RESIDUAL INCOME VALUATION:

Transcription

1 RESIDUAL INCOME ALUATION: ALUING COMMON EQUITY RESIDUAL INCOME Economic Profi Presener enue Dae Abnormal Earnings Residual Income Economic alue Added RESIDUAL INCOME EXAMPLE: RESIDUAL INCOME Ne Equiy Residual Income Charge Income Toal asses $5,,. EBIT $4,. Deb o oal capial raio.6 Cos of deb (before ax) 8% NOPAT Capial Charge Residual Income Cos of equiy 12% Tax rae 4%

2 EXAMPLE: RESIDUAL INCOME EXAMPLE: RESIDUAL INCOME EBIT $4, Less ineres Expense $24, Preax income $16, Less income ax expense $64, Ne income $96, Equiy capial $2,, Equiy charge $24, Ne income $96, Less equiy charge $24, Residual income $144, RELATED MEASURES S USES S OF RESIDUAL INCOME Economic l alue Added (EA ) NOPAT C% TC aluaion - NOPAT = Ne operaing profi afer axes - C% = Cos of capial Measuring Goodwill Impairmen Marke alue Added d (MA) - TC = Toal capial Marke alue of he Firm Book alue of Tl Toal Capial Measuring Inernal Corporae Performance Deermining Execuive Compensaion

3 FORECASTING RESIDUAL INCOME RI E rb 1 e EXAMPLE: FORECASTING RESIDUAL INCOME 1 2 Earnings $2.5 $3. Residual income per share Earnings per share (EPS) Required reurn on equiy (Re) Beginning book value per share (BPS) Dividends $1. $1.1 1 Book value $2. Required equiy reurn 1% EXAMPLE: FORECASTING RESIDUAL INCOME IN ONE YEAR Charge for Equiy Capial = Required reurn on equiy Beginning book value per share 1% $2. = $2. Residual Income in Year 1 = EPS Charge for equiy capial $2.5 $2. = $.5 EXAMPLE: FORECASTING RESIDUAL INCOME IN TWO YEARS End-of-Year Book alue for Year 1 = Beginning-of-year book value + Earnings Dividends $2. + $2.5 $1. = $21.5 Beginning book value for year 2 Charge for Equiy Capial in Year 2 = Required reurn on equiy Beginning book value per share 1% $21.5 = $2.15 Residual Income in Year 2 = $3. $2.15 = $.85

4 ALUING COMMON STOCK USING RESIDUAL INCOME RI 1 (1 r) E rb 1 1 (1 r) B B EXAMPLE: ALUATION USING RESIDUAL INCOME From he Previous Example: Beginning book value a ime = $2. Residual income in year 1 = $.5 Residual income in year 2 = $.85 Required reurn on equiy = 1 percen Addiionally, Assume: Residual income in year 3 = $1. The firm ceases operaions in hree years EXAMPLE: ALUATION USING RESIDUAL INCOME $.5 $.85 $1. $ $2 $1.91 $21.91 DETERMINANTS SOF RESIDUAL INCOME r B 1 RI ROE ROE > r RI > > B ROE < r RI < < B

5 RESIDUAL INCOME ALUATION AND THE P/B EXAMPLE: USING A SINGLE-STAGE RESIDUAL INCOME MODEL ROE r B r g B ROE r 1 B r g Book value of equiy yp per share $3. Reurn on equiy 18% Required reurn on equiy 12% Residual income growh rae 8% EXAMPLE: USING A SINGLE-STAGE RESIDUAL INCOME MODEL ROE r B B r g $3 $ $1.8 $3 $ EXAMPLE: USING A SINGLE-STAGE RESIDUAL INCOME MODEL Suppose ha he curren sock price is $8 in he previous example. Wha is he implied growh rae? $8 $3 $3.12 g $5 g $ g 8.4%

6 CONTINUING RESIDUAL INCOME CONTINUING RESIDUAL INCOME AND PERSISTENCE FACTORS = Long-Term Residual Income Poenial Scenarios: RI is consan forever RI is zero a he erminal period RI gradually declines o zero where ROE = r RI gradually declines o a consan level where ROE > r High Persisence Low dividend payou Hisorically high indusry ROEs Low Persisence Exreme ROE Exreme levels l of special iems Exreme accouning accruals ALUING CONTINUING RESIDUAL INCOME T 1 E r E B 1 E r E B T 1 B T1 1 (1 re) (1 re )(1 re) Persisence Facor (ω) ω 1 ω =1 Residual income will no fade ω = Residual income will no persis afer he iniial forecas o rise ω =.62 I has been observed, on average, empirically EXAMPLE: MULTISTAGE RESIDUAL INCOME MODEL From he Firs aluaion Example: Beginning book value a ime = $2. Residual income in year 1 = $.5 Residual income in year 2 = $.85 Residual income in year 3 = $1. Required reurn on equiy = 1 percen alue was $21.91 Now Assume: The firm coninues operaions afer hree years

