Concept Questions: Chapter Five Accrual Accounting and Valuation: Pricing Book Values

CHAPTER FIVE
Accrual Accounting and Valuation: Pricing Book Values
Concept Questions
C5.1. True. A firm with positive expected residual earnings (produced by an ROCE
above the cost of capital) must be valued at a premium.
C5.2. To trade at book value, we expect the ROCE to be equal to the cost of capital,
10%. (The current ROCE is not relevant here: P/B is based on expected future ROCE.)
C5.3. A P/B of 1.0 implies a future ROCE equal to the cost of capital. An ROCE of 52.2
% is high relative to the cost of capital, so the P/B implies the ROCE is unusually high
and will drop in the future.
C5.4. No. If the firm is expected to earn an ROCE in excess of the required return, it
should sell at a premium over book value. Given the forecast, the firm is a BUY if it
trades below book value.
C5.5. False. If the firm maintains a low ROCE it will be valued at a discount on book
value. But it can survive: it has a positive going-concern value.
C5.6. Firms create residual earnings through ROCE and growth in net assets. The
ROCE for Dell are level (and declining in 2005), but the book values are increasing. With
constant ROCE and growing book values, residual earnings increase.
Accrual Accounting and Valuation: Pricing Book Values 97

C5.7. (a) Share issues produce more earnings because there are more assets earning
in the business. And dividends reduce earnings.
(b) ROCE is a ratio and, as share issues (usually) affect the numerator and
denominator of a ratio in different proportions, the ratio changes. But RE is not affected
by share issues or dividends (in the case of a firm with no leverage).
C5.8. Yes. Value is generated by growing book values if the book rate of return is
higher than the required return.
C5.9. If the analyst does not forecast all sources of earnings (that is, comprehensive
earnings) then she will ignore some part of the payoff to shareholders, and will lose some
value in her calculation of a value from the forecast.
C5.10. The price-to-book valuation has nothing to do with free cash flow. Look at the
General Electric example in the chapter. GE has negative free cash flows (in Chapter 4),
but a large P/B ratio (in this chapter). Growth in investment determines the P/B ratio
(along with return on investment), but investment reduces free cash flow.
p. 98 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

Exercises
Drill Exercises
E5.1. Calculating Return on Common Equity and Residual Earnings
Set up the pro forma as follows:
2006 2007 2008 2009
Eps 3.00 3.60 4.10

Dps 0.25 0.25 0.30
Bps 20.00 22.75 26.10 29.90
ROCE 15.00% 15.83% 15.71%
RE (10% charge) 1.00 1.325 1.49
a. The answer to the question is in the last two lines of the pro forma
b. As forecasted residual earnings are positive, the shares of this firm are worth a
premium over book value.
E5.2. ROCE and Valuation
As expected ROCE is equal to the required return, expected residual earnings are zero. So
the shares are worth their book value per share. Book value per share = $3,200/500 =
$6.40.
E5.3. A Residual Earnings Valuation
This question asks you to convert a pro forma to a valuation using residual earnings
methods. First complete the pro forma by forecasting book values from earnings and
dividends. Then calculate residual earnings from the completed pro forma and value the
firm.
2007E 2008E 2009E 2010E 2011E
Earnings 388.0 570.0 599.0 629.0 660.4

Dividends 115.0 160.0 349.0 367.0 385.4

Book value 4,583.0 4,993.0 5,243.0 5,505.0 5,780.0
ROCE 9.0% 12.4% 12.0% 12.0% 12.0%

Residual earnings -43.0 111.7 99.7 104.7 109.9
(10%)
Growth in RE -10.7% 5.0% 5.0%
Growth in Book value 8.9% 5.0% 5.0% 5.0%
Discount factor 1.110 1.210 1.331 1.464 1.611
PV of RE -39.1 92.3 74.9
a. Forecasted book values, ROCE, and residual earnings are given in the completed
pro forma above. Book value each year is the prior book value plus earnings and
minus dividends for the year. So, for 2008 for example,
Book value = 4583 +570 160 = 4,993.
The starting book value (in 2006) is 4,310. Residual earnings for each year is
earnings charged with the required return in book value. So, for 2008,
RE is 570 (0.10 4,583) = 111.7.
b. Forecasted growth rates in book value and residual earnings are given above.
c. The growth rate in residual earnings is 5% after 2009. Assuming this growth rate
will continue into the future, the valuation is a Case 3 valuation with the
continuing value calculated at the end of 2009:
Book value, 2006 4,310.0

Total present value of RE to 2009 (from last line above) 128.1
104 .7
Continuing value (CV), 2009: 2094 .0
1.10 1.05
Present value of CV: 2094/1.331 1,573.3
Value of the equity, 2006 6,011.4
Per share value (on 1,380 million shares) 4.36
d. The premium is 6,011.4 4,310 = 1,701.4, or 1.23 on a per-share basis.
The P/B ratio is 6,011.4/4,310 = 1.39.
E5.4. Residual Earnings Valuation and Target Prices (Easy)
This problem applies the residual earnings model and its dividend discount equivalent.
Develop the pro forma as follows:
2006 2007 2008 2009 2010 2011

Eps 3.90 3.70 3.31 3.59 3.90
Dps 1.00 1.00 1.00 1.00 1.00
Bps 22.00 24.90 27.60 29.91 32.50 35.40
(a) RE (0.12) 1.26 .71 0 0 0
Discount rate 1.12 1.2544
PV 1.125 .57
Total PV 1.70
(b) Value 23.70
(c) As residual earnings are expected to be zero after 2011, the equity is expected
to be worth its book value of $35.40.
(d) The expected premium at 2011 is zero because subsequent residual income is
expected to be zero.
As aside:
Note that the dividend discount formula can be applied because we now have a basis for
calculating its terminal value. The terminal value is the expected terminal price, and this

can be calculated at the end of 2008 because, at this point, expected price equals book
value.
T
V0E t d t TV T / T
t 1
The TV2008 is given by the expected 2008 book value:
TV2008 = 27.60
So the calculation goes as follows:
2006 2007 2008
Dps 1.00 1.00

