Spring 2009 NBA 5060

Lecture 10 – Implementing Valuation

1. Implementing valuation

2. Short-cut valuation using residual income model

For next time, read SBW chapter 14.

Lecture 10 Page 1 of 11
Implementing Valuation

In theory, value depends on payoffs over an infinite forecast horizon.

To simplify matters, however, the forecasting period is limited to a finite

number of years, after which a simplifying assumption is used.

In particular, if we forecast until the firm reaches ‘steady state’, then a

perpetuity, or a perpetuity with a constant growth rate can be used (this is
the familiar Gordon growth model):

DividendsT
Terminal Value =
re − g
To get the present value, it needs to
be discounted to today by a factor of
(1+re)-(T-1)

Note: to use this formula, the terminal value estimate has to be a perpetuity
or have a constant growth rate.

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Implementing Valuation

With the steady-state assumption and the perpetuity with growth formula,
equity value can be expressed as:

FCFE Valuation:

T −1 FCFEt FCFET
Equity Value = ∑ +
t =1 (1 + re ) t ( re − g )(1 + re ) T −1

Residual Income Valuation:

T −1 NI - re BVEt −1 NI T − re BVET −1
Equity Value = BVE0 + ∑ t
+
t =1 (1 + re ) t (re − g )(1 + re ) T −1

Residual Income Valuation based on ROE:

T -1 ROEt - re ROET - re
Equity Value = BVE0 + ∑ t
BVEt −1 + T −1
BVET −1
t =1 (1 + re ) (re − g )(1 + re )

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What values do we assign to the parameters?
(1) Explicitly forecast FCFE, RI, and BVE using pro-forma financial
statements.

(2) Terminal Growth Rate (g) represent growth in abnormal earnings in

perpetuity. Growth in GDP is a good assumption for g because it assumes that, in
steady state, the company’s growth keeps pace with growth in the economy. At a
maximum, g cannot exceed the GDP growth rate or else the firm would subsume
the entire economy. Note that the forecasted financial statements in year T
should equal the projected accounts in year 10, growing at your projected
terminal growth rate (g) – see CBRL spreadsheet.

(3) Cost of Equity Capital (re): This parameter is the source of ongoing debate in
Finance. Alternatives include:

(a) DCF approach or implied cost of capital – uses internal rate of return.

(b) Asset Pricing Approach – e.g. Capital Asset Pricing Model.

Implementing the CAPM:

re = r f + β ( E (rm ) − r f )
The risk free interest rate.
Use long term US bond yield
for long horizon projects The systematic risk of a The expected risk premium
stock, estimated using for the market index over
time series regressions long-term bonds.

rf and βcan be taken straight from Yahoo. Use the 10-year U.S. Treasury Bond for
rf. As for the risk premium, 5.77% is the arithmetic mean from 1968-2007, so use
this amount unless you have reason to adjust otherwise.

You can also adjust betas for mean reversion as follows:

adj = 1/3 + 2/3* historical

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e.g. CBRL Cost of Equity Capital:

Unadjusted: re = 2.70%+ 1.80*(5.77%) = 13.09%

Adjusted: re = 2.70%+ 1.53*(5.77%) = 11.55%

10-year T-Bond in Feb. 2009 Avg. equity premium, 1968-2007

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Valuation Date Adjustments:

All forecasts using pro-formas are inherently treated as of the date of the previous fiscal
year end (i.e., the balance sheet date). Hence, adjustments need to be made to bring
value current to today’s date.

General Technique:

1. Estimate days outstanding from the valuation date and the last fiscal year end.

2. Adjust your final value to reflect the passage of time since the prior fiscal year end.

Current value = Estimated value*(1+re)(months since last fiscal year end / 12)

or Current value = Estimated value*(1+re)(days since last fiscal year end / 365)

For example, if you are 9 months into the year (i.e., September 30 for a calendar
year company), have a 10% cost of capital, and derived a value of $30 as of the last
fiscal year end, your value today would be:
$30*(1.10)9/12 = $32.22

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Example of Final Valuation Parameters and Calculations

Valuation Assumptions
Long-run growth rate 4.10%
Beta (Adjusted) 1.53
Risk-free rate 2.70%
Equity Risk Premium 5.77%
Cost of Equity 11.55%
Balance Sheet Date 7/31/2008
Valuation Date 2/17/2009
Days Since BS Date 201
Valuation Date Adjustment 106.2%
Shares Outstanding (MM) 22.39

FCFE I 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Terminal
Net Income 48.7 50.4 58.9 67.5 75.7 84.1 92.3 100.1 107.4 115.4 120.1
Less: Increase in Equity 23.8 76.7 75.7 76.8 75.2 74.3 70.0 72.7 74.7 75.3 32.3
FCFE 24.9 -26.3 -16.9 -9.3 0.5 9.8 22.2 27.4 32.7 40.0 87.8
PV of FCFE - Finite $35.8
PV of FCFE - Terminal $395.2
Equity Value - BS Date $431.0
Valuation Date Adjustment 106.2%
Equity Value - Current Date $457.75
Shares Outstanding 22.39
Equity Value per Share $20.44

