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Valuation

Class 11
Residual Income Model
Some notes based on Easton, et al (2001)
Outline
Residual Income: What is it? why is it useful?

Alternative Forms of Valuation Models

Deriving Residual Income Model (RIM)
Single period, multiperiod, infinite period
How RIM works
RIM Drivers

RIM Spreadsheet
RIM through explicit pro forma forecast
RIM with analyst forecast

Readings: The Key to Creating Wealth, Metric War
Measuring Wealth


Residual Income as a single-period
performance metric
RI
t+1
= Earnings
t+1
- (r*Capital
t
)
RI

- Edwards & Bell (63); Ohlson (92)
EVA
tm
- Stern Stewart (91)
Economic Profit
tm
- McKinsey & Co. (95)
Abnormal earnings

- Palepu et. al. (97)
Cost-of-
capital
Asset base
What we
earned
x
( )
-


What did the author claim?



What is his argument and evidence?



Does it make sense?

Why is EVA/Residual Income Model so useful?
Discussion: The Key to Creating Wealth


Economic Value Added: How do you create wealth?
Company evaluation: it helps company focus on
projects

Project evaluation: it helps company monitor how
effective its capital is.

Measuring performance and determining compensation:
e.g. bonus is determined by examining how EVA has
improved





Why is EVA/Residual Income Model so useful?







Helps clarify thinking


Management Compensation based on performance:


Also, if you can get lower cost of capital, then you generate higher
EVA.
Any examples?

EVA/Residual Earning Model: Why is it useful?

EVA Help management focus on the value drivers in
every aspect of the business: ROCE and growth in equity

Management has to focus on higher return project

E.g. Coke dumps less profitable businesses in pasta ,
instant tea, plastic cutlery, desalinization equipment, and
wine. Instead it focuses on profitable soft drink business.

It helps management use less capital:

E.g. Coke uses cheap plastic containers instead of
expensive metal containers for concentrates







What is intrinsic value?
The intrinsic (equity) value of a firm is the
PV of all future payoffs to shareholders"
Equity valuation methods differ in terms of technique, but
they have the same objective: to measure the present value of
the eventual payoffs to shareholders
I t involves forecasting
Future cash flows, discount rates
I t is an educated guess
Subjective, imprecise
Outline
Residual Income: What is it? why is it useful?

Alternative Forms of Valuation Models

Deriving Residual Income Model (RIM)
Single period, multiperiod, infinite period
How RIM works
RIM Drivers

RIM Spreadsheet
RIM through explicit pro forma forecast
RIM with analyst forecast

Readings: The Key to Creating Wealth, Metric War
Measuring Wealth


A Review of Alternative Valuation Models
Source: Penman (2000)
CF from investments
CF from operations
Operating revenue
Operating expenses
Free cash flow
CF to shareholders
(net dividends)
CF to debtholders
Different Valuation Models focus on alternative CF measures
Source: Penman (2000)
DDM DCF RIM
Wealth distribution Wealth Creation

Firm Value
t
= Capital
t
+
PV of future wealth
creating activities
In each future period t+i

(Earnings
t+i
- r*Capital
t
)(1+r)
-i

Residual Income as a valuation tool
Key: The three components of this equation must be
consistently defined.
Once Capital is defined, r must be the cost of that capital
and Earnings must be the expected flow to that capital,
subject to the Clean-Surplus Relation. (CSR: Capital
t

= Capital
t-1
+ Earnings
t
- Dividend
t
)
Capital Cost of
Capital
Earnings Examples in
literature
I. Value to both debtholders and shareholders:

1. Net op. assets (or
Total assets +/-
adjustments for
specific items)
WACC EBI or NOPLAT +/-
specific adjustments
(depending on how
capital is defined)
Stewart: EVA
TM
McKinsey.:
Economic Profit
Model
TM
2. Net fin. assets WACC Free Cash Flow (EBI
+/- accounting
accruals +/- net
capital exp.)
Rappaport:
ALCAR
TM
; Copeland
et al.: Discounted
Cashflow Model
3. Net op. assets with
inflation and other
adjustments
WACC EBI with specific
adjustments (incl.
inflation)
Holt Value
Associates: CFROI
TM
II. Value to shareholders only:

1. Shareholder's equity
(reported book value)
under a particular
country's GAAP
Cost of equity NI to shareholders
under the same
GAAP
Frankel & Lee
(1998), Penman et al.
(1998): EBO or
Discounted Residual
Income Model

Alternative valuation methods
Outline
Residual Income: What is it? why is it useful?

