Equity Valuation: Residual Income Model

Question 1

Economic Value Added (EVA)

Answer 1

EVA = NOPAT - (WACC X Total Capital)

Question 2

Residual Income Model (hint: solve for Vo rather than Po/Bo)

Answer 2

Vo = Bo + ∑RIt / (1+r)^t

• Bo: Book Value per share*
• RI: Residual Income*

Question 3

Single Stage Residual Income Valuation (like Justified P/B from fundamentals)

Answer 3

Vo = Bo + (ROE-r) / r-G

Bo: Current Book Value per share

Question 4

Multistage Residual Income Valuation (hint: like Po/Bo from RI + the future Pn-Bn)

Answer 4

Vo = Bo + ∑ RIt/(1+r)^t + (Pn - Bn)/(1+r)^n

• • Pn: expected price at n period*
• • Bn: expected BV per share at n period*
• • For long periods the second term can be excluded*

Question 5

When is Residual Income Models Appropriate?

Answer 5

1. When expected free cash flows are expected to be negative for the foreseeable future.
2. When dividends are uneven

RI models will show declining value when RI is negative and rising value if RI is positive.

Question 6

Residual Income Persistence Factors (high vs. low)

Answer 6

Low: extreme ROEs, Extreme Special Items, Extreme Accruals

High: Low dividend payouts, High historical persistence in industry

Question 7

Forecasted Book Value

Answer 7

B1 = Bo + E1 - D1

Question 8

Economic Value Added (EVA)

Answer 8

EVA = NOPAT - (C% X TC)

C% = Cost of Capital

TC = Total Capital

Question 9

Market Value Added (MVA)

Answer 9

MVA = Market Value - Invested Capital

• • Market value of Equity (share price X #shares)
• Market Value of Debt (could be a given discount)*

Question 10

Solve for implied growth rate in residual income

Answer 10

G = r - [(ROE - r)XBo / (Vo - Bo)]

Question 11

Clean surplus relationship

Answer 11

Ending BV = Beg BV + NI - Divs

• • Can be broken by currency translation adjustments*
• • Certain Pension adjustements*
• • Fair value changes in some financial instruments (not held for trading)*