Balance Sheet Valuation Methods: Book Value Measure

Balance Sheet Valuation Methods
Book Value Measure: It is the net worth of a

company as shown in the balance sheet.
Dow Chemical Balance Sheet Dec 31, 19921 ($ Million)

Assets
Liabilities and Owners Equity
23,360
Liabilities
17,286
Common Equity
8,074
273 million shares outstanding
Book value per share = 8074/273 = 29.57

Book value per share of Dow Chemical stock on Dec 31,
1992 was $29.58. On that day Dow stock had a market
price of $57.25
The above two prices differ because book value is based
on balance sheet figure as determined by accounting
rules. On the other hand, market value of stock is based
on firms value as a going concern i.e. market consensus
estimate of the present value of the firms expected
future cash flows.
It is unlikely that market price will be same as
book value. Also, book value cannot always be
floor for stocks price .

Liquidation Value: This represents the amount of
money that could be realized by liquidating the firm i.e.
selling its assets, repaying debts, and distributing the
remainder to the shareholders.
Liquidation value per share is considered to be the floor

for the stocks price because if market price of stock
(value as a going concern) goes below the liquidation
value the firm becomes attractive for takeover.

Replacement Cost: This is the cost to replace
firms assets less its liabilities. The market value of firm

can not go too far above its replacement cost because if
it did competitors would try to replicate the firm, this in
turn will drive down the value equal to the replacement
cost.
The ratio of market price to replacement cost is known
as Tobins q. According to this, in the long run this ratio
will tend toward 1.
However, evidence indicates for very long periods of
time, the ratio can significantly differ from 1.
Intrinsic Value Vs. Market Price

Current price per share Po = 48
Expected dividend per share E(D1) = 4
Expected price per share E(P1) = 52
Therefore, Expected HPR = 16.7%
which consists of dividend yield i.e. E(D1) Po
and capital gains yield i.e. [ E(P1) Po ] Po
The required rate of return on stock is the rate

that investors expect to earn on a security and
when prices are in equilibrium it can be
determined by CAPM i.e. k = rf - [E(rM rf)]

The required return on a security indicates the
return that investors will need from any other
investment of equivalent risk.
If a stock is priced correctly, its expected return will
equal to the required return.
If risk free rate is 6%, beta = 1.2, and market risk
premium = 5%, then required rate of return or
market capitalization rate k = 12%
Therefore, based on the available information the
expected rate of return exceeds the required return
by 4.7%. As such, investors will try to include more
this stock in their portfolio.

Another way to make the above decision is to
compare intrinsic value (V) of a stock to its market
value or price (Po).
The current market value or price is 48.
and the intrinsic value is Vo = 50 (discounted by r.r.)
This indicates the stock is underpriced in the market
and should be included in the portfolio if investor is
not following a passive strategy.
In market equilibrium, the current price will reflect
the intrinsic value estimates of all market
participants i.e. there is no differences of the market
consensus estimates of E(D1), E(P1), or k. A common
term for the market consensus value of the required
rate of return i.e. k is the market capitalization rate.
Stock Prices & Investment Opportunity

Cash Cow Inc. (firm with considerable cash flow but
limited investment prospects)
Growth Prospect (GP)

Both the companies expected earnings per share (EPS) is 5 and
this can be paid out as perpetual dividend per share.
If the market capitalization rate k = 12.5%, then value per share
of both the companies will be d1/k = 5/.125 = 40
If earnings are not reinvested both the companies value will
remain same without any growth i.e. earnings and dividend will
not grow.

Now Growth Prospect involves in project which generates
ROE of 15% i.e. greater than k = 12.5%
If earnings are retained, can be invested at 15%, if distributed
among shareholders, will earn 12.5%.
b = Earnings retention ratio, also known as Plowback ratio and

1 b = Dividend payout ratio
If b = 60% then 1-b = 40%, therefore, dividend per share will be
2 instead of 5.

