Dealing with Negative or Abnormally Low Earnings

Steps in Cash Flow Estimation

Estimate the current earnings of the firm
• If looking at cash flows to equity, look at earnings after interest expenses - i.e. net income
• If looking at cash flows to the firm, look at operating earnings after taxes

Consider how much the firm invested to create future growth
• If the investment is not expensed, it will be categorized as capital expenditures. To the extent that depreciation provides a cash flow, it will cover some of these expenditures.
• Increasing working capital needs are also investments for future growth
If looking at cash flows to equity, consider the cash flows from net debt issues (debt issued - debt repaid)

Measuring Cash Flows

Measuring Cash Flow to the Firm


EBIT ( 1 - tax rate)
- (Capital Expenditures - Depreciation)
- Change in Working Capital
= Cash flow to the firm
Where are the tax savings from interest payments in this cash flow?


From Reported to Actual Earnings

Estimating the Cost of Debt

The cost of debt is the rate at which you can borrow at currently, It will reflect not only your default risk but also the level of interest rates in the market.
The two most widely used approaches to estimating cost of debt are:
• Looking up the yield to maturity on a straight bond outstanding from the firm. The limitation of this approach is that very few firms have long term straight bonds that are liquid and widely traded.

• Looking up the rating for the firm and estimating a default spread based upon the rating. While this approach is more robust, different bonds from the same firm can have different ratings. You have to use a median rating for the firm

When in trouble (either because you have no ratings or multiple ratings for a firm), estimate a synthetic rating for your firm and the cost of debt based upon that rating. The rating for a firm can be estimated using the financial characteristics of the firm. In its simplest form, the rating can be estimated from the interest

coverage ratio.

                                              Interest Coverage Ratio = EBIT / Interest Expenses


Companies in countries with low bond ratings and high default risk might bear the burden of country default risk, especially if they are smaller or have all of their revenues within the country.

Larger companies that derive a significant portion of their revenues in global markets may be less exposed to country default risk. In other words, they may be able to borrow at a rate lower than the government.


The weights used to compute the cost of capital should be the market value weights for debt and equity.
There is an element of circularity that is introduced into every valuation by doing this, since the values that we attach to the firm and equity at the end of the analysis are different from the values we gave them at the beginning.
As a general rule, the debt that you should subtract from firm value to arrive at the value of equity should be the same debt that you used to compute the cost of capital.

Estimating Beta

The standard procedure for estimating betas is to regress stock returns (Rj) against market returns (Rm) -

Rj = a + b Rm

• where a is the intercept and b is the slope of the regression.

The slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock. This beta has three problems:

• It has high standard error

• It reflects the firm’s business mix over the period of the regression, not the current mix

• It reflects the firm’s average financial leverage over the period rather than the current leverage.

Solutions to the Regression Beta Problem

Modify the regression beta by

• changing the index used to estimate the beta

• adjusting the regression beta estimate, by bringing in information about the fundamentals of the company

Estimate the beta for the firm using

• the standard deviation in stock prices instead of a regression against an index

• accounting earnings or revenues, which are less noisy than market prices.

Estimate the beta for the firm from the bottom up without employing the regression technique. This will require

• understanding the business mix of the firm

• estimating the financial leverage of the firm

Use an alternative measure of market risk not based upon a regression

Within any business, firms with lower fixed costs (as a percentage of total costs) should have lower unlevered betas. If you can compute fixed and variable costs for each firm in a sector, you can break down the unlevered beta into business and operating leverage components.

                     Unlevered beta = Pure business beta * (1 + (Fixed costs/ Variable costs))

The biggest problem with doing this is informational. It is difficult to get information on fixed and variable costs for individual firms. In practice, we tend to assume that the operating leverage of firms within a business are similar and use the same unlevered beta for every firm.

Calculating Equity Betas and Leverage

Conventional approach- If we assume that debt carries no market risk (has a beta of zero), the beta of equity alone can be written as a function of the unlevered beta and the debt-equity ratio.

                                             βL = βu (1+ ((1-t)D/E))

In some versions, the tax effect is ignored and there is no (1-t) in the equation. Debt Adjusted Approach: If beta carries market risk and you can estimate the beta of debt, you can estimate the levered beta as follows
                                           βL = βu (1+ ((1-t)D/E)) - βdebt (1-t) (D/E)

While the latter is more realistic, estimating betas for debt can be difficult to do.

Estimating Discount Rates

Critical ingredient in discounted cash flow valuation. Errors in estimating the discount rate or mismatching cash flows and discount rates can lead to serious errors in valuation. At an intuitive level, the discount rate used should be consistent with both the riskiness and the type of cash-flow being discounted. If the cash flows being discounted are cash flows to equity, the appropriate discount rate is a cost of equity. If the cash flows are cash flows to the firm, the appropriate discount rate is the cost of capital. The currency in which the cash flows are estimated should also be the currency in which the discount rate is estimated. If the cash flows being discounted are nominal cash flows (i.e., reflect expected inflation), the discount rate should be nominal.

The cost of equity should be higher for riskier investments and lower for safer investments.While risk is usually defined in terms of the variance of actual returns around an expected return, risk and return models in finance assume that the risk that should be rewarded (and thus built into the discount rate) in valuation should

be the risk perceived by the marginal investor in the investment. Most risk and return models in finance also assume that the marginal investor is well diversified, and that the only risk that he or she perceives in an

investment is risk that cannot be diversified away (I.e, market or non-diversifiable risk).

