Residual Income Valuation vs. Justified P/B Ratio
Residual income models can be used to estimate justified price multiples. From the justified P/B ratio based on fundamentals: $$\frac{\text{P}_{0}}{\text{B}_{0}}=\frac{\text{ROE}-\text{g}}{\text{r}-\text{g}}$$ Which is mathematically equivalent to: $$\frac{\text{P}_{0}}{\text{B}_{0}}=1+\frac{\text{ROE}-\text{r}}{\text{r}-\text{g}}$$ The approximated value of a share is the book value per share plus…
Fundamental Determinants of Residual Income (2022)
The fundamental drivers of residual income can be recognized by assuming a constant growth in dividends and earnings. Assuming constant growth, a stock’s intrinsic value under the residual income model, can be expressed as: $$\text{V}_{0}=\text{B}_{0}+\frac{\text{ROE}-\text{r}}{\text{r}-\text{g}}\text{B}_{0}$$ If the return on…
Residual Income Model
The residual income model analyzes the intrinsic value of equity as the sum of: The current book value of equity; and The present value of expected future residual income. Residual income is computed as net income minus an equity…
Use of Residual Income Models
A company with positive residual income—generating more income than its cost of capital—is creating value. A company with negative residual income is destroying value. A higher residual income is associated with a higher valuation. Residual income models have been…
Residual Income
Residual income deducts a charge for equity capital to determine whether the company is earning a return above the opportunity costs for equity investors. Residual income is equivalent to economic profit. It is calculated as: $$\begin{align*}\text{Residual income}&=\text{Net income}-\text{Equity charge}\\…
Measuring Central Tendency in Multiples
Averaging Multiples/The Harmonic Mean The harmonic mean and the weighted harmonic mean are applied to average a group of price multiples. Example: Measuring Central Tendency in Multiples Consider a portfolio that contains two stocks. Assuming the portfolio owns 100…
Momentum Valuation Indicators
Momentum indicators relate to price or a fundamental, such as earnings, to the time series of their past values or the fundamental’s expected value. There are three major momentum indicators: Earnings surprise. Standardized unexpected earnings. Relative strength. Earnings Surprise/Unexpected…
EV Multiples
Enterprise value multiples are relatively less sensitive to the financial leverage effects relative to price multiples when one is comparing companies that use different amounts of leverage. In addition, they take a control perspective. Enterprise Value to EBITDA EBITDA…
International Considerations When Using Multiples
Comparing companies across borders is complicated as it involves differences in accounting methods, economic differences, cultural differences, and resulting differences in growth and risk opportunities. P/E ratios for firms in the same industry but in different countries have been…
Using P/Es to Obtain Terminal Value in Multistage Dividend Discount Models
When estimating the terminal value, analysts use price multiples such as P/Es and P/Bs to estimate terminal values. There are two significant approaches to computing terminal values based on multiples: I. Terminal Price Multiples based on Fundamentals The terminal…
