Why Genus plc. uses the residual earning based models:
1. Forecast-based model (include direct approach and indirect approach) 2. The residual earning based models (include direct approach and indirect approach) The reasons why Genus plc. Chose the residual earning models:
Firstly, the firm’s profitability, it was showed on the return on equity, and it can show that how well the managers did in the past year.
Secondly, the growth of investment, in this case, the valuation can be more informative if it showed the public and investors that how the company is expected to grow in the future.
Thirdly, the accrual concept, that is about the cash flow.
Last but not least, items accounting variables in financial statement and forecasting.
3. More accurate estimation:
Genus plc. Preferred using the indirect approach to the direct approach. Because it will be more accurate estimation of the firm’s value, and the indirect approach focuses on the value of operation directly instead of the book value of equity and uses WACC, which shows the cost of capital more precisely.
4. The CAPM model
WACC, calculate it from cost of debt, cost of equity and leverage ratio and assume that these rates are perpetually constant.
Cost of debt = net borrowing cost in 2010.
Calculating cost of equity in which risk free rate is 10-year UK gilt yield, equity beta is 0.63,
market risk premium is 5%.
As result, WACC of Genus equals to 6.7%.
5. The sensitivity analysis to value, the growth is aggressive or conservative.
Positive residual earning = get a high return on equity
The report said, the firm is expected to have a high return on equity in the future due to our P/B and P/E valuation showed that the P/B ratio of Genus plc. is more than twice as high as the normal P/B ratio, so the market over-evaluated the share price of this firm.
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