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CFA Level II Equities > Reading 38 - Residual Income Valuation > Flashcards

Reading 38 - Residual Income Valuation Flashcards

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CFA flashcards
1
Q

Define Residual Income…….

A

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

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2
Q

How do you calculate Residual Income?

A

= Net Income - Equity Charge

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3
Q

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

A

= equity capital * cost of equity

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4
Q

What is NOPAT?

A

Net Operating _P_rofit _A_fter Tax

= EBIT * (1-T)

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5
Q

What is Economic Value Added (EVA) ?

A

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

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6
Q

How do you calculate Economic Value Added (EVA) ?

A

= NOPAT - (WACC * Invested Capital)

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

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7
Q

What is Market Value Added (MVA)?

A

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

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8
Q

How do you calculate Market Value Added (MVA)?

A

= Market Value - Invested Capital

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9
Q

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

A
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10
Q

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?

A
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11
Q

What is a persistence factor in regards to residual income?

A

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

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12
Q

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

A
  • 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
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13
Q

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

A
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14
Q

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

A
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15
Q

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

A
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16
Q

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

A
17
Q

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

A
  • 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
18
Q

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

A
  • 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 Bt = Bt-1 + Et-Dt

19
Q

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

A
  • 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
20
Q

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

A
  • clean surplus accounting relation is violated significantly
  • there is significant uncertainty concerning the estimates of book value and return on equity
21
Q

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

A
  • 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
22
Q

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.

A

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
23
Q

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

A
24
Q

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%

A
25
Q

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?

A

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

26
Q

How do you calculate beginning book value ?

A

Bt-1 = Total Equity

   = Common Shares + Retaining Earnings (\*\*from B/S)
27
Q

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…

A

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

28
Q

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

A
29
Q

How do you calculate ROE ?

A

EPS / Current Book Value

30
Q

How do you calculate current yr book value ?

A

Bt = Bt-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)

31
Q

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

A

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

CFA Level II Equities (10 decks)

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