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CHAPTER 2 Approaches to Valuation Analysts use a wide range of models in practice, ranging from the simple to the sophisticated. These models often make very different assumptions, but they do share some common characteristics and can be classified in broader terms. There are several advantages to such a classification: It makes it easier to understand where individual models fit into the big picture, why they provide different results, and when they have fundamental errors in logic. In general terms, there are three approaches to valuation. The first, discounted cash flow (DCF) valuation, relates the value of an asset to the present value (PV) of expected future cash flows on that asset. The second, relative valuation, estimates the value of an asset by looking at the pricing of comparable assets relative to a common variable such as earnings, cash flows, book value, or sales. The third, contingent claim valuation, uses option pricing models to measure the value of assets that share o

e second, relative valuation, estimates the value of an asset by looking at the pricing of comparable assets relative to a common variable such as earnings, cash flows, book value, or sales. The third, contingent claim valuation, uses option pricing models to measure the value of assets that share option characteristics. Some of these assets are traded financial assets like warrants, and some of these options are not traded and are based on real assets, (projects, patents, and oil reserves are examples). The latter are often called real options. There can be significant differences in outcomes, depending on which approach is used. One of the objectives in this book is to explain the reasons for such differences in value across different models, and to help in choosing the right model to use for a specific task. DISCOUNTED CASH FLOW VALUATION While discounted cash flow valuation is only one of the three ways of approaching valuation and most valuations done in the real world are relativ

for such differences in value across different models, and to help in choosing the right model to use for a specific task. DISCOUNTED CASH FLOW VALUATION While discounted cash flow valuation is only one of the three ways of approaching valuation and most valuations done in the real world are relative valuations, it is the foundation on which all other valuation approaches are built. To do relative valuation correctly, we need to understand the fundamentals of discounted cash flow valuation. To apply option pricing models to value assets, we often have to begin with a discounted cash flow valuation. This is why so much of this book focuses on discounted cash flow valuation. Anyone who understands its fundamentals will be able to analyze and use the other approaches. This section considers the basis of this approach, a philosophical rationale for discounted cash flow valuation, and an examination of the different subapproaches to discounted cash flow valuation. Basis for Discounted Cash

ands its fundamentals will be able to analyze and use the other approaches. This section considers the basis of this approach, a philosophical rationale for discounted cash flow valuation, and an examination of the different subapproaches to discounted cash flow valuation. Basis for Discounted Cash Flow Valuation This approach has its foundation in the present value rule, where the value of any asset is the present value of expected future cash flows on it. where n = Life of the asset CFt = Cash flow in period t r = Discount rate reflecting the riskiness of the estimated cash flows The cash flows will vary from asset to asset—dividends for stocks, coupons (interest) and the face value for bonds, and after-tax cash flows for a real project. The discount rate will be a function of the riskiness of the estimated cash flows, with higher rates for riskier assets and lower rates for safer projects. You can in fact think of discounted cash flow valuation on a continuum. At one end of the spec

nds, and after-tax cash flows for a real project. The discount rate will be a function of the riskiness of the estimated cash flows, with higher rates for riskier assets and lower rates for safer projects. You can in fact think of discounted cash flow valuation on a continuum. At one end of the spectrum you have the default-free zero coupon bond, with a guaranteed cash flow in the future. Discounting this cash flow at the riskless rate should yield the value of the bond. A little further up the risk spectrum are corporate bonds where the cash flows take the form of coupons and there is default risk. These bonds can be valued by discounting the cash flows at an interest rate that reflects the default risk. Moving up the risk ladder, we get to equities, where there are expected cash flows with substantial uncertainty around the expectations. The value here should be the present value of the expected cash flows at a discount rate that reflects the uncertainty. Underpinnings of Discounted

default risk. Moving up the risk ladder, we get to equities, where there are expected cash flows with substantial uncertainty around the expectations. The value here should be the present value of the expected cash flows at a discount rate that reflects the uncertainty. Underpinnings of Discounted Cash Flow Valuation In discounted cash flow valuation, we try to estimate the intrinsic value of an asset based on its fundamentals. What is intrinsic value? For lack of a better definition, consider it the value that would be attached to the firm by an unbiased analyst, who not only estimates the expected cash flows for the firm correctly, given the information available at the time, but also attaches the right discount rate to value these cash flows. Hopeless though the task of estimating intrinsic value may seem to be, especially when valuing young companies with substantial uncertainty about the future, making the best estimates that you can and persevering to estimate value can still pa

aches the right discount rate to value these cash flows. Hopeless though the task of estimating intrinsic value may seem to be, especially when valuing young companies with substantial uncertainty about the future, making the best estimates that you can and persevering to estimate value can still pay off because markets make mistakes. While market prices can deviate from intrinsic value (estimated based on fundamentals), you are hoping that the two will converge sooner rather than later. Categorizing Discounted Cash Flow Models There are literally thousands of discounted cash flow models in existence. Investment banks or consulting firms often claim that their valuation models are better or more sophisticated than those used by their contemporaries. Ultimately, however, discounted cash flow models can vary only a couple of dimensions. Equity Valuation and Firm Valuation There are two paths to valuation in a business: The first is to value just the equity stake in the business, while th

more sophisticated than those used by their contemporaries. Ultimately, however, discounted cash flow models can vary only a couple of dimensions. Equity Valuation and Firm Valuation There are two paths to valuation in a business: The first is to value just the equity stake in the business, while the second is to value the entire business, which includes, besides equity, the other claimholders in the firm (bondholders, preferred stockholders). While both approaches discount expected cash flows, the relevant cash flows and discount rates are different under each. Figure 2.1 captures the essence of the two approaches. Figure 2.1 Equity versus Firm Valuation The value of equity is obtained by discounting expected cash flows to equity (i.e., the residual cash flows after meeting all expenses, reinvestment needs, tax obligations, and interest and principal payments) at the cost of equity (i.e., the rate of return required by equity investors in the firm). where n = Life of the asset CF to e

iscounting expected cash flows to equity (i.e., the residual cash flows after meeting all expenses, reinvestment needs, tax obligations, and interest and principal payments) at the cost of equity (i.e., the rate of return required by equity investors in the firm). where n = Life of the asset CF to equityt = Expected cash flow to equity in period t ke = Cost of equity The dividend discount model is a special case of equity valuation, where the value of equity is the present value of expected future dividends. The value of the firm is obtained by discounting expected cash flows to the firm (i.e., the residual cash flows after meeting all operating expenses, reinvestment needs, and taxes, but prior to any payments to either debt or equity holders) at the weighted average cost of capital (WACC), which is the cost of the different components of financing used by the firm, weighted by their market value proportions. where n = Life of the asset CF to firmt = Expected cash flow to firm in peri

rior to any payments to either debt or equity holders) at the weighted average cost of capital (WACC), which is the cost of the different components of financing used by the firm, weighted by their market value proportions. where n = Life of the asset CF to firmt = Expected cash flow to firm in period t WACC = Weighted average cost of capital While these approaches use different definitions of cash flow and discount rates, they will yield consistent estimates of value for equity as long as you are consistent in your assumptions in valuation. The key error to avoid is mismatching cash flows and discount rates, since discounting cash flows to equity at the cost of capital will lead to an upwardly biased estimate of the value of equity, while discounting cash flows to the firm at the cost of equity will yield a downwardly biased estimate of the value of the firm. Illustration 2.1 shows the equivalence of equity and firm valuation. ILLUSTRATION 2.1: Effects of Mismatching Cash Flows and Di

dly biased estimate of the value of equity, while discounting cash flows to the firm at the cost of equity will yield a downwardly biased estimate of the value of the firm. Illustration 2.1 shows the equivalence of equity and firm valuation. ILLUSTRATION 2.1: Effects of Mismatching Cash Flows and Discount Rates Assume that you are analyzing a company with the following cash flows for the next five years. Assume also that the cost of equity is 13.625% and the firm can borrow long term at 10%. (The tax rate for the firm is 50%.) The current market value of equity is $1,073, and the value of debt outstanding is $800. The cost of equity is given as an input and is 13.625%, and the after-tax cost of debt is 5%. Given the market values of equity and debt, we can estimate the cost of capital. METHOD 1: DISCOUNT CASH FLOWS TO EQUITY AT COST OF EQUITY TO GET VALUE OF EQUITY We discount cash flows to equity at the cost of equity: METHOD 2: DISCOUNT CASH FLOWS TO FIRM AT COST OF CAPITAL TO GET VA

of debt is 5%. Given the market values of equity and debt, we can estimate the cost of capital. METHOD 1: DISCOUNT CASH FLOWS TO EQUITY AT COST OF EQUITY TO GET VALUE OF EQUITY We discount cash flows to equity at the cost of equity: METHOD 2: DISCOUNT CASH FLOWS TO FIRM AT COST OF CAPITAL TO GET VALUE OF FIRM Note that the value of equity is $1,073 under both approaches. It is easy to make the mistake of discounting cash flows to equity at the cost of capital or the cash flows to the firm at the cost of equity. ERROR 1: DISCOUNT CASH FLOWS TO EQUITY AT COST OF CAPITAL TO GET TOO HIGH A VALUE FOR EQUITY ERROR 2: DISCOUNT CASH FLOWS TO FIRM AT COST OF EQUITY TO GET TOO LOW A VALUE FOR THE FIRM The effects of using the wrong discount rate are clearly visible in the last two calculations (Error 1 and Error 2). When the cost of capital is mistakenly used to discount the cash flows to equity, the value of equity increases by $175 over its true value ($1,073). When the cash flows to the firm

