Residual Income

Residual Income
FRANSISCA THARIA, MM
A L L M AT E R I A L I S TA K E N F R O M C FA
INVESTMENT SERIES BOOK
THIS MATERIAL BELONGS TO UNIVERSITAS PRASETIYA MULYA. DO NOT COPY OR SHARE THIS MATERIAL ON PUBLIC DOMAIN. FOR PRIVATE USE ONLY.
Residual Income
Economic
Profit
Abnormal Residual
Earnings
Income
Economic
Value
Added
Residual Income
⇐÷→"*y
shareholder
:
perspective
Net Equity Residual

Income Charge Income
capital holder
perspective EBITCI -
Tax )
Capital Residual
NOPAT
Net operating Profit Charge Income
After Tax
Example: Residual Income
TA =
Tlc
Total assets $5,000,000.00
É
Debt-to-total capital ratio 0 .60 '
Cost of debt (before tax) 8%
Cost of equity 12%
Tax rate 40%

BV equity
of 5,000,000 (1 -
6040) = 2,009000
8%11 40% ) + (1-0.6) 12%

0.6
7.68%
-
wacc
=
.
.
=
.
EBIT $400,000
I.
Less interest Expense $240,000
Pretax income $160,000
Less income tax expense $64,000
Net income $96,000

Rt =
96,000 -
12% .
2,000,000 = 96,000 -
240,000 =
-
144,000
-
EVA 400,000 ( I 40% ) 7.68% 5,000,000 384,000

-144,0--00
-
240,000
= -
= -
=
.
Equity capital $2,000,000
Equity charge $240,000
Net income $96,000

Less equity charge $240,000
Residual income -–$144,000
Related Measures
Economic
Value
NOPAT C% × TC
Added
(EVA)
◦ NOPAT = Net operating profit after taxes

◦ C% = Cost of capital
◦ TC = Total capital
Market
Market Book Value
Value
Value of of Total
Added
the Firm Capital
(MVA)
Uses of Residual Income
Valuation
Measuring Goodwill Impairment
Measuring Internal Corporate Performance

C.
Determining Executive Compensation
Forecasting Residual Income
din Book Value
/BIf→
t ,
,
Rt Eps pg
Per share
- .
RIt = Et − re Bt −1 Bt
F
Beginning
Residual Earnings Required
book value
income per per share return on
per share
share (EPS) equity (Re)
(BVPS)
Example: Forecasting Residual Income
0 1 2
Earnings (FPS) $2.50 $3.00

-
( DPS)
Dividends $1.00 $1.10
201-2-5 -
Book value $20.00

☐ 21.5
Required equity return 10%

25 -
10%-20 3- 10%(21-5)
RI = $0.5 = $0.85
in One Year
Charge for Equity Capital =
• Required return on equity × Beginning book value per share
• 10% × $20.00 = $2.00
Residual Income in Year 1 =

• EPS – Charge for equity capital
• $2.50 – $2.00 = $0.50
in Two Years
End-of-Year Book Value for Year 1 =
• Beginning-of-year book value + Earnings – Dividends
• $20.00 + $2.50 – $1.00 = $21.50
• Beginning book value for Year 2
Charge for Equity Capital in Year 2 =

• Required return on equity × Beginning book value per share
• 10% × $21.50 = $2.15
Residual Income in Year 2 =

• $3.00 – $2.15 = $0.85
Valuing Common Stock Using Residual
Income
§
∞
RIt
h
$12022
B0 + ∑
V0 = £
-9
[
Vzozl =
Bvaoz , +
e- 2022T¥
t =1 (1 + r )
t
Et − rBt −1 ∞
V0 = B0 + ∑
t =1 (1 + r )
t
Year
Bo =
Ending BV at 0
Example: Valuation Using Residual
Income
From the Previous Example:
;÷ ÷
+
• Beginning book value at time 0 = $20.00 Vo = 20 +
;÷
+
• Residual income in Year 1 = $0.50

• Residual income in Year 2 = $0.85 =
20 1- 1.908
• Required return on equity = 10% = 21 .

908
Additionally, Assume:
• The firm ceases operations in three years
Example:
Valuation Using Residual Income
$0.50 $0.85 $1.00
V0 = $20 + 1
+ 2
+ 3
1.10 1.10 1.10
V0 = $20 + $1.91
V0 = $21.91 RI =
Nl - Ke .
But -1
ROE =
Nl_
But -1
ke;÷ ]
But
In
[
-
,
Ri
- .
But -
t
RI =
( ROE
-
ke ) But I
-
Determinants of Residual Income
RIt = ( ROE t − r ) Bt −1 ✓
ROE > r RI > 0 V>B create value
ROE < r RI < 0 V<B destroy value
One stage
Residual Income Valuation and the P/B

Vo = Po
ROE − r Po
RoE-r- Bo
V0 = B0 +
Bo
B0
=
+ -
r−g
r
00
g
-
E. = # +
RI÷
-
¥?
Boo
Bo
V0 ROE − r ±
= 1+ R;÷
= ' +
r−g
Bo
B0
0
Example:
Using a Single-Stage Residual Income Model
Book value of equity per share $30.00
É
Return on equity ' 18% "
Required return on equity 12%
Q.ro
Residual income growth rate 8%
1%0,2%9,0-0
30 + 30
30+45
7¥
= =
.
=
Example:
ROE − r
V0 = B0 + B0
r−g
0.18 − 0.12
V0 = $30 + $30
0.12 − 0.08
$1.80
V0 = $30 +
0.12 − 0.08
= $75.00 ②
=< $175T
slightly
}
Fair value
.
overvalued
$80
Example: current value .

