Discounted Cash flow methods

Residual Income Model1Residual Income ModelAlso known as:Discounted Abnormal Earnings Model orEdwards-Bell-Ohlson ModelCommercial implementationsEconomic Value Added (EVA) = NOPAT (C% * TC)Where: NOPAT = Net Operating Profit After TaxC% = the cost of capitalTC = total capital2Residual Income ModelUse GAAP to adjust for items and arrive at NOPAT and TCCapitalize and amortize R&D (do not expense)Suspend charge for capital until date for strategic investments that are not expected to generate an immediate returnGoodwill is capitalized and not amortizedDeferred taxes are eliminated such that only cash taxes are treated as an expense.Add back to capital any inventory LIFO reserve Operating leases are treated as capital leases and nonrecurring items are adjusted.3Residual Income ModelRI Model analyses the intrinsic value of equity as the sum of two components:The current book value of equityPresent value of expected future residual incomeIntrinsic Value of Common Stock:

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Residual Income ModelThe General Residual Income Model

Do example 5-65

Residual Income ModelMultistage Residual Income Valuation Continuing Residual IncomeAssumptionsResidual income continuous indefinitely at a positive levelResidual income is zero from the terminal year forward Residual income decline to zero as ROE reverts to the cost of equity over timeResidual income reflects the reversion of ROE to some mean levels

6Residual Income ModelMultistage Residual Income Valuation Continuing Residual Income

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Residual Income ModelMultistage Residual Income ValuationDo example 5-88Residual Income ModelStrengths and weaknesses of residual income modelBroad guidelines for using a Residual Income Model9