Session-12

Evaluating Business Performance:

 Pricing Book Values (P/BV)
 Residual Earnings valuation Model.

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 Agenda for discussion
2

 What “residual earnings” is ?. How forecasting residual

earnings gives the premium over book value and the P/B ratio
 What is meant by a “normal price-to-book ratio”
 How residual earnings are driven by return on common equity
(ROCE) and growth in book value
 The difference between a Case 1, 2 and 3 residual earnings
valuation
 How the residual earnings model applies to valuing bonds,
projects, strategies as well as equities
 How the residual earnings model captures value added in a
strategy

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 Analyst point
3

 Although a company's income statement includes a

charge for the cost of debt capital in the form of
interest expense, it does not include a charge for
the cost of equity capital.
 Was the company profitable enough to satisfy
shareholders? A company can have positive net
income but may still not be adding value for
shareholders if it does not earn more than the cost
of equity capital.

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 Residual Income
4

 Conceptually, residual income is net income less a

charge (deduction) for common shareholders'
opportunity cost in generating net income.

 Note: The appeal of residual income models stems from a

shortcoming of traditional accounting.

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5 27/08/2020
 Implication
6

 The after-tax net operating return on total assets is

€140,000/€2,000,000 = 7 percent, which is less than WACC
(WACC= 8.45%) by 1.45 percentage points.
 Initially, AXCI equity is selling for book value or €l0,00,000

with 100,000 shares outstanding. Thus, AXCl's book value per

share and initial share price are both €10. Earnings per share
(EPS) are €91,000/100,000 = €0.91.
1. Earnings will continue at the current level indefinitely.
2. All net income is distributed as dividends-(No growth
environment).

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 Implication
7

 Because AXCI is not earning its cost of equity, as shown in

Example, the company's share price should fall.
 We Know that for a no-growth company, as here, the earnings
yield (E/P) is an estimate of the expected rate of return.
Therefore, when price reaches the point at which E/P equals
the required rate of return on equity, an investment in the stock
is expected to just cover the stock's required rate of return.
With EPS of €0.91, the earnings yield is exactly 12 percent
(AXCl's cost of equity) when share price is €7 .58333. At a
share price of €7.58333, the total market value ofAXCI equity
is €758,333. At this level, the equity charge is €91,000
(€758,333 X 12%) and residual income is zero.
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 Implication
8

 When a company has negative residual income, we expect

shares to sell at a discount to book value.
 In this example, AXCl's price-to-book ratio (P/B) would be
0.7583 (7.5833/10). Conversely, if we changed the data in
Example- so that AXCI earned positive residual income, we
would conclude that its shares would sell at a premium to book
value.
 In summary, we expect higher residual income to be associated
with higher market prices (and higher P/Bs), all else equal.

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 Residual Income
9

 As an economic concept, residual income has a long

history. As far back as the 1920s, General Motors
employed the concept in evaluating business
segments.
 More recently, residual income has received
renewed attention and interest, sometimes under
names such as economic profit, abnormal earnings,
or economic value added.

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 The capital market:
Investing in a Business Trading value

The firm: The investors:

The value generator The claimants on value

Cash from loans

Cash from sale
of debt
Interest and loan
repayments
Operating

Financing
Activities

Activities

Activities
Investing

Cash from share

issues Cash from sale
of shares
Dividends and cash
from share repurchases

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
10 27/08/2020
1-10
 Valuation Models
11

 The valuation models most commonly used by

analysts and investors:
1. Asset based valuation models
2. Discounted cash flow (DCF) models
Additionally, we explore a third class which has
characteristics of the above two:
3) The abnormal Earnings or Edward-Bell-Ohlson
(EBO) model

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 1: Asset based valuation models
12

 Asset based valuation models assign a value to the

firm based on current market value of the individual
component of assets. Liabilities are also at current
market value are deducted to arrive at the market
value of equity.

Value = Current market value of Assets-Current value of Liabilities

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 2: Discounted cash flow (DCF) models
13

CFi
Value  i 1
t r is the discount rate or
(1  r )i required rate of return

1. CFi are the expected cash flows from period 1 to t

2. DCF models vary as to the appropriate measure of cash flows
(CF), defined variously as streams of future dividends, earnings or
free cash flows.

