Page 33 - FINAL CFA II SLIDES JUNE 2019 DAY 8

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

EXAMPLE: Calculating value with a multistage residual income model (part 1): JM is expecting an ROE of 15% over each of
the next five years. Its current BV is $5.00 per share, it pays no dividends, and all earnings are reinvested. The required return on
equity is 10%. Forecasted earnings in years 1 through 5 are equal to ROE times beginning book value. Calculate the intrinsic
value of the company using a residual income model, assuming that after five years, continuing residual income falls to zero.

Under the assumption that residual income after five years is zero
(i.e., ω = 0), intrinsic value today is:

Fin calc:
CF0 = 5,
C01 = 0.25,
C02 = 0.29,
C03 = 0.33,
C04 = 0.38,
C05 = 0.44,
I = 10,
CPT → NPV = $6.25.

EXAMPLE: Calculating value with a multistage residual income model (part 2): Suppose we change our assumption
regarding JM’s residual income after five years to assume instead that it remains constant at $0.44 forever. New value?

Higher as RI now persists at the same level forever, so RI 5
= RI = . . . = $0.44, and ω = 1. The $0.44 perpetuity
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beginning in Year 5 is worth $4.40 ($0.44/0.10) in Year 4.