M The effects of using the wrong discount rate are clearly visible in the last two calculations (Error 1 and Error 2). When the cost of capital is mistakenly used to discount the cash flows to equity, the value of equity increases by $175 over its true value ($1,073). When the cash flows to the firm are erroneously discounted at the cost of equity, the value of the firm is understated by $260. It must be pointed out, though, that getting the values of equity to agree with the firm and equity valuation approaches can be much more difficult in practice than in this example. We return to this subject in Chapters 14 and 15 and consider the assumptions that we need to make to arrive at this result. Cost of Capital versus APV Approaches In Figure 2.1, we noted that a firm can finance its assets, using either equity or debt. What are the effects of using debt on value? On the plus side, the tax deductibility of interest expenses provides a tax subsidy or benefit to the firm, which increases w

t. Cost of Capital versus APV Approaches In Figure 2.1, we noted that a firm can finance its assets, using either equity or debt. What are the effects of using debt on value? On the plus side, the tax deductibility of interest expenses provides a tax subsidy or benefit to the firm, which increases with the tax rate faced by the firm on its income. On the minus side, debt does increase the likelihood that the firm will default on its commitments and be forced into bankruptcy. The net effect can be positive, neutral or negative. In the cost of capital approach, we capture the effects of debt in the discount rate: Cost of capital = Cost of equity(Proportion of equity used to fund business) + Pretax cost of debt (1 – Tax rate) (Proportion of debt used to fund business) The cash flows discounted are predebt cash flows and do not include any of the tax benefits of debt (since that would be double counting). In a variation, called the adjusted present value (APV) approach, we separate the eff

etax cost of debt (1 – Tax rate) (Proportion of debt used to fund business) The cash flows discounted are predebt cash flows and do not include any of the tax benefits of debt (since that would be double counting). In a variation, called the adjusted present value (APV) approach, we separate the effects on value of debt financing from the value of the assets of a business. Thus, we start by valuing the business as if it were all equity funded and assess the effect of debt separately, by first valuing the tax benefits from the debt and then subtracting out the expected bankruptcy costs. Value of business = Value of business with 100% equity financing + Present value of expected tax benefits of debt - Expected bankruptcy costs While the two approaches take different tacks to evaluating the value added or destroyed by debt, they will provide the same estimate of value, if we are consistent in our assumptions about cash flows and risk. In chapter 15, we will return to examine these approac

f debt - Expected bankruptcy costs While the two approaches take different tacks to evaluating the value added or destroyed by debt, they will provide the same estimate of value, if we are consistent in our assumptions about cash flows and risk. In chapter 15, we will return to examine these approaches in more detail. Total Cash Flow versus Excess Cash Flow Models The conventional discounted cash flow model values an asset by estimating the present value of all cash flows generated by that asset at the appropriate discount rate. In excess return (and excess cash flow) models, only cash flows earned in excess of the required return are viewed as value creating, and the present value of these excess cash flows can be added to the amount invested in the asset to estimate its value. To illustrate, assume that you have an asset in which you invested $100 million and that you expect to generate $12 million in after-tax cash flows in perpetuity. Assume further that the cost of capital on this

excess cash flows can be added to the amount invested in the asset to estimate its value. To illustrate, assume that you have an asset in which you invested $100 million and that you expect to generate $12 million in after-tax cash flows in perpetuity. Assume further that the cost of capital on this investment is 10 percent. With a total cash flow model, the value of this asset can be estimated as follows: Value of asset = $12 million/.1 = $120 million With an excess return model, we would first compute the excess return made on this asset: Excess return = Cash flow earned – Cost of capital × Capital invested in asset = $12 million – .10 × $100 million = $2 million A SIMPLE TEST OF CASH FLOWS There is a simple test that can be employed to determine whether the cash flows being used in a valuation are cash flows to equity or cash flows to the firm. If the cash flows that are being discounted are after interest expenses (and principal payments), they are cash flows to equity and the disc

S There is a simple test that can be employed to determine whether the cash flows being used in a valuation are cash flows to equity or cash flows to the firm. If the cash flows that are being discounted are after interest expenses (and principal payments), they are cash flows to equity and the discount rate used should be the cost of equity. If the cash flows that are discounted are before interest expenses and principal payments, they are usually cash flows to the firm. Needless to say, there are other items that need to be considered when estimating these cash flows, and they are considered in extensive detail in the coming chapters. We then add the present value of these excess returns to the investment in the asset: Value of asset = Present value of excess return + Investment in the asset = $2 million/.1 + $100 million = $120 million Note that the answers in the two approaches are equivalent. Why, then, would we want to use an excess return model? By focusing on excess returns, th

o the investment in the asset: Value of asset = Present value of excess return + Investment in the asset = $2 million/.1 + $100 million = $120 million Note that the answers in the two approaches are equivalent. Why, then, would we want to use an excess return model? By focusing on excess returns, this model brings home the point that it is not earnings per se that create value, but earnings in excess of a required return. Chapter 32 considers special versions of these excess return models. As in this simple example, with consistent assumptions, total cash flow and excess return models are equivalent. Applicability and Limitations of Discounted Cash Flow Valuation Discounted cash flow valuation is based on expected future cash flows and discount rates. Given these estimation requirements, this approach is easiest to use for assets (firms) whose cash flows are currently positive and can be estimated with some reliability for future periods, and where a proxy for risk that can be used to

on is based on expected future cash flows and discount rates. Given these estimation requirements, this approach is easiest to use for assets (firms) whose cash flows are currently positive and can be estimated with some reliability for future periods, and where a proxy for risk that can be used to obtain discount rates is available. The further we get from this idealized setting, the more difficult (and more useful) discounted cash flow valuation becomes. Here are some scenarios where discounted cash flow valuation might run into trouble and need to be adapted. Firms in Trouble A distressed firm generally has negative earnings and cash flows, and expects to lose money for some time in the future. For these firms, estimating future cash flows is difficult to do, since there is a strong probability of bankruptcy. For firms that are expected to fail, discounted cash flow valuation does not work very well, since the method values the firm as a going concern providing positive cash flows t

uture. For these firms, estimating future cash flows is difficult to do, since there is a strong probability of bankruptcy. For firms that are expected to fail, discounted cash flow valuation does not work very well, since the method values the firm as a going concern providing positive cash flows to its investors. Even for firms that are expected to survive, cash flows will have to be estimated until they turn positive, since obtaining a present value of negative cash flows will yield a negative value for equity1 or for the firm. We will examine these firms in more detail in chapters 22 and 30. Cyclical Firms The earnings and cash flows of cyclical firms tend to follow the economy—rising during economic booms and falling during recessions. If discounted cash flow valuation is used on these firms, expected future cash flows are usually smoothed out, unless the analyst wants to undertake the onerous task of predicting the timing and duration of economic recessions and recoveries. In the

ring economic booms and falling during recessions. If discounted cash flow valuation is used on these firms, expected future cash flows are usually smoothed out, unless the analyst wants to undertake the onerous task of predicting the timing and duration of economic recessions and recoveries. In the depths of a recession many cyclical firms look like troubled firms, with negative earnings and cash flows. Estimating future cash flows then becomes entangled with analyst predictions about when the economy will turn and how strong the upturn will be, with more optimistic analysts arriving at higher estimates of value. This is unavoidable, but the economic biases of the analysts have to be taken into account before using these valuations. Firms with Unutilized Assets Discounted cash flow valuation reflects the value of all assets that produce cash flows. If a firm has assets that are unutilized (and hence do not produce any cash flows), the value of these assets will not be reflected in the

into account before using these valuations. Firms with Unutilized Assets Discounted cash flow valuation reflects the value of all assets that produce cash flows. If a firm has assets that are unutilized (and hence do not produce any cash flows), the value of these assets will not be reflected in the value obtained from discounting expected future cash flows. The same caveat applies, in lesser degree, to underutilized assets, since their value will be understated in discounted cash flow valuation. While this is a problem, it is not insurmountable. The value of these assets can always be obtained externally2 and added to the value obtained from discounted cash flow valuation. Alternatively, the assets can be valued as though they are used optimally. Firms with Patents or Product Options Firms sometimes have unutilized patents or licenses that do not produce any current cash flows and are not expected to produce cash flows in the near future, but are valuable nevertheless. If this is the

e assets can be valued as though they are used optimally. Firms with Patents or Product Options Firms sometimes have unutilized patents or licenses that do not produce any current cash flows and are not expected to produce cash flows in the near future, but are valuable nevertheless. If this is the case, the value obtained from discounting expected cash flows to the firm will understate the true value of the firm. Again, the problem can be overcome, by valuing these assets in the open market or by using option pricing models, and then adding the value obtained from discounted cash flow valuation. Chapter 28 examines the use of option pricing models to value patents. Firms in the Process of Restructuring Firms in the process of restructuring often sell some of their assets, acquire other assets, and change their capital structure and dividend policy. Some of them also change their ownership structure (going from publicly traded to private status and vice versa) and management compensati

