If foreign currency translation gains are expected to continue in the future for a company that uses All-current method, and you use RI to estimate ROE, BV, and intrinsic value of the company *prior* to realizing this fact, how would these values change after you consider how the company is treating these foreign currency translation gains? Do these values go up, down, or remain unchanged?
i have a hard time understanding the question but if i get it correctly :
you have positive CTA directly into the other comprhensive income so :
ROE would be lower since E is higher
BV is higher since you have more equity,
since BV is higher and ROE is lower then RI is lower. i would guess that intrinsic value would go down to. there will be a scenario that the higher BV will offset the lower RI but i would say that this is probably not a significant number of scenario…
ok then, here is the full question:
Kim Dae-Eun, CFA, values Zues Printing Company at $46 per share with a
residual income model using historical data to estimate return on equity and
book value as reported on the balance sheet. Subsequently, he determines that
Zues uses the all-current method of foreign currency translation and has, for the
past ten years, consistently reported foreign currency translation gains as part of
comprehensive income. He expects these foreign currency gains will continue in
the future. What will be the effect on his forecasts of return on equity (ROE),
book value. and intrinsic value if he revises his valuation estimate to take this
new information into account?
i think this is very tricky…
i would go for LOWER ROE , because of higher Equity
Higher BV, because of higher equity
and i would say higer price. because of the more important effect of the bigger BV… lol but that’s a flip.
OCI gains are hitting income so thie would be probbaly cause the initial value to be understated. if he expects the gains to persist/continue a portion should probaly be booked as profits so it would equity would decrease and ROE increase…since eqy is lower i’d have go lower BV.
You got one correct.
i hope it’s not the flip one. Hahaha
Summerside, I bet it is the flip one.
Lower BV, Higher ROE, Higher Intrinsic value
skwak you got 2 right.
Well I was assuming that you add changes in the CTA to N/I to compare with firms using the temporal method. Then, N/I will go up and BV will go down, which increases ROE and decreases BV, and increase… waittttt DECREASES the intrinsic value. Totally forgot about the BV being separate item in the residual income valuation. ROE = UP BV = DOWN Intrinsic = DOWN Final answer.
skwak…now you’ve got only 1 correct!
ok…this got me too b/c I havn’t reviewed FRA yet, but they say ROE up, BV no change, IV up.
The justification they give is the following:
The foreign currency translation gains were recorded directly to equity as part of comprehensive income and were not reflected in income, so his ROE forecast was understated. If he expects these gains to continue, he should revise his forecast upward of ROE. Book value was not affected, however, because the gains were recorded to equity. Correcting the valuation to reflect these changes would cause his ROE estimate to increase, the book value per share to stay the same, and the intrinsic value from the residual income model to increase.
I see. Since translation gain is expected to be recurring, you view it as a component to net income, equity is unaffected and intrinsic value goes up. Good review - thanks!