The Terminal Value and Inflation Controversy

This journal recently published what was effectively a debate between Gunther Friedl and Bernhard Schwetzler (hereafter “F&S”), on the one hand, and Michael Bradley and Gregg Jarrell (“B&J”). B&J initiated the first round of the debate by criticizing the constant growth valuation model, commonly known as the “Constant Growth Model” or “Gordon Growth Model.” The Gordon Growth Model was introduced by Myron Gordon and Eli Shapiro (“G&S”) in a 1956 paper and has long been widely used by corporate and investment practitioners. F&S responded to B&J with a defense of the original G&S formulation. In revisiting this debate, the authors find that the models B&J and F&S advocate are at bottom two different versions of the same G&S constant growth model, but with quite different assumptions about the effect of inflation on the amount of capital reinvestment required to sustain businesses over time. The authors resolve the dispute by showing that both models, when using a consistent set of assumptions about inflation and capital reinvestment, produce identical growth rates and estimates of value. At the same time, however, the authors recognize that the two models (the G&S/F&S model, on the one hand, and the B&J model on the other) are likely to be appropriate for very different kinds of companies, and each for only small subsets of companies.     

Value‐Added Per Share (VAPS): A Value‐Relevant Corporate Performance Metric

The authors introduce Value Added Per Share (VAPS) as a value‐relevant metric that is intended to complement earnings per share (EPS) in helping corporate managers and analysts understand and overcome the limitations of GAAP‐based reporting. VAPS discounts a firm's past and projected cash flows at its “cost of capital,” allowing companies to avoid the subjective accounting accrual process and other practices that often make EPS misleading. A company's VAPS is calculated in three main steps: (1) estimate the change in the capitalized value of after‐tax operating cash flow by taking the net change (plus or minus) of the firm's operating cash flow after taxes and dividing that number by the firm's cost of capital; (2) subtract total investment expenditures; and (3) divide by the number of shares outstanding. By capitalizing the change in after‐tax operating cash flow, one finds the net change in a firm's current operations value. By subtracting investment expenditures from that change in current operations value, the analyst gets a clearer picture of the benefit to shareholders net of the funds used to create that benefit. Consistent with basic theory, VAPS is positive when a company earns a return at least equal to its cost of capital and negative otherwise. Because of their fundamental differences, EPS and VAPS are likely to send different signals, and VAPS is expected to provide greater insight into stock price changes. The authors provide the findings of statistical tests showing the superior explanatory power of VAPS and recommend that companies publish statements of VAPS along with standard GAAP results, especially since the former can be readily calculated using the available income statement, balance sheet, and cash flow statement data.     

The Asymptotic Optimality of Residual Income Maximization

Residual income subtracts from operating income an interest charge for invested capital. Residual income can be calculated each period from current accounting information, unlike discounted cash flow (DCF), which requires the knowledge of future cash flows. This paper provides a normative justification for residual-income maximization by showing that if investment decisions are made myopically each period to maximize residual income, the resulting path asymptotically maximizes discounted cash flow. Thus, under the assumptions of the model, residual-income maximization is a heuristic that leads to the long-run DCF-optimum.     

Incorporating Competition into the APV Technique for Valuing Leveraged Transactions

According to a recent survey, the discounted cash flow approach is the valuation technique most widely used by companies evaluating acquisition targets. But because the DCF approach is inappropriate when the capital structure is changing during the forecast period, many analysts turn to the adjusted present value (APV) approach, which can easily accommodate a changing capital structure. Still, the finance literature has not shown how to incorporate assumptions about the effect of competition in the post-forecast period into an APV analysis.
This paper provides two new tools for calculating horizon values with changing leverage and competition. First, it provides a new model, based on more realistic assumptions, for valuing a growing annuity of free cash flows when ROIC is expected to decline due to competition. Second, it provides a model for valuing tax shields that correctly incorporates the impact of competition in the post-forecast period. When used together with the APV approach, these two new tools allow an analyst to estimate the value of a company with a changing capital structure that faces competition in the post-forecast period.     

