R.32 Residual Income Valuation

Question 1

Economic Value Added (EVA) - aka Capital charge approach; aka pre-levered RI

Market Value Added (MVA)

Answer 1

EVA = NOPAT - (WACC% x Total Capital)

= EBIT(1-T) - (WACC% x TC)

• Net Operating Profit After-Taxes (NOPAT) is same as EBIT(1-t)
• Economic Value Added is commercial version of RI concept
• Less cost of total capital (TC)
• Computed from accounting statements with adjustments such as:
  
  • R&D exp is capitalized
  • Cash taxes only expensed (not deferred taxes)
  • LIFO reserve added back to capital
  • Operating leases treated as capital leases

MVA = (MV of total company) - (BV of total company)

• Also relates to economic profit
• MV and BVs of both equity and debt are included.

Question 2

Residual Income

Estimating & Calculating Future Residual Income

Answer 2

Question 3

RI Strengths & Weaknesses (and when to use and when not)

Answer 3

Question 4

Accounting adjustments and international considerations

Answer 4

Per Kaplan, if RI model shows up on exam, the most likely accounting issues encountered tend to be balance sheet related.

Adjustments to RI model in practice include:

1. Adjust BV of common equity adjustments for off-Balance Sheet items
   * Off-balance sheet items should be analyzed and potentially included. Reported assets and liabilities should be adjusted to their fair value. Adjustments are often needed for inventory, operating leases, intangible assets, and deferred tax assets and liabilities.
   * Intangible assets can have significant value even if it is not reflected in the book value. Often the intangible assets are not recognized until they are acquired in an acquisition. For example, advertising could create a valuable brand that would not appear as an asset unless the company owning the brand was acquired.

The recognition of intangible assets after an acquisition could make the combined value of a company not equal to the sum of the two companies.

Research and development (R&D) costs also create intangible assets. Successful R&D will increase the ROE over time.

2. Adjust reported NI to get comprehensive income
   * Violations of the Clean Surplus Relationship

Violations of the clean surplus accounting assumption occur if changes are made directly to stockholders’ equity, bypassing the income statement. Examples of this include the market value changes of some investments and foreign currency translation adjustments. The book value is accurate, but the net income is not complete.

Comprehensive income is defined as all changes in equity for a given period. This includes net income and other comprehensive income. Residual income forecasts should be based on comprehensive income rather than net income.

International Considerations

Because accounting standards differ internationally, accounting-based valuation methods may not work in international contexts. Reliable earnings forecasts and clean surplus accounting are needed. Fortunately, IFRS is becoming widely used. This should reduce the number of accounting discrepancies when comparing companies from different countries.

Question 5

Residual Income

Residual Income Model

Clean Surplus Relationship

Constant Growth

Answer 5

Residual Income calc

RI = NI - equity charge

where equity charge = r_e x BV_{beg PERIOD!}

= EPS_t - (r_e x BV_{t-1 i.e. beg!})

= (ROE_t - r_e) x BV_{t-1 i.e. beg!}

Residual Income Model

V₀ = B₀ + sum of future RIs each discounted by Time t

Steps:

1. Find BV_BEG and BV_END for all periods

T(1) T(2)

BV_beg(T1) BV_end(T-1)

+ EPS

• DIV_paid

= BV_end

2. Find Equity Charge = r_e x BV_beg
   * For each period. Remember it’s beginning period BV!

​3. Find RI_t = Subtract EC from EPS for each period

RI_t = EPS_t - EC_t

Clean Surplus Relationship

B_t = B_t-1 + E_t − D_t

Constant Growth

V₀ = B₀ + [(ROE - r_e) / (r_e-g)] (B₀)