2.5.2 The Residual Income Valuation Model
The residual income model has become a widely recognized tool in the valuation of equity stock of firms both in practice and research. Residual income is an economic concept which is obtained by deducting from a firm’s net income, charges with respect to shareholders' opportunity cost in generating the net income of such a firm. The residual income model was developed to cater for the lapses associated with the traditional financial statements (particularly the income statement), which are prepared to reflect earnings available to owners. Thus, from the traditional financial statements, the net income of a firm includes interest expense which simply represents the cost of debt capital since they are
…show more content…
The theory shows that share price of the firm can be expressed in terms of fundamental statements of financial position and profit or loss components (Scott, 2003). Ohlson (1995), who based his theory of valuation on the Residual Income Valuation Model (RIVM), argued that under certain conditions share price can be expressed as a weighted average of book value and earnings. This model has generated notable empirical debates on the examination of the relevance of financial statements’ variables in determining the value of …show more content…
Auer (1996) for instance, conducted a study on Swiss firms which switched from Swiss GAAP to either the European Directives or to IFRS. The focus of this study (Auer, 1996) was on market volatility and the basic assumption was that the major indicator of higher information processing by market forces was higher price volatility which by extension is an evidence of greater value‐relevance of accounting data. The results from the study of Auer (1996) however revealed that the variance of abnormal returns changed significantly for firms that switched to the European Directives or IFRS. In Bahrain, Joshi & Basteki (1999) conducted a survey on 36 companies in which questionnaires were designed and administered. Their study found that majority of the respondents (86%) believed that the application of IASs gave the contents of their financial statements more relevance. Contrary to the above, Barth, et al (1998) examined whether the application of IAS is associated with higher accounting quality, but found amongst others that firms applying IAS exhibit less earnings smoothing and a higher degree of association between accounting numbers with share prices and returns. In a similar vein, some studies conducted in Australia (Goodwin & Ahmad, 2006; and Goodwin, Ahmed & Heaney, 2008) found that differences between IFRS and Australian
Earlier 2002, the stock price of Agnico-Eagle Mines sharply decreased by $1 finally closed at $13.89. This price has reached one of the lowest level, from the company's historical perspective. As a professional equity portfolio manager, who has a large number of AEM stocks on hand. Acker and his team are necessary to find a proper way to estimated the fair value of AEM as well as its equity. Discounted Cash Flow (DCF) has been chosen to do this job. The theory behind DCF valuation approach is that the firm's value can be estimated by using the expected future free cash flow discounted by an appropriate discounted rate (Koller etc 2005). However several assumptions need to be clearly examined within this approach. The following sections are showing the process of DCF step by step.
A very slim minority of firms distribute dividends. This truism has revolutionary implications. In the absence of dividends, the foundation of most - if not all - of the financial theories we employ in order to determine the value of shares, is falsified. These theories rely on a few implicit and explicit assumptions:
A strong balance sheet gives an investor an idea of how financially stable the company really is. Many professionals consider the top line, or cash, the most important item on a company’s balance sheet. The big three categories on any balance sheet are “assets, liabilities, and shareholder equity.” Evaluating Barnes & Noble’s assets for the time 2014 at $3,537,449, 2013 at $3,732,536 and 2012 at $3,774,699, the company’s performance summarizes that it is remaining stable. These numbers reflect a steady rate over the three year period. Like assets, liabilities are current or noncurrent. Current liabilities are obligations due within a year. Key investors look for companies with fewer liabilities than assets. Analyzing this type of important information, informs a potential investor that if the company owes more money than they are bringing in that this company is in financial trouble. Assessing the liabilities of the balance sheet, for the same time period, it is also consistent with the assets. The cash flow demonstrates a stable performance in the company’s assets and would be determined that the liabilities of this company are also stable. Equity is equal to assets minus liabilities, and it represents how much the company’s shareholders actually have a claim to. Investors customarily observe closely
Discounted Cash Flow Method takes the forecast free cash flows during forecasted horizon. Then we estimate the cost of capital (weighted average cost of capital) and estimate continuing value (value after forecast horizon). The future value is discounted to the present value. We than add back cash ($13 Million) and non-current assets and deduct total debt. With the information provided several assumptions had to be made to obtain reasonable values (life period of 30-years, Capital expenditures not to exceed $1 million dollars, depreciation to stay constant at $1.15 Million and a discounted rate of 10%). Based on our analysis, the company has a stand-alone value of $51 Million at the end of fiscal year end 1990 with a net present value of cash flows of $33 million that does not include the cash and non-current assets a cash of and non-current assets.