estructuring Firms in the process of restructuring often sell some of their assets, acquire other assets, and change their capital structure and dividend policy. Some of them also change their ownership structure (going from publicly traded to private status and vice versa) and management compensation schemes. Each of these changes makes estimating future cash flows more difficult and affects the riskiness of the firm. Using historical data for such firms can give a misleading picture of the firm's value. However, these firms can be valued, even in the light of the major changes in investment and financing policy, if future cash flows reflect the expected effects of these changes and the discount rate is adjusted to reflect the new business and financial risk in the firm. Chapter 31 takes a closer look at how value can be altered by changing the way a business is run. Firms Involved in Acquisitions There are at least two specific issues relating to acquisitions that need to be taken in

count rate is adjusted to reflect the new business and financial risk in the firm. Chapter 31 takes a closer look at how value can be altered by changing the way a business is run. Firms Involved in Acquisitions There are at least two specific issues relating to acquisitions that need to be taken into account when using discounted cash flow valuation models to value target firms. The first is the thorny one of whether there is synergy in the merger and how its value can be estimated. To do so will require assumptions about the form the synergy will take and its effect on cash flows. The second, especially in hostile takeovers, is the effect of changing management on cash flows and risk. Again, the effect of the change can and should be incorporated into the estimates of future cash flows and discount rates and hence into value. Chapter 25 looks at the value of synergy and control in acquisitions. Private Firms The biggest problem in using discounted cash flow valuation models to value

n, the effect of the change can and should be incorporated into the estimates of future cash flows and discount rates and hence into value. Chapter 25 looks at the value of synergy and control in acquisitions. Private Firms The biggest problem in using discounted cash flow valuation models to value private firms is the measurement of risk (to use in estimating discount rates), since most risk/return models require that risk parameters be estimated from historical prices on the asset being analyzed and make assumptions about the profiles of investors in the firm that may not fit private businesses. One solution is to look at the riskiness of comparable firms that are publicly traded. The other is to relate the measure of risk to accounting variables, which are available for the private firm. Chapter 24 looks at adaptations to valuation models that are needed to value private businesses. The point is not that discounted cash flow valuation cannot be done in these cases, but that we have

r is to relate the measure of risk to accounting variables, which are available for the private firm. Chapter 24 looks at adaptations to valuation models that are needed to value private businesses. The point is not that discounted cash flow valuation cannot be done in these cases, but that we have to be flexible enough to adapt our models. The fact is that valuation is simple for firms with well-defined assets that generate cash flows that can be easily forecasted. The real challenge in valuation is to extend the valuation framework to cover firms that vary to some extent or the other from this idealized framework. Much of this book is spent considering how to value such firms. RELATIVE VALUATION While we tend to focus most on discounted cash flow valuation when discussing valuation, the reality is that most valuations are relative valuations. The values of most assets, from the house you buy to the stocks you invest in, are based on how similar assets are priced in the marketplace. T

UATION While we tend to focus most on discounted cash flow valuation when discussing valuation, the reality is that most valuations are relative valuations. The values of most assets, from the house you buy to the stocks you invest in, are based on how similar assets are priced in the marketplace. This section begins with a basis for relative valuation, moves on to consider the underpinnings of the model, and then considers common variants within relative valuation. Basis for Relative Valuation In relative valuation, the value of an asset is derived from the pricing of comparable assets, standardized using a common variable such as earnings, cash flows, book value, or revenues. One illustration of this approach is the use of an industry-average price-earnings ratio to value a firm, the assumption being that the other firms in the industry are comparable to the firm being valued and that the market, on average, prices these firms correctly. Another multiple in wide use is the price–book

ion of this approach is the use of an industry-average price-earnings ratio to value a firm, the assumption being that the other firms in the industry are comparable to the firm being valued and that the market, on average, prices these firms correctly. Another multiple in wide use is the price–book value ratio, with firms selling at a discount on book value relative to comparable firms being considered undervalued. Revenue multiple are also used to value firms, with the average price-sales ratios of firms with similar characteristics being used for comparison. While these three multiples are among the most widely used, there are others that also play a role in analysis—EV to EBITDA, EV to invested capital, and market value to replacement value (Tobin's Q), to name a few. Underpinnings of Relative Valuation Unlike discounted cash flow valuation, which is a search for intrinsic value, relative valuation relies much more on the market being right. In other words, we assume that the marke

nvested capital, and market value to replacement value (Tobin's Q), to name a few. Underpinnings of Relative Valuation Unlike discounted cash flow valuation, which is a search for intrinsic value, relative valuation relies much more on the market being right. In other words, we assume that the market is correct in the way it prices stocks on average, but that it makes errors on the pricing of individual stocks. We also assume that a comparison of multiples will allow us to identify these errors, and that these errors will be corrected over time. The assumption that markets correct their mistakes over time is common to both discounted cash flow and relative valuation, but those who use multiples and comparables to pick stocks argue, with some basis, that errors made in pricing individual stocks in a sector are more noticeable and more likely to be corrected quickly. For instance, they would argue that a software firm that trades at a price-earnings ratio of 10 when the rest of the secto

les and comparables to pick stocks argue, with some basis, that errors made in pricing individual stocks in a sector are more noticeable and more likely to be corrected quickly. For instance, they would argue that a software firm that trades at a price-earnings ratio of 10 when the rest of the sector trades at 25 times earnings is clearly undervalued and that the correction toward the sector average should occur sooner rather than later. Proponents of discounted cash flow valuation would counter that this is small consolation if the entire sector is overpriced by 50 percent. Categorizing Relative Valuation Models Analysts and investors are endlessly inventive when it comes to using relative valuation. Some compare multiples across companies, while other compare the multiple of a company to the multiples it used to trade at in the past. While most relative valuations are based on the pricing of comparable assets at the same time, there are some relative valuations that are based on fund

valuation. Some compare multiples across companies, while other compare the multiple of a company to the multiples it used to trade at in the past. While most relative valuations are based on the pricing of comparable assets at the same time, there are some relative valuations that are based on fundamentals. Fundamentals versus Comparables In discounted cash flow valuation, the value of a firm is determined by its expected cash flows. Other things remaining equal, higher cash flows, lower risk, and higher growth should yield higher value. Some analysts who use multiples go back to these discounted cash flow models to extract multiples. Other analysts compare multiples across firms or time and make explicit or implicit assumptions about how firms are similar or vary on fundamentals. Using Fundamentals The first approach relates multiples to fundamentals about the firm being valued—growth rates in earnings and cash flows, reinvestment and risk. This approach to estimating multiples is eq

d make explicit or implicit assumptions about how firms are similar or vary on fundamentals. Using Fundamentals The first approach relates multiples to fundamentals about the firm being valued—growth rates in earnings and cash flows, reinvestment and risk. This approach to estimating multiples is equivalent to using discounted cash flow models, requiring the same information and yielding the same results. Its primary advantage is that it shows the relationship between multiples and firm characteristics, and allows us to explore how multiples change as these characteristics change. For instance, what will be the effect of changing profit margins on the price-sales ratio? What will happen to price-earnings ratios as growth rates decrease? What is the relationship between price–book value ratios and return on equity? Using Comparables The more common approach to using multiples is to compare how a firm is valued with how similar firms are priced by the market or, in some cases, with how t

rice-earnings ratios as growth rates decrease? What is the relationship between price–book value ratios and return on equity? Using Comparables The more common approach to using multiples is to compare how a firm is valued with how similar firms are priced by the market or, in some cases, with how the firm was valued in prior periods. As we see in the later chapters, finding similar and comparable firms is often a challenge, and frequently we have to accept firms that are different from the firm being valued on one dimension or the other. When this is the case, we have to either explicitly or implicitly control for differences across firms on growth, risk, and cash flow measures. In practice, controlling for these variables can range from the naive (using industry averages) to the sophisticated (multivariate regression models where the relevant variables are identified and controlled for). Cross-Sectional versus Time Series Comparisons In most cases, analysts price stocks on a relative

