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Case Assignment

Introduction

Valuation is the calculation of the total worth of the business or its resources taking into account different conditions of the business (How the Valuation Process Works, 2019). In this assignment, the different factors influencing the valuation or relating to the valuation methods will be discussed in this report like the different factors affecting or relation with the P/E ratios, meaning of the sustainable earnings or how the good news of the firm affect the stock price of the firm and many more aspects like these.

1- Describe the role of accounting numbers in corporate valuation.

Accounting numbers play a significant role in corporate valuation as the valuation of a company majorly done by using different accounting figures of the business like the profit of the business, the total accounted assets, accounted sales figure of the business and many more accounting figures like these. Without the accounting numbers, the corporate valuation becomes limited as the data in the market of other company's valuation will have to take into account for valuation. The valuation without the accounting numbers will not be able to take into account different aspects of its business performance like the growth rate of the business, the prospects of the business and the current return rate of the business. These the valuation by this method will have a high risk of being inaccurate and vague. Therefore, the accounting numbers play a highly important role in the corporate valuation as it helps the user in the calculation of the total value of the business according to its current financial position.

2- P/E ratios are a useful indicator and tool when performing valuation and comparing firms. List three factors that should be considered or adjusted for when comparing P/E ratios among different firms.

P/E ratio is the ratio which is used for valuation of the firm in which the market price of the firm is compared with the earning of the firm (What the Price-to-Earnings Ratio Tells Us, 2019). The three factors that should be considered or adjusted for when comparing P/E ratios among the different firms are growth rate, risk and accounting model of these different firms and the detail discussion about these factors are given below.

• Growth rate - The Growth rate of each firm should be taken into account and adjusted in the calculation of the P/E ratios of these different firms as the growth rate of the business influence the performance of the business significantly and also show the potential of the firm to give high return to its investor in the future.

• Risk - The risk of each firm should be taken into account and adjusted in the calculation of the P/E ratios of the different firms as the different risk of a firm is one of the main factors that influence the performance of the firm in the market.

• Accounting models- The accounting models used in these different firms should be considered, and the implication of these used accounting models should be identified. Then the reported earnings of these firms should be adjusted which will be taken into account for the calculation of P/E ratios of these firms. It has to be done to remove the biasness that the use of a particular accounting model creates on the result of the P/E ratios comparison of the different firms. This will enable a fair comparison of the different firms according to the P/E ratios.

3- What is meant by sustainable earnings?

The sustainable earning is the amount of net income that the business is earning after paying its all expenses and tax obligation and which is generated from the normal or daily activities of the business. On the other word, it can be said that the sustainable earning is that portion of the net income is generated from the sales of the products or services of the business and show the profit earning ability or sustainability of the business (Sustainable Earnings - Financial Definition, 2019). The sustainable earnings do not include the income from the sale of the assets of the business as it will not help the sustainability of the business in the long term. For example, the profit from the sales of the old machine of the business is not sustainable earning of the business whereas the profit from the sale of the particular product of the business is sustainable earnings of the business.

4- Discuss how a firm's P/E ratio is related to the firm's choice of accounting methods.

Accounting methods are those rules, guidelines and policies that the firm follows to report the financial result of the business in a particular period. The accounting method influences the calculated financial result of the business in many ways like the assumption in a particular accounting method influence the valuation of the assets of the business. The accounting method also impacts the reported sales or revenue figure of the business as the accrual method of accounting report the sales in accrual basis, and cash basis method of accounting reports the sales on cash basis. This creates a substantial difference in the reported sales or revenue of the business as different accounting methods will give different reported sales of the business (Accounting Model of Equity Valuation Limitations, 2019). The difference in the reporting of the value of the assets of the firm or the sales of the business will create a significant difference in the P/E ratio of the firm as the reported earnings or financial performance of the firm taken into account for the calculation of the P/E. This makes the P/E calculation highly dependent on the firm's choice of accounting method due to the above condition, and in this way, P/E ratio is related to a firm's choice of accounting methods.

5- Discuss how a firm's P/E ratio is related to the present value of growth opportunities available to the firm.

