1、RESIDUAL INCOME VALUATIONI. PRINCIPLESA. Conceptually, residual income is1. Shareholder cash flow less a charge for the cost of shareholder capital (rE), or2. Firm cash flow less a charge for the cost of firm capital (using WACC)B. Although Net Income includes a charge for debt capital (i.e., intere

2、st expense), it does not include a charge for equity capital1. Residual income makes a deduction for this missing chargeC. Conceptually, residual income models view the intrinsic value of a firm as the initial book (i.e., invested capital) plus the present value of residual income (i.e., value creat

3、ed)D. Example 5-1 (p.263)1. Using Equity Capital Approach a. Residual Income = NI Equity Chargeb. Residual Income = NI Equity Capital x rE(%)c. Residual Income = (ROE rE) x Equity Capital1. ROE = Return on Equity2. ROE = NI/Equity Capital3. Residual Income = (ROE rE) x Equity Capital2. Using Investe

4、d Capital Approacha. Residual Income = EBIT(1 T) Invested Capital Chargeb. Residual Income = NOPAT Invested Capital Chargec. Residual Income = NOPAT Invested Capital x WACC(%)1. NOPAT = Net Operating Profit After Tax2. ROIC = Return on Invested Capital3. ROIC = NOPAT/Invested Capitald. Residual Inco

5、me = (ROIC WACC) x Invested Capital3. These simple expressions show very clearly what creates and destroys value in a company in general terms.E. References1. The Quest for Value by G. Bennett Stewart, III (Harper Business, © 1991.a. He introduces Economic Value Added (EVA), a brand name for re

6、sidual income.2. Valuation: Measuring and Managing the Value of Companies, 3rd edition by Copeland, Koller and Murrin (Wiley © 2000)a. Similar to Stewarts book, but perhaps a bit more tractableII. USING RESIDUAL INCOME FOR VALUATIONA. Equity Capital Approach. Conceptually, residual income model

7、s view the intrinsic value of a firms equity as the initial book (i.e., invested equity capital) plus the present value of future residual income (i.e., value created), or1. Can be implemented using either an aggregate or per share approachB. Equity Capital Approach. Alternatively, one can value the

8、 intrinsic value of the entire firm as the initial book (i.e., invested capital) plus the present value of future residual income (i.e., value created), or1. One would then deduct the outstanding debt to arrive at equity value.C. In the EVA vernacular, the value of a firms equity is the Invested Equ

9、ity Capital plus the present value of all future EVA, orD. Example 5-3 (p.267), Example 5-5 (p.272)E. Example 5-4 (p.268)F. Example 5-6 (p.273) using I.D.1.c aboveIII. ADVANTAGES AND DISADVANTAGES OF RESIDUAL INCOME MODELSA. Advantages1. Terminal value is a relatively smaller portion of present valu

10、e2. Uses readily available accounting data3. Applies to dividend and non-dividend paying companies4. Can be used when cash flows are unpredictable5. Focuses on economic valueB. Disadvantages1. Uses readily available accounting data (e.g., accounting manipulations)2. Accounting data may need to be ad

11、justed for distortions. (See below)3. The model requires that the clean surplus relation holds (i.e., changes in book value equals NI less dividends; that is, all changes to book value other than ownership transactions flow through earnings). C. Therefore, the model is useful when1. A company does n

12、ot pay dividends or dividends are not predictable2. FCF is negative over a comfortable forecast horizon3. There is great uncertainty in estimating terminal valuesD. Not useful when1. there are significant departures from clean surplus accounting. For example, a. Gains on marketable securities are re

13、flected in stockholders equity as “comprehensive income” rather than as income on the income statementb. Wide use of employee stock options (see Example 5-6)c. Foreign currency translationsd. Some pension adjustments2. determinants of residual income (e.g., book value and ROE) are not predictableIV.

14、 RESIDUAL INCOME AND PRICE-TO-BOOK (P/B)A. Single-Stage Residual Income Model1. Assuming that residual income is a growing perpetuity. Then, II.A.1 becomesa. Called Single-Stage Residual Income Model (Example 5-8)2. Divide through by BB. Can be used to examine fundamental determinants of valueC. Can

15、 be used to estimate justified P/B ratio or terminal value in a multi-stage DDM modelD. Can be used to help estimate terminal value created under Premium over Book Value approach below.E. Implied growth rate (Example 5-9, p.285)V. THE CREATION AND DESTRUCTION OF VALUE IN RI MODELSA. Base Case Exampl

16、e1. All-equity firm2. Equity Capital = $1,0003. NI = $250 into perpetuity4. ROE = 250/1,000 = 25%5. rE = 15%, orB. New Investment w/ ROI > r1. New Investment = $1,000 additional capital2. ROI = 20%a. Notice the ROI is less than the current ROE, but greater than rE.3. Equity Capital = $1,000 + $1,

