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Presenter
Venue
Date
RESIDUAL INCOME
Economic
Profit
Abnormal
Earnings
Economic
Value
Added
Residual
Income
RESIDUAL INCOME
Net
Income
Equity
Charge
Residual
Income
NOPAT
Capital
Charge
Residual
Income
Total assets
Debt-to-total capital
ratio
Cost of debt (before tax)
$5,000,000.00
0 .60
8%
Cost of equity
12%
Tax rate
40%
EBIT
$400,000
$240,000
Pretax income
$160,000
$64,000
Net income
$96,000
Equity capital
$2,000,00
0
Equity charge
$240,000
Net income
Less equity charge
Residual income
$96,000
$240,000
-
$144,000
RELATED MEASURES
Economic
Value
Added
(EVA)
NOPAT
C% TC
Market
Value
Added
(MVA)
Market
Value of
the Firm
Book
Value of
Total
Capital
Valuation
Measuring Goodwill Impairment
Measuring Internal Corporate
Performance
Determining Executive Compensation
RIt Et re Bt 1
Residual
income
per share
Earnings
per share
(EPS)
Required
return on
equity (Re)
Beginning
book
value per
share
(BVPS)
Earnings
$2.50
$3.00
Dividends
$1.00
$1.10
Book value
Required equity
return
$20.00
10%
RIt
V0 B0
t
t 1 (1 r )
Et rBt 1
V0 B0
t
t 1 (1 r )
EXAMPLE:
VALUATION USING RESIDUAL INCOME
V0 $20
$0.50
1
1.10
V0 $20 $1.91
V0 $21.91
$0.85
1.10
$1.00
1.10
RIt ROE t r Bt 1
ROE > r
RI > 0
V>B
ROE < r
RI < 0
V<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%
12%
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%
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
High Persistence
Low Persistence
Low dividend
payout
Historically high
industry ROEs
Extreme ROE
Extreme levels
of special items
Extreme
accounting
accruals
Et rE Bt 1
Et rE BT 1
V0 B0
t
(1)(1
rE ) rE
t 1 (1 rE )
T 1
T 1
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
Et rE Bt 1
ET rE BT 1
V0 B0
t
T 1
(1
r
)
(1
)(1
r
)
t 1
E
E
E
T 1
$0.50 $0.85
$1.00
V0 $20
1
2
1.10 1.10
(1 0.10 0)(1.10 2 )
$0.50 $0.85
$1.00
V0 $20
1
2
1.10 1.10
(1.10)(1.10 2 )
V0 $21.91
Et rE Bt 1
ET rE BT 1
V0 B0
t
T 1
(1
r
)
(1
)(1
r
)
t 1
E
E
E
T 1
$0.50 $0.85
$1.00
V0 $20
1
2
1.10 1.10
(1 0.10 1.0)(1.10 2 )
$0.50 $0.85
$1.00
V0 $20
1
2
2
1.10 1.10
(0.10)(1.10 )
V0 $29.42
Et rE Bt 1
ET rE BT 1
V0 B0
t
T 1
(1 rE )(1 rE )
t 1 (1 rE )
T 1
$0.50 $0.85
$1.00
V0 $20
1
2
1.10 1.10
(1 0.10 0.60)(1.10 2 )
$0.50 $0.85
$1.00
V0 $20
1
2
1.10 1.10
(0.50)(1.102 )
V0 $22.81
Et rE Bt 1 PT BT
V0 B0
t
T
(1 rE )
t 1 (1 rE )
T
1
2
3
1.10 1.10 1.10
1.103
V0 $23.79
Residual Income
Model Valuation
Required return
on equity
Book value + PV
(residual income)
Dividend and
FCFE Model
Valuations
Required return
on equity
PV (equity cash
flows)
$1.00
$7.00
10%
Value =
Book value + PV
(residual income)
Value =
PV (Early cash
flows + Terminal
value)
Large weight on
current book value
Large weight on
later cash flows
Weaknesses
Relies on accounting data
May require adjustments to
accounting data
Relies on clean surplus relation
Assumes that Cost of debt =
Interest expense
Least Appropriate
When the clean surplus relationship does not hold
When the determinants of residual income are not
predictable
Beginning
book
value of
equity
Net
income
Dividends
Ending
book
value of
equity
SUMMARY
Residual Income = Income Leftover after All Capital
Charges
SUMMARY
Relative to Other Valuation Models