Suppose that the current stock price is $80 in the previous
example. What is the implied growth rate?
0.18 − 0.12
$80 = $30 + $30
0.12 − 0g
$1.80
$50 =
0.12 − g
$80 $80
@
Fair Value Vs current Value =
g = 8.4%
= .
Continuing Residual Income
= Long-Term Residual Income
Potential Scenarios:
• RI is constant forever → One stage Model
→
• RI is zero at the terminal period ( → TV = o ROE = r )
* • RI gradually declines to zero, where ROE = r

→
• RI gradually declines to a constant level, where
ROE > r
Continuing Residual Income
and Persistence Factors
High Persistence Low Persistence
• Low dividend • Extreme ROE

payout • Extreme levels of clean surplus relationshi
• Historically high special items µ. . .

. .
.
+ Nl Div
industry ROEs
-
• Extreme
.
accounting
accruals
Valuing Continuing Residual Income
"""→
I
Et − rE Bt −1
T −1
Et − rE BT −1
V0 = B0 + ∑ + T −1
t =1 (1 + rE ) t
(1 + r −
E 0ω)(1 + r E )
Persistence Factor (ω)

• 0≤ω≤1
• ω = 1 Residual income will not fade
• ω = 0 Residual income will not persist after the initial forecast to rise
• ω = 0.62 It has been observed, on average, empirically
Example: Multistage
Residual Income Model
From the First Valuation Example:
I
• Beginning book value at Time 0 = $20.00
}
• Required return on equity = 10%
• Value was $21.91
Now Assume:
• The firm continues operations after three years
Example: Multistage Model
Case 1: ω = 0 → TV = 0
.
Et − rE Bt −1
T −1
ET − rE BT −1
V0 = B0 + ∑ + T −1
t =1 (1 + rE ) t
(1 + rE − ω)(1 + rE ) -
$0.50 $0.85 $1.00

V0 = $20 + + +
1
1.10 1.10 2
(1 + 0.10 − 0)(1.10 )
2
-
to
$0.50 $0.85 $1.00

V0 = $20 + 1
+ 2
+ 2
1.10 1.10 (1.10)(1.10 )
→ V0 = $21.91
-
Case 2: ω = 1.0 = a
Et − rE Bt −1
T −1
ET − rE BT −1
V0 = B0 + ∑
TV =
29.42 21.91
+
-
7.51
T −1
+ t
+ − ω +
=
t =1 (1 rE ) (1 rE )(1 rE )
$0.50 $0.85 $1.00
V0 = $20 + + +
1
1.10 1.10 2
(1 + 0.10 − 1.0)(1.102 )
V0 = $20 +
$0.50 $0.85
1
+
1.10 1.10 2
+
$1.00
(0.10)(1.102 ) €
V0 = $29.42
Case 3: ω = 0.60 -
Et − rE Bt −1
T −1
ET − rE BT −1
V0 = B0 + ∑ + T −1
t =1 (1 + rE ) t
(1 + rE − ω)(1 + rE )
$0.50 $0.85 $1.00
V0 = $20 + + +
1
1.10 1.10 2
(1 + 0.10 − 0.60)(1.10 )
2
$0.50 $0.85 $1.00

V0 = $20 + 1
+ 2
+
1.10 1.10 (0.50)(1.102 )
V0 = $22.81
= .
Case 4 =
W
=0
(,+ÉÉ
Vo =
20 +
0 +
+
1. 1
20 1- 3.223
=
=
23.22
=
.
?⃝
Using the €
P/B
Calculate the PV of continuing residual income using P/B
-17
• Use this to determine terminal value
Assume for the previous example

• Book value in Year 3 = 1--1 P 25 1. I
=27
J
$25.00 .
= .
• P/B is projected in Year 3 as 1.10
The projected stock price in Year 3:

• $25 × 1.10 = $27.50
?⃝
Free Cash Flow Model
Example: Multistage Model TVs =
FY÷
Using the P/B
Iv .
Rt
Et − rE Bt −1 PT − BT
T Tvz =
4 -
V0 = B0 + ∑
.
+ A
t =1 (1 + rE ) (1 + rE )
t T
$0.50 $0.85 $1.00 $27.50 − $25.00

V0 = $20 + 1
+ 2
+ 0
3
+ 0
1.10 1.10 1.10 1.103
V0 = $23.79 =
Residual Income and
Dividend and FCFE Model Valuations
Residual Income Dividend and FCFE

