CHAPTER FIVE

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Prepared by: Stephen H. Penman – Columbia
University
With contributions by
Nir Yehuda – Northwestern University
Mingcherng Deng – University of Minnesota
Peter D. Easton and Gregory A. Sommers – Notre Dame and
Southern Methodist Universities
Luis Palencia – University of Navarra, IESE Business School 5-2
 What You Will Learn From This Chapter

• 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 business strategies
• How the residual earnings model captures value added in a strategy
• The advantages and disadvantages of using the residual earnings model and
how it contrasts to dividend discounting and discounted cash flow analysis
• How residual earnings valuation protects the investor from paying too much for
earnings added by investment
• How residual earnings valuation protects the investor from paying for earnings
that are created by accounting methods

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 The Big Picture for the Chapter

Value = Anchor + Extra Value

• The Anchor is Book Value:

Value = Book Value + Extra Value

• The Principle for adding extra value to book

value:
Add extra value if the rate of return of
book value is expected to be greater than
the required return

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 Valuing a One-Period Project (1)

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

Residual earnings1 = Earnings1 - (Required return x Investment)

= 40 - (0.10 x 400)

=0

0
Value = 400 +
1.10

= 400

This is a Zero-RE project

This is a zero NPV project:

440
DCF Valuation: V= = 400
1.10

5-5
 Valuing a One-Period Project (2)

Investment $400
Required return 10%
Revenue forecast $448
Expense forecast 400
Earnings forecast $ 48

Residual earnings1 = 48 - (0.10 x 400) = 8

8
Value Project = 400 + = 407.27
1.10
The project adds value

é 448 ù
ê DCF value = = 407.27 ú
ë 1.10 û

5-6
 Valuing a Savings Account
Forecast Year
________________________________________

2012 2013 2014 2015 2016 2017

Earnings withdrawn each year (full payout)

Earnings 5 5 5 5 5
Dividends 5 5 5 5 5
Book value 100 100 100 100 100 100

Residual earnings 0 0 0 0 0
______________________________________________________________________________________

No withdrawals (zero payout)

Earnings 5 5.25 5.51 5.79 6.08

Dividends 0 0 0 0 0
Book value 100 105 110.25 115.76 121.55 127.63

Residual earnings 0 0 0 0 0

______________________________________________________________________________________

Value = Book Value + Present Value of Residual Earnings

= 100 + 0

= 100

5-7
 Lessons from the Savings Account

1. An asset is worth a premium or discount to its book value only if the book value is
expected to earn non-zero residual earnings.

2. Residual earnings techniques recognize that earnings growth does not add value if
that growth comes from investment earning at the required return.

3. Even though an asset does not pay dividends, it can be valued from its book value
and earnings forecasts.

4. The valuation of the savings account does not depend on dividend payout. The two
scenarios have different expected dividends, but the same value.

5. The valuation of a savings account is unrelated to free cash flows: The two
accounts have the same value, but different free cash flow.

5-8
 The Normal Price-to-Book Ratio

Normal P/B = 1.0

(Price = Book Value)

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.

5-9
 An Anchoring Principle

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

Correspondingly, if one forecasts that an asset will earn a return on

book value greater than its required return -positive residual earnings -
it must be worth more than book value; there is extra value to be added.

5-10
 A Model for Anchoring Value on Book Value

Where RE is residual earnings for equity:

Residual earnings = comprehensive earnings - (required

return for equity x beginning - of -

period book value)

5-11
 ROCE (Return on Common Equity)

• The Return on Common Equity (ROCE) ratio refers to the return that
common equity investors receive on their investment.
• ROCE is different from Return on Equity (ROE) in that it isolates the
return that the company sees on its common equity, rather than
measuring the total returns that the company generated on all of its
equity.
• Capital received from investors as preferred equity is excluded from this
calculation, thus making the ratio more representative of common equity
investor returns.
• Preferred shares (also known as preferred stock or preference shares) are
securities that represent ownership in a corporation, and that have a
priority claim over common shares on the company’s assets and earnings.
The shares are more senior than common stock but are more junior
relative to bonds in terms of claim on assets. Holders of preferred stock
are also prioritized over holders of common stock in dividend payments.
 Return on Common Shareholders’ Equity (ROCE)

Comprehensive earnings to common t

ROCE t =
Book value t-1

5-13
 Relation Between P/B Ratios and Subsequent RE
_____________________________________________________________________________________

Residual Earnings for

P/B Years After P/B Groups Are Formed (Year 0)
Group P/B _____________________________________________________________
0 1 2 3 4 5 6
_____________________________________________________________________________________

