Chapter 6 Set 2 Residual Income Model

Chapter 6 Set 2
Residual Income Model

KRAMER CORPORATION
Review the following terms:

EPS
Dividend payout ratio
Retained Earnings vs. Additions to Retained
Earnings
Cost per share
Book value per share
Market value per share
P/E ratio
KRAMER CORPORATION
Income Statement
For the Year Ended December 31, 2014
Sales 2,000,000
Cost of goods sold 1,500,000
Gross profits 500,000
Selling and administrative expense 270,000
Depreciation expense 50,000
Operating profit (EBIT) 180,000
Interest expense 20,000
Earnings before taxes (EBT) 160,000
Taxes 49,500
Earnings after taxes (EAT) or Net Income 110,500
Preferred stock dividends 10,500
Earnings available to common stockholders $ 100,000
Shares outstanding 100,000 shares
Earnings per share $ 1.00
EPS= Earnings available to common stockholders / shares outstanding
Earnings available to common stockholders $ 100,000
Shares outstanding 100,000 shares
Earnings per share $ 1.00

EPS= Earnings available to common stockholders / shares outstanding
Dividend paid to common stockholders $50,000

Dividend Payout ratio = Dividend paid to common stockholders / Shares outstanding
=$50,000/100,000shares = 0.5 =50%

Additions to Retained Earnings =
Earnings available to common stockholders Dividend paid
= $100,000-50,000 = $50,000
Statement of Retained Earnings

For the Year Ended December 31, 2014
Retained earnings, balance, January 1, 2014 $250,000
Add: Additions to Retained Earnings, 2014 50,000
Retained earnings, balance, December 31, 2014 $300,000

Retained earnings
Retained earnings is accumulated earnings
from the onset of the business operation. For
instance, the company started business in
Jan. 2011. Next slide shows a list of earnings
from the past three years giving the
assumption that the company has dividend
payout ratio of 0.4 (40%) for the past three
years and then increase dividend payout
ratio to 0.5 (50%) for year 2014.
Retained earnings
Net Income
to common Earnings kept for Retained earnings
stockholders Dividends future investment end of each year
(end of year) (60% of earnings)
$150,000 (2011) $60,000 $90,000 $90,000
$160,000 (2012) $64,000 $96,000 90,000+96,000= $186,000
$106,666.67 (2013) $42,666.67 $64,000 $186,000+64,000= $250,000
Since dividend payout ratio changed to 50%

$100,000 (2014) $50,000 $50,000 $250,000+50,000=$300,000
KRAMER CORPORATION
Balance Sheet
December 31, 2014
Assets
Current assets:
Cash $ 40,000
Marketable securities 10,000
Accounts receivable $ 220,000
Less: Allowance for bad debts 20,000 200,000
Inventory 180,000
Prepaid expenses 20,000
Total current assets 450,000
Other assets:
Investments (long-term) 50,000
Fixed assets:
Plant and equipmnet, original cost 1,100,000
Less: Accumulated depreciation 600,000
Net plant and equipment 500,000
Total Assets $ 1,000,000
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $80,000
Notes payable 100,000
Accrued expenses 30,000
Total current liabilities $210,000
Long-term liabilities:
Bonds payable, 2010 90,000
Total liabilities $300,000
Stockholders' equity
Preferred stock, $100 par value 50,000
Common stock, $1 par value 100,000
Capital paid in excess of par 250,000
Retained earnings 300,000
Total stockholders' equity $700,000
Total liabilities and stockholders' equity $1,000,000
The sum of these three items is the common stockholders equity value.
Total Assets $1,000,000
Less: Total Liabilities 300,000
Stockholders' equity 700,000
Less: Preferred stock equity 50,000
Net worth assigned to common 650,000
Common shares outstanding 100,000
Net worth, or book value, per share $ 6.50
= common shareholders equity / Number of
common shares outstanding
If company has preferred shareholders, then use

the following formula
=(Total shareholders' equity - preferred stock
equity) /Number of common shares outstanding
Common shareholders equity
= Common stock + capital paid in excess of par + retained earnings
= 100,000 + 250,000 + 300,000 = $650,000
Book value per share = $650,000/100,000 = $6.5
Cost of issuing stock

= common stock + capital paid in excess of par =$100,000+
$250,000 = $350,000
Since the company issued 100,000 shares, so the cost per share =
$350,000/100,000 = $3.5
Market value per share = the current stock price
PE ratio = Market value per share / Earnings per share

Assuming that the companys earnings per share is $1 and PE
ratio is 15, what is the stock price? Since P/E = 15 and Earnings
per share is $1, so the stock price (P) is $15. This indicates that
investors are willing to pay $15 to buy one share of stock in
exchange of getting $1 earnings.
Total Common Equity = 650,000
Book Value per share = $650,000/100,000 shares =
$6.50
When Additions to RE increase, book value per share
Residual Income Model (RIM), I.
We have valued only companies that pay dividends.
But, there are many companies that do not pay dividends.

