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Chapter 8:
Prospective
Analysis:
Valuation
Implementation

Computing a Discount Rate

• One Common approach to estimating the cost of equity is to

use the Capital Asset Pricing Model (CAPM):
– Only the risk that an asset contributes to (a fully diversified)
portfolio must be compensated
– This type of risk is labeled beta or systematic risk and is created
by the correlation between the asset’s return and the returns of
the other investments in the portfolio
– Cost of equity is the sum of (i) the risk-free rate and (ii) the
premium for systematic risk:

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Beta, Risk-Free Rate and Market Risk

Premium
• Risk-free rate:
– Rate on intermediate-term or long-term government bonds
– Yields on 10-year government bonds: Germany (1.36%), UK (2.74%),
and USA (2.60%)
• Market Risk Premium:
– Palepu, Healy, and Peek (5.0% - 5.5%), Ibbotson (6.62%), Brealey,
Myers and Allen (7.3%), McKinsey (between 4.5% - 5.5%), see also
Damodaran’s website for current estimates of the market risk premium

• Beta:
– Historical association between 60 monthly firm-specific and market
returns
– Raw beta: Ri = α + βRm + ε (market model)
– Adjusted beta = 0.33 + 0.67 x (Raw beta)
– Use of industry betas; see next slide (Lundhlom and Sloan, 2007, and
Damodaran’s website for current estimates)

Industry Betas

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Loewe’s Cost of Equity

• Risk-free rate:
– Average yield on a 10-year government bond in the euro area at
the end of 2008: 4.0 percent
• Market premium: 5.0 percent
• Beta:
– Regression analysis of 60 monthly returns between January
2004 and December 2008:

• Cost of Equity:

Firm Size Effect

• Smaller firms (measured by market capitalization) tend to generate

higher returns in subsequent periods
• It could mean either that smaller firms are riskier than indicated by
the CAPM or that they are underpriced at the point their market
capitalization is measured
• Investors in the top two deciles of the size distribution have realized
returns of, on average, 11.2 to 12.5 percent
• In contrast, firms in the smallest two deciles have realized
significantly higher returns of, on average, 13.8 to 21.5 percent
• If we use firm size as an indicator of the cost of capital, we implicitly
assume that large size is indicative of lower risk
• Adjustment to CAPM: re = rf + β[E(rm) – rf] + rsize

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Firm Size Effect

Firm Size Effect

Source: Lundholm and Sloan (2007).

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Estimating the WACC

• The appropriate discount rate to value a company’s assets (debt plus
equity) is the WACC, which takes into account debt and equity sources of
financing:

• Cost of debt = (net) interest rate on (net) debt

– If the assumed capital structure in the future is the same as the
historical structure, then the current interest rate on debt will be a good
proxy for this
– Hence, a starting point is the current ratio of net interest expense after
tax to net debt
– If the capital structure is expected to change, one approach is to
estimate the expected credit rating of the company at the new level of
debt and use the appropriate interest rate for that category
• Weighting the costs of debt and equity
– Use book value of net debt and market value of equity
– Assume target ratios of net debt to net capital and equity to net capital

Estimation of Loewe’s WACC

• We assume that the after tax cost of debt is equal to 2.6 percent – the
ratio of net interest expense to beginning net debt in 2008
• The company’s cost of equity was calculated as equal to 12.5 percent
(after adjusting the equity beta of the firm for the increase in its
leverage)
• Loewe’s equity market values at the end of 2006, 2007 and 2008 were
€ 162.6, € 203.6, and € 112 million, respectively
• The book values of its net debt were € 60, € 61.9, and € 31.4 million,
respectively
• Using these numbers we can calculate the historical average “market
value” weights of debt and equity in the company’s capital structure as
equal to 24 percent and 76 percent, respectively
• Based on our assumptions, we expect that the net debt to net capital
ratio will increase, changing the weights of net debt and equity to 32%
and 68%
• WACC = (32% x 2.6%) + (68% x 12.5%) = 9.3%

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Recap: Estimating the Costs of Debt and