PV .89 .80
Total PV of divs. 1.69
TV 27.60
PV of TV 22.00
Value 23.69
E5.5. Residual Earnings Valuation and Return on Common Equity
(a) Set the current year as Year 0.
Earnings, Year 1 = 15.60 0.15 = 2.34
Residual earnings, Year 1 = 2.34 (0.10 15.60)
= 0.78
This RE is a perpetuity, so
RE 0
V0 B 0
0.10
0.78
15 .60 23 .40
0.10
P B 23.40 15.60 1.5
(b) No effect: future payout does not affect current price (unless you have a tax
story) and future dividends dont affect current book value.
P/B is still 1.5
E5.6. Using Accounting-Based Techniques to Measure Value Added for a Project
(a)
Time line: 0 1 2 3 4 5
Depreciation 30 30 30 30 30
Book value 150 120 90 60 30 0
Earnings (15%) 22.5 18 13.5 9 4.5
RE (0.12) 4.5 3.6 2.7 1.8 0.9
PV of RE 4.02 2.87 1.92 1.14 0.51
Total PV of RE 10.47
Value of Project 160.47
The investment added $10.47 million over the cost.
(b)
Time line 0 1 2 3 4 5
Earnings 22.5 18.0 13.5 9.0 4.5

Depreciation 30.0 30.0 30.0 30.0 30.0
Cash from operations 52.5 48.0 43.5 39.0 34.5
t
PV of cash flow (1.12t) 46.88 38.27 30.96 24.79 19.58

Total PV of cash flow 160.47
Cost 150.00
NPV 10.47
The NPV is the value added.

E5.7. Using Accounting-Based Techniques to Measure Value Added for a Going
Concern
(a)
Time line: 0 1 2 3 4 5 6 7
Investment 150 150 150 150 150 150 150 150

1
Depreciation 30 60 90 120 150 150 150
Book value2 270 360 420 450 450 450 450
Revenue 52.5 100.5 144.0 183.0 217.5 217.5 217.5

Depreciation 30.0 60.0 90.0 120.0 150.0 150.0 150.0
Earnings (15%) 22.5 40.5 54.0 63.0 67.5 67.5 67.5
RE (0.12) 4.5 8.1 10.8 12.6 13.5 13.5 13.5
PV of RE 4.0 6.5 7.7 8.0
Total of PV of RE 26.2
Continuing value3 112.5
PV of CV 71.5
Value 247.7
Lost 150
Value added 97.7
1. Depreciation is $30 million per year for each project in place
2. Book value (t) = Book value (t-1) + Investment (t) Depreciation (t)
13 .5
3. CV = = 112.5
0.12
The value of the firm is $247.7 million. The continuing value is based on a forecast of
residual earning of 13.5 in year 5 continuing perpetually with no growth. This is a Case 2
valuation.
(b) The value added is $97.7 million
(c) The value added is greater than 15% of the initial investment because there is growth
in investment: value is driven by the rate of return of 15% (relative to a cost of capital of
12%) but also by growth.
E5.8. Creating Earnings and Valuing Created Earnings
a. Earnings = Revenues Expenses

= $440 - $360 = $80
Earnings in the text example were $40. Clearly earnings have been created,
by expensing $40 of the investment in the prior period and thus reducing
Year 1 expenses by $40.
b. ROCE = $80/$360 = 22.22%

Residual earnings = $80 (0.10 360) = 44
$44
c. Value = $360 = $400
1.10
Even though earnings have been created, the calculated value is the same as that
in the text (before earnings were created).
E5.9. Reverse Engineering
With a P/B ratio of 2.0 and a price of $26, the book value per share is $13. Thus,
Residual earnings (2007) = $2.60 (0.10 13.0) = $1.30
Reverse engineering solves for g in the following model:
1.30
$26 = $13
1.10 g
The solution is g = 1.0. That is, the growth rate is zero: The market expects residual
earnings to continue at $1.30 per share after 2007.

Applications
E5.10. Valuing Dividends or Return on Equity: General Motors Corp
a. P/B = 28/49 = 0.57; ROCE = 0.69/49 = 1.41%
b. Yes; the required return is not stated, but any reasonable return is far greater than
1.41 percent. As GM is expected to earn an ROCE far below its required return, it
should have a P/B well below 1.0.
c. The analyst makes a mistake in focusing on the dividend (yield). An unprofitable

firm will drop its dividend as GM has done in the past in bad times and GM
does not look profitable. The dividend they have been paying is not a good
indicator of value. A firm can pay a high dividend in the short run, but if
fundamentals give a different message, follow the fundamentals. The dividend
yield (dividend/price) is high because price is low, because of poor prospects.
E5.11. Residual Earnings Valuation: Black Hills Corp

The pro forma for the exercise is as follows:
Forecast Year
____________________________________
1999 2000 2001 2002 2003 2004
Eps 2.39 3.45 2.28 2.00 1.71

Dps 1.06 1.12 1.16 1.22 1.24
Bps 9.96 11.29 13.62 14.74 15.52 15.99
ROCE 24.0% 30.6% 16.7% 13.6% 11.0%

RE (11% charge) 1.294 2.208 0.782 0.379 0.003
Discount rate (1.11)t 1.110 1.232 1.368 1.518 1.685
Present value of RE 1.166 1.792 0.572 0.250 0.002
Total present value of RE to 2004 3.78
Continuing value (CV) 0.0
Present value of CV 0.00
Value per share 13.74
a. ROCE and residual earnings are in the pro forma

b. If ROCE is to continue at 11% after 2004, then residual earnings are expected to be
zero. The continuing value is zero. The value is $13.74 per share a Case 1
valuation.
c. As the CV = 0, the target price is equal to forecasted bps of $15.99 at 2004.
E5.12. Reverse Engineering: Ford Motor Company
a. In January, the 2005 eps forecast was $1.825 (the midpoint of the range). So,
RE(2005) = $1.825 (0.12 8.76) = $0.774
In April, the 2005 forecast was $1.38 (the midpoint of the range). So,
RE(2005) = $1.375 (0.12 8.76) = 0.324
b. The reverse engineering problem is
0.774
E
V2004 $14.50 $8.76
1.12 g
Set g = 1.0 (a zero growth rate) and the value is $15.21. So the market was expecting a
decline in residual earnings after 2005.
c. The reverse engineering problem is now
0.324
E
V2004 $11.50 $8.76
1.12 g
The solution is (approximately) g = 1.0 (no growth). That is, the market is
expecting RE to stay at the same level after 2005.
How can a drop in price be associated with an increase in the RE growth rate?
Well the increase is due to a lower base: RE for 2005 is now 0.324 rather than 0.774.
E5.13. Reverse Engineering the S&P 500 Index
(a)
With a P/B ratio is 2.8, investors are paying $2.80 for every dollar of book value in the
S&P 500 companies. With an ROCE of 17%, the current residual earnings on a dollar of
book value is:
RE0 = (0.17 0.09) 1.0
= 0.08