A Better Way to Measure Operating Performance (or Why the EVA Math Really Matters)

Most companies rely heavily on earnings to measure operating performance, but earnings growth has at least two important weaknesses as a proxy for investor wealth. Current earnings can come at the expense of future earnings through, for example, short‐sighted cutbacks in investment, including spending on R&D. But growth in EPS can also be achieved by investing more capital with projected rates of return that, although well below the cost of capital, are higher than the after‐tax cost of debt. Stock compensation has been the conventional solution to the first problem because it's a discounted cash flow value that is assumed to discourage actions that sacrifice future earnings. Economic profit—in its most popular manifestation, EVA—has been the conventional solution to the second problem with earnings because it includes a capital charge that penalizes low‐return investment. But neither of these conventional solutions appears to work very well in practice. Stock compensation isn't tied to business unit performance—and often fails to provide the intended incentives for the (many) corporate managers who believe that meeting current consensus earnings is more important than investing to maintain future earnings. EVA doesn't work well when new investments take time to become profitable because the higher capital charge comes before the related income. In this article, the author presents two new operating performance measures that are likely to work better than either earnings or EVA because they reflect the value that can be lost either through corporate underinvestment or overinvestment designed to increase current earnings. Both of these new measures are based on the math that ties EVA to discounted cash flow value, particularly its division of current corporate market values into two components: “current operations value” and “future growth value.” The key to the effectiveness of the new measures in explaining changes in company stock prices and market values is a statistical model of changes in future growth value that captures the expected effects of significant increases in current investment in R&D and advertising on future profits and value.     

Inflation and the Constant Growth Model: Reconciling the Literature

We formulate a generalized constant growth valuation model incorporating inflation and capital maintenance. We find that in general there are two sources of growth: growth due to capital maintenance and growth due to net new investments. The generalized version of the constant growth model allows the reconciliation of the existing literature, particularly the works of Gordon and Shapiro (1956), Lally (1988), and Bradley and Jarrell (2008), which all employ particular definitions of capital maintenance. Evaluating the practical relevance of either model we find that each model is best suited for a very particular company set‐up, which does not necessarily correspond to the commonly observed business models. The generalized version of the constant growth valuation model, however, presents a flexible approach that is capable of capturing various conceptions of capital maintenance.     

Portfolio performance and accounting measures of earnings: an alternative look at usefulness

Measures of economic performance, such as accounting earnings, working capital and cash flows, have been evaluated in tests of relative explanatory power of regressions of market returns on earnings, working capital and cash flows. We employ a different test. Using Basu’s (J Finance 663–682, 1977) investment trading strategy, we measure portfolio returns based on these three accounting measures of earnings. The objective is to ascertain whether investment performance also supports the findings of the explanatory power studies that accounting earnings is the premier measure of performance. The evidence does not support this conclusion. Our findings are at variance with prior conclusions that accounting earnings is more useful than cash flow. The Basu trading strategy is effective for all three measures. Excess market returns are observed for all three measures, even when controlled for risk and for low priced stocks. But accounting earnings portfolios do not dominate working capital or cash flow portfolios. In fact, the raw returns to cash flow portfolios are marginally (statistically) larger than accounting earnings portfolios. Economically, a dollar invested in a portfolio using accounting earnings to select the stock would have an accumulated value of 22.73 while the same dollar investment using cash flow instead of accounting earnings would accumulate a value of22.73 while the same dollar investment using cash flow instead of accounting earnings would accumulate a value of 33.94 over the same 16 years starting with the second quarter of 1988 and concluding at the end of the first quarter of 2004. Thus, our results have implications for the studies of explanatory power of different measures of earnings and their comparison in the US and other markets.     

Valuing Companies with Cash‐Flow@Risk

The classic DCF approach to capital budgeting—the one that MBA students in the world's top business schools have been taught for the last 30 years—begins with the assumption that the corporate investment decision is “independent of” the financing decision. That is, the value of a given investment opportunity should not be affected by how a company is financed, whether mainly with debt or with equity. A corollary of this capital structure “irrelevance” proposition says that a company's investment decision should also not be influenced by its risk management policy—by whether a company hedges its various price exposures or chooses to leave them unhedged. In this article, the authors—one of whom is the CFO of the French high‐tech firm Gemalto—propose a practical alternative to DCF that is based on a concept they call “cash‐flow@risk.” Implementation of the concept involves dividing expected future cash flow into two components: a low‐risk part, or “certainty equivalent,” and a high‐risk part. The two cash flow streams are discounted at different rates (corresponding to debt and equity) when estimating their value. The concept of cash‐flow@risk derives directly from, and is fully consistent with, the concept of economic capital that was developed by Robert Merton and Andre Perold in the early 1990s and that has become the basis of Value at Risk (or VaR) capital allocation systems now used at most financial institutions. But because the approach in this article focuses on the volatility of operating cash flows instead of asset values, the authors argue that an internal capital allocation system based on cash‐flow@risk is likely to be much more suitable than VaR for industrial companies.     