Equity
• Cost of debt:
– Should reflect the current interest rate(s)
– Must be net of taxes because after-tax cash flows are being
discounted
• Cost of equity:
– A complex topic
– The CAPM provides one approach
– CAPM may be combined with firm size

Detailed Forecasts of Performance

• Assumptions underlying the forecasts are all-important

– Strategy analysis is critical to determine if current performance is
sustainable
– Accounting analysis helps understand:
• A company’s current performance, as reported
• The reliability of reported information used in forecasts
• Typically, selected financial statement line items are
forecasted instead of complete financials.
– See Tables 8-3 and 8-4 in the text

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Performance Forecasts for Loewe

Terminal Values

• Explicit forecasts of the various elements of a firm’s performance

generally extend for a period of five to ten years
• The final year of this forecast period is labeled the terminal year
• The terminal value represents the present value of future
abnormal earnings or free cash flows for the remainder of the firm’s
life
• The analyst must adopt some assumption that simplifies the process
of forecasting
• The continuation of a sales growth rate that is significantly greater
than the average growth rate of the economy is unrealistic over a
very long horizon
• Should a firm’s sales growth rate settle down to the rate of the
inflation or the GDP growth rate?

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Terminal Values with Competitive

Equilibrium Assumption (AE model)
• The long-term growth in sales does not matter, if the firm earns a
return on equity equal to its cost of equity capital, or in other words
if the company has zero abnormal profits
• In this case, the firm’s terminal value, under the abnormal earnings,
model will be equal to zero regardless of the rate of sales growth
• Competitive Equilibrium Assumption
– High profits attract enough competition to drive down a firm’s margins,
and therefore its returns, to a normal level
– At this point the firm is earning its cost of capital with no abnormal
earnings or terminal value
– Terminal Value = 0
• Exceptions: There are firms that manage to maintain their
competitive advantage and achieve returns in excess of their cost of
capital

Competitive Equilibrium Assumption

only on Incremental Sales (AE model)
• An alternative assumption is to assume that the company will
continue to earn abnormal earnings on the nominal sales it had in
the terminal year, but there will be no abnormal earnings on any
incremental sales for years beyond the terminal year
• In other words, we expect that the abnormal earnings of the
company will remain constant at the level of the terminal year
• Terminal Value = (Abnormal Earnings(TY) / re) / (1+re)TY, where TY =
terminal year, re = cost of equity capital

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Terminal Values with Persistent Abnormal

Performance and Growth (AE model)
• There are circumstances where the analyst is willing to assume that
the company is able to defy competitive forces and earn abnormal
rates of return on new projects for many years
• In this case, we project growth in abnormal earnings at a constant
rate
• For example, we can assume that sales remain constant in real
terms or in other words sales are growing at the rate of inflation
(between 2% and 4%)
• If we hold all performance ratios constant in this period, sales,
abnormal earnings and free cash flows all grow at the same
constant rate
• Terminal Value = [Abnormal Earnings(TY) x (1 + g) / (re – g] /
(1+re)TY, where TY = terminal year, g = constant growth rate, re =
cost of equity capital

Terminal Values With Constant Growth After

the Terminal Year (Loewe)

• Note: Terminal growth rate = 4.0 percent; Cost of equity = 12.5 percent

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Calculating the Terminal Value for

Loewe

Computing Asset and Equity Values:

Loewe Example

• The estimated value of the firm’s equity per share was above the observed
value of € 7.04 at the end of January 2009
• The market made less optimistic assumptions than the authors
• The range of analysts’ target prices was from € 8 to € 17

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Other Issues Related to Value

Estimates
• It is useful to check assumptions used against the time series
trends for a company’s performance ratios
• Stock prices of publicly traded companies are good to
compare estimates of value with
• Sensitivity analysis for different economic scenarios are a
good idea to conduct
– If Loewe is able to capture a greater market share and grow in line with
the market as a whole (7.5% growth in LCD sales in 2009), its
fundamental value per share would be € 14.73
– If, on the other hand, its differentiation strategy results in excessive
selling expenditures, resulting in an increase in SG&A ratio to 26% by
2015, the fundamental value per share would be € 10.10

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