How much news is there in aggregate accounting earnings? I provide evidence that earnings changes at the stock market level are correlated with new information about not only expected future cash flows but also discount rates. A comprehensive investigation of the link to discount rates reveals that aggregate earnings changes are tied to news about all components of the expected future stock market return, i.e., the real riskless rate, expected inflation, and the expected equity risk premium. Over the sample period studied, cash flow news and discount rate news in aggregate earnings changes covary positively and have offsetting impacts on stock market prices. As a result, stock market prices appear to be insensitive to aggregate earnings changes. The findings highlight the importance of separating cash flow news from discount rate news when evaluating the information content of accounting earnings at the stock market level. Overall, my study sheds new light on the informativeness and relevance of accounting earnings for valuation at the stock market level.
corporate valuation holthausen pdf 17
The paper seeks to develop a comprehensive framework to cross-border discounted cash flow valuation. Although the literature on company valuation and on international financial management is vast, such a framework has not yet been proposed. We build upon well-known fundamentals and relevant contributions, e.g. on the derivation of the risk-adjusted rate of return. Relevant risks are exchange rate risk, business risk, financial risk, the risk of the tax effects induced by debt financing, and the risk of default. Additional tax effects beyond the well-known tax shield on interest expenses must be considered. Risk discounts from cash flows and risk premia to be added to risk-free interest rates are derived according to the global capital asset pricing model. A conceptual choice occurs not only between the foreign currency and the home currency approach, but also regarding the estimation of future exchange rates. The paper shows how a valuation can be implemented with or without consideration of covariances between cash flows and rate of returns with exchange rates. It also derives the discount rates if forward exchange rates are applied. We discuss the consequences of assuming the uncovered interest parity to hold. We assume deterministic debt and apply the adjusted present value approach. In addition, we derive the RADR to be used in the flow to equity and weighted average cost of capital approach. The paper addresses not only the valuation of a foreign company, but also the valuation of a domestic company that generates cash flows in foreign currency and/or uses debt in foreign currency.
The literature on company valuation is vast. Key contributions to discounted cash flow (DCF) valuation were made by Modigliani and Miller (1958, 1963), Miles and Ezzell (1980), Harris and Pringle (1985) and Inselbag and Kaufold (1997). Of course, this is also true for the literature on international financial theory. For example, forecasting and hedging flexible exchange rates, international parity theories, the properties of international capital markets, or the pricing of assets in these markets has been of interest to researchers over decades. The textbooks of Sercu (2009) and Bekaert and Hodrick (2018) provide a good overview and a thorough analysis of this field.
The interface between these two streams of the literature, the cross-border valuation of companies, has been analyzed extensively when it comes to the expected rate of returns for shareholders (cost of equity). Numerous papers have analyzed the risk-return relationship based on the capital asset pricing model (CAPM). Mehra (1978), Solnik (1974), Sercu (1980) and Stulz (1995) suggested different models, which have been discussed in the following from a conceptual perspective (see for example Ruiz de Vargas and Breuer 2018, 2019) while e.g. Ejara et al. (2019) provide an empirical analysis. Several papers and chapters in textbooks address the valuation of cash flows in foreign currency (FC) using the home currency (HC) and the foreign currency (FC) approach (e.g. Bekaert and Hodrick 2018; Breuer 2001; Butler et al. 2013; Ruiz de Vargas 2019). Leading textbooks on corporate finance such as Berk and DeMarzo (2020) or Brealey et al. (2019) cover cross-border valuations only briefly. This is true also for Koller et al. (2015), although these authors cover the use of the CAPM for cross-border valuation more closely than Berk and DeMarzo (2020) or Brealey et al. (2019). Holthausen and Zmijewski (2020) provide a reconciliation between the FC and the HC approach, and cover additional aspects, e.g. tax effects.