That is, 8 cents per dollar of book value. The value of an asset (with a constant growth
rate is mind) is calculated as:
RE 0 g
V0 B0
g
(One always capitalizes the one-year-ahead amount.) So, for every dollar of book value
worth $2.80,
0.08 g
2.8 1.0
1.09 g
Solving for g,
g = 1.0438 (a 4.38 growth rate)
What does this mean? If the S&P 500 firms can maintain an ROCE of 17%, then
investment in net assets must grow by 4.38%. Alternatively, if ROCE were to
improve, a growth in residual earnings of 4.38% can be maintained with a lower
growth rate. Is a 4.38% growth rate reasonable? What is the prospect for ROCE for
the market as a whole? Is the market appropriately priced?
(Analysis in Module II of the course will help answer these questions.)
(b)
See the last paragraph. With a constant ROCE, the growth in residual earnings is
determined by the growth in net assets (book value). Remember, residual earnings is
driven by two factors:
1. Profitability of net assets: ROCE
2. Growth in net assets
E5.14. The Merck Revaluation
Book value of shareholders equity = $15,576 million

Shares outstanding = 2,222 million
Book value per share = $7.01
Required rate of return = 10%
Forward P/E = 15.05
Forward Earnings2004 = $2.99
Forward Earnings2005 = $3.12
Current price = $45.00
Dividend per share = $1.52
Payout ratio = $1.52/$2.99 = 50.8%
a. Prepare the pro forma and calculate residual earnings by charging prior book
value at 10%
2003 2004 2005
Eps 2.99 3.12

Dps 1.52 1.586
Bps 7.01 8.48 10.01
Residual earnings 2.289 2.272
b. Apply the residual earnings model:
2.272 g
1.10 g
2.289 2.272
V0E 7.01
1.10 1.10 2
1.10 2
Setting g = 1.04 (a 4.00% growth rate), we get VoE $43.52 . Thus, Merck was
reasonably priced at $45.
(Strictly speaking, the $43.52 valuation is that in January, 2004. The September value
would be this value reinvested for nine months at a 10% per annum rate.)
c.
Target price2005 = Book value2004 + Continuing value (CV)
The calculation of continuing value:
RE g 2.272 1.04
CV 39.38
E g 1.10 1.04
Target price2005 = 10.01 + 39.38 = 49.39
d. Prepare the pro forma and calculate residual earnings by charging prior book
value at 10%
2003 2004 2005
Eps 2.91 3.04

Dps 1.52 1.588
Bps 7.01 8.40 9.85

Residual earnings 2.209 2.200
Applying the residual earnings model:
2.200 g
1.10 g
2.209 2.200
V0E 7.01
1.10 1.10 2
1.10 2
If a firm can maintain net profit margins and sales-to-book ratios (and constant cost of
capital), the growth rate for residual income equals to the sales growth rate.
Setting g = 1.037 (a 0.30% reduction), we get VoE $40.76
Based on the calculation, the 25% drop in price was not warranted.
e.
The calculation of continuing value:
RE g 2.200 1.037
CV 36.213
E g 1.10 1.037
Target price2005 = 9.85 + 36.213 = 46.063
P2005 Value of Dividends P2004

Rate of return 1
P2004
46.063 (1.52 1.10) 1.588 34
1
34
45.06%
The value of dividends received is the terminal value at the end of 2005, that is, the 2005
dividend plus the 2004 dividend reinvested for one year. (The calculation here assumes
that dividends for 2004 are not paid yet. The rate of return will be lower if Merck already
distributed some dividends to shareholders)
f. Mercks P/B= Price/BV=34/7.01=4.85

ROCE2004=Earnings2004/BV2003=2.91/7.01=0.415
ROCE2005=Earnings2005/BV2004=3.04/8.40=0.362
Because the value of intangible assets (i.e., R&D expense) is omitted in the book value,
Merck trades with a high P/B and ROCE. All else equal, if Mercks book value is
consistently under-valued, it will report ROCE that is higher than the required return of
10%. Because of competition within the industry, Mercks profitability might decline in
the future, but probably never as low as 10%.
E5.15. Analysts Forecasts and Valuation: Hewlett Packard
(a)
Time line: 1999A 2000E 2001E 2002E 2003E 2004E 2005E
Eps 3.33 3.75 4.32 4.83 5.42 6.07 6.80

Dps1 0.64 0.71 0.82 0.92 1.03 1.15 1.29
BPS 19.36 22.40 25.90 29.81 34.20 39.12 44.63
RE (0.12) 1.43 1.63 1.72 1.84 1.97 2.11
Growth in RE 14.0% 5.5% 7.0% 7.0% 7.0%

Discount factor 1.12 1.2544 1.405
t 1.28 1.30 1.22
PV of RE(1.12 )
Total PV of RE to 2002 3.80
Continuing value2 36.80
PV of CV 26.19
1. The dps forecast is based on maintaining the same pay out ratio as in 1999.
1.84
2. CV = = 36.80, where 7% is the long-term growth ratio in RE, set at the
1.12 1.07
growth rate for 2003-2005.
PV of CV = 36.80/1.405 = 26.19.

The valuation from the forecasts is less than the market price of $83. The forecasts imply
a SELL, not a BUY. (The 7% growth rate in perpetuity is a high one, to boots.)
Note that one could also calculate the continuing value at the end of 2002, based on the
1.72 of RE in 2002 growing at 7%, and get the same answer.
(b) Suppose the market sets the $83 price using analysts forecasts for 2000 and 2001
plus a long-term growth rate forecast after 2001. The continuing value at 2001 will be
BPS, 1999 19.36

