Financial Accounting Theory Tutorial Seven

TUTORIAL SEVEN

Tutorial Seven beginning 24th March 2023

TOPIC: Free Cash Flow Valuation and Multiples

Question One
A Discounted Cash Flow Valuation: General Mills, Ltd.
At the beginning of its fiscal year 2020, an analyst made the following forecast for
General Mills, Ltd., the consumer foods company, for 2020-2023(in millions of dollars):

2020 2021 2022 2023

Cash flow from operations $2,014 $2,057 $2,095 $2,107
Cash investment in operations $300 $380 $442 $470

General Mills reported $6,192 million in short-term and long-term debt at the end of 2019 but
very little in interest-bearing debt assets. Use a required return of 9 percent to calculate both
the enterprise value and equity value for General Mills at the beginning of 2020 under two
forecasts for long-run cash flows:
a. Free cash flow will remain at 2023 levels after 2023.
b. Free cash flow will grow at 3 percent per year after 2023.
General Mills had 369 million shares outstanding at the end of 2019, trading at $47 per
share. Calculate value per share under both scenarios.

Solution
 Financial Accounting Theory Tutorial Seven

a. The exercise involves calculating free cash flows, discounting them to present value, then
adding the present value of a continuing value. For part (a) of the question, the continuing
value has no growth:

2020 2021 2022 2023

Cash flow from operations 2,014 2,057 2,095 2,107
Cash investment in operations 300 380 442 470
Free cash flow (FCF) 1,714 1,677 1,653 1,637
Discount rate 1.09 1.1881 1.2950
1.4116
Present value of FCF 1,572 1,411 1,276
1,160

Total of PV to 2023 5,419

Continuing value (CV) 18,189
PV of CV 12,885
Enterprise value 18,304
Net debt 6,192
Equity value 12,112

Value per share on 369 million shares = $32.82

1,637
CV (no growth) = = 18,189
0.09
18,189
PV of CV = = 12,885
1.4116

b. With growth of 3% after 2023, the continuing value is:

1,637  1.03
CV = = $28,102
1.09 − 1.03
The present value of the continuing value is $28,102/1.4116 = $19,908.
Do the valuation is as follows:

Total of PV to 2023 5,419

Continuing value (CV) 28,102
PV of CV 19,908
Enterprise value 25,327
Net debt 6,192
Equity value 19,135

Value per share on 369 million shares = $51.86.

Question Two

A Discounted Free Cash Flow Valuation

 Financial Accounting Theory Tutorial Seven

At the end of 2019, you forecast the following cash flows (in millions) for a firm with net debt
of $759 million:

2020 2021 2022

Cash flow from operations $1,450 $1 ,576 $1,718
Cash investment 1,020 1,124 1,200

You forecast that free cash flow will grow at a rate of 4 percent per year after 2022.
Use a required return of 10 percent in answering the following questions.
a. Calculate the firm's enterprise value at the end of 2019.
b. Calculate the value of the equity at the end of 2019.

Solution

2019 2020 2021 2022

Cash flow from operations $1,450 1,576 1,718

Cash investment $1,020 1,124 1,200
Free cash flow $ 430 452 518

Discount rate (1.10)t 1.10 1.21 1.331

PV of cash flows 391 374 389
Total PV to 2022 $1,154
Continuing value* 8,979
PV of CV 6,746
a. Enterprise value $7,900 million
Net debt 759
b. Value of equity $7,141 million

518  1.04
* Continuing value = = 8,979
1.10 − 1.04

Question Three

Value Harvey Norman as at March 2023 using the P/E method of comparables using JB Hi-
Fi as a benchmark. Use forward earnings. Explain why the P/E based valuation of Harvey
Norman may be different from the share price as at March 2023 of $3.69. Explain some
limitations of this approach to valuation.
 Financial Accounting Theory Tutorial Seven

The information to compute the forward P/E can be obtained from Yahoo Finance and is
reproduced below of which is as at March 2023. Some additional information that may
explain the difference between the P/E based valuation and the current share price is also
provided.

https://au.finance.yahoo.com/quote/HVN.AX/analysis?p=HVN.AX&.tsrc=fin-srch

https://au.finance.yahoo.com/quote/JBH.AX/analysis?p=JBH.AX

https://www.reuters.com/companies/JBH.AX/profile
Financial Accounting Theory Tutorial Seven
 Financial Accounting Theory Tutorial Seven

