,690)

(910)

(26,379)

14,259

(1,930)

Earnings

12,735

13,684

14,118

15,002

16,593

1.29

1.38

1.42

1.50

1.60

EPS

future has no bearing on value. This is easily appreciated

in the case of a (valuable) rm like Cisco Systems that pays
no dividends: we might forecast that dividends will be zero
over the next few years, and be reasonably condent in this
prediction, but that tells us nothing about value; we have
not anchored on what we know about value.
Dividends pertain to the distribution of value, not the
generation of value, and the timing of distributions may
have nothing to do with value generation. Value is generated by trading with customers, not by paying dividends out
of that value. We need to articulate what is going on inside
the rm to quantify the generation of value. We need to do
some accounting on the rm. Refer to this as accounting
for value. A valuation model is really just a prescription
for accounting for value. Just as there can be good and bad
accounting, so we can have good and bad accounting for
value, and good and bad valuation models.
Anchoring on Cash Flows: Cash Accounting and
Discounted Cash Flow Valuation
The popular discounted cash ow (DCF) model accounts
for value using cash accounting:

The value of the equity is enterprise value (the value of the

rm) minus the net debt, and the enterprise value is given by
the present value of forecast free cash ows, FCF.2 Accounting for value is accomplished by accounting for (future) cash
ows from the business (as in the cash ow statement):
Free cash ow (FCF) = Cash ow from operations
Cash investment
In terms of our three components of value, the model
relies on component (2) forecasts for the near term up to
2. To be technically correct, the discount rate now is the enterprise discount rate, the
so-called weighted-average cost of capital.

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Journal of Applied Corporate Finance Volume 18 Number 2

a horizon, Tand component (3), the so-called terminal

value or continuing value, which is based on a speculative
forecast about the long-term growth rate of free cash ow.
Does this anchor on what we know? Well, component (1) is
not present. And we may also run into problems if we put our
weight on the near term, component (2). Are free cash ows
forecast over the next few years a good indicator of value?
They can be, but often are not. Free cash ow is reduced by
cash investment, but investment (generally) adds value rather
than reducing it. Firms like General Electric, Wal-Mart, and
Home Depot have consistently reported negative cash ows,
not because they are troubled rms but because they are
valuable rms with a lot of investment opportunities.
To understand how DCF analysis can frustrate a valuation, consider the free cash ows that GE reported for
2000-2004 shown in Table 1.3 Pretend that you are standing
at the end of 1999 and have been given advance knowledge
of the cash ows that will be reported over the next ve
years. Go ahead and value the rm. With such privileged
information, one might be condent in the exercise, but
students given this task balk (of course). The free cash ows
are negative in all years except 2003, and the 2003 ow is
positive only because of a drop in investment. The terminal
value, the speculative component, is over 100% of the value
(for a positive price), but there is no indication how we might
calculate it. Applying a growth rate to a negative 2004 cash
ow is problematic, to say the least. As a practical matter, we
have model failure. The extensive investments that result in
the negative cash ows will probably generate positive cash
ows after 2004, so one can extend the forecasting horizon.
But that requires speculation about the long run.
Free cash ow is an unreliable indicator of value, not
something to anchor on. In a sense, it is a liquidation
concept: companies can increase free cash ow by reducing investment (as GE did in 2003) and reduce free cash
ows by making investments that add value (as in the other
years). The DCF model gives the correct value because it
3. These cash ows are slightly different from those reported in GEs cash ow statement because they have been unlevered by removing the interest and other nancing cash
ows that GAAP includes in operating ows.