PV of RE to 2001: (1.28+ 1.30) 2.58
Present value of continuing value at 2001 ?
The implied PV of CV (?) is 61.06. The implied CV at the end of 2001 = 61.06 x 1.122 =
76.59. The implied growth rate in the CV is that which solves the CV calculation:
76.59 = (1.63 x g)/(1.12 g)
Thus g = 1.0967 (an implied growth rate of 9.67%).
(c) Difficulties:
1. Analysts did not give a forecast of dps (which affects forecasted eps
and bps). We used a constant-payout forecast, but is this what analysts had in mind in
forecasting the eps (that are displaced by dividends)?
2. We relied on analysts long-run eps growth forecasts to calculate a
value. These forecasts are suspect. Research shows they are not very accurate and are
usually too optimistic.
3. We relied on analysts forecasts to 2002 to get the implied long-run
growth rate from the current market price. Are these good forecasts?
E5.16. Residual Earnings Valuation and Accounting Methods
a. Inventory in the balance sheet is carried at historical cost but is written down to
market value if market value is less than cost. The carrying amount of inventory
on the balance sheet becomes cost of good sold when the inventory is sold. So, a
write-down of $114 million in 2006 means cost of goods sold in 2007 will be
$114 million lower, and earnings will be $114 million higher, that is, $502
million. The book value at the end of 2006 is $114 million lower, or $4,196
million. So,
ROCE = 502/4,196 = 11.96
This is an increase over the 9% (388/4,310) before the impairment.
b. Refer to the answer to Exercise 5.3. With earnings of $502 million forecasted for
2007, residual earnings is now 502 (0.10 4,196) = $82.4 million. The present
value of this RE is $82.4/1.10 = $74.9 million. As the present value of RE for
2007 prior to the impairment was $-39.1 million, the change in the PV of RE in
the valuation is $114 million. As this is the change in the 2006 book, value the
valuation remains unchanged.
The full pro forma under the changed accounting is below:
2007E 2008E 2009E 2010E 2011E
Earnings 502.0 570.0 599.0 629.0 660.4

Dividends 115.0 160.0 349.0 367.0 385.4
Book value 4,583.0 4,993.0 5,243.0 5,505.0 5,780.0
ROCE 11.96% 12.4% 12.0% 12.0% 12.0%

Residual earnings 82.4 111.7 99.7 104.7 109.9
Growth in RE -10.7% 5.0% 5.0%

Growth in Book value 8.9% 5.0% 5.0% 5.0%
Discount factor 1.110 1.210 1.331 1.464 1.611
PV of RE 74.9 92.3 74.9
Note that the pro forma is unchanged after 2007 as 2007 book values are the same as
before.
The valuation now runs as follows:
Book value, 2006 4,196.0

Total present value of RE to 2009 (from last line above) 242.1
104 .7
Continuing value (CV), 2009: 2094
1.10 1.05
Present value of CV: 2094/1.331 1,573.3
Value of the equity, 2006 6,011.4
Per share value (on 1,380 million shares) 4.36
This is the same valuation as before.
c. The taxes will affect 2007 earnings and 2006 book values by the after-tax amount
of the impairment:
After-tax effect on 2007 earnings = $114 (1 0.35) = $74.1

After-tax effect on book value in 2006 = $114 (1 0.35) = $74.1
Accordingly,
Earnings, 2007 = 388 + 74.1 = 462.1
Book value at the end of 2006 = 4,310 74.1 = 4,235.9
ROCE, 2007 = 462.1/4235.9 = 10.91%
As both 2007 earnings and 2006 book values are affected by the same amount, the value
of the equity is unchanged (following the same calculation as in b).
E5.17. Impairment of Goodwill
(a) As the asset is at fair value (the acquisition price) on the balance sheet, it is
expected to earn at the required return on book value: Residual earnings is
projected to be zero. (Fair value in an acquisition always prices the acquisition to
earn at the required rate of return.)
(b) The book value must be marked down to fair market value under FASB Statement
No. 142. The book value at the end of 2007, before the write down, is 301 + 79 =
380 (the depreciated amount of the tangible assets plus the good will).
Forecasted earnings for 2008 on this book value (at the forecasted ROCE of 9%) is
380 x 0.09 = 34.2
For a 10% required return, the book value that yields residual earnings in 2008 equal
to zero = 34.2 x 10 = 342:
RE2008 = 34.2 (0.10 x 342) = 0
A book value of 342 is thus fair value.
Accordingly, the amount of impairment = 380 342 = 38.

Minicases
M5.1 Forecasting from Traded Price-to-Book Ratios: Cisco Systems

Inc.
Price = $21 Required equity return = 12%

Forward P/E = $21/$0.89 = 23.60
Book value per share = $25,826/6,735 = $3.835
P/B = $21/3.835 = 5.48
Introduction
Part A of this case asks you to challenge the market price of $21 or, alternatively stated,
to challenge the current P/B ratio of 5.48. As a P/B ratio is based of expected residual
earnings, this comes down to asking whether the P/B ratio is justified on the basis of
residual earnings forecasts.
Given that we have only two years of analysts forecasts, we do not have the complete
set of forecasts to challenge the $21 price. Of course, we might develop a full analysis to
do this (as will be done in Chapters 7 15), but for now we are asked to challenge the
price with the limited forecasts. Reverse engineering gives us the handle: What are the
forecasts implicit in the market price, and are these reasonable? This is done in three
steps:
1. Calculate the implied residual earnings growth rate after 2006 that is implicit in
the market price.
2. Translate the residual earnings growth rate into an eps growth rate
3. Ask whether, given our knowledge of Cisco and its operations, the implied eps
growth rates are reasonable.
The assembly of the building blocks of the valuation to separate the speculative part of
the valuationalso provides insights.
Part B of the case is a check on analysts recommendations, first against their target price
and, second, against their forecasts. Are the recommendations consistent with their target
price and their forecasts for the stock?
The Questions
Part A:
1. Implied Residual Earnings Growth Rates
With a required return on the equity of 12%, the pro forma for a price of $21 is as
follows:
2004 2005 2006
Eps 0.89 1.02

Dps 0.00 0.00
Bps 3.835 4.725 5.745
Residual earnings (RE) 0.4298 0.4530

Discount factor 1.12 1.2544
PV of RE 0.3838 0.3611
Total PV to 2006 0.745
PV of CV 16.420
CV ______ 20.597
Value of Equity 21.000
The present value (PV) of the continuing value (CV) is the plug between $21 and the
other two components of the valuation:
PV of CV = $21.00 3.835 0.745 = $16.42
The continuing value (at the end of 2006) is the future value of this number:
CV = $16.42 1.2544 = $20.597
Given the analysts forecasts for 2005 and 2006 are reasonable, this is the continuing
value that the market forecasts; that is, the market attributes $16.42 of the $21 price to
value to be delivered after 2006. From this continuing value, we can impute the implied
residual earnings growth rate after 2006:
0.4530 g
CV = 20.597
1.12 g
So g = 1.0959. The market is forecasting a growth rate for residual earnings of 9.59% per
year indefinitely. Keeping in mind the average GDP growth rate of 4% as a benchmark,
this looks a bit high.
Notice that we have anchored on the book value and the two years of analysts forecasts
in order to challenge the speculation in the market price. We would have to revise our
analysis (to anchor solely on the book value) if we were not confident in the integrity of
the analysts forecasts.
2. Implied Eps growth rates