7 EXAMPLE: MULTISTAGE MODEL CASE 1: = E r B E r B 1 E B 1 E B 1 T E T E T B T1 1 (1 re) (1 re )(1 re) $2 $.5 $.85 $ (1.1 1 )(1.1 )(11 ) $.5 $.85 $1. $ (1.1)(1.1 ) $ $21.91 EXAMPLE: MULTISTAGE MODEL CASE 2: = 1. E rb E rb T E T E T B T1 1 (1 r E) (1 r E )(1 r E ) $2 $.5 $.85 $ (1.1 1.)(1.1 1 ) $.5 $.85 $1. $ (.1)(1.1 ) $29.42 EXAMPLE: MULTISTAGE MODEL CASE 3: =.6 E rb E r B T E T E T B T1 1 (1 r E ) (1 r E )(1 r E) $.5 $.85 $1. $ (1.1.6)(1.1 1 ) $.5 $.85 $1. $ (.5)(1.1 ) $22.81 EXAMPLE: MULTISTAGE MODEL USING THE P/B Calculae he P of coninuing residual income using P/B Use his o deermine erminal value Assume for he previous example Book value in year 3 = $25. P/B is projeced in year 3 as 1.1 The projeced sock price in year 3: $ = $27.5

8 EXAMPLE: MULTISTAGE MODEL USING THE P/B RESIDUAL INCOME AND DIIDEND AND FCFE MODEL ALUATIONS E r B P B 1 T E T T B T 1 (1 re) (1 re) $.5 $.85 $1. $27.5 $25. $ $23.79 Residual Income Model aluaion Required reurn on equiy Book value + P (residual income) Dividend and FCFE Model aluaions Required reurn on equiy P (equiy cash flows) EXAMPLE: RESIDUAL INCOME AND DIIDEND MODELS Example Assumpions All earnings are paid ou as dividends so book value is consan Earnings and dividends are consan forever Earnings per share $1. Book value of equiy $7. Required reurn on equiy 1% EXAMPLE: RESIDUAL INCOME AND DIIDEND MODELS aluaion Using a Consan Dividend Model Assume a 1 percen dividend payou raio D / r $1/1 $1..1 $1. $1 aluaion Using a Residual Income Model $7. $.3 /.1 $7. $3. $1.

9 RESIDUAL INCOME S. DIIDEND AND FCFE MODELS RESIDUAL INCOME MODEL STRENGTHS AND WEAKNESSES Residual Income Model aluaion Dividend and FCFE Model aluaions Srenghs Weaknesses alue = Book value + P (residual income) Large weigh on curren book value alue = P (Early cash flows + Terminal value) Large weigh on laer cash flows Pus less weigh on he erminal value Uses available accouning daa Is useful for non-dividend-paying firms Is useful for firms wihou free cash flows Is useful when cash flows are unpredicable Is based on economic value Relies on accouning daa May require adjusmens o accouning daa Relies on clean surplus relaion Assumes ha Cos of deb = Ineres expense RESIDUAL INCOME MODEL APPROPRIATENESS CLEAN SURPLUS ACCOUNTING Mos Appropriae A non-dividend-paying firms A firms wihou free cash flows When erminal values are highly uncerain Leas Appropriae When he clean surplus relaionship does no hold When he deerminans of residual income are no predicable Beginning i Ending book Ne book Dividends value of income value of equiy equiy

10 ACCOUNTING ADJUSTMENTS FOR THE RESIDUAL INCOME MODEL SUMMARY Example Over several years, Firm A has consisenly recorded losses in is available-for-sale securiies Firm B consisenly capializes expendiures ha should have been expensed Firm C has recorded foreign currency ranslaion losses on is balance shee over several years; he losses are expeced o coninue Firm D acceleraes revenues o he curren period and defers expenses o laer periods Adjusmen o Financial Saemen Adjus ne income downward Adjus ne income and book value downward Adjus ne income downward Adjus ne income and book value downward Residual Income = Income Lefover afer All Capial Charges = Ne income (Equiy required reurn Book value) = (ROE Equiy required reurn) Book value Relaed o EA and MA Equiy alue = Book alue + P (Residual Income) Can be used wih single-sage and mulisage models Can be specified wih a persisence facor Firms wih sronger marke posiions will have greaer persisence facors SUMMARY Relaive o Oher aluaion Models Is useful when firm does no have dividends or free cash flow Pus less emphasis on laer cash flows Use of faccouning Daa Assumes clean surplus relaion holds May require adjusmens o accouning daa