growth estimates and terminal value Flashcards
what are the 3 main ways to estimate g?
- Historical: g is estimated based on the historical growth in Earnings per Share (EPS)
- Analysts’ Estimates: g is based on analysts’ estimates of EPS growth
- Fundamental: g is estimated looking at fundamentals of EPS’s growth
what different approaches can one use when computing an historical estimate of g?
use an arithmetic average, geometric average or through a regression of log(NI) against time where Beta is the % change in NI due to time.
what are difficulties to consider when computing an historical average of g?
estimation period must be chosen carefully, earnings might be subjected to high volatility and outliers, size effects–> as firm grows g declines, changes in EPS given by stock splits.
what are the problems with estimates of g by analysts?
quality might be affected by Number of analysts covering a firm. Extent of disagreement among analysts
and Independence of analysts’ estimates. Additionally analysts might have problems of Tunnel vision. Too focused on the industry
(ii) “Lemmingitis” (aka, herding). Urge to revise when others do, in same direction and
magnitude as others
(iii) Stockholm Syndrome. Identification with the managers
(iv) Factophobia. Relying on “stories” rather than facts
(v) Dr. Jekill/Mr. Hyde. Bring business to investment banks
what are underlying assumptions when g is estimated as ROE*retention rate?
constant ROE over time
No equity issuance allowed, therefore NI Growth = EPS growth-
No other comprehensive income in the book value of equity
what are underlying assumptions when g is estimated as ROC*reinvestment rate?
Constant ROC and EBIT margins over time
reinvestment rate from recent financial statements is forward looking.
Accounting ROC is a good measure of required returns on assets (to be checked against industry average)
No other comprehensive income (OCI) in the book value of equity.
what if the firm has negative return on capital?
(i) Estimate growth rates in Revenues over time- Use historical revenue growth to get estimates of revenue growth in the near future- Decrease the growth rate as the firm becomes larger (growth’s convexity)- keep track of absolute revenues to make sure the growth is feasible.
(ii)Estimate expected operating margins every year- Set a target margin that the firm will move towards- Adjust the current margin towards the target margin- Use target margin in perpetuity
(iii) Estimate the capital to be invested to generate expected revenue growth / margins
(iiii) be sure the new estimated ROC is in line with industry/economy growth in the long run.
what if you’re estimating g in a transition period where ROC/ROE/ non-cash ROE are changing?
dividend approach: g = Retention Ratio(b) ·ROE+∆% ROE- FCFE approach: g = Equity Reinvestment Rate· non-cash ROE+∆% non-cash ROE- FCFF approach: g = Reinvestment Rate·ROC+∆% ROC
how long is the explicit projection usually?
According to international practice, the length of the explicit projection period varies- From 7to10years in low-capital-intensive sectors- Upto10-15 years in industries whose specific assets have long economic/technical lives
(hydroelectric, petrochemical, …)
what is the financial meaning of the TV?
Acompany’s TV can assume two different meanings
1. The company breakup value (or liquidation value)
2. The equilibrium value of the company
what are the 3 methods to estimate TV?
Breakup value for firms whose assets can easily be liquidated individually and whose value can be estimated easily.
Multiples for a relative valuation
stable Growth value which is the soundest but requires most assumptions.
what are the 2 methods to estimate liquidation value?
BV approach where assets are assumed to be valued at their book value adjusted for inflation at the end of the explicit forecast
Earnings’ Power Approach
The Liquidation Value is the present value at appropriate discount rate r of expected CF from the assets over their remaining useful lives.
what are 3 important assumptions that we need to make if we want to estimate TV as the value of Stable growth?
-lenght of the high growth period
-firm characteristics (BETA, Debt capacity and excess return must shift towards equilibrium values)
-transition to stable growth…how fast?
why doesn’t the growth formula incorporate any qualitative element?
because these must translate in quantitative CF drivers to actually dictate growth.
how do qualitative factors (management quality, strategy, marketing and partnerships) influence growth projections?
Quality of management affects:
(i) The ROC firms earn on new investments
(ii) how long they can sustain these returns
=⇒ Management quality may be one reason to justify why a firm’s ROC can stay above CoC.
2. Marketing strength affects:
(i) Operating margins
(ii) Turnover ratios
3. Partnership with other firms (acquisitions, R&D, etc.) affects:- Projected ROC: more effective firms/partnership strategies command and sustain higher ROC
4. Strategic vision: size of excess return.