The reduced DPS will depress the price of share initially, but the
subsequent growth in assets will produce positive impact on share
price, as such price of share will rise.
Figure 18.1 shows dividend growth under two earnings
reinvestment plans.
The low reinvestment plan results in higher initial DPS but lower
dividend growth rate. On the other hand,
The high reinvestment plan results in lower initial DPS but higher
dividend growth rate. And if the growth rate is high enough the
stock will worth more under high reinvestment strategy.
For example if GP starts with 100 million investment with all
equity financed, then return on investment or equity will be 15%
of 100 million = 15 million.

If 60% of 15 million earnings are reinvested, then the firms
capital stock will increase by .6 x 15m = 9 million.
The percentage increase in capital stock = 15% x 60% = 9%
With 9% more capital, the company earns 9% more income, pays
9% higher dividends. The growth rate of dividend will be same as
growth rate of capital i.e. g = ROE x b =.15 x .60 = .09 or 9%
If stock price equals its intrinsic value, it will sell at
Po = d1/(k g) = 2/(.125 - .09) = 57.14
When GP pursued no-growth strategy its stock price was 40 This
can be interpreted as value per share of assets already in place or
at initial stage.

Growth Prospect
The reason for increase of stock price is that the expected rate of
return from investment is greater than the required rate of return.
In other words, it can be said that the investment
opportunities have positive NPV and the value of firm
rises by the amount of NPV. This NPV is also known as
present value of growth opportunities or PVGO
Therefore, the value of firm equals no-growth value + PVGO
No-growth value = 40, therefore, PVGO = 57.14 40 = 17.14

Stock price Po = D1 or E1 /k + PVGO = 40 + 17.14 = 57.14
Growth increases value only if ROE > K

Cash Cow Inc.
Cash Cows ROE is equal to k i.e. 12.5%. As such the NPV of its
investment opportunity will be equal to zero. With zero growth
strategy, b = 0, g = 0, and value of cash cow will be 40 per share
If cash cow plows back 60% of its earnings, then its growth rate
g will be ROE x b = .125 x .6 = .075 and stock price will still be
40 per share.
DPS (d1) = .4 x 5 = 2, k = 12.5%, and g = 7.5%,
Po = d1/(k g) = 2/(.125 - .075) = 40
This indicates if firm can not reinvest earnings at a rate
higher than what shareholders can earn by investing on
their own, the firm can not add value. If ROE is equal or
less than k, there is no advantage of plowing funds back
into the firm. Example 18.4 demonstrates this fact.
Life Cycles & Multistage Growth Models

Firms typically pass through life cycles with very different dividend
profiles in different phases.
In early years, there are ample opportunities for profitable
reinvestment. Payout ratios are low and growth is rapid.
In later years the firm matures, competitors enter the market,
reinvestment opportunities become limited. In this phase, the firm
may choose to increase the dividend payout ratio rather than
retain earnings. The dividend level increases but it grows at a
slower rate.
Industry
Return on
Assets
(Average)
Retention
Ratio b
(Average)
Drugs and
Pharm.
25.35%
89.83%
Food
Products
24.97%
68%
Payout
Growth rate
Ratio 1-b
of EPS
(Average) 1999 2004
(Average)
10.17%
60.83%
32%
2.8%

EPS for the year ended March 31, 2004 of Infosys Technologies
Limited was 46.27.
Forecasted EPS for the next two years i.e. 2005 and 2006 are 68
and 93 respectively.
Projected growth rate is 44% till year 2008
Long term steady growth rate of 6% is assumed after
year 2008.
Market capitalization rate k is determined as per CAPM, which is
13.1%

Infosys Technologies Ltd.
Year
2004 2005 2006 2007
2008
2009
EPS
46.27
192.8
204.4
DPS as per
60% payout
Beta
Risk free rate
of return
Market Risk
Premium
68
40.8
0.81
5%
10%
93
133.9
55.8 80.34 115.68
115.68 x
1.06

Infosyss intrinsic value in 2004 is 1262
The market price on March 31 2004 was 1234.55
This indicates the stock was slightly under priced.
The reliability of this fact depends on the accuracy of the

estimated values of the variables (as per assumptions) used to
determine the intrinsic value. The assumptions were made
regarding the amount of dividends, the growth rate of dividends,
and market capitalization rate. Moreover, it is assumed the
company follows a simple two-stage growth process. In reality,
the growth of dividends may follow more complicated pattern and
even a small errors in estimations can entirely change a decision.

