CHAPTER

5
RESIDUAL INCOME
VALUATION
LEARNING OUTCOMES

After completing this chapter, you will be able to do the following :

• Calculate and interpret residual income and related measures (e.g., economic value added
and market value added).
• Discuss the use of residual income models.
• Calculate future values of residual income given current book value, earnings growth esti-
mates, and an assumed dividend payout ratio.
• Calculate the intrinsic value of a share of common stock using the residual income model.
• Discuss the fundamental determinants or drivers of residual income.
• Explain the relationship between residual income valuation and the justified price-to-book
ratio based on forecasted fundamentals.
• Calculate and interpret the intrinsic value of a share of common stock using a single-stage
(constant-growth) residual income model.
• Calculate an implied growth rate in residual income given the market price-to-book ratio
and an estimate of the required rate of return on equity.
• Explain continuing residual income and list the common assumptions regarding continu-
ing residual income.
• Justify an estimate of continuing residual income at the forecast horizon given company
and industry prospects.
• Calculate and interpret the intrinsic value of a share of common stock using a multistage
residual income model, given the required rate of return, forecasted earnings per share over
a finite horizon, and forecasted continuing residual earnings.
• Explain the relationship of the residual income model to the dividend discount and free
cash flow to equity models.
• Contrast the recognition of value in the residual income model to value recognition in
other present value models.
• Discuss the strengths and weaknesses of the residual income model.
• Justify the selection of the residual income model for equity valuation, given characteristics
of the company being valued.
• Discuss the major accounting issues in applying residual income models (e.g., clean surplus
violations, variations from fair value, intangible asset effects on book value, and nonrecur-
ring items) and appropriate analyst responses to each issue.

41
42 Learning Outcomes, Summary Overview, and Problems

SUMMARY OVERVIEW

This chapter has discussed the use of residual income models in valuation. Residual income
is an appealing economic concept because it attempts to measure economic profit, which is
profit after accounting for all opportunity costs of capital.

• Residual income is calculated as net income minus a deduction for the cost of equity capi-
tal. The deduction is called the equity charge and is equal to equity capital multiplied by
the required rate of return on equity (the cost of equity capital in percent).
• Economic value added (EVA) is a commercial implementation of the residual income
concept.
EVA ⫽ NOPAT ⫺ (C% ⫻ TC)

where
NOPAT ⫽ net operating profit after taxes
C% ⫽ the percent cost of capital
TC ⫽ total capital.
• Residual income models (including commercial implementations) are used not only for
equity valuation but also to measure internal corporate performance and for determining
executive compensation.
• We can forecast per-share residual income as forecasted earnings per share minus the
required rate of return on equity multiplied by beginning book value per share. Alternatively,
per-share residual income can be forecasted as beginning book value per share multiplied by
the difference between forecasted ROE and the required rate of return on equity.
• In the residual income model, the intrinsic value of a share of common stock is the sum of
book value per share and the present value of expected future per-share residual income. In
the residual income model, the equivalent mathematical expressions for intrinsic value of a
common stock are
⬁
RIt ⬁
E t − rBt −1 ⬁
(ROEt − r )Bt −1
V0 = B0 + ∑ = B + ∑ = B + ∑
t = 1 (1 + r ) t =1 (1 + r ) (1 + r )t
t 0 t 0
t =1

where
V0 ⫽ value of a share of stock today (t ⫽ 0)
B0 ⫽ current per-share book value of equity
Bt ⫽ expected per-share book value of equity at any time t
r ⫽ required rate of return on equity (cost of equity)
Et ⫽ expected earnings per share for period t
RIt ⫽ expected per-share residual income, equal to Et – rBt–1 or to (ROE – r) ⫻Bt–1
• In most cases, value is recognized earlier in the residual income model compared with other
present value models of stock value, such as the dividend discount model.
• Strengths of the residual income model include the following:
• Terminal values do not make up a large portion of the value relative to other models.
• The model uses readily available accounting data.
• The model can be used in the absence of dividends and near-term positive free cash flows.
• The model can be used when cash flows are unpredictable.
Chapter 5 Residual Income Valuation 43

• Weaknesses of the residual income model include the following:

