Question

E5.3. A Residual Earnings Valuation (Easy) An analyst presents you with the following pro forma (in millions of dollars) that gives her forecast of earnings and dividends for 2013–2017. She asks you to value the 1,380 million shares outstanding at the end of 2012, when common shareholders' equity stood at $4,310 million. Use a required return for equity of 10 percent in your calculations. 2013E 2014E 2015E 2016E 2017E Earnings 388.0 570.0 599.0 629.0 660.4 Dividends 115.0 160.0 349.0 367.0 385.4 Chapter 5 Accrual Accounting and Valuation: Pricing Book Values 169 a. Forecast book value, return on common equity (ROCE), and residual earnings for each of the years 2013-2017. b. Forecast growth rates for book value and residual earnings for each of the years 2014-2017 c. Calculate the per-share value of the equity from this pro forma. Would you call this a Case 1, 2, or 3 valuation? d. What is the premium over book value given by your calculation? What is the P/B ratio?

Answer 1

Step 1 of 4
Return on Capital Employed

Return on Capital Employed measures the company’s ability to generate profits from the capital employed in the company. It is a ratio of net operating profit and capital employed. The higher the ratio, the more the profits that can be reinvested in the company for the future of the company as well as for shareholders’ benefits.

Residual Income

Residual Income is the excess net income that is generated by the company after meeting minimum required rate of return. This is useful in measuring the performance of internal management, where the management evaluates the returns that are generated in relation to minimum requirement.

Step 2 of 4
The company has presented earnings and dividends forecasts for the years 2010-12. In 2009, the book value per share is $20 and required rate of return is 10% per year. Based on the information, the questions are answered below.

Step 3 of 4
a. ROCE and Residual Earnings

The ROCE and Residual Earnings are computed below-

Picture 1

Explanation

The Earnings per Share and Dividends per Share is given in the question. The Book Value per Share is computed as . The ROCE is computed as. Residual earnings is computed as.

The ROCE and Residual Earnings for the year 2010-12 is computed in the table.

Step 4 of 4
b. Conclusion about company’s share price

As the residual earnings are positive and also are increasing in nature. This means that the company is profitable and share price of the company is at premium over the book value of the share. This means that the shareholders are earning returns that are higher than the required rate of return