Residual Income Valuation

Question 1

What is residual income & formula?

Answer 1

• income that remains after accounting for the cost of all sources of capital

RI = NI - equity charge

RI = residual income
NI = net income

Question 2

What is formula for EVA?

Answer 2

EVA = NOPAT - (C% * TC)

EVA = economic value added
NOPAT = net operating profit after taxes
C% = cost of capital
TC = total capital

Question 3

What is the formula for MVA?

Answer 3

MVA = market value of company - account book value of total capital = (DMV +EMV) - (DBV +EBV)

DMV = market value of debt
EMV = market value of equity
DBV = book value of debt
EBV = book value of equity

Question 4

What is the formula for residual income model, and what are 2 extended formulas for residual income?

Answer 4

V0 = B0 + (RI/(1+r)^t)

V0 = intrinsic value
B0 = book value of equity
RI = residual income
r = discount rate or required rate of return

RI = Et - (r*Bt)

RI = residual income
Et = expected EPS
r = cost of equity
Bt = expected per share book value of equity at time t

RI = (ROE - r) * Bt-1

RI = residual income
ROE = return on equity
r = cost of equity
Bt = expected per share book value of equity at time t

Question 5

What is formula for clean surplus accounting?

Answer 5

Bt = Bt-1 + Et - Dt

Bt = expected book value per share
Et = expected EPS
Dt = dividend

Question 6

What is formula for justified P/B from drivers of residual income?

Answer 6

P/B = (ROE - G) / (r-g) = 1 + ((ROE-r)/(r-g))

ROE = return on equity
G = sustainable growth rate
r = required return on equity

Question 7

What is formula for single-stage residual income model with a constant growth rate?

Answer 7

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

B0 = per share book value of equity

Question 8

What is formula for Tobins Q?

Answer 8

Tobins Q = market value of debt & equity / replacement cost of total assets

Question 9

What are the 2 adjustments needed in order to use the residual income model?

Answer 9

• Adjust the book value of common equity for off-balance sheet items
• Adjust the reported net income to get comprehensive income.

Question 10

What is formula for multistage residual income model if a specified premium is assumed at the end of the time horizon?

Answer 10

V0 = B0 + {((Et - r*Bt-1)/ (1+r)^t) + ((Pt - Bt) /(1+r)^t)}

Pt = terminal value (present value of terminal value)
B0 = current book value of equity
Et = expected EPS
r = cost of equity
Bt = expected per share book value of equity at time t

Question 11

What is formula for multistage residual income model if residual income fades over time?

Answer 11

V0 = B0 + {((Et - rBt-1)/ (1+r)^t) + ((Et - rBt-1) / (1+r-w) * (1+r)^(t-1))}

B0 = current book value of equity
Et = expected EPS
r = cost of equity
Bt = expected per share book value of equity at time t
w = persistence factor

Question 12

What does a persistence factor of 1 & 0 mean? Additionally, when would a higher persistence factor be recommended?

Answer 12

• persistence factor of w = 1 means there is no fading
• persistence factor of w = 0 means the residual income will not continue after time
• higher persistence factor is recommended if the company has a relatively low dividend payout ratio or persistence levels have historically been high in its industry