The Residual Income Model Defined

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The Residual Income Model Defined
Is defined as

• Equity Level--Model produces the value of common
  equity
• Operating Level--Model produces value of the core
  operations

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Conceptual Basis for RIM

• COMEQ BVEQ Assets Liabilities

• True only if all economic assets and liabilities
  are reported on the balance sheet at their fair
  market values.

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Conceptual Basis for RIM

• COMEQ BVEQ market value of all assets
  liabilities not in BVEQ

• Market value of all net assets not in BVEQ PV
  of the cash flows from those net assets not in
  BVEQ

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Conceptual Basis for RIM
PV of the cash flows from those net assets not in
BVEQ Residual income
Residual income Expected income Base income
Expected income NIt
Base income BVEQt-1 X ke net income the firm
would earn in period t if the return on equity is
the same as cost of equity
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Residual Income Model at the Equity Level
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Illustration
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But
What is the value of BV1 ?
To find it we have to forecast the debt flows.
What is the value of NI1 ?
To find it we have to forecast the non-operating
cash flows.
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Residual Income Model at the Operating Level
Is easier to implement because it allows us to
avoid forecasting debt service and
non-operating flows
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Residual Income Model at the Operating Level
COMEQ CORE(MV) NONOP DEBT - OCAP
COMEQ CORE(BV) PV of Residual income
NONOP DEBT - OCAP
CORE OPNA CORE Assets
CORE Liabilities
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Residual Income Model at the Operating Level
Continued
Value of core operations
Present value of residual income from core
operations
Book value of core operations
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Residual Income Model at the Operating Level
Continued
NOPAT Net operating profit after tax
NOPAT Adjustments FCF
Remember, each of those adjustments reflected
changes in operating assets or liabilities (see
p. 224). Therefore
NOPATt - ? OPNA FCFt OPATt (OPNAt OPNAt-1)
OPNAt OPNAt-1 NOPATt - FCFt
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Terminal Value Assumptions

• Should give the same value regardless of
  accounting method
• The forecast must be feasible, given the capacity
  forecast to be in place by the end of the
  forecast horizon

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Three Terminal Value Assumptions

• Zero Net Present Value Investments
• Residual Income is Zero in the Long Run
• Residual Income is a Perpetuity

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Assumption 1 Zero Net Present Value Investments

• Ignores additional capital investments in the
  valuation
• Assumes the firm would continue to operate
  indefinitely at same level of capacity

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Assumption 1 Zero Net Present Value Investments

• Allows for growth in the free cash flow stream at
  a normal rate to account for expected inflation
• Not practical
• Residual income does not grow at a constant rate

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Assumption 1 Zero Net Present Value Investments
Instead, use formula that is consistent without
zero NPV investment assumption
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Assumption 2 Residual Income is Zero in the
Long Run
This assumption is incorrect

• Is not based on an underlying economic assumption
  about the firm or its industry
• Violates criteria for a reasonable terminal value
  calculation

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Assumption 3 Residual Income is a Perpetuity
This assumption is incorrect

• Residual incomes do not grow at the same rate, or
  even a constant one
• Is not based on an assumption about the
  underlying economic of the firm or industry

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Assumption 3 Residual Income is a Perpetuity
Cont.

• Assumes a pattern in residual income that may or
  may not be reasonable
• PV of Perp at tN RIN1
  ke-gp

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3 Terminal Value Assumptions
Recommendation
Use the first terminal value assumption of zero
net present value investments
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A Comparison of the Free Cash Flow and Residual
Income
Because of the interrelationships among the
income statement
balance sheet
and the cash flow statement
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A Comparison of the Free Cash Flow and Residual
Income Cont.
the residual income model actually is a cash
flow model
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Accounting Difference and Residual Income
Valuation
Changing accounting numbers without changing
cash flows does not affect value under the
residual income model
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Cash Flow Differences and Residual Income
Valuation
Changing the free cash flow forecast does
change the value, regardless of whether the
change in cash flow affects income
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Portion of Value in Terminal Value in Residual
Income Valuation
The potential error in the valuation is
identical under the two methods
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Summary
We have learned

• Residual income model definitions of equity level
  and operating level
• Three terminal value assumptions

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Summary Continued

• To use the first terminal value assumption of
  zero net present value investments
• The residual income model is a cash flow model