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RESIDUAL INCOME VALUATION - Coggle Diagram
RESIDUAL INCOME VALUATION
Residual income (RI), or economic profit, is the net income of a firm less a charge that measures stockholders’ opportunity cost of capital.
Economic value added (EVA)= EVA = NOPAT – (WACC x total capital) = EBIT x (1 – t) - $WACC.
Capitalize and amortize research and development charges (rather than expense them), and add them back to earnings to calculate NOPAT.
Add back charges on strategic investments that will generate returns in the future.
Eliminate deferred taxes and consider only cash taxes as an expense.
Treat operating leases as capital leases and adjust nonrecurring items.
Add LIFO reserve to invested capital and add back change in LIFO reserve to NOPAT.
Market value added (MVA) = Market value of the company − Accounting book value of total capital
The residual income model of valuation analyzes the intrinsic value of equity as the sum of two components: The current book value of equity + The present value of expected future residual income
Single-stage residual income valuation model If ROE > r → The second term ( (ROE − r) x B0 r − g ) > 0 → V0 > B0 → The justified P/B ratio > 1
Implied growth rate in residual income = r − ((ROE − r) x B0) / (V0 − B0)
Continuing residual income
Residual income is expected to persist at its current level forever.
ω = 1, như GGM
Residual income is expected to drop immediately to zero
ω = 0, năm đó chiết khấu về luôn
Residual income is expected to decline over time as ROE falls to the cost of equity (in which case residual income is eventually zero)
persistence factor, ω (0 ≤ ω ≤ 1).
Residual income is expected to decline to a long-run average level consistent with a mature industry.
PV = PT - BT
PT = BT x forecasted P/B ratio
PV = (PT − BT + RIT) / 1 + r
Tobin’s Q = (market value of debt + market value of equity)/replacement cost of total assets
Comparing RI models to DDM and FCF models
Residual income models
Less sensitive to terminal value estimates
Start with a book value and add to this the present value of the expected stream of residual income to derive the intrinsic value
DDM and FCF models
More sensitive to terminal value estimates
Discount a stream of expected cash flows to derive the intrinsic value
Strengths
Terminal value does not dominate the intrinsic value estimate.
Residual income models use accounting data, which is usually easy to find.
The models are applicable to firms that do not pay dividends or that do not have positive expected free cash flows in the short run.
The models are applicable even when cash flows are volatile.
The models focus on economic profitability rather than just on accounting profitability.
Weaknesses
The models rely on accounting data that can be manipulated by management.
Reliance on accounting data requires numerous significant adjustments.
The models assume that the clean surplus relation holds or that its failure to hold has been properly taken into account.
Use cases of RI models
Appropriate circumstances
A firm does not pay dividends, or the stream of payments is too volatile to predictable. be sufficiently
Expected free cash flows are negative for the foreseeable future.
The terminal value forecast is highly uncertain, which makes dividend discount or free cash flow models less useful.
Not appropriate circumstances
There is significant uncertainty concerning the estimates of book value and return on equity.
The clean surplus accounting relation is violated significantly.
Accouting effect on RI model
Non Recurring item
Intangible asset
International accounting differences
The accrual method of accounting causes many balance sheet items to be reported at book values that are significantly different than their market values.
Reserves and allowances should be adjusted.
Inventory for companies that use LIFO should be adjusted to FIFO by adding the LIFO reserve to inventory and equity, assuming no deferred tax impact.
Special purpose entities (SPEs) whose assets and liabilities are not reflected in the financial statements of the parent company should be consolidated.
The pension asset or liability should be adjusted to reflect the funded status of the plan.
Operating leases should be capitalized by increasing assets and liabilities by the present value of the expected future operating lease payments. Interest expense should be close to the true cost of debt.
Deferred tax liabilities should be eliminated and reported as equity if the liability is not expected to reverse.
The clean surplus relationship (i.e., ending book value = beginning book value + net income − dividends) may not hold when items are charged directly to shareholders’ equity and do not go through the income statement.
Foreign currency translation gains and losses that flow directly to retained earnings under the current rate method.
Certain pension adjustments.
Gains/losses on certain hedging instruments
Changes in revaluation surplus (IFRS only) for long-lived assets.
Changes in the value of certain liabilities due to changes in the liability’s credit risk (IFRS only).
Changes in the market value of debt and equity securities classified as available for-sale.