Equity #37 - Residual Income Valuation Flashcards Preview

CFA Level 2 2016 > Equity #37 - Residual Income Valuation > Flashcards

Flashcards in Equity #37 - Residual Income Valuation Deck (22)
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1
Q

residual income

A

LOS 37.a

  • residual income (RI):
    • equivalent to “economic profit”
    • RI = net inc - opportunity cost of equity capital
  • accounting income will overstate returns from equity investor perspective because it ignores cost of equity
  • RI explicitly deducts all capital costs–debt & equity
2
Q

relation of RI to other valuation models

A

LOS 37.a

  • residual income is related to :
    • PVGO model: P = EPS1 / r + PVGO
    • P/B ratio using fundamentals:
      • P/B = (ROE - g) / (r - g)
    • Porter’s 5 Forces model and competitive strategies
3
Q

equation forms of residual income

A

LOS 37.a

RI = net inc - opportunity cost of equity capital

RI = NOPAT - WACC x total capital

RI = EBIT(1 - t) - WACC x total capital;
t = marginal tax rate

RIt = EPSt - (BVPSt-1 * r)

RIt = (ROE - r)BVPSt-1

4
Q

uses for residual income models

A

LOS 37.b

  • measuring company management effectiveness & executive compensation
  • equity valuation
  • measuring goodwill impairment
5
Q

intrinsic value and residual income

A

LOS 37.c

  • RI approach: Value = BV + PV(all RI’s)
  • formula similar to DDM:

V0 = B0 + (RI1/(1+r)1 + (RI2/(1+r)2+ … + (RIn/(1+r)n

B0 = BV of equity

6
Q

calculating future RI

A

LOS 37.c

Two methods for calculating RIt:

  • RIt = EPSt - (r * BVt-1)
  • RIt = (ROEt - r) * BVt-1

intrinsic value calculation:

V0 = B0 + sum[(ROEt - r) * Bt-1 / (1 + r)t]

7
Q

difference in value recognition: RI vs. DCF models

A

LOS 37.c

  • value is recognized earlier under RI model than under DCF, so RI less sensitive to terminal value
8
Q

value drivers of residual income

A

LOS 37.d

if ROE > re:

  • RI will be positive
  • justified MV/BV > 1

if ROE = re:

  • justified MV = BV
  • MV/BV = 1
9
Q

single-stage RI constant growth model

A

LOS 37.f

assumptions: constant ROE and constant g (EPS growth)

V0 = B0 + RI1 = B0 + (ROE - r) * B0 / (r-g)

10
Q

Calculating implied growth rate

A

LOS37.g

g = r - [B0(ROE - r) / (V0 - B0]

assume P0 = V0 (mkt is in equilibrium)

V0 = market price of stock = P/B * B/S

B0 = book value

r = required return on equity

11
Q

continuing residual income

A

LOS 37.h

continuing RI: expected RI beyond the estimated horizon

  • depends on form’s ability to generate ROE > r, premium over BV
  • relates to Porter’s competitive advantage
  • depends on industry opportunities
  • depends on firm able to keep competitive edge over the long term
12
Q

persistence factor w

A

LOS 37.h

  • persistence factor w, between 0 and 1
  • high w ⇒ longer period in which ROE > 1
  • factors suggesting higher w:
    • low Div payout
    • high RI industry persistence
  • factors suggesting lower w:
    • high ROE
    • large special items
    • large accounting accruals
13
Q

continuing RI approaches

A

LOS 37.h

  1. drop immediately to zero (w = 0); no competitive advantage, “pure competition”
  2. persist at current level forever (w = 1); prepetual competitive advantage
  3. decline over time to zero
  4. decline over time to steady state “mature industry” level
14
Q

multi-stage RI model

A

LOS 37.h

Intrinsic value = sum of 3 components:

V0 = B0 + PV(high-grow RI) + PV(cont. RI)

  1. calculate current BV +
  2. calulate RI for yrs 1 to T-1 (T=terminal year) +
  3. calculate cont. RI as: PV(cont RIT-1+) = RIT / (1 + r - w)
15
Q

strengths of residual income model

A

LOS 37.j

  1. terminal value doesn’t dominate V0
  2. accounting data easily accessible
  3. works even without dividiends or positive CF
  4. works even when CFs are volatile or unpredictable
  5. focuses on economic profitability
16
Q

weaknesses of residual income model

A

LOS 37.j

  1. account data can be manipulated by management
  2. requires many adjustments
  3. assumes “clean surplus” relation holds (assumes no direct adjustments to equity i.e. all income flows through IS:

Bt = Bt-1 + Et - Dt

17
Q

accounting issues affecting RI

A

LOS 37.k

Point: while RI is straightforward, in practice it requires many adjustments:

  1. clean surplus relationship violations
  2. off-BS items
  3. nonrecurring items on IS
  4. aggressive accounting practices
  5. international accounting differences
18
Q

examples of clean surplus relationship violations

A

LOS 37.k

  • FX translation gain/(loss)
  • BS adjustements to fair value
  • pension liability (remeasurements)
  • unrecognized gain/(loss) on avail-for-sale securities
  • deferred gain/(loss) on cash flow hedges
  • change in revaluation surplus of PP&E, long-life assets and intangibles (IFRS only)
  • change in value of certain liabilities due to credit risk changes
19
Q

effect of/solution for clean surplus relationship violations

A

LOS 37.k

Effects

  • BV correct but NI and ROE forecast are incorrect
  • issue OCI items that do not reverse over time

Solution

  • calc ROE using comprehensive income (NI + d(OCI items)
  • note OCI is cinsidered income under clean surplus accounting
20
Q

Off-Balance Sheet item examples

A

LOS 37.k

  • operating leases
  • off-BS SPEs
  • LIFO to FIFO inventory
  • deferred tax assets and liabilites
21
Q

nonrecurring item examples

A

LOS 37.k

  • discontinued operations
  • accounting changes
  • restructuring charges

Effect: exclude nonrecurring items on the IS; RI should be based on recurring items only

22
Q

aggressive accounting examples

A

LOS 37.k

  • accelereating revenues to current period
  • deferring expenses to later period
  • using reserves to smooth income
  • unrealistic accounting estimates

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