Residual Income Model

 The Residual Income Model (RIM) represents a

Residual Income firm value based on accounting earnings.
 It is an algebraic transformation of the dividend
Model discount model. But this representation reflects
value creation rather than value distribution.
 One assumption: the accounting system satisfies
“clean surplus relation”.

Clean Surplus Relation Example

 The clean surplus relation is Common
stock
APIC Retained
earnings
Treasury
stock
Total

BVt = BVt-1 + Inct – Divt Balance at December 31, 2013 96,047 177,647 605,928 -86 879,536

where Stock dividends 46,325 - -46,325 - -

BVt = Book Value at end of period t Issuance of common and treasury stock 384 9,846 - 86 10,316
upon exercise of executive stock options
Inct = Reported net income of period t
Cash dividends, $0.03867 per share - - -5,376 - -5,376
Divt = Period t Dividends (as defined in DDM)
Net Income-2014 - - 169,543 - 169,543

 If Inc is comprehensive income, the relation holds Balance at December 31, 2014 142,756 187,493 723,770 - 1,054,019

true automatically. But if Inc is net income, the

BV14 = BV13 + Inc14 – Div14
relation may or may not hold.
1,054,019 = 879,536 + 169,543 – (5,376 – 10,316)
 Clean Surplus Relation Residual Income Model
 If there is no item in other comprehensive incomes, net
 Solving for Dividends,
income from income statement is the only income
Divt = BVt-1 + Inct – BVt
affecting the equity section. In that case, the clean surplus
is satisfied.  Substituting this expression for Divt into the Dividend
 When the clean surplus relation is violated, we need to Discount Model yields:
redefine income as comprehensive income to restore the
relation. Div1 Div2 Div3
V0     ...
 However, there still could be hidden dirty surplus, due to (1  r ) (1  r ) (1  r ) 3
1 2

accounting loopholes (mainly stock option grants).

BV0  Inc1  BV1 BV1  Inc 2  BV2
   ...
(1  r )1 (1  r ) 2

Residual Income Model Residual Income Model

 Rearranging the expressions yields:  So that in a compact form,

Inct  rBVt 1

(Inc1  rBV0 )  (1 r)BV0  BV1
V0 
(1 r)1 V0  BV0 
t 1 (1  r )t
(Inc2  rBV1)  (1 r)BV1  BV2
  ...
(1 r)2
 Value = Book value + Future Residual Incomes
Inc1  rBV0 Inc2  rBV1 BV2 = Anchor + Premium
V0  BV0     ...
(1 r)1 (1 r)2 (1 r)2
 Residual Income at period t Residual Income at period t
 Let’s define return on equity (ROE or ROCE) as
(Income/ beg. BV). Then when we divide residual
Re sInc t  Inc t  r  BVt 1
 required  income by beginning book value, we get
income beginning
rate of ResInct/BVt-1 = ROE – r
return book
value

   so that ResInc > 0 when ROE > r
cost of capital
   ResInc < 0 when ROE < r
abnormal earnings
where r is the cost of equity capital.

Residual Income Model EVA and ResInc

 The RIM “works” for any set of accounting rules.  EVA™ = NOPAT – (wacc x total capital)
where NOPAT =after-tax operating income
 If based on consistent forecasts, the DDM and RIM wacc = weighted average cost of capital
will produce identical estimates of value (V0). total capital = equity + LT debts
However insuring consistent forecasts can be very  EVA™ is a variation of the residual income.
difficult.
 A difference: EVA is based on capital provider
(creditors & shareholders) perspective while RIM is
based on shareholder perspective.
 EVA and RIM EVA and RIM
 MVA™ = MV of firm – Capital  If plug (2) into (1),

where MV of firm = market value of equity & LT debts EVA t
MVE = BVE +  (3)
Capital = shareholder equity + LT debts t 1 (1  wacc) t
 If book value of debts = market value of debts, then
MVA = MVE – BVE (1)  If there is no debt, you can find that (3) becomes
RIM.
 In ideal circumstances, there should be the following
link:

EVA t
MVA =  (2)
t 1 (1  wacc)
t

Using the Residual Income Model Using the Residual Income Model
 The actual application of the RIM is similar to the  Residual Income Valuation Model
use of DDM. We first divide the future into t T
E t  r ( BVt 1 )  1  ResInc (1  g )

T
V0  BV0  

r
-
g
 
• a finite forecasting period of T periods and t 1 (1  r ) t  (1  r )
T

• an infinite period beyond the Tth period.
where V0 = value at time zero
 Then we forecast earnings and book value for the BV0 = book value at time zero
finite forecasting period, and then project residual Et = expected earnings for period t
income into the infinite future beyond. r = cost of capital
ResIncT = residual income at time T
g = growth rate for residual income
Using the Residual Income Model Example
 Suppose investors have invested $10,000 in common
 Residual income depends on beginning period equity in a company. Given the risk of the company,
book value of equity, which depends on the payout the investors expect to earn a 12% return. Suppose
ratio: investors expect the firm will earn net income of
Payout ratio (PO) = Dividend/ Net Income $1,000 in year 1, $2,000 in year 2, $1,500 in year 3,
 Therefore, and $1,200 each year thereafter and they expect the
BVt = BVt-1 + Inct – Divt = BVt-1 + (1 – PO)Inct company to pay out 100% of income in dividends
each year. Calculate the firm value.

