文稿分析成果msc fa2lecture

1、1Financial Accounting 2MN50325Lecture week 11Residual eWhat is residual e?Residual e is net e less a charge (deduction) for common shareholders opportunity cost in generating net e.Recent years have seen a resurgence in its use as a valuation approach, also under such names as economic profit, abnor

2、mal earnings and Economic Value Added. It has also been used as a framework for researching financial accounting Primary uses of residual eMeasurement of internal corporate performanceEstimation of the intrinsic value of common stockWe will focus on the residual e model for valuation of common stock

3、.How can we establish the intrinsic value of common stock?Intrinsic value is our own, personal value or the present value of delaying our consumption when we consider buying a shareIf our intrinsic value is less than the market value we sell and if it is more we buyWe can use simple multiples such a

4、s the PE ratio to get a value. For example if we think next years eps is 20p and the correct PE ratio is 16 then our intrinsic value is 3.20. If the market price of the share is less than this we would buy.Discounted Cash Flow (DCF) Methods DCF methods are more sophisticated than multiple (PE) metho

5、dsFuture cash flows are estimated then discounted to get a present valueExamples are the dividend discount model (DDM), free cash flow to the firm discounted at WACC, free cash flow to equity and residual e modelsAll methods should give equivalent values if based on the same forecast financial state

6、mentsWe are studying residual e because it requires accounting numbers and therefore makes accounting useful for decision makingResidual e versus traditional accounting eTraditional financial statements are prepared to reflect earnings available to owners. Net e includes an expense to represent the

7、cost of debt capital (interest expense). Dividends or other charges for equity capital are not deducted. Traditional accounting leaves to the owners the determination as to whether earnings are sufficient to meet the cost of equity capital. The economic concept of residual e, on the other hand, expl

8、icitly considers the cost of equity capital. An example of equity residual eAxis Manufacturing Company (AMC) has total assets of 2,000,000 financed 50% with debt and 50% with equity capital. The cost of debt capital is 7% pre-tax (4.9% after tax) and the cost of equity capital is 12%. Net e for AMC

9、can be determined as follows:EBIT 200,000Less: Interest Expense (70,000)Pre-Tax e 130,000 e Tax Expense (30%) (39,000)Net e 91,000The company appears to be making healthy profits but are the shareholders happy? No, they have a 9.1% (91,000/1m) return when they want a 12% returnExample continuedWhat

10、is AMCs residual e? One approach is to compute the cost of equity capital, which we term an equity charge, and subtract this from net e, as follows:Equity Charge = Equity Capital Cost of Equity Capital in %Cost of Equity = 1,000,000 12% = 120,000Net e 91,000Equity Charge(120,000)Residual e (29,000)A

11、MC did not earn enough to cover the cost of equity capital. As a result, it has negative residual e. The company has not created value for its equity holders as its profits are less than the required return. Investors should have had their money elsewhere.Residual e model of valuationIn the Residual

12、 e Model (RIM) of valuation, the intrinsic value of the firm has two components:The current book value of equity, plusThe present value of future residual eThis can be expressed algebraically asIn the model, B0 is the current book value of equity, Bt is the book value of equity at time t,RIt is the

13、residual e in future periods, r is the required rate of return on equity,Et = net e during period t,RIt = Et rBt-1. Student ActivityA company will earn 1.00 per share forever, and the company also pays out all of this as dividends, 1.00 per share. The equity capital invested (book value) is 6.00 per

14、 share. Because the earnings and dividends will offset each other, the future book value of the stock will always stay at 6.00. The required rate of return on equity (or the percent cost of equity) is 10%.RequirementCalculate the value of this stock using the dividend discount model.What will be the

15、 residual e each year? Calculate the value of the stock using a residual e valuation model.Create a table summarizing the recognition of value in the dividend discount model and the residual e model. AnswerSolution to 1. Since the dividend is a perpetuity,P0 = D / r = 1.00 / 0.10 = 10.00 per share.S

