RESIDUAL INCOME VALUATION:

VALUING COMMON EQUITY

Presenter
Venue
Date
 RESIDUAL INCOME

Economic
Profit

Abnormal Residual
Earnings
Income

Economic
Value
Added
 RESIDUAL INCOME

Net Equity Residual

Income Charge Income

Capital Residual
NOPAT
Charge Income
 EXAMPLE: RESIDUAL INCOME

Total assets $5,000,000.00

Debt-to-total capital ratio 0 .60

Cost of debt (before tax) 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 $2,000,000

Equity charge $240,000

Net income $96,000

Less equity charge $240,000
Residual income -$144,000
 RELATED MEASURES

Economic
Value
NOPAT C% TC
Added
(EVA)

- NOPAT = Net operating profit after taxes

- C% = Cost of capital
- TC = Total capital

Market Market Book

Value Value of Value of
Added the Firm Total
(MVA) Capital
 USES OF RESIDUAL INCOME

Valuation

Measuring Goodwill Impairment

Measuring Internal Corporate

Performance

Determining Executive Compensation

 FORECASTING RESIDUAL INCOME

RIt Et re Bt 1

Beginning
Residual Earnings Required book
income per share return on value per
per share (EPS) equity (Re) share
(BVPS)
EXAMPLE: FORECASTING RESIDUAL INCOME

0 1 2

Earnings $2.50 $3.00

Dividends $1.00 $1.10

Book value $20.00

Required equity return 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 1 (1 r )
t

Et rBt 1
V0 B0
t 1 (1 r )
t
 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%

Additionally, Assume:
Residual income in Year 3 = $1.00
The firm ceases operations in three years
 EXAMPLE:
VALUATION USING RESIDUAL INCOME

$0.50 $0.85 $1.00

V0 $20 1
2
3
1.10 1.10 1.10
V0 $20 $1.91
V0 $21.91
DETERMINANTS OF RESIDUAL INCOME

RIt ROEt 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 Extreme ROE

payout Extreme levels
Historically high of special items
industry ROEs Extreme
accounting
accruals
 VALUING CONTINUING RESIDUAL INCOME

Et rE Bt 1
T 1
Et rE BT 1
V0 B0 T 1
t 1 (1 rE ) (1 rE )(1 rE )
t

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%
Value was $21.91

Now Assume:
The firm continues operations after three years
 EXAMPLE: MULTISTAGE MODEL
CASE 1: = 0

Et rE Bt 1
T 1
ET rE BT 1
V0 B0 T 1
t 1 (1 rE ) t
(1 rE )(1 rE )
$0.50 $0.85 $1.00
V0 $20
1.10 1.10 (1 0.10 0)(1.10 )
1 2 2

$0.50 $0.85 $1.00

V0 $20 1
2
2
1.10 1.10 (1.10)(1.10 )
V0 $21.91
 EXAMPLE: MULTISTAGE MODEL
CASE 2: = 1.0

Et rE Bt 1
T 1
ET rE BT 1
V0 B0 T 1
t 1 (1 rE ) t
(1 rE )(1 rE )
$0.50 $0.85 $1.00
V0 $20
1
1.10 1.10 2
(1 0.10 1.0)(1.102 )
$0.50 $0.85 $1.00
V0 $20 1
2

1.10 1.10 (0.10)(1.102 )
V0 $29.42
 EXAMPLE: MULTISTAGE MODEL
CASE 3: = 0.60

Et rE Bt 1
T 1
ET rE BT 1
V0 B0 T 1
t 1 (1 rE ) (1 rE )(1 rE )
t

$0.50 $0.85 $1.00

V0 $20
1.10 1.10 (1 0.10 0.60)(1.10 )
1 2 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

T
Et rE Bt 1 PT BT
V0 B0
t 1 (1 rE ) (1 rE )
t T

$0.50 $0.85 $1.00 $27.50 $25.00

V0 $20 1
2
3
3
1.10 1.10 1.10 1.10
V0 $23.79
 RESIDUAL INCOME AND
DIVIDEND AND FCFE MODEL VALUATIONS

Dividend and
Residual Income
FCFE Model
Model Valuation
Valuations
Required return
on equity Required return
on equity
Book value + PV
(residual income) PV (equity cash
flows)
 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% 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 Dividend and FCFE

Model Valuation Model Valuations

Value =
Value =
PV (Early cash
Book value + PV
flows + Terminal
(residual income)
value)

Large weight on Large weight on

current book value later cash flows
 RESIDUAL INCOME MODEL
STRENGTHS AND WEAKNESSES

Strengths Weaknesses

Puts less weight on the terminal Relies on accounting data

value May require adjustments to
Uses available accounting data accounting data
Is useful for non-dividend-paying Relies on clean surplus relation
firms Assumes that Cost of debt =
Is useful for firms without free Interest expense
cash flows
Is useful when cash flows are
unpredictable
Is based on economic value
 RESIDUAL INCOME MODEL
APPROPRIATENESS

Most Appropriate
At non-dividend-paying firms
At firms without free cash flows
When terminal values are highly uncertain

Least Appropriate
When the clean surplus relationship does not hold
When the determinants of residual income are not
predictable
 CLEAN SURPLUS ACCOUNTING

Beginning Ending
book Net book
Dividends
value of income value of
equity equity
 ACCOUNTING ADJUSTMENTS FOR THE
RESIDUAL INCOME MODEL
Example Adjustment to Financial Statement
Over several years, Firm A has Adjust net income downward
consistently recorded losses in its
available-for-sale securities
Firm B consistently capitalizes Adjust net income and book value
expenditures that should have been downward
expensed
Firm C has recorded foreign currency Adjust net income downward
translation losses on its balance sheet
over several years; the losses are
expected to continue
Firm D accelerates revenues to the Adjust net income and book value
current period and defers expenses to downward
later periods
 SUMMARY

Residual Income = Income Leftover after All Capital

Charges
= Net income (Equity required return Book value)
= (ROE Equity required return) Book value
Related to EVA and MVA

Equity Value = Book Value + PV (Residual Income)

Can be used with single-stage and multistage models

Can be specified with a persistence factor
Firms with stronger market positions will have greater
persistence factors
 SUMMARY

Relative to Other Valuation Models

Useful when a firm does not have dividends or

free cash flow
Puts less emphasis on later cash flows

Use of Accounting Data

Assumes clean surplus relation holds

May require adjustments to accounting data