Transcript Valuation: Principles and Practice: Part 3– Residual Income Valuation 03/10/08

Valuation: Principles and
Practice: Part 3– Residual
Income Valuation
03/10/08
Ch. 12
Basis for RI valuation
 The appeal of the residual income (RI) model
is based on the fact that traditional
accounting does not include a “charge” for
equity capital.
 Specifically, a company may generate a
positive net income but may not be adding
value to its shareholders if it does not earn
more than the cost of equity.
Basis for RI valuation
 RI is sometimes referred to as the economic
profit earned by firms.
 One example of a residual income model is
referred to as the Economic Value Added
(EVA) model.
Strengths of the RI model
 Terminal value does not make up a large
portion of the total value
 The model can be used for companies that
do not pay dividends and/or firms that have
near-term negative free cash flows
 The model can be used when cash flows are
unpredictable or difficult to forecast. This can
be particularly true for financial institutions.
Weaknesses of the RI model
 The model relies on accounting data that can
be subject to manipulation
 When book value and ROE are
unpredictable, the resulting estimate is less
valid.
The RI valuation model
 The RI model analyzes the intrinsic value of
equity into two components:


The current book value of equity, plus
The present value of expected future residual
income
The RI valuation model
 The intrinsic value of common stock can be
expressed as:
t 
RI t
Et  re * Bt 1
V0  Value/shar e of Equity = B0  
 B0  
t
t
(
1
+r
)
(
1

r
)
t =1
t 1
e
e
t =
where
B0 = current book value of equity per share
Bt = expected per-share book value at period t
Et = expected EPS for period t
RIt = expected residual income per share for period t
The RI valuation model
 In the model book value each period is determined
by the following clean surplus relation:
Bt = Bt -1  E t - D t
 The model also assumes that the growth in book
value comes by the firm earning more than the
cost of equity (ROE > re). The numerator of the
second term can therefore be defined as:
E t - re * B t -1 = (ROE - re ) * B t -1
Single-stage RI valuation
 If we assume that the firm’s book value (and RI per
share) will grow at a constant rate, g, forever, we
can value a firm using a single-stage RI model:
ROE  re
V0  B0 
* B0
re  g
Multi-stage RI valuation
 If the assumption of constant growth is not appropriate, which
may be particularly true if the firm currently generates a high
ROE relative to the cost of equity, we can model the firm using
two stages.
 During the first stage we calculate present values of residual
incomes individually.
 In the second (terminal) stage we make one of the following
assumptions about continuing residual income:
 Residual income remains constant through perpetuity (and
ROE > re) from the terminal year forward
 Residual income is zero from the terminal year forward
(ROE = re)
Multi-stage RI valuation
 We can calculate the value today using a multi-
stage model using the following formula
T
V0  B0  
t 1
( ROE t  re ) * Bt 1 Terminal Value

t
(1  re )
(1  re )T
 If RI is expected to be constant through perpetuity
from terminal year forward, terminal value = RIT / re
 If RI is expected to be zero from terminal year
forward, terminal value = 0