Reading 23: Residual Income Valuation

propertyPage No. 759th Nov 2022 WecDate//Reading 23ResidiaincomeValuation* ConceptTraditional linancial statements are prepared to reflectearnings availables to owners Net income includesan interest charge to represent the cost of debtCapital (int exp)Div or other charges for equity Capital are not explicitdeductedGRAP accounting leaves equity owners the the taskto determine wheter the resulting carnings exceededthe cost of equity CapitalResidual Income (RI) / Eco profit / EVAResidual income has close links to other valuationsmodels already covered :PVGO model: P= EPS, + PVGOr Page No. 76RI is linked to P/BDate//P/B ratio using fundamentalP =ROE gBr- - gThe five force model and competitive strategies.*Defining Residual IncomeResidual Income (RI) :- Equivalent to economic profit-RI = Net income less opportunity cost of equity CaptAccording income will overstate returns from equityinvestor Residual perspective because it ignores cost of equityincome explicitly deducts all capital costs ofboth debt and equityNot income = BV XROEUsing a post - leverage figure :RI = Net Income - (Equity Capital X cost of equity )Alternatively , using a pre -leverage figure :No PAT-$ WACC/ghomRI = EBIT (1-t) - ( total capital X WALL % )Investedtotal- Recall , WALL implicitly Capilal accounts for both the cost of debtand equity on a / weighted - avg basis# CtB Page No 77Date / /Exl: Est 2009 EPS = =$120BV per share 2008 = $10 Beg}Equity req return = 10%rRl = EPS, - CBVPS+ xr)0.20 = 1.20 - (10 x 0.10)Thefirmearnedpositive RI of0.20 providing valuetoboth debt and equityholdersEX2: Assets = 100.8 Liability = 40.2 Equity = 60.6Pretax cost of debt= 7.17. lost of equity = 13.3% Tax rate=hor.Calculate residualincomefrom EPS or EBIT801" EBIT7,560,000- Int2,854,000Pre-taxincome4,706,000- Income tax4882,400Net income2,823,600(A-L)SolEquity Charges = Equity Capital X lost of equity=60.6 X 0.133= 8,059,800RI = = NI - Equity charges= 2,823,600 - 8,059,800= A-5,236,20665/17/20gdIN)AVIPositive accounting Income -Ve economic income tdols doving 11 AVN Adjustmentof Capitize and amortize research & development (R4D) exps isAdd R&D exp back to earningsPage No.Deferred taxed are eliminated to pick up Dateonly Cash taxes/23Operating leases are treated at Capital leases*Alternative Rl measure : EVAEconomic value added (EVA) measures valued addedtoShareholders by management.Net operating profit after taxEVA = NOPAT - C WACC % x Invested cap )BV of LTfBV ofNo PAT = EBIT(1-t)debtEquity+ve :- Management is adding value-ve :- Value not addedEvaluatetherelativechangeinEVAovertimeAlternative RI measure : Market value Added (MVA)MVA measures the effect on value of managementdecisions since the fitminceptionMVADebt + equity= market value of firm - Invested Capitalmarket A Company value producing tve MVA will have an excess ofAccounting BV of total Cap HovertheBVofinvestedCapitalEvaluate the Charge in MVA over timeMVA Can be described as the PV of future expected EVAMVA=(mvofdebtEquity)(BV of debt & equity) Page No 74Date / /EVABeg of yrInvested CapitalMVREND of yrInvested capitalUsesof1.operating leveloge is notInternalcorporateperform anceCManagerialeffectivenessGEVAExecutivecompensationTo measue goodwillimpairment&Eco incomeEx : Equity : 10,000Ke 8000Kd: 12.5%Tax20%Sales : 10,000COGS 2,000NOPAT: EBIT X(1- +) or EATH Int (1-t)Sale10,000COG'S2,0008000+ (1-0.2)5600 +1000 (1-0.2)EBIT8,000Int1,0006,4006,400EBT7,000Tax1400WACC $ : WACC X Total CapitalEAT5600Equity charge1500 ,12.8% X18000RI / EP I EVA41002300RI EF :NOPAT - WACC $6400 - 23004100 Page No. 85Date//Adj to financial statn1R&D expense T net of amort is added back to earning2Charges on strategic investments that are not expectedto generate immediate returns, are added back3Defered takes are eliminated and only cash taxes aretraded as an exp4LIFOreserveisaddedbacktocapitalandchangeinUFO reserve to NOPAT5Operating lease s are traded as capital leasesandnun recurring items are adjustIntrinsic Value and Residual IncomeCFORI approach : Value = BV + PV all future RIBV of equityIMPVo =Bo +RliRlz(1+r)' (Hr)2PV of expected futureresidual incomeCalculating Future RIR model breaks intrinsic value Vo of equity intothese two Components: Page No. 81Date / /1CurrentBVofequityBoPV+2ofexpectedfutureRltnVo =Bo +WRltForecastedt=1(1+r)+residual IpcomRlt=Eqt(rx8B+1)IMPExpectedIEPSOpeningReqBVTwoRetuinmethodsforcalculatingRltIRlt = EPS+ - Cr x BVt-12Rlt = (ROE, c) X BVtWithalittleSubstitution8single stage Rl modelVo=Bo+5( ROEBEIt=1Example:IntrinsicValueandResidualIncomeReq return on equity = 14%EBV /share = Ez C$ 6.50 bey of 20X1Earningsforecast:20x1=C $1.10i20x2= C$1.00 2083 = 0-5-E3Div:20x1D.