TheResidualIncomeModelWhatCanRIMDoForMe.docVIP

PAGE9 The Residual Income Model: What Can RIM Do For Me? This document was prepared by Jeffery Abarbanell for the purpose of class discussion. Revised 1/27/99 The purposes of this handout are 1) to provide a simple intuitive discussion of how the multiperiod residual income model (RIM) can be used to value a firm’s equity, 2) to point out some advantages to adopting RIM over the DCF approach, and 3) to discuss implementation issues when going from theory to practical valuation. 1. The Underlying Logic of the Residual Income Model Value Creation Fundamental to the valuation exercise is recognition of the importance of the creation of wealth. In any given year, a firm creates value by generating earnings from capital investment in excess of the cost of using the capital that generated the earnings. We represent this notion in accounting terms through the concept of abnormal earnings, denoted : (1) Where, xt is actual earnings (i.e., flow during year t) derived from beginning stock of capital, bvt, for year t and r is the required return on capital (i.e., the cost of capital). If the symbol r* is used to denote the actual rate of return on capital, then we can rewrite equation 1 as: (2) Thus, in any year a firm must earn more than the required rate of return in order to create wealth. Equation 2 is very general in that it describes the creation of wealth without answering the question for whom has wealth been created. If one does not make the distinction between debt and equity providers of capital, then bvt represents the book value of all assets at the beginning of year t, xt represents earnings before interest costs for the year t, and r represents the weighted average cost of capital, i.e.: (3) Or, similar to the transformation of equation 1 to equation 2: (4) Equation 4 highlights the fact that a firm only creates wealth for its capital providers if its return on assets exceeds its average cost of capital. The question