1 (High) 6.20 .173 .230 .218 .213 .211 .200 .204

2 3.66 .121 .144 .142 .140 .148 .149 .139
3 2.82 .101 .112 .108 .108 .101 .103 .116
4 2.33 .089 .100 .099 .096 .097 .108 .123
5 2.00 .076 .082 .080 .088 .085 .086 .094
6 1.76 .064 .066 .064 .058 .066 .071 .076
7 1.58 .057 .058 .058 .056 .061 .059 .073
8 1.43 .047 .052 .047 .049 .053 .060 .068
9 1.31 .040 .040 .041 .044 .046 .055 .056
10 1.22 .035 .036 .035 .040 .047 .054 .054
11 1.13 .032 .034 .035 .040 .045 .051 .055
12 1.05 .028 .027 .028 .032 .040 .043 .046
13 .98 .023 .023 .025 .031 .035 .037 .045
14 .94 .018 .019 .025 .029 .035 .037 .039
15 .85 .009 .008 .013 .020 .028 .033 .041
16 .79 -.001 -.001 .006 .015 .023 .024 .024
17 .72 -.011 -.015 -.005 .008 .011 .021 .022
18 .64 -.024 -.024 -.012 -.003 .008 .010 .017
19 .54 -.042 -.044 -.028 -.015 -.007 -.007 -.006
20 (Low) .39 -.068 -.070 -.041 -.028 -.020 -.017 -.014
_____________________________________________________________________________________

Residual income is deflated by book value at the beginning of year 0, the year the P/B groups are formed.

5-14
 The Model for Finite Forecasting Horizons

RE1 RE 2 RE T VTE - B T
V0E = B0 + + 2 + ..... + T +
ρE ρE ρE ρ TE

Book Value Residual Earnings Continuing Value:

Anchor Forecast Value not booked
at time T

5-15
 Ingredients of the Model

For finite horizon forecasts we need three ingredients,

besides the cost of capital:

1. The current book value

2. Forecasts of residual earnings to horizon

3. Forecasted premium at the horizon

Component 3 is called the continuing value

RE1 RE 2 RE T VTE - BT
V0E = B0 + + 2 + ..... + T +
ρE ρE ρE ρ TE

(1) (2) (3)

5-16
 Alternative Measure of Residual Earnings

Earningst - (r E - 1)Bt -1 = [ROCEt - (r E - 1)]´ Bt -1

RE = ROCE Spread ´ Book value

5-17
 Drivers of Residual Earnings

Two Drivers:

1. ROCE

• If forecasted ROCE equals the required return, then RE will be zero,

and V = B

• If forecasted ROCE is greater than the required return, then V > B

• If forecasted ROCE is less than the required return, then V < B

2. Growth in book value (net assets) put in place to earn the ROCE

RE will change with change with ROCE and growth in book value

5-18
P/B, ROCE and Growth in Book Value

5-19
ROCE and P/B Ratios: S&P 500, 2010

5-20
 Steps for Applying the Model

1. Identify the book value in the most recent balance sheet.

2. Forecast earnings and dividends up to a forecast horizon.
3. Forecast future book values from current book values and your forecasts of
earnings and dividends.
4. Calculate future residual earnings from the forecasts of earnings and book
values.
5. Discount the residual earnings to present value.
6. Calculate a continuing value at the forecast horizon.
7. Discount the continuing value to the present value.
8. Add 1, 5, and 7.

RE1 RE 2 RE T VTE - B T
V0E = B0 + + 2 + ..... + T +
ρE ρE ρE ρ TE

5-22
 How the Residual Earnings Model Works

Current Data Forecasts

Current year Year 1 ahead Year 2 ahead Year 3 ahead

Current Book Book

ROCE1 book value ROCE2 value1 ROCE3 value2
Current Current
book value book value

Residual earnings1 Residual earnings2 Residual earnings3

PV of RE1
Discount by r

PV of RE2 Discount by r2

PV of RE3 Discount by r3

5-23
 A Simple Demonstration and a Simple Model
In millions of dollars. Required return is 10% per year.

Forecast Year

0 1 2 3 4 5

Earnings 12.00 12.36 12.73 13.11 13.51 13.91

Dividends 9.09 9.36 9.64 9.93 10.23 10.53
Book value 100.00 103.00 106.09 109.27 112.55 115.93
RE (10% charge) 2.36 2.43 2.50 2.58 2.66
RE growth rate 3% 3% 3% 3%

. RE1
V = B0 +
E

r-g
0

With g = 1.03 and ρ = 1.10, the valuation is:

$2.36
V0E = $100 + = $133.71 million
1.10 - 1.03
The intrinsic price-to-book ratio (P/B) is $133.71 / $100 = 1.34.

5-24
 Buying Residual Earnings:
Flanigan’s Enterprises Inc. Case 1:
Zero RE after the Forecast Horizon

V0E = B0 + PV of RE for T periods

V0E = 4.53 = 3.58 + 0.95
Continuing Value (CVT ) = 0
5-25
 Forecasting Residual Earnings:
General Electric Case 2:
Constant RE after the Forecast Horizon

V0E = 13.07 = 4.32 + 3.27 + 5.48

RE T +1 0.882
CVT = = = 8.82 (Constant RE: no growth)
r E -1 0.10
5-26
Forecasting Residual Earnings:
Nike, Inc. Case 3:
Growing RE after T

5-27
 Continuing Values are Speculative

— The continuing value is the most speculative part of the valuation.