, controlling for these variables can range from the naive (using industry averages) to the sophisticated (multivariate regression models where the relevant variables are identified and controlled for). Cross-Sectional versus Time Series Comparisons In most cases, analysts price stocks on a relative basis, by comparing the multiples they are trading at to the multiples at which other firms in the same business are trading at contemporaneously. In some cases, however, especially for mature firms with long histories, the comparison is done across time. Cross-Sectional Comparisons When we compare the price-earnings ratio of a software firm to the average price-earnings ratio of other software firms, we are doing relative valuation and we are making cross-sectional comparisons. The conclusions can vary depending on our assumptions about the firm being valued and the comparable firms. For instance, if we assume that the firm we are valuing is similar to the average firm in the industry, we

irms, we are doing relative valuation and we are making cross-sectional comparisons. The conclusions can vary depending on our assumptions about the firm being valued and the comparable firms. For instance, if we assume that the firm we are valuing is similar to the average firm in the industry, we would conclude that it is cheap if it trades at a multiple that is lower than the average multiple. If, however, we assume that the firm being valued is riskier than the average firm in the industry, we might conclude that the firm should trade at a lower multiple than other firms in the business. In short, you cannot compare firms without making assumptions about their fundamentals. Comparisons across Time If you have a mature firm with a long history, you can compare the multiple it trades at today to the multiple it used to trade at in the past. Thus, Ford Motor Company may be viewed as cheap because it trades at six times earnings, if it has historically traded at 10 times earnings. To m

cross Time If you have a mature firm with a long history, you can compare the multiple it trades at today to the multiple it used to trade at in the past. Thus, Ford Motor Company may be viewed as cheap because it trades at six times earnings, if it has historically traded at 10 times earnings. To make this comparison, however, you have to assume that your firm's fundamentals have not changed over time. For instance, you would expect a high-growth firm's price-earnings ratio to drop over time and its expected growth rate to decrease as it becomes larger. Comparing multiples across time can also be complicated by changes in interest rates and the behavior of the overall market. For instance, as interest rates fall below historical norms and the overall market increases in value, you would expect most companies to trade at much higher multiples of earnings and book value than they have historically. Applicability and Limitations of Multiples The allure of multiples is that they are simpl

as interest rates fall below historical norms and the overall market increases in value, you would expect most companies to trade at much higher multiples of earnings and book value than they have historically. Applicability and Limitations of Multiples The allure of multiples is that they are simple and easy to relate to. They can be used to obtain estimates of value quickly for firms and assets, and are particularly useful when a large number of comparable firms are traded on financial markets, and the market is, on average, pricing these firms correctly. They tend to be more difficult to use to value unique firms with no obvious comparables, with little or no revenues, and with negative earnings. By the same token, multiples are also easy to misuse and manipulate, especially when comparable firms are used. Given that no two firms are exactly alike in terms of risk and growth, the definition of comparable firms is a subjective one. Consequently, a biased analyst can choose a group of

arnings. By the same token, multiples are also easy to misuse and manipulate, especially when comparable firms are used. Given that no two firms are exactly alike in terms of risk and growth, the definition of comparable firms is a subjective one. Consequently, a biased analyst can choose a group of comparable firms to confirm his or her biases about a firm's value. Illustration 2.2 shows an example. While this potential for bias exists with discounted cash flow valuation as well, the analyst in DCF valuation is forced to be much more explicit about the assumptions that determine the final value. With multiples, these assumptions are often left unstated. ASSET-BASED VALUATION MODELS There are some analysts who add a fourth approach to valuation to the three described in this chapter. They argue that you can value the individual assets owned by a firm and aggregate them to arrive at a firm value—asset-based valuation models. In fact, there are several variants on asset-based valuation m

e some analysts who add a fourth approach to valuation to the three described in this chapter. They argue that you can value the individual assets owned by a firm and aggregate them to arrive at a firm value—asset-based valuation models. In fact, there are several variants on asset-based valuation models. The first is liquidation value, which is obtained by aggregating the estimated sale proceeds of the assets owned by a firm. The second is replacement cost, where you estimate what it would cost you to replace all of the assets that a firm has today. The third is the simplest: use accounting book value as the measure of the value of the assets, with adjustments to the book value made where necessary. While analysts may use asset-based valuation approaches to estimate value, they are not alternatives to discounted cash flow, relative, or option pricing models since both replacement and liquidation values have to be obtained using one or another of these approaches. Ultimately, all valua

ecessary. While analysts may use asset-based valuation approaches to estimate value, they are not alternatives to discounted cash flow, relative, or option pricing models since both replacement and liquidation values have to be obtained using one or another of these approaches. Ultimately, all valuation models attempt to value assets; the differences arise in how we identify the assets and how we attach value to each asset. In liquidation valuation, we look only at assets in place and estimate their value based on what similar assets are priced at in the market. In traditional discounted cash flow valuation, we consider all assets and include expected growth potential to arrive at value. The two approaches may, in fact, yield the same values if you have a firm that has no growth potential and the market assessments of value reflect expected cash flows. ILLUSTRATION 2.2: The Potential for Misuse with Comparable Firms Assume that an analyst is valuing an initial public offering (IPO) of

two approaches may, in fact, yield the same values if you have a firm that has no growth potential and the market assessments of value reflect expected cash flows. ILLUSTRATION 2.2: The Potential for Misuse with Comparable Firms Assume that an analyst is valuing an initial public offering (IPO) of a firm that manufactures computer software. At the same time,3 the price-earnings multiples of other publicly traded firms manufacturing software are: Firm Multiple Adobe Systems 23.2 Autodesk 20.4 Broderbund 32.8 Computer Associates 18.0 Lotus Development 24.1 Microsoft 27.4 Novell 30.0 Oracle 37.8 Software Publishing 10.6 System Software 15.7 Average PE ratio 24.0 While the average PE ratio using the entire sample is 24, it can be changed markedly by removing a couple of firms from the group. For instance, if the two firms with the lowest PE ratios in the group (Software Publishing and System Software) are eliminated from the sample, the average PE ratio increases to 27. If the two firms w

g the entire sample is 24, it can be changed markedly by removing a couple of firms from the group. For instance, if the two firms with the lowest PE ratios in the group (Software Publishing and System Software) are eliminated from the sample, the average PE ratio increases to 27. If the two firms with the highest PE ratios in the group (Broderbund and Oracle) are removed from the group, the average PE ratio drops to 21. The other problem with using multiples based on comparable firms is that it builds in errors (overvaluation or undervaluation) that the market might be making in valuing these firms. In Illustration 2.2, for instance, if the market has overvalued all computer software firms, using the average PE ratio of these firms to value an initial public offering will lead to an overvaluation of the IPO stock. In contrast, discounted cash flow valuation is based on firm-specific growth rates and cash flows, so it is less likely to be influenced by market errors in valuation. CONTI

using the average PE ratio of these firms to value an initial public offering will lead to an overvaluation of the IPO stock. In contrast, discounted cash flow valuation is based on firm-specific growth rates and cash flows, so it is less likely to be influenced by market errors in valuation. CONTINGENT CLAIM VALUATION Perhaps the most revolutionary development in valuation is the acceptance, at least in some cases, that the value of an asset may be greater than the present value of expected cash flows if the cash flows are contingent on the occurrence or nonoccurrence of an event. This acceptance has largely come about because of the development of option pricing models. While these models were initially used to value traded options, there has been an attempt in recent years to extend the reach of these models into more traditional valuation. There are many who argue that assets such as patents or undeveloped reserves are really options and should be valued as such, rather than with

were initially used to value traded options, there has been an attempt in recent years to extend the reach of these models into more traditional valuation. There are many who argue that assets such as patents or undeveloped reserves are really options and should be valued as such, rather than with traditional discounted cash flow models. Basis for Approach A contingent claim or option is a claim that pays off only under certain contingencies—if the value of the underlying asset exceeds a prespecified value for a call option or is less than a prespecified value for a put option. Much work has been done in the past 20 years in developing models that value options, and these option pricing models can be used to value any assets that have optionlike features. Figure 2.2 illustrates the payoffs on call and put options as a function of the value of the underlying asset. An option can be valued as a function of the following variables: the current value and the variance in value of the under

els can be used to value any assets that have optionlike features. Figure 2.2 illustrates the payoffs on call and put options as a function of the value of the underlying asset. An option can be valued as a function of the following variables: the current value and the variance in value of the underlying asset, the strike price and the time to expiration of the option, and the riskless interest rate. This was first established by Fischer Black and Myron Scholes in 1972 and has been extended and refined subsequently in numerous variants. While the Black-Scholes option pricing model ignore dividends and assumes that options will not be exercised early, it can be modified to allow for both. A discrete-time variant, the binomial option pricing model, has also been developed to price options. Figure 2.2 Payoff Diagram on Call and Put Options An asset can be valued as an option if the payoffs are a function of the value of an underlying asset. It can be valued as a call option if when that v

iscrete-time variant, the binomial option pricing model, has also been developed to price options. Figure 2.2 Payoff Diagram on Call and Put Options An asset can be valued as an option if the payoffs are a function of the value of an underlying asset. It can be valued as a call option if when that value exceeds a prespecified level the asset is worth the difference. It can be valued as a put option if it gains value as the value of the underlying asset drops below a prespecified level, and if it is worth nothing when the underlying asset's value exceeds that specified level. Underpinnings of Contingent Claim Valuation The fundamental premise behind the use of option pricing models is that discounted cash flow models tend to understate the value of assets that provide payoffs that are contingent on the occurrence of an event. As a simple example, consider an undeveloped oil reserve belonging to Petrobras. You could value this reserve based on expectations of oil prices in the future, bu

scounted cash flow models tend to understate the value of assets that provide payoffs that are contingent on the occurrence of an event. As a simple example, consider an undeveloped oil reserve belonging to Petrobras. You could value this reserve based on expectations of oil prices in the future, but this estimate would miss the fact that the oil company will develop this reserve only if oil prices go up and will not if oil prices decline. An option pricing model would yield a value that incorporates this right. When we use option pricing models to value assets such as patents and undeveloped natural resource reserves, we are assuming that markets are sophisticated enough to recognize such options and incorporate them into the market price. If the markets do not do so right now, we assume that they will eventually; the payoff to using such models comes about when this correction occurs. Categorizing Option Pricing Models The first categorization of options is based on whether the under

