Equity #37 - Residual Income Valuation

Question 1

residual income

Answer 1

LOS 37.a

• residual income (RI):
  
  • equivalent to “economic profit”
  • RI = net inc - opportunity cost of equity capital
• accounting income will overstate returns from equity investor perspective because it ignores cost of equity
• RI explicitly deducts all capital costs–debt & equity

Question 2

relation of RI to other valuation models

Answer 2

LOS 37.a

• residual income is related to :
  
  • PVGO model: P = EPS₁ / r + PVGO
  • P/B ratio using fundamentals:
    
    • P/B = (ROE - g) / (r - g)
  • Porter’s 5 Forces model and competitive strategies

Question 3

equation forms of residual income

Answer 3

LOS 37.a

RI = net inc - opportunity cost of equity capital

RI = NOPAT - WACC x total capital

RI = EBIT(1 - t) - WACC x total capital;
t = marginal tax rate

RI_t = EPS_t - (BVPS_t-1 * r)

RI_t = (ROE - r)BVPS_t-1

Question 4

uses for residual income models

Answer 4

LOS 37.b

• measuring company management effectiveness & executive compensation
• equity valuation
• measuring goodwill impairment

Question 5

intrinsic value and residual income

Answer 5

LOS 37.c

• RI approach: Value = BV + PV(all RI’s)
• formula similar to DDM:

V₀ = B₀ + (RI₁/(1+r)¹ + (RI₂/(1+r)²+ … + (RI_n/(1+r)ⁿ

B₀ = BV of equity

Question 6

calculating future RI

Answer 6

LOS 37.c

Two methods for calculating RI_t:

• RI_t = EPS_t - (r * BV_t-1)
• RI_t = (ROE_t - r) * BV_t-1

intrinsic value calculation:

V₀ = B₀ + sum[(ROE_t - r) * B_t-1 / (1 + r)^t]

Question 7

difference in value recognition: RI vs. DCF models

Answer 7

LOS 37.c

• value is recognized earlier under RI model than under DCF, so RI less sensitive to terminal value

Question 8

value drivers of residual income

Answer 8

LOS 37.d

if ROE > r_e:

• RI will be positive
• justified MV/BV > 1

if ROE = r_e:

• justified MV = BV
• MV/BV = 1

Question 9

single-stage RI constant growth model

Answer 9

LOS 37.f

assumptions: constant ROE and constant g (EPS growth)

V₀ = B₀ + RI₁ = B₀ + (ROE - r) * B₀ / (r-g)

Question 10

Calculating implied growth rate

Answer 10

LOS37.g

g = r - [B₀(ROE - r) / (V₀ - B₀]

assume P₀ = V₀ (mkt is in equilibrium)

V₀ = market price of stock = P/B * B/S

B₀ = book value

r = required return on equity

Question 11

continuing residual income

Answer 11

LOS 37.h

continuing RI: expected RI beyond the estimated horizon

• depends on form’s ability to generate ROE > r, premium over BV
• relates to Porter’s competitive advantage
• depends on industry opportunities
• depends on firm able to keep competitive edge over the long term

Question 12

persistence factor w

Answer 12

LOS 37.h

• persistence factor w, between 0 and 1
• high w ⇒ longer period in which ROE > 1
• factors suggesting higher w:
  
  • low Div payout
  • high RI industry persistence
• factors suggesting lower w:
  
  • high ROE
  • large special items
  • large accounting accruals

Question 13

continuing RI approaches

Answer 13

LOS 37.h

1. drop immediately to zero (w = 0); no competitive advantage, “pure competition”
2. persist at current level forever (w = 1); prepetual competitive advantage
3. decline over time to zero
4. decline over time to steady state “mature industry” level

Question 14

multi-stage RI model

Answer 14

LOS 37.h

Intrinsic value = sum of 3 components:

V₀ = B₀ + PV(high-grow RI) + PV(cont. RI)

1. calculate current BV +
2. calulate RI for yrs 1 to T-1 (T=terminal year) +
3. calculate cont. RI as: PV(cont RI_T-1⁺) = RI_T / (1 + r - w)

Question 15

strengths of residual income model

Answer 15

LOS 37.j

1. terminal value doesn’t dominate V₀
2. accounting data easily accessible
3. works even without dividiends or positive CF
4. works even when CFs are volatile or unpredictable
5. focuses on economic profitability

Question 16

weaknesses of residual income model

Answer 16

LOS 37.j

1. account data can be manipulated by management
2. requires many adjustments
3. assumes “clean surplus” relation holds (assumes no direct adjustments to equity i.e. all income flows through IS:

B_t = B_t-1 + E_t - D_t

Question 17

accounting issues affecting RI

Answer 17

LOS 37.k

Point: while RI is straightforward, in practice it requires many adjustments:

1. clean surplus relationship violations
2. off-BS items
3. nonrecurring items on IS
4. aggressive accounting practices
5. international accounting differences

Question 18

examples of clean surplus relationship violations

Answer 18

LOS 37.k

• FX translation gain/(loss)
• BS adjustements to fair value
• pension liability (remeasurements)
• unrecognized gain/(loss) on avail-for-sale securities
• deferred gain/(loss) on cash flow hedges
• change in revaluation surplus of PP&E, long-life assets and intangibles (IFRS only)
• change in value of certain liabilities due to credit risk changes

Question 19

effect of/solution for clean surplus relationship violations

Answer 19

LOS 37.k

Effects

• BV correct but NI and ROE forecast are incorrect
• issue OCI items that do not reverse over time

Solution

• calc ROE using comprehensive income (NI + d(OCI items)
• note OCI is cinsidered income under clean surplus accounting

Question 20

Off-Balance Sheet item examples

Answer 20

LOS 37.k

• operating leases
• off-BS SPEs
• LIFO to FIFO inventory
• deferred tax assets and liabilites

Question 21

nonrecurring item examples

Answer 21

LOS 37.k

• discontinued operations
• accounting changes
• restructuring charges

Effect: exclude nonrecurring items on the IS; RI should be based on recurring items only

Question 22

aggressive accounting examples

Answer 22

LOS 37.k

• accelereating revenues to current period
• deferring expenses to later period
• using reserves to smooth income
• unrealistic accounting estimates