Its difficult to think in terms of residual earnings growth rates, so convert the growth rate
to eps growth rates using the formula to reverse engineer residual earnings:
Earningst = (Bt-1 0.12) + REt
The following pro forma gives forecasts RE (growing at 9.59% after 2006) and converts
the RE forecasts to eps forecasts in order to derive eps growth rates:
2005 2006 2007 2008 2009 2010
RE 0.430 0.453 0.496 0.544 0.596 0.653

Bps 4.725 5.745 6.930 8.306 9.899 11.740
Eps 0.89 1.02 1.185 1.376 1.593 1.841
Eps growth
rate 14.61% 16.18% 16.12% 15.77% 15.57%
3. Evaluate Implied Growth Rates
Are these growth rates reasonable? Well, we do not know enough about Cisco to make
the evaluation here, but an analyst who is familiar with the company might well conclude
that these rates are too high, too high, or too low. She might conclude: I just cannot see
Cisco maintaining such high growth rates for such a long period of time. The following
plot will help her:
Plotting the markets implied Eps growth rates:
20.0%
19.0% BUY
18.0%
17.0%
EPS Growth Rate
16.0% 16.18% 16.12%

15.77% 15.57%
15.0%
14.61%
14.0%
13.0%
SELL
12.0%
11.0%
10.0%
2006 2007 2008 2009 2010
If the analyst forecasts growth rates above the path implied by the market, she would say
that Cisco was underpriced at $21. If the analyst forecasts growth rates below the path
implied by the market, she would say that Cisco was overpriced at $21. The path
separates the BUY and SELL regions. To be confident in her assessment, she would
model the eps path, using the full financial statement analysis and pro forma analysis that
we will move on to in Chapters 7-15, and then compare her path to that implied by the
market.
Identifying the speculative component of the market price: the Building Blocks
Refer to Figure 5.7 in the text. The speculative component is that which involves the
more uncertain forecasts for the longer term. The building blocks are:
1. Block 1: Book value $3.84

2. Block 2: Value from two years of forecasts:
1 0.4530
Value in Block 2 = 0.4298 3.75
1.12 0.12
3. Block 3: Value in speculation about growth 13.41

21.00

The building blocks for Cisco:
$21.00
Current Market Value
Value Per Share
$13.41
$7.59
$3.75
$3.84
Book Value
(1) (2) (3)

Book Value Value from Value from
short-term long-term
forecasts forecasts
A considerable portion of the market price involves speculation about growth in the long
term (Block 3).
At this point, the analyst asks whether this speculation is justified. Maybe the market is
pricing events beyond the forecast horizon or other factors, other than immediate
eps growth, that are pertinent to the value. The analyst (and the student) asks:
what is the market anticipating that I do not anticipate; what do others know that
is not factored into my forecasts? What is the market speculating about to give
Cisco such a high Block 3 value? Is the firm on a takeover list? (Unlikely for
Cisco) Does it have new strategic plans? Is it ripe for breakup? (Unlikely for
Cisco) Having posed these questions, the analyst furthers his research to check on
the answers before being confident in his BUY/HOLD/SELL recommendation.
Note:
We have proceeded with a CAPM required return of 12%. CAPM technology is quite
imprecise, so we must be sensitive to this. We do this by asking if our assessment will
change if the required return is different. A sensitivity analysis for a 10% cost of capital
follows:
2004 2005 2006
Eps 0.89 1.02

Dps 0.00 0.00
Bps 3.835 4.725 5.745
Residual earnings (RE) 0.5065 0.5475 (Using a 10% required return)

Discount factor 1.10 1.21
PV of RE 0.4605 0.4525
Total PV to 2006 0.913
PV of CV 16.252
CV ______ 19.665
Value of Equity 21.000
0.5475 g
CV = 19.665
1.10 g
So g = 1.0702, or a 7.02% growth rate. Proceed from here, as before. A 7.02% growth
rate is lower, of course, but still high relative to the GDP growth rate. You can now
prepare a similar plot to that above with this 7.02% growth rate (and also a building block
diagram).
Part B:
This part of the case conducts two tests to challenge the integrity analysts
recommendation (to buy, hold or sell Cisco). Is the recommendation consistent with their
analysis?
First, is the recommendation consistent with the target price?
If one bought Cisco at $21 at the beginning of 2005 and accepted 12% as the required
return, a target price of $23.52 at the end of 2005 would yield the required (normal)
return: $21 1.12 = $23.52 (there are no dividends). So, a target price of $24 would be a
(marginal) buy. (Of course, analysts may have a lower required return, which would
make a $24 target price a solid BUY). Analysts were indeed recommending a BUY at the
time (on average).
Second, is the recommendation consistent with analysts forecasts?
To start, work with analysts 2006 forecast. Their forecast for growth in residual earnings
for 2006 (from the pro forma above) is
Growth rate for RE2006 = 0.4530/0.4298 = 1.054 (a 5.4%growth rate).