ptions and incorporate them into the market price. If the markets do not do so right now, we assume that they will eventually; the payoff to using such models comes about when this correction occurs. Categorizing Option Pricing Models The first categorization of options is based on whether the underlying asset is a financial asset or a real asset. Most listed options, whether they be options listed on the Chicago Board Options Exchange or callable fixed income securities, are on financial assets such as stocks and bonds. In contrast, options can be on real assets such as commodities, real estate, or even investment projects; such options are often called real options. A second and overlapping categorization is based on whether the underlying asset is traded. The overlap occurs because most financial assets are traded, whereas relatively few real assets are traded. Options on traded assets are generally easier to value, and the inputs to the option pricing models can be obtained from fi

g categorization is based on whether the underlying asset is traded. The overlap occurs because most financial assets are traded, whereas relatively few real assets are traded. Options on traded assets are generally easier to value, and the inputs to the option pricing models can be obtained from financial markets. Options on nontraded assets are much more difficult to value, since there are no market inputs available on the underlying assets. Applicability and Limitations of Option Pricing Models There are several direct examples of securities that are options—LEAPS, which are long-term equity options on traded stocks; contingent value rights, which provide protection to stockholders in companies against stock price declines; and warrants, which are long-term call options issued by firms. There are other assets that generally are not viewed as options but still share several option characteristics. Equity, for instance, can be viewed as a call option on the value of the underlying fir

panies against stock price declines; and warrants, which are long-term call options issued by firms. There are other assets that generally are not viewed as options but still share several option characteristics. Equity, for instance, can be viewed as a call option on the value of the underlying firm, with the face value of debt representing the strike price and the term of the debt measuring the life of the option. A patent can be analyzed as a call option on a product, with the investment outlay needed to get the project going considered the strike price and the patent life becoming the time to expiration of the option. There are limitations in using option pricing models to value long-term options on nontraded assets. The assumptions made about constant variance and dividend yields, which are not seriously contested for short-term options, are much more difficult to defend when options have long lifetimes. When the underlying asset is not traded, the inputs for the value of the unde

m options on nontraded assets. The assumptions made about constant variance and dividend yields, which are not seriously contested for short-term options, are much more difficult to defend when options have long lifetimes. When the underlying asset is not traded, the inputs for the value of the underlying asset and the variance in that value cannot be extracted from financial markets and have to be estimated. Thus the final values obtained from these applications of option pricing models have much more estimation error associated with them than the values obtained in their more standard applications (to value short-term traded options). CONCLUSION There are three basic, though not mutually exclusive, approaches to valuation. The first is discounted cash flow valuation, where cash flows are discounted at a risk-adjusted discount rate to arrive at an estimate of value. The analysis can be done purely from the perspective of equity investors by discounting expected cash flows to equity at

xclusive, approaches to valuation. The first is discounted cash flow valuation, where cash flows are discounted at a risk-adjusted discount rate to arrive at an estimate of value. The analysis can be done purely from the perspective of equity investors by discounting expected cash flows to equity at the cost of equity, or it can be done from the viewpoint of all claimholders in the firm, by discounting expected cash flows to the firm at the weighted average cost of capital. The second is relative valuation, where the value of an asset is based on the pricing of similar assets. The third is contingent claim valuation, where an asset with the characteristics of an option is valued using an option pricing model. There should be a place for each among the tools available to any analyst interested in valuation. QUESTIONS AND SHORT PROBLEMS In the problems following, use an equity risk premium of 5.5 percent if none is specified. 1. Discounted cash flow valuation is based on the notion that

ion pricing model. There should be a place for each among the tools available to any analyst interested in valuation. QUESTIONS AND SHORT PROBLEMS In the problems following, use an equity risk premium of 5.5 percent if none is specified. 1. Discounted cash flow valuation is based on the notion that the value of an asset is the present value of the expected cash flows on that asset, discounted at a rate that reflects the riskiness of those cash flows. Specify whether the following statements about discounted cash flow valuation are true or false, assuming that all variables are constant except for the one mentioned: a. As the discount rate increases, the value of an asset increases. True____False____ b. As the expected growth rate in cash flows increases, the value of an asset increases. True____False____ c. As the life of an asset is lengthened, the value of that asset increases. True____False____ d. As the uncertainty about the expected cash flow increases, the value of an asset incre

alse____ b. As the expected growth rate in cash flows increases, the value of an asset increases. True____False____ c. As the life of an asset is lengthened, the value of that asset increases. True____False____ d. As the uncertainty about the expected cash flow increases, the value of an asset increases. True____False____ e. An asset with an infinite life (i.e., it is expected to last forever) will have an infinite value. True____False____ 2. Why might discounted cash flow valuation be difficult to do for the following types of firms? a. A private firm, where the owner is planning to sell the firm. b. A biotechnology firm with no current products or sales, but with several promising product patents in the pipeline. c. A cyclical firm during a recession. d. A troubled firm that has made significant losses and is not expected to get out of trouble for a few years. e. A firm that is in the process of restructuring, where it is selling some of its assets and changing its financial mix. f.

patents in the pipeline. c. A cyclical firm during a recession. d. A troubled firm that has made significant losses and is not expected to get out of trouble for a few years. e. A firm that is in the process of restructuring, where it is selling some of its assets and changing its financial mix. f. A firm that owns a lot of valuable land that is currently unutilized. 3. The following are the projected cash flows to equity and to the firm over the next five years: The firm has a cost of equity of 12% and a cost of capital of 9.94%. Answer the following questions: a. What is the value of the equity in this firm? b. What is the value of the firm? 4. You are estimating the price-earnings multiple to use to value Paramount Corporation by looking at the average price-earnings multiple of comparable firms. The following are the price-earnings ratios of firms in the entertainment business. Firm PE Ratio Disney (Walt) 22.09 Time Warner 36.00 King World Productions 14.10 New Line Cinema 26.70 a.

e to use to value Paramount Corporation by looking at the average price-earnings multiple of comparable firms. The following are the price-earnings ratios of firms in the entertainment business. Firm PE Ratio Disney (Walt) 22.09 Time Warner 36.00 King World Productions 14.10 New Line Cinema 26.70 a. What is the average PE ratio? b. Would you use all the comparable firms in calculating the average? Why or why not? c. What assumptions are you making when you use the industry-average PE ratio to value Paramount Corporation? 1 The protection of limited liability should ensure that no stock will sell for less than zero. The price of such a stock can never be negative. 2 If these assets are traded on external markets, the market prices of these assets can be used in the valuation. If not, the cash flows can be projected, assuming full utilization of assets, and the value can be estimated. 3 These were the PE ratios for these firms at the end of 1992. HAPTER 3Understanding Financial Statemen

on external markets, the market prices of these assets can be used in the valuation. If not, the cash flows can be projected, assuming full utilization of assets, and the value can be estimated. 3 These were the PE ratios for these firms at the end of 1992. HAPTER 3Understanding Financial Statements Financial statements provide the fundamental information that we use to analyze and answer valuation questions. It is important, therefore, that we understand the principles governing these statements by looking at four questions: 1. How valuable are the assets of a firm? The assets of a firm can come in several forms—assets with long lives such as land and buildings, assets with shorter lives such as inventory, and intangible assets that nevertheless produce revenues for the firm such as patents and trademarks. 2. How did the firm raise the funds to finance these assets? In acquiring assets, firms can use the funds of the owners (equity) or borrowed money (debt), and the mix is likely to

such as inventory, and intangible assets that nevertheless produce revenues for the firm such as patents and trademarks. 2. How did the firm raise the funds to finance these assets? In acquiring assets, firms can use the funds of the owners (equity) or borrowed money (debt), and the mix is likely to change as the assets age. 3. How profitable are these assets? A good investment is one that makes a return greater than the cost of funding it. To evaluate whether the investments that a firm has already made are good investments, we need to estimate what returns these investments are producing. 4. How much uncertainty (or risk) is embedded in these assets? While we have not yet directly confronted the issue of risk, estimating how much uncertainty there is in existing investments, and the implications for a firm, is clearly a first step. This chapter looks at the way accountants would answer these questions, and why the answers might be different when doing valuation. Some of these differe

ed the issue of risk, estimating how much uncertainty there is in existing investments, and the implications for a firm, is clearly a first step. This chapter looks at the way accountants would answer these questions, and why the answers might be different when doing valuation. Some of these differences can be traced to the differences in objectives: Accountants try to measure the current standing and immediate past performance of a firm, whereas valuation is much more forward-looking. THE BASIC ACCOUNTING STATEMENTS There are three basic accounting statements that summarize information about a firm. The first is the balance sheet, shown in Figure 3.1, which summarizes the assets owned by a firm, the value of these assets, and the mix of financing (debt and equity) used to finance these assets at a point in time. Figure 3.1 The Balance Sheet The next is the income statement, shown in Figure 3.2, which provides information on the revenues and expenses of the firm, and the resulting inco

firm, the value of these assets, and the mix of financing (debt and equity) used to finance these assets at a point in time. Figure 3.1 The Balance Sheet The next is the income statement, shown in Figure 3.2, which provides information on the revenues and expenses of the firm, and the resulting income made by the firm, during a period. The period can be a quarter (if it is a quarterly income statement) or a year (if it is an annual report). Figure 3.2 Income Statement Finally, there is the statement of cash flows, shown in Figure 3.3, which specifies the sources and uses of cash to the firm from operating, investing, and financing activities during a period. The statement of cash flows can be viewed as an attempt to explain what the cash flows during a period were, and why the cash balance changed during the period. Figure 3.3 Statement of Cash Flows ASSET MEASUREMENT AND VALUATION When analyzing any firm, we want to know the types of assets that it owns, the value of these assets, and

