Page 30 - FINAL CFA II SLIDES JUNE 2019 DAY 8

LOS 32.h: Explain continuing residual income READING 32: RESIDUAL INCOME VALUATION
and justify an estimate of continuing residual
income at the forecast horizon, given company MODULE 32.4: CONTINUING RESIDUAL INCOME
and industry prospects.

Continuing residual income is the residual income that is expected over the long term (beyond the immediate short-term in
which we assume to be constant), depending on the fortunes of the industry, as well as on the sustainability of a specific firm’s
competitive prospects over the longer term. The projected rate of fade over the life cycle of the firm is captured by a
persistence factor, ω (0<ω<1):
Key assumptions are that Residual income is expected to: Test firm’s position in
1. Persist at its current level forever. its industry and the
2. Drop immediately to zero. structure of the
3. Decline over time as ROE falls to the cost of equity (in which case residual income is eventually zero). industry to justify one
4. Decline to a long-run average level consistent with a mature industry. of these assumptions.

The third scenario is the most realistic if we assume that over time, industry competition reduces economic profits to the point
at which firms begin to leave the industry and ROE stabilizes at a long-run normal level.

The strength of the persistence factor will depend partly on the sustainability of the firm’s competitive advantage and the
structure of the industry. The more sustainable the competitive advantage and the better the industry prospects, the higher the
persistence factor. Higher persistence factors will be associated with the following:
• Low dividend payouts.
• Historically high residual income persistence in the industry
• Lower persistence factors will be associated with the following:
• High return on equity.
• Significant levels of nonrecurring items.
• High accounting accruals.