For example, if the estimated growth rate is 5% instead of 6% in
2008, this will change the intrinsic value to 1122.
Therefore, estimation of intrinsic value is very sensitive to
the different assumptions that are made to determine it.
As such, it is very important that sensitivity analysis be done
in valuation of stocks.
The sensitivity analysis will highlight the variable that needs to be
carefully examined. For instance, besides growth rate, a small
change in capitalization rate will change the intrinsic value
substantially, whereas reasonable changes in dividend forecast
between 2005 and 2008 would have a small impact on intrinsic
value.
Price Earnings Ratio

P E ratio or multiple is the ratio of PPS and EPS.
Company
Cash Cow
Inc.
Growth
Prospect
ROE
Retention
Ratio b
12.5% 12.5%
0%
15%
12.5%
60%
PPS
EPS
40
PE
Ratio
8
57.14
11.4

The P E ratio indicates future expectations about growth
opportunities. Growth opportunities are reflected by P/E
ratio as follows:
Po 1
PVGO
1
E
E1 k
When PVGO = 0 the above equation shows that Po = E1/k The

stock is valued like a non growing perpetuity of E1 and the P/E
ratio is just 1/k. However, as PVGO becomes increasingly
dominant contributor to price, the P/E ratio can rise
dramatically.

The ratio of PVGO to E/k indicates the component of firm value
due to growth opportunities to the component of value due to
assets in place or initial stage i.e. the no growth value of the
firm.
When future growth opportunities dominate the estimate of
total value, the firm will command high price relative to current
earnings. Therefore, a high P/E multiple indicates that a firm
has ample growth opportunities.
The differences in expected growth opportunities implies

differentials in P/E ratios across firms. The P/E ratio actually is
an indication of the markets optimism regarding a firms
growth prospects.

According to constant DDM formula
Po = D1 / (k g)
The payout ratio is 1 b, E1 is expected EPS, g = ROE x b
Therefore the above formula can be written as follows:
Po = E1(1 b) / (k ROE x b)
Po/E1 = (1 b) / (k ROE x b)
The P/E ratio increases for higher plow back as long as ROE
exceeds k.
Table 18.3
Market Capitalization Rate k = 12%
Plow back
Ratio
ROE
10%
12%
14%
.25
.50
.75
5%
6%
7%
7.5%
9%
10.5%
7.14%
5.56%
8.33%
10.00%
8.33%
16.67%
A. Growth Rate g
0
0
0
2.5%
3%
3.5%
ROE
10%
B. P/E Ratio
8.33%
7.89%
12%
14%
8.33%
8.33%
8.33%
8.82%

It is evident from Table 18.3 that higher plow back increases
growth rate but higher plow back does not necessarily
increase P/E ratio.
A higher plow back increases P/E ratio only if investment
undertaken by the firm offer an expected rate of return
(ROE) greater than the market capitalization rate.
However, P/E ratios are in general considered to be proxies
for expected growth in dividends or earnings. As per Wall
Street rule of thumb, the growth rate should be roughly
equal to P/E ratio i.e. the ratio of P/E to g or PEG ratio
should be about 1.
Example 18.5
Price Earnings Ratio & Stock Risk

One important implication of any stock valuation model is that
riskier stock will have lower P/E multiples holding all else equal.
This can be examined by analyzing the following formula
P
1 b
E
k g
Riskier firms will have higher required rates of return i.e. k,
therefore, P/E multiple will be lower. Moreover, if future
dividends are discounted at a higher rate, the price will be
lower and also the P/E ratio.
It is also observed that many small, risky, new companies have
very high P/E ratios, this indicates markets expectation of high
growth rates for those companies. Therefore, with a given
growth projection, the P/E multiple will be lower when risk is
perceived to be higher.
Pitfalls in P/E Analysis