3. Conceptually the DCF and asset based approaches to valuation are

related through the actual rate of return ( r* ) earned by the firm on its
equity investment.

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 Analyst’s point
14

For an infinite constant cash flow stream:

Value = CF/r
Where: CF is cash flows , r is the required rate of return
(Discount rate), then: CF = r*×BV
Where, r* is the actual rate of return earned by the firm.
BV is the book value of the firm = CSE.
Value = (r*×BV)/r
A) If r* = r, then : Value = (r*×BV)/r = BV
This equation suggest that value can be equivalently defined as either a stock
of assets, or the flows those assets generate.

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 Analyst’s point
15

B) If r* is not equals to r, then

CF = r*BV = r × BV + (r*-r)× BV
Hence, Value = ((r × BV) + (r*-r)× BV))/r
r*  r 
 BV     BV
 r 
1. Thus value of shares of a firm should sell at a price below or above
the BV depends on r* and r.
2. If r*>r is the characteristics of the firm with positive growth,
opportunities leading to market values greater than BV.
3. That’s why research use (1-B/P) as growth proxy.

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 Conceptual Framework for
Residual Earnings Model
16

 Fundamental Analysis anchors valuation in the financial

statements. Book Value provides an anchor.
Value = BV + Premium
 A measure that captures the value added to BV is RE or RI
(Residual income).
RE = Et- (RR×Investment0 ),
where as Et=Comprehensive earnings at t.
Note: RE sometimes referred to as abnormal earnings or
excess profits.
A model that measures value added from forecasts of RE is
called as residual earnings model.
Value = BV + present value of expected residual
27/08/2020 earnings.
Valuing a One-Period Project

Investment 400
Required return 10%
Revenue forecast 440
Expense forecast 400
Forecasted earnings 40

Residual earnings 1  Earnings 1  ( Required return x Investment )

 40 - (0.10 x 400)

0

0
Value  400 
1.10

 400
440
V   400
1 . 10
 Valuing a One-Period Project
18

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
19

A. Normal P/B = 1.0

B. (Price = Book Value)

Note:
 The Normal P/B firm earns an expected rate of return on its

book value equal to the required return.

 The Normal P/B firm earns expected residual earnings of zero.

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 An Anchoring Principle
20

 If one forecasts that an asset will earn a return on

its book value equal to the required return, it must
be worth its book value

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 Residual Income Model (RIM)
21

The residual income model (RIM) of valuation

analyses the intrinsic value of equity into two
components:
1. current book value of equity, plus
2. present value of expected future residual income.
 According to the residual income model, the intrinsic
value of common stock can be expressed as follows:

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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

(1) (2) (3)

Value from Value from Value from
Accumulated short-term long-term
Net assets forecasts forecasts

NO Risk Some Risk More Risk

 Residual Income Model (RIM)
23

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 Model for Anchoring Value on Book Value
24

 Value of common equity:

RE 1 RE 2 RE 3
 B0     .......... .( 1 )
E
V0
(1  r ) 1
(1  r ) 2
(1  r ) 3

Where, RE is residual earning for equity.

A. RE t = Et-(r×Bt-1 )
B. ET is the comprehensive income in current period.
C. B0 is the current BV of equity on the balance sheet.
D. r is the require return, also called the cost of equity.

Note: V0 –B0 is the intrinsic premium over BV as the present

value of future RE , which is the missing value in the Balance
sheet. 27/08/2020
 Implication
25

E
V0
B0 Is the intrinsic price to book value .

If we expect the firm to earn income for shareholders

over that required return on BV of equity (i.e. a
positive RE), its equity will be worth more than its BV
and should sell at premium.

Higher the earnings relative to BV, the higher will

be the premium.

