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Session-11-12-Residual Income Valuation - PGP
Session-11-12-Residual Income Valuation - PGP
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Agenda for discussion
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Analyst point
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Residual Income
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Implication
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Implication
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Residual Income
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The capital market:
Investing in a Business Trading value
Financing
Activities
Activities
Activities
Investing
Business investment and the firm: value is surrendered by investors to the firm, the firm adds or losses
value, and value is returned to investors. Financial statements inform about the investments. Investors trade
in capital markets on the basis of information on financial statements
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1-10
Valuation Models
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1: Asset based valuation models
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2: Discounted cash flow (DCF) models
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CFi
Value i 1
t r is the discount rate or
(1 r )i required rate of return
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Analyst’s point
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Analyst’s point
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Conceptual Framework for
Residual Earnings Model
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Investment 400
Required return 10%
Revenue forecast 440
Expense forecast 400
Forecasted earnings 40
40 - (0.10 x 400)
0
0
Value 400
1.10
400
440
V 400
1 . 10
Valuing a One-Period Project
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Investment 400
Required return 10%
Revenue forecast 448
Residual earnings1 48 - (0.10 x 400) = 8
Earnings forecast 48 (Revenue 448- Depreciation 400)
8
Value Project 400 407.27
1.10
The project adds value
448
DCF value 407 .27
1.10
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Normal Price-to-Book Ratio
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Note:
The Normal P/B firm earns an expected rate of return on its
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An Anchoring Principle
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Residual Income Model (RIM)
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Building Blocks of a Residual
Earnings Valuation
$520
Current Market Value Residual Earnings $214.50
Value Per Share
$305.78
Residual Earnings $142.36
$163.42
BooK Value at
Current
Period
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Model for Anchoring Value on Book Value
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E
V0
B0 Is the intrinsic price to book value .
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Derivation of the Equity
Valuation Model (one period)
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to get Earnings1 (r B0 ) P1 B1
P0 B0
(1 r)1
(1 r)1
RE1 P1 B1
P0 B0
(1 r)1 (1 r)1
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Derivation of the Equity Valuation
Model: Multi-period
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E RE 1 RE 2 RE T VT B T
V0 B0 ....
(1 r) 1 (1 r) 2 (1 r) T (1 r) T
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Example
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Solution
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Relation Between P/B Ratios and
Subsequent RE
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_____________________________________________________________________________________
R e s id u a l E a r n in g s fo r
P /B Y e a r s A fte r P /B G r o u p s A r e F o r m e d ( Y e a r 0 )
G roup P /B _____________________________________________________________
0 1 2 3 4 5 6
_ _Sl.No.
___________________________________________________________________________________
1 (H ig h ) 6 .2 0 .1 7 3 .2 3 0 .2 1 8 .2 1 3 .2 1 1 .2 0 0 .2 0 4
2 3 .6 6 .1 2 1 .1 4 4 .1 4 2 .1 4 0 .1 4 8 .1 4 9 .1 3 9
3 2 .8 2 .1 0 1 .1 1 2 .1 0 8 .1 0 8 .1 0 1 .1 0 3 .1 1 6
4 2 .3 3 .0 8 9 .1 0 0 .0 9 9 .0 9 6 .0 9 7 .1 0 8 .1 2 3
5 2 .0 0 .0 7 6 .0 8 2 .0 8 0 .0 8 8 .0 8 5 .0 8 6 .0 9 4
6 1 .7 6 .0 6 4 .0 6 6 .0 6 4 .0 5 8 .0 6 6 .0 7 1 .0 7 6
7 1 .5 8 .0 5 7 .0 5 8 .0 5 8 .0 5 6 .0 6 1 .0 5 9 .0 7 3
8 1 .4 3 .0 4 7 .0 5 2 .0 4 7 .0 4 9 .0 5 3 .0 6 0 .0 6 8
9 1 .3 1 .0 4 0 .0 4 0 .0 4 1 .0 4 4 .0 4 6 .0 5 5 .0 5 6
10 1 .2 2 .0 3 5 .0 3 6 .0 3 5 .0 4 0 .0 4 7 .0 5 4 .0 5 4
11 1 .1 3 .0 3 2 .0 3 4 .0 3 5 .0 4 0 .0 4 5 .0 5 1 .0 5 5
12 1 .0 5 .0 2 8 .0 2 7 .0 2 8 .0 3 2 .0 4 0 .0 4 3 .0 4 6
13 .9 8 .0 2 3 .0 2 3 .0 2 5 .0 3 1 .0 3 5 .0 3 7 .0 4 5
14 .9 4 .0 1 8 .0 1 9 .0 2 5 .0 2 9 .0 3 5 .0 3 7 .0 3 9
15 .8 5 .0 0 9 .0 0 8 .0 1 3 .0 2 0 .0 2 8 .0 3 3 .0 4 1
16 .7 9 -.0 0 1 -.0 0 1 .0 0 6 .0 1 5 .0 2 3 .0 2 4 .0 2 4
17 .7 2 -.0 1 1 -.0 1 5 -.0 0 5 .0 0 8 .0 1 1 .0 2 1 .0 2 2
18 .6 4 -.0 2 4 -.0 2 4 -.0 1 2 -.0 0 3 .0 0 8 .0 1 0 .0 1 7
19 .5 4 -.0 4 2 -.0 4 4 -.0 2 8 -.0 1 5 -.0 0 7 -.0 0 7 -.0 0 6
2 0 (L ow ) .3 9 -.0 6 8 -.0 7 0 -.0 4 1 -.0 2 8 -.0 2 0 -.0 1 7 -.0 1 4
_____________________________________________________________________________________
R e s id u a l in c o m e is d e fla te d b y b o o k v a lu e a t th e b e g in n in g o f y e a r 0 , th e y e a r th e P /B g r o u p s a r e fo r m e d .
