Residual Income Valuation

Terms in this set (14)

Continuing residual income is the residual income that is expected over the long-term. Residual income will continue beyond a specified earnings horizon depending on the fortunes of the industry, as well as on the sustainability of a specific firm's competitive prospects over the longer-term. The projected rate at which residual income is expected to fade over the lifecycle of the firm is captured by a persistent factor, w, which is between zero and one

We typically make one of the following assumptions about continuing residual income at the end of the short-term:
1) Residual income is expected to persist at its current level forever (w=1), so residual income in every year after T equals residual income in year T. The present value of continuing residual income at the end of year T-1 is the present value of a perpetuity:
PV of continuing RI in year T-1 = RIt/r
2) Residual income is expected to drop immediately to zero (w=0),
PV of continuing RI in year T-1 = RIt/1+r
3) Residual income is expected to decline over time as ROE falls to the cost of equity (0<_w<_1),
PV of continuing RI in year T-1 = RIt/1+r-w
4) Residual income is expected to decline to a long-run average level consistent with a mature industry,
PV of continuing RI in year T = Pt - Bt
Pt = Bt x (forecasted price-to-book ratio)
PV of continuing RI in year T-1 =(Pt-Bt)+RIt / 1+r

The strength of the persistence factor will depend partly on the sustainability of the firm's competitive advantage and the structure of the industry. The more sustainable the competitive advantage and the better the industry prospects, the higher the persistence factor. Higher persistence factors will be associated with the following:
1) Low dividend payouts.
2) Historically high residual income persistence in the industry.
Lower persistent factors will be associated with the following:
1) high return on equity
2) significant levels of nonrecurring items
3) high accounting accruals
Strengths of residual income models include the following:
1) Terminal value does not dominate the intrinsic value estimate, as is the case with dividend discount and free cash flow valuation models.
2) Residual income models use accounting data, which is usually easy to find.
3) The models are applicable to firms that do not pay dividends or that do not have positive expected free cash flows in the short-term.
4) The models are applicable even when cash flows are volatile.
5) The models focus on economic profitability rather than just on accounting profitability.

Weaknesses of residual income models include the following:
1) The models rely on accounting data that can be manipulated by management.
2) Reliance on accounting data requires numerous and significant adjustments.
3) The models assume that the clean surplus relation holds or that its failure to hold has been properly taken into account. Any accounting charges that are taken directly to the equity accounts (such as currency translation gains and losses) will cause the clean surplus relation not to hold.
4) A drawback to the single-stage model is that it assumes the excess ROE above the cost of equity will persist indefinitely.

Residual income models are appropriate under the following circumstances:
1) A firm does not pay dividends, or the stream of payments is too volatile to be sufficiently predictable.
2) Expected free cash flows are negative for the foreseeable future.
3) The terminal value forecast is highly uncertain, which makes dividend discount or free cash flow models less useful.
Residual income models are least appropriate when:
1) significant departures from clean surplus accounting exist, or
2) significant determinants of residual income, such as book value and ROE, are not predictable.
Clean Surplus Violations:
The clean surplus relationship may not hold when items are charged directly to shareholders' equity and do not go through the income statement. Items that can bypass the income statement include:
1) foreign currency translation gains and losses that flow directly to retained earnings under the current rate method.
2) Certain pension adjustments.
3) Gains/losses on certain hedging instruments.
4) Changes in revaluation surplus (IFRS only) for long-lived assets.
5) Changes in the value of certain liabilities due to changes in the liability's credit risk (IFRS only).
6) Changes in the market value of debt and equity securities classified as available for sale under US GAAP and "equity instruments measured at fair value through other comprehensive income" under IFRS.
The effect of violations of the clean surplus relationship is that net income is not correct, but the book value is still correct. The risk in applying the residual income model when the clean surplus relation doesn't hold is that the ROE forecast will not be accurate if the clean surplus relation are not expected to offset in future years.

Variations from Fair Value:
The accrual method of accounting causes many balance sheet items to be reported at book values that are significantly different than their market values. Common adjustments to the balance sheet necessary to reflect fair value include the following:
1) operating leases should be capitalized by increasing assets and liabilities by the present value of the expected future operating lease payments.
2) Special purpose entities whose assets and liabilities are not reflected in the financial statements to the parent company should be consolidated.
3. Reserves in allowances should be adjusted. For example, the loans for bad debts, which is an offset to the accounts receivable should reflect the expected loss experience.
4) Inventory for companies that use LIFO should be adjusted to FIFO by adding the LIFO reserve to inventory and equity, assuming no deferred tax impact.
5) The pension asset or liability should be adjusted to reflect the funded status of the plan, which is equal to the difference between the fair value of the plan assets and the projected benefit obligation.
6) Deferred tax liabilities should be eliminated and reported as equity if the liability is not expected to reverse.

Intangible Asset Effects on Book Value:
Recognition of an identifiable intangible asset in the group accounts that was not previously recorded in the investee company balance sheet creates a distortion in valuation under a residual income model. The amortization of such intangible assets reduces the combined ROE, and hence results in lower valuation of the combined entity compared to the sum of the values of individual entities prior to acquisition. To remove this distortion, the amortization of intangibles capitalized doing acquisition should be removed prior to computing the ROE used for residual income valuation.
The suggested analytical treatment of R&D expenditures is less definitive, but we can make a general statement that the ROE estimate for a mature company should reflect the long term productivity of the company's R&D expenditures: productive R&D expenditures increase ROE and residual income, and unproductive expenditures reduce ROE and residual income.

Nonrecurring Items and Other Aggressive Accounting Practices:
Nonrecurring items should not be included in residual income forecasts because they represent items that are not expected to continue in the future. Items that may need adjustment in measuring recurring earnings include discontinued operations, accounting changes, unusual items, extraordinary items, and restructuring charges.

International accounting differences:
Residual income models, which are based on accrual accounting information, may not be as useful in valuing foreign firms because of differences in national accounting standards. Frankel and Lee concluded that there are three primary considerations in applying a residual income model internationally:
1) the availability of reliable earnings forecasts
2) systematic violations of the clean surplus assumption
3) poor quality accounting rules that results in delayed recognition of value changes