16、olution to 2. The net e is 1.00 each year, the book value is always 6.00, and the required return is 10%, so the residual e in every year will be:RIt = Et rBt-1 = 1.00 0.10 (6.00) = 1.00 0.60 = 0.40.The value, using a residual e approach, is the current book value plus the present value of future re

17、sidual e. The residual e is a perpetuity:P0 = Book value + PV of Residual e = 6.00 + 0.40 / 0.10 = 6.00 + 4.00 = 10.00.RI valuation versus other DCF modelsThe stylized example presented above demonstrates that conceptually valuation is not all that different whether a discounted cash flow approach o

18、r residual e model are used. Why then does the analyst need a residual e model? In a simple case such as the perpetuity, both DDM and RI are easily applied. For other examples, there are two important differencesTiming of recognition of value. Forecasting of future dividends and cash flows is often

19、difficult. One key advantage to a residual e model over other models is the timing of the recognition of value. In DCF approaches most of the value is found in future dividends and in the terminal value computation. The longer the forecast period the higher the uncertainty that will exist regarding

20、these future cash flows. Terminal value. Further, as we will see shortly, in many residual e valuation contexts the terminal value is deemed to be zero. The determination of book value today is much easier than the determination of a terminal value ten or twenty years hence. When to use RI valuation

21、A residual e model is most appropriate when:A firm is not paying dividends or if it exhibits an unpredictable dividend pattern.A firm has negative free cash flow many years out, but is expected to generate positive cash flow at some point in the future (for example, a young or rapidly growing firm w

22、here capital expenditures are being made to fuel future growth).There is a great deal of uncertainty in forecasting terminal values.Derivation of the RI Model of valuationStart with the DDM:The relationship between earnings, dividends and book value is given by the clean surplus equation asE is comp

23、rehensive eDerivation of RI Model of valuationThis means that Dt = Et (Bt Bt-1) = Et + Bt-1 Bt Substituting this into the DDM:As RI = Et -r.Bt-1, this equation can be simplified: Derivation of RI Model of valuationThis can also be expressed as:This equation is logically equivalent to the one above s

24、ince RIt = (ROEt r)Bt-1. Other than the required rate of return, the inputs to the residual e model are based upon accounting data. RIM valuation exampleSimon Investment Trust (SIT) is expected to earn 4.00, 5.00, and 8.00 for the next three years. SIT will pay annual dividends of 2.00, 2.50, and 20

25、.50 in each of these years. The last dividend includes the liquidating payment to shareholders at the end of year 3 when the trust will terminate. SITs book value is 8 per share and its required return on equity is 10%.A.What is the current value per share of SIT according to the dividend discount m

26、odel?B.Calculate the book value and residual e for SIT for each of the next 3 years and use those results to find the stocks value using the residual e model.C.Calculate return on equity and use it as an input to the residual e model to calculate SITs value.RIM valuation exampleP0 = Present Value of

27、 the future dividendsP0 = 2/1.10 + 2.50/(1.1)2 + 20.50/(1.1)3 P0 = 1.818 + 2.066 + 15.402 = 19.286The book values and residual es for the next 3 years are:Year123Beginning Book Value8.0010.0012.50Retained earnings (NIDIV)2.00 2.50(12.50)Ending Book Value10.0012.500.0Net e4.00 5.008.00Less equity cha

28、rge (r Begin Bk Val)0.80 1.001.25Residual e3.20 4.006.75P0 = 8.00 + 3.20/1.1 + 4.00/(1.1)2 + 6.75/(1.1)3P0 = 8.00 + 2.909 + 3.306 + 5.071 = 19.286RIM of valuation exampleC.Year123Net e4.00 5.008.00Begin. Bk Value8.0010.0012.50ROE (return on equity)50%50%64%ROE r40%40%54%Residual e (ROEr) Begin Bk Va

