Explain the fundamentals that determine residual income
The idea
Residual income is positive when return on equity exceeds the required return, so its fundamental determinants are the spread between ROE and r and the size and growth of the equity base. In the single-stage model the justified price-to-book ratio is 1 + (ROE − r) ÷ (r − g), so the premium over book depends on how far ROE exceeds r and how fast book value grows. A company earning exactly r has zero residual income and should trade at book value however fast it grows. Competition tends to push ROE towards r, so abnormal returns usually fade. The trap is thinking that faster growth always adds value, when growth in book value adds value only if ROE exceeds r.
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- Work out economic value added, market value added and residual income and explain what they mean
- Explain what residual income models are used for
- Value a common share with the residual income model and contrast when value is recognised under it and under other present value models
- Explain how residual income valuation links to the justified P/B ratio derived from forecasted fundamentals
- Work out a common share's intrinsic value with residual income models that have one constant-growth stage or several stages, and explain the result
- Back out the growth rate implied in residual income from the market P/B ratio and an estimated required return on equity
- Explain continuing residual income and defend an estimate of it at the forecast horizon in light of the firm's and industry's outlook
- Contrast residual income models with free cash flow and dividend discount models
- Explain where residual income models are strong and weak and argue for using one to value a firm's common stock
- Set out the accounting problems that arise when residual income models are applied