Chapter 5 - Return on equity, value creation, and firm value. The following will be discussed in this chapter: A model of firm value based on roe and value creation, market-to-book ratios, using the ROE valuation model to estimate firm market value, predicting future ROE, incorporating ROE predictions into the valuation model,. | Chapter 5 Return on Equity, Value Creation, and Firm Value A Model of Firm Value Based on ROE and Value Creation Expression 1 V = The present value of the expected future returns A Model of Firm Value Based on ROE and Value Creation Expression 2 V = The sum of the present values of each future annual expected return A Model of Firm Value Based on ROE and Value Creation Expression 3 V = The dollar value of shareholders’ equity plus the sum of the present values of each future annual expected return A Model of Firm Value Based on ROE and Value Creation Expression 4 V = The current value of shareholders’ equity plus the returns expected by the shareholders in the predictable forecast horizon plus returns expected by the shareholders in the long-run forecast assumption, discounted for the time value of money. Market-to-Book Ratio Market value = Market value per share x Number of shares o/s Book value = Total Shareholders equity Expected (discounted future) ROE is the difference Market-to-Book Ratio If market value equals book value, the firm is expected to create -0- value for the shareholders in the future. If market value is less than book value, the firm is expected to destroy value for the shareholders in the future. If market value is more than book value, the firm is expected to create value for the shareholders in the future. Predicting Future ROE Assess the business environment. Read and study the financial statements and notes. Assess management’s reporting bias. Analyze the level and determinants of historical ROE. Predicting future earnings and/or cash flow. Assessing the Business Environment What is the nature of the company’s operations? What strategy is being employed to generate profits? What is the company’s industry? Who are the major players? Competition? What are the relationships between the company and its customers and suppliers? How are the company’s sales and profits affected by changes in the economy? Reading and Studying the Financial Statements and Notes Read the audit report. Identify significant transactions major acquisitions, discontinuance or disposal of a business segment, unresolved litigation, major write-downs of receivables or inventories, etc. Read the financial statements and footnotes. Read Management’s Discussion and Analysis for forward-looking information about management’s plans. Assess Management’s Reporting Bias How can management’s self-serving bias be taken into consideration when attempting to predict future ROE? What incentives are there for management to “manage” earnings? Is there evidence that management has acted upon it’s incentive to manage earnings? Analyze the Determinants of ROE How has the company created (destroyed) value in the past? Has ROA been the primary value driver, or has it been leverage? What are the company’s strengths and weaknesses compared to its competitors? Copyright © 2009 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.