Drivers of Shareholder Returns in Tech Industries (or How to Make Sense of Amazon's Market Value)

Earnings according to GAAP do a notoriously poor job of explaining the current values of the most successful high‐tech companies, which in recent years have experienced remarkable growth in revenues and market capitalizations. But if GAAP earnings fail to account for the values of such companies, are there other measures that do better? The authors address this question in two main ways. They begin by summarizing the findings of their recent study of both the operating and the stock‐market performance of 169 publicly traded tech companies (with market caps of at least $1 billion). The aim of the study was to identify which of the many indicators of corporate operating performance—including growth in revenues, EBITDA margins, and returns on equity—have had the strongest correlation with shareholder returns over a relatively long period of time. The study's main conclusion is that investors appear to be looking for signs of neither growth nor efficiency in using capital alone, but for an optimal mix or balancing of those goals. And that mix, as the study also suggests, is captured in a cash‐flow‐based variant of “residual income” the authors call “residual cash earnings,” or RCE. In the second part of their article, the authors show how and why RCE does a much better job than reported net income or EPS of explaining the current market value of Amazon.com , one of the best‐performing tech companies in the world. Mainly by treating R&D spending as an investment of capital rather than an expense, RCE reveals the value of a company that is distinguished by both the amount and the productivity of its ongoing investment—both of which have been obscured by GAAP.     

Dynamic Effects of Information Disclosure on Investment Efficiency

This paper studies how information disclosure affects investment efficiency and investor welfare in a dynamic setting in which a firm makes sequential investments to adjust its capital stock over time. We show that the effects of accounting disclosures on investment efficiency and investor welfare crucially depend on whether such disclosures convey information about the firm's future capital stock (i.e., balance sheet) or about its future operating cash flows (i.e., earnings). Specifically, investment efficiency and investor welfare unambiguously increase in the precision of disclosures that convey information about the future capital stock, since such disclosures mitigate the current owners' incentives to underinvest. In contrast, when accounting reports provide information about future cash flows, the firm can have incentives to either under‐ or overinvest depending on the precision of accounting reports and the expected growth in demand. For such disclosures, investment efficiency and investor welfare are maximized by an intermediate level of precision. The two types of accounting disclosures act as substitutes in that the precision of capital stock disclosures that maximizes investment efficiency (and investor welfare) decreases as cash flow disclosures become more informative and vice versa.     

A Review of Acquisition Valuation Models

The article critically examines two methods of acquisition valuation. The first concentrates on a comparison of the earnings per share of the combined companies with that of the acquiror alone on a present value basis. The second method is discounted cash flow model which is based on several established normative models of share price valuation. The article concludes that because of the difficulties in computing an accurate weighted average cost of capital for the combined group and the differences in cash flow and reported earnings, the earnings per share approach is not valid, and therefore the cash flow approach is to be preferred and adopted.     

Understanding Stock Price Volatility: The Role of Earnings

In an efficient capital market, asset prices vary when investors change their expectations about cash flows, discount rates, or both. Using dividends to measure cash flows, previous research shows that the aggregate dividend‐price ratio varies due to changes in expected discount rates (returns) rather than expected cash flows. In contrast, using accounting earnings instead of dividends as a measure of cash flows, this paper shows that as much as 70% of the variation in the dividend‐price ratio can be explained by changes in expected earnings. Moreover, the paper documents a significant negative correlation between expected returns and expected earnings, suggesting that variations in a common factor to both may generate significant price volatility. The results are consistent with the dividend‐policy irrelevance hypothesis.     