• The model is based on accounting data that can be subject to manipulation by management.
• Accounting data used as inputs may require significant adjustments.
• The model requires that the clean surplus relation holds, or that the analyst makes
appropriate adjustments when the clean surplus relation does not hold.
• The residual income model is most appropriate in the following cases:
• A company is not paying dividends or it exhibits an unpredictable dividend pattern.
• A company has negative free cash flow many years out but is expected to generate posi-
tive cash flow at some point in the future.
• A great deal of uncertainty exists in forecasting terminal values.
• The fundamental determinants or drivers of residual income are book value of equity and
return on equity.
• Residual income valuation is most closely related to P/B. When the present value of
expected future residual income is positive (negative), the justified P/B based on funda-
mentals is greater than (less than) one.
• When fully consistent assumptions are used to forecast earnings, cash flow, dividends, book
value, and residual income through a full set of pro forma (projected) financial statements,
and the same required rate of return on equity is used as the discount rate, the same esti-
mate of value should result from a residual income, dividend discount, or free cash flow
valuation. In practice, however, analysts may find one model easier to apply and possibly
arrive at different valuations using the different models.
• Continuing residual income is residual income after the forecast horizon. Frequently, one
of the following assumptions concerning continuing residual income is made:
• Residual income continues indefinitely at a positive level. (One variation of this assump-
tion is that residual income continues indefinitely at the rate of inflation, meaning it is
constant in real terms.)
• Residual income is zero from the terminal year forward.
• Residual income declines to zero as ROE reverts to the cost of equity over time.
• Residual income declines to some mean level.
• The residual income model assumes the clean surplus relation of Bt ⫽ Bt–1 + Et – Dt . In
other terms, the ending book value of equity equals the beginning book value plus earn-
ings minus dividends, apart from ownership transactions.
• In practice, to apply the residual income model most accurately, the analyst may need to
ⴰ Adjust book value of common equity for
• Off-balance-sheet items.
• Discrepancies from fair value.
• The amortization of certain intangible assets.
ⴰ Adjust reported net income to reflect clean surplus accounting.
ⴰ Adjust reported net income for nonrecurring items misclassified as recurring items.

PROBLEMS

1. Based on the following information, determine whether Vertically Integrated Manufacturing

(VIM) earned any residual income for its shareholders:
• VIM had total assets of $3,000,000, financed with twice as much debt capital as
equity capital.
44 Learning Outcomes, Summary Overview, and Problems

• VIM’s pretax cost of debt is 6 percent and cost of equity capital is 10 percent.
• VIM had EBIT of $300,000 and was taxed at a rate of 40 percent.
Calculate residual income by using the method based on deducting an equity charge.
2. Use the following information to estimate the intrinsic value of VIM’s common stock
using the residual income model:
• VIM had total assets of $3,000,000, financed with twice as much debt capital as
equity capital.
• VIM’s pretax cost of debt is 6 percent and cost of equity capital is 10 percent.
• VIM had EBIT of $300,000 and was taxed at a rate of 40 percent. EBIT is expected
to continue at $300,000 indefinitely.
• VIM’s book value per share is $20.
• VIM has 50,000 shares of common stock outstanding.
3. Palmetto Steel, Inc. (PSI) maintains a dividend payout ratio of 80 percent because of
its limited opportunities for expansion. Its return on equity is 15 percent. The required
rate of return on PSI equity is 12 percent, and its long-term growth rate is 3 percent.
Compute the justified P/B based on forecasted fundamentals, consistent with the
residual income model and a constant growth rate assumption.
4. Because New Market Products (NMP) markets consumer staples, it is able to make use
of considerable debt in its capital structure; specifically, 90 percent of the company’s total
assets of $450,000,000 are financed with debt capital. Its cost of debt is 8 percent before
taxes, and its cost of equity capital is 12 percent. NMP achieved a pretax income of $5.1
million in 2006 and had a tax rate of 40 percent. What was NMP’s residual income?
5. In 2007, Smithson-Williams Investments (SWI) achieved an operating profit after taxes
of €10 million on total assets of €100 million. Half of its assets were financed with debt
with a pretax cost of 9 percent. Its cost of equity capital is 12 percent, and its tax rate is
40 percent. Did SWI achieve a positive residual income?
6. Calculate the economic value added (EVA) or residual income, as requested, for each of
the following:
A. NOPAT ⫽ $100
Beginning book value of debt ⫽ $200
Beginning book value of equity ⫽ $300
WACC ⫽ 11 percent
Calculate EVA.
B. Net income ⫽ €5.00
Dividends ⫽ €1.00
Beginning book value of equity ⫽ €30.00
Required rate of return on equity ⫽ 11 percent
Calculate residual income.
C. Return on equity ⫽ 18 percent
Required rate of return on equity ⫽ 12 percent
Beginning book value of equity ⫽ €30.00
Calculate residual income.
7. Jim Martin is using economic value added (EVA) and market value added (MVA) to
measure the performance of Sundanci. Martin uses the following fiscal year 2000
information for his analysis:
Chapter 5 Residual Income Valuation 45

• Adjusted net operating profit after tax (NOPAT) is $100 million.