17、000 = $2,0004. NI = $250 + $200 = $450 into perpetuity5. ROE = 450/2,000 = 22.5%6. rE = 15%, or7. Although firm value increased by $1,333 only $333 of value has been created because $1,000 of the growth was additional invested capitalC. New Investment w/ ROI < r1. New Investment = $500 additional

18、 capital2. ROI = 10%a. Notice the ROI is positive, but less than rE.3. Equity Capital = $1,000 + $500 = $1,5004. NI = $250 + $50 = $300 into perpetuity5. ROE = 300/1,500 = 20%6. rE = 15%, or7. Although firm value increased by $333, the initial investment was $500. Therefore, $167 of value was destro

19、yed because ROI < ROE.D. Cut costs or increase revenue w/o additional investment1. Suppose average ROE increases to 30%.2. In this case, the value of the firm increases to $2,000. 3. However, no additional investment was required so the entire growth of the firm is due to value creation.E. Reduce

20、 investment w/o affecting NOPAT1. Suppose we can reduce capital to $667, but keep NI at $250.2. ROE = 250/667 = 37.5%3. The value of the firm remains unchanged because we reduced invested capital $333 and created $333 in value in the process.F. Liquidate underperforming assets1. Similarly, suppose w

21、e liquidate $500 of assets that are generating $25 of income each year. That is, they have and ROI of 5%.a. Equity Capital = $1,000 - $500 = $500b. NI = $250 - $25 = $225 into perpetuityc. ROE = 225/500 = 45%d. rE = 15%2. Even though the firm is smaller, weve added value because we liquidated $500 o

22、f capital, decreasing firm value by only $167. The $333 is all value created. VI. ACCOUNTING CONSIDERATIONSA. Equity Equivalents1. The Stewart book referenced above outlines a fairly detailed list of adjustments, called Equity Equivalents, one might make in arriving at NOPAT and Invested Capital. Fo

23、r example,a. Research and Development (R&D)1. Recognizes R&D as cash invested in the firm, like additions to PP&E in the form of cap. ex.2. Add back R&D expense to earnings to compute NOPAT3. Added to invested capital (i.e., capitalized) and amortized against NOPAT over subsequent ye

24、arsb. Deferred Income Tax1. Recognize actual cash taxes paid2. Add increases in Deferred Tax Liability to compute NOPAT3. Include Deferred Tax Liability as part of Invested Capitalc. LIFO Reserve1. LIFO understates Inventory and hence capital2. Add LIFO Reserve to compute Invested Capital3. Increase

25、 in LIFO reserve (after-tax) is added to compute NOPATi. Essentially adding in unrecognized COGSd. Goodwill Amortization1. Represents cash invested in the firm2. Add-back after-tax Amortization to compute NOPAT3. Add Cumulative Amortization to compute Invested Capital4. Note: Recent accounting chang

26、es no longer amortize Goodwill. It is written-off when it is deemed impaired. However, the same concept applies to these write-offs.e. Operating Leases1. Should be treated as capital leases2. Add capitalized value of operating lease payments to compute Invested Capital3. Add-back after-tax lease pay

27、ments to compute NOPATf. Successful Efforts to Full Cost1. All investments (successful and unsuccessful) represent cash invested in the firm2. Add cumulative loss to compute Invested Capital and amortized against NOPAT over expected payoff period.3. Treat unsuccessful expensing just like R&D abo

28、ve.2. Analysts differ in the adjustments they make to Invested Capital and NOPAT (or Equity Capital and Net Income under the equity approach) to arrive at residual incomeB. Violations of Clean Surplus Accounting1. Some events are not reported on the income statement, but do find their way to the Equ

29、ity section of the balance sheet. In these cases, the book value of equity is correct, but Net Income is not. a. These omissions from Net Income can distort naïve forecasts of Net Income and ROE.b. Other times, these positive and negative omissions can offset each other over time (e.g., foreign

30、 currency translations).c. The analyst must determine how these items will affect future forecasts2. For example, increases in fair value of some financial assets increase the value of equity through “Comprehensive Income”, but these gains are not included on the income statement.a. The analyst can

31、adjust for this by adding the gain to NI in calculating ROE.b. The reverse would hold for decreases in fair valuec. No adjustment to Invested Capital is necessary b/c it already reflects the change in market value through the comprehensive income calculation.3. Major areas of comprehensive income in

32、clude:a. Foreign currency translationsb. Pension fund value adjustmentsc. Fair value changes of some financial instrumentsC. Non-Recurring Items1. As before, the analyst should look for non-recurring items in the footnotes and not just rely on income statement classifications. Sometimes “unusual items” recur consistently. Things to look out for are:a. Restructuring charges (whats cash flow/ROE in the current year and what is likely to affect cash flow/ROE in future years?)b. Discontinued operationsc. Extraordinary i