Reading 38 - Residual Income Valuation

Question 1

Define Residual Income…….

Answer 1

Is the net income of a firm less a charge that measures stockholder’s opportunity cost of capital

Question 2

How do you calculate Residual Income?

Answer 2

= Net Income - Equity Charge

Question 3

How do you calculate the Equity Charge used in calculating Residual Income?

Answer 3

= equity capital * cost of equity

Question 4

What is NOPAT?

Answer 4

Net Operating _P_rofit _A_fter Tax

= EBIT * (1-T)

Question 5

What is Economic Value Added (EVA) ?

Answer 5

it measures the value added for shareholders by management during a given year

Question 6

How do you calculate Economic Value Added (EVA) ?

Answer 6

= NOPAT - (WACC * Invested Capital)

Invested Capital = book value of long term debt + book value of equity

Question 7

What is Market Value Added (MVA)?

Answer 7

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

Question 8

How do you calculate Market Value Added (MVA)?

Answer 8

= Market Value - Invested Capital

Question 9

Assuming the stock is correctly priced (ie P₀ = V₀), how can value be expressed in terms of book value?

Answer 9

Question 10

How do you calculate the implied growth rate in residual income when given the market price to book ratio and an estimate of the required rate of return?

Answer 10

Question 11

What is a persistence factor in regards to residual income?

Answer 11

the projected rate at which residual income is expected to fade over the life cycle of the firm

Question 12

What are the four main assumptions that can be made about continuing residual income?

Answer 12

• residual income is expected to persist at its current level forever
• residual income is expected to drop immediately to zero
• residual income is expected to decline to a long run average level consistent with a mature industry
• residual income is expected to decline over time as ROE falls to the cost of equity

Question 13

How do you calculate the PV of continuing residual income if it continues at the current level forever?

Answer 13

Question 14

How do you calculate the PV of continuing residual income if it drops immediately to zero?

Answer 14

Question 15

How do you calculate the PV of continuing residual income if it declines over time to zero?

Answer 15

Question 16

How do you calculate the PV of continuing residual income if it declines to the long run level in a mature industry?

Answer 16

Question 17

What are some of the strengths of using a residual income model?

Answer 17

• Terminal value does not dominate the intrinsic value estimate
• 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 FCF in the short run
• models are applicable when cash flows are volatile
• models focus on economic profitability rather than just accouting profitability

Question 18

What are some of the weaknesses of using residual income models?

Answer 18

• the models rely on accounting data that can be manipulated by management
• reliance on accounting data requires numerous and significant adjustments
• models assume that the clean surplus relation holds

***clean surplus is B_t = B_t-1 + E_t-D_t

Question 19

Under what circumstances in it appropriate to use a Residual Income model?

Answer 19

• 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 foreseeabe future
• terminal values forceast is highly uncertain, which makes dividend discount or FCF models less useful

Question 20

Under what circumstances is it not appropriate to use residual income models?

Answer 20

• clean surplus accounting relation is violated significantly
• there is significant uncertainty concerning the estimates of book value and return on equity

Question 21

What are some adjustments that have to be made to net income so the Clean Surplus isn’t violated?

Answer 21

• Foreign currency translation gains and losses that flow directly to retained earnings
• The minimum liability adjustment in pension accounting
• Changes in market value of debt and equity securities classified as available for sale

Question 22

What are the steps to calculate SS’s common stocks justified value if the present value of projected residual income for the next 5 years plus beginning book value is $75 per share. Beyond that time horizon, the firm will sustain residual income of $11.25 per shares, which is the residual income for year 6.

Answer 22

Step 1 : Calculate the terminal value as of yr 5

          TV = 11.25 / 0.10  = 112.50

Step 2 : Calculate the PV of this yr5 TV

         PV = 112.50 / (1.10)<sup>5 </sup>= 69.85

Step 3: Calculate the justified value

            = 112.50 + 69.85

Question 23

Calculate the Residual Income at Yr end given the following information

Required rate of return = 8%

Beginning book value = 10.62

EPS is 20% of beginning book value

Will pay out 40% of EPS in Dividends

Answer 23

Question 24

Given the following facts, how do you calculate the PV of continuing residual income as of yr end 2009……

Price as of 2010 : $59.64

Book value as of 2010 : $14.91

Residual Income for 2010 : $1.59

Required rate of return : 8%

Answer 24

Question 25

An investor is considering purchasing a stock with a price to book value of 5. The ROE is expected to be 18% , the market price is $25 , and the growth rate is expected to be 8%. Assume the shares are currently price at their fair value. How do you calculate the cost of equity implied by the current P/B ratio?

Answer 25

Given the below equation we can re-arrange to the following: B₀ = V₀ / PB We get BV = $5 Insert $5 into the formula and solve for r

Question 26

How do you calculate _beginning book value_ ?

Answer 26

B_t-1 = Total Equity = Common Shares + Retaining Earnings (\*\*from B/S)

Question 27

Company ABC has a book value of $15 per share and is expected to earn $3 per share indefinitely. The company does not reinvest any of its earnings. Its beta is 0.75, the risk free rate is 4% and the expected market risk premium is 8%. Calculate the value of ABC's stock using the Dividend Discount Model and the Residual Income Model...

Answer 27

r = 4 + (0.75 \* 8) = 10% **_For DDM_** since does not reinvest any of its earnings; dividend = earnings = $3 value = 3 / 0.10 = $30 **_For Residual Income_** residual income = $3 - (0.10 \* 15) = 1.5 value = 15 + ( 1.50 / 0.10) = $30

Question 28

How do you calculate P/B given ROE, required rate of return and the growth rate?

Answer 28

Question 29

How do you calculate ROE ?

Answer 29

EPS / Current Book Value

Question 30

How do you calculate **_current yr book value_** ?

Answer 30

B_t = B_t-1 + E - D Bt = current yr book value Bt-1 = last yrs book value E = earnings per shares D = dividends paid per share (dividends are EPS\* Payout ratio)

Question 31

What is the formula for the multi stage residual income model?

Answer 31

V₀ = B₀ + PV of interim high-growth RI + PV of continuing RI