Residual Income Valuation Flashcards
Residual Income =
net income - deduction for common shareholders’ opportunity cost in generating net income
Residual Income is the
remaining income after considering the costs of all a company’s capital
The income statement shows____ however does not_____
net income after deducting an expense for the cost of debt capital (i.e. interest expense), however does not deduct dividends or other charges for equity capital
Equity Charge =
Equity Capital x Cost of Equity Capital
How to adjust for total cost of capital?
NOPAT (Calculate net operating profit after tax)
Adjust NOPAT for the entire capital charge (equity and debt)
Debt Charge =
After tax cost of debt x debt amount
A company with positive residual income is
creating value
A company with negative residual income is
destroying value
High residual income =
higher valuations
Companies that earn more than the cost of capital should sell for
more than book value (vice versa)
Forecasting BV per share
Beginning BV + (EPS forecast - dividend forecast) = Forecasting ending BV –> carries onto next year
Estimating RI per share
EPS (or NI per share) - Equity Charge
Stock Price =
BV per share + PV (expected future per share RI)
If PV of expected future per share residual income is positive then…
intrinsic value (V0) is greater than BV per share (B0)
RI applies to firms ____
without dividends or near-term positive free cash flows
