Residual Income Valuation

Calculate residual income

Residual income is net income less a charge for common shareholders' opportunity cost in generating the net income. Alternatively, residual income explicitly deducts the estimated cost of equity capital from net income. Residual Income = Net Income - (Equity Capital x Cost of Equity Capital %)

 Example: If a firm has earnings of $180,000 and has $1 million of capital split equally between debt and equity and the cost of equity capital is 12%, then the firm's residual income is: $180,000-($500,000 * 0.12) = $180,000 - $60,000 = $120,000.

Describe and calculate alternative measures of residual earnings (i.e., economic value added, market value added)
Economic Value Added (EVA) is a commercial application of the economic profit concept. EVA begins with net operating profit after tax (NOPAT) and deducts a similar capital charge. EP and EVA differ in that there are several common adjustments including: R&D expense, goodwill capitalization, deferred tax, inventory valuation and operating leases to arrive at the variables below: EVA = NOPAT - (Cost of Capital % x Total Capital)

 Market Value Added (MVA) is related to EVA. MVA evaluates a firm's ability, over time, to add positive EVA. Positive MVA is achieved should the market value exceed the accounting book value of its capital. MVA = Market value of a company - Total capital (book value) Example: Net operating profit after tax for sunrise Coffee Company is $200 million, their adjusted equity capital is $600 million and total capital is $1.2 billion. The cost of equity is 15% and the after tax cost of debt is 5%. Compute the EVA for Sunrise: EVA = NOPAT (Capital $ * Cost of Capital %) = $200 ($1200 *((15%+5%)/2) = $200 - $120 = $80.

Calculate future values of residual income, given current book value, consensus earnings growth estimates, and an assumed dividend payout ratio

RI model breaks intrinsic value of a stock into two components:

Current book value of equity Present value of expected future RI

Calculating Future RI continued

CSC RI Forecast
Current market price Book value per share Consensus annual EPS estimates $45.00 $17.00

January 2002 January 2003 Required return

Annualized DIV for 2002 and 2003

$2.30 $2.74 12%

$0.60

Calculating Future RI continued

2002 2003 $17.00 $18.70 2.30 2.74 0.60 0.60 18.70 2.04 $0.26 20.84 2.24 $0.50

Beginning book value (BV0) Earnings per share forecast (E) Dividend forecast (D) Forecast book value per share (BV0 + E D)
Equity charge per share (BV0 r) Per share RI (EForecast equity charge)

Calculate Intrinsic Value Using RI continued

An analyst has determined that Tallulah Energy has a required rate of return of 11% and has compiled the following information about the firm for the next three years. After 2005, the firm will cease doing business and will distribute a liquidating dividend.

Calculate Intrinsic Value Using RI continued

2003 Beg. book value per share (BV0) Earnings per share forecast (E) Dividends per share forecast (D) Forecast book value per share (BV0 + E D) Equity charge per share (BV0 r) Per share RI (EForecast equity charge) 1.30 0.60 7.20 0.72 2004 1.50 0.70 8.00 0.79 2005 $8.00 2.15 10.15 0.00 0.88 $1.27 $6.50 $7.20

$0.58 $0.71

Calculate Intrinsic Value Using RI continued

Using the RI methodology, the value of a share is:

$8.53 is also the discounted value of the dividends

In theory, RI is consistent with DCF

Discuss the strengths and weaknesses of the residual income model;

The strengths of the RI model include the following: Terminal values do not make up a large portion of the total present value, relative to other DCF models. Readily available accounting data. Model can be applied to companies that pay no dividends or have no near-term positive cash flow. Can be used when cash flows are unpredictable. Appealing focus on economic profitability as opposed to accounting figures.

 The weaknesses of the RI model include the following: Manipulation can still occur with the accounting data. Requires too many adjustments to the accounting data. The models require that the clean surplus relation holds, or that the analyst makes appropriate adjustments when the clean surplus relation does not hold. The clean surplus relation in accounting requires the condition that all changes in the book value of equity other than transactions with owners are reflected in income.

Justify the choice of the residual income model for equity valuation given characteristics of the company being valued; A residual income valuation model is most appropriate or suitable when A company pays no dividends, or the dividends are very small or not predictable. A company's expected free cash flow is negative. There is a high level of uncertainty in forecasting the terminal value in other DCF models.

 A residual income model is least appropriate or suitable when There are significant departures in the charges to book value and how they differ from transactions reflected in income; Significant determinants of residual income, such as book value and ROE, are not predictable.

Discuss the fundamental determinants or drivers of residual income

The residual income model makes no assumptions regarding future earnings and dividend growth. In order to derive the fundamental determinants of residual income, assume constant earnings and dividend growth (g),

 Fundamental determinants or drivers of residual income The higher the ROE relative to growth, the higher the residual income, all else constant. The lower the required rate of return, the greater the residual income intrinsic value. The higher the company's initial book value, the higher the residual income. The current book value captures a large portion of total value.

