EARNINGS VERSUS CASH BASED VALUATION
TECHNIQUES ABSTRACT KEY WORDS 1. INTRODUCTION In general, there are two approaches to valuation. The first, being discounted cashflow valuation, relates the value of an asset to the present value of expected future cashflows generated by that asset. The second, the capitalised earnings approach, is where a stream of maintainable earnings is capitalised at a price/earnings multiple to arrive at equity value. In theory, both methods are capable of producing the same estimates of intrinsic value, but in actuality, there can be significant differences in outcomes, depending upon which method is adopted (Francis, Olsson & Oswald, 2000:7). Both earnings and cash flow valuation techniques are widely used in practice. Whilst neither method is so flawed that they cannot be relied upon, over time it has come to be recognised that cash flow valuation techniques result in more accurate and reliable results than earnings based techniques. It is useful to acknowledge from the outset that valuation is an imprecise science. All valuations, be they cash or earnings based, involve an educated guess whereby analysts peer into an uncertain future and attempt to predict what a company might be worth (Lee, 2003:4). The purpose of this essay is to investigate both earnings and cash flow valuation techniques so as to ascertain:
2. GENERAL PRINCIPLES
These basic observations on value imply that valuations are forward looking i.e. they look to future income flows, only using past income flows as a means of corroborating the forecasts. It is now recognised that the most relevant form of income to be predicted is the entity’s ability to generate cash, in particular ‘marginal free cash’ (Stewart, 1991:307). Adjusting for risk requires an assessment to be made of the market price of risk i.e. the compensation required by investors for taking on the risk, rather than investing in risk free investments. The Capital Asset Pricing Model (hereafter CAPM), which calculates the cost of equity, is most commonly used for making this assessment for discounted cashflow (hereafter DCF) valuations. Although CAPM is potentially flawed, no universally acceptable technique has emerged to replace it (Black, Wright & Bachman, 1998:2932). 3. CASH BASED VALUATIONS Free Cash Flow (hereafter FCF) is the net cash generated from operations after taking into account the cash reinvested to fund future growth. It is the primary source of cash available to repay the suppliers of debt and equity and to compensate them for risk, and thus it is the key component of value creation (Copeland,et al. 2000:167169). The present value of the expected free cash flows from the asset results in the value of that asset. The discount rate when discounting cash flows is always the cost of capital, which is the weighted average of cost of equity and cost of debt, using target market weightings (Brealey & Meyers, 2003:531). 3.2 Advantages
3.3 Derivations of the
Free Cash Flow Methodology
The CVA approach was popularised by Professors Eric Ottosson and Fredrik Weissenrieder of the Department of Economics, Gothenburg University, Sweden. Ottoson & Weissenrieder (1996) describe the approach as one which makes a distinction between the uses to which cash is put, being either strategic or nonstrategic. The authors believe that a focus on strategic investments will give managers a better chance to form the future of their companies. 3.4 Practical Considerations
3.4.2 Terminal value The relative importance that a company’s terminal value assumes in a company’s total value is largely determined by the length of the forecast period contained in the DCF model. The forecast period is dependent on the forecast risk inherent to the industry. Recently, in an 8 year forecast period for a typical company in the tobacco industry, the continuing value typically represented 56 percent of the total value of the company; for sporting goods, the continuing value represented 81 percent. For a typical hightechnology company, continuing value typically represented 125 percent of total value, which means that the PV of the FCF for the first 8 years of the company’s life would have been negative. All the value of the company would derive from the expected cash flow beyond the first 8 years (Lee, 2003:5). 3.4.3 Adjusting for Risk
– The Cost of Equity: Shortterm government security rates Since investors are looking ahead, they want to know what the ‘riskfree’ rate is over the length of time used for the forecasted cash flows. For an investment to be risk free, the exact return over the life of the investment must be known. A 6 month treasury bill would not be risk free for the purposes of considering an 8 year cash flow. It would not be risk free because the investor would have to reinvest it at the end of each 6 months period at a currently unknown rate. In this case the appropriate risk free rate would be an 8 year zero coupon government bond rate (Damodaran, 2000:5). Historical premiums Many people, who use the CAPM to come up with the cost of equity, prefer to use historical premiums. They use historical data on share and bond returns over a past period; determine the average return made on shares and on a risk free asset over the period, and take the difference, which is the historical risk premium. How the historical risk premium is computed matters. The result depends on several factors: what historical period is used and what type of investment is defined as the riskfree rate. Historically, using as long a time period as possible is desirable, which is a little counterintuitive. Since the market risk premium is a random variable, a longer time frame (which encompasses a stock market crash, expansions, recessions, two world wars and stagflation) is a better estimate of the future than a short, more recent time frame (Copeland, et al. 2000:217). A different way of thinking about the risk premium is to estimate an implied equity premium, i.e. letting the market decide what the premium is. If analysts have ready access to the following:
