Spring 2009 NBA 5060

Lecture 2 – Basic Valuation and the Role of Accounting Numbers

1. Basic valuation theory

2. The relation between earnings and returns

3. Additional Notes: Deriving the Residual Income Model

Teaching Assistants
Ruchit Agarwal ra343@cornell.edu
Manish Bhargava mb724@cornell.edu
Odelia D’Mello od36@cornell.edu
David Wu dw326@cornell.edu

For 01/27/08:

Familiarize yourself with the 10-K for Cracker Barrel (CBRL). We will be applying all
the tools we learn in class to CBRL. You can download the 10-K from the SEC Edgar
website (http://www.sec.gov/edgar.shtml).

Answer questions on handout regarding the Company’s industry, strategy, and

accounting policies.

Lecture 2 Page 1 of 12
Valuation

Economic theory teaches that the value of any resources equals the
present value of the payoffs expected from the resource, discounted at a
rate compensating for the inherent risk & delayed consumption of the
payoffs.

The first financial model for common equity (and the basis for all models
used today) is the dividend-discounting model:

 ∞ Dividends t + j 
Equity Valuet = Et  ∑ j 
 j =1 (1 + re ) 

Lecture 2 Page 2 of 12
Residual Income Valuation

The basic assumption is the clean surplus relation. Essentially, we need:

BVEt = BVEt-1 + Net Incomet – Dividendst

Where dividends include net capital transactions (issuance less repurchase

of equity).

Then, using the dividend-discounting model, we get the following (see last
page of notes for a derivation):
Residual Income is simply
earnings less a charge for
the use of capital

Et ( NI t + 1 - re BVEt ) Et ( NI t + 2 - re BVEt +1 )
Equity Valuet = BVEt + + + ...
(1 + re ) (1 + re ) 2

Thus, the residual income valuation model is very straightforward in theory.

It simply states that the value of an investment is equal to the amount
invested, plus the present value of all future abnormal earnings or residual
income.

Lecture 2 Page 3 of 12
The Residual Income Model reformulated in terms of ROEs:

Define ROE as to be earnings divided by beginning total equity. That is,

ROEt = NIt / BVEt-1

Then, substitute NIt+1 = ROEt+1*BVEt into the above equation to get:

Et [ ( ROEt +1 - re ) BVEt ] Et [ ( ROEt + 2 - re )( BVEt +1 ) ]

Equity Valuet = BVEt + + + ...
(1 + re ) (1 + re ) 2

Thus, equity value is simply the book value of equity plus the present value
of future abnormal returns on equity, weighted by the BVE outstanding at
the time.

Why focus on earnings and book values?

But, is the focus on accounting numbers justified?

Lecture 2 Page 4 of 12
Nichols and Wahlen (2004): How do accounting numbers relate to
stock returns?
Figure 1
The Three Links Relating Earnings to Stock Returns

Link 1
Expected Future
Current Period Earnings Link 1 assumes that current Earnings
period earnings numbers
provide information that equity
shareholders can use to form
expectations for future earnings.

Link 2 assumes
that current and
Test: expected future
How do earnings profitability
numbers relate to determines the
share prices? firm’s expected
Link 2
future dividend-
paying capacity.

Link 3
Expected Future
Current Share Price
Link 3 assumes that share Dividends
prices reflect the present value
of all expected future dividends.

Remember, price depends on the information known to the market at time t.

If information changes from period t to period t+1, price should change
between those dates.

Thus, it is important to isolate the new information in earnings when

examining the association between earnings and returns.

To make sure the changes in price reflect revised expectations of payoffs

and not just differences in risk, we subtract returns on a portfolio of firms
with comparable size.

Lecture 2 Page 5 of 12
Testing the three links: The relation between earnings changes and
stock returns

Compare earnings this year (t) to earnings last year (t-1). If the change is
positive, put the firm in one portfolio; if the change is negative, put the firm
in another portfolio. Do the same thing for operating cash flows.

The average abnormal returns of the portfolios are graphically depicted

below.

Testing
the three
links,

continued: Sign and magnitude of earnings changes

Lecture 2 Page 6 of 12
Instead of forming portfolios on just the sign of the change, group firms into
10 portfolios based on the magnitude of earnings (scaled by assets to allow
cross-sectional comparability).

Testing
link 1:
Earnings

persistence and stock returns

If new earnings will persist, then the new earnings should have a greater
effect on price.

Lecture 2 Page 7 of 12
Another test of the three links: Does accounting provide new
information to market participants?

Rank all firms based on the magnitude of their quarterly earnings surprise
using analyst forecasts 5 days before the announcement as an
expectation.

Lecture 2 Page 8 of 12
 Is the
market

completely efficient with respect to accounting information?

Rank all firms based on the magnitude of their quarterly earnings surprise
using analyst forecasts 60 days before the announcement as an
expectation.

Take a long position in the 10% of firms with the greatest unexpected
earnings, and an offsetting short position in the 10% of firms with the lowest
unexpected earnings. Hold these stocks for either 60 (trading) days.

Lecture 2 Page 9 of 12
Nichols and Wahlen (2004): Summary and Takeaways

Accounting earnings capture many of the same events affecting firm value
that are reflected in price.

The accrual accounting process starts with cash flows and adds
information about transactions and events during the year to arrive at a
more useful measure of firm performance (earnings).

The information in accounting earnings is credible, despite concerns of

earnings management.

In some cases, the accounting system provides new information to the

capital markets.

Evidence strongly suggests that stock prices are not fully efficient with
respect to accounting information.

Lecture 2 Page 10 of 12
Additional Notes: Deriving the Residual Income Model from the DDM

Recall that we can define dividends as follows:

Dividends1 = Net Income1 – Change in Common Equity1 = NI1 – (BVE1 – BVE0)

Thus, we can express the value of the equity as follows (expectation operators are
omitted for simplicity):

NI 1 - ( BVE1 - BVE0 ) NI 2 - ( BVE2 - BVE1 )

Value0 = + + ...
(1 + re ) (1 + re ) 2
NI 1 - BVE1 + BVE0 NI 2 - BVE2 + BVE1
= + + ...
(1 + re ) (1 + re ) 2
Add and subtract reBVE0 (sum=0). We can then
rearrange to express value as a function of
beginning BVE and future residual income.

NI 1 − re BVE0 - BVE1 + BVE0 + re BVE0 NI 2 − re BVE1 - BVE2 + BVE1 + re BVE1

= + + ...
(1 + re ) (1 + re ) 2

NI 1 − re BVE0 - BVE1 + (1 + re ) BVE0 NI 2 − re BVE1 - BVE2 + (1 + re ) BVE1

= + + ...
(1 + re ) (1 + re ) 2

NI 1 − re BVE0 BVE1 BVE1 NI 2 − re BVE1 BVE2 BVE2

= BVE0 + − + + − + + ...
(1 + re ) (1 + re ) (1 + re ) (1 + re ) 2 (1 + re ) 2 (1 + re ) 2

NI 1 − re BVE0 NI 2 − re BVE1
= BVE0 + + + ...
(1 + re ) (1 + re ) 2

Lecture 2 Page 11 of 12
This works as long as . But thanks to our steady state assumption,
BVET −1
lim =0
T → ∞ (1 + r )T
e

BVE grows at g in perpetuity, and g < (1+re).

Lecture 2 Page 12 of 12