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 Derivation of the Equity
Valuation Model (one period)
26

Valuing a one-period payoff equation: P0 

P1  d1 
(1  r)1

Substitute for the expected dividend d1  Earnings 1  (B1  B 0 )

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

The amount, Earnings 1  r  B0  is called Residual Earnings

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 Derivation of the Equity Valuation
Model: Multi-period
27

Forecasting to infinity that is required for going on concern

model at Eq (1) is a challenge. Practically, we develops a
model for forecasts over finite horizons and shows that it
captures the returns to investing in stocks. For a forecasts
over a T period horizons :
RE 1 RE 2 RE T PT  B T
P0  B 0    ....  
(1  r) 1 (1  r) 2 (1  r) T (1  r) T

Efficient prices are equals to intrinsic values , so we can

express this model with intrinsic values rather than efficient
prices.

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
28

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 Solution

29 27/08/2020
 Relation Between P/B Ratios and
Subsequent RE
30

_____________________________________________________________________________________

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
31

 Residual earnings is the rate of return on equity, ROE,

expressed as a dollar excess return on equity rather than a
ratio. But it can be expressed in ratio form:
Earningst  r  Bt 1   ( ROEt  r )  BVt 1 
 ROEt = Et/Bt-1 is the rate of return on common equity.
 Value drivers of RE is ROE and BV. Firms increase their value
over BV by increasing their ROE above cost of capital. But they
further increase their value by growth in BV (net assets) that
will earn at this ROE.
 That’s why profitable firms prefer high retention rate than high
pay out ratio.
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 Empirical evidence
32

 Current P/B is related to subsequent ROE and

growth in BV.
(Refer; The P/B-ROE valuation Model Research paper.)

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 Continuing Value after T
33

RE is forecasted to be zero in perpetuity at the horizon

So,
CVT  0

The forecasted premium at the horizon is

VTE  BT  0
The continuing value is the most speculative part of the valuation. Be
careful not to add speculation.
Forecasting Target Prices:

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
34
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.
35

 Consensus analyst’s forecast for a Nike Inc. made after fiscal

2008 financial statements were published.
 Forecasts for 2009-2010 are point estimates and for other
periods indicate 5 year intermediate term EPS growth term for
EPS of 13% per year.
 Analyst’s do not forecast DPS, usually is assumed that the
current pay-out will continue.
 Analysts do not forecast earnings for very long run, but if we
were to forecast that RE after 2009 were to grow at a long
term rate equal to the typical rate of growth in GDP of 4%.

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 Year-1 Year-2 Year-3 Year-4 Year-5
2008A 2009E 2010E 2011E 2012E 2013E

EPS 3.8 3.9 4.41 4.98 5.63 6.36

DPS 0.88 0.90 1.01 1.15 1.29 1.46
BPS 15.93 18.93 22.33 26.16 30.49 35.39

ROCE 24.48% 23.28% 22.31% 21.51% 20.85%

RE(10%Charge) 2.31 2.51 2.75 3.01 3.31
PV Factor @ Discount Rate (1.10)' 1.10 1.21 1.331 1.464 1.611
Present Value of RE 2.097 2.077 2.064 2.057 2.054
Total PV to 2013 10.350
Continuing Value (CV) 57.37
Present Value of CV 35.61
Value per share 61.891

The continuing value based on GDP growth rate:

CV = 3.31x1.04 = 58.24 P/B= 3.885205

1.10-1.04
36 27/08/2020
 Reverse Engineering for Nike Inc.
37

P2008 = $60

Consensus forecast of Earnings for 2009 = $3.90

Consensus forecast of Earnings for 2010= $4.41

2.557  (1  g )
2.307 2.557
P2008  $60  $15.93    0.10  g
1.10 1.21 1.21

g  1 .045 (a 4.5% growth rate)

Which is close to GDP growth rate.

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 Example: Analyst’s forecasts and valuation-
Pepsi and Coca-Cola
38

 Refer the Material for discussion.

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 Some facts
39

 P/B ratio differs from 1.0 because accountants do

not measure the full value of the equity in the
balance sheet.

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 Some more facts
40

1. BV captures value and residual earnings captures value

added to BV.
2. Protection from paying too much for earnings generated by
investment.
3. Protection from paying too much for earnings created by the
accounting.
4. Capturing value not on the balance sheet-for all accounting
methods.
5. Residual earnings are not affected by dividends, share issues,
or share repurchases.

