Test 2

1. What cashflow models have you incorporated into your project spreadsheet and which are likely to
give the most accurate valuation?
2. Expalin Ohlson’s earning-valuation model including every variable and parameter?
3. Be able to explain the how you would estimate phi (φ) and gamma (γ) in the modified Ohlson equation.
4. Be able to calculate a Castagna and Matolcsy Z score and understand its usefulness.
5. Discuss the valuation models you used in your project and explain how you choose the best one.
6. Explain whether accounting variables can be used to predict corporate failure
7. How will you measure which valuation measure gives the “best” valuation for your target company?

1. Cashflow models in project

The utilisation of cash flow models helps to overall manage cash flows and maintain
an efficient use of company cash and short-term investments. The models help to
develop a stable and profitable plan and forecast of the sources and uses of cash of the
company as well as being able to analyse the impact of drivers on cash flow and
improve decision-making. Within the spreadsheets we have developed, they have
incorporated the Dechow and Dichev (DD) distress model, Castagna and Matolcsy
model, Altman model, mostly for use of comparison as well as devising a discounted
cash flow (DCF) valuation.
The Dechow and Dichev model is based around the Quality of Accruals and Earnings
paper devised by these authors where the model is constructed the relationship
between accruals and cash flows. A role of the accruals is to adjust the recognition of
cash flows over time so that the adjusted earnings become a better measure of firm
performance. This is however limited because accruals require assumptions and
estimates of future cash flows, which can vary between different industries.
The DCF valuation is one of the most common methods of valuation where it
analyses the net present value of a company by forecasting its future free cash flows
by discounting at a suitable rate. Some of the main advantages of using the DCF,
especially for REIT’s, is that i) it values the entire cash flow available to shareholders,
ii) the main inputs are transparent, iii) the ‘cash flow is king’ is particularly relevant
for this industry since real estates are viewed as having reliable cash flow
characteristics (Nussbaum, NYU, 2006). It is limited however in the wide variety of
inputs that may impact results, the subjective decisions gone into cash flow
predictions, the magnitude of terminal value and the use of a perpetuity rate as
opposed to a multiplier for the terminal value.

2. Ohlson’s earning-valuation model

Ohlson’s earning valuation model is derived from the notion that capitalised current
earnings determine value, where the model also recognises that for some firms,
earnings might not be the best determinant of value. The model also incorporates the
book value of a company’s net assets, in the event that a firm produces no earnings or
there are no negative earnings, or when the value of the firm lies more in its assets.
The nature of the assets and the accounting methods used will determine if the
earnings of assets is the book value of net assets or the market value of the net assets.
From these components, the model has two parts; the valuation of current earnings:
𝑘𝜙𝑋𝑡 and the book value: (1 − 𝑘)𝑌𝑡 + 𝑄𝑉𝑡 . When added together with a value
parameter for book value (gamma), they produce a modified valuation of 𝑃𝑡 =
𝑘𝜙𝑋𝑡 + (1 − 𝑘)𝛾𝑌𝑡 , where 𝑃𝑡 = price per share at time t, k = weight of capital
(between 0 and 1), 𝜙 = capitalisation rate for earnings, 𝛾 = PB (price to book ratio),
 𝑋𝑡 = earnings per share at time t, and 𝑌𝑡 = net asset backing per share at time t. Its
advantages include a focus on fundamental valuation issues, considering the effect of
retained earnings on future earnings and revitalising the profitability aspect of
valuations.
The process of applying Ohlson’s Theory of value as a model involves:
1. Estimate historical “true’ or “permanent” earnings.
2. Forecast future maintainable or “permanent” earnings (expectations)
3. Estimate phi – which is the capitalisation rate for normal earnings
4. Estimate a value for the weight k

3. Estimating phi and gamma

The capitalisation rate for earnings is mainly determined via the use of price-earnings
(𝑃 +𝑑 )
ratios, where theoretically 𝜙 = 𝑡𝑋 𝑡 , even though price-earnings ratios are an
𝑡
1+𝑟
invalid concept in regard to valuations. In the specific model, 𝜙 = 𝑟 which can then
be multiplied by earnings per share at time t and therefore determines the current
earnings aspect of the valuation model. 𝛾 on the other hand, is estimated by utilising a
historic/indicator PB value from analysis. This value must be less than 1 otherwise if
PB is greater than 1, then weight k will equal 1.

Typically, the price/earnings ratio is a function of expected changes in future

profitability and the price/book ratio is a function of the expected level of
profitability, where when placed together, the ratios should reveal information about
expected future profitability relative to current profitability. Alternatively, the PE can
be expressed as a function of capitalised current earnings plus the capitalised present
value of changes in future abnormal earnings, which may be more applicable in
Ohlson’s model (the previous description was more relevant to the dividend discount
model).

PE can be calculated as market price per share divided by earnings per share, and PB
ratio can be calculated as the market price per share divided by the book value per
share. These ratios can also be derived from benchmark valuation methods that
estimate stock prices of a firm based on the price multiples of a certain firm’s
comparable firm (Cheng & McNamara).
It is expected that gamma and phi would vary from industry to industry but remain
relatively stable intra-industry (same industries involving trade of similar products).

4. Z score usefulness
The Castagna and Matolcsy study examines failure within the market context and
tries to identify and analyse the characteristics of companies prior to failure. This z-
score model utilises a combination of numerous financial ratios that cover
components such as liquidity, leverage and return on equity to derive a z-score, in
which if it falls under or equal to zero, the company survives. If the z-score falls in a
range greater than zero however, then the company fails. This type of model is more
intricate than other models such as Altman’s, which only incorporates around five
different ratios and can be more abstract than the C&M model, since there is a grey
area result which can cause uncertainty.

5. Valuation models used in project and which was the best

 The valuation models used in the project vary greatly and range from the Dividend
Valuation Model to the Ohslon Valuation and Discounted Cash Flow Valuation
model.

6. Can accounting variables be used to predict corporate failure

http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.138.2328&rep=rep1&type
=pdf
https://www.jstor.org/stable/2490653?seq=11#page_scan_tab_contents
Though many businesses can be at risk of failure, studies have shown that small,
private and newly founded companies with ineffective control procedures and poor
cash flow planning were ultimately more vulnerable to financial distress as opposed
to large and well-established public firms. Early detection of financial distress is
preferable to protection under bankruptcy law and so it is essential that failure
predictions models are used efficiently. Evidence has also shown that the market
value of distressed firms declines substantially prior to their ultimate collapse, thereby
affecting suppliers of capital, investors, creditors, management and employees.

Development of an effective model is extremely important to minimise distress, and

this can be done by implementing accounting variables, such as financial ratios, from
company data to predict company outcomes. An important accounting variable to
examine however is the role of cash flows from operating activities. A lack thereof of
sufficient cash flows causes an onset of an inability to repay debt and interest
obligations, one of the major reasons for failure.

Of course, the usefulness of accounting information depends upon the predictive

ability of the information and the types of interpretations that can be developed.
Corporate failures can be explained by the Castagna and Matolcsy model which is
derived solely on financial ratio. It is believed by these authors that the financial ratios
capture the influences of management policy, macro-economic factors and industry
specific factors in which a company operates. The model can be used in situations
such as (i) removing companies from portfolios that are at risk of failure, or to focus
analysis on them, (ii) establishing the appropriateness of ‘the going concern’
assumption for client companies for auditors, (iii) providing warning for corporate
managers to correct potential future failure and (iv) assessing the potential of loan
default.

7. Measuring which valuation measure gives the best valuation for target company