Question

Question 3
3.1
A trainee analyst makes the following statement: “The terminal value element in the Residual Income Valuation Model typically accounts for a much larger proportion of the estimated intrinsic value of equity than the terminal value element in the Discounted Free Cash Flow and Dividend Discount Models. This makes the Residual Income Valuation Model inferior to the other two models”. Critically assess the statement.
(18 %)
3.2
Using the Residual Income Valuation Model please demonstrate what determines a company’s price-to-book (P/B) multiple. Explain why the P/B multiple of information technology companies is usually higher than the P/B of banks, and discuss which of these types of companies is likely to be more reliably valued by the P/B multiple.
(15 ? %)
(TOTAL 33? %)

Answer 1

STEP1: RESIDUAL INCOME VALUATION MODEL :

Residual income valuation (RIV; also, residual income model and residual income method, RIM) is an approach to equity valuation that formally accounts for the cost of equitycapital. Here, "residual" means in excess of any opportunity costs measured relative to the book value of shareholders' equity; residual income (RI) is then the income generated by a firm after accounting for the true cost of capital. The approach is largely analogous to the EVA/MVA based approach, with similar logic and advantages.

STEP :2 COMPARISION WITH OTHER MODELS:

As can be seen, the residual income valuation formula is similar to the dividend discount model (DDM) (and to other discounted cash flow (DCF) valuation models), substituting future residual earnings for dividend (or free cash) payments (and the cost of equity for the weighted average cost of capital).

However, the RI-based approach is most appropriate when a firm is not paying dividends or exhibits an unpredictable dividend pattern, and / or when it has negative free cash flow many years out, but is expected to generate positive cash flow at some point in the future. Further, value is recognized earlier under the RI approach, since a large part of the stock's intrinsic value is recognized immediately – current book value per share – and residual income valuations are thus less sensitive to terminal value.

At the same time, in addition to the accounting considerations mentioned above, the RI approach will not generally hold if there are expected changes in shares outstanding or if the firm plans to bring in "new" shareholders who derive a net benefit from their capital contributions.

Although EVA is similar to residual income, there will be technical differences between EVA and RI, recommend a fairly large number of adjustments to NOPAT before the methodology may be applied.

Residual Income Model (RIM) and Dividend Discount Model (DDM) are the two most widely used valuation techniques in finance, and in accounting. Researchers have been arguing on the superiority of one model over the other, however. Yet, none of them have investigated the reason behind this difference in the empirical tests of the models. The RIM is an algebraic derivation of the DDM under some robust assumptions. The RIM is based on simplified accounting relationship as well as on the assumption of DDM. The RIM is seductive because it purports to provide assessments of performance at any given point in time. The rejection of RIM is logically equivalent to prices not being equal to the present value of expected future dividends. The researchers deny the fact that the RIM is at fault, rather they have been arguing on the empirical testing methods. Bernard (1995), Penman and Sougiannis (1998), Francis et al. (2000), Frankel and Lee (1998) have argued that RIM provides a better measure of the asset value than that of DDM. Although in theory, both DDM and RIM yield identical value estimates of the intrinsic value; in practice, they will differ if the sets of assumptions differ. In this paper, we focus on the reason behind getting different value estimates from DDM and RIM. We show that the presence of terminal value provides the same value estimates of the models. With the perpetual growth rate, the RIM is regarded as a better measure for valuing an asset. We show that this belief is misleading and both of the models will provide the same value estimate if the transversality condition of RIM holds.

STEP:3 DEMONSTRATING PRICE TO BOOK MULTIPLE BY USING RESIDUAL INCOME VALUATION MODEL:

In economics, valuation using multiples is a process that consists of:

• identifying comparable assets (the peer group) and obtaining market values for these assets.
• converting these market values into standardized values relative to a key statistic, since the absolute prices cannot be compared. This process of standardizing creates valuation multiples.
• applying the valuation multiple to the key statistic of the asset being valued, controlling for any differences between asset and the peer group that might affect the multiple.

Multiples analysis is one of the oldest methods of analysis. It was well understood in the 1800s and widely used by U.S. courts during the 20th century, although it has recently declined as Discounted Cash Flow and more direct market-based methods have become more popular.

Although not used as often as the P/E ratio, the Price to Book ratio can sometimes provide investors with useful information. The P/B ratio is even more dependent on the industry the company is in than is the P/E ratio. Just like the P/E ratio, P/B is highly affected by the industry. For example many technology companies can trade at a price to book of 10 or more, while banks will mostly trade around 1. What accounts for this massive difference? The biggest difference is highlighted by the industry’s use of capital. Technology firms do not use much physical capital to create earnings. A perfect example is Microsoftwhich is mainly a software company. Microsoft mainly needs human capital to create earnings; the business model is not capital intensive. On the other hand, banks require a lot of capital such as bank deposits, and bonds and so on. And because banks tend to hold relatively liquid assets on their balance sheets, these assets can be valued at their fair market value. This means that a bank’s balance sheet should be equal to the fair market value of its assets or 1.

One of the useful ways of using the price to book valuation metric is to attempt to value the balance sheet of company. Less liquid assets can carry greater values on the balance sheet than they are truly worth. In boom times the book value can rarely be used for ‘bargain hunting’ as most companies will not trade under a book value (clear net assets) of 1. In busts or in recessions, the P/B is of more use at it lets investors bargain hunt for deeply undervalued companies.

A P/B ratio of under 1 for liquid companies such as banks (or others) usually happens when the market is fearful of a destruction of the equity value of the company. This can happen due to leverage - does the financial crisis ring a bell? As a general rule, the more liquid are a company’s assets the closer the Price to Book will be to 1, all else being equal. And the more earnings a company can generate through balance sheet assets, the higher the Price to Book will be.

A final note on valuation
There are no valuation measures that completely tell the whole story or that even comes close to telling the whole story, but knowing some of the basic pitfalls can help investors avoid expensive mistakes.