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 Concept Behind P/B Ratio
41

1. BV represents shareholder’s investment in the firm. BV also

assets minus liabilities that is net assets.
2. The value of NET ASSETS is based on how much the
investment (net assets) is expected to earn in the future.
3. There in lies the concept of P/B ratio.
4. BV is worth more or less , depending on the future earnings
that the net assets are likely to generate.
5. Accordingly, the intrinsic P/B ratio is determined by the
expected return on BV.

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 Concept Behind P/B Ratio
42

6. This concept fits with our idea that shareholder’s buy

earnings.
7. The price in the numerator of P/B ratio is based on the
expected future earnings that investors are buying.
8. So higher is the expected earnings relative to BV, the higher
the P/B.

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 Analyst’s point
43

1. P/B ratio differs from 1.0 because accountants do

not measure the full value of the equity in the
balance sheet.
2. However the missing value is ultimately realized in
the future earnings that assets produce, and these
earnings can be forecasted.
3. P/B is determined by expected earnings that have
not yet been booked to BV, and higher the future
earnings relative to BV , the higher the P/B ratio.

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 Beware of paying too much for Earnings
44

1. Basic precept for investing is that investment add

value only if they earn above their required
return.
2. P/B ratio prices expected return on BV, but it does
not price return that is equal to the required return
on BV.
3. Note: This analysis is designed to prevent you from
making the mistake of paying too much for
earnings.

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 Implication
45

 If we assume constant earnings and dividend growth (at g), we

can derive a version of the residual income model that is useful
for illustrating the fundamental drivers of residual income.
 PIB based on forecasted fundamentals, assuming the Gordon
(constant growth) DDM and the sustainable growth rate
equation, g = b X ROE.

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 Implication
46

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
47

which is mathematically equivalent to

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 Analyst point
48

 The second term, (ROE - r) X Bo/(r - g), represents additional value

expected because of the company's ability to generate returns in excess of
its cost of equity; the second term is the present value of the company's
expected economic profits.
 Unfortunately, both U.S. and international accounting rules enable
companies to exclude some liabilities from their balance sheets, and neither
set of rules reflects the fair value of many corporate assets.
 There is, however, a move internationally toward fair value accounting,
particularly for financial assets. Controversies, such as the failure of Enron
Corporation in the United States, have highlighted the importance of
identifying off-balance- sheet financing techniques.

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 Analyst point
49

 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
50

 In an ideal world, where the book value of equity represents

the fair value of net assets and clean surplus accounting
prevails, the term Bo reflects the value of assets owned by the
company less its liabilities.

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 Part III: Calculation BV
51

 Unfortunately, both U.S. and international accounting rules

enable companies to exclude some liabilities from their
balance sheets, and neither set of rules reflects the fair value
of many corporate assets.
 There is, however, a move internationally toward fair value
accounting, particularly for financial assets. (IFRS Conversant
Financial Statements)
 Controversies, such as the failure of Enron Corporation in the
United States, have highlighted the importance of identifying
off-balance- sheet financing techniques.

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 Calculation BV
52

 In order to have a reliable measure of book value of equity,

an analyst must identify and scrutinize significant off-balance-
sheet assets and liabilities.
 Additionally, reported assets and liabilities should be adjusted
to fair value when possible.
 Off-balance-sheet assets and liabilities may become apparent
by an examination of the financial statement footnotes.

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 Calculation BV
53

 Examples include pension liabilities, the use of operating

leases, and the use of special purpose entities to remove both
debt and assets from the balance sheet.
 Some items such as the pension liability often result in an
understatement of liabilities and overstatement of equity.
 Others, such as leases, may not affect the amount of equity
(for example off-balance-sheet assets offset off-balance-sheet
liabilities) but can impact an assessment of future earnings for
the residual income component of value.

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 Implication for ROE
54

 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.

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 Implication of Intangible assets
55

 Intangible assets can have a significant impact on book value.

 In the case of specifically identifiable intangibles that can be
separated from the entity (e.g., sold), it is appropriate to
include these in the determination of book value of equity.
 If these assets are wasting (declining in value over time), they
will be amortized over time as an expense.

