CFA Level II, Equity investments, Residual Income Valuation
RI = net income - equity charge
EVA= NOPAT - (WACC * invested capital) NOPAT = EBIT * (1-t) invested capital = net working capital + net fixed assets = book value of long term debt + book value of equity
adjustments to be made
capitalization when possible, use FIFO and consider cash expenses only: capitalize and amortize R&D add back charges on strategic investments capitalize goodwill, add amortization expense back to earnings eliminate deferred taxes treat operating leases as capital leases add LIFO reserve to invested capital, add back change in LIFO reserve to NOPAT
market value added
MVA = market value - invested capital market value = market value of equity and debt invested capital = net working capital + net fixed assets = book value of long term debt + book value of equity
use of residual income models
measurement of managerial effectiveness equity valuation measure goodwill impairment
RI = E - (r * B t-1)
residual income valuation model
current book value + present value of expected future residual income
is value recognized earlier in RI approach than other pv approaches?
does RI approach have less forecast error?
fundamental determinants of RI
ROE , ROE - r
Q = (market value of debt + market value of equity) / replacement cost of total assets
continuing residual income
RI expected over the long run
RI expect to persist at current level w=1 RI drop to zero w=0 RI decline to a long run average RI decline over time as ROE falls to cost of equity
higher persistence factors
low dividend payouts historically high residual income persistence
lower persistence factors
high return on equity significant levels of nonrecurring items high accounting acruals
PV continuing RI
PV = RIt / (1+r-w)
alternative method to estimating continuing RI?
PV of continuing RI = Pt - Bt Pt = Bt * (forecasted P/B) PV of continuing RI year T-1 = ((Pt - Bt) + RIt) / (1+r)
terminal value does not dominate, use accounting data, applicable to firms that do not pay dividends, or do not have positive expected FCF, cash flow volatile, focus on economic profitability
rely on accounting data, numerous adjustments, clean surplus realtion Bt = Bt-1 + Et - Dt
appropriate to use RI when?
no dividends or too volatile expected FCF negative terminal value uncertain
not appropriate to use RI when?
clean surplus violated uncertainty of book value and ROE estimates
clean surplus violations
foreign currency translation under all current method minimum liability adjustment in pension accounting available for sale securities
effect of clean surplus violations
net income not ok, book value ok.
variations from fair value
operating leases should be capitalized,SPEs consolidated, reserves and allowances adjusted, inventory using FIFO, reflect funded status, eliminate deferred tax liabilities (report as equity if liability is not expected to reverse)
intangible asset effects
goodwill should be included, effect of amortization excluded