Model Valuation Model Valuations
• Required return on • Required return on
equity equity
• an
Book value + PV • PV (equity cash
(residual income) flows)
FV
F
TV .
Example: Residual Income and
Dividend Models
Example Assumptions
All earnings are paid out as dividends so book value is constant
I Earnings and dividends are constant forever → growth = 0% .
Earnings per share ① $1.00 →

DPs = $1
Book value of equity $7.00
Required return on equity 10%

121 = I -
10% 7 .
=
0.3
Example: Residual Income and
Dividend Models
Valuation Using a Constant Dividend Model
Assume a 100% dividend payout ratio
V0 = D / r = $1.00 / 0.10 = $10.00
Valuation Using a Residual Income Model
V0 = $7.00 + $0.30 / 0.10

IF
V0 = $7.00 + $3.00
V0 = $10.00
-
Residual Income vs.
Dividend and FCFE Models
Residual Income Dividend and FCFE
Model Valuation Model Valuations
Value = Value =
Book value + PV PV (Early cash flows
(residual income) + Terminal value)
→ →
Large weight on Large weight on

current book value later cash flows
Strengths and Weaknesses
Strengths Weaknesses
• Puts less weight on the terminal • Relies on accounting data

value • May require adjustments to
• Uses available accounting data accounting data
• Is useful for non-dividend-paying • Relies on clean surplus relation
firms • Assumes that Cost of debt =
• Is useful for firms without free cash Interest expense
flows
• Is useful when cash flows are
unpredictable
• Is based on economic value
Appropriateness
Most Appropriate
is not
• At non-dividend-paying firms •
When the
company 's PIB Far
From 1
• At firms without free cash flows
.
• When terminal values are highly uncertain
Least Appropriate
• When the clean surplus relationship does not hold
• When the determinants of residual income are not
predictable
• When the company share price differ significantly with the BVPS .
Clean Surplus Accounting
Beginning Ending
Net
book value Dividends book value
income
of equity of equity
Accounting Adjustments for the
Example Adjustment to Financial Statement
Over several years, Firm A has Adjust net income downward
consistently recorded losses in its
available-for-sale securities → Oct
'
Firm B consistently capitalizes Adjust net income and book value
expenditures that should have been downward
expensed
=o
Firm C has recorded foreign currency
-
translation losses on its balance sheet

over several years; the losses are
Adjust net income downward
- -
expected to continue * OCI
1.
Firm D accelerates revenues to the Adjust net income and book value
-
current period and defers expenses to downward

later periods
Summary
Residual Income = Income Leftover after All Capital Charges
• = Net income – (Equity required return × Book value)

• = (ROE – Equity required return) × Book value
• Related to EVA and MVA
Equity Value = Book Value + PV (Residual Income)
• Can be used with single-stage and multistage models

• Can be specified with a persistence factor
• Firms with stronger market positions will have greater
persistence factors
Summary
Relative to Other Valuation Models
• Useful when a firm does not have dividends or free cash flow
• Puts less emphasis on later cash flows
Use of Accounting Data
• Assumes clean surplus relation holds

• May require adjustments to accounting data

Residual Income

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Residual Income

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Residual Income

Net Equity Residual

Cost of equity 12%

Tax rate 40%

8%11 40% ) + (1-0.6) 12%

Pretax income $160,000

Less income tax expense $64,000

Net income $96,000

EVA 400,000 ( I 40% ) 7.68% 5,000,000 384,000

Net income $96,000

◦ NOPAT = Net operating profit after taxes

Measuring Goodwill Impairment

Measuring Internal Corporate Performance

Earnings (FPS) $2.50 $3.00

Book value $20.00

Required equity return 10%

Residual Income in Year 1 =

Charge for Equity Capital in Year 2 =

Residual Income in Year 2 =

• Residual income in Year 1 = $0.50

• Required return on equity = 10% = 21 .

ROE > r RI > 0 V>B create value

ROE < r RI < 0 V<B destroy value

Residual Income Valuation and the P/B

Required return on equity 12%

Using a Single-Stage Residual Income Model

* • RI gradually declines to zero, where ROE = r

• Low dividend • Extreme ROE

• Historically high special items µ. . .

Persistence Factor (ω)

$0.50 $0.85 $1.00

$0.50 $0.85 $1.00

$0.50 $0.85 $1.00

Assume for the previous example

• P/B is projected in Year 3 as 1.10

The projected stock price in Year 3:

Example: Multistage Model TVs =

$0.50 $0.85 $1.00 $27.50 − $25.00

Residual Income Dividend and FCFE

All earnings are paid out as dividends so book value is constant

I Earnings and dividends are constant forever → growth = 0% .

Earnings per share ① $1.00 →

Book value of equity $7.00

Required return on equity 10%

V0 = D / r = $1.00 / 0.10 = $10.00

Valuation Using a Residual Income Model

V0 = $7.00 + $0.30 / 0.10

Large weight on Large weight on

• Puts less weight on the terminal • Relies on accounting data

• When terminal values are highly uncertain

translation losses on its balance sheet

expected to continue * OCI

current period and defers expenses to downward

• = Net income – (Equity required return × Book value)

Equity Value = Book Value + PV (Residual Income)

• Can be used with single-stage and multistage models

Use of Accounting Data

• Assumes clean surplus relation holds

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