Alternative Forms of Valuation Models

Deriving Residual Income Model (RIM)
Single period, multiperiod, infinite period
How RIM works
RIM Drivers

RIM Spreadsheet
RIM through explicit pro forma forecast
RIM with analyst forecast

Readings: The Key to Creating Wealth, Metric War
Measuring Wealth


Firm Value
t
= Capital
t
+ PV (future residual income)
Residual Income Model (to Shareholders)

where:
P
t
= value of equity at time t
B
t
= book value at time t
r
e
= cost of equity capital
ROE
t
= return on book equity for period t
( ) | |
( )

=
+ +
+

+ =
1
1
*
1
i
i
e
i t e i t t
t
t
r
B r ROE E
B
P
*
Derivation of the Residual Income Model: One Period
Valuing a one-period payoff equation:



Substitute for the expected dividend



to get



or


The amount, is called Residual Earnings
E
1 0 1 1
0

P ) B (B Earnings
P
+
=
) B (B Earnings d
0 1 1 1
=
E
1 1
E
0 E 1
0 0

B P

1)B ( Earnings
B P

+

+ =
( )
0 E 1
B 1 Earnings
( )
E
1 1
0

d P
P
+
=
Derivation of the Residual Income Model: Multiperiod
Substituting comprehensive earnings and book value for dividends in each
period,








If we set ,






( ) ( )
( )
T
E
T T
T
E
1 T E T
2
E
1 E 2
E
0 E 1
0 0

B P

B 1 Earnings
...
...

B 1 Earnings

B 1 Earnings
B P

+

+
+

+

+ =

( )
1 t E t t
B 1 Earnings RE

=
T
E
T T
T
E
T
2
E
2
E
1
0 0

B P

RE
....

RE

RE
B P

+ + + + + =
The Residual Income Model:
Infinite Horizon
The model can be extended for
infinite horizons







or






( ) ( )
( )
1 E 0 2 E 1
0 0
2
E E
T E T 1
T
E
Earnings 1 B Earnings 1 B
P B ...

Earnings 1 B
... ...



= + + +

+ +
.....

RE

RE

RE

RE

RE
B P
5
E
5
4
E
4
3
E
3
2
E
2
E
1
0 0
+ + + + + + =
How the Residual Earnings Model
Works
ROCE
1

Current
book value ROCE
2

Growth in
book
value
1

ROCE
3

Growth in
book
value
2

Year 3 ahead Year 2 ahead Year 1 ahead
Residual earnings
1
Residual earnings
2
Residual earnings
3

Current
book value
Current year
PV of RE
1

Discount by
Forecasts
PV of RE
2

PV of RE
3

Current
book value
Discount by
3

Discount by
2

Current Data
Drivers of Residual Earnings
Residual earnings is the rate of return on equity, ROCE,
expressed as a dollar excess return on equity rather than a
ratio:



TWO DRIVERS
(1) ROCE
(2) Book Value
( ) ( ) | |
1 1
1 1
t- E t t- E t
B ROCE B earn =
(1) (2)
Outline
Residual Income: What is it? why is it useful?

Alternative Forms of Valuation Models

Deriving Residual Income Model (RIM)
Single period, multiperiod, infinite period
How RIM works
RIM Drivers

RIM Spreadsheet
RIM through explicit pro forma forecast
RIM with analyst forecast