What about them?
It turns out that there is an elegant way to value these companies,
too.
The model is called the Residual Income Model (RIM).
Major Assumption (known as the Clean Surplus Relationship, or

CSR): The change in book value per share is equal to earnings per share
minus dividends. (implied that EPS the change in book value per share =
dividends)
EPS = Dividend + Additions to RE
where Additions to RE impact Book Value per Share
When a company doesnt pay dividend, we look at

the difference between the book value at the
beginning of the year and the book value at the end
of the year which is called the change in book value.
Then we take EPS minus the change in book value =

dividend. Using this concept to estimate the stock
price for a company who doesnt pay dividend.
Residual Income Model (RIM), III.
EPS1 B0 g

k g
D1
could be treated as
k g
B0 * g is the additions to Retained Earnings
NI = Dividend paid + Additions to Retained
Earnings (RE)
NI/shares outstanding = EPS
EPS = Div per share + additions to RE per
share
Inputs needed:
Earnings per share at time 0, EPS 0
Book value per share at time 0, B 0 This is
Earnings growth rate, g
Discount rate, k RI
RI1 = Actual EPS - Required
1 1
1 EPS
There are two equivalent formulas for the Residual Income
Model: = Actual EPS1 - B0 * k
EPS 0 (1 g) B 0 k
P0 B 0
kg
or
EPS1 B 0 g
P0
kg
EPS0 (1 g) B0 k
P0 B0
k g
B0 (k g) EPS0 (1 g) B0 k

k g kg
B * k B0 * g EPS1 B0 k
0
kg
Additions to
EPS1 B0 g Retained
Earnings
k g BTW, it turns out that
D1 the RIM is
It could be treated as mathematically the
k g
same as the constant
Using the Residual Income Model
DuckwallAlco Stores, Inc. (DUCK)

It is July 1, 2010shares are selling in the market for
$10.94.
Using the RIM:
EPS0 = $1.20
DIV = 0
B0 = $5.886
g = 0.09
k = .13
What can we say

about the market
price of DUCK?
RI1 (Residual Income at time 1) = EPS1 - B0 * k
= $1.308 0.76518
= $0.54282
EPS1 B 0 * k EPS 2 B1 * k EPS3 B 2 * k

P0 B 0
1 k 1 k 2
1 k 3
RI1 RI 2 RI 3
B0
1 k 1 k 1 k
2 3
Assume that earnings grow at a constant rate of g;
therefore, RI grows at a constant rate of g:
EPS1 B 0 * k EPS2 B1 * k EPS3 B 2 * k
P0 B 0
1 k 1 k 2
1 k 3
RI1 RI 2 RI 3
B0
1 k 1 k 1 k
2 3
RI1 RI1 * (1 g ) RI 2 * (1 g )
B0 ....
1 k 1 k 2
1 k 3
RI1
B0
k - g
EPS1 B 0 * k
B0
kg
EPS0 (1 g) B0 k
P0 B0
kg
1.2 * (1 0.09 ) 5.886 0.13
$5.886
0.13 0.09
$5.886 13.5705 $19.46
EPS1 B0 g 1.2 * (1 0.09) 5.886 0.09

P0 $19.46
kg 0.13 0.09
Major Assumption (known as the Clean Surplus Relationship, or
CSR): The change in book value per share is equal to earnings per
share minus dividends.
Then RI1 = EPS1 - B = EPS1 - (EPS1 - D1) = D1.

Chapter 6 Set 2 Residual Income Model

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Chapter 6 Set 2

Residual Income Model

Review the following terms:

Shares outstanding 100,000 shares

Earnings per share $ 1.00

Dividend paid to common stockholders $50,000

=$50,000/100,000shares = 0.5 =50%

Statement of Retained Earnings

Retained earnings, balance, January 1, 2014 $250,000

Add: Additions to Retained Earnings, 2014 50,000

Retained earnings, balance, December 31, 2014 $300,000

Since dividend payout ratio changed to 50%

If company has preferred shareholders, then use

Cost of issuing stock

Market value per share = the current stock price

PE ratio = Market value per share / Earnings per share

We have valued only companies that pay dividends.

But, there are many companies that do not pay dividends.

The model is called the Residual Income Model (RIM).

Major Assumption (known as the Clean Surplus Relationship, or

When a company doesnt pay dividend, we look at

Then we take EPS minus the change in book value =

DuckwallAlco Stores, Inc. (DUCK)

What can we say

EPS1 B 0 * k EPS 2 B1 * k EPS3 B 2 * k

EPS1 B0 g 1.2 * (1 0.09) 5.886 0.09

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