CH 14 OperatingIncomeBased Valuation Residual Operating Income ROPI

CH 14 Operating-Income-Based Valuation

Residual Operating Income (ROPI) Valuation Model • Firm value = NOA + Present Value of ROPI • Residual operating income (ROPI) is computed as follows: – ROPI = NOPAT – (rw Net operating assets) – where • NOPAT is net operating profit after tax • rw is weighted average cost of capital (WACC) • NOA is Net operating assets.

Residual Operating Income (ROPI) Valuation Model • • ROPI model estimates firm value equal to the current book value of net operating assets plus the present value of expected ROPI. The computation is similar to that for DCF and involves 3 steps: – Forecast and discount ROPI for the horizon period. – Forecast and discount ROPI for the terminal period. – Sum the present values of the horizon and terminal periods and then add to the current book value of net operating assets (net working capital plus long-term assets) to get firm value. As with the DCF model, the value of the equity is then computed as the value of the firm less the value of its debt.

Apply the Residual Operating Income valuation model to estimate Intrinsic value per share

Managerial Insights from the ROPI Model Actions to increase firm value: • Decrease the NOA required to generate a given level of NOPAT • Increase NOPAT with the same level of NOA investment

Reduction of NOA Reduction of net working capital: Reduction of long-term operating assets:

Increasing NOPAT

DCF and ROPI Models

ROPI Valuation Model

“Comparing the Accuracy and Explainability of Dividend, Free Cash Flow, and Abnormal Earnings Equity Value Estimates, ” Francis, Olsson and Oswald, Journal of Acct. Research 2000 Research question • Which model provides the most accurate valuation estimates? Methodology • Calculate three estimates of equity value using three different valuation models. • Forecast data is obtained from Value Line for four sample years, 1989 -1993 • Compare each estimate to the actual market price of the company’s stock • The estimate that (1) has the smallest deviation from actual price, and (2) has the highest correlation with actual price, is the winner.

Conclusions • AE estimates are more accurate than DIV or FCF estimates • AE estimates explain more of the cross-sectional variation in price than DIV or FCF models. • Advantage of AE model is consistent across various sample partitions (High vs Low R&D, High vs. Low Accruals)

“Accounting valuation, market expectation, and crosssectional stock returns, ” Richard Frankel and Charles Lee, Journal of Accounting and Economics, 1998 Research Questions • Does V/P, the ratio of Value estimated using the residual income model and published analysts’ forecasts, predict future stock returns? • Can V/P be used in a profitable trading strategy? • How does V/P compare to B/P in predicting future stock returns?

“Accounting valuation, market expectation, and cross-sectional stock returns” • Forecasts of future book values are obtained from iteratively applying: Where k is the dividend payout rate in the most recent year and ROEt+1=F(Nit+1)/Bt • The value estimate is obtained using forecasts of the next three years ROE. Notice that the third term assumes a perpetuity

“Accounting valuation, market expectation, and cross-sectional stock returns” Conclusions • V/P is a reliable predictor of cross-sectional returns, particularly over longer horizons. • Over a 12 -month horizon, the predictive power of V/P is comparable to that of B/P. However, over a 36 -month horizon, V/P has much stronger predictive power than B/P. • Predictive power of V/P is incremental to predictive power of B/P. • Returns to V/P are not explained by differences in size or Beta.