e viewed as an attempt to explain what the cash flows during a period were, and why the cash balance changed during the period. Figure 3.3 Statement of Cash Flows ASSET MEASUREMENT AND VALUATION When analyzing any firm, we want to know the types of assets that it owns, the value of these assets, and the degree of uncertainty about this value. Accounting statements do a reasonably good job of categorizing the assets owned by a firm, a partial job of assessing the value of these assets, and a poor job of reporting uncertainty about asset value. This section begins by looking at the accounting principles underlying asset categorization and measurement, and the limitations of financial statements in providing relevant information about assets. Accounting Principles Underlying Asset Measurement An asset is any resource that has the potential either to generate future cash inflows or to reduce future cash outflows. While that is a general definition broad enough to cover almost any kind of a

s in providing relevant information about assets. Accounting Principles Underlying Asset Measurement An asset is any resource that has the potential either to generate future cash inflows or to reduce future cash outflows. While that is a general definition broad enough to cover almost any kind of asset, accountants add a caveat that for a resource to be an asset a firm has to have acquired it in a prior transaction and be able to quantify future benefits with reasonable precision. The accounting view of asset value is to a great extent grounded in the notion of historical cost, which is the original cost of the asset, adjusted upward for improvements made to the asset since purchase and downward for the loss in value associated with the aging of the asset. This historical cost is called the book value. While the generally accepted accounting principles (GAAP) for valuing an asset vary across different kinds of assets, three principles underlie the way assets are valued in accounting s

nward for the loss in value associated with the aging of the asset. This historical cost is called the book value. While the generally accepted accounting principles (GAAP) for valuing an asset vary across different kinds of assets, three principles underlie the way assets are valued in accounting statements: 1. An abiding belief in book value as the best estimate of value. Accounting estimates of asset value begin with the book value, and unless a substantial reason is given to do otherwise, accountants view the historical cost as the best estimate of the value of an asset. 2. A distrust of market or estimated value. When a current market value exists for an asset that is different from the book value, accounting convention seems to view this market value with suspicion. The market price of an asset is often viewed as both much too volatile and too easily manipulated to be used as an estimate of value for an asset. This suspicion runs even deeper when a value is estimated for an asset

book value, accounting convention seems to view this market value with suspicion. The market price of an asset is often viewed as both much too volatile and too easily manipulated to be used as an estimate of value for an asset. This suspicion runs even deeper when a value is estimated for an asset based on expected future cash flows. 3. A preference for underestimating value rather than overestimating it. When there is more than one approach to valuing an asset, accounting convention takes the view that the more conservative (lower) estimate of value should be used rather than the less conservative (higher) estimate of value. Thus, when both market and book value are available for an asset, accounting rules often require that you use the lesser of the two numbers. Measuring Asset Value The financial statement in which accountants summarize and report asset value is the balance sheet. To examine how asset value is measured, let us begin with the way assets are categorized in the balan

, accounting rules often require that you use the lesser of the two numbers. Measuring Asset Value The financial statement in which accountants summarize and report asset value is the balance sheet. To examine how asset value is measured, let us begin with the way assets are categorized in the balance sheet. First there are the fixed assets, which include the long-term assets of the firm, such as plant, equipment, land, and buildings. Next, we have the short-term assets of the firm, including inventory (raw materials, work in progress, and finished goods, receivables (summarizing moneys owed to the firm), and cash; these are categorized as current assets. We then have investments in the assets and securities of other firms, which are generally categorized as financial investments. Finally, we have what is loosely categorized as intangible assets. These include not only assets such as patents and trademarks that presumably will create future earnings and cash flows, but also uniquely ac

ts and securities of other firms, which are generally categorized as financial investments. Finally, we have what is loosely categorized as intangible assets. These include not only assets such as patents and trademarks that presumably will create future earnings and cash flows, but also uniquely accounting assets such as goodwill that arise because of acquisitions made by the firm. Fixed Assets Generally accepted accounting principles (GAAP) in the United States require the valuation of fixed assets at historical cost, adjusted for any estimated loss in value from the aging of these assets. While in theory the adjustments for aging should reflect the loss of earning power of the asset as it ages, in practice they are much more a product of accounting rules and convention, and these adjustments are called depreciation. Depreciation methods can very broadly be categorized into straight line (where the loss in asset value is assumed to be the same every year over its lifetime) and accele

ages, in practice they are much more a product of accounting rules and convention, and these adjustments are called depreciation. Depreciation methods can very broadly be categorized into straight line (where the loss in asset value is assumed to be the same every year over its lifetime) and accelerated (where the asset loses more value in the earlier years and less in the later years). While tax rules, at least in the United States, have restricted the freedom that firms have on their choices of asset life and depreciation methods, firms continue to have a significant amount of flexibility on these decisions for reporting purposes. Thus, the depreciation that is reported in the annual reports may not be, and generally is not, the same depreciation that is used in the tax statements. Since fixed assets are valued at book value and are adjusted for depreciation provisions, the value of a fixed asset is strongly influenced by both its depreciable life and the depreciation method used. M

rts may not be, and generally is not, the same depreciation that is used in the tax statements. Since fixed assets are valued at book value and are adjusted for depreciation provisions, the value of a fixed asset is strongly influenced by both its depreciable life and the depreciation method used. Many firms in the United States use straight-line depreciation for financial reporting while using accelerated depreciation for tax purposes, since firms can report better earnings with the former, at least in the years right after the asset is acquired.1 In contrast, firms in other countries often use accelerated depreciation for both tax and financial reporting purposes, leading to reported income that is understated relative to that of their U.S. counterparts. Current Assets Current assets include inventory, cash, and accounts receivable. It is in this category that accountants are most amenable to the use of market value, especially in valuing marketable securities. Accounts Receivable Ac

e that is understated relative to that of their U.S. counterparts. Current Assets Current assets include inventory, cash, and accounts receivable. It is in this category that accountants are most amenable to the use of market value, especially in valuing marketable securities. Accounts Receivable Accounts receivable represent money owed by entities to the firm on the sale of products on credit. When the Home Depot sells products to building contractors and gives them a few weeks to make their payments, it is creating accounts receivable. The accounting convention is for accounts receivable to be recorded as the amount owed to the firm based on the billing at the time of the credit sale. The only major valuation and accounting issue is when the firm has to recognize accounts receivable that are not collectible. Firms can set aside a portion of their income to cover expected bad debts from credit sales, and accounts receivable will be reduced by this reserve. Alternatively, the bad debts

only major valuation and accounting issue is when the firm has to recognize accounts receivable that are not collectible. Firms can set aside a portion of their income to cover expected bad debts from credit sales, and accounts receivable will be reduced by this reserve. Alternatively, the bad debts can be recognized as they occur, and the firm can reduce the accounts receivable accordingly. There is the danger, however, that absent a decisive declaration of a bad debt, firms may continue to show as accounts receivable amounts that they know are unlikely ever to be collected. Cash Cash is one of the few assets for which accountants and financial analysts should agree on value. The value of a cash balance should not be open to estimation error. Having said this, we note that fewer and fewer companies actually hold cash in the conventional sense (as currency or as demand deposits in banks). Firms often invest the cash in interest-bearing accounts, commercial paper or in Treasuries so as

cash balance should not be open to estimation error. Having said this, we note that fewer and fewer companies actually hold cash in the conventional sense (as currency or as demand deposits in banks). Firms often invest the cash in interest-bearing accounts, commercial paper or in Treasuries so as to earn a return on their investments. In either case, market value can sometimes deviate from book value. While there is minimal default risk in either of these investments, interest rate movements can affect their value. The valuation of marketable securities is examined later in this section. Inventory Three basic approaches to valuing inventory are allowed by GAAP: first in, first out (FIFO); last in, first out (LIFO); and weighted average. 1. First in, first out (FIFO). Under FIFO, the cost of goods sold is based on the cost of material bought earliest in the period, while the cost of inventory is based on the cost of material bought later in the year. This results in inventory being va

last in, first out (LIFO); and weighted average. 1. First in, first out (FIFO). Under FIFO, the cost of goods sold is based on the cost of material bought earliest in the period, while the cost of inventory is based on the cost of material bought later in the year. This results in inventory being valued close to current replacement cost. During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three valuation approaches, and the highest net income. 2. Last in, first out (LIFO). Under LIFO, the cost of goods sold is based on the cost of material bought toward the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year. During periods of inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three approaches, and the lowest net income. 3. Weighted average. Under the weighted

. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year. During periods of inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three approaches, and the lowest net income. 3. Weighted average. Under the weighted average approach, both inventory and the cost of goods sold are based on the average cost of all material bought during the period. When inventory turns over rapidly, this approach will more closely resemble FIFO than LIFO. Firms often adopt the LIFO approach for its tax benefits during periods of high inflation. The cost of goods sold is then higher because it is based on prices paid toward to the end of the accounting period. This, in turn, will reduce the reported taxable income and net income while increasing cash flows. Studies indicate that larger firms with rising prices for raw materials and labor, more variable inventory growth, and an absence of other tax loss carryforwards are muc

e end of the accounting period. This, in turn, will reduce the reported taxable income and net income while increasing cash flows. Studies indicate that larger firms with rising prices for raw materials and labor, more variable inventory growth, and an absence of other tax loss carryforwards are much more likely to adopt the LIFO approach. Given the income and cash flow effects of inventory valuation methods, it is often difficult to compare the profitability of firms that use different methods. There is, however, one way of adjusting for these differences. Firms that choose the LIFO approach to value inventories have to specify in a footnote the difference in inventory valuation between FIFO and LIFO, and this difference is termed the LIFO reserve. It can be used to adjust the beginning and ending inventories, and consequently the cost of goods sold, and to restate income based on FIFO valuation. Investments (Financial) and Marketable Securities In the category of investments and mark

O and LIFO, and this difference is termed the LIFO reserve. It can be used to adjust the beginning and ending inventories, and consequently the cost of goods sold, and to restate income based on FIFO valuation. Investments (Financial) and Marketable Securities In the category of investments and marketable securities, accountants consider investments made by firms in the securities or assets of other firms, as well as other marketable securities, including Treasury bills or bonds. The way in which these assets are valued depends on the way the investment is categorized and the motive behind the investment. In general, an investment in the securities of another firm can be categorized as a minority passive investment, a minority active investment, or a majority active investment, and the accounting rules vary depending on the categorization. Minority Passive Investments If the securities or assets owned in another firm represent less than 20 percent of the overall ownership of that firm,

ority passive investment, a minority active investment, or a majority active investment, and the accounting rules vary depending on the categorization. Minority Passive Investments If the securities or assets owned in another firm represent less than 20 percent of the overall ownership of that firm, an investment is treated as a minority passive investment. These investments have an acquisition value, which represents what the firm originally paid for the securities, and often a market value. Accounting principles require that these assets be subcategorized into one of three groups—investments that will be held to maturity, investments that are available for sale, and trading investments. The valuation principles vary for each. For an investment that will be held to maturity, the valuation is at historical cost or book value, and interest or dividends from this investment are shown in the income statement. For an investment that is available for sale, the valuation is at market value,

e valuation principles vary for each. For an investment that will be held to maturity, the valuation is at historical cost or book value, and interest or dividends from this investment are shown in the income statement. For an investment that is available for sale, the valuation is at market value, but the unrealized gains or losses are shown as part of the equity in the balance sheet and not in the income statement. Thus, unrealized losses reduce the book value of the equity in the firm, and unrealized gains increase the book value of equity. For a trading investment, the valuation is at market value, and the unrealized gains and losses are shown in the income statement. Firms are allowed an element of discretion in the way they classify investments and, subsequently, in the way they value these assets. This classification ensures that firms such as investment banks, whose assets are primarily securities held in other firms for purposes of trading, revalue the bulk of these assets at

n element of discretion in the way they classify investments and, subsequently, in the way they value these assets. This classification ensures that firms such as investment banks, whose assets are primarily securities held in other firms for purposes of trading, revalue the bulk of these assets at market levels each period. This is called marking to market, and provides one of the few instances in which market value trumps book value in accounting statements. Note, however, that this mark-to-market ethos did not provide any advance warning in 2008 to investors in financial service firms of the overvaluation of subprime and mortgage-backed securities. Minority Active Investments If the securities or assets owned in another firm represent between 20 percent and 50 percent of the overall ownership of that firm, an investment is treated as a minority active investment. While these investments have an initial acquisition value, a proportional share (based on ownership proportion) of the ne

ities or assets owned in another firm represent between 20 percent and 50 percent of the overall ownership of that firm, an investment is treated as a minority active investment. While these investments have an initial acquisition value, a proportional share (based on ownership proportion) of the net income and losses made by the firm in which the investment was made is used to adjust the acquisition cost. In addition, the dividends received from the investment reduce the acquisition cost. This approach to valuing investments is called the equity approach. The market value of these investments is not considered until the investment is liquidated, at which point the gain or loss from the sale relative to the adjusted acquisition cost is shown as part of the earnings in that period. Majority Active Investments If the securities or assets owned in another firm represent more than 50 percent of the overall ownership of that firm, an investment is treated as a majority active investment. In

relative to the adjusted acquisition cost is shown as part of the earnings in that period. Majority Active Investments If the securities or assets owned in another firm represent more than 50 percent of the overall ownership of that firm, an investment is treated as a majority active investment. In this case, the investment is no longer shown as a financial investment but is instead replaced by the assets and liabilities of the firm in which the investment was made. This approach leads to a consolidation of the balance sheets of the two firms, where the assets and liabilities of the two firms are merged and presented as one balance sheet.2 The share of the equity in the subsidiary that is owned by other investors is shown as a minority interest on the liability side of the balance sheet. To provide an illustration, assume that Firm A owns 60% of Firm B. Firm A will be required to consolidate 100% of Fir m B's revenues, earnings, and assets into its own financial statements and then sh

wned by other investors is shown as a minority interest on the liability side of the balance sheet. To provide an illustration, assume that Firm A owns 60% of Firm B. Firm A will be required to consolidate 100% of Fir m B's revenues, earnings, and assets into its own financial statements and then show a liability (minority interest) reflecting the accounting estimate of value of the 40% of Firm B's equity that does not belong to it. A similar consolidation occurs in the other financial statements of the firm as well, with the statement of cash flows reflecting the cumulated cash inflows and outflows of the combined firm. This is in contrast to the equity approach used for minority active investments, in which only the dividends received on the investment are shown as a cash inflow in the cash flow statement. Here again, the market value of this investment is not considered until the ownership stake is liquidated. At that point, the difference between the market price and the net value

estments, in which only the dividends received on the investment are shown as a cash inflow in the cash flow statement. Here again, the market value of this investment is not considered until the ownership stake is liquidated. At that point, the difference between the market price and the net value of the equity stake in the firm is treated as a gain or loss for the period. Intangible Assets Intangible assets include a wide array of assets, ranging from patents and trademarks to goodwill. The accounting standards vary across intangible assets. Patents and Trademarks Patents and trademarks are valued differently depending on whether they are generated internally or acquired. When patents and trademarks are generated from internal research, the costs incurred in developing the asset are expensed in that period, even though the asset might have a life of several accounting periods. Thus, the intangible asset is not valued in the balance sheet of the firm. In contrast, when an intangible a

trademarks are generated from internal research, the costs incurred in developing the asset are expensed in that period, even though the asset might have a life of several accounting periods. Thus, the intangible asset is not valued in the balance sheet of the firm. In contrast, when an intangible asset is acquired from an external party, it is treated as an asset. Intangible assets have to be amortized over their expected lives, with a maximum amortization period of 40 years. The standard practice is to use straight-line amortization. For tax purposes, however, firms are generally not allowed to amortize goodwill or other intangible assets with no specific lifetime, though recent changes in the tax law allow for some flexibility in this regard. Goodwill Goodwill is the by-product of acquisitions. When a firm acquires another firm, the purchase price is first allocated to tangible assets, and the excess price is then allocated to any intangible assets such as patents or trade names. An

the tax law allow for some flexibility in this regard. Goodwill Goodwill is the by-product of acquisitions. When a firm acquires another firm, the purchase price is first allocated to tangible assets, and the excess price is then allocated to any intangible assets such as patents or trade names. Any residual becomes goodwill. While accounting principles suggest that goodwill captures the value of any intangibles that are not specifically identifiable, it is really a reflection of the difference between the book value of assets of the acquired firm and the market value paid in the acquisition. This approach is called purchase accounting, and goodwill is amortized over time. Until 2000, firms that did not want to see this charge against their earnings often used an alternative approach called pooling accounting, in which the purchase price never shows up in the balance sheet. Instead, the book values of the two companies involved in the merger were aggregated to create the consolidated

that did not want to see this charge against their earnings often used an alternative approach called pooling accounting, in which the purchase price never shows up in the balance sheet. Instead, the book values of the two companies involved in the merger were aggregated to create the consolidated balance of the combined firm. The rules on acquisition accounting have changed substantially in the past decade both in the United States and internationally. Not only is purchase accounting required on all acquisitions, but firms are no longer allowed to automatically amortize goodwill over long periods (as they were used to doing). Instead, acquiring firms are required to reassess the values of the acquired entities every year; if the values have dropped since the acquisition, the value of goodwill must be reduced (impaired) to reflect the decline in value. If the acquired firm's values have gone up, though, the goodwill cannot be increased to reflect this change.3 ILLUSTRATION 3.1: Asset

the acquired entities every year; if the values have dropped since the acquisition, the value of goodwill must be reduced (impaired) to reflect the decline in value. If the acquired firm's values have gone up, though, the goodwill cannot be increased to reflect this change.3 ILLUSTRATION 3.1: Asset Values for Boeing and the Home Depot in 1998 The following table summarizes asset values, as measured in the balance sheets of Boeing, the aerospace giant, and the Home Depot, a building supplies retailer, at the end of the 1998 financial year (in millions of dollars): Boeing Home Depot Net fixed assets $ 8,589 $ 8,160 Goodwill $ 2,312 $ 140 Investments and notes receivable $ 41 $ 0 Deferred income taxes $ 411 $ 0 Prepaid pension expense $ 3,513 $ 0 Customer financing $ 4,930 $ 0 Other assets $ 542 $ 191 Current Assets Cash $ 2,183 $ 62 Short-term marketable investments $ 279 $ 0 Accounts receivables $ 3,288 $ 469 Current portion of customer financing $ 781 $ 0 Deferred income taxes $ 1,495