How to Create Value Without Earnings: The Case of Amazon

Investors and commentators often equate GAAP accounting metrics, especially earnings per share, with financial success. The reality, however, is that there is no simple, linear relationship between GAAP earnings and intrinsic value, which is defined as the present value of expected future cash flows. And adjustments of GAAP metrics, though admittedly subjective, are often required to understand the economic reality of a business. http://Amazon.com Inc. provides a case study that throws into sharp relief the need to look beyond GAAP in order to analyze underlying fundamentals and value. In this paper, the authors argue that Amazon has done a superb job of building shareholder wealth, all the while reporting low and declining operating and net income margins. The article provides a framework for thinking about Amazon's underlying profitability that is based on the concept of return on capital in relation to the cost of capital, and shows how that profitability has been masked by GAAP accounting. The authors demonstrate that the company is now investing very large amounts of capital with the expectation of earning rates of return well above its cost of capital. And their analysis suggests that if such investment can continue over the long term, Amazon's current market value of $140 billion can be readily justified.     

Net working capital investment and capital budgeting analysis: Some pedagogical insights

Net working capital (NWC) investment, as a factor in discounted cash flow (DCF) analysis, receives little attention in the capital budgeting literature and accounting textbooks. The purpose of this paper is to explore the ways in which this important component of the analysis can be intregrated into the classroom and thus add to the student's overall understanding of capital budgeting. Four areas are discussed: (1) the significance of NWC investment in capital budgeting analysis, (2) the opportunity cost nature of the NWC investment, (3)measurement of the components of the NWC investment, and (4) use of the NWC investment to help restore the bottom line in DCF analysis to a pure cash flow basis. Integration of the fourth point into the topic of capital budgeting is found to be a convenient way to reinforce the student's understanding of the statement of cash flows.     

Two Different Ways of Treating Corporate Cash in FCF Valuations—and the Importance of Getting the Cost of Capital Right

The methods for calculating free cash flow presented in texts on financial statement analysis and valuation appear to be very different from those in corporate finance texts, causing some confusion among academics as well as practitioners. Financial statement analysis and valuation texts generally begin by valuing just the enterprise operations—that is, the entity that engages in the firm's primary revenue‐generating activities—and then adding back the value of its cash holdings and other financial assets. The corporate finance approach is typically to value all the assets together, including financial assets that are not used in the production of the goods and services provided by the firm. Using a simple example, the authors show that the valuation of the equity ownership of the firm should be the same for both methods of calculating free cash flow, provided the analyst makes the appropriate adjustments to the method for calculating the cost of capital (WACC) used to discount forecasted free cash flows to a present value.     

Valuation with Market Multiples: How to Avoid Pitfalls When Identifying and Using Comparable Companies1

An important part of the market multiple valuation process is selecting companies for comparison that are really comparable to the company being valued. The goal of assessing comparability is to align the relevant value drivers—especially risk and growth—of the comparable companies with those of the company being valued. In this paper, the authors examine the relevant value drivers for commonly used market multiples such as EBIT and EBITDA. They show that, in addition to risk and growth, analysts doing market multiple valuations need to take account of differences in variables such as cost structure, working capital, and capital expenditure requirements when assessing comparability. The authors also show that the degree to which different value drivers are important for assessing the comparability of companies differs across commonly used market multiples. In other words, some multiples are more sensitive than others to changes in certain value drivers. For example, when using a multiple like EBITDA in which certain expenditures (such as capital investments, working capital investments, and some expenses) are not deducted in the calculation of the denominator, assessing comparability based on such expenditures is more important than when using a multiple like free cash flow that deducts that expenditure in calculating the denominator. Or to cite another example, since EBIT and EBITDA make no attempt to reflect income taxes, using income tax cost structures to assess comparability is more important for enterprise value multiples based on these measures than for enterprise value multiples based on “after‐tax” measures of income such as unlevered earnings or free cash flow. In addition, not all multiples control for differences in cost structure, such as cost of goods sold or SG&A. If a multiple is affected by differences in those value drivers, the comparable companies must be similar to the company being valued on that dimension. Finally, the authors show that differences in capital expenditure and working capital requirements can also have large effects on certain multiples; and as a result, such value drivers also must be considered when assessing comparability.     