Past Sales, EPS and Growth Rates

Harvey
29/06/2018 29/06/2019 29/06/2020 9/06/2021
Norman Average
Sales 2,792,523 3,205,302 3,378,455 4,147,606
Sales Growth 14.78% 5.40% 22.77% 14.32%

EPS 0.32 0.34 0.39 0.68

Eps Growth 6.25% 14.71% 74.36% 31.77%

JB Hi-Fi
Sales 6,854,300 7,095,300 7,918,900 8,916,100
Sales Growth 3.52% 11.61% 12.59% 9.24%

EPS 2.03 2.17 2.63 4.41

Eps Growth 6.90% 21.20% 67.68% 31.93%

Solution

The basic model to arrive a valuation using multiples is:

 Financial Accounting Theory Tutorial Seven

(1) Value = Summary performance measure of firm being valued * Market Multiple

Therefore:

(2) Valuation of Harvey Norman = Forward Earnings for Harvey Norman * Forward PE
for JB Hi-Fi *

Where:

Forward PE = current stock price / predicted next annual earnings period.

Step One. Get Forward P/E for JB Hi-Fi

The analysts forecast of next period earnings will be available at most finance web-sites
such as Reuters, Google finance, Yahoo finance etc. In our case we will need the forecast
annual earnings for the year ended 30 June 2023. Based on the relevant snapshots from
Yahoo finance the forecasts earnings per share is $4.17 and the current share price is
$45.86. Thus:

The forward looking P/E for JB Hi-Fi as at March 2023 is $45.86/4.49 = 10.21.

Step Two. Get Forward EPS for Harvey Norman

Forward earnings of Harvey Normal = $0.40.

Step Three. Compute Valuation

• Valuation of Harvey Norman = Forward PE for JB Hi-Fi * Forward Earnings for

Harvey Norman

• Valuation of Harvey Norman = 10.21 * $0.40

• Valuation of Harvey Norman = $4.084

• Current Share Price of Harvey Norman = $3.69

Explain the Difference between the P/E Valuation of $4.084 and the current share price of
$3.69

There are two broad explanations.

The first is that the market is inefficient and that Harvey Norman is overvalued. However
there is an inherent inconsistency in this explanation and using market multiples to value
listed companies. By choosing to value a specific company using market multiples, the
investor presumes the target company (Harvey Norman) is not fairly valued. However this
relies on the market being efficient in pricing JB Hi-Fi.

The second explanation is that JB Hi-Fi and Harvey Norman are not identical on all of the
three fundamental inputs that determine a P/E ratio and thus JB Hi-Fi is not a comparable
company to Harvey Norman. The PE ratio is a function of three factors:
 Financial Accounting Theory Tutorial Seven

(1) Expected Growth

(2) Risk
(3) Accounting Methods

In selecting comparables to use for valuing a firm we should consider if expected earnings
growth, risk and that the accounting methods used to compute earnings is the same. Thus
any of these three factors could explain the difference. Lets consider each in turn.

Differences across firms in accounting methods and accounting principles can drive
differences in PE ratios (see explanation further below). However in this we case we can
assume that there is no differences in accounting methods as we are using analysts
earnings forecasts and we can assume that the analysts are using the same accounting
methods to forecast earnings.

Differences across firms in accounting methods and accounting principles can drive
differences in PE ratios. For example the choice between reducing balance and straight-line
method of depreciation.

For example assume two identical firms (XYX and ABC) that are both correctly valued at
$15. Assume their accounting methods and principles differ and that XYZ reports earnings of
$1.30 and ABC reports earnings of $1.10.

Then the PE ratio of XYZ is 11.53 (15/1.30 ) and the PE ratio of ABC is 13.63 (15/$1.10).
Assume we use the PE ratio of ABC to value XYZ.
Estimate value of XYZ = $1.30 * 13.63 = $17.72.

Thus the difference between the correct market value of $15 and our estimated value based
on P/E ratios is simply due to variation in accounting methods between the two firms.

Is the risk of JB Hi-Fi and Harvey Norman the same?

The beta of JB-Hi-Fi and Harvey Norman per Yahoo finance is 0.82 and 0.70 respectively.

As the beta of JB Hi-Fi and Harvey Norman is not the same this could give rise to a difference
between our P/E valuation and the market price.

The higher risk of JB Hi-Fi implies, certeris paribus, a lower price and thus a lower P/E for JB
Hi-Fi. If we use the P/E ratio of JB Hi-Fi to value to Harvey Norman the estimated valuation
will be lower than the true fundamental value due to JB Hi-Fi’s lower risk.