RIM I 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Terminal
Net Income 48.7 50.4 58.9 67.5 75.7 84.1 92.3 100.1 107.4 115.4 120.1
re 11.5% 11.5% 11.5% 11.5% 11.5% 11.5% 11.5% 11.5% 11.5% 11.5% 11.5%
Beg. BVE 92.8 116.6 193.3 269.0 345.8 421.0 495.3 565.3 638.0 712.8 788.1
Residual Income 38.0 36.9 36.6 36.4 35.7 35.5 35.1 34.8 33.8 33.1 29.1
Beg. BVE $92.8
PV of RI - Finite $207.3
PV of RI - Terminal $131.0
Equity Value - BS Date $431.0
Valuation Date Adjustment 106.2%
Equity Value - Current Date $457.75
Shares Outstanding 22.39
Equity Value per Share $20.44

Lecture 10 Page 7 of 11
Lecture 10 Page 8 of 11
Shortcut Valuation using the Residual Income Model

Basic concept uses analyst forecasts of earnings to derive a quick residual

income valuation that does not require forecasting pro-forma financial statements.

Basic Idea:

T -1 ROEt - re ROET - re
Equity Value = BVE0 + ∑ BVEt −1 + BVET −1
t =1 (1 + re ) t (re − g )(1 + re ) T −1

1. Use current book value and forecasts of future earnings, earnings growth rates, and
dividend payout ratios (think of as 1 – plowback rate) to compute future ROEs.

2. Use this stream of future ROEs to compute the finite period valuation

3. Use industry median ROE to get the terminal value ROET

4. Compute an Equity Value.

Can use this to determine intrinsic value estimate, given the cost of capital and
other parameters. Alternatively, this framework can be used to back out the cost
of capital given the forecasts and the current market price (uses excel’s goal seek
command).

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 Growth
This Year Next Year for Years
(July 09) (July 10)
3 to 5
Cracker Barrel $2.65 $2.84 11.03 %

Required Inputs to the shortcut valuation model:

EPS Forecasts– get these from any commercial service collecting analyst forecasts.
You need FY1, FY2, and Long-term growth forecasts.

Book value per share – As of the last fiscal year end.

Discount rate – cost of capital as computed elsewhere

Dividend Payout ratio– the portion of earnings expected to be paid out as net
dividends (including repurchases). This will impact the future book value, and hence
the abnormal ROE computation.

Current Fiscal Month – the adjustment to get value as of today

Target ROE– the long-run ROE of the firm. The industry average is a good starting
point. A conservative approach is to set the target ROE to the cost of equity capital –
this implies no abnormal earnings beyond the terminal year.

Lecture 10 Page 10 of 11
Shortcut Residual Income Model for CBRL Based on Analysts Forecasts

Cracker Barrel
as of Feb. 2009

PARAMETERS FY1 FY2 Ltg

EPS Forecasts 2.65 2.84 11.03% Model 1: 12-year forecasting horizon (T=12).
Book value/share (last fye) 4.14 and a 5-year growth period.
Discount Rate 11.55%
Payout Ratio 60.0%
Next Fsc Year end 2009
Current Fsc Mth (1 to 12) 7
Terminal Growth 4.1%
Target ROE (industry avg.) 15.0%

Implied price (date adjusted) 23.25

Year 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Long-term EPS Growth Rate (Ltg) 0.1103 0.1103 0.1103
Forecasted EPS 2.65 2.84 3.15 3.50 3.89 4.13 4.29 4.33 4.24 4.00 3.61 3.06
Beg. of year BV/Shr 4.14 5.20 6.34 7.60 9.00 10.56 12.21 13.92 15.66 17.35 18.95 20.40
Implied ROE 0.640 0.546 0.497 0.461 0.432 0.392 0.351 0.311 0.271 0.231 0.190 0.150
Abnormal ROE 0.524 0.430 0.382 0.345 0.316 0.276 0.236 0.196 0.155 0.115 0.075 0.035
required rate (r) 0.115 0.115 0.115 0.115 0.115 0.115 0.115 0.115 0.115 0.115 0.115 0.115
discount rate 1.115 1.244 1.388 1.548 1.727 1.926 2.149 2.397 2.674 2.983 3.327 3.711
PV of future Residual Income 1.95 1.80 1.74 1.69 1.65 1.51 1.34 1.14 0.91 0.67 0.43

PV of Finite Residual Income 14.83

PV of Terminal Value RI 2.84
Beg. of year BV/Shr 4.14
Implied Price 21.81

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