Explain the relationship between residual income valuation and the justified price to- book ratio based on forecasted fundamentals Recall, sustainable growth (g) = b x ROE or growth equals the retention ratio times return on equity, and that the justified price-to-book ratio based on fundamentals is P0/B0 = (ROE-g) /(r-g) Mathematically,

ROE g 1 ROE r r g rg

Discuss the major accounting issues in applying residual income models

Violations of clean surplus relationship

Foreign currency translation Certain pension adjustments Fair value changes of financial instruments

Accounting Issues in RI Models continued

Balance sheet adjustments for fair value
Inventory (LIFO to current value) Deferred tax assets and liabilities Pension assets and liabilities Operating leases Special purpose entities Reserves and allowances; bad debts Intangible assets

Accounting Issues in RI Models continued Intangible assets Nonrecurring items (RI should be based on recurring items only)
Unusual items Extraordinary items Restructuring charges Discontinued operations Accounting changes

Accounting Issues in RI Models continued Other aggressive accounting practices

Overstating assets or earnings Accelerate or defer expenses

International considerations
Reliable earnings forecasts Violation of clean surplus assumption Poor quality accounting rules

Define continuing residual income and list the common assumptions regarding continuing residual income
Continuing residual income is the residual income used as the terminal value. The terminal value is based on a continuing residual income model similar to those used in the DDM and DCF models. Unlike the DCF and DDM approaches, the terminal value is not a major driver of value in the residual income approach. In fact, as ROE reverts to an average approaching the cost of equity, the residual income tends to approach zero over time.

 There are several assumptions concerning continuing residual income: Residual income continues indefinitely at a positive level; Residual income is zero from the terminal year forward; Residual income declines to zero as ROE approaches the cost of equity over time; Residual income reflects the reversion of ROE to a mean value.

Persistence factor
0< persistence factor() < 1 Low continuing RI falls quickly lower valuation High continuing RI falls slowly higher valuation

Multistage RI Model
Expected ROE over 5 years = 15% for the next five years Beginning BV = $5.00 per share Required rate of return = 10% The firm pays no dividends Continuing RI = 0 after 5 years Assume all earnings are reinvested

Multistage RI Model
Expected ROE over 5 years = 15% for the next five years Beginning BV = $5.00 per share Required rate of return = 10% The firm pays no dividends Continuing RI = 0 after 5 years Assume all earnings are reinvested

Multistage RI Model continued

Yr EPS End. BV $5.00 5.75 6.61 7.60 8.74 10.05 ROE Equity Charge 0.15 0.15 0.15 0.15 0.15 $0.50 0.57 0.66 0.76 0.87 Residual Income PV of RI

0 1 $0.75 2 0.86 3 0.99 4 1.14 5 1.31

$0.25 0.23 0.29 0.24 0.33 0.25 0.38 0.26 0.44 0.27 PV(RI) = $1.25

Multistage RI Model continued

V0 = B0 + sum of discounted RIs + PV of continuing RI (PV of terminal value) = $5.00 + $1.25 + $0 = $6.25

Multistage RI Model continued

Suppose instead RI remains constant after year 5 at $0.44.

Multistage RI Model continued

Suppose instead continuing RI persistence factor is 0.40.

Multistage RI Model continued

Value Based Metrics

Similar to RI Gage economic profit rather than accounting profit Two major concepts
EVA CFROI

Calculate net operating profit after tax NOPAT),($WACC),(EVA) EVA = NOPAT $WACC NOPAT = EBIT x (1 t) = [sales COGS SGA depr] x (1 t) $WACC = WACC x invested capital WACC = [Rd x Wd* x (1 t)] + [Re x We* ] Invested capital = Net WC + PP&E = long-term debt + stockholder equity

Calculating EVA: An Example

EBIT = $100 Tax rate = 40% Rd = 8% (pre-tax) Re = 14% We* = 70% Invested capital = $1,000 Compute EVA

Step 1: Compute NOPAT, WACC, and $WACC

NOPAT = EBIT x (1 t) NOPAT = 100 x (1 0.4) = $60 WACC = (8% x 0.3 x 0.6) + (14% x 0.7) = 11.24% $WACC = WACC x invested capital = 0.1124 x 1,000 = $112.40

Calculate and Interpret EVA

EVA = NOPAT $WACC = $60 $112.40 = $52.40 EVA is negative; hence, management did not earn enough NOPAT to cover the capital charge ($WACC) Management has destroyed value

Differentiate between accounting profitability as measured by ROE and economic profitability as measured by EVA

Accounting profit does not include any recognition of the cost of equity capital committed to the enterprise Accounting income overstates profitability EVA explicitly recognizes the cost of capital

Explain the significance of a positive or negative EVA

EVA measures whether or not management has added value in the current period Positive EVA: management has added value to the invested capital Negative EVA: management has destroyed value EVA spread = [EVA/capital] WACC Positive spread = value added

Describe methods for increasing EVA

Increase revenue Reduce operating expenses Use less capital (increase asset efficiency) Exploit positive NPV projects Reduce WACC

CFROI
IRR-type calculation If CFROI > WACC, management is adding value LOS says to describe process

Describe the process for determining cash flow return on investment (CFROI);

Step 1: Compute average life of assets

Gross depreciable assets / depr. exp

Step 2: Compute gross CF

NI adjusted for non-cash exp and financing exp (i.e., interest)

Step 3: Compute gross investment

Gross PP&E + PV op lease + goodwill + acc. goodwill amortization

Process for Calculating CFROI continued Step 4: Compute sum of non-depreciating assets (land, WC, etc) Step 5: Compute CFROI (like and IRR)
PV is gross investment FV is non-depreciating assets PMT is gross cash flow N is average life Solve for I/Y (interpret like IRR)

Explain why the spread between CFROI and WACC is similar to the concept of EVA spread EVA spread = [NOPAT/capital] WACC CFROI spread = CFROI WACC Both gauge whether management is providing returns greater than the required return