This is considerably below the markets implied growth rate of 9.59% for subsequent
years.
Now work with analysts 5-year growth rate. Analysts see a growth rate for eps of 14.5%
after 2006 and, on the basis of that forecast, recommend a BUY. But the plot above puts a
growth rate of 14.5% in the SELL region: the implicit market forecast is greater than this.
The recommendation is inconsistent with analysts forecast.
There are two provisos to these conclusions.
First, analysts may see higher growth after their 5-year forecast horizon (2010), and are
basing their recommendation on this.
Second, analysts may indeed see the lower growth in the future, but may anticipate that
the market price will (irrationally) increase: the price will move away from fundamentals.
In making a call on the target price, they are predicting prices, not values.
One further point should be noted. There is a possibility that the market is pricing based
on analysts consensus forecasts and both a wrong! Indeed, there are claims that
mispricing is led by analysts (poor) forecasting, as in the bubble. If we do not trust
analysts forecasts, there is no avoiding developing our own. Chapters 7-19 of the book
are designed to do this.
Note that, by the end of Ciscos 2005 fiscal year, the stock price had dropped to $19.
M5.2 Analysts Forecasts and Valuation: PepsiCo and Coca Cola
Introduction
Parts A and B of this case ask students to reverse engineer the traded prices for PepsiCo
and Coca-Cola and then ask whether the implied earnings forecasts are different from
those that analysts are making. Set up the case with two questions:
1. How do we understand the forecasts that are implicit in the market price?
2. How do we challenge the market price?
The first question leads to the second: Rather than challenging a price, we challenge a
forecast. The core tool is the implied earnings growth plot, like that displayed for Nike in
Figure 5.6. This plots the markets implied earnings growth path and separates BUY and
Sell regions for the analyst who disagrees with the markets forecast. The case uses
residual earnings methods; a companion case (Minicase M6.2 in Chapter 6) applies
abnormal earnings growth methods.
Part C of the case embellishes students understanding of the P/B ratio, emphasizing that
the P/B is determined by how the accounting for net assets is carried out.
The Questions
A. The implied earnings forecasts are calculated in two steps. First, reverse engineer the
RE valuation model to get the implied growth rate in residual earnings. Second, reverse
engineer the residual earnings calculation to get forecasted eps.
The pro forma to calculate the growth in RE is as follows:
PepsiCo
2003 2004 2005

Earnings 2.310 2.560
Dividends (payout = 42.4%) 0.980 1.086
Book value 6.98 8.31 9.784
Residual earnings (9%) 1.682 1.812

Growth rate in RE 7.74%
Reverse engineer the RE model:
1.682 1.812 1 1.812 g

E
V2003 6.98
1.09 1.09 2
1.09 2 1.09 g

Setting V E0 = $49.80, then g = 1.0497 (a 4.97% growth rate)
With this growth rate, the RE for 2006 onwards can be forecasted. For example, RE for
2006 = 1.812 1.0497 = 1.902. RE forecasts are then reversed engineered to deliver
earnings forecasts:
Earningst = (Book valuet-1 0.09) + REt
So, for 2005, eps = (9.784 0.09) + 1.902 = 2.783.
The following pro forma gives the conversion for years, 2006-2008.
2005 2006 2007 2008
RE (growing at 4.97%) 1.902 1.997 2.096

Book value 9.784
Bt-1 0.09 0.881 1.025 1.181
Eps 2.783 3.022 3.277
Dps (payout = 42.4%) 1.180 1.282 1.389
Book value 11.387 13.127 15.105
Coca Cola
2003 2004 2005

Earnings 1.990 2.100
Dividends (payout = 50.3%) 1.000 1.056
Book value 5.77 6.760 7.804
Residual earnings (9%) 1.471 1.492

Growth rate in RE 1.43%
Reverse engineer the RE model:
E 1.471 1.492 1 1.492 g

5.77
1.09 1.092 1.092 1.09 g
V2003
Setting V E0 = $40.70, then g = 1.0492 (a 4.92% growth rate)
Now, again, reverse engineer the residual earnings formula:
Earningst = (Book valuet-1 0.09) + REt
The following pro forma gives the conversion for years, 2006-2008.
2005 2006 2007 2008
RE (growing at 4.92%) 1.565 1.642 1.723

Book value 7.803
Bt-1 0.09 0.702 0.804 0.913
Eps 2.267 2.446 2.636
Dps (payout = 50.3%) 1.140 1.230 1.326
Book value 8.930 10.146 11.456
B. From the pro forma in part a, EPS growth rates for each year are:
PepsiCo 2004 2005 2006 2007 2008
EPS 2.31 2.56 2.783 3.022 3.277
Growth rates (%) 10.83 8.71 8.59 8.44
Coke Cola 2004 2005 2006 2007 2008
EPS 1.99 2.10 2.267 2.446 2.636

Growth rates (%) 5.53 7.95 7.47 7.77
These growth rates can be depicted in a plot, like that in Figure 5.6 for Nike. This plot
separates BUY and SELL regions:

Implied EPS Growth: PepsiCo
11.00%
10.83%
10.50%
10.00%
EPS Growth Rate
9.50% BUY
9.00%
8.71%
8.50%
SELL 8.59%
8.44%
8.00%
2005 2006 2007 2008
Implied EPS Growth: Coke
8.50%
BUY
8.00% 7.95%
7.77%
7.50% 7.47%
EPS Growth Rate
7.00%
6.50% SELL
6.00%
5.50% 5.53%
5.00%
2005 2006 2007 2008
For PepsiCo, analysts were forecasting a five-year eps growth rate of 11%, consistent
with their 10.83% growth rate for 2005. The eps growth rate implied by the
market price is lower than that forecasted by analysts. The market is seeing lower
eps growth than that forecasted by analysts. If the analysts forecasts are to be
believed, the market price is too low: A BUY is indicated. The alternative
interpretation is that analysts are too optimistic in their forecasts. Indeed, sell-side
analysts are notorious for being too high with their 5-year eps growth rates.
For Coca-Cola, analysts were forecasting a growth rate of 8%. This is in line with the
implied forecasts by the market.
There is a proviso to these conclusions: Maybe the market is pricing events beyond the
forecast horizon or other factors, other than immediate eps growth, that are
pertinent to the value. The analyst (and the student) asks: what is the market
anticipating that I do not anticipate; what do others know that is not factored into
my forecasts? Is the firm on a takeover list? (Unlikely for Coke or Pepsi.) Does it
have new strategic plans? Is it ripe for breakup? (Unlikely for Coke or Pepsi.)
Having posed these questions, the analyst furthers his research to check on the
answers before being confident in his BUY/HOLD/SELL recommendation.

