Financial Accounting Essay

2137 words - 9 pages

The Role of Financial Information
in Valuation, Cash Flow Analysis,
and Credit Risk Assessment

Learning objectives
1. The basic steps in corporate valuation.
2. What free cash flows are and how they are used to value a

3. How accounting earnings are used in valuation.
4. Why current earnings are considered more useful than current
cash flows for assessing future cash flows.
5. How and why the permanent, transitory, and valuation-irrelevant
components of earnings affect price-earnings multiples.

Learning objectives:
6. What factors influence earnings quality.
7. How the abnormal earnings valuation approach is used
in practice.
8. How stock prices respond to ...view middle of the document...

Corporate valuation:
DCF illustration

Estimated DCF
value per share

Goodwill impairment and DCF

Corning goes on to say:
• The impairment charge would have been $225 higher if the discount rate was 12.5%.
• No impairment charge would have been made if the discount rate was only 11.0%.

Earnings or cash flow?

The traditional approach to stock
valuation relies on forecasted free
cash flows.

Why then do many analysts and
investors pay such close attention to
accrual earnings?

According to the FASB, it’s because
accrual earnings is more helpful in
forecasting a company’s future cash
flows (SFAC No. 1).

The role of earnings in valuation

Accrual earnings takes a longhorizon view that smoothes out the
“lumpiness” in year-to-year cash

Research evidence shows that:
1. Current earnings are a better
forecast of future cash flows than
are current cash flows.

Linkage between stock price and accrual earnings

2. Stock returns correlate better with
accrual earnings than with realized
operating cash flows.

The role of earnings in valuation:
Zero growth example
• To appreciate the link between earnings and future cash flows,
let’s take another look at the free cash flow valuation model:

Current earnings ( X 0 ) is assumed to be a good forecast of future free cash flow

 The zero growth assumption means that expected future earnings,
and thus expected future free cash flows, form a perpetuity so that:

Estimated share price

Price earning ratio (P/E) or
earnings multiple

Earnings and stock prices:
Evidence on value relevance

If investors use accrual earnings to
price stocks, then earnings
differences across firms should
explain differences in stock prices.

The test:

Pi  $9.54  8.18 X i
R 2  30.0%


per share
2002 P/E relationship for 40 restaurant companies

price at
$0 EPS

Earnings multiple
(should be statistically

Earnings and stock prices:
Sources of variation in P/E multiples

Why doesn’t current earnings
explain 100% of the variation in
stock price?

Stock prices (and thus P/E multiples)
are also influenced by:
1. Risk
2. Growth opportunities
3. The mix of earnings components

Sustained over time


One time event


No future cash flow impact

Pi  $9.54  8.18 X i
R 2  30.0%

2002 P/E relationship for 40 restaurant companies

Earnings and stock prices:
Earnings components illustration

• Stock prices reflect information about the
components of earnings.
e.g. income from
continuing operations

e.g. loss from

e.g. cumulative effect
of changes in
accounting methods

Earnings and stock prices:
Earnings components and P/E

Differences in earnings components mix
produces differences in P/E

Earnings and stock prices:

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