Residual Income

RESIDUAL INCOME VALUATION

I. PRINCIPLES

A. Conceptually, residual income is

1. Shareholder cash flow less a charge for the cost of shareholder capital (r_E), or

2. Firm cash flow less a charge for the cost of firm capital (using WACC)

B. Although Net Income includes a charge for debt capital (i.e., interest expense), it does not include a charge for equity capital

1. Residual income makes a deduction for this missing charge

C. Conceptually, residual income models view the intrinsic value of a firm as the initial book (i.e., invested capital) plus the present value of residual income (i.e., value created)

D. Example 5-1 (p.263)

1. Using Equity Capital Approach

a. Residual Income = NI – Equity Charge

b. Residual Income = NI – Equity Capital x r_E(%)

c. Residual Income = (ROE – r_E) x Equity Capital

1. ROE = Return on Equity

2. ROE = NI/Equity Capital

3. Residual Income = (ROE – r_E) x Equity Capital

2. Using Invested Capital Approach

a. Residual Income = EBIT(1 – T) – Invested Capital Charge

b. Residual Income = NOPAT – Invested Capital Charge

c. Residual Income = NOPAT – Invested Capital x WACC(%)

1. NOPAT = Net Operating Profit After Tax

2. ROIC = Return on Invested Capital

3. ROIC = NOPAT/Invested Capital

d. Residual Income = (ROIC – WACC) x Invested Capital

3. These simple expressions show very clearly what creates and destroys value in a company in general terms.

E. References

1. The Quest for Value by G. Bennett Stewart, III (Harper Business, © 1991.

a. He introduces Economic Value Added (EVA), a brand name for residual income.

2. Valuation: Measuring and Managing the Value of Companies, 3^rd edition by Copeland, Koller and Murrin (Wiley © 2000)

a. Similar to Stewart’s book, but perhaps a bit more tractable

II. USING RESIDUAL INCOME FOR VALUATION

A. Equity Capital Approach. Conceptually, residual income models view the intrinsic value of a firm’s equity as the initial book (i.e., invested equity capital) plus the present value of future residual income (i.e., value created), or

1. Can be implemented using either an aggregate or per share approach

B. Equity Capital Approach. Alternatively, one can value the intrinsic value of the entire firm as the initial book (i.e., invested capital) plus the present value of future residual income (i.e., value created), or

1. One would then deduct the outstanding debt to arrive at equity value.

C. In the EVA vernacular, the value of a firm’s equity is the Invested Equity Capital plus the present value of all future EVA, or

D. Example 5-3 (p.267), Example 5-5 (p.272)

E. Example 5-4 (p.268)

F. Example 5-6 (p.273) – using I.D.1.c above

III. ADVANTAGES AND DISADVANTAGES OF RESIDUAL INCOME MODELS

A. Advantages

1. Terminal value is a relatively smaller portion of present value

2. Uses readily available accounting data

3. Applies to dividend and non-dividend paying companies

4. Can be used when cash flows are unpredictable

5. Focuses on economic value

B. Disadvantages

1. Uses readily available accounting data (e.g., accounting manipulations)

2. Accounting data may need to be adjusted for distortions. (See below)

3. The model requires that the clean surplus relation holds (i.e., changes in book value equals NI less dividends; that is, all changes to book value other than ownership transactions flow through earnings).

C. Therefore, the model is useful when

1. A company does not pay dividends or dividends are not predictable

2. FCF is negative over a comfortable forecast horizon

3. There is great uncertainty in estimating terminal values

D. Not useful when

1. there are significant departures from clean surplus accounting. For example,

a. Gains on marketable securities are reflected in stockholder’s equity as “comprehensive income” rather than as income on the income statement

b. Wide use of employee stock options (see Example 5-6)

c. Foreign currency translations

d. Some pension adjustments

2. determinants of residual income (e.g., book value and ROE) are not predictable

IV. RESIDUAL INCOME AND PRICE-TO-BOOK (P/B)

A. Single-Stage Residual Income Model

1. Assuming that residual income is a growing perpetuity. Then, II.A.1 becomes

a. Called Single-Stage Residual Income Model (Example 5-8)

2. Divide through by B

B. Can be used to examine fundamental determinants of value

C. Can be used to estimate justified P/B ratio or terminal value in a multi-stage DDM model

D. Can be used to help estimate terminal value created under Premium over Book Value approach below.

E. Implied growth rate (Example 5-9, p.285)

V. THE CREATION AND DESTRUCTION OF VALUE IN RI MODELS

A. Base Case Example

1. All-equity firm

2. Equity Capital = $1,000

3. NI = $250 into perpetuity

4. ROE = 250/1,000 = 25%

5. r_E = 15%

, or

B. New Investment w/ ROI > r

1. New Investment = $1,000 additional capital

2. ROI = 20%

a. Notice the ROI is less than the current ROE, but greater than r_E.

3. Equity Capital = $1,000 + $1,000 = $2,000

4. NI = $250 + $200 = $450 into perpetuity

5. ROE = 450/2,000 = 22.5%

6. r_E = 15%

, or

7. Although firm value increased by $1,333 only $333 of value has been created because $1,000 of the growth was additional invested capital

C. New Investment w/ ROI <>

1. New Investment = $500 additional capital

2. ROI = 10%

a. Notice the ROI is positive, but less than r_E.

