Residual Income

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residual income (application in real life) - 4 questions

Hi 1. is there a scenario where residual income will be helpful in valuing a publicly listed company? 2. What would be the objective of using residual income in such scenario? 3. is this method more useful for valuing certain sectors? 4. would it be helpful in valuing any listed company in... Read More

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by Elvina J.

added 6 years ago

Using book value in Residual Income

I think you made three mistakes in how you calculated equity value using RI. 1) You forgot to add the current book value to your valuation estimate. You should either add cell I12 to K25-L25, or better, bring in the 2005 book value from the core model ($53,171) in cell H12. 2) Equity charges s... Read More

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by Richard S.

added 8 years ago

Re: Using book value in Residual Income

You are correct on all three counts and truth be told we're a bit embarrassed by the multiple lapses on this analysis. Ummm... in our defense, "no one" uses Residual Income approach and it's highly academic...? :-) We're not trying to skirt away here - we take full responsibility for not getting it... You are correct on all three counts and truth be told we're a bit embarrassed by the multiple lapses on this analysis. Ummm... in our defense, "no one" uses Residual Income approach and it's highly academic...? :-) We're not trying to skirt away here - we take full responsibility for not getting it correct and thank you for bringing it to our attention - and we did need a bit of time to look into your observations.

Detailed response to your items (let this post serve as official ERRATA notice as well for this module):

1) Yes, indeed current book value (last known actual book value, in this case, last year's book value). We would definitely bring in 2005 book value from the BS of the Core Model into cell H12, we would then make H12 white and add it as a third component to K25 and L25 for the Equity Value range. We would not use cell I12 since that is a projection and this analysis is dated as of end of 2005 (or beginning of 2005) so we should use Year 0 as the base figure and not Year 1.

2) Equity charges should also be corrected as you mentioned to using PY (prior year) book value. I14 indeed would be based on H12 and not I12 and then copied to the right. We would avoid altering row 12 for two reasons: (i) BS figures are always ending balance unless otherwise noted; and (ii) for #1 above, we need Year 0 (2005) ending book value figure.

3) Here we would agree with you that Price to Book is an acceptable terminal value calculation approach for Residual Income approach to valuation. There is clearly a relationship with book value; however we wouldn't automatically rule out Gordon Growth either - just like a "regular" DCF analysis, we would include multiple approaches, such as TEV/EBITDA and Gordon Growth. You can totally decide to place emphasis and priority on P/B - we wouldn't argue against that logic.

In terms of selecting what premium to book value, you selected 1.5x - 2.5x ? however, WMT's Market Cap at the time of the analysis is about $190B (either from the Trading Statistics tab from Package 2 or from Complex Trading Comps in Package 4), and their PY book value is about $53B (as you noted in your original post), giving a P/B of about 3.5x. Therefore, we would want to spend more time justifying the P/B multiple either by comps or historical average.

Thank you very much for catching these errors and for taking the time to post them for the benefit of the community! Read More

by Hamilton L.

added 8 years ago