If the growth rate is expected to be stable, the value of the share can be written as the basic Gordon Growth Model. The only unknown in the above equation is the required rate of return. The required rate of return is the implied cost of equity. One of the advantages of the implied equity premium is that it can be estimated for any market in the world. Historical data is not needed (Damodaran, 2000:8). Estimating beta Beta measures the risk of a share relative to a diversified portfolio. Most services estimate betas for emerging market companies using the local index. These betas mean very little if the shares are to be included in a portfolio that includes nonlocal shares. To be meaningful, the beta of these companies ought to be estimated not against a local index but against a global index. An even more troubling problem with beta is that the betas for emerging markets can be completely counterintuitive. The largest and safest companies could look riskiest; the smallest and riskiest companies could look safest. This phenomenon is caused by index domination. The weighted average beta for all shares is one. In Brazil for example, Telebras (Telecomunicacoes Brasileiras) which comprises 50% of the Bovespa share index, recently had a beta of 1.11.In the index, eight other shares had betas greater than one and 169 had betas below one. Some of the solutions to the regression beta problem are:
4. EARNINGS VALUATIONS Earnings valuation approaches capitalise a maintainable
earnings stream at a multiple so as to arrive at an equity value. Earnings
valuations techniques include market multiples such as Price Earnings,
Forecasted Price Earnings, Enterprise Value over Sales, Enterprise Value
over EBITDA and Enterprise Value over EBIT (Lie & Lie, 2002:46). 4.1 Price Earnings Multiples The P/E multiple is driven largely by the cost of capital and the growth rate of earnings. Holding the cost of capital constant, the P/E ratio is primarily a function of the expected growth rate in earnings. High P/E companies are expected to grow their earnings quickly relative to today’s earnings (Lee, 2003:9). In its relative form, where firms are ranked on the basis of the ratio of P/E ratio to expected growth, the rankings will provide a measure of relative value, if:
If these assumptions are not fulfilled, a direct comparison of the ratio of P/E to expected growth may not be justified because a higher risk firm should be expected to have a lower P/E ratio than another firm with the same expected growth rate but much less risk. Similarly, the P/E ratio for a firm where high growth is expected to last 5 years will be lower than the P/E ratio for a firm where the same high growth is expected to last 10 years. 4.2 Advantages
4.3 Practical Considerations 4.3.2 Quality of Earnings 4.3.3 Comparable Firm When markets make systematic errors in valuing entire sectors, using the average P/E ratio of these shares will build that error into the valuation (Damodaran, 1996: 291). Alford (Lie & Lie, 2002:47) studied the effects of the choice of comparable companies on valuation accuracy when the P/E multiple is used and found that comparable companies chosen on the basis of industry yielded the smallest estimation of error when valuing companies by use of the P/E multiple. 4.3.4 Companies with
High Intangible Value Dotcom companies are typical examples of the above as most of their value is tied to their potential to become major players in the future. Multiples are not suited for valuing these companies and analysts should resort to valuing the vast real options embedded in these companies’ assets (Lie & Lie, 2002:51/52). 4.3.5 Accuracy 4.3.7 Losses 5. EARNINGS PREDICTIONS
OF CASH FLOWS Predicting the future from the past is always a risky thing. In the case where the company is neither growing nor shrinking the scale of its operations, cash flow and earnings reflect the same results. When the company is scaling up or down, earnings reflect the operating cycle that the company may replicate in future, while cash flows mix this operating information with information about investment and divestment (O’ Brian, n.d. :). 5.1 Caveats
5.2 Earnings and Credibility The best number for forecasting future cash flows is the one that credibly conveys the results of replicable operating cycles. Earnings measure the results of operating cycles, but involve judgement, which reduces their credibility. Cash flows involve less judgment, but do not measure the results of operating cycles (O’ Brian, n.d. :). 6. CONCLUSION Rarely will earnings and cash flow depict the same result. It is in these cases only that earnings can be deemed a surrogate for cash, and earnings based valuation techniques can be used in conjunction with cash based techniques so as to cross correlate results. In all other cases, the DCF method is superior to earnings based methodologies. The value of a company is a function of the company’s cash flows, its expected growth, the length of the growth period and the cost of capital. Naïve attention to accounting earnings will often lead to value destroying decisions. Investors, who use the DCF approach to valuation, focusing on increasing longterm cash flow, ultimately will be rewarded by higher share prices (Copeland, et al. 2000:87). BIBLIOGRAPHY BLACK, A; WRIGHT, P & BACHMAN, J 1998: In Search of Shareholder Value. London: Pitman Publishing. BREALEY, RA & MYERS, SC 2003: Principles of Corporate Finance; seventh edition. New York: McGrawHill. COPELAND, T; KOLLER, T & MURRIN, J 2000: Valuation: Measuring and Managing the Value of Companies; third edition. NewYork: John Wiley & Sons, Inc. DAMODARAN, A 1996: Investment Valuation. New York: John Wiley & Sons, Inc. DAMODARAN, A 2000: Value Enhancement and Cash Driven Valuation Models. [OnLine]. Accessed on 22/ 7/ 2003. Available: http://www.aimrpubs.org/cp/issues/v2000n1/pdf/p0000004a.pdf FRANCIS, J; OLSSON, P & OSWALD, D 2000: Comparing the Accuracy and Explainability of Dividend, Free Cash Flow and Earnings Value Estimates. Journal of Accounting Research, Spring. 2000. GRAHAM, B 1995: Formula Valuations of Common Stocks. Financial Analysts Journal. JanuaryFebruary 1995. LEE, CM 2003: Choosing the Right Valuation Approach. [OnLine]. Accessed on 20/ 7/ 2003. Available: http://www.aimrpubs.org/cp/issues/v2003n2/pdf/p0030004a.pdf LIE, HJ & LIE E, 2002: Multiples Used to Estimate Corporate Value. [OnLine]. Accessed on 22/ 7/2003. Available: http://www.aimrpubs.org/faj/issues/v58n2/pdf/f0580044a.pdf MCCONNELL, P 2003: Quality of Earnings:
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