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
The idea
With constant ROE and constant growth, the single-stage model gives V0 = B0 + (ROE − r) × B0 ÷ (r − g). Multistage models forecast residual income year by year for a horizon, then add a continuing residual income term whose form depends on what is assumed afterwards: persistence at a constant level, an immediate drop to zero, or gradual fading governed by a persistence factor ω between zero and one. With fading, the continuing term valued at year T − 1 is RI(T) ÷ (1 + r − ω), which is then discounted over T − 1 periods. The trap is discounting that continuing value over T periods, or applying ω to the wrong year's residual income.
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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 the fundamentals that determine residual income
- Explain how residual income valuation links to the justified P/B ratio derived from forecasted fundamentals
- 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