Question 7-2 and 7-7 Solutions

Question 7-2. Explain why terminal values in accounting-based valuation are significantly

lower than those for DCF valuation.

DCF terminal values include the present value of all expected cash flows beyond the

forecast horizon. Note that the expected cash flows beyond the forecast horizon can be

broken down into two parts: normal and abnormal. Since the terminal value in the

accounting-based technique includes only the abnormal earnings (expected earnings

minus cost of capital times beginning book value of equity), the terminal values in

accounting-based valuation are significantly less than those for DCF valuation. The

accounting-based approach recognizes that current book value and earnings within the

forecast horizon already reflect many of the cash flows expected to arrive after the

forecast horizon.

Question 7-7. What types of companies have:

a. a high PE ratio and a low market-to-book ratio?

Recovering firms are expected to rebound from temporarily low earnings levels but will

not be able to return to an abnormally high level of ROE due to competition. PE ratio

looks high due to low current earnings.

b. a high PE ratio and a high market-to-book ratio?

“Rising stars” which are expected to grow quickly and enjoy high ROEs during the

growth period and/or after the growth occurs.

c. a low PE ratio and a high market-to-book ratio?

“Falling stars” that enjoy high ROEs on existing investments but are no longer growing

fast. PE ratio is low due to relatively high earnings in current year.

d. a low PE ratio and a low market-to-book ratio?

“Dogs” which have little prospect for either growth or high ROEs.