The firm-foundation stresses that a stock’s value should be based on the stream of earnings a firm will be able to
The financial aspect of the company is studied using various methodologies such as cash flow analysis and various investment appraisal methods. In this project we have chosen to use NPV and IRR methods of investment appraisal because of several reasons. Investment appraisal could have also been performed by other methods like Payback Period, but the drawback of this method is that it does not consider cash flows that arrive after the payback period and hence can lead to nonsensical decision in some cases. On the other hand NPV and IRR both are more reliable because they consider all cash flows till the end of the project. Further in Payback Period method equal weight is given to all cash flows arriving before payback period, in spite of the fact that more distant cash flows are less valuable. This problem is also overcome with NPV and IRR methods because both consider time value of money. Again NPV and IRR methods also help to ensure whether the investment will increase the firm’s value. Other methods cannot provide this information. The accounting rate of return method of investment appraisal has also been rejected for use in this project because it considers only profits that do not equal cash and also it does not consider time value of money.
One of the most debatable topics in the accounting industry today is the extent in which we should make the financial statements understandable to the general population. The FASB currently gears its reporting standards toward...
In the world of international finance there are two major accounting systems; GAAP, which stands for Generally Accepted Accounting Principles, and IFRS, which stands for International Financial Reporting Standards. The United States prefers GAAP while the European market, as well as many other countries, prefers IFRS. By 2015 the Securities Exchange Commission is anticipating a total transfer to IFRS in the United States. Though the differences between GAAP and IFRS are few, they could affect accuracy of financial reporting throughout the world. It is important to understand the differences and similarities between both GAAP and IFRS if one is to globalize ones market (Logue).
This report will critically review the capital structure of the Royal Mail (RM) and the implications this has for the company with reference to its apparent value and the return required by equity investors. The report will take data from the latest set of accounts published by the RM and it accompanying investor reports. It will also refer to investors analysis and news item in an attempt to gain a qualitative impression of RM’s share value.. The numerical analysis will not use information that relates to time past the last full accounting period, however the conclusion will attempt reconcile any share price movement with the analysis. The report will assess three models for their suitability in analysing the capital structure of the RM, (Weighted Average Cost of Capital (WACC), Capital Asset Pricing Model (CAPM) and the dividend valuation model).
Rappaport (1988) recommended the Shareholder Value Analysis (SVA) on how decisions of management can affect value of cash to shareholders. Two stages can be considered, identifying the free cash flows coming from operations and calculating shareholder value. This analysis is relatively simple to use, highlighting key decision areas which affects the shareholder value the most.
residual earnings growth from 2009 to 2010, and then dividing this figure by the difference between the cost of equity and the residual growth.
Today financial corporate managers are continually asking, “What will today’s investment look like for the future health of the company? Should financial decisions be put on hold until the markets become stronger? Is it more profitable to act now to better position the company’s market share?” These are all questions that could be clearly answered if the managers had a magical financial crystal ball. In lieu of the crystal ball, managers have a way of calculating the financial risks with some certainty to better predict positive financial investment outcomes through the discounted cash flow valuation (DCF). DCF valuation is a realistic approach, a tool used, to “determine the future and present value of
Managers within any company can use this measure in order to obtain any crucial information they may need when making crucial decisions. When broken up EVA can simply be defined as an estimate of the amount by which earnings exceed or fall short of the required lowest rate of return that shareholders could receive by investing in the company. The main aim of any company should be to maximise the wealth of their shareholders, and as put forward by Stern-Stewart, EVA should be an aid to managers of company’s striving for this common target. The value of a company can also be easily judged with the aid of EVA by analysing the extent to which shareholders expect earnings to exceed or fall short of the total cost of capital. EVA takes into account the full cost of operating costs and capital costs including the full cost of equity.
Judgement is a notion of relevance and reliability in developing and applying accounting policies. It is a requirement of management that they exercise a high degree of professional judgement when selecting appropriate accounting policies in the preparation of financial statements that is relevant to decision-making and assessment needs of users. Management should also consider the applicability of IFRS and AASB in dealing with similar and related issues and then the definitions, recognition criteria in the Conceptual Framework when there is no IFRS standard or interpretation in certain circumstances that are specifically applicable. Management may also consider the most current pronouncements of other standard-setting bodies to the extent that do not conflict with IFRS and AASB in developing accounting standards and accepted industry practices by using a similar conceptual framework.
GAAP is exceptionally useful because it attempts to regulate and normalize accounting definitions, assumptions, and methods. Because of generally accepted accounting principles one is able to presuppose that there is uniformity from year to year in the methods that are used to prepare a company's financial statements. And even though variations might exist, one can make realistically confident conclusions when comparing one company to another, or when comparing one company's financial statistics to the statistics for the industry as a whole. Over the years the generally accepted accounting principles have become more multifaceted because financial transactions have become more intricate (Accounting Principles, 2011).