When applying the RI model, can you capitalize negative residual income when determining instrinsic equity value? Just curious.
Say the company has postive earnings over the past five years (although negative RI) and the horizon seems unlikely to change much, can you just capitalize the negative RI and add that to book value?? I realize in this case they are slowly destroying book value and therefore theoretically capping those losses would result in zero equity value.
It’s a situation that wasn’t proffered in the text. Maybe this is an example of when RI is not the best valuation method.
How negative RI erodes the book value? & If it does then in the valuation equation using RI the first component is book value at time 0 which must contains all the erosion done by the company in the past in terms of negative RI. Though I still have doubt how RI can erode book value as it is calculated as NI - Equity charge. And the book value at t=1 is calculated as
B(1) = B0 + NI(1) - D(1)
Equity charge is not involved here.
I can think of one possibility when the dividends are paid equal to the required rate of return and the NI is not that much then the erosion of book value can occur and again it would reflect in the valaution equation in B0.
If the equity charge applied to future projected earnings exceeds those earnings, then RI is negative and destroys book value. Such is the case when ROE>R. I’m thinking more cash flow/income statement and you’re thinking more balance sheet/clean-surplus, but negative RI applies across both.
The intrinsic value is Bo + PV of future RI. In my example, if you assume that the company continues to slowly destroy Bo with negative RI (a dubious situation and worth another conversation altogether), how can you capture the losses associated with the negative future RI, capitalize them like with a ggm ?? That was my question, i’m just not sure it makes sense to capitalize a negative number.
BMiller, it sure does makes sense. Companies do. I am sure we can find many.
To look for obvious examples - closed end mutual funds that sell at a discount. No accouting issues - book value = fair value. However the market price is lower - due to expectation that the manager is going to continue to ‘destroy’ value (which they probably do by charging fees for delivering lousy performance - i.e. negative alpha).