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Equity Valuation and Portfolio Management by Harry M. Markowitz, Frank J. Fabozzi

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FORMULATION OF THE BASIC MODEL

Our basic FFM expresses a firm's theoretical value as the sum of two level payment annuities reflecting a current earnings stream (the tangible value, TV) and a flow of net profits from expected future investments (the franchise value, FV):

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TV is the economic book value associated with annual earnings derived from current businesses without the addition of new capital. In the FFM, we obtain a valuable simplification by viewing this earnings stream as a perpetual annuity, with annual payments E. This model annuity is presumed to have the same present value as the actual projected earnings stream. Any pattern of projected earnings can be replicated, in present value terms, by an appropriately chosen perpetual earnings stream.

In actuality, analysts use either trailing or forward-looking earnings projections. Realized earnings exhibit considerable year-to-year variability and optimistic earnings projections are often “front-loaded” with rapid growth in the early years and more stable and possibly declining earnings in later years. The opposite path is also possible: slow earnings growth projected in the early years and more rapid growth later.

If k is the risk-adjusted discount rate (usually taken as equivalent to the cost of equity capital), then3

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The ...

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