It is important to note through that the beta estimates provided by Yahoo Finance could
measure the true beta and thus the systematic risk with error. Data vendors such as Yahoo
Finance use an automated algorithm usually based on an OLS regression of a company’s
return on market return across a 5 year window to estimate beta. An OLS regression will be
severely influenced by extreme observations so if there are one or two months of extreme
returns this can create a biased estimate of beta.

To assess the reasonableness of a beta estimate it can be assumed that the average beta is
one. A company that is more risky than average should have a beta greater than one. A
company that is less risky than average should have a beta lower than one.
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Is the expected growth of the two firms the same? To assess this consider both the similarities
of the business model and use past growth to provide some evidence. As shown in the table
the past growth seems to be reasonably similar.

Consistent with this the two firms sell a similar range of products. In fact, JB Hi-Fi has recently
become more like Harvey Norman following its acquisition of the Good Guys which is a direct
competitor.

However, there are important differences in the business models between the two companies
which could give rise to differences in expected growth (and also risk). HVN has a large
investment portfolio, HVN has operations in a number of other countries, and finally HVN has
franchise stores whereas JBK appears to operate its own stores.

In summary there is no clear single factor that is different between JB Hi-Fi and Harvey
Norman. However it is possible that the expected growth of Harvey Norman is lower than JB
Hi Fi due to some differences in the business model.

Reverse Engineering

The trade price of a share contains useful information of the markets expectation of the
growth of that stock. Therefore obtaining the markets estimate of g may provide useful
information as an input into fundamental valuation.

How to obtain a the markets estimate of g for a company? This can be reverse engineered
from the markets share price valuation as follows.

Assume a simple valuation model of the present value of an annuity with growth which is

Price = E/(r-g)

Therefore some simple re-arranging we can derive: g = r – E/P

An application of estimating g for Harvey Norman is as follows assuming we estimate r to be

12%. Then from the screen shots we know that E = $0.34 and current share price is $3.69.
Thus

• g = 0.12 –( $0.40/$3.69)
• g = 1.15%

Question Five

The Shiller P/E ratio (also known as cyclically adjusted price-to-earnings ratio) is a widely
measure of the P/E of the overall US stock market. The ratio is computed as the current
price of the S&P 500 divided by the average earnings from the past ten years of the all the
companies in the S&P 500. Because this factors in earnings from the previous ten years, it is
less prone to short-term volatility in any one year.

Some investors use this ratio to make a judgment as whether the overall stock market is
overvalued or undervalued. It is argued the higher the Shiller P/E ratio, the more overvalued
a market.
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Consider the graph of the Shiller PE ratio across time below. As can been seen since 1980
there has been a systematic increase in the PE ratio. The current Shiller PE ratio is 34. For
context, over more than 100 years, the average and median Shiller P/E ratio has been
around 15 or 16. I have also produced a PE graph below of the Australian market which
also shows a systematic increase in the PE ratio across time.

Provide an both accounting method and an economic explanation as to why the Shiller PE
ratio and the Australian PE ratio may be increasing across time.

Shiller PE Ratio

Note that the mean and median P/E ratios across time are 16.94 and 15.87. A useful
benchmark.
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Long-Term Trend in P/E in Australia

Solution

The PE ratio is a function of three factors:

(1) Expected Growth
(2) Risk
(3) Accounting Methods

An economic explanation for the increase in P/E ratio across time is that the cost of equity
(risk) has declined as interest rates have declined significantly across this time period. See
graph below of declining interests rates across the past 40 years. Declining cost of equity
across time will imply an increase in price across time relative to earnings. This will
therefore give rise to an increase in P/E across time. See graph below of declining interests
rates which is highly correlated with the increasing P/E ratio.
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PE ratios may differ due to differences in accounting methods and principles. All else equal
increasing investment in internally generated assets will bias downward reported earnings.
This is because intangible assets for example R&D is being expensed as incurred (see
Week 2) biasing downward reported earnings. As earnings are biased downward this will
increasing the PE ratio. Across the time period since 1980 there has been a significant
increase in investment in intangible assets (see graph of intangible investment below).
Therefore assume price has stayed constant but earnings are increasing biased downward
then we will observe an increase in the PE ratio across time.

Interest Rates Across the Past 40 Years

Long-Term Trend of Cost of Debt (Australia)

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Increasing Investment in Intangibles