A basic point to be made from the case (and indeed the material in the Chapter):
Valuation models are not formulas into which you plug in numbers and magically
an intrinsic value pops out. Yes, you can use the models to convert a forecast to a
valuation. But the models are, more broadly, a way of developing tools for
challenging the market price. They enable you to convert a price to a forecast
which you can then compare to your own forecast. Indeed, the scheme enables
you to challenge your own forecasts with the forecast in the market price.
Broadly, valuations models tell you how to think about the problem (of
appropriate pricing) and to bring tools to resolving the problem. They get you
asking the right questions before reaching a conclusion.
C. The high P/B ratios.
Firms have high P/B ratios if accountant leave value off the balance sheet. For these two
firms, value lies in their brands Coke, Pepsi, Frito-Lay, and so on. Brand assets are not
booked to the balance sheet. So, one expects these firms to have high P/B ratios.
PepsiCos P/B is $49.80/$6.98 = 7.13 and Cokes is $40.70/$5.77 = 7.05.
Correspondingly, one expects these firms to have high ROCE (and residual earnings):
Earnings from the brands are in the numerator, but the brand asset is missing from the
denominator. PepsiCos forecasted ROCE for 2004 is $2.31/$6.98 = 33.1% and Cokes is
$1.99/$5.77 = 34.5%.
M5.3 The Goldman Sachs IPO
Introduction
This case introduces residual earnings valuation that evaluates price-to-book
ratios, emphasizes the limitations of short-term forecasts, and compares pro forma
valuation with multiple analysis. It also shows how we separate what we know from
speculation when valuing shares. And it leads to a discussion of whether share
transactions in acquisitions can add value for shareholders.
As an introduction, remember the maxim: price is what you pay, value is what
you get. And be particularly careful when the seller is an insider, as in this IPO. There is
an additional wrinkle here: With the $70 offer price at nearly 4 times book value, the
partners have an real incentive to go to market, for without a floatation, they only receive
the book value of their interests when the withdraw from the partnership.
A. The pro forma is simple:
1998A 1999E 2000E
Eps 4.69 4.26

Dps 0.48 0.48
Bps 17.80 22.01 25.79
RE(0.10) 2.91 2.06

ROCE 26.3% 19.4%
With a forecast for a limited period, start with a Case 2 valuation. With this pro forma
and a forecast that the 2000E residual earnings is a good estimate of residual earnings
after 2000, the (Case 2) valuation of Goldman is:
2.91 2.06
V1998 17.80 /1.10
1.10 0.10

= $39.17
This value is considerably lower than the market price of $70. But this valuation assumes
no growth in residual earnings after 2000E. The analysts have not given enough
information to complete this valuation. The market price of $70 has an implied growth
rate that can be tested:
2.91 2.06 2.06 g

70 17.80 / 1.21
1.10 1.21 1.10 g
g = 1.062 (a 6.2% growth rate)
Note that, while the analysis demonstrates the limitation on having only short-term
forecasts, it serves to illustrate the maxim on fundamental analysis: Distinguish what you
know from speculation and put weight on what you know. We know the book value and
may feel relatively secure in our short-term forecasts (for 1999 and 2000), but the long
term is more speculative. The g here identifies the part of the valuation that is more
speculative. Can we come up with scenarios that justify a growth rate of 6.2% for
Goldman? Remember growth in RE come from two factors:
increase in ROCE
increase in net assets earning at the ROCE
Much of the apparatus in Part Two of the book bears on the analysis of ROCE and
growth in net assets, bringing focus to this issue of RE growth.
B. Corzine and Paulson saw growth coming from acquisitions. So a complete
analysis would involve acquisition strategy. Who were potential acquirees? An
insurance firm (as in the Citicorp Travelers merger)? A larger asset management
business? Chase? The analysis would also involve costs of acquisitions. Were cheap
acquisitions available? Were synergistic merges a possibility? Or would Goldman have
to pay a fair price and earn a normal return (a zero RE) on the acquisition?
Do shares give a firm currency? Not if those shares are fairly priced in the
market; using shares in an acquisition gives up the same value as the cash equivalent.
Goldman might face borrowing constraints to raise the cash, however. And, if it found
itself in a position of having its shares overvalued in the market, it might use the shares to
buy another firm cheaply. Which brings us to the question C.
C. If Merrill and Morgan Stanley were appropriately priced the use of
multiples is a reasonable way of getting a valuation, with any adjustments for
differences between the firms. But if the prices of comparison firms were too
highas some maintainedthen the Goldman partners may indeed have been
taking advantage of a mispricing. Remember the issue of Ponsi schemes in
multiples (in Chapter 3)? There is further discussion on the Chapter 3 web
page.
Postscript: This case was written in October 1999. Goldmans strategy might be more
apparent when you read this case later, and its effects can be incorporated into this
analysis. With later numbers, the question arises whether the $70 price was justified. Did
the partners deliver on the growth rates implicit in the $70 price? Here are the actual
results for subsequent years:
1999 2000 2001 2002

Eps 5.69 6.33 4.53 4.27
Dps 0.48 0.48 0.48 0.48
One can see that, while more earnings were delivered in 1999 and 2000 than forecasted,
earnings (and residual earnings) subsequently declined.
At the end of fiscal 2003, GS traded at $91. Adding the terminal value of $2.93 from
getting 48 cents in dividends for 4 years. The cum-dividend price at 2003 was $93.93.
This is an annualized return of 5.8%, less than the 10% required return of 10% specified
(and close to the 30-year bond rate in 1999).

M5.4. Strategy and Valuation: Weyerhaeuser Company
This case can be combined with the Weyerhaeuser Minicase M2.3 in Chapter 2 to
compare asset-based valuation with pro forma analysis.
The case introduces the analysis of strategies and highlights the problems one
often has in translating statements about strategy into forecasts and a valuation. It also
motivates students to dig for further information.
Some preliminary calculations
Bps, 1997 (on 199.486 million shares) 23.30

Bps, 1998 (on 199.009 million shares) 22.74
1.48
ROCE, 1998 6.4%
23.30
P/B ratio, 1998 (at price of $55) 2.4
P/E ratio, 1998 (dividend-adjusted) 38.2
To answer the questions, develop a pro forma based on the plans and their forecasted
outcomes:
Effect on 1999 eps:
Eps, 1998 $1.48

Effect of increasing harvest 0.85
Effect of cost cutting 0.72
Effect of price increases 0.40
Effect of capacity utilization 0.20
Eps, 1999 $3.65
A pro forma that forecasts 1999 residual earnings is as follows:
1997A 1998A 1999E
Eps 1.48 3.65

