Tài chính ngân hàng - Residual income valuation: Valuing common equity

Residual Income Valuation:Valuing Common EquityPresenterVenueDateResidual IncomeEconomic ProfitAbnormal EarningsEconomic Value AddedResidual IncomeResidual IncomeNet IncomeEquity ChargeResidual IncomeNOPATCapital ChargeResidual IncomeExample: Residual IncomeTotal assets $5,000,000.00EBIT $400,000 .00Debt-to-total capital ratio0 .60Cost of debt (before tax)8%Cost of equity12%Tax rate40%Example: Residual IncomeEBIT$400,000Less interest Expense$240,000Pretax income$160,000Less income tax expense$64,000Net income$96,000Example: Residual IncomeEquity capital$2,000,000Equity charge$240,000Net income$96,000Less equity charge$240,000Residual income–$144,000Related MeasuresNOPAT = Net operating profit after taxes C% = Cost of capitalTC = Total capitalEconomic Value Added (EVA©) NOPATC% × TCMarket Value Added (MVA) Market Value of the Firm Book Value of Total CapitalUses of Residual IncomeValuation Measuring Goodwill ImpairmentMeasuring Internal Corporate PerformanceDetermining Executive CompensationForecasting Residual IncomeResidual income per share Earnings per share (EPS)Required return on equity (Re)Beginning book value per share (BVPS)Example: Forecasting Residual Income012Earnings$2.50 $3.00 Dividends$1.00 $1.10 Book value$20.00 Required equity return10%Example: Forecasting Residual Incomein One YearCharge for Equity Capital = Required return on equity × Beginning book value per share10% × $20.00 = $2.00Residual Income in Year 1 = EPS – Charge for equity capital$2.50 – $2.00 = $0.50Example: Forecasting Residual Incomein Two YearsEnd-of-Year Book Value for Year 1 =Beginning-of-year book value + Earnings – Dividends$20.00 + $2.50 – $1.00 = $21.50Beginning book value for year 2Charge for Equity Capital in Year 2 = Required return on equity × Beginning book value per share10% × $21.50 = $2.15Residual Income in Year 2 = $3.00 – $2.15 = $0.85Valuing Common Stock Using Residual IncomeExample: Valuation Using Residual IncomeFrom the Previous Example:Beginning book value at time 0 = $20.00Residual income in year 1 = $0.50Residual income in year 2 = $0.85Required return on equity = 10 percentAdditionally, Assume:Residual income in year 3 = $1.00The firm ceases operations in three yearsExample: Valuation Using Residual IncomeDeterminants of Residual IncomeROE > rRI > 0V > BROE rContinuing Residual Income and Persistence FactorsHigh PersistenceLow dividend payoutHistorically high industry ROEsLow PersistenceExtreme ROEExtreme levels of special itemsExtreme accounting accrualsValuing Continuing Residual IncomePersistence Factor (ω)0 ≤ ω ≤ 1ω = 1  Residual income will not fadeω = 0  Residual income will not persist after the initial forecast to riseω = 0.62  It has been observed, on average, empiricallyExample: Multistage Residual Income ModelFrom the First Valuation Example:Beginning book value at time 0 = $20.00Residual income in year 1 = $0.50Residual income in year 2 = $0.85Residual income in year 3 = $1.00Required return on equity = 10 percentValue was $21.91Now Assume:The firm continues operations after three yearsExample: Multistage ModelCase 1:  = 0Example: Multistage ModelCase 2:  = 1.0Example: Multistage ModelCase 3:  = 0.60Example: Multistage ModelUsing the P/BCalculate the PV of continuing residual income using P/BUse this to determine terminal value Assume for the previous exampleBook value in year 3 = $25.00P/B is projected in year 3 as 1.10The projected stock price in year 3: $25 × 1.10 = $27.50Example: Multistage ModelUsing the P/BResidual Income andDividend and FCFE Model ValuationsResidual Income Model ValuationRequired return on equityBook value + PV (residual income)Dividend and FCFE Model ValuationsRequired return on equityPV (equity cash flows)Example: Residual Income andDividend ModelsExample AssumptionsAll earnings are paid out as dividends so book value is constantEarnings and dividends are constant foreverEarnings per share$1.00Book value of equity$7.00Required return on equity10%Example: Residual Income andDividend ModelsValuation Using a Constant Dividend ModelAssume a 100 percent dividend payout ratioValuation Using a Residual Income ModelResidual Income vs.Dividend and FCFE ModelsResidual Income Model ValuationValue = Book value + PV (residual income)Large weight on current book valueDividend and FCFE Model ValuationsValue = PV (Early cash flows + Terminal value)Large weight on later cash flowsResidual Income Model Strengths and WeaknessesStrengthsPuts less weight on the terminal valueUses available accounting dataIs useful for non-dividend-paying firmsIs useful for firms without free cash flows Is useful when cash flows are unpredictable Is based on economic valueWeaknessesRelies on accounting dataMay require adjustments to accounting dataRelies on clean surplus relationAssumes that Cost of debt = Interest expenseResidual Income ModelAppropriatenessMost AppropriateAt non-dividend-paying firmsAt firms without free cash flows When terminal values are highly uncertainLeast AppropriateWhen the clean surplus relationship does not holdWhen the determinants of residual income are not predictableClean Surplus AccountingBeginning book value of equityNet incomeDividendsEnding book value of equityAccounting Adjustments for theResidual Income ModelExampleAdjustment to Financial StatementOver several years, Firm A has consistently recorded losses in its available-for-sale securitiesAdjust net income downwardFirm B consistently capitalizes expenditures that should have been expensedAdjust net income and book value downwardFirm C has recorded foreign currency translation losses on its balance sheet over several years; the losses are expected to continueAdjust net income downwardFirm D accelerates revenues to the current period and defers expenses to later periodsAdjust net income and book value downwardSummaryResidual Income = Income Leftover after All Capital Charges= Net income – (Equity required return × Book value)= (ROE – Equity required return) × Book valueRelated to EVA and MVAEquity Value = Book Value + PV (Residual Income)Can be used with single-stage and multistage modelsCan be specified with a persistence factorFirms with stronger market positions will have greater persistence factorsSummaryRelative to Other Valuation ModelsIs useful when firm does not have dividends or free cash flowPuts less emphasis on later cash flowsUse of Accounting DataAssumes clean surplus relation holdsMay require adjustments to accounting data