• Total capital is $700 million (no debt).
• Closing stock price is $26.
• Total shares outstanding is 84 million.
• The cost of equity is 14 percent.
Calculate the following for Sundanci. Show your work.
A. EVA for fiscal year 2000.
B. MVA as of fiscal year-end 2000.
8. Protected Steel Corporation (PSC) has a book value of $6 per share. PSC is expected to
earn $0.60 per share forever and pays out all of its earnings as dividends. The required
rate of return on PSC’s equity is 12 percent. Calculate the value of the stock using the
following:
A. Dividend discount model.
B. Residual income model.
9. Notable Books (NB) is a family controlled company that dominates the retail book
market. NB has book value of $10 per share, is expected to earn $2.00 forever, and pays
out all of its earnings as dividends. Its required return on equity is 12.5 percent. Value
the stock of NB using the following:
A. Dividend discount model.
B. Residual income model.
10. Simonson Investment Trust International (SITI) is expected to earn $4.00, $5.00, and
$8.00 for the next three years. SITI will pay annual dividends of $2.00, $2.50, and
$20.50 in each of these years. The last dividend includes a liquidating payment to
shareholders at the end of year 3 when the trust terminates. SITI’s book value is $8 per
share and its required return on equity is 10 percent.
A. What is the current value per share of SITI according to the dividend discount
model?
B. Calculate per-share book value and residual income for SITI for each of the next
three years and use those results to find the stock’s value using the residual income
model.
C. Calculate return on equity and use it as an input to the residual income model to
calculate SITI’s value.

11. Foodsco Incorporated (FI), a leading distributor of food products and materials to
restaurants and other institutions, has a remarkably steady track record in terms of
both return on equity and growth. At year-end 2007, FI had a book value of $30 per
share. For the foreseeable future, the company is expected to achieve an ROE of 15
percent (on trailing book value) and to pay out one-third of its earnings in dividends.
The required return is 12 percent. Forecast FI’s residual income for the year ending 31
December 2012.
12. Lendex Electronics (LE) had a great deal of turnover of top management for several years
and was not followed by analysts during this period of turmoil. Because the company’s
performance has been improving steadily for the past three years, technology analyst
Steve Kent recently reinitiated coverage of LE. A meeting with management confirmed
Kent’s positive impression of LE’s operations and strategic plan. Kent decides LE merits
further analysis.
46 Learning Outcomes, Summary Overview, and Problems

Careful examination of LE’s financial statements revealed that the company had neg-
ative other comprehensive income from changes in the value of available-for-sale secu-
rities in each of the past five years. How, if at all, should this observation about LE’s
other comprehensive income affect the figures that Kent uses for the company’s ROE
and book value for those years?
13. Retail fund manager Seymour Simms is considering the purchase of shares in upstart
retailer Hot Topic Stores (HTS). The current book value of HTS is $20 per share, and
its market price is $35. Simms expects long-term ROE to be 18 percent, long-term
growth to be 10 percent, and cost of equity to be 14 percent. What conclusion would
you expect Simms to arrive at if he uses a single-stage residual income model to value
these shares?
14. Dayton Manufactured Homes (DMH) builds prefabricated homes and mobile homes.
Favorable demographics and the likelihood of slow, steady increases in market share
should enable DMH to maintain its ROE of 15 percent and growth rate of 10 percent
through time. DMH has a book value of $30 per share and the required rate of return
on its equity is 12 percent. Compute the value of its equity using the single-stage residual
income model.
15. Use the following inputs and the finite horizon form of the residual income model to
compute the value of Southern Trust Bank (STB) shares as of 31 December 2007:
• ROE will continue at 15 percent for the next five years (and 10 percent thereafter)
with all earnings reinvested (no dividends paid).
• Cost of equity equals 10 percent.
• B0 ⫽ $10 per share (at year-end 2007).
• Premium over book value at the end of five years will be 20 percent.
16. Shunichi Kobayashi is valuing United Parcel Service (NYSE: UPS). Kobayashi has made
the following assumptions:
• Book value per share is estimated at $9.62 on 31 December 2007.
• EPS will be 22 percent of the beginning book value per share for the next eight years.
• Cash dividends paid will be 30 percent of EPS.
• At the end of the eight-year period, the market price per share will be three times the
book value per share.
• The beta for UPS is 0.60, the risk-free rate is 5.00 percent, and the equity risk pre-
mium is 5.50 percent.
The current market price of UPS is $59.38, which indicates a current P/B of 6.2.
A. Prepare a table that shows the beginning and ending book values, net income, and
cash dividends annually for the eight-year period.
B. Estimate the residual income and the present value of residual income for the eight
years.
C. Estimate the value per share of UPS stock using the residual income model.
D. Estimate the value per share of UPS stock using the dividend discount model. How
does this value compare with the estimate from the residual income model?
Chapter 5 Residual Income Valuation 47

17. Boeing Company (NYSE: BA) has a current stock price of $49.86. It also has a P/B of
3.57 and book value per share of $13.97. Assume that the single-stage growth model
is appropriate for valuing the company. Boeing’s beta is 0.80, the risk-free rate is 5.00
percent, and the equity risk premium is 5.50 percent.
A. If the growth rate is 6 percent and the ROE is 20 percent, what is the justified P/B
for Boeing?
B. If the growth rate is 6 percent, what ROE is required to yield Boeing’s current P/B?
C. If the ROE is 20 percent, what growth rate is required for Boeing to have its
current P/B?