A Morgan Stanley Publication Spring 2006

compensates for the near-term forecast with a corrective

long-term forecast, but the effect is to shift the weight in the
valuation from component (2) to component (3). Benjamin
Graham would not approve. Is there an alternative accounting that introduces a valuation component (1) and provides
a component (2) on which we can place some weight?
Anchoring on Book Value and Earnings:
Accrual Accounting Valuation
Accrual accounting, which focuses on the balance sheet
(book value) and the income statement (earnings) rather
than the cash ow statement, differs from cash accounting
in two ways: First, investments are placed on the balance
sheet rather than subtracted from earnings; second,
accrual components of income (value ows other than
cash ows) are recognized in earnings. The rst feature
is clearly desirable, for the perverse feature of free cash
ows is avoided. The second recognizes that value can be
gained or lost for shareholders without a cash ow. Paying
wages with stock options is a good example; others include
paying wages with pension promises (pension accruals)
and recognizing revenue from a receivable (rather than
on payment of the receivable). A fundamental accounting
equation states that:
Earnings (before interest) = Free cash ows +
Investments + Accruals
This correction to free cash ows looks like a good basis
for measuring value added. General Electric, while reporting
negative free cash ows, reported a string of positive, growing
earnings for 2000-2004 (see Table 1). Accrual accounting,
in principle, aims to measure the value added from trading
with customers and does that by an appropriate treatment
of investment (a cost of trading with future, not current,
customers) and recognition of non-cash components of
valued added in the trading process. I emphasize in principle because this does not mean that GAAP accounting is
completely successful in the endeavor, but it is important to
appreciate that accrual accounting in principle serves business valuation well.
Suppose one were reasonably condent of ones
earnings forecasts for the next two years and felt those
forecasts were something to anchor on. (Analysts typically
forecast point estimates of earnings for only two years
ahead.) Then valuation with accrual accounting proceeds
under the following formula, the residual earnings model

(or residual income model). For a two-year forecasting

horizon,

Residual earnings, REt = Earningst (r Bt-1), is earnings

in excess of a charge against the book value of common
equity, B, which is the net assets employed in generating
the earnings. Residual earnings can also be calculated as
REt = (ROEt r) Bt-1, where ROE is expected earnings
relative to book value. If we forecast ROE = r for all future
periods, then V0 = B0 and the intrinsic price-to-book ratio,
P/B, is 1.0; if we forecast ROE > r, then we conclude that
the intrinsic P/B is greater than 1.0; and if we forecast ROE
< r, then we conclude that the intrinsic P/B is less than 1.0.
In contrast to the doubtful free cash ow concept, residual
earnings is a logically consistent way to look at value added:
a rm adds value to its book value only if it earns a rate of
return on book value greater than the required return.
As a point of theory, this valuation will always be equivalent to a dividend discount valuation and a DCF valuation
if we somehow could forecast dividends and cash ow for
very long (innite) horizons, or if we somehow could get the
correct (but different) growth rates for each model. However,
in separating what we know from speculation, this model
breaks down the components of the valuation differently. We
now have a component (1), the book value, which we observe
in the present. If mark-to-market accounting is applied,
the book value gives the complete valuation, as in the case
of an investment fund where one trades as net asset (book)
value. More generally, book value is not sufcient so one adds
forecasts of residual earnings for the near term, component
(2), and speculation about the long term, component (3), to
estimate the difference between value and book value.
It makes eminent sense to anchor the rst component on
something in the (audited) nancial statements rather than
a forecast of the future. In doing this, we are recognizing
where the rm is now, before moving to the more tentative task of adding value for the future. General Electrics
per-share book value in its 2004 nancial statements was
$10.47. In April, 2005, analysts were forecasting consensus earnings per share (EPS) of $1.71 for 2005 and $1.96
for 2006. Using a required return, r, of 10 percent and
setting the long-term growth rate equal to the average GDP
growth rate of 4% yields a valuation of $23.69.4 GE traded
at $36 at the time. Of course, if one had some condence in

4. The calculation goes as follows:

where RE1 = $1.71 (0.10 10.47) = $0.663, book value forecasted for the end of year
1 = $10.47 + 1.71 0.91 = $11.27 (with a dividend of $0.91 per share indicated for
2005), and RE2 = $1.96 (0.10 11.27) = $0.833.