First, the denominator in the P/E ratio is accounting earnings
which are influenced by accounting rules such as depreciation
and inventory valuation methods. At high inflation historic cost
depreciation and inventory costs will be under priced. As such,
P/E ratio will be lower. It is shown in figure 18.3
Firms get considerable flexibility in case of earnings
management (i.e. the practice of using flexibility in accounting
rules to improve apparent profitability of firm), as such justified
P/E ratio becomes difficult to determine.
Justified or Normal P/E ratio implicitly assumes that earnings

rise at a constant rate or on a smooth trend line, however,
reported earnings can fluctuate dramatically with business
cycle.

In other words, the calculated P/E ratio indicates the ratio of
current price to trend value of future earnings. But in the
financial pages of Newspaper report P/E multiple as a ratio of
current price to the most recent past earnings.
In DDM earnings are defined as net of economic

depreciation (i.e. maximum flow of income that the firm could
pay out without depleting its productive capacity. However, the
reported earnings are calculated as per GAAP and do not
correspond to economic earnings.

In other words, the calculated P/E ratio indicates the ratio of
current price to trend value of future earnings. But in the
financial pages of Newspaper report P/E multiple as a ratio of
current price to the most recent past earnings.
In DDM earnings are defined as net of economic

depreciation (i.e. maximum flow of income that the firm could
pay out without depleting its productive capacity. However, the
reported earnings are calculated as per GAAP and do not
correspond to economic earnings.
Combination of P/E & DDM

P/E ratios can also be used in conjunction with earnings
forecasts to estimate price of stock. For example, if
projected P/E for 2008 is 15 of Infosys stock and EPS
forecast for the same year is 192.8, this implies price in
2008 = 15 x 192.8 = 2892. With this estimate of 2008
price, intrinsic value in 2004 is 1,973 which is quite
closer to the average price of Infosys in 2004.
Other comparative valuation ratios

Price to Book Ratio: This is ratio of price per share and
book value per share. Some analysts consider this ratio
to be an indicator of how aggressively the market values
the firm.
Price to Cash Flow Ratio: Some analysts prefer to use
this ratio (i.e. PPS to CFPS) rather than P/E ratio as
cash flow is relatively less affected by accounting
practices or rules. Operating cash flow per share and
free cash flow per share (i.e. operating cash flow net of
new investment) are also used in computing this ratio.
Other comparative valuation ratios

Price to Sales Ratio: Many start up firms have no
earnings. As such, P/E ratio does not provide any
useful information. The ratio of price per share
and annual sales per share i.e. price to sales
ratio is now being commonly used for valuing
these firms. However, this ratio may differ
significantly across industries as profit margin
vary widely.
Free Cash Flow Valuation Approach

The valuation approaches so far discussed are
based on the assumption that retained earnings
were the only source of financing new equity
investment.
Now it will be examined if external equity and
debt were used instead of retained earnings how
it will affect the value of a firms share, i.e. how
dividend policy and capital structure affect the
same?

The answer to this question has been provided by MM
theory, which states that if a firms future investment is
considered to be given, then the value of its existing
common stock will not be affected by how those
investments are financed. As such, neither the firms
dividend policy nor its capital structure should affect the
value of share.
The reason is that the intrinsic value of equity depends
on the present value of net cash flows to shareholders
that can be produced by firms existing assets plus net
present value of any investment to be made in future.
Given those existing and expected future investments,
firms dividend and financing decisions will affect only
the form in which existing shareholders will receive their
future returns (i.e. either dividends or capital gains).

One of the out comes of their proof of the above
propositions is the free cash flow approach to valuation.
This approach estimates the value of the firm as a whole
and determined the value of equity by subtracting the
market value of all nonequity claims. The estimate of the
value of the firm is found as the present value of cash
flows, assuming all equity financed plus the net present
value of the interest tax shields for using debt.

