Residual Income Valuation

Question 0

Residual income breaks firm value into these two components:

Answer 0

1. Adjusted current BV of equity

2. PV of expected future RI

Question 1

What is residual income (or economic profit)

Answer 1

RI = Net income - equity charge

Equity charge = equity capital * cost of equity

Question 2

Calc Intrinsic value of stock with RI model

Answer 2

V0 = B0 + (RI1/(1+r)^1 + RI2/(1+r)^2 + …)

B0 = current book

Question 3

Single stage RI model value calc

Answer 3

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

Question 4

Strengths of residual income model

Answer 4

• terminal value doesn’t dominate
• uses available accounting data
• applicable to non-dividend paying firms
• focuses on economic profits

Question 5

Limitations of residual income

Answer 5

• accounting data can be manipulated
• may require adjustment
• assumes clean surplus relationship (ending BV = beginning BV + earnings - dividends)

Question 6

Residual income is most appropriate for …

Answer 6

Non dividend paying firms
Firms with negative FCF
Firms with high uncertainty about terminal value of equity

Question 7

Accounting issues w/residual income model

Answer 7

• any direct charge to equity causes relationship to break down
• BS adjustments such as changing inventory from LIFO to current, capitalization of operating leases, pension asset/liability issues, goodwill

Question 8

How to calc multistage residual income

Answer 8

V0 = B0 + (PV of interim high growth RI) + (PV of continuing residual income)

Question 9

Persistence factor w is included in RI model with the following assumptions:

Answer 9

RI persists forever; w = 0
RI drops immediately to zero; w = 1
RI declines over long run; 0<1 (to cost of equity or avg level consistent with industry)

Question 10

If a competitive advantage is more sustainable and industry is stronger, persistence factor will be…

Answer 10

Higher