Dps 1.60 1.60
Bps 23.30 22.74 24.79
RE (0.12) (1.32) 0.92

ROCE 6.4% 16.1%
Answering the Questions
A. The plans and their forecasted affects yield an ROCE for 1999 of 16.1%, just
short of the goal of 17%.
B. Valuing the firm from the forecast.
Suppose the forecasted residual earnings for 1999 are to continue
indefinitely.
Then the value per share would be:
0.92
V1998 22.74
0.12
= 30.41
This value is well below the market price of $55. If the cost of capital were 8%,
the value would be $45.62 per share.
But this valuation is incomplete because there may be growth in RE (and
there may be a decline, negative growth, in RE). What growth is the market
forecasting at $55?
0.92
55 22.74
1.12 - g
g 1.0915 ( or a growth rate of 9.15%)
So, to pay $55, we have to be able to forecast a growth of 9.15% in RE.
This translates into a growth rate in eps of 9%-10% if the $1.60 dps is maintained.
C. The question introduces operating leverage: with fixed cost more of each
additional dollar of revenue goes to the bottom line.
D. There are a number of concerns:

(i) The forecasted ROCE for 1999 is high by historical standards and is for
anticipated upswing in the cycle. Shouldnt the valuation be based on the average, long-
term ROCE for the cycle?
(ii) The excess capacity gives us a red flag. Will some of this capacity have to
be written off in a restructuring or more accelerated depreciation in the future? These
actions will lower ROCE.
(iii) Will Weyerhaeuser resist the temptation to overinvest at the top of the
next cycle?
(iv) The increased harvest is a concern. Is the firm planning to cut timber for
short-term gain at the expense of the long-term? Is the anticipated cutting in excess of
accretion through tree growth? Are the timberlands more valuable uncut?
E. There are two issues on which we want further information.
(i) Is the ROCE forecasted for 1999 sustainable? The issues raised in part (d)
are relevant to this question.
(ii) Getting a handle on the long-term growth is clearly the key here. A
forecast (or objective) for ROCE is not enough. Growth in investment (book value) must
be considered.
The student does not have the tools to develop growth forecasts at this stage.
These are at the heart of the analysis in Part Two of the book. A key element is the
growth in revenues, for growth in revenues is the primary driver of growth in RE.
Weyerhaeusers revenues had been flat or declining, over the prior three years. Is this to
change? The professor could explore the growth issue as an introduction to Part Two
Another question: Is Weyerhaeuser worth more than its going concern value?
Look back at the asset-based valuation in case M3.4 in Chapter 3. Should timberlands
not be cut because the return they produce from cutting is valued less than their value
uncut?
The student might look at how Weyerhaeuser has performed since 1999. Was the
$55 price (that rose to $70 by mid 1999) justified ex post?

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Concept Questions: Chapter Five Accrual Accounting and Valuation: Pricing Book Values

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Concept Questions: Chapter Five Accrual Accounting and Valuation: Pricing Book Values

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CHAPTER FIVE

Accrual Accounting and Valuation: Pricing Book Values

above the cost of capital) must be valued at a premium.

and will drop in the future.

trades below book value.

value. But it can survive: it has a positive going-concern value.

constant ROCE and growing book values, residual earnings increase.

Accrual Accounting and Valuation: Pricing Book Values 97

in the business. And dividends reduce earnings.

by share issues or dividends (in the case of a firm with no leverage).

higher than the required return.

value in her calculation of a value from the forecast.

p. 98 Solutions Manual to accompany Financial Statement Analysis and Security Valuation

E5.1. Calculating Return on Common Equity and Residual Earnings

Set up the pro forma as follows:

2006 2007 2008 2009

Eps 3.00 3.60 4.10

E5.2. ROCE and Valuation

E5.3. A Residual Earnings Valuation

2007E 2008E 2009E 2010E 2011E

Earnings 388.0 570.0 599.0 629.0 660.4

Accrual Accounting and Valuation: Pricing Book Values 99

ROCE 9.0% 12.4% 12.0% 12.0% 12.0%

Book value = 4583 +570 160 = 4,993.

RE is 570 (0.10 4,583) = 111.7.

continuing value calculated at the end of 2009:

Book value, 2006 4,310.0

Present value of CV: 2094/1.331 1,573.3

Value of the equity, 2006 6,011.4

Per share value (on 1,380 million shares) 4.36

d. The premium is 6,011.4 4,310 = 1,701.4, or 1.23 on a per-share basis.

E5.4. Residual Earnings Valuation and Target Prices (Easy)

Develop the pro forma as follows:

2006 2007 2008 2009 2010 2011

(a) RE (0.12) 1.26 .71 0 0 0

Discount rate 1.12 1.2544

(b) Value 23.70

to be worth its book value of $35.40.

Accrual Accounting and Valuation: Pricing Book Values 101

The TV2008 is given by the expected 2008 book value:

So the calculation goes as follows:

2006 2007 2008

Dps 1.00 1.00

E5.5. Residual Earnings Valuation and Return on Common Equity

(a) Set the current year as Year 0.

Earnings, Year 1 = 15.60 0.15 = 2.34

Residual earnings, Year 1 = 2.34 (0.10 15.60)

P B 23.40 15.60 1.5

story) and future dividends dont affect current book value.

P/B is still 1.5

E5.6. Using Accounting-Based Techniques to Measure Value Added for a Project

The investment added $10.47 million over the cost.

Earnings 22.5 18.0 13.5 9.0 4.5

PV of cash flow (1.12t) 46.88 38.27 30.96 24.79 19.58

The NPV is the value added.

Accrual Accounting and Valuation: Pricing Book Values 103

Investment 150 150 150 150 150 150 150 150

Revenue 52.5 100.5 144.0 183.0 217.5 217.5 217.5

RE (0.12) 4.5 8.1 10.8 12.6 13.5 13.5 13.5

PV of RE 4.0 6.5 7.7 8.0

Continuing value3 112.5

1. Depreciation is $30 million per year for each project in place

12%) but also by growth.

E5.8. Creating Earnings and Valuing Created Earnings

a. Earnings = Revenues Expenses

b. ROCE = $80/$360 = 22.22%

E5.9. Reverse Engineering

Residual earnings (2007) = $2.60 (0.10 13.0) = $1.30

Reverse engineering solves for g in the following model:

Accrual Accounting and Valuation: Pricing Book Values 105

E5.10. Valuing Dividends or Return on Equity: General Motors Corp

a. P/B = 28/49 = 0.57; ROCE = 0.69/49 = 1.41%

c. The analyst makes a mistake in focusing on the dividend (yield). An unprofitable

E5.11. Residual Earnings Valuation: Black Hills Corp

Eps 2.39 3.45 2.28 2.00 1.71

ROCE 24.0% 30.6% 16.7% 13.6% 11.0%