Journal of Applied Corporate Finance Volume 18 Number 2

A Morgan Stanley Publication Spring 2006

51

Figure 1

Building Blocks of a Valuation for General Electric, April 2005

forecasting growth rates for the immediate term (over the

three to ve years for which analysts typically forecast EPS
growth rates, for example), one could expand the forecast
horizon to incorporate these intermediate-term projections
that might differ from the GDP growth rate expected for
the very long term.
Dealing with the Speculative Component
in a Valuation
In making the $23.69 valuation for GE, we have refused to
speculate about the long-term growth rate. We have set it
solely on what we know from the past, the average for the
economy. In Grahamite fashion, we might well choose to
anchor on the 4% and refuse to speculate further. However,
we recognize that individual rms growth rates may vary.
Before retiring, there is something else we can do: we can
reverse engineer the model to get an understanding of the
growth rate implicit in the market price of $36, and then
challenge the markets expectation.
Figure 1 displays the three components that make up
the market price of $36.5 The book value component of
$10.47 we know for certain. We are reasonably sure of the
$8.18 component (and would be even more condent if
this were calculated from our own forecasts rather than the
analysts consensus). Component (3), consisting of $17.35
of the $36, is speculative value, corresponding to the last
5. The second component is calculated as follows:

Two-year-ahead residual earnings, $0.833, are capitalized as a perpetuity, that is, with no

52

Journal of Applied Corporate Finance Volume 18 Number 2

term in the two-period residual model. Anchoring on what

we know in components (1) and (2), we can solve for the
growth rate: g = 7.0%. We may not know the long-term
growth rate but, with an exercise in reverse engineering, we
can understand the growth rate that the market sees at a
price of $36. We understand what we are buying if we buy
at the market price.
We can now turn to challenge the markets speculation:
given what we know, is the markets growth forecast a reasonable one, or is it out of line? We might conclude (or not) that
GE can maintain a growth rate, perpetually, in excess of the
GDP rate. Or we might put in some effort to pro forma the
growth under alternative reasonable scenarios to challenge
the 7.0% rate. Note that the calculated growth rate refers
to growth in residual earnings, not earnings, but with a
forecast of dividends, a residual earnings forecast can readily
be converted to an earnings per share forecast. The 7.0%
growth rate translates to an EPS forecast of $2.11 for 2007,
and so on for subsequent years.6 The analyst asks herself: do
I see it differently?
In anchoring on book value and two years of earnings
forecasts, we have explained $18.65, or 51.8%, of GEs market
price (in the rst two building blocks). If we had anchored
on two years of forecast cash ows and they were negative (as
with GE in Table 1), we would have had a calculated negative
amount, with over 100% of the market value identied with
growth. The speculative growth has been shifted to the third component.
6. The calculation reverse engineers the residual earnings formula:
Earnings for 2007 = (Book value for 2006 0.10) + Residual earnings forecasted
for 2007.