29、l3.20 4.006.75P0 = 8.00 + 3.20/1.1 + 4.00/(1.1)2 + 6.75/(1.1)3P0 = 8.00 + 2.909 + 3.306 + 5.071 = 19.286Constant growth residual e modelA firms intrinsic value under a residual e approach can be expressed as:The first term, B0, reflects the value of assets owned by the firm less its liabilities, the

30、 same as the book value of equity. The second term, B0(ROE-r)/(r-g), represents additional value that is expected due to the firms ability to generate returns in excess of its cost of equity. The second term represents the value of the firms economic profits (also called abnormal earnings). In an ef

31、ficient market, if a firm earns exactly the cost of equity it has zero abnormal e and its market value should equal its book value.Residual e, dividend, and free cash flow valuation modelsResidual e models, dividend discount models (DDM), and free cash flow models (FCF) are all theoretically sound.T

32、he difference is that DDM and FCF models forecast future cash flows and find the value of stock by discounting them back to the present using the required return. The RI model approaches this process differently. It starts with a beginning value, the book value or investment in equity, and then make

33、s adjustments to this value by adding the present values of future residual e (which can be positive or negative).The recognition of value is different, but the total present value of these values (whether future dividends, future free cash flow, or book value plus future residual e) should be logic

34、ally identical. Using Residual e in ResearchAccounting information is value relevant if it affects stock returns.Stock returns are based on changes in value (capital gains) and dividends.New accounting standards will change the way in which e is determined and assets valued. Book values of equity wi

35、ll therefore change.Residual e valuation links book values with market values.It therefore provides a framework when examining the value relevance of new accounting standards.Most research relies on the Feltham and Ohlson (1995) framework.Feltham and Ohlson (1995)This paper models the relation betwe

36、en a firms market value and accounting data concerning operating and financial activities. Book value equals market value for financial activities, but they can differ for operating activities. Market value is assumed to equal the net present value of expected future dividends, and is shown, under c

37、lean surplus accounting, to also equal book value plus the net present value of expected future abnormal earnings (which equals accounting earnings minus an interest charge on opening book value). A linear model specifies the dynamics of an information set that includes book value and abnormal earni

38、ngs for operating activities. Model parameters represent persistence of abnormal earnings, growth, and accounting conservatism. The model is sufficiently simple to permit derivation of closed form expressions relating market value to accounting data and other information. Feltham, G.A., and Ohlson,

39、J.A., (1995). Valuation and clean surplus accounting for operating and financial activities. Contemporary Accounting Research, 11, pp. 689732Feltham and Ohlson (1995) CriticismThe paper was criticised by Dechow et al (1999) as the RIV approach adds little to the DDM approach as they are theoreticall

40、y equivalent. They also say that future earnings has little relationship to current book value.However, they say that the value in Feltham and Ohlsons approach is the inclusion of the other information in their model.For example, over time residual e must be zero and a RIV can include fade rates rep

41、resenting this process. Analysts forecasts can be included to improve model accuracy.A RIV approach avoids the need to directly predict dividends as researchers need to directly predict abnormal e instead. Student ActivityRIV and DDM are theoretically equivalent so why do some researchers claim that

42、 RIV valuation is better than DDM as predicting future share price?Assume the average market to book ratio is 2 and the average dividend yield is 4%. Applying Residual e in PracticeThe residual e valuation model has two components (book value and future earnings) that have a balancing effect on each

43、 other, provided that the clean surplus relationship is followed. Unfortunately, there are several possible problems in practice: Implementing the Clean Surplus RelationshipBalance Sheet Adjustments for Fair ValueIntangible AssetsNon-Recurring ItemsAggressive Accounting PracticesInternational consid

44、erations Implementing the clean surplus relationshipViolations of clean surplus accounting occur when accounting standards permit charges directly to stockholders equity, bypassing the e statement. In the past, accountants have allowed changes in value to bypass the e statement. For example, positiv

