Valuation Class 11

Residual Income Model

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

RIt+1 = Earningst+1- (r*Capitalt)

“RI” - Edwards & Bell (63); Ohlson (92)

“EVAtm” - Stern Stewart (91)

“Economic Profittm” - 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

Þ It involves forecastingÞ Future cash flows, discount rates

Þ It is an educated guessÞ 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 operationsOperating 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)

DDMDCFRIM

Wealth distributionWealth Creation

Firm Valuet = Capitalt + PV of future wealth creating activities

In each future period t+i

(Earningst+i- r*Capitalt)(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: Capitalt = Capitalt-1 + Earningst - Dividendt)

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: EVATM

McKinsey.: Economic Profit ModelTM

2. Net fin. assets WACC Free Cash Flow (EBI +/- accounting accruals +/- net capital exp.)

Rappaport: ALCARTM; 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: CFROITM

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 Valuet = Capitalt + PV (future residual income)

Residual Income Model (to Shareholders)

where:Pt = value of equity at time tBt = book value at time tre = cost of equity capitalROEt = return on book equity for period t

1

1*

1ii

e

iteitttt r

BrROEEBP

*

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

10110 ρ

P)B(BEarningsP

)B(BEarningsd 0111

E

11

E

0E100 ρ

BP

ρ

1)B(ρEarningsBP

0E1 B1ρEarnings

E

110 ρ

dPP

Derivation of the Residual Income Model: Multiperiod

Substituting comprehensive earnings and book value for dividends in each period,

If we set ,

TE

TTTE

1TET

2E

1E2

E

0E100

ρ

BP

ρ

B1ρEarnings...

...ρ

B1ρEarnings

ρ

B1ρEarningsBP

1tEtt B1ρEarningsRE

TE

TTTE

T2E

2

E

100 ρ

BP

ρ

RE....

ρ

RE

ρ

REBP

The Residual Income Model: Infinite Horizon

The model can be extended forinfinite horizons

or

1 E 0 2 E 10 0 2

E E

T E T 1TE

Earnings ρ 1 B Earnings ρ 1 BP B ...

ρ ρ

Earnings ρ 1 B... ...

ρ

.....ρ

RE

ρ

RE

ρ

RE

ρ

RE

ρ

REBP

5E

54E

43E

32E

2

E

100

How the Residual Earnings Model Works

ROCE1

Current book value ROCE2

Growth in book

value1

ROCE3

Growth in book

value2

Year 3 aheadYear 2 aheadYear 1 ahead

Residual earnings1 Residual earnings2 Residual earnings3

Current book value

Current year

PV of RE1 Discount by

Forecasts

PV of RE2

PV of RE3

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

11 11 t-Ett-Et BROCEBearn

(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 FE2EPS Forecasts NA NA NAEPS 2.750Book value/share (last fye) 9.550reqd rate of return 14.8000%K (dividend payout) 0.250ROE-industry 0.190Year 1993growth 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 2004Net 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 12.75K 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25Book 9.55 11.17 13.74 17.34 22.00 27.31 33.15 39.56 46.62 54.39 62.94 71.98ROE 0.23 0.31 0.35 0.36 0.32 0.28 0.26 0.24 0.22 0.21 0.19 0.18Book*(ROE-r) 0.74 1.78 2.76 3.65 3.83 3.73 3.65 3.56 3.46 3.35 2.74 2.09Discount 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 0.40SUM PV(Residual Earning) 14.883TV 9.53PV(TV) 1.819Market Value 26.253

Timberland as of 12/1/93 FE0 FE1 FE2EPS Forecasts 2.750 2.08 3.22EPS 2.750Book value/share (last fye) 9.550reqd rate of return 14.8000%K (dividend payout) 0.250ROE-industry 0.190Year 1993growth 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 0.25Book 9.55 11.11 13.53 16.37 19.72 23.66 28.30 33.77 39.95 46.86 54.48 62.80ROE 0.22 0.29 0.28 0.27 0.27 0.26 0.26 0.24 0.23 0.22 0.20 0.19Book*(ROE-r) 0.67 1.58 1.79 2.04 2.34 2.69 3.10 3.24 3.30 3.23 3.02 2.64Discount 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 0.50SUM PV(Residual Earning) 11.668TV 20.36PV(TV) 3.886Market 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 re = rf + b (mkt risk prem) Currently, mkt risk prem is around 3%. rf 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 re = rf + b (mkt risk prem) Currently, mkt risk prem is around 3%. rf 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.