23 Residual Income Flashcards
Residual income (RI)
is the net income of a firm less a charge that measures stockholders’ opportunity cost of capital.
equity charge =
equity capital × cost of equity
RI is calculated as:
net income - equity charge
Economic value added
measures the value added for shareholders by management during a given year.
EVA is calculated as
Market value added (MVA)
difference between the market value of a firm’s long-term debt and equity and the book value of invested capital supplied by investors
MVA is calculated as:
MVA = market value − total capital
Example: Calculating EVA and MVA
VBM, Inc., reports NOPAT of $2,100, a WACC of 14.2%, and invested capital of $18,000 at the beginning of the year and $21,000 at the end of the year. The market price (year-end) of the firm’s stock is $25 per share, and VBM has 800 shares outstanding. The market value (year-end) of the firm’s long-term debt is $4,000. Calculate VBM’s EVA and MVA.
Residual Income Formula
The residual income valuation formula
single-stage residual income valuation model.
fundamental drivers of residual income:
If return on equity (ROE) is equal to the required return on equity, the justified market value of a share of stock is equal to its book value.
[(ROE−r)×B0r−g] is the additional value generated by the firm’s ability to producereturns in excess of the cost of equity
Example: Calculating value with a single-stage residual income model
Western Atlantic Railroad has a book value of $23.00 per share. The company’s return on new investments (ROE) is 14%, and its required return on equity is 12%. The dividend payout ratio is 60%. Calculate the value of the shares using a single-stage residual income model and the present value of expected economic profits.
continuing residual income model
V0 = B0 + (PV of interim high-growth RI) + (PV of continuing residual income)
PV of continuing residual income in year T – 1
Residual income models are appropriate under the following circumstances:
A firm does not pay dividends, or the stream of payments is too volatile to be sufficiently predictable.
Expected free cash flows are negative for the foreseeable future.
The terminal value forecast is highly uncertain, which makes dividend discount or free cash flow models less useful.
Compare residual income models to dividend discount and free cash flow models.
Theoretically, the intrinsic value derived using expected dividends, expected free cash flow to equity, or book value plus expected residual income should be identical if the underlying assumptions used to make the necessary forecasts are the same.
Describe accounting issues in applying residual income models.
Clean Surplus Violations
Variations from Fair Value
Intangible Asset Effects on Book Value
Nonrecurring Items and Other Aggressive Accounting Practices
International Accounting Differences
Clean Surplus Violations
The clean surplus relationship (i.e., ending book value = beginning book value + net income − dividends) may not hold when items are charged directly to shareholders’ equity and do not go through the income statement.