Be careful not to add speculation.

— Might we also use the GDP historical GDP growth rate (something
else we know)? See later.

— Financial statement analysis (in Part Two of the book helps in the
determination of the growth rate).

5-28
 Converting an Analyst’s Forecast to a Valuation:
Nike, Inc., 2010
Analysts’ forecasts:
2011 $4.29
2012 $4.78
Five-year eps growth rate forecast: is 11%
Required Return = 9%
_____________________________________________________________________

5-29
Strategy Evaluation: Residual Earnings Approach
Forecast Year t ,
0 1 2 3 4 5 6…
Residual Earnings Approach
Revenues $430 $890 $1,350 $1,730 $1,980 $1,980 …
Depreciation 216 432 648 864 1,080 1,080 …
Strategy income 214 458 702 866 900 900 …
Book value $1,200 2,184 2,956 3,504 3,840 3,840 3,840 …
Book rate of return 17.8% 21.0% 23.8% 24.7% 23.4% 23.4%
Residual Income (0.12) 70 195.9 347.8 445.5 439.2 439.2 …
PV of RE 62.5 156.2 247.5 283.0 249.3
Total PV of RE 1
999
Continuing value 3,660
PV of CV 2,077
Value of strategy $4,276 Value add: $3,076
Discounted Cash Flow Approach
Cash inflow $430 $890 $1,350 $1,730 $2,100 $2,100 …
Investment $(1,200) (1,200) (1,200) (1,200) (1,200) (1,200) (1,200)
Free cash flow (FCF) (1,200) (770) (310) 150 53 0 900 900…
PV of FCF (687.5) (247.2) 106.8 336.7 510.7
Total PV of FCF 20
2
Continuing value 7,500
PV of CV 4,256
Value of Strategy $4,276 Net present value: $3,076

1
CV= 439.2/0.12=$3,660.
2
CV=900/0.12=$7,500.

5-31
 Effects of dividends, share issues or share
repurchases

• Are residual earnings affected by expected dividends, share issues

or share repurchases?

• No, these transactions affect both earnings and book values in the
residual earnings calculation such that their effect cancels to leave
residual earnings unaffected.
• See exhibit 5.3.
 What the Residual Earnings Model Misses

• It misses the gain or loss if the share issues or

share repurchases are carried out at a price
that is different from fair value.
 Advantages and Disadvantages of the Residual
Earnings Model
Advantages Disadvantages
• Focus on value drivers: focuses on profitability of • Accounting complexity:
investment and growth in investment that drive requires an understanding of
how accrual accounting works
value; directs strategic thinking to these drivers • Suspect accounting: relies on
• Incorporates the financial statements: incorporates accounting numbers that can
the value already recognized in the balance sheet be suspect (Chapter 18)
(the book value); forecasts value added in the
income statement and balance sheet rather than the
cash flow statement
• Uses accrual accounting: uses the properties of
accrual accounting that recognize value added ahead
of cash flows, matches value added to value given up
and treats investment as an asset rather than a loss of
value
• Versatility: can be used with a wide variety of
accounting principles (Chapter 17)
• Aligned with what people forecast: analysts forecast
earnings (from which forecasted residual earnings
can be calculated)
• Protection: protects from paying too much for
growth
• Reduces reliance on speculation: relies less on
uncertain continuing values and uncertain long-term
growth rates
5-34
 Protection from Paying Too Much for
Earnings Generated by Investment
Invest $50 million in Year 1 with proceeds from a share issue:

Forecast Year

0 1 2 3 4 5

Earnings 12.00 12.36 17.73 18.61 19.56 20.57

Net dividends 9.09 (40.64) 9.64 9.93 10.23 10.53

Book value 100.00 153.00 161.09 169.77 179.10 189.14

RE (10% charge) 2.36 2.43 2.50 2.58 2.66

RE growth rate 3% 3% 3% 3%

Beware!
$2.36
V0E = $100 + = $133.71 million
1.10 - 1.03

5-35
 Protection from Paying Too Much for Earnings Created
by the Accounting: the Simple Example

Writing inventory down by $8 million in Year 0 creates lower \

cost-of-goods sold in Year 1:
Forecast Year

0 1 2 3 4 5

Earnings 4.00 20.36 12.73 13.11 13.51 13.91

Dividends 9.09 9.36 9.64 9.93 10.23 10.53

Book value 92.00 103.00 106.09 109.27 112.55 115.93

RE (10% charge) 11.16 2.43 2.50 2.58 2.66

RE growth rate 3% 3% 3%

Beware!
é 2.43 ù
11.16 ê1.10 - 1.03 ú
V0E = $92 + +ê
1.10 ê 1.10ú = $133.71 million.
ú
ë û

5-37
 Tracking V/P Ratios:
All U.S. Stocks, 1975 - 2001

RE1 RE2 RE2 x g

V0E = B0 + + +
Inputs: r r2 r 2 (r - g )

Analysts’ consensus forecasts

Required return = Risk-free rate + 5%
g = 4% (average GDP growth rate)
5-38