Residual income model - tangible and intangible asset

CFA Level II
#1

If the majority of assets is tangible, RI method is recommanded.

If the company has lot of intangible assets (research, pattents,…), we must not use RI method.

Am I correct?

#2

I’m not sure but it seems that you are correct, because intangibles’ fair value is tricky to determine and has higher chance of deviating from book values.

#3

But then what else will you use to vaue such a company?

#4

you use income-approach (DCF) or market-multiple approach?

#5

Ok, sounds reasonable. And if it doesn’t satisfy the criteria of paying dividends, positive cfs or if it is a small company with no comparables as such, then we are left with no option but to use RI?

I am positive there won’t be such an extreme question on the exam, so i think i’ll go with what you are saying Edbert. Thanks!

#6

I always thought that residual income was similar to EEM (although this is for private companies), where it values the intagible assets, therefore we need to add back BV to include the tangibles?

Intangibles = (NI - BV*r)/(r-g)

Tangibles = BV

Similarly:

Intangibles = (NOI - R*WCinv - R*FCinv)/(r-g)

Tanginbles = WCinv + FCInv

#7

so, you means if company has lot of intangibles, we must use RI method?

#8

Thats my understanding… but someone please correct me if im wrong?

The way i see it is that the residual income is the income left over after you’ve removed equity charges and debt charges (since NI removed interest already). Therefore its the return on intangibles since youve deducted the return on fixed and working assets. The same as EEM for private companies.

Am i losing my mind?

#9

in your case, you use RI method to value unidentifiable intangibles, not to value the company.

wait a sec…

#10

I believe you have to obtain Net Assets from the equation A = L + E, and removing L from A using TOTAL ASSETS and TOTAL LIABILITIES. I haven’t done that otherwise. Intangibles are recognized for a reason, and expenses have been made to recognize them.

I believe an analyst is free to remove these assets from the calculation if he/she sees fit. But for the exam, unless any hints/instructions tell you otherwise, its Total Assets - Total Liabilities.