A Morgan Stanley Publication Spring 2006

the speculative component.7 But that would not incorporate

what we know from the accrual accounting. Accrual accounting in principle effectively brings value forward in time; cash
accounting defers it to the speculative future. This is the
principle reason for moving from discounted cash ow valuation to residual earnings valuation.
That move to accrual accounting valuation, of course,
begs the question of what is the appropriate accrual accounting. For GE, we have observed some advantages in using
GAAP accounting. However, the quality of GAAP accounting is suspect on a number of dimensions. For example,
GAAP accounting expenses investments in R&D; GAAP
applies cash accounting to R&D, resulting in low earnings
and even reported losses for (valuable) R&D rms, and thus
introduces the same valuation problems we have observed
with cash accounting. But what constitutes the appropriate
accrual accounting is a question for another day.
Reverse Engineering and Enhanced Screening
If one wishes to engage in stock screening, one might
screen on implied growth rates rather than simple P/B
or P/E ratios. This builds what we know in the rst two
building blocks into the screen and isolates the most speculative component of the price that is presumably subject
to mispricing. However, there is another aspect of the
valuation model that is also subject to speculation, one
that we have overlooked to this point: we do not know
the required return. If we had set the required return for
GE at 9% (a risk premium of 4.5% over the 4.5% yield
on the 10-year treasury note at the time) rather than the
10% in the valuation above (a risk premium of 5.5%), we
would have calculated a per-share value of $28.53, closer
to the money, and the implied growth rate would have
been 5.5%. If we are condent in our estimate of the risk
premium, we might proceed on this basis, but risk premiums are very much a guess.
Alternatively, we might admit our ignorance and
proceed (as a fundamentalist would) on the basis of what
we know, grouping rms into perceived risk classes based
on an analysis of their fundamental risk characteristics. This
ordinal grouping into risk classes admits (honestly) that
we cannot distinguish risk within a class, only differences
7. To be fair, GE is a particular (but not unusual) case. DCF valuation works OK for
cases where cash ows are aligned with the value generation. The Coca Cola Company,
for example, regularly produces positive free cash ows that grow at about the same rate
as residual earnings from their operations.
When applying DCF valuation, analysts sometimes make adjustments to cash ows
(distinguishing maintenance investments from growth investments, for example) to deal
with the investment problem. These adjustments are really a form of accrual accounting
and beg the question as to the appropriate accrual accounting for valuation. From a
fundamentalists point of view, accrual accounting should not embrace too much speculation. Maintenance capex is notoriously hard to identify, so one must ask whether applying such an accrual concept builds too much speculation into the accounting.

between classes; this is as ne an identication as our knowledge will allow. Then, to complete the screen, rank rms on
implied growth rates within risk classes. With this control
for perceived risk, one reasonably screens out stocks where
the market might be overly speculative.
Enhancements in Challenging Growth
Speculations
Forecasting a constant growth rate after two years is somewhat
unsatisfactory; one typically thinks of higher growth in the
intermediate term, declining to normal growth in the long
term. This view can be implemented by extending the horizon
for forecasting residual earnings (to ve years, for example),
and then estimating an implied long-term growth rate thereafter. However, there is another way to go about it.
By recognizing that the change in book value is determined by (comprehensive) earnings before net dividends,
the two-period residual earnings model can be written as

where RE2 is the change in residual earnings in year 2 over

year 1. This presents the valuation in the form of a P/E ratio
rather than a P/B ratio. Investors and analysts tend to talk in
terms of P/E ratios rather than P/B ratios: value is based on
forward earnings, capitalized, plus a premium for growth.
That growth comes from growth forecast two years ahead
plus a long-term growth rate.8 With some reorganization,
the formula expresses this idea more clearly:

where G2 is the forecast EPS growth rate two years ahead.9

This version, known as the Ohlson-Juettner model after its
architects, explicitly identies the forward earnings multiplier.10
Figure 2 applies this model to Cisco Systems. In September 2004, Cisco traded at $21 per share and analysts were
forecasting EPS of $0.89 for scal year ending July, 2005
and $1.02 for 2006. Since Cisco pays no dividends, forecast
8. The transformation of the residual earnings model to the P/E form here recognizes
that

That is, anchoring on book value plus forward residual earnings capitalized (without
growth) is the same as anchoring on capitalized forward earnings (without growth). In the
spirit of anchoring on something in the nancial statements, the modeling permits anchoring on reported earnings rather than book value, in which case the focus is on the trailing
P/E rather than the forward P/E:

In this case, the current EPS0 should be a measure of core EPS to purge the earnings
of transitory items that do not produce growth.