Readings: The Key to Creating Wealth, Metric War
Measuring Wealth


RIM using explicit earning forecasts from
pro forma model
From last class, we produce an explicit pro forma forecasts
of future items in balance sheet, income statement, free
cash flows, etc.
In particular, it implies a set of future earnings.
RIM using explicit forecast from pro
forma model
Timberland as of 12/1/93 FE0 FE1 FE2
EPS Forecasts NA NA NA
EPS 2.750
Book value/share (last fye) 9.550
reqd rate of return 14.8000%
K (dividend payout) 0.250
ROE-industry 0.190
Year 1993
growth rate of earning (g) (2002 to 04) 5.75%
Long term residual earning growth 0.00
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Net Income (From the DCF model) 2.16 3.43 4.80 6.21 7.09 7.77 8.55 9.41 10.36 11.40 12.052 12.745
Net Income 2.16 3.43 4.80 6.21 7.09 7.77 8.55 9.41 10.36 11.40 12.05 12.75
K 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25
Book 9.55 11.17 13.74 17.34 22.00 27.31 33.15 39.56 46.62 54.39 62.94 71.98
ROE 0.23 0.31 0.35 0.36 0.32 0.28 0.26 0.24 0.22 0.21 0.19 0.18
Book*(ROE-r) 0.74 1.78 2.76 3.65 3.83 3.73 3.65 3.56 3.46 3.35 2.74 2.09
Discount factor 1.148 1.318 1.513 1.737 1.994 2.289 2.628 3.017 3.463 3.976 4.564 5.240
PV(Residual Earning) 0.65 1.35 1.83 2.10 1.92 1.63 1.39 1.18 1.00 0.84 0.60 0.40
SUM PV(Residual Earning) 14.883
TV 9.53
PV(TV) 1.819
Market Value 26.253
Timberland as of 12/1/93 FE0 FE1 FE2
EPS Forecasts 2.750 2.08 3.22
EPS 2.750
Book value/share (last fye) 9.550
reqd rate of return 14.8000%
K (dividend payout) 0.250
ROE-industry 0.190
Year 1993
growth rate of earning (LTG) (last 5 yr) 17.75%
Long term residual earning growth 0.00
Assumption 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
EPS
yr1-2 (FE1&FE2), yr 3 to
yr 7(LTG), yr 8 to yr 12
(according to ROE) 2.08 3.22 3.79 4.46 5.26 6.19 7.29 8.24 9.21 10.17 11.09 11.93
K 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25
Book 9.55 11.11 13.53 16.37 19.72 23.66 28.30 33.77 39.95 46.86 54.48 62.80
ROE 0.22 0.29 0.28 0.27 0.27 0.26 0.26 0.24 0.23 0.22 0.20 0.19
Book*(ROE-r) 0.67 1.58 1.79 2.04 2.34 2.69 3.10 3.24 3.30 3.23 3.02 2.64
Discount factor 1.148 1.318 1.513 1.737 1.994 2.289 2.628 3.017 3.463 3.976 4.564 5.240
PV(Residual Earning) 0.58 1.20 1.18 1.18 1.17 1.17 1.18 1.07 0.95 0.81 0.66 0.50
SUM PV(Residual Earning) 11.668
TV 20.36
PV(TV) 3.886
Market Value 25.104
RIM using analysts earning forecasts
Using the RIM Valuation Spreadsheet Instruction Sheet

KEY PARAMETERS
1. EPS Forecasts. FY1, FY2, and Ltg are earnings per share (EPS) estimates, supplied by the
user. FY1 and FY2 are the one- and two-year-ahead forecasts, respectively. Ltg is the expected long-
term earnings growth rate. For publicly traded firms, all three variables can usually be obtained from
commercial services that collect analyst earnings forecasts -- for example, I/B/E/S, Zack's, First Call,
or Value-Line.
2. Book Value Per Share. The book value (or total shareholder's equity) per share as of the last
fiscal year end. Typically available from last year's annual report.
3. Discount Rate. The cost of common equity for the firm. This is the expected rate of return,
and should reflect the riskiness of the cash flows to common shareholders. Use CAPM to figure out
the discount rate. As a benchmark, large U.S. corporations typically have had historical discount rates
of 12 percent. Smaller, more leverage firms, and firms in more volatile industries require higher rates.
Since 1997, implied discount rates in the U.S. have dropped sharply and now a typical large cap. firm
(Beta=1) calls for a rate of around 9%.
4. Dividend Payout Ratio. The proportion of earnings expected to be
paid out in "net dividends" (dividends + share repurchases - new equity
issues) over the forecast period. This variable is typically estimated by
dividing the actual dividends per share (DPS) by the earnings per share
(EPS). If a firm has a consistent share repurchase policy, the number may
need to be adjusted upwards. In case of negative earnings, divide DPS by
(6% X total assets per share).
5. Next Fiscal Year-end. The fiscal year corresponding to the FY1
forecast.
6. Target ROE (industry avg.) This is the equilibrium ROE for the
industry. The spreadsheet is designed to mean revert to this level of ROE
from year 7 to year 12.
For a detailed discussion of the theory and
implementation of EBO models, see Charles M. C. Lee,
"Measuring Wealth," the CA Magazine, Canadian
Institute of Chartered Accountants, April 1996.

