13-1
in whole or in part.
CHAPTER 13
VALUATION: EARNINGS-BASED APPROACH
13.1 Valuation Approach Equivalence. Conceptually, valuation based on dividends,
free cash flows for common equity shareholders, and residual income yield equiv-
13.2 Required Income. Required income represents the amount of income the firm
justify an investment in the company by shareholders who have alternative in-
capital.
13.3 Residual Income. Residual income measures the differential amount of income
the firm generates relative to the required income necessary just to satisfy the
common equity shareholders’ required rate of return. Residual income can be pos-
return on equity capital and hence can be interpreted as value-destroying.
13.4 Residual Income Valuation Theory. The theory behind the residual income
valuation approach is that the firm’s book value of equity represents equity value
common equity shareholders, even though it does not represent reported earnings,
because it represents the incremental amount of income that increases shareholder
wealth beyond shareholders’ required return on investment.
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Valuation: Earnings-Based Approach
13-2
in whole or in part.
13.5 Residual Income Valuation Approach. Book value of common shareholders’
equity plays two roles in the residual income valuation approach. First, book
required level of earnings, holding all else equal.
13.6 Interpreting Residual Income. If a firm’s residual income for a particular year is
positive, the firm was profitable and in fact earned income that exceeded the
amount of income required to meet shareholders’ required return on their invested
exactly cover the firm’s costs of capital and provide the required rate of return to
investors, no more, no less.
13.7 Effects of Investments on Residual Income. If the firm invests incremental
equity capital in assets that generate a return less than the required return of 10%,
current returns the firm generates on existing projects.
13.8 Effects of Borrowing on Residual Income. If the firm borrows capital from a
13.9 Effects of Competition on Residual Income. If the firm competes in a very
competitive, mature industry, competitive conditions will drive residual income
Chapter 13
Valuation: Earnings-Based Approach
13-3
in whole or in part.
will diminish as the firm’s competitive advantage diminishes. You can query stu-
net income and, therefore, residual income.
13.10 Effects of Conservative Accounting on Residual Income Valuation. The
residual income value estimates will not be distorted by conservative accounting
Coca-Cola (with a large and valuable off-balance-sheet brand value), provides a
numeric example of this question.
required earnings that are “too high” and thus residual income that is “too low.”
13.12 Appropriate Discount Rates. It is appropriate to use a required rate of return on
for common equity shareholders.
13.13 Computing Residual Income.
a. Required return on equity capital:
Chapter 13
Valuation: Earnings-Based Approach
13-4
in whole or in part.
b. Required Income:
c. Residual Income:
lowest market value.
13.14 Computing Residual Income.
a. Required return on equity capital:
b. Required Income:
c. Residual Income:
d. The rankings based on residual income relative to book value of equity in
Year +1 are as follows:
Chapter 13
Valuation: Earnings-Based Approach
13-5
in whole or in part.
set and will create the largest amount of shareholder wealth (nearly $13 bil-
lion) in Year +1, Intel will generate over $4 billion of shareholder wealth in
13.15 Computing Residual Income.
a. Required return on equity capital:
b. Required Income:
c. Residual Income:
d. The rankings based on residual income relative to book value of equity in
Year +1 are as follows:
explains, in part, the huge difference between market value and book value
(explained in depth in Chapter 14).
Chapter 13
Valuation: Earnings-Based Approach
13-6
in whole or in part.
13.16 Equity Valuation Using the Residual Income Model.
Morrissey Tool Company:
a. Comprehensive Required Residual Present Value Present
Year Income Incomea Income Factor Value
Present Value of Continuing Value:
Comprehensive
Year Start of Year + Income – Dividends = End of Year
should consider selling the firm at or before Year +5. The rate of return on
common shareholders’ equity, with equity measured as of the beginning of the
year instead of on average over the year, is as follows:
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Valuation: Earnings-Based Approach
13-7
in whole or in part.
13.17 Equity Valuation Using the Residual Income and Dividend Discount Models.
Priority Contractors:
a. Comprehensive Required Residual Present Value Present
Year Income Incomea Income Factor Value
Present Value of Continuing Value:
Comprehensive
Year Start of Year + Income – Dividends = End of Year
b. Given 5% expected growth in Year +6, the amounts for comprehensive income
and common shareholders’ equity at the end of the year equal 105% of the
amounts for the preceding year. The dividend is the plug to reconcile the change
in common shareholders’ equity under the clean surplus relation.
ous intermediate computations.
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Valuation: Earnings-Based Approach
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in whole or in part.
13.18 Equity Valuation Using the Residual Income, Free Cash Flow, and Dividend
Discount Models.
Steak n’ Shake:
a. Net Required Residual Present Value Present
Year Income Incomea Income Factor Value
beginning of each year.
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in whole or in part.
b. Present Value of Free Cash Flows to Common Equity Shareholders
Cash Cash Cash Free Present
Flow Flow Flow (Inc.) Dec. Cash Value Present
Year Oper. Invest. Debt in Cash Flow Factor Value
+1 $ 45.4 $ (35.2) $ (0.5) $ 3.0 $ 12.7 0.915 $ 11.6
+2 51.2 (41.1) 2.0 (0.7) 11.4 0.836 9.5
+3 56.3 (41.9) — (0.8) 13.6 0.765 10.4
computed in Solution b above.
d. The valuations in Solutions a–c are identical. If the valuations were not
identical and the amounts were small, the explanation would likely be
rounding errors. If the valuations differed more significantly, the valuation
models probably were not applied correctly.
underpriced this firm.
13.19 Residual Income Valuation.
This is an extensive integrated problem that illustrates the topics of Chapter 13
The FSAP file containing these analyses is available for download by instructors
Chapter 13
Valuation: Earnings-Based Approach
13-10
in whole or in part.
(not students) from the book’s website for instructors. Go to Instructor’s resources
In this problem, we estimate cost of equity capital for Coca-Cola and use the
residual income valuation approach to estimate Coca-Cola’s share value. The
Part I—Computing Coca-Cola’s Share Value Using the Residual Income
Valuation Approach.
a. Following the CAPM, Coca-Cola faces a required rate of return on equity cap-
ital of 7.50% at the end of 2012. This rate is computed as follows:
for Years +1 through +5 to present value, computing continuing value based
on residual income in Year +6, adding book value of common equity as of the
beginning of Year +1, and computing share value. The share value estimate is