Example Special Case

$1,000  (0.12 x $10,000) $2,000  (0.12 x $10,000)  Constant ResInc growth starting at t=0,
V0  $10,000  
(1.12) (1.12) 2
$1,500  (0.12 x $10,000) $1,200  (0.12 x $10,000) ResInc1 ResInc 0 (1  g )

r
-
g

r
-
g
 3
 V0  BV0   BV0 
(1.12) t 4 (1.12) t

= $10,000 – $178 + $638 + $214 + 0

 We will use this formula later repeatedly. So
please memorize this!
 Exercise No Growth Firm
 Let’s apply the RIM to valuation of BUD.  Assume the following
 Data (in million): • Expected net income for the year ended 2015.12.31 equals
the actual net income for the year ended 2014.12.31.
• Book value of equity on 2014.12.31 = $49,972 • Expected residual income for all years beyond 2015.12.31
• Net income for year ended 2014.12.31 = $4,465 (we will will be the same as for the year ended 2014.12.31.
use NI instead of CI.)
• Dividends for year ended 2014.12.31 = $4,858
• Shares outstanding on 2014.12.31 = 1,634
• Estimated cost of equity capital (r) = 7%

Exercise Constant Growth Firm

 Assume the following
$4,465  (0.07 x $49,972) • Expected net income for the year ended 2015.12.31 will be
V2014.12.31  $49,972 
(0.07) 3% greater than actual net income for the year ended
2014.12.31.
= $63,785.7 • Residual income for all years beyond 2015.12.31 is
expected to grow at a rate of 3% per year.
P2014.12.31 = Estimated per share value on 2014.12.31
= $39.03
 Exercise Using Analyst Forecasts
 Assume the following
$4,465 x 1.03  (0.07 x $49,972) • Analysts have forecasted annual earnings per share of
V2014.12.31  $49,972 
(0.07  0.03) $4.54 for 2015 and $4.80 for 2016.
= $77,494.7
• A dividend payout ratio of 46%.
Resid2015
• Cost of capital is 7%.
P2014.12.31 = Estimated per share value on 2014.12.31 • Residual income (not net income) is expected to grow at
a rate of 3% for years ending Dec 2016 and beyond.
= $47.42

Exercise Anheuser Busch InBev (BUD, 14)

Compute estimated per share value on 2014.12.31.  Now let’s compare these price estimates with its
undistributed
4.54 x1,634  (0.07 x49,972) actual stock price on 2014.12.31 :
V2014.12.31  $49,972  income2015
1.07 • No growth value $39.42
4.80 x 1,634  (0.07 x (49,972  0.54x4.54x1,634)) • Constant growth value $47.42

(1.07) 2
• Analysts’ forecasts value $86.53
{4.80 x 1,634  (0.07 x (49,972  0.54x4.54x1,634))} x 1.03
 • Market price on 2014.12.31 $ 112.32
(0.07  0.03)(1.07) 2

= $141,381.9

P2014.12.31 = $86.53
 Advantage of RIM Empirical Evidence
 RI is a value creation measures (built on Inc and BV). So  Penman (2002) estimated a firm value with 5 year real
interpretation is intuitive. This allows us to avoid dividends earnings and cash flows in the past and calculated valuation
irrelevancy. error, that is, (real price – estimated value) / real price.
 Analysts forecast earnings. Those forecasts can be readily  That exercise was done for each portfolio of firms. So he
incorporated into the model. In contrast, there is no dividend could report the average valuation errors for each portfolio.
or cash flows forecast.
 It still can’t escape from the forecast horizon problem.
However, in an industry where there is no entry barrier and
customer’s switch cost is low, competition will drive residual
income down to zero. In this situation, terminal value may be
assumed to be zero.

Valuation error (price – est.) / price

Portfolio FCF/Price DCF RIM 2.50

1 -1.85 1.98 0.07 2.00 Valuation error:

2 -0.50 2.12 0.11
3 -0.31 1.60 0.22 1.50

4 -0.21 1.45 0.21 1.00

5 -0.15 1.13 0.27
0.50
6 -0.10 1.12 0.19
7 -0.07 1.29 0.16 0.00
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
8 -0.04 0.99 0.20 -0.50
9 -0.01 0.91 0.28
10 0.00 0.61 0.25 -1.00
3.00
11 0.01 -0.07 0.18 FCF/price 2.50
12 0.03 0.59 0.13 2.00 Portfolio classified by FCF/price
13 0.04 0.38 0.12 1.50

14 0.06 -0.08 -0.06 1.00

15 0.09 -0.21 -0.09 0.50

0.00
16 0.12 0.02 -0.11 -0.50
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
17 0.18 0.41 -0.11 -1.00
18 0.27 -0.42 -0.15 -1.50
19 0.40 0.30 -0.23 -2.00

20 2.69 2.24 -0.07 -2.50