Journal of Applied Corporate Finance Volume 18 Number 2

A Morgan Stanley Publication Spring 2006

53

Figure 2

Projected EPS Growth Forecast Implicit in the Market Price of $21 for
Cisco Systems Inc., September 2004

EPS growth for 2006 was $1.02/$0.89 = 14.6%. Once again

setting the required return at 10% and the long-term growth
rate at the GDP growth rate of 4%, the calculated forward
(intrinsic) P/E is 17.68 which, when applied to forward EPS
of $0.89, yields a per-share value of $15.73. Moving into
reverse engineering mode, one could set r = 10% and calculate the long-term growth rate implied by the market price
of $21: g = 6.6%. The EPS growth rates that this implies,
for years beyond 2006, are plotted in Figure 2. From the
14.6% growth forecast by analysts for 2006, we see a gradual
decay in the growth rate. A geometric decay is built into the
model and suitably so, for we typically expect high earnings
growth to decline over years as growth rms become less
protable under competition and their P/E ratios revert to
normal levels. Indeed, if we were to extrapolate these EPS
growth rates out to the very long run, we would see that they
converge to the 6.6% long-term growth rate implied by the
market price.
The projected EPS growth path distinguishes buy and
sell regions in Figure 2. If, on the basis of our own analysis,
we feel that Cisco cannot maintain this growth path that the
market sees, we must sell. If we see growth rates above the
path, we buy.
However, we have again built in speculation about the
required return. Do both GE and Cisco have the same
required return of 10%? (With a beta of 0.4 for GE and 1.6

for Cisco, we might give them a different required return,

though we would be speculating about how much that
difference should be.) This formulation of the model does
give us another degree of freedom to work with, however.
We do have a grasp on the average GDP growth rate, so if
we are willing to put this into the set of what we know, we
can set g = 4%. Then, anchoring on everything else in the
formula, we can reverse engineer to get the implied r in the
market price rather than the implied g. For Cisco at $21, a
G2 of 14.6%, and g set to 4%, the implied r = 9.0%. It is
important to note that this implied r is the required return
only if the market price is a fair (efcient) one. Rather, it
is the implied rate of return to be earned from buying the
stock at the market price, and a higher price yields a lower
return. If we were looking for a higher return for the risk
borne (say 10%), we would sell Cisco. In screening mode, we
would rank rms on their implied r and buy those with high
r and sell those with low r. Before ranking, we might group
rms into fundamental risk classes, and then rank within
risk class, so that Cisco (with a beta of 1.6) would demand
a higher implied return than GE (with a beta of 0.4). This
approach serves us well if we deem the (very) long-term
growth rate to be the same for all rms: we have anchored
on near-term forecasts about which we felt comfortable and
on a long-term growth rate that must correspond to average
GDP growth.

9. Strictly, G2 is the forecasted growth rate in cum-dividend earnings, that is, with the
reinvestment of any dividends expected to be paid in year 1:

This recognizes that dividends can be reinvested to earn further earnings (by buying
the stock with the dividend, for example).
10. See J. Ohlson and B. Juettner-Nauroth, Expected EPS and EPS Growth as Determinants of Value, Review of Accounting Studies, Vol. 10 (2005), pp. 350-365. See also the
discussion of the model by S. Penman on pp. 368-378 of the same issue of the Review
of Accounting Studies.

