Lecture 2 - Financial Statements and Electives

Question 1

What is absolute valuation (fundamental analysis) and what are its benefits?

Answer 1

▪ relies on gathering and analysing information,
▪ forecasting firm-specific payoffs and growth rates based on information,
▪ to derive the intrinsic value of the firm based on these forecasts.
→ Less likely to be influenced by market errors in valuation

Question 2

What is the equation for the dividend discount model?

Answer 2

Question 3

What is the equation for the free cash flow discount model?

Answer 3

notice the rho_w

and the Vd

Question 4

Abnormal earnings discount model (Residual income model)

Answer 4

Notice the Book Value term and the rho_e which is the equity cost of capital.

Question 5

Equation for abnormal earnings

Answer 5

Question 6

Why don’t the dividend discount model, discounted cash flow model and abnormal earnings discount model yield the same equity value in practice?

Answer 6

However, in practice and empirical research the models frequently yield different values
▪ Three reasons:
1. Inconsistent forecasts error
2. Inconsistent discount rate error
3. Missing cash flows error

Question 7

Pros and Cons of the three discount models

Answer 7

Question 8

Advantages and Disadvantages of Abnormal Earnings model

Answer 8

Advantages
* Focuses on profitability of investment and growth in investment → drive value
* Directs strategic thinking to these drivers
* Incorporates the information in financial statements
* Properties of accrual accounting: allow for shorter forecast horizons compared to DCF
* Accounting principles have no effect
* Anchors on book value: protection to pay too much for future growth

Disadvantages
* Relies on accounting numbers → can be managed (accounting quality analysis!)