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Alternative Measure of Residual Earnings
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Continuing Value after T
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Target Price T B T CV T
Note: Long term CV is speculative and hence its weight should be reduced.
Will discuss the same in P/E Model.
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Converting an Analyst’s Forecast to
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a Valuation: Nike Inc.
Analysts forecast EPS two years ahead ($3.90 for 2009 and $
4.45 for 2010) and also give a five year EPS growth rate of
13 percent. Forecasts for 2011-2013 apply this consensus EPS
growth rate to the 2010 estimate. Dividends per share (DPS)
are set at the 2008 payout rate of 23 percent of earnings.
Required rate of return is 10 percent. Years labeled ‘A’ are
actual numbers, years label ‘E’ are expected numbers.
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Nike Inc.
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Year-1 Year-2 Year-3 Year-4 Year-5
2008A 2009E 2010E 2011E 2012E 2013E
P2008 = $60
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Example: Analyst’s forecasts and valuation-
Pepsi and Coca-Cola
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Some facts
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Some more facts
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Concept Behind P/B Ratio
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Concept Behind P/B Ratio
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Analyst’s point
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Beware of paying too much for Earnings
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Implication
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Implication
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Other than the required rate of return on common stock, the inputs
to the residual income model come from accounting data.
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Implication
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Analyst point
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Analyst point
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The single-stage residual income model also assumes that the company's
positive residual income continues indefinitely and that book value grows at
a constant rate. More likely, a company's ROE will revert to a mean value
of ROE over time and at some point, the company's residual income will be
zero.
In light of these considerations, the residual income model has been
adapted in practice to handle declining residual income and deficiencies in
the current accounting model. For example, Lee and Swaminathan (1999)
and Lee, Myers, and Swaminathan (1999) used a residual income model to
value the Dow 30 assuming that ROE fades (reverts) to the industry mean
over time. Lee and Swaminathan found that the residual income model had
more ability to predict future returns than traditional price multiples.
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Implication
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Part III: Calculation BV
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Calculation BV
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Calculation BV
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Implication for ROE
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Implication of Intangible assets
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Implication of Goodwill
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Consider two companies, Alpha and Beta, with the following summary financial
Example:
information (all amounts in thousands, except per-share data):
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Implication of Goodwill
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Implication of Goodwill
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Implication of Goodwill
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Implication of Goodwill
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Implication of Goodwill
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Why should the combined company be worth less than the two
separate companies? Assuming that a fair price was paid to the former
shareholders, the combined value should not be lower.
1. This amount is the same as the sum of the values of the companies on a
separate basis. Recently, U.S. GAAP has altered the treatment of goodwill
amortization. Goodwill is still listed as an asset when purchased but is no
longer amortized?
2. Under lAS, goodwill is currently required to be amortized over a period not to
exceed 20 years.
3. To ensure international comparability and to avoid the adverse impact of
amortization noted above, analysts recommend adjusting earnings to remove
any amortization of goodwill.
4. Note- goodwill impairment test. If goodwill is later deemed to be impaired, a
write-off or loss is taken
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Implication of Goodwill
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Implication of Goodwill
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Implication of Goodwill
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Implication of Goodwill
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Implication of Goodwill
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Research and development costs
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