RESIDUAL INCOME VALUATION I. PRINCIPLES A. Conceptually, residual income is 1.

Shareholder cash flow less a charge for the cost of shareholder capital (rE), or 2. Firm cash flow less a charge for the cost of firm capital (using ACC) !. Although "et #ncome includes a charge for de$t capital (i.e., interest e%pense), it does not include a charge for e&uity capital 1. 'esidual income ma(es a deduction for this missing charge C. Conceptually, residual income models )iew the intrinsic )alue of a firm as the initial $oo( (i.e., in)ested capital) plus the present )alue of residual income (i.e., )alue created) *. E%ample +,1 (p.2-.) 1. /sing Equity Capital Approach a. 'esidual #ncome 0 "# 1 E&uity Charge $. 'esidual #ncome 0 "# 1 E&uity Capital % rE(2) c. 'esidual #ncome 0 ('3E 1 rE) % E&uity Capital i. '3E 0 'eturn on E&uity ii. '3E 0 "#4E&uity Capital iii. 'esidual #ncome 0 ('3E 1 rE) % E&uity Capital 2. /sing Inv !t " Capital Approach a. 'esidual #ncome 0 E!#5(1 1 5) 1 #n)ested Capital Charge $. 'esidual #ncome 0 "36A5 1 #n)ested Capital Charge c. 'esidual #ncome 0 "36A5 1 #n)ested Capital % ACC(2) i. "36A5 0 "et 3perating 6rofit After 5a% ii. '3#C 0 'eturn on #n)ested Capital iii. '3#C 0 "36A54#n)ested Capital d. 'esidual #ncome 0 ('3#C 1 ACC) % #n)ested Capital .. 5hese simple e%pressions show )ery clearly what creates and destroys )alue in a company in general terms. E. 'eferences 1. The Quest for Value $y 7. !ennett Stewart, ### (8arper !usiness, 9 1::1. a. 8e introduces Econo#ic Valu A"" " (EVA), a $rand name for residual income. 2. Valuation: Measuring and Managing the Value of Companies , .rd edition $y Copeland, ;oller and <urrin ( iley 9 2===) a. Similar to Stewart>s $oo(, $ut perhaps a $it more tracta$le

II. USIN$ RESIDUAL INCOME %OR VALUATION F. Equity Capital Approach. Conceptually, residual income models )iew the intrinsic )alue of a firm>s e&uity as the initial $oo( (i.e., in)ested e&uity capital) plus the present )alue of future residual income (i.e., )alue created), or

V E = Bo +
t =1

RI t (1 + rE ) t Et rE Bt 1 (1 + rE ) t ROE t rE Bt 1 (1 + rE ) t

V E = Bo +
t =1

V E = Bo +
t =1

1. Can $e implemented using either an aggregate or per share approach 7. Equity Capital Approach. Alternati)ely, one can )alue the intrinsic )alue of the entire firm as the initial $oo( (i.e., in)ested capital) plus the present )alue of future residual income (i.e., )alue created), or
V F = Bo +
t =1

RI t (1 + WACC ) t NOPATt WACCxBt 1 (1 + WACC ) t ROIC t WACC Bt 1 (1 + WACC ) t

V F = Bo +
t =1

V F = Bo +
t =1

1. 3ne would then deduct the outstanding de$t to arri)e at e&uity )alue. 8. #n the E?A )ernacular, the )alue of a firm>s e&uity is the #n)ested E&uity Capital plus the present )alue of all future E?A, or V E = EquityCapital o +
t =1

EVAt (1 + rE ) t Et rE EquityCapital t 1 (1 + rE ) t ROEt rE EquityCapital t 1 (1 + rE ) t

V E = EquityCapital o +
t =1

V E = EquityCapital o +
t =1

#. E%ample +,. (p.2-@), E%ample +,+ (p.2@2) A. E%ample +,B (p.2-C) ;. E%ample +,- (p.2@.) 1 using #.*.1.c a$o)e 2

III. ADVANTA$ES AND DISADVANTA$ES O% RESIDUAL INCOME MODELS D. Ad)antages 1. 5erminal )alue is a relati)ely smaller portion of present )alue 2. /ses readily a)aila$le accounting data .. Applies to di)idend and non,di)idend paying companies B. Can $e used when cash flows are unpredicta$le +. Focuses on economic )alue <. *isad)antages 1. /ses readily a)aila$le accounting data (e.g., accounting manipulations) 2. Accounting data may need to $e adEusted for distortions. (See $elow) .. 5he model re&uires that the clean surplus relation holds (i.e., changes in $oo( )alue e&uals "# less di)idendsF that is, all changes to $oo( )alue other than ownership transactions flow through earnings). ". 5herefore, the model is useful when 1. A company does not pay di)idends or di)idends are not predicta$le 2. FCF is negati)e o)er a comforta$le forecast horiGon .. 5here is great uncertainty in estimating terminal )alues 3. "ot useful when 1. there are significant departures from clean surplus accounting. For e%ample, a. 7ains on mar(eta$le securities are reflected in stoc(holder>s e&uity as Hcomprehensi)e incomeI rather than as income on the income statement $. ide use of employee stoc( options (see E%ample +,-) c. Foreign currency translations d. Some pension adEustments 2. determinants of residual income (e.g., $oo( )alue and '3E) are not predicta$le

IV. RESIDUAL INCOME AND PRICE&TO&'OO( )P*'+ 6. Single,Stage 'esidual #ncome <odel 1. Assuming that residual income is a growing perpetuity. 5hen, ##.A.1 $ecomes
V E = Bo + ROEt rE Bo rE g

a. Called Single,Stage 'esidual #ncome <odel (E%ample +,C) 2. *i)ide through $y !

