7. Residual Income Valuation Flashcards
Explain residual income.
Residual income or economic profit is the net income of a firm less a charge that measures stockholders’ opportunity cost of capital. The rationale for the residual income approach is that it recognizes the cost of equity capital in the measurement of income. This concept of economic income is not reflected in traditional accounting income, whereby a firm can report positive net income but not meet the return requirements of its equity investors.
Residual Income = Net Income - Equity Charge
Equity Charge = kE * Equity Capital
Explain EVA.
Economic value added (EVA) measures the value added for shareholders by management during a given year.
EVA = NOPAT - (WACC * Total Capital)
= EBIT * (1-t) - $WACC
*For the purpose of EVA, we use beginning-of-year total capital. For MVA, we use end-of-year total capital.
Analysts should make the following adjustments (if applicable) before calculating NOPAT and invested capital:
1) Capitalize and amortize research and development charges (rather than expense them), and add them back to earnings to calculate NOPAT
2) Add back charges on strategic investments that will generate returns in the future
3) Eliminate deferred taxes and consider only cash taxes as an expense
4) Treat operating leases as capital leases and adjust nonrecurring items
5) Add LIFO reserve to invested capital and add back change in LIFO reserve to NOPAT
Explain MVA.
Market value added (MVA) is the difference between the market value of a firm’s long-term debt and equity and the book value of invested capital supplied by investors. It measures the value created by management’s decisions since the firm’s inception.
MVA = Market Value - Total Capital
For the purpose of EVA, we use beginning-of-year total capital. For MVA, we use end-of-year total capital.
How to forecast residual income given some basic accounting information?
RI(t) = EPS(t) - (r*B(t-1))
= (ROE - r) * B(t-1)
RI(t): residual income per share in year t
EPS(t): expected ESP for year t
r: required return on equity
B(t-1): book value per share in year t-1
ROE: expected return on new investments
Explain residual income valuation.
The residual income valuation model breaks the intrinsic value of a stock into two elements:
1) current book value of equity
2) present value of expected future residual income
V0 = B0 + [RI1/(1+r) + RI2/(1+r)^2+…]
B0: current book value of equity
RI(t)= EPS(t) - (rB(t-1) = (ROE - r)B(t-1)
The expression says that a stock’s intrinsic value, V0, is equal to its current book value per share, B0, plus the present value of all its expected future residual income, which is the difference between end-of-period earnings and equity charges based on beginning-of-period book value.
Explain the ‘Single-Stage Residual Income Valuation Model’.
The general residual income models make no assumptions regarding the long-term future earnings or dividend growth. However, if we make the simplifying assumption of a constant dividend and earnings growth ratem we can develop a residual income model that highlights the fundamental drivers of residual income.
Assuming the stock is correctly priced (i.e. P0=V0), value can be expressed in terms of book value:
V0 = B0 + [(ROE - r)*B0/(r-g)]
How to calculate the implied growth rate in residual income, given the market P/B ratio and an estimate of ROE?
g = r - [B0 * (ROE-r)/(V0-B0)]
Explain the continuing residual income model.
Think of the continuing residual income model as a multistage model similar to the multistage DDM and CFC models. In the residual income model, intrinsic value is the sum of three components:
V0 = B0+(PV of interim high-g RI) + (PV of continuing RI)
PV of continuing RI = RI(t)/(1+r-w), aqui ainda n é o valor presente em t=0
w = persistence factor, 0<=w<=1
*If the RI perist at current level forever, w=1
*If the RI drops immediately to zero, w=0
* If RI declines to long-run leven in mature industry, P = B * P/B, use (PV of continue RI) = (P - B) + RI/(1+r)
Explain strenghts and weaknesses of residual income models.
STRENGHTS
- Terminal value does not dominate the intrinsic value estimate, as is the case with dividend discount and free cash flow valuation models
- Residual income models use accounting data, which is usually easy to find
- The models are applicable to firms that do not pay dividends or that do not have positive expected free cash flows in the short run
- The models are applicable even when cash flows are volatile
- The models focus on economic profitability rather than just on accounting profitability
WEAKNESSES
- The models rely on accounting data that can be manipulated by management
- Reliance on accounting data requires numerous and significant adjustments
- The models assume that the clean surplus relation holds or that its failure to hold has been properly taken into account
- The clean surplus: B/S(t) = B/S(t-1) + EPS(t) - D/S(t)
In which circumstances Residual Income Models are appropriate/not appropriate?
APPROPRIATE
- 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 highy uncertain, which makes dividend discount or free cash flow models less useful
NOT APPROPRIATE
- The clean surplus accounting relation is violated significantly
- There is significantly uncertainty concerning the estimates of book value and return on equity
Which are main common accounting issues in applying residual income models.
1) Clean Surplus Violations:
Ending book value = Beginning book value + Net income - Dividends
2) Variations from Fair Value: the accrual method of accounting causes many balance sheet items to be reported at book values that are significantly different than their market values.
3) Intangible Asset Effects on Book Value
4) Nonrecurring items and other aggressive accounting practices
5) International Accounting Differences