45、e purchased goodwill used to be written off to reserves (it is now an asset under IFRS3). Research based on databases of accounting data may have missed such items.Nowadays we have the other comprehensive e (OCI) statement. Examples of OCI items are foreign currency translation adjustments, pension

46、adjustments and hedge fund adjustments.So we have clean surplus if Earnings in RIV includes OCI.However, most databases still only record earnings as profit after tax The market reacts to EPS which is based on profit in IAS33Analysts forecast EPS not OCIThis presents problems for the researcher who

47、has to predict profits and OCI to get the clean surplus relationship to work. SOFP adjustments In order to have a reliable measure of book value of equity, the SOFP sheet should be scrutinized for significant off-balance sheet assets and liabilities. Additionally, reported assets and liabilities sho

48、uld be adjusted to fair value where possible. Some common items to review include: InventoryDeferred tax assets and liabilitiesPension plan assets and liabilitiesOperating leasesSpecial purpose entitiesReserves and allowances (for example, bad debts)Intangible assets Intangible assetsFor specificall

49、y identifiable intangibles that can be separated from the entity (e.g., sold), it is appropriate to include these in the determination of book value of equity. If these assets are wasting (declining in value over time), they will be amortized over time as an expense. Goodwill, on the other hand, req

50、uires special consideration, particularly due to recent changes in accounting for goodwill. Goodwill is generally not recognized as an asset unless it results from an acquisition (under most international accounting standards, internally generated goodwill is not recognized on the balance sheet). Go

51、odwill represents the excess of the purchase price of an acquisition over the value of the net assets acquired. Research and development costs provide also must be given careful consideration. Under U.S. GAAP, R&D is expensed to the e statement directly. Under IAS, some R&D costs can be capitalized

52、and amortized over time. While R&D may lead to the existence of an “asset in theory,” this is reflected in the firms ROE and hence residual e over time. If a firm engages in unproductive R&D expenditures, these will lower residual e through the expenditures made. If a firm engages in productive R&D

53、expenditures they should result in higher revenues to offset the expenditures over time. On an ongoing basis this should be reflected in ROE forecasts for a mature firm. Nonrecurring itemsIn applying a residual e model, it is important to develop a forecast of future residual e based upon recurring

54、items. Often companies report non-recurring charges as part of earnings or classify non-operating e (e.g., sale of assets) as part of operating e. These misclassifications can lead over-estimates and under-estimates of future residual earnings if no adjustments are made. Note that adjustments to boo

55、k value are not necessary for these items since non-recurring gains and losses do impact the value of assets in place. Non-recurring items sometimes result from accounting rules and at other times result from “strategic” management decisions.Analysts and researchers should examine the financial stat

56、ement notes and other sources for potential items that may warrant adjustment in determining recurring earnings such as:Unusual itemsRestructuring chargesDiscontinued operationsAccounting changesIn some cases, management may be recording restructuring or unusual charges in every period. In these cas

57、es, the item may be considered an ordinary operating expense and may not require adjustment. Other aggressive accounting practicesFirms may engage in accounting practices that result in the overstatement of assets (book value) and/or overstatement of earnings. For example, a firm may accelerate reve

58、nues to the current period or defer expenses to a later period. Both activities simultaneously increase earnings and book value. For example, a firm might ship unordered goods to customers at year-end, recording revenues and a receivable. Conversely, a firm could capitalise rather than expense a cas

59、h payment resulting in lower expenses and an asset. The analyst must carefully evaluate a firms accounting policies and consider the integrity of management in assessing the inputs in a residual e model. Firms may also manage earnings. For example, some use “cookie jar” provisions where excess losse

60、s or expenses are recorded in an earlier period (for example in conjunction with an acquisition or restructuring) and then used to reduce expense and increase e in future periods. The analysts should carefully examine the use of provisions in an assessment of residual earnings. International conside