There are various models to calculate cost of Equity, however the most popular one being CAPM 

Consider the standard approach to estimating cost of equity:

Cost of Equity = Rf + Equity Beta * (E(Rm) - Rf)

where,

Rf = Riskfree rate

E(Rm) = Expected Return on the Market Index (Diversified Portfolio)

In practice, Short term government security rates are used as risk free rates, Historical risk premiums are used for the risk premium & Betas are estimated by regressing stock returns against market returns.

On a risk-free asset, the actual return is equal to the expected return. Therefore, there is no variance around the expected return. For an investment to be riskfree, then, it has to have a) No default risk b) No reinvestment risk. Thus, the riskfree rates in valuation will depend upon when the cash flow is expected to occur and will vary across time. In valuation, the time horizon is generally infinite, leading to the conclusion

that a long-term riskfree rate will always be preferable to a short term rate, if you have to pick one. 

But what happens in a situation like that in Greece, where there is no riskfree/default free assest to be found, how do we then estimate a Riskfree Rate when there are no default free entities. 

Estimate a range for the riskfree rate in local terms.

-Approach 1: Subtract default spread from local government bond rate: Government bond rate in local currency terms - Default spread for Government in local currency.

-Approach 2: Use forward rates and the riskless rate in an index currency (say Euros or dollars) to estimate the riskless rate in the local currency.

Do the analysis in real terms (rather than nominal terms) using a real riskfree rate, which can be obtained in one of two ways –

• from an inflation-indexed government bond, if one exists

• set equal, approximately, to the long term real growth rate of the economy in which the valuation is being done.

Do the analysis in a currency where you can get a riskfree rate, say US dollars.

Valuation in different scenarios

Valuation in Acquisition Analysis:

Valuation should play a central part of acquisition analysis. The bidding firm or individual has to decide on a fair value for the target firm before making a bid, and the target firm has to determine a reasonable value for itself before deciding to accept or reject the offer. There are special factors to consider in takeover valuation. First, there is synergy, the increase in value that many managers foresee as occurring after mergers because the combined firm is able to accomplish things that the individual firms could not. The effects of synergy on the combined value of the two firms (target plus bidding firm) have to be considered before a decision is made on the bid. Second, the value of control, which measures the effects on value of changing management and restructuring the target firm, will have to be taken into account in deciding on a fair price. This is of particular concern in hostile takeovers. As we noted earlier, there is a significant problem with bias in takeover valuations. Target firms may be over-optimistic in estimating value, especially when the takeover is hostile, and they are trying to convince their stockholders that the offer price is too low. Similarly, if the bidding firm has decided, for strategic reasons, to do an acquisition, there may be strong pressure on the analyst to come up with an estimate of value that backs up the acquisition.

Valuation in Corporate Finance:

There is a role for valuation at every stage of a firm’s life cycle. For small private businesses thinking about expanding, valuation plays a key role when they approach venture capital and private equity investors for more capital. The share of a firm that a venture capitalist will demand in exchange for a capital infusion will depend upon the value she estimates for the firm. As the companies get larger and decide to go public,

valuations determine the prices at which they are offered to the market in the public offering. Once established, decisions on where to invest, how much to borrow and how much to return to the owners will be all decisions that are affected by valuation. If the objective in corporate finance is to maximize firm value, the relationship between financial decisions, corporate strategy and firm value has to be delineated. As a final note, value enhancement has become the mantra of management consultants and CEOs who want to keep stockholders happy, and doing it right requires an understanding of the levers of value. In fact, many consulting firms have come up with their own measures of value (EVA and CFROI, for instance) that they contend facilitate value enhancement.

Applicability of multiples and limitations

The allure of multiples is that they are simple and easy to relate to. They can be used to obtain estimates of value quickly for firms and assets, and are particularly useful when there are a large number of comparable firms being traded on financial markets, and the market is, on average, pricing these firms correctly. In fact, relative valuation is tailor made for analysts and portfolio managers who not only have to find under valued equities in any market, no matter how overvalued, but also get judged on a relative basis. An analyst who picks stocks based upon their PE ratios, relative to the sectors they  operate in, will always find under valued stocks in any market; if entire sectors are over valued and his stocks decline, he will still look good on a relative basis since his stocks will decline less than comparable stocks(assuming the relative valuation is right). By the same token, they are also easy to misuse and manipulate, especially when comparable firms are used. Given that no two firms are exactly similar in terms of risk and growth, the definition of 'comparable' firms is a subjective one. Consequently, a biased analyst can choose a group of comparable firms to confirm his or her biases about a firm's value. While this potential for bias exists with discounted cash flow valuation as well, the analyst in DCF valuation is forced to be much more explicit about the assumptions which determine the final value. With multiples, these assumptions are often left unstated. The other problem with using multiples based upon comparable firms is that it builds in errors (over valuation or under valuation) that the market might be making in valuing these firms. If, for instance, we find a company to be under valued because it trades at 15 times earnings and comparable companies trade at 25 times earnings, we may still lose on the investment if the entire sector is over valued. In relative valuation, all that we can claim isthat a stock looks cheap or expensive relative to the group we compared it to, rather than make an absolute judgement about value. Ultimately, relative valuation judgements depend upon how well we have picked the comparable companies and how how good a job the market has done in pricing them.