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 Implication of Goodwill
56

 Goodwill, on the other hand, requires special consideration,

particularly in light of recent changes in accounting for
goodwill. Goodwill represents the excess of the purchase price
of an acquisition over the value of the net assets acquired.
 Goodwill is generally not recognized as an asset unless it
results from an acquisition (most international accounting
standards do not allow the recognition of internally generated
goodwill on the balance sheet).

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 Example:
57

Consider two companies, Alpha and Beta, with the following summary financial
information (all amounts in thousands, except per-share data):

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 Implication of Goodwill
58

 Each company pays out all net income as dividends

(no growth), and the clean surplus relation holds.
Alpha has a 12 percent ROE and Beta has a 15
percent ROE, both expected to continue indefinitely.
Each has a 10 percent required rate of return. The
fair market value of each company's property,
plant, and equipment is the same as its book value.
 What is the value of each company in a residual
income framework?

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 Implication of Goodwill
59

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 Implication of Goodwill
60

 The value of the companies on a combined basis would be

€7 ,500. Note that both companies are valued more highly than
the book value of equity because they have ROEs in excess of the
required rate of return.
 Absent an acquisition transaction, the financial
statements of Alpha and Beta do not reflect this
value.
 If either is acquired, however, goodwill would appear as an
asset and result in higher book value of equity.

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 Implication of Goodwill
61

 For instance, suppose Alpha acquires Beta by paying Beta's

former shareholders €1,500 in cash. Alpha has just paid €500
in excess of the value of Beta's total assets (€1,000), which is
recorded as goodwill.
 The balance sheet of Alpha immediately after the acquisition
would be:

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 Note that the total book value of equity did not

change, because cash was used in the transaction.
 Assuming that goodwill is amortized over a 10-year
period, the combined company's expected net
income would be €700 (€600 + €150 - €50
amortization).
 Expected ROE would be 14 percent (700/5000).
Under a residual income model with adjustment for
goodwill amortization, the value of the combined
company would be:
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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.

The lower value results from a reduction in ROE due to the

amortization of goodwill.

If goodwill were not amortized (or we added back the amortization

expense before computing ROE), net income would be €750 and ROE
would be 15 percent. The value of the combined27/08/2020
entity would be
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64

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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 Would the answer be different if the acquiring

company used newly issued stock rather than cash in
the acquisition?

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 The form of currency used to pay for the transaction

should not impact the total value. If Alpha used
€1,500 of newly issued stock to acquire Beta, its
balance sheet would be

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 Projected earnings, excluding the amortization of

goodwill, would be €750, and projected ROE would
be 11.538 (750/6500) percent. Value under the
residual income model would be

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 The overall value remains unchanged. The book

value of equity is higher but offset by the impact on
ROE. Once again, this assumes that the buyer paid
a fair value for the acquisition.
 If an acquirer overpays for an acquisition, this
should become evident in a reduction in future
residual income and write-off of previously
recorded goodwill.

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70
Advantages and Disadvantages
Advantages Disadvantages

 Accounting complexity: requires

 Focus on value drivers: focuses on profitability of an understanding of how
investment and growth in investment that drive value; accrual accounting works
directs strategic thinking to these drivers  Suspect accounting: relies on
accounting numbers that can be
 Incorporates the financial statements: incorporates the suspect (Chapter 17)
value already recognized in the balance sheet (the
 Forecast horizon: forecast
book value); forecasts the income statement and horizons can be shorter than for
balance sheet rather than the cash flow statement DCF analysis and more value is
typically recognized in the
 Uses accrual accounting: uses the properties immediate future; also, forecasts
of accrual accounting that recognize value added up to the horizon give an
ahead of cash flows, matches value added to value indication of profitability and
given up and treats investment as an asset rather than growth for a continuing value
calculation; but the forecast
a loss of value horizon does depend on the
 Versatility: can be used with a wide variety quality of the accrual
accounting (Chapter 16)
of accounting principles (Chapter 16)
 Aligned with what people forecast: analysts forecast
earnings (from which forecasted residual earnings can
be calculated)
 Validation: forecasts of residual earnings
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can be validated in subsequent audited financial
statements 5-70