54

Journal of Applied Corporate Finance Volume 18 Number 2

A Morgan Stanley Publication Spring 2006

The View from Corporate Finance

So far, this paper has been written from the point of view of
an investor evaluating a buy or sell of a stock. The tools readily translate to corporate nance, however. The CFO and
the rms banker need to understand the markets pricing of
the rms stock. An implied growth rate turns the price into
an earnings forecast that the CFO can evaluate as realistic or
not; it articulates the markets expectations. (For the calculations, he or she anchors on the rms near-term forecasts, of
course, not those of analysts.)
With these tools, the CFO can get a sense of the underor overpricing of the rms shares for such decisions as timing
share offerings and share repurchases, or choosing between
debt and equity offerings. He or she understands value in
acquisitions, not only the valuation of the target, but also
the valuation of the rms own shares to decide whether
(overpriced) those shares should be offered in exchange.
The CFO, along with the associated investment banker,
can also challenge due diligence valuations used to justify
prices. For acquisitions, the methods here, though maintaining some simplicity, surely dominate too-simple relative P/E
approaches; indeed, the methods are essentially a renement
of the relative P/E approach using more information.
A CFO with a dened hurdle rate may choose to use
that rate for r in the analysis and focus on implied growth
rates. Implied r ts naturally into corporate nance, however,
because it is essentially the internal rate of return (IRR) so
familiar in project nance. The CFO has some advantage in
developing an accounting for value rather than relying on
GAAP accounting, for presumably he has better information
with which to capitalize and amortize R&D and other investments, and to evaluate when GAAP rules are arbitrary and
misleading with respect to his rm. (Be careful about building
in too much speculation into the accounting, however!)
In corporate nance we usually work with enterprise
valuations rather than the equity valuations above, but the
residual earnings model can be adapted to enterprise valuations. With a two-year forecasting horizon, the value of the
equity can be expressed as

where ReOIt = Operating incomet (r Net Operating
Assetst-1) and r is now the weighted-average cost of capital.
Operating income is income from the business (earnings
before interest) and net operating assets is the capital
invested in the businessthat is, equity plus net debt. All of
the analysis can be done with operating income substituted
for EPS and residual operating income (ReOI) substituted
for residual earnings (RE) in the formulas above.11 Reverse
11. For details, see S. Penman, Financial Statement Analysis and Valuation, referenced

Journal of Applied Corporate Finance Volume 18 Number 2

engineering proceeds with enterprise market price (equity

price + net debt) substituted for equity price.
Conclusions
Valuation is a question of handling uncertainty. Valuation
models supposedly accomplish this by specifying expected
growth rates and discount rates that discount for uncertainty
(risk). However, growth ratesand the discount rate itself
are highly uncertain, even speculative, leading to Benjamin
Grahams objection to valuation models at the head of this
paper. Valuation models, expressed as mathematical formulas, look precise, but can be abused to convey fake precision.
To handle uncertainty, we need a means of handling the
uncertainty embedded in valuation models.
This paper has attempted to nesse the problems with
valuation models that so concerned Benjamin Graham, and
in a way that honors the fundamentalist creed from which
those concerns arise. Valuation models are implemented
under a discipline that separates what we know, based on solid
fundamental information, from speculation. Accounting is
important, for accounting discovers what we know about a
business. Accordingly, accrual accounting methods of valuation
(and residual earnings methods) are preferred to cash accounting
(and discounted cash ow methods). These models are implemented in a rather unconventional way, however. They are used
to incorporate what we know and then turn that knowledge
around to identify the speculative component of market prices.
Further, they express that speculation in the form of earnings
forecasts that can be challenged with fundamental analysis.
And, with additional input about fundamental risk characteristics, uncertainty about discount rates can also be handled.
Equity investing is not a game against nature and valuation models should not be seen as identifying a true intrinsic
value. Rather, equity investing is a game against other investors and valuation models should be used to understand how
an investor thinks differently from the market. Thus the right
question is not what the right value is, but rather whether a
model can help an investor understand what perceptions best
explain the market price, and then compare those perceptions
to his own. The paper shows how to handle valuation models
under this approach, and in a way that meets the objections in
the Graham quote at the top of the paper.
stephen penman is the George O. May Professor of Accounting at
Columbias Graduate School of Business, as well as co-director, with
Trevor Harris, of the schools Center for Excellence in Accounting and
Security Analysis. He is widely recognized as one of the leading scholars
in nancial statement analysis, having published numerous papers on
the subject along with a well-received book entitled Financial Statement
Analysis and Security Valuation.

above, Chapters 13-14.

A Morgan Stanley Publication Spring 2006

55

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