3. Equity Capital = $1,000 + $500 = $1,500

4. NI = $250 + $50 = $300 into perpetuity

5. ROE = 300/1,500 = 20%

6. r_E = 15%

, or

7. Although firm value increased by $333, the initial investment was $500. Therefore, $167 of value was destroyed because ROI <>

D. Cut costs or increase revenue w/o additional investment

1. Suppose average ROE increases to 30%.

2. In this case, the value of the firm increases to $2,000.

3. However, no additional investment was required so the entire growth of the firm is due to value creation.

E. Reduce investment w/o affecting NOPAT

1. Suppose we can reduce capital to $667, but keep NI at $250.

2. ROE = 250/667 = 37.5%

3. The value of the firm remains unchanged because we reduced invested capital $333 and created $333 in value in the process.

F. Liquidate underperforming assets

1. Similarly, suppose we liquidate $500 of assets that are generating $25 of income each year. That is, they have and ROI of 5%.

a. Equity Capital = $1,000 - $500 = $500

b. NI = $250 - $25 = $225 into perpetuity

c. ROE = 225/500 = 45%

d. r_E = 15%

2. Even though the firm is smaller, we’ve added value because we liquidated $500 of capital, decreasing firm value by only $167. The $333 is all value created.

VI. ACCOUNTING CONSIDERATIONS

A. Equity Equivalents

1. The Stewart book referenced above outlines a fairly detailed list of adjustments, called Equity Equivalents, one might make in arriving at NOPAT and Invested Capital. For example,

a. Research and Development (R&D)

1. Recognizes R&D as cash invested in the firm, like additions to PP&E in the form of cap. ex.

2. Add back R&D expense to earnings to compute NOPAT

3. Added to invested capital (i.e., capitalized) and amortized against NOPAT over subsequent years

b. Deferred Income Tax

1. Recognize actual cash taxes paid

2. Add increases in Deferred Tax Liability to compute NOPAT

3. Include Deferred Tax Liability as part of Invested Capital

c. LIFO Reserve

1. LIFO understates Inventory and hence capital

2. Add LIFO Reserve to compute Invested Capital

3. Increase in LIFO reserve (after-tax) is added to compute NOPAT

i. Essentially adding in unrecognized COGS

d. Goodwill Amortization

1. Represents cash invested in the firm

2. Add-back after-tax Amortization to compute NOPAT

3. Add Cumulative Amortization to compute Invested Capital

4. Note: Recent accounting changes no longer amortize Goodwill. It is written-off when it is deemed impaired. However, the same concept applies to these write-offs.

e. Operating Leases

1. Should be treated as capital leases

2. Add capitalized value of operating lease payments to compute Invested Capital

3. Add-back after-tax lease payments to compute NOPAT

f. Successful Efforts to Full Cost

1. All investments (successful and unsuccessful) represent cash invested in the firm

2. Add cumulative loss to compute Invested Capital and amortized against NOPAT over expected payoff period.

3. Treat unsuccessful expensing just like R&D above.

2. Analysts differ in the adjustments they make to Invested Capital and NOPAT (or Equity Capital and Net Income under the equity approach) to arrive at residual income

B. Violations of Clean Surplus Accounting

1. Some events are not reported on the income statement, but do find their way to the Equity section of the balance sheet. In these cases, the book value of equity is correct, but Net Income is not.

a. These omissions from Net Income can distort naïve forecasts of Net Income and ROE.

b. Other times, these positive and negative omissions can offset each other over time (e.g., foreign currency translations).

c. The analyst must determine how these items will affect future forecasts

2. For example, increases in fair value of some financial assets increase the value of equity through “Comprehensive Income”, but these gains are not included on the income statement.

a. The analyst can adjust for this by adding the gain to NI in calculating ROE.

b. The reverse would hold for decreases in fair value

c. No adjustment to Invested Capital is necessary b/c it already reflects the change in market value through the comprehensive income calculation.

3. Major areas of comprehensive income include:

a. Foreign currency translations

b. Pension fund value adjustments

c. Fair value changes of some financial instruments

C. Non-Recurring Items

1. As before, the analyst should look for non-recurring items in the footnotes and not just rely on income statement classifications. Sometimes “unusual items” recur consistently. Things to look out for are:

a. Restructuring charges (what’s cash flow/ROE in the current year and what is likely to affect cash flow/ROE in future years?)

b. Discontinued operations

c. Extraordinary items

VII. MULTI-STAGE RESIDUAL INCOME MODELS

A. Terminal Value Created

1. The longer the forecast, the greater the chance that the residual income convergences to zero à zero terminal value created

a. In the long run, industry economic profits (RI) tend toward zero because positive economic profits attract competition and negative economic profits encourage consolidation and/or exit.

2. Premium Over Book Value as Terminal Value Created

3. Persistence Model

a. ω is a persistence factor

1. Suppose ω is 0à residual income dissipates immediately after forecast period.

i. That is, no RI after period T.

2. Suppose ω is 1à perpetual residual income

i. That is, RI persists into perpetuity after period T.

b. Empirically, one study estimates a persistence factor of 0.62.

1. Implies a 38% rate of decay per year, on average.

c. Factors affecting persistence

1. Low persistence

i. Extreme ROEs

ii. Extreme accruals

iii. Extreme special items

2. High persistence

i. Low dividend payout

ii. High historical persistence

iii. Persistent identifiable barriers to entry

4. Examples 5-10, 5-11, 5-12 (p.287+)