Estimating the Cost of Capital Using Stock Prices and Near‐term Earnings Forecasts

Earnings‐based valuation models, although long used by finance practitioners, have become increasingly popular among finance academics as well. Among the most important reasons for academics' increased acceptance of earnings‐based valuation is the well‐documented claim that earnings over a short (three‐ to four‐year) forecast horizon tend to capture a large fraction—as much as 80%—of today's value, much more than is captured by near‐term forecasts of free cash flow, the measure long advocated by finance theorists as the basis for DCF valuation. But most important for the purposes of this article, the recognition that such a large percentage of the current values of many public companies is captured within a short forecast horizon has led to a large academic literature that uses earnings‐based valuation models together with current stock prices to “back out” estimates of the companies' implied expected rates of return and costs of equity capital. The effectiveness and precision of such reverse engineering depend on the reliability of the forecasts both within a finite forecast horizon and beyond. And although the models tested in academic work, which are based on large samples of forecasts and hard‐to‐verify assumptions about earnings beyond the forecast horizon, often do not appear to provide useful estimates, the author argues that such reverse engineering of the valuation models should become straightforward and workable once reliable forecasts of earnings are obtained—say, from the corporate (or investment) analysts who are familiar with the operations of the companies they work for (or cover).     

GOODWILL ACCOUNTING: EVERYTHING HAS CHANGED AND NOTHING HAS CHANGED

In issuing Statements No. 141 and No. 142, the FASB has attempted to make accounting statements better reflect the economics of the exchange of value that takes place in business combinations. At the very least, requiring a single method of accounting reduces the costs of accounting, puts all acquirers on an equal accounting footing, and removes the incentive to incur significant costs to be able to report on a pooling-of-interests basis.
But if the FASB rules have changed significantly, investors' expectations for acquiring companies have not. Therefore, accounting rules should have no impact on acquisition pricing or structuring unless they affect cash flows. Recorded goodwill and return on capital are the artificial result of accounting rules, and largely without economic content. However, understanding the growth value implicit in the price paid is key to helping ensure that acquisitions create value. Boards of directors and executives must understand the minimum annual performance targets they have set for themselves by paying a premium to acquire a company.
The ideal measure of goodwill, which has not been contemplated by the FASB, would capture the premium of the current acquisition price over the value of the target firm's current operating value—that is, the discounted NPV of its current operating cash flows. Using such an economist's definition of goodwill, financial analysts could then come up with the variable that is of greatest interest to investors-namely, the expected improvements in operating performance that are necessary to justify the acquirer's investment in the target company. The economic framework and future growth value analysis based on EVA can be used to answer this question, regardless of the accounting rules du jour.     

会计盈余、现金流量的价值相关性实证研究基于沪深股市的实证证据

已有的研究结果说明会计盈余具有价值相关性。从盈余等于经营现金流量与应计利润之和这一新的视角切入，以实证的方法对沪深两地上市的A股公司进行三大样本检验。并通过建立股票报酬与应计利润和现金流量的回归方程，利用应计利润回归系数的显著性对会计盈余与现金流量的价值相关性做比较，结果表明，会计盈余的价值相关性要大于现金流量的价值相关性。     

Valuation of Corporate Innovation and the Pricing of Risk in the Biopharmaceutical Industry: The Case of Gilead

Much of a firm's market value derives from expected future growth value rather than from the value of current operations or assets in place. Pharmaceutical companies are good examples of firms where much market value comes from expectations about drugs still in the development “pipeline.” Using a new osteoporosis drug being developed by Gilead Sciences, Inc., the author combines discounted cash flow methods values and real option models to value it. Alone, discounted cash flow (DCF) calculations are vulnerable to the assumptions of growth, cost of capital, and cash flows. But by integrating the real options approach with the DCF technique, one can value a new product in the highly regulated, risky and research‐intensive Biopharmaceutical industry. This article shows how to value a Biopharmaceutical product, tracked from discovery to market launch in a step‐by‐step manner. Improving over early real option models, this framework explicitly captures competition, speed of innovation, risk, financing need, the size of the market potential in valuing corporate innovation using a firm‐specific measure of risk and the industry‐wide value of growth operating cash flows. This framework shows how the risk of corporate innovation, which is not fully captured by the standard valuation models, is priced into the value of a firm's growth opportunity. The DCF approach permits top‐down estimation of the size of the industry‐wide growth opportunity that competing firms must race to capture, while the contingency‐claims technique allows bottom‐up incorporation of the firm's successful R&D investment and the timing of introduction of the new product to market. It also specifically prices the risk of innovation by modeling its two components: the consumer validation of technology and the expert validation of technology. Overall, it estimates the value contribution per share of a new product for the firm.