ROEt rE VE =1+ Bo rE g

J. Can $e used to e%amine fundamental determinants of )alue '. Can $e used to estimate Eustified 64! ratio or terminal )alue in a multi, stage **< model S. Can $e used to help estimate terminal )alue created under 6remium o)er !oo( ?alue approach $elow. 5. #mplied growth rate (E%ample +,:, p.2C+)

V. T,E CREATION AND DESTRUCTION O% VALUE IN RI MODELS /. !ase Case E%ample 1. All,e&uity firm 2. E&uity Capital 0 K1,=== .. "# 0 K2+= into perpetuity B. '3E 0 2+=41,=== 0 2+2 +. rE 0 1+2
V = Bo + ROE rE Bo rE

0.25 0.15 V = 1,000 + 1,000 = $1,667 0.15

NI EquityCapitalChrg rE 250 150 = $1,667 0.15

, or

V = Bo +

V = 1,000 +

?. "ew #n)estment w4 '3# L r 1. "ew #n)estment 0 K1,=== additional capital 2. '3# 0 2=2 a. "otice the '3# is less than the current '3E, $ut greater than r E. .. E&uity Capital 0 K1,=== M K1,=== 0 K2,=== B. "# 0 K2+= M K2== 0 KB+= into perpetuity +. '3E 0 B+=42,=== 0 22.+2 -. rE 0 1+2
V = BO + ROE rE BO rE

0.225 0.15 V = 2,000 + 2,000 = $3,000 0.15

, or

V = Bo +

NI EquityCapitalChrg rE 450 300 = $3,000 0.15

V = 1,000 +

@. Although firm )alue increased $y K1,... only K... of )alue has $een created $ecause K1,=== of the growth was additional in)ested capital

. "ew #n)estment w4 '3# N r 1. "ew #n)estment 0 K+== additional capital 2. '3# 0 1=2 a. "otice the '3# is positi)e, $ut less than rE. .. E&uity Capital 0 K1,=== M K+== 0 K1,+== B. "# 0 K2+= M K+= 0 K.== into perpetuity +. '3E 0 .==41,+== 0 2=2 -. rE 0 1+2
V = Bo + ROE rE Bo rE

0.20 0.15 V = 2,000 + 1,500 = $2,000 0.15

NI EquityCapitalChrg rE 300 225 = $2,000 0.15

, or

V = Bo +

V = 1,000 +

@. Although firm )alue increased $y K..., the initial in)estment was K+==. 5herefore, K1-@ of )alue was destroyed $ecause '3# N '3E. O. Cut costs or increase re)enue w4o additional in)estment 1. Suppose a)erage '3E increases to .=2. 2. #n this case, the )alue of the firm increases to K2,===. .. 8owe)er, no additional in)estment was re&uired so the entire growth of the firm is due to )alue creation. P. 'educe in)estment w4o affecting "36A5 1. Suppose we can reduce capital to K--@, $ut (eep "# at K2+=. 2. '3E 0 2+=4--@ 0 .@.+2
V = BO + ROE rE BO rE 0.375 0.15 667 = $1,667 0.15

V = 667 +

.. 5he )alue of the firm remains unchanged $ecause we reduced in)ested capital K... and created K... in )alue in the process.

Q. Di&uidate underperforming assets 1. Similarly, suppose we li&uidate K+== of assets that are generating K2+ of income each year. 5hat is, they ha)e and '3# of +2. a. E&uity Capital 0 K1,=== , K+== 0 K+== $. "# 0 K2+= , K2+ 0 K22+ into perpetuity c. '3E 0 22+4+== 0 B+2 d. rE 0 1+2
V = BO + V = 500 + ROE rE BO rE 0.45 0.15 500 = $1,500 0.15

2. E)en though the firm is smaller, we>)e added )alue $ecause we li&uidated K+== of capital, decreasing firm )alue $y only K1-@. 5he K... is all )alue created.