However, there is a gap in the literature when it comes to a comprehensive analysis of a cross-border DCF valuation of unlevered and levered companies. Topics to be addressed are, for instance, the identification of the relevant risks and the pricing of these risks, or a consistent integration of the effects of capital structure on cash flows and risks. A thorough understanding of these topics is necessary for a consistent implementation of the established DCF approaches to the FC approach and the HC approach. This includes the definition of risk adjusted discount rates (RADR). Relevant risks are the exchange rate risk, business risk, financial risk, the risk of the tax effects caused by debt financing, and the risk of default. The application of the CAPM for the pricing of risk and the derivation of the RADR, as well as the proper definition of the terminal value impose additional challenges for the valuation of a foreign company or a domestic company that generates cash flows in FC and/or uses debt denominated in a FC. Basically, the established tool kit to DCF valuation has to be extended in order to cope with different currencies by linking fundamental contributions of macroeconomics and financial theory. This leads to conceptual choices not only between the FC and the HC approach, but also regarding the estimation of exchange rates to be used over the forecast horizon. To the best of my knowledge, a paper that tries to develop a comprehensive framework is still missing. This paper aims at filling this gap.
For achieving this objective, Sect. 2 presents assumptions. It discusses basic principles by applying Cox et al. (1979). It also contains a parsimonious application of the value additivity principle (Schall 1972; Haley and Schall 1979) to cross-border valuation. This second part of Sect. 2 shows in principle how a cross-border valuation can be implemented consistently. This will prove helpful for the valuation of an unlevered foreign company (Sect. 3) and a levered foreign company (Sect. 4). In Sects. 2, 3, and 4, we introduce a series of risk categories beginning with exchange rate risk (Sect. 2), followed by business risk (Sect. 3), financial risk (Sect. 4), the risk of default (Sect. 4), and the risk attributable to tax effects (Sect. 5). For the pricing of risk, we will refer to the global CAPM. We discuss the link between the inputs to the CAPM for the HC perspective and for the FC perspective. We derive RADR definitions and value equations, if expected spot exchange rates or forward exchange rates are used, for both unlevered (Sect. 3) and levered companies (Sect. 4). If forward exchange rates are used, we discuss the consequences of assuming the uncovered interest parity to hold. Section 5 deals with the valuation of a domestic company that uses debt denominated both in domestic and in foreign currency. This requires the consideration of a tax effect beyond the well-known tax shield on interest expenses, because repayments are also subject to exchange rate risk. In Sect. 6, we compare our findings with selected literature contributions. Section 7 provides conclusions.
Domestic and foreign corporate income is subject to a constant and identical corporate tax rate (for differential international taxes see Senbet 1979). Personal income taxes, barriers to repatriation of cash flows, and transaction costs do not exist.Footnote 2
We consider a binomial one-period case first. A multi-period model can be derived by analyzing a chain of single period models in which the intertemporal connection of states (stochastic independence vs. stochastic dependence) becomes relevant, and a recursive valuation (roll-back-procedure) is to be applied. We use a multi-period setting later, but simplify the model by using expected values without addressing the intertemporal connections, and by applying the global CAPM in a multi-period setting. The latter assumption implies that risk-free rates are deterministic over an infinite time span, and that the distribution of the return on the market portfolio is time invariant.
First, we summarize the fundamental links between current spot exchange rates, expected spot exchange rates and forward exchange rates. We then prepare the analysis of cross-border valuations by valuing an investment in one unit of FC.
The expected spot exchange rate is of interest for a cross-border valuation. While the current spot exchange rate and the forward exchange rate are observable, the expected spot exchange rate is not directly observable. However, we can establish a link between different exchange rates, and can come up with a definition of the expected spot exchange rate. For a binomial distribution of the exchange rates, the expected spot exchange rate can be defined with reference to F and one of the state-contingent exchange rates. With the risk-neutral definition of F1 in Eq. (4), the spot exchange rate in the up-state follows the spot exchange rate in the down-state:
The expected spot exchange rate depends upon the premium for the exchange rate risk, zVS, which may be estimated empirically, and the risk-free interest rates and the spot exchange rate, which are observable at the valuation date.
Based upon these fundamental links, we develop a general understanding of how to discount an expected cash flow in FC (A) occurring one year from now to its present value in the HC (VHC). We will address the definition of the cash flow to be discounted and the derivation of the RADR in later chapters. In this section, we apply the value additivity principle (Schall 1972; Haley and Schall 1979) to DCF valuation (see Schüler 2018a). 2ff7e9595c
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