e taxes $ 411 $ 0 Prepaid pension expense $ 3,513 $ 0 Customer financing $ 4,930 $ 0 Other assets $ 542 $ 191 Current Assets Cash $ 2,183 $ 62 Short-term marketable investments $ 279 $ 0 Accounts receivables $ 3,288 $ 469 Current portion of customer financing $ 781 $ 0 Deferred income taxes $ 1,495 $ 0 Inventories $ 8,349 $ 4,293 Other current assets $ 0 $ 109 Total current assets $16,375 $ 4,933 Total assets $36,672 $13,465 There are five points worth noting about these asset values: 1. Goodwill. Boeing, which acquired Rockwell in 1996 and McDonnell Douglas in 1997, used purchase accounting for the Rockwell acquisition and pooling for McDonnell Douglas. The goodwill on the balance sheet reflects the excess of acquisition value over book value for Rockwell and is being amortized over 30 years (which Boeing would not be able to do under current rules). With McDonnell Douglas, there is no recording of the premium paid on the acquisition among the assets, suggesting that the acquisition w

lects the excess of acquisition value over book value for Rockwell and is being amortized over 30 years (which Boeing would not be able to do under current rules). With McDonnell Douglas, there is no recording of the premium paid on the acquisition among the assets, suggesting that the acquisition was structured to qualify for pooling, which would also not be allowed under current rules. 2. Customer financing and accounts receivable. Boeing often either provides financing to its customers to acquire its planes or acts as the lessor on the planes. Since these contracts tend to run over several years, the present value of the payments due in future years on the financing and the lease payments is shown as customer financing. The current portion of these payments is shown as accounts receivable. The Home Depot provides credit to its customers as well, but all these payments due are shown as accounts receivable, since they are all short-term. 3. Inventories. Boeing values inventories using

is shown as customer financing. The current portion of these payments is shown as accounts receivable. The Home Depot provides credit to its customers as well, but all these payments due are shown as accounts receivable, since they are all short-term. 3. Inventories. Boeing values inventories using the weighted average cost method, while the Home Depot uses the FIFO approach for valuing inventories. 4. Marketable securities. Boeing classifies its short-term investments as trading investments and records them at market value. The Home Depot has a mix of trading, available-for-sale, and held-to-maturity investments and therefore uses a mix of book and market value to value these investments. 5. Prepaid pension expense. Boeing records the excess of its pension fund assets over its expected pension fund liabilities as an asset on the balance sheet. Finally, the balance sheet for Boeing fails to report the value of a very significant asset, which is the effect of past research and developm

5. Prepaid pension expense. Boeing records the excess of its pension fund assets over its expected pension fund liabilities as an asset on the balance sheet. Finally, the balance sheet for Boeing fails to report the value of a very significant asset, which is the effect of past research and development (R&D) expenses. Since accounting convention requires that these be expensed in the year that they occur and not be capitalized, the research asset does not show up in the balance sheet. Chapter 9 considers how to capitalize research and development expenses and the effects on balance sheets. MEASURING FINANCING MIX The second set of questions that we would like to answer, and would like accounting statements to shed some light on, relate to the mix of debt and equity used by the firm, and the current values of each. The bulk of the information about these questions is provided on the liabilities side of the balance sheet and the footnotes to it. Accounting Principles Underlying Liability

ting statements to shed some light on, relate to the mix of debt and equity used by the firm, and the current values of each. The bulk of the information about these questions is provided on the liabilities side of the balance sheet and the footnotes to it. Accounting Principles Underlying Liability and Equity Measurement Just as with the measurement of asset value, the accounting categorization of liabilities and equity is governed by a set of fairly rigid principles. The first is a strict categorization of financing into either a liability or an equity based on the nature of the obligation. For an obligation to be recognized as a liability, it must meet three requirements: 1. The obligation must be expected to lead to a future cash outflow or the loss of a future cash inflow at some specified or determinable date. 2. The firm cannot avoid the obligation. 3. The transaction giving rise to the obligation has to have already happened. In keeping with the earlier principle of conservatis

n must be expected to lead to a future cash outflow or the loss of a future cash inflow at some specified or determinable date. 2. The firm cannot avoid the obligation. 3. The transaction giving rise to the obligation has to have already happened. In keeping with the earlier principle of conservatism in estimating asset value, accountants recognize as liabilities only cash flow obligations that cannot be avoided. The second principle is that the values of both liabilities and equity in a firm are better estimated using historical costs with accounting adjustments, rather than with expected future cash flows or market value. The process by which accountants measure the value of liabilities and equities is inextricably linked to the way they value assets. Since assets are primarily valued at historical cost or at book value, both debt and equity also get measured primarily at book value. The next section examines the accounting measurement of both liabilities and equity. Measuring the Va

d equities is inextricably linked to the way they value assets. Since assets are primarily valued at historical cost or at book value, both debt and equity also get measured primarily at book value. The next section examines the accounting measurement of both liabilities and equity. Measuring the Value of Liabilities and Equities Accountants categorize liabilities into current liabilities, long-term debt, and long-term liabilities that are not debt or equity. Next, we will examine the way they measure each of these. Current Liabilities Under current liabilities are categorized all obligations that the firm has coming due in the next year. These generally include: Accounts payable, representing credit received from suppliers and other vendors to the firm. The value of accounts payable represents the amounts due to these creditors. For this item, book and market values should be similar. Short-term borrowing, representing short-term loans (due in less than a year) taken to finance the op

ng credit received from suppliers and other vendors to the firm. The value of accounts payable represents the amounts due to these creditors. For this item, book and market values should be similar. Short-term borrowing, representing short-term loans (due in less than a year) taken to finance the operations or current asset needs of the business. Here again, the value shown represents the amounts due on such loans, and the book and market values should be similar, unless the default risk of the firm has changed dramatically since it borrowed the money. Short-term portion of long-term borrowing, representing the portion of the long-term debt or bonds that is coming due in the next year. Here again, the value shown is the actual amount due on these loans, and market and book values should converge as the due date approaches. Other short-term liabilities, which is a catchall component for any other short-term liabilities that the firm might have, including wages due to its employees and t

again, the value shown is the actual amount due on these loans, and market and book values should converge as the due date approaches. Other short-term liabilities, which is a catchall component for any other short-term liabilities that the firm might have, including wages due to its employees and taxes due to the government. Of all the items in the balance sheet, absent outright fraud, current liabilities should be the one for which the accounting estimates of book value and financial estimates of market value are closest. Long-Term Debt Long-term debt for firms can take one of two forms. It can be a long-term loan from a bank or other financial institution, or it can be a long-term bond issued to financial markets, in which case the creditors are the investors in the bond. Accountants measure the value of long-term debt by looking at the present value of payments due on the loan or bond at the time of the borrowing. For bank loans, this will be equal to the nominal value of the loan.

sued to financial markets, in which case the creditors are the investors in the bond. Accountants measure the value of long-term debt by looking at the present value of payments due on the loan or bond at the time of the borrowing. For bank loans, this will be equal to the nominal value of the loan. With bonds, however, there are three possibilities: When bonds are issued at par value, for instance, the value of the long-term debt is generally measured in terms of the nominal obligation created (i.e., principal due on the borrowing). When bonds are issued at a premium or a discount on par value, the bonds are recorded at the issue price, but the premium or discount is amortized over the life of the bond. As an extreme example, companies that issue zero coupon debt have to record the debt at the issue price, which will be significantly below the principal (face value) due at maturity. The difference between the issue price and the face value is amortized each period and is treated as a

of the bond. As an extreme example, companies that issue zero coupon debt have to record the debt at the issue price, which will be significantly below the principal (face value) due at maturity. The difference between the issue price and the face value is amortized each period and is treated as a noncash interest expense that is tax deductible. In all these cases, the value of debt is unaffected by changes in interest rates during the life of the loan or bond. Note that as market interest rates rise or fall, the present value of the loan obligations should decrease or increase. This updated market value for debt is not shown on the balance sheet. If debt is retired prior to maturity, the difference between book value and the amount paid at retirement is treated as an extraordinary gain or loss in the income statement. Finally, companies that have long-term debt denominated in nondomestic currencies have to adjust the book value of debt for changes in exchange rates. Since exchange ra

ifference between book value and the amount paid at retirement is treated as an extraordinary gain or loss in the income statement. Finally, companies that have long-term debt denominated in nondomestic currencies have to adjust the book value of debt for changes in exchange rates. Since exchange rate changes reflect underlying changes in interest rates, it does imply that this debt is likely to be valued much nearer to market value than is debt in the domestic currency. Other Long-Term Liabilities Firms often have long-term obligations that are not captured in the long-term debt item. These include obligations to lessors on assets that firms have leased, to employees in the form of pension fund and health care benefits yet to be paid, and to the government in the form of taxes deferred. In the past two decades accountants have increasingly moved toward quantifying these liabilities and showing them as long-term liabilities. Leases Firms often choose to lease long-term assets rather th