VI. ACCOUNTIN$ CONSIDERATIONS AA. E&uity E&ui)alents 1. 5he Stewart $oo( referenced a$o)e outlines a fairly detailed list of adEustments, called Equity Equivalents, one might ma(e in arri)ing at "36A5 and #n)ested Capital. For e%ample, a. 'esearch and *e)elopment ('R*) i. 'ecogniGes 'R* as cash in)ested in the firm, li(e additions to 66RE in the form of cap. e%. ii. Add $ac( 'R* e%pense to earnings to compute "36A5 iii. Added to in)ested capital (i.e., capitaliGed) and amortiGed against "36A5 o)er su$se&uent years $. *eferred #ncome 5a% i. 'ecogniGe actual cash ta%es paid ii. Add increases in *eferred 5a% Dia$ility to compute "36A5 iii. #nclude *eferred 5a% Dia$ility as part of #n)ested Capital c. D#F3 'eser)e i. D#F3 understates #n)entory and hence capital ii. Add D#F3 'eser)e to compute #n)ested Capital iii. Increase in D#F3 reser)e (after,ta%) is added to compute "36A5 i. Essentially adding in unrecogniGed C37S d. 7oodwill AmortiGation i. 'epresents cash in)ested in the firm ii. Add,$ac( after,ta% AmortiGation to compute "36A5 iii. Add Cumulati)e AmortiGation to compute #n)ested Capital i). "oteS 'ecent accounting changes no longer amortiGe 7oodwill. #t is written,off when it is deemed impaired. 8owe)er, the same concept applies to these write,offs. e. 3perating Deases i. Should $e treated as capital leases ii. Add capitaliGed )alue of operating lease payments to compute #n)ested Capital iii. Add,$ac( after,ta% lease payments to compute "36A5 f. Successful Efforts to Full Cost i. All in)estments (successful and unsuccessful) represent cash in)ested in the firm ii. Add cumulati)e loss to compute #n)ested Capital and amortiGed against "36A5 o)er e%pected payoff period. iii. 5reat unsuccessful e%pensing Eust li(e 'R* a$o)e. 2. Analysts differ in the adEustments they ma(e to #n)ested Capital and "36A5 (or E&uity Capital and "et #ncome under the e&uity approach) to arri)e at residual income !!. ?iolations of Clean Surplus Accounting 1. Some e)ents are not reported on the income statement, $ut do find their way to the E&uity section of the $alance sheet. #n these cases, the $oo( )alue of e&uity is correct, $ut "et #ncome is not. a. 5hese omissions from "et #ncome can distort naT)e forecasts of "et #ncome and '3E. 8

$. 3ther times, these positi)e and negati)e omissions can offset each other o)er time (e.g., foreign currency translations). c. 5he analyst must determine how these items will affect future forecasts 2. For e%ample, increases in fair )alue of some financial assets increase the )alue of e&uity through HComprehensi)e #ncomeI, $ut these gains are not included on the income statement. a. 5he analyst can adEust for this $y adding the gain to "# in calculating '3E. $. 5he re)erse would hold for decreases in fair )alue c. "o adEustment to #n)ested Capital is necessary $4c it already reflects the change in mar(et )alue through the comprehensi)e income calculation. .. <aEor areas of comprehensi)e income includeS a. Foreign currency translations $. 6ension fund )alue adEustments c. Fair )alue changes of some financial instruments CC. "on,'ecurring #tems 1. As $efore, the analyst should loo( for non,recurring items in the footnotes and not Eust rely on income statement classifications. Sometimes Hunusual itemsI recur consistently. 5hings to loo( out for areS a. 'estructuring charges (what>s cash flow4'3E in the current year and what is li(ely to affect cash flow4'3E in future yearsU) $. *iscontinued operations c. E%traordinary items

VII. MULTI&STA$E RESIDUAL INCOME MODELS **. 5erminal ?alue Created 1. 5he longer the forecast, the greater the chance that the residual income con)ergences to Gero Gero terminal )alue created a. #n the long run, industry economic profits ('#) tend toward Gero $ecause positi)e economic profits attract competition and negati)e economic profits encourage consolidation and4or e%it. 2. 6remium 3)er !oo( ?alue as Terminal Value Created

V E = Bo +
t =1 T

E t rE Bt 1 PT BT + (1 + rE ) t (1 + rE ) T ROEt rE P BT Bt 1 + T t (1 + rE ) (1 + rE ) T

V E = Bo +
t =1

.. 6ersistence <odel

V E = Bo +
t =1

T 1

Et rE Bt 1 ET rE BT 1 + t (1 + rE ) (1 + rE )(1 + rE ) T 1

a. V is a persistence factor i. Suppose V is = residual income dissipates immediately after forecast period. i. 5hat is, no '# after period 5. ii. Suppose V is 1 perpetual residual income i. 5hat is, '# persists into perpetuity after period 5. $. Empirically, one study estimates a persistence factor of =.-2. i. #mplies a .C2 rate of decay per year, on a)erage. c. Factors affecting persistence i. Dow persistence i. E%treme '3Es ii. E%treme accruals iii. E%treme special items ii. 8igh persistence i. Dow di)idend payout ii. 8igh historical persistence iii. 6ersistent identifia$le $arriers to entry B. E%amples +,1=, +,11, +,12 (p.2C@M)

10