Chapter 5 - Residual Income Valuation

Calculation of Residual Income Using a Given EBIT

Example for Slides 4-6
ASSUMPTIONS
Total assets
EBIT
Debt-to-total capital ratio
Cost of debt (before tax)
Cost of equity
Tax rate

$5,000,000
$400,000
0.60
8.0%
12.0%
40.0%

OUTPUT - Residual Income

EBIT
Less: Interest expense
Pretax income
Less: Income tax expense
Net income

$400,000
$240,000
$160,000
$64,000
$96,000

Equity capital
Equity charge
Net income
Less: Equity charge
Residual income

$2,000,000
$240,000
$96,000
$240,000
-$144,000

Chapter 5 - Residual Income Valuation

Forecasting Residual Income
Example for Slides 9-12
ASSUMPTIONS
0

E
D
B
r

$2.50
$1.00

$3.00
$1.10

$20.00
10%

OUTPUT - Forecasted Residual Income

1

Beginning B
E
D
Ending B

20.00
2.50
1.00
21.50

21.50
3.00
1.10
23.40

E
Equity Charge
Residual Income

2.50
2.00
0.50

3.00
2.15
0.85

E = Earnings per share

D = Dividends per share
B = Book value of equity per share
r = Required return on equity

Chapter 5 - Residual Income Valuation

Using Residual Income to Value Common Stock
Example for Slides 14-15
ASSUMPTIONS
0

RI
B
r

$0.50

$0.85

$1.00

$20.00
10%

OUTPUT - Valuing Common Stock Using Residual Income and the Persistence Factor
PV of the residual income
$0.45
$0.70
$0.75

Book value of equity

Add: PV of the residual income stream
Total Value of Common Stock

$20.00
$1.91
$21.91

RI = Residual income per share

B = Book value of equity per share
r = Required return on equity

e Persistence Factor

Chapter 5 - Residual Income Valuation

Using a Single-Stage Residual Income Model to Value Common Stock
Example for Slides 18-19
ASSUMPTIONS
Book value of equity per share
Return on equity
Required return on equity
Residual income growth rate

$30.00
18%
12%
8%

OUTPUT - Valuing Common Stock Using a Single-Stage Residual Income Model

RI

$1.80

Book value of equity

Add: PV of the residual income stream

$30.00
$45.00

Total value of common stock

$75.00

Using a Single-Stage Residual Income Model to Derive an Implied Growth Rate

Example for Slide 19
ASSUMPTION
Current stock price

$80.00

OUTPUT - Deriving an Implied Growth Rate Using a Single-Stage Residual Income Model
Implied RI growth rate

8.4%

Income Model

d Growth Rate

e Residual Income Model

RI = Residual income per share

Chapter 5 - Residual Income Valuation

Using a Multi-Stage Residual Income Model with a Persistence Factor to Value Common St
Example for Slides 23-29
ASSUMPTIONS
0

RI
B
r

$0.50

$0.85

$1.00

$20.00
10%
0.60

OUTPUT - Valuing Common Stock Using Residual Income

PV of the residual income
$0.45
$0.70

$0.75

Book value of equity

Add: PV of residual income in periods 1 to 2
Add: PV of the continuing residual income

$20.00
$1.16
$1.65

Total value of common stock

$22.81

ASSUMPTIONS for Using Projected P/B Ratios

Book value in Year 3
Projected P/B ratio in Year 3

$25.00
$1.10

OUTPUT - Valuing Common Stock Using Residual Income and a Forecasted P/B Ratio
PV of the residual income
$0.45
$0.70
$0.75
Projected stock price
$27.50

Book value of equity

Add: PV of residual income in periods 1 to 3
Add: PV of the continuing residual income
Total value of common stock

$20.00
$1.91
$1.88
$23.79

or to Value Common Stock

ecasted P/B Ratio

RI = Residual income per share

B = Book value of equity per share
r = Required return on equity
= Persistence factor for continuing residual income

Chapter 5 - Residual Income Valuation

Using a Residual Income Model and a Dividend Discount Model to Arrive at the Same Comm
Example for Slides 30-31
ASSUMPTIONS
All earnings paid out as dividends so book value is constant
Earnings and dividends are constant forever
Earnings per share
Book value of equity
Required return on equity

$1.00
$7.00
10%

OUTPUT - Valuing Common Stock using the Dividend Discount Model and a Constant Divide
Dividend discount model valuation
$10.00
OUTPUT - Valuing Common Stock using the Residual Income Model and Constant Residual
Income required to cover equity capital charge
$0.70
Residual income
$0.30
PV of residual income
Add: Book value
Residual income valuation

$3.00
$7.00
$10.00

at the Same Common Stock Value

d a Constant Dividend

Constant Residual Income