Business Analysis for Investment

Valuation 2

1: A Residual Earnings Valuation

An analyst presents you with the following pro forma (in millions of dollars) that gives her forecast of earnings and dividends for 2013–2017.
She asks you to value the 1,380 million shares outstanding at the end of 2012, when common shareholders’ equity stood at $4,310 million. Use a
required return for equity of 10 percent in your calculations.

2013E 2014E 2015E 2016E 2017E

Earnings 388.0 570.0 599.0 629.0 660.45
Dividends 115.0 160.0 349.0 367.0 385.40

a. Forecast book value, return on common equity (ROCE), and residual earnings for each of the years 2013–2017.

b. Forecast growth rates for book value and residual earnings for each of the years 2014–2017.

c. Calculate the per-share value of the equity from this pro forma. Would you call this a Case 1, 2, or 3 valuation?

d. What is the premium over book value given by your calculation? What is the P/B ratio?
This question asks you to convert a pro forma to a valuation using residual earnings methods. First complete the pro forma by

forecasting book values from earnings and dividends. Then calculate residual earnings from the completed pro forma and value

the firm.

Answer:

2013E 2014E 2015E 2016E 2017E

Earnings 388.0 570.0 599.0 629.0 660.45
Dividends 115.0 160.0 349.0 367.0 385.40
Book value 4,583.0 4,993.0 5,243.0 5,505.0 5,780.0

ROCE 9.0% 12.4% 12.0% 12.0% 12.0%

Residual earnings -43.0 111.7 99.7 104.7 109.9
(10%)
Growth in RE -10.7% 5.0% 5.0%
Growth in Book value 8.9% 5.0% 5.0% 5.0%
Discount factor 1.10 1.210 1.331 1.464 1.611
PV of RE -39.1 92.3 74.9

a. Forecasted book values, ROCE, and residual earnings are given in the completed pro forma above. Book value each year is the prior
book value plus earnings and minus dividends for the year. So, for 2014 for example, Book value = 4583 +570 –160 = 4,993.

The starting book value (in 2012) is 4,310. Residual earnings for each year is earnings charged with the required return in
book value. So, for 2014 for example, RE is 570 – (0.10 × 4,583) = 111.7.

b. Forecasted growth rates in book value and residual earnings are given above.

c. The growth rate in residual earnings is 5% after 2014. Assuming this growth rate will continue into the future, the valuation is a Case 3

valuation with the continuing value calculated at the end of 2014. That continuing value is the RE for 2015 of $99.7 growing at 5% per

year.

d. The premium is 6,011.3 – 4,310 = 1,701.3, or 1.23 on a per-share basis.

The P/B ratio is 6,011.3/4,310 = 1.39.

Book value, 2012 4,310.0
Total present value of RE to 2015 (-39.1 + 128.10
92.3+74.9)
Continuing value (CV), 2015: 104.7/(1.10-1.05) 2094
Present value of CV: 2,094/1.331 1,573.25
Value of the equity, 2012 6,011.3

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

2: Residual Earnings Valuation

Black Hills Corporation is a diversified energy corporation and a public utility holding company. The following gives the firm’s
earnings per share and dividends per share for the years 2000–2004.

1999 2000 2001 2002 2003 2004

EPS 2.39 3.45 2.28 2.00 1.71
DPS 1.06 1.12 1.16 1.22 1.24
BPS 9.96

Suppose these numbers were given to you at the end of 1999, as forecasts, when the book value per share was $9.96, as indicated. Use
a required return of 11 percent for calculations below.

a. Calculate residual earnings and return of common equity (ROCE) for each year, 2000–2004.

b. Value the firm at the end of 1999 under the assumption that the ROCE in 2004 will continue at the same level subsequently. Would
you call this a Case 1, Case 2, or Case 3 valuation?

c. Based on your analysis, give a target price at the end of 2004.

Answer:
The pro forma for the exercise is as follows:

Forecast Year

1999 2000 2001 2002 2003 2004

Eps 2.39 3.45 2.28 2.00 1.71

Dps 1.06 1.12 1.16 1.22 1.24
Bps 9.96 11.29 13.62 14.74 15.52 15.99

ROCE 24.0% 30.6% 16.7% 13.6% 11.0%

RE (11% charge) 1.294 2.208 0.782 0.379 0.003
Discount rate (1.11)t
1.110 1.232 1.368 1.518 1.685
Present value of RE 1.166 1.792 0.572 0.250 0.002
Total present value of RE to 2004 3.78
Continuing value (CV) 0.0
Present value of CV 0.00
Value per share 13.74

a. ROCE and residual earnings are in the pro forma

b. If ROCE is to continue at 11% after 2004, then residual earnings are expected to be zero. The continuing value is zero. The
value is $13.74 per share – a Case 1 valuation.
c. As the CV = 0, the target price is equal to forecasted bps of $15.99 at 2004.
3: Abnormal Earnings Growth Valuation

An analyst presents you with the following pro forma (in millions of dollars). The pro forma gives her forecasts of earnings and
dividends for 2013–2017. She asks you to value the 1,380 million shares outstanding at the end of 2012. Use a required return for
equity of 10 percent in your calculations.

2013 2014 2015 2016 2017

Earnings 388.0 570.0 599.0 629.0 660.45
Dividends 115.0 160.0 349.0 367.0 385.40
a. Forecast growth rates for earnings and cum-dividend earnings for each year, 2014–2017.
b. Forecast abnormal earnings growth (in dollars) for each of the years 2014–2017.
c. Calculate the per-share value of the equity at the end of 2012 from this pro forma (assume the growth rate of AEG after 2017 will
continue into the future). Would you call this a Case 1 or Case 2 abnormal earnings growth valuation?

Answer:

2013E 2014E 2015E 2016 2017

Earnings 388.0 570.0 599.0 629.0 660.45

Dividends 115.0 160.0 349.0 367.0 385.40
Reinvested dividends 11.5 16.0 34.9 36.70
Cum-div earnings 581.5 615.0 663.9 697.15
Normal earnings 426.8 627.0 658.9 691.90
Abnormal earn growth 154.7 -12.0 5.0 5.25

Growth rates:
Earnings growth 46.91% 5.09% 5.00%
Cum-div earn growth (AEG) 49.87% 7.89% 10.83% 5.00%
10.83%
Growth in AEG 5.0%
 1.331
Discount rate 1.100 1.210
PV of AEG 140.64 -9.92 3.76
Note that the AEG for 2014 and 2015 are discounted back to the end of 2013.

a. Forecasted abnormal earnings growth (AEG) is given in the pro forma above.

AEG is the difference between cum-dividend earnings and normal earnings. So, for 2014, AEG = 581.5 – 426.8 = 154.7.

Cum-dividend earnings is earnings plus prior year’s dividend reinvested at the required rate of return. So, for 2014,

Cum-dividend earnings = 570.0 + (115 × 10%) = 581.5

Normal earnings is prior year’s earnings growing at the required rate. So, for 2014,
Normal earnings = 388 × 1.10 = 426.8 Abnormal earnings growth can also be calculated as AEG = (cum-div growth rate – required

rate) × prior year’s earnings. So, for 2014, AEG = (0.4987 – 0.10) × 388 = 154.7

b. The growth rates are given in the pro forma.

c.
Earnings in 2013 388
Total PV of AEG for 2014-2016 134.48
(140.64-9.92+3.76)
CV at 2016=5.25/(1.1-1.05) 105
PV of CV=105/1.331 78.89
Total value at year 2013 601.36
Capitalization rate 10%
Value of equity=601.36/10% 6013.6
Value per share on 1,380 million shares 4.36