For a more updated reference list, see Lee, C.M.C., 1999,
"Accounting-based Valuation: Impact on Business
Practice and Research," Accounting Horizons, December.

See roe_coe document for an industry-by-industry
estimation of ROE and Cost of Equity.

Basic Information for RIM Valuation
and Where to Find It
Accounting Fundamentals
(dividend-per-share, book
value-per-share, and SIC code)

Analyst forecasts of
earnings (FY1, FY2, Ltg)
Discount rates and Industrial target
ROEs
Yahoo! Finance
http://quote.yahoo.com/
Lots of useful information under
"Profile" and "Research."
Yahoo! Finance
http://quote.yahoo.com/. Has
FY1, FY2, and LTG. Data
not as fresh as First Call
(updated weekly).

CAPM model
r
e
= r
f
+ b (mkt risk prem)
Currently, mkt risk prem is around
3%. r
f
is approx. 6%. Est. of "b"
available from many sources.
Market Guide
http://www.marketguide.com
Full fundamentals & stock
screens. Select financial
information free. Target ROEs.

Market Guide
http://www.marketguide.com
Consensus FY1, FY2, and
LTG. Get ID and password
for full use of this site.
Our website
Our website.
Industrial Risk Premiums and Median
ROEs downloadable under "Research"
and "Analytical Toolbox."

Disclosure Global Access
http://www.disclosure.com/dga/
Direct download F/S into Excel.
Don't need password if accessing
from Johnson computers.

Bloomberg
Has consensus FY1 and FY2
as of yesterday, no LTG

Implied Cost-of-capital study
Tables 1, 2 and 3 from "Toward an
Implied Cost of Capital" paper by
Gebhardt et. al. (1999) discusses firm
and industry specific adjustments.

Basic Information for RIM Valuation
and Where to Find It
Accounting Fundamentals
(dividend-per-share, book
value-per-share, and SIC code)

Analyst forecasts of
earnings (FY1, FY2, Ltg)
Discount rates and Industrial target
ROEs
Yahoo! Finance
http://quote.yahoo.com/
Lots of useful information under
"Profile" and "Research."
Yahoo! Finance
http://quote.yahoo.com/. Has
FY1, FY2, and LTG. Data
not as fresh as First Call
(updated weekly).

CAPM model
r
e
= r
f
+ b (mkt risk prem)
Currently, mkt risk prem is around
3%. r
f
is approx. 6%. Est. of "b"
available from many sources.
Market Guide
http://www.marketguide.com
Full fundamentals & stock
screens. Select financial
information free. Target ROEs.

Market Guide
http://www.marketguide.com
Consensus FY1, FY2, and
LTG. Get ID and password
for full use of this site.
Our website
Our website.
Industrial Risk Premiums and Median
ROEs downloadable under "Research"
and "Analytical Toolbox."

Disclosure Global Access
http://www.disclosure.com/dga/
Direct download F/S into Excel.
Don't need password if accessing
from Johnson computers.

Bloomberg
Has consensus FY1 and FY2
as of yesterday, no LTG

Implied Cost-of-capital study
Tables 1, 2 and 3 from "Toward an
Implied Cost of Capital" paper by
Gebhardt et. al. (1999) discusses firm
and industry specific adjustments.

Basic Information for RIM Valuation
and Where to Find It
Accounting Fundamentals
(dividend-per-share, book
value-per-share, and SIC code)

Analyst forecasts of
earnings (FY1, FY2, Ltg)
Discount rates and Industrial target
ROEs
Laser Disclosure
In the library
Full text of SEC filings and
annual reports, including
graphics

I/B/E/S Express
Daily update of individual
analyst forecast data. In
library.
CCQ by Ibbotson Associates
Industrial betas and costs of equity.
These estimates are typically too high
for investment purposes today (may
be alright for capital budgeting).
Compact Disclosure
(CD-Rom based, available in
most business school libraries)
Can download information in
user defined reports

Compact Disclosure
Reports IBES consensus as
of last quarter (not recent)
has FY1, FY2 and LTG


SEC Edgar
http://www.edgar-online.com/
Electronic filings of annual
reports, 10Ks, and 10Qs. Free
public access.