The present value of the growth opportunities means the present value of the future cash flow that the different growth prospect of the firm can create for the business in the future period. Some of the growth opportunities depend on the economic condition of the industry or the market in which the firm operates and some on the firm own individual condition in the market (Finance.zacks.com, 2019). The investors also like to take into account the future growth prospects of the business. Therefore, the different market and business condition like inflation rate or growth rate of the business or industry and its predicted impact on firm performance are taken into account in time of calculating the earning which is used in the P/E ratio, and this changes the result of the P/E ratio significantly. For example, the positive market or business conditions will better the P/E ratio of the firm and the negative market or business conditions will negatively impact the P/E ratio of the firm. This is how a firm's P/E ratio is related to the present value of growth opportunities available to the business.

6- One measure for determining expected earnings this quarter (t) could be considering earnings for the same quarter last year (t-4). List some of the disadvantages to using this measure.

The use of the past year's same quarter earnings to estimate the expected earnings of this year's same quarter which in this case study is given as (t) is not a good method to estimate the earnings of the business. There are different disadvantages to this method, and some of these disadvantages to using this method are listed below.

• One of the main disadvantages of this measure is that it does not account the growth of the business and this cause the management to undervalue the estimated earning of that quarter of the business and this could lead to the inadequate or inefficient allocation of assets.

• Another disadvantage of this measure is that it does not take into account; the time value of money and this prevent the estimation from showing the real earnings of the business.

• This measure also does not account the current market or business condition of the business which most probably will lead to inaccurate estimation under this measure, and this is another disadvantage of this method.

All these are the disadvantage of this measure which prevents past estimation being a good measure of the business.

7- Define "abnormal earnings" and describe the key features of the abnormal earnings approach to valuation.

Abnormal earning can be defined as that portion of the earnings which earned above the normal rate of return of the business. It can also be assessed to be the amount of earnings that is left after deducting the opportunity cost of the business from the total net earnings of the business (Abnormal Earnings Valuation - Overview, Formula, and Key Concepts, 2019). In other words, the portion of the rate of return above the expected return of the business is called abnormal earnings of the business (Brainmass.com, 2019). One of the valuation methods estimating the abnormal earning of the business or the project is called Residual Income Valuation.

Some of the key features of the abnormal earnings approach to valuation are listed below.

• The earning above the normal or expected earnings of the business is called positive abnormal earning.

• The earning below the normal earnings of the business is called negative abnormal earnings.

• Under the abnormal earning approach to valuation, the ability of the management to generate a higher return than expected from the investment or asset is assessed (How the Abnormal Earnings Valuation Model Works, 2019).

• This approach is also used by the investors to select a particular investment among all the available investment options and the investment with the highest positive abnormal earnings is selected by the investor under this approach.

8- Why do the stock returns of firms reporting "good news" drift upwards before the earnings announcement date?

The stock market and stock price of the different firms in it are highly influenced by predictions and perception of the investors from the different news that floats in this market. The stock of the firm which is reporting "good news" drifts upwards due to some of the predictions and perception of the investors, and some of these perceptions and prediction are listed below.

• The investor predicts that the firm will distribute dividend and this gives the investors a chance to get a portion of return quickly from the stock by buying it then. Therefore, this prediction creates an increase in the demand of the firm's stock in the market which results in stock price drifting upwards.

• The investor sometimes predicts that the reported good new will increase the growth of the business significantly and it will be able to gain high return from these stocks in the future, and for this reason, they are ready to pay a premium or high price for these stocks.

• The investor also predicts that the good news will increase the profit of the business which will eventually lead to the increase in the stock price of the business and this prediction led to the increase in the stock price before the earnings announcement date.

Conclusion

The findings of the assignment include identification of different aspects of valuation. The first finding includes the accounting number plays a significant role in the valuation. The second finding is risk, growth rate and accounting model should be adjusted before comparing different firms through P/E ratios. The meaning of sustainable earnings had been identified. Then the relationship of the P/E ratios with different factors mentioned had been explained. Then the disadvantages of using past earning as a measure of estimation of future earning had been given. Then abnormal earnings and its features had been identified. At last, the reasons had been given for the good news of the firm before the earnings announcement data resulting in the increase of the stock price of the firm.

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