Example of MiMo Corporation
EBIT = 1 million in the year just ended and it will grow @
6% per year forever.
For keeping this growth the firm will invest an amount
equal to 15% of pretax cash flow each year.
The tax rate is 30%.
Annual depreciation in the year just ended = 100,000 and
it will grow @ 6% per year forever also.
The appropriate market capitalization rate for unlevered
cash flow = 10% per year
The current amount of debt = 2 million

Calculation of Free Cash Flow of MiMo Corporation
Before tax cash flow from operation

Annual depreciation
Taxable income
Tax @ 30%
After tax unlevered income
After tax cash flow from operations
New Investment (15% of cash flow from oper.)
Free C F (A. Tx. C.F. from oper. less New Inv.)
1060,000
106,000
954,000
286,200
667,800
773,800
159,000
614,800
Note that the projected free cash flow is the firms cash flow under
all equity financing, it ignores interest expense and any tax
savings from interest expense.

The PV of all future free cash flow Vo = C1/(k g)
= 614800/(.10 - .06)
= 15,370,000
This is the value of the whole firm i.e. debt plus equity.
As debt = 2 million, therefore, equity = 13,370,000
If it is assumed that interest tax shield from using debt has
increased the firms value by .5 million, the total value of the
firm will be 15,370,000 + 500,000 = 15,870,000 and the
value of equity will be 13,870,000.

It should be noted that the market capitalization rate
used for discounting future cash flows under Free Cash
Flow approach and other approaches are different.
Under Free Cash Flow approach the market
capitalization rate is appropriate for unleveraged equity,
in case of other approaches, the market capitalization
rate that was used, is appropriate for leveraged equity.
Inflation and Equity Valuation

As long as real values are unaffected, the stocks current
price will not be affected by inflation. The following
relationship exists between real and nominal variables
Variable
Real
Nominal
Growth rate
g* g = (1+g*)(1+i) 1
Capitalization rate
k* k = (1+k*)(1+i) 1
ROE
ROE* ROE=(1+ROE*)(1+i) 1
Expected DPS
D1* D1 = D1* (1 + i)
Plow back ratio
b*
(1 + b* x ROE*)(1+i) - 1
b=-------------------------(1 + ROE*)(1+i) - 1

Note that, expected reported earnings (nominal) do not,
in general, equal to expected real earnings multiplied by
one plus inflation rate i.e. E1 is not equal to E1*(1 + i).
This is because historical cost accounting distorts the

measured cost of goods sold, which in turn distorts the
reported earnings. This also influences the P/E ratio. When
inflation rate increases P/E ratio decreases as is
indicated in figure 18.3
Many companies show gains in reported earnings during
inflationary periods, even when real earnings may be
unaffected.

For many years it has been thought that stocks are
inflation-neutral investments and changes in inflation rate
has no effect on the expected real rate of return on
common stocks. However, recent research indicates that
the real rates of return are negatively correlated with
inflation. In reference to the constant DDM, this means that
increase in inflation is associated with a decrease in D1 ,
an increase in k, a decrease in g, or some combination of
all three.
As per another view, economic shocks such as oil price
hikes can simultaneously increase in inflation & decline in
expected real earnings & dividends. This will result in
negative correlation between inflation & real stock returns.

Still another view implies that the higher the rate of
inflation, the riskier the stock return. The reason is that
higher inflation is an indication of greater uncertainty in the
economy, which in turn induces to increase required
return.
Also higher inflation results in lower real dividends

because after tax real earnings reduces as the inflation
rate rises.
Finally, during the period of high inflation, nominal interest
rate rises but real rate may not increase. Investors
mistakenly considering the rise in nominal rate, undervalue
stocks.

Balance Sheet Valuation Methods: Book Value Measure

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Balance Sheet Valuation Methods: Book Value Measure

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Balance Sheet Valuation Methods

Book Value Measure: It is the net worth of a

Dow Chemical Balance Sheet Dec 31, 19921 ($ Million)

Liabilities and Owners Equity

Book value per share = 8074/273 = 29.57