=0.5i20x2=060DuDiv in 20x3isliquidatingeventD,=?CulculateIntrinsicvalueusingRlmodel BVBeg " End Date PageNo. 82//CleansurplusRelation20X120x220x3Beg BV/Shale6.57.17.5(BE-1)1.11.00.95EPS forecast (Et)RE=ZDPS forecast (De) - 50% payout0.50.68.45BV /7.17.5share forecast (B+1 -+++++++0.014%14%Equity Charge / Share (rx Bt-1)0.910.991.05RI/ Share (EE -(rxBt-)0.190.01-0.10BV6Rl.R12R136 (Fo = 6.5CF, = 0.19 / CF = 0.01 / CF3 = 0.1#1=1481CPTNPV =6.61 > equityvalue todayDiv(Fo =0.5CF, = 0.60 0 LF3 = 8.45I = 14%NPV6.61Differences arrive from inpotsDiffinvalueRecognition:Bet"RIVs.PCFModelsValueisrecognizedearlierunderRImodel(BV.)thanunder theDCFmodel,+thereforelesssensitivetoEterminal est.BYusuallyrepresentsalarge%ofintrencicvaluevalue In the est, DDM which or is FCF model + to terminal value if most of thesubjectsubstantialduetotheforecastandtherelationshipforecastingriskhorizonbetfg Page No. 83Date//Value Drivers of RIROE-YROE>ReqReturn:PIBF-gRIwillbe+veJustifiedmarket to - Book>1ROE = Req Return :Justified MV = BVMarket -toBlookratio=IResidualIncomeValuation&justifiedP/BRatiorelationshipRIMscanbeusedtoestablishmarketmulti ples suchas thePIBratiobasedonforecastROE & EPSRIMsaremostcloselyrelatedthe justifiedP/Band Tobin's9ratio(MVdebt+MVEquity)/Replacementcost of total assetsWhenthePVofexpectedfutureRIis+ve,thejustifiedP/Bbasedonfundamentalsisgreaterthan1.0Equity QTobin's QEquityMV of debt + MV of EquityAsset DebtReplacementCost of total assets drop to the KePage No. 84Assumption : RI declines to zero as ROEDate //dutifiedROE car, t then Vo = B ,PIB=ITROE>r ,thenVoBP/B>1+ROE IDOM /FCF-Bothinvolvediscountingoffuturebenefits- RI : BV + PV ofRI- DDM FCF:PVofrelevant CFs company with extreme accounting rates of retainPage No. 86typically have w factorDate / /*Continuing Residual IncomeTheprojectedrateatwhichRIisexpectedtofedeoverthelifeccycleof the firm is captured byper sistencefactorwhich is bet 0 & 1.,w,meg aPersistente Factor =WHighLowlow div payoutshigh ROEhistoricallyhigh RISignificant level of nor recurringpersistancein industryitemhigh Alciny aurs,(PV of Control Continuing -RlTRI in year T-1ltr-wW= 0 stopPartyparty= 1continue= D 41Excepted to dropRI expected to persistdecline over asimmediately to 0at current levelbeg in TtlRUE fall toforever after yr T-1Cost of equityslowely deline Net income = ROE:XBVPage No. 87Date / /ofRIdeclinestolongRunlevelinmatureIndustry, then :PV of Continuing RI = (PT -B7) + RItin yr T-1I trPossibleapproachesforcontinuingRI :IDropimmediatelytozero(w=o)+nocompetitiveadvantagepure competition2PersistatCurrentlevelforever(W=1)tperpetual(g=0)Competitiveadvantage3Declineovertimetozero(0< w<1) (g<0)4DeclinetomatureindustrylevelNde :ItisRIafterforecasthorizonVo = Bo + PV of high-growth RI + PV of Continuing RIfluitsPV of Continuing RI n-1=RI,1+r-wIfRI persistsatcurrentlvlforeeverthenW=1RIdropsimmediatleyto0thenwRIdeclinesovertimeto0,thenwisbet0&IPVofContinuingRIattime(f)Canalsobeculculateas:MVt -BVPVofContinuingRIattinet-1:MVtBVt)+Rlo+ Page No. 88Date / /Multi - stage Residual Income ModelIntrinsic value = Sum of three Components :Vo = B. t CPV high-growth RI) + CRV Cont RI)Three parts:ICaclutate Current BV ) +2(Calculate R for yr 1 through T-1) +3(calculate continuing RI) as:thePV (Gont RI in yr T-1) =Rltltr-wApproch-11:Droptozero(w=0)PV( ContRLinyrT-1)=RIT=RI1+r-0 ltrr-gApproach 2 :Currentlevelforever(wel) g=0;ThinkPV(ContRIinT-1)=yrR/T=RITper petuityltr-1to=Rltr-gApproach h Q: MatureindustryMarket value = BV + PV ( Cont RI in yr T )PV C cont RI in yrT) = PT -BT. Approach 3 : Decline slowly to ( O