Using Residual Income Model (RIM) to Separate Market Share Price Components

A simple and effective way to exploit the accounting-fundamental-based valuation model like Residual Income model is to use it to breakdown components of firm’s share price based on past, current, and future fundamentals.
Value from the Past
• Economic Nature: these are firm values based on past operations, which even if the firm stops operating today shareholders would be able to fetch from selling the firm assets (and paying off liabilities).
• Accounting measure: Book value of the shareholder equity is a good approximation.
Value from the Current
• Economic Nature: these are firm values from current operations without changing strategies; in other words, firm keeps doing what they are doing going forward.
• Accounting measure: sum of (1) PV of residual income estimates from next two years and (2) PV of constant residual income for year 3, 4 … (a perpetuity) at the level of year 2 residual income. (Why residual, not total, earnings? If firms simply earn the expected earnings, then current operation will not generate extra value beyond current book-value.)
Value from the Future (Speculation)
• Economic Nature: these are firm values based on any future deviations (from current operations) such as changing strategies, which are not incorporated in the “Value from the Current” portion.
• Accounting measure: Accounting typically expressly excludes these future activities or transactions; share prices will reflect information relevant about these future activities known to some traders but will also reflect pure speculation about these future activities unsupported by any evidence.
• Implied Measure from Market Price: Value from the future = Share Price – Value from the Past – Value from the Current.

Mini-case Instructions

• Required: Choose a US publicly-traded company of your liking and build an Excel Spreadsheet to
o generate a price-breakdown chart/graph and paste the graph below Boeing’s graph
o fill-in the details of the table below under the column “your company” and
o fill-in the sources of the financial data (e.g., Yahoo! Finance)
o Answer the following questions:
 Are there speculations contained in value from the past?
Hints:
• Most accounting assets measures are conservative
• Some fixed assets (inventory and PPE) may be subject to technology shocks
• Intangible assets and goodwill may contain speculation from past M&A transactions
• Are there contingent liabilities not reflected in Book value?
 Are there speculations contained in value from the current?
Hints:
• EPS estimate too biased for this company?
• DPS typically quite sticky
• Discount rate based on market data?
• Is the assumption that RI for Y2 persists for Y3, Y4, … too unrealistic for this company?
• Hint: I provide an excel spreadsheet to facilitate the calculations. You can use this one or make your own. You will learn more if you build your own spreadsheet. However, the one I provide can always serve as a reference.

Market Price Breakdown Exercise Table
Model Input Class Example (Boeing) Your Company
Year 1 Year 2 Year 1 Year 2 Notes
Forecasted Earnings per share (EPS) $(9.73) $1.25 Estimated by (source)?
Forecasted Dividend per share (DPS) $0 $0 Estimated by (source)?
Number of shares outstanding at year 0 564.53M Based on (source)?
Total Shareholders Equity at year 0 $(8,617) Based on (source)?
Discount Rate 10.39% Estimated by (source)?

Model Output (computed in the excel file) Notes on Breakdown Quality (see p.3)
Shareholders Equity per share (BPS) $(15.26)
PV of Year 1 and Year 2 Residual Income $(4.22)
PV of Constant Residual Income for Year 3, 4,… $30.39
Market Price of Stock today $206.09
Price-Implied PV of Residual Income growth of Year 3, 4, … 8.99%

Company Name _____Boeing____________

Company Name _________________
[Paste price-breakdown graph based on the valuation of the company of your choice]

 

 

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