RESIDUAL INCOME VALUATION:
VALUING COMMON EQUITY
Presenter
Venue
Date
RESIDUAL INCOME
Economic
Profit
Abnormal
Earnings
Economic
Value
Added
Residual
Income
RESIDUAL INCOME
Net
Income
Equity
Charge
Residual
Income
NOPAT
Capital
Charge
Residual
Income
EXAMPLE: RESIDUAL INCOME
Total assets
EBIT
Debt-to-total capital
ratio
Cost of debt (before tax)
$5,000,000.00
$400,000 .00
0 .60
8%
Cost of equity
12%
Tax rate
40%
EXAMPLE: RESIDUAL INCOME
EBIT
$400,000
Less interest Expense
$240,000
Pretax income
$160,000
Less income tax expense
$64,000
Net income
$96,000
EXAMPLE: RESIDUAL INCOME
Equity capital
$2,000,00
0
Equity charge
$240,000
Net income
Less equity charge
Residual income
$96,000
$240,000
$144,000
RELATED MEASURES
Economic
Value
Added
(EVA)
NOPAT
C% TC
- NOPAT = Net operating profit after taxes
- C% = Cost of capital
- TC = Total capital
Market
Value
Added
(MVA)
Market
Value of
the Firm
Book
Value of
Total
Capital
USES OF RESIDUAL INCOME
Valuation
Measuring Goodwill Impairment
Measuring Internal Corporate
Performance
Determining Executive Compensation
FORECASTING RESIDUAL INCOME
RIt Et re Bt 1
Residual
income
per share
Earnings
per share
(EPS)
Required
return on
equity (Re)
Beginning
book
value per
share
(BVPS)
EXAMPLE: FORECASTING RESIDUAL INCOME
0
Earnings
$2.50
$3.00
Dividends
$1.00
$1.10
Book value
Required equity
return
$20.00
10%
EXAMPLE: FORECASTING RESIDUAL INCOME
IN ONE YEAR
Charge for Equity Capital =
Required return on equity Beginning book value per
share
10% $20.00 = $2.00
Residual Income in Year 1 =
EPS Charge for equity capital
$2.50 $2.00 = $0.50
EXAMPLE: FORECASTING RESIDUAL INCOME
IN TWO YEARS
End-of-Year Book Value for Year 1 =
Beginning-of-year book value + Earnings Dividends
$20.00 + $2.50 $1.00 = $21.50
Beginning book value for year 2
Charge for Equity Capital in Year 2 =
Required return on equity Beginning book value per share
10% $21.50 = $2.15
Residual Income in Year 2 =
$3.00 $2.15 = $0.85
VALUING COMMON STOCK USING RESIDUAL
INCOME
RIt
V0 B0
t
t 1 (1 r )
Et rBt 1
V0 B0
t
t 1 (1 r )
EXAMPLE: VALUATION USING RESIDUAL
INCOME
From the Previous Example:
Beginning book value at time 0 = $20.00
Residual income in year 1 = $0.50
Residual income in year 2 = $0.85
Required return on equity = 10 percent
Additionally, Assume:
Residual income in year 3 = $1.00
The firm ceases operations in three years
EXAMPLE:
VALUATION USING RESIDUAL INCOME
V0 $20
$0.50
1
1.10
V0 $20 $1.91
V0 $21.91
$0.85
1.10
$1.00
1.10
DETERMINANTS OF RESIDUAL INCOME
RIt ROE t r Bt 1
ROE > r
RI > 0
V>B
ROE < r
RI < 0
V<B
RESIDUAL INCOME VALUATION AND THE P/B
ROE r
V0 B0
B0
rg
V0
ROE r
1
B0
rg
EXAMPLE:
USING A SINGLE-STAGE RESIDUAL INCOME MODEL
Book value of equity per
share
$30.00
Return on equity
18%
Required return on equity
12%
Residual income growth
rate
8%
EXAMPLE:
USING A SINGLE-STAGE RESIDUAL INCOME MODEL
ROE r
V0 B0
B0
rg
0.18 0.12
V0 $30
$30
0.12 0.08
$1.80
V0 $30
$75.00
0.12 0.08
EXAMPLE:
USING A SINGLE-STAGE RESIDUAL INCOME MODEL
Suppose that the current stock price is $80 in the
previous example. What is the implied growth rate?
0.18 0.12
$80 $30
$30
0.12 g
$1.80
$50
0.12 g
g 8.4%
CONTINUING RESIDUAL INCOME
= Long-Term Residual Income
Potential Scenarios:
RI is constant forever
RI is zero at the terminal period
RI gradually declines to zero where ROE = r
RI gradually declines to a constant level
where ROE > r
CONTINUING RESIDUAL INCOME
AND PERSISTENCE FACTORS
High Persistence
Low Persistence
Low dividend
payout
Historically high
industry ROEs
Extreme ROE
Extreme levels
of special items
Extreme
accounting
accruals
VALUING CONTINUING RESIDUAL INCOME
Et rE Bt 1
Et rE BT 1
V0 B0
t
T 1
(1 rE )(1 rE )
t 1 (1 rE )
T 1
Persistence Factor ()
01
= 1 Residual income will not fade
= 0 Residual income will not persist after the initial forecast to rise
= 0.62 It has been observed, on average, empirically
EXAMPLE: MULTISTAGE
RESIDUAL INCOME MODEL
From the First Valuation Example:
Beginning book value at time 0 = $20.00
Residual income in year 1 = $0.50
Residual income in year 2 = $0.85
Residual income in year 3 = $1.00
Required return on equity = 10 percent
Value was $21.91
Now Assume:
The firm continues operations after three years
EXAMPLE: MULTISTAGE MODEL
CASE 1: = 0
Et rE Bt 1
ET rE BT 1
V0 B0
t
T 1
(1
r
)
(1
)(1
r
)
t 1
E
E
E
T 1
$0.50 $0.85
$1.00
V0 $20
1
2
1.10 1.10
(1 0.10 0)(1.10 2 )
$0.50 $0.85
$1.00
V0 $20
1
2
1.10 1.10
(1.10)(1.10 2 )
V0 $21.91
EXAMPLE: MULTISTAGE MODEL
CASE 2: = 1.0
Et rE Bt 1
ET rE BT 1
V0 B0
t
T 1
(1
r
)
(1
)(1
r
)
t 1
E
E
E
T 1
$0.50 $0.85
$1.00
V0 $20
1
2
1.10 1.10
(1 0.10 1.0)(1.10 2 )
$0.50 $0.85
$1.00
V0 $20
1
2
2
1.10 1.10
(0.10)(1.10 )
V0 $29.42
EXAMPLE: MULTISTAGE MODEL
CASE 3: = 0.60
Et rE Bt 1
ET rE BT 1
V0 B0
t
T 1
(1 rE )(1 rE )
t 1 (1 rE )
T 1
$0.50 $0.85
$1.00
V0 $20
1
2
1.10 1.10
(1 0.10 0.60)(1.10 2 )
$0.50 $0.85
$1.00
V0 $20
1
2
1.10 1.10
(0.50)(1.102 )
V0 $22.81
EXAMPLE: MULTISTAGE MODEL
USING THE P/B
Calculate the PV of continuing residual income using P/B
Use this to determine terminal value
Assume for the previous example
Book value in year 3 = $25.00
P/B is projected in year 3 as 1.10
The projected stock price in year 3:
$25 1.10 = $27.50
EXAMPLE: MULTISTAGE MODEL
USING THE P/B
Et rE Bt 1 PT BT
V0 B0
t
T
(1 rE )
t 1 (1 rE )
T
$0.50 $0.85 $1.00 $27.50 $25.00
V0 $20
1
2
3
1.10 1.10 1.10
1.103
V0 $23.79
RESIDUAL INCOME AND
DIVIDEND AND FCFE MODEL VALUATIONS
EXAMPLE: RESIDUAL INCOME AND
DIVIDEND MODELS
Example Assumptions
All earnings are paid out as dividends so
book value is constant
Earnings and dividends are constant
forever
Earnings per share
$1.00
Book value of equity
$7.00
Required return on equity
10%
EXAMPLE: RESIDUAL INCOME AND
DIVIDEND MODELS
Valuation Using a Constant Dividend Model
Assume a 100 percent dividend payout ratio
V0 D / r $1.00 / 0.10 $10.00
Valuation Using a Residual Income Model
V0 $7.00 $0.30 / 0.10
V0 $7.00 $3.00
V0 $10.00
RESIDUAL INCOME VS.
DIVIDEND AND FCFE MODELS
RESIDUAL INCOME MODEL
STRENGTHS AND WEAKNESSES
RESIDUAL INCOME MODEL
APPROPRIATENESS
CLEAN SURPLUS ACCOUNTING
ACCOUNTING ADJUSTMENTS FOR THE
RESIDUAL INCOME MODEL
Example
Adjustment to Financial Statement
Over several years, Firm A has
consistently recorded losses in its
available-for-sale securities
Adjust net income downward
Firm B consistently capitalizes
expenditures that should have been
expensed
Adjust net income and book value
downward
Firm C has recorded foreign currency
translation losses on its balance sheet
over several years; the losses are
expected to continue
Adjust net income downward
Firm D accelerates revenues to the
current period and defers expenses to
later periods
Adjust net income and book value
downward
SUMMARY
SUMMARY
