Residual Income Valuation: Valuing Common Equity

1. Residual Income Valuation:Valuing Common Equity Presenter Venue Date

2. Residual Income

3. Residual Income

4. Example: Residual Income

5. Example: Residual Income

6. Example: Residual Income

7. Related Measures • NOPAT = Net operating profit after taxes • C% = Cost of capital • TC = Total capital

8. Uses of Residual Income

9. Forecasting Residual Income

10. Example: Forecasting Residual Income

11. Example: Forecasting Residual Incomein 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

12. Example: Forecasting Residual Incomein 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

13. Valuing Common Stock Using Residual Income

14. 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

15. Example: Valuation Using Residual Income

16. Determinants of Residual Income

17. Residual Income Valuation and the P/B

18. Example: Using a Single-Stage Residual Income Model

19. Example: Using a Single-Stage Residual Income Model

20. 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?

21. Continuing Residual Income

22. Continuing Residual Income and Persistence Factors

23. Valuing Continuing Residual Income Persistence Factor (ω) • 0 ≤ ω ≤ 1 • ω = 1  Residual income will not fade • ω = 0  Residual income will not persist after the initial forecast to rise • ω = 0.62  It has been observed, on average, empirically

24. 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

25. Example: Multistage ModelCase 1:  = 0

26. Example: Multistage ModelCase 2:  = 1.0

27. Example: Multistage ModelCase 3:  = 0.60

28. Example: Multistage ModelUsing 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

29. Example: Multistage ModelUsing the P/B

30. Residual Income andDividend and FCFE Model Valuations

31. Example: Residual Income andDividend Models

32. Example: Residual Income andDividend Models Valuation Using a Constant Dividend Model Assume a 100 percent dividend payout ratio Valuation Using a Residual Income Model

33. Residual Income vs.Dividend and FCFE Models

34. Residual Income Model Strengths and Weaknesses

35. Residual Income ModelAppropriateness

36. Clean Surplus Accounting

37. Accounting Adjustments for theResidual Income Model

38. Summary

39. Summary