Back out the growth rate implied in residual income from the market P/B ratio and an estimated required return on equity
The idea
The single-stage residual income model can be inverted to reveal the growth the market expects. Setting price equal to value in the single-stage model, P0 = B0 + (ROE − r) × B0 ÷ (r − g), leaves growth as the only unknown. Solving for it, and dividing through by B0 for the ratio form, gives g = r − (ROE − r) × B0 ÷ (P0 − B0) = r − (ROE − r) ÷ (P/B − 1). A high implied growth rate for a company whose ROE is only slightly above r signals demanding expectations. When ROE is below r, a price above book cannot come from the current spread and implies the market expects ROE to rise above r. The trap is algebraic: the denominator is price minus book, or P/B minus one, not price or P/B alone.
In the app: 1 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Residual Income Valuation
- 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
- 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
- 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