residual income valuation

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RESIDUALINCOMEVALUATIONI.PRINCIPLESA.Conceptually,residualincomeis1.Shareholdercashflowlessachargeforthecostofshareholdercapital(rE),or2.Firmcashflowlessachargeforthecostoffirmcapital(usingWACC)B.AlthoughNetIncomeincludesachargefordebtcapital(i.e.,interestexpense),itdoesnotincludeachargeforequitycapital1.ResidualincomemakesadeductionforthismissingchargeC.Conceptually,residualincomemodelsviewtheintrinsicvalueofafirmastheinitialbook(i.e.,investedcapital)plusthepresentvalueofresidualincome(i.e.,valuecreated)D.Example5-1(p.263)1.UsingEquityCapitalApproacha.ResidualIncome=NI–EquityChargeb.ResidualIncome=NI–EquityCapitalxrE(%)c.ResidualIncome=(ROE–rE)xEquityCapital1.ROE=ReturnonEquity2.ROE=NI/EquityCapital3.ResidualIncome=(ROE–rE)xEquityCapital2.UsingInvestedCapitalApproacha.ResidualIncome=EBIT(1–T)–InvestedCapitalChargeb.ResidualIncome=NOPAT–InvestedCapitalChargec.ResidualIncome=NOPAT–InvestedCapitalxWACC(%)1.NOPAT=NetOperatingProfitAfterTax2.ROIC=ReturnonInvestedCapital3.ROIC=NOPAT/InvestedCapitald.ResidualIncome=(ROIC–WACC)xInvestedCapital3.Thesesimpleexpressionsshowveryclearlywhatcreatesanddestroysvalueinacompanyingeneralterms.E.References1.TheQuestforValuebyG.BennettStewart,III(HarperBusiness,©1991.a.HeintroducesEconomicValueAdded(EVA),abrandnameforresidualincome.2.Valuation:MeasuringandManagingtheValueofCompanies,3rdeditionbyCopeland,KollerandMurrin(Wiley©2000)a.SimilartoStewart’sbook,butperhapsabitmoretractable10 USINGRESIDUALINCOMEFORVALUATIONA.EquityCapitalApproach.Conceptually,residualincomemodelsviewtheintrinsicvalueofafirm’sequityastheinitialbook(i.e.,investedequitycapital)plusthepresentvalueoffutureresidualincome(i.e.,valuecreated),or1.CanbeimplementedusingeitheranaggregateorpershareapproachB.EquityCapitalApproach.Alternatively,onecanvaluetheintrinsicvalueoftheentirefirmastheinitialbook(i.e.,investedcapital)plusthepresentvalueoffutureresidualincome(i.e.,valuecreated),or1.Onewouldthendeducttheoutstandingdebttoarriveatequityvalue.C.IntheEVAvernacular,thevalueofafirm’sequityistheInvestedEquityCapitalplusthepresentvalueofallfutureEVA,orD.Example5-3(p.267),Example5-5(p.272)E.Example5-4(p.268)F.Example5-6(p.273)–usingI.D.1.cabove10 ADVANTAGESANDDISADVANTAGESOFRESIDUALINCOMEMODELSA.Advantages1.Terminalvalueisarelativelysmallerportionofpresentvalue2.Usesreadilyavailableaccountingdata3.Appliestodividendandnon-dividendpayingcompanies4.Canbeusedwhencashflowsareunpredictable5.FocusesoneconomicvalueB.Disadvantages1.Usesreadilyavailableaccountingdata(e.g.,accountingmanipulations)2.Accountingdatamayneedtobeadjustedfordistortions.(Seebelow)3.Themodelrequiresthatthecleansurplusrelationholds(i.e.,changesinbookvalueequalsNIlessdividends;thatis,allchangestobookvalueotherthanownershiptransactionsflowthroughearnings).C.Therefore,themodelisusefulwhen1.Acompanydoesnotpaydividendsordividendsarenotpredictable2.FCFisnegativeoveracomfortableforecasthorizon3.ThereisgreatuncertaintyinestimatingterminalvaluesD.Notusefulwhen1.therearesignificantdeparturesfromcleansurplusaccounting.Forexample,a.Gainsonmarketablesecuritiesarereflectedinstockholder’sequityas“comprehensiveincome”ratherthanasincomeontheincomestatementb.Wideuseofemployeestockoptions(seeExample5-6)c.Foreigncurrencytranslationsd.Somepensionadjustments2.determinantsofresidualincome(e.g.,bookvalueandROE)arenotpredictable10 RESIDUALINCOMEANDPRICE-TO-BOOK(P/B)A.Single-StageResidualIncomeModel1.Assumingthatresidualincomeisagrowingperpetuity.Then,II.A.1becomesa.CalledSingle-StageResidualIncomeModel(Example5-8)2.DividethroughbyBB.CanbeusedtoexaminefundamentaldeterminantsofvalueC.CanbeusedtoestimatejustifiedP/Bratioorterminalvalueinamulti-stageDDMmodelD.CanbeusedtohelpestimateterminalvaluecreatedunderPremiumoverBookValueapproachbelow.E.Impliedgrowthrate(Example5-9,p.285)10 THECREATIONANDDESTRUCTIONOFVALUEINRIMODELSA.BaseCaseExample1.All-equityfirm2.EquityCapital=$1,0003.NI=$250intoperpetuity4.ROE=250/1,000=25%5.rE=15%,orB.NewInvestmentw/ROI>r1.NewInvestment=$1,000additionalcapital2.ROI=20%a.NoticetheROIislessthanthecurrentROE,butgreaterthanrE.3.EquityCapital=$1,000+$1,000=$2,0004.NI=$250+$200=$450intoperpetuity5.ROE=450/2,000=22.5%6.rE=15%,or7.Althoughfirmvalueincreasedby$1,333only$333ofvaluehasbeencreatedbecause$